Monetary
Highlights There are many things that central bankers know they don't know. "Known unknowns" include the outlook for growth (both actual and potential), NAIRU, the neutral rate of interest, and the true shape of the Phillips curve. "Unknown unknowns" are, by definition, unknowable, but are often at the heart of economic downturns. Central bankers, like military leaders, tend to fight the last war. They have tirelessly waged a battle against deflation over the past decade, so it is logical to conclude that they will err on the side of keeping monetary policy too loose rather than too tight. This will prolong the recovery, but it also means that economic and financial imbalances will be greater by the time the next downturn rolls around, most likely in 2020. Keep a close eye on credit spreads. Stay overweight risk assets for now, but look to move to neutral later this year and outright underweight in the first half of 2019. Bond yields will fall as the next recession approaches, but they will do so from higher levels than today. Feature Reports that say that something hasn't happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns - the ones we don't know we don't know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones. - Donald Rumsfeld, former Secretary of Defense under George W. Bush Uncertainty Galore Central bankers know many things. They know that growth is currently strong across most of the world, unemployment is falling and inflation, while still low, has been slowly trending higher. Unfortunately, there are also many things they don't know. These include things they know they don't know, as well as things that are not even on their radar screens - the "unknown unknowns" that Donald Rumsfeld famously warned about. Known Unknowns Let's start with five "known unknowns." 1. Will Growth Stay Strong? Global growth has likely peaked, but should remain comfortably above-trend over the remainder of this year (Chart 1). The OECD's Global Leading Economic Indicator (LEI) has leveled off, while the diffusion index, which tabulates the share of countries with rising LEIs, has dropped below 50 percent. A fall in the diffusion index has often foreshadowed outright declines in the composite LEI. Consistent with this prognosis, the Citi global Economic Surprise Index has swooned, the Chinese Keqiang index has decelerated, and Korean export growth - a leading indicator for global trade - has slowed. Global manufacturing PMIs have also edged off their highs (Chart 2). The one exception is the U.S., where the ISM index continues to power higher. Despite the occasional blip such as this week's retail sales report - which was probably depressed by tax refund delays - recent U.S. economic data have been reasonably upbeat. Goldman Sachs' Current Activity Indicator remains near cycle highs, implying strong momentum going into the second quarter. Chart 1Global Growth Has Peaked ##br##But Will Remain Above Trend Chart 2Global Manufacturing PMIs ##br##Are Off Their Highs Changes in financial conditions tend to lead growth by about six-to-nine months. U.S. financial conditions have eased a lot more since the start of 2017 than elsewhere (Chart 3). In addition, U.S. fiscal policy is likely to be much more expansionary over the next two years than in the rest of the world (Chart 4). All this suggests that the composition of global growth will shift in favor of the U.S. over the coming months. Chart 3Composition Of Global ##br##Growth Will Shift To The U.S. ... Chart 4U.S. Fiscal Policy Will Become More ##br##Expansionary Than In R.O.W. 2. Will Potential Growth Accelerate? The U.S. unemployment rate has declined from a high of 10% in 2009 to 4.1% in February 2018, even though real GDP growth has averaged a meager 2.2% over this period. Extremely weak productivity growth explains why the output gap has managed to contract in the face of subdued GDP growth. Sluggish capital spending has exacerbated the productivity downturn, but probably did not cause it. Chart 5 shows that productivity growth began to decelerate well before the financial crisis erupted. The slowdown has been pervasive across countries and sectors. Economists have a poor track record of predicting productivity trends. Not only did they fail to predict the productivity revival in the late 1990s, but because of data lags and subsequent revisions, they did not even know it had happened until the early 2000s. It is too early to say whether robotics and AI will yield the same sort of productivity windfall that the Internet did. My colleagues, Mark McClellan and Brian Piccioni, have cast a skeptical eye on some of the alleged revolutionary breakthroughs in both fields.1 If it turns out that the late 1990s was the exception rather than the rule, and that we are going back to the lackluster productivity performance of the 1970s, this will make life more challenging for central bankers. 3. What Is The True Level Of NAIRU? Spare capacity has diminished in most countries, but questions linger over how much slack remains. No one truly knows where NAIRU - the so-called Non-Accelerating Inflation Rate of Unemployment - really stands. The Fed and the Congressional Budget Office believe that NAIRU has fallen from over 6% in the late 1970s to around 4.5%-to-4.7% today (Chart 6). Chart 5Productivity Growth Slowdown ##br##Has Been Pervasive Chart 6NAIRU Is Low By Historic Standards An aging workforce has reduced frictional unemployment because older workers are less likely to switch jobs than younger ones. The internet has also made it easier for employers to find suitably qualified workers. On the flipside, globalization, automation, and the opioid crisis have likely made it difficult for a growing list of workers to hold down a job for long. Our best guess is that the U.S. economy is operating at close to full employment. This is confirmed by various employer surveys, which show that companies are struggling to find qualified workers (Chart 7). The fact that the share of people outside the labor force who want a job has fallen to pre-recession levels also suggests that labor slack is running thin (Chart 8). Chart 7U.S. Economy: Operating At ##br##Close To Full Employment Chart 8Few People Left Who Are Eager ##br##To Rejoin The Labor Force There is more slack outside the United States. Labor underutilization is still 2.5 percentage points higher in the euro area than it was in 2008. Taking Germany out of the picture, labor underutilization is nearly six points higher (Chart 9). A number of major emerging markets, most notably Brazil and Russia, also have a lot of excess cyclical unemployment. The Japanese labor market has tightened significantly in recent years, but there is probably a fair amount of hidden underemployment left, particularly in the service sector (factoid of the week: there are more police officers in Tokyo than in New York City).2 4. Where Is The Neutral Rate Of Interest? One of the most vexing questions facing central banks is how high interest rates can go before they move into restrictive territory. There are a variety of reasons for thinking that the neutral real rate of interest - the rate consistent with full employment and stable inflation - is lower today than it was in the past. Trend real GDP growth has fallen. This has reduced the need for firms to expand capacity. The shift to a capital-lite economy - where value-added increasingly takes the form of bits and bytes rather than factory output - has further reduced the need for fresh investment. Meanwhile, a reluctance to take on new debt has restrained spending. Rising inequality has shifted more wealth into the hands of people who tend to save a lot. Globally, savings must equal investment. If desired savings go up and desired investment goes down, interest rates must fall to push down the former and push up the latter (Chart 10). Chart 9Euro Area: There Is Still Labor ##br##Market Slack Outside Of Germany Chart 10Interest Rates Must Fall If Desired Savings ##br##Increase And Desired Investment Declines None of these forces are immutable, however. Investment demand appears to be picking up, as judged by capex intention surveys (Chart 11). Consumer credit is rising anew. The U.S. personal saving rate is back near an all-time low (Chart 12). A tighter labor market is likely to cause labor's share of income to rise, just like it did in the late 1990s (Chart 13). This should boost aggregate demand. An unprecedented increase in the U.S. budget deficit should help absorb much of the savings from cash-rich corporations (Chart 14). Meanwhile, savings are likely to decline over the long haul as well-paid baby boomers retire en masse. All this is causing the neutral rate to move higher. Chart 11Upswing In Global Capex Is Underway Chart 12U.S. Consumer Credit Revival Chart 13Tight Labor Market And Rising Labor ##br##Share Of Income: A Replay Of The 1990s? Chart 14Now Is The Time For Fiscal Consolidation, Not Profligacy 5. What Is The Shape Of The Phillips Curve? Central bankers assume that dwindling spare capacity will lead to higher inflation, a relationship immortalized by the so-called Phillips curve. The fact that inflation has barely risen over the past few years is an obvious challenge to this theory. It may simply be that the Phillips curve is "kinked" at very low levels - it only steepens when the economy has gone beyond full employment. The fact that it has taken this long to reach the kink could explain why inflation has not taken off sooner. The success that central banks have enjoyed in anchoring long-term inflation expectations is another reason why the Phillips curve has become flatter. Chart 15An Overheated Economy Led To ##br##Rising Inflation In The 1960s The problem is that there is no God-given reason why inflation expectations should stay well anchored. Core inflation was remarkably low and stable in the first half of the 1960s. However, the combination of low real interest rates and increased fiscal spending associated with Lyndon Johnson's Great Society programs and the Vietnam War led to a surge in inflation starting in 1966 (Chart 15). Inflation kept climbing thereafter, rising to 6% in 1970. This was three years before the first oil shock occurred, suggesting that an overheated economy, rather than OPEC, was the main inflationary culprit. Unknown Unknowns Then there are the things central bankers are not even thinking about, or even worse, the things they think are true but aren't.3 In the lead-up to the Great Recession, U.S. policymakers blithely assumed that house prices could not fall at the nationwide level. This caused them to turn a blind eye to soaring home prices and the deterioration of underwriting standards in the mortgage market. Warren Buffet once said, "Only when the tide goes out do you discover who's been swimming naked." Our guess is that rising rates will expose a lot of things one would rather not see in the corporate debt market. In the latest issue of the Bank Credit Analyst, my colleague Mark McClellan estimated that the interest coverage ratio for U.S. companies would drop from 4 to 2.5 if rates increased by 100 basis points across the corporate curve. Such a move would take the coverage ratio to the lowest level in the 30-year history of our sample (Chart 16A and Chart 16B).4 Consumer staples, tech, and health care would be the most adversely affected. Chart 16AU.S. Interest Coverage Ratio ##br##Breakdown By Sector (I) Chart 16BU.S. Interest Coverage Ratio ##br##Breakdown By Sector (II) Political shocks are also very difficult for policymakers to foresee. President Trump's decision to impose steel and aluminum tariffs spooked the markets. NAFTA negotiations remain stalled and the odds are high that the U.S. will pursue trade sanctions against China for alleged intellectual property theft. That said, as we noted last week, an all-out trade war would cause equities to crater.5 Trump remains focused on the value of the stock market as a gauge of the success of his presidency. This will curb his hawkishness. Unemployment is also very low these days, which limits the attractiveness of protectionist policies. The specter of trade wars will escalate if a recession causes stocks to tumble and unemployment to rise in key midwestern swing states. Other "unknown unknowns" include another flare-up in sovereign debt markets in Europe, a hard landing in China, and a supply-induced spike in oil prices. Investment Conclusions It may be tempting to think that central banks can calibrate monetary policy as events unfold in order to keep economies on an even keel. If only it were so easy. Monetary policy affects the economy with a lag of 12-to-24 months. By the time it is clear that either more or less monetary stimulus is needed, it is often too late to act. Central bankers have to work with incomplete or inaccurate data. One of the reasons that inflation spiraled out of control in the 1970s was because the Federal Reserve systematically overstated the size of the output gap (Chart 17). This led the Fed to falsely conclude that slower growth was the result of inadequate demand rather than a deceleration in the economy's supply-side potential. It is impossible to know what mistakes central banks will make in the future, but it is almost certain that something will go awry. Central bankers, like military leaders, tend to fight the last war. They have tirelessly waged a battle against deflation over the past decade, so it is logical to conclude that they will err on the side of keeping monetary policy too loose rather than too tight. This will prolong the recovery, but it also means that economic and financial imbalances will be greater by the time the next downturn rolls around. As we discussed several weeks ago, the next recession is most likely to arrive in 2020.6 Investors should stay overweight risk assets for now, but look to move to neutral later this year and outright underweight in the first half of 2019. Bond yields will fall as the next recession approaches, but they will do so from higher levels than today. Similar to the 1970s, investors should expect inflation and bond yields to make a series of "higher highs" and "higher lows" with every boom/bust episode (Chart 18). Chart 17The Fed Continuously Overstated The ##br##Magnitude Of Economic Slack In The 1970s Chart 18A Template For The Next Decade? Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Technology Sector Strategy Special Report, "The Coming Robotics Revolution," dated May 16, 2017; The Bank Credit Analyst, "Did Amazon Kill The Phillips Curve?" dated August 31, 2017; and The Bank Credit Analyst, "The Impact Of Robots On Inflation," dated January 25, 2018. 2 "As crime dries up, Japan's police hunt for things to do," The Economist, May 18, 2017. 3 Mark Twain is often credited for saying that "It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so." It's a great quote, but there's only one problem: There is no evidence that he ever said it. 4 Please see The Bank Credit Analyst, "Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector," dated February 22, 2018. 5 Please see Global Investment Strategy Weekly Report, "Trump's Tariffs: A Q&A," dated March 9, 2018. 6 Please see Global Investment Strategy Weekly Report, "The Next Recession: Later But Deeper," dated February 23, 2018. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The global economic mini-cycle is set to weaken while the euro is set to grind higher. Upgrade Telecoms to overweight. Also overweight Healthcare and Airlines. Underweight Banks, Basic Materials and Energy. Overweight France, Ireland, U.K., Switzerland and Denmark. Underweight Italy, Spain, Sweden and Norway. The Eurostoxx50 will struggle to outperform the S&P500. Feature We are strong believers in Investment Reductionism, a philosophy synthesized from the Pareto Principle and Occam's Razor.1 Investment reductionism offers a liberating thesis - the incessant barrage of investment research, newsfeeds and ten thousand word commentaries is largely superfluous to the investment process. What seems like a complexity of investment choice usually reduces to getting a few over-arching decisions right. Chart of the WeekIn Quadrant 4, Overweight Domestic Defensives And Underweight International Cyclicals For equity sector and country allocation, two over-arching decisions dominate: Whether the global economic mini-cycle is set to strengthen or weaken (Chart I-2). Whether the domestic currency is set to strengthen or weaken. Chart I-2The Empirical Evidence For Credit And Economic Mini-Cycles Is Irrefutable The four permutations of these two decisions create the four quadrants of cyclical investing (Chart of the Week). Right now, European investors find themselves in quadrant four: the global economic mini-cycle is set to weaken while the euro is set to grind higher. This favours an overweight stance to defensives, especially domestic-focused defensives. Therefore today, we are upgrading Telecoms to overweight. We also recommend an underweight stance to the most cyclical sectors, especially international-focused cyclicals such as Basic Materials and Energy. Country allocation then just drops out of this sector allocation. The Global Economic Mini-Cycle Is Set To Weaken We can predict the changes of the seasons and the tides of the sea with utmost precision. How? Not because we have an ingenious leading indicator for the seasons and tides, but because we recognise that these phenomena follow perfectly regular cycles. Regular cycles create predictability. Significantly, global bank credit flows also exhibit remarkably regular cycles with half-cycle lengths averaging around eight months. Recognizing these mini-cycles is immensely powerful because, just as for the seasons and the tides, it creates predictability. Furthermore, if most investors are unaware of these cycles, the next turn will not be discounted in today's price - providing a compelling investment opportunity for those who do recognise the predictability. The empirical evidence for credit mini-cycles is irrefutable. The theoretical foundation is also rock solid, based on an economic model called the Cobweb Theory.2 This states that in any market where supply lags demand, both the quantity supplied and the price must oscillate. Given that credit supply clearly lags credit demand, the quantity of credit supplied and its price (the bond yield) must experience mini-cycles (Chart I-3). And as the quantity of credit supplied is a marginal driver of economic activity, economic activity will also experience the same regular oscillations. Today, the global 6-month credit impulse is turning from mini-upswing to mini-downswing, with all three subcomponents - the euro area, the U.S. and China - now in decline (Chart I-4). This is exactly in line with prediction. Mini half-cycles average eight months, and the latest mini-upswing started eight months ago. Chart I-3The Global Economic Mini-Cycle##br## Is Set To Weaken Chart I-4All Three Subcomponents Of The Global 6-Month ##br##Credit Impulse Are Now Declining More importantly, as we enter a mini-downswing, we can also predict that global growth is likely to experience at least a modest deceleration through the coming two to three quarters. The Euro Is Set To Grind Higher, Except Versus The Yen Chart I-5Lost In Translation Nowadays, mainstream stock markets tend to be eclectic collections of multinational companies which happen to be quoted on bourses in Frankfurt, Paris, New York, and so on. For example, BASF is not really a German chemical company, it is a global chemical company headquartered in Germany. For operational hedging, multinational companies like BASF will intentionally diversify their sales and profits across multiple major currencies, say euros and dollars. But of course, the primary stock market quotation will be in the currency of its home bourse, euros. Therefore, when the euro strengthens, the company's multi-currency profits, translated back into a stronger euro, will necessarily weaken (Chart I-5). Clearly, more domestic-focused companies like telecoms will not experience such a strong currency-translation headwind. We expect the main euro crosses to continue strengthening over the next 8 months, with the exception being the cross versus the Japanese yen. Our central thesis is that the payoff profile for a foreign exchange rate just tracks the bond yield spread. This means that when a central bank has already taken bond yields close to their lower bound, its currency possesses a highly attractive asymmetry called positive skew. In essence, as the ECB is at the realistic limit of ultra-loose policy, long-term expectations for the ECB policy rate possess an asymmetry: they cannot go significantly lower, but they could go significantly higher. Exactly the same applies to long-term expectations for the BoJ policy rate. In contrast, long-term expectations for the Fed policy rate possess full symmetry: they could go either way, lower or higher. This stark asymmetry of central bank 'degrees of freedom' favours the euro and the yen over the dollar. Which Sectors And Countries To Own And Which To Avoid? Pulling together the preceding two sections, the global economic mini-cycle is set to weaken while the euro is set to grind higher. This puts Europe in quadrant four of our four quadrant framework for cyclical investing. Unsurprisingly, the relative performance of the most cyclical sectors - Banks, Basic Materials and Energy - very closely tracks the regular mini-cycles in the global 6-month credit impulse. In a mini-downswing these cyclical sectors always underperform (Chart I-6, Chart I-7 and Chart I-8). Accordingly, underweight these three sectors on a two to three quarter horizon. Chart I-6In A Mini-Downswing, ##br##Banks Always Underperform Chart I-7In A Mini-Downswing,##br## Basic Materials Always Underperform Chart I-8In A Mini-Downswing,##br## Energy Always Underperforms Conversely, overweight the relatively defensive Healthcare sector. Also overweight the Airlines sector. Airlines' performance is a mirror-image of the oil price cycle, given that aviation fuel comprises the sector's main variable cost. Furthermore, as aviation fuel is priced in dollars, it also insulates European Airlines against a strengthening euro. Today, we are also upgrading the Telecoms sector to overweight given its relative non-cyclicality (Chart I-9), its domestic-focus, and the excessively negative groupthink towards it (Chart I-10). Chart I-9In A Mini-Downswing, ##br##Telecoms Always Outperform Chart I-10Telecoms Are Due ##br##A Trend Reversal In summary: Overweight: Healthcare, Telecoms, and Airlines Underweight: Banks, Basic Materials and Energy Then to arrive at a country allocation, just combine the cyclical view on the major sectors with the country sector skews in Box 1. The result is the following unchanged European equity market allocation. Overweight: France, Ireland, U.K., Switzerland and Denmark Neutral: Germany and Netherlands Underweight: Italy, Spain, Sweden and Norway Lastly, what is the prognosis for the Eurostoxx50 relative to the S&P500? Essentially, this reduces to a battle between the multinational cyclicals - especially banks - that dominate euro area bourses and the multinational technology giants that dominate the U.S. stock market. With the global economic mini-cycle set to weaken and the euro set to grind higher, the Eurostoxx50 will struggle to outperform the S&P500. Box 1: The Vital Few Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks. France (CAC) is underweight Banks and Basic Materials. Italy (MIB) is overweight Banks. Spain (IBEX) is overweight Banks. Netherlands (AEX) is overweight Technology, underweight Banks. Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy. And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound. Switzerland (SMI) is overweight Healthcare, underweight Energy. Sweden (OMX) is overweight Industrials. Denmark (OMX20) is overweight Healthcare and Industrials. Norway (OBX) is overweight Energy. The U.S. (S&P500) is overweight Technology, underweight Banks. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 The Pareto Principle, often known as the 80-20 rule, says that 80% of effects come from just 20% of causes. Occam's Razor says that when there are many competing explanations for the same effect, the simplest explanation is usually the best. 2 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11, 2018 and available at eis.bcaresearch.com. Fractal Trading Model* This week's recommended trade is to short the Helsinki OMX versus the Eurostoxx600. Apply a profit target of 3% with a symmetrical stop-loss. In other trades, we are pleased to report that short Japanese Energy versus the market achieved its 8% profit target at which it was closed. This leaves four open positions. 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 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 Bond Strategy: The investment backdrop is broadly evolving the way that we forecasted in our 2018 Outlook, thus we continue to maintain our core strategic recommendations. Maintain below-benchmark portfolio duration and overweight global corporate debt versus government bonds (focused on the U.S.). Look to reverse that positioning sometime during the latter half of 2018 after global inflation increases and central banks tighten policy more aggressively. Japan Corporates: Japanese companies are in excellent financial shape, according to our new Japan Corporate Health Monitor. Although softening Japanese growth and a firming yen may prevent an outperformance of Japanese corporate debt in the coming months. Feature "I love it when a plan comes together." - Hannibal Smith, Leader of The A-Team Many investors likely came down with serious case of a sore neck last week, given the head-turning headlines that came out: Chart 1A Pause In The 'Inflation Scare' U.S. President Donald Trump announcing a blanket tariff on metals imports, then exempting some important countries (Canada, Mexico, Australia) only days later. Trump agreeing to an unprecedented meeting with North Korean leader Kim Jong Un on the nuclear issue, only to have the White House press secretary later announce that no meeting would take place without North Korean "concessions". The European Central Bank (ECB) hawkishly altering its forward guidance to markets at the March monetary policy meeting, but then having that immediately followed by dovish comments from ECB President Mario Draghi. The strong headline number on the February U.S. employment report blowing away expectations, but the soft readings on wages suggesting that the Fed will not have to move more aggressively on rate hikes. For bond markets in particular, the ECB announcement and the U.S. Payrolls report were most important. Investors had been growing worried about a more hawkish monetary policy shift in Europe or the U.S. This was especially true in the U.S. after the previous set of employment data was released in early February showing a pickup in wage inflation that could force the Fed to shift to a more hawkish stance. That created a spike in Treasury yields and the VIX and a full-blown equity market correction. Since then, inflation expectations have eased a bit and market pricing of future Fed and ECB moves has stabilized, helping to bring down volatility and supporting some recovery in global equity markets (Chart 1). With all of these "tape bombs" hitting the news wires, investors can be forgiven for re-thinking their medium-term investment strategy in light of the changing events. We think it is more productive to check if the initial expectations on which that strategy was based still make sense. On that note, the developments seen so far this year fit right in with the key themes we outlined in our 2018 Outlook, which we will review in this Weekly Report. The Critical Points From Our Outlook Still Hold Up In a pair of reports published last December, we translated BCA's overall 2018 Outlook into broad investment themes (and strategic implications) for global fixed income markets. We repeat those themes below, with our updated assessment on where we currently stand. Theme #1: A more bearish backdrop for bonds, led by the U.S.: Faster global growth, with rebounding inflation expectations, will trigger tighter overall global monetary policy. This will be led by Fed rate hikes and, later in 2018, ECB tapering. Global bond yields will rise in response, primarily due to higher inflation expectations. ASSESSMENT: UNFOLDING AS PLANNED, BUT WATCH INFLATION EXPECTATIONS. Economic growth is still broadly expanding at a solid pace, as evidenced by the elevated levels of the OECD leading economic indicator and our global manufacturing PMI (Chart 2). The U.S. is clearly exhibiting the strongest growth momentum looking at the individual country PMIs (bottom panel), while there is a more mixed picture in the most recent readings in other countries and regions. Importantly, all of the manufacturing PMIs remain well above the 50 line indicating expanding economic activity. Last week's U.S. Payrolls report for February showed that great American job creation machine can still produce outsized employment gains with only moderate wage inflation pressures, even in an economy that appears to be at "full employment". The +313k increase in jobs, which included upward revisions to both of the previous two months of a combined +54k, generated no change in the U.S. unemployment rate which stayed unchanged at 4.1% with the labor force participation rate increasing modestly (Chart 3). Chart 2U.S. Growth Leading The Way Chart 3The Fed Can Still Hike Rates Only 'Gradually' The wage data was perhaps the most important part of the report, given that the spike in global market volatility seen last month came on the heels of an upside surprise in U.S. average hourly earnings (AHE) for January. There was no follow through of that acceleration in February, with the year-over-year growth rate of AHE slowing back to 2.6% from 2.9%, reversing the previous month's increase (middle panel). The immediate implication is that the Fed does not have to start raising rates faster or by more than planned. That pullback in U.S. wage growth, combined with the continued sluggishness of inflation in the other developed economies and the sideways price action seen in global oil markets, does suggest that inflation expectations may struggle to be the main driver of higher global bond yields in the near term. Overall nominal bond yields are unlikely to decline, however, as real yields are slowly rising in response to faster global growth and markets pricing in tighter monetary policy in response (Chart 4). Chart 4Real Yields Rising Now,##BR##Inflation Expectations Will Rise Again Later We have not seen enough evidence to cause us to change our view on inflation expectations moving higher over the course of 2018, particularly with BCA's commodity strategists now expecting oil prices to trade between $70-$80/bbl in the latter half of 2018.1 One final point: it is far too soon to determine if the protectionist trade leanings of President Trump will alter the current trajectory of global growth and interest rates. The implication is that investors should not change their overall planned investment strategy for this year at this juncture. Theme #2: Growth & policy divergences will create cross-market bond investment opportunities: Global growth in 2018 will become less synchronized compared to 2016 & 2017, as will individual country monetary policies. Government bonds in the U.S. and Canada, where rate hikes will happen, will underperform, while bonds in the U.K. and Australia, where rates will likely be held steady, will outperform. ASSESSMENT: UNFOLDING AS PLANNED. As shown in Chart 2, the big coordinated upward move in global growth seen in 2017 is already starting to become less synchronized in 2018. Recent readings on euro area growth have softened a bit while, more worryingly, a growing list of Japanese data is slowing. U.K. data remains mixed, while the Canadian economy is showing few signs of cooling off. China's growth remains critical for so many countries, including Australia, but so far the Chinese data is showing only some moderation off of last year's pace. Net-net, the data seen so far this year is playing out according to our 2018 Themes - better in the U.S. and Canada, softer in the U.K. and Australia. We are sticking to our view that the rate hikes currently discounted by markets in the U.S. and Canada will be delivered, but that there will be little-to-no monetary tightening in the U.K. and Australia (Chart 5). Theme #3: The most dovish central banks will be forced to turn less dovish: The ECB and Bank of Japan (BoJ) will both slow the pace of their asset purchases in 2018, in response to strong domestic economies and rising inflation. This will lead to bear-steepening of yield curves in Europe, mostly in the latter half of 2018. The BoJ could raise its target on JGB yields, but only modestly, in response to an overall higher level of global bond yields. ASSESSMENT: UNFOLDING AS PLANNED, ALTHOUGH WE NOW EXPECT NO BoJ MOVE TO TAKE PLACE THIS YEAR. Both central banks have already dialed back to pace of the asset purchases in recent months. This is in addition to the Fed beginning its own process of reducing its balance sheet by not rolling over maturing bonds in its portfolio. Growth of the combined balance sheet of the "G-4" central banks (the Fed, ECB, BoJ and Bank of England) has been slowing steadily as a result (Chart 6). The ECB continues to contribute the greatest share of that aggregate "G-4" liquidity expansion, although that is projected to slow over the balance of 2018 as the ECB moves towards a full tapering of its bond buying program by the end of the year (top panel). Chart 5Not Every Central Bank##BR##Will Deliver What's Priced Chart 6Risk Assets Are##BR##Exposed To ECB Tapering Barring a sudden sharp downturn in the euro area economy, the ECB is still on track for that taper. We have been expecting a signaling of the taper sometime in the summer, likely after the ECB gains even greater confidence that its inflation target can be reached within its typical two-year forecasting horizon. That story will not be repeated in Japan, however, where core inflation is still struggling to stay much above 0% and economic data is softening. We see very little chance that the BoJ will make any alterations of its current policy settings - with negative deposit rates and a target of 0% on the 10-year JGB yield - this year, as we discussed in a recent Special Report.2 We continue to expect a diminishing liquidity tailwind for global risk assets over the rest of 2018 (bottom two panels). Theme #4: The low market volatility backdrop will end through higher bond volatility: Incremental tightening by central banks, in response to faster inflation, will raise the volatility of global interest rates. This will eventually weigh on global growth expectations over the course of 2018, and create a more volatile backdrop for risk assets in the latter half of the year. ASSESSMENT: UNFOLDING AS PLANNED. We saw a sneak preview of how this theme would play out during that volatility spike at the beginning of February, triggered by only a brief blip up higher in U.S. wage inflation. With a more sustained increase in realized global inflation likely to develop within the next 3-6 months, a return to that world of high volatility is still set to unfold in the latter half of 2018, in our view. After reviewing our four investment themes for 2018 in light of the latest news, we conclude that the themes are largely playing out. Therefore, we will continue to stick with the investment strategy conclusions for this year that were derived from those themes (Table 1):3 Table 1A Pro-Risk Recommended Portfolio In H1/2018, Looking To Get Defensive Later In The Year 2018 Model Bond Portfolio Positioning: Target a moderate level of portfolio risk, with below-benchmark duration and overweights on corporate credit versus government debt. These allocations will shift later in the year as central banks shift to a more restrictive monetary policy stance and growth expectations for 2018 become more uncertain. Chart 7Tracking Our Recommendations 2018 Country Allocations: Maintain underweight positions in the U.S., Canada and the Euro Area, keeping a moderate overweight in low-beta Japan, and add small overweights in the U.K. and Australia (where rate hikes are unlikely). The year-to-date performance of the main elements of our model bond portfolio are shown in Chart 7. All returns are shown on a currency-hedged basis in U.S. dollars. Our country underweights are shown in the top panel, our country overweights in the 2nd panel, our credit overweights in the 3rd panel and our credit underweights in the bottom panel. The broad conclusion is that our best performing underweight is the U.S. and best performing overweight is Japan. All other country allocations are essentially flat on the year (in currency-hedged terms). Our call to overweight corporate debt vs. government debt, focused on the U.S., has performed well, but mostly through our overweight stance on U.S. high-yield. Bottom Line: The investment backdrop is broadly evolving the way that we forecasted in our 2018 Outlook, thus we continue to maintain our core strategic recommendations. Maintain below-benchmark portfolio duration and overweight global corporate debt versus government bonds (focused on the U.S.). Look to reverse that positioning sometime during the latter half of 2018 after global inflation increases and central banks tighten policy more aggressively. Introducing The Japan Corporate Health Monitor Japan's relatively small corporate bond market has not provided much excitement for non-Japanese investors over the years. Japanese companies have always been highly cautious when managing leverage on their balance sheets, and have traditionally relied heavily on bank loans, rather than bond issuance, for debt financing. The result is a corporate bond market with far fewer defaults and downgrades compared to other developed economies, with much lower yields and spreads as well. Due to its small size, poor liquidity and low yields/spreads, we have not paid much attention to Japanese corporate debt in the past. Thus, we don't have the same kinds of indicators available to us for Japanese corporate bond analysis as we have in the U.S., euro area or U.K. One such indicator is the Corporate Health Monitor (CHM) to assess the financial health of corporate issuers.4 We are changing that this week by adding a Japan CHM to our global CHM suite of indicators. In other countries, we have both top-down and bottom-up versions of the CHM. The former uses GDP-level data on income statements and balance sheets to determine the individual ratios that go into the CHM (a description of the ratios is shown in Table 2), while the latter uses actual reported financial data at the individual firm level which is aggregated into the CHM. Table 2Definitions Of Ratios##BR##That Go Into The CHM Consistent and timely data availability is an issue for building a top-down CHM, as there is no one source of top-down data on the corporate sector. Some data is available from the BoJ or the Ministry of Finance, or even from international research groups like the OECD, but not all are presented using a consistent methodology. Some data is only available on an annual basis, which significantly diminishes the usefulness of a top-down CHM as a timely indicator for bond investment. Thus, we focused our efforts on only building a bottom-up version of a Japan CHM, using publically available financial information released with higher frequency (quarterly). We focused on non-financial companies (as we do in the CHMs for other countries) and exclude non-Japanese issuers of yen-denominated corporate bonds. In the end, we used data on 43 companies for our bottom-up CHM. By way of comparison, there are only 36 individual issuers in the Bloomberg Barclays Japan Corporate Bond Index that fit the same description of non-financial, non-foreign issuers, highlighting the relatively tiny size of the Japanese corporate bond market. Our new Japan bottom-up CHM is presented in Chart 8. The overall conclusions are the following: Japanese corporate health is in overall excellent shape, with the CHM being in the "improving health" zone for the full decade since the 2008 Financial Crisis. Corporate leverage has steadily declined since 2012, mirroring the rise in company profits and cash balances over the same period. Return on capital is currently back to the pre-2008 highs just below 6%, although operating margins remain two full percentage points below the pre-2008 highs. Interest coverage and the liquidity ratio are both at the highest levels since the mid-2000s, while debt coverage is steadily improving. The overall reading from the CHM is one of solid Japanese creditworthiness and low downgrade and default risks. It is no surprise, then, that corporate bond spreads have traded in a far narrower range than seen in other countries. In Chart 9, we present the yield, spread, return and duration data for the Bloomberg Barclays Japanese Corporate Bond Index. We also show similar data for the Japanese Government Bond Index for comparison. Japanese corporates have a much lower index duration than that of governments, which reflects the greater concentration of corporate issuance at shorter maturities. Chart 8The Japan Corporate Health Monitor Chart 9The Details Of Japan Corporate Bond Index Japanese corporates currently trade at a relatively modest spread of 36bps over Japanese government debt, although that spread only reached a high of just over 100bps during the 2008 Global Financial Crisis - a much lower spread compared to U.S. and European debt of similar credit quality. That is likely a combination of many factors, including the small size of the Japanese corporate market and the relatively smaller level of interest rate volatility in Japan versus other countries. Given the dearth of available bond alternatives with a positive yield in Japan, the "stretch for yield" dynamic has created a demand/supply balance that is very favorable for valuations - especially given the strong health of Japanese issuers. Chart 10Japan Corporates Do Not Like A Rising Yen It remains to be seen how the market will respond to a future economic slowdown in Japan, which may be starting to unfold given the recent string of sluggish data. On that note, the performance of the Japanese yen bears watching, as the currency has a positive correlation to Japanese corporate spreads (Chart 10). The linkage there could be a typical one of risk-aversion, where the yen goes up as risky assets selloff. Or it could be linked to growth expectations, where markets begin to price in the impact on Japanese growth and corporate profits from a stronger currency. Given our view that the BoJ is highly unlikely to make any changes to its monetary policy settings this year, the latest bout of yen strength may not last for much longer. For now, given the link between the yen and Japanese credit spreads, we would advise looking for signs that the yen is rolling over before considering any allocations to Japanese corporate debt. Bottom Line: Japanese companies are in excellent financial shape, according to our new Japan Corporate Health Monitor. Although softening Japanese growth and a firming yen may prevent an outperformance of Japanese corporate debt in the coming months. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst Ray@bcaresearch.com 1 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Getting Comfortable With Higher Prices", dated February 22nd 2018, available at ces.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, "What Would It Take For The Bank Of Japan To Raise Its Yield Target?", dated February 13th 2018, available at gfis.bcareseach.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Our Model Bond Portfolio In 2018: A Tale Of Two Halves", dated December 19th 2017, available at gfis.bcaresearch.com. 4 For a summary of all of our individual country CHMs, including a description of the methodology, please see the BCA Global Fixed Income Strategy Weekly Report, "BCA Corporate Health Monitor Chartbook: No Improvement Despite A Strong Economy", dated November 21st 2017, available at gfis.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
Highlights BCA's view is that while a major trade war is unlikely, trade tensions will persist. The Fed, not protectionism, will end the cycle. There have been five episodes in the past 35 years when global growth surged and fiscal, monetary and regulatory policy were all aligned to boost the U.S. economy. The March Beige Book keeps the Fed on track to hike four times this year. Feature The Trump Administration's announcement last week to slap hefty tariffs on steel and aluminum runs the risk of provoking a "tit-for-tat" trade war. This proposed levy follows a similar move earlier this year to impose tariffs on washers and solar panels. The EU has retaliated with a threat to introduce tariffs on Harley Davidson motorcycles and Levi's jeans. Even if a trade war develops, our Global Investment Strategy team notes1 that the U.S. would suffer less in a trade war than other nations, and that higher tariffs may lead to more domestic demand, a more aggressive Fed and a stronger dollar. Certainly, the tariff issue does not signal the end of the U.S. economic expansion or equity bull market. BCA's view is that while a major trade war is unlikely, trade tensions will persist. Our Geopolitical Strategy service states2 that investors should closely monitor bellwether factors for trade policies, including Trump's position on NAFTA, exemptions granted on the steel and aluminum tariffs to countries (such as Mexico and Canada) and most importantly, the treatment of intellectual property trade with China. Bottom Line: The end of the equity bull market will probably be due to an overheated U.S. economy and rising financial imbalances, and not escalating trade protectionism. Investors should remain overweight global equities for now, but look to pare back exposure later this year. Policy Panacea The backdrop for U.S. economic growth remains solid. Consensus global GDP projections for 2018 and 2019 have perked up, in contrast with prior years when forecasters issued relentless lower GDP estimates (Chart 1). Moreover, global exports growth is in a persistent uptrend since the earlier part of 2016 (Chart 2). Chart 1U.S. & Global Growth Expectations Are Still Accelerating The surge in global growth occurs even as China's economy is poised to slow. Among the components of BCA's Li Keqiang Leading Indicator (an index designed to lead turning points in the Li Keqiang), all six series are in a downtrend, and five fell in January (the growth in M2 was the exception).3 Although China's economy is decelerating, BCA's view is that a repeat of the late 2015/early 2016 shock is unlikely (Chart 3). Chart 2Global Exports##BR##Are Booming... Chart 3Our Composite LKI Indicator Suggests##BR##A Benign Slowdown In Growth In China The U.S. economy and financial markets will benefit from the uptick in global growth, a large dose of fiscal policy, still accommodative monetary policy, and a decline in regulation. Table 1 and Chart 4 show that there have been four other junctures in the past 35 years when these factors all pulled in the same direction to boost the U.S. economy. The current episode of synchronized policy commenced in January 2016. All four previous periods occurred closer to the start and not the end of a business cycle; BCA's stance is that the U.S. economy is in the late stages of an economic expansion that began in 2009. These phases lasted, on average, for just under two years. The current phase is entering its third year. The longest was in the early 2000s (2002-2004), while the shortest was a 14-month interval in the first year of the 1991-2001 economic expansion. Three of the prior four periods ended as fiscal policy turned restrictive. In the early 1980s' chapter, a reversal in global IP signaled the end of the growth sweet spot. Performance Of U.S. Financial Assets, Gold, Oil And Earnings When Global Growth Is Increasing Alongside Stimulative Monetary, Fiscal And Regulatory Policy .... Chart 4Global Growth, Fiscal, Monetary And Regulatory Policy##BR##All Pulling In The Same Direction Not surprisingly, risk assets perform well during these "tailwind" points (Table 1 again and Chart 5). The S&P 500 rose in the previous four periods and again in the current one. However, BCA's stock-to-bond ratio fell in the early 1990s and early 2000s. Credit tends to outperform Treasuries when monetary, fiscal and regulatory policy are synchronized, and small caps outperform large. This is the case in the current episode that began in January 2016. Gold and oil also perform well when global growth is surging, fiscal and monetary policy is stimulative and regulations are on the wane. However, on average, the dollar falls during these intervals as demonstrated in the early 2000s and early 2010s. S&P 500 earnings growth is solid and well above average during these phases. Chart 5U.S. Risk Assets In Periods Of Strong Global Growth And Synchronized Policy Push Table 2 shows that U.S. risk assets tend to struggle in the year after these legs end, but the economy keeps flourishing. Stocks underperformed bonds a year after the end of two of the four periods, but none of those periods coincided with a recession. Investment-grade and high-yield credit underperforms Treasuries in the ensuing 12 months, while small caps struggle to keep up with large. Gold performs well in three of the four periods, but oil posts a mixed performance. The dollar rises and S&P 500 earnings per share increase in the year after stretches of synchronous policy, but at a much slower pace than when the stimulative fiscal policy, deregulation and easy monetary policy are all in place. Table 2... What Happens In The 12 Months After These Episodes End... Tighter Fed policy will end the current era of pro-growth policies. BCA's stance is that the Fed will raise rates four times this year and another three or four times next year, pushing monetary policy into restrictive territory. U.S. fiscal policy will likely add to growth into the next year, thanks to tax cuts and the lifting of spending caps, and Trump will continue to look for deregulation opportunities. Bottom Line: Fed tightening will end the latest era of deregulation, easy monetary policy and stimulative fiscal policy, but not until early next year. Until then, a favorable backdrop will persist for stocks over bonds, credit, S&P 500 earnings and oil. Stay long stocks and credit, and underweight duration. This forecast assumes that the trade spat does not degenerate into a trade war. If that occurs, we would recommend reducing our overweight to risk assets sooner than early next year. Beige Book: More Tailwinds Fed Chair Powell's February 27 testimony to Congress noted that "some of the headwinds the U.S. economy faced in previous years have turned into tailwinds."4 The Beige Book released on March 7 highlights many of those tailwinds, keeps the Fed on track to boost rates at least three times this year and highlights the impact of the tax bill on the economy. BCA's quantitative approach5 to the Beige Book's qualitative data points to underlying strength in GDP and a tighter labor market. Furthermore, the disconnect between the Beige Book's view of inflation and the market's stance has eased. Moreover, references to a stronger dollar have disappeared from the Beige Book and business uncertainty is significantly reduced, reflecting the tax cut bill and Trump's assault on regulation. The latest Beige Book ran from mid-January to February 26 and, therefore, did not capture the business community's reaction to the tariff announcement in early March. Chart 6, panel 1 shows that at 67% in March, BCA's Beige Book Monitor stayed near its cycle highs, which reconfirms that the underlying economy was upbeat in early 2018. The number of 'weak' words in the Beige Book returned to near four-year lows after ticking higher in the wake of last summer's hurricanes. Moreover, there were 15 mentions of the tax bill in the March Beige Book, up from 12 in January and only 3 in November 2017 (not shown). The tax bill was cast in a positive light in 87% of the remarks in March versus 75% in January. In November, the references to either the tax bill (or tax reform) cited the consequent uncertainty as a constraint on growth. Chart 6Latest Beige Book Supports##BR##The Fed's View On Rates, Inflation And Economy Based on the minimal references to a robust dollar in the past six Beige Books, the greenback should not be an issue in Q4 2017 or Q1 2018. This sharply contrasts with 2015 and early 2016 when there were surges in Beige Book mentions (Chart 6, panel 4). The last time that six consecutive Beige Books had so few remarks about a strong dollar was in late 2014. BCA's stance is that the dollar will move modestly higher in 2018. Business uncertainty over government policy (fiscal, regulatory and health) multiplied in the past few Beige Books as Congress debated the tax bill. However, in general, these comments have dropped since Trump took office in early 2017. The implication is that the business community is correctly focused on policy and not politics in D.C. (Chart 6, panel 5). However, the controversy associated with the tariffs on steel and aluminum will add to business unease in the coming months unless Trump reverses his position. The disagreement between the Fed and the market on inflation narrowed in the March edition of the Beige Book (Chart 6, panel 3). The number of inflation words in the Beige Book rose to an 8 month high in March, reflecting the abrupt change in sentiment on inflation in early 2018 both in the business community and the market. In the past year, inflation words in the Beige Book climbed as the readings on CPI and PCE rolled over. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. Bottom Line: The March Beige Book supports BCA's view that the U.S. economy is poised to expand above its long-term potential in the first half of 2018. Moreover, the elevated soundings on inflation in the Beige Book in recent years have again proved prescience, as price measures are poised to turn higher. While the first few Beige Books in 2018 showed that the business and financial communities welcomed tax cut legislation, the next edition will likely reflect elevated concern over the nation's trade policies. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Global Investment Strategy Weekly Report "Trump's Tariffs: A Q&A", published March 9, 2018. Available at gis.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Client Note "Market Reprices Odds Of A Global Trade War", published March 6, 2018. Available at gps.bcaresearch.com. 3 Please see BCA Research's China Investment Strategy Weekly Report "China And The Risk Of Escalation", published March 7, 2018. Available at cis.bcaresearch.com. 4 https://www.federalreserve.gov/newsevents/testimony/powell20180226a.htm 5 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Great Debate Continues," published April 17, 2017. Available at usis.bcaresearch.com.
Highlights Policymakers & Volatility: The major developed market central banks (Fed, ECB, BoJ), facing low unemployment rates and slowly rising inflation, are less able to respond to volatility spikes with more dovish monetary policies compared to past years. Investors should get used to a structurally higher level of volatility, likely for the remainder of the current business cycle upturn. Higher Volatilty & Spread Product: The relative risk-adjusted attractiveness of global spread product looks different when using a higher level of yield volatility, particularly when hedged into U.S. dollars. Continue to favor U.S. investment grade and high yield corporate debt over euro area and emerging market equivalents, even with the more elevated volatility backdrop. Feature If there is one lesson to be learned from recent events, it is that global policymakers can no longer be trusted to always make the most market-friendly decisions. Central bankers in most countries have shifted from solely supporting growth to fighting inflation pressures. The White House is now willing to risk a disruptive trade war to try and "correct" the large U.S. trade deficit, rather than focusing on stimulating growth solely through fiscal policy. Even geopolitical headlines have become more worrisome for investors, with Russia announcing new nuclear capabilities, China appointing a "president for life", the U.K. government remaining vague on the details of its Brexit negotiating stance and Italy's elections producing a hung parliament with anti-establishment parties outperforming expectations. The idea that central bankers have been explicitly putting a floor under risk assets, by focusing so much on financial conditions as a critical input into their economic and inflation forecasts, has become very entrenched among investors. The implication is that if risky assets sell off, central banks will shift to a more dovish stance, thus causing interest rate expectations to shift lower which eventually causes risk assets to rebound and financial conditions to ease. This has been most evident in the U.S., where a belief in the "Fed Put" - the idea that the Fed has implicitly sold investors a put option on equities by responding dovishly to market selloffs - goes all the way back to the Greenspan era. In the U.S., however, there is now greater uncertainty that a "Powell Put" even exists - or at least one as valuable as the "Yellen Put" and "Bernanke Put" before it. In other words, it may now take a much larger decline in risk assets to cause the Fed to question its economic forecasts enough to change them. New Fed Chairman Jay Powell said as much in his first appearance before the U.S. Congress last week, where he noted that the recent equity market turbulence was not "weighing heavily" on the Fed's outlook. In fact, Powell talked up a very bullish view on the U.S. economy, which markets took as a sign that the Fed could hike rates four times in 2018 - more than the three hikes currently embedded in the Fed's projections. A similar dynamic is playing out in Europe and Japan, where the European Central Bank (ECB) and Bank of Japan (BoJ) have been more vocal about the potential end of their respective asset purchase programs given the underlying strength of the euro area and Japanese economies. The belief in a "Draghi Put" or "Kuroda Put" is also strong, but is starting to wane. Central Bankers As Options Traders Chart 1A Smaller Response To Higher Volatility One way to see this changing backdrop is to look at the response of monetary policy expectations to increases in market volatility. During 2017, there were a few small flare-ups of equity market volatility in the U.S., euro area and Japan. In each of those episodes, interest rate markets were quick to price in easier monetary policy through a lower projected level of the funds rate in the U.S. or by pushing out the timing of the eventual first rate hike in Europe and Japan (Chart 1). The story is much different in 2018, where volatility has soared higher but there has been little change to the expected path of interest rates. Markets now understand that inflation-fighting central banks, who strongly believe in the Phillips Curve, now have to focus more on inflation than asset prices with unemployment rates at or below full employment levels. Using the language of options markets, the "strike price" on the put options allegedly sold by central bankers is now much lower. The implication is that bouts of market turbulence cannot generate lasting decreases in government bond yields that can eventually restore calm to financial assets. In other words, policymakers are now implicitly, but not intentionally, putting a floor under volatility rather than asset prices. This has made the investment backdrop much more challenging in 2018, as both absolute market returns and, especially, risk-adjusted returns will be far lower than investors have enjoyed over the past couple of years. This is one of the key themes that we outlined in our 2018 Outlook.1 It will take signs that more volatile markets are damaging economic growth and inflation expectations for this new dynamic to change. Yet there is little sign of that happening, at least among the "Big 3" central banks. The Federal Reserve In the U.S., economic data continues to print strongly. The February ISM manufacturing Index hit a 13-year high (Chart 2, top panel), with the export index hitting the highest level since 1988! The Conference Board index of consumer confidence hit the highest level since 2000 (2nd panel), while the Board's index of leading indicators continues to accelerate (3rd panel). The ISM new orders index remains at elevated levels that suggest that the latest upturn in capital spending should continue (bottom panel). Meanwhile, U.S. inflation gauges continue to grind slowly higher. The 3-month annualized growth rate of the core PCE deflator rose to 2.1% in January - above the Fed's 2% target - while the ISM Manufacturing Prices Paid index is now at a 6-year high (Chart 3). Inflation expectations from the TIPS market have recently stalled below levels that we deem consistent with the Fed's inflation objective (between 2.3% and 2.5% on both the 10-year TIPS breakeven and the 5-year TIPS breakeven, 5-years forward), but they continue to trend in the direction of the Fed's target. If the wage numbers in this Friday's February Payrolls report build on the breakout seen in the January data, then breakevens should begin to climb higher once again and would all but ensure that another Fed rate hike will occur later this month. Chart 2Fed Chair Powell Is Right##BR##To Be Optimistic On U.S. Growth Chart 3U.S. Inflation Now Moving##BR##Towards The Fed Target The ECB Chart 4Will The ECB Pull Forward Its Projections? Turning to the euro area, economic data has begun to dip lower in recent readings for cyclical indicators like the manufacturing PMI, which complicates the story for the ECB heading into this Thursday's policy meeting. We continue to expect any decision on a tapering of the ECB's asset purchase program to not take place until the summer. However, some minor changes to its forward guidance, like removing language suggesting that asset purchases could be increased if necessary, could happen this week. The more meaningful signal will come from the new set of ECB economic forecasts. Core euro area HICP inflation is not projected to return close to the ECB's 2% target until 2020, and if that timetable is pulled forward in the new forecasts, that would give the ECB a credible reason to begin signaling a taper later this year. With full euro area unemployment hitting an 8-year low of 8.6% in January - dipping below the OECD full employment NAIRU estimate of 8.7% - the ECB could raise its projections for both wage growth and core inflation (Chart 4). With our own core HICP diffusion index showing a sharp increase in January, the risk of future upside surprises in euro area realized inflation has increased. Yet core inflation is still only 1.0% - a long way from the ECB's 2% target. This is already reflected in measures of inflation expectations like CPI swap forwards, which remain between 50-75bps below the levels that prevailed the last time euro area core inflation was around 2% (bottom two panels). This suggest further upside for euro area bond yields if core inflation does start to print higher later this year. For now, the ECB is unlikely to make any earth-shattering changes to its monetary policy this week, but should signal another small incremental step towards a full-blown taper later in 2018. The BoJ BoJ Governor Haruhiko Kuroda threw a bit of a surprise at the markets last week in his testimony before the Japanese parliament following his reappointment as the head of the central bank. In response to a question on when the BoJ could consider beginning to exit its current Yield Curve Control (YCC) program, Kuroda stated that it could happen in fiscal year 2019 if the BoJ's inflation projections are realized. The media headlines took that as a sign that the BoJ was starting to change its forward guidance about its monetary policy, but that is an overreaction, in our view. Chart 5The Yen Leads The BoJ, Not Vice Versa Realized inflation remains well below the BoJ's target, with headline CPI inflation hitting 1.3% and 0.4%, respectively, in January (Chart 5). Even given the continued strength of the Japanese economy, with the unemployment rate now sitting at a 29-year low of 2.4%, inflation will have no realistic shot of reaching the BoJ 2% target without a weaker Japanese yen. The markets understand that dynamic, as our Japan months-to-hike measure - measuring the time until the first 25bps rate hike is priced into the Overnight Index Swap curve - has recently drifted up from 38 months to 47 months alongside the current appreciation of the yen (bottom panel). The BoJ remains the one major central bank that can still talk dovishly because inflation remains so low. Yet investors are aware that the BoJ is having greater difficulty operationally executing its asset purchase program, given its huge ownership share of Japanese government bonds and equity ETFs. So, like the Fed and the ECB, the BoJ's ability to credible respond in a dovish fashion to rising market turbulence - manifested through a rising yen - is severely hamstrung. Bottom Line: The major developed market central banks (Fed, ECB, BoJ), facing low unemployment rates and slowly rising inflation, are less able to respond to volatility spikes with more dovish monetary policies compared to past years. Investors should get used to a structurally higher level of volatility, likely for the remainder of the current business cycle upturn. What A Higher Volatility Regime Means For Global Spread Product If policymakers are now unable to take actions that can restore the low volatility regime seen last year, then this has implications for the relative attractiveness of global fixed income spread product. One way to see is this is to look at the ranking of volatility-adjusted yields for various global spread sectors. We present that in Table 1, where we take the currency-hedged yields for spread sectors and rank them according to two metrics: a) the outright hedged yield and b) the hedged yield relative to its trailing yield volatility.2 The sector yields are then re-ranked using the average ranking of those two metrics. We present the table with yields hedged into the four major developed market currencies (U.S. dollar, euro, yen and British pound). The level of those yields, shown against credit ratings, are graphically presented in the Appendix on pages 11 and 12. Table 1Ranking Currency-Hedged Global Spread Product Yields We also show two versions of the yield rankings - one using trailing volatility over the past year in the denominator of the risk-adjusted yield, and the other using trailing volatility over three years in the denominator. This is important, as bond volatility over the past year has been historically depressed and is much lower than the three-year volatility measure for almost every spread sector. The conclusion is that many sectors that look most attractive using the more recent low volatility look less appealing with a more "normal" volatility level. For example, U.S. high-yield corporates are the top ranked sector in USD terms using a trailing one-year volatility, but that ranking falls to #10 using a higher three year volatility. Euro area high yield falls from #6 to #11 when applying the different volatility measures, while emerging market USD-denominated sovereign debt falls from #3 to #6. While the differences in the yield rankings are not as meaningful for higher-quality sectors, and for other base currencies besides the U.S. dollar, the main takeaway is that a higher volatility environment can alter the relative attractiveness of spread sectors given the current low level of yields. Thus, if central banks now have reduced ability to respond to volatility shocks by signaling a more dovish stance - given strong growth, tight labor markets and slowly rising inflation - then investors should judge spread product, and risk assets in general, using a higher level of volatility than seen last year. The conclusion is that we should be using the upper left column of Table 1, using the more "normal" level of yield volatility, when assessing the attractiveness of spread sectors within our recommended investment universe that uses the U.S. dollar as the base currency. With regards to corporate bonds in our model bond portfolio, that means favoring U.S. investment grade over euro area and emerging market equivalents and favoring U.S. high yield over euro area high yield. We are happy to report that we already have those recommendations implemented in our portfolio. While the absolute valuations of U.S. investment grade corporates, from a perspective of breakeven spreads, do look historically tight (Chart 6, middle panel), the same can be said for euro area investment grade corporates (Chart 7, middle panel). We are willing to take that trans-Atlantic spread risk favoring the U.S., however, given that currency hedging costs continue to favor U.S. dollar investments over euro-denominated equivalents. Chart 6Favor U.S. Corporate Bonds... Chart 7...Especially Versus Euro Area Corporates The story is cleaner for U.S. high yield over euro are high yield, as the default-adjusted spreads in the former (Chart 6, bottom panel) look far more attractive than in the latter (Chart 7, bottom panel). Bottom Line: The relative risk-adjusted attractiveness of global spread product looks different when using a higher level of yield volatility, particularly when hedged into U.S. dollars. Continue to favor U.S. investment grade and high yield corporate debt over euro area and emerging market equivalents, even with the more elevated volatility backdrop. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Appendix Appendix Chart 1Global Spread Product Yields, Hedged Into U.S. Dollars Appendix Chart 2Global Spread Product Yields, Hedged Into Euros Appendix Chart 3Global Spread Product Yields, Hedged Into British Pounds Appendix Chart 4Global Spread Product Yields, Hedged Into Japanese Yen 1 Please see BCA Global Fixed Income Strategy Weekly Report, "2018 Key Views: BCA's Outlook & What It Means For Global Fixed Income Markets", dated December 5th 2017, available at gfis.bcareseach.com. 2 Using rolling averages of 60-day realized hedged yield volatility. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Easier fiscal policy will cause U.S. inflation to rise or force the Fed to raise rates more aggressively than the market is discounting. Either outcome is likely to lead to a real appreciation in the dollar. Policy developments are starting to work in the greenback's favor. The Fed's leadership is turning somewhat more hawkish. Trade protectionism is also on the rise. Contrary to yesterday's market reaction, this will end up being dollar-bullish. The only plausible scenario where the dollar weakens in the face of bountiful fiscal stimulus is one where U.S. rates rise a lot but foreign rate expectations rise even more. Such an outcome is not particularly likely, considering that the U.S. is going from laggard to leader in the global growth horserace and most central banks are tightening monetary policy much more gingerly than the Fed. Nevertheless, it cannot be excluded, which is why investors should consider going long 30-year U.S. Treasurys versus German bunds in currency-unhedged terms. This position would pay off if EUR/USD weakens, while also providing downside protection in the case where the greenback comes under pressure due to a narrowing in the long-term interest rate spread between Germany and the U.S. Held to maturity, investors stand to gain 40% on this position. Feature Beware Of "Arguments By Accounting Identity" One of the biggest mistakes economic commentators make is that they engage in "arguments by accounting identity." These arguments almost always fall flat. This is because there are plenty of ways for accounting identities to hold true, only a small number of which are consistent with how people actually respond to economic incentives. Consider the often-cited identity which says that the difference between what a country saves and what it invests is equal to its current account balance or, in algebraic terms, S-I=CA. The U.S. is currently operating at close to full employment. It is sometimes asserted, using this formula, that a large dollop of fiscal stimulus will drain national savings, thereby increasing America's current account deficit. A bigger current account deficit is normally associated with a weaker currency. Ergo, fiscal stimulus must be dollar-bearish. It is a plausible sounding argument, but it makes no sense because it confuses cause and effect.1 It is analogous to saying that an increase in the number of apples coming to market means that the price of apples will fall even when it is apparent that farmers are planting more apple trees because the demand for apples is rising. If the government cuts taxes and boosts outlays, aggregate spending will increase. Should the value of the dollar simultaneously fall, the composition of that spending will shift towards domestically produced goods and services. Not only will people want to spend more, but they will also want to devote a larger share of their spending on U.S.-made goods. But how exactly is the economy supposed to generate all this additional output? It is already running at full capacity! The only story that makes sense is one where the value of the dollar rises. That would allow aggregate spending to go up, while ensuring that spending on American-made goods and services remains the same. Table 1 illustrates this point using a stylized example of a hypothetical economy. Table 1A Stronger Currency Can Be A Counterweight To Fiscal Stimulus U.S. imports account for about 15% of GDP (Chart 1). Assuming no change in the exchange rate, spending on domestically produced goods and services will rise by about 85 cents in response to every $1 increase in aggregate demand. If the economy cannot produce this additional output due to a lack of available workers, one of two things will happen: Either inflation will go up or the Fed will be forced to raise rates more aggressively than it otherwise would. Chart 1U.S. Trade As A Share Of The Economy Both outcomes imply a "real appreciation" in the dollar exchange rate, which can be thought of as the value of foreign goods and services that can be acquired by selling a basket of U.S. goods and services.2 In the former case, the real dollar exchange rate will appreciate because the U.S. price level will rise relative to prices abroad. In the latter case, the real dollar exchange rate will appreciate because higher interest rates will put upward pressure on the nominal value of the currency. Two Paths To A Real Dollar Appreciation The catch is that it is impossible to know how much of the real appreciation will occur through higher inflation and how much of it will occur through a stronger nominal dollar. In theory, one could envision a scenario where the real value of the dollar rises even as the nominal value declines. This would happen if the Fed fell so far behind the curve that inflation rocketed higher. Alternatively, one could contemplate a scenario where the Fed raises rates too aggressively, driving the dollar up so much that the economy falters and inflation declines. Our baseline scenario lies somewhere between these two extremes. We expect U.S. fiscal stimulus to push up inflation, while also pushing up the nominal trade-weighted dollar. It rarely happens that real and nominal exchange rates move in opposite directions (Chart 2). Thus, if the real dollar exchange rate appreciates, the nominal exchange rate is bound to appreciate as well. Chart 2Nominal And Real Exchange Rates Tend To Move In The Same Direction Global Growth: Back To The USA So why, then, has the dollar been on the back foot over the past year? The answer is better economic prospects at home were more than matched by stronger growth abroad. Keep in mind that the discussion above does not need to be confined to fiscal stimulus. Anything that causes domestic demand to accelerate is apt to trigger a real appreciation of the currency. After a sluggish recovery following the sovereign debt crisis, euro area growth accelerated last year as credit markets thawed and pent-up demand was unleashed. Sensing better economic times ahead, investors bid up the euro. The global growth revival was assisted by a rebound in global manufacturing activity. The manufacturing sector tends to be highly procyclical; when global growth accelerates, manufacturing production usually accelerates even more. The U.S. manufacturing sector accounts for only 12% of GDP, compared to 18% in the euro area, 21% in Japan, and 30% in China (Chart 3). As such, an improving manufacturing outlook disproportionately helped the rest of the world. Meanwhile, a rebound in commodity prices aided emerging markets and other economies with large natural resource sectors. Looking out, the picture for global growth is murkier. Global manufacturing PMIs have likely peaked. Korean exports, a leading indicator for the global business cycle, have softened (Chart 4). China is decelerating, with this week's weaker-than-expected official PMI print being the latest example. This could weigh on metals prices (Chart 5). As we discussed last week, slower global growth tends to benefit the dollar.3 Meanwhile, the composition of global demand growth should shift back toward the U.S. thanks to the lagged effects from the relative easing in financial conditions that the U.S. enjoyed last year, as well as all the fiscal stimulus coming down the pike (Chart 6). Chart 3Global Manufacturing Revival ##br##Not Benefiting The U.S. Much Chart 4Global Growth Seems To Be Peaking Chart 5Chinese Slowdown Will Weigh On Metal Prices Chart 6Lagged Easing In Financial Conditions ##br##And Fiscal Stimulus Bode Well For Growth A More Dollar-Friendly Policy Backdrop Policy developments are starting to work in the dollar's favor. Jerome Powell tried not to rock the boat during his Humphrey-Hawkins testimony this week. However, he did stress that the economic outlook did improve since the Fed last met in December, seemingly opening the door to four rate hikes this year. That was enough to lift the DXY by 0.4%. Powell is not a doctrinaire hard-money type, but he is no Yellen clone either. Remember this was the guy who said back in 2012 that "We look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that is our strategy."4 Critically, there are still four vacancies on the Fed's Board of Governors. If the nomination of Martin Goodfriend - who is definitely no good friend of easy money - is part of a broader trend, the composition of the board will shift in a somewhat more hawkish direction. Meanwhile, the Trump administration has introduced tariffs on imported steel and aluminum. While we do not expect this decision to trigger an all-out trade war, it will almost certainly prompt retaliatory actions. There are three reasons why an escalation in trade protectionism would help the dollar. First, a decrease in global trade would likely reduce trade surpluses and deficits alike. This would shift demand back towards economies such as the U.S., which run trade deficits, at the expense of surplus economies such as Japan, China, and the euro area. Second, a slowdown in trade flows would curb global growth. As noted above, slower global growth tends to be dollar-bullish. Third, the specter of trade wars would exacerbate geopolitical risks. A more uncertain political landscape, even when instigated by the U.S., tends to prop up the dollar. It is true that foreign powers could retaliate against the U.S. by buying fewer Treasurys. But why would they? This would only drive down the dollar, giving U.S. exporters an even greater advantage. The smart strategic response would be to intervene in currency markets with the aim of bidding up the dollar. All this suggests that the dollar may be ripe for a rebound. Positioning has gotten fairly short the dollar (Chart 7). This raises the odds of a short-covering rally. Momentum measures have also improved over the past few weeks, an important consideration given that the dollar is one of the most momentum-driven currencies out there (Chart 8). Chart 7Speculative Positioning Has Gotten Increasingly Dollar-Bearish Chart 8Momentum Matters, And It May Be Starting To Move Back In The Dollar's Favor A Safer Way To Go Long The Dollar: Buy 30-Year Treasurys/Short 30-Year German Bunds, Currency-Unhedged The only scenario where the dollar weakens in the face of bountiful fiscal stimulus is one where U.S. rates rise a lot but foreign rate expectations rise even more. Sharply higher U.S. interest rates would offset the stimulative effects of a weaker dollar, thus preventing the economy from overheating. Such an outcome is not particularly likely, given that the U.S. is going from laggard to leader in the global growth horserace, and most central banks are tightening monetary policy much more gingerly than the Fed. Nevertheless, it cannot be excluded. As such, investors should consider going long 30-year U.S. Treasurys versus German bunds in currency-unhedged terms. This position would pay off if EUR/USD weakens, while also providing downside protection in the case where the greenback comes under pressure due to a narrowing in the long-term interest rate spread between Germany and the U.S. The trade is effectively a bet that the interest rate differential between bunds and Treasurys - which has widened sharply this year, even as the dollar has weakened - will revert to its former self (Chart 9). Over the long haul, it is hard to see how one could lose money on this trade. As we go to press, 30-year Treasurys are yielding 3.11% while 30-year bunds yield only 1.29%. The euro would have to strengthen to 2.10 against the dollar over the next 30 years to cancel out the 182 bps in additional carry that U.S. bonds are offering. Even if one assumes that the fair value for the euro climbs by 0.4% annually due to lower inflation in the common-currency bloc, this would still leave the euro 40% overvalued.5 To maintain consistency with our other trade recommendations, we are closing our short 30-year Treasury trade for a gain of 3.8% and opening a new trade going long 30-year TIPS breakevens. Chart 10 shows that long-term inflation expectations as gauged by 30-year breakevens are still 27 basis points below where they were on average between 2010 and 2013. Chart 9EUR/USD And Long-Term Spreads Will Recouple Chart 10More Upside To Long-Term TIPS Breakevens Investment Conclusions We expect the dollar to strengthen over the coming months. EUR/USD should ultimately bottom at around 1.15. EM currencies will also struggle on the back of slower Chinese growth and higher financing costs for dollar-denominated loans. Among commodity producers, we favor "oily" currencies such as the Canadian dollar and Norwegian krone over metal exporters such as the Australian dollar. Our commodity strategists expect Brent and WTI to average $74 and $70/bbl this year, above current market expectations of $66 and $62, respectively. They note that Saudi Arabia has a strong incentive to boost oil prices by curtailing production in the lead up to Aramco's initial public offering. The yen is better positioned to hold its ground, considering that it is still very cheap and positioning remains heavily short (Chart 11). My colleague, Mathieu Savary, discussed the yen's prospects two weeks ago.6 A rebound in the dollar and creeping protectionism will pose headwinds for global equities. Nevertheless, with corporate earnings continuing to surprise on the upside, this is unlikely to derail the cyclical bull market in stocks. However, investors should prepare for a lot more volatility, as we flagged in several reports earlier this year.7 At the regional level, U.S. equities have underperformed their global peers in common-currency terms since the start of 2017, but outperformed in local-currency terms (Chart 12). We could see a reversal of that pattern over the coming months as the dollar begins to firm. Chart 11The Yen Is Cheap And ##br##Positioning Is Short Chart 12A Stronger Dollar Could Reverse ##br##U.S. Equity Relative Performance Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Paul Krugman made a similar point more than 20 years ago. 2 The real exchange rate between two currencies is the product of the nominal exchange rate and the ratio of prices between the countries. A real appreciation tends to make a country less competitive, either through a nominal increase in its currency or through an increase in prices in that country relative to those of its trading partners. 3 Please see Global Investment Strategy Weekly Report, "The Next Recession: Later But Deeper," dated February 23, 2018. 4 Please see FOMC Meeting Transcript, "Meeting of the Federal Open Market Committee on October 23-24, 2012," Federal Reserve. 5 For this calculation, we assume that the fair value for EUR/USD is 1.32, which is close to the IMF's Purchasing Power Parity (PPP) estimate. The inflation differential of 0.4% is based on 30-year CPI swaps. This implies that the fair value for EUR/USD will rise to 1.49 after 30 years. If the euro needs to strengthen to 2.10 over 30 years to cover the cost of carry, this would leave it 41% (2.10/1.49) overvalued. Our assessment would not change much if we used Germany rather than the euro area as the basis for the analysis. We estimate that the fair value exchange rate for Germany is 1.45, which is higher than the fair value exchange rate for the euro area as a whole. However, the differential in 30-year CPI swaps between Germany and the U.S. is only 16 basis points. Thus, if the fair value German exchange rate evolves in line with inflation differentials, it would rise to only 1.52. This would still leave Germany 38% (2.10/1.52) overvalued against the U.S. after 30 years. 6 Please see Foreign Exchange Strategy, "The Yen's Mighty Rise Continues...For Now," dated February 16, 2018. 7 Please see Global Investment Strategy Special Report, "The Return Of Vol," dated February 6, 2018; and Weekly Report, "Take Out Some Insurance," dated February 2, 2018. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Fiscal Stimulus To Prolong The Expansion The market swoon in early February should not induce investors to lower risk. The stock market correction (the first for almost two years) was triggered by a couple of inflation and wage readings that came in slightly above expectations, and was exacerbated by some technical factors such as automated trading by volatility-target funds. But, significantly, it was not accompanied by the usual signals of rising risk aversion: for example, credit spreads barely widened and the gold price was stable (Chart 1). Volatility is likely to remain high but, as our U.S. Investment Strategy service recently found, the VIX has not been a useful indicator of recessions and bear markets: many times over the past 30 years it has spiked higher without risk assets producing negative returns over the subsequent 12 months (Chart 2).1 Recommended Allocation Chart 1Sell-Off Didn't Trigger Risk Signals Chart 2Spike In Vix Is Not A Sell Signal Fiscal policy moves in the U.S. make us believe, rather, that the current economic expansion will last longer than we previously forecast. A combination of tax cuts plus recent spending proposals (including $165 billion on the military and $45 billion on disaster relief) will boost GDP by about 0.8% of GDP this year and 1.3% next, compared to the IMF's earlier forecast of a fiscal contraction this year (Chart 3).2 Add to that the boost from the 8% trade-weighted depreciation of the U.S. dollar over the past 12 months (which should add 0.3% to growth over two years), and it is difficult to imagine U.S. GDP growth turning down any time soon. Accordingly, BCA has shifted its recession call from the second half of 2019 to sometime in 2020. Of course, this is not all good news. The U.S. budget deficit is likely to increase to 5½% of GDP in 2019, which will put upward pressure on interest rates. The fiscal impulse will hit an economy already at full capacity, and so will be inflationary. The scenario we envisage is boom-and-bust, leading to a nastier recession than we had previously expected. Nonetheless, the boost to growth should be positive for risk assets over the next 12 months. Our model of earnings growth now suggests that U.S. EPS should continue to grow at close to a 20% rate for the rest of this year (Chart 4). Chart 3Fiscal Boost To U.S. Growth Chart 4Earnings Growth Gets A Boost Too How quickly will the Fed push back against the potentially inflationary implications of this higher growth? We have found a remarkable turnaround in investors' perceptions of inflation over the past few weeks. Whereas last year most argued that structural forces (online shopping, the gig economy etc.) meant that inflation would stay depressed, now many worry that it will quickly shoot above 2% and force the Fed to tighten policy aggressively. This has caused them to over-react, for example, to the (rather obvious) statement from the last FOMC minutes that "participants noted that a stronger outlook for economic growth raised the likelihood that further gradual policy firming would be appropriate." Our view remains that core PCE inflation - the Fed's favorite measure - is likely to move back gradually to 2% (from 1.5% currently), but not accelerate dramatically. Unit labor costs remain subdued (Chart 5), the continued rise in the participation rate means there is more slack in the labor market than implied by headline unemployment (Chart 6), and inflation expectations remain low. This should allow new Fed chair Jerome Powell to continue to withdraw accommodation at a measured pace. The market has already priced in that the Fed will tighten this year at least in line with its dots (Chart 7). We expect four, rather than the Fed's projected three, hikes this year, but this should not be too hard for the market to absorb. Chart 5Unit Labor Costs Don't Point To Jump In Inflation Chart 6 Still Some Slack In Labor Market Chart 7Market Has Caught Up To The Fed We have for some months now advised long-term, more risk-averse investors to consider dialing back risk, and the volatility in February was a good example of why. We would expect further such bouts of volatility. However, with a recession still probably two years away, and a combination of stronger-than-expected growth and a Fed reluctant to accelerate tightening, the next 12 months should remain positive for equities and other risk assets. Fixed Income: We now expect the 10-year U.S. Treasury bond yield to rise to 3.3-3.5%. This will come from a further 40 BP increase in inflation expectations (taking them back to a level compatible with the Fed achieving its inflation target) plus a rise in the real yield, as markets start to price in the end of secular stagnation (Chart 8). The rise in global yields will be exacerbated by increasing net supply, as fiscal deficits rise and central banks wind down QE (Chart 9). We are, accordingly, underweight duration, and prefer inflation-linked bonds to nominal ones. We will likely reduce our exposure to credit before we turn defensive on equities. But, for now, strong economic growth and higher oil prices mean spread product is likely to outperform government bonds. Chart 8Inflation Expectations And Real Yields To Rise Chart 9Net Government Bond Supply To Increase Currencies: Rising interest rate differentials have failed to cause the dollar to rally (Chart 10). FX markets are trading, rather, on valuations (the euro and yen are, indeed, undervalued), on current account positions (the euro zone and Japan have large surpluses), and on the narrative that U.S. twin deficits historically caused the dollar to weaken. Our FX strategists find this is true only when, as in 2001-3, U.S. real rates were falling; after the Reagan tax cuts in 1981, real rates rose, pushing up the dollar (Chart 11). The key, therefore, is how quickly the Fed reacts this time. The dollar currently has strong downward momentum (especially against the yen) and this could continue. But as global growth slows relative to the U.S., relative interest rates are likely to reassert themselves as a factor, causing the dollar to strengthen again. Chart 10Rising Rate Differentials Fails To Boost Dollar Chart 11Do Twin Deficits Matter For Dollar? Equities: Given the macro environment, we continue to recommend pro-cyclical equity tilts, with overweights in higher beta markets such as the euro zone and Japan, and cyclical sectors such as financials, energy, and industrials. Our underweight on EM equities is based on the risk of a slowdown in China (where tighter financial conditions point to a slowing of the industrial sector, Chart 12), the possibility of a U.S. dollar rebound, and the vulnerability of highly leveraged foreign-currency EM borrowers to a rise in U.S. interest rates. Commodities: Our energy team has further revised up their oil price forecast, on expectations that the OPEC agreement will be extended, which will cause a greater draw-down in oil inventories (Chart 13).3 They see Brent crude averaging $74 a barrel this year, with spikes above $80. However, the response of the U.S. shale industry will begin to kick in, pushing the price down to below $60 by end-2019. We are neutral on industrial commodities, which will benefit from stronger global growth but are at risk in the event of dollar appreciation and slowdown in China. Chart 12Tighter Monetary Conditions In China Chart 13Oil Inventories To Draw Down Further Please note that, due to the Easter holidays in some countries, the GAA Quarterly Portfolio will be published one day later than usual, on April 3. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report, "Late Innings," dated 26 February 2018, available at usis.bcaresearch.com 2 For details, please see The Bank Credit Analyst, "March 2018," available at bca.bcaresearch.com 3 Please see Commodity & Energy Strategy Weekly Report, "OPEC 2.0: Getting Comfortable With Higher Prices," dated 22 February 2018, available at ces.bcaresearch.com GAA Asset Allocation
Highlights Federal Reserve: Is the U.S. neutral rate now higher? ECB: How much has the euro rally damaged European growth? Bank of Japan: Will a stronger yen tip Japan back into deflation? Bank of England: Will higher real wages offset Brexit uncertainties? Bank of Canada & Reserve Bank Of Australia: How much spare capacity truly exists? Feature We have not published a regular Weekly Report in Global Fixed Income Strategy since February 6th. We instead published necessary Special Reports on two countries of immediate relevance: Japan, because of the recent surprising strength in the yen, and Italy, because of the upcoming election. The pause in our regular commentary on the state of the markets, however, was useful. It has given us more time to reflect on the potential for a continuation of the global bond bear market after the volatility spike earlier in the month. What we find interesting is that, despite the common narrative that the back-up in global bond yields seen in 2018 has been about rising inflation fears, market pricing suggests the big shift has instead been in real bond yields and central bank policy expectations. In Table 1, we present the year-to-date change in the 10-year government bond yield for the major developed markets. We also show the changes in various other interest rate measures, including: Table 12018 Year-To-Date Changes In Government Bond Yield Components Our 12-month Policy Rate Discounters, which show the change in short-term interest rates priced into money market curves Our proxy measure of the market pricing of the real neutral ("terminal") interest rate - the 5-year Overnight Index Swap (OIS) rate, 5-years forward minus the 5-year CPI swap rate, 5-years forward Our estimate of the term premium on the 10-year government bond yield. What stands out in the table is that markets have moved to price in both a higher amount of expected rate hikes over the next year (Chart 1) and a higher neutral real interest rate, even with very little change in expected inflation. This can also been seen by looking at recent declines in the correlations between inflation expectations and nominal bond yields in the major economies, which are off from the peaks seen late in 2017 (Chart 2). Chart 1Rising Rate Expectations Have##BR##Been Pushing Yields Higher Of Late... Chart 2...Rather Than Higher##BR##Inflation Expectations The obvious conclusion is that the bulk of the rise in global bond yields seen year-to-date has been driven by increases in the real yield component, which itself has been heavily influenced by expected changes to central bank policy rates. Keeping that in mind, in this Weekly Report, we take a look at the most important question faced by each major central bank, and what that means for future decisions on policy interest rates - and by extension, for government bond yields. The Federal Reserve: "Is The U.S. Neutral Rate Now Higher?" With the 10-year U.S. Treasury yield having taken several runs at the critical 3% level in recent weeks, the debate has raged among investors as to whether that should be considered a breakout point or a buying opportunity. Comparing the U.S. economy now to what it looked like the last time the 10-year yield was at 3% at the end of 2013 suggests that yields could have more upside: Real GDP growth: 1.7% then, 2.3% now1 The unemployment rate: 6.7% then, 4.1% now Headline CPI inflation: 1.4% then, 2.1% now Core CPI inflation: 1.7% then, 1.8% now Average Hourly Earnings growth: 1.9% then, 2.9% now Growth is faster, there is less spare capacity, and inflation is higher now than it was just over four years ago. Yet when looking at the decomposition of the 10-year U.S. Treasury yield into its real and inflation expectations component (Chart 3, 2nd panel), we find that the mix is only slightly more skewed to real yields today: Chart 3Treasury Yields Still Have More Upside,##BR##Based On 2013 Comparisons Nominal 10-year Treasury yield: 3.03% then (December 31st, 2013), 2.87% now (February 26th, 2018) Inflation expectations (10-year CPI swap): 2.54% then, 2.30% now Real yields (nominal 10-year yield minus 10-year CPI swap): 0.49% then, 0.57% now In other words, the real yield today is 20% of the total nominal 10-year yield compared to 16% back at the end of 2013. Not a major difference. Yet there are much bigger discrepancies between the elements that go into our real neutral rate proxy for the U.S. (bottom two panels): 5-year OIS rate, 5-years forward: 4.1% then, 2.6% now 5-year CPI swap rate, 5-years forward: 2.9% then, 2.3% now Real neutral rate proxy: 1.2% then, 0.3% now The market is now pricing in a real neutral funds rate that is nearly one full percentage point below the level that prevailed the last time the 10-year Treasury yield reached 3% prior to 2018. Even though the U.S. economy is now growing faster, with far less spare capacity and higher inflation, than it did at the end of 2013. This does suggest that the level of the neutral real fed funds rate has likely gone up, which the 43bps increase in our market-implied real neutral rate proxy so far in 2018 is likely reflecting. But does the Fed actually believe that the neutral funds rate should be higher? The minutes from the January FOMC meeting, released last week, noted that there was discussion on the neutral funds rate, but one that was different than during previous FOMC meetings in 2017 - the actual appropriate level of the neutral funds rate was a topic of debate: "Some participants also commented on the likely evolution of the neutral federal funds rate. [...] the outlook for the neutral rate was uncertain and would depend on the interplay of a number of forces. For example, the neutral rate, which appeared to have fallen sharply during the Global Financial Crisis when financial headwinds had restrained demand, might move up more than anticipated as the global economy strengthened. Alternatively, the longer-run level of the neutral rate might remain low in the absence of fundamental shifts in trends in productivity, demographics, or the demand for safe assets."2 Any change in the Fed's estimation of the long-run neutral funds rate is critical for the future path of Treasury yields, given where market pricing is at the moment. The U.S. OIS curve has now fully converged to the FOMC interest rate projections (the "dots") for this year and next year. More importantly, the market-implied terminal rate (the nominal 5-year OIS rate, 5-years forward) has now caught up to the FOMC terminal rate dot (Chart 4). The implication is that any further meaningful increase in Treasury yields can only come from higher inflation expectations - unless the Fed signals that a higher neutral rate is required. Our colleagues at our sister publication, U.S. Bond Strategy, recently noted that the Fed has historically been much more reluctant to raise its terminal rate projection in response to rising inflation than it was in cutting the projection when inflation falls.3 The conclusion is that inflation expectations will likely need to return to levels consistent with the Fed's inflation target - 2.3-2.5% on both the 10-year TIPS breakeven rate and the 5-year breakeven rate, 5-years forward - before the Fed would make any significant upward revisions to its terminal rate projection. In the meantime, Treasury yields are more likely to see a near-term consolidation, as U.S. data surprises have rolled over, market positioning has become very short, momentum is oversold and market pricing has fully converged with Fed expectations (Chart 5). In terms of data, the release of the next U.S. Employment report on March 9th is critical for the Treasury market in the near term, given that the January uptick in wage growth was the trigger for the spike in bond yields, and subsequent equity market correction, at the beginning of February (bottom panel). Chart 4Could The Fed Move##BR##The Interest Rate 'Goalposts'? Chart 5Treasury Selloff May Be##BR##Due For A Pause The ECB: "How Much Has The Euro Rally Damaged European Growth?" The European Central Bank (ECB) has been slowly preparing markets for an eventual withdrawal of its extraordinary monetary policy stimulus since last summer. Specifically, the ECB has begun a discussion of what it would take to end its bond buying program. Already, the central bank cut the monthly pace of its asset purchases in half at the beginning of 2018, and the topic of "tapering" has come up in many speeches from ECB officials. The ECB has been trying to not present an overly hawkish message when discussing an eventual end to its hyper-easy monetary stance. The overall level of government bond yields - both in the core and Periphery of the Euro Area - has been drifting higher, but by less than the increases seen in the U.S. Inflation expectations have been rising since the middle of 2017, although most of the 23bps increase in the benchmark 10-year German Bund yield seen so far in 2018 can be attributed to rising real yields (Chart 6). The market-implied real neutral rate has also been increasing, but still remains below zero (-0.2%). Yet despite only the modest increase in European interest rate expectations, there has been a substantially larger move in the euro. The trade-weighted euro has bond up by 8% over the past year, bringing the currency back to levels last seen in 2014 (Chart 7, top panel). The appreciating euro has become a subject of focus by the ECB, although it is not yet a cause for worry according to the minutes of the January ECB meeting released last week: Chart 6Only A Modest Rise In European Yields, So Far Chart 7A Potential ECB Dilemma "[...] although the past appreciation of the euro had so far had no significant impact on euro area external demand, volatility in foreign exchange markets represented a further increase that need monitoring."4 Chart 8No Damage Yet To European##BR##Exports From The Euro Rally The ECB is correct that the rising euro has not yet impacted Euro Area exports, the growth rate of which remains solid at 8% (bottom panel). This contrasts sharply with the performance the last time the trade-weighted euro was at current levels in 2014, when exports were barely growing at all. The difference is a much stronger global economy that is demanding far more European goods and services now compared to four years ago. For now, the ECB can look to the stability of export demand as a sign that the euro has not become a drag on the economy, but some warning signals may be flashing. Euro Area economic data surprises have plunged sharply, and the manufacturing PMI data has been softer in the past couple of months (Chart 8). While the absolute levels of the PMIs suggest an economy that is still growing at an above-trend pace, a continuation of the recent drops could pose a problem for the ECB as it tries to communicate its next policy move to the markets. The surging euro has done very little to drag down overall Euro Area headline inflation, given the strength in global oil prices over the past year (3rd panel). Core inflation has struggled to stay much above 1% over the past year or so, but our core inflation diffusion index - which measures the number of core Euro Area HICP sectors with rising inflation rates versus those with falling inflation rates - has surged in the past couple of months, which typically leads to a faster rate of core inflation (bottom panel). As long as the Euro Area export growth data holds up, the ECB is likely to focus more on rising core inflation than a stronger euro and should begin signaling an end to the asset purchase program by year-end. The Bank Of England: "Will Faster Wage Growth Offset Brexit Uncertainty?" The Bank of England (BoE) has surprised markets with its more hawkish commentary of late, particularly given the reason for the change - faster wage growth. The BoE had previously been cautious on its outlook for the U.K. economy, which was suffering from two powerful drags. First, the uncertainty over the Brexit negotiations was dampening business confidence and restraining capital spending. Second, the surge in realized inflation following the post-Brexit collapse of the British Pound triggered a period of contracting real wages that would be a drag on consumer spending. Until these were resolved, the BoE would be cautious with its future policy moves. Next month's European Union (EU) summit can provide some news on Brexit, as the U.K. government will be seeking a transition agreement that would give U.K. businesses a firm timeline for the separation of the U.K. from the EU. The U.K. government is reported to be seeking a two-year period for the agreement, but it may take longer than that to hammer out all the deals involved with the contentious issues of trade, immigration, etc. The longer the Brexit transition period, the more likely that U.K. firms will hold back on long-term investment spending because of uncertainty. As for the wage side of the story, the annual growth rate of Average Weekly Earnings has increased from 1.7% to 2.6% since the April 2017 low, but this is still below the headline CPI inflation rate of 3% (Chart 9, bottom panel). With the U.K. unemployment rate at a cyclical low of 4.4% - far below the OECD's estimate of the full employment NAIRU rate of 5.1% - additional increases in wage growth are possible if hiring demand does not begin to slow. Yet with U.K. data surprises rolling over (top panel), and with the OECD's U.K. leading economic indicator decelerating (middle panel), there is a growing risk that economic growth will slow in the coming quarters, to the detriment of hiring activity and wages. The current market pricing shows that there remains a wide gap between U.K. inflation expectations and nominal Gilt yields (Chart 10). The real 10-year Gilt yield is -1.84% (deflated by CPI swaps), while the market-implied neutral real interest rate is -1.94%. While such a deeply negative interest rate is unlikely to be a permanent state of affairs in the U.K., such an accommodative policy setting is required to prevent the economy from falling into a deep slump. Chart 9Is The BoE More Worried About##BR##Wage Pressures Than Growth? Chart 10Real Gilt Yields Rising,##BR##But Still Very Low As we noted back in January, we do not see the BoE being able to raise rates much at all this year given the likelihood of prolonged sluggishness of the U.K. economy and some reversal of the currency-fueled surge in inflation seen in 2017.5 The BoE choosing to tackle rising wage inflation while growth was decelerating would be a huge policy error that would eventually benefit the performance of U.K. Gilts. The Bank Of Japan: "Will A Stronger Yen Tip Japan Back Into Deflation?" The extraordinary monetary policy accommodation provided by the Bank of Japan (BoJ) makes an analysis of Japanese Government Bond (JGB) yields far less interesting. After all, when the central bank is actively intervening in large quantities to hold the level of the 10-year JGB around 0%, do the signals sent from money market and bond yield curves have any meaning vis-à-vis the actual Japanese economy? Right now, the pricing of the real 10-year JGB yield (deflated by CPI swaps) is just below 0%, as is the real terminal rate proxy from the Japanese OIS curve (Chart 11). Keeping JGB yields at such low levels is part of the BoJ's attempt to raise Japanese inflation back towards the central bank's 2% yield target. The mechanism by which that should happen is through a weaker Japanese yen. Yet the yen has been showing surprising strength in recent weeks, most notably the USD/JPY exchange rate that has been falling in the face of rising U.S.-Japan interest rate differentials (Chart 12, top panel). Chart 11Negative Real Rates Still Necessary In Japan Chart 12An Unwelcome Rise In The Yen The risk going forward is that the strengthening yen will create a drag on headline Japanese inflation that has recently accelerated back to 1% (middle panel). Given that both core CPI and nominal wages barely growing at all (bottom panel), the odds are increasing that Japanese inflation could begin to move lower without getting anywhere close to the BoJ's 2% target. As we discussed in our recent Special Report, a much weaker yen (i.e. USD/JPY between 115 and 120) is the first necessary precondition before the BoJ would consider raising its yield target on the 10-year JGB.6 We had placed odds of no more than 20% that the BoJ would raise its yield target in 2018, but if the yen continues to hold firm or even strengthen further from current levels, those odds fall to zero. Bank Of Canada & Reserve Bank Of Australia: "How Much Spare Capacity Truly Exists?" We are lumping the Bank of Canada (BoC) and Reserve Bank of Australia (RBA) together in this report, as both are facing the same critical question. The BoC has already raised its policy rate three times since last summer, in response to accelerating growth and diminished spare capacity in Canada. Canadian bond yields have risen in response through higher inflation expectations, rising real yields and greater expected rate increases from the BoC (Chart 13). The real 10-year Canadian yield has risen back to the highs last seen in late 2013, while inflation expectations are not quite back to those levels - a similar story to that seen in the U.S. The BoC's own estimate of the Canadian output gap flipped into positive territory at the end of 2017, signifying that there was no longer any spare capacity in the Canadian economy (Chart 14, top panel). The signal from the Canadian labor market is similar, with the unemployment rate now at 5.9% - well below the OECD NAIRU estimate of 6.5% (middle panel). Yet Canadian inflation rates, both for headline and core CPI, are only at 1.7% and 1.5%, respectively - both not even at the midpoint of the BoC's 1-3% target band (bottom panel). At the same time, wages have been accelerating, with the annual growth rate of Average Hourly Earnings now up to a two-year high of 3.3%. Chart 13All Bond Yield Components Rising In Canada Chart 14Where's The Inflation? Such a wide gap between price inflation and wage growth does throw into the question if the BoC's own output gap estimate is correct. We expect Canadian price inflation to eventually begin to close the gap with wage inflation, which will keep the BoC on its current expected rate hiking path in 2018 as long as the economy does not begin to slow meaningfully. The CPI inflation reports will be the most important data to watch in Canada over the next few months to determine if our view will pan out. In Australia, the market pricing is nowhere near as hawkish as in Canada, with inflation expectations (10-year CPI swaps) having been stuck in a range between 2.2-2.4% for the past two years (Chart 15, 2nd panel). The market-implied neutral real interest rate is stuck at 0% and has not been sustainably above that level since 2014 (bottom panel). Yet, like Canada, there are questions about the true degree of slack in the economy. The Australian unemployment rate is currently at 5.5%, well below NAIRU (Chart 16, top panel). The last time that the Australian economy ran for so long beyond full employment was in 2010-11, when headline inflation breached the upper limit of the RBA's 1-3% target band (bottom panel). Yet the so-called "underemployment rate" - essentially, those working part-time that would like to work full-time - has been much higher in recent years and now sits at 8.3%. This also fits with the IMF's estimate of the Australian output gap, which is still a very large -1.8%. Chart 15Australian Yields Are Stuck In A Range Chart 16Very Different Than 2011-12 Given these signs of excess capacity in both the labor market and the overall economy, it is no surprise that Australian inflation has struggled to surpass even the 2% midpoint of the RBA target band. The implication is that the Australian NAIRU is much lower than the official OECD estimate, and that the RBA is under no pressure to contemplate any interest rate increases for at least the rest of 2018. Net-net, while both the BoC and RBA are facing questions over the true amount of spare capacity in their economies, the situation is much more bullish for Australian government bonds than Canadian equivalents given the greater slack Down Under. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 These are average quarterly growth rates of U.S. real GDP for the full calendar year of 2013 and 2017, respectively. 2 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20180131.pdf 3 Please see BCA U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20th, 2018, available at usbs.bcaresearch.com. 4 https://www.ecb.europa.eu/press/accounts/2018/html/ecb.mg180222.en.html 5 Please see BCA Global Fixed Income Strategy Weekly Report, "A Melt Up In Equities AND Bond Yields?", dated January 23rd, 2018, available at gfis.bcaresearch.com. 6 Please see BCA Global Fixed Income Strategy Special Report, "What Would It Take For The Bank Of Japan To Raise Its Yield Target?", dated February 13th 2018, available at gfis.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
Highlights Fed: The Fed is getting more optimistic on growth and continues to forecast a rebound in inflation. Nevertheless, the March FOMC meeting is probably too soon to expect an upward revision to the Fed's rate hike expectations. Inflation: The headwinds working against inflation are set to fade this year. The core goods and medical care sectors will lead the way, but there are even tentative signs that the deceleration in shelter inflation might start to ease. Spread Product: A survey of investment grade bond sectors shows that municipal bonds, Foreign Agency bonds and Local Authority bonds are all attractively valued relative to corporates. In contrast, USD-denominated Sovereign bonds are expensive. At the upper-end of the credit spectrum, Consumer ABS offer good value but deteriorating credit fundamentals. Feature One byproduct of this year's increase in Treasury yields is that market expectations for the near-term path of Fed rate hikes have converged with the Fed's most recent median projection (Chart 1). At present, the overnight index swap curve is priced for a fed funds rate of 2.19% by the end of this year and 2.54% by the end of 2019. The Fed's most recent median projection calls for a fed funds rate between 2% and 2.25% by the end of 2018, and of 2.75% by the end of 2019.1 Chart 1Market Expectations Have Converged With The Fed Dots This convergence makes the next few Fed meetings particularly interesting. Will the Fed revise up its rate projections, giving the market permission to push short-dated yields even higher? Or will the Fed continue to signal three hikes this year and 2-3 more in 2019, restraining the bear market in short-dated bonds? Fortunately, last week we received a lot of information to help us answer these questions. Several FOMC members made noteworthy public remarks and the Fed released the minutes from the January FOMC meeting. What To Expect From The March FOMC Meeting The Fed's Rosy Growth Outlook The minutes from the January FOMC meeting showed a great deal of optimism about the U.S. recovery, from both the Fed staff and FOMC participants. Chart 2Substantial Stimulus In The Pipeline The minutes noted that the Fed staff submitted stronger economic projections at the January meeting than at previous meeting, noting that: [T]he forecast for real GDP growth was revised up, reflecting a reassessment of the recently enacted tax cuts, along with higher projected paths for equity prices and foreign economic growth and a lower assumed path for the foreign exchange value of the dollar. It's important to note that while these projections include the impact of recent changes to the tax code, they do not include the potential impact from the newly proposed two-year appropriations bill that is poised to pass through Congress in the next few weeks. This bill is significant with large outlays for disaster relief ($45 billion), the military ($165 billion) and non-defense discretionary items ($131 billion), spread over the next two years. Chart 2 demonstrates how much this spending bill and the recent tax cuts have altered the growth outlook. It shows two estimates of fiscal thrust, the initial economic impulse of changes in government tax and spending policies.2 One estimate is the IMF's baseline forecast that was made before the tax legislation was passed. That estimate showed that fiscal policy would have been contractionary this year, trimming about 0.5% from GDP, and only slightly expansionary in 2019. The second estimate, which incorporates both the tax legislation and the proposed spending bill, shows that the fiscal impulse will be +0.8% this year and +1.3% next year. A major turnaround, and the most stimulative fiscal policy since the immediate aftermath of the financial crisis. Staying The Course On Inflation At the January FOMC meeting the Fed saw a presentation on the performance of different inflation models, an exercise that is particularly important given that the Fed's traditional expectations-augmented Phillips curve model was not able to explain why prices decelerated last year. The staff concluded that while the prediction errors from Phillips curve-style models have been larger in recent years than during the 2001-07 period, they were not completely out of line with history. This synchs up with our own analysis. We re-created the Fed's expectations-augmented Phillips curve model using details from a speech given by Janet Yellen in 2015 (Chart 3).3 That model certainly shows a large prediction error in 2017, but one that is not inconsistent with past errors. The message is that 2017 was not an outlier in terms of the Fed's ability to forecast inflation, but rather that inflation is quite often difficult to forecast. The Fed staff did provide a couple reasons for why inflation lagged the model's predictions last year: [S]tructural changes in the price setting for some items, such as medical care, and the effects of idiosyncratic price shocks, such as the unusual drop in prices of wireless telephone services. And also forecast that inflation would reverse course in 2018: [C]ore PCE prices were forecast to rise notably faster in 2018, importantly reflecting both the expected waning of transitory factors that held down 12-month inflation measures in 2017 as well as the projected further tightening in resource utilization. We agree with this assessment. In fact, both CPI and PCE inflation measures have formed tentative troughs in the past few months and should see further near-term upside from both the core goods and medical care components (Chart 4). Core goods inflation has still not caught up with accelerating import prices (Chart 4, panel 2) and the PPI data show a recent large jump in health-care prices (Chart 4, panel 3). Chart 3The Fed's Inflation Model Chart 4Inflation Headwinds Will Fade On medical care, research from the San Francisco Fed has shown that a major reason for lower inflation in recent years has been the slower growth of Medicare payments to physicians and hospitals as mandated by the Affordable Care Act. But these payments are also forecast to grow 2% this year, much higher than the 0.6% growth seen last year and the 0.9% growth seen in 2016.4 It is even possible that the deceleration in shelter inflation could moderate in the months ahead, given the renewed decline in the rental vacancy rate (Chart 4, panel 4). Meanwhile, we continue to expect that stronger wage growth will eventually pressure core services inflation (excluding shelter and medical care) higher (Chart 4, bottom panel). But What Are They Saying? Even though the minutes conveyed a decidedly optimistic tone with regards to both growth and inflation, Fed speakers were much more cautious last week. Philadelphia Fed President Patrick Harker said that "based on the relatively strong economy, but the continued stubbornness of inflation, I've penciled in two hikes for 2018." Atlanta Fed President Raphael Bostic said he is "comfortable continuing with a slow removal of policy accommodation" but also that "that doesn't necessarily mean as many as three or four moves per year." St. Louis Fed President James Bullard also said that 100 basis points of rate hikes in 2018 "seems like a lot." At the very least it appears that upward revisions to GDP growth forecasts are not sufficient for these three members to revise their rate projections higher. But these three members also already projected shallower paths for rate hikes than the median FOMC member (Table 1). Table 1Composition Of The FOMC More important is whether FOMC members whose projections are consistent with the median - those with a "neutral" policy bias in Table 1 - are inclined to get more hawkish. One of those members is San Francisco Fed President John Williams who said last week that "it makes sense to think about three or four rate increases in 2018." Chart 5Still Not Back To Target At the moment, the median Fed projection calls for three rate hikes in 2018, and that median will only move higher in March if four out of the six members who currently forecast three hikes this year decide to increase their dots. Given the cautious tone struck by most Fed speakers last week, we think the odds of an upward revision to the Fed's 2018 rate hike forecasts at the March meeting are low. Bottom Line: The Fed is getting more optimistic on growth and continues to forecast a rebound in inflation. Nevertheless, the March FOMC meeting is probably too soon to expect an upward revision to the Fed's rate hike expectations. Our own assessment is that the headwinds working against inflation are set to fade this year and that 3-4 Fed rate hikes are likely. In either case, bond yields are still biased higher given that they are still not priced for an eventual return of inflation to the Fed's target (Chart 5). Maintain a below-benchmark duration stance. Searching For Late-Cycle Value In Spread Product As we have noted repeatedly in recent reports, we anticipate that we will start to de-risk the spread product side of our U.S. bond portfolio sometime in 2018, possibly quite soon depending on the future path of inflation.5 So this week we perform a survey of investment grade spread product sectors, with an eye towards identifying sectors that look attractively valued and also present a low risk of spread widening. Our primary tool for identifying value is the 12-month breakeven spread. The 12-month breakeven spread is the basis point spread widening required on a 12-month horizon for a sector to earn zero excess returns versus a duration-equivalent position in Treasury yields.6 Table 2 shows the 12-month breakeven spread for each sector split by credit rating. Table 212-Month Breakeven Spreads By Credit Rating The first thing we notice is the attractive spreads offered by municipal bonds after adjusting for the tax advantage. In fact, for investors exposed to the top marginal tax rate, the 12-month breakeven spread on a Aaa-rated municipal bond exceeds the spread offered by a Baa-rated corporate bond. We have previously noted that when the tax-adjusted spread on a 10-year Aaa-rated municipal bond exceeds the spread offered by the duration-matched investment grade corporate bond index, it has historically been a signal that the credit cycle is very late. We are not seeing this signal yet, but it is getting very close (Chart 6). The second observation that jumps out is that USD-denominated Sovereign debt is not attractive compared to U.S. corporate debt. This is true across the entire investment grade credit spectrum. Further, Chart 7 shows that Sovereign bonds typically exhibit greater excess return volatility than U.S. corporate bonds. Chart 6Positive Muni/Corporate Spreads##br## Are A Late-Cycle Indicator Chart 712-Month Breakeven Spread Versus ##br##Excess Return Volatility We anticipate getting an opportunity to shift out of corporate bonds and into Sovereign debt at some point during the next 12 months, but expect some poor performance from Sovereign bonds first. A quicker expected pace of Fed rate hikes has historically coincided with Sovereign bond underperformance (Chart 8), and if that plays out while growth outside the U.S. starts to moderate - a risk that has been flagged by both our leading indicators for the Chinese economy and the performance of EM/JPY currency carry trades - then this would further exacerbate the underperformance of Sovereign bonds by putting upward pressure on the U.S. dollar.7 A third observation from Table 2 is that Foreign Agency bonds look very attractive, and Chart 7 also shows that the sector has historically exhibited quite low volatility. Foreign state-owned energy companies make up a large portion of the Foreign Agency index, and this sector's performance closely tracks the price of oil (Chart 9). With our commodity strategists now calling for average 2018 crude oil prices of $74/bbl and $70/bbl for Brent and WTI respectively, the Foreign Agency sector should stay well supported.8 Local Authority bonds are also attractively valued, though to a lesser extent than Foreign Agencies, and also tend to exhibit relatively low excess return volatility. We continue to recommend an overweight position in this sector that is comprised principally of taxable municipal debt and USD-denominated Canadian provincial bonds. Chart 8Underweight Sovereigns Chart 9Overweight Foreign Agencies Finally, we notice that credit card and auto loan backed Consumer ABS offer very attractive spreads and relatively low volatility. While we retain a neutral allocation to Consumer ABS, we note that credit trends are starting to shift against the sector. Bank are now tightening lending standards on both credit cards and auto loans, and the delinquency rate has made a cyclical bottom (Chart 10). Aaa-rated non-Agency CMBS also offer an attractive breakeven spread, though this sector has historically been much more volatile. Here too we see that banks are tightening lending standards, but the tightening has moderated in recent quarters. If this continues then delinquencies could start to roll over and property prices could start to accelerate (Chart 11). We remain underweight non-agency CMBS for now, but note the tentative improvement in credit quality. Chart 10Neutral Consumer ABS Chart 11A Nascent Improvement In Credit Quality Bottom Line: A survey of investment grade bond sectors shows that municipal bonds, Foreign Agency bonds and Local Authority bonds are all attractively valued relative to corporates. In contrast, USD-denominated Sovereign bonds are expensive. At the upper-end of the credit spectrum, Consumer ABS offer good value but deteriorating credit fundamentals. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 We exclude the forecast provided by the St. Louis Fed President as an outlier and calculate the median from the remaining forecasts. 2 The fiscal thrust is defined as the change in the cyclically-adjusted budget balance, expressed as a percentage of GDP. 3 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 4 https://www.frbsf.org/economic-research/publications/economic-letter/2017/november/contribution-to-low-pce-inflation-from-healthcare/ 5 Please see U.S. Bond Strategy Weekly Report, "On The MOVE", dated February 13, 2018, available at usbs.bcaresearch.com 6 We calculate the 12-month breakeven spread as the average index option-adjusted spread divided by the average index duration. We ignore the impact of convexity. 7 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 8 Please see Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Getting Comfortable With Higher Prices", dated February 22, 2018, available at ces.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification