Financial Markets
Highlights Global equities and other risk assets will trade sideways with elevated volatility over the coming weeks before grinding higher for the remainder of the year, as global growth finally accelerates after a series of false starts. We now see the Fed raising rates more slowly than we had previously envisioned, but ultimately having to scramble to hike rates in order to quell inflation. The fed funds rate will probably plateau at 4% in 2021, implying nine quarter-point hikes more than the market is currently discounting. Over a 12-month horizon, investors should overweight global equities, underweight government bonds, and maintain a neutral allocation to cash. The dollar will peak in the second quarter and then weaken over the remainder of the year and into 2020, before starting to strengthen again late next year. Investors should prepare to temporarily upgrade EM and European stocks over the coming weeks, while increasing exposure to cyclical equity sectors. Industrial metals and oil will strengthen over the course of the year. Gold should be bought on any dip. Investors should begin to de-risk their portfolios in late-2020 in anticipation of a recession in 2021. Feature Here We Go Again? After having become more defensive last June, we turned bullish on stocks following the December post-FOMC meeting plunge. As stocks continued to rebound, we tempered our optimism. In the beginning of March, we wrote that “having rallied since the start of the year, global stocks will likely enter a ‘dead zone’ over the next six-to-eight weeks as investors nervously await the proverbial green shoots to sprout.”1 Last Friday’s release of disappointing European PMI data poured some herbicide on the green shoots thesis. Germany’s manufacturing PMI hit a six-year low, with the new orders component registering the weakest reading since the Great Recession. This took the 10-year German bund yield into negative territory for the first time since 2016. The U.S. 10-year Treasury yield also fell to a 15-month low, causing the 3-month/10-year curve to invert. Historically, an inverted yield curve has been a reliable predictor of U.S. recessions (Chart 1). Chart 1Yield Curve Inversions, Recessions, And The Term Premium President Trump’s decision to appoint TV commentator Stephen Moore to the Fed’s Board of Governors did not help matters. Recommended by fellow supply-side “economist” Larry Kudlow, Moore is best known for dismissing concerns over the state of the housing market in 2007, his spot-on 2010 prediction that QE would cause hyperinflation, and his belief that the Trump tax cuts would lead to a smaller budget deficit. Global Growth Will Accelerate In The Second Half Of The Year Given all these worrisome developments, is it time to turn cyclically bearish on the economic outlook and risk assets again? We do not think so. While the next few weeks could be challenging for equities – a risk that our MacroQuant model is currently flagging – sentiment should improve as global growth finally accelerates after a series of false starts. Indeed, some positive signs are already visible: The diffusion index of our global leading economic indicator, which tracks the share of countries with rising LEIs, has moved higher (Chart 2). It leads the global LEI. Service sector PMIs have also generally improved, suggesting that the weakness in global growth remains concentrated in trade and manufacturing. And even on the trade front, a few forward-looking indicators such as the Baltic Dry Index and the weekly Harpex shipping index, which measures global container shipping activity, have bounced off their lows. We would downplay the signal from the yield curve, as it currently is severely distorted by a negative term premium. If the 10-year Treasury term premium were back to where it was in 2004, the 3-month/10-year slope would be more than 200 bps steeper, and nobody would be talking about this issue. In fact, given today’s term premium, the curve would have almost certainly inverted in 1995. Anyone who got out of stocks back then would have missed out on one of the greatest bull markets in history. It should also go without saying that some of the decline in the U.S. 10-year yield reflects a positive development: The Fed has turned more dovish! If one looks at the 10-year/30-year portion of the yield curve, it has actually steepened. This is a sign that the market is seeing the Fed’s actions as being reflationary in nature. There is no clear causal mechanism by which an inverted yield curve slows economic activity, apart from it potentially becoming a self-fulfilling prophecy where the yield-curve inversion scares investors, thereby leading to a tightening in financial conditions (Chart 3). Such “doom loops” are conceptually possible, but as we discussed earlier this year, they are unlikely to occur in the current environment.2 At any rate, financial conditions have eased since the start of the year. This should boost growth in the coming months. Chart 2Global Growth May Be ##br##Starting To Stabilize Chart 3Easier Financial Conditions Since The Start Of The Year Bode Well For Global Growth Chinese Credit Growth Set To Rise Global growth has been weighed down by a slowing Chinese economy. Last year’s deleveraging campaign led to a significant deceleration in investment spending, which had negative repercussions for capital equipment and commodity producers all over the world (Chart 4). Historically, China has loosened the reins on the financial sector whenever credit growth has fallen towards nominal GDP growth (Chart 5). It appears we have reached this point. Despite a weak seasonally-distorted February print, credit growth has finally accelerated on a year-over-year basis. Chart 4China: The Deleveraging Campaign Had Adverse Effects On Investment Spending Chart 5Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth We do not expect Chinese credit growth to rise as much as in past releveraging cycles. However, this is because the economy is in better shape, not because there is some intrinsic constraint to increasing debt from current levels. China’s elevated savings rate has kept interest rates well below trend nominal GDP growth, which is the key determinant of debt sustainability (Chart 6).3 As long as the central government maintains an implicit guarantee on most local and corporate debt, as it is currently doing, default risk will remain minimal. In any case, given that total debt stands at 240% of GDP, even a one percentage-point increase in credit growth would generate a hefty 2.4% of GDP in credit stimulus. The Chinese credit impulse leads imports by about six-to-nine months (Chart 7). This bodes well for global trade in the second half of the year. Chart 6China's High Savings Rate Has Kept Interest Rates Well Below Trend Nominal GDP Growth Chart 7Global Trade Will Benefit From A Chinese Reflationary Impulse A Lull In The Trade War? A de-escalation in the trade war would help matters. As a self-professed master negotiator, Donald Trump needs to secure a deal with China before next year‘s presidential election, while also convincing American voters that the agreement was concluded on favorable terms for the United States. Reaching a deal with China early on in his term would have been risky for Trump if it had failed to bring down the bilateral trade deficit – an entirely likely outcome given how pro-cyclical U.S. fiscal policy is. At this point, however, Trump could crow about making a great deal with China while reassuring voters that the product of his brilliance will be realized only after he has been re-elected. Thus, the likelihood that Trump will seek to strike a deal has risen. For their part, the Chinese want as much negotiating leverage as they can muster. This means being able to convincingly demonstrate that their economy is strong enough to handle the repercussions from turning down a trade deal that fails to serve their interests. Since the credit cycle is the dominant driver of Chinese growth, this requires putting the deleveraging campaign on the backburner. Faster Global Growth And Stronger Domestic Demand Will Benefit Europe Stronger Chinese growth will help the European export sector later this year. The export component of the Chinese Caixin PMI has moved up from its lows. It leads the euro area PMI by about three months. Meanwhile, euro area domestic demand will benefit from a more accommodative fiscal policy and lower bond yields. The decline in bond yields will be especially helpful to Italy. The spike in yields and loss of business confidence following the election of a populist government last March plunged the economy into recession (Chart 8). Now that the 10-year BTP yield has fallen more than 100 bps from its highs, the Italian economy should start to perk up. The ECB will not raise rates this year even if domestic growth speeds up, but the market will probably price in a few rate hikes in 2020 and beyond. This will allow for a modest re-steepening of yield curves in core European bond markets, which should be positive for long-suffering bank profits. Brexit remains a concern. The ongoing saga has reached the farcical stage where: 1) The U.K. has voted to leave the EU; but 2) Parliament has voted to stay in the EU unless it reaches a satisfactory deal with Brussels; while 3) rejecting the only deal with Brussels that was on offer. Given that most British voters no longer want Brexit (Chart 9), we think that the government will kick the proverbial can down the road until a second referendum is announced or a “soft Brexit” deal is formulated. Either outcome would be welcomed by markets. Chart 8Italian Bond Yields Are A Headwind No More Chart 9U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win What Will The Fed Do? Last year’s “Christmas Crash” clearly shifted the Fed’s reaction function in a more dovish direction. We do not expect Jay Powell to raise rates over the next few months, but a reacceleration in global growth is likely to prompt the Fed to tighten anew in December. The Fed will continue raising rates once per quarter in 2020, before accelerating the pace of tightening in 2021 in response to rising inflation. In all, we see the fed funds rate increasing to around 4% by the end of this cycle. This represents nine quarter-point hikes more than the market is currently discounting (Chart 10). We were stopped out of our short fed funds futures trade, but we recommend that clients short the June-2021 fed funds futures or a similar instrument. The U.S. Economy: Great Again Fundamentally, the U.S. economy is on solid ground and can handle higher interest rates. Unlike a decade ago, the housing market is in good shape (Chart 11). The homeowner vacancy rate stands near a record low. Judging by FICO scores, the quality of mortgage lending remains high. The labor market is also firm, with job openings hitting another record high in February (Chart 12). The combination of a healthy housing and labor market is invariably good for consumers. Chart 11U.S. Housing Fundamentals Are Solid Chart 12The U.S. Labor Market Is Firm The personal savings rate currently stands at 7.6%, notably higher than one would expect based on the ratio of household net worth-to-disposable income (Chart 13). A decline in the savings rate would allow consumer spending to increase more quickly than income. With the latter being propped up by rising wages, this will be bullish for consumption. Capital spending intentions have dipped over the past few months, but remain elevated by historic standards (Chart 14). The real nonresidential capital stock has grown by an average of only 1.7% since the start of the recovery, down from 3% in the pre-recession period (Chart 15). A cyclical upswing in productivity growth, rising labor costs, and low levels of spare capacity should all motivate businesses to invest in new plant and equipment. Chart 14Capital Spending Intentions Have Softened, But Remain Elevated Chart 15There Is Room For More U.S. Capital Investment Corporate Debt: How Much Of A Risk? Chart 16U.S. Corporate Debt Is Not Extreme By Global Standards Corporate debt levels have increased significantly in recent years, while underwriting standards have deteriorated, as evidenced by the proliferation of covenant-lite loans. Nevertheless, the situation is far from dire. Relative to other countries, U.S. corporate debt is quite low (Chart 16). At 143% of GDP, corporate debt in France is twice that of the United States. This is not to suggest that everything is fine in the French corporate sector; but the fact is that France has not had a corporate debt crisis. This signals that the U.S. is not at imminent risk of one either. Netting out cash, U.S. corporate debt as a share of GDP is at the same level it was in 1989, a year in which the fed funds rate was close to nine percent. The ratio of corporate net debt-to-EBITD remains reasonably low. The interest coverage ratio is above its historic average. In addition, corporate assets have also risen quite briskly over the past few years, which has kept the corporate debt-to-asset ratio broadly stable (Chart 17). The corporate sector financial balance – the difference between corporate income and spending – is still in positive territory at 1% of GDP. Every recession in the past 50 years began when the corporate sector financial balance was in deficit (Chart 18). Chart 17U.S. Corporate Debt: How High? Chart 18Corporate Sector Financial Balance Still In Surplus Unlike mortgages, which are often held by leveraged institutions, most corporate debt is held by unleveraged players such as pension funds, insurance companies, mutual funds, and ETFs. Bank loans account for only 18% of nonfinancial corporate sector debt, down from 40% in 1980 (Chart 19). The share of leveraged loans held by banks has declined from about 25% a decade ago to less than 10% today. Moreover, banks today hold much more high-quality capital than in the past (Chart 20). This makes corporate debt less systemically important for the economy. Chart 19Banks Have Reduced Their Exposure To The Corporate Sector Chart 20U.S. Banks Are Well Capitalized One of the reasons we turned more bullish on risk assets in December was because stocks had plunged and corporate spreads widened without much follow-through in financial stress indices. For example, the infamous TED spread barely budged (Chart 21). Chart 21TED Spreads Are Well Behaved, Indicating No Major Signs Of Financial Stress Everyone Agrees With Larry Given the lack of major imbalances in the U.S. economy, why do investors believe that the Fed cannot raise rates further even though the Fed funds rate in real terms is barely above zero? The answer is that investors appear to have bought into Larry Summers’ secular stagnation thesis, which posits that the neutral rate of interest is much lower today than it was in the past. We have some sympathy for this thesis, but it is important to remember that it is a theory about the long-term determinants of interest rates such as productivity and demographic trends. The theory says little about the cyclical drivers of interest rates, including the amount of spare capacity in the economy, the stance of fiscal policy, credit growth, and wage trends. Earlier this decade, when we were still very bullish on bonds, one could have plausibly argued that the economy needed extremely low interest rates: The output gap was still large; the deleveraging cycle had just begun; home and equity prices were depressed; wage growth was anemic; and fiscal policy had turned restrictive after a brief burst of stimulus during the Great Recession. Far From Neutral? All of the forces mentioned above have either fully or partially reversed course over the past few years. Take fiscal policy as one example. The IMF estimates that the U.S. structural budget deficit averaged 3.3% of GDP in 2014-15. In 2019-20, the IMF reckons the deficit will average 5.6% of GDP. To what extent has easier fiscal policy raised the U.S. neutral rate of interest? Let us conservatively assume that every $1 of additional fiscal stimulus adds $1 to aggregate demand. In this case, fiscal policy has added 2.3% of GDP to aggregate demand over the past five years. Suppose that a one-percentage point increase in aggregate demand raises the neutral rate of interest by 1%, which is in line with the specification of the Taylor Rule that former Fed Chair Janet Yellen favored. This implies that fiscal policy alone has raised the neutral rate by over two percentage points. The discussion above suggests that cyclical factors may have pushed up the neutral rate considerably, even if long-term structural factors are still dragging it down. Since the Fed is supposed to set interest rates with an eye on what is appropriate for the economy over the next year or two, rates may end up staying too low for too long. This will cause the economy to overheat, eventually leading to a surge in inflation. The Inflation Boogeyman The good news is that none of our favorite indicators point to a major imminent inflationary upswing (Chart 22): Despite higher tariffs, consumer import price inflation has slowed; core intermediate producer price inflation has decelerated; the prices paid components of the ISM and regional Fed surveys have plunged; inflation surprise indices have rolled over; and both survey and market-based measures of inflation expectations remain below where they were last summer. In keeping with these developments, BCA’s proprietary Pipeline Inflation Indicator has fallen to a two-and-a-half-year low. Wage growth has accelerated, but productivity growth has increased by even more. As a result, unit labor cost inflation has been coming down since the middle of last year. Unit labor costs lead core CPI inflation by about 12 months (Chart 23). This implies that consumer price inflation is unlikely to reach uncomfortably high levels at least until the second half of next year. Chart 22No Symptoms of An Imminent Major Inflationary Upswing In The U.S. ... Chart 23... And Decelerating Unit Labor Costs Will Dampen Inflationary Pressures For The Time Being At that point, risks are high that inflation will move up. This could force the Fed to start raising rates aggressively in early-2021, a course of action that will push up the dollar and cause equities and spread product to sell off. The resulting tightening in financial conditions will probably plunge the U.S. and the rest of the world into recession in mid-to-late 2021. Stay Bullish Global Equities For Now, Turn Defensive Late Next Year Chart 24Analyst Expectations Are Quite Muted The two-stage Fed tightening cycle discussed above – gradual rate hikes starting in December and continuing into 2020, and more aggressive hikes thereafter in response to rising inflation – shapes our investment views over the next few years. The Key Financial Market Forecasts Chart at the beginning of this publication provides a rough sketch of where we think the main asset classes are heading. We suspect that equities and other risk assets will be able to digest the first stage of rate tightening, albeit with heightened volatility around the time when the Fed starts preparing the market for another hike later this year. Unlike last September, earnings estimates are much more conservative. Bottom-up estimates foresee EPS rising by 3.9% in the U.S. and 5.4% in the rest of the world in 2019 (Chart 24). The combination of faster growth, easier financial conditions, and ongoing share buybacks implies some upside to these numbers. Perhaps more importantly, unlike in September, the Fed will only start hiking rates if the economy is performing well. Powell erred in saying that “rates were a long way from neutral” just when the U.S. economy was starting to slow. Had he uttered those words when U.S. growth was still accelerating, investors would have probably disregarded them. Jay Powell won’t make the same mistake again. Rather, he will make a different one: He will let the economy overheat to the point where the Fed finds itself clearly behind the curve and forced to scramble to catch up. The resulting stagflationary environment – where growth is slowing due to a shortage of available workers and inflation is on the upswing – will be toxic for equities and other risk assets. While it is difficult to be precise about timing, we recommend that investors maintain a modestly pro-risk stance over the next 12-to-18 months. However, they should pare back exposure to equities and spread product late next year before the Fed ramps up the pace of rate hikes. Prepare To Temporarily Upgrade International Stocks The U.S. stock market tends to be “low beta” compared to other bourses. If global growth accelerates in the second half of this year, international stocks will outperform their U.S. counterparts. We sold our put on the EEM ETF for a gain of 104% on Jan 3rd, and now recommend being outright long EM equities. We will be looking to upgrade both EM and European equities to overweight in the coming weeks in currency-unhedged terms once we see more confirmatory evidence of a global growth revival. We have mixed feeling about Japanese stocks. Stronger global growth will benefit Japanese multinationals, but firms focused on the domestic market may suffer if the government goes ahead and raises the sales tax in October. We would hold off upgrading Japanese stocks for the time being. At the global sector level, we pared back our defensive tilt earlier this year, after having turned more cautious last summer. We recommend that investors overweight energy and industrials. We are also warming up to financials and materials. The former will benefit from a steepening in yield curves later this year as well as from faster credit growth. The latter will gain from a more robust Chinese economy. We would maintain a neutral allocation to health care, info tech, and communication services. Real estate and utilities will both suffer once bond yields start moving higher. Classically defensive sectors such as consumer staples will also underperform. Global Bond Yields Likely To Rise Global bond yields are likely to rise over the next 12-to-18 months as growth surprises on the upside. Yields will continue rising into the first half of 2021 as inflation accelerates. Unlike in past risk-off episodes, Treasurys will not provide much of a safe haven in the lead up to the next recession. As noted above, one of the reasons that bond yields are so low today is because the term premium is very depressed. The cumulative effect of Fed bond purchases has probably depressed the term premium, but the bigger impact has stemmed from the fact that investors see Treasurys as an insurance policy against various macro risks. Investors are accustomed to thinking that when an economy slides into recession, equity prices will fall, the housing market will deteriorate, wage gains will recede, job prospects will worsen, but at least the value of their bond portfolio will go up! The problem with this reasoning is that it is only valid when the Fed is hiking rates in response to stronger growth. If the Fed is hiking rates because inflation is getting out of hand, Treasury yields could end up rising while stocks are falling. This was actually the norm between the late-1960s and early-2000s (Chart 25). Chart 25Treasury Yields Could Rise While Stocks Fall If Treasurys lose their safe-haven status, the term premium will move higher. A vicious circle could develop where rising bond yields weaken the stock market, causing investors to flood out of both stocks and bonds and into cash, leading to even higher bond yields and lower equity prices. Investors should maintain a modest short duration stance towards Treasurys over the next 12 months, and then move to maximum underweight duration in mid-2020 as inflation starts to break out. Going long duration will only make sense once the Fed has raised interest rates into restrictive territory and the economy slides into recession. That is not likely to occur until the second half of 2021. Regionally, we favor European, Canadian, Australian, New Zealand, and especially Japanese government bonds over the next 12 months relative to U.S. Treasurys. The U.S. economy is at the greatest risk of overheating. In currency-hedged terms, the 10-year U.S. Treasury yield is among the lowest in the world (Table 1). Japanese 10-year bonds, for example, offer 2.72% in currency-hedged terms, while German bunds command 2.94%. Table 1Bond Markets Across The Developed World The U.S. Dollar: Heading Towards A Soft Patch Gauging the outlook for the U.S. dollar is a bit tricky. Even though the Fed will only be raising rates gradually over the next 12 months, it will still hike more than what is discounted by markets. With most other central banks still sitting on the sidelines, short-term rate differentials are likely to move in favor of the greenback. That said, aside from Japan, stronger global growth will likely prompt investors to price in a few more rate hikes in other developed economies in 2020 and beyond. Consequently, long-term yield differentials may not widen by as much as short-term differentials. Perhaps more importantly, the U.S. dollar is a countercyclical currency, meaning that it moves in the opposite direction of global growth (Chart 26). This countercyclicality stems from the fact that the U.S. economy is more geared towards services than manufacturing compared with the rest of the world (Chart 27). As such, when global growth accelerates, capital tends to flow from the U.S. to the rest of the world, translating into more demand for foreign currency and less demand for dollars. Chart 26The Dollar Is A Countercyclical Currency Chart 27The U.S. Is A Low-Beta Play On Global Growth If global growth picks up in the back half of this year, the dollar will likely peak in the second quarter and weaken over the remainder of 2019 and into 2020. The dollar’s trajectory may thus follow a similar course to the one in 2017, a year in which the Fed raised rates four times, but the broad trade-weighted dollar nevertheless managed to weaken by 7%. Chart 28The Yen Is A Risk-Off Currency As was the case in 2017, the euro will probably gain ground later this year against the U.S. dollar as will most EM and commodity currencies. However, just as the Japanese yen failed to participate in the rally that most currencies experienced against the dollar in 2017, it will struggle to gain much traction against the greenback. The yen is a “risk-off” currency and thus tends to fall whenever global risk assets rally (Chart 28). In addition, the yen will suffer if global bond yields move up relative to JGB yields later this year, as will likely be the case if the BoJ is forced to prolong its yield curve control regime in the face of tighter fiscal policy. We would go long EUR/JPY on any break below 123. After First Weakening, The Dollar Will Rally Again Late Next Year As the U.S. economy encounters ever more supply-side constraints in 2020, growth will slow and inflation will accelerate. The Fed will respond by hiking rates more quickly than inflation is rising. The resulting increase in real interest rates will put upward pressure on the dollar. In this stagflationary environment, equities will tumble and credit spreads will widen. Tighter U.S. financial conditions will reverberate around the world, causing global growth to decelerate even more than it would have otherwise. This will further turbocharge the dollar. The greenback will only peak once the Fed starts cutting rates in late-2021. Commodities: Getting More Bullish A weaker dollar later this year, along with stronger global growth led by a resurgent China, will be bullish for commodities. BCA’s commodity strategists recommend going long copper at current prices. They are also maintaining their bullish bias towards oil. They expect Brent to average $75/bbl this year and $80/bbl in 2020. Higher U.S. shale output will be offset by delays in building out deepwater export facilities, which will keep supply fairly tight. In past reports, we discussed the merits of buying gold as an inflation hedge. However, we held back from doing so because of our bullish dollar view. Now that we see the dollar peaking over the next few months, we would be buyers of gold on any break below $1275/ounce. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Weekly Report, “Gretzky’s Doctrine,” dated March 1, 2019. 2 Please see Global Investment Strategy Weekly Report, “Low Odds Of An FCI Doom Loop,” dated January 4, 2019. 3 Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades
Highlights Just when it looked like the agricultural complex was starting to perk up, it was slapped down again. After crawling its way back from a mid-2018 crash – retracing more than half of its decline – the CCI Grains and Oilseeds index plummeted in February, declining by nearly 9% (Chart Of The Week). The decline was broad-based, but was led by wheat, which was dragged down by muted demand and accounted for most of the index’s decline. Looking forward, we expect U.S. financial conditions and developments on the trade-war front to remain the main forces driving ag prices. Ample inventories will provide the cushion necessary to moderate the impact of potential supply-side shocks. Highlights Energy: Overweight. Venezuela suffered another power outage earlier this week, indicating the deterioration of its infrastructure is accelerating. While officials claim to have restored power, we expect more such outages going forward, which will severely reduce the country’s production and export capacity. Separately, Aramco announced it will buy 70% of Sabic, a Saudi state-owned petchem producer, for $69 billion, according to the Wall Street Journal. Base Metals: Neutral. China’s MMG Ltd was set to declare force majeure following protests at its Las Bambas mine in Peru earlier this week. The mine produces ~ 385k MT p.a., most of which goes to China. Precious Metals: Neutral. The inversion of the U.S. yield curve put a bid into the gold market this week, as investors sought a safe-haven refuge. Continued weakness in bond yields, and accommodative central banks responding to low inflation expectations globally will continue to support gold. Agriculture: Underweight. A more patient Fed will be supportive of ag prices in 2H19, as we discuss below. Feature Chart of the WeekWheat Had A Rough Start To 2019 A Patient Fed Will Support Ags In 2H19 While differences across ag markets will arise due to idiosyncratic supply shocks and targeted trade policies, a common determinant of ag price movements more generally is U.S. financial conditions. Since our last assessment of global ag markets, Fed policymakers have adopted a much more patient approach to monetary policy.1 In line with the pause in the Fed’s rates-normalization policy, financial conditions have eased considerably (Chart 2). We believe this will, ceteris paribus, bring relief to commodity markets in general, ags in particular, in the second half of this year. Chart 2Easier Financial Conditions Bode Well For Ags The bulk of this relief will be transmitted through the impact of a weaker dollar. Since the dollar is a countercyclical currency, its weakness implies an improvement in global growth. This more solid economic backdrop is associated with greater aggregate demand, particularly in EM economies, as well as demand for agricultural products. The lagged effects of financial tightening, weak Chinese credit growth and the trade war will persist in 2Q19. Furthermore, when the USD weakens against the currencies of ag exporting countries, farmers there are incentivized to hoard or cut exports – thus reducing supply – awaiting periods when a stronger greenback will raise their profits. At the same time, ags priced in USD become relatively more affordable for importing nations, incentivizing them to raise consumption. The net impact of this contraction in supply amid greater demand will pull up prices – illustrated by the relatively tight inverse relationship between ag prices and the dollar (Chart 3). Chart 3A Weaker USD Will Be A Tailwind In 2H19 Going into mid-2019, we expect global economic indicators to continue to be uninspiring. The lagged effects of financial tightening, weak Chinese credit growth and the trade war will persist in 2Q19. However, as these factors fade and give way to an improvement in global economic conditions and easier financial conditions, we expect the dollar to peak around mid-year. As such, a resurgence in global growth in the second half of the year will be reflected in an improvement in the value of the currencies of major ag exporters ex-U.S. (Chart 4). Ceteris paribus, this also benefits ag prices. Chart 4Weak Local Currencies Supporting Farm Profits, Incentivizing Production China’s Economy Remains Central Our outlook hinges on developments in the Chinese economy. Peter Berezin – our Chief Global Investment Strategist – expects Chinese authorities to not only stabilize credit growth, but also increase it, creating room for improvement in the world’s second largest economy.2 This combination of supportive global growth and a softer dollar bodes well for ag prices in 2H19. The Fed pause and associated easing in U.S. financial conditions will support global growth, causing the U.S. dollar to weaken – a bullish force for ag markets. Apart from the currency impact, easy financial conditions are supportive of global growth. A rise in income levels of emerging economies will support demand for goods and services generally, and agricultural commodities specifically.3 The market now expects 36 and 51 basis points of rate cuts over the coming 12 and 24 months, respectively. Similarly, following last week’s FOMC meeting, the median Fed dot indicates no rate hikes this year from the U.S. central bank, and only one in 2020. While our Global Investment Strategists would not be surprised to see a hike this year, the noticeably less hawkish tone in the Fed’s forward guidance and dot plots are positive for ag markets.4 Looking beyond that into late-2020 or early 2021, a potential pick-up in inflation will force the Fed to take a more hawkish stance, and once again support the U.S. dollar. This will weigh down on ag prices over the strategic time horizon. Bottom Line: The Fed pause and associated easing in U.S. financial conditions will support global growth, causing the U.S. dollar to weaken – a bullish force for ag markets. However, this is unlikely to occur before mid-year. In the meantime, a stronger dollar on the back of the lagged effects of growth dampening events in 2018, will remain a headwind. Ample Inventories Will Cushion Against Supply Shocks Putting aside the more or less uniform impact of U.S. financial conditions, individual supply-demand fundamentals will manifest as idiosyncratic risks and opportunities. The USDA has been revising its projections for ending stocks higher in its monthly World Agricultural Supply and Demand Estimates (WASDE) across the board since it released the first projections for the 2018/2019 crop year last May. However, we find that solely on the back of fundamentals, soybeans are more likely to resist upward pressure from easier U.S. financial conditions in 2H19 vs. wheat and corn. The USDA’s latest projections for the current crop year indicate that global bean markets are well supplied. Expectations of a global surplus this crop year – for the seventh consecutive year – will add to the growing cushion (Chart 5). Chart 5Beans Surplus Will Add To the Glut Since May, global ending bean stocks have been revised higher by a total of 20.47mm MT. The change in projections comes on the back of upward revisions to production and beginning stocks, compounded by downward revisions to consumption. The latter will likely contract further if the U.S. and China do not reach an agreement on the trade front (see below). Consequently, unless a weather disruption weakens supply, we expect soybean inventories to stand at record highs relative to consumption at the end of the current crop year. In the case of wheat, the impact on prices will likely be marginal. The global balance is expected to shift to a deficit in the current marketing year, following five years of surplus (Chart 6). While this is a positive for wheat prices, given that global inventory levels are relatively elevated – capable of supporting 37% of consumption – and the current deficit is relatively small, we do not expect the deficit to pressure prices in the near term. Chart 6Elevated Wheat Inventories Will Cushion Against Minor Deficit Despite continued downward revisions to the USDA’s wheat production projections, expectations of ending stocks have actually risen on the back of downward revisions to consumption. Similarly, corn fundamentals are also unlikely to sway prices much. The grain is expected to remain in deficit for the second consecutive year, which will pull inventories down off their 2016/17 peak to be capable of covering ~27% of global consumption (Chart 7). Despite this contraction in availability, global supplies remain relatively elevated, especially compared to the 2003 to 2012 period. Thus unless there is a significant supply shock, we don’t expect much support from fundamentals. Chart 7A Global Corn Deficit ... Unlike wheat demand, which has been downgraded, the USDA has revised corn consumption up relative to the first projections for the crop year released last May. Nevertheless, stronger expectations of consumption have been overwhelmed by upward revisions to production and beginning inventory levels. Given that world inventories already are bloated, we do not expect the likely deficit in wheat and corn supplies this crop year to pressure prices much to the upside. Since the mid-1990s, U.S. farmers had been planting more corn and wheat at the expense of soybean acreage (Chart 8). On a global level, while wheat remains more popular in terms of acreage, it is generally trending downwards, while corn and soybean plantings are trending up. However, over the longer term, U.S. farmers are expected to dedicate more land to corn relative to soybeans. Chart 8... Will Be Met By Rising U.S. Acreage Bottom Line: Given that world inventories already are bloated, we do not expect the likely deficit in wheat and corn supplies this crop year to pressure prices much to the upside. Similarly, a global glut in soybean supplies will only add to swelling inventories. The Trade War And Soybeans: It Ain’t Over Till It’s Over Aside from U.S. financial conditions and supply-demand balances, U.S. trade policy has also been roiling ag markets since China slapped U.S. soybeans with 25% tariffs in mid-2018. In fact, since the escalation of the trade dispute, soybean prices have been moving largely in response to developments on the trade front (Chart 9). As developments since the G20 Summit in Buenos Aires last December have been more favorable, soybean markets are on the path to recovery. Chart 9Markets Optimistic Of A Trade War Resolution So far, even though U.S. soybean exports to China picked up over the past two months, total U.S. exports still lag levels typical for this time of year (Chart 10). This comes despite U.S. efforts to raise shipments to other trading partners. Furthermore, U.S. exports will now be in direct competition with the Brazilian crop, which usually dominates trade flows at this time of year (Chart 11). While the U.S. tariff hike from 10% to 25% on $200bn of Chinese goods has been postponed, a resolution to the trade war has yet to occur. The path to a resolution is fraught with risks. While the U.S. tariff hike from 10% to 25% on $200bn of Chinese goods has been postponed, a resolution to the trade war has yet to occur. The path to a resolution is fraught with risks. The Trump-Xi meeting that was expected to occur in late-March was postponed; the next most likely date for a meeting is at the G20 summit in end-June. This leaves another 3 months of trade uncertainty. Nevertheless, our models indicate that soybeans are now priced at fair value, based on U.S. financial variables – absent a trade war (Chart 12). Furthermore, the premium priced into Brazilian beans above those traded on the CBOT has returned to its historical average (Chart 13). Thus, we do not expect a further reduction in the premium in the event Sino-U.S. trade negotiations are successful. Chart 13Premium For Brazilian Beans Has Normalized Rather, markets will be disappointed if the U.S. and China are unable to conclude a deal. This would put CBOT prices at risk and support the premium on those traded in Brazil. Given that our geopolitical strategists assign a non-negligible 30% probability that the trade war escalates further, we believe markets are overly optimistic that a deal will be concluded.5 If the trade war drags on and turns into a multi-year conflict, soybean markets will likely take a more meaningful hit. According to the USDA’s latest long-term projections released earlier this month, China’s soybean imports were projected to rise 32.1mm MT during the 2018-28 period – a massive downward revision from the 46mm MT expected for the 2017-2027 period contained in the previous long-run projections. Furthermore, outbreaks of African swine fever in China may put demand there at risk. Over 100 cases have so far been reported in China, with several cases already reported in Vietnam as well. This threatens to depress China’s need for soybean as animal feed, regardless of what happens on the trade front. Bottom Line: A positive outcome from the U.S.-China trade negotiations is not a given. Nevertheless, soybean markets are treating it as such. Our geopolitical strategists assign 30% odds that a final deal falls through. This non-negligible probability threatens to cause soybean prices to relapse anew, should Sino-U.S. trade negotiations break down. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Footnotes 1 Please see “2019 Key Views: Policy-Induced Volatility Will Drive Markets,” published by BCA Research’s Commodity & Energy Strategy December 13, 2018. It is available at ces.bcaresearch.com. 2 Please see BCA Research’s Global Investment Strategy Weekly Report titled “What’s Next For The Dollar,” dated March 15, 2019, available at gis.bcaresearch.com. 3 Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Global Financial Conditions Will Drive Grain Prices In 2018,” dated November 30, 2017, available at ces.bcaresearch.com. 4 Please see BCA Research’s Global Investment Strategy Weekly Report titled “Questions From The Road,” dated March 22, 2019, available at gis.bcaresearch.com. 5 Please see BCA Research’s Geopolitical Strategy Special Report titled “China-U.S. Trade: A Structural Deal?,” dated March 6, 2019, available at gps.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Trades
Highlights For the Eurostoxx50 to outperform the S&P500, the big euro area banks have to outperform the big U.S. tech stocks. Tactically overweight Eurostoxx50 versus S&P500 as well as other pro-cyclical positions such as overweight EM versus DM… …but prepare to take profits in the summer months. In the medium term, the euro area versus U.S. long-bond yield spread has plenty of scope to compress from its current -180 bps… …and EUR/USD has the scope to head higher. Feature Without a shadow of a doubt, the chart that causes the greatest stir among our clients is the Chart of the Week. It shows that one of the biggest investment decisions, the choice between the euro area and U.S. equity markets, reduces to the choice between the three large euro area banks – Santander, BNP Paribas, and ING – and the three U.S. tech behemoths – Apple, Microsoft, and Google. Chart of the WeekEurostoxx50 Vs. S&P500 Is Just 3 Banks Vs. 3 Tech Stocks! Clients are simultaneously amazed and unsettled by this manifestation of the Pareto Principle, which states that the vast majority of an effect is explained by a tiny minority of causes. Financials feature large in the Eurostoxx50 while tech giants dominate the S&P500. But the amazing thing is that almost all of the relative performance can be explained by just three stocks in each market. The vast majority of an effect is explained by a tiny minority of causes. The chart creates a cognitive dissonance. What about the things that are supposed to matter for stock market selection: relative economic growth, profits growth, margins, valuations and geopolitics? The answer is that all of these are interesting areas of study, but they are mere details in the big picture. For the Eurostoxx50 to outperform the S&P500, the big euro area banks have to outperform the big U.S. tech stocks (Chart I-2). Period. Chart 2For The Eurostoxx50 To Outperform The S&P500, Euro Area Banks Have To Outperform U.S. Tech Our view is that in the immediate future this is certainly possible, but that over the long haul it will prove to be a very tall order. When The Mean Is Meaningless The structural performances of vastly different equity sectors can diverge for a very long time. How long? Japanese banks have underperformed U.S. tech for thirty years and counting! In this situation, mean-reversion and ‘standard deviations’ from the mean become meaningless concepts (Chart I-3). Chart I-3Japanese Banks Have Underperformed U.S. Tech For Thirty Years And Counting! The statistical concept of a standard deviation is only meaningful if the underlying data is stationary, which is to say mean-reverting. If it isn’t, then it is impossible to say that a sector price or valuation is stretched either versus another sector, or versus its own history. One problem is that sector performances and valuations undergo phase-shifts when they enter a different economic climate. The structural outlook for bank profits experiences a phase-shift when a debt super-cycle ends. Therefore, comparing a bank valuation after a debt super-cycle with the valuation during a debt super-cycle is as meaningless as comparing your height as an adult to your height when you were a child! Sector performances and valuations undergo phase-shifts when they enter a different economic climate. To which, a frequent riposte is: within the same sector, euro area companies appear cheaper than their counterparts elsewhere in the world. But again, this apparent value is deceptive because it is simply an adjustment for the so-called ‘currency translation effect’ and the anticipated long-term moves in exchange rates. If investors anticipate the euro ultimately to strengthen – because they see that it is trading well below purchasing power parity – then a multinational company listed on a euro area bourse will suffer a future headwind to its mixed-currency denominated profits when they are translated back to a stronger euro. To discount this anticipated headwind, the euro area multinational must trade cheaper compared with a peer in, say, the U.S. But the cheapness is a false impression. Pulling together these complexities of sector effects, phase-shifts in sector valuations and currency effects, making the big call between Europe and America on the basis of performance or valuation mean-reversion is dangerous. Instead, we come back to the basic question: should you tilt towards euro area financials or towards U.S. tech? Own Banks For The Short Term Only Japanese financial sector profits peaked in 1990 and stand at less than half that level today. Euro area financial sector profits peaked in 2007, and are tracking the Japanese experience with a 17-year lag. If euro area financial profits continue to follow in Japan’s footsteps, expect no sustained growth through the next 17 years (Chart I-4). Chart I-4Euro Area Financial Profits Are Following Japanese Footsteps In a post credit boom era, banks lose the lifeblood of their business: credit creation. This loss becomes a multi-decade headwind to financial sector profit growth and share price performance. Bank profits are dependent on two other drivers. One is operational leverage – the amount of equity held against the balance sheet. More stringent European regulation is making this a headwind too. Banks have to hold more equity capital against assets, diluting their profitability. The other driver is the net interest margin – the difference between rates received on loans and rates paid on deposits. In this regard, both fintech and the blockchain are likely to create a further headwind to bank profitability. Japan’s experience suggests that euro area financials will struggle to outperform structurally. Admittedly, U.S. tech may also face its own headwinds or phase-shift, most obviously antitrust lawsuits to counter its near-monopoly status. But even allowing for this, Japan’s experience suggests that euro area financials will struggle to outperform structurally. Rather, financials is a sector to play for outperformance phases lasting no more than a few quarters. Last autumn, we noted that short-term credit impulses in the major economies were flipping from a sharp down-oscillation into an up-oscillation phase (Chart I-5). On that basis, we recommended a tactical overweight to Eurostoxx50 versus S&P500 as well as other pro-cyclical positions such as overweight EM versus DM. Those pro-cyclical sector positions have broadly succeeded, but they are still appropriate given that up-oscillation phases very reliably last around nine months. Chart I-5Short-Term Credit Impulses Have Flipped To Up-Oscillations The caveat is: prepare to take profits in the summer months. The Fed Is Now At ‘Neutral’, But Where Is The ECB? Last week, the Federal Reserve confirmed that “the Federal funds rate (at 2.5 percent) is now in the broad range of estimates of neutral – the rate that tends neither to stimulate nor to restrain the economy.” This begs the question: where is the ECB policy rate (now at 0 percent) relative to its neutral? Our very high conviction view is that the ECB policy rate is well below neutral. Financials is a sector to play for outperformance phases lasting no more than a few quarters. The twenty year life of the euro captures multiple manias and crises, some centred in Europe, some in the U.S. Through these twenty years, the euro area versus U.S. long bond yield spread has averaged -50 bps1 (Chart I-6). Over this same period, the euro area versus U.S. annual inflation differential has also averaged -50 bps (Chart I-7). Ergo, the real interest rate differential has averaged zero. Meaning, the ex-post neutral real interest rates in the euro area and the U.S. have been exactly the same. Chart I-6The Euro Area Vs. U.S. Yield Spread Has Averaged -50 Bps... Chart I-7...The Euro Area Vs. U.S. Inflation Spread Has Also Averaged -50 Bps With little difference in the neutral real rates over the past two decades, is there a valid reason to expect a difference in the future? An obvious response is the fragility of the euro area’s banking system will require the ECB to persist with its zero interest rate policy for years. In Germany and France, bank lending is healthy, and could easily weather modestly tighter monetary policy. In fact, the evidence suggests that this fear is exaggerated. In Germany and France, bank lending is healthy, and could easily weather modestly tighter monetary policy (Chart I-8). The problem has been localised in Italy, where bank lending relapsed once again in 2018. Chart I-8Bank Lending Is Healthy In Germany And France However, on closer examination this was a direct result of political tensions. Recently, Italian bank lending has been a very tight (inverse) function of the Italian bond yield. The BTP yield spiked last year when Rome escalated its budget spat with Brussels, and bank lending took a hard hit. But now that the Italian bond yield has retraced, lending should recover (Chart I-9). Chart I-9Italian Bank Lending Should Recover Now That The Bond Yield Has Come Down The central issue is can the U.S. policy rate – which is at neutral – and the ECB policy – which is below neutral – diverge much from here? Our high conviction answer is no. Therefore, in the medium term, the euro area versus U.S. long-bond yield spread has plenty of scope to compress from its current -180 bps, one way or the other (Chart I-10). Chart I-10Can Interest Rate Expectations Diverge Much From Here? It also implies that after remaining range-bound in the immediate future, EUR/USD has the scope to head higher. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System This week’s recommended trade is to go long SEK/NOK, as it is close to the limit of tight liquidity that has signaled many previous technical reversals in this currency cross. Set a profit target of 1.5 percent with a symmetrical stop-loss. In other trades, the on-going rally in government bonds caused the short position in 30-year T-bonds to hit its stop-loss. This leaves us with five open positions. Long SEK/NOK. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 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. * 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 Footnotes 1 Calculated from the over 10-year government bond yield: euro area average, weighted by sovereign issue size, less U.S. Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Driven by its fear that deflation is a more intractable danger than inflation, the Federal Reserve has enshrined its pause for the remainder of 2019 in order to lift inflation expectations. Since the U.S. business cycle expansion is not over, the Federal Reserve’s plan to put policy on hold this year raises the odds that the economy will overheat. Global growth is set to bottom during the second quarter in response to easier financial conditions. Accommodative policy, rebounding global economic activity and a softening dollar will boost risk asset prices during the remainder of the year. Safe-haven bonds, including Treasurys, will underperform cash over the coming 12 to 18 months. The rally in risk assets will ultimately prove the last hurrah as the Fed will resume tightening later this year or in 2020, and a bear market lies down the road. Only investors with tactical investment horizons should aggressively play this rally. Those with longer investment horizons should use this rally to lighten up their exposure to risk. Feature Introduction Following the introduction of the word “patience” into the Federal Reserve’s lexicon, a move lower in the so-called Fed dots was to be anticipated. The FOMC now expects no rate increases in 2019 and only one hike in 2020. The interest rate market remains skeptical that the Fed will be able to deliver on its forecast. For now, the OIS curve is pricing in a 75% probability of a cut this year, and rates at 1.9% by the end of 2020. With the 10-year/3-month yield curve inverting last week and the U.S. Leading Economic Indicator still decelerating, it is no wonder that investors are betting on the Fed becoming ever more dovish (Chart I-1). BCA is inclined to take the Fed at its word – the next move will be a hike, not a cut. This call rests on our view of the business cycle: The fed funds rate is still somewhat below neutral, U.S. economic activity can expand further, and global growth is likely to trough soon. The current dovish inclination of global central banks will only nurture the cycle a little bit longer. Consequently, we continue to recommend a positive stance on stocks for the coming quarters, while keeping in mind that the cycle is long in the tooth, and that beyond this last climb lies a significant bear market. The U.S. Business Cycle Has Further To Run… The Fed remains data dependent, but this now means that depressed inflation expectations in the private sector need to be vanquished before the hiking can resume (Chart I-2). With the view that low realized inflation has curtailed expectations now common across major central banks, this implies that a temporary overshoot in actual core PCE will be tolerated in order to lift expectations. Chart I-1Worrisome Signs For Growth Chart I-2The Fed Wants To Lift Inflation Expectations Since consumer prices are a lagging variable, lifting both realized and anticipated inflation will only be possible if we move ever further along the business cycle, further pressuring the economy. Our base case remains that the risk of a recession is low in 2019, and is even receding in 2020. First, U.S. credit-dependent cyclical spending currently constitutes only 25.3% of potential GDP. As Chart I-3 illustrates, this is in line with its historical average, and well below the levels recorded near the end of previous business cycles. This suggests that the amount of vulnerability caused by misallocated capital is not yet in line with previous cycles. It also indicates that the share of output generated by the sectors most sensitive to higher rates is also low. Chart I-3U.S. Cyclical Spending: Limited Signs Of Vulnerability Second, the consumer remains in good shape. Households have deleveraged, and debt-service payments relative to disposable income are still near multi-generational lows (Chart I-4). Moreover, thanks to a saving rate of 7.6%, consumer spending is likely to move in line or even outperform income growth. On this front, the outlook is also good. As Chart I-5 demonstrates, the link between wages and salaries relative to the employment-to-population ratio for prime-age workers – a measure of labor utilization unaffected by the demographic changes that have muddied the interpretation of the unemployment rate – is still as tight as it was 20 years ago. Thus, as long as the labor market does not suddenly collapse, wage growth will continue to accelerate, supporting household income and consumption. Chart I-4Household Balance Sheets Are Solid Third, at 0.4% of GDP, the fiscal thrust remains positive. In other words, fiscal policy will still add to GDP in 2019. Fourth, we do not see the traditional symptoms associated with a fed funds rate above neutral. After dipping sharply in the second half of 2018, mortgage for purchase applications are back near their cycle highs (Chart I-6). Moreover, the performance of homebuilders’ equities relative to the broad market has begun to rebound, which is inconsistent with a fed funds rate above neutral. Chart I-6Mortgage Applications Do Not Suggest Policy Is Tight Fifth, there is scope for the contribution from housing sector activity to morph from a negative to a positive. A fed funds rate below neutral historically is correlated with an improving housing market. Rising mortgage rates from 3.8% to 4.6% depressed home sales and construction output, and the fall in mortgage rates over the past x month 4.3% should stimulate housing activity (Chart I-7). Chart I-7Residential Activity Will Rebound This Year Bottom Line: U.S. first-quarter GDP growth will be dismal, but one quarter does not make a trend. The low degree of economic vulnerability in the U.S., and the likelihood that the fed funds rate will stay below neutral for a while suggest that growth should rebound to the 2-2.5% range and should remain above-trend for the remainder of 2019. … And Global Growth Will Soon Trough As the cliché goes, it is darkest before the dawn. This is a fitting description of the world economy outside the U.S. right now. Global trade is depressed, global PMIs are moribund and nothing feels good. But it is exactly when nothing is going well that one needs to wonder what may cause the outlook to turn for the better. Thankfully, green shoots are emerging. To begin with, central banks around the world have taken a more dovish slant. This dovish forward guidance is nurturing global activity via a significant easing in global financial conditions, which is undoing the severe brake-pumping imposed on global growth in the fourth quarter of 2018 (Chart I-8). Chart I-8Global Financial Conditions Are Easing This more dovish forward guidance has helped our Financial Liquidity Index, which sharply deteriorated through 2009, rebound. Historically, this presages an improvement in the BCA Global Leading Economic Indicator (Chart I-9). Improving liquidity conditions have already been reflected in lower real rates around the globe, creating a reflationary impulse. EM financial conditions are responding positively, pointing to an upcoming pick-up in industrial activity, as measured by our Global Nowcast (Chart I-10). Chart I-9Improving Global Liquidity Backdrop Chart I-10A Tailwind From EM? Our Global LEI diffusion Index has begun to reflect some of these developments. After forming a trough in 2018, more than 50% of the countries in our Global LEI are currently experiencing a sequential improvement in their LEIs. We are now entering the normal lag after which a broadening growth impulse converts into aggregate activity moving higher (Chart I-11). Most interestingly, investors do not seem to be anticipating such a rebound. There is therefore room for growth surprises around the world. Chart I-11Scope For Growth Surprises China has a role to play in this story, will likely morph from a headwind to global growth to a positive. Positive may be a strong word, but at the very least, we expect China to stop detracting from global growth. Premier Li-Keqiang recently put the accent on stability and preserving employment, suggesting Chinese policymakers are likely to de-emphasize deleveraging over the coming 12-18 months. For Chinese growth to improve, deleveraging does not even have to stop. As both theory and history have shown, a slower pace of deleveraging means that the credit impulse moves back into positive territory and growth re-accelerates, even if only temporarily (Chart I-12). Chart I-12Growth Can Improve Even If Deleveraging Continues As a thought experiment, if Chinese leverage were to stabilize this year and nominal growth were to hit 8% – the lower bound of the real GDP target of 6-6.5% and inflation of 2% – the Chinese credit impulse would surge to more than 10% of GDP (Chart I-13)! We are not forecasting such a large rebound in the impulse, but this exercise clearly shows that if the Chinese authorities – who are cutting taxes and trying to ease credit conditions for small- and medium-sized enterprises – want to favor stability and employment for just one year, the impact on growth will be non-negligible, even if deleveraging continues. Since domestic demand responds to the credit impulse, and imports sport an elevated beta to domestic demand, Chinese imports are likely to soon morph from a negative to something more neutral – maybe even a small positive for the rest of the world. Chart I-13A Thought Experiment Finally, as weak as Europe is right now, it will likely be an important source of positive surprises in the second half of the year. To begin with, Europe is much more sensitive to EM growth conditions than the U.S. (Chart I-14). In the same way as Europe felt the full force of the deceleration in global trade last year, it will benefit from any improvement in trade this year. A myriad of idiosyncratic shocks rammed through the euro area last year, worsening an already difficult situation. The new WLTP emission standards caused German auto production to collapse by nearly 20%. Nonetheless, as contracting domestic manufacturing orders and a large inventory pullback in the final quarter of last year suggest, the inventory overhang has been worked off (Chart I-15, top panel). Chart I-15Passing European Idiosyncratic Shocks Just as critically, Italy’s technical recession should end soon. The country’s economic malaise reflected the tightening in financial conditions that followed the violent battle between Rome and Brussels early last year. Ultimately, Rome folded: The budget deficit is 2.3% of GDP, not above 6%, and threats of leaving the union have been abandoned. Consequently, financial conditions are easing. Italian bond auctions are massively oversubscribed this year, and rising bond prices are supporting the solvency of the Italian banking system. The last hurdle affecting Europe was the fact that funding stress in the Italian and Spanish banking systems have been directly addressed by the TLTRO-III announced three weeks ago by the European Central Bank. Spanish and Italian banks have to refinance EUR 425 billion of TLTRO-II this June, in a year where a sizeable amounts of European bank bonds also needs to be refinanced. This is simply too much. With the ECB again bankrolling Italian and Spanish financial institutions, funding stress in the periphery can decline. Consequently, the European credit impulse, which had formed a valley in 2018 Q1, can continue its ascent (Chart I-15, bottom panel). Bottom Line: Investors expect little from the global economy outside the U.S., yet easing liquidity and financial conditions, a temporary shift in Chinese policy preferences and passing idiosyncratic shocks in Europe all point to improvement in global economic activity. U.S. Inflation Expectations Will Allow The Fed To Resume Rate Hikes Above-potential growth in the U.S. and rebounding economic activity in the rest of the world are consistent with higher – not lower – U.S. inflation. First, rebounding global growth is normally associated with a weakening dollar (Chart I-16). This time will not be different, especially as U.S. equity valuations relative to global stocks suggest that investors are particularly pessimistic on non-U.S. growth. A weaker dollar will lift import prices, commodity prices, and goods prices, helping inflation move higher. Chart I-16The USD Is Counter-Cyclical Second, the change in the velocity of the money of zero maturity in the U.S. is consistent with a further strengthening in core inflation (Chart I-17). Chart I-17The Fisher Equations Points To Gently Rising Inflation Third, above-trend U.S. growth in the context of elevated capacity utilization is also consistent with rising inflation (Chart I-18). Chart I-18Elevated U.S. Capacity Utilization If these three forces can cause core PCE inflation to move slightly above 2% in the second half of 2019, this will likely result in inflation expectations firming. Moreover, the combination of positive growth surprises around the world and easy monetary and liquidity conditions will prove supportive of asset prices globally, implying further easing in global and U.S. financial conditions. This set of circumstances will allow the Fed to shift its tone toward the end of 2019, in order to crystalize additional hikes in 2020. Additionally, we estimate the U.S. terminal policy rate to be around 3.25%. In fact, a longer-than-originally-anticipated Fed pause reinforces confidence in this assessment, even if it means that it will take longer to reach the terminal level than we previously thought. Bottom Line: Our growth outlook is consistent with robust inflation and improving inflation expectations. This means we disagree with interest rate markets and anticipate the Fed will resume its hiking campaign instead of cutting rates next year. Moreover, easier-for-longer policy also strengthens our view that the fed funds rate can end this cycle near 3.25%. Stay Positive On Risk Assets For Now… Most bear markets are linked to recessions. It follows that if the U.S. business cycle can be extended and the Fed remains on the easy side of neutral for longer, then the S&P 500 has more upside (Chart I-19). So do global equities. Chart I-19Low Bear-Market Risk This view is reinforced by the fact that buy-side analysts and investors alike have aggressively curtailed their expectations for EPS growth this year, to 3.9% for the U.S. and 4.9% outside the U.S. Yet, our profit model suggests that U.S. EPS growth is likely to come in at around 8.1% this year. Earnings revisions are pro-cyclical. Hence, our expectation that the BCA global Leading Economic Indicator meaningfully revives in the second half of 2019 points toward analysts having ample room to revise global earnings higher in the second half of the year (Chart I-20). Chart I-20Global Profit Margins Will Improve If Growth Rebounds Moreover, global valuations experienced a reset last year. Despite a rebound, the forward P/E ratio for the MSCI All-Country World Index remains in line with 2014 levels, 12.5% lower than at their apex last year. When looking at the U.S., our composite valuation index has also improved meaningfully (Chart I-21). This improvement in valuations increases the probability that a bottom in global growth will lift stock prices. Chart I-21Large Improvement In The Equity / Risk Reward Ratio Our Monetary Indicator further reinforces this message. After being a headwind for stocks over the past eight quarters, now that the Fed has paused and is essentially guaranteeing low real rates for an extended period, this gauge is growing more supportive of further equity price gains (Chart I-22). Chart I-22Stock-Friendly Monetary Backdrop A below-benchmark duration exposure for fixed-income portfolio still makes sense, even if the Fed has prolonged its pause. As per our U.S. Bond Strategy service’s “Golden Rule Of Treasury Investing,” if the Fed increases rates more than the market has priced in 12 months prior, Treasurys underperform cash (Chart I-23). Even if the Fed does nothing this year, it will still be more than the OIS curve is currently pricing in. Moreover, the dollar is likely to soften and the Fed is increasingly taking the risk of falling behind the realized inflation curve. This should create upside not only for inflation breakevens but also for term premia, which are depressed everywhere across the G-10. The yield curve should modestly steepen in this environment. It may take a bit more time than we originally expected, but safe-haven bond yields are trending higher, not lower. Chart I-23The Golden Rule Of Treasury Investing Spread products are also likely to continue to do well. Easy monetary policy, a soft U.S. dollar, an ongoing U.S. business expansion, an upcoming rebound in global growth and rising asset values all point toward a delay of the inevitable wave of defaults. Corporate bonds may offer poor value and credit quality has deteriorated, but an end to the business cycle and a tighter Fed will be key to catalyzing these poor fundamentals. We are not there yet. The Brexit saga continues to have the potential to unsettle markets. Nonetheless, we would fade any broad market sell-off linked to poor British headlines. As Marko Papic writes in this month's Special Report, despite continued political uncertainty in Westminster this year, the risk of a no-deal Brexit is dwindling by the minute, and political logic suggests that there is a high probability that the U.K. will ultimately remain in the EU in two to three years. Bottom Line: After the reset in valuations and earning expectations last year, markets should continue their ascent. The Fed has showed that its “put” is alive and well. This will both favor risk-taking and extend the duration of the business cycle. If global growth can rebound in the second quarter, it will create fertile ground for strong asset prices over the bulk of 2019. Treasury yields will also exhibit upside, even if achieving these higher rates will take more time now. … But Beware What Lurks Below The benign outlook for this year masks that the rally in risk assets is living on borrowed time. A Fed willingly falling behind the curve may fan speculative flames this year, but it doesn’t mean that policy will stay easy forever. On the contrary, the inevitable rise in inflation will push rates higher down the road and the unavoidable recession will ultimately materialize, most likely somewhere around 2021. Since asset valuations will only grow more inflated between now and then, a bigger fall will ultimately ensue. Our Composite Valuation Indicator may currently be flashing a positive signal, but dynamics within its components already point to brewing trouble down the road (Chart I-24). First, the balance sheet group of indicators has showed no improvement. In other words, without last year’s rebound in profitability, stocks would not be as attractively valued as the overall indicator suggests. Chart I-24Disconcerting Internal Dynamics Second, the interest rate group is currently flattering aggregate valuations. To remain supportive of higher returns ahead, this group depends on interest rates staying constrained. Here, the Fed will play a particularly perverse role. Its willingness to tolerate inflationary pressures right now means lower rates today at the price of a higher cost of capital tomorrow. Once it becomes obvious that the Fed is falling behind the curve – something more likely to happen once inflation expectations normalize – safe-haven yields will rise sharply. The interest rate group will suddenly look a lot less supportive than it does today. Third, the profit components of our valuation indicator may look healthy today, but this will not remain the case. At 31.7%, EBITD margins are currently extraordinary elevated. In fact, if the profit margins were to normalize to their historical average, the Shiller P/E would skyrocket to 40.3 from 29.9 today, implying the stock market may be just as expensive as it was at the start of 2000. For margins to remain wide, wages will have to stay depressed relative to selling prices (Chart I-25). However, the combination of an economy at full employment and the Fed goosing economic growth points to rising wages. Since the pass-through from wages to prices is below 100%, unless productivity rises more than labor costs, profitability will suffer and P/E ratios will start sending the same message as the price-to-sales ratio, a multiple that currently stands near record highs. Chart I-25Rising Wages Will Ultimately Hurt Profits Valuations are not the only danger lurking for stocks: Spread products will morph from a tailwind to a headwind for equities. Whether or not it steepens a bit this year, the yield curve’s previous big flattening already points toward rising financial market volatility (Chart I-26). The Fed’s recent dovish tilt can keep the VIX and the MOVE compressed for a while longer. However, since inflation expectations will ultimately move higher, likely within a year or so, the Fed will once again tilt to the hawkish side, and volatility will follow its path of least resistance higher. Carry trades of all kinds will suffer, and spreads will widen. The deteriorating credit quality this cycle, with BBB and lower-rated issues constituting 60.1% of the corporate universe, could make this widening more violent than normal. This phenomenon will hurt stocks. Chart I-26Volatility Is A Coiled Spring Finally, the improvement in global growth this year is likely to prove temporary. China may want to slow the pace of deleveraging this year, but pushing debt loads lower and reforming the economy remains Beijing’s number one priority on a multi-year horizon. China has created USD 26 trillion worth of yuan since 2008, making the Chinese money supply larger than the euro area’s and the U.S.’s together. As a result, China’s incremental output-to-capital ratio continues to trend lower, implying large misallocation of capital (Chart I-27). State-owned enterprises, the recipients of much of the credit created over the past 10 years, now generate lower RoAs than their cost of borrowing, an unmistakable sign of poorly allocated funds. Chart I-27The Biggest Threat To China's Long-Term Prosperity Correcting this structural impediment will require the Chinese credit impulse to once again move back into negative territory. This means that unless Chinese policymakers abandon their efforts to prise the country off easy credit, Chinese growth will morph back into a headwind for the world somewhere in 2020, i.e. not so late as to encourage excesses, but not so early as to sharply slow the economy ahead of the Communist Party’s one-hundredth birthday in July 2021. In 2018, the global economy nearly ground to a halt after China had shifted from stimulus to policy tightening. The next time around, we doubt that a global recession will be avoided. The second half of 2020 may set up to be one tumultuous period. Bottom Line: In all likelihood, global risk assets should perform well this year, but we are living on borrowed time. In the background, equity valuations are deteriorating meaningfully, a phenomenon that will worsen once the Fed’s desired outcome comes to fruition: higher inflation. Wage pressures and higher interest rates will reveal how fully rotten stock valuations genuinely are. Compounding this effect, higher volatility and a resumption of China’s deleveraging efforts will likely achieve the coup de grace for stocks in the second half of 2020. Conclusion The FOMC wants to lift inflation expectations in order to defuse any lingering deflationary risk. Consequently, the Fed’s pause will last longer than we originally anticipated, but terminal rates are likely to climb higher than would have otherwise been the case. Before last week’s Fed meeting, the U.S. was already set to grow above trend. Now, the Fed will only extend the business cycle further, fanning greater inflationary pressures in the process. This potentially misguided reflationary impulse, which is echoed around the world, will contribute to a rebound in global growth that will become fully evident by the summer. Consequently, we expect risk assets to climb to new highs over the coming 12 months. Treasurys will likely underperform cash over that timeframe, as interest rate markets are currently too sanguine. Investors are facing a real dilemma. On one hand, the potential for elevated stock market returns is high over the coming 12 months. On the other, poor valuations will only grow more onerous, and the Fed will ultimately have to tighten policy even more following the on-hold period. Moreover, Chinese policymakers are unlikely to ignore the pressing danger created by misallocating capital for an extended period of time. Consequently, the outlook for long-term returns is deteriorating. As a result, we recommend more tactically minded investors to stay long stocks, with a growing preference for international equities that are both cheaper and more exposed to global growth than U.S. ones. However, longer-term asset allocators should use this period of strength to progressively move out of stocks and into safer alternatives. Mathieu Savary Vice President The Bank Credit Analyst March 28, 2019 Next Report: April 25, 2019 II. The State Of Brexit So What? It makes sense for long-term investors to buy the GBP. However, short-term investors should instead buy the 2-year call while selling 3-month ones. Why? The U.K. electorate is not staunchly Euroskeptic. In fact, Bregret has already set in. Volatility is the only sure bet over the tactical and strategic time horizons. The most likely scenario is that Theresa May either resigns and is replaced by a soft-Brexit Tory, or that she agrees to a long-term extension to give the U.K. time to call a new election. Brexit is unsustainable over the secular time horizon. Our low-conviction view is that in the long term, the U.K. will remain inside the European Union. The hour is late in the ongoing Brexit saga. The original deadline, once spoken of with religious reverence, will be tossed aside for one, potentially two, extensions. In this analysis, we attempt to consider the state of Brexit from multiple time horizons. First, we offer our tactical view, what will happen in the next several weeks and months. Second, we offer our strategic view, surveying the Brexit process to the end of the year. Third, we consider the secular view and attempt to answer the question of whether the U.K. will ever fully exit the EU. We then assign investment recommendations across the three time horizons. How Did We Get Here? In March 2016, three months ahead of the fateful June referendum, BCA’s Geopolitical Strategy and European Investment Strategy published a joint report on the topic that drew three conclusions: The probability of Brexit was understated by the market. “According to our modeling results, roughly 64% of Tory undecided voters would have to swing to the “Stay” camp in order to ensure that the vote crosses the 50% threshold in favour of continued EU membership … Conventional wisdom suggests that the probability of Brexit is around 30%, anchoring to the 1975 referendum results. Our own analysis of current polling data suggests that it is much closer to 50%, as in too close to call.” The biggest loser of Brexit, domestically, would be the Conservative Party. “The risk is that the British populace realizes that leaving the EU was a sub-optimal result and that little sovereignty was recovered. As such, there could be a backlash against the Tories in the next general election. In this scenario, the winner would not necessarily be UKIP, but rather the Jeremy Corbyn-led Labour Party – as close to the Michael Foot-led opposition in the early 1980s as any Labour Leadership.” The EU would survive, intact, with no further “exits.” “European integration is therefore a gambit for relevance by Europe’s declining powers. Brexit will not create centrifugal forces that tear the EU apart, and could in fact enhance the sinews that bind EU member states in a bid for 21st century geopolitical relevance.” Thus far, all three predictions have proven prescient. Not only was the probability of Brexit understated, but the electorate actually voted to exit the EU.1 The Conservative Party has wrapped itself into an intellectual pretzel trying to deliver on a referendum that the pro-Brexit Tories – a minority in the party – promised would not mean losing access to the Common Market. And the EU has not only seen no other “exits,” but has held firm and united in the negotiations with the U.K. while witnessing an increase in the support for its troubled currency union, both in the Euro Area in aggregate as well as in crisis-ridden Italy (Chart II-1). Chart II-1The Euro Area Stands Unified The net assessment we conducted in 2016 correctly gauged what the Brexit referendum was about and what it was not about. Our view was that behind the angst lay factors too general to be laid at the feet of European integration. Decades of supply-side reforms combined with competition from emerging economies led to a sharp rise in U.K. income inequality (Chart II-2), the erosion of its manufacturing economy (Chart II-3), and the ballooning of the country’s financial sector (Chart II-4). As a result, the U.K.’s income inequality and social mobility were, in 2016 as today, much closer to those of its Anglo-Saxon peer America than to those of its continental European neighbors (Chart II-5). Chart II-2Brits Saw Inequality Surge Chart II-3Manufacturing Jobs Collapsed Chart II-4The Financial Bubble Burst The underlying economic angst has continued to influence British politics since Brexit. Campaigning on an anti-austerity platform in the summer of 2017, the Labour Party leader Jeremy Corbyn nearly won the general election, only underperforming the Conservative vote by 2% (Chart II-6). The election was supposed to politically recapitalize Theresa May and allow her to lead the U.K. out of the EU. But the failure to secure a single-party majority created the political math in the House of Commons that is today preventing the prime minister from executing on Brexit. There are simply not enough committed Brexiters in Westminster to deliver on the relatively hard Brexit – no access to the EU Common Market or customs union – that Prime Minister May has put on offer (Chart II-7). The decision not to pursue a customs union arrangement with the EU is particularly disastrous. As our colleague Dhaval Joshi – Chief Strategist of BCA’s European Investment Strategy – has pointed out, remaining in the customs union would have protected the cross-border supply chains that are vital to many U.K. businesses and would have avoided a hard customs border on the island of Ireland.2 However, the slim margin of the Tory victory in 2017 has boosted the influence of the 20-to-40 hard-Brexiters in the party. They pushed Theresa May to the extreme, where a customs union arrangement – let alone access to the Common Market – became politically unpalatable. Had the British electorate genuinely wanted “Brexit über alles,” or the relatively hard Brexit on offer today, the margin of victory for Leave would have been greater. Furthermore, the electorate would not have come so close to giving the far-left Corbyn – who nonetheless supports the softest-of-soft Brexits – a majority in mid-2017. The slim margin of victory effectively tied May’s hands in her subsequent negotiations with both the EU and her own party. But there was more to the 2016 referendum than just general malaise centered on the economy and inequality. There were idiosyncratic events that provided tailwinds for the Leave campaign. Or, as we put it in 2016: Certainly, a number of ills have befallen the continent in quick succession: the euro area sovereign debt crisis, Russian military intervention in Ukraine, rampant migrant inflows from Africa and the Middle East, and terrorist attacks in France. It is no surprise that the U.K. populace wants to think twice about tying itself even more closely to a Europe apparently on the run from the Four Horsemen of the Apocalypse. The two issues we would particularly focus on were the migrant crisis and terrorist attacks in Europe. Data ahead of the referendum clearly gave credence to the view that the influx of migrants was raising “concerns about immigration and race.” This angst was primarily focused on EU migrants who came to the U.K. legally (Chart II-8), but the influx of millions of migrants into the EU in 2015 – peaking at 172,000 in the month of October – certainly bolstered the anxiety in the U.K. (Chart II-9).3 Chart II-8EU Migrants A Source Of Anxiety In 2016 Chart II-9The Refugee Crisis Boosted Brexit Vote Terrorism was another concern. In the 18 months preceding the referendum, continental Europe experienced 13 deadly terror attacks. Two were particularly egregious: the November 2015 Paris terror attack that led to 130 deaths, and the March 2016 Brussels terror attack that led to 32 deaths. Both the migration and terror crises, however, were temporary and caused by idiosyncratic variables with short half-lives. BCA’s Geopolitical Strategy argued that both would eventually abate. The migration crisis would subside due to firming European attitudes towards asylum seekers and the exhaustion of the supply of migrants as the Syrian Civil War drew to its tragic close. The extremist Islamic terror attacks would dwindle due to the decrease in the marginal utility of terror that has been observed in previous waves of terrorism (Chart II-10). Neither forecast was popular with our client base, but both have been spot on. Chart II-10Fewer Attacks Due To Declining Marginal Utility Of Terror The point is that the British electorate was never as Euroskeptic as the Euroskeptics cheering on Brexit thought. Support for EU integration has waxed and waned for decades (Chart II-11). Instead, a combination of macro-malaise caused by the general plight of the middle class – the same factors that have given tailwinds to populist policymakers across developed markets – and idiosyncratic crises in the middle of this decade created the context in which the public voted to leave the EU. Whatever the vote was for, we can say with a high degree of certainty that it was not in favor of the current deal on offer, a relatively hard Brexit. After all, the pro-Leave Tories almost universally campaigned in favor of remaining in the Common Market post-Brexit.4 Chart II-11Data Does Not Support Euroskeptic U.K. Today, Bregret has clearly set in. Not only on the specific issue of whether the U.K. should leave the EU – where the gap between Bremorseful voters and committed Brexiters is now 8% (Chart II-12), a 12% swing since just after the referendum – but also on the more existential question of whether U.K. citizens feel European (Chart II-13). Chart II-12Bregret Has Set In... Chart II-13...And Brits Feeling More European The political reality of Bregret is the most important variable in predicting Brexit. Not only is it difficult for Prime Minister May to deliver her relatively hard Brexit in Westminster due to the mid-2017 electoral math, but it is especially the case when the electorate does not want it. Yes, the mid-2016 referendum is an expression of a democratic will that must be respected. But no policymaker wants to respect the referendum at the cost of disrespecting the current disposition of the median voter, which is revealed through polls. Doing so will cost them in the next election. Reviewing “how we got here” is essential in forecasting the tactical, strategic, and secular time horizons in the ongoing Brexit imbroglio. To this task we now turn. Bottom Line: The U.K. electorate is not staunchly Euroskeptic: data clearly support this fact. The Brexit referendum simply came at the right time for the Leave vote, as the secular forces of middle-class discontent combined with idiosyncratic crises of migration and terror. Three years following the referendum, the discontent remains unaddressed by British policymakers while the idiosyncratic crises have abated. As such, Bregret has set in, creating a new reality that U.K. policymakers must respond to if they want to retain political capital. Where Are We Going? The Tactical And Strategic Time Horizons The EU has offered a two-step delay to the Article 50 deadline of March 29. The first option is a delay until May 22, but only if Theresa May successfully passes her Brexit plan through Westminster. The second option is a delay until April 12. This would come in effect if the House of Commons rejects the deal on offer. The short time frame is supposed to pressure London to come up with the next steps, which the EU has inferred would either be to get out of the bloc without a deal or to plan for a long-term extension. Although there are no official conditions to awarding a long-term extension, it is clear that the EU only envisages three options: Renegotiate the terms of Brexit, to include either a customs union or full Common Market membership (a softer Brexit); Hold a general election to break the impasse; Hold another referendum. The EU is suggesting that it could deny the U.K. an extension if London does not come back with a plan. There are two reasons why we would call the EU’s bluff. First, it is likely an attempt to help May get the deal through the House of Commons by creating a sense of urgency. Second, the European Court of Justice (ECJ) ruled in December 2018 that the U.K. could “revoke that notification unilaterally, in an unequivocal and unconditional manner, by a notice addressed to the European Council in writing.”5 The only requirement is that the notification be sent to Brussels prior to March 29 (or, in the case of a mutually agreed upon extension, prior to April 12). It is increasingly likely that, after the deal on offer fails, Theresa May will have to go “hat-in-hand” to the EU to ask for a much longer extension. She will have until April 12 to ask for that extension, but it would require participation in the European Parliamentary (EP) elections on May 23. Prime Minister May has said that the U.K. will not hold those elections. We beg to differ. Not holding the election would allow the EU to end the U.K.’s membership in the bloc, which would by default mean contravening the Parliament’s will to reject a no-deal Brexit (which it did in a rebuke to the government in March). As such, the U.K. will absolutely hold an EP election in May. Yes, it will be a huge embarrassment to the Conservative government. And we would venture that the election would turn out a huge pro-EU majority from the U.K., given that it is the Europhile side of the aisle that is now excited and activated, further embarrassing the ruling government. The most likely scenario, therefore, is that Theresa May either resigns and is replaced by a soft-Brexit Tory, or that she agrees to a long-term extension to give the U.K. time to call a new election. As we have been arguing throughout the year, the only way to break the impasse without calling a referendum – is to call a new election. A new election would be contested almost exclusively on the issue of Brexit – unlike the 2017 election, which Jeremy Corbyn managed to be almost exclusively contested on the issue of austerity. As such, the winner would have a clear political mandate to pursue the Brexit of their choice. If it is Jeremy Corbyn, this would mean a second referendum, given his recent conversion to supporting one. If Theresa May remains prime minister, it would be her relatively hard Brexit option; if another Tory replaces her, it would potentially be a softer Brexit. Intriguingly, Theresa May is coming up to the average “expiry date” of a “takeover” prime minister, which is 3.3 years (Chart II-14). Why do we think that Theresa May would be replaced with a soft Brexit Tory? Because there are simply not enough members of parliament in the Conservative Party caucus to elect a hard Brexiteer. Furthermore, the current deal on offer, which is a form of hard Brexit, clearly has no chance of passing in the House of Commons. Theresa May herself did not support the Leave campaign, but she converted into a hard Brexiteer due to the pressures in the Conservative Party caucus. If, on the other hand, we are wrong and the Conservative Party elects a hard Brexit Tory as leader, the odds of losing the election to the Labour Party would increase. Furthermore, the impasse in the House of Commons would not be resolved as Theresa May would be replaced by a prime minister with essentially the same approach to Brexit. Confused? You are not alone. Diagram II-1 illustrates the complexity of the tactical (0-3 months) and strategic (3-12 months) time horizons. There are so many options over the next six months alone that we ran out of space in our diagram to consider the consequences of the general election. Needless to say, an election would induce volatility in the market as it would put Jeremy Corbyn close to the premiership. While he has now promised a second referendum, his government would also implement policies that could, especially in the short term, agitate the markets. Our forecasts of the currency moves alone suggest that volatility is the only sure bet over tactical and strategic time horizons. We do not have a high-conviction view on a directional call on the pound or U.K. equities. However, global growth concerns, combined with political uncertainty, should create a bond-bullish environment. Bottom Line: Over the course of the year, political uncertainty will remain high in the United Kingdom. A general election is the clearest path to breaking the current deadlock. However, it is not guaranteed, as Labour’s recent decline in the polls appears to be reversing since Jeremy Corbyn finally succumbed to the demands that he support a new referendum (Chart II-15). Chart II-15Labour Party Revives On Referendum Support The Secular Horizon BCA Geopolitical Strategy believes that the median voter is the price maker in the political market place. Politicians are merely price takers. This is why Theresa May’s notion that the sanctity of the 2016 referendum cannot be abrogated is doubly false. First, she cannot truly claim from the slim 52%-48% result that U.K. voters want her form of Brexit. The referendum therefore may be a sacred expression of the democratic will, but her “no customs union” Brexit option is not holy water: It is an educated guess at best, pandering to hard Brexit Tories (a minority of the electorate) at worst. Given that 48% of the electorate wanted to remain in the EU and that a large portion of Brexit voters wanted a Common Market membership as part of Brexit, it is mathematically obvious that the softest of soft Brexit options was the desire of the median voter in June 2016. Furthermore, polling data (presented in Chart II-12 and Chart II-13 on page 28) now clearly show that the median voter is migrating away from even the softest of soft Brexit options to the “Stay” camp. Bregret has set in and a strong plurality of voters no longer supports Brexit. The question behind Chart II-12 is unambiguous. It clearly asks, “In hindsight, do you think Britain was right or wrong to vote to leave the EU?” What does all of this infer for the long term, or secular, horizon? First, an election this year could usher in a Labour government that delivers a new referendum. At this time, given the polling data and the geopolitical context, sans terror and migration crises, we would expect such a referendum to lead to a win for the Stay camp. Second, an election that produces a soft Brexit prime minister or negotiated outcome would allow the U.K. to leave the EU in an orderly fashion. A new Tory prime minister, pursuing a soft Brexit outcome, could even entice some Labour MPs to cross the aisle and support such an exit from the bloc. However, over a secular time horizon of the next two-to-three years, we doubt that a soft Brexit outcome would be viable. Investors have to realize that the vote on leaving the EU does not conclude the U.K. long-term deal with the bloc. That negotiating phase will last during the transition phase, over the next two-to-three years, and would conclude in yet another Westminster vote – and likely crisis – at the end of the period. If this deal entails membership in the Common Market, our low- conviction view over the long term is that it will ultimately fail. Take the financial community’s preferred soft Brexit option, the so-called super soft “Norway Plus” option. A Norway Plus option would entail the highest loss of sovereignty imaginable, given that the U.K. would essentially pay full EU membership fees with no ability to influence the regulatory policies that London would have to abide by. There is also a debate as to whether London would be able to constrict immigration from the EU under that option over the long term, a key demand of Brexiters.6 As such, the only viable option would be to switch to a customs union relationship. However, we fear that even this option may no longer be available to U.K. policymakers. Conservative Party leaders have wasted too much time and lost too much of the public’s good will. With only 40% of the electorate now considering Brexit the correct decision, it is possible that even a customs union arrangement will be unacceptable by the end of the transition period. Aside from the electorate’s growing Bregret, there is also the economic logic – or lack thereof – behind a customs union. A customs union would ensure the unfettered transit of goods between the U.K. and the continent, but not of services. This arrangement greatly favors the EU, not the U.K., as the latter has a wide (and growing) deficit in goods and an expanding surplus in services with the bloc (Chart II-16). Chart II-16Services Are Key For The U.K. The only logic behind selecting a customs union over the Common Market is that a customs union would allow the U.K. to conclude separate trade deals with the rest of the world. While that may be a fantasy of the few remaining laissez-faire free traders in the U.K. Conservative Party, the view hardly represents the desire of the median voter. Other than a potential trade deal with the U.S., it is practically inconceivable to expect the U.K. electorate to support a free trade agreement with China or India, both of which would likely entail an even greater loss of blue-collar jobs. Even a trade deal with the U.S. would likely face political opposition, given that the U.K. is highly unlikely to be given preferential treatment by an economy seven times its size.7 The fact of the matter is that the Conservative Party has wasted its window of opportunity to push a hard, or moderately hard (customs union), Brexit through Parliament. Bregret has set in, as the doyens of Brexit increasingly pursued an unpopular strategy. On the other hand, a Brexit that retains the U.K. membership in the Common Market has never had much logic to begin with. Where does this leave the U.K. in the long term? Given the time horizon and the uncertainty on multiple fronts, our low-conviction view is that it leaves the U.K. inside the European Union. Bottom Line: The combination of increasing Bregret, lack of economic logic behind a customs union membership alone, and the lack of a political logic behind a Common Market membership, suggests that Brexit is unsustainable over the secular time horizon. This imperils the ultimate deal between the U.K. and the EU, which we think will not be able to pass the House of Commons in two-to-three years when it comes up for approval. This is a low-conviction view, however, as political realities can change. Support for Brexit could turn due to exogenous factors, such as a global recession that renews the Euro Area economic imbroglio or a major geopolitical crisis. Both are quite likely over the secular time horizon. Investment Implications Today, cable is cheap, trading at an 18% discount to its long-term fair value as implied by purchasing-power parity models (Chart II-17). The growing probability that the U.K. may, down the road, remain in the European Union means that, at current levels the pound is indeed attractive, especially against the U.S. dollar. Chart II-17Cable Attractive On Higher Odds Of Bremain However, when it comes to short-term dynamics, the picture is much murkier. The low probability of a no-deal Brexit implies limited downside. However, the path to get the U.K. to abandon the current relatively hard Brexit is also one that involves a new election. This implies that before a resolution is reached, multiple scenarios are possible, including one where Corbyn becomes the next prime minister. Jeremy Corbyn could be the most left-of center leader of any G-10 nation since Francois Mitterrand in France in the early 1980s. Mitterrand’s audacious nationalization and left-leaning policies were met with a collapse in the French franc (Chart II-18). Chart II-18A Left-Wing Leader Bodes Ill For The Currency Global growth also has an impact on cable. Despite all the noise around Brexit, the reality remains that exports constitute 30% of U.K. GDP, a larger contribution to output than in the euro area. This means that if global growth deteriorates, GBP/USD will face another headwind. If, however, global growth improves, then cable would face a new tailwind. Since BCA is of the view that global growth will likely trough by the summer, we are inclined to be positive on the pound. Netting out all those factors, it makes sense for long-term investors to buy the GBP, using the dips along the way to build a larger position in this currency. Even on a six-to-twelve-month basis, the path of least resistance for cable is likely upward. The problem is that risk-adjusted returns are likely to be poor as volatility will remain very elevated. We therefore recommend that short-term investors instead buy the 2-year call while selling 3-month ones (Chart II-19). Chart II-19Volatility Will Be A Challenge For Short Term Investors Marko Papic Senior Vice President Chief Geopolitical Strategist Mathieu Savary Vice President The Bank Credit Analyst III. Indicators And Reference Charts Equities have had a volatile month of March, something that was bound to happen after the violent rally witnessed from the end of December to the end of February. When a rally is being tested, it always make sense to review our indicators to gauge whether or not a trend change is in the offing. Generally, our indicators remain broadly positive. Our Willingness-to-Pay (WTP) indicators for the U.S. and the euro area continue to improve. Meanwhile, it has begun to hook back up in Japan. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The current readings in major advanced economies thus suggest that investors are still inclined to add to their stock holdings. Our Revealed Preference Indicator (RPI) has however once again deteriorated, suggesting that the period of churn in global equities prices could last a bit longer. This indicator is essentially saying that in order to resume their ascent, stocks need a bit more time to digest their previous surge. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. According to BCA’s Composite Valuation Indicator, an amalgamation of 11 measures, the U.S. stock market remains slightly overvalued from a long-term perspective. Nonetheless, despite this year’s rally, the S&P 500 offers a much more attractive risk/reward profile than it did in the fall. Moreover, our Monetary Indicator has shifted out of negative territory for stocks, and is now decisively in stimulative territory. The Fed’s dovish forward guidance last week only reinforces the message from this indicator. Our Composite Technical Indicator for stocks had broken down in December, but it is finally flashing a buy signal. This further confirms that the current period of churn is most likely to ultimately make way for a continued rally in the S&P 500. The 10-year Treasury yield remains within its neutral range according to our valuation model. Moreover, our technical indicator flags a similar picture. This means that without signs of improvements in global growth, price action alone will not be enough to lift bond yields higher. That being said, since BCA expects that over the next 24 months, the Fed will lift rates more than the OIS curve anticipates, and since the term premium is incredibly low, once green shoots for global growth become evident, bonds could suffer a violent selloff. The U.S. dollar is still very expensive on a PPP basis. Our Composite Technical Indicator is not as overbought as it once was, but it is far from having reached oversold levels either. This combination suggests that the greenback could experience further downside this year. However, for this downside to materialize, global growth will first have to stabilize. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1 At the time of publication of our March report, we still had a low-conviction view that the vote would swing towards Stay at the last moment. 2 Please see BCA Research European Investment Strategy Weekly Report, “Important Message From The Currency Markets,” dated March 14, 2019, available at eis.bcaresearch.com. 3 Trying to play up the threat of unchecked migration, the U.K. Independence Party ran a famous campaign poster showing hundreds of refugees on a road under the title of “Breaking Point – The EU has failed us all.” Despite the fact that the U.K. accepted only around 10,000 Syrian refugees since the 2015 crisis. Germany has accepted over 700,000 while Canada – which is located across the Atlantic Ocean on a different continent – accepted over 40,000. Even the impoverished Serbia has accepted more Syrian refugees than the U.K. 4 One of the most prominent Leave supporters, Boris Johnson, famously quipped after the referendum result that “There will continue to be free trade and access to the single market.” 5 Please see The European Court of Justice, “Judgement Of The Court,” In Case C-621/18, dated December 10, 2018, available at curia.europa.eu. 6 Proponents of the Norway Plus option point out that Article 112(1) of the European Economic Area (EEA) Agreement allows for restriction of movement of people within the area. However, these restrictions are intended to be used in times of “serious economic, societal or environmental difficulties.” It certainly appears to be an option for London to restrict EU migration, but it is not clear whether Europe would agree for this to be a permanent solution. Liechtenstein has been using Article 112 to impose quantitative limitations on immigration for decades, but that is because its tiny geographical area is recognized as a “specific situation” that justifies such restrictions. 7 President Donald Trump may want to give the U.K. preferential trade terms on the basis of the filial Anglo-Saxon relationship alone, but it is highly unlikely that the increasingly protectionist Congress would do the same. There is also no guarantee that President Trump will be around to bring such trade negotiations across the finish line. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:
Highlights Analysis on Turkey is published below. The key reason why we believe the ongoing EM rally will falter is that EM corporate earnings have begun to contract. When EPS growth turns negative, low interest rates typically do not prevent share prices from selling off. The recent pick-up in China’s credit and fiscal spending impulse suggests the bottom in EM corporate profit growth will only occur toward the end of 2019. There are several key differences between the economic backdrops and financial markets signposts between now and 2016. The current profiles of both EM and DM share prices are a close match to those in 2011-2012 when the strong rally in the first quarter was followed by a major selloff in the second quarter. Feature The common narrative in the market is that the current policy backdrop – a pause by the Fed and policy stimulus from China – is a repeat of early 2016. As such, market participants expect moves in global risk assets to be analogous to those during that period. We too could easily adopt this simple narrative, and recommend investors to chase EM higher. Instead, we have chosen to take on the very difficult task of expounding why 2019 is not a repeat of 2016 in EM and China-related financial markets. Based on this, our view remains that investors should not be chasing the current EM rally. The essential pillar of our negative thesis on EM is that their corporate profits will contract this year. This will be bad news not only for EM share prices but also for EM credit markets and currencies. Chart I-1 illustrates that during the past 10 years, EM stock prices plunged every time profit contraction commenced. Having rallied meaningfully in the past three months, EM financial markets will sell off as EM corporate earnings begin to shrink. Chart I-1EM EPS Is Beginning To Contract The basis for EM profit contraction is the continued slowdown in China. Chart I-2 illustrates that China’s credit and fiscal spending impulse leads EM EPS growth by about 12 months. Hence, the recent pick-up in the former entails the bottom in the latter only toward the end of 2019. Chart I-2EM EPS Growth Will Bottom Only Toward The End Of 2019 In brief, even assuming China’s credit and fiscal spending impulse has bottomed and will improve going forward, EM EPS contraction will deepen for now. EM share prices are unlikely to embark on a cyclical bull market until EM EPS growth bottoms. Earnings Versus Interest Rates Lower interest rates are typically bullish for both equity and credit markets so long as corporate profits do not contract. However, when EPS growth turns negative, low interest rates usually do not prevent share prices from selling off. In general, when discussing the effect of interest rates on equities, one should differentiate between economic and financial linkages. Given the cornerstone narrative of this EM rally has been declining U.S. interest rate expectations, we examine the nexus between EM risk assets and U.S. interest rates. The economic link refers to the impact of borrowing costs on aggregate spending, and hence corporate profits. The pertinent question is as follows: Was the Fed tightening responsible for the growth deceleration in EM/China in 2018? The short answer is not really. Chart I-3 illustrates that as of the end of February, while Korean, Taiwanese, Japanese and Singaporean exports to the U.S. expanded by 10% from a year ago, their shipments to China contracted by 10%. Chart I-3Global Trade Slowed Due To China Not The U.S Hence, the slowdown in EM corporate profits has not been caused by Fed policy. U.S. domestic demand in general and imports in particular have so far been expanding at a healthy pace and they have not been instrumental to EM corporate earnings cycles (Chart I-4). This signifies that lower U.S. interest rates should not have a material impact on EM growth, and thereby corporate profits. Chart I-4EM EPS Growth Has Not Been Driven By Sales To U.S. Notably, one can argue that the economic and financial market dynamics that prevailed in 2018 worked in the opposite direction: It was China’s slowdown that ultimately imperiled U.S. manufacturing growth, causing U.S. equity and credit markets to sell off, thereby forcing a reversal in the Fed’s stance. The financial link refers to a declining discount rate for EM risk assets as U.S. interest rates drop. A drop in the discount rate lifts the present value of future cash flows and boosts risk asset prices. However, EM equity multiples have not been historically negatively correlated with U.S. bond yields, as shown on the top panel of Chart I-5. Besides, EM credit spreads do not always positively correlate with U.S. borrowing costs, as widely expected (Chart I-5, middle panel). Chart I-5U.S. Bond Yields And EM: No Stable Relationship Further, EM currencies have not been negatively correlated with either U.S. bond yields or with the interest rate differential between the U.S. and EM (Chart I-5, bottom panel). As to EM local bond yields, especially in high-yielding markets, it is EM exchange rates that drive EM domestic bond yields and their differential over U.S. Treasurys. When EPS growth turns negative, low interest rates usually do not prevent share prices from selling off. Finally, Chart I-6 illustrates the relationship between the returns on EM assets on one hand and U.S. bond yields on the other. This chart corroborates the evidence from Chart I-5 – that the relationship between U.S. interest rates and EM asset markets is not stable. Chart I-6U.S. Bond Yields And EM Risk Assets: No Stable Relationship Even though in the short term financial markets in developing countries seem to react to changes in U.S. interest rates, in the medium and long run there is no stable relationship between EM risk assets and U.S. Treasury yields. In short, lower U.S. interest rate expectations is not a sufficient condition to be positive on EM risk assets. How do we explain the absence of a strong relationship between these financial and economic variables? Our take is as follows: When EPS growth turns negative, low interest rates typically do not prevent share prices and credit markets from selling off. That is why there is no clear and strong relationship between EM risk assets and U.S. interest rates. Was the Fed tightening responsible for the growth deceleration in EM/China in 2018? The short answer is not really. Corporate earnings are the key to sustaining this EM rally. What is needed for EM corporate profits to recover is a revival in Chinese demand. The latter is not yet imminent, implying that EM assets will likely hit an air pocket before a more durable bottom occurs. Are lower interest rates in China a justification for the latest EM equity rebound? Chart I-7 demonstrates that both EM and Chinese investable stock indexes positively correlate with interest rates in China. The reason is because all of them are driven by Chinese growth: When growth accelerates, these share prices and Chinese local bond yields rise, and vice versa. Chart I-7Chinese Interest Rates And EM / China Share Prices: Positive Correlation Bottom Line: Lower interest rates in the U.S. or in China in and of themselves do not constitute sufficient conditions for a cyclical rally in EM share prices. The primary driver of EM share prices in the past 10 years has been Chinese growth, because the latter has a considerable bearing on EM corporate profits. For now, there have been no substantive signs of a growth revival in China. How 2019 Is Different From 2016 We elaborated in detail on how the current round of policy stimulus in China differs from the one in 2015-‘16 in our report titled, Dissecting China’s Stimulus, and will not discuss it here. Instead, we offer several economic and financial signposts illustrating how the EM/China outlook and financial market dynamics in 2019 will differ from those of 2016: Presently, there is no meaningful policy stimulus for the real estate market in China, and property sales will continue to shrink (Chart I-8). This is the opposite of what occurred in 2015-‘16 when the Chinese central bank literally monetized excessive housing inventories by financing residential real estate via its Pledged Supplementary Lending (PSL) facility. The ensuing surge in property demand substantially contributed to the business cycle recovery on the mainland in 2016-‘17. Chart I-8A Downbeat Outlook For Chinese Housing EM share prices have been underperforming the DM equity index since late December. In contrast, EM began outperforming DM in January 2016 (Chart I-9). Chart I-9EM Equities Have Been Underperforming DM Ones Since Late December In early 2016, the pace of EM profit contraction stabilized after 18 months of deepening shrinkage (Chart I-1 on page 1). What’s more, investor sentiment on EM was very downbeat in early 2016. Presently, the EM profit contraction is just commencing, and its rate of change will bottom only in late 2019, as per Chart I-2 on page 2. In the meantime, investors are ill prepared for bad news, as their sentiment on EM is extremely buoyant. Finally, the broad trade-weighted U.S. dollar began selling off in early 2016, corroborating the EM rally. This year the broad measure of the trade-weighted dollar has not sold off. Hence, the dollar has not yet confirmed the EM rebound (Chart I-10). Chart I-10The U.S. Dollar And EM Share Prices Is 2019 Akin To 2012? In terms of share-price patterns, the current profiles of both EM and DM are a close match to those in 2011-2012 (Chart I-11). Following a major plunge in the second half of 2011, share prices bottomed in December 2011 and rallied sharply in the following three months. Not only is the duration similar to what transpired with share prices in 2011-’12, but also the magnitude (Chart I-11). Chart I-11Is 2018-19 Akin To 2011-12? As to the economic backdrop in 2011-‘12, the euro area was in the midst of a credit crisis and China/EM growth was slowing due to the preceding Chinese policy tightening. After the strong rally in January-March 2012, both EM and DM bourses sold off sharply in the second quarter of 2012, re-testing their late 2011 lows. Critically, like the present and unlike early 2016, EM stocks were underperforming DM ones during the early 2012 rally. Lower U.S. interest rate expectations is not a sufficient condition to be positive on EM risk assets. On the surface, it appears that the magic words of the European Central Bank President Mario Draghi that “…the ECB is ready to do whatever it takes to preserve the euro” that halted the global selloff. Yet, in reality, Draghi’s speech was the trigger for – not the cause of – the markets’ reversal. In retrospect, the primary reason for a major bottom in global risk assets in June 2012 was the bottom in the global business cycle in the second half of 2012 (Chart I-12, top panel). Chart I-12Global Growth Has Not Yet Bottomed As can be seen on this panel, global equity prices are often coincident with “soft” economic data like global manufacturing PMI. Global stocks typically lead “hard” economic data and corporate profits but do not always lead “soft” data. Presently, the bottom in global manufacturing and trade is not yet in sight. The bottom panel of Chart I-12 shows that Taiwanese exports of electronics products parts are still nose-diving, and they typically lead global manufacturing PMI by a few months. These electronics parts are inputs into final goods; when producers of these goods plan to increase production they first order these parts. As a result, trade in these electronics parts lead the broader trade/manufacturing cycle. Taiwanese exports of electronics products parts are still nose-diving, and they typically lead global manufacturing PMI by a few months. On the whole, odds are that China’s business cycle as well as global trade and manufacturing have not yet hit a durable bottom and are not about to recover. Countries/industries leveraged to China will experience a meaningful profit contraction. Hence, there is a significant probability that EM stocks re-test their recent lows akin to what transpired in 2012. Investment Considerations There is no meaningful evidence indicating that China’s business cycle and global trade and manufacturing have bottomed. Global cyclical equity sectors have rebounded but have not yet decisively broken above their 200-day moving averages (Chart I-13). Crucially, their relative performance to the overall global index has been rather sluggish (Chart I-14). This corroborates the lack of global growth tailwinds behind this global equity rally. Chart I-13Global Cyclical Equity Sectors: Absolute Performance Chart I-14Global Cyclical Equity Sectors: Relative Performance Asset allocators should continue to underweight EM stocks and credit markets within their global equity and credit portfolios, respectively. Without an improvement in the global business cycle, the rebound in EM currencies is not durable. As China’s growth disappoints, EM currencies will depreciate versus the dollar, the euro and the yen. Renewed currency depreciation will erode returns on EM local currency bonds for international investors. For dedicated EM local bond portfolios, our recommended overweights are Mexico, Brazil, Chile, Russia, central Europe, Thailand and Korea (Chart I-15). Our underweights are South Africa, Indonesia, India and today we are downgrading Turkish local bonds to underweight (please refer to section on Turkey starting on the next page). Chart I-15Favor These Local Currency Bond Markets Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Turkey: Brewing Policy Reversal? The odds of a policy reversal in Turkey are rising. The government’s patience with tight monetary policy may be running thin. The nation’s GDP contracted by 3% in the final quarter of 2018 from a year ago. Further contraction is in the cards. Chart II-1 signifies that monetary policy is indeed tight: Lira-denominated bank loan growth is at zero, and in real (inflation-adjusted) terms bank lending has shrunk by about 18% from a year ago. The ongoing painful economic retrenchment (Chart II-2) and rising unemployment may lead the authorities to loosen monetary policy/liquidity conditions via “backdoor” liquidity easing – something the Turkish central bank has done often over the current decade. Specifically, the central bank’s liquidity provisions to the banking system will likely begin to rise (Chart II-3). The severe liquidity tightening, underway since October 2018 via reduced lending to banks, has been partially responsible for the stability in the exchange rate. As the central bank augments liquidity provisions to the banking system, the lira will again come under renewed selling pressure. Rising unemployment may lead the authorities to loosen monetary policy/liquidity conditions via “backdoor” liquidity easing. The goal of liquidity provisioning would be to bring down interbank rates and, ultimately, lending rates. Presently, the spread between commercial banks’ lending rates and the interbank rate is negative (Chart II-4, top panel). This is unsustainable. The authorities have forced banks to bring down their lending rates in recent months. As a result, the gap between banks’ lending and deposit rates has also narrowed considerably (Chart II-4, bottom panel). This will weigh on the banks’ profitability. Consequently, we are closing our tactical long Turkish banks / short EM banks trade. The government cannot force banks to reduce their lending rates further without reducing their cost of funding. Hence, the central bank might opt to inject excess reserves into the system to bring down interbank rates. Thereafter, the authorities could “guide” banks to further lower their lending rates. Policy easing might not be in the form of outright policy rate cuts to avoid a negative reaction from financial markets. Instead, the central bank could push down inter-bank rates by way of obscure liquidity injections into the banking system. To be sure, the odds of the currency reacting poorly to such loosening of liquidity are non-trivial. This, along with the ongoing recession, the shrinking bank net interest margins and the slow pace of bank loan restructuring, are leading us to downgrade the Turkish bourse that is heavy in bank stocks. Investment Recommendations Downgrade Turkish stocks and local currency bonds back to underweight. We closed our short/underweight positions in the Turkish currency, bonds and equities on August 15, 2018. For details, please see the report Turkey: Booking Profits On Shorts. This has proved to be a timely move as Turkish markets have rebounded notably and outperformed their EM peers (Chart II-5). In our opinion, it is now time to downgrade it again. We are also closing our tactical long Turkish banks / short EM banks trade. This position has netted a modest 2.3% gain since its initiation on November 29, 2018. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Investors should use the following dynamic for tactical asset allocation: 1. Sum the 10-year yields on the T-bond, German bund, and JGB. 2. When the sum is near 4 percent, it is prudent to de-risk portfolios and sit aside, at least for a while. It is a good level to buy a mixed portfolio of high-quality 10-year government bonds. 3. Just below this level, a sum in the 3-4 percent range defines a kind of ‘no man’s land’ in which equities drift sideways. 4. When the sum is near 3 percent, the seemingly rich valuations of equities versus bonds is fully justified. And it is appropriate to redeploy tactically from bonds to equities (Chart of the Week). 5. Use the 65-day fractal dimension to pinpoint the precise transition points between asset-classes: as for example, successfully achieved for the DAX versus German bunds. Right now, with the sum near 3 percent, it is still appropriate to be overweight equities versus bonds, and our preferred expression is overweight the DAX versus the German long bund. Feature Chart of the WeekThe Rule Of 4 Becomes The Rule Of 3 The global long bond yield recently hit a two-year low (Chart I-2). This is the direct result of central banks’ pivot to dovish – a commitment to keep policy rates at current levels, rather than to hike, for the foreseeable future. Chart I-2The Global Long Bond Yield Recently Hit A Two-Year Low One consequence is that high-quality bonds have become riskier. Consider a German bund or a JGB which is yielding zero percent. The short-term potential for capital appreciation – nominal or real – has almost vanished, while the potential for vicious losses has increased dramatically. The technical term for this negative asymmetry is negative skew. Years of research in a field of behavioural economics called Prospect Theory concludes that negative skew is the metric that best encapsulates investment risk. The Correct Way Of Thinking About Investment Risk A great misunderstanding of finance is to equate risk with volatility. Risky assets, such as equities, are risky not because they are volatile in the conventional sense. After all, who minds when their asset price goes up sharply? Risky assets are risky because they have the propensity to experience much larger short-term losses than short-term gains – captured in the saying: equities climb up the stairs on the way up, but they jump out of the window on the way down. High-quality bonds have become riskier. Another great misunderstanding of finance is the idea that bonds offer a diversification benefit and, therefore, that investors should accept a lower return from them. This argument is also flawed. The bond market is bigger than the equity market, and just as bonds are a diversifier for equity investments, equities are a diversifier for bond investments. Indeed, equities have protected bond investors during vicious sell-offs in the bond market such as after Trump’s shock victory in 2016. So we could equally argue that equities offer a diversification benefit. In fact, the correct way of thinking about investment risk is as follows: An investment’s risk depends on the negative asymmetry of its short-term returns. At very low bond yields, bond returns develop the same negative asymmetry as equity returns (Chart I-3). This means that equities lose their excess riskiness versus bonds, requiring equity valuations to experience a phase transition sharply higher (Chart I-4). But when bond yields normalize, equities regain their excess riskiness versus bonds – and their valuations must suffer a phase transition sharply lower. The phase transition in equity valuations is most pronounced when the global 10-year bond yield goes up or down through 2 percent (Chart I-5). This dynamic proved to be the biggest driver of asset allocation in 2018, and is likely to be a big driver in 2019 too. Essentially, higher bond yields can suddenly and viciously undermine the valuation support of equities, triggering a plunge in the stock market and other risk-assets which threatens a disinflationary impulse. The unsurprising response from central banks is to pivot back to dovish, pulling back bond yields to previous lows. These lower bond yields then push up equity (and other risk-asset) valuations back to previous highs. An investment’s risk depends on the negative asymmetry of its short-term returns. The good news is that record high valuations of risk-assets are fully justified if bond yields remain at current levels or decline further. But the longer-term danger is that these rich valuations are hyper-sensitive to rising bond yields. The Bubble In Everything The current episode of elevated risk-asset valuations is not unprecedented, but there is a crucial difference. Previous episodes of elevated risk-asset valuations tended to be localised, either by geography or sector: 1990 was focussed in Japan; 2000 was focussed in the dot com related sectors; 2008 was focussed in the U.S. mortgage and credit markets. Extraordinary monetary policy has boosted the valuations of all risk-assets across all geographies and all asset-classes. By comparison, the post-2008 global experiment with quantitative easing, and zero and negative interest rate policy has boosted the valuations of all risk-assets across all geographies and all asset-classes – equities (Chart I-6), credit (Chart I-7), and real estate (Chart I-8). This makes it considerably more dangerous, because we estimate that the total value of global risk-assets including real estate is $400 trillion, equal to about five times the size of the global economy.1 Chart I-6Equities Remain Richly Valued Chart I-7Credit Remains Richly Valued Chart I-8The EM Real Estate Boom Happened After 2008 Let’s say you had a risk-asset that was priced to generate 5 percent a year over the next decade. Now imagine that the valuation boost from ultra-accommodative monetary policy capitalises all of those future returns to today. For those future returns to drop to zero, today’s price must surge by 63 percent.2 If you were prudent, you might amortise today’s windfall to generate the original 5 percent a year over the next decade. But if you were imprudent, you might spend a large amount of the windfall today. The total value of global risk-assets equals five times the size of the global economy. Now let’s imagine a valuation derating moves the risk-asset’s returns back to the future. For those that had prudently amortised the original windfall, nothing has really changed and future spending patterns would not be impacted. But not everybody is prudent. For those that had imprudently spent the original windfall, future spending would inevitably suffer a nasty recession. The Rule Of 4 Becomes The Rule Of 3 How can we sense the crucial 2 percent level in the global 10-year bond yield? The answer is that it broadly equates to when the sum of the 10-year yields on the T-bond, German bund and JGB is at a 4 percent level (Chart I-9). This is the genesis of our very successful ‘Rule of 4’. In 2019, just as in 2018, investors should use the following dynamic for tactical asset allocation. The rule of 4 identifies when the global 10-year bond yield is at 2 percent. Chart I-9When The Sum Of 10-Year Yields On The T-Bond, Bund, And JGB Equals 4 Percent, The Global 10-Year Yield Equals 2 Percent Sum the 10-year yields on the T-bond, German bund, and JGB. When the sum is near 4 percent, it is prudent to de-risk portfolios and sit aside, at least for a while. It is a good level to buy a mixed portfolio of high-quality 10-year government bonds. Just below this level, a sum in the 3-4 percent range defines a kind of ‘no man’s land’ in which equities drift sideways. When the sum is near 3 percent, the seemingly rich valuations of equities versus bonds is fully justified. And it is appropriate to redeploy tactically from bonds to equities. Use the 65-day fractal dimension to pinpoint the precise transition points between asset-classes: as for example, successfully achieved for the DAX versus German bunds (Chart I-10). Overweight equities versus bonds. With the sum of the three 10-year yields now near 3 percent, the rule of 4 has, in a sense, become the rule of 3. It is still appropriate to be tactically overweight equities versus bonds, and our preferred expression is to overweight the DAX versus the German long bund. Chart I-10Use The 65-Day Fractal Dimension To Pinpoint The Precise Transition Points Between Asset-Classes Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Please see the European Investment Strategy Weekly Report “Trapped: Have Equities Trapped Bonds?”, September 13, 2018 available at eis.bcaresearch.com. 2 5 percent compounded over ten years.
Highlights Portfolio Strategy As growth becomes scarce, investors flock to sectors that are slated to outgrow the broad market and shy away from the ones that are forecast to trail the SPX’s growth rate. This week we rank sectors and subsectors by EPS growth in our universe of coverage, and identify sweet and trouble spots. Fired up crack spreads, firming refining industry operating metrics, reaccelerating exports along with washed out technicals and compelling valuations, all signal that the time is ripe to buy into refining weakness. The cable industry’s demand headwinds are reflected in depressed relative valuations at a time when industry pricing power is trying to stage a comeback and a drifting lower greenback may also provide positive profit offsets. Stick with a benchmark allocation. Recent Changes Boost the S&P Oil & Gas Refining & Marketing index to overweight all the way from underweight today, locking in relative profits of 21%. Table 1 Feature Equities broke out last week and surpassed the upper band of their recent trading range, despite economic data releases that continued to surprise to the downside. Two weeks ago, we cautioned investors not to put cash to work as a tactical indigestion period loomed, with the SPX facing stiff resistance near the 2,800 level. In addition, we posited that most of the good news related to the U.S./China trade spat front was reflected in the S&P 500’s V-shaped recovery (top panel, Chart 1). In relative terms, the bottom panel of Chart 1 confirms that the easy money has already been made on the assumption of a positive resolution to the U.S./China trade dispute. Chart 1Trade Deal Priced In Going forward, the earnings juggernaut will have to remain in place in order for stocks to vault to fresh all-time highs, likely in the back half of the year. The Trump administration’s massive fiscal stimulus artificially fueled profit growth last year both by lowering the corporate tax rate and by encouraging overseas cash repatriation. The latter boosted share buybacks to an all-time record. Despite 24% EPS growth and $1tn in equity retirement, the SPX ended 2018 6% lower. Why? It became clear that EPS growth was headed lower. In order to gauge trend EPS growth we opt to use EBITDA, a cash flow proxy measure that strips out the direct impact of last year’s fiscal easing. Chart 2 clearly shows that trend growth took a step down following the positive base effects of the GFC-induced collapse and averaged close to 5%/annum from 2012 to 2014. Subsequently, the late-2015/early-2016 manufacturing recession sunk EBITDA into contraction, but the euphoria surrounding the newly elected President pushed trend EBITDA growth to near 10%/annum for two full years in 2017 and 2018. Chart 2Return To 5% Growth? Since the late-2018 peak, 12-month forward EBITDA growth continues to drift lower and is now hovering just shy of 3%. Our sense is that 5% organic profit growth is consistent with nominal GDP printing 4%-4.5% at this stage of the business cycle, signaling that a return to the 2012-2014 growth backdrop is likely later in the year. As a reminder, positive profit growth in calendar 2019 remains one of the three pillars underpinning stocks that we have highlighted since the beginning of this year. Stocks have come full circle recovering all of last December’s losses, but in order to make fresh all-time highs, profits will have to deliver. We deem that an earnings validation phase is transpiring and there are early signs that profit growth will trough sometime in the first half of the year. Not only has EBITDA breadth put in a bottom (Chart 2), but also economically hypersensitive indicators suggest that forward EBITDA growth will soon tick higher. Namely, the ISM manufacturing new orders component has perked up on a year-over-year basis. The trough in lumber futures momentum corroborates this message, as does the tick higher in the U.S. boom/bust indicator (Chart 3). Chart 3Growth Green-shoots Given the current macro backdrop and awaiting the profit validation, when growth becomes scarce investors flock to sectors that are outgrowing the broad market and shy away from ones that trail the SPX’s growth rate. Typically, in recessionary times that would equate to investors bidding up defensive sectors that command stable cash flow businesses and avoiding highly cyclical industries. But, BCA does not expect a recession in the coming year. Thus, in order to identify high growth sectors that should outperform during the current soft patch and growth laggards that should underperform, we compiled a table with the GICS1 sectors and all the subsectors we cover. First, we rank the GICS1 sectors and then within each sector we rank the subsectors, both times by absolute 12-month forward EPS growth using I/B/E/S/ data (see second columns, Table 2). We aim to reproduce this table once a quarter. Table 2Identifying S&P 500 Sector EPS Growth Leaders And Laggards The third columns in Table 2 show the sector growth rate relative to the SPX. The final columns in Table 2 highlight the trend in relative growth. In more detail, they compare the current relative growth rate to that of three months ago: a positive sign indicates an upgrade in analysts’ relative estimates and a negative sign a downgrade in analysts’ relative estimates. Industrials and financials (we are overweight both) are leading the pack outpacing the broad market by 410bps and 350bps, respectively, and enjoy a rising profit trend. On the flip side, energy (overweight) and real estate (underweight) trail the broad market by 490bps and 1480bps, respectively, and showcase a deteriorating EPS trend. With regard to energy, we first identified that analysts are really punishing this sector in the January 22 Weekly Report and the sector’s 2019 EPS contribution was and remains negative.1 Our overweight call will be offside if oil prices suffer a new setback, but our Commodity & Energy strategy service remains bullish on oil, implying relative EPS outperformance in 2019. Year-to-date, energy has bested the SPX by 170bps. This week, we make an energy sector subsurface tweak, and also update a communication services subgroup. Light My Fire Last summer we took refiners down to a below benchmark allocation as all of the good news was perfectly reflected in soaring relative share prices (top panel, Chart 4), at a time when cracks were forming. Now we are compelled to book gains of 21% and boost exposure all the way to overweight. Chart 4Crack Spreads Are On Fire Today, refiners paint a near exact opposite picture compared with last July. Relative share prices are no longer rising by 50%/annum. Instead, momentum has collapsed and is now contracting (middle panel, Chart 4). Sell-side analyst exuberance has turned into outright pessimism: refiners’ profits are expected to trail the broad market in the coming year. By comparison, last summer they were penciled in to beat the market by 30 percentage points (bottom panel, Chart 4). Granted M&A activity had also added fuel to the fire, but now all the hot air has come out of the refining industry, and then some. Refiners’ riches move in tandem with crack spreads. When refining margins widen, profits excel and vice versa. Now that refining margins are in a slingshot recovery, refining ills will turn into fortunes (bottom panel, Chart 4). Importantly, wide Brent-WTI spreads underpin crack spreads. Moreover, the crude oil versus refined product inventory backdrop currently reinforces a widening in refining margins. In absolute terms, gasoline stockpiles are being worked off (gasoline inventories shown inverted, bottom panel, Chart 5) and grinding higher demand for refined petroleum products (top panel, Chart 5) will further tighten the industry’s inventory outlook. Chart 5Healthy Supply/Demand Backdrop One way domestic refiners are taking advantage of the still wide Brent-WTI differential is via the export markets. Net refined products exports are running at over 3mn barrels/day (bottom panel, Chart 6), and the softening greenback since November will further boost profits with a slight lag as U.S. refining exports will grab an even larger slice of the global pie (U.S. dollar shown inverted and advanced, middle panel, Chart 6). Chart 6U.S. Dollar Softness Is A Boon To Refining Profits On the valuation front, both the relative forward P/E and P/S have undershot their respective historical means and EPS breadth is as bad as it gets, offering investors an excellent entry point in the pure-play oil & gas refining industry (Chart 7). Chart 7Extreme Analyst Pessimism Reigns In sum, fired up crack spreads, firming refining industry operating metrics, reaccelerating exports along with washed out technicals and compelling valuations, all signal that the time is ripe to buy into refining weakness. Bottom Line: Lift the S&P oil & gas refining & marketing index to overweight all the way from a below benchmark allocation, crystalizing 21% in relative profits since last summer’s inception. The ticker symbols for the stocks in this index are: BLBG: S5OILR – PSX, MPC, VLO, HFC. Cable’s Down But Not Out Cable & satellite stocks had been in an uninterrupted run from the depths of the Great Recession until the peak in relative share prices in August 2017. Since then, cord cutting news and the proliferation of on demand streaming services have wreaked havoc on the industry and cable stocks have trailed the market by over 33% from peak to the most recent trough (top panel, Chart 8). Chart 8Cable Signals Are… This deteriorating demand backdrop more than offset the industry’s reaction function, which has been intra and inter-industry M&A. Now that the M&A dust has settled, what is next in store for the industry? We reckon that leading profit indicators are a mixed bag and we continue to recommend a benchmark allocation in this niche communications services subgroup. The top panel of Chart 8 shows that relative outlays on cable are on a slippery slope, and will continue to weigh heavily on relative share prices for the coming quarters. Nevertheless, the ISM services survey ticked higher recently and is on the cusp of making fresh recovery highs, unlike its sibling the ISM manufacturing survey. This is encouraging news for cable executives and suggests that demand for cable services may not be as moribund as the PCE release is projecting (second panel, Chart 9). Chart 9..A Mixed… While the cable demand backdrop is unclear, industry pricing power has managed to exit deflation. Cable selling prices have been positive for the better part of the past decade, but starting in late-2017 they collapsed by roughly 600bps relative to overall inflation. True, this deflationary impulse dented profit margins, but currently the industry’s selling prices – and to a much lesser extent profit margins – are in a V-shaped recovery mostly courtesy of base effects (middle & bottom panels, Chart 8). Absent a sustained hook up in cable demand, selling price inflation will prove fleeting and the recent margin expansion phase will also lose steam. Meanwhile, cable stocks and the U.S. dollar enjoy a positive correlation as most of the constituents’ earnings are derived domestically (Chart 10). The recent U.S. dollar softness will, at the margin, weigh on relative profits and thus relative share prices, especially if the Fed stays pat and refrains from raising rates for the rest of the year as the bond market currently expects. Chart 10…Bag Finally, earnings breadth continues to fall, but relative valuations are still well below the historical mean (third & bottom panels, Chart 9). Netting it all out, cable’s demand headwinds are well reflected in depressed relative valuations at a time when industry pricing power is trying to stage a comeback and a drifting lower greenback may both provide positive profit offsets. Bottom Line: Remain on the sidelines in the S&P cable & satellite index. The ticker symbols for the stocks in this index are: BLBG: S5CBST – CMCSA, CHTR, DISH. Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA U.S. Equity Strategy Weekly Report, “Dissecting 2019 Earnings” dated January 22, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights Every diversified currency portfolio should hold the yen as insurance against rising market volatility. However, for tactical investors, the latest dovish shift by global central banks almost guarantees the Bank of Japan will err on the side of stronger stimulus (explicitly or indirectly). Our bias is that USD/JPY could trade sideways in the next three to six months, but EUR/JPY could test 132 by year-end. Carefully monitor any shift in yen behavior in the coming months, in particular its role as a counter-cyclical currency. Investors who need to hedge out sterling volatility should favor GBP calls. Hold onto the USD/SEK shorts established last week, currently 1.6% in the money. USD/NOK shorts are looking increasingly attractive, as will be discussed in next week’s report. Feature The yen has proven an extremely tough currency to forecast in the last few years. Carry-trade investors who used widening interest rate differentials between the U.S. and Japan in 2018 to forecast yen weakness got decimated in the February and March 2018 equity drawdowns. More agile investors who timed the global equity market bottom in early 2016 have been shifted to the wayside on yen shorts, as the currency has strengthened since then. For value-based investors, the yen that was 14% cheap on a fundamental basis in 2015 is 19% cheaper vis-à-vis fair value today. Seasoned investors recognize the need to pay heed to correlation shifts, as they can make or break forecasts. In the currency world, the most recent have been dollar weakness after the Federal Reserve first tightened policy in December 2016, dollar weakness in 2017 despite four Fed rate hikes and more recently, yen resilience despite the equity market rally since 2016. In this report, we revisit traditional yen relationships to identify which have been broken down, and which still stand the test of time. Trading Rules A rule of thumb still holds true for yen investors: buy the currency on any equity market turbulence (Chart I-1). In of itself, this advice is not sufficient. If one could perfectly time equity market corrections, being long the yen will be low on a long list of alpha-generating ideas. Chart I-1The Yen Is A Risk-Off Currency The power of the signal comes when macroeconomic conditions, valuations and investor sentiment all align in a unifying message. Back in late 2016, global growth was soft, the yen was very cheap and everyone was short the currency on the back of a dovish shift by the Bank of Japan (BoJ). Having recently introduced yield curve control (YCC), the market was grappling with the dovish implications for the currency, arguably the most significant change in monetary policy by any central bank over the last several years. In retrospect, this was the holy grail for any contrarian investor. Given that backdrop, the yen strengthened by circa 10% from December 2016 to mid-2017, even as equity markets remained resilient. When the equity market drawdown finally arrived in early 2018, it carried the final legs for the yen rally. This backdrop underlines the golden rule for trading the yen, primarily as a safe-haven currency. Economically, the net international investment position of Japan is almost 60% of GDP, one of the largest in the world. On a yearly basis, Japan receives almost 4% of GDP as income receipts, which more than offsets the trade deficit it has been running since the middle of last year (Chart I-2). It is therefore easy to see why any volatility in markets could lead to powerful repatriation flows back to Japan. Chart I-2Japan's Income Receipts Are Quite Large One other factor to consider is that during bull markets, countries that have negative interest rates are subject to powerful outflows from carry trades. The impact of these are difficult to measure, but it is fair to assume that periods of low hedging costs (which tend to correspond to periods of lower volatility) can be powerful catalysts. As markets get volatile and these trades get unwound, unhedged trades become victim to short-covering flows (Chart I-3). Chart I-3Hedging Costs Have Risen The global picture today has some echoes from 2016. Growth is slowing everywhere and markets have staged a powerful bounce from the December lows. This has been in anticipation of a better second half of this year. In the occasion that data disappointments persist beyond the first half, especially out of China, stocks will remain in a “dead zone,” which will be potent fuel for the yen. This is not our baseline scenario, as we expect growth to bottom in the second half of this year, but it remains an important alternative to consider at a time when Japanese growth is surprising to the downside. If the BoJ is preemptive and eases monetary policy, the yen will weaken. But the odds are highly in favor of the yen strengthening before. Bottom Line: Every diversified currency portfolio should hold the yen as insurance against rising market volatility. The BoJ’s Next Move By definition, any data dependent central bank will be behind the curve, but the incentive for the BoJ to act preemptively this time around is getting stronger. The starting point is that history suggests the consumption tax hike, scheduled for October this year, will be disastrous for the economy. Since the late 1990s, every time the consumption taxed has been hiked, the economy has slumped by an average of over 1.3% in subsequent quarters. For an economy with a potential growth rate of just 0.5%-1%, this is a highly unpalatable outcome (Chart I-4). More importantly, similar to past episodes, the consumption tax is being hiked at a time when the economy is slowing, with growth in the third quarter of last year clocking in at -2.4%. Chart I-4The Consumption Tax Hike Will Be Negative However, things are not that simple for the Japanese Prime Minister Shinzo Abe’s administration. Despite relatively robust economic conditions since the Fukushima disaster, consumption has remained tepid, even though there has been tremendous improvement in labor market conditions. By the same token, the savings ratio for workers has surged (Chart I-5). If consumers are caught in a Ricardian equivalence negative feedback loop,1 exiting deflation becomes a pipe dream for the central bank. Chart I-5Strong Labor Market, Weak Consumption The good news is that the government realizes this and has been taking steps to remedy the situation. At the margin, this is positive: The Japanese government recently passed a law that will allow the largest inflow of foreign workers into the country. There are about 1.5 million foreign workers in Japan today, who collectively constitute circa 2% of the labor force. The importance of foreign labor cannot be understated. Due to Japan’s demographic cliff, foreign workers were responsible for 30% of all new jobs filled in 2017. Assuming public aversion towards immigration remains benign, as is the case now (these are mostly lower-paying jobs in sectors with severe labor shortages), the government’s target to attract 350,000+ new workers by 2025 will go a long way in alleviating the country’s chronic labor shortage. This will also be marginally beneficial for consumption. Abe’s government hopes to offset the consumption tax hike with increased social security spending, especially on child education. For example, preschool and tertiary education will be made free of charge, financed by the tax hike. Labor reform has gone a long way to increase the participation ratio of women in the labor force (Chart I-6), but the reality is that almost 50% of single mothers in Japan still live below the poverty line, according to the BoJ. This is because many of them remain temporary workers. Temporary workers receive about half the pay of full-time workers’ and are not privy to most social security benefits. This has contributed to the surge in the worker’s savings ratio. Alleviating this source of uncertainty could help solve the consumption problem. Chart I-6Rising Female Participation In The Labor Force Transactions made via cashless payments (for example, via mobile pay) will not be subject to the 2% tax increase for nine months. Cashless payments in Japan account for less than 25% of overall transactions – among the lowest of developed economies. Increasing the share of cashless payments will help lift the velocity of money, which will be a positive development for the BoJ (Chart I-7). Chart I-7Money Velocity Is Still Falling Finally, the Phillip’s curve appears to be finally working in Japan, with wages accelerating at a 1.4% pace. Provided the government continues to indirectly put pressure on big firms to raise wages by at least 2-3% in upcoming Shunto wage negotiations, this trend should continue. An extended period of rising wages will help shift the adaptive mindset of Japanese households away from deflation (Chart I-8). Chart I-8Rising Wages Will Help At The Margin The BoJ pays attention to three main variables when looking at inflation: Core CPI prices, the GDP deflator and the output gap, in addition to other measures. The recent slowdown in the economy has tipped two of those indicators in the wrong direction (Chart I-9). This makes it difficult for the Abe administration to declare victory over deflation – something he plans to do before his term expires by September 2021. Chart I-9Inflation Variables Are Softening The perfect cocktail for the Japanese economy will be expansionary monetary and fiscal policy. But despite government efforts to offset the consumption tax hike with higher spending, the IMF still projects the fiscal drag in Japan to be 0.7% of GDP in 2019. This puts the onus on the BoJ to ease financial conditions. At minimum, this suggests that either the stealth tapering of asset purchases by the BoJ could reverse and/or new stimulus could be announced. Bottom Line: The swap markets are currently pricing some form of policy easing in Japan over the next 12 months. Ditto for Japanese banks (Chart I-10A and Chart 10B). Given the recent dovish shift by global central banks, the probability of a move by the BoJ has risen. Any surprise move will initially strengthen USD/JPY. However, given the probability that the dollar weakens in the second half of this year, our bias will be to fade this move. Portfolio investors can use this as an opportunity to buy insurance, should markets become turbulent in the next few months. Chart I-10AThe Market Is Pricing In A Dovish BoJ (1) Chart I-10BThe Market Is Pricing In A Dovish BoJ (2) Corporate Governance, Profits And The Equity/Yen Correlation Once global growth eventually bottoms, inflows into Japan could accelerate, given cheap equity valuations and improved corporate governance that has been raising the relative return on capital (Chart I-11). Depending on whether investors choose to hedge these inflows or not, this will dictate the yen’s path. At present, the cost of hedging does not justify sterilizing portfolio flows (see Chart I-3). Chart I-11Corporate Governance Could Lift Return On Capital The traditional negative relationship between the yen and the Nikkei still holds (Chart I-12). Weakening global growth is negative for the export-dependent Nikkei, and positive for the yen. This is because weakening global growth dips Japanese inflation expectations, and leads to higher real rates. This tends to lift the cost of capital for Japanese firms. Chart I-12The Yen/Equity Correlation Could Shift That said, another factor has been at play. Over the past few years, an offshoring of industrial production has been eroding the benefit of a weak yen/strong Nikkei. In a nutshell, if company labor costs are no longer incurred in yen, then the translation effect for profits is minimized on currency weakness. Investors will need to monitor the equity market/yen correlation over the next few years. It remains deeply negative, but could easily shift, dampening the yen’s counter-cyclical nature. Back in the 80s and 90s, the yen did shift into a pro-cyclical currency. Bottom Line: A dovish shift is increasingly likely by the BoJ. Meanwhile, our bias remains that if markets rebound in the second half of this year, this will be marginally negative for JPY. This could also put EUR/JPY near 132 by year end. A Few Notes On The Pound Recent market developments have become incrementally bullish for sterling. After Tuesday’s second defeat for Prime Minister Theresa May's Brexit deal, and again Wednesday’s rejection of a no-deal Brexit by 312 votes to 308, the probability is rising that the U.K. will either forge a deal for a more orderly separation with the EU or hold a new referendum altogether. Tuesday’s loss was expected because the EU had not offered a viable compromise to the Irish backstop - a deal that will keep Northern Ireland in the EU customs union beyond the transition date of December 2020. Meanwhile, Wednesday’s vote to leave the union sans arrangement was simply unpalatable for Parliament, given economics 101. Almost 50% of U.K. exports go to the E.U. A no-deal Brexit at a time when global exports are in a soft patch, and with much higher tariffs, was a no go for the majority.2 Complete sovereignty of a nation is and has always been a desirable fundamental right. For the average U.K. voter that has not benefited much from globalization, the risk was that Parliament repeatedly failed to pass a motion asking for an extension to the March 29 deadline. As we go to press, this risk has faded as MPs have voted 412 to 202 for a delay. An extension will likely be granted till the May 23-26 EU elections. The preference for an extension has been echoed by EU Commissioner President Jean-Claude Junker, Chief Negotiator Michel Barnier and Dutch Prime Minister Mark Rutte, all heavyweights in this imbroglio. For sterling investors, what is clear is that developments over the next few weeks will be volatile, but increasingly bullish. Admittedly, GBP has already rallied from its December lows. But long-term GBP calls still remain cheap, despite rising volatility (Chart I-13). Our fundamental models also suggest cable is cheap relative to its long-term fair value and it will be tough to the pound to depreciate if the dollar weakens in the second half of this year (Chart I-14). Chart I-13GBP Calls Are Cheap Chart I-14The Pound Is Cheap Bottom Line: The probability of a no-deal Brexit has fallen. Going forward, risk reversals suggest sterling calls remain relatively cheap to puts. Investors who need to hedge out any sterling volatility should therefore favor GBP calls. Housekeeping Our short AUD/NZD position hit its target of 1.036 this week. We are closing this trade for a 7% profit. As highlighted in last week’s report,3 a lot of bad news is already priced into the Australian dollar, which is down 37% from its 2011 peak. Outright short AUD bets are therefore at risk from either upside surprises in global growth, or simply the forces of mean reversion. Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Ricardian equivalence suggests in simple terms that public sector dissaving will encourage private sector savings. 2 Please see Geopolitical Strategy Weekly Report, titled “The Witches’ Brew Keeps Bubbling…,” dated March 13, 2019, available at gps.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled “Into A Transition Phase,” dated March 8, 2019, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Data in the U.S. continue to soften: The nonfarm payrolls came in at 20k in February, missing the forecast by 160k. Core consumer prices in February decelerated to a 2.1% year-on-year growth. Nonetheless, February average hourly earnings increased 3.4% year-on-year. Moreover, the unemployment rate in February fell to 3.8%. Lastly, retail sales in January grew at 0.2% month-on-month, outperforming expectations. The DXY index depreciated by 0.7% this week. The U.S. economy keeps growing above trend, but at a slower pace than last year. During the 60 minutes interview with CBS last weekend, Federal Reserve Chair Jerome Powell emphasized that while it is difficult for the economy to keep growing near 4% every year, it remains very healthy and any near-term recession is unlikely. We favor underweighting the dollar as we enter into a transition phase, where non-U.S. growth outperforms. Report Links: Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been promising: German factory orders in January came in at -3.9% year-on-year, improving from the last reading of -4.5%. The euro area industrial production month-on-month growth came in at 1.4% in January, outperforming expectations. In France, the Q4 nonfarm payrolls increased to 0.2% quarter-on-quarter, double the forecast. German consumer prices stayed at 1.7% year-on-year in February. EUR/USD appreciated by 1.2% this week. We favor overweighting the euro as easing financial conditions put a floor under growth. Report Links: Into A Transition Phase - March 8, 2019 A Contrarian Bet On The Euro - March 1, 2019 Balance Of Payments Across The G10 - February 15, 2019 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: M2 money supply missed expectations in February, coming in at 2.4%. Besides, machine tool orders fell by -29.3% year-on-year in February. Total machinery orders were also weak in January, coming in at -2.9% on a year-on-year basis. Lastly, foreign investment in Japanese stocks was -1.2 trillion yen, while investment in Japanese bonds fell to 245.7 billion yen. USD/JPY has been flat this week. A dovish move by the BoJ is likely and it could further cheapen the yen. If global growth bottoms in the later half of this year, this will be bad news for the yen, given its counter-cyclical nature. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Yen Fireworks - January 4, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been mostly positive: In January, industrial production and manufacturing production both outperformed expectations, with industrial production coming in at -0.9% year-on-year and manufacturing production coming in at -1.1% year-on-year. GDP growth in January came in at 0.5% month-on-month, higher than expectations. GBP/USD appreciated by 1.1% this week. Cable rallied after the parliament vote on Wednesday. The sentiment remains positive since chances of a no-deal Brexit have diminished. We recommend long-term call options on cable to capture any upside potential. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Deadlock In Westminster - January 18, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia continue to deteriorate: Home loan growth in January contracted to -2.6%. The National Australian Bank business confidence index fell to 2 in February, while the business conditions index fell to 4. Consumer confidence in March decreased to -4.8%. AUD/USD moved up by 0.4% this week. The housing market and overall economy continue to weaken in Australia. However, the Australian dollar is at a 10-year low suggesting much of the bad news is priced in. Report Links: Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: Electronic card retail sales came in at 3.4% yoy, slightly lower than the previous reading of 3.5%. Food price index in February fell to 0.4% month-on-month. NZD/USD increased by 0.9% this week. We remain underweight NZD/USD, on overvaluation grounds. We are also closing our short AUD/NZD position for a 7% profit. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have confirmed robust labor market conditions: The unemployment rate in February came in line at 5.8% while the participation rate increased to 65.8%. New jobs created in February were 55.9k, the strongest since 1981, beating analysts’ forecasts of zero job creation. February average hourly wage growth also increased to 2.25% year-on-year. However, housing starts in February fell to 173.1k, underperforming expectations. USD/CAD fell by 0.6% this week. The Canadian economy, especially the housing sector continues to show signs of weakness, despite a strong labor market. The risk is that overvaluation in the housing market and elevated debt levels impair consumer spending power. While the rising oil price helps, we think the benefits are more marginal than in the past. Report Links: Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been negative: Producer and import price growth in February fell to -0.7% year-on-year. EUR/CHF appreciated by 0.3% this week. Our long EUR/CHF trade is now 0.5% in the money since initiated on December 7, 2018. We continue to favor the euro versus the swiss franc as the later benefits less from a bottoming in global growth. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mostly positive: Overall consumer price inflation in February fell to 3% year-on-year; however, core inflation increased to 2.6% yoy. Producer prices also increased by 8% year-on-year in February. USD/NOK depreciated by 1.8% this week. Our long NOK/SEK trade is 2.8% in the money over two months. We continue to overweight NOK due to the cheap valuations and rising oil prices. The pickup in inflation also allows the Norges bank to become incrementally hawkish. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been disappointing: In February, consumer price inflation fell to 1.9% yoy. The unemployment rate climbed to 6.6% in February. USD/SEK depreciated by 1.5% this week, mainly due to the recent weakness in the dollar. We remain positive on the SEK versus USD based on an expected pickup in the Swedish economy and cheap valuations. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades