Economy
Highlights Global trade data we track as indicators of current and expected commodity demand - particularly EM import volumes - will provide a lift to oil prices over the course of 1H18. We continue to expect global oil demand growth, led by EM growth, to rise by 1.7mm and 1.6mm b/d this year and next, respectively. Against this still-positive backdrop, heightened geopolitical tensions are ratcheting up volatility in our outlook. A global trade war - now a factor following the Trump administration's bellicose rhetoric - would reduce our oil demand forecasts. That said, our Geopolitical Strategy team notes past U.S. administrations have used the threat of trade wars to cheapen the USD, which would be bullish commodities.1 Energy: Overweight. Even though it is not a surprise, the anti-trade rhetoric coming out of Washington is a wake-up call for oil markets. Trade is deeply entwined with EM income growth, which drives commodity demand globally. A shock to global trade would be a shock to aggregate demand and oil demand, hence oil prices. Base Metals: Neutral. President Trump announced 25% and 10% tariffs on steel and aluminum last week. Markets are fretting over the possibility of a full-blown trade war if the U.S. zeroes in on China, as it apparently is doing, and Washington's allies impose retaliatory tariffs, should the Trump administration level tariffs on their exports.2 Precious Metals: Neutral. A global trade war would boost gold's appeal, and we continue to recommend it as a strategic portfolio hedge. Ags/Softs: Underweight. In a series of tweets earlier this week, President Trump suggested concessions on steel and aluminum tariffs to Canada and Mexico in exchange for concessions on NAFTA. Neither Mexico nor Canada supported this link. Feature Our short-term models of global trade volumes continue to indicate EM imports - a key variable in our analysis of industrial commodity demand - will continue to grow (Chart of The Week).3 This will be supportive of commodity prices generally, particularly oil, in 1H18. In 2H18 and beyond, the outlook is getting cloudier. And more volatile. A fundamental underpinning of our oil-demand expectation for this year and next is that a slowdown in China in 2H18 will be offset by a pickup in EM and DM aggregate demand - and trade volumes - ex-China, in line with the IMF's expectation for EM and DM growth this year and next (Chart 2).4 DM markets and India likely will take up the slack created by China's slight slowdown. In fact, India already is moving out ahead: Based on official data, India's economy grew at a 7.2% rate in December, topping China's 6.8% rate, according to a Reuters survey at the end of February.5 Chart 1EM Import Volumes Will Continue To Grow Chart 2EM Growth Ex-China Keeps Oil Demand Strong EM Import Volumes Are Important To Oil Prices EM demand drives global oil demand. Over the long haul, the relationship between oil prices and EM import volumes has been strong: A 1% increase in EM import volumes has translated into roughly a 1% increase in Brent and WTI prices since 2000 (Chart 3).6 These variables all are linked: EM economic growth correlates with higher incomes, higher commodity demand and higher import volumes. All else equal (i.e., assuming supply is unchanged), this increases oil prices (via higher demand). The biggest weight in the EM import volume variable is China's imports, so the sustainability of the current Chinese growth is important, as is how smoothly policymakers there slow the economy in 2H18 as we expect. Chinese imports are sensitive to industrial output, which is captured by the Li Keqiang index, global PMIs, and FX markets (Chart 4). Provided policymakers can maintain income growth as the country pivots - once again - away from heavy industrial-export-led growth to consumer- and services-led growth, oil demand will not be materially affected, and should continue growing. At present, China's import volume growth has leveled off as Chart 4 shows, indicating income growth is holding up. China recently guided toward a GDP growth target of 6.5% for this year. Given they have a solid track record of achieving such targets, this indicates that they do not expect a severe slowdown. However, a hard economic landing - always a risk in transforming such a huge economy - would force us to reconsider our growth estimates. Chart 3EM Imports Supportive Of Prices Chart 4Growth In China's Import Volumes Levels Off In our analysis, we do not yet have enough information to determine whether the Trump administration will launch a trade war with China. The impact of President Trump's proposed steel and aluminum tariffs on China is de minimis: Chinese exports of these commodities to the U.S. amount to less than 0.2% of China's total exports, as our colleagues at BCA Research's China Investment Strategy note in this week's analysis.7 The big risk from these tariffs lies in what happens next. If they are the first step in additional tariffs directed at industries far more important to China, they could invite retaliation.8 If the recently announced tariffs expand to a global trade war - already the EU, Canada and Mexico have indicated they will not sit idly by while tariffs are imposed on exporters in their countries - the threat to world trade, and EM imports in particular, rises considerably. This would threaten crude oil prices. Trade Wars And Oil Flows Other than exports from the U.S., which could be targeted by states retaliating against tariffs, it is difficult to imagine the flow of oil being affected by a trade war in the short term: Oil is an internationally traded commodity, and traders adapt quickly to disruptions - e.g., re-routing crude flows in response to events affecting production, consumption, inventories or shipping.9 However, it does not require much of an intellectual leap to see EM trade volumes being significantly impacted by a trade war via the slowing in income growth globally. Such a turn of events would reduce aggregate demand in that part of the market - EM - that is responsible for the bulk of commodity demand growth. Falling EM trade volumes would be the natural result of falling incomes. This would be disinflationary, as well, which is not unexpected (Chart 5). We have found a long-term relationship with strong co-movement properties between EM import volumes and U.S. CPI and PCE inflation indexes. Our modelling indicates a 1% decrease (increase) in EM import volumes translates into a decrease (increase) in these U.S. inflation indexes of 15 to 20bp with a 6- to 12-month lag. These are non-trivial quantities: For instance, a decline in EM import volumes of 10% or more could shave as much as 2 points from U.S. inflation (Chart 6). Such a disinflation impulse once again coming from the real economy would, in all likelihood, force the Fed to throttle back on its interest-rate normalization policy or reverse course. Chart 5Lower EM Import Volumes##BR##Would Take U.S. Inflation Lower Chart 6EM Trade Volumes##BR##Over Time Volatility Likely To Pick Up As we noted above, our Geopolitical Strategy (GPS) colleagues point out the threat of tariffs and quotas has been used by U.S. administrations in the past to get systemically important central banks to support a weaker USD.10 The end game always is to spur exports to boost economic growth. The downside risk from trade wars discussed above is fairly obvious. Not so obvious is the upside commodity-price risk arising from a depreciation in the USD, which falls out of a strategy of using the threat of tariffs to ultimately weaken the USD. Our GPS colleagues quote Paul Volcker's summary of a similar gambit by Richard Nixon, who also ran a mercantilist presidential campaign in the late 1960s, to ultimately weaken the USD: The conclusion reached by some that the United States shrugged off responsibilities for the dollar and for leadership in preserving an open world order does seem to me a misinterpretation of the facts ... The devaluation itself was the strongest argument we had to repel protectionism. The operating premise throughout was that a necessary realignment of exchange rates and other measures consistent with more open trade and open capital markets could accomplish the necessary balance-of-payments adjustment. It is impossible to say whether such a depreciation is the Trump administration's end-game. However, if it is, this would be bullish commodities generally, gold and base metals in particular. For oil, a weaker USD would be bullish, but, as we have shown recently, fundamentals now drive oil price formation.11 Bottom Line: Current and expected EM import volumes indicate oil prices will continue to be supported by rising demand over the course of 1H18. We continue to expect global oil demand growth, led by EM growth, to rise by 1.7mm and 1.6mm b/d this year and next, respectively. Still, heightened geopolitical tensions brought on by bellicose trade signaling from the U.S. are ratcheting up volatility in our outlook. A global trade war would force us to lower our forecast for Brent and WTI crude oil from our current $74 and $70/bbl expectations for this year. However, as our Geopolitical Strategy team notes, past U.S. administrations have used the threat of trade wars to cheapen the USD. Should this turn out to be the Trump administration's strategy, the weaker USD would be bullish for commodity prices. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Weekly Report "Market Reprices Odds Of A Global Trade War," published March 6, 2018. It is available at gps.bceresearch.com. Our colleagues note, "Import tariffs ought to be bullish for the greenback, given that they lead to higher domestic policy rates as inflationary pressures rise (and not just passing ones). However, as the previous two examples of U.S. protectionism teach us, the U.S. uses threats of tariffs so that it can get a cheaper USD. From Washington's perspective, both accomplish the same thing. Intriguingly, the U.S. dollar has sold off on the most recent news of protectionism." (Emphasis added.) 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Global Aluminum Deficit Set To Ease," published March 1, 2018, particularly the discussion beginning on p. 7. It is available at ces.bcaresearch.com. 3 Our 3-month ahead projections are based on two components: (1) the first principal component of a basket of currencies exposed to global growth; and (2) lagged U.S. monetary variables. Our modeling shows that exchange rates are forward-looking variables containing information of future fundamentals. Therefore, by selecting currencies exposed to global and EM growth, this allows us to run short-term forecasts of EM import volumes. The analysis is also confirmed using Granger-causality tests. 4 Please see "Brighter Prospects, Optimistic Markets, Challenges Ahead," in the IMF's January 22, 2018, World Economic Outlook Update, which notes its revised forecast calling for stronger global growth reflects improved DM growth expectations. 5 Please see "India regains status as fastest growing major economy," published by reuters.com on February 28, 2018. 6 These results fall out of co-integration regressions. 7 Please see BCA Research's China Investment Strategy Weekly Report "China And The Risk Of Escalation," published March 7, 2018. It is available at cis.bcaresearch.com. See also footnote 2 above. 8 President Trump reportedly is considering broadening the tariffs on a range of Chinese imports and limiting Chinese investment in the U.S., to punish the country for "its alleged theft of intellectual property," according to Bloomberg. Please see "U.S. Considers Broad Curbs on Chinese Imports, Takeovers," published by Bloomberg.com, March 6, 2018. 9 The U.S. is exporting a little over 1.5mm b/d of crude oil and 4.6mm b/d of refined products at present, according to EIA data. A drawn-out trade war resulting in U.S. oil exports being hit with retaliatory tariffs or quotas could derail the expansion of crude exports brought on by the growth in shale-oil output in America. The IEA expects the U.S. to account for the largest increase in crude exports in the world between now and 2040, "propelling the region above Russia, Africa and South America in the global rankings." This has the effect of reducing net U.S. crude imports to 3mm b/d by 2040 from 7mm b/d at present. An increase in product exports - from 2mm b/d to 4mm b/d - makes the U.S. a net exporter of crude and product, based on the IEA's analysis. The largest demand for crude imports comes from Asia over this period, which grows 9mm b/d to 30mm b/d in total. Please see "WEO Analysis: A sea change in the global oil trade," published by the IEA February 23, 2018, on its website at iea.org. 10 We urge our readers to pick up BCA Research's Geopolitical Strategy Weekly Report cited in footnote 1 above, which lays out our GPS team's analytical framework regarding trade wars. They note, "If constraints to trade protectionism were considerable, Trump would not have the ability to surprise the markets with bellicose rhetoric on a whim. BCA Research's Geopolitical Strategy cannot predict individual triggers for events. But our framework allows us to elucidate the constraint context in which policymakers operate. On protectionism, Trump operates in a poorly constrained context. This is why we have been alarmist on trade since day one." 11 We found that the more backwardated oil forward curves are the less impact the USD has on the evolution of prices. Please see BCA Research's Commodity & Energy Strategy Weekly Report "OPEC 2.0 Getting Comfortable With Higher Prices," published on February 22, 2018. It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Highlights The direct impact of recently proposed U.S. import tariffs on steel and aluminum is likely to be small, both for China and the world. In isolation, this development is not very relevant for investment strategy. However, the lessons learned from studying the game of Prisoner's Dilemma suggest that investors should be legitimately concerned about an iterative "tit-for-tat" exchange of retaliation between the U.S. and its major trade partners if the Trump administration continues to pursue aggressively protectionist trade policies. Recent data releases show that the ongoing economic slowdown continues. While the Caixin manufacturing PMI is a bright spot, it is not likely heralding a major turning point for the Chinese economy. Investors should closely watch three bellwethers to judge the likelihood of a full-blown global trade war. Barring a major deterioration on this front, or a sharp further slowdown in Chinese economic growth, investors should stay overweight Chinese ex-tech stocks vs global. Feature The looming threat of U.S. protectionism came into full force over the past week, as President Trump stated that sweeping tariffs on all U.S. imports of steel and aluminum would soon be formalized. The tariff situation continues to evolve as we go to press, but the facts as they currently stand are the following: The proposed tariffs would be 25% on steel, and 10% on aluminum imports No exceptions are planned for any country, although statements from U.S. leadership on Monday suggested that Canada and Mexico may be exempt if NAFTA is renegotiated in the U.S.' favor Key European Union leaders threatened to retaliate against the U.S.' proposed tariffs, and the U.S. threatened to counter-retaliate China has taken a more cautious stance on the issue of retaliation, and is strongly seeking to negotiate with the Trump administration Minimal Direct Impact The developments over the past week raise two questions about China's economy that matter for investment strategy: What is the direct impact of the tariffs on China's exports likely to be? What is the implication for global growth? On the first question, the answer is fairly clear that the direct impact is likely to be small. The proposed tariffs do not disproportionately target China, and Chinese exports of steel and aluminum to the U.S. account for less than 0.2% of total exports (Chart 1). Exports of these products to all countries as a share of total exports is still quite small (panel 2). The second question is much more difficult to answer, and it has wide implications for both the Chinese economy and for investment strategy. When approaching the question, it is first important to note that the threat to the global economy from the imposition of the proposed tariffs comes from the potential for a series of retaliations from major trading partners, not the tariffs themselves. U.S. imports of steel and aluminum make up less than 1% of global goods exports, and Chart 2 presents a long-term history of average U.S. tariff rates along with our estimate of the impact of the U.S.' proposal. While the imposition of the announced tariffs would certainly change the trend that has been in place for some time, the rise is not very significant. Critically, even after the tariffs are imposed, U.S. tariffs rates will still be fractional when compared with those that prevailed during the early-1930s, when the Smoot-Hawley Tariff Act materially exacerbated the Great Depression. Chart 1Chinese Steel And Aluminum Exports##br## Are Not Significant Chart 2We're A Long, Long Way Away##br## From Smoot-Hawley China's cautious stance towards retaliation is, at first blush, an encouraging development, but it may not be as hopeful of a sign as it seems. First, despite a general feeling among investors that China was the intended target of the U.S.' proposed tariffs, a global tariff on steel and aluminum is likely to disproportionately affect developed countries rather than China. It is therefore not surprising that China has signaled a somewhat conciliatory stance. In our view, the likelihood of Chinese retaliation is considerably higher if further tariffs are announced on goods that make up a larger share of their exports. In addition, as we noted above, the European Union has already highlighted some U.S. goods that may be subject to higher retaliatory tariffs in response to the news (which already elicited a threat of counter-retaliation from the U.S.), and both Canada and Mexico have also threatened retaliation if they are not granted an exemption from the proposed tariffs. In our view, these threats should be treated seriously, especially after revisiting the lessons of one of the most famous experiments in game theory. Bottom Line: The direct impact of proposed U.S. import tariffs on steel and aluminum is likely to be small, both for China and the world. Retaliation Risk And The Prisoner's Dilemma The dynamics of trade renegotiations can be examined, at least conceptually, through the lens of game theory. It is difficult to model these dynamics precisely because of the complexity of the relationship between trade and potential growth, but it is worth revisiting the lessons learned by the repeated playing of Prisoner's Dilemma, one of the most well-known examples of the application of game theory. To summarize, the Prisoner's Dilemma scenario describes two criminals who have been arrested, and whose statement to the authorities affects the manner in which punishment (if any) is distributed between the two of them. The standard payoff structure of the game is set up such that one prisoner is able to largely avoid punishment if (s)he accuses the other of the crime and the other prisoner remains silent, but that both prisoners receive a punishment if they both accuse each other that is greater than the punishment received if they both remain silent (Table 1). Given that tariffs and other forms of trade protectionism can only durably succeed at improving net domestic economic outcomes if they do not result in retaliation, from the perspective of trade renegotiation, accusing the other player in the game of Prisoner's Dilemma is tantamount to restricting trade, and remaining silent is equivalent to allowing existing trade relationships to persist. Table1In The Prisoner's Dilemma, It's Better To Return Defection With Defection The success of strategies employed in repeated games of Prisoner's Dilemma was studied most famously by Robert Axelrod in 1980.1 The winning strategy (in both of Axelrod's tournaments) was "Tit for Tat", which follows two very simple rules: cooperate initially, and thereafter copy the other player's decision in the previous round. This strategy has three attributes that Axelrod showed to be highly successful when playing repeated games of Prisoner's Dilemma: niceness (not being the first player to accuse/defect/renege), being provocable (responding to defections with in-kind retaliation), and forgiveness (not allowing one-time defections to impact future choices beyond a one-time retaliation). Chart 3 illustrates the performance of the "Tit for Tat" strategy in the first Axelrod tournament, along with the average scores of several other strategies. The most important lesson from both tournaments is summarized nicely in the chart: the average score of a series of "nice" strategies was considerably higher than those that were not nice. But Chart 4 also highlights that niceness is only a relatively successful strategy because of its ability to produce an optimal outcome with other nice strategies: all strategies, nice or not, tend to generate poor outcomes when played against strategies that are not nice. This is because the payoff structure of Prisoner's Dilemma is such that, compared with defection, co-operation makes a player worse off if their opponent defects. Chart 3In Repeated Games Of Prisoner's Dilemma,##br## "Nice" Strategies Pay Off... Chart 4...But Only Because They Do Well Against ##br##Other "Nice" Strategies In the context of global trade, this can be seen as the likelihood of outsized job losses (or the lack of job gains in a protected industry) from a failure to retaliate. The key point for investors is that the most basic lesson of the Prisoner's Dilemma suggests that market participants should be legitimately concerned about retaliation from the U.S.' trade partners (and subsequent counter-retaliation) if it continues to pursue a protectionist agenda, because it can be a rational response for an individual country even if it leads to poor outcomes for everyone involved. In addition, three assumptions of the Prisoner's Dilemma game are not valid in the real world (or the current environment), which in two of these cases further increases the risk of an iterative exchange of retaliation: Chart 5The U.S. Has A Trade Deficit ##br##With Many Trading Partners In terms of the payoffs associated with the game, Prisoner's Dilemma assumes an equal starting position (of zero "points") on both sides, which is not the case in the current environment. The U.S. has a sizeable trade deficit with the world (Chart 5), and several important trading partners with the U.S. (especially China) maintain significant non-tariffs barriers to trade. Regardless of whether this inequity has been caused by an unfair trading relationship, in the parlance of Axelrod's tournaments, this implies that the U.S. strategy is likely to be not nice due to the perception on the part of the Trump administration of an unequal starting position. The implication is that the odds of an escalation of the imposition of relatively small tariffs into a full-blown trade war are higher than would normally be the case. Prisoner's Dilemma has clear and symmetric payoffs, which is also not the case in the current environment. The Trump administration apparently feels that the payoff to the U.S. of certain trade restrictions is a net positive even assuming retaliation, which raises the possibility of a negative outcome for the global economy. Worryingly, in our view the chances are high that calculations of the net benefit of any trade restriction are being done on a political basis, rather than an economic one. Prisoner's Dilemma assumes that the participants are unable to communicate, which is a limitation that does not exist in a real-world trade negotiation scenario. This lowers the probability that the U.S. and its major trading partners will engage in a spiraling tit-for-tat trade war relative to what the game of Prisoner's Dilemma would imply, even if the recently announced tariffs on steel and aluminum stand and major partners do retaliate. Bottom Line: The lessons learned from studying the game of Prisoner's Dilemma suggest that investors should be legitimately concerned about an iterative "tit-for-tat" exchange of retaliation between the U.S. and its major trade partners if the Trump administration continues to pursue aggressively protectionist trade policies. No Help From The Domestic Economy A protectionist agenda from the U.S. is also coming at an inconvenient time for Chinese policymakers, even if they were not blindsided by the move. Policymakers already have to contend with managing the impact of renewed reforms on economy's financial and industrial sectors, and the potential addition of the external sector to this list of problems needing attention is unwelcome. While a cooling of the economy was an inevitable result from the government's deleveraging campaign and shadow banking crackdown, Table 2 highlights how broadly leading economic indicators have decelerated. The table presents recent data points for several series that we identified in November Special Report as having leading properties for the Chinese business cycle,2 as well as the most recent month-over-month change, an indication of whether the series is currently above its 12-month moving average, how long this has been the case. Table 2No Convincing Signs Of An Impending Upturn In China's Economy Among the components of the BCA Li Keqiang Leading Indicator (an index designed to lead turning points in the Li Keqiang index), all six series are in a downtrend and 5 out of these 6 fell in January (the growth in M2 was the exception). A similar story is borne out in the housing price data, with a variety of diffusion indexes having also fallen in January.3 The Caixin Manufacturing PMI remains the one bright spot, having recently risen above its 12-month moving average and having risen in January, in stark contrast to the official PMI (which fell a full point). But as Chart 6 highlights, following the last four episodes when the Caixin PMI exceeded the official PMI by this magnitude, the subsequent trend in the average of the two was down in every case. The implication is that the outlier nature of the current Caixin PMI shown in Table 2 is just that, and not a heralding a major upturn in China's economy. Chart 6The Caixin PMI Is Probably The Noise, Not The Signal Bottom Line: Recent data releases show that the ongoing economic slowdown continues. While the Caixin manufacturing PMI is a bright spot, it is not likely heralding a major turning point for the Chinese economy. Conclusions For Investment Strategy Chart 7 illustrates the decision tree for Chinese stocks that we presented in our first report of the year. While there has been a modest further deterioration in the industrial sector, the pace of the decline is still consistent with the controlled slowdown scenario that we outlined in an October Weekly Report.4 As such, the recent softness in the data is not significant enough to cause us to change our recommended investment strategy. The key change over the past week has been the threat posed by U.S. protectionism to the global economy, which is the very first question to answer in our decision tree. The now high-beta nature of the Chinese stock market underscores that U.S. protectionism can significantly (negatively) impact the relative performance of Chinese equities if it destabilizes the global stock market, even if Chinese exports were to emerge from the exchange relatively unscathed. For now, we judge the likelihood of a full-blown tit-for-tat trade war to be a risk, and thus not a probable event. For now, market participants seem to agree: U.S. and global equities rebounded earlier this week in response to a feeling that the negative repercussions for global growth are likely to be minimal. Nonetheless, this is a risk that needs to be monitored closely, and to facilitate this our Geopolitical Strategy service has highlighted the following three bellwethers that they will be watching in order to judge the likelihood of a major escalation:5 Chart 7The Chinese Equity "Decision Tree" Tariff exceptions for allies: Given the national security basis for the steel and aluminum tariffs, it is likely that exceptions will be made for allies such as Canada and Europe. If yes, then the measure is unlikely to be part of a truly "America First" mercantilist strategy and is instead a veiled swipe at China to satisfy Trump's base ahead of the midterm elections NAFTA: Our geopolitical team has argued that the probability of NAFTA abrogation is around 50%.6 If the administration continues the negotiations in light of tariff announcements, however, it suggests that the revealed preference of the White House is less protectionist than it appears. Chinese intellectual property (IP) theft: The Trump administration is investigating Chinese technology transfer and IP theft under Section 301 of the Trade Act of 1974. If China is found to have acted unfairly, penalties would likely include a combination of tariffs and restrictions on Chinese investment in the U.S. This might include an indemnity for cumulative losses from past violations, which would be rare, if not unprecedented, and which China would reject outright. This could produce across-the-board tariffs of a sort that the U.S. has not imposed since the Nixon shock. Chart 8China Is Outperforming Global In Ex-Tech Terms In the meantime, Chart 8 highlights that investable Chinese ex-technology stocks (proxied by the MSCI China Index ex-technology) remain in an uptrend versus their global peers, which underscores that investors should have a high threshold for reducing exposure to China. This underscores that investors should have a high threshold for reducing exposure to China. While the ongoing slowdown in China's economy is likely to cause earnings growth to decelerate over the coming year, the continued likelihood of decently positive earnings growth coupled with a sizeable valuation discount relative to global signals that Chinese ex-tech stocks are remain attractive on a risk/reward basis. Investors should stay overweight. Bottom Line: Investors should closely watch three bellwethers to judge the likelihood of a full-blown global trade war. Barring a major deterioration on this front, or a sharp further slowdown in Chinese economic growth, investors should stay overweight Chinese ex-tech stocks vs global. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 "Effective Choice in the Prisoner's Dilemma" and "More Effective Choice in the Prisoner's Dilemma" by Robert Axelrod, The Journal of Conflict Resolution, Vol. 24 Nos.1 and 3, March and September 1980. 2 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of The Chinese Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. 3 However, as discussed in our February 8 Weekly Report, we are keeping an eye on residential floor space sold given its history of leading China's housing market cycles. 4 Please see China Investment Strategy Weekly Report, "Tracking The End Of China's Mini-Cycle", dated October 12, 2017, available at cis.bcaresearch.com. 5 Please see Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War", dated March 6, 2018, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "NAFTA - Populism Vs. Pluto Populism", dated November 10, 2017, available at gps.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights We re-examine our Yield and Protector portfolios to find out which assets will hold up best if there is a material correction. Our tactical view on gold is neutral, but the risk in gold prices will remain skewed to the upside this year. Are tariffs on aluminum and steel the start of a trade spat or a trade war? Feature Fears of a trade war and a hawkish tone from Fed Chair Jay Powell at his first Humphrey Hawkins testimony to Congress pushed the U.S. equity market lower last week. The ten-year Treasury yield barely budged however, buffeted by a more hawkish Fed on one side and a trade-induced slowdown in global growth on the other. The dollar was modestly higher last week, but oil and gold prices moved lower. The S&P 500's 4% loss in February was the worst single month since October 2016 and worst February since 2009. Both investment-grade and high-yield credit spreads widened last week, and have yet to return to their late January lows. Moreover, at 22, the VIX remained elevated relative to start of the year, consistent with our view that markets have entered a more volatile, late-cycle phase. With the 2.8% run-up in the S&P 500 since the February 8 low, investors are less concerned that the early February pullback in risk assets was a signal that the equity bull market is over and a recession is right around the corner. Nonetheless, some clients with a more strategic outlook are considering paring back risk now. Others want to know how to protect gains while still participating in the bullish tone for the market BCA expects in the next 12 months. Our Yield and Protector portfolios might provide a way for investors to protect against the downside while still participating in the S&P 500. Preparing For A Pullback BCA recommends investors stay overweight on equities and U.S. spread product, but expects that positions should be moved to neutral later this year and then to underweight sometime in 2019.1 Long-term investors should already consider paring back their exposures to both asset classes given that valuations are stretched. We have periodically recommended that a variety of investments be added as portfolio "insurance" to help guard against a material correction in equities. We recently highlighted two forms of insurance: our Yield and Protector Portfolios. We introduced the Yield Portfolio in October 20142 and first discussed the Protector Portfolio in October 2015.3 This week, we revisit the issue by comparing both portfolios with a more common form of insurance: shifting from cyclical to defensive stocks within an equity allocation. The Yield Portfolio (YP) emphasizes "high quality carry", along with some protection via TIPS (25% of the Portfolio), if inflation begins to surprise on the upside after investors are conditioned to expect only deflation shocks. The YP performs well in an environment of slow nominal growth, no recession and gradual interest-rate hikes. On the other hand, the Protector Portfolio (PP) is designed to provide insulation against both deflationary (gold and trade-weighted dollar) and inflationary (TIPS) tail risks. Therefore, the PP may underperform risk assets for a time if tail risks keep receding. Still, it has done well during the equity rally and conservative investors should consider adopting it. As discussed in the section below, our tactical view on gold is neutral, but the BCA Commodity & Energy Strategy notes that the risk in gold prices will remain skewed to the upside this year. Charts 1, 2, and 3 show a breakdown of the relative performance of S&P 500 defensives along with our Yield and Protector Portfolios. Panels 2 and 3 of Charts 1, 2 and 3 present the rolling one-year beta and alpha of each strategy versus the S&P 500. Alpha is presented as the difference between the actual year-over-year excess return of the portfolio (versus short-term Treasury bills) and what would have been expected given the portfolio's beta. This measure is also referred to as "Jensen's alpha." Chart 1S&P 500 Defensives##BR##A Modestly Low Beta Option Chart 2A Lower Beta##BR##Than Defensives Chart 3A Beta Near Zero,##BR##And Positive Alpha Based on the historical beta of the three portfolios versus the S&P 500, defensive stocks are the most correlated with the overall equity market. Our PP had a negative correlation to the broad market until earlier this year, when it turned slightly positive. BCA's YP is somewhere in between, with a positive but relatively low beta. This is consistent with the equity composition of the three portfolios (shown in Table 1). Note that our protector portfolio is composed entirely of non-equity assets. Table 1A Breakdown Of Three##BR##Portfolio Insurance Options After accounting for their lower betas, all three portfolios have outperformed the S&P in risk-adjusted terms since the onset of the global economic recovery. However, the three portfolios have experienced a relative decline versus the S&P 500 since Trump's election. This has occurred due to passive rather than active underperformance. In other words, they have underperformed because they failed to keep up with the S&P 500 rather than because of losses in absolute terms. We draw two important conclusions from Charts 1, 2 and 3 for U.S. multi-asset investors. First, the lower beta of our YP and PP compared with S&P defensives means that the former represent a better insurance against a sell-off in the equity market rather than the latter. Secondly, the persistently positive volatility-adjusted returns for our insurance portfolios highlights an investor preference for these assets in the past few years. However, since late 2017 when investors began to significantly upgrade the prospects for global growth and U.S. corporate profits, all three portfolios struggled to outperform the S&P 500 on a risk-adjusted basis. BCA's forecast implies that these portfolios may continue to struggle in the next year or so. For now, our investment bias towards equities over government bonds makes us less inclined to favor a low beta position within a balanced portfolio. Our analysis suggests that clients who anticipate the need for portfolio insurance in the coming year should back our YP and PP over a defensive-sector allocation. We would likely extend this recommendation to all clients if there is any material progression towards the sell-off triggers identified in the Bank Credit Analyst's February 2018 publication.4 Bottom Line: Investors seeking protection against a potential equity market sell-off should look to our Yield and Protector Portfolios over defensive-sector positioning. We do not currently recommend these portfolios for all clients, but we may do so if our key sell-off triggers are breached. Gold Bugged Our tactical view on gold is neutral, but the BCA Commodity & Energy Strategy notes that the risk in gold prices will remain skewed to the upside this year. The yellow metal is supported by increasing inflation and inflation expectations, heightened geopolitical risks and greater volatility in equity markets.5 However, the higher inflation and inflation expectations will be countered by Fed rate hikes, which will boost the U.S. dollar and lift real rates in our base case. Strategically, we expect that gold will provide a good hedge against any downturn in equities when the bull market turns bear in 2H19. Chart 4 shows that the price of gold in real terms is still very expensive. On a nominal basis, gold is at the top end of a trading channel initiated in early 2012 (Chart 5). There has been a significant gap between the model value and the actual price of gold for the past four years. The real price of gold remains elevated, although inflation has been well contained. Chart 4Model Suggests Gold Is Overvalued Chart 5Testing Top End Of A Downward Channel However, the macro environment BCA envisions for 2018 is also supportive for gold (Table 2). Gold tends to perform well when oil prices rise and as the 2/10 Treasury curve steepens. Moreover, gold prices tend to go up when the U.S. economy benefits from fiscal thrust and tax cuts. Furthermore, the soundings on the February ISM manufacturing index support higher gold prices. When the headline index is above 60 as it was in February (60.8), gold climbs by an average of 31%. Even 12 months after ISM is above 60, gold returns are over 20%. The elevated level of ISM new orders (64.2) and price (74.2) indices in February also suggest solid increases for gold. Finally, gold prices climb in the late stages of an economic expansion, such as the current one that began in 2009.6 Even so, our 6 to 12-month view on gold is that it will take its cues from Fed policy and policy expectations. The Fed is not behind the curve on inflation, and inflation expectations and measured inflation remain low. Our CPI and PCE models (Chart 6) show only a modest acceleration in inflation by year-end, which will be sufficient to keep the Fed on track this year as it continues to shrink its balance sheet and boost rates four times. Thus, there is no pressing need to hold gold as a hedge against inflation in the next year. Nonetheless, for those investors too concerned about a pullback that turns into a correction or a bear market, we note that gold has a 33% weight in our Protector Portfolio. Table 2Favorable Macro Backdrop For Gold Chart 6BCA's Inflation Models Show Only##BR##Modest Acceleration Through Year-End Bottom Line: Gold is expensive in real terms relative to a set of fundamentals that have explained its real price since 1970. However, it may have a better value on a strategic basis or as part of a portfolio designed to protect against falling equity prices. Moreover, our macro backdrop forecast for the next 12 months supports higher gold prices. Keep gold as a strategic portfolio hedge. Trade Off BCA's Geopolitical Strategy team has long argued that two sources of geopolitical risk this year are China's trade surplus and Trump's position on trade relations with China, Canada and Mexico. Specifically, the view is that weak poll numbers may lead Trump to trigger trade disputes with important trading partners such as China, Mexico and Canada. However, our geopolitical analysts also point out that investors should not confuse a trade spat with a trade war. There are very few legal or constitutional constraints on Trump over trade issues (Table 3). It will be his decision whether to adopt sweeping tariffs (trade war) as opposed to a more targeted approach (trade spat). Clearly, the former is more disruptive and raises more uncertainty, so this is the key distinction to keep in mind. Presidents Nixon, Reagan, Bush (II) and Obama all imposed temporary tariffs on items (including steel and aluminum, and including by citing national security concerns) without triggering a trade war. Late last week, Trump indicated that he would announce tariffs on steel and aluminum this week. He implied that he would go for a broad-based approach of penalizing all steel and aluminum imports, which points toward the more aggressive approach. But the details (whether he exempts U.S. allies and partners or narrows the scope of goods) will not be certain until he issues his official proclamation. Table 3Trump Faces Few Constraints On Trade Steel and aluminum get the headlines, but account for only a small share of U.S. trade and GDP7 (Chart 7). BCA is more concerned about the Administration's stance on more deeper issues, like the WTO, NAFTA, or (in China's case) intellectual property and state-owned enterprises.8 The issues here are harder to quantify, have few precedents, and have more structural and ideological issues which are at stake. The U.S. has a massive trade surplus in services and in intellectual property,9 so a prolonged disruption would pose a serious threat to the U.S. economy, at least in the short term. Trump's decision on intellectual property trade with China is due on August 12, but could occur earlier. BCA's stance on U.S.-China relations is bearish in the long run.10 We place high odds on an eventual trade war, but the timing is a tougher call. Investors should not view China's proportional retaliation on an item-by-item basis as the start of a trade war. BCA's view is that China's leadership will try to offer reforms and investment opportunities to pacify Trump. However, there is a risk either that China offers no reforms (in which case Xi Jinping's rampant Communism exacerbates trade conflicts) or that Trump may introduce broad sweeping measures that give China no choice but to respond in kind, leading to a trade war. Our Geopolitical Strategy service notes that the probability of Trump abrogating NAFTA is as high as 50%. The seventh round of NAFTA talks concludes this week; an eighth round is scheduled for late March. Negotiations could drag on right to the Mexican election on July 1, but if they are not looking more optimistic by this spring then the risk of the U.S. (or Mexico) walking away will rise. The U.S. economy has been largely unaffected by NAFTA and would likely experience no disruption if Trump abrogated the deal and began negotiations on bilateral trade agreements with Canada and Mexico (Chart 8). Chart 7Steel And Aluminum In Perspective Chart 8U.S. Economy: Largely Unaffected By NAFTA Bottom Line: Elevated trade tensions with China,11 Canada and Mexico are near-term risks to global growth. From now through April could be a decisive time for the Trump Administration with China and NAFTA. We are bearish on U.S.-China relations in the long term. If Trump abandons NAFTA, the implications for the U.S. economy would be muted, although U.S. inflation may push higher. Such a decision would also send a clear signal to other key U.S. allies. However, if Trump stands by NAFTA, then it signals that he has sided with the establishment on trade. This would be bullish for risk assets and would lower geopolitical risk premia. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Research's Global Investment Strategy Weekly Report, "The Next Recession: Later But Deeper," published February 23, 2018. Available at gis.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Ice Storm", published October 20, 2014. Available at usis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "A Tenuous Relief Rally", published on October 12, 2015. Available at usis.bcaresearch.com. 4 Please see BCA Research's Bank Credit Analyst Monthly Report, February 2018. Available at bca.bcaresearch.com. 5 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Gold Still Shines Despite Threat Of Higher Inflation", published February 1, 2018. Available at ces.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View", published October 16, 2017. Available at usis.bcaresearch.com. 7 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Global Aluminum Deficit Set To Ease", published March 1, 2018. Available at ces.bcaresearch.com. 8 Please see BCA Research's Geopolitical Strategy Weekly Report, "America Is Roaring Back", published January 31, 2018. Available at gps.bcaresearch.com. 9 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Can The Service Sector Save The Day?", published June 5, 2017. Available at usis.bcaresearch.com. 10 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin", published January 18, 2017. Available at gps.bcaresearch.com. 11 Please see BCA Research's Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China", published February 28, 2018. Available at gps.bcaresearch.com.
Highlights Easier fiscal policy will cause U.S. inflation to rise or force the Fed to raise rates more aggressively than the market is discounting. Either outcome is likely to lead to a real appreciation in the dollar. Policy developments are starting to work in the greenback's favor. The Fed's leadership is turning somewhat more hawkish. Trade protectionism is also on the rise. Contrary to yesterday's market reaction, this will end up being dollar-bullish. The only plausible scenario where the dollar weakens in the face of bountiful fiscal stimulus is one where U.S. rates rise a lot but foreign rate expectations rise even more. Such an outcome is not particularly likely, considering that the U.S. is going from laggard to leader in the global growth horserace and most central banks are tightening monetary policy much more gingerly than the Fed. Nevertheless, it cannot be excluded, which is why investors should consider going long 30-year U.S. Treasurys versus German bunds in currency-unhedged terms. This position would pay off if EUR/USD weakens, while also providing downside protection in the case where the greenback comes under pressure due to a narrowing in the long-term interest rate spread between Germany and the U.S. Held to maturity, investors stand to gain 40% on this position. Feature Beware Of "Arguments By Accounting Identity" One of the biggest mistakes economic commentators make is that they engage in "arguments by accounting identity." These arguments almost always fall flat. This is because there are plenty of ways for accounting identities to hold true, only a small number of which are consistent with how people actually respond to economic incentives. Consider the often-cited identity which says that the difference between what a country saves and what it invests is equal to its current account balance or, in algebraic terms, S-I=CA. The U.S. is currently operating at close to full employment. It is sometimes asserted, using this formula, that a large dollop of fiscal stimulus will drain national savings, thereby increasing America's current account deficit. A bigger current account deficit is normally associated with a weaker currency. Ergo, fiscal stimulus must be dollar-bearish. It is a plausible sounding argument, but it makes no sense because it confuses cause and effect.1 It is analogous to saying that an increase in the number of apples coming to market means that the price of apples will fall even when it is apparent that farmers are planting more apple trees because the demand for apples is rising. If the government cuts taxes and boosts outlays, aggregate spending will increase. Should the value of the dollar simultaneously fall, the composition of that spending will shift towards domestically produced goods and services. Not only will people want to spend more, but they will also want to devote a larger share of their spending on U.S.-made goods. But how exactly is the economy supposed to generate all this additional output? It is already running at full capacity! The only story that makes sense is one where the value of the dollar rises. That would allow aggregate spending to go up, while ensuring that spending on American-made goods and services remains the same. Table 1 illustrates this point using a stylized example of a hypothetical economy. Table 1A Stronger Currency Can Be A Counterweight To Fiscal Stimulus U.S. imports account for about 15% of GDP (Chart 1). Assuming no change in the exchange rate, spending on domestically produced goods and services will rise by about 85 cents in response to every $1 increase in aggregate demand. If the economy cannot produce this additional output due to a lack of available workers, one of two things will happen: Either inflation will go up or the Fed will be forced to raise rates more aggressively than it otherwise would. Chart 1U.S. Trade As A Share Of The Economy Both outcomes imply a "real appreciation" in the dollar exchange rate, which can be thought of as the value of foreign goods and services that can be acquired by selling a basket of U.S. goods and services.2 In the former case, the real dollar exchange rate will appreciate because the U.S. price level will rise relative to prices abroad. In the latter case, the real dollar exchange rate will appreciate because higher interest rates will put upward pressure on the nominal value of the currency. Two Paths To A Real Dollar Appreciation The catch is that it is impossible to know how much of the real appreciation will occur through higher inflation and how much of it will occur through a stronger nominal dollar. In theory, one could envision a scenario where the real value of the dollar rises even as the nominal value declines. This would happen if the Fed fell so far behind the curve that inflation rocketed higher. Alternatively, one could contemplate a scenario where the Fed raises rates too aggressively, driving the dollar up so much that the economy falters and inflation declines. Our baseline scenario lies somewhere between these two extremes. We expect U.S. fiscal stimulus to push up inflation, while also pushing up the nominal trade-weighted dollar. It rarely happens that real and nominal exchange rates move in opposite directions (Chart 2). Thus, if the real dollar exchange rate appreciates, the nominal exchange rate is bound to appreciate as well. Chart 2Nominal And Real Exchange Rates Tend To Move In The Same Direction Global Growth: Back To The USA So why, then, has the dollar been on the back foot over the past year? The answer is better economic prospects at home were more than matched by stronger growth abroad. Keep in mind that the discussion above does not need to be confined to fiscal stimulus. Anything that causes domestic demand to accelerate is apt to trigger a real appreciation of the currency. After a sluggish recovery following the sovereign debt crisis, euro area growth accelerated last year as credit markets thawed and pent-up demand was unleashed. Sensing better economic times ahead, investors bid up the euro. The global growth revival was assisted by a rebound in global manufacturing activity. The manufacturing sector tends to be highly procyclical; when global growth accelerates, manufacturing production usually accelerates even more. The U.S. manufacturing sector accounts for only 12% of GDP, compared to 18% in the euro area, 21% in Japan, and 30% in China (Chart 3). As such, an improving manufacturing outlook disproportionately helped the rest of the world. Meanwhile, a rebound in commodity prices aided emerging markets and other economies with large natural resource sectors. Looking out, the picture for global growth is murkier. Global manufacturing PMIs have likely peaked. Korean exports, a leading indicator for the global business cycle, have softened (Chart 4). China is decelerating, with this week's weaker-than-expected official PMI print being the latest example. This could weigh on metals prices (Chart 5). As we discussed last week, slower global growth tends to benefit the dollar.3 Meanwhile, the composition of global demand growth should shift back toward the U.S. thanks to the lagged effects from the relative easing in financial conditions that the U.S. enjoyed last year, as well as all the fiscal stimulus coming down the pike (Chart 6). Chart 3Global Manufacturing Revival ##br##Not Benefiting The U.S. Much Chart 4Global Growth Seems To Be Peaking Chart 5Chinese Slowdown Will Weigh On Metal Prices Chart 6Lagged Easing In Financial Conditions ##br##And Fiscal Stimulus Bode Well For Growth A More Dollar-Friendly Policy Backdrop Policy developments are starting to work in the dollar's favor. Jerome Powell tried not to rock the boat during his Humphrey-Hawkins testimony this week. However, he did stress that the economic outlook did improve since the Fed last met in December, seemingly opening the door to four rate hikes this year. That was enough to lift the DXY by 0.4%. Powell is not a doctrinaire hard-money type, but he is no Yellen clone either. Remember this was the guy who said back in 2012 that "We look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that is our strategy."4 Critically, there are still four vacancies on the Fed's Board of Governors. If the nomination of Martin Goodfriend - who is definitely no good friend of easy money - is part of a broader trend, the composition of the board will shift in a somewhat more hawkish direction. Meanwhile, the Trump administration has introduced tariffs on imported steel and aluminum. While we do not expect this decision to trigger an all-out trade war, it will almost certainly prompt retaliatory actions. There are three reasons why an escalation in trade protectionism would help the dollar. First, a decrease in global trade would likely reduce trade surpluses and deficits alike. This would shift demand back towards economies such as the U.S., which run trade deficits, at the expense of surplus economies such as Japan, China, and the euro area. Second, a slowdown in trade flows would curb global growth. As noted above, slower global growth tends to be dollar-bullish. Third, the specter of trade wars would exacerbate geopolitical risks. A more uncertain political landscape, even when instigated by the U.S., tends to prop up the dollar. It is true that foreign powers could retaliate against the U.S. by buying fewer Treasurys. But why would they? This would only drive down the dollar, giving U.S. exporters an even greater advantage. The smart strategic response would be to intervene in currency markets with the aim of bidding up the dollar. All this suggests that the dollar may be ripe for a rebound. Positioning has gotten fairly short the dollar (Chart 7). This raises the odds of a short-covering rally. Momentum measures have also improved over the past few weeks, an important consideration given that the dollar is one of the most momentum-driven currencies out there (Chart 8). Chart 7Speculative Positioning Has Gotten Increasingly Dollar-Bearish Chart 8Momentum Matters, And It May Be Starting To Move Back In The Dollar's Favor A Safer Way To Go Long The Dollar: Buy 30-Year Treasurys/Short 30-Year German Bunds, Currency-Unhedged The only scenario where the dollar weakens in the face of bountiful fiscal stimulus is one where U.S. rates rise a lot but foreign rate expectations rise even more. Sharply higher U.S. interest rates would offset the stimulative effects of a weaker dollar, thus preventing the economy from overheating. Such an outcome is not particularly likely, given that the U.S. is going from laggard to leader in the global growth horserace, and most central banks are tightening monetary policy much more gingerly than the Fed. Nevertheless, it cannot be excluded. As such, investors should consider going long 30-year U.S. Treasurys versus German bunds in currency-unhedged terms. This position would pay off if EUR/USD weakens, while also providing downside protection in the case where the greenback comes under pressure due to a narrowing in the long-term interest rate spread between Germany and the U.S. The trade is effectively a bet that the interest rate differential between bunds and Treasurys - which has widened sharply this year, even as the dollar has weakened - will revert to its former self (Chart 9). Over the long haul, it is hard to see how one could lose money on this trade. As we go to press, 30-year Treasurys are yielding 3.11% while 30-year bunds yield only 1.29%. The euro would have to strengthen to 2.10 against the dollar over the next 30 years to cancel out the 182 bps in additional carry that U.S. bonds are offering. Even if one assumes that the fair value for the euro climbs by 0.4% annually due to lower inflation in the common-currency bloc, this would still leave the euro 40% overvalued.5 To maintain consistency with our other trade recommendations, we are closing our short 30-year Treasury trade for a gain of 3.8% and opening a new trade going long 30-year TIPS breakevens. Chart 10 shows that long-term inflation expectations as gauged by 30-year breakevens are still 27 basis points below where they were on average between 2010 and 2013. Chart 9EUR/USD And Long-Term Spreads Will Recouple Chart 10More Upside To Long-Term TIPS Breakevens Investment Conclusions We expect the dollar to strengthen over the coming months. EUR/USD should ultimately bottom at around 1.15. EM currencies will also struggle on the back of slower Chinese growth and higher financing costs for dollar-denominated loans. Among commodity producers, we favor "oily" currencies such as the Canadian dollar and Norwegian krone over metal exporters such as the Australian dollar. Our commodity strategists expect Brent and WTI to average $74 and $70/bbl this year, above current market expectations of $66 and $62, respectively. They note that Saudi Arabia has a strong incentive to boost oil prices by curtailing production in the lead up to Aramco's initial public offering. The yen is better positioned to hold its ground, considering that it is still very cheap and positioning remains heavily short (Chart 11). My colleague, Mathieu Savary, discussed the yen's prospects two weeks ago.6 A rebound in the dollar and creeping protectionism will pose headwinds for global equities. Nevertheless, with corporate earnings continuing to surprise on the upside, this is unlikely to derail the cyclical bull market in stocks. However, investors should prepare for a lot more volatility, as we flagged in several reports earlier this year.7 At the regional level, U.S. equities have underperformed their global peers in common-currency terms since the start of 2017, but outperformed in local-currency terms (Chart 12). We could see a reversal of that pattern over the coming months as the dollar begins to firm. Chart 11The Yen Is Cheap And ##br##Positioning Is Short Chart 12A Stronger Dollar Could Reverse ##br##U.S. Equity Relative Performance Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Paul Krugman made a similar point more than 20 years ago. 2 The real exchange rate between two currencies is the product of the nominal exchange rate and the ratio of prices between the countries. A real appreciation tends to make a country less competitive, either through a nominal increase in its currency or through an increase in prices in that country relative to those of its trading partners. 3 Please see Global Investment Strategy Weekly Report, "The Next Recession: Later But Deeper," dated February 23, 2018. 4 Please see FOMC Meeting Transcript, "Meeting of the Federal Open Market Committee on October 23-24, 2012," Federal Reserve. 5 For this calculation, we assume that the fair value for EUR/USD is 1.32, which is close to the IMF's Purchasing Power Parity (PPP) estimate. The inflation differential of 0.4% is based on 30-year CPI swaps. This implies that the fair value for EUR/USD will rise to 1.49 after 30 years. If the euro needs to strengthen to 2.10 over 30 years to cover the cost of carry, this would leave it 41% (2.10/1.49) overvalued. Our assessment would not change much if we used Germany rather than the euro area as the basis for the analysis. We estimate that the fair value exchange rate for Germany is 1.45, which is higher than the fair value exchange rate for the euro area as a whole. However, the differential in 30-year CPI swaps between Germany and the U.S. is only 16 basis points. Thus, if the fair value German exchange rate evolves in line with inflation differentials, it would rise to only 1.52. This would still leave Germany 38% (2.10/1.52) overvalued against the U.S. after 30 years. 6 Please see Foreign Exchange Strategy, "The Yen's Mighty Rise Continues...For Now," dated February 16, 2018. 7 Please see Global Investment Strategy Special Report, "The Return Of Vol," dated February 6, 2018; and Weekly Report, "Take Out Some Insurance," dated February 2, 2018. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Dear Client, I am travelling this week meeting clients in Asia, so this report has been written by my colleagues, Billy Zicheng Huang and Sophie McGrath. Greece, the epicentre of the euro debt crisis, is finally recovering. Declining net NPLs, an upturn in investor confidence and improving employment are encouraging. But there is a risk that growth will lose some momentum amid the country's exit from the third economic adjustment program. Hence, we are recommending a neutral weighting in the Greek equity market as a whole comprising four overweight ideas counterbalanced by four underweight ideas. We expect companies with essential product focus, low debt levels and strong asset health to outperform non-essential product providers, highly leveraged players and weak asset-quality counterparts. Dhaval Joshi Best Overweight And Underweight Ideas Table I-1Single-Stock Statistics On Select Greek Companies* Greece: The Long Road To Recovery Macro indicators in Greece have improved and investors have become more confident. This is highlighted by the recent upgrade of Greece's long-term sovereign credit rating to B and an oversubscribed seven-year bond sale, confirming high investor demand. Nevertheless, there is a risk that growth will lose some momentum amid the country's exit from the third economic adjustment program. Listing the improvements, economic sentiment is approaching previous peaks (Chart I-1), the unemployment rate has dropped to its lowest level since 2011 (Chart I-2) and the youth unemployment rate has fallen around 20 percentage points from its high (Chart I-3). Chart I-1Economic Sentiment Has Improved Chart I-2Unemployment Is Down... Chart I-3...Youth Unemployment Even More So Furthermore, the most intense headwinds from fiscal drag are over. In the depths of the debt crisis, fiscal drag reached 7% of annual GDP. While Greece is not set to receive a sustained fiscal 'thrust' in the medium term, it appears the worst is over on the austerity front (Chart I-4). The most promising indicator is competitiveness. Greece appears to have made the necessary adjustments to unit labor costs and is no longer a euro area outlier (Chart I-5). Chart I-4Peak Fiscal Drag##br## Is Over Chart I-5Unit Labour Costs Are Now In Line ##br##With Euro Area Counterparts Recent developments in the banking system are also encouraging. Bank liquidity has improved, and the use of ECB Emergency Liquidity Assistance (ELA) has significantly diminished (Chart I-6). Net NPLs have declined sharply and are now covered by bank equity capital (Chart I-7). An unprecedented legal foundation is now in place to address the NPL stockpile. These measures include the introduction of electronic auctions to recover claims, the simplification of the out-of-court settlement process and reducing the liability of individuals involved. If net NPLs continue to fall, we can expect a healthier banking sector to support the economy, as witnessed in Spain, Ireland, and more recently in Italy. Chart I-6Banks Are No Longer Reliant ##br##On Emergency Funding Chart I-7Bank Equity Capital Finally ##br##Exceeds Net NPLs Despite these encouraging signs, the consumption recovery is fragile as households continue to delever (Chart I-8). Additionally, retail sales have dipped again recently (Chart I-9). Chart I-8Households Continue To Delever Chart I-9Retail Sales Have Dipped Regarding the bailout exit and debt sustainability, markets have seemingly priced in the wrapping up of the third review later this year, with the Eurogroup meeting on January 22 having recorded progress. However, what is more uncertain is whether this will take the form of a 'clean' or 'dirty' exit. The level of post-bailout monitoring that is agreed upon will ultimately dictate the pace of Greece's return to capital market normalcy. Considering the uncertainties in the overall picture, we recommend a market neutral portfolio in Greece with an overall beta of 0.15, consisting of four overweight companies versus four underweight counterparts from the consumer discretionary, telecoms, real estate, banking, consumer staples and energy sectors (Table I-2). Through our selection process we focused on companies with better growth profiles in essential sectors of the Greek economy. Table I-2Select Companies And 12-Month Beta Vs. MSCI EM Sector Specifics/Dynamics Our overweight (OW) basket performance over the past three years has been exceptionally strong relative to the underweight (UW) names. The OW basket has outperformed by 59% (Chart I-10A). However, this was primarily due to a selloff in Piraeus Bank (UW) in the second half of 2015. On a short-term horizon we see a different picture. Looking at one-year performance, the OW basket has actually just closed the underperformance gap over the past two months (Chart I-10B). Chart I-10AThree-Year Performance: ##br##Overweight Vs. Underweight Basket Chart I-10BOne-Year Performance: ##br##Overweight Vs. Underweight Basket Valuations favor the OW basket, especially from the second half of 2017 on, when OW and UW share prices began to diverge. Compared to historical valuations, OW names are currently trading close to their three-year average P/E, while their UW counterparts are trading at one standard deviation above historical P/E (Chart I-11A, Chart I-11B, and Chart I-11C). Chart I-11AOW Basket Displays Appealing Valuations##br## Relative To UW Basket... Chart I-11B...And Its Own ##br##Historical Average... Chart I-11C...While UW Basket Is Trading One Standard##br## Deviation Above Mean Non-bank OW companies display stronger operating margin dynamics, despite a recent dip, while the OW bank demonstrates superior net interest margins. Both margin trends are translating into solid profitability (Chart I-12A and Chart I-12B). Chart I-12ARobust Operational Level Performance... Chart I-12B...Feeds Into Solid Profitability Additionally, the OW basket displays more favorable debt dynamics, with debt remaining at low levels and trending down, whereas the debt ratio in the UW basket is already at an elevated level and continues to climb (Chart I-13). Meanwhile, free cash flow yield has favored UW players since mid-2016 when banks are excluded (Chart I-14). Chart I-13Debt Levels Remain ##br##Low In OW Companies Chart I-14Free Cash Flow Yield Favors ##br##UW Non-bank Names Specifically for banks, Alpha Bank (OW) enjoys a much healthier asset quality profile compared to Piraeus Bank (UW), with a combination of a lower NPL ratio and a higher tier-1 ratio (Chart I-15). Please also note that EPS growth is not shown as we normally do in our reports due to abrupt volatility in both baskets, which prevents us from drawing comparative conclusions. Dividend yield is also omitted due to the fact that most companies we have selected do not pay dividends. Chart I-15Alpha Bank Illustrates Healthier Asset Quality The Overweight Basket Jumbo (BELA GA) Jumbo (BELA GA) (Chart I-16) Chart I-16Performance Since February 2017: ##br##Jumbo Vs. MSCI EM Jumbo reported financial results for the fiscal 2017 year on October 12. Revenue increased by 7% year over year. Despite a difficult year in Greece, sales were compensated largely by organic growth in Romania and Bulgaria, with one new store open in each country respectively. EBITDA grew by 6% year over year, on the back of an effective cost management effort, while EBITDA margin remained virtually flat at 25.2%. As a result, the bottom line expanded by 8% year over year, with profit margin up 20 basis points to 19.2% Jumbo is currently trading at a forward P/E of 15.5x, while the market is forecasting an EPS CAGR of 6.3% over the next three years. The company is expected to continue its strong expansion drive in Eastern Europe, with one more store open in Romania in November 2017 (the 9th store) and one more store to be open next year in Bulgaria. At the same time, a drop in unemployment and a pick-up in household consumption will help Jumbo's recovery in the Greek market, signaling upside potential for the share price. Hellenic Telecom (HTO GA) Hellenic Telecom (HTO GA) (Chart I-17) Chart I-17Performance Since February 2017: ##br##Hellenic Telecom Vs. MSCI EM Hellenic Telecom (OTE) reported full-year 2017 results on February 22. Revenues declined slightly year over year by 1.3% to €3857 million, dragged down mainly by mobile operations in Albania, where revenues declined by 11.8%. Mobile operations in Romania remained positive, aided by a strong fourth-quarter performance which saw revenues increase by 14.4% year over year. Revenue growth in Greece remained solid in both mobile and fixed line, increasing by 0.7% and 1% year over year respectively. EBITDA shrank by 1.3% year over year, while EBITDA margin remained flat at 33.8%. As a result of muted top line growth on an annual basis as well as elevated operating costs, the bottom line contracted by 20% year over year, in line with market expectations. Hellenic Telecom is currently trading at a forward P/E of 86x, while the market is forecasting an EPS CAGR of 6.9% over the next three years. Management guidance indicates that free cash flow (FCF) and adjusted capex will start to return to normal levels in 2018 after heavy investments in both its fixed and mobile network capabilities in 2017. Additionally, growing confidence in the company's outlook is signalled by its announcement of a new shareholder return policy, where 100% of the FCF will be distributed through a combination of a dividend payout and share buybacks. We expect that its recent investment in mobile and fixed capabilities and an improving Greek economy should drive a positive performance in 2018. Grivalia Properties (GRIV GA) Grivalia Properties (GRIV GA) (Chart I-18) Chart I-18Performance Since February 2017: ##br##Grivalia Properties Vs. MSCI EM Grivalia Properties reported stellar full-year 2017 financial results on January 31. The top line displayed solid results, with rental income advancing 7% year over year. Furthermore, the company realized a strong net gain of EUR18.8 million from fair value adjustments on investment property, compared to a EUR13.6 million loss in 2016. This was mainly driven by new property investments. As a result, operating profit surged by 102% year over year. All this translated into 139% year-over-year net income growth. Due to loan growth, the loan-to-value ratio grew by 8 percentage points to 14%, while NAV per share expanded by 5% year over year. Grivalia Properties is trading at a forward P/E of 15x, while the market is forecasting an EPS contraction of 1% over the next three years. The company announced in February the acquisition of office space in Maroussi, which has already been leased out to multinational companies. Two more properties were acquired in Greece in the same month. We believe a stabilizing property market leaves ample room for recovery, which is expected to support Grivalia's overweight Greek real estate portfolio and its risk diversification. Alpha Bank (APLHA GA) Alpha Bank (APLHA GA) (Chart I-19) Chart I-19Performance Since February 2017: ##br##Alpha Bank Vs. MSCI EM Alpha Bank reported solid third-quarter 2017 financial results on November 30. Net interest income improved by 2% year over year, with net interest margin growing 20 basis points to 2.9%. However, on a quarter-over-quarter basis, growth was negative. Fee income depicted a similar picture, up 2% year over year but down 7% quarter over quarter. On the positive side, operating expenses were under control, declining by 3% year over year, effectively pushing down the cost/income ratio. With the help of a decline in impairment losses, net income surged by 386% year over year. Asset quality showed a pattern of recovery: The NPL ratio went down by 7.4 percentage points to 33.2% year over year, while the tier-1 ratio improved by 1 percentage point to 17.8%. Moreover, ELA has trended down year to date. The market is forecasting an EPS CAGR of 53.6% over the next three years. Despite uncertainty regarding stress testing and the overall trajectory of Greek economic growth, Alpha Bank has demonstrated a solid pace of recovery in terms of a better asset-liability mix, improved liquidity and steady disengagement with the ELA. As guided by management, ELA funding is expected to be further replaced by strong deposit inflows, deleveraging initiatives and an increase in interbank lending. The Underweight Basket Intralot (INLOT GA) Intralot (INLOT GA) (Chart I-20) Chart I-20Performance Since February 2017:##br## Intralot Vs. MSCI EM Intralot reported mixed third-quarter financial results on November 27. Top-line growth was solid, up 10% year over year, mainly boosted by licensed operations in Jamaica, Azerbaijan and Poland. This also drove up gross margin by 2.8 percentage points to 18.1% year over year. However, a cost hike took a bite out of profits, with operating expenses expanding by 8%. Along with a 49% surge in R&D costs, the bottom line was still in negative territory. On a year-to-date basis, cash flow grew by 23%. However, this was mainly boosted by financing activities, with operating cash flow almost unchanged. Meanwhile, long-term debt has grown by over 50% year over year, which has prompted questions on solvency and the ability to further carry the interest payment burden. The market is forecasting negative EPS over the next three years. We believe the 80% share sale of the company's Peruvian operations reflects its need for cash inflow and raises concerns on balance sheet health. Coca-Cola HBC (EEE GA) Coca-Cola HBC (EEE GA) (Chart I-21) Chart I-21Performance Since February 2017:##br## Coca-Cola HBC Vs. MSCI EM Coca-Cola HBC reported solid full-year 2017 financial results on February 14. Revenues came in strong, growing by 5% year over year. Sales volume in developed markets, developing markets and emerging markets went up 1%, 7%, and 7% respectively. Looking at product lines, Sparkling was the best seller, driven by new flavor launches (such as lime, lemon, and cucumber). Stripping out foreign exchange effects, FX-neutral revenue grew by 6% year over year. Cost of sales ticked up by 4% year over year. EBITDA expanded by 10% year over year, while EBITDA margin added 60 basis points to 14.3%. As a result, the bottom line expanded by 24% year over year, beating market expectations. Coca-Cola HBC is currently trading at a forward P/E of 20x, while the market is forecasting an EPS CAGR of 11% over the next three years. The stock price rallied in the second half of 2017 following the company's announcement that it was acquiring 54.5% of Coca-Cola Beverages Africa (CCBA), indicating market complacency toward a strong synergy effect the deal could bring. However, given its weak profitability, CCBA is not expected to be as accretive as many investors believe. With the acquisition news priced in, CCHBC's year-to-date stock price has begun reverting to its true fundamentals. Hellenic Petroleum (ELPE GA) Hellenic Petroleum (ELPE GA) (Chart I-22) Chart I-22Performance Since February 2017:##br## Hellenic Petroleum Vs. MSCI EM Hellenic Petroleum reported full-year 2017 financial results on February 22. Revenue increased by 21% year over year, driven by higher volumes (exports +12% and +14% in domestic net sales, mainly helped by aviation and bunkering) in the refining division and improved average selling prices. However, this result was offset by higher cost of sales, up 23% year over year, driven by increased input prices, sending gross margin 160 basis points lower to 13.6%. Operating income was 4.7% higher year over year, helped by lower operating expenses. EBITDA was up 14% year over year, while EBITDA margin was 200 basis points lower, finishing at 10.6%. The company secured bottom line growth of 15.7%, but came in below the market expectation by 4.5%. Hellenic Petroleum is currently trading at a forward P/E of 6.5x, while the market is forecasting an EPS CAGR of 4.6% over the next three years. The reopening of the Elefsina refinery will enable Hellenic Petroleum to return to normal capacity in 2018. However, continued maintenance work expected to end in March 2018 and higher crude prices will continue to place pressure on margins. We expect weak domestic demand to continue to impact carbon revenue, despite strong sales growth from increased tourism. Piraeus Bank (TPEIR GA) Piraeus Bank (TPEIR GA) (Chart I-23) Chart I-23Performance Since February 2017: ##br##Piraeus Bank Vs. MSCI EM Piraeus Bank delivered disappointing third-quarter 2017 financial results on November 9. Net interest income came in weak, sliding 3% year over year, with net interest margin remaining virtually flat at 2.7%. On the positive side, net fee income displayed strong growth, up 24% year over year. Operating expenses contracted by 5% year over year, pushing down the cost/income ratio by 5 percentage points to 51%. Despite robust pre-provisional income, the impairment on loans dragged down net income into negative territory, compared to a positive bottom line during the same period last year. Asset quality was a mixed bag: The NPL ratio went down by 2.6 percentage points to 48.3%, but is still the highest among its peers. The loan-to-deposit ratio declined, with ELA loan exposure trending slightly down year-to-date. The market is forecasting an EPS contraction of 8.8% over the next three years. Piraeus Bank has shown little signs of operational recovery, with most cost-savings efforts achieved through branch reductions (-8% year to date) and employee layoffs (-7% year to date). We believe the bank is still a long way away from a real turning point and prefer to monitor on the sidelines. How To Trade? The EMES team recommends gaining exposure to the sector through a basket of the listed stocks below, which would consist of overweight positions in four select Greek companies and underweight positions in the other four. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index-hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): Jumbo (BELA GA) vs. Intralot (INLOT GA) Hellenic Telecom (HTO GA) vs. Coca-Cola HBC (EEE GA) Grivalia Properties (GRIV GA) vs. Hellenic Petroleum (ELPE GA) Alpha Bank (ALPHA GA) vs. Piraeus Bank (TPEIR GA) ETFs: There are no ETFs that would allow for an overweight/underweight position in the same sector. Funds: There are no funds that would allow for an overweight/underweight position in the same sector. Please note this trade recommendation is strategic and based on an overweight/underweight pair trade. We do not see a need for specific market timing for this call (for technical indicators please refer to our website link). For convenience, the performance of both market cap-weighted and equal-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To Our Investment Case Because of the overall market neutral exposure, the portfolio performance will be largely immune to the direction of Greek economic growth and political developments. Some macro risk factors stem from a slower-than-expected property market recovery, which would affect the rental income of Grivalia Properties. Other major macro risks include an oil price drop, which would benefit Hellenic Petroleum's profit margins within its refining operations. Also, a slow recovery of consumer sentiment and retail sales would put downward pressure on Jumbo's domestic top-line performance. Company specific risks worth mentioning include remarkable management efforts in CCBA's financial performance in the coming quarters. This would send the market a bullish signal on Coca-Cola HBC's stock price due to potentially strong synergies, posing upside risk to the underweight basket. Furthermore, Jumbo would be negatively affected by excessive focus on overseas markets, and thus it could miss further business development and market share expansion opportunities in the domestic market. Last but not least, asset quality remains problematic among banks, reflected by elevated NPLs, which would weigh on performance indefinitely if not properly tackled. Billy Zicheng Huang, Research Analyst billyh@bcaresearch.com Sophie McGrath, Research Assistant sophiemc@bcaresearch.co.uk
Fiscal Stimulus To Prolong The Expansion The market swoon in early February should not induce investors to lower risk. The stock market correction (the first for almost two years) was triggered by a couple of inflation and wage readings that came in slightly above expectations, and was exacerbated by some technical factors such as automated trading by volatility-target funds. But, significantly, it was not accompanied by the usual signals of rising risk aversion: for example, credit spreads barely widened and the gold price was stable (Chart 1). Volatility is likely to remain high but, as our U.S. Investment Strategy service recently found, the VIX has not been a useful indicator of recessions and bear markets: many times over the past 30 years it has spiked higher without risk assets producing negative returns over the subsequent 12 months (Chart 2).1 Recommended Allocation Chart 1Sell-Off Didn't Trigger Risk Signals Chart 2Spike In Vix Is Not A Sell Signal Fiscal policy moves in the U.S. make us believe, rather, that the current economic expansion will last longer than we previously forecast. A combination of tax cuts plus recent spending proposals (including $165 billion on the military and $45 billion on disaster relief) will boost GDP by about 0.8% of GDP this year and 1.3% next, compared to the IMF's earlier forecast of a fiscal contraction this year (Chart 3).2 Add to that the boost from the 8% trade-weighted depreciation of the U.S. dollar over the past 12 months (which should add 0.3% to growth over two years), and it is difficult to imagine U.S. GDP growth turning down any time soon. Accordingly, BCA has shifted its recession call from the second half of 2019 to sometime in 2020. Of course, this is not all good news. The U.S. budget deficit is likely to increase to 5½% of GDP in 2019, which will put upward pressure on interest rates. The fiscal impulse will hit an economy already at full capacity, and so will be inflationary. The scenario we envisage is boom-and-bust, leading to a nastier recession than we had previously expected. Nonetheless, the boost to growth should be positive for risk assets over the next 12 months. Our model of earnings growth now suggests that U.S. EPS should continue to grow at close to a 20% rate for the rest of this year (Chart 4). Chart 3Fiscal Boost To U.S. Growth Chart 4Earnings Growth Gets A Boost Too How quickly will the Fed push back against the potentially inflationary implications of this higher growth? We have found a remarkable turnaround in investors' perceptions of inflation over the past few weeks. Whereas last year most argued that structural forces (online shopping, the gig economy etc.) meant that inflation would stay depressed, now many worry that it will quickly shoot above 2% and force the Fed to tighten policy aggressively. This has caused them to over-react, for example, to the (rather obvious) statement from the last FOMC minutes that "participants noted that a stronger outlook for economic growth raised the likelihood that further gradual policy firming would be appropriate." Our view remains that core PCE inflation - the Fed's favorite measure - is likely to move back gradually to 2% (from 1.5% currently), but not accelerate dramatically. Unit labor costs remain subdued (Chart 5), the continued rise in the participation rate means there is more slack in the labor market than implied by headline unemployment (Chart 6), and inflation expectations remain low. This should allow new Fed chair Jerome Powell to continue to withdraw accommodation at a measured pace. The market has already priced in that the Fed will tighten this year at least in line with its dots (Chart 7). We expect four, rather than the Fed's projected three, hikes this year, but this should not be too hard for the market to absorb. Chart 5Unit Labor Costs Don't Point To Jump In Inflation Chart 6 Still Some Slack In Labor Market Chart 7Market Has Caught Up To The Fed We have for some months now advised long-term, more risk-averse investors to consider dialing back risk, and the volatility in February was a good example of why. We would expect further such bouts of volatility. However, with a recession still probably two years away, and a combination of stronger-than-expected growth and a Fed reluctant to accelerate tightening, the next 12 months should remain positive for equities and other risk assets. Fixed Income: We now expect the 10-year U.S. Treasury bond yield to rise to 3.3-3.5%. This will come from a further 40 BP increase in inflation expectations (taking them back to a level compatible with the Fed achieving its inflation target) plus a rise in the real yield, as markets start to price in the end of secular stagnation (Chart 8). The rise in global yields will be exacerbated by increasing net supply, as fiscal deficits rise and central banks wind down QE (Chart 9). We are, accordingly, underweight duration, and prefer inflation-linked bonds to nominal ones. We will likely reduce our exposure to credit before we turn defensive on equities. But, for now, strong economic growth and higher oil prices mean spread product is likely to outperform government bonds. Chart 8Inflation Expectations And Real Yields To Rise Chart 9Net Government Bond Supply To Increase Currencies: Rising interest rate differentials have failed to cause the dollar to rally (Chart 10). FX markets are trading, rather, on valuations (the euro and yen are, indeed, undervalued), on current account positions (the euro zone and Japan have large surpluses), and on the narrative that U.S. twin deficits historically caused the dollar to weaken. Our FX strategists find this is true only when, as in 2001-3, U.S. real rates were falling; after the Reagan tax cuts in 1981, real rates rose, pushing up the dollar (Chart 11). The key, therefore, is how quickly the Fed reacts this time. The dollar currently has strong downward momentum (especially against the yen) and this could continue. But as global growth slows relative to the U.S., relative interest rates are likely to reassert themselves as a factor, causing the dollar to strengthen again. Chart 10Rising Rate Differentials Fails To Boost Dollar Chart 11Do Twin Deficits Matter For Dollar? Equities: Given the macro environment, we continue to recommend pro-cyclical equity tilts, with overweights in higher beta markets such as the euro zone and Japan, and cyclical sectors such as financials, energy, and industrials. Our underweight on EM equities is based on the risk of a slowdown in China (where tighter financial conditions point to a slowing of the industrial sector, Chart 12), the possibility of a U.S. dollar rebound, and the vulnerability of highly leveraged foreign-currency EM borrowers to a rise in U.S. interest rates. Commodities: Our energy team has further revised up their oil price forecast, on expectations that the OPEC agreement will be extended, which will cause a greater draw-down in oil inventories (Chart 13).3 They see Brent crude averaging $74 a barrel this year, with spikes above $80. However, the response of the U.S. shale industry will begin to kick in, pushing the price down to below $60 by end-2019. We are neutral on industrial commodities, which will benefit from stronger global growth but are at risk in the event of dollar appreciation and slowdown in China. Chart 12Tighter Monetary Conditions In China Chart 13Oil Inventories To Draw Down Further Please note that, due to the Easter holidays in some countries, the GAA Quarterly Portfolio will be published one day later than usual, on April 3. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report, "Late Innings," dated 26 February 2018, available at usis.bcaresearch.com 2 For details, please see The Bank Credit Analyst, "March 2018," available at bca.bcaresearch.com 3 Please see Commodity & Energy Strategy Weekly Report, "OPEC 2.0: Getting Comfortable With Higher Prices," dated 22 February 2018, available at ces.bcaresearch.com GAA Asset Allocation