Financial Markets
Highlights Portfolio Strategy A supply/demand imbalance has created a playable opportunity in the niche refining energy sub-index. Increase exposure to overweight. Safe haven demand is supporting gold mining equities, but shifting macro forces suggest that it will soon be time to move to the sidelines. Global gold miners are now on downgrade alert. Recent Changes Lift the S&P oil & gas refining & marketing index to overweight today. Put the global gold mining equity index (ticker GDX:US) on downgrade alert. Table 1 Feature The S&P 500 moved laterally last week as sustained geopolitical uncertainty offset encouraging economic data. Synchronized global growth coupled with the related global liquidity-to-growth transition remain the dominant macro themes. Dovish Fed speeches triggered a recalibration of market rate hike expectations and a lower 10-year Treasury yield. As long as lower bond yields reflect a less hawkish Fed rather than a deflationary relapse, they should underpin stock prices. Encouragingly, the latest ISM manufacturing survey catapulted higher to a level last seen in early 2011, diverging steeply from the bond market, as manufacturing optimism reigns supreme (Chart 1). The labor market confirmed this data. The most cyclical parts of the U.S. economy are firing on all cylinders, with manufacturing and construction job creation comprising 1/3 of nonfarm payroll growth last month (Chart 2). This is the highest reading since July 2011. Chart 1Unsustainable Divergence Chart 2Manufacturing Flexing Its Muscle Meanwhile, despite the Trump administration's shortcomings, America's CEOs are going against the grain. Capex is up smartly for the second consecutive quarter adding to real GDP growth and our capital spending model remains upbeat heralding additional outlays for the remaining two quarters of the year (Chart 3). Similarly, regional Fed surveys of capex intentions point to a sustainable pickup in capital spending in the coming months (Chart 3). Still generationally low interest rates, a less hawkish sounding Fed, coupled with a tamed greenback (Chart 4) and synchronized global growth have combined to revive animal spirits. The implication is that profit growth rests on solid foundations, a message corroborated by our S&P 500 EPS growth model (Chart 5). Chart 3CapEx To The Rescue Chart 4Dollar... Chart 5...And EPS Model Waving Green Flag Adding it up, the macro backdrop remains favorable for stocks. In fact, it represents a goldilocks equity scenario. This week we continue to add some cyclicality to our portfolio by further boosting a niche energy play. We also update our view on a portfolio hedge. Buy Refiners For A Trade In early July, we lifted refiners to neutral and locked in impressive gains for our portfolio, but three reasons kept us at bay and prevented us from turning outright bullish on this niche energy sub-sector.1 Namely, all-time high refining production, high refined product stocks and breakneck pace refinery runs were offsetting the nascent recovery in gasoline consumption, rising crack spreads and a mini V-shaped recovery in industry shipments. Net, we posited that a balanced EPS outlook would prevail in coming quarters. Hurricane Harvey has significantly changed this calculus and now clearly refiners are in a sweet earnings spot for at least the remainder of the year, compelling us to lift exposure to overweight. Severe refinery shutdowns are likely to return industry production levels to what prevailed early in the decade, representing a major, albeit temporary, setback (Chart 6). This production curtailment will result in sizable petroleum products inventory drawdowns and a likely halt (if not reversal) in refined product net exports in order to satisfy domestic demand. The longer it takes for refinery production to return to normalcy, the greater the inventory whittling down. Historically, relative share price momentum has been inversely correlated with inventory growth and the Harvey-related inventory clear-out is heralding additional relative performance gains (bottom panel, Chart 7). It is notable that both industry net exports and inventories had already been receding since the beginning of 2017, suggesting that hurricane Harvey will only accelerate a downtrend that was already in place. Chart 6Hurricane Related Blues... Chart 7... Are A Boon For Crack Spreads Taken together, this represents an ultra-bullish pricing power backdrop for the U.S. refining industry, at a time when capacity additions are also likely to, at least, pause for breath (bottom panel, Chart 6). Chart 8Brisk Demand Indeed, refining margins have jumped recently and will likely remain elevated as the Brent/WTI spread is widening anew (middle panel, Chart 7). Surging crack spreads are synonymous with higher earnings for this extremely capital-intensive and high operating leverage industry. Nevertheless, the refining supply disruptions only tell half the story. Refined product demand is exploding higher, pushing all-time highs and signaling that a substantial supply/demand imbalance is in the works (top panel, Chart 8). Typically this gets resolved via higher gasoline prices, further boosting industry EPS prospects (third panel, Chart 8). As a result, we expect a re-rating phase in relative valuations in the coming months, reversing the year-to-date deflation in the relative price-to-sales ratio. The second panel of Chart 8 shows that relative valuations and refined product consumption move in lockstep, and the current message is to expect a catch up phase in the former. In sum, a playable rally in refiners is in the offing on the back of a budding profit recovery that has yet to filter through analysts' EPS estimates (bottom panel, Chart 8). The longer-than-usual hurricane Harvey-related refining production disruptions, along with the spike in refined product demand, have created an exploitable opportunity. Bottom Line: Boost the S&P oil & gas refining & marketing index (PSX, VLO, MPC, ANDV) to overweight. What To Do With Gold Mining Equities? Gold and gold mining equities serve as great portfolio hedges especially in times of duress. Recent geopolitical jitters surrounding North Korea along with inaction in Washington and the substantial year-to-date selloff in the U.S. dollar have served as catalysts for gold to shine anew, hitting one-year highs. So is it time to trim exposure to shiny metal equities? The short answer is not yet. Real yields are sinking courtesy of a moderately less hawkish Fed (top panel, Chart 9). The probability of a December Fed hike has now collapsed to 30%, and the 5th hike this cycle is only priced in for next June. This is keeping a bid under gold and gold miners, as zero yielding bullion and near-zero yielding gold mining equities appear at the margin relatively more appealing. The equity risk premium has also stopped falling owing largely to the lower 10-year Treasury yield (bottom panel, Chart 9), representing another source of support for global gold miners. Meanwhile, policy uncertainty in the U.S. and around the globe is hooking up especially given North Korea's unpredictability, Washington's polarization, the upcoming German elections and, most importantly, the looming Chinese Congress. Historically, the policy uncertainty index and relative performance have been joined at the hip and the current message is positive for bullion related stocks (middle panel, Chart 9). Similarly, the Philly Fed's Partisan Conflict Index2 ("The Partisan Conflict Index tracks the degree of political disagreement among U.S. politicians at the federal level by measuring the frequency of newspaper articles reporting disagreement in a given month. Higher index values indicate greater conflict among political parties, Congress, and the President.") and bullion enjoy a tight positive correlation since the early 1980s (Chart 10), likely warning that the precious metal's run has more upside in the short term. Chart 9Shining Chart 10Increase In Partisanship Is Bullish Gold Moreover, demand for safe haven assets remains upbeat as evidenced by recent flows into gold-related ETFs. Positioning in the commodity pits are also signaling that more gains are in store for gold and the relative share price ratio (Chart 11). Nevertheless, there are some pockets of weakness that are pointing to a more cautious stance toward this portfolio hedge. The improving U.S. economic backdrop is weighing on gold mining equities (ISM manufacturing shown inverted, middle panel, Chart 12). Not only U.S. growth, but also synchronized global growth suggests that eventually demand for bullion will subside. In fact, global growth expectations continue to perk up (GDP expectations shown inverted, Chart 12), and G10 economic surprises are also shooting higher, anchoring gold and gold related equities (economic surprise index shown inverted, top panel, Chart 12). Chart 11Safe Haven Demand Comeback Chart 12Not All The Glitters Is Gold Tack on the inevitable liquidity withdrawal once the Fed starts to wind down its balance sheet later this month, and the handoff from liquidity-to-growth represents a bearish backdrop for gold and gold mining equities. Chart 13 shows that the Fed's balance sheet is positively correlated with bullion's relative performance versus the broad commodity complex, warning that the recent push toward multi-decade highs in relative performance are on borrowed time. Finally, our relative EPS model for the global gold mining index encapsulates most of these macro forces and suggests that relative profit growth will gravitate lower in the coming months (Chart 14). Chart 13Watch The Fed's Balance Sheet Chart 14EPS Model Is Outright Bearish Bottom Line: While our confidence in maintaining the gold-related equity portfolio hedge has fallen a notch, we are staying patient before moving to the sidelines. Put the global gold mining index (ticker GDX:US) on downgrade alert. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see the July 10, 2017 U.S. Equity Strategy Report titled "SPX 3,000?", available at uses.bcaresearch.com 2 https://www.philadelphiafed.org/research-and-data/real-time-center/partisan-conflict-index Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlights Based on long-term moving averages and the advance/decline line, the dollar selloff is still only a severe correction. These factors need to be monitored closely as they stand on the edge. To rebound, the dollar will need U.S. inflation to pick up, which will lift the U.S. OIS curve. Signs are accumulating that U.S. inflation will trough toward the end of 2017. Buying the dollar versus the yen is a much safer bet than shorting the euro. The CAD has more upside, especially on its crosses. Feature The U.S. dollar continues to be tested by investors. As paradoxical as it may sound, it is still too early to sound the death knell for the dollar bull market. However, it is not time either to aggressively bet on a rebound. For that to happen, U.S. inflation must regain its footing in a more convincing fashion. Why Isn't The Bull Market Dead? There are many facets to this question, but let's begin with technical considerations. First, the dollar's advance / decline line has not broken down (Chart I-1). A breakdown in this measure would be one of the key technical signals that the dollar has begun a new cyclical downtrend. In the mid-1990s, the dollar did experience a period of correction. During that time frame, the A/D line was also unable to break down, later highlighting that what was initially perceived as the beginning a new bear market was ultimately a prolonged period of consolidation. Chart I-1Still Not A Cyclical Bear Market Second, the dollar's trend has been best approximated by the four-year moving average of monthly prices. Since the Smithsonian Agreement of 1971, during bear markets, the dollar tends to find its ceiling around this indicator, and during bull markets, it tends to put a floor around this moving average (Chart I-2). Today, the dollar has yet to end a month below this measure. Third, positioning in the dollar is now depressed, as investors have purged their stale USD longs (Chart I-3). When one looks at net long speculative positions in EUR/USD - the most convenient and liquid instrument to bet on the dollar - investors are clearly enamored with the euro, which by definition illustrates their dislike of the greenback. Chart I-2No Trend Break For Now Chart I-3Dollar Downside Is Limited Technical indicators argue that we have experienced a painful correction in the USD, but valuation considerations suggest it will be difficult for these technical indicators to deteriorate enough to begin flagging a cyclical bear market. Our long-term fair value model, which incorporates productivity differentials, highlights that the dollar never hit the nosebleed levels associated with bull market tops in 1985 or in 2001 (Chart I-4). The stability in the trade balance and the current account - both have been stable at around 3% of GDP and 2.5% of GDP, respectively - are at odds with the sharp deterioration in the balance of payments that has occurred when the dollar has been genuinely expensive. Our intermediate-term valuation models point to an even more unequivocal conclusion. Based on this metric, the DXY is at its cheapest level since 2009, a discount that historically has been associated with dollar bottoms, at least temporary ones (Chart I-5). This gives us comfort that the A/D line is unlikely to break down for now, or that the dollar will end September significantly below its crucial four-year moving average. However, if these things happen, the dollar could experience significant downside. Chart I-4The Dollar Never Reached Nosebleed Valuations Chart I-5Big Discount To IRP Economic forces too do not point to a sharp move in the DXY below 91 - one that could drive the dollar down into the low 80s. After a period of deep underperformance, the U.S.'s economic surprises relative to the G10 have begun to stabilize, as have inflation surprises. More saliently, the incredible strength in the U.S. ISM manufacturing index, especially when compared to other PMIs around the world, points to a rebound in the USD, or at the very least, stabilization (Chart I-6). Finally, the market has now all but priced out additional hikes from the U.S. interest rate curve. There are only 30 basis points of hikes priced in over the next 24 months. Moreover, the probability of the fed funds rate remaining between 1% and 1.25% only falls below 50% in September 2018 (Table I-1). This seems to be a sanguine scenario. Chart I-6Cyclical Support ##br## For USD Table I-1Investors See U.S. Rates At Current ##br##Levels Until Late 2018 Bottom Line: The dollar's technicals are not yet indicative of the end of the cyclical bull market. However, they do need to be monitored closely. Additionally, the dollar is trading at a large discount to interest rate parity relationships, and the Federal Reserve is not expected to execute its next hike until late 2018. While these factors may not point to an imminent rebound in the USD, they do suggest that the down-wave in the dollar is very long in the tooth. Chasing the dollar lower is dangerous. Too Early To Bet The House On A Renewed Upleg Chart I-7The Global Deflation Anchor This observation on the probability of a Fed move brings us to the vital question of what could lift the U.S. interest rate curve higher, and thus the dollar. This would be the outlook for inflation. As Fed Governor Lael Brainard clearly argued this week, the Fed is not meeting its inflation mandate, warranting a slower pace of rate increases as global deflationary forces remain very potent. The dovish path implied by interest rate markets shows that investors already agree with this assessment. There is no denying that inflation has been globally and structurally pulled down by various forces. While the "Amazon effect" has grabbed headlines, Mark McClellan argues in The Bank Credit Analyst this month that the effect of e-commerce on inflation is no greater than that of Walmart in the 1990s - and probably amounts to a meagre 0.1-0.2% depressive impact on inflation.1 Instead, we peg the capacity buildup in EM and China - which has lifted the global capital stock massively since the turn of the millennia - as the main source of global deflation (Chart I-7). Now that global credit growth is lower than it was before 2008, it has become clearer that the global supply side of the economy has expanded faster than underlying demand, resulting in downward pressure on prices. Nonetheless, while there is a lid on inflation, this does not imply that cyclical determinants of inflation have been fully neutered. They simply have become weaker. Inflation can still ebb and flow in response to the business cycle, but the upside is not as strong as it once was. This limits how high nominal interest rate can go, which is why it is hard to envision a terminal rate much above 3% - a very low reading by post-war standards. Here, we continue to see a turning point coming later this year for inflation, one that would pull core PCE closer to the 2% mark wanted by the Fed in 2018. In the background, our composite capacity utilization indicator is now firmly in "no slack" territory, an environment in which inflation tends to perk up and where interest rate exhibit upside (Chart I-8). This is not enough to warrant fears of inflation, but healthy growth in this context should be a red flag for deflationists. This is exactly the set of circumstances we envision for the next 12 months, even if hurricane Harvey and its potential successors create noise in upcoming data. The U.S. economy has benefited from a strong easing in financial conditions since February 2016. The recent fall in real rates, which has been the key driver of the 60 basis-points fall in Treasury yields since December 2016, is now demonstrably reflationary. Lumber prices are once again at the top of their trading range since 2013, and gold prices have regained vigor. In this optic, the ratio of metal to bond prices - adjusted for their very different volatilities - has been a reliable leading indicator of U.S. growth (Chart I-9). Today, it is pointing to an acceleration of GDP growth relative to potential, the very definition of declining slack. Chart I-8Tight U.S. Capacity Is Inflationary Chart I-9Relfation Will Boost U.S. Growth Above Trend The labor market continues to display signs of resilience as well. True, the last employment report was paltry, but August has been marked by seasonal weaknesses for the past seven years. Moreover, August weaknesses have tended to be minimized in the wake of the notorious revisions typical of the U.S. Department of Labor. However, the strength in the labor market components of the NFIB small businesses survey highlights the potential for more job gains going forward. Where this indicator really shines though, is in its capacity to forecast household total wages and salaries (Chart I-10). Today, this gauge highlights that the income of middle class households will accelerate over the next six months. This matters because if the middle class - a category of U.S. households that gather the vast majority of their income from wages - experiences strong income growth, this will create robust support for consumption. With consumption accounting for 70% of U.S. GDP, a boost to this component would go a long way in lifting aggregate growth. Stronger growth in a tight economy is inflationary, and monetary dynamics confirm this risk. The U.S. velocity of money has picked up meaningfully, and now suggests that inflation will gather steam later this year (Chart I-11). Chart I-10The Labor Market Is Still Strong Chart I-11Monetary Dynamics Point To More Inflation We therefore expect that when this turnaround in inflation emerges, investors will re-assess their expectations for the path of U.S. monetary policy, and the dollar will finally be able to resume its upward trek toward new highs. But until inflation turns the corner, the dollar will continue to struggle to rally durably. Bottom Line: The U.S. economy is still on a firming path. With the amount of slack in the economy vanishing and with the velocity of money accelerating, this will lead to a pick-up in inflation late this year. The end of Q4 is likely to prove the moment when the dollar will finally be able to begin firming up. Investment Implications Shorting the Yen Is Still The Safest Bet Shorting the yen remains the best way to play a dollar rebound for now. The yen has not benefited much from the recent bout of risk aversion prompted by the renewed flare-up of in tensions in the Korean peninsula. It remains weak on its crosses like EUR/JPY, CAD/JPY or even AUD/JPY. USD/JPY seems incapable of staying below 108.5, and may even be forming a consolidation pattern reminiscent of the one experienced in 2013 (Chart I-12). In late 2013, this pattern was resolved by U.S. bond yields moving higher. This time is likely to be similar. The recent weakness in Japanese wages remains a key hurdle that the Bank of Japan does not seem able to shake off. Wage growth hit it slowest pace since 2015 and real wages are worryingly weak (Chart I-13). This is not the picture of an economy with any hint of inflation, even if the labor market is tight. Illustrating this point, contrarily to the euro area, Japanese inflation expectations have not kept pace with the U.S. in recent months (Chart I-14). This argues that the BoJ faces the greatest burden of any central bank. With the BoJ now packed with doves, we expect that interest rates and bond yields in Japan will remain capped for the foreseeable future. As a result, if U.S. bond yields can rise in the face of a strong U.S. economy, JGB yields will not follow higher. This will flatter USD/JPY. Chart I-12Consolidation Pattern In USD/JPY Chart I-13Falling Labor Income In Japan Chart I-14Japanese CPI Swaps Are Outliers A More Complex Picture For The Euro As investors have become more comfortable with the economic and political prospects of the euro area, the euro has become increasingly over-owned, but most importantly, has completely deviated from interest rate parity relationship (Chart I-15). At first glance, this would indicate the euro is greatly vulnerable. This reality, along with very long positioning of speculators in EUR/USD, highlights that it will be difficult for the euro to stay above 1.20 in the coming months. However, for the euro to move below 1.15, U.S. inflation has to pick up. Thus, for the remainder of the year, the EUR/USD is likely to remain range bound between these two numbers. Two factors make the picture less clear for EUR/USD than for USD/JPY. First, the European Central Bank is intent on beginning to taper its asset purchases this year, a move that will be announced in October. At yesterday's press conference, ECB President Mario Draghi was unequivocal about this, despite the slight curtailments to the central bank's inflation forecasts. Moreover, the seeming lack of concern vis-à-vis this year's 6% increase in the trade-weighted euro was perceived by investors as a green light to keep betting on a stronger EUR/USD. Second, as we argued five months ago, exchange rate dynamics are more a function of assets' expected returns than just interest rate differentials.2 As Chart I-16 illustrates, when a portfolio of eurozone stocks, bonds and cash outperforms a similar U.S. one, this leads to a durable rally in EUR/USD. Today, the relative performance of this European portfolio is toward the bottom of its historical distribution, and may even be already turning the corner. If this move has durability, inflows into the euro area could push EUR/USD back into the 1.3 to 1.4 range. Chart I-15Euro Is Expensive ##br##To IRP Chart I-16Outperforming Euro Area Assets##br### Could Support EUR/USD The Loonie Will Keep Flying The Bank of Canada delivered another rate hike this week. The BoC continues to focus on closing the Canadian output gap and the strong economy, ignoring weak wages and inflation. The BoC was rather sanguine regarding the slowdown in real estate activity in Toronto, Canada's largest city, and seemed comfortable with the CAD's recent strength, arguing it was a reflection of Canada's strength and not yet an impediment to it. The CAD interpreted this announcement bullishly. We agree. In a Special Report written last July, we argued that the BoC was among the best-placed central banks to tighten policy among the G10.3 Additionally, the CAD is cheap, trading at a 7% discount to PPP. It is also still below its fair value, implied by interest rate differentials. As such, we continue to overweight the Canadian dollar, being long the loonie against the euro and the Aussie. It also has upside against the USD, but could prove vulnerable to a pick-up in U.S. inflation. Thus, we remain committed to buying the CAD on its crosses. Bottom Line: The euro may be expensive relative to interest rate differentials, but the anticipation around the ECB's tapering continues to represent a support under EUR/USD. As a result, this pair is likely to remain range-bound, roughly between 1.2 and 1.15. USD/JPY has more upside as Japanese inflation expectations and wages are sagging, suggesting the BoJ is nowhere near the ECB in terms of moving away from an ultra-accommodative stance. The CAD will continue to experience upside for the remainder of the year; stay long the loonie on its crosses. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see The Bank Credit Analyst Monthly Report, "Did Amazon Kill The Phillips Curve?" dated August 3, 2017, available at bca.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, "The Fed And The Dollar: A Gordian Knot", dated April 14, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy And Global Alpha Sector Strategy Special Report, "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The dollar had a particularly eventful week. With Fed officials Brainard and Kashkari unleashing their dovish remarks, the greenback suffered as investors pushed down 10-year yields. While Brainard highlighted her concern over the "recent low readings of inflation", Kashkari took it further and said that the hikes may be "doing real harm" to the economy. Adding to the Fed's concerns, Stanley Fischer, a long-serving Fed official and an ardent supporter of policy normalization, announced his resignation on Wednesday. Mario Draghi's hawkish press conference added further downward pressure on the dollar, with the DXY making a new low of 91.41. It is unlikely that the dollar will be able to meaningfully rally until inflation re-emerges, a year-end event. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Fade North Korea, And Sell The Yen - August 11, 2017 Balance Of Payments Across The G10 - August 4, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The euro reacted very positively to the ECB monetary policy speech. Draghi highlighted the uncertainty associated with the strong currency, but noted that the ECB doesn't expect it to have a large impact on inflation, which helped the euro hit a high of EUR/USD 1.2018. He nonetheless highlighted that achieving the ECB's price mandate will require "patience" and "persistence" and he expects inflation to hit its target by 2020. Additionally, the ECB lowered its inflation forecasts, while increasing its 2017 growth forecasts. In terms of QE, Draghi clarified that details will be revealed in the next meeting held on October 26, but that interest rates will remain accommodative for an extended period of time. Although President Draghi laid out some concerns about the strong euro, it seems momentum is unlikely to falter unless markets become more positive on the dollar or the pound. We expect this to occur by the end of this year, when inflation picks up again in the U.S. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been negative: Industrial production yearly growth declines substantially from June's 5.5% number, coming in at 4.7%. This data point also underperformed expectations. Housing starts contracted by 2.3% on a YoY basis, also underperforming expectations. Meanwhile, labor cash earnings also contracted by 0.3% on a yearly basis, underperforming expectations. As we highlighted a few weeks ago, multiple indicators are signaling a slowdown in the Japanese economy. The recent batch of negative data seems to confirm this view, which means that the dovish bias of the BoJ will only be further reinforced. Consequently the yen will be the mirror image of U.S. bonds. Given that rate expectations have collapsed to the point that the market is only anticipating 30 basis points in hikes in the U.S. over the next 2 years, risks point upwards for USD/JPY. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Fade North Korea, And Sell The Yen - August 11, 2017 Balance Of Payments Across The G10 - August 4, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in U.K. has been mixed: Markit manufacturing PMI increased from August to July, coming in at 56.9. This data point also outperformed expectations. Meanwhile, both construction and Markit services PMI underperformed expectations coming in at 51.2 and 53.2, respectively. Finally, nationwide house price year-on-year growth also underperformed expectations, coming in at 2.1%. At the beginning of August, we warned of a repricing of rate expectations in the U.K. given that the pass through from the currency was set to dissipate, while the housing market and real disposable income were undergoing a major slowdown. So far, this view has proven correct, with the pound falling against the dollar and the euro. We expect that GBP/USD has further downside on a 12 month basis, as rate expectations in the U.S. have likely found a bottom. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Data out of Australia was not particularly strong: TD Securities Inflation dropped on an annual basis to 2.6% from 2.7%; Gross operating profits contracted at a 4.5% rate, below the expected 4% contraction; Current account balance came in at AUD -9.862 bn, below expectations, following a 59% decrease in the trade balance from the last quarter, and a 4% decrease in the net primary income; Most notably, GDP grew at the expected 1.8% annual rate, albeit faster than the previous growth rate of 1.7%. The RBA decided to leave rates unchanged, but with a slightly hawkish tone. While growth is generally in line with the Bank's forecasts, it was also highlighted that the appreciating exchange rate and low wages remain headwinds for inflation. A brighter housing market was noted as house price increases are slowing down, owing to macroprudential measures. While the Bank sees an improving labor market, we remain skeptical as the underemployment rate has not improved, which is limiting wage growth. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Surprisingly, in spite of the weakness of the U.S. dollar, the kiwi has been falling for the past month. This has been in part due to some weak data coming out of New Zealand: Building permits continued their decline, with a Month-on-Month decline in July of 0.7%. Both the ANZ Activity Outlook and the Business Confidence indicators declines in August relative to July. The New Zealand terms of trade Index underperformed expectations, coming in at 1.5%. Additionally July's number was revised down from 5.1% to 3.9%. The recent weakness in the NZD might be indicative of some weakness permeating from EM, given that the New Zealand economy is highly sensitive to the global economy. If an EM selloff materializes we expect significant downside for the NZD particularly against the yen. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Data has been quite strong out of the Canadian economy recently: The current account deficit was better than expected at CAD -16.32 bn, with the merchandise trade balance also improving; Manufacturing PMI came in at 51.7, beating the expected 51.3; GDP growth came in at an astonishing 4.5% annualized rate; Accordingly, the BoC raised the overnight rate to 1%. Markets were expecting hawkish remarks, but not a hike. The CAD rallied more than 1% against USD on the news, and outperformed all other G10 currencies. Current expectations for a December hike are at 68%, and we agree. The CAD will see further strength against all G10 currencies except USD by the end of the year. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Gross Domestic Product yearly growth came in at 0.3%, underperforming expectations and deaccelerating from a month ago. Headline inflation came in line with expectations at 0.5%, it also increase from the previous month reading of 0.3%. Real retails sales underperformed expectations, contracting by 0.7% on a YoY basis. However the SVME PMI outperformed and increased from the July reading, coming in at 61.2. After reaching 1.15 in early August, EUR/CHF has stabilized around to 1.135. Overall the Swiss economy is still too weak for the SNB to change their stance on currency intervention. Core Inflation will have to pick up to at least 1% for the SNB to consider a change in stance and let go of the implied floor in EUR/CHF. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Retails sales monthly growth came in at 0.4%, recovering from last month negative reading ad outperforming expectations. Manufacturing output growth also outperformed expectations, coming in at 1.5%. Finally registered unemployment came in at 2.7%, declining from last month reading and coming in line with expectations. USD/NOK has continued to go down as rate expectations for the U.S. have decreased and oil prices have increased thanks to the refining shut-downs in Texas due to hurricane Harvey. We expect this trend to reverse once rate expectations in the U.S. start to go up. However, we do expect more downside in EUR/NOK as this cross is much more sensitive to oil prices. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish data was largely downbeat: Retail sales are growing at a 3.7% annual rate, in line with expectations; The Swedish trade balance went into a deficit in July of SEK -0.5 bn from a SEK 5.4 bn surplus in June; Consumer confidence decreased to 100.3 from 102.2 and below the expected 103; Manufacturing PMI also disappointed at 54.7, below the expected 60; Swedish IP is growing at a still high 5.3% annual pace, but less than the previous 8.9% rate; While this data was somewhat weak, Swedish inflation is at or above its target across all measures. The Riksbank left its repo rate unchanged at -0.5%. In its press release, the Bank highlighted high growth and inflation but stated that the rate will not be increased until the middle of 2018. It also increased inflation forecasts, with CPI and CPIF predicted at 2.9% and 2.1% by 2019. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades
Highlights The ECB can talk down the euro, but not by much. The central bank has previously expressed comfort with EUR/USD at 1.15. The cyclical and structural direction of EUR/USD is higher... ...because the euro area versus U.S. long bond yield spread should ultimately compress to -40 bps from today's -130 bps. Remain neutral in Germany's DAX and underweight Sweden's OMX. Equity markets with a strong base currency and a large exposure to exporters will come under pressure. Overweight German consumer services equities versus German exporters and the DAX. Underweight U.K. consumer services equities versus the FTSE100. Feature When mariners know that a sea-change is coming, their concern is not whether it comes today, tomorrow or the day after tomorrow. The big issue is the sea-change itself - because it brings major implications for navigating the seas. In the same way, when currency markets know that a sea-change in monetary policy is coming, their concern is not whether the policy announcement comes on September 7, October 26 or December 141 - or indeed whether the sea-change will happen suddenly or gradually. At a sea-change, currency markets look much further ahead. Just as for mariners, the big issue is the sea-change itself. EUR/USD is now moving in lockstep with the expected differential between euro area and U.S. policy interest rates not next year, nor the year after next, but rather the differential five years out (Chart I-2). Chart I-1AA Strong Euro Is Good For ##br##German Consumer Services... Chart I-1B...A Weak Pound Is Bad For##br## U.K. Consumer Services Chart I-2EUR/USD Is Moving In Line With The Interest ##br##Rate Differential Expected In 2022 The ECB Can Talk Down The Euro, But Not By Much Chart I-3EUR/USD Might Find Support At 1.15 Therefore, if the ECB really wants to unwind the euro's sharp appreciation this year, the central bank must tell the market that the expectation for a sea-change is completely wrong. In other words, the ECB must indicate that it has no intention to dial back its emergency monetary accommodation. Such a volte-face is unlikely, for two reasons. First, the ECB likes to adjust market expectations incrementally rather than violently. The last policy meeting made the case "for proceeding gradually and prudently when approaching adjustments in the monetary policy stance and communication." Second, not to dial-back its emergency monetary accommodation flies in the face of a euro area economic expansion that is solid, broad, and among the strongest and best-established among major developed economies. "Postponing an adjustment for too long could give rise to a misalignment between the Governing Council's communication and its assessment of the state of the economy, which could (eventually) trigger more pronounced volatility in financial markets." Nevertheless, at the margin, dovish words from Draghi could pare back the euro. How much? Consider that at the last policy meeting EUR/USD stood at 1.15 and the ECB justified this level on the basis of the improved "relative fundamentals in the euro area vis-à-vis the rest of the world." (Chart I-3) Given that these relative fundamentals are still intact, 1.15 might provide a level of support in a technical retracement. Of course, EUR/USD also depends on the Federal Reserve and expectations for its policy rate five years out. EUR/USD would sink if the market became much more hawkish about where it sees the U.S. 'terminal' interest rate. However, for the terminal rate expectation to rise suddenly and sharply in the U.S. relative to the euro area would also fly in the face of the economic data on both sides of the Atlantic. Recently, there has been little difference in either economic growth or inflation rates. The 'Neutral' Real Interest Rates In The Euro Area And U.S. Are The Same More fundamentally, there is little difference in the so-called 'neutral' (or mid-cycle) real interest rates in the euro area and the U.S. Through the 19 years of the euro's life, the euro area versus U.S. long bond yield spread has averaged -40 bps2 (Chart I-4). Over this same period, the euro area versus U.S. annual inflation differential has also averaged -40 bps (Chart I-5). Ergo, the real interest rate differential has averaged zero. Meaning, the neutral real interest rates in the euro area and the U.S. have been exactly the same. Chart I-4Euro-U.S.: Average Interest ##br##Differential = -40bps Chart I-5Euro Area-U.S.: ##br##Inflation Differential = -40bps Bear in mind that the 19 year life of the euro captures multiple manias and crises, some centred in Europe, some in the U.S. Hence, 1999-2017 is a good representation of what the future holds, at least in relative terms if not in absolute terms. With little difference in the neutral real rates over the past two decades, is there any reason to expect a big difference in the future? Our starting assumption has to be no. Chart I-6If Composition Differences Were Removed, ##br##Euro Area And U.S. Inflation Would Be Near-Identical In fact, even the -40 bps annual inflation shortfall in the euro area is due to a compositional difference in the consumer price baskets. The euro area does not include owner occupied housing costs, whereas the U.S. does at a hefty weighting.3 If this compositional difference were removed, inflation would also be near-identical (Chart I-6). Still, each central bank must target inflation as it is defined in its respective jurisdiction, so let's assume the annual inflation differential continues to average -40 bps. In this case, the long bond yield spread should also ultimately compress to -40 bps from today's -130 bps. The biggest risk to this view is if the existential threat to the euro resurfaced. Looking at the political calendar, the German Federal Election on September 24 poses no such threat. Meanwhile, ahead of the Italian general election to be held no later than May 20 2018, even the non-establishment Five Star Movement and Northern League are toning down their anti-euro rhetoric. As my colleague Marko Papic, our Chief Geopolitical Strategist, puts it: "euro area politics are a red herring." On this basis, our central expectation is that the euro area versus U.S. yield spread has the scope to compress much further from its current -130 bps. This means that after a possible near-term retracement, we expect the cyclical and the structural rally in the euro to resume. German Consumers Are Winners, U.K. Consumers Are Losers When European currencies strengthen, the big winners are European consumers because they become richer in terms of the goods and services they can buy in international markets. This is significant because Europe imports its food and energy in large (and inelastic) volumes. Hence, their price decline in local currency terms significantly boosts the real spending power of consumers. And vice-versa (Chart I-7). As if to prove the point, German consumer services equities have rallied strongly this year (Chart I-8). And their outperformance has closely tracked euro strength (Chart of the Week, left panel). Across the English Channel, it is the mirror-image story. The pound has slumped. And the big losers are U.K. consumers, whose real spending power is evaporating as food and energy prices - in pound terms - rise. Again, to prove the point, U.K. consumer services equities have struggled to make any headway this year (Chart I-9). And their underperformance has closely tracked the trade-weighted pound's weakness (Chart of the Week, right panel). Chart I-7German Consumption Accelerating,##br## U.K. Consumption Decelerating Chart I-8German Consumer Services ##br##Have Rallied Chart I-9U.K. Consumer Services ##br##Have Struggled If the euro has more cyclical and structural upside - as we anticipate - then these equity performance trends have further to run. Chart I-10The Exporter Heavy DAX And##br## OMX Have Struggled Remain overweight German consumer services equities versus German exporters and the DAX. And remain underweight U.K. consumer services equities versus the FTSE100. At the same time, equity markets with a strong base currency and a large exposure to exporters will come under pressure. Mostly, this is because the translation of multi-currency international earnings into a strengthening base currency hurts index profits. For the time being, this influences our allocation to Germany's DAX - in which we have been neutral relative to the Eurostoxx600 - and Sweden's OMX - in which we have been underweight (Chart I-10). Next week, we will update our overall European country allocation. Given the large sector skews in European equity indexes, this country allocation is heavily dependent on the stance towards Healthcare and Banks. Hence, we await any incremental communication from the ECB. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 These are the dates of the ECB's three remaining monetary policy meetings in 2017. 2 Calculated from the over 10-year government bond yield: euro area average, weighted by sovereign issue size, less U.S. 3 The imputed cost of owner occupied housing (owners' equivalent rent of residences) comprises 25% of the U.S. consumer price basket but 0% of the euro area consumer price basket. Fractal Trading Model Basic materials equities are technically overbought. Initiate a short position relative to the broad market with a profit target / stop loss at 2.5%. In other trades, long Mediaset Espana / short IBEX35 hit its stop-loss. 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 Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations
Highlights Chart 1"Trump Trade" Progress Report One of our seven investment themes for 2017, published in a Special Report last December, is that the combination of strong U.S. growth and accommodative Fed policy creates a cyclical sweet spot in which risk assets will outperform. After last week's GDP revisions we now know that real growth averaged 2.1% in the first half of the year, solidly above the Fed's 1.8% estimate of trend. Meanwhile, weak inflation has caused markets to discount an exceptionally shallow path for Fed rate hikes - only 19 bps of rate hikes are priced for the next 12 months. This divergence between growth and inflation is reflected in Treasury yields. The real 10-year yield is 24 bps above its pre-election level, while the compensation for inflation protection is only 5 bps higher (Chart 1). Not surprisingly, the cyclical sweet spot has led corporate bonds to outperform duration-matched Treasuries by 296 bps since the election. The persistence of the cyclical sweet spot leads us to believe that last month's politically-driven spread widening should be seen as an opportunity to increase exposure to corporate bonds. Remain at below-benchmark duration and overweight spread product in U.S. fixed income portfolios. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 62 basis points in August, dragging year-to-date excess returns down to 146 bps. The average index option-adjusted spread widened 8 bps on the month to reach 110 bps. In last week's report,1 we demonstrated that to properly assess corporate bond valuations it is not sufficient to simply look at the average index spread. We need to adjust for the fact that both the average credit rating and duration of the index change over time. We also need to consider corporate spreads relative to other similar stages of the economic cycle, not relative to long-run averages. In this respect, considering the breakeven spread2 for each credit tier relative to where it traded in the early stages of prior Fed tightening cycles gives us the best sense of the value proposition in corporate bonds. At present, this analysis shows that while Aaa corporate spreads are expensive, the other investment grade credit tiers all appear fairly valued (Chart 2). Corporate profit data for the second quarter was released last week and showed a big jump in our measure of EBITD (panel 4). This makes it extremely likely that net corporate leverage declined in Q2. All else equal, this lengthens the window for corporate bond outperformance Table 3.3 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 67 basis points in August, dragging year-to-date excess returns down to 378 bps. The index option adjusted spread widened 26 bps to end the month at 378 bps, 55 bps above the mid-2014 cycle low. Back in March4 we tested a strategy of buying the High-Yield index relative to Treasuries whenever spreads widened by more than 20 bps in a single month, and then holding the trade for a period of one, two or three months. We found that this "buy the dips" strategy works very well when inflationary pressures are low, but performs poorly when inflation is high and rising. When inflation is low the Fed needs to support the recovery by adopting a more dovish posture whenever financial conditions tighten. With the St. Louis Fed Price Pressures Measure5 at only 6% (Chart 3), we expect a "buy the dips" strategy will continue to work for some time. In terms of valuation, our estimated default-adjusted spread stands at 245 bps. Historically, this level is consistent with excess returns of just under 3% versus duration-matched Treasuries over the subsequent 12 months. Our estimated default-adjusted spread is based on an expected default rate of 2.6%, and an expected recovery rate of 49%. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 12 basis points in August, dragging year-to-date excess returns down to -9 bps. The conventional 30-year MBS yield fell 13 bps in August, driven by an 18 bps decline in the rate component. This was partially offset by a 4 bps increase in the compensation for prepayment risk (option cost) and a 1 bp widening of the option-adjusted spread (OAS). The Fed is likely to announce the run-off of its balance sheet when it meets later this month. For its part, the market has been pricing-in this eventuality for most of the year, leading to a significant widening in MBS OAS. More recently, the option cost component of MBS spreads has joined in, widening alongside falling mortgage rates and expectations of rising prepayments (Chart 4). In this sense, the Fed's commitment to proceed with balance sheet normalization no matter the outlook for the future pace of rate hikes is doubly negative for MBS spreads. OAS are biased wider as Fed buying exits the market, while low rates encourage faster prepayments and a higher option cost component of spreads. Going forward, the option cost component of spreads will decline as mortgage rates cease their downtrend, but OAS still appear too tight relative to trends in net issuance. Despite robust issuance so far this year and the Fed backing away as a buyer, the conventional 30-year MBS OAS remains well below its pre-crisis mean (panel 2). While MBS are starting to look more attractive, especially relative to Aaa credit (panel 3), we think it is still too soon to buy. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 5 basis points in August, bringing year-to-date excess returns up to 154 bps. The Foreign Agency and Local Authority sectors drove the index outperformance in August. Both beat the duration-matched Treasury benchmark by 12 bps. Sovereigns outperformed the benchmark by 3 bps, Supranationals outperformed by 1 bp, and Domestic Agency bonds underperformed by 2 bps. We took a detailed look at the Sovereign index in a recent report,6 both at the aggregate and individual country levels. At the aggregate level, the two main factors we consider when deciding whether to add USD-denominated sovereigns to our portfolio at the expense of domestic U.S. credit are relative valuation and the outlook for the U.S. dollar (Chart 5). At present, relative valuation is skewed heavily in favor of domestic U.S. credit (panel 2). Added to that, given downbeat Fed rate hike expectations, we view further dollar weakness as unlikely on a 6-12 month horizon. Taken together, we continue to favor U.S. credit over USD-denominated Sovereign debt. At the country level, we identified several countries where USD-backed debt appears attractive. We found that Finland, Mexico and Colombia all offer attractive spreads. However, the spread pick-up available in Mexican and Colombian debt is compensation for heightened exchange rate volatility. Finnish debt appears the most attractive on a risk/reward basis. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 40 basis points in August (before adjusting for the tax advantage). Munis have outperformed the Treasury benchmark by 144 bps, year-to-date. The average Municipal / Treasury (M/T) yield ratio held flat in August, and it remains extremely tight relative to its post-crisis trading range (Chart 6). The M/T yield ratio remains very low despite the fact that state & local government net borrowing continues to rise. Net borrowing increased to $209 billion in Q2, the highest level since the second quarter of last year. Further, the Trump administration appears to be finally tackling the issue of tax reform. While comprehensive tax reform is probably too ambitious, some form of corporate and personal tax cuts seems likely, probably in the first half of next year. Lower tax rates are obviously a negative for municipal bonds, but some of the negative impact could be offset if current tax deductions (such as the deduction of state & local income tax) are removed. All else equal, fewer available tax deductions elsewhere makes the tax exemption of municipal bonds look more attractive. Of course, the municipal bond tax exemption itself could also be threatened, but at least so far this appears less likely. The bottom line is that current M/T yield ratios are far too low given the looming risks of rising state & local government borrowing and looming federal tax cuts. Remain underweight. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bull flattened in August. The 2/10 slope flattened 17 bps and the 5/30 slope flattened 2 bps. The market moved to discount an even shallower path for Fed rate hikes in August. At the end of July the market had expected 27 bps of rate hikes during the next 12 months, and that number has now fallen to 19 bps (Chart 7). Consequently, our recommendation to short the July 2018 fed funds futures contract has suffered. The position is now 17 bps in the red, but we continue to believe that the market's expected rate hike path is too benign. From current levels, a position short the July 2018 fed funds futures contract will return 35 bps if there are two hikes between now and next July and 61 bps if there are 3 hikes. We also continue to recommend a position long the 5-year bullet versus a duration-matched 2/10 barbell on the view that the Treasury curve will steepen as inflation and TIPS breakevens move higher. This position has earned 28 bps since initiation last December, but valuation is starting to look less attractive. Our butterfly spread model7 suggests that the 5-year bullet is now slightly expensive compared to the 2/10 barbell (panel 3). Or put differently, that the 2/10 Treasury slope will have to steepen by more than 20 bps during the next 6 months for our trade to earn a positive return. TIPS: Overweight Chart 8TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 36 basis points in August, dragging year-to-date excess returns down to -169 bps. The 10-year TIPS breakeven inflation rate fell 6 bps on the month and, at 1.76%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. Despite robust growth, extremely weak realized inflation has caused breakevens to tighten this year. Last week's July PCE release was yet another disappointment. The year-over-year core inflation rate fell from 1.51% to 1.41% and the year-over-year trimmed mean rate fell from 1.68% to 1.64% (Chart 8). However, measures of pipeline inflation pressure such as the supplier deliveries and prices paid components of the ISM Manufacturing survey point towards higher inflation. The supplier deliveries component increased from 55.4 to 57.1 in August (panel 4) while the prices paid component held firm at an elevated 62 (panel 3). Adding it all up, and incorporating the fact that employment growth should stay strong enough to maintain downward pressure on the unemployment rate, we think it is very likely that core inflation will soon reverse course and resume the steady uptrend that began in early 2015. TIPS breakevens will widen alongside. At present, our TIPS Financial model suggests that breakevens are trading in line with other financial market instruments (panel 2). In other words, there is no apparent mis-valuation in breakevens relative to other financial markets, and higher realized inflation is likely required before breakevens move sustainably wider. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in August, bringing year-to-date excess returns up to 71 bps. Aaa-rated ABS outperformed the benchmark by 10 bps in August, bringing year-to-date excess returns up to 63 bps. Meanwhile, non-Aaa ABS outperformed by 26 bps in August, bringing year-to-date excess returns up to 147 bps. Credit card ABS outperformed the Treasury benchmark by 10 bps in August, bringing year-to-date excess returns up to 69 bps. Auto loan ABS outperformed by 12 bps, bringing year-to-date excess returns up to 71 bps. The index option-adjusted spread for Aaa-rated ABS tightened 4 bps on the month, and remains well below its average pre-crisis level (Chart 9). At 36 bps, the option-adjusted spread for Aaa-rated ABS is now the same as the option-adjusted spread for conventional 30-year Agency MBS. Meanwhile, lending standards are now tightening for both auto loans and credit cards. Further, the New York Fed's Household Debt and Credit Report for the second quarter revealed that "flows of credit card balances into both early and serious delinquencies climbed for the third straight quarter - a trend not seen since 2009."8 While overall credit card charge-offs in ABS collateral pools remain low (panel 4), it is clear that the cyclical winds are shifting against consumer ABS. If the trends of tightening lending standards and rising delinquencies continue, then it will soon be time to reduce consumer ABS exposure, possibly shifting into Agency MBS. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 19 basis points in August, bringing year-to-date excess returns up to 116 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 2 bps on the month, and is approaching one standard deviation below its average pre-crisis level (Chart 10). The combination of tightening lending standards and weaker demand for commercial real estate (CRE) loans (as evidenced by the Fed's Senior Loan Officer Survey) suggests that credit concerns are starting to mount in the CRE space. Meanwhile, CMBS delinquency rates have leveled-off during the past few months and remain much lower in the multi-family space (panel 5). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 14 basis points in August, bringing year-to-date excess returns up to 79 bps. The average index option-adjusted spread for the Agency CMBS index held flat at 48 bps on the month. This compares favorably to the 36 bps offered by both Aaa-rated consumer ABS and conventional 30-year Agency MBS. Not only does the Agency CMBS sector continue to offer an attractive spread relative to both consumer ABS and Agency MBS, but its agency guarantee and concentration in the multi-family space (where delinquencies are still low) makes it look particularly attractive. Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.67% (Chart 11). Our 3-factor version of the model (not shown), which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.68%. The Global Manufacturing PMI rose to 53.1 in August, from 52.7 in July, reaching a 75-month high (panel 3). Meanwhile, bullish sentiment toward the U.S. dollar continues to plunge (bottom panel). Taken together, these two factors suggest that not only is global growth accelerating but that the global economic recovery is increasingly broad based. This is an extremely bond-bearish development. A broad based global recovery means that when U.S. data finally start surprising positively, it is less likely that any increase in Treasury yields will be met with an influx of foreign demand. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.16%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Policy Reflections", dated August 29, 2017, available at usbs.bcaresearch.com 2 The 12-month breakeven spread is the basis point widening required over a 12-month period before a corporate bond delivers losses relative to a duration-matched Treasury security. We assume no impact from convexity and calculate the breakeven spread as OAS divided by duration. 3 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com 5 The Price Pressures Measure is a composite indicator which shows the percent chance that PCE inflation will exceed 2.5% during the next 12 months. 6 Please see U.S. Bond Strategy Weekly Report, "The Upside Of A Weaker Dollar", dated August 15, 2017, available at usbs.bcaresearch.com 7 For further details on our models please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 8 https://www.newyorkfed.org/microeconomics/hhdc Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)
Highlights Some caution warranted here. Hurricane Harvey's impact on the economy and markets. Tensions in North Korea will linger. NIPA and S&P now telling same story on profits, margins. Is the August employment report enough for the Fed? Feature The impact of Hurricane Harvey will ripple through the economic data in the coming months, but will not impact the overall trajectory of the economy or the Fed. However, elevated equity valuations, escalating tensions in North Korea, a widening disconnect between the bond market and the Fed and profit growth that is poised to peak in the second half of the year warrants careful attention from investors. Nonetheless, we remain slightly overweight stocks and favor stocks over bonds. Caution On Risk Assets We recommend that clients be prudent, paring back any overweight positions and holding some safe-haven assets within diversified portfolios. BCA research has demonstrated that U.S. Treasuries, Swiss bonds and JGBs were the best performers during a crisis (Chart 1). The same is true for the Swiss franc and the Japanese yen, such that the currency exposure should not be hedged in these cases. The dollar is more nuanced. It tends to perform well during financial crises, but not in geopolitical crises or recessions. Chart 1Gold Loves Geopolitical Crises Gold tends to perform well in geopolitical events, although not in recessions or financial crunches. Our base case projects stocks outperforming cash and bonds over the next 6-12 months. BCA's dollar and duration positions have disappointed so far this year. Much hinges on U.S. inflation. Investors appear to have adopted the stance that structural headwinds to inflation will forever dominate the cyclical pressures. Therefore, the bond market is totally unprepared for any upside shocks on the inflation landscape. Admittedly, a rise in bond yields may not be imminent, but the risks appear to be predominantly to the upside. Harvey's Lingering Aftermath History shows that natural disasters such as Hurricane Harvey have a temporary effect on the U.S. economy, the financial markets and the Fed. Ultimately, the macro environment in place before the storm will reassert itself. Nonetheless, it may be a few months before investors determine the long-term impact of the record rainfall and flooding in Houston. Chart 2 shows the ranking of Harvey's preliminary damage estimate of $30B versus other storms of similar magnitude. We are still several weeks away from the peak of the Atlantic hurricane season (mid-September) and two of the most destructive storms in the past 25 years made landfall in mid-to-late October (Wilma and Sandy). Chart 2Economic Impact From Major Hurricanes Chart 3 shows the performance of key economic, inflation and financial market indicators in the past two years and also around five major hurricanes since 1992. Most of the activity-related economic statistics are volatile in the aftermath of the storms and then they recover. The Citi economic surprise index initially moves higher after a storm, and then fades (Chart 3A). There are big swings in housing starts and industrial production and employment growth slows. Inflation tends to climb post-landfall (Chart 3B). In prior episodes, core PCE and core CPI have accelerated along with gasoline prices. Consumer confidence dips initially, but then recovers. Wages are volatile, but tend to accelerate after several months. Chart 3C shows that stocks drift lower for several months following hurricanes and subsequently recoup the losses. The stock-to-bond ratio also moved lower, but regains its pre-storm heights about two months later. Treasury yields fall after storms, but we note that yields have been in a secular decline for 25 years. Chart 3AMajor Hurricane Impact##BR##On Activity Data Chart 3BMajor Hurricane Impact On##BR##Sentiment And Inflation Data Chart 3CMajor Hurricane Impact On##BR##Financial Markets & The Fed Hurricane Harvey will not shake the Fed. Nonetheless, the central bank will acknowledge the disaster in the FOMC statement, the FOMC minutes, and/or in Fed Chair Janet Yellen's news conference. We are unchanged in our view that policymakers will begin to pare its balance sheet later this month and bump up rates again in December, assuming that core inflation shows some signs of strength between now and then. History shows (Chart 3C) that, on average, the Fed funds rate tends to move higher in the months after storms hit, but the primary message is that the Fed just continues to do whatever it was doing before the storm. The Fed cut rates in the aftermath of Hurricane Andrew in 1992 in what turned out to be the final rate reduction of the cycle that began in 1989. Ivan hit in September 2004, but the monetary authority raised rates in the final three FOMC meetings of 2004, including at the meeting only a week after the hurricane made landfall. Similarly, the Fed clung to its rate hike regime after Wilma in October 2005. In 2008, Ike arrived in Texas two days before Lehman Brothers collapsed in mid-September. The Fed, which had been cutting rates since September 2007, lowered rates in the final months of 2008. The Fed announced QE3 in late summer 2012 and continued with the program after Sandy came ashore at the end of October 2012. Harvey will be a game changer in some respects: the devastation reduces the odds of a government shutdown or of failing to increase the debt ceiling. We have maintained that there were extremely low odds that the debt ceiling would not be raised. We stated that there was a 25% chance of a government shutdown between October 1, when the current funding expires, and sometime in mid-October when the debt ceiling will hit according to the Congressional Budget Office. However, it would be unfathomable to shut down the government and force the Federal Emergency Management Agency (FEMA) to cease operations. The resulting outrage would damage the Republicans, especially in Texas. Bottom Line: Harvey may have a near-term impact on the economy, but the Fed will stick to its plan. The catastrophe makes it increasingly likely that the debt ceiling will be raised and a resolution will be passed to keep the government operating into the new fiscal year. Thus, equity investors can safely ignore these two risks, and focus on the key risk in the outlook: North Korea. North Korea Could Linger Over Markets BCA believes that the probability of a war on the Korean Peninsula is very low,1 but it may take a while before the uncertainty in Northeast Asia is resolved. Between now (escalating tensions) and then (a negotiated settlement), there will be more provocations and market volatility. There are long-standing constraints to war. The first is a potentially high death toll: Pyongyang can inflict massive civilian casualties in Seoul with a conventional artillery barrage. Furthermore, U.S. troops, and Japanese forces and civilians, would also suffer. Secondly, China is unlikely to remain neutral. Strategically, China will not tolerate a U.S. presence on its border with North Korea. Nevertheless, Washington must establish a credible threat of military action if it is to convince Pyongyang that negotiations offer a superior outcome. It is unclear how long it will take Trump to convince North Korea that the threat of a U.S. preemptive strike is credible. Chart 4 shows the arc of diplomacy2 that the U.S. took with Iran between 2010 and 2014. From an investor perspective, it will be difficult to gauge whether the brinkmanship and military posturing are part of this territorial threat display or evidence of real preparations for an actual attack. More market volatility may occur, but for the time being, we do not think that the tensions in the Korean peninsula will end the bull market in global equities. Positions in traditional safe-haven assets, such as gold, U.S. Treasuries, Swiss francs and (perhaps) Japanese yen, should be considered as hedges against increased market swings. Chart 4Arc Of Diplomacy: Tensions Ramp Up As Nuclear Negotiations Begin Update: Equity Valuations, Sentiment And Technicals U.S. equity valuations are stretched, but elevated valuations alone are not enough to prompt a sell-off in stocks. The BCA valuation indicator is in overvalued territory, where it has been since late 2013. History shows3 that stocks can stay overvalued for extended periods, even when the Fed is raising rates, but policy is still accommodative as it is today. BCA's composite valuation indicator is still shy of the +1 standard deviation level that defines extremely over-valued (Chart 5). However, this is due to the components that compare equity prices with bond yields. The other three elements of the equity indicator, which are unrelated to bond yields, suggest that stock valuation is stretched (Chart 5 panels 2, 3 and 4). That said, equities are attractively priced relative to competing assets, such as corporate bonds and Treasuries (Chart 6). Chart 5U.S. Equities##BR##Are Overvalued... Chart 6...But Look Less Expensive##BR##Relative To Competing Assets Valuation is not a reliable tool to time market turning points and, absent a significant deterioration in the economic, profit and margin environment, we do not forecast a sustained pullback in stocks. Looking beyond BCA's tactical 6-12 month window, above-average market multiples alone imply below-average returns for stocks across a strategic time horizon. Chart 7No Strong Signal From##BR##Sentiment Or Technicals BCA's technical and sentiment indicators are not at extremes (Chart 7). The BCA technical indicator, while above zero, is not at a level that in the past has triggered a stock pullback. Similarly, the BCA investor sentiment composite index, while at the top end of its bull market range, is not at an extreme. Moreover, only 50% of the stocks in the NYSE composite are above their 10-week moving average, a level which has not been previously associated with major equity sell-offs. Bottom Line: The solid earnings backdrop remains in place for U.S. stocks as measured by either the S&P or the national accounts. We anticipate that profit growth has peaked according to S&P 500 data on a 4-quarter moving total basis due to tough comparisons although it will slip only modestly in the second half of the year. Next year will see EPS growth drop back into the mid-single digit range. The consensus estimate for 2018 EPS growth is 11%. While valuations are elevated, neither sentiment nor technical indicators are flashing red. We recommend stocks over bonds in the next 6-12 months, but acknowledge that risks to BCA's stance are climbing. A Reconnection In Q2 The Q2 data show that the NIPA and S&P earnings measures have reconnected. In our July 3, 2017 Weekly Report "Summer Stress Out"4 we highlighted the apparent disconnect between the S&P and NIPA, sales earnings and margin data through Q1 2017. The release of the Q2 corporate profits data in the national accounts and the end the Q2 S&P 500 reporting season allow us to provide an update. The year-over-year reading on the NIPA earnings measure ticked up in Q2 while the S&P-based metric ticked down. That said, while there are marked differences in annual growth rates between the two measures, the levels were close to the same point in the second quarter of 2017 (Chart 8, bottom panel). Chart 9 shows that a wide difference persists between corporate sales measured by S&P and the national accounts. Margins calculated on the S&P basis climbed in Q2 while NIPA margins held steady. Even so, a modest gap still remains between NIPA margins at 15.2% and S&P margins at 13.2%. Most of the divergence is related to the denominator of the calculation. The NIPA denominator is corporate sector Gross Domestic Product (GDP). This is a value-added concept that is different from sales. It is not clear why, but GDP has grown much faster than sales since the end of 2014. Chart 8S&P And NIPA##BR##Profit Comparison Chart 9Denominator Explains##BR##S&P/NIPA Margin Divergence We believe that the S&P statistics are painting a more accurate picture because sales are easier to measure while value-added is more complicated. The slow growth of sales is not a bullish point for stocks. Nonetheless, it does not appear that financial engineering has distorted bottom-up company data to such an extent that the S&P readings are falsely signaling strong profit growth. We expect the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, the profit backdrop is positive for stocks for now. Is The August Jobs Report Enough For The Fed? Chart 10Labor Market Conditions##BR##Favor Risk Assets U.S. payrolls expanded by 156,000 in August. Relative to the underlying growth rate in the labor force, this is still a healthy pace of jobs growth. Nevertheless, it fell short of expectations for a 180,000 increase and the prior two months saw a cumulative downward revision of 41,000. The August data were not impacted by Hurricane Harvey. Aggregate hours worked, a measure of total labor inputs based on changes in employment and the workweek, fell by 0.2% m/m. That said, aggregate hours worked are up 1.3% at a quarterly annualized rate thus far in Q3. This is consistent with GDP growth of a bit over 2%, which has been the trend in the current economic expansion. Meanwhile, wage gains remain muted. Average hourly earnings rose just 0.1% m/m. Annual wage inflation has been steady at 2.5% for several months now (Chart 10, bottom panel). If productivity is expanding modestly around 1%, the current pace of wage gains would suggest that unit labor costs are growing around 1.5%. This will make it difficult for general price inflation to accelerate to the Fed 2% target. Nonetheless, the reacceleration in the 3-month change in average hourly earnings from 1.9% in January 2017 to 2.6% in August supports the Fed's view on inflation. Finally, the unemployment rate ticked up to 4.4% from 4.3%. This was because the separate household survey showed a 74,000 drop in employment. The participation rate held steady at 62.9% in August. Bottom Line: While falling short of expectations in August, U.S. employment growth remains solid and job gains are continuing at a pace consistent with the 2% GDP growth rate of recent years. However, muted wage gains mean that progress to the Fed's 2% inflation target is looking suspect. We anticipate that the Fed will announce the process of running down its balance sheet at the September FOMC meeting. Rate hikes are on hold at least until the December FOMC meeting, and even then only if core inflation shows some signs of strength in the next few months. U.S. risk assets should continue to benefit from moderate growth, low inflation and a "go slow" approach by the Fed. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?", August 16, 2017. It is available at gps.bcaresearch.com. 2 Please see BCA's Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets? ,"May 24, 2017, available at gps.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Sizing Up The Second Half", July 10, 2017, available at usis.bcaresearch.com. 4 Please see BCA's U.S. Investment Strategy Weekly Report, "Summer Stress Out", July 3, 2017, available at usis.bcaresearch.com.
Feature Dear Client, In addition to this abbreviated Weekly Report, I am sending you a Special Report written by Mark McClellan, Managing Editor of the monthly Bank Credit Analyst. Mark makes a compelling case that the deflationary effects of the "Amazon economy" are overstated. I trust you will find his report very informative. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Chart 1September Is Generally ##br##Not A Good Time Of Year For Stocks My colleagues and I convened a meeting earlier this week to discuss whether to abandon our long-standing cyclically bullish view towards risk assets. Several of them felt it was time to turn more cautious. I am sympathetic to their concerns: Valuations are stretched, volatility is low, and geopolitical risks (most notably North Korea) are on the rise. Profit growth is likely to decelerate later this year, as the easy comps stemming from the depressed level of earnings in the first half of 2016 vanish. Meanwhile, stocks are entering the volatile early autumn months, a period which has historically seen poor returns (Chart 1). Nevertheless, at times like these, it is useful to fall back on our time-tested indicators. Bear markets have almost always coincided with economic recessions, with the latter usually causing the former (Chart 2). None of our recession-timing signals are flashing red: To cite just a few examples, ISM manufacturing new orders are strong, initial unemployment claims are low, core capital goods orders are accelerating, and the yield curve is not in any immediate risk of inverting (Chart 3). Chart 2Recessions And Bear Markets Usually Overlap Chart 3No Warnings Of Recession Here U.S. financial conditions have eased sharply this year, which should support growth over the next few quarters (Chart 4). A recent IMF report highlighted that easier U.S. financial conditions tend to generate positive spillovers onto other countries.1 The fact that all 45 countries monitored by the OECD are on track to grow this year - the first time this has happened since 2007 - is a testament to the strong fundamentals underpinning the global economy. Chart 4Easing Financial Conditions Bode Well For Growth The Fed's Dot Problem In this light, the Fed's projection that the unemployment rate will end this year at 4.3% and only fall to 4.2% by end-2018 no longer looks credible. If U.S. GDP growth remains above trend, as we expect, the unemployment rate could fall below its 2000 low of 3.8% by next summer. That will be enough to prompt investors to price in a few more rate hikes. Considering that the market expects just 22 basis points in hikes through to end-2018, this is not a high bar to clear. A bit more fiscal stimulus would add to the pressure to tighten monetary policy. While any meaningful progress on tax reform will be difficult to achieve, the odds are good that Congress will agree to cut statutory corporate and personal tax rates, with the latter focusing mainly on middle-income earners. Failure to raise the debt ceiling or extend federal spending authority beyond the current budget window could scuttle the benefits from lower tax rates. Fortunately, the risks of such an outcome have receded. If there is a silver lining from Hurricane Harvey, it is that the disaster could at least temporarily overcome the political impasse in Washington. Congress will need to appropriate additional disaster relief funds over the coming weeks. Politicians who are seen as creating roadblocks to such funding will face the electorate's wrath. The odds of an infrastructure bill passing through Congress have also risen. All recoveries eventually run out of steam, but this one can last at least until the second half of 2019, which will make it the longest U.S. expansion on record. As we discussed several weeks ago, the next recession is likely to be triggered by the Fed scrambling to hike rates in response to rising inflation.2 This is not an immediate concern, given that it usually takes a while for an overheated economy to generate inflation - especially since the U.S. currently can satisfy rising domestic demand with higher imports. However, the risks of overheating will increase as unemployment falls further and excess capacity elsewhere in the world is absorbed. Draghi After Jackson Hole Chart 5A Stronger Euro Is Deflationary Textbook economic theory states that a shift in consumption towards imported goods requires a real appreciation of the currency. The dollar, of course, has done exactly the opposite of that, depreciating by 6.6% in trade-weighted terms since the start of the year. The euro, in particular, has gained significant ground against the greenback, rising above $1.20 at one point this week. Mario Draghi's failure to express concerns about the resurgent euro during his Jackson Hole address was construed by many market participants as a green light for further currency strength. We are skeptical of this "saying nothing means you are saying something" interpretation. Draghi wanted to acknowledge (and partly take credit for) the recovery across the euro area, but he is cognizant of the problems posed by a stronger euro. The ECB's June forecast showed inflation rising to only 1.6% in 2019. In the period since those forecasts were compiled, the trade-weighted euro has appreciated by 3.9%, bringing the year-to-date gain to 6.2% (Chart 5). ECB staff calculations, which Draghi has approvingly quoted, show that a 10% appreciation in the euro would reduce inflation by 0.2 percentage points in the first year and 0.6-to-0.8 points in the subsequent two years.3 Better-than-expected growth since the June forecasts will offset some of the deflationary impact from the stronger euro, but probably not by much, given that the Phillips curve is quite flat at high-to-moderate levels of spare capacity. With labor market slack across the euro area still 3.2 percentage points higher today than in 2008 (and 6.7 points higher outside of Germany), it will be a while before stronger growth generates markedly higher inflation. We expect the ECB to reduce its 2018/2019 inflation forecast by 0.1-to-0.2 percentage points next week. It would be awkward for the central bank to play up the prospect of monetary policy normalization while it is simultaneously trimming its inflation projections. This suggests that the ECB's communications could turn more dovish, thereby limiting further upside for the euro. EUR/USD is currently trading near the top of the $1.10-to-$1.20 range that we foresee lasting for the next 10 months. Thus, our expectation is that the euro will weaken over the next few months, ending the year near $1.15, and potentially moving back towards its 2017 lows in the second half of next year, as an overheated U.S. economy forces the Fed to pick up the pace of rate hikes. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see "Getting The Policy Mix Right," IMF Global Financial Stability Report, (Chapter 3), (April 2017). 2 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery to Retro-Recession?" dated August 18, 2017. 3 Please see European Central Bank, "March 2017 ECB Staff Macroeconomic Projections For The Euro Area." APPENDIX 1 Tactical Global Asset Allocation Monthly Update To complement our analysis, we use a variety of time-tested models to assess the global investment outlook. At present, these models favor global equities over bonds over a three-month horizon (Appendix Table 1). Appendix Table 1BCA's Tactical Global Asset Allocation Recommendations* Our business cycle equity indicators remain in bullish territory, as reflected in strong global growth and rising corporate earnings. Our monetary and financial indicators are also generally supportive. In contrast, our sentiment readings are sending mixed signals. On the one hand, implied equity volatility remains low and institutional exposure to stocks is quite high. On the other hand, surveys of retail investors show a healthy skepticism towards the bull market, which is a positive contrarian indicator. As has been the case for some time, our valuation measures are signaling that stocks are expensive, but these are typically useful only over horizons beyond one or two years. As we flagged last month, stocks tend to do poorly in August and September, which may hurt returns over the next few weeks. The stronger euro will negatively impact earnings in the euro area. This has caused our models to suggest a slight downgrade to European equities. However, we are inclined to fade this signal, given our expectation that the euro will give up some of its recent gains. Japanese stocks continue to score well on our metrics, buoyed by strengthening corporate profits and attractive valuations. Emerging market equities are fairly valued, although China still appears cheap. The rally in U.S. Treasurys has caused the gap between the 10-year yield and our model's fair value estimate to widen to around 50 basis points, the highest since last September. European and Japanese bonds also look somewhat overvalued, although the latter will continue to receive support from the BoJ's yield curve targeting operations. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of August 30th, 2017. The model has continued to reduce its allocation to the U.S. driven by worsening liquidity condition, and it's the second consecutive month that the U.S. allocation is the largest underweight. Australia is downgraded to neutral on concern of valuation. Germany and Netherland continued to receive more allocation and Canada's underweight is reduced as well, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 18 bps in August, entirely due to the 43 bps outperformance of Level 2 model where the overweight in Italy and Germany versus the underweight in Japan, Spain and Canada worked very well. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of August 30, 2017. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The model is optimistic on global growth and maintains in cyclical tilt. However, the magnitude of overweight in cyclical sectors has reduced on the back of momentum indicators. The biggest change has been utilities which has moved from a 2% underweight to a 1.7% overweight. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com
Feature Shrugging Off The Political Noise All the political noise of August (White House resignations, Charlottesville, North Korean missile launches, the looming U.S. debt ceiling) could do no more than trigger a minor market wobble: at the worst point, global equities were off only 2% from their all-time high. The reason is that global cyclical growth remains strong, earnings are accelerating, and central banks have no immediate need to turn hawkish. In such an environment, risk assets should continue to outperform over the next 12 months. The political risks will not disappear (and will no doubt produce further hair-raising moments), but they are unlikely to have a decisive impact on markets. BCA's geopolitical strategists think eventually there will be a diplomatic solution to the North Korean situation - albeit only after a significant further rise in tension forces the two sides to the negotiating table.1 It is hard to imagine the debt ceiling not being raised, since Republicans control both houses of Congress and the White House, and they would be blamed for any disruption caused by a failure to raise it. Recent personnel changes in the White House have left - for now - a more pragmatic "Goldman Sachs clique" in charge. We believe there is still a reasonable likelihood of tax cuts, not least since the Republicans are on track to lose a lot of seats in next year's mid-term elections unless they can boost the administration's popularity (Chart 1). Recent growth data has been decent. U.S. Q2 GDP growth was revised up to 3% QoQ annualized, and the regional Fed NowCasts point to 1.9-3.4% growth in Q3. If anything, growth momentum in the euro area (2.4% in Q2) and Japan (4%) is even better. Corporate earnings growth continues to accelerate too, with S&P 500 EPS growth in the second quarter coming in at 10% YoY, compared to a forecast of just 6% before the results season started. BCA's models suggest that, in all regions, earnings growth is likely to continue to accelerate for a couple more quarters (Chart 2). Chart 1Republicans Need A Popularity Boost Chart 2Earnings Continue To Accelerate The outlook for the dollar remains the key to asset allocation. The market currently assumes that the dollar will weaken further, as U.S. inflation stays low and the Fed, therefore, stays on hold. Futures markets currently price only a 38% probability of a Fed hike in December, and only 25 BP of hikes over the next 12 months. If markets are right, this scenario would be positive for emerging market equities and commodity currencies, and would mean that long-term rates would be likely to stay low, around current levels. But we think that assumption is wrong. Diffusion indexes for core inflation have begun to pick up (Chart 3). The tight labor market should start to push up wages, dollar deprecation is already coming through in the form of rising import prices, and some transitory factors (pre-election drugs price rises, for example) will fall out of the data soon. The Fed is clearly nervous that it has fallen behind the curve, especially since financial conditions have recently eased significantly (Chart 4). A moderate stabilization of inflation by December would be enough to push the Fed to hike again - and to reiterate its plan to raise rates three times next year. Chart 3Inflation To Pick Up? Chart 4Financial Condition: Easy In The U.S., Tight In Europe Meanwhile, long-term interest rates in developed economies look too low given growth prospects (Chart 5). As inflation picks up, the Fed talks more hawkishly, and the dollar begins to appreciate again, rates are likely to move up in the U.S. and in the euro zone. Our view, then, is that the Fed will tighten faster than the market expects, long-term rates will rise and the dollar will appreciate. Equities might wobble initially as they price in the tighter monetary policy but, as long as growth continues to be strong, should outperform bonds on a 12-month basis. Our scenario would be positive for euro zone and Japanese equities, but somewhat negative for EM equities. Equities: We prefer DM equities over EM. Emerging equities have been boosted over the past 12 months by the weaker dollar and Chinese reflation. With the dollar likely to appreciate (for the reasons argued above), and a slowdown in Chinese money supply growth pointing to slower growth in that economy (Chart 6), we think EM equities will struggle over coming quarters. Meanwhile, there is little sign that domestic growth momentum is improving in emerging economies (Chart 7). Within DM, our underlying preference is for euro zone and Japanese equities. Our quants model now points to an underweight for the U.S. We haven't implemented this yet because 1) of our view that the USD will strengthen, and 2) we prefer not to make too frequent changes to recommendations. We will review this in our next Quarterly. Chart 5Rates Lag Behind Global Growth Chart 6Slowing Chinese Money Growth Is A Risk For EM Chart 7EM Domestic Growth Anemic Text below Fixed Income: BCA's model of fair value for the 10-year U.S. Treasury yield (the model incorporates the Global Manufacturing PMI and USD bullish sentiment) points to 2.6%, almost 50 BP above the current level (Chart 8). We therefore expect G7 government bonds to produce a negative return over the next 12 months, as inflation expectations rise and monetary policy continues to "normalize". We still find some attraction in spread product, especially in the U.S. (Chart 9). While spreads are quite low compared to history, U.S. high-yield spreads remain 119 BP above historic lows, while euro area ones are only 65 BP above. Chart 8U.S. Rate Fair Value Is Around 2.6% Chart 9Credit Spreads Not At Record Lows Currencies: The euro has likely overshot. Long speculative positions are close to record levels (Chart 10) and the currency has returned to its Purchasing Power Parity level against the USD (Chart 11). An announcement of a "dovish" tapering of asset purchases by ECB President Draghi in September could persuade the market that the ECB will continue to be much more cautious about tightening than the Fed. The yen is also likely to weaken against the US dollar as global rates rise, since the BoJ will not change its yield curve control policy despite the better recent growth numbers, given how far inflation is still from its target. Chart 10There Are A Lot Of Euro Bulls Chart 11Euro Is No Longer Undervalued Commodities: Our forecast that a drawdown in crude inventories will push the WTI price back up is slowing coming about. U.S. crude inventories have fallen by 25.3 million barrels since the start of the year. The after-effects of Hurricane Harvey might affect the data for a while but, as long as global demand holds up, the crude oil price should rise further, with WTI moving over $55 a barrel by year-end. Metals prices have moved largely sideways year to date, and future movements depend mostly on the outlook for Chinese growth, which may begin to slow. In particular, the recent run-up in copper prices (which have risen by 20% since early June) seems unsustainable. The bullish sentiment was mostly due to short-term supply/demand imbalances caused by labor disruptions at some major mines. However, Chinese copper demand, especially for construction, is likely to weaken over coming months.2 Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report "Can Pyongyang Derail The Bull Market," dated 16 August 2017, available at gps.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report "Copper's Getting Out Ahead Of Fundamentals, Correction Likely," dated 24 August 2017, available at ces.bcaresearch.com Recommended Asset Allocation