Europe
Highlights Price inflation is paradoxically deflationary for European consumers, because there is no feedthrough from price inflation to wage inflation. Whenever price inflation has risen towards the ECB's highly-misguided 2% target, euro area real wages have gone into recession. The same is true in the U.K. Do not expect a structural sell-off in high-quality bonds. Go overweight the broad-based Eurostoxx600 versus the bank-heavy Eurostoxx50. Stay overweight the international dollar-earning FTSE100 versus the more domestic pound-earning FTSE250. Feature We have a love-hate relationship with inflation. Love, if the inflation refers to our wages. Hate, if the inflation refers to our weekly grocery bill. Put another way, inflation is good for our purchasing power when wages are going up faster than prices; it is bad when prices are going up faster than wages. Unfortunately, recent inflation has been unequivocally bad for European purchasing power. Through the past 7 years, euro area nominal wages have been growing at a remarkably steady 1-2% clip. Whereas price inflation has swung between -0.5% and 3% (Chart I-2). Therefore, whenever price inflation has stayed close to 0% (the true definition of price stability), real wages have grown very healthily. But whenever inflation has risen towards the ECB's highly-misguided 2% target, euro area real wages have gone into recession (Chart of the Week). Chart I-1The Inflation Paradox: When Price Inflation Rises to 2%, Real Wages Go Into Recession Chart I-2Nominal Wages Have Been Growing At A Remarkably Steady 1-2% The same is true in the U.K. There has been no feedthrough from price inflation to wage inflation (Chart I-3 and Chart I-4). If anything, an inverse relationship has existed. Hence, whenever inflation has declined, it has boosted real wages. And whenever inflation has risen, it has choked real wages (Chart I-5 and Chart I-6). Chart I-3Very Little Connection... Chart I-4...Between Price Inflation And Wage Inflation Chart I-5When Price Inflation Has Declined,##br## It Has Boosted Real Wages Chart I-6When Price Inflation Has Increased,##br## It Has Choked Real Wages Households Dislike 2% Price Inflation An argument we frequently hear is that highly indebted economies need higher inflation to 'inflate away their high debts'. But this logic only works if inflation is boosting the incomes of those burdened with the high debt, such as households. The problem, as we have just seen, is that there has been very little connection between the price inflation that central banks are targeting and the wage inflation that eases households' debt burdens. To its credit, the Bank of England recognises this paradox. "Continued moderation in pay growth and higher import prices following sterling's depreciation are likely to mean materially weaker household real income growth over the coming few years" 1 Inflation is ultimately a transfer of resources from those paying the higher prices to those receiving them. In a closed economy, the winners and losers might balance out. However, Europe is a large net importer of food and energy, whose demand is inelastic and whose prices are denominated in dollars. Therefore, currency weakness transfers resources from domestic consumers to foreign producers. As the BoE goes on to say: "Over the next few years, a consequence of weaker sterling is that the higher imported costs resulting from it will boost consumer prices... and the hitherto resilient rates of household spending growth will slow as real income gains weaken." Exactly the same dynamic applies to the euro area as a consequence of the weaker euro. The difference is that sterling's Brexit-induced slump was out of the BoE's control, whereas the euro's weakness is a direct consequence of the ECB's extreme and experimental monetary easing. The ECB is keen to tell us about the benefits of its extreme monetary easing; it is less keen to tell us about the costs. However, we believe that the benefits have diminished while the costs are rapidly rising. And absent a major shock, the ECB should end its risky experiment. What's Up With Wage Growth? The intriguing question is: why has there been little connection between price inflation and wage inflation? The BoE observes that pay growth has remained persistently subdued by historical standards - strikingly so in light of the decline in the rate of unemployment to below 5%. This outcome is likely to reflect a substantial decline in the 'equilibrium unemployment rate', the point at which wage pressures start to bubble up. The explanation comes from the type of jobs created in recent years. ECB research points out that the dynamics of wages not only reflect changes in wages at the individual level, but are also influenced by changes in the composition of employment. "The structure of recent employment creation may have contributed to low wage growth in the euro area. Since the second quarter of 2013, employment creation in the euro area has been stronger in sectors associated with relatively lower wage levels and wage growth rates. This employment composition effect puts a drag on average wage growth." 2 Automation and Artificial Intelligence (AI) are major drivers of this composition effect. Moreover, as we argued in The Superstar Economy: Part 2,3 the effect has much further to run. "Many of the jobs that AI will destroy - like credit scoring, language translation, or managing a stock portfolio - are regarded as skilled, have limited human competition and are well-paid. Conversely, many of the jobs that AI cannot (yet) destroy - like cleaning, gardening, or cooking - are relatively unskilled and are low-paid." With well-paid jobs being displaced by low-paid jobs, job creation itself might still seem very healthy and the unemployment rate might be falling to levels associated with 'full employment' - prompting some people to warn that wage inflation is about to take off. Except it won't, for two reasons: first, the AI-displaced formerly well-paid workers are downshifting to lower-paid work; second, the added supply of labour competing for the lower-paid work keeps a lid on the wages for that lower-paid work. In the U.S., the Federal Reserve Board of San Francisco points out that: "As long as employers can keep their wage bills low by replacing or expanding staff with lower-paid workers, labour cost pressures for higher price inflation could remain muted for some time." 4 A further point is that if employment creation is in jobs with lower wages, wage growth, and job security, then it will also constrain credit growth. Lacking income growth or security, households will be unwilling to borrow and banks will be unwilling to lend. Absent strong credit growth, we subscribe to a monetarist conclusion: a generalised and sustained inflation - a wage-price spiral - cannot take hold. Some Investment Considerations For the foreseeable future, there will be little feedthrough from price inflation to wage inflation. So whenever price inflation picks up - as is now happening in the U.K. and the euro area - it will choke real wages. Therefore paradoxically, price inflation will be deflationary for European consumers. This will prevent a structural sell-off in high-quality bonds. For a U.K. equity portfolio at this juncture, it means tilting towards international exposure. Stay overweight the international dollar-earning FTSE100 versus the more domestic pound-earning FTSE250 - especially given that sterling could come under renewed pressure after the U.K. formally files for its divorce from the EU (Chart I-7). For a broader European equity portfolio, prefer non-financials over financials. A very easy way to implement this is to go overweight the broad-based Eurostoxx600 versus the bank-heavy Eurostoxx50 (Chart I-8). Chart I-7Overweight The International Dollar-Earning ##br##FTSE100 Versus The FTSE250 Chart I-8Overweight The Broad Eurostoxx600##br## Versus The Bank-Heavy Eurostoxx50 Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 From the Bank of England Monetary Policy Summary and minutes of the Monetary Policy Committee meeting on February 1, 2017. 2 From the ECB Economic Bulletin, Issue 3 / 2016: Recent wage trends in the euro area. 3 Published on January 19, 2017 and available at eis.bcaresearch.com 4 From the FRBSF Economic Letter March 7, 2016: What's Up with Wage Growth? Fractal Trading Model* This week's recommendation is a commodity pair-trade: long tin / short copper. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights Markets are facing large tail risks - both negative and positive; Donald Trump is a "Fat-Tail" president; European politics offer both a right-tail risk - German Europhile turn ... ... And a left-tail risk - Italian election and a shock in France; Investors should turn to the options market for opportunities. Feature "Stock market hits new high with longest winning streak in decades. Great level of confidence and optimism - even before tax plan rollout!" President Donald Trump "tweet" - February 16, 2017 Global stocks continue their tear as the market shrugs off President Trump's tweets, European Black Swans, saber-rattling in the South China Sea, and fears of de-globalization. Some of the optimism is backed by economic data, but mostly by the "soft data," or survey-based indicators (Chart 1).1 Chart 1Not Much Behind The Optimism Aside From Animal Spirits So, why the party? It's the Animal Spirits. The bears are in retreat ... or facing deportation! We think investors are betting that the combination of the Brexit referendum and election of Donald Trump has forced policymakers to take their heads out of the sand. The market believes that policymakers have heard the angry electorate whose message is that dithering over economic policies must stop. BCA has been in this camp since last summer, when our colleague Peter Berezin penned an optimistic missive titled "The Upside To Populism."2 The hope that urgency will translate to expediency is what we think has propelled the S&P 500 to one of its best post-election performances (Chart 2). Trump's market performance is in the 83rd percentile of post-election outcomes. As promised, Trump has delivered a win. Chart 2Trump Is Winning The S&P 500 Contest The danger is that the market is extrapolating from the Trump presidency all the "right-tail" or super-positive policy outcomes without accounting for any left-tail events. Trump is a "Fat-Tails" president, an unorthodox politician that could break the gridlock and deliver positive change, but whose brand of nationalist populism may also produce paradigm-shifting crises along the way. Several indicators suggest that caution is warranted. Our U.S. Equity Strategy colleagues offer two measures of complacency, the valuation-to-volatility ratio (Chart 3) and "Complacency-Anxiety Index" (Chart 4).3 Both are stretched and suggest that the market has never been as engrossed by the right-tail narrative as today. Given our constraints-based methodology, we are concerned by how certain the market appears. It seems to believe that all the wonderful things that Trump has promised will face no constraints, while his nationalism and mercantilism will be discarded. Chart 3Market Sees Only Right Tails Chart 4Complacency Reigns First, on the domestic front, Trump faces several mounting constraints: Political capital: Trump is an unpopular president (Chart 5), at least by the standards of his peers who enjoyed a post-election "honeymoon." This could affect his relationship with the GOP-controlled Congress that hardly warmed up to him in the first place. Precedent: Congress is struggling to produce Obamacare-replacement legislation, which the GOP had six years to prepare for. This bodes poorly for the timeliness of other legislation, like tax reform. Paying for stimulus: Republicans and the White House appear to be at odds over how to pay for the coming household and corporate tax cuts. The former want to pass the controversial border adjustment tax (BAT),4 while the Trump administration may not care how tax cuts are paid for. The BAT proposal is also facing opposition from major retailers and its legality under the WTO is still in question. Infrastructure: Spending on infrastructure, which is a no-brainer and has broad public support (Chart 6), has not seen a concrete plan despite Trump's emphasis on it during his inaugural address and campaign. Chart 5Trump's Approval Ratings Dismal Chart 6Everyone Loves New Roads In addition to the domestic political agenda, investors must deal with a packed European political calendar that we elucidated in last week's report5 (Table 1) and a potential U.S.-China trade war that could spill over into military tensions in the South China Sea.6 Table 1Busy Calendar For Europe This Year Investors may have been lulled into complacency by the February 10 phone call between presidents Xi and Trump. During the call, Trump committed to uphold the "One China" policy that has formed the bedrock of the Beijing-Washington rapprochement since 1972. A week later, on February 16, China suspended all imports of coal from North Korea - 50% of the country's entire export haul - until the end of the year. The move was a big nod to Donald Trump, a message by Beijing that China can play the role of an indispensable partner - if not outright ally - in the region. These moves have put fears of trade protectionism, our main candidate for a catalyst of a market correction, on the backburner. Investors can certainly be disappointed by smaller-than-expected tax cuts and tepid infrastructure spending, but such policy reversals will only encourage the Fed to stay easy and thus prolong the party. In the context of a synchronized global growth recovery - with both the global (Chart 7) and U.S. (Chart 8) economies looking decent - investors will not be deterred from bullishness merely by congressional intrigue. Chart 7Global Growth Looks Solid ... Chart 8... And So Does U.S. Growth The problem for investors is that the main two risks to global markets in 2017 have no set timeline. Last week, we pointed out that the main political risk in Europe is the Italian election whose date could be in autumn, or even as late as spring 2018. Today we add the French election to the list, where Marine Le Pen is mounting a furious rally on the back of rioting in the banlieue of Aulnay-sous-Bois. Similarly, Trump's mercantilism may remain dormant as he focuses on immigration, the "dishonest media," and cabinet appointees, even though it is very real. His administration is laser-focused on correcting a major perceived ill of the U.S. economy: the current account deficit. Therefore, investors should certainly welcome the Xi-Trump phone call, but the fact that the two leaders spent valuable time reaffirming a policy set 45 years ago should not be encouraging. In fact, the Trump administration has since asked the U.S. Trade Representative's office to consider changing how it calculates the U.S. trade deficit. According to the Wall Street Journal, Trump's White House is looking to exclude "re-exports" - goods imported into the U.S. merely so they can be assembled and then exported - from the calculation of U.S. exports.7 This would naturally balloon the U.S. trade deficit and give the Trump administration greater political ammunition - particularly against Mexico - for retaliation. Given solid global growth data, extremely positive surveys, and a market narrative still focused on the "Upside of Populism," it is tempting for investors to throw caution to the wind. Every time we encounter a bear in a client meeting or conference, we ask if he or she would "buy on dips" in case a correction happened. Their answer is almost universally "yes." It is difficult to see how a correction occurs in such an environment, where nobody actually expects a bear market. Although we are throwing in the towel with our two hedges - both the S&P 500 and Eurostoxx hedges have stopped out, we continue to stress that the market has priced in none of the left-tail risks that remain. We have a Fat-Tail President in the White House and an increasingly binary resolution to the euro area saga in the making in Europe. Fat Tails In Europe Since late 2016, we have suspected that Merkel's rule is unsustainable.8 However, while most investors fretted that Merkel would be replaced by a Euroskeptic, we considered that outcome extremely unlikely (at least in the current electoral cycle). For one, the refugee crisis that befell Europe would be short-lived, and indeed it is now over (Chart 9). For another, Germans are not Euroskeptics. What is astonishing is how quickly the German political establishment has realized and sought to profit from these facts. Instead of opposing Merkel with a cautious choice, the center-left Social Democratic Party (SPD) has turned to an unabashed Europhile, former President of the European Parliament Martin Schulz. Schulz is a relative unknown in Germany and was perceived by Merkel's coterie as a lightweight. On the surface, this made sense. Schulz has no university education and worked as a bookseller before becoming a politician. However, he knows EU politics extremely well, as he has been a member of the European Parliament since 1994. He has therefore heard every Euroskeptic argument on the continent and has learned to counter it emphatically. And he seems to understand the benefits that euro area membership has bestowed upon Germany, a view he appears to share with 80% of the German public, if the latest polls are to be believed (Chart 10)! Chart 9Migrant Crisis Waning Chart 10Germans See The Euro As A Great Deal Thus far, Schulz's campaign has focused on three main lines of attack: the traditional SPD call for greater economic redistribution, general appeal for European solidarity, and blaming Merkel for the rise of populists. To everyone's surprise - other than folks who understand how Germany works - this has been a successful approach. In just three weeks, the SPD has gone from trailing Merkel's Christian Democratic Union (CDU) by double digits to leading in the polls for the first time since 2001 (Chart 11). What should investors make of Schulz's meteoric rise? For one, nobody should get too excited, as the election is still a long seven months away. However, the SPD's resurrection suggests that the German political marketplace has been demanding a genuinely pro- euro area political alternative to the overly cautious Angela Merkel for some time. In other words, Schulz has realized that the median voter in Germany is far more Europhile than the conventional wisdom and Merkel have thought. Again... Chart 10 says it all! Unfortunately for the euro, Germany's Europhile turn may be too little too late. Italy's election is a major risk. As with the threat of American mercantilism, Italian elections are a risk that we cannot properly time. Furthermore, polls remain extremely close in Italy, suggesting that the election could go either way between the establishment and Euroskeptic parties. At this point, the best outcome may be a hung parliament. Meanwhile, the ongoing unrest in the northeast suburb of Paris, Aulnay-sous-Bois, appears to have given Marine Le Pen some wind in her sails (Chart 12). She has closed her head-to-head polling gap against Francois Fillon and Emmanuel Macron to just 12% and 20% respectively. Our net assessment is that she is not going to win, but our conviction level is declining. Her subjective probability has climbed to well over 20% at this point. Chart 11Pro-Europe Sentiment Drives SPD Revival Chart 12Le Pen Lags By 12-20% In Second Round Similar rioting in 2005 launched the political career of one Nicolas Sarkozy, who, as the country's Minister of Interior, took a hard line approach to the unrest, which launched him into the presidency. The lesson from Sarkozy's rise is important for two reasons. First, unrest in France's banlieues is politically relevant. These frequent bursts of violence support the National Front (FN) narrative that the integration of migrants has failed, that the country needs full control over its borders, and that the elites in Paris are not serious about law and order. The second lesson is that centrist, establishment politicians have no problem with being tough on crime, minorities, or immigrants. Sarkozy's rhetoric in 2007 mirrored much of the FN electoral platform. There is enough time, in other words, for Macron and Fillon to do the same in 2017. This will be particularly easy for Fillon, whose immigration policies already echo those of the FN. Chart 13ECB Policy Will Stimulate Core Europe Macron, however, could be in trouble in the second round. And at the moment, he is more likely to face Le Pen in the second round than Fillon. As we pointed out in last week's missive, Macron could struggle to get right-wing voters to support him in the second round. We still do not have a historical case where right-wing voters were the ones who swung against the FN. In both the 2002 presidential election and the 2015 regional elections, it was mostly left-wing voters who swung to the center-right to keep the FN out of power. Will French conservative voters come out and support a centrist candidate like Macron who may be perceived as "soft" on crime? Time will tell. His polling appears to be holding up well against Le Pen, but her momentum is now rising. Bottom Line: Europe faces its own version of Fat Tails in 2017. On the one hand, we expect the ECB to remain easier than consensus would have it, given the mounting political risks in the periphery. We expect the ECB to ignore the broad euro area economy and focus on the interest rates that the periphery - namely Italy - needs (very low for very long time) (Chart 13). When combined with a Europhile turn in Germany and a positive fiscal thrust as the EU Commission turns against austerity, we see a Goldilocks scenario for euro area assets over the short and medium term. We are betting that this right-tail risk will ultimately prevail. On the other hand, Italian elections could knock the train off the rails at any time. Due to the announced leadership race in the ruling Democratic Party (PD), the election will most likely have to take place after the summer. Or, it may have to be put off until Q1 2018. But whenever it is announced, it will become the risk to European and global assets. For now, we continue to recommend that clients remain overweight euro area equities. However, vigilance will be needed as the market climbs the wall of worry. Investment Implications - Trading Fat Tails In A Low-Vol World What should investors do in a world that is increasingly exemplified by our Fat-Tails thesis? Current levels of the VIX suggest that the market is not pricing in a potentially higher level of volatility, which we would intuitively expect to rise in a Fat-Tail world (Chart 14). On the other hand, current low levels of volatility may merely be the calm before the storm. Investors may be "frozen" by the high probability of both left- and right-tail outcomes and thus choosing to sit on the sidelines instead of committing to any one narrative. Chart 14Volatility Extremely Low One way to think about investing in this world is to turn to the options market. The options market is unique in that it allows investors to take a view on the dispersion of the expected returns of the asset against which the option is written.9 This is because one of the critical components of a call or put option's value is the expected volatility of returns for the asset underlying the option itself. Volatility is trading-market shorthand for the annualized standard deviation of expected returns for the underlying asset. Volatility is a calculated value, whereas the other components of an option's price - i.e. the underlying asset's price, the strike price, time to expiration, and interest rates - are known inputs. Volatility, like the price of the underlying asset, is "discovered" when a trade occurs. After an option trades and its premium is known, an option-pricing model - e.g., the Black-Scholes-Merton model - can be run backwards, so to speak, to see what level of volatility solves the pricing model for the value that cleared the market. This is known as the option's implied volatility, because it is the expected standard deviation of returns implied by the price at which the option clears the market. One reason investors and traders buy and sell options is to express a view on implied volatility. Option buyers who think the market is underestimating the likelihood of sharply higher returns can express this view by buying out-of-the-money options. This can arise for any number of reasons, but they all boil down to one essential point: option buyers think there is a higher probability that returns will be higher or lower during the life of an option than what is being priced in the options market.10 Option sellers, on the other hand, are expressing the opposite view. We believe the geopolitical tail risks we have discussed in this report are not being fully reflected in the options markets most sensitive to this information, among them the gold market. Our own assessment of these risks implies much fatter tails than we currently observe in out-of-the-money gold options. For this reason, we are recommending investors consider buying $1,200/oz gold puts and $1,300/oz gold calls expiring in either June or December of this year. This is a strategic recommendation. We leave it to investors to set their own stop-loss, if they are not comfortable foregoing the full premium paid to hold these options to expiry, possibly expiring worthless. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Robert Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Downside To Full Employment," dated February 3, 2017, available at gis.bcaresearch.com. 2 Please see Global Investment Strategy Special Report, "The Upside To Populism," dated August 19, 2016, available at gis.bcaresearch.com. 3 Please see U.S. Equity Strategy Weekly Report, "Bridging The Gap," dated February 6, 2017, available at uses.bcaresearch.com. 4 Please see Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?" dated February 8, 2017, available at gps.bcaresearch.com. 5 Please see Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 6 Please see Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?," dated January 25, 2017, and "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 7 "Please see William Mauldin and Devlin Barrett, "Trump Administration Considers Change In Calculating U.S. Trade Deficit," Wall Street Journal, February 19, 2017, available at www.wsj.com. 8 Please see Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 9 Call options give the buyer the right to go long an underlying asset at the price at which an option contract is struck - i.e. the option's strike price. Puts give option buyers the right to go short the underlying asset at the price at which the contract is struck. While an option buyer is not required to ever exercise an option, option sellers must take the other side of the deal if the buyer chooses to exercise. Option buyers pay a premium for the put or call they purchase. 10 This probability also can be expressed in terms of price levels, which allows investors to take an explicit view of the likelihood of a particular price being realized during the life of the option being purchased. Please see Bob Ryan and Tancred Lidderdale, "Energy Price Volatility and Forecast Uncertainty," published by the U.S. Energy Information Administration (2009), for a discussion of options markets and implied volatility. "Appendix II: Derivation of the Cumulative Normal Density for Futures Prices" beginning on p. 22 shows how to transform the returns distribution into a price distribution. It is available at https://www.eia.gov/outlooks/steo/special/pdf/2009_sp_05.pdf. Geopolitical Calendar
Dear Client, In addition to our regular Weekly Report, we sent you a Special Report on Wednesday prepared by my colleague Marko Papic, BCA's chief geopolitical strategist, assessing the election landscape in Europe this year. Best regards, Peter Berezin, Senior Vice President Global Investment Strategy Highlights Global growth has accelerated, corporate earnings are rebounding, and leading indicators suggest that these positive trends will persist over the remainder of the year. This supports our cyclically bullish view on global equities. Looking further out, the impulse to growth from the easing in financial conditions that began in early 2016 will fade, setting the stage for a slowdown in 2018. If growth does falter next year, easier fiscal policy could provide an offsetting tailwind. However, there continues to be a large gap between what politicians are promising and what they can realistically deliver. What is different this time is that spare capacity is much lower than it was during previous mid-cycle slowdowns. Thus, while global bond yields could eventually dip, they remain in a secular uptrend. Feature The Elusive Correction We have been arguing since last fall that stronger global growth will help fuel a variety of reflationary trades.1 This part of our view has panned out nicely. What has surprised us is just how relentlessly the market has traded that view. With the exception of a few small wobbles, the S&P 500 has basically marched higher since the morning following the U.S. presidential election. Reflecting this development, the VIX fell to near record low levels earlier this week (Chart 1). The market's failure to take a breather has sabotaged our efforts to have our cake and eat it too - to maintain an overweight stance on global equities, while also profiting from the occasional correction. In contrast to our last three tactical hedges - which generated a cumulative return of 42% - our latest hedge is now down 9%. That's a lot of red ink. Out of pure risk management considerations, we will close this trade if the loss breaches 10%. Nevertheless, most indicators continue to warn of a looming correction. In particular, our U.S. equity strategists' new "Complacency-Anxiety" index is at an all-time high, suggesting that stocks have entered a technical overshoot phase (Chart 2).2 Chart 1VIX Is Near Record Lows Chart 2Complacency Reigns Cyclical Picture Still Solid In contrast to the short-term outlook, the 12-month cyclical picture for risk assets still looks reasonably good. Measures of current activity are rebounding as animal spirits begin to kick in (Chart 3). Falling unemployment and stronger wage growth are causing households to open their wallets. Against the backdrop of decreasing spare capacity, firms are reacting to this by increasing investment spending. Capital goods orders in the G3 economies have jumped higher in recent months, and capex intention surveys are pointing to further upside (Chart 4). Chart 3Current Activity Indicators Are Rebounding Chart 4An Upswing In Capex Corporate earnings have also accelerated on the back of faster economic growth. Consensus estimates call for global EPS to expand by 12% in local-currency terms this year, with the S&P 500 registering 10.4% growth, the STOXX Europe 600 gaining 14.3%, Japan's TOPIX adding 12.5%, and MSCI EM leading the pack at 16%. Outside the U.S., year-to-date earnings revisions have generally been positive, particularly in Japan and EM (in the U.S., 2017 EPS estimates have ticked down a modest 0.8%). BCA's in-house earnings models are consistent with this optimistic profit picture (Chart 5). What accounts for this fortuitous turn of events? A number of reasons help explain why growth accelerated in the second half of 2016: The drag on global growth from the plunge in commodity sector investment ran its course. U.S. energy sector capex, for example, tumbled by 70% between Q2 of 2014 and Q3 of 2016, knocking 0.7 percent off the level of U.S. GDP. The fallout for commodity-exporting EMs such as Brazil and Russia was considerably more severe. The global economy emerged from a protracted inventory destocking cycle (Chart 6). In the U.S., inventories made a negative contribution to growth for five straight quarters starting in Q2 of 2015, the longest streak since the 1950s. The U.K., Germany, and Japan also saw notable inventory corrections. Fears of a hard landing in China and a disorderly devaluation of the RMB subsided as the Chinese government ramped up fiscal stimulus, helping to reflate the economy. Global growth benefited with a lag from the easing in financial conditions that began in earnest in early 2016. Government bond yields fell to record low levels in July. In addition, junk bond spreads collapsed, dropping from a peak of 7.9% in February to 4.3% by year-end (Chart 7). Higher equity prices, particularly in a number of beaten down emerging markets, also helped. Chart 5Broad-Based Acceleration In Corporate Earnings Chart 6Inventory Destocking Was A Drag On Growth Chart 7Corporate Borrowing Costs Have Fallen How Much Longer? Chart 8Improvement In Global ##br##Leading Economic Indicators The key question for investors is how long the good times will last. Right now, most leading indicators that we follow are signaling that the expansion will endure for the remainder of this year (Chart 8). As we look towards 2018, however, things get murkier. Conceptually, it is the change in financial conditions that matters for growth. While the ongoing rally in global equities and continued narrowing in credit spreads has contributed to some easing in financial conditions since the U.S. presidential election, this has been partly offset by higher government bond yields. A stronger dollar has also led to an incremental tightening in the U.S., as well as in some emerging markets with high levels of U.S. dollar-denominated debt. As such, it is likely that the positive "impulse" to economic growth from the easing in financial conditions that took place last year will begin to dissipate towards the end of this year. Fiscal Policy To The Rescue? If growth does slow next year, easier fiscal policy could provide an offsetting tailwind. The fiscal thrust for developed economies turned positive in 2016, the first year this happened since 2010 (Chart 9). However, it remains to be seen whether this trend will continue. There is little support among Republicans in Congress for a big infrastructure program. It once seemed possible that Chuck Schumer and his fellow Democrats could find common ground with President Trump on this issue, but that is looking less likely with each passing day, given the level of vitriol in Washington. Broad-based tax cuts are a certainty, but the risk is that they will be coupled with cuts to government spending. Empirically, the latter have a larger "multiplier effect" on GDP than the former. To complicate matters, the introduction of a border adjustment tax - something to which we assign 50% odds - could generate significant near-term dislocations for the global economy.3 Meanwhile, much of Trump's regulatory agenda is in limbo. A repeal of Dodd-Frank is off the table. Senate Republicans do not have the 60 votes needed to scrap it. The Volcker rule is here to stay. On the other side of the Atlantic, the European Commission has recommended a further loosening in fiscal policy this year, but member states themselves are actually targeting somewhat smaller fiscal deficits (Chart 10). As is often the case, budgetary overruns are likely, but with the Greek bailout program now back on the ropes, Germany and a number of other countries may begin to dial up the austerity rhetoric. Chart 9Will Fiscal Policy Continue To Ease? Chart 10European Commission Recommending Greater Fiscal Expansion Uncertainty over the slew of European elections slated for this year could also weigh on business sentiment. Marine Le Pen is likely to place first in the initial round of the French presidential election, but faces an uphill battle in the subsequent runoff. Nevertheless, betting markets are assigning a one-in-three chance of Le Pen becoming president - similar to the odds they were assigning to a Brexit "yes vote" and a Trump victory (Chart 11). Italy also remains a risk, as my colleague Marko Papic, BCA's chief geopolitical strategist, discussed in this week's Special Report.4 Anti-euro sentiment is now stronger there than in any other major European economy (Chart 12). Chinese fiscal policy has already tightened significantly, with the year-over-year rate of change in government spending falling from a high of 25% in November 2015 to zero at present (Chart 13). So far the Chinese economy has held up well, but there is a risk that this may change. Despite Trump's backpedaling on the "One China" question, we expect the Trump administration to declare China a currency manipulator later this year. This will pave the way for higher tariffs on a variety of Chinese goods, which could lead to retaliatory measures by China. Chart 11Brexit, Then Trump... Is Le Pen Next? Chart 12Italy: Anti-Euro Sentiment Is A Risk Chart 13China: Fiscal Stimulus Is Fading Investment Conclusions Chart 14Diminished Slack In The Global Economy Global growth continues to be strong, and is likely to stay that way for the remainder of this year. However, there is a heightened risk that the global economy will falter in 2018. We remain cyclically overweight global equities and underweight government bonds, but are not dogmatic about this view. As the discussion above suggests, plenty of things could derail the reflation trade. If evidence begins to mount that a slowdown is coming earlier than we think, we will turn more bearish on stocks. Given that equities are technically overbought at present, we would not fault anyone for taking some money off the table. If growth does slow in 2018, does this mean that bond yields will fall back towards last year's lows? We don't think so. For one thing, a major deflationary commodity bust of the sort we endured in 2014-15 is not in the cards. In addition, there is less slack in the global economy now than there was last year, or for that matter, anytime since early 2008 (Chart 14). As we discussed in our Q1 Strategy Outlook, potential GDP growth is likely to remain structurally depressed across much of the world, owing to slower productivity and labor force growth.5 Lower potential growth means that excess capacity could continue to be absorbed even if growth slows somewhat from its current well-above trend pace. In the U.S., this absorption of excess capacity is nearly complete, with most labor market indicators suggesting that the economy is approaching full employment (Chart 15). In this vein, we would heavily discount the decline in average hourly earnings in January's employment report. Chart 16 shows that this was mainly driven by an anomalous drop in compensation in the financial sector. Broader measures continue to point to brewing wage pressures (Chart 17). We expect the Fed to raise rates three times this year, one more hike than the market is now pricing in. If this happens, the dollar is likely to strengthen modestly over the remainder of the year. Chart 15U.S. Economy Approaching ##br##Full Employment Chart 16Financial Sector Dragging ##br##Down Hourly Earnings In The U.S. Chart 17U.S.: Broad Measures Pointing ##br##To Rising Wage Pressures Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen," dated October 14, 2016, available at gis.bcaresearch.com. 2 Please see U.S. Equity Strategy Weekly Report, "Bridging The Gap," dated February 6, 2017, available at uses.bcaresearch.com. 3 Please see Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. 4 Please see Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 5 Please see Global Investment Strategy, "Strategy Outlook First Quarter 2017: From Reflation To Stagflation," dated January 6, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Bonds are universally unloved. The economic 'mini-upswing' is extended. 6-month bank credit impulses have rolled over. Europe is entering a period of high-impact political events. Equities are universally loved. If bond prices bounce back, Bank equities are losers and Real Estate equities are winners. Feature From time to time it is worth stepping out of the herd and asking: is the herd heading in the right direction? Given the seemingly universal dislike of high-quality government bonds, this week's report goes through five reasons why bonds could make a surprising comeback in the coming months.1 Chart of the WeekBrexit And Trump Distorted An Otherwise Typical Mini-Cycle Upswing 1. Bonds Are Universally Unloved The extent of herding in bonds is extreme on both a 65-day and 130-day basis (Chart I-2). The herd is a good metaphor for financial markets given the capacity for investor sentiment to move en masse. However, excessive herding is dangerous, because it destroys market liquidity. Chart I-2The Extent Of Herding In Bonds Is Extreme Liquidity - defined as the ability to buy or sell an investment in large volume without moving its price - requires healthy disagreement. After all, at today's price, if you sell a bond and I buy it from you, we are disagreeing about the attractiveness of the price. If many investors disagree on the attractiveness of the price, then there will be plenty of liquidity. The main reason for healthy disagreement and plentiful liquidity is that the market is usually split between short-term momentum traders and long-term value investors. If the price fluctuates downwards, the momentum trader interprets this as a strong sell-signal but the value investor sees it as an equally strong buying-opportunity. Hence, the two types of investor can trade with each other in large volume without moving the price (much). However, if the value investor flips to become a momentum trader and sells rather than buys, the price must fall until it attracts a bid from a deep value investor. If the deep value investor then also flips to become a momentum trader, the price must fall further until it attracts a bid from an even deeper value investor. And so on... As everybody in turn flips to the same view, the herd and the trend will get stronger and stronger. The tipping point comes when there is nobody left to flip and to join the herd. If a value investor then suddenly reverts to type and puts in a buy order, he will find that there are no sellers left. Liquidity has evaporated, and to replenish it might require a substantial reversal in the price. On both our 130-day and 65-day herding indicators, bonds appear vulnerable to such a reversal in the coming weeks. 2. The Economic 'Mini-Upswing' Is Extended Chart 1-3Major Economies Exhibit ##br##Very Clear 'Mini-Cycles' A typical business cycle lasts multiple years. But within this longer cycle, major economies exhibit very clear 'mini-cycles' whose upswings and downswings last 6-12 months (Chart I-3). As we demonstrated in Slowdown: How And When? 2 these mini-cycles result from the perpetual interplay between changes in bond yields, accelerations/decelerations in credit growth, and accelerations/decelerations in economic growth. The inception of the current mini-upswing coincided with last February's G20 meeting in Shanghai. At the start of 2016, global growth appeared to be stalling and financial markets were fragile. In response, a so-called 'Shanghai Accord' facilitated a synchronized stimulus in the major economies - either directly, or in the case of the U.S., a watering down of monetary tightening expectations. By spring last year, bond yields were forming a typical mini-cycle bottom. But in June, the Brexit shock sent yields sharply, but briefly, lower. Conversely, the Trump shock-victory in November accelerated the upswing in yields that was already well underway (Chart of the Week). Absent these two political shocks, 2016 produced a typical mini-upswing whose duration is now approaching 12 months - making it long in the tooth. Mini-upswings do not die of old age. But it would be highly unusual for the economy's credit-sensitive sectors not to feel a strong headwind now from the sharp upswing in bond yields. 3. 6-Month Bank Credit Impulses Have Rolled Over 6-month credit impulses have indeed rolled over in the major economies (Chart I-4 and Chart I-5), exactly as would be expected after a sustained upswing in bond yields. Chart I-46-Month Credit Impulses Have ##br##Rolled Over In Major Economies... Chart I-5... And ##br##Globally Now you could argue that the upswing in bond yields is simply a response to improved expectations for growth. The problem with that argument comes from the inter-temporal and geographical distribution of that potential growth pickup. U.S. fiscal stimulus and infrastructure spending is an uncertain tailwind to be felt in 2018, or end 2017 at the earliest. Furthermore, this stimulus is unlikely to benefit Europe or other economies outside the U.S. Yet the recent rise in bond yields and weakening of credit impulses has occurred everywhere. Compared to Trump's intangible stimulus, the choke on credit-sensitive sectors is a certain headwind whose impact will be felt sooner and more universally. 4. Europe Is Entering A Period Of High-Impact Political Events The next few months will also see a sequence of potentially high-impact political events in Europe. The Netherlands and France hold elections in which disruptive populist politicians are likely to perform well, though probably not well enough to gain power. Meanwhile, Greece appears to be reneging on the terms and conditions of its latest bailout - whose next tranche of funds it needs to make a large debt repayment in July. Into this sensitive mix, add the start of the formal and potentially acrimonious divorce proceedings between the U.K. and the EU27, due to start by the end of March. To be clear, the probability of a shock outcome in any of these individual events is low. But the probability of a shock from at least one of these multiple events is not so low. If the probability of an individual shock is, let's say, 20% then the probability that the event goes smoothly is clearly 80%. Therefore, the probability that all four events go smoothly would be 0.8 to the power of 4, equal to 41%.3 Which means that the probability of at least one shock would be a significant 59%. Perhaps the probability of an individual shock in any of these four events is less than 20%. However, there are also other more nebulous sources of risk, such as the possibility of early elections in Italy, and a disruptive outcome. To reiterate, an individual risk might be low or very low. But the chance of at least one shock in the upcoming sequence of events must be close to evens. And this is the chance that high-quality government bonds will receive significant haven demand at some point in the coming months. 5. Equities Are Universally Loved High-quality government bonds are universally unloved, but mainstream equities have the opposite problem. They are universally loved. The extent of herding in equities is extreme on a 65-day basis (Chart I-6). Chart I-6The Extent Of Herding In Equities Is Extreme This perfect symmetry of herding behaviour suggests to us that if investors suddenly fall out of love with equities - even briefly - then unloved bonds would be the very likely beneficiaries. Pulling all of the five arguments above together, we conclude that the odds of a tactical retracement in high-quality government bond yields in the next 3-6 months are more than evens. And we would position accordingly. In this eventuality, stock market investors should note that the sector that might be most vulnerable is Bank equities (Chart I-7). Conversely, the sector that might be one of the biggest beneficiaries is Real Estate equities (Chart I-8). Chart I-7If Bond Prices Bounce Back, ##br##Bank Equities Are Losers... Chart I-8... And Real Estate ##br##Equities Are Winners Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Our analysis throughout uses the JP Morgan Global Government Bond Index as the best representation of the direction of high-quality government bonds, including those in Europe. 2 Published on February 2, 2017 and available at eis.bcaresearch.com 3 Strictly speaking, this assumes that all four events are independent - that is, the outcome of one does not influence the outcome of another. Fractal Trading Model There are no new trades this week. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights The USD bull case is now well known by the market, but this is not strong enough a hurdle to end the dollar's run. The behavior of positioning, the U.S. basic balance of payments, interest rate expectations, and relative central bank balance sheets suggest we are entering the overshoot phase of the rally. Volatility will increase and differentiation on the dollar's pairs is becoming more important. Reflation plays are especially in danger, and the euro could be handicapped by political risk. The yen remains the preferred mean to play the ongoing dollar correction. Feature The dollar bull market has been echoing the path traced in the 1990s (Chart I-1). The key question for investors now is whether the dollar can continue to follow this road map or is the bull market over. The dollar bullish arguments are now well known by market participants, increasing the risk that purchases of the dollar might exhaust themselves. We review the indicators that worry us most and conclude that the dollar bull market could run further. However, as the dollar is now moving into overshoot territory, we expect that the volatility of the rally will only grow. Also, divergences in the dollar on its pairs are becoming more likely. We remain short USD/JPY, and explore the risks to the euro's near-term outlook. Signs Of An Overshoot? Sentiment The first factor that worries us about the future of the USD bull market is the near universality of the positive disposition of investors toward the dollar. However, two observations are in order. First, both sentiment and net speculative positions are not nearly as stretched as they were at the top of the Clinton USD bull market (Chart I-2). Second, it took six years of elevated bullishness and long positioning to prompt the end of the bull market in 2002. Either way, the dollar can continue to climb despite this handicap. Chart I-1Will History Repeat Itself? Chart I-2In The 1990s, The Consensus Was Right This reflects the fact that currency markets can often fall victim to something called the "band-wagon" effect, where a strong trend attracts more funds and perpetuates itself. Chart I-3America Is Great Again, ##br##At Least According To Investors We think this is caused by two factors. Valuation signals in the currency market have a poor track record at making money on a less than 2-year basis. This means that such signals need to be extremely strong before investors act on them. The dollar being 10% overvalued does not fit this description, instead a 20% to 25% overvaluation would hit that mark. Also, a strong upward move in a currency attracts funds to that economy. This creates liquidity in that nation's banking sector, alleviating some of the economic pain created by a rising currency or the tighter monetary policy that often caused the currency in question to rise in the first place. Today, the U.S. economy fits this bill, as private investors are rapaciously grabbing U.S. assets (Chart I-3). The Basic Balance Of Payments We have been struggling with how to interpret a strong basic balance of payment position. On the one hand, an elevated basic balance suggests that there is buying out there supporting a nation's currency. On the other hand, a strong basic balance position, especially if not caused by a current account surplus, suggests that market participants have already implemented their purchases of that nation's currency's and assets. These investors thus need further positive shocks to buy even more of that currency in order to lift its exchange rate ever higher. Today, the basic balance of payments in the U.S. is at a record high of 3.8% of GDP, begging the question of how it can climb higher from here (Chart I-4). However, as the same chart reveals, each of the previous dollar bull markets ended a few years after the U.S. basic balance of payments had peaked. Thus, we currently continue to expect the dollar to strengthen even if the U.S. basic balance position were to deteriorate. Additionally, the euro area basic balance is very depressed today at -3.4% of GDP, despite a current account surplus of 3% of GDP. However, in 1999, the region's basic balance bottomed at -5.6% of GDP, and it took until 2002 before the euro could durably rally, at which point the euro area basic balance had move back near 0% of GDP. Therefore, we would need to see a marked improvement in the euro area's basic balance in order to buy and hold the euro on a 12-to-18 months basis. Interest Rate Expectations Investors have rarely been as convinced as they are today that the Fed will increase interest rates over the coming months. This implies that the room for disappointment is large. However, as Chart I-5 illustrates, this is still not a reason to begin betting on an end to the dollar cyclical bull market. An overshoot in the dollar is marked by a fall in expectations of interest rate hikes as the strong dollar hurts the economy, preventing the Fed from hiking as much as anticipated. Moreover, except in 1994, a decreasing prevalence of rising rate expectations has lead dollar bear markets by more than a year. This suggests that there is room for the dollar to strengthen even if markets downgrade their U.S. rates expectations. Chart I-4The Basic Balance##br## Is A Small Hurdle Chart I-5In An Over Shoot, The Dollar Can Rally ##br##Even If Investors Doubt The Fed Even when looked comparatively, the broad consensus of investors regarding the continuation of monetary divergences between the Fed and the ECB is not yet a hurdle for the dollar to continue beating the euro on a 12-18 months basis. Not only is EUR/USD currently trading in line with relative expectations, previous euro rallies have been preceded by a big upgrade of the expected path of policy in Europe relative to the U.S. We currently expect the ECB to go out of its way to telegraph that even if asset purchases get curtailed in the second half of 2017, this will in no way foretell an imminent increase in European rates. Meanwhile, the Fed is in a firm position to increase rates as U.S. slack has dissipated (Chart I-6). Moreover, the proposed fiscal stimulus of the Trump administration should create inflationary pressures in this environment, solidifying the Fed's resolve to hike rates further. Chart I-6The Fed Pass Toward Higher Rates In Being Cleared Balance Sheet Positions One indicator concerns us more than the others at this point in time. As we wrote two weeks ago, one factor that has propelled the dollar higher has been its relative scarcity. The limited supply of dollar in the offshore markets - courtesy of the meltdown in the prime money-market funds industry and the heavier regulatory burden on banks - has caused cross-currency basis swap spreads to widen, pushing the greenback higher.1 Chart I-7Balance Sheet Dynamics And##br## The Scarcity Of Dollars Currently, the cross-currency basis swap spreads are hovering near record lows. However, as Chart I-7 illustrates, the surplus of euros created by the ECB's balance-sheet expansion as the Fed stopped its own purchases had a role to play in this phenomenon. While we expect the ECB to stand pat on the interest rate front for the foreseeable future, a further tapering of asset purchases in the second half of 2017 and beyond is very likely. This could limit the widening in cross-currency basis swap spreads that has been so helpful to the dollar, especially if the Fed elects not to curtail the size of its balance sheet. Net Net Many indicators suggest that the potential for dollar buying may be on the verge of exhausting itself. However, when looked closer, while these factors are a cause for concern, they still do not preclude an overshoot in the dollar. In fact, if anything, they suggest that the dollar is only now beginning its overshoot phase, a leg of the bull market that historically begins to inflict deeper pain on the U.S. economy as the dollar gets ever more dissociated from its fundamentals. So What? While the above indicators do not yet point to an end of the bull market, they in no way suggest that the dollar cannot suffer episodic corrections. We believe we are in the midst of such an event. Can the correction last further? Yes. To begin with, while the heavy net long positioning in the dollar does not represent much of a cyclical hurdle to beat, it does still constitute an important tactical risk. Our models corroborate this view. DXY is only currently fairly valued based on our intermediate-term timing model. Historically, tactical corrections fully play out once this model is in cheap territory (Chart I-8). Moreover, our capitulation index paints a similar story. This indicator has corrected some of its overbought excesses but remains above levels suggestive of an oversold environment. To the contrary, the fact that this index is still below its 13-week moving average points to additional selling pressures on the USD (Chart I-9). Chart I-8The Dollar Tactical Correction Is Not Over Chart I-9Confirming The Dollar Tactical Downside However, other factors suggest that the dollar could strengthen on certain pairs. The outlook seems especially grim for the reflation plays like the commodity currencies. Our reflation gauge, based on the prices of lumber, industrial metals, and platinum, has moved upward exactly as the U.S. dollar has rallied, a short-lived phenomenon that happened in 2001, 2002, and 2009. In all these cases, the Fed was easing policy and U.S. rates were softening relative to the rest of the world (Chart I-10). We doubt this phenomenon can continue much longer, especially as the Fed is currently tightening policy and U.S. rates are rising relative to the rest of the world. Moreover, Chinese fiscal stimulus was crucial in supporting this divergence in both 2009 and 2016. However, Chinese government spending went from growing at a 25% annual rate in November 2015, to a near 0% rate now. Moreover, the PBoC has already increased rates twice on its medium-term facilities and has also stopped injecting liquidity in the interbank market despite recent upward pressures on the SHIBOR. This tightening could prove problematic for natural resources like coking coal, iron ore, or copper, commodities highly levered to the Chinese real estate market and of which China recently accumulated large inventories (Chart I-11). Chart I-10An Unusual Move Chart I-11Elevated Chinese Metal Inventories Additionally, on the back of the longest expansion in the global credit impulse in a decade, G10 economic surprises have become very perky. However, it will be difficult to beat expectations going forward. Not only have investors ratcheted up their global growth expectations, the recent increase in global interest rates limits the capacity of the credit impulse to grow further. In fact, the recent tightening in U.S. banks credit standards for consumer loans, the fall in the quit rates in the U.S. labor market, and the underperformance of junk bonds relative to Treasurys since late January only re-inforce this message. Sagging global growth, even if temporary, is always a problem for commodities and commodity currencies. The euro faces its own risk: France. Last week, along with our colleagues from BCA's Geopolitical Strategy service, we wrote that the chance of a Le Pen electoral victory is still extremely low and we would buy the euro on any sell-off caused by a rising euro-area breakup risk premium.2 Yet, we are not oblivious to the risk that before the second round of the election is over on May 7th, investors can continue to place bets that Marine will win and that France will exit the euro area. The recent widening of the OAT/Bund spread reflects these exact dynamics as François Fillon's hardship and Macron's love life have taken center stage. So real has been the perception of this risk that spreads on Italian and Spanish bonds have followed suit (Chart I-12). While we are inclined to lean against this move, it is a risk that investors may want to bet on or hedge against. At the current juncture, the euro is fully pricing in these developments, and no mispricing is evident. However, as our model based on real rates differentials, commodity prices, and intra-European spreads shows, if France spreads were to widen further, EUR/USD could suffer (Chart I-13). In fact, if French spreads retest their 2011 levels, the euro could fall toward parity. Chart I-12Le Pen Is Causing A Repricing ##br##Of The Euro Area's Breakup Chance Chart I-13The Euro Will Suffer If French ##br##Bonds Underperform Further Investors wanting to speculate on the French election but wanting to avoid taking on some USD exposure can do so by shorting EUR/SEK, a very profitable strategy when the euro crisis was raging (Chart I-14) or could short EUR/GBP, as interest rates expectations have begun to move against the common currency and in favor of the pound (Chart I-15). While EUR/CHF tends to weaken during times of euro-duress, it is currently trading close to the unofficial SNB floor and we worry that growing intervention by the Swiss central bank will limit any downside on this pair. The currency that is likely to benefit the most against the dollar remains the yen. Not only are investors still very short the yen, but based on our intermediate-term timing model, the yen remains very attractive (Chart I-16). Moreover, the recent large improvement In the Japanese inventory-to-shipment ratio only highlights that the Japanese economy has gathered momentum, decreasing the likelihood of an enlargement of the current set of ultra-stimulative measures from the BoJ. Chart I-14Short EUR/SEK: A Hedge Against Le Pen Chart I-15Downside Risk For EUR/GBP Chart I-16Yen: Biggest Winner If USD Corrects Additionally, any risk-off event caused by a correction of the reflation trade would benefit the yen. Falling commodity prices will hurt Japanese inflation expectations and lift real rate differentials in favor of the yen. A correction in the reflation trade would also put downward pressure on global bond yields, which means that due to the low yield-beta of JGBs, Japanese nominal interest rates spread would further contribute to a narrowing of real interest rate differentials in favor of the JPY. Finally, if investors begin to bet even more aggressively on a breakup of the euro area fueled by the perceived prospects of a Le Pen electoral victory, the vicious wave of risk aversion unleashed around the globe by such an event would likely support the yen beyond our expectations. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please refer to the Foreign Exchange Strategy Weekly Report, "Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism", dated January 27, 207, available at fes.bcaresearch.com 2 Please refer to the Foreign Exchange/ Geopolitical Strategy Special Report, "The French Revolution", dated February 3, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 As we highlighted in previous reports, DXY's losses extended no further than the 99-100 support range, and the index has rebounded since then. A key external driver of the USD is EUR, whose roll-over has coincided with the DXY's rebound. In the coming months, EUR/USD could display downside risk as markets price in election jitters. This could be bullish for the greenback. The budget plan is in discussion. Due in around a month, the tentative plan comprises tax cuts and defense spending mostly. While this is still speculative, this plan may be bullish for the dollar. Until then, it is likely that the DXY will follow in its seasonal trend and be largely unchanged with little upside this month. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 U.S. Border Adjustment Tax: A Potential Monster Issue For 2017 - January 20, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Two main factors are weighing on the euro this week. Firstly, Draghi continues to retain his dovish stance. He stated that there is still "significant degree of labour market slack", which is limiting wage growth, a key contributor to underlying inflation. Secondly, and more substantial, are politically-induced anxieties in the run up to the European elections. In particular, French elections have increased risk premia, forcing the 10-year OAT-Bund spread to reach early-2014 highs. Greek 2-year yields have also spiked above 10%. Volatility is likely to be elevated in the lead up to the French election and possibly through Italian elections. The longer-term outlook will remain dictated by the development of the ECB's monetary policy stance. Report Links: The French Revolution - February 3, 2017 GBP: Dismal Expectations - January 13, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Then yen continues to rally, with USD/JPY already down by almost 5% this year. Uncertainty surrounding the European elections should help continue this trend, given that the yen should benefit from safe haven flows. Nevertheless, the outlook for the yen remains bearish on a cyclical basis, as the measures that the BoJ has taken, such as anchoring 10-year rates near 0, and switching to de facto price level targeting will eventually lower Japanese real rates vis-à-vis the rest of the world. The BoJ has taken these measures to kick start an economy plagued by deflation. Early returns from this policy are mixed: Machinery Orders grew by 6.7% YoY, outperforming expectations. However both housing starts growth and Nikkei Manufacturing PMI fell below expectations, coming at 3.9% and 52.7 respectively. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 On Wednesday, the U.K. House of Commons finally gave their approval to a bill authorizing the government to start exits talks with the European Union. The House of Lords will be the next hurdle that Brexit hopefuls will have to overcome. Although cable suffered from some volatility following the decision it has remained relatively unaffected. We continue to think that the pound has further upside, particularly against the euro, as the negative consequences of Brexit on the British economy are already well priced into cable. Furthermore, increasing uncertainty regarding the French elections should also be bearish for EUR/GBP. If the fear of a Le Pen presidency starts to increase, Brexit will become an afterthought as exiting the European Union takes on a completely different meaning if the integrity of the EU starts being put into question. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The RBA held rates at 1.5% this week on the basis of upbeat business and consumer confidence, and above-trend growth in advanced economies. This decision helped the AUD, as investors repriced dovish bets and interpreted a change in stance. While above-trend growth is possible, Chinese demand is particularly important for Australia. Last week, the PBoC silently tightened their 7-, 14-, and 28-day reverse repo rates by 10 bps each to help alleviate looming risks in the real estate market and general financial stability. This may signal an end to an easing cycle, which may limit demand growth going forward. Australia has its own financial worries. Household debt is at its highest ever, at 186% of disposable income, which would be catastrophic if rates are raised. Lowe also highlighted concerns about a strong AUD and its impact on Australia's economic transition. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The RBNZ decided to keep interest rates unchanged at 1.75% in their monetary policy meeting this Wednesday. Additionally, as expected, Governor Graeme Wheeler stated that the RBNZ had shifted from having a dovish bias to a having neutral one. Nevertheless, the kiwi has depreciated sharply since the announcement, not only because Governor Wheeler highlighted that the currency "remains higher than is sustainable for balanced growth" but also because the RBNZ showed a cautious approach by stating that "premature tightening of policy could undermine growth and forestall the anticipated gradual increase in inflation". However, we believe that the RBNZ will turn more hawkish, as inflationary forces in the economy will eventually put upward pressure on rates. This will lift the NZD, particularly against the AUD. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Uncertainty has come up as a key issue in the Bank of Canada's headlights, as Poloz remains nervous about the future of U.S.-Canada relations. CAD has recently displayed some strength despite this uncertainty. It has appreciated against USD, AUD and NZD. This is likely due to a brightening perception of the Canadian economy with the Ivey PMI recording a reading above 50 for January, at 52.3, above the previous 49.3. Additionally, housing starts beat expectations, dampening housing market concerns. Exports have been strong, which has also fed into this appreciation. A rapidly appreciating currency would exacerbate trade concerns further and adversely affect the Canadian economy. Therefore, it is likely that the BoC remains tilted to the dovish side, which will generate downside for the CAD through rate differentials. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has reached its lowest level since August 2015. At around 1.065, this cross is hovering in the lower range of the implied floor set by the SNB. Increased uncertainty caused by the upcoming European elections cycle will continue to test this floor, as the increased odds of an Eurosceptic government in France will not only decrease the value of the euro but will also put upward pressure on the franc, given its safe haven status. Nevertheless, the SNB will do everything in its power to weaken its currency as the Swiss economy continues to be plagued by deflationary forces: After showing glimpses of a recovery last month Real retail sales contracted by 3.5% YoY, falling well short of expectations. The SVMI Purchasing Manager's Index also came below expectations coming in at 54.6. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has rebounded after reaching 8.20, its lowest level since Trump got elected. Interestingly, the NOK has not been as correlated with oil prices since the start of 2017 as it has been in the past. This is a trend worth monitoring. The inflation picture remains complex, although core and headline inflation have deaccelerated slightly as of late, inflation expectations are at their highest level of the last 9 years. Additionally house prices are growing at nearly 20%, a pace not seen since before the 2008 crisis. The Norges Bank is now facing a tough dilemma between risking an inflation overshoot if they keep their dovish bias or raising rates in an economy where growth for employment, real retail sales and nominal GDP is still in negative territory. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The SEK continues to duplicate the dollar's movements, rolling over slightly from the 7% appreciation it saw over a month and a half. A more accurate measure of the SEK's value, EUR/SEK, paints a similar picture. These movements have been more or less in line with the Riksbank's desired developments, as it indicates a deceleration in the pace of recent appreciation. However, we believe that the rebound in EUR/SEK is not likely to run further. Political turbulence is being priced into the euro. After sustaining near oversold levels, the rebound could be nothing more than momentum exiting from oversold territories. Nevertheless, it is likely that EUR/SEK will correct in the coming months due to European elections. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Global competitiveness equalisation occurs: For Germany, at EUR/USD = 1.35 For the Euro area, at EUR/USD = 1.20 For Spain, at EUR/USD = 1.17 For France, at EUR/USD = 1.15 For Italy, at EUR/USD = 1.10 But today EUR/USD = 1.07. The main culprit for the over-competitive euro is the ECB. Feature President Trump is right about one thing. The ECB's own analysis - available at https://www.ecb.europa.eu/stats - shows that the trade-weighted euro needs to appreciate by 10% to cancel the euro area's competitive advantage versus its major trading partners including the United States. To cancel Germany's competitive advantage, the ECB calculates that the euro needs to appreciate by 25% (Chart I-1). Chart I-1ECB Analysis Supports President Trump: ##br##The Euro Is Over-Competitive Even more controversially, the central bank's own analysis shows that the ECB itself is to blame for the euro area's significant competitive advantage. Prior to the ECB's extreme and unprecedented policy easing, the euro area's competitiveness was exactly in line with its trading partners (Chart I-2). The ECB says that it does not target the exchange rate, but it is fully aware that negative interest rates and trillions of euros of asset purchases carry major ramifications for the euro's value. Chart I-2The ECB Caused The Over-Competitive Euro The ECB's Ultra-Looseness Is Counterproductive The ECB could be forgiven for its ultra-looseness if the euro area were on the edge of a deflationary abyss. But as we showed in Fake News In Europe1 euro area inflation and inflation expectations are little different to those in other major economies when compared on an apples for apples basis. Chart I-3Emergency Monetary Policy##br## Not Needed Furthermore, the euro area is among the world's top-performing major economies through the past three years (well before ECB easing started), and the percentage of the working age population in employment is at an all-time high. These are hardly the hallmarks of an imminent deflationary threat which warrants emergency monetary policy (Chart I-3). Perhaps the ECB's ultra-looseness is trying to quell a flare-up of ever-present political risk. If so, the strategy is becoming counterproductive. As well as irking President Trump, the extreme policy is riling Germany's Finance Minister, Wolfgang Schäuble, who has blamed Mario Draghi for "50 per cent" of the success of the populist right-wing Alternativ Für Deutschland. And by frustrating voters worried about the low interest rates on their hard-earned savings, the ECB is also playing right into the hands of Marine Le Pen's Front Nationale. Admittedly, the euro area's current economic 'mini-upswing' is likely approaching its end. But as we showed last week in Slowdown: How And When?,2 a deceleration is likely to be even more pronounced outside the euro area. Even the ECB acknowledges that "the risks surrounding the euro area growth outlook relate predominantly to global factors" rather than domestic factors. If the ECB is right, the extent of anticipated monetary tightening outside the euro area is overdone. If the ECB is wrong, then the extent of anticipated monetary tightening inside the euro area is underdone (Chart I-4 and Chart I-5). Either way, the investment conclusion is the same. Chart I-4Expected Divergence In Monetary Policy Drives##br## Relative Bond Market Performance... Chart I-5... And ##br##The Euro Stay underweight German bunds versus U.S. Treasuries. Stay long the euro, with our preferred crosses being euro/pound in the near term and euro/yuan in the long term. And given that euro/pound (inversely) drives relative stock market performance, stay underweight Eurostoxx600 versus FTSE100. The Great Currency Manipulation Manipulation: (noun) - the controlling or influencing of a situation cleverly. The creation of the euro in 1999 was arguably the greatest currency manipulation of modern times. To be absolutely clear, this is not a criticism, just a statement of fact. In 1999, when European policymakers killed national currencies such as the deutschemark, franc, lira and peseta and replaced them with the new-born euro, the action clearly fitted the dictionary definition of manipulation. Our preceding analysis about the euro area's competitive advantage today assumes that the euro started its life at the right value. The evidence suggests that this assumption is correct. In 1999, the euro area' external trade was in balance, and the bloc's real competitiveness versus its major trading partners was exactly in line with its long-term average. Likewise the evidence suggests that national currencies such as the deutschemark, franc, lira and peseta converted to the euro at the right exchange rates. The euro area's constituent economies had much in common in 1999 and were broadly in balance with each other. Surprising as it now seems, in 1999 Germany and Italy scored identically on exports as a share of GDP (Chart I-6) and on total debt as a share of GDP (Chart I-7). And German wages had been rising in lockstep with productivity (Chart I-8). Chart I-6After The Euro, Germany's ##br##Exports Soared Chart I-7After The Euro,##br## Italy's Debt Soared Chart I-8After The Euro, German Wages##br## Lagged Productivity It was only in the decade after 1999 that the euro area developed its major internal imbalances. Germany depressed its wages relative to productivity and used the resulting ultra-competitiveness to build an export-driven business model. In the seven years before 1999, net exports had made zero contribution to Germany's economic growth (Chart I-9), but in the seven years after 1999, net exports accounted for all of Germany's economic growth (Chart I-10). Chart I-9Germany Pre Euro: Net Exports ##br##Contributed Nothing To Growth Chart I-10Germany Post Euro: Net Exports Contributed ##br##Everything To Growth Prior to the one-size-fits-all exchange rate, a rising deutschemark would have largely snuffed out the increased competitiveness from wage depression and thereby thwarted the export-driven business model. However, once locked in the euro, Germany's exchange rate could no longer rise sufficiently to choke off external demand. Meanwhile, Italy and Spain could suddenly rely on a debt-driven business model - especially given that their strong national cultures of homeownership provided the perfect collateral for borrowing. Prior to the one-size-fits-all interest rate, higher domestic interest rates would have thwarted this business model. But once locked in the monetary union, their interest rates could no longer rise sufficiently to choke off borrowing. By 2010, the imbalances had become monsters. Germany, through its wage depression, had become 20% over-competitive versus its major trading partners. Spain and Italy, through their reliance on debt-fuelled growth, had become 20% under-competitive. Understand that this is not a morality tale of good versus bad, as many commentators portray. The mirror-image imbalances were just the opposite sides of the same (euro) coin. Spain Is The Star-Performer Today, the good news is that the euro area's internal imbalances have narrowed sharply, as the under-competitive economies have taken draconian corrective measures. External competitiveness has also been boosted by a substantially weaker euro. The bad news is that Germany's over-competitiveness versus the world remains excessive. But as Wolfgang Schäuble correctly argues, it is extremely difficult for Germany to rebalance its global competitiveness when it is swimming against the tide of the ECB's extreme easing and resulting depression of the euro. The award for the most spectacular rebalancing goes to Spain. Eight years ago, Spain was 15% less competitive than France on the ECB's harmonised competitiveness indicator based on unit labour costs. Today, on the same measure Spain is 2% more competitive than France. This makes it very difficult to justify any yield premium on Spanish Bonos versus French OATs. The yield premium is a compensation for perceived redenomination risk. The expected annual loss of owning a Bono versus an OAT equals: The annual probability of euro breakup Multiplied by The expected undervaluation of a new peseta versus a new franc. But if Spain is now as competitive as France, a new peseta ultimately should be as valuable as a new franc. The second item of the multiplication would be zero (Chart I-11). So irrespective of the probability of euro breakup, the yield premium should also be zero. Yet today, Spanish 10-year Bonos are still trading at a substantial 65 bps yield premium over French 10-year OATs (Chart I-12). Chart I-11Spain Is As Competitive ##br##As France... Chart I-12... Bonos Should Not Have A ##br##Yield Premium Over OATs Stay long Spanish Bonos versus French OATs. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Published on January 26, 2017 and available at eis.bcaresearch.com 2 Published on February 2, 2017 and available at eis.bcaresearch.com Fractal Trading Model* A tactically short position in equities is warranted. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-13 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations