Inflation/Deflation
Highlights We believe 2019 and 2020 will be a tale of two markets; … : The latter stages of the long post-crisis party may be rewarding, but the inflection points that will herald a bear market and a recession are not too far off. … the first will be broadly favorable for investors in risk assets, … : The combination of ample monetary accommodation and the indiscriminate fourth-quarter markdown in risk assets provides the springboard for one last advance. … but the second will mark the end of the post-crisis bull market, … : Nothing lasts forever, and we wouldn’t be overweight risk assets at this stage were it not for last quarter’s selloff. … as the Fed pulls the plug on the expansion: Our base-case scenario does not call for a deep or lengthy recession, but once Fed policy transits from accommodative to restrictive, the going will become much rougher for stocks, corporate bonds and the economy. Feature We spent the week of January 14th meeting with clients in South Africa. It is always good to exchange views with investors, especially when they are at a distant remove from the echo chamber which inevitably colors our perspective, no matter how much we try to resist it. It was also a pleasure to swap a week of winter at home for summer abroad, where our clients’ golf talk helped boil our views down to a simple analogy. We see the next twelve to twenty-four months as a double-breaker putt. 2019-20’s Double Breaker The undulating terrain of some golf-course greens sets up putts that break one way and then the other on their path to the hole. That is the way we view the next twelve-plus months, following the fourth quarter’s sharp, sudden tightening in financial conditions (Chart 1). The selloff pulled hard on the financial-condition reins, checking some of the pressure on the economy to overheat, and allowing the Fed to pause its rate-hiking campaign. Relieved investors immediately bid stocks higher, and corporate-bond spreads tighter, retracing nearly half of the tightening in financial conditions, but we expect the Fed to remain on the sidelines until June anyway. Chart 1A Swift Tightening In Financial Conditions A Fed pause delays the date when monetary policy will turn restrictive by a few months. We see the monetary policy inflection point as the key event presaging all of the inflection points that matter most to investors: the transition from an equity bull market to a bear market; the point at which credit performance deteriorates, and spreads widen, in earnest; and the transition from expansion to recession. The delay, and the lower entry points provided by the selloff, set the stage for a last hurrah in risk assets over the next six to nine months. With the Fed in the background, investors will be able to focus on the above-trend growth driven by the remaining fiscal thrust (Chart 2) and what we expect will be better calendar 2019 S&P 500 earnings than investors currently anticipate. Chart 2Fiscal Fuel Will Keep 2019 Growth Above Trend Better-than-expected conditions will ultimately prove to be self-limiting, however. The more momentum the economy gathers while the Fed is on hold, the more budding inflation pressures will become evident. The more that inflation pressures reveal themselves, the more forcefully the Fed will have to act to counter them. The upshot for investors is that the last burst of the good times will necessarily bring forth a slowdown, and they therefore confront a putt that will break twice over the next year or two: equities and spread product will outperform Treasuries and cash over the first stretch, but underperform over the next.1 Inflation Pressure Our oft-repeated view that the fiscal stimulus will promote inflation pressures is not at all controversial. Force-feeding stimulus into an economy already operating at capacity should lead to inflation. Businesses and other investors, recognizing that the above-trend boost in aggregate demand is temporary and unsustainable, will not expand capacity to meet it. Imports may relieve some of the pressure, but prices should nonetheless rise as aggregate demand exceeds aggregate supply. Inflation pressures emanating from the labor market provoke much more pushback. Investors, tired of hearing that a pickup in wages is right around the corner, harbor considerable doubts about the Phillips Curve, which posits that there is an inverse relationship between the unemployment rate and wage growth. We acknowledge that the 1960s belief in a mechanical tradeoff between inflation and unemployment – policymakers could have lower inflation if they were willing to tolerate higher unemployment, or lower unemployment if they were willing to tolerate higher inflation – was shattered by the stagflation of the 1970s. We further acknowledge that the relationship between unemployment and compensation is not linear. We continue to believe, however, that the laws of supply and demand apply, and that the relationship between compensation and unemployment has been slow to assert itself this time around because the Phillips Curve is kinked. That is to say that the sensitivity of wage growth to a drop in unemployment is a function of the level of the unemployment rate itself. A decline in unemployment from 10% to 9%, 9% to 8%, or 8% to 7% does not exert upward pressure on wages because there are many more qualified candidates than there are openings at such elevated unemployment rates (Chart 3, top panel). When the unemployment rate is 5% or less, on the other hand, wages do respond to unemployment declines because the lack of labor market slack ensures that employers have to compete to attract qualified candidates (Chart 3, bottom panel). Estimates of the United States’ natural rate of unemployment in recent years have typically hovered around 5%. Over the 50-plus years covered by the average hourly earnings (AHE) series, real AHE growth has tended to peak (Chart 4, bottom panel) following unemployment’s sub-natural-rate trough (Chart 4, top panel). It has not yet reached an elevated level, but wages did begin accelerating sharply a year after the unemployment gap turned negative in early 2017. With the unemployment rate on track to continue to fall throughout 2019 (it only takes about 110,000 net new jobs a month to hold it in place), we expect that real AHE growth has further to run. Chart 4Don't Count Dr. Phillips Out Just Yet Taking the analysis a step further to consider real wage growth relative to productivity growth exhibits an even stronger link with the unemployment gap. From the early ‘70s through 2001, when productivity and real wages grew at the same rate (Chart 5, middle panel), real wages fell behind productivity when the unemployment gap was positive and caught up when it was negative (Chart 5, bottom panel). Capital has seized a disproportionate share of the gains in productivity since 2002, with the real-wages-to-productivity ratio able to stabilize only when the unemployment gap turned negative from 2006 to 2008. Chart 5Productivity-Adjusted Real Wages Rise When Unemployment Bottoms We expect that the coming cyclical trough in the unemployment gap will be consistent with past troughs, which have been associated with cyclical peaks in compensation gains. The linkage between compensation and consumer prices isn’t firmly established, but investors don’t have to sweat it. As long as the Fed perceives a connection, which it clearly does, it can be counted upon to respond to higher wages by tightening policy. A swift recovery in oil prices – our Commodity & Energy Strategy service sees Brent crude averaging $80/barrel, and WTI averaging $74, across 2019 – will also help keep the Fed’s attention squarely focused on price stability after ten years of full-employment fixation. Bottom Line: Unnecessary fiscal stimulus will continue to exert upward pressure on prices, while an extremely tight labor market will place steady upward pressure on wages. The Fed will respond by removing accommodation, pushing the fed funds rate above the neutral level, and bringing down the curtain on the record-long expansion sometime in 2020. Upgrading Corporate Bonds We noted two weeks ago that the spread-widening in high-yield corporate bonds was extreme, and that overweighting spread product would mesh well with our renewed equity overweight. Our U.S. Bond Strategy colleagues have since upgraded credit,2 and we are following their lead. We now recommend that investors overweight equities, underweight fixed income and equal-weight cash. Within fixed income, we recommend that investors significantly underweight Treasuries while overweighting both investment-grade and high-yield corporate bonds. Consistent with our above-consensus inflation expectations, we prefer TIPs to nominal Treasuries. We harbor no illusions that a new credit cycle has begun. It is late in an already lengthy cycle, and we view the projected near-term decline in high-yield default rates as a final unwind of the default spike that accompanied the shale-drilling rout in 2016 (Chart 6). We do not expect a recession in 2019, but the next one is likely not too far off, and defaults begin to pick up well ahead of a recession. Our spread-product upgrade is an opportunistic short-term move, not a change in our cyclical view. Chart 6A New Credit Cycle Has Not Begun High-yield spreads widened so much in the fourth quarter, relative to their history, that their capital-gain prospects have flipped. We had been at equal weight, anticipating an eventual move to underweight, because spreads were unusually tight. The capital-gain stretch of the cycle was long gone, and excess returns over Treasuries were limited to coupon spreads that were likely to be eroded by capital losses as spreads widened ahead of an approaching recession. The lurch in spreads from the 25th percentile to the 75th percentile in double-B, B and triple-C bonds (Chart 7) restores potential capital gains as a cushion that should protect the coupon spread against unanticipated economic weakness. Chart 7Irrational Gloom The Fed’s newly conciliatory stance should support spread product just as it should support equities. All three monetary-policy elements of our bond strategists’ peak-spread checklist are issuing the all-clear signal: twelve-month fed funds rate hike projections have collapsed (Chart 8, second panel), gold has revived (Chart 8, third panel), and the dollar’s relentless upward march has finally been halted (Chart 8, bottom panel). Chart 8Monetary Policy Argues For Lower Spreads ... The jury is still out on the global-growth elements of our bond team’s peak-spread checklist. Our China Investment Strategy service’s Market-Based China Growth Indicator looks spry3 (Chart 9, third panel), and industrial mining stocks may be in the midst of bottoming (Chart 9, bottom panel), but the CRB raw industrials index is still scuffling (Chart 9, second panel). A blowout in spreads accompanied by a less-hawkish Fed and rebounding global growth would be a no-brainer reason to own spread product, but two out of three ain’t bad, and spreads would not have blown out in the first place if global growth were poised to surge. The biggest threat to our constructive economic and market views is a slowdown in China, and its uncertain direction is a risk to overweighting credit. On balance, though, we believe the current level of option- and default-adjusted spreads adequately compensate credit investors over the next three to six months, especially after factoring in the Fed’s benign turn. Chart 9... But The Jury's Still Out On Global Growth Bottom Line: We are upgrading spread product to take advantage of its fourth-quarter selloff and a Fed pause that may last until June, despite uncertainty around the global growth outlook. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com Footnotes 1 The wise men and women gathered at the Barron’s annual roundtable foresee a similar setup, but with the direction reversed. They expect markets and the U.S. economy to encounter rough going in the first half of 2019 before conditions become more hospitable in the second half and in 2020, ahead of the next election. “Goodbye to Gloom,” Rublin, Lauren R., Barron’s, January 14, 2019, pp. 21-34. 2 Please see the January 15, 2019 U.S. Bond Strategy Weekly Report, “Buy Corporate Credit,” available at usbs.bcaresearch.com. 3 Please see the November 21, 2018 China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem,” available at cis.bcaresearch.com.
Highlights The Eurostoxx600’s short bursts of outperformance require either global technology to underperform or the euro to underperform. EM’s short bursts of outperformance usually coincide with the global healthcare sector’s short bursts of underperformance. Remain tactically overweight to Europe and EM, but expect to reverse position later in the year. The ECB is justified in setting an accommodative monetary policy, but it is not justified in setting an ultra-accommodative monetary policy. Soft inflation prints will cap the extent to which bond yields can rise in the near term. Italian BTPs are an attractive long-term proposition, especially relative to other euro area bonds. Feature Chart of the WeekEuro Area Inflation Appears To Be Underperforming... ...But Adjusted For Its 'Negative Space' It Is Not “The music is not in the notes, but in the silence between” – Wolfgang Amadeus Mozart As Mozart pointed out, true awareness lies not in appreciating what is there, but in appreciating what is not there. This is the concept of ‘negative space’: to understand an object, you have to understand the empty space that defines it. This week’s report extends the concept of negative space into the fields of investment and economics to make more sense of Europe’s recent past and its future. The Negative Space In Stock Markets Picking stock markets is a relative game. This means that what a stock market does not contain – its negative space – is often more important than what it does contain (Table I-1). This is not an abstract proposition, it is a mathematical truth. When a major global sector is strongly outperforming, a stock market’s zero or near-zero exposure to that sector will create a strong headwind to relative performance. And when the major sector is underperforming, its absence in the stock market will necessarily create a strong tailwind to relative performance. For the European stock market, the negative space is technology, a sector in which European equities have a near-zero exposure. But there is another factor to consider: the currency. The technology sector’s global profits are mostly translated into shares quoted in dollars, while European equities’ global profits are mostly translated into shares quoted in euros. It follows that the Eurostoxx600’s short bursts of outperformance require at least one of the following two conditions (Chart I-2): Chart I-2The Eurostoxx600 Usually Outperforms When Technology Underperforms Technology to underperform. Or: The euro to underperform. For emerging market (EM) equities, the negative space is healthcare, a sector in which EM has a near-zero exposure. Therefore unsurprisingly, EM’s short bursts of outperformance usually coincide with the healthcare sector’s short bursts of underperformance (Chart I-3). Sceptics will raise an obvious question: what is the cause and what is the effect? The answer is that sometimes EM is the driver of healthcare relative performance, and at other times vice-versa. Chart I-3EM Usually Outperforms When Healthcare Underperforms A sharp slowdown emanating from emerging economies would undoubtedly drag down global equities. In the ensuing bear market, the more defensive healthcare sector would almost certainly outperform the financials. Under these circumstances the direction of causality would clearly be from EM to healthcare’s relative performance. On the other hand, absent a major bear market, in a common or garden reassessment of sector relative valuations versus their growth prospects, the causality would run in the other direction: sector rotation would drive the relative performance of equity markets: healthcare’s underperformance would help EM to outperform; and technology’s underperformance would help European equities to outperform. As we have explained in recent reports, the major sectors – and therefore the major stock markets – are now in this latter configuration in a brief countertrend burst before reverting to their structural trends later this year (Chart I-4 and Chart I-5). So for the time being, remain tactically overweight to Europe and to EM.1 Chart I-4The Eurostoxx600 Outperformance Is A Countertrend Burst Chart I-5The EM Outperformance Is A Countertrend Burst The Negative Space In European Inflation And Unemployment On the face of it, inflation is structurally underperforming in the euro area versus the U.S. But on closer examination this is only because of what the euro area harmonised index of consumer prices (HICP) does not contain: owner occupied housing costs – which tend to rise faster than other items in the price basket. Adjusting for this negative space in the HICP, the euro area and the U.S. have both achieved the exact same modest structural inflation, which their central banks define as ‘price stability’ (Chart of the Week). In a similar vein, the unemployment rate disregards changes in the labour participation rate. When people join the labour force – as they are in their tens of millions in Europe (Chart I-6) – the joining cohort tends to have a slightly higher unemployment rate given its inexperience in the formal labour market. So the joiners tend to lift the overall unemployment rate too. The paradox is that the percentage of the working age (15-74) population in employment also rises at the same time. Looking at this alternative measure of labour market health, the euro area employment market is in a structural uptrend and much healthier than it was at the peak of the last cycle in 2008 (Chart I-7). Chart I-6Europeans Are Joining The Labour Force In Their Tens Of Millions Chart I-7The European Employment To Population Ratio Is In A Structural Uptrend Hence, once we adjust for what is missing in euro area inflation and the euro area unemployment rate, neither inflation nor employment market performance appear to be too cold or too hot. This means that the ECB is justified in setting an accommodative monetary policy, but it is not justified in setting an ultra-accommodative monetary policy. The Negative Space In Monetary Policy The negative space in monetary policy is literally the negative space, by which we mean that interest rates cannot go deeply into negative territory. With the deposit rate already at -0.4 percent, the ECB’s room for manoeuvre in the dovish direction is limited. On the other hand, neither can monetary policy get meaningfully hawkish in the near term. The simple reason is that the ECB, like other central banks, is now even more wedded to ‘data-dependency’. The problem with this is that the data on which the central banks depend is always backward-looking. So policy will reflect what was happening one or two months ago, rather than what is happening now. Specifically, the plunge in the price of crude oil will depress both headline and core inflation rates (Chart I-8). And the recent wobble in risk-asset prices has weighed down some sentiment surveys (Chart I-9). Having promised to be data-dependent, the central banks have effectively created ‘an algorithm’ for their policy setting, an algorithm which everyone can see and read. It follows that the data, especially soft inflation prints, will cap the extent to which bond yields can rise in the near term. Chart I-8The Plunge In The Price Of Crude Will Subdue Inflation Chart I-9The Stock Market Sell-Off Hurt Sentiment However, core euro area bonds are an unattractive long-term proposition. When yields are so close to their lower bound, there is little scope for a capital gain, even in a crisis. Whereas the scope for a capital loss is considerably greater. By contrast, Italian BTPs are an attractive long-term proposition, especially relative to other euro area bonds. Almost all of the 2.75 percent yield on 10-year BTPs is a premium for euro break-up risk. Yet the populists in Italy do not want to break up the euro. And despite their rhetoric, neither do the populists in the core countries. To understand why, we must explain the negative space of ECB QE. When the ECB bought BTPs from Italian investors, what the Italian investors did not do was deposit the cash in Italian banks. Instead, they deposited it in German banks – something that we can see very clearly in the euro area’s mirror-image Target2 imbalances (Chart I-10). Chart I-10ECB QE Has Exacerbated The Target2 Imbalances In effect, the core countries, through their equity in the Eurosystem, are holding a huge quantity of Italy’s €2.7 trillion of BTPs. Meaning that if the euro broke up, the core countries would be the ones picking up the tab. For the euro area’s future, this is the most important negative space of all. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System* There are no new trades this week. But all four of our open trades – long PKR/INR, industrials versus utilities, litecoin and ethereum, and MIB versus Eurostoxx – are in profit. 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. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Footnotes 1 Please see the European Investment Strategy Weekly Report, “Why 2019 Is The Mirror-Image Of 2018”, dated January 10, 2019, available at eis.bcaresearch.com. Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Yield Curve Drivers: A rebound in rate hike expectations will cause the curve to steepen somewhat during the next few months, though accelerating wages limit the upside. The yield curve will not invert until after long-dated inflation expectations are fully re-anchored, probably not until late in the year. Yield Curve Positioning: Correlations that have been in place since the financial crisis show that the 5-year and 7-year maturities are most sensitive to changes in near-term rate hike expectations. With the discounter likely to move higher in the coming months, investors should favor yield curve trades that are short that portion of the curve. Investment Recommendation: Close our recommended long 2-year short 1-year/5-year trade for a profit of 2 bps. Replace it with a position short the 7-year bullet and long a duration-matched 2-year/30-year barbell. Feature The yield curve flattened throughout most of 2018, and actually fell enough that talk of curve inversion hit a fever pitch last November, around the same time that the market started to doubt the Fed’s ability to lift rates (Chart 1). As of today, the 2/10 Treasury slope sits at a mere 17 basis points, but we don’t see it falling below zero any time soon.1 Chart 1Too Soon For Curve Inversion In this week’s report we consider the factors that will determine how the slope of the curve evolves over the next few months, and also recommend an investment strategy to take advantage of those movements. Yield Curve: Macro Drivers Driver 1: Rate Hike Expectations The number one factor that will influence the slope of the yield curve in the coming months is the market’s assessment of the near-term path for Fed rate hikes. Chart 2 shows the 5-year rolling correlation between monthly changes in the 2/10 slope and monthly changes in our 12-month Fed Funds Discounter. A positive correlation means that the 2/10 slope steepens when the market prices in more rate hikes and flattens when it prices in fewer hikes. A negative correlation means that the slope flattens when the market prices in more hikes and steepens when it prices in fewer hikes. Chart 2Rising Rate Expectations = Steeper 2/10 Slope The correlation was consistently negative throughout the pre-crisis period because the 2-year yield reacted more to changes in near-term rate hike expectations than the 10-year yield. In other words, a given increase (decrease) in the discounter would lead to a larger increase (decrease) in the 2-year yield than in the 10-year yield, and the curve flattened (steepened) as a result. But this correlation flipped following the Great Recession. Zero-bound interest rates and Fed forward guidance were an important reason for the switch. But even during the past few months, as the 12-month discounter fell from 66 bps in early November to -1 bp currently, the 10-year yield fell by 45 bps and the 2-year yield by only 36 bps. Even with interest rates off zero and the Fed scaling back its forward guidance, the positive correlation between the 2/10 slope and the 12-month discounter persists. We think that the 12-month discounter is close to its near-term bottom. Our Fed Monitor has fallen somewhat in recent months but it remains above zero, suggesting that the economy requires further monetary tightening (Chart 3). A look at the three components of our Monitor gives us even more confidence that the discounter is near its trough. The economic growth component of the Monitor is nicely above zero (Chart 3, panel 3), and the inflation component continues to trend up (Chart 3, panel 4). All of the Fed Monitor’s recent weakness can be attributed to tighter financial conditions (Chart 3, bottom panel). As we discussed in last week’s report, now that the market views Fed policy as much more accommodative, it is only a matter of time before financial conditions ease.2 Chart 3Fed Monitor Still Suggests Tightening In fact, some easing has already begun (Chart 4): Chart 4Financial Conditions Starting To Ease The stock-to-bond total return ratio has bottomed (Chart 4, top panel) High-Yield spreads have peaked (Chart 4, panel 2) The VIX has moderated (Chart 4, panel 3) The trade-weighted dollar has started to depreciate (Chart 4, bottom panel) Ironically, easier financial conditions will give the Fed the green light to re-start rate hikes, probably by June, and this could re-test risk assets in the second half of the year. But between now and then, a move higher in 12-month rate expectations will apply some steepening pressure to the 2/10 slope. Driver 2: Inflation Expectations Instead of looking at nominal yields and rate hike expectations, another approach is to split yields into their real and inflation components. This is potentially revealing in the current environment since a large portion of the recent drop in yields was driven by the cost of inflation compensation. Since the November 8 peak in the discounter, the cost of 10-year inflation protection fell 26 bps and the real 10-year yield fell 19 bps. The cost of 2-year inflation protection declined 46 bps while the real 2-year yield actually rose 10 bps. Based on those numbers, it is evident that when the cost of inflation compensation fell alongside the oil price, it exerted a steepening pressure on the yield curve that was offset by a flattening in the real yield curve. One might conclude that a rebound in inflation will cause the curve to flatten going forward. That is probably true in the event of a pure inflation shock that does not impact global growth. But such a shock is highly unlikely. Oil (and other commodity) prices fell during the past few months because of a slowdown in global growth. A rebound in commodity prices that drives inflation higher will almost certainly occur alongside stronger global growth. In other words, splitting nominal yields into the real and inflation components probably doesn’t get us any closer to figuring out the near-term path for the yield curve. A better way to incorporate the cost of inflation compensation into our thinking about the yield curve is to focus on the 5-year/5-year forward TIPS breakeven inflation rate. That rate is currently 1.99%, well below the range of 2.3%-2.5% that has historically been consistent with well-anchored inflation expectations (Chart 5). Chart 5Inflation Expectations Are Too Low For The Fed It is difficult to believe that the Fed would allow the yield curve to invert with the 5-year/5-year breakeven rate so low. The combination of an inverted yield curve and below-target inflation expectations would signal that the Fed wants to run a restrictive monetary policy before inflation has fully recovered. That would be completely contrary to the Fed’s mandate. From this argument, we reason that the 2/10 slope is unlikely to sustainably fall below zero until the 5-year/5-year forward TIPS breakeven rate is at least above 2.3%. With the 2/10 slope already at 17 bps, this means it is much more likely to stay near its current level or steepen somewhat during the next few months. Driver 3: Wage Growth The third factor driving our yield curve view is the pace of wage growth. Stronger wage growth is tightly correlated with a flatter yield curve, though the yield curve tends to lead wage growth by 6-12 months (Chart 6). Chart 6A Flatter Curve Leads Faster Wage Growth Higher Wage Growth = Flatter Curve In fact, a typical cyclical pattern is for the 2/10 slope to flatten rapidly and then stay at a low (but positive) level for some time as wage growth catches up. In that sense, this cycle is playing out just like every other. The yield curve has already undergone its large flattening and wage growth is now accelerating to catch up. Bottom Line: The three factors discussed above lead us to expect a small amount of curve steepening during the next few months. A rebound in rate hike expectations due to easier financial conditions will cause the curve to steepen, though accelerating wages limit the upside. The yield curve will not invert until after long-dated inflation expectations are fully re-anchored, probably not until late in the year. Yield Curve Positioning In the first section of this report we noted that the 10-year yield fell by more than the 2-year yield between the early-November peak in the 12-month discounter and today. But Table 1 shows that the 5-year and 7-year yields fell by even more. This is the expected result. Table 1Treasury Curve From Peak In 12-Month Discounter To Present Turning once again to the correlations between different segments of the yield curve and our 12-month discounter, we see that yield curve segments out to the 5-year maturity point are all positively correlated with the 12-month discounter. Also, curve segments beyond the 7-year maturity point are all negatively correlated with the discounter. The 5/7 slope has virtually no correlation (Chart 7). Chart 75-Year & 7-Year Are Most Sensitive To Rate Expectations These correlations tell us that we should expect the 5-year and 7-year yields to move the most in response to changes in the 12-month discounter. In other words, if we expect the discounter to move higher in the coming months we should maintain short exposure to this part of the curve. This short exposure should be offset by long exposure at either the very short-end or the very long-end of the curve, where yields will see less upside when the discounter rebounds. To figure out where to focus this long exposure we can turn to our butterfly spread models.3 Table 2 presents the raw residuals from our butterfly spread models. These models are based on regressions of different butterfly spreads versus the slope of the yield curve segment that spans the two wings of the barbell portion of the trade. For example, Table 2 shows a residual of -9 bps for the 5-year bullet relative to the 2/10 barbell. This means that the 5-year appears 9 bps expensive versus the 2/10 barbell, given where the slope of the 2/10 curve is today. Table 3 shows the standardized residuals from the different curve models so that they can be compared against each other. Table 2Butterfly Strategy Valuation: Residuals Table 3Butterfly Strategy Valuation: Standardized Residuals Notice in Tables 2 and 3 that almost all of the numbers are negative. This means that bullet trades are currently expensive relative to barbell trades. Using our criteria of wanting to be short the 5-year or 7-year part of the curve, we can use the tables to see that a position short the 7-year bullet and long the duration-matched 2-year/30-year barbell has an attractive standardized residual of -1.00. This appears to be the most attractive curve trade for the current environment. As such, today we close our current yield curve recommendation to favor the 2-year bullet over the 1-year/5-year barbell for a gain of 2 bps. This recommendation had been in place since November 5. In its place, we initiate a recommendation to go long a duration-matched barbell consisting of the 2-year and 30-year maturities and short the 7-year note. Bottom Line: Correlations that have been in place since the financial crisis show that the 5-year and 7-year maturities are most sensitive to changes in near-term rate hike expectations. With the discounter likely to move higher in the coming months, investors should favor yield curve trades that are short that portion of the curve. With that in mind, we close our 2-year over 1-year/5-year trade and initiate a position short the 7-year bullet and long a duration-matched 2-year/30-year barbell. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 We don’t expect to see sustained yield curve inversion until late this year. For further details please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com 3 For further details on the models please see U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Because inflation has remained contained, the Fed feels comfortable adopting a more dovish policy stance in response to tighter financial conditions. Looking at its monthly changes, core CPI has increased by roughly 0.2% in each of the past three months.…
Highlights Corporates: The same indicators that called the early-2016 peak in credit spreads are once again sending a positive signal. Investors should tactically increase exposure to corporate bonds at the expense of Treasuries. Duration: Treasury yields will rise in the coming months as credit spreads tighten and financial conditions ease. Maintain below-benchmark portfolio duration. TIPS: The 10-year TIPS breakeven inflation rate has fallen too far, and it is now well below the fair value reading from our Adaptive Expectations model. Remain overweight TIPS versus nominal Treasury securities. Feature We continue to view the 2015/16 episode as the appropriate comparable for current market behavior, and the same indicators that called the early-2016 peak in credit spreads are once again sending a positive signal. As such, we recommend increasing portfolio allocations to both investment grade and high-yield corporate bonds at the expense of Treasury securities (see the Recommended Portfolio Specification Table on the last page of this report). Importantly, our cyclical view of the credit cycle has not changed. Elevated corporate debt balances and a relatively flat yield curve suggest that we are in the awkward middle phase of the cycle when excess returns from corporate credit tend to be positive, but low.1 However, recent spread widening has been excessive for this middle phase of the cycle, and we expect spreads to tighten from oversold levels during the next few months. Three Reasons To Upgrade Credit (& One Key Risk) Reason 1: Elevated Spreads The first reason to upgrade corporate credit is the attractive entry point (Chart 1). Outside of the Aaa space, 12-month breakeven spreads for every credit tier (encompassing both investment grade and junk) are above their respective historical medians. For example, the 12-month breakeven spread for the Baa credit tier is at 59%. This means that the spread has been tighter than its current level 59% of the time since 1988 and wider than its current level 41% of the time. Historically, spreads tend to hover within the tight-end of their historical range during this middle phase of the credit cycle, and only cheapen significantly when the yield curve inverts and the default rate moves higher. Chart 1Corporate Bonds: Attractive Entry Point Reason 2: Fed Capitulation The 2015/16 roadmap is applicable to the current market because in both cases credit spread widening was driven by the combination of weaker global growth and relatively hawkish Fed policy.2 With that in mind, an important pre-condition for spread tightening is a shift in the market’s expectations for Fed policy. Investor psyche must change from viewing monetary policy as restrictive to viewing it as accommodative. Chart 2 shows the three indicators we’ve been monitoring to signal when this shift occurs. All three called the early-2016 peak in credit spreads, and all are sending a strong buy signal at the moment. Chart 2Fed Capitulation Indicators Send A Strong Signal... Our 12-month Fed Funds Discounter, the change in the fed funds rate that is priced into the overnight index swap curve for the next 12 months, has collapsed from an early-November peak of 66 bps all the way to -4 bps (Chart 2, top panel). The gold price has also rebounded smartly (Chart 2, panel 2). Gold tends to rally when the market perceives that monetary policy is becoming more accommodative because the increased risk of future inflation makes gold’s “store of value” characteristics more appealing.3 Finally, the trade-weighted dollar has started to depreciate (Chart 2, bottom panel). This signals that U.S. monetary policy is easing relative to the rest of the world, and is historically correlated with stronger global growth. Reason 3: Imminent Global Growth Rebound The high-frequency global growth indicators that called the early-2016 peak in credit spreads are not sending as strong a signal as the monetary policy indicators, but there has been some positive movement (Chart 3). Chart 3...While There Is Positive Movement In Global Growth Indicators The CRB Raw Industrials index has only flattened-off in recent weeks (Chart 3, top panel), but the Market-Based China Growth Indicator created by our China Investment Strategy team has been rising quickly (Chart 3, panel 2).4 Finally, the price of global industrial mining stocks is no longer in free-fall. Rather, it is showing some signs of stabilization (Chart 3, bottom panel). Of the six indicators shown in Charts 2 and 3, four are sending strong buy signals and the other two are more or less neutral. In sum, we think this is enough of a signal to upgrade exposure to corporate bonds. One Key Risk The key risk to our tactical upgrade is that there is no follow-through from Fed easing to stronger global growth. In 2016, Fed capitulation coincided with a ramp-up in Chinese stimulus efforts. Chart 4 shows that our China Investment Strategy team’s Li Keqiang Leading Indicator moved sharply higher in early 2016.5 Moreover, all six components of the indicator participated in the uptrend. At present, only some components of the Leading Index have rebounded and the overall index has merely leveled-off. Chart 4Chinese Growth Is The One Key Risk When it comes to Chinese growth, a trade deal with the U.S. would certainly help matters. However, the risk remains that Chinese policymakers continue to curb credit growth so much that the pass through from easier Fed policy to global growth is weaker than in 2016. Bottom Line: With Fed rate hikes priced out of the market and signs of stabilization in high-frequency global growth indicators, the toxic combination of tight Fed policy and weak global growth is disappearing. This should allow credit spreads to tighten from current oversold levels. The rapid shift in monetary policy expectations makes us think that spread tightening could occur over a relatively short timeframe. As such, we would recommend this upgrade only to tactical (3-6 month) investors. Those with longer investment horizons may be better served by waiting for spreads to tighten and then using that opportunity to reduce cyclical corporate bond exposure. A Note On Portfolio Duration As mentioned above, the market has completely priced out Fed rate hikes. At present, the overnight index swap curve discounts 4 bps of rate cuts over the next 12 months and 17 bps of rate cuts over the next 24 months. This shift in market rate expectations is the main reason for our rosier outlook on corporate spreads, but it’s important to remember that the causation between credit spreads and policy expectations runs both ways (Chart 5). It is the recent spread widening and sharp tightening in financial conditions that caused the Fed to adopt a more accommodative policy stance in the first place (Chart 6). In the background, the U.S. economic data remain robust. The New York Fed’s GDP Nowcast model projects above-trend real GDP growth of 2.5% in 2018 Q4 and 2.1% in 2019 Q1. The corollary is that once credit spreads tighten and financial conditions ease, the Fed will have no further reason to stay on hold. Chart 6Financial Conditions Likely Going To Ease Going Forward If financial conditions ease during the next few months, as we expect, then it is very likely that the Fed will be ready to lift rates again at the June FOMC meeting. The fed funds futures curve currently discounts less than a 20% chance of that happening. Bottom Line: The U.S. economic data are solid. The sharp fall in rate hike expectations and Treasury yields is purely a reaction to tighter financial conditions. Treasury yields will rise in the coming months as credit spreads tighten and financial conditions ease. Maintain below-benchmark portfolio duration. Inflation & TIPS The main reason why the Fed feels comfortable responding to tighter financial conditions by adopting a more dovish policy stance is that inflation remains well contained. Last week’s CPI report showed that core CPI grew by 2.2% in 2018, somewhat below levels that are consistent with the Fed’s target (Chart 7).6 Chart 7Inflation Remains Well Contained Looking at the monthly changes, we also see that core CPI has increased by roughly 0.2% in each of the past three months. This translates to an annualized rate of approximately 2.4%, in line with the Fed’s target (Chart 8). The monthly changes shown in Chart 8 also reveal that the year-over-year growth rate in core CPI will almost certainly decline next month when the strong 0.35% print from last January falls out of the trailing 12-month sample. Chart 8Muted Inflationary Pressures For Now However, after next month base effects start to turn supportive. Our Base Effects Indicator, an indicator that compares rates of change in core CPI ranging from 1 to 11 months, predicts that year-over-year core CPI inflation will be higher six months from now (Chart 9). Chart 9Expect Higher Inflation Six Months From Now The conclusion is that inflationary pressures appear muted right now, and will continue to appear muted through the end of February. However, we expect them to ramp up again as we head into March. Come June, it is quite likely that the Fed will be feeling the pressure to lift rates as inflation approaches target. Coincident with a renewed uptick in inflation, TIPS breakeven inflation rates are also biased higher during the next six months. Slowing global growth and falling oil prices drove long-maturity breakevens lower during the past few months, with the result that the 10-year TIPS breakeven inflation rate is now 1.83%, 14 bps below the fair value reading from our Adaptive Expectations model (Chart 10).7 Chart 10Message From Our Adaptive Expectations Model Our Adaptive Expectations model contains three independent variables: The 10-year trailing rate of change in core CPI (Chart 10, panel 3) The 12-month trailing rate of change in headline CPI (Chart 10, panel 4) The New York Fed’s Underlying Inflation Gauge (Chart 10, bottom panel) Of those three variables, the 10-year trailing rate of change in core CPI carries the largest weight. This long-run measure of core inflation is currently running at an annualized pace of 1.83%. This translates roughly to an average monthly increase of 0.15%. In other words, as long as monthly core inflation prints above the 0.15% level, the fair value from our Adaptive Expectations model will continue to rise. Bottom Line: Core inflation has been steady during the past few months, but base effects will turn positive after next month’s report. This means that we will probably see higher year-over-year core CPI inflation in six months. With the 10-year TIPS breakeven inflation rate already well below the fair value reading from our Adaptive Expectations model, we expect TIPS will outperform nominal Treasuries during the next six months. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “An Oasis Of Prosperity?”, dated August 21, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “A Signal From Gold?”, dated May 1, 2018, available at usbs.bcaresearch.com 4 For further details on how this indicator is constructed please see China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com 5 The Li Keqiang Leading Indicator is a composite indicator of money and credit growth measures designed to predict changes in the Li Keqiang Index (a coincident indicator of Chinese economic activity). For further details on how the Leading Index is constructed please see China Investment Strategy Special Report, “The Data Lab: Testing The Predictability Of China’s Business Cycle”, dated November 30, 2017, available at cis.bcaresearch.com 6 The Fed targets 2% PCE inflation. CPI inflation tends to run about 0.4%-0.5% higher than PCE, which means the Fed’s target is roughly 2.4%-2.5% for CPI. 7 For further details on the model please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Falling gasoline price weighed on headline CPI, pushing its month-to-month change into negative territory for the first time since March 2018. The reading was in line with expectation. Meanwhile, U.S. core CPI rose 0.210% month over month in December, or an…
Highlights Survey data are easing, but that should not come as a surprise: The economy should decelerate as fiscal thrust is dialed back. Just a little patience (yeah-eah): A chorus of Fed speakers have taken to the podiums to reassure the public that the FOMC is taking its concerns seriously. The labor force participation rate popped in December, but investors shouldn’t count on it to produce a Goldilocks dual-mandate outcome: The demographic obstacle to continued part-rate gains is formidable. It is too early to de-risk portfolios: We remain constructive on risk assets and the economy. Feature Walking past flat-screen TVs during the workday has become considerably more pleasant. CNBC has switched out its red-drenched Market Sell-Off backdrop for a bright-green backdrop framing cheerful messages like, “Stocks are on track to rise for the third day in four.” In the ten sessions following Christmas Eve, the S&P 500 gained a stout 10%. Even a sharply negative preannouncement from Apple, and the prospect that 8% of Amazon’s outstanding shares could eventually hit the market, failed to halt the upward march. Only the disappointing December ISM Manufacturing survey has managed to bother the equity market over the course of the snapback rally, but the disappointment was quickly forgotten upon the next morning’s release of the gangbusters December employment report. The down-2.5%-one-day-up-3.5%-the-next action highlighted the fragility of the investor psyche. Markets are deeply uncertain about the economy, and how the Fed’s rate-hiking campaign will impact it. This week, we consider the evidence from the ISM and NFIB surveys, the recent wave of comments from Jay Powell and the regional Fed presidents, and the labor market to reassess our outlook for financial markets and the economy. Survey Says Over the first two weeks of January, the ISM surveys, the NFIB small business survey and the Job Openings and Labor Turnover Survey (JOLTS) all indicated slowing in their subject areas. An investor could point to them as evidence that the expansion is on its last legs, but we interpreted them as mixed, and do not see them as an argument for de-risking portfolios. Recall that the economy grew so far above trend in 2018 because of a generous helping of fiscal stimulus; as the stimulus is throttled back, the economy will decelerate. Markets had already factored the survey results into their expectations and took them in stride (Chart 1). Chart 1Soft Data Are Not A Surprise The magnitude of the weakness in the manufacturing ISM survey did come as a surprise. Beneath the headline (Chart 2, top panel), the employment reading slipped (Chart 2, second panel) and prices paid plunged (Chart 2, third panel), suggesting that the economy may not be so robust after all, but at least stagflation is not yet a concern. New orders, the component with the best leading properties, fell a whopping eleven points to get uncomfortably close to the boom/bust line (Chart 2, bottom panel). Chart 2Manufacturing May Be Wobbling, ... Manufacturing accounts for a modest share of U.S. employment and output, and we don’t dwell too much on it per se, but it may provide a window into global conditions. Trade tensions’ impact on global growth has been our foremost worry this year, and it is possible that the weakening manufacturing ISM points to weakness in the global economy. The U.S. is fairly inured from global weakness relative to other economies, but there is no such thing as decoupling. Weakness in the rest of the world will eventually make itself felt in the U.S., and we are watching the trade climate and global conditions carefully. The services ISM also declined more than expected, but a reading in the 57-58 range is strong, and points to an economy growing above trend. Employment (Chart 3, second panel) and new orders (Chart 3, bottom panel) both remain at or above a standard deviation above the mean. It is often true that markets care more about incremental changes than levels, but it is not an always-and-everywhere rule. In the context of an economy operating well above capacity, some slowing is both inevitable and desirable. We will watch the services ISM for signs of continued slowing, but we do not yet see any cause for concern. Chart 3... But Services Are Still Strong Small-business optimism continues to support a constructive take on the economy, despite the modest pullback in the NFIB survey and some of its key components. The headline index has come off of the all-time highs it set in 2018, but remains at very high levels relative to history (Chart 4, top panel). Job openings hit an all-time high in December (Chart 4, second panel), underscoring the message from the persistently strong payrolls data, and the share of small businesses deeming it a good time to expand (Chart 4, third panel) and that plan to expand headcount over the next three months (Chart 4, bottom panel) are well above one-standard-deviation levels. Surveys are soft data, but both the headline optimism index and the good-time-to-expand component have begun to slide well in advance of the last three recessions, suggesting they’re useful leading indicators. Chart 4Small-Businesses Are Still Bulled Up As strong as the employment picture has been, it is only a coincident indicator. The dot-com recession took employers (Chart 5, top panel) and job-hopping employees (Chart 5, bottom panel) by surprise, but there is nothing in the rate of job openings or quits in the JOLTS (Job Openings and Labor Turnover Survey) data that should inspire concern about the state of the economy. The series are off their highs, but there’s nothing to worry about at their still-elevated levels. Chart 5Softer, But Hardly Soft Bottom Line: Survey data have weakened as fiscal stimulus has waned, just as investors should have expected. We are keeping a close eye on the new orders component of the ISM Manufacturing survey, but nothing in the services ISM, NFIB or JOLTS surveys merits too much concern. FOMC Members Speak (And Speak, And Speak) The New Year brought an avalanche of comments from FOMC members. Chairman Powell, Vice Chairman Clarida, and seven regional presidents gave speeches, made appearances, or sat for interviews in the first two weeks of January, and New York Fed president Williams gave a long interview to CNBC two days after the December meeting. Away from uber-dove Bullard (St. Louis), who warned in a Wall Street Journal interview that further rate hikes could tip the economy into a recession, the various officials stressed the Fed’s open-mindedness. (Bullard, who is an FOMC voter this year, has repeatedly urged caution about hiking too much.) The overall thrust of the remarks has been to accentuate the FOMC’s commitment to go where the data lead. Echoing the language in the December minutes, several speakers noted that the Fed can be “patient,” given that inflation shows no signs of breaking out. The impact has been to soothe markets, which seem to be acutely concerned that rate hikes might go too far. (Though the speakers did little to ease concerns about balance-sheet reduction, or “quantitative tightening,” the Treasury, corporate-bond, and equity markets retraced much of their risk-off moves anyway.) Jay Powell set the tone for the overall message in a public appearance on January 4th, when he said the Fed “was listening sensitively to the message the markets are sending.” He underlined the data-dependency theme in an appearance last week, in which he said that, “we can be patient and flexible and wait and see what does evolve, and I think for the meantime, we’re waiting and watching. You should anticipate that we’re going to be patient and watching, and waiting and seeing.” His FOMC colleagues took care to drive home the same talking points, noting that data dependency includes following sentiment surveys, talking with business contacts, and watching markets. The speakers and the minutes also highlighted the discrepancy between robust 2018 growth of at least 3% and the much gloomier outlook implied by financial markets’ dreadful fourth quarter. None of the sensitive listeners disregarded the markets’ concerns, though Boston president Rosengren suggested that the markets may have gotten carried away. “My own view is that the economic outlook is actually brighter than the outlook one might infer from recent financial market movements.” Although we think the Fed will hike several more times before reaching this cycle’s terminal fed funds rate, the uniformity of the FOMC member comments leads us to expect that it will take a break, perhaps until June. Bottom Line: Our terminal fed funds rate estimate remains considerably higher than the money market’s, but we expect the Fed will pause for a few meetings. A pause may soothe markets and unwind the tightening of financial conditions that occurred in the fourth quarter, clearing the way for the Fed to resume its tightening campaign. Labor-Market Goldilocks The December employment report pointed the way to an outcome that could satisfy financial markets and FOMC doves like Minneapolis president Kashkari. Despite the outsize expansion in nonfarm payrolls, the unemployment rate rose by two ticks because of a surge in labor force participation. Last week, Kashkari attributed his ongoing aversion to rate hikes to the possibility that there’s more slack in the labor market than the committee may realize. “There might be a lot more people out there that we just don’t know [about] that are uncounted. Let’s go figure that out, and if we see inflationary pressures building, we can always hike rates then.” If the participation rate rises at a pace that allows new labor supply to offset continuing demand for workers, expanding payrolls don’t have to exert any generalized upward pressure on wages. Absent upward wage pressure, inflation could easily remain well-behaved. One month doesn’t make a trend, but December’s 63.1% reading brought the part rate back to the top of the range that has been in place for five years (Chart 6). A breakout could point the way to a Goldilocks outcome of inflation-free employment gains, but demographics suggest that there’s a limit to how much the part rate can advance. Chart 6Back To The Top Of The Range The demographic drag on participation is largely a function of the baby boomers’ extended departure from the work force. AARP estimates that at least 10,000 of them turn 65 every day, and will continue to do so into the 2030s. Boomer employment was in its heyday in the late ‘90s, when potential participation exceeded 67% (Chart 7, top panel), and all of the baby boomers were in their prime working years.1 Now that they are exiting the labor force in a lengthy procession, labor force participation is swimming upstream, and it may not be able to do much more than hold the level it’s maintained since 2014. Chart 7How Much More Slack? The shrinking supply of discouraged workers (workers who would start a job tomorrow if they were offered one, but are no longer actively looking for work and are therefore not counted as unemployed), suggests that much of the slack in the labor market has already been consumed (Chart 7, bottom panel). The disability rolls could be a source of Kashkari’s “uncounted” potential workers, however. The share of idled workers receiving disability benefits rose after the crisis (Chart 8), accounting for some of the widening gap between the part rate and the demographically-adjusted part rate. It is possible that some people who weren’t truly disabled will be motivated to come back to work, and their return to the work force may account for some of the pickup in participation, but our best guess is that they represent no more than a marginal source of labor supply. Chart 8Disability Claimants Won't Save The Day Bottom Line: The available evidence suggests that the labor market is quite tight. We expect that upward wage pressures will become increasingly apparent across 2019. Investment Implications An increasingly conciliatory Fed offers additional support for our equity overweight. A Fed pause might relieve some upward pressure on interest rates, but we expect that relief will only be temporary. As financial markets heal, easier financial conditions will clear the way for the Fed to resume its rate-hiking campaign. The sharp decline in Treasury yields at longer maturities only increases our conviction in underweighting Treasuries and maintaining below-benchmark duration positioning in all bond portfolios. As we noted last week, we think the high-yield bond market overreacted last quarter. Against a benign default outlook for 2019, 200 basis points of spread-widening seems extreme. A spread-product upgrade would fit with our equity upgrade, but we will wait until our U.S. Bond Strategy colleagues complete their review of their own recommendation before we consider changing our call. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com Footnotes 1 Workers between the ages of 25 and 54, inclusive, are considered to be in their prime working years. The boomers were born between 1946 and 1964, and they were all in their prime working years from 1989 (when the youngest cohort turned 25) to 2000 (when the oldest cohort turned 54). 2018 was the last year that any of the boomers were between 25 and 54.
BCA has previously argued that the Phillips curve is “kinky” – that is it tends to be flat when unemployment is high, but to steepen sharply once unemployment falls below 5%. With the unemployment rate likely stuck below 4% for this year, wage growth will…
Highlights Are Markets Too Pessimistic On U.S. Growth & Inflation? What Is China’s Economic Pain Threshold To Trigger A Policy Response? Have Central Banks Become Less Concerned About Financial Markets? Feature Happy New Year! 2019 has started much like 2018 ended, with elevated global market volatility. The combination of more evidence of slowing global growth – fueled by spillovers from U.S.-China trade tensions – and central banks perceived to be overly hawkish has crushed investor sentiment. Money has flooded out of risk assets like equities and corporate debt and shifted into the traditional safe haven assets – government bonds, surplus currencies like the Japanese yen and even gold. U.S. equities and credit, which had been a refuge from the global market weakness for much of last year, have underperformed sharply as markets have moved to price in the global economic softness reaching U.S. shores. These market trends obviously run counter to our recommended positioning for overall portfolio duration (below benchmark) and credit exposure (neutral overall, favoring the U.S. over Europe and Emerging Markets). Yet we advise staying the course with our recommendations, as market pricing has become too pessimistic relative to likely global growth and inflation outcomes. The bulk of the recent decline in global bond yields has come from falling inflation expectations, which have been linked to the sharp fall in oil prices seen in the final months of 2018 (Chart of the Week). This is shown in Table 1, which presents the breakdown of the decline in the 10-year benchmark government bond yields for the major developed markets since the peak in U.S. Treasury yields back on November 8. Real yields have fallen by a more modest amount than inflation expectations in most countries, even with the pullback in cyclical indicators like the global PMI. Expected 2019 rate hikes are now fully priced out of money market curves, most notably in the U.S. Chart of the WeekSlowing Growth Is Not Why Yields Have Plunged Table 1Decomposing 10-Year Yield Changes Since The November 2018 Peak In our view, there are three vital questions regarding the recent market turbulence that must be answered before determining the appropriate global fixed income investment strategy over the next 6-12 months. The answers lead us to maintain our current recommendations on duration, country allocation and credit exposure, even with the recent market turbulence. 1) Are Markets Too Pessimistic On U.S. Growth & Inflation? The December reading for the U.S. ISM Manufacturing purchasing managers’ index (PMI) released last week showed the largest single month deceleration since 2008 (Chart 2). All the main subcomponents of the ISM index fell, including the New Orders and Export indices which are now close to falling below the 50 threshold (Chart 3). Coming on the heels of China’s PMI dipping below 50, markets became more worried that the mighty U.S. economy was being dragged down to the weaker pace of growth seen outside the U.S. Chart 2Decomposing 10-Year Yield Changes Since The November 2018 Peak Chart 3U.S. ISM Overstating U.S. Economic Weakness Yet when looking a broader array of U.S. indicators, the domestic economy still appears to be in good shape, albeit with some lost growth momentum. Consumer confidence remains solid, employment growth is accelerating, household incomes are growing at a faster pace and the personal savings rate remains elevated – all of which provide support for a faster pace of consumer spending (third panel). At the same time, the U.S. Conference Board leading economic indicator is still pointing to a healthy above-trend pace of GDP growth in 2019. U.S. Treasury yields have fallen to levels consistent with the drift lower in the ISM index (top panel), with the market now discounting one full 25bp rate cut to occur within the next twelve months. That will not happen given the tightness of the U.S. labor market and persistence of underlying domestic inflation pressures. The robust December gain reported in last Friday’s U.S. Payrolls report (+312k) may have surprised the markets, but our U.S. Employment Growth model had been signaling a faster pace of job growth for the past several months (Chart 4). The year-over-year growth in Average Hourly Earnings rose to 3.2%, the highest level in nearly a decade. With the overall unemployment still at a historically low 3.9% as labor demand is increasing, wages are likely to remain under upward pressure in the next 6-12 months. Chart 4U.S. Employment & Wages Are Accelerating Given this backdrop of economic growth that is likely to remain above-trend throughout 2019, it will be difficult to generate a sustained downturn in U.S. inflation this year, even given the lagged impact of the strong U.S. dollar and lower oil prices. While some decline in headline inflation measures is inevitable in the coming months given the rapid pace and magnitude of the 2018 oil plunge, BCA’s Commodity & Energy Strategy team continues to see a positive demand/supply balance helping push oil prices back towards the $80/bbl level in 2019.1 That would ensure that any decline in headline U.S. inflation would be short in duration, and of far less magnitude than the move that occurred after the 2014/15 oil plunge given the more robust domestic inflation backdrop (Chart 5). Chart 5This Is NOT A Repeat Of the 2015/16 Deflation Scare A sober assessment of the U.S. economic and inflation data leads us to conclude that U.S. interest rate markets have swung too far to the dovish side. The inflation expectations component of U.S. Treasury yields is now too low, and the Fed rate cut that is now discounted in money markets will not materialize. Rate hikes are the more likely outcome, the repricing of which will put renewed upward pressure on Treasury yields. 2) What Is China’s Economic Pain Threshold To Trigger A Policy Response? Of the potential catalysts that could turn the current investor pessimism into optimism, signs of improving Chinese growth would likely top the list. China’s economy has lost considerable momentum, with year-over-year real GDP growth slowing to 6.5% in the third quarter of last year and higher frequency data showing a further deceleration in the fourth quarter. The profit warning issued by Apple last week, prompted by an unexpectedly sharp slowing of Chinese mobile phone demand, is a sign that Chinese consumer spending may be faltering. There are several causes for the growth slump, both domestic and foreign. Chinese authorities have been clamping down on domestic leverage given elevated private debt levels, while also taking action to reduce domestic pollution levels – policies that all have helped dampen industrial activity. More recently, and more importantly, the U.S.-China tariff war has started to have a real economic impact on the economy through slowing trade activity and diminished business confidence. Given the Chinese government’s perpetual interest in maintaining domestic stability by limiting any cyclical increases in unemployment, the incentive is there for policymakers to provide renewed stimulus to put a floor under economic growth. The last such boost came in 2015/16, when the Chinese government implemented an aggressive expansion of fiscal spending alongside monetary policy measures such as interest rate cuts, reductions in reserve requirement ratios and currency depreciation. That package was enough to cause a sharp reacceleration of the Chinese economy, but only after nominal GDP growth had fallen to an 16-year low of 6.4% at the end of 2015 (Chart 6). Chart 6Nominal China Growth Less Than 7.5% Should Trigger More Stimulus … Policymakers will likely be forced into action again in 2019 if nominal GDP growth, which hit 9.6% in the third quarter of 2018, falls back below 7.5%. Forward-looking economic measures like our Li Keqiang leading indicator and the export orders component of China’s manufacturing PMI suggest that weaker growth outcome could occur by mid-2019. China’s policymakers are likely to announce some form of stimulus in the first half of the year help counteract the growth slump, which could help boost global investor confidence (especially if it is accompanied by a new trade agreement with the U.S.). While Chinese policymakers are now under more pressure to provide stimulus measures, the tools available to them are more limited than was the case in 2015/16 (Chart 7). Interest rate cuts could happen if growth continues to fall more rapidly than expected, but that would create a burst in private sector leverage that policymakers would seek to avoid. The currency could also be weakened further, but the USD/CNY exchange rate is already back to near the 7.0 level reached in the 2016 devaluation. Chart 7...Atlhough Policy Options Are More Limited Than 2016 That leaves additional cuts in the reserve requirement ratio and increases in fiscal spending as the two most likely means for China to stimulate its economy in the coming months. Yet even the fiscal channel has limits, given the much higher starting point for the budget deficit today (3.7% of GDP) than in 2015 (2%). So while the trigger for a China policy stimulus will likely be reached by mid-2019, the magnitude of the stimulus will be nowhere near as large as the 2015/16 measures. This will help stabilize global growth expectations, but likely not by enough to provide a major boost to global commodity prices or export demand from emerging market countries that are heavily dependent on China. This leads us to remain cautious on emerging market credit exposure, as we prefer to own U.S. corporate debt instead where the growth/profit outlook is better. 3) Have Central Banks Become Less Concerned About Financial Markets? A popular market narrative of late has been that the Fed “made a mistake” with its last rate hike in December. A similar argument was made for the ECB choosing the end its Asset Purchase Program last month with inflation still well short of its target and European growth decelerating. The idea that central banks had fallen “out of tune” with financial markets has spooked investors who fear that policymakers are carrying out a pre-conceived plan to normalize monetary policy without any regard to financial markets. We find this to be a highly dubious conclusion. Central bankers still care about financial markets – or, more accurately, financial conditions – but the hurdle for policymakers to respond to falling asset prices is higher now than in previous years because of a lack of spare economic capacity. Simply put, any tightening of financial conditions must be large enough to trigger a slowing of growth to a below-potential pace, resulting in rising unemployment and weaker inflation pressures. That has not been the case – yet – in the major developed economies. Financial conditions indices (FCIs) – which measure the combined impact of equity prices, credit spreads and currencies – typically lead economic growth by 2-3 quarters. The latest selloffs in equity and credit markets in the U.S. and Europe, while significant, have not been large enough to push FCIs for those regions to levels that would be consistent with below-trend growth, using the 2015/16 episode as a reference point (Chart 8). Chart 8Tightening Financial Conditions Not Signaling Below-Trend Growth...Yet Financial conditions in the U.S. are much closer to that 2015/16 reference point than in Europe, where bond yields remain very depressed and the euro is still an undervalued currency. Yet the domestic U.S. economy is in a much better state than was the case in 2015/16, as discussed earlier in this report. It is highly likely that the level of the U.S. FCI that would trigger a move to below-trend U.S. growth is much different today than in 2015/16. In other words, it would take a bigger widening of U.S. corporate credit spreads, or a sharper selloff in U.S. equity values, to generate the same type of drag on U.S. growth relative to 2015/16. Yet U.S. interest rate markets have already responded as if there was no such change in the amount of FCI tightening that would result in a more dovish Fed policy. The U.S. money markets have gone from pricing three rate hikes in 2019 to one rate cut, while bond investors have largely neutralized their bearish Treasury duration positioning (Chart 9). Chart 9USTs Now Discounting Too Much Fed Dovishness That swing in sentiment on the Fed’s next move flies in the face of the underlying health of the U.S. economic data, as well as our Fed Monitor which continues to signal the need for more Fed rate hikes (Chart 10). Our other Central Bank Monitors tell a similar story (outside of Australia), with the Monitors signaling no need for easier monetary policy but with money markets pricing out any probability of a rate hike over the next year. This leaves global government bond yields exposed to any sign that global growth momentum is stabilizing, particularly with the inflation expectations component of bond yields also vulnerable to a rebound in oil prices (Chart 11). Chart 10Bond Yields Are Now Exposed To A Repricing Of Rate Hikes Chart 11Bond Yields Are Now Exposed To A Rebound In Oil Prices Our conclusion is that financial conditions in the major economies have not yet tightened by enough to end the process of normalizing global monetary policy from the extraordinarily accommodative settings seen in recent years. In other words, bond yields have not yet peaked for this cycle. Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Footnotes 1 Please see BCA Commodity & Energy Strategy Weekly Report, “Oil Volatility Will Persist: 2019 Brent Forecast Lowered to $80/bbl”, dated January 3rd 2018, available at ces.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns