Financial Markets
Highlights Major central banks outside the U.S. have fired a warning shot across the bow of global bond markets by signaling that "emergency" levels of monetary accommodation are no longer required. Pipeline inflation pressures have yet to show up at the consumer price level outside of the U.K. Most central bankers argue that temporary factors are to blame, but longer-lasting forces could be at work. There are numerous examples of deflationary pressure driven by waves of innovation, cost cutting and changing business models. However, this is not confirmed in the productivity data. Productivity is dismally low and we do not believe it is due to mismeasurement. The Phillips curve is not dead. We expect that inflation will firm by enough to allow central banks to continue scaling back monetary stimulus. The real fed funds rate is not far from the neutral short-term rate, but it is still well below the Fed's estimate of the long-run neutral rate. Market expectations for the Fed are far too complacent; keep duration short. The failure to repeal Obamacare could actually increase the motivation of Republicans to move forward on tax cuts. Expansionary fiscal policy would make life more difficult for the FOMC, given that unemployment is on course to reach the lowest level since 2000. This would force the Fed to act more aggressively, possibly triggering a recession in 2019. The peak Fed/ECB policy divergence is not behind us, implying that recent dollar weakness will reverse. However, the next dollar upleg has been delayed. Fading market hopes for U.S. fiscal stimulus this year have not weighed on equities, in part because of a solid earnings backdrop. Global EPS growth continues to accelerate in line with the recovery in industrial production. In the U.S., results so far suggest that Q2 will see another quarter of margin expansion. Overall earnings growth should peak above our 20% target later this year. It will be tougher sledding in the equity market once profit growth peaks in the U.S. because of poor valuation. Expect to downgrade stocks in the first half of 2018. Corporate bonds are also benefiting from the robust profit backdrop. Balance sheet health continues to deteriorate, but the spark is missing for a sustained corporate bond spread widening. Feature Chart I-1Sell-Off In Global Bond Markets ##br##Triggered By Central Bank Talk Major central banks outside the U.S. fired a warning shot across the bow of global bond markets by signaling a recalibration of monetary policy at the ECB's Forum on Central Banking in late June (Chart I-1). The heads of the Bank of England (BoE), Bank of Canada (BoC) and Swedish Riksbank all took a less dovish tone, warning that the diminished threat of deflation has reduced the need for ultra-stimulative policies. The BoC quickly followed up in July with a rate hike and a warning of more to come. The central bank now expects the economy to reach full employment and hit the inflation target by mid-2018, much earlier than previously expected. The Riksbank also backed away from its easing bias at its most recent policy meeting. The ECB's shift in stance was evident even before its Forum meeting, when President Draghi gave a glowing description of the underlying strength of the Euro Area economy. The labor market is about two percentage points closer to full employment than the U.S. was just before the infamous 2013 Taper Tantrum.1 European core inflation is admittedly below target today, but so was the U.S. rate leading up to the 2013 Tantrum. We have not forgotten about Europe's structural problems or the inherent contradictions of the single currency. Banks are still laden with bad debt (although the recapitalization of Italian banks has gone well so far). Nonetheless, from a cyclical economic standpoint, solid momentum this year will allow Draghi to scale back the ECB's ultra-accommodative monetary stance by tapering its asset purchase program early in 2018. The message that "emergency" levels of monetary accommodation are no longer needed is confirmed by our Central Bank (CB) Monitors, which measure pressure on central bankers to raise or lower interest rates (Chart I-2). The Monitors became less useful when rates hit the zero bound and quantitative easing was the only game in town, but they are becoming relevant again as more policymakers consider their exit strategy. All of our CB Monitors are currently in "tighter policy required" territory except for Japan and the Eurozone (although even those are close to the zero line). The Monitors have been rising due to both their growth and underlying inflation components. Another tick higher in PMI's for the advanced economies in July underscored that the rebound in industrial production is continuing (Chart I-3). Our short-term forecasting models, which include both hard and soft data, point to stronger growth in the major countries in the second half of 2017 (Chart I-4). Chart I-2Most In The "Tighter Policy Required" Zone Chart I-3Industrial Production Recovery Is Intact On the inflation side, our pipeline indicators have all signaled a modest building of underlying inflation pressure over the past year (although they have softened recently in the U.S. and Eurozone; Chart I-5). In terms of the components of these indicators, rising core producer price inflation has been partly offset by slower gains in unit labor costs in some economies. Chart I-4Our Short-Term Growth Models Are Bullish Chart I-5Some Rise In Pipeline Inflation Pressure These pipeline pressures have yet to show up at the consumer level. Most central bankers argue that temporary special factors are to blame, but many investors are wondering if longer-lasting forces are at work. There are numerous examples of deflationary pressure driven by waves of innovation, cost cutting and changing business models. Amazon, Uber, robotics and shale oil production are just a few examples. If this is the main story, then the inability for central banks to reach their inflation targets is a "good thing" because it reflects the adaptation of game-changing new technology. There is no doubt that important strides are being made in certain areas where new technologies are clearly driving prices down. The problem is that, at the macro level, it is not showing up in the productivity data. Productivity is dismally low across the major countries and we do not believe it is simply due to mismeasurement. A Special Report from BCA's Global Investment Strategy2 service makes a convincing case that mismeasurement is not behind the low productivity figures. In fact, it appears that productivity is over-estimated in some industries. It is also important to keep in mind that technological change is nothing new. There is a vigorous debate in academic circles on whether today's new technologies are anywhere near as positive as previous ones like indoor plumbing, electricity, the internal combustion engine and the internet. We are wowed by today's new gizmos, but they are not as transformative as previous innovations. While productivity is surging in some high-profile firms, studies show that there is a long tail of low-productivity companies that drag down the average. A full discussion is beyond the scope of this report and more research needs to be done, but we are not of the view that technology and productivity preclude rising inflation. We expect that inflation will firm by enough to allow central banks to continue scaling back monetary stimulus in the coming months and quarters. Did Yellen Turn Dovish? As with other central banks, the consensus among Fed policymakers is willing to "look through" low inflation for now. Yellen's Congressional testimony did not deviate from that view, although investors interpreted her remarks as dovish. The financial press focused on her statement that "...the policy rate is not far from neutral." However, this was followed up by the statement that "...because we also anticipate that the factors that are currently holding down the neutral rate will diminish somewhat over time, additional gradual rate hikes are likely to be appropriate over the next few years to sustain the economic expansion and return inflation to our 2 percent goal." Chart I-6Bond Market Does Not Believe The Fed The Fed believes there are two neutral interest rates: short-term and long-term. Yellen argued that the actual policy rate is currently close to the short-term neutral level, which is depressed by economic headwinds. However, Yellen and others have made the case that the short-term neutral rate is trending up as headwinds diminish, and will converge with the long-term neutral rate over time. The Fed's Summary of Economic Projections reveals what the FOMC thinks is the neutral long-term real fed funds rate; the median forecast calls for a nominal fed funds rate of 2.9% at the end of 2019 and 3% in the longer run. Incorporating a 2% inflation target, we can infer that the Fed anticipates a real neutral rate of 1% in the longer run. The Fed is likely tracking the real neutral fed funds rate using an estimate created by Laubach and Williams (LW).3 Chart I-6 shows this estimate of the neutral rate, called R-star, alongside the real federal funds rate that is calculated using 12-month trailing core PCE. The resulting real fed funds rate has risen sharply during the past seven months due to both three Fed rate hikes and a decline in inflation. If the Fed lifts rates once more this year and core inflation stays put, then the real fed funds rate would end 2017 close to zero, only 42 bps below neutral. However, it's more likely that the Fed will need to see inflation rebound before it delivers another rate hike. In a scenario where core inflation rises to 1.9% and the Fed lifts rates once more, then the real fed funds rate would actually decline between now and the end of the year. The implication is that the real fed funds rate is not far from R-star, but the nominal rate will have to rise a long way before the real rate reaches the Fed's estimate of the long-term neutral rate. Investors simply don't believe Fed policymakers. According to the bond market, the real fed funds rate will not shift into positive territory until 2021 (see real forward OIS line in Chart I-6). We think this is far too complacent. U.S. Health Care Reform: RIP The speed at which short-term rates converge with the long-run neutral rate will depend importantly on the path of fiscal policy. The Republicans' failure to pass their health care legislation is leading the investors to doubt the prospect for (stimulative) tax cuts. This may be premature. Ironically, the failure to jettison Obamacare may turn out to be a blessing in disguise for President Trump and the Republican Party. According to the Congressional Budget Office, the proposed legislation would have caused 22 million fewer Americans to have health insurance in 2026 compared with the status quo. The Senate bill would have also led to substantial cuts to Medicaid relative to existing law, as well as deep cuts to insurance subsidies for many poor and middle-class families. Many of these voters came out in support of Trump last year. The failure to repeal Obamacare could actually increase the motivation of Republicans to move forward on tax cuts anyway. The chances for broad tax reform have certainly diminished, since that will be just as difficult to get passed as healthcare reform. The GOP also wanted to use the roughly $200 billion in savings from healthcare reform to fund reduced tax rates. However, tax cuts are something that all Republicans can easily agree too, and they will need to show a legislative victory ahead of next year's mid-term elections. The difficulty will be how to pay for these cuts. We expect them to be "fully funded" in the sense that there will be offsetting spending cuts, but these will be back-loaded toward the end of the 10-year budget window, whereas the tax cuts will be front-loaded. This would generate a modest amount of fiscal stimulus over the next few years. Sub-4% U.S. Unemployment Rate Followed By Recession? Chart I-7Inside The Fed's Forecasts Expansionary fiscal policy would make life more difficult for the FOMC, which may have already fallen behind the curve. The unemployment rate is below the Fed's estimate of the full employment level, and it will continue to erode unless productivity picks up soon. We backed out the productivity growth rate implied by the Fed's latest Summary of Economic Projections, given its assumption that real GDP growth will be roughly 2% over the next couple of years and that the unemployment rate will stabilize near the current level. This combination implies that productivity growth will accelerate from the average rate observed so far in this expansion (0.7%) to about 1%, which is consistent with monthly payrolls of 135,000 assuming real GDP growth of 2% (Chart I-7). If we instead assume that productivity does not accelerate (and real GDP growth is 2%), then payrolls must jump to 160,000 and the unemployment rate would fall below 4% next year. The implication is that the unemployment rate is likely to soon reach levels not seen since 2000, which would force the FOMC to tighten more aggressively. The Fed would hope for a soft landing as it tries to nudge the unemployment rate higher, but the more likely result is a recession in 2019. For this year, we expect the Fed to begin balance sheet runoff in the autumn, followed by a rate hike in December. The latter hinges importantly on at least a modest rise in core PCE inflation in the coming months. A rebound in oil prices would help the Fed reach its inflation goal, even though energy prices affect the headline by more than the core rate. Saudi Energy Minister Khalid al-Falih indicated at a recent press conference in St. Petersburg that no changes are presently needed to the production deal under which OPEC and non-OPEC producers pledged to remove 1.8mn b/d from the market. The Saudi energy minister's remarks leave open the possibility of deeper cuts later this year if global inventories do not draw fast enough, or for the cuts to be extended beyond March 2018 if officials are not satisfied with progress on the storage front. We still believe they are capable of meeting this goal, despite rising shale production. Chart I-8Forecast Of Oil Inventories Our commodity strategists expect OECD oil inventories to reach their five-year average level by year-end or early 2018 Q1 (Chart I-8). In the absence of additional cuts, the five-year average level of OECD inventories will be higher than we estimated earlier this year, indicating that our expectation for the overall inventory drawdown later this year has been trimmed. Still, our oil strategists believe the inventory drawdowns will be sufficient to push WTI above the mid-$50s by year-end. If this forecast pans out, rising oil prices will push up headline inflation and inflation expectations in the major advanced economies. The bottom line is that the backdrop has turned bond-bearish now that central bankers in the advanced economies are in the process of scaling back the easier monetary policy that followed the deflationary 2014/15 oil shock. Duration should be kept short within global fixed income portfolios. In terms of country allocation, our global fixed income strategists have downgraded the Eurozone government bond market to underweight, joining the Treasury allocation, in light of the pending ECB tapering announcement that could place more upward pressure on yields. This was offset by upgrading Japan to maximum overweight. Max Policy Divergence Has Not Been Reached Chart I-9Europe Has A Lower Neutral Rate The change in tone by central bankers outside the U.S. has weighted heavily on the U.S. dollar. The Canadian dollar and the Euro have been particularly strong. Investors have apparently decided that the peak Fed/ECB policy divergence is now behind us. We do not agree. The ECB may be tapering, but rate hikes are a long way off because there remains a substantial amount of economic slack in the Eurozone. Laubach and Williams estimate R-star in the Eurozone to be close to zero, which is 50 basis points below the U.S. neutral rate (Chart I-9). The difference is related to slower potential growth and greater unemployment. Labor market slack across the euro area as a whole is still 3.2 percentage points higher than in 2008, and 6.7 points higher outside of Germany. The current real short-term rate is about -1%. We expect U.S. R-star to rise in absolute terms and relative to the neutral rate in the Eurozone because the U.S. is further advanced in the economic expansion. As Fed rate hike expectations ratchet up in the coming months, interest rate differentials versus Europe will widen in favor of the dollar. It is the same story for the dollar/yen rate because the Bank of Japan is a long way from raising or abandoning its 10-year bond yield peg. Japanese core inflation has fallen back to zero and medium-to-long-term inflation expectations have dipped so far this year. The annual shunto wage negotiations this summer produced little in the way of salary hikes. The major exception to our "strong dollar" call is the Canadian loonie, which we expect to appreciate versus the greenback. We also like the Aussie dollar, provided that the Chinese economy continues to hold up as we expect. Stocks Get A Free Pass For Now Chart I-10Global EPS And Industrial Production Fading market hopes for U.S. fiscal stimulus have weighed on both U.S. Treasury yields and the dollar, but the equity market has taken the news in stride. Are equity investors simply in denial? We do not think so. The equity market appears to have been given a "free pass" for now because earnings have been supportive. The combination of robust earnings growth, steady real GDP growth of around 2%, and low bond yields has been bullish for stocks so far in this expansion. At the global level, EPS growth continues to accelerate in line with the recovery in industrial production, which is a good proxy for top line growth (Chart I-10). Orders and production for capital goods in the major advanced economies have been particularly strong in recent months. The global operating margin flattened off last month according to IBES data, although margins continued to firm in the U.S. and Europe (Chart I-11). The profit acceleration is widespread across these three economies in the Basic Materials and Consumer Discretionary sectors. Industrials, Energy, Health Care and Consumer Staples are also performing well in most cases. Telecom is the weak spot. Our sector profit diffusion indexes paint an upbeat picture for the near term (Chart I-12). Chart I-11Operating Margins On The Rise Chart I-12Earnings Diffusion Indexes Are Bullish In the U.S., the second quarter earnings season is off to a good start. Results so far suggest that Q2 will see another quarter of margin expansion. We believe that U.S. margins are in a secular decline, but they are in the midst of a counter-trend rally that will last for the rest of this year. Using blended results for the second quarter, trailing S&P 500 EPS growth hit 18½% on a 4-quarter moving total basis (Chart I-13). The acceleration in earnings is impressive even after excluding the Energy sector. We projected early this year that EPS growth would peak at around 20%4 by year end, but it appears that earnings will overshoot that level. Chart I-13Robust EPS Growth Even Without Energy It will be tougher sledding in the equity market once profit growth peaks in the U.S. because of poor valuation. We are expecting to scale back our overweight equity recommendation sometime in the first half of 2018, although the global rally could be extended by constructive earnings data in Europe and Japan. The earnings recovery in both economies is behind the U.S., such that peak growth will come later in 2018. There is also more room for margins to expand in Europe than in the U.S. The relative earnings cycle is one of the reasons why we continue to favor Eurozone and Japanese stocks to the U.S. in local currency terms. Japanese stocks are also cheap to the U.S. based on our top-down valuation indicator (Chart I-14). European stocks are not far from fair value relative to the U.S., after adjusting for the fact that Europe trades structurally on the cheap side. The message from our top-down valuation indicator for European stocks is confirmed when using the bottom-up information contained in the new BCA Equity Trading Strategy platform. The Special Report beginning on page 20 describes a bottom-up valuation measure that we will use in conjunction with our top-down (index-based) measures. Corporate Bonds: Kindling And Sparks Healthy EPS growth momentum is also constructive for corporate bonds, although overall balance sheet health continues to erode in the U.S. The release of the U.S. Flow of Funds data allows us to update BCA's Corporate Health Monitor (CHM) for the first quarter (Chart I-15). The level of the CHM moved slightly deeper into "deteriorating health territory." Chart I-14Top-Down Relative Equity Valuation Chart I-15Deteriorating Since 2015, But... The Monitor has been a reliable indicator for the trend in corporate bond spreads over the years, calling almost all major turning points in advance. However, spreads have trended tighter over the past year even as the CHM began to signal deteriorating health in early 2015. Why the divergence? The CHM is only one of three key items on our checklist to underweight corporate bonds versus Treasurys. The other two are tight Fed policy (i.e. real interest rates that are above the neutral level) and the direction of bank lending standards for C&I loans. On its own, balance sheet deterioration only provides the kindling for a spread blowout. It also requires a spark. Investors do not worry about high leverage or a profit margin squeeze, for example, until the outlook for defaults sours. The latter occurs once inflation starts to rise and the Fed actively targets slower growth via higher interest rates. Banks see trouble on the horizon and respond by tightening lending standards, thereby restricting the flow of credit to the business sector. Defaults start to ramp up, buttressing banks' bias to curtail lending in a self-reinforcing negative feedback loop. The three items on the checklist normally occurred at roughly the same time in previous cycles because a deteriorating CHM is typically a late-cycle phenomenon. But this has been a very different cycle. High stock prices and rock-bottom bond yields have encouraged the corporate sector to leverage up and repurchase stock. At the same time, the subpar, stretched-out recovery has meant that it has taken longer than usual for the economy to reach full employment. It will be some time before U.S. short-term interest rates reach restrictive territory. As for banks, they tightened lending standards a little in 2015/16 due to the collapse of energy prices, but this has since reversed. The implication is that, while corporate health has deteriorated, we do not have the spark for a sustained corporate bond spread widening. Indeed, Moody's expects that the 12-month default rate will trend lower over the next year, which is consistent with constructive trends in corporate lending standards, industrial production and job cut announcements (all good indicators for defaults). Chart I-16 presents a valuation metric that adjusts the HY OAS for 12-month trailing default losses (i.e. it is an ex-post measure). In the forecast period, we hold today's OAS constant, but the 12-month default losses are a shifting blend of historical losses and Moody's forecast. The endpoint suggests that the market is offering about 200 basis points of default-adjusted excess yield over the Treasury curve for the next 12 months. This is roughly in line with the mid-point of the historical data. In the past, a default-adjusted spread of around 200 basis points provided positive 12-month excess returns to high-yield bonds 74% of the time, with an average return of 82 basis points. It is also a positive sign for corporate bonds that the net transfer to shareholders, in the form of buybacks, dividends and M&A activity, eased in the fourth quarter 2016 and the first quarter of 2017 (Chart I-17). Ratings migration has also improved (i.e. moderating net downgrades), especially for shareholder-friendly rating action, which is a better indicator for corporate spreads. The diminished appetite to "return cash to shareholders" may not last long, but for now it supports our overweight in both investment- and speculative-grade bonds versus Treasurys. That said, excess returns are likely to be limited to the carry given little room for spread compression. Chart I-16Still Some Value In ##br##High-Yield Corporates Chart I-17Net Transfers To Shareholders ##br##Eased In Past Two Quarters Within balanced portfolios, we recommend favoring equities to high-yield at this stage of the cycle. Value is not good enough in HY relative to stocks to expect any sustained period of outperformance in the former, assuming that the bull market in risk assets continues. Investment Conclusions A key change in the global financial landscape over the past month is a signal from central banks that they see the need for policy recalibration. Policymakers view sub-target inflation as temporary, and some are concerned that low interest rates could contribute to the formation of financial market bubbles. The bond market remains skeptical, given persistent inflation undershoots and growing anecdotal evidence that new technologies are very deflationary. It would be extremely bullish for stocks if these new technologies were indeed boosting the supply side of the economy at a faster pace than the official data suggest. Robust advances in output-per-worker would allow profits to grow quickly, and would provide the economy more breathing space before hitting inflationary capacity limits (keeping the bond vigilantes at bay). We acknowledge that there are important technological breakthroughs being made, but we do not see any evidence that this is occurring on a widespread basis sufficient to "move the dial" in terms of overall productivity growth. Indeed, the stagnation of middle class personal income is consistent with a poor productivity backdrop. Chart I-18 highlights that "creative destruction" is in a long-term bear market. Chart I-18Less Creative Destruction That said, the equity market is benefiting from the mini-cycle in corporate profits, which are still recovering from the earnings recession in 2015/early 2016. We expect the recovery to be complete by early 2018, which will set the stage for a substantial slowdown in EPS growth next year. It won't be a disaster, absent a recession, but demanding valuations suggest that the market could struggle to make headway through next year. We expect to trim exposure sometime in the first half of 2018. To time the exit, we will watch for a roll-over in the growth rate of S&P 500 EPS on a 4-quarter moving total basis. Investors should look for a peak in industrial production growth as a warnings sign for profits. We are also watching for a contraction in excess money, which we define as M2 divided by nominal GDP. Finally, a rise in core PCE inflation to 2% would be a signal that the Fed is about to ramp up interest rates. For now, remain overweight equities relative to bonds and cash. Favor equities to high yield, but within fixed-income portfolios, overweight investment- and speculative-grade corporates versus Treasurys. We are comfortable with our pro-risk recommendations and our below-benchmark duration stance. Unfortunately, that can't be said of our bullish U.S. dollar and oil price house views. Both are controversial calls among our strategists. As for oil, supply and demand are finely balanced and our positive view hinges importantly on OPEC agreeing to more production cuts. The obvious risk is that these cuts do not materialize. The dollar call has gone against us as the latest signs of improving global growth momentum have admittedly been outside the U.S. Meanwhile, the U.S. is stuck in a political morass, which delays the prospect of fiscal stimulus. This is not to say that U.S. growth will slow. Rather, the growth acceleration may fall short of the high expectations following last November's election. We continue to believe that the market is too complacent on the pace of Fed rate hikes in the coming quarters. An upward adjustment in rate expectations should push the dollar higher on a trade-weighted basis, as outlined above. Nonetheless, this shift will require higher U.S. inflation, the timing of which is highly uncertain. We remain dollar bulls on a 12-month horizon, but we are stepping aside and calling for a trading range in the next three months. Mark McClellan Senior Vice President The Bank Credit Analyst July 27, 2017 Next Report: August 31, 2017 1 Please see Global Fixed Income Strategy Weekly Report, "Central Banks Are Now Playing Catch-Up," dated July 4, 2017, available at gfis.bcaresearch.com 2 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 3 Kathryn Holston, Thomas Laubach, and John C. Williams "Measuring The Natural Rates Of Interest: International Trends And Determinants," Federal Reserve Bank of San Francisco, Working Paper 2016-11 (December 2016). 4 Calculated as a year-over-year growth rate of a 4-quarter moving total of S&P data. II. The BCA ETS Trading Platform Approach To Valuing Eurozone Stocks The performance of European stocks relative to the U.S. has been dismal in the post-Lehman period. However, the Eurozone economy is performing impressively, profit growth is accelerating and margins are rising. This points to a period of outperformance for Eurozone stocks, at least in local currency terms. Standard valuation measures based on index data suggest that Eurozone stocks are cheap to the U.S. Nonetheless, the European market almost always trades at a discount, due to persistent lackluster profit performance. In Part II of our series on valuation, we approach the issue from a bottom-up perspective, utilizing the powerful analytics provided by BCA's exciting new Equity Trading Strategy (ETS) platform. The ETS software allows us to compare U.S. and European companies on a head-to-head basis and rank them based on a wide range of characteristics. The bottom-up approach avoids the problems of index construction. Investors can be confident that they will make money on a 12-month horizon by taking a position when the new bottom-up indicator reaches +/-1 standard deviations over- or under-valued, although technical information should be taken on board to sharpen the timing. The +/-2 sigma level gives clear buy/sell signals irrespective of fundamental or technical factors. Valuation alone does not justify overweight Eurozone positions at the moment, although we like the market for other reasons. The bottom-up valuation indicator will not replace our top-down version that is based on index data, but rather will be considered together when evaluating relative value. Total returns in the European equity market have bounced relative to the U.S. since 2016 in both local-currency and common currency terms (Chart II-1). However, this has offset only a tiny fraction of the dismal underperformance since 2007. In local currencies, the relative EMU/U.S. total return index is still close to its lowest level since the late 1970s. Compared with the pre-Lehman peak, the U.S. total return index is more than 96% higher according to Datastream data, while the Eurozone total return index is only now getting back to the previous high-water mark when expressed in U.S. dollars (Chart II-2). Chart II-1EMU Stocks Lag Massively... Chart II-2...Due To Depressed Earnings The yawning return gap between the two equity markets was almost entirely due to earnings as market multiples have moved largely in sync. Earnings-per-share (EPS) generated by U.S. companies now exceed the pre-Lehman peak by about 19%. In contrast, earnings produced by their Eurozone peers are a whopping 48% below their peak (common currency). This reflects both a slower recovery in sales-per-share growth and lower profit margins. Operating margins in Europe have been on the upswing for a year, but are still depressed by pre-Lehman standards. Margin outperformance in the U.S. is not a sector weighting story; in only 2 of 10 sectors do European operating margins exceed the U.S. The return-on-equity data tell a similar story. Nonetheless, a turning point may be at hand. Chart II-3Europe Trades At A Discount The Eurozone economy has been performing well, especially on a per-capita basis, and forward-looking indicators suggest that growth will remain above-trend for at least the next few quarters. U.S. profit margins have also been (temporarily) rising, but the Eurozone economy has more room to grow because there is still slack in the labor market. There is also more room for margins to rise in the Eurozone corporate sector than is the case in the U.S., where the profit cycle is further advanced. Traditional measures of value based on the MSCI indexes suggest that European stocks are on the cheap side. But are they really that cheap? Based on index data, Eurozone stocks trade at a hefty discount across most of the main valuation measures (Chart II-3). This is the case even for normalized measures such as price-to-book (P/B). However, Eurozone stocks have almost always traded at a discount. There are many possible explanations as to why there is a persistent valuation gap between these two markets, including differences in accounting standards, discount rates and sector weights. The wider use of stock buybacks in the U.S. also favors American stock valuations relative to Europe. But most important are historical differences in underlying corporate fundamentals. U.S. companies on the whole were significantly more profitable even before the Great Financial Crisis (Chart II-3). U.S. companies also tend to have lower leverage and higher interest coverage. Better profitability metrics in the U.S. are not solely an artifact of sector weighting either. RoE and operating margins are lower in Europe even applying U.S. sector weights to the European market.1 Why corporate Europe has been a perennial profit under-achiever is beyond the scope of this paper. U.S. companies reaped most of the benefit from productivity gains over the past 25 years, with the result that the capital share of income soared while the labor share collapsed. European companies were less successful in squeezing down labor costs. Measuring Value In the first part of our two-part Special Report on valuation, published in July 2016, we took a top-down approach to determine whether Eurozone stocks are cheap versus the U.S. after adjusting for different sector weights and persistent differences in the underlying profit fundamentals. A regression approach that factored in various profitability measures performed reasonably well, but the top-down "mechanical" approach that relied on a 5-year moving average provided the most profitable buy/sell signals historically. We approach the issue from a bottom-up perspective in Part II of our series, utilizing the powerful analytics provided by BCA's exciting new Equity Trading Strategy (ETS) platform. The software allows us to compare U.S. and European companies on a head-to-head basis and rank them based on a wide range of characteristics. The bottom-up approach avoids the problems of index construction when trying to gauge valuation across countries. The web-based platform uses over 24 quantitative factors to rank approximately 10,000 individual stocks in 23 countries, allowing clients to find stocks with winning characteristics at the global level. Users can rank and score individual equities to support a broad set of investment strategies and apply macro and sector views to single-name investments. The ETS approach has an impressive track record. Historically, the top-decile of stocks ranked using the "BCA Score" methodology have outperformed stocks in the bottom decile by over 25% a year.2 The BCA Score includes all 24 factors when ranking stocks, but we are interested in developing a valuation metric that provides valued added on its own and is at least as good as the top-down index-based measure developed in Part I. The five valuation measures in the ETS database are trailing P/E, forward P/E, price-to-book, price-to-sales and price-to-cash flow. We combine all of the Eurozone and U.S. companies that have total assets of greater than $1 billion into one dataset. The ETS platform then ranks the stocks from best to worst on a daily basis (i.e. cheapest to most expensive), using an equally-weighted average of the five valuation measures. The average score for U.S. stocks is subtracted from the average score for European stocks, and then divided by the standard deviation of the series. This provides a valuation metric that fluctuates roughly between +/- 2 standard deviations. Chart II-4 presents the resulting bottom-up indicator, along with our previously-published top-down valuation measure. A high reading indicates that European stocks are cheap to the U.S., while it is the opposite for low readings. Chart II-4Eurozone Equity Relative Valuation Indicators The underlying bottom-up data extend back to 2000. However, the bursting of the tech bubble in the early 2000's causes major shifts in relative valuation among sectors and between the U.S. and Eurozone that skew the indicator when constructed using the entire data set. We obtain a cleaner indicator when using only the data from 2005. As with any valuation indicator, it is only useful when it reaches extremes. We calculated the historical track record for a trading rule that is based on critical levels of over- and under-valuation. For example, we calculated the (local currency) excess returns over 3, 6, 12 and 24-month horizon generated by (1) overweighting European stocks when that market was one and two standard deviations cheap versus the U.S. market, and (2) overweighting the U.S. when the European market was one and two standard deviations expensive (Table II-1). Table II-1Value Indicator: Trading Rule Returns And Batting Average The trading rule returns were best when the indicator reached two standard deviations cheap or expensive, providing average returns of almost 11 percent over 12 months. The trading rule returns when the indicator reached +/-1 standard deviation were not as good, but still more than 3% on 12- and 24-month horizons. Table II-1 also presents the trading rule's batting average. That is, the number of positive excess returns generated by the trading rule as a percent of the total number of signals. The batting average ranged from 50% on a 3-month horizon to 68% over 24 months when buy/sell signals are triggered at +/- 1 standard deviation. The batting average is much higher (80-100%) using +/- 2 standard deviations as a trigger point, although there were only five months over the entire sample when the indicator reached this level. The charts and tables in the Appendix present the results of the same analysis at the sector level. The results are equally as good as the aggregate valuation indicator, with a couple of exceptions. European stocks are cheap to the U.S. in the Energy, Financials, and Utilities sectors, while U.S. stocks offer better value in Consumer Discretionary, Consumer Staples, Health Care, Industrials and Technology. Materials, Real Estate, and Telecommunications are close to equally valued. Sharpening The Buy/Sell Signals We then augmented the valuation analysis by adding information on company fundamentals, such as EPS growth and profit margins among others. The ETS software ranked the companies after equally-weighting the valuation and fundamental factors. However, this approach yielded poor results in terms of the trading rule. This is because, for example, when European stocks reach undervalued levels relative to the U.S., it is usually because the European earnings fundamentals have underperformed those of the U.S. companies. Thus, favorable value is offset by poor fundamentals, muddying the message provided by valuation alone. In contrast, adding some information from the technical factors in the ETS model does add value, at least when using +/-1 standard deviations as the trigger point for trades (Chart II-5). Excess returns to the trading rule rise significantly when the medium-term momentum and long-term mean reversion factors are included in the valuation indicator (Table II-2). The batting average also improves. Chart II-5Indicators: Value And Value With Technical Information Table II-2Value And Technical Indicator: Trading Rule Returns And Batting Average Adding technical information does not improve the trading rule performance when +/-2 sigma is used as the trigger point. Investment Conclusions Our new ETS platform provides investors with a unique way of picking stocks by combining top-down macro themes with company-specific information. It also allows us to develop valuation tools that avoid some of the pitfalls of index data by comparing stocks on a head-to-head basis. Historical analysis using a trading rule demonstrates that the new bottom-up valuation indicator provides real value to investors. We would normally evaluate its track record using stretching analysis, where we use only the historical information available at each point in time when determining relative value. However, the relatively short history of the available data precludes this test because we need at least a few cycles to best gauge the underlying volatility in the data. Still, investors can be fairly confident that they will make money on a 12-month horizon by taking a position when the bottom-up indicator reaches +/-1 sigma over- or under-valued, although technical information should be taken on board to sharpen the timing. The +/-2 sigma level gives clear buy/sell signals irrespective of the fundamental or technical factors. The bottom-up valuation indicator will not replace our top-down version that is based on index data, but rather will be considered together when evaluating relative value. At the moment, the top-down version proposes that European stocks are somewhat cheap to the U.S., while the bottom-up indicator points to slight overvaluation. Considering the two together suggests that valuation is close enough to fair value that investors cannot make the decision on value alone. Valuation indicators need to be near extremes to be informative. Our global equity strategists recommend overweighting Eurozone stocks versus the U.S. at the moment, although not because of valuation. Rather, the Eurozone economy and corporate earnings have more room to grow because of lingering labor market slack. This also means that the ECB can keep rates glued to the zero bound for at least the next 18 months while the Fed hikes, which will place upward pressure on the dollar and downward pressure on the euro. Mark McClellan Senior Vice President The Bank Credit Analyst Appendix: Trading Rule Returns By Sector Chart II-6, Chart II-7, Chart II-8, Chart II-9, Chart II-10, Chart II-11, Chart II-12, Chart II-13, Chart II-14, Chart II-15, Chart II-16. Chart II-6Consumer Discretionary Chart II-7Consumer Staples Chart II-8Energy Chart II-9Financials Chart II-10Health Care Chart II-11Industrials Chart II-12Materials Chart II-13Real Estate Chart II-14Utilities Chart II-15Technology Chart II-16Telecommunication 1 Please see The Bank Credit Analyst Special Report, "Are Eurozone Stocks Really That Cheap?" July 2016, available at bca.bcaresearch.com. 2 Please see Equity Trading Strategy Special Report, "Introducing ETS: A Top Down Approach to Bottom-Up Stock Picking," December 2, 2015, available at ets.bcaresearch.com. III. Indicators And Reference Charts Stocks continue to outperform bonds against a constructive backdrop of improving global economic prospects and accelerating EPS growth, while low inflation is expected to keep central banks from tightening quickly. Our main equity and asset allocation indicators remain bullish for risk, with a few exceptions. Our new Revealed Preference Indicator (RPI) jumped back to a 100% equity weighting in July. We introduced the RPI in last month's Special Report. Quite simply, it combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks for the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. The U.S. WTP remains bullish, but has topped out, suggesting that flows into the U.S. market are beginning to moderate. In contrast, the WTP indicators for both the Eurozone and Japan are rising from a low level. This suggests that a rotation into these equity markets is underway, although it has not yet shown up in terms of equity market outperformance versus the U.S. On the negative side, our Monetary Indicator last month fell a little further below the zero line and our composite Technical Indicator appears to be rolling over; the latter generates a 'sell' signal when it drops below its 9-month moving average. Value is stretched, but our Valuation Indicator has not yet reached the +1 standard deviation level that indicates clear over-valuation. As highlighted in the Overview section, the U.S. and global earnings backdrop continues to support equity markets. Forward earnings estimates are in a steep uptrend, and the recent surge in the net revisions ratio and the earnings surprise index suggests that EPS growth will remain impressive for the remainder of the year. Bond valuation is largely unchanged from last month, sitting very close to fair value. We still believe that fair value is rising as economic headwinds fade. However, much depends on our forecast that core inflation in the major countries will grind higher in the coming months. Central banks stand ready to "remove the punchbowl" if they get the green light from inflation. The dollar's downdraft in July reduced some of its overvaluation based on purchasing power parity measures. The dollar appears less overvalued based on other measures. Our composite Technical Indicator has fallen hard, but has not reached oversold levels. This suggests that the dollar has more downside before it finds a bottom. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen TechnicalsChart III-21Euro/Yen Technicals Chart III-20Euro TechnicalsChart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China
Highlights Portfolio Strategy The chemicals bear market is over. Synchronized global growth, receding global capacity and improving domestic operating conditions compel us to lift exposure to neutral. As a result, our materials sector exposure also moves to the neutral column. While chemicals and materials are beneficiaries of an upgrade in global economic expectations, utilities sit at the opposite end of the table, and thus warrant a downgrade to a below benchmark allocation. Recent Changes S&P Chemicals - Upgrade to neutral, lock in profits of 10.2%. S&P Materials - Lift to neutral, take profits of 12.8%. S&P Utilities - Trim to underweight. Table 1 Feature Equities broke out last week. While still early, earnings season served as a catalyst and outweighed political/reform uncertainty and the budding global tightening interest rate cycle. Barring any unforeseen surprises, profits will remain the focal point in the coming weeks and sustain the equity blow-off phase. Two weeks ago we highlighted three ways to SPX 3,0001, and posited that this was a reasonable peak cycle level before the next recession hits. This week we dissect GICS1 sector profit composition and conclude that low double-digit EPS growth is attainable in 2018. Table 2 shows sector contribution to the S&P 500's profit growth in calendar 2017 and 2018, sector earnings weights for these two years and current market cap weights using Standard & Poor's data. Table 2Earnings Decomposition Charts 1 & 2 portray the high sector profit contribution concentration, with four sectors comprising 82% of the earnings growth year-over-year in 2017. For calendar 2018 such concentration still exists, but the same four sectors' profit contribution weight falls to 70% (based on bottom up estimates). Chart 1Sector Contribution To 2017 Profit Growth Chart 2Sector Contribution To 2018 Profit Growth Charts 3-5 show the sector earnings weight minus their market capitalization weight. Energy is the clear standout, but keep in mind that this resource sector is coming off a very depressed absolute profit level. As of Q1/2017, energy stocks have the widest gap of -574bps among the 11 sectors, with tech, real estate and staples also registering a small negative gap of roughly -100bps. The upshot is that even on modest assumptions, the energy sector's profit weight can renormalize close to its market cap weight (bottom panel, Chart 4). Chart 3Profit Weight... Chart 4... VS. Market Cap Weight... Financials is another standout sector. This early cyclical sector has consistently delivered a positive profit/market cap weight differential with the exception of the GFC. In fact, the 12-year average gap up to end-2007 has been over 700bps with a range of 425-1140bps, despite a rising financials market cap weight (second panel, Chart 3). Financials now sit near the bottom of the pre-crisis profit/market cap gap range. If our bullish thesis on financials (please see the May 1st Weekly Report) pans out, then this sector should command a larger share of the S&P 500's earnings pie with the profit/market cap gap widening closer to the pre-GFC average, assuming a cyclical earnings recovery. In sum, while sector profit contribution composition is highly concentrated in both 2017 and 2018, the earnings recovery is broad based with over three quarters of the 63 S&P 500 sector indexes we cover registering expanding forward EPS growth (Chart 6). Energy and financials profits will likely continue to surprise to the upside, and suggest that low double-digit EPS growth is realistic for the broad market. Our S&P 500 macro based profit model also corroborates this message. Chart 5... Across Sectors Chart 6Broad Based EPS Recovery One risk to our forecast is an oil price relapse that would put our energy profit assumptions offside. However, our Commodity & Energy strategists continue to expect higher crude oil prices into 2018. This week we continue to tweak our portfolio and add cyclical exposure by upgrading a deep cyclical sector, while simultaneously downgrading a defensive one. Chemicals No Longer Deserve An Underweight In the summer of 2014 we went underweight the S&P chemicals index, anticipating an earnings underperformance phase. We were expecting a deflationary industry impulse on the back of a slipup in global growth at a time when the chemicals manufacturers were furiously adding capacity to benefit from lower domestic feedstocks. This view has largely panned out, and it no longer pays to remain bearish on this highly cyclical industry. In line with our recent tweaks in our U.S. equity portfolio toward a more cyclical bent, we recommend locking in gains of 10.2% and upgrading the S&P chemicals index to a benchmark allocation. Three factors underpin our more neutral bias: synchronized global growth, receding global capacity and improving domestic operating conditions. The global manufacturing PMI has recently reaccelerated and jumped to a six year high. Similarly, the U.S. ISM manufacturing survey also vaulted higher. Synchronized global growth suggests that final demand is on the upswing and should bode well for chemical top- and bottom-line growth (Chart 7). Such synchronized global growth is giving way to a coordinated G10 Central Bank (CB) tightening cycle. Already, the BoC lifted rates recently and likely other CBs will take cover under the Fed's leadership and follow suit. Given that U.S. CPI continues to surprise to the downside, this implies that the U.S. dollar will remain under pressure as the Fed's next hike is penciled in only for December. This is significant for the export relief valve of U.S. chemical producers. As the euro shoots higher, U.S. exports become more competitive in the global chemicals market place and result in market share gains versus their Eurozone competitors (top panel, Chart 8). Currently, it seems as if U.S. chemicals exports are displacing German exports: German chemicals factory orders have plummeted on a short-term rate of change basis opening a wide gap with rebounding U.S. chemical exports (bottom panel, Chart 8). Chart 7Levered To Global Gross Chart 8Global Market Share Gains Global chemicals M&A supports our expectation of demand-driven pricing power gains. The current wave of mega-mergers started at the end of 2015 with the historic tie-up of Dow Chemical and DuPont. It has since grown to include more than half of the S&P chemicals sector by market cap and has a value greater than the previous seven years combined (Chart 9). We think the benefits of consolidation are twofold: First, reduced revenues of the past decade have left the industry with outsized cost structures; consolidation should sweep that away under the guise of synergy, driving margins higher. Second, industry overcapacity has historically impaired profitability due to soaring overhead and more competitive pricing; greater scale should impose greater capital discipline. Finally, domestic operating conditions have taken a turn for the better. Industry shipments have staged a 10 percentage point recovery from the 2015 trough and are now rising at a healthy clip. Chemical production has troughed and the firming U.S. leading economic indicator signals that output is on the verge of expanding. This improving domestic final demand backdrop is reflected in higher resource utilization rates. The upshot is that pricing power gains have staying power (Chart 10). Nevertheless, there are also three headwinds that merit close attention and prevent us from turning outright bullish. U.S. capacity additions are worrisome and, if not held in check, risk sabotaging the nascent pricing power recovery. Moreover, a wholesale and manufacturing inventory channel check suggests that there is a modest supply buildup. If there is any demand mishap it could also prove deflationary for chemical manufacturers. Tack on the recent spike in our chemicals wage bill proxy, and a profit margin squeeze could rapidly materialize (Chart 11). Chart 9M&A Boom Is Pricing Power Positive Chart 10Firming Domestic Backdrop Chart 11Three Risks To Monitor Bottom Line: There is tentative evidence that the bear market in chemicals producers is over. Take profits of 10.2% since inception and upgrade the S&P chemicals index to neutral. This will also move the S&P materials index to a benchmark allocation. Upgrade Materials To Neutral Chemicals stocks comprise over 73% of the S&P materials index, and this bump to a neutral stance also moves the broad materials index to a benchmark allocation, resulting in 12.8% profits for our portfolio since inception. Chinese economic data have been in a broad based recovery mode, and real GDP troughed mid-year 2016. Wholesale manufacturing and raw materials prices are climbing steadily (Chart 12), with core and services CPI also accelerating in marked contrast with the developed markets. This is impressive given the current dual Chinese monetary tightening via the currency and interest rate channels and modest deceleration in the fiscal thrust. China matters to materials producers as it is the largest commodity consumer. Thus, China's fortunes are closely aligned with the overall materials sector. Historically, the Keqiang Index has been positively correlated with materials revenue growth and the current message is positive. Similarly, the firming Chinese pricing backdrop also bodes well for materials EPS prospects (third & fourth panels, Chart 12). While we take Chinese data with a pinch of salt, the recently surging Australian dollar suggests that China is at least not relapsing (middle panel, Chart 13). Beyond China, the emerging markets are also in a cyclical recovery mode. The emerging Asia leading economic indicator (EALEI) has enjoyed a V-shaped recovery in the aftermath of the late-2015/early-2016 global manufacturing recession. Appreciating EM currencies corroborate the EALEI message, and should continue to underpin materials exports (top & bottom panels, Chart 13). Chart 12Recovering China... Chart 13... And EM Are A Boon For Materials Not only are emerging markets reviving, but also advanced economies are in excellent shape. Synchronized global growth and the coordinated brewing tightening cycle should lead to a selloff in most G7 bond markets. At a minimum, this implies that relative materials performance has put in a cyclical trough (top panel, Chart 14). Importantly, materials producers have made significant headway in improving their finances. The sector's interest coverage ratio (EBIT/interest expense) has bounced smartly and net debt/EBITDA has also dropped by a full turn. Bond investors have taken notice and this balance sheet improvement is reflected in the collapse in junk materials bond yields (yield shown inverted, middle panel, Chart 14). Our newly introduced S&P materials relative EPS model captures this positive macro backdrop for the sector and signals that the relative EPS recovery still has breathing room (Chart 15). However, a few risks hold us back from getting overly excited about materials stocks. First, Chinese money supply growth is not responsive. M1 growth is decelerating and M2 growth is plumbing all-time lows. Second, commodity inflation is also showing signs of fatigue. Similarly, U.S. core PCE and CPI inflation are stalling (Chart 16). This is significant because basic materials are synonymous with hard assets and excel in times of inflation, but falter in times if disinflation/deflation (please refer to our early December inflation-related Special Report). Finally, from a domestic operating perspective, our materials wage bill proxy has sharply reaccelerated giving us cause for concern, especially if there is a pricing power letdown. Under such a backdrop, profit margins would suffer a squeeze, and thereby profits would underwhelm (wage bill shown inverted, bottom panel, Chart 16). Chart 14Improving Finances Chart 15EPS Recovery Has Breathing Room Chart 16Three Risks Keep Us At Bay Netting all out, the S&P materials outlook has brightened a notch, but not sufficiently to turn us into bulls. Bottom Line: Lift the S&P materials sector to a benchmark allocation, and lock in profits of 12.8% since inception. Trim Utilities To Underweight Chart 17Blackout Warning While chemicals and materials are beneficiaries of an upgrading in global economic expectations, utilities sit at the opposite end of the table (global manufacturing PMI shown inverted, top panel, Chart 17), and therefore warrant a downgrade to a below benchmark allocation. Now that the Fed is ready to start unwinding its balance sheet, the ECB is preparing the waters for QE tapering and a slew of CBs are on the cusp of a new tightening interest rate cycle, there are high odds that still overvalued fixed income proxies will continue to suffer. Synchronized global growth and coordinated tightening in monetary policy spells trouble for bonds. Our sister publication U.S. Bond Strategy expects a bond selloff for the remainder of the year. Given that utilities essentially trade as a proxy for bonds, this macro backdrop leaves them vulnerable to a significant underperformance phase (Treasury yield shown inverted, bottom panel, Chart 17). Importantly, the stock-to-bond (S/B) ratio and utilities sector relative performance also has a tight inverse correlation (S/B shown inverted, second panel, Chart 17). The implication is that downside risks remain acute. Without the support of continued declines in bond yields, or of indiscriminate capital flight from all riskier assets, utilities advances depend on improving fundamentals. The news on the domestic operating front is grim. Contracting natural gas prices, the marginal price setter for the industry, suggest that recent utilities pricing power gains are running on empty (Chart 18). Tack on waning productivity, with labor additions handily outpacing electricity production, and the ingredients for a margin squeeze are in place (Chart 18). Importantly, industry utilization rates are probing multi-decade lows and overcapacity is negative for pricing power. Chart 18 confirms that utilities construction is relentless at a time when turbine and generator inventories have been hitting all-time highs. This is a deflationary backdrop, and suggests that sell-side analyst optimism is wrong footed. Put differently, it is unreasonable to expect profits to grow fast enough to support continued overvaluation (Chart 19). Chart 18Pricing Power Blues Chart 19Valuation Crunch Ahead Bottom Line: We are making room for the niche S&P materials upgrade to neutral by downgrading the equally small S&P utilities sector to a below benchmark allocation. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see the July 10th, 2017 U.S. Equity Strategy Service Report titled "SPX 3,000?", available at www.bcaresearch.com Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlights The era of divergent monetary policies between the ECB and the Fed is over. Re-convergence has a lot further to go. As the ECB ends its ultra-accommodation, it will also liberate Sweden's Riksbank. Go long Swedish krone/dollar as an alternative or addition to long euro/dollar. Bond investors should underweight Swedish government bonds versus a European or global benchmark, currency hedged. Equity investors should remain overweight European banks and retailers versus U.S. banks and retailers, currency unhedged. The risk of persistent inflation will rise only after the next severe global downturn. Feature "Is the 2% inflation target still a very realistic aim?" - Ewald Nowotny, ECB Governing Council member As the ECB Governing Council gathers for its latest monetary policy meeting, some voices within its ranks are starting to question the ECB's first commandment: the 2% inflation target. Respected and influential ECB Governing Council member, Ewald Nowotny, has asked whether there should "be an easing of the 2% inflation goal in the sense of setting a range instead of a clear-cut target." Across the Baltic Sea, Sweden's Riksbank is one step ahead. Recently, it suggested (re)introducing a variation band of 1% either side of the 2% inflation target1 to acknowledge that persistent 2% inflation is very difficult, or impossible, to achieve (Chart of the Week). More concerning, the single-minded pursuit of 2% inflation creates risks and instabilities. The Riksbank's inflation target has forced it into an absurd position: with inflation undershooting for over five years, the policy interest rate is now at -0.5% when Swedish GDP growth was recently running at a world-beating 4.5% clip (Chart I-2). Chart I-1Mission Impossible:##br## 2% Inflation Chart I-2Absurd: Interest Rate At -0.5% ##br##When Growth Is At 4.5% Hence, Riksbank Governor, Stefan Ingves, recently proposed that "central banks should also have the explicit responsibility for financial stability." The former governor of the Bank of Japan, Masaaki Shirkawa agrees. "My worry with setting a precise number (of 2%) is that it can crowd out other very important considerations, such as financial stability." What's So Special About 2% Inflation Anyway? Given the almost religious significance of the 2% inflation target for central banks, you would think that there is a well-established theoretical and empirical basis both for inflation targeting and for the 2% number. But you would be wrong. As we explained two years ago in our special report Mission Impossible: 2% Inflation,2 inflation targeting only became established in the 1990s, and the magic 2% number was pulled out of the air. Chart I-3The Riksbank Has Undershot ##br##Its 2% Inflation Target For 5 Years At the Federal Reserve's July 1996 policy meeting, Chairman Alan Greenspan argued that if the aim of inflation targeting was a truly stable price level, it entailed an inflation target of 0-1% (because measured inflation slightly overstates true inflation.) But one of the persons present was not so sure. The dissenter was a Fed governor called Janet L. Yellen. She countered that if inflation ended up at 0-1%, the zero-bound of interest rates would prevent "real interest rates becoming negative on the rare occasions when required to counter a recession." Yellen's pragmatism won the day, and Greenspan summarized "we have now all agreed on 2%" Meanwhile in Europe, the ECB's original inflation target of below 2% was close to Greenspan's proposal of 0-1%. But in 2003 the ECB changed its inflation target to its current "below but close to 2%". The reason, according to Mario Draghi: "The founding fathers of the ECB thought about the adjustment within the euro area, the rebalancing of the different members. To rebalance these disequilibria, since the countries do not have the exchange rate, they have to readjust their prices. This readjustment is much harder if you have zero inflation than if you have 2%." Hence, the Fed, ECB and other central banks are targeting inflation at a low but arbitrary number, 2%, to always allow some leeway for negative real rates; and in the case of the ECB, to allow easier convergence among disparate euro area economies. But as the Riksbank and other central banks have now acknowledged, trying to hit and hold inflation at a point target of 2% is both futile and dangerous (Chart I-3). Why 2% Inflation Is A Mission Impossible The crux of the issue is that inflation is a notoriously non-linear phenomenon. A defining feature of a non-linear phenomenon is that you cannot just turn it up or down like the volume dial on your music system. Non-linear phenomena experience sudden and violent phase-shifts from stability to instability, making it very difficult to hit and hold a point target like 2%. To experience this difficulty for yourself, try pulling a brick across a table using an elastic band. Initially, the brick doesn't move because of the friction with the table. But at a tipping point the brick does move, and the friction simultaneously decreases, self-reinforcing the brick's acceleration. Meanwhile, your pull on the elastic continues to increase as you react with a time-lag. The result is that this non-linear system suddenly phase-shifts from stability - the brick doesn't move - to violent instability - the brick hits you in the face! Try as hard as you might, it is near-impossible to pull the brick across the table at a constant speed of, say, 2mph. A very similar dynamic applies to inflation. The system suddenly phase-shifts from stability - near-zero inflation - to violent instability. It is near-impossible to keep inflation at an arbitrary constant of, say, 2%. To understand why, consider the standard identity of monetary economics: MV = PT M is the broad money supply, V is its velocity of circulation, P is the price level and T is the volume of transactions. PT is effectively nominal GDP. Theoretically and empirically, both M and V are notoriously non-linear phenomena (Chart I-4, Chart I-5, Chart I-6, Chart I-7) - because they are subject to the same conditions as the brick pulled by an elastic band: inertia, then self-reinforcement with delayed controlling feedback. Chart I-4The Velocity Of Money... Chart I-5...Is A Non-Linear Phenomenon Chart I-6The Money Multiplier... Chart I-7...Is A Non-Linear Phenomenon As policymakers try to take inflation away from its natural state of near-zero, nothing happens at first. But at a tipping point, the self-reinforcement of inflation expectations becomes explosive. Whereupon, the money supply, M, gaps up because it becomes rational for banks to lend as much as possible. And its velocity, V, also gaps up because it becomes rational to spend the money - both newly created and pre-existing balances - as quickly as possible. Hence, the product MV experiences an even sharper non-linearity. Well-intentioned policymakers would think they could apply a controlling feedback to MV. But how? Economic and monetary data are noisy, imprecise and take time to collect and parse. As we have shown, inappropriate and/or delayed feedback just adds to the system's instability. Seen in this light, inflation-targeting in the 1990s worked because central banks were just helping economies move from an unnatural state - uncontrolled inflation - towards a natural state - price stability (Table I-1 and Chart I-8). But now that economies have reached a natural near-zero inflation rate, point targeting an unnatural inflation rate is both futile and dangerous. Table I-1For 700 Years U.K. Inflation ##br##Averaged Near-Zero Chart I-8Excluding Wars, Persistent Inflation Was ##br##Very Unusual... Until The Late 20th Century The Investment Implications The ECB's Nowotny argues that "the 2% inflation target should include a certain flexibility." The Riksbank's Ingves agrees, and adds that extreme and unprecedented loose monetary policy endangers financial stability. Central banks tend not to volte-face as it damages their credibility. But to us, it is clear that the ECB and Riksbank are switching their focus from sub-2% inflation to their economies' robust growth. And to the risk that ultra-accommodative policy poses to financial stability and market distortion. Hence, the era of divergent monetary policies between the ECB and the Fed is over. Re-convergence has a lot further to go. As the ECB ends its ultra-accommodation, it will also liberate the Riksbank whose policy has inevitably mirrored Frankfurt - for fear of a sharp appreciation of the Swedish krone versus the euro. Our currency mantra this year has been "euro first, pound second, dollar third." The strategy has performed extremely well, and into this mix we can add the Swedish krone. Go long Swedish krone/dollar as an alternative or addition to long euro/dollar (Chart I-9). Chart I-9Long SEK/USD Is An Alternative ##br##To Long EUR/USD Chart I-10Underweight Swedish Bonds Is An Alternative To Underweight German Bunds The bond market corollary is to underweight Swedish government bonds - just like German bunds - versus a European or global benchmark, currency hedged (Chart I-10). The equity market implication is to remain overweight European banks and retailers versus U.S. banks and retailers, currency unhedged. Finally, given that inflation could ultimately phase-shift to violent instability, when should we worry about it? Not yet. To expand the broad money supply, someone has to borrow money. So if policymakers really want to create rampant inflation, the government has to borrow and spend money at will,3 with the central bank creating it. In other words, the central bank loses its independence and fiscal policy becomes irresponsibly loose. The risk of this remains low until the next severe downturn - when policymakers may be forced into desperate measures for a desperate situation. Until then, own some bonds. Our preference is Spanish Bonos and U.S. T-bonds. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 The Swedish FSA has said that the Riksbank should delay the change until a parliament review of Riksbank policy rules is completed in about 2 years. 2 Published on August 20, 2015 and available at eis.bcaresearch.com. 3 For example, by giving all public sector workers a 50% pay rise! Fractal Trading Model* The sell-off in Spanish media (Mediaset Espana Comunicacion) is technically overdone. This week's trade is to go long Mediaset Espana Comunicacion versus the market with a 5% profit-target and symmetric stop-loss. In other trades, long FTSE100/short IBEX35 hit its 4% profit-target, while short EUR/USD hit its 2% 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 Reduced demand in oil-exporting countries and higher supplies from distressed states is whittling down the amount of oil being removed from the market this year, based on our latest supply-demand balances. As a result, even though OECD inventories will be drawn down to their five-year average levels by year end, this average will be a higher end-point than we projected last month. The Kingdom of Saudi Arabia (KSA) continues to reassure markets through anonymous media leaks it will cut production further to accommodate higher Libyan and Nigerian production. This is not unexpected, but it still is speculative. Ecuador's opting out of OPEC 2.0's production cuts raises the odds other financially distressed non-Gulf producers also will head for the exits. Energy: Overweight. Crude oil prices remain supported by actual production cuts, and the promise of further reductions by KSA and possibly other OPEC 2.0 members. Base Metals: Neutral. Labor and management at the Zaldívar copper mine in Chile are negotiating, according to Metal Bulletin. Separately, a three-year deal was agreed at the Centinela copper mine in Chile last week. Precious Metals: Neutral. Gold rallied on the back of lower inflation readings in the U.S., which suggested the Fed will back off aggressively pursuing its rates normalization policy. This would leave real rates low. Our strategic long portfolio hedge is up 1.0% since it was initiated May 4, 2017. Ags/Softs: Underweight. We maintain our bearish view on grains. Fears that extreme heat in the U.S. Midwest and Plains will not be sufficient to counter the still-high ending-stocks expectations published in the USDA's WASDE last week. Feature Higher oil production is seeping into global balances. Lower prices, which are stimulating demand in oil-importing markets, are reducing incomes and demand in oil-exporting provinces. As a result, the rate at which inventories will draw this year is slowing. Our latest supply - demand balances shown in Table 1 indicate the net 900k b/d physical deficit we expected for 2017 has been whittled down to just under 500k b/d, as a result of production increases in Libya and Nigeria, and slower demand growth in oil exporters generally (Chart of the Week). Table 1BCA Global Oil Supply -##BR##Demand Balances (mm b/d) Chart of the WeekHigher Production And Lower Demand Reduce##BR##Physical Deficits Versus Last Month's Projections Ecuador, a small-ish OPEC member producing about 550k b/d, opted out of the Agreement negotiated by KSA and Russia to remove some 1.8mm b/d of production from the markets. This indicates weaker states that are party to the OPEC 2.0 Agreement are finding it impossible to maintain compliance with the cuts they've obliged themselves to undertake in the face of lower oil prices. As a result, they are compelled to increase production in an attempt to recover lost revenue (R), by increasing their quantity (Q) sold when prices (P) are weak, so as to maximize P*Q = R while they can. This only works if they are alone in increasing production while others - notably KSA, other Gulf states and Russia - restrict output to revive prices. Otherwise, if all the distressed states in the OPEC 2.0 coalition took the same action, markets would be flooded with oil. This was demonstrated in the mid-1980s during KSA's netback-pricing regime, when the Kingdom priced its oil as a function of prices received by refiners. This collapsed prices, and, eventually, reined in free-riding on KSA's production cuts.1 While few of these states, mostly outside the Gulf, are capable of significantly increasing production, at the margin, they can have an impact. Production Increases In OPEC, U.S. Partly Counter OPEC 2.0's Best Efforts Year-to-date to June, Iran and Libya have added 110k and 140k b/d of production to the market vs. their respective Oct/16 benchmark levels of 3.7mm and 550k b/d against which the OPEC 2.0 deal is being assessed. June production for these states was up 120k and 300k b/d for Iran and Libya, respectively, vs. October levels, while Nigeria's output was up 90k b/d (Chart 2). Libya and Nigeria are not parties to the OPEC 2.0 deal. Nonetheless, these states together with Iran added close to 500k b/d vs. their Oct/16 output levels in June, without an offsetting decline from members of the OPEC 2.0 coalition. Gulf OPEC ex Iran production is down some 850k b/d on average at 24.6mm b/d in 1H17 vs. Oct/16 levels, while non-Gulf OPEC production is down 215k b/d at 7.5mm b/d. We still see OPEC 2.0's production significantly below the EIA's estimate to March 2018 (Chart 3), which drives our view of inventory behavior. U.S. production also was higher in 1H17, as WTI prices rallied in response to the OPEC 2.0 production-cutting deal (Chart 4). For 1H17, U.S. crude oil production was up 230k b/d vs. 4Q16 levels, at 9.04mm b/d, led by higher shale-oil output. Chart 2Almost 500k b/d Added To Oct/16 Output##BR##By Iran, Libya, And Nigeria In June Chart 3OPEC 2.0 Cuts Drive##BR##Inventory Draws Chart 4U.S. Crude Production##BR##Grows In 1H17 Slower Demand Growth Reduces Storage Draw On the demand side, we've lowered our estimate of demand growth this year to close to 1.37mm b/d, down nearly 110k b/d vs. our earlier May estimate. This results from lower consumption in oil exporting states. The combination of stronger supply growth and weaker demand growth reduces our estimated physical deficit for this year to 470k b/d from close to 900k b/d in our May balances estimates. These revised supply - demand estimates still produce enough of a physical deficit to allow storage to fall to five-year average levels (Chart 5). However, with the drawdowns prolonged by slower supply losses and reduced demand, inventories are now projected to remain above 2.8 billion bbls versus our earlier estimate of inventories declining to ~2.75 billion barrels by end-2017 or early 2018. Chart 5OECD Storage Draws To Five-Year Average Levels, But Higher Supply And Lower Demand Keep This Level Higher Chart 5OECD Storage Draws To Five-Year Average Levels, But Higher Supply And Lower Demand Keep This Level Higher Net, at the end of this drawdown, storage will be higher than expected, even if it does make it to five-year average levels. This will leave less room for OPEC 2.0 members to implement a strategy to backwardate the forward WTI curve so as to slow the rate at which shale-oil rigs return to the field, which we've discussed in previous research.2 More Cuts Required By OPEC 2.0 Going into its St. Petersburg meetings next week, there are clearly defined issues to be addressed by OPEC 2.0. The foregoing suggests additional cuts will be needed to empty storage sufficiently by yearend for OPEC 2.0 to be able to move to the next phase of its plan to regain some influence over the evolution of oil prices, particularly the U.S. benchmark WTI price, which drives hedging and profitability of U.S. shale producers. Over the short term, this effort likely will be clearly supported by KSA's stated intention to reduce exports to the U.S. market (Chart 6). All else equal, this will result in sharper draws in the high-frequency U.S. weekly inventory data, by augmenting reduced shipments to the U.S. from OPEC overall (Chart 7). Chart 6KSA's To Reduce##BR##Exports To The U.S. Chart 7OPEC Exports To The U.S. To Fall Further##BR##When KSA Reduces Shipments More substantive price-support and inventory-draining measures, as noted at the top of this article, will have to involve further production cuts by OPEC 2.0. KSA again is signaling it is open to additional production cuts, in order to normalize oil inventories.3 We have no doubt the Kingdom's Gulf allies - particularly Kuwait and the UAE - will support KSA in this effort. We also expect Russia to be supportive of this effort. The size of the cuts likely will exceed 500k b/d, so as to offset the production gains of Libya and Nigeria. Iran's higher production discussed herein, and Iraq's recent assertiveness in claiming "the right" to increase its production given the size of its reserves, suggests a short and a long game for the leadership of OPEC 2.0. In the short-term, Iran, Iraq, Libya and Nigeria will be constrained by lack of funds to significantly increase production. Thus, OPEC 2.0 - mostly KSA and its allies - can cut production without triggering an immediate response from these states, which will allow storage to resume drawing at a faster rate. For OPEC 2.0 to have a meaningful effect on U.S. shale production, the stronger storage draws in the near term would have to be accompanied by forward guidance from KSA, Russia and their allies that production will be increased in the medium term - 6 months or so out - so that continued demand growth can be accommodated by higher supplies. This would require storage and production flexibility by OPEC 2.0's leaders. Should all of this fall in place, we would expect a backwardation to develop toward yearend, which would be the first step in a longer-term strategy by OPEC 2.0 to slow the rate at which horizontal rigs return to drilling in the shale fields. Bottom Line: Higher oil production from Libya, Iran and Nigeria, coupled with a slight downgrade in demand growth, will reduce the physical deficit we expected this year. This will, all else equal, reduce the rate at which OECD storage draws, and raise the level of five-year average inventory levels by yearend. We do not believe this is a favorable outcome for OPEC 2.0, particularly KSA and Russia, if they are intent on regaining some influence over the evolution of oil prices. For this reason, we believe KSA and its Gulf Arab allies will reduce production further to put the inventory draws back on track. We remain long low-risk calls spreads in Dec/17 WTI and Brent - long $50/bbl strikes vs. short $55/bbl strikes - and will look for opportunities to gain upside exposure once we get clear signaling from OPEC 2.0 leadership. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA's Commodity & Energy Strategy Weekly Report "Sideshow In Vienna," published October 23, 2014, for a review of netback pricing by KSA. It is available at ces.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Reports of April 6, 2017, entitled "The Game's Afoot In Oil, But Which One," and March 30, 2017, entitled "KSA's, Russia's End Game: Contain U.S. Shale Oil" for a discussion of this strategy. Both are available at ces.bcaresearch.com. 3 Please see "Saudi Arabia still aims to reduce supply; weighs Nigerian, Libyan barrels," published by reuters.com on July 18, 2017. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016
Highlights To change our EM strategy, we would need to change our view on China and accept that China's credit bubble - especially in combination with the ongoing policy tightening - does not constitute a material risk to mainland growth in the foreseeable future. We are simply not ready to make this call. It is a matter of time until mainland's growth relapses and China-related plays (including commodities and EM) enter a bear market. Even though the headline growth numbers out of China have so far remained solid, their second derivatives - change in growth rate - have turned negative. Asian export growth has already rolled over, and a slowdown will become pronounced in the months ahead. This will likely halt and reverse the EM rally. Having taken into consideration various factors, we believe it would be wrong to change our strategy at the moment. Feature The U.S. dollar has tumbled and EM risk asset prices have spiked following last week's testimony by Federal Reserve Chair Janet Yellen to Congress. This week we review what has gone wrong with respect to our view, as well as weigh the pros and cons of altering strategy at this point. Our bearish view on EM has been contingent on two pillars: Our downbeat view on EM over the past year has rested on higher U.S. bond yields pushing up the U.S. dollar. This view played out in the second half of last year but has been wrong since early this year. We have continuously argued that EM risk assets are vulnerable due to China's growth relapse amid ongoing liquidity tightening and the lingering credit bubble. Even though the headline growth numbers out of China have so far remained solid, their second derivatives - change in growth rate - have turned negative (more details are provided in the section below). We maintain that our theme of slower mainland growth still has high odds of playing out later this year. We expect meaningfully weak data (on a first-, not second-derivative basis) out of China before year end. If equity markets are forward-looking, they should start pricing in such a scenario now. What has surprised us is the fact that EM investors have utterly and altogether ignored political woes in a number of EM countries, lower commodities prices and lingering structural and cyclical problems in many developing economies, as well as China's tightening amid the credit excesses. Instead, EM investors have singularly focused on downward surprises in U.S. inflation - even ignoring strong employment data in America. Remarkably, EM share prices historically plunged when U.S. inflation and inflation expectations dropped (Chart I-1). Hence, the year-to-date negative correlation between EM stocks and U.S. inflation is out of sync with the historical relationship. We review some other inconsistencies and contradictions below. Chart I-1U.S. Inflation And EM Stocks Were Historically Positively Correlated, But Not This Year Inconsistencies In Prevalent Narrative The purpose of this section is not to justify our investment strategy, which has been wrong-footed, but to elaborate on financial markets' nuances that have been much less clear-cut than popular financial market narratives imply. The reality is much more complicated than the following prevalent among investors narrative: low U.S. inflation entails little tightening by the Fed, resulting in a weak U.S. dollar and an EM rally. There are some contradictions in this story: If U.S. household consumption growth in nominal terms is as weak as portrayed by the latest retail sales and inflation readings (Chart I-2), how can U.S. corporate earnings continue to grow at a double-digit rate, as most investors currently expect? The only way this can happen is if productivity growth is really strong and profit margins continue to expand. Productivity is a black box that no one can measure accurately in real time. If underlying productivity growth is indeed robust, the bull market will persist and bears will be humiliated. The snag is that productivity assessment is a judgement call, and only time will reveal true productivity dynamics. Not having more insight, we have so far assumed that the official statistics on productivity in the U.S. and EM are generally right. If U.S. productivity data are close to reality, unit labor costs - calculated as wages divided by productivity - are rising faster than underlying inflation (Chart I-3, top panel). This entails that U.S. corporate profit margins should be contracting. The middle and bottom panels of Chart I-3 portray our macro proxy for U.S. corporate profit margins based on core PCE inflation and unit labor costs. Chart I-2The U.S.: Very Low Nominal Growth Chart I-3A Macro Proxy For U.S. Corporate Profit Margins Entails Shrinking Margins Overall, if low inflation and weak U.S. nominal retail sales data are a true representation of current U.S. economic conditions, the corporate profit outlook cannot be benign, and American stock prices should be lower - not higher. If lower inflation and nominal growth of recent months in the U.S. were an aberration, U.S. interest rate expectations will have to be revised higher and the U.S. dollar will rally. We are even more puzzled by the nature of the drop in U.S. bond yields, and EM financial markets' reaction to it. Typically, EM risk assets negatively correlate with real (TIPS) yields (Chart I-4), and positively correlate with the inflation component of U.S. bond yields (Chart I-1 on page 1). The decline in U.S. bond yields since the beginning of the year has been almost entirely driven by the inflation component, with U.S. real yields actually not dropping at all. Yet, EM risk assets have rallied sharply. This goes against the predominant correlation of the past several years and is very puzzling. In short, the historical correlations between EM stocks and currencies on one hand and U.S. real yields and inflation expectations on the other, have in the past six months reversed for no reason. If the weaker U.S. dollar and lower U.S. bond yields/rate expectations represent an unwinding of the "Trump trade", why has the S&P 500 - which has surged amid "Trump trade" - not yet corrected? Broadly speaking, if U.S. bond yields drop further and the greenback continues deprecating, it would signal a major relapse in U.S. growth and U.S. share prices will dive. On the contrary, if U.S. growth is solid, the dollar selloff is overdone and the greenback is close to a major bottom. In addition, EM risk assets have decoupled from commodities prices, as we have detailed many times since early this year. Also, as a side note, the broad trade-weighted U.S. dollar decoupled from precious metals prices this whole year up until last week. These are non-trivial divergences that are by and large puzzling. Finally, EM net earnings-per-share revisions have rolled over, yet share prices have continued to move higher (Chart I-5). Such decoupling has simply never happened before. Chart I-4Another Breakdown In Correlations: ##br##EM Currencies And U.S. TIPS Yields Chart I-5EM EPS Net Revisions ##br##Have Failed To Turn Positive Besides, EM EPS net revisions have not turned positive throughout this 18-month rally. In short, analysts in aggregate have not upgraded their EPS estimates for EM companies at all. Bottom Line: There are a number of contradictions and inconsistencies that cannot be explained by the prevailing financial market narrative. What About Global Growth? One way to square the above inconsistencies is to argue that the drop in the U.S. dollar and the EM rally have little to do with U.S. dynamics and much to do with strength in the rest of the world, especially outside the U.S. This is coherent reasoning. We review global growth dynamics in this section and elaborate on China in the following one. Without disputing the fact that there has been a notable recovery in global growth and trade in the past year, we would like to emphasize that on a rate-of-change (second derivative) basis, global trade, and particularly Asian export growth, has already rolled over, and a slowdown will become pronounced in the months ahead. Consistently, the U.S. dollar should rise or EM risk assets should reverse their gains in the near future, if and as global trade/EM growth falters: The pace of export growth in key Asian manufacturing hubs such as Korea, Taiwan and Singapore has already rolled over (Chart I-6). Both Taiwanese exports of electronic parts and the country's overall exports to China have rolled over - the latter two lead global export volumes and Chinese exports, respectively, by a few months, as shown in Chart I-7. Chart I-6Asian Export Growth Has Rolled Over Chart I-7Global Export Growth Has Peaked The reason why Taiwanese exports of electronic parts lead global trade cycles is because these parts are used in the assembly of final products, and producers order and receive these parts before final products are made and shipped. Similarly, a lot of Taiwanese exports to China serve as inputs into final products assembled in China and are shipped worldwide. This is why Taiwanese shipments to China lead mainland aggregate exports. Provided U.S. consumer spending has recently weakened, as depicted by core retail sales, U.S. imports are bound to slump sooner than later (Chart I-8). Consequently, Asian and European shipments to America are likely to roll over soon. Imports are more volatile than domestic demand, reflecting inventory re-stocking and de-stocking cycles. The decoupling between the not-so-strong U.S. final demand and robust imports suggests an inventory re-stocking cycle in the U.S. has recently been taking place. As such, this will be followed by a period of destocking, i.e., weaker imports, weighing on the rest of the world's shipments to the U.S.. A genuine area of global growth acceleration has been continental Europe. Undoubtedly, growth is extremely robust in these economies, and there is no reason for European economies to plunge into recession. That said, U.S. growth dynamics following the 2008 crisis have generally been "two steps forward, one step back." This has typically held true for post-crisis economic recoveries in all major economies. There is no reason why Europe's economic recovery will be any different. As such, having experienced "two steps forward" in the past year, European growth is more than likely to take a "one step back" - i.e., slow down a bit. In brief, if growth dynamics in Europe were to resemble that of the U.S. post-crisis era, mean reversion in European growth is overdue. Finally, global auto sales growth has rolled over decisively (Chart I-9, top panel). The deceleration is very broad-based including the U.S., Europe (Chart I-9, bottom panel) and China (please refer to Chart I-12 on page 10). Chart I-8Weak U.S. Retail Sales Entail ##br##U.S. Import Deceleration Chart I-9Global Vehicle Sales ##br##Growth Heading South Bottom Line: If the global growth recovery has been behind the U.S. dollar selloff and the EM rally, the forthcoming reversal in global trade will at minimum halt and reverse the EM rally. China is critical to our theme of slowdown in global trade. China's Growth: Looking Beyond Headlines China's headline growth numbers for GDP and industrial production have been on the strong side, but forward-looking variables such as money growth and various liquidity measures entail a major deceleration by the end of this year: Narrow and broad money growth - which have historically led the business cycle in China - have relapsed (Chart I-10). Although credit growth has not yet decelerated, money often leads or coincides with credit growth, suggesting a credit slowdown is forthcoming. Furthermore, commercial banks' excess reserves at the central bank are key to their lending capacity. The top panel of Chart I-11 demonstrates that China's money multiplier - the ratio of broad money-to-excess reserves, or banks' assets-to-excess reserves - have surged, implying that banks are over-extended. Chart I-10China: Money Leads Business Cycle Chart I-11China: Bank Loan Growth To Slow In addition, banks' shrinking excess reserves point to a rollover in bank loan growth in the months ahead (Chart I-11, bottom panel). The pace of growth in China's many economic indicators has already rolled over - i.e., their second derivative has turned negative. These include total and ex-oil imports, electricity output and auto production (Chart I-12). Finally, the central bank will continue to tighten liquidity. The recent softness in interest rates may have been temporary, as June is a month in which liquidity demand spikes, and the People's Bank of China probably did not want a replay of the June 2013 SHIBOR crisis. Notably, both core consumer prices and consumer services inflation measures in China are grinding higher (Chart I-13). This, along with "a mandate of preventing bubble formations," will all but ensure that the PBoC tightens further. Chart I-12China: The Pace Of Growth Has Already Rolled Over Chart I-13China: Inflation Is Rising Tighter liquidity/higher interest rates along with regulatory tightening on banks and shadow banking will cause credit growth to slow down considerably, weighing on the real economy. Bottom Line: In China, liquidity is tightening and interest rates are rising amid a credit bubble. Meanwhile, investors remain complacent, and the overwhelming majority of the global investment community believes that China will be able to deflate its financial bubbles and deleverage its corporate sector without a meaningful impact on the real economy. The reality is there has been no historical precedent of this occurring in any country. Strategy Considerations: The Dollar And China Hold The Key The greenback holds the key to EM strategy - not only because it mechanically drives the performance of EM financial markets, but also because it reflects many global financial and economic trends. Having taken into consideration various factors, we believe it would be wrong to change our strategy at a time when: There has already been capitulation by U.S. dollar bulls, the greenback is technically oversold and the Fed will soon commence reduction of its balance sheet. All of this makes us reluctant to change our view on the U.S. dollar and EM at the moment. Notably, the U.S. dollar is at a critical technical level against numerous currencies (Chart I-14A and I-14B). Chart I-14AThe U.S. Dollar Is At A Critical Technical Level (II) Chart I-14BThe U.S. Dollar Is At A Critical Technical Level (I) In short, it is too late to abandon a positive view on the dollar. We have been and remain much more certain about the U.S. dollar strength versus EM, commodities, and Asian currencies than against the euro. Meanwhile, EM financial markets are overbought, and implied volatility across most global financial markets in general and EM in particular is at record-low levels (Chart I-15). Chart I-15Implied Volatilities Are Depressed ##br##Across Most Asset Markets The Fed will shrink its balance sheet, and high-power U.S. dollar liquidity will diminish. Besides, the PBoC will continue to tighten liquidity and guide interest rates higher amid lingering credit excesses. These developments are at the margin bullish for the greenback, and invariably bearish for EM/China-related plays. China's industrial cycle has peaked and Asian exports have rolled over, as we have illustrated above. China's narrow money (M1) growth is slowing, and broad money (M2) growth is at an all-time low. Money leads business cycles in China. Our biggest concerns have been and remain continued strong flows to EM and how well risk assets have been trading. Past flows are no guarantee of future flows. However, both DM and EM risk assets have been trading really well. It is hard to know and forecast when this will change. That said, we maintain that the next 20% move in EM share prices and commensurate moves in other EM risk assets will be down - not up. Weighing the pros and cons, we are reluctant to alter our view and recommended strategy at the moment. To change our EM strategy, we would need to change our view on China and accept that China's credit bubble - especially in combination with the ongoing policy tightening - does not constitute a material risk to mainland growth in the foreseeable future. We are simply not ready to make this call. It is a matter of time until mainland growth relapses and China-related plays (including commodities and EM) enter a new bear market. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights DM Rates Strategy: Many central banks are responding to the strong global economic backdrop by signaling not only a shift in the bias of monetary policy, but actual changes in interest rates or asset purchases. We continue to recommend a below-benchmark overall portfolio stance, but with more diverse views on country allocation: underweight the U.S., Euro Area, & Canada; maximum overweight on Japan; and neutral on the U.K. and Australia. Expect steeper yield curves in the U.S., Euro Area and U.K., and continued flattening in Canada. U.S. Corporate Bond Liquidity: There are few signs of diminished liquidity in U.S. corporate bond markets, despite the sharply reduced inventories of primary dealers. ETFs and institutional investors have picked up the slack from the dealers, as has electronic trading directly between market participants. Feature Chart of the Week2013 Revisited Developed Market (DM) policymakers continue to push towards a less accommodative monetary stance. Last week, the Bank of Canada (BoC) became the second central bank to hike rates this year, following the Fed's earlier tightenings. The European Central Bank (ECB) continues to signal a move to reduce the pace of its asset purchases, likely to be announced at the September policy meeting. A very public debate has opened up among the members of the Bank of England (BoE) policy committee against the stagflationary backdrop of high inflation and cooling growth. This current backdrop is reminiscent of the 2013 synchronized global economic upturn that also put pressure on policymakers to become less accommodative according to our Central Bank Monitors (Chart of the Week). That year was terrible for government bonds, but spread product held in well given the solid growth backdrop. A big difference now is that there is greater evidence of diminished economic slack (lower unemployment rates, higher capacity utilization) than in 2013, so the underlying inflation pressures should be greater. Realized inflation rates remain subdued in most countries (excluding the U.K.), but central bankers are attributing that to temporary factors that should soon fade. That forecast may prove to be wrong, which risks a potential policy mistake if interest rates move up too much or too fast. For now, however, central banks are in charge and bond investors should position accordingly by limiting duration exposure and overweighting growth-sensitive assets like corporate bonds versus sovereign debt. A Country-By-Country Summary Of Our Interest Rate Views With central banks now in the process of adjusting policy settings to varying degrees, financial markets are starting to show a greater level of diversification than in previous years. This can be seen in the moves in bond yields, equity markets and currencies since the speech by ECB President Mario Draghi on June 27 that ignited the latest bond sell-off (Chart 2). The largest yield moves have occurred in the Euro Area, U.K., Canada and Australia, which have also coincided with currency strength and equity market underperformance in those countries. As the markets now try to sort out the growing divergences between monetary policies, this has opened up opportunities for diversification of duration exposures, country allocation and yield curve strategies. This week, we present a brief summary of our individual country recommendations for the remainder of the year. United States: underweight duration, underweight country allocation, steeper yield curve, long inflation protection The Fed remains on track for a move to begin reducing its balance sheet at the September FOMC meeting, with another rate hike expected in December. The inflation data of late has started to raise concern among some FOMC members about how many more interest rate increases will be necessary for this tightening cycle. We expect U.S. growth to show solid improvement over the latter half of 2017, and for this current downdraft in realized inflation to soon bottom out led by tightening labor markets and the lagged impact of this year's decline in the U.S. dollar. Treasury yields will continue to grind higher in the months ahead, led more by rising inflation expectations that will bear-steepen the yield curve. (Chart 3) Chart 2Market Moves Since Draghi's Portugal Speech Chart 3U.S. Rates Strategy Summary Germany: underweight duration, underweight country allocation, steeper yield curve, long inflation protection France: underweight duration, underweight country allocation, steeper yield curve, long inflation protection Italy: underweight duration, underweight country allocation (versus Spain), steeper yield curve The ECB is clearly signaling that a taper of its asset purchase program will begin in 2018. The Wall Street Journal reported last week that Mario Draghi will speak at the upcoming Fed Jackson Hole conference in late August.1 Similar to his speech at the ECB Forum in late June, this will likely be another opportunity for Draghi to prepare financial markets and other central bankers for the ECB's policy shift. We expect an announcement of a "Fed-like" tapering of bond purchases that will begin in January and end sometime in the fourth quarter of 2018. A rate hike is still some time away, most likely in the first half of 2019 at the earliest. The ECB will want to see more signs of lower unemployment and sustainable higher core Euro Area inflation before contemplating higher short-term interest rates - especially given the likely positive impact on the euro from such a move that would risk an unwanted tightening of financial conditions. There is far more risk in longer-dated bond yields to reprice via higher term premia and/or inflation expectations, thus we are recommending a bearish stance not only on European duration and country allocation, but also a bias toward steeper yield curves (Chart 4 & Chart 5). Tapering will also put upward pressure on Peripheral European yields and spreads, particularly in Italy, as risk premiums normalize away from the tight levels seen during the ECB asset purchase program. We do not anticipate a rout in Italian debt given the current improvements in the domestic economy and the positive moves seen in consolidating and recapitalizing the troubled Italian banking sector. However, we do see continued underperformance of Italian debt versus Spanish sovereigns, thus we are maintaining an overweight stance on Spain versus Italy in our model bond portfolio (Chart 6). Chart 4Germany Rates Strategy Summary Chart 5France Rates Strategy Summary Chart 6Italy & Spain Strategy Summary U.K.: underweight duration, neutral country allocation, neutral yield curve We have been maintaining a neutral allocation to U.K. Gilts, but with an underweight duration exposure and a curve steepening bias (Chart 7). The growing rift among the members of the BoE Monetary Policy Committee does suggest that there could be more two-way risk in U.K. interest rates than at any time seen since last year's Brexit vote. The BoE responded to that political surprise with rate cuts and a new round of asset purchases, even though the U.K. economy was operating at full employment at the time and inflation pressures were rising. Now, the chickens have come home to roost for the BoE, with inflation remaining stubbornly high despite signs of slowing growth (Chart 8). With real wage growth slowing substantially and household saving rates at very low levels, the risk of a consumer spending slowdown - that the BoE was flagging earlier in the year - is increasing. Chart 7U.K. Rates Strategy Summary Chart 8Stagflation In The U.K. Given the ongoing uncertainties from the upcoming Brexit negotiations that will likely continue to weight on business confidence and investment spending, and with consumption likely to continue losing steam, we see little case for the BoE to seriously consider a rate hike before year-end. We are only recommending a neutral stance on Gilts, though, as realized inflation continues to run well above the BoE's target, supported by the stubbornly soft British pound. We continue to recommend a steepening bias on the Gilt curve until there is more decisive evidence that U.K. inflation is rolling over. Japan: overweight duration, maximum overweight country allocation, neutral yield curve and neutral inflation protection We continue to recommend a maximum overweight on Japanese government bonds (JGBs). JGBs are a low-beta market with the BoJ still targeting a 0% level on the benchmark 10-year yield, even as other global bond markets sell off. The BoJ has been particularly aggressive in capping any rise in JGB yields of late, offering to buy 10-year bonds in unlimited size and also increasing its purchases at shorter maturities (Chart 9). With Japanese inflation still struggling to stay in positive territory, even with the economy estimated to be operating at full employment, the BoJ will do the only thing it can do to put a floor under inflation - keep JGB yields at low levels to trigger a new wave of yen weakness and, hopefully, some imported inflation pressures via the currency. Against this backdrop, JGBs will continue to outperform other DM bond markets during this move towards strong growth and less accommodative monetary policies outside of Japan. Stay overweight Japan against global hedged bond benchmarks. Canada: underweight duration, underweight country allocation, flatter yield curve, long inflation protection We moved our Canadian country allocation to underweight last week in advance of the BoC's expected rate hike, but we had been recommending bearish Canadian trades (curve flatteners and spread wideners versus U.S. Treasuries) in our Tactical Overlay Trade Portfolio for much of the year so far.2 The BoC's 180-degree policy shift over the past month has taken many investors by surprise, but the very strong upturn in the Canadian economy is forcing the BoC into action. With the BoC now projecting the Canadian output gap to be closed this year, expect another one, even two, rate hikes by the end of 2017. This will put additional upward pressure on Canadian bond yields and bear-flatten the Canadian government bond yield curve (Chart 10). Australia: neutral duration, neutral country allocation, neutral curve Australia has been one of the trickier markets on which to have a strong opinion, given the combination of a tight labor market, low inflation, mixed readings on domestic demand and heavy exposure to China's economy. This has led us to be neutral across the board on Australian bonds (Chart 11). We will be covering the outlook for Australia in a Special Report to be published next week, in which we will re-examine our current Australia recommendations. Chart 9Japan Rates Strategy Summary Chart 10Canada Rates Strategy Summary Chart 11Australia Rates Strategy Summary Bottom Line: Many central banks are responding to the strong global economic backdrop by signaling not only a shift in the bias of monetary policy, but actual changes in interest rates or asset purchases. We continue to recommend a below-benchmark overall portfolio stance, but with more diverse views on country allocation: underweight the U.S., Euro Area, & Canada; maximum overweight on Japan; and neutral on the U.K. and Australia. Expect steeper yield curves in the U.S., Euro Area and U.K., and continued flattening in Canada. An Update On The State Of U.S. Corporate Bond Market Liquidity In the Fed's latest Monetary Policy Report, presented by Janet Yellen to the U.S. Congress last week, an entire section was devoted to the state of U.S. corporate bond market liquidity.3 The Fed's conclusion was that, according to many commonly used metrics like average bid/ask spreads, corporate debt has not become more difficult to trade in recent years. This goes against the intuition of many bond investors who have perceived a deterioration of liquidity in corporate credit markets since the 2008 Financial Crisis. The Fed likely felt compelled to dedicate three pages of its Monetary Policy Report to a topic as mundane as bond market functionality as a defense of its current regulatory framework for U.S. banks. The Fed has taken a lot of flak from major U.S. financial institutions, conservative free-market politicians and, since last November, the Trump White House over the "heavy-handed" rules shackling the banks. Chart 12U.S. Dealers Don't Matter Regulations such as the Volcker Rule and the Supplementary Leverage Ratio have almost certainly reduced the odds of another financial crisis caused by undercapitalized banks speculating in risky assets. Yet the critics continue to point out that banks which are more worried about meeting regulatory targets are less able to make loans or, in the case of investment banks, make markets in risky assets like corporate debt. This is important for bond investors given the sharply reduced footprint of investment banks in corporate debt markets. The Fed's data on primary dealer positioning in corporates shows a massive decline from the pre-crisis peak in 2007 of $280bn to only $20bn this year (Chart 12). Over the same period, the size of the U.S. corporate bond market has more than tripled to $6.5 trillion (using the market capitalization of the Barclays Investment Grade and High-Yield indices as a proxy). On the surface, that indicates that dealers held 10% of "the market" at the peak. Now, dealer inventories barely represent only 0.3% of corporate debt outstanding. While that is low, it is not much lower than the share of corporates held by dealers in the early 2000s. When looking at the full span of the available data, the huge dealer footprint in the U.S. corporate bond market in the years prior to the Financial Crisis was the exception and not the norm. Like most other market participants in those years, the investment banks were seduced by the extended period of low macro and market volatility and ended up taking too much risk on their balance sheets. Now, dealers are much more cautious when trading with clients, acting more as an "agent" that matches buyers and sellers for individual trades and less as a "principal" that holds the bonds themselves. The smaller presence of dealers could create a liquidity problem for corporate debt, especially if dealers in their usual role as market-makers cannot be there to absorb the selling pressure from investors during market sell-offs. Yet corporate bond markets have functioned well since the dark days of the Lehman crisis. According to data from SIFMA, average daily trading volumes in the U.S. corporate bond market rose from a low in 2008 of $14bn to $30bn in 2016 (Chart 13). Corporate bond issuance has surged as well, but corporate bond turnover - total annualized trading volumes relative to total bonds outstanding - has improved by nearly 35% since the 2008 low. In addition, the reduced dealer presence has not resulted in any unusual widening of typical relationships like the basis between Credit Default Swaps and corporate bond spreads (bottom panel). The Fed noted this in its Monetary Policy Report as a sign that market liquidity was not impaired since there were not many "unrealized arbitrage opportunities". It is evident that other market participants have picked up the slack from the dealers in U.S. corporate bond trading. Exchange Traded Funds (ETFs) are the obvious candidate, led by the popular iShares HYG and the SPDR JNK funds that have a combined $30bn in assets under management. According to the Fed's database on the Financial Accounts of the United States (formerly known as the Flow of Funds), the share of corporate bonds held by all retail funds, including ETFs, soared from 6.5% in 2008 to nearly 19% in Q1 of this year (Chart 14). This nearly offset the decline in the share of corporates held directly by households, as individual investors shifted their preferences toward the ease of trading corporate debt ETFs over individual bonds. Chart 13U.S. Corporate Bond Market Turnover Has Improved Chart 14Shifting Ownership Patterns For U.S. Corporates Importantly, institutional investors like insurance companies and pension funds have seen their influence in corporate bond markets increase, as they now hold a combined 35% of corporate debt, up from 26% in 2008 (bottom two panels). These groups will likely control an even greater share of the corporate bond market in the years to come with the growing usage of so-called "all-to-all" electronic trading platforms like MarketAxess or Bloomberg that allow users to trade directly with each other. All-to-all has already established a major market footprint, as activity on MarketAxess now represents 16% of all trading volume in U.S. Investment Grade corporates and 34% for High-Yield, according to The Economist.4 This is a hugely important development. If more professional bond investors can now transact directly with one another, this helps to alleviate any reduction in market liquidity caused by a smaller dealer presence in the market. Even with so much evidence pointing to no serious liquidity problems in U.S. corporate debt, some worrisome issues remain. Chart 15Market Performance Leads Fund Inflows,##BR##Not Vice Versa Average trade sizes in corporates are smaller now compared to pre-crisis levels - perhaps as much as 20% smaller according to estimates by the New York Fed.5 This is likely the result of the reduced risk-taking by the dealers and the growing share of direct electronic trading. This creates an effect where it may feel like liquidity is impaired since it now takes longer to execute a large bond trade, even though transaction costs for individual trades have not been increasing, on average. Corporate bond ETFs are easier to trade than the underlying bonds held in the ETFs themselves. This has worried many investors who fear that a corporate bond market downturn could turn into a much larger rout if rapid ETF redemptions cause "fire sales" of the bonds held in the ETFs to quickly raise cash. Admittedly, the unique ETF structure - where the shares of the ETF are traded and not the underlying bonds, similar to a closed-end mutual fund - has not yet been tested in a true credit bear market. However, there have been several episodes of "risk-off" bond sell-offs over the past few years, most notably for High-Yield ETFs during the 2014/15 oil bear market, which did not result in any disorderly disruption of corporate bond markets. If anything, the historical experience of U.S. corporate bond mutual funds shows that net flows into funds tend to follow, and not lead, the performance of markets (Chart 15). This may exaggerate bond market moves at turning points but, in general, outflows are a symptom, not a cause, of corporate bond downturns. Net-net, we agree with the assessment of the Fed that corporate bond market liquidity shows little sign of impairment and does not represent a threat to market stability. Bottom Line: There are few signs of diminished liquidity in U.S. corporate bond markets, despite the sharply reduced inventories of primary dealers. ETFs and institutional investors have picked up the slack from the dealers, as has electronic trading directly between market participants. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 https://www.wsj.com/articles/draghi-may-address-future-of-ecb-stimulus-at-jackson-hole-1499944342 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Dangerous Duration", dated July 11 2017, available at gfis.bcaresearch.com. 3 https://www.federalreserve.gov/monetarypolicy/files/20170707_mprfullreport.pdf 4 https://www.economist.com/news/finance-and-economics/21721208-greater-automation-promises-more-liquidity-investors-digitisation-shakes-up 5 http://libertystreeteconomics.newyorkfed.org/2015/10/has-us-corporate-bond-market-liquidity-deteriorated.html Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index
Highlights Key Portfolio Updates Synchronized global economic growth is driving real yields higher and boosting equities (Chart 1). Meantime, core inflation remains muted which will ensure that Fed policy stays sufficiently accommodative (Chart 2). Outside of the U.S., monetary tightening cycles are kicking into high gear, and this will sustain downward pressure on the greenback for now (Chart 3). Easy financial conditions are a boon for S&P 500 profit margins, and a slow moving Fed suggests that investors will extrapolate this goldilocks equity scenario for a while longer (Chart 4). Almost all of the S&P 500's advance year-to-date has been earnings driven (Chart 5). Buoyant EPS breadth bodes well for additional gains, a message in line with our SPX profit model. In terms of how far the broad market can advance from current levels before the next recession hits, we posit three ways to SPX 3,000 (Table 1). The ongoing sector rotation is a healthy development, and is not a precursor to a more viscous and widespread correction (Chart 6). Historically, receding sector correlations represent fertile ground for the overall equity market (Chart 7). Our macro models are signaling that investors should position for a sustained rebound in economic growth. Our interest rate-sensitive models are coming out on top, deep cyclicals are attempting to trough, while defensives took a turn for the worse (Chart 8). Deep cyclical sectors are the most overvalued followed by early cyclicals, while defensives remain in undervalued territory. Interest rate sensitives have recently become overbought, while both deep cyclicals and defensives are in the oversold zone (Charts 9 & 10). The most attractive combination of macro, valuation and technical readings are in the financials and consumer discretionary sectors. The least attractive combinations are in materials, technology and utilities sectors. Prospects for a durable synchronized global economic growth, a coordinated tightening G10 central bank backdrop and cheapened U.S. currency warrant an early cyclical portfolio tilt, with the defensive/deep cyclical stance shifting to a more neutral setting. Chart 1Synchronized Global Growth Chart 2Muted Core Inflation Chart 3G10 Central Banks Map Chart 4Easy Financial Conditions Boost Margins Chart 5Buoyant Breadth Bodes Well Table 1SPX Dividend Discount Model SPX EPS & Multiple Sensitivity ERP Analysis Chart 6Healthy Rotation Chart 7Falling Correlations Boost The S&P 500 Chart 8Interest Rate Sensitives Come Out On Top Chart 9Underowned... Chart 10...And Undervalued Defensives Chart 11Earnings Growth Set To Accelerate Chart 12Consumers Are Feeling Flush Chart 13Improving Fundamentals Signal A Trough Chart 14Staples Remain The Household's Choice Chart 15Weaker Rents And Higher Vacancies Bode Ill Chart 16Profits Look Set To Downshift Chart 17Cyclical Recovery Driving Backlogs Lower Chart 18Margin Recovery Appears Priced In Chart 19Pricing Collapse Driving Earnings Decline Chart 20Productivity Declines Will##br## Keep A Cap On Valuations Chart 21Valuations At Risk##br## When Inflation Returns Feature S&P Financials (Overweight) Our financials cyclical macro indicator (CMI) has climbed to new cyclical highs, supported by broad-based improvement among its components. Firming employment data, historically a precursor to credit growth and capital formation, has been a primary contributor to the lift in the CMI. Importantly, a tight labor market has not yet driven sector costs higher, which bodes well for near term profits (Chart 11 on page 8). A budding revival in loan demand is corroborated by our bank loan growth model, which points to the largest upswing in credit growth of the past 30 years. Soaring consumer and business confidence, rising corporate profits and a potential capital spending revival underpin our loans and leases model (Chart 11 on page 8). Expanding housing prices, increased housing turnover and rebounding mortgage purchase applications support household capital formation (Chart 11 on page 8). A recent lift in share prices partially reflects this much-improved cyclical outlook. Still, the message from our valuation indicator (VI) is that there is significant running room. Our technical indicator (TI) has retreated from overbought levels, but remains solidly in the buy zone, setting the stage for the next leg up in the budding relative bull market. We expect sentiment to steadily improve, buoyed by deregulation moving closer to reality as a partial Dodd-Frank replacement passed the House. Chart 22 S&P Consumer Discretionary (Overweight) Our CMI has snapped back after a tough year, driven by improving real wage growth. Higher home prices, a tighter labor market and increasing disposable income have consumers feeling flush, which should boost discretionary outlays. Importantly, consumer deleveraging is far advanced with the debt service ratio hovering near decade lows (Chart 12 on page 9). Further, our Consumer Drag Indicator remains near its modern high, suggesting EPS gains will prove resilient (Chart 12 on page 9). Although somewhat expensive from a historical perspective, our VI remains close to the neutral zone, underscoring that profits will be the primary sector price driver. Our TI has fully recovered from oversold levels, and is flirting with the buy zone, underscoring additional recovery potential. We continue to recommend an overweight position, favoring the media-oriented sub-indices. Chart 23 S&P Energy (Overweight) Our CMI has recently ticked up from its all-time lows, and is now diverging positively from the share price ratio. Ongoing gains in domestic production, partially offset by a still-high sector wage bill, underlie the recent CMI uptick. The steepest drilling upcycle in recent memory is showing some signs of fatigue. Baker Hughes reported the first weekly decline in 24 weeks in the oil rig count for the week ending June 30th. At least a modest deceleration in shale oil production is likely. Encouragingly, U.S. crude oil inventories are contracting, which could presage a renormalization of domestic inventories, market share gains for domestic production and at least a modest rally in energy shares (Chart 13 on page 9). Our S&P energy sector relative EPS model echoes this cautiously optimistic industry backdrop, indicating a burgeoning recovery in sector earnings (Chart 13 on page 9). The TI has returned to deeply oversold levels, suggesting that an oversold bounce could soon occur at a time when valuations are gravitating back to earth. Chart 24 S&P Consumer Staples (Overweight) The consumer staples CMI has turned lower recently, held back by healthy economic data, particularly among confidence indicators. That should drive a preference for spending over saving after a long period of thrift, although a relative switch from staples into discretionary consumption has not yet taken firm hold. The savings rate has also stayed resilient, despite consumer euphoria (Chart 14 on page 10). The good news is that tamed commodity prices and a soft U.S. dollar should provide bullish offsets for this global-exposed (Chart 14 on page 10) and commodity-input dependent sector. A modestly weaker outlook for staples is more than reflected in our VI, which is still parked in undervalued territory. Technical conditions are completely washed out, signaling widespread bearishness, which is positive from a contrary perspective. Chart 25 S&P Real Estate (Neutral) Ongoing improvements in commercial & residential real estate prices continues to push our real estate CMI higher. However, the outlook for REITs has darkened; rents have crested while the vacancy rate found its nadir in 2016, suggesting further rent weakness on the horizon (Chart 15 on page 10). Further, bankers appear less willing to extend commercial real estate credit; declines in credit availability will directly impact REIT valuations. Our VI is consistent with our Treasury bond indicator, indicating that both are at fair value. Our TI is starting to firm from extremely oversold levels, a positive indication for both 12- and 24-month relative performance. Chart 26 S&P Health Care (Neutral) Our CMI has rolled over, driven by a steep decline in pharma pricing power (Chart 16 on page 11). In fact, the breadth of sector pricing power softness has spread, just as the majority of the industries we cover is enjoying a selling price revival. The divergence between the CMI and recent sector relative performance suggests that the latter has been mostly politically motivated, and may lack staying power. Worrisomely, the sector wage bill has spiked; in combination with a weaker top line, the earnings resilience of the sector could be at risk. Relative valuations remain appealing, but technical conditions are shaky, as our TI has bounced from oversold levels but is still in negative territory. Taken altogether, we would lean against the recent advance in relative performance. Chart 27 S&P Industrials (Neutral) The CMI has recovered smartly in the past couple of quarters, lifted mostly by a weaker U.S. dollar. The sector has moved laterally since the U.S. election. The improved export outlook is a positive, but a lack of response in hard economic data to the surge in confidence is a sizable offset. An inventory imbalance has largely unwound over the past six months, as durable goods orders are easily outpacing inventories, coinciding with a return of some pricing power to the sector (Chart 17 on page 11). Still, years of capacity growth in excess of production and the resulting low utilization rates mean that pricing gains may stay muted unless demand picks up substantially. Our valuation gauge is near the neutral zone, but there is a wide discrepancy beneath the surface, with construction & engineering trading cheaply and railroads and machinery commanding premium valuation multiples. Our TI has returned close to overbought levels, potentially setting the stage for another move higher. Chart 28 S&P Utilities (Neutral) Our CMI for the utilities sector remains in a long-term downtrend, albeit one with periodic countertrend moves. Most of the weakness in the CMI relates to external factors, such as robust leading indicators of global economic growth (Chart 18 on page 12). Encouragingly, the sector's wage bill has slowed from punitively high levels, and combined with improving pricing power should allow for some margin recovery (Chart 18 on page 12). Utilities have outperformed other defensive sectors, likely due to the expectation that the new U.S. administration's long-awaited tax reform will have outsized benefits to this domestic-focused industry. As a result, valuations have been creeping up, though not sufficiently enough to warrant an underweight position. Our TI has reversed its steep fall over the past year, but is unlikely to bounce through neutral levels in the absence of a negative economic shock. Ergo, our preferred strategy is to remain at benchmark, but look for tradable rally opportunities. Chart 29 S&P Telecom Services (Underweight) Our CMI for telecom services has moved laterally, as much-reduced wage inflation is fully offset by the sector's plummeting share of the consumer's wallet and extremely deflationary conditions (Chart 19 on page 12). Our sales model paints a much darker picture, pointing to double-digit topline declines for at least the next few quarters, owing to the plunge in pricing power deep into negative territory (Chart 19 on page 12). The sector remains chronically cheap, and has all the hallmarks of a value trap, as relative forward earnings remain in a relentless secular downtrend. It would take a recession to trigger a valuation re-rating. Our Technical Indicator has nosedived but, like the VI, cycles deep in the sell zone have not proven reliable indicators that a relative bounce is in the offing. Chart 30 S&P Materials (Underweight) Recent Fed rate hikes have driven down the CMI close to all-time lows. The sector has historically performed very poorly in tightening cycles owing to U.S. dollar appreciation and the ensuing strains on the emerging world. Weak signals from China have also helped take the steam out of what looked like a recovery in the CMI last year. Commodity-currencies have rallied, but not by enough to offset a relapse in pricing power and weak sector productivity (Chart 20 on page 13). The heavyweight chemicals group (comprising more than 73% of the index) continues to suffer; earnings growth relies heavily on global reflation, an elusive ingredient in the era of a globally synchronized tightening cycle. Sagging productivity warns that profitability will remain under pressure. Valuations have now spent some time in overvalued territory; without a recovery in earnings growth, a derating is a high probability outcome. Our TI has dipped into the sell zone, indicating a loss of momentum and downside relative performance risks. It would be highly unusual for the sector to stay resilient in the face of a negative TI reading. Chart 31 S&P Technology (Underweight) The technology CMI is in full retreat, driven by ongoing relative pricing power declines and new order weakness. However, the sector had been resilient, until recently, as a mini-mania in a handful of stocks and the previously red-hot semiconductor group have provided resilient support. That reflected persistently low inflation and a belief that interest rates would still low forever. After all, tech stocks thrive in a disinflationary/deflationary environment and suffer during inflationary periods (Chart 21 on page 13). Nevertheless, a recovering economy from the first quarter's lull and tight labor market suggest that an aggressive de-rating in sky-high valuations in previous juggernauts is a serious threat, especially if recent disinflation proves transitory. Our relative EPS model signals a profit slide this year. In the context of analyst estimates of double-digit earnings growth, sector downside risk is elevated. Our VI is not overdone, but that partly reflects the massive overshoot during the bubble years. Our TI is extremely overbought, suggesting that profit-taking is likely to persist. Chart 32 Size Indicator (Overweight Small Vs. Large Caps) Our size CMI has retraced some of its 2016 climb, but remains firmly above the boom/bust line. Keep in mind that this CMI is not designed as a directional trend predictor, but rather as a buy/sell oscillator. Small company business optimism is near modern highs, as pricing and consumption vigor push domestic revenues higher. A smaller government footprint, i.e. fewer regulatory hurdles, and tax relief will disproportionately benefit SMEs. The prospect of trade barriers clearly favors the domestically focused small cap universe and underlie part of the post-election euphoria. Top line growth will need to persist if small businesses are to offset a higher wage bill, as labor looks more difficult to import and the economy pushes against full employment. Valuations have improved and the share price ratio has fully unwound previously overbought conditions. We expect the recent rally to gain steam.\ Chart 33 Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com Chris Bowes, Associate Editor chrisb@bcaresearch.com
Highlights Yellen pointed out that the U.S. R-star is low but that it will rise as temporary depressing factors pass. The Fed is determined to push rates toward 3% over time. The euro area R-star is substantially lower than that of the U.S., limiting the capacity of the ECB to follow the Fed's path and pace. Traders are massively long the euro. Abe's woes do not signal the end of Abenomics, in fact they point toward more stimulus. The BoC has hiked and will keep doing so, continue to favor the CAD. Feature Janet Yellen offered both a fascinating and telling glimpse on the Federal Reserve's thinking this week. She argued that the equilibrium fed funds rate is currently very depressed, which is limiting the pace at which the FOMC can increase interest rates before plunging the economy into recession. However, she also noted that the Fed anticipates equilibrium interest rates will continue to rise over time, which means the actual fed funds rate has more upside on a multi-year horizon, despite what will be a slow pace of increases. With this additional information on the Fed's mindset, investors should be even more comfortable in their assessment that the period of maximum policy divergence between the euro area and the U.S. is behind us, which justified bullish bets on the euro. However, the broader picture is a bit more complex. Different Equilibria The idea that the neutral fed funds rate is still low but rising explains why the Fed is still pegging its terminal rate at 3%. Currently, the Laubach and Williams formulation of the neutral real fed funds rate (also known as R-star) is at 0.4%, while the current real fed funds rate stands at -0.5%, which implies 0.9% upside in real rates over the next two years or so (Chart I-1). Moreover, if as we expect core inflation moves back toward 2% over the Fed's forecast horizon, the upside to rates would be closer to 150 basis points. In the euro area, however, the same long-term R-star stands at -0.1%, depressed by lower population growth, a higher savings rate and lower structural productivity gains. Since the real policy rate is at -0.7%, this signifies that the gap between the actual real policy rate and its equilibrium is a smaller 0.6% (Chart I-2). This means that euro area rates have much less upside than U.S. ones before generating a deleterious impact on growth. Chart I-1U.S. R-Star Vs. Policy Rates Chart I-2Euro Area R-Star Vs. Policy Rates It is easy to argue that R-star differences are nice theoretical concepts, with little practical implications for currency investors. After all, interest rate differentials at the long end of the curve are clearly a function of the relative GDP per capita between the euro area and the U.S. (Chart I-3). These same GDP-dynamics also have an impact - albeit a less tight one - on EUR/USD. Chart I-3Yield Differentials And Relative GDP Chart I-4How R-Star And GDP Tango Yet, R-star spreads do affect growth differentials between the euro area and the U.S. As Chart I-4 illustrates, when the euro area real policy rate crosses above its equilibrium, euro area real GDP per capita growth sags soon after. The same holds true for the U.S. This suggests the capacity of European GDP per capita to outperform that of the U.S. is currently limited, or at the very least needs rates in Europe to remain quite low relative to the U.S., anchored lower by the depressed level of the R-star in Europe vis-a-vis the U.S. Moreover, the recent outperformance of European GDP per capita relative to the U.S. has a lot to do with the poor performance of U.S. GDP in 2016. However, U.S. GDP should firm in the coming quarters, particularly since household income levels are well supported. As Chart I-5 shows, based on an average of the pay-related and hiring-related components of the NFIB small businesses survey, the aggregate wages and salaries received by U.S. households are set to accelerate, both in nominal and real terms. This represents a boost to aggregate income and should support consumption, or almost 70% of the U.S. economy. Additionally, the rebound in U.S. capex should continue. Both the NFIB and the various regional Fed capex intention surveys remain healthy. This, along with labor market tightness, should be accretive to per capita GDP. As Chart I-6 shows, a composite indicator based on the NFIB survey capex and "jobs hard to fill" components is very strong, which historically has led to an acceleration of real-GDP-per capita growth. Chart I-5U.S. Household Income Will Accelerate Chart I-6U.S. Real GDP Per Capita Will Strengthen As a result, we are inclined to bet on a renewal of strength in the U.S. economy, which will support R-star there and help the Fed hike rates by more than the 43 basis points currently anticipated over the next 24 months. Bottom Line: The U.S. long-term equilibrium real fed funds rate is low, but remains substantially higher than the R-star in the euro area. This suggests that U.S. rates have more upside than European ones. Moreover, the outlook for U.S. per capita GDP is healthy, while that of Europe will continue to require low rates to remain on an upward path. Tactical Considerations Around EUR/USD EUR/USD is well bid, and our base case scenario remains that the 1.15 to 1.16 zone will be retested. However, some technical indicators have made us leery to chase this move, and might even prevent this target zone from ever being breached. To begin with, the number of long speculative bets on the euro has hit a record high, while the number of short bets has collapsed (Chart I-7). Net long speculative positions are not at a record high yet, but are in the upper echelons of the distribution of the past 17 years. Interestingly - and some would argue almost mechanically - while speculators' optimist or pessimist extremes can be used as contrarian indicators, commercial traders tend to be disproportionally short or long the euro at the appropriate time - i.e., when the euro is set to plummet or rally, respectively. Theoretically, commercial and non-commercial traders' positions should be in perfect balance as they are counterparties to one another, but in practice this is rarely the case. Because of this observation, we decided to amplify the message of both series by subtracting the net long commercial positions from net long non-commercial ones. This indicator tends to work best at highlighting tops in EUR/USD. The current reading has been indicative of an upcoming period of weakness in this pair (Chart I-8). The only exception was in 2007, a period when unlike today, the Fed was cutting rates while the ECB policy rate was being lifted all the way to July 2008. Chart I-7Record Longs In The Euro Chart I-8Aggregate Positioning Points To A Lower Euro Moreover, the buying pressure on EUR/USD may be exhausting itself. Wednesday, despite a seemingly dovish message from Fed Chair Yellen and despite stronger-than-anticipated industrial production numbers out of the euro area, EUR/USD weakened 0.6% instead of appreciating. In fact, our European Investment Strategy Senior Vice President Dhaval Joshi's Fractal Dimension indicator - a measure of group-think in the market - is now at 1.25, a level that also warns of an imminent trend change (Chart I-9).1 Chart I-9A Risk Of Reversal As a result, we do not yet think it is time to be betting aggressively on a fall in EUR/USD, especially as next week's ECB meeting might give an occasion for President Mario Draghi to re-affirm his optimism, giving the euro its final push toward 1.15-1.16. However, nimble traders should begin building small short positions in the euro on the optic of expanding their bets if the EUR/USD gathers downward momentum. Bottom Line: The euro may well hit the 1.15-1.16 range, but positioning in EUR/USD is currently extremely overstretched, and the euro's trading action suggests that groupthink has become prevalent, confirming the message of positioning. This means the euro is at risk. Nimble traders should begin building small short positions in EUR/USD, but it is not yet time to bet aggressively on this pair. Shinzo's Troubles Are Not The Demise Of Abenomics Japanese Prime Minister Shinzo Abe's popularity has been in freefall in recent weeks, hitting the most dismal levels of his current premiership (Chart I-10). The flogging received by the LDP in the recent Tokyo Metropolitan Assembly election is indeed being perceived as a rejection of the party's policy stance since 2012. Does this represent the coup de grace that will end Abenomics? We doubt it. The key behind the recent dip in Abe's popularity is not his economic policy but his move away from it. Instead, his focus on changing the pacifist constitution of post-war Japan is the source of the LDP's and Abe's woes, as this topic remains anathema with the Japanese public. Moreover, we are not willing to bet on the demise of the LDP. The Tokyo election was a one-off event. The new Tomin First no Kai (Tokyoites First) party that is now the largest force in the regional assembly is led by the very popular Tokyo governor Yuriko Koike, and will rely on the pacifist Komeito to control the Tokyo Metropolitan Assembly. At the national level, the DPJ remains in tatters, and no potential new party is in place to carry the torch of the opposition. Japan is still effectively a one-party democracy. So what are the market implications of these political developments? We expect a doubling down by Abe on economic stimulus. If Abe ever wants a passing chance to have, let alone win, a referendum to increase Japan's militarism, the economy needs to be stronger than it is. Thus, we think this boot of unpopularity will be key to unlocking more fiscal stimulus out of Tokyo. When more fiscal stimulus finally does materialize, if it boosts growth, it will also lift long-term inflation expectations (Chart I-11). Chart I-10Abe's Plummeting##br## Popularity Chart I-11If Fiscal Stimulus Is Implemented ##br##CPI Expectations Will Rise... In this context, we would expect continued pressure on the Bank of Japan to remain one of the two most dovish central banks in the G10, as to not undo the benefits of fiscal stimulus. Moreover, the BoJ cannot remove stimulus, as realized CPI excluding food and energy remains in negative territory. Tokyo's CPI report, which offers a one-month lead on the national release, shows that core inflation is still in negative territory. National summer wage negotiations point to negative wage growth next year, making a revival of domestically generated inflation a remote event without an easing of financial conditions (Chart I-12). Additionally, the recent rollover in the leading diffusion index suggests the economic upswing may already be fading (Chart I-13). Continued BoJ support and higher inflation expectations would hurt Japanese real yields and handicap the yen. Chart I-12...But That Will Also Require Easy Monetary##br## And Financial Conditions Chart I-13A Slowdown ##br##In Japan The recent upswing in global bond yields is thus likely to continue to weigh on the yen, leading to a higher USD/JPY. As this week illustrated, rising global yields are forcing the BoJ to increase its amount of JGB purchases to cap the upside in Japanese 10-year yields. Tactically, USD/JPY has been in an upswing, but has hit an important resistance close to 114.5. A few more days of weakness could ensue, but such weakness should be used by investors to sell the yen. Bottom Line: Abe's political problems do not represent the end of Abenomics. Instead, they illustrate the Japanese public's lack of appetite toward abandoning Japan's post-war pacifism. If Abe is serious about holding a referendum on this topic, he will have to support growth going forward - which implies higher fiscal stimulus and inflation expectations. Meanwhile, the absence of inflation in Japan continues to hamstring the BoJ in keeping policy extremely supportive, limiting the upside to nominal interest rates across the Japanese yield curve. Real rate differentials will continue to support USD/JPY. Use any weakness in this pair to buy the dollar versus the yen. Canada: Poloz Delivers The Bank of Canada on Wednesday increased interest rates by 25 basis points to 0.75%, the first central bank to follow the Fed's lead. Our analysis two weeks ago suggested that the BoC was faced with some of the most supportive conditions in the world to follow the Fed's path.2 More interesting than the decision itself was the accompanying quarterly Monetary Policy Report. In the report, the BoC moved forward its estimation of the closure of the output gap from 2018 to 2017. Additionally, despite expecting a slowdown in household consumption in 2018, the BoC upgraded its GDP forecast by 0.2% in 2017 and 0.1% in 2018, to 2.8% and 2%, respectively. Obviously, the market took note of these views, with USD/CAD falling three big figures on the news. The tone of the report was quite bullish on the Canadian economy, highlighting robust as well as broad-based growth and increasing signs of vanishing slack. In fact, the message reiterated that of the summer Business Outlook Survey, which showed strong growth, growing difficulty meeting demand, and growing and intensifying labor shortages (Chart I-14). As a result, the BoC expects the weak Canadian CPI to rebound, after the transitory effects of low food inflation, automobile rebates, and Ontario's electricity subsidies dissipate. We are inclined to agree with this assessment. At 2% per annum, Canadian employment growth is robust and the unemployment rate has fallen significantly. Now that oil prices have stabilized, employment is improving, suggesting that even the weakest regions of the economy are participating in the party. Additionally, our Canadian economic diffusion index - based on retail trade, manufacturing sales, building permits and employment data in the 10 provinces - has sharply accelerated, pointing to a continued rise in GDP growth (Chart I-15). Chart I-14Canada Is Booming And Slack Is Shrinking Chart I-15Strong Data Across The Board USD/CAD continues to trade at a discount to real interest rate differentials, signaling further upside on the CAD. Also, while investors have begun to curtail their shorts on the loonie, there do remain enough stale shorts for the CAD advance to persevere. We continue to prefer playing the CAD's strength on its crosses such as versus the AUD and the EUR, as the risk profile seems cleaner on these pairs than versus the USD. Short EUR/CAD looks particularly attractive. Our long CAD/NOK trade is near its target, and we are closing this position. Bottom Line: The Bank of Canada has not only hiked rates, but it has also highlighted that the Canadian economy is strong and inching closer to full capacity. The market has taken note, with the loonie rallying violently. The CAD has more upside going forward, especially against the euro and the AUD. We are booking profits on our long CAD/NOK position. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see European Investment Strategy Special Report titled, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com 2 Please see Foreign Exchange Strategy And Global Alpha Sector Strategy Special Report titled, "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 greenback has largely been flat this week, despite Yellen's statements regarding rate hikes and balance sheet normalization at her Congressional Testimony, even if, 10-year yields went down. U.S. economic data has a soft tone: NFIB Business Optimism Index came in lower than expected at 103.6, reflecting broad-based softness in the details of the survey; JOLTS job openings also came in lower than expected at 5.666 mn; Initial jobless claims underperformed expectations, coming in at 247,000; Additionally, continuing jobless claims were higher than expected at 1.945 mn. While data remains mixed, the Fed is still intent on tightening policy. The dollar will follow suit, especially if inflation moves as the Fed expects. Report Links: Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Data out of Europe this week was reasonably strong: Both exports and imports increased at a 1.4% and 1.2% monthly pace, respectively; The current account beat expectations; Industrial production increased by 4%, more than the expected 3.6%; However, despite this upbeat data, the euro remained largely flat this week. This behavior is justified from a technical perspective: the RSI is close to overbought levels; the MACD line is rolling over and closing the gap with the signal line; the number of speculators with long positions is at its highest level ever. The considerable weakness in EUR/SEK and EUR/NOK on Thursday shows underlying weakness in the euro. This decreases the likelihood that EUR/USD breaches the 1.15-1.16 zone. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Labor cash earnings yearly growth outperformed expectations and grew from last month, coming in at 0.7%. However, machinery orders yearly growth was far below expectations, coming in at 0.6%. In spite of the selloff in the dollar, USD/JPY has rallied by more than 1% since last week, stopping its ascent after hitting a key technical level at 114.5. We continue to be yen bears, even in the face of the declining popularity of Shinzo Abe: the champion for expansionary fiscal policy in Japan. Instead, we are confident that Abe will double down on fiscal spending as his decline in popularity has been precisely because he has strayed away from this key policy pillar which made him so popular. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Updating Our Intermediate Timing Models - April 28, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Halifax House prices grew by only 2.6% YoY, underperforming expectations of 3.1%. Industrial Production contracted by 0.2% year-on-year, also underperforming expectations. While the unemployment rate decreased, coming in at 4.5% and also beating expectations, average earning growth fell to 1.8%. After appreciating by almost 2% this week, and reaching 0.895, EUR/GBP has come down to 0.885, but the pound is likely to have short term downside against the euro. Furthermore, GBP/USD is also likely to have downside, as the pound is not as attractive as it was in the beginning of the year from a valuation standpoint. Indeed, sentiment has turned much more positive on the outcome of Brexit, which means that the significant discount in the pound has disappeared. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD has seen a broad-based increase this week, except for against the CAD. This increase has largely been a factor of Chinese data, although domestic conditions also played a role: Chinese exports and imports both increased at a 11.3% and 17.2% annual pace, respectively; China's trade balance in June was USD 42.77 bn, better than expected; Chinese new loans came in at RMB 1,540 bn; NAB Business Conditions and Confidence both beat expectations; However, investment lending for homes is still contracting at 1.4%, albeit at a lesser than expected pace of 2.3%; Also, home loans are increasing at a lesser than expected pace of 1%. We retain our view of the inherent weakness in the Australian economy, which will restrict the RBA from changing its view. This will weigh on the AUD in the near future. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 AUD/NZD has rallied by almost 1.3% since last week. This in part, was the market reaction to an approved housing infrastructure fund by Prime Minister Bill English worth NZ$1 Billion aimed at increasing the supply of housing in the country. This measure provides the RBNZ with some breathing room, as it is a policy aimed at cooling housing market, which has prices growing at a 14% rate. The increase in housing supply alleviates the pent up demand generated by the dramatic increase in population in New Zealand in recent years. The RBNZ is unlikely to join the BoC and the Fed this year, as they remain cautious, and have opted for macro prudential measures to eliminate any imbalances in the economy. Stay short the NZD against the dollar and the yen. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canada followed the footsteps of its partner in the south, joining the U.S. as the only two central banks in the G10 space raising interest rates. The Bank of Canada highlighted that "the adjustment to lower oil prices is largely complete" and that "both the goods and services sectors are expanding". Alberta's economy validates this stance as all sectors of the economy are growing at a very brisk pace. The BoC estimates that the output gap will now close at the end of 2017, instead of the previous forecast of the first half of 2018, further escalating their hawkish rhetoric. The press release noted that the recent restrain in inflationary pressures will be transitory, as "excess capacity is absorbed". Recent data corroborates this view with strong employment data and stronger than expected housing starts. USD/CAD declined 1.3% at the end of the day of the hike, and outperformed all other currencies. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Unemployment remains very low, coming in at 3.2% However, producer and import prices contracted by 0.1% year-on-year, coming below expectations and decreasing from the previous month. The low unemployment number is not the only indicator that shows a tight labor market, as employment is also growing at an astonishing 5% yearly rate. However, this tightness in the labor market is not translating to higher wages, as wages are growing at a paltry 0.6%, anchored by strong deflationary forces. Thus, the SNB will continue with their ultra-dovish monetary policy and with their interventions in the currency market. Nevertheless, we will monitor if the recent plunge in the CHF against the euro creates any kind of inflationary dynamics in the economy, and causes the SNB to rethink their stance. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Manufacturing output contracted by 0.3%, falling sharply from last month number. Additionally, although both core and headline inflation came above expectations at 1.6% and 1.9% respectively, they still fell from last month reading. The Krone has appreciated sharply the past week, with USD/NOK falling by 1.45% and EUR/NOK falling by 1.15%. This has been a result of the rebound in oil prices caused by the massive draws in inventories the past couple of weeks. Indeed, last week's number, which showed an inventory draw of 7.6 million barrels was the biggest since 2011. Overall, we expect that OPEC should be able to continue managing supply, and therefore, oil should rise until the end of the year. This will be negative for EUR/NOK. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The Riksbank's change in rhetoric was perfectly timed, as Sweden's economy is increasingly showing signs of strength. Data has outperformed these past two weeks: Manufacturing PMI came in at 62.4, beating expectations of 59.8; Industrial production increased at a 8% annual pace in May; Inflation in Sweden is firming, coming in at 1.7% in June and beating expectations. The SEK appreciated 0.7% against EUR, and 0.6% against USD. Markets are pricing in stronger growth and a further escalation of hawkish rhetoric from the central bank, especially as Stefan Ingves as tabulated to leave this Riksbank in a few months. Part of the reason for Sweden's strength is also a stronger European economy. With Germany leading the pack, Sweden's largest export partner is also lifting the largest Scandinavian economy. Report Links: Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades