Asset Allocation
Highlights Stay tactically long the SEK. Our preferred expression is long SEK/GBP. Stay tactically short the NOK. Our preferred expression is long AUD/NOK. Take profits in the underweight to Poland... ...and open a tactical countertrend position: long Poland's Warsaw General Index, short Italy's MIB. A coalition of populists governing Italy might ruffle some feathers in Brussels, but the main risk appears to be contained. Both The League and 5 Star Movement have dropped calls for a referendum on Italy's membership of the monetary union. Feature Italy And The U.K. Compete For Political Risk The European political lens is once again focussed on Italy as the two anti-establishment parties - The League and 5 Star Movement - negotiate to form a government. A coalition of populists governing Italy might ruffle some feathers in Brussels, but the main risk appears to be contained. Both parties have dropped calls for a referendum on Italy's membership of the monetary union, and have instead turned their fire on the EU's fiscal rules, specifically the 3 per cent limit on budget deficits. Chart of the WeekThe SEK Is Due A Tactical Rebound The populist demand for some fiscal relaxation is actually smart economics. When the private sector is paying down debt - as it is in Italy - private sector demand shrinks. To prevent a recession, the government must step in to borrow and spend the paid-down debt. And what seems to be fiscal largesse does not lead to crowding out, inflation, or surging interest rates. This means that as long as Italian populists correctly push back on the EU's draconian fiscal rules rather than the monetary union per se, the market is right to regard Italian politics as a drama, rather than an existential risk to the euro (Chart I-2). Chart I-2The Market Remains Unconcerned ##br##About Euro Break-Up Risk Maybe the European political lens should be focussed instead on Britain. The Conservative party remains as bitterly divided as ever on its vision for the U.K.'s future trading and customs relationships with the EU and the rest of the world. Paralysed and frightened by this division, Theresa May is delaying the legislative passage of three crucial bills - the EU Withdrawal Bill, the Trade Bill, and the Customs Bill. When these bills eventually reach a vote in the House of Commons later this year, any one of them could result in a humiliating defeat for May - and, quite likely, resignations from the government. Meanwhile, as the government kicks the issue into the long grass, firms are holding fire on long-term spending commitments in the U.K. and rechannelling the investment to elsewhere in Europe. Buy SEKs, Avoid NOKs For all the recent swings in the euro versus the dollar and pound, the trade-weighted euro has remained a paragon of relative stability (Chart I-3). This is because the moves versus the dollar and pound have largely cancelled out (Chart I-4). Earlier this year, euro weakness versus the pound coincided with strength versus the dollar; more recently, euro weakness versus the dollar has coincided with strength versus the pound. Chart I-3The Trade-Weighted Euro Has ##br##Remained Relatively Stable... Chart I-4...Because Moves Versus The Dollar And The ##br##Pound Have Largely Cancelled Out Interestingly, the driver of the trade-weighted euro remains the same as it has been for the past fifteen years - it is simply the euro area's long bond yield shortfall versus the U.K. and U.S. (Chart I-5). With the ECB already at the realistic limit of ultra-loose policy, the path for policy rate expectations cannot go meaningfully lower. This means that the trade-weighted euro has some long-term support given that the BoE and/or the Fed have tightening expectations that could be priced out, while the ECB effectively doesn't. Chart I-5The Trade Weighted Euro Is A Function Of The Euro Area's ##br##Long Bond Yield Shortfall Versus The U.K. And U.S. Put another way, for the trade-weighted euro to drift significantly lower, relative surprises in the economic, financial and political news have to be significantly worse in the euro area than in both the U.K. and the U.S. We think this configuration is unlikely. Nevertheless, the more interesting tactical opportunities lie elsewhere: the Swedish krona and the Norwegian krone. Recent tweaks to monetary policy frameworks in Sweden and Norway are responsible, at least partly, for technically exaggerated moves in their currencies which are likely to reverse. In the case of Sweden, the inflation target is unchanged at 2 per cent but the Riksbank introduced a variation band of 1-3 per cent, because "monetary policy is not able to steer inflation in detail." Given that Sweden's inflation rate is now close to 2 per cent, the market interpreted this tweak as very dovish - because it permits the continuation of ultra-accommodative policy. The upshot was that the SEK sold off. But our tried and tested indicator of excessive groupthink suggests that the currency may have overreacted (Chart of the Week). Hence, the tactical opportunity is to stay long the SEK, and our preferred expression is long SEK/GBP. In the case of Norway, a Royal Decree on Monetary Policy lowered the Norges Bank inflation target from 2.5 to 2.0 per cent. This followed years of failure to achieve the higher target. The market interpreted this change as hawkish, as it created the scope for tighter - or at least, less loose - policy than was previously expected. The upshot was that the NOK rallied. But again, the market reaction shows evidence of a technical overreaction (Chart I-6). Hence, the tactical opportunity is to stay short the NOK, and our preferred expression is long AUD/NOK. Chart I-6Our Preferred Expression Of Short NOK Is Versus The AUD Financial Markets Are Not Complicated, But They Are Complex The words 'complicated' and 'complex' appear to be interchangeable, but their meanings are quite distinct. The distinction is important because financial markets are not complicated, but they are complex. Something that is complicated is the sum of a large number of separate parts or processes. For example, making a car is complicated. But predicting the performance of financial markets over the medium term - say, a year or longer - is uncomplicated. The philosophy of Investment Reductionism teaches us that investment strategy is not made up of many separate parts or processes. It reduces to just three things: Predicting the evolution of the global economy. Predicting central bank reaction functions. Predicting tail-events: political, economic and financial. For example, this week's lesson in Investment Reductionism is to illustrate that the medium term decision to allocate between emerging market equities and the Eurostoxx600 largely reduces to the prospects for global metal prices (Chart I-7). Chart I-7EM Versus Eurostoxx600 = Metal Prices By contrast, something that is complex is not the sum of its parts, because the parts interact in unpredictable ways. Complexity characterizes the behaviour of financial markets over the short term - say, up to around six months. Therefore, the best way to model the behaviour of any investment over the very short term is to think of it as a complex adaptive system. A complex adaptive system is a system with a large number of mutually interacting agents, which can learn from their interactions and thereby adapt their subsequent behaviour. Examples include traffic flows, crowds in stadiums, and of course financial markets. A crucial property of all such systems is they possess an endogenous tipping point of instability, at which the behaviour undergoes a 'phase-shift'. This is the essence of how we identify likely short-term trend reversals in any investment such as the SEK and the NOK. This week's final trade recommendation uses this idea once again. Poland's equity market has underperformed recently in line with the general underperformance of the emerging market basket - and our underweight in the Warsaw General Index versus the Eurostoxx600 is handsomely in profit. However, looking at the market as a complex adaptive system, the extent of Poland's underperformance is overdone (Chart I-8). Chart I-8The Extent Of Poland's Underperformance Is Overdone Hence we are taking profit on our underweight in Poland and putting on a short-term countertrend position: long Poland's Warsaw General Index, short Italy's MIB. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* As discussed in the main body of the report, this week's new trade recommendation is a pair-trade: long Poland's Warsaw General Index, short Italy's MIB. The profit target is 5% with a symmetrical stop loss. Our preferred expression of long SEK is versus the GBP which is already in profit since initiation. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 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 Portfolio Strategy Firming industry demand at a time when global energy capital spending budgets are renormalizing, along with rising crude oil prices, signal that high-beta energy services equities have more running room. Our confidence in additional significant bank relative price gains has decreased. There is budding evidence that the bank/yield curve correlation is getting re-established, as we had posited last autumn, and coupled with later cycle dynamics signal that the bank outperformance is getting long in the tooth. Recent Changes Crystalize gains of 6% in the S&P banks index and remove from the high-conviction overweight call list. Put the S&P banks index on downgrade alert. Prefer large caps to small caps (please refer to the May 10th Sector Insight). Table 1 Feature Equities staged a breakout attempt last week and the SPX reclaimed the 50-day moving average, with the energy sector leading the pack. However, the lateral move in place over the past quarter is not over yet as the market is still digesting the February 5th drawdown. Importantly, EPS euphoria cannot last forever and the inevitable profit growth deceleration post the calendar 2018 onetime tax reform fillip is weighing on the market. The 12-month forward EPS growth rate has come down to 15%, and as we move into the back half of 2018 it will continue to glide toward a still impressive 10% (or two times nominal GDP growth), which is where the calendar 2019 estimate currently stands (Chart 1). Following up from last week's 'Til Debt Do Us Part' Special Report, the overall market's (ex-financials and ex-real estate) 'Altman Z-score' is waving a mini yellow flag. Cyclical momentum in this indicator is giving way and the broad market's deteriorating creditworthiness is also, at the margin, anchoring profit growth (Chart 2). Chart 1Unsustainable EPS Euphoria Chart 2Watching Balance Sheets... Nevertheless, we remain constructive on the broad market from a cyclical 9-12 month horizon as the odds of recession are close to nil, and interpret recent market action as a sign of resiliency. The SPX refuses to give way to the bearish narrative plagued by geopolitical uncertainty/fears and slowing global growth. Chart 3 shows an extremely economically sensitive indicator, lumber, alongside the ISM manufacturing survey. Since 1969 when lumber futures first commenced trading, these two series have been tightly positively correlated. Recently, a rare and steep divergence is visible and our inclination is to expect all-time high lumber prices to arrest the ISM's fall in the coming months. True, lumber prices reflect a NAFTA-related premium and at the current juncture cannot be fully trusted that they are emitting an accurate economic signal. We, thus, resort to another - daily reported - global growth barometer, the Baltic Dry Index (BDI). The third panel of Chart 3 shows that a wide gap has opened between the ISM manufacturing index and the BDI. If our assessment is correct and this global growth soft patch is transitory, then the ISM will remain squarely clear of the 50 boom/bust line. Taken together, these two economically sensitive high frequency series comprise our Global Trade Indicator which is underscoring that global export growth will pick up in the back half of the year (bottom panel, Chart 3). Finally, on the domestic freight front,1 the composite freight index is also reaccelerating, signaling that domestic demand conditions are firing on all cylinders (fourth panel, Chart 3). Circling back to profit growth, long-term S&P 500 EPS growth expectations have vaulted to the highest level since the dotcom bubble (bottom panel, Chart 4). While in isolation, this measure signals we are in overshoot territory and such breakneck EPS growth is clearly unsustainable, the SPX PEG ratio tells a different story (we divide the 12-month forward price to earnings ratio by the long-term EPS growth rate to arrive at the current reading near 1 on the S&P 500 PEG ratio, Chart 4). Chart 3...But Economy Is Humming Chart 4Market Is Cheap According To PEG Ratio On this valuation measure the SPX appears cheap. Historically, every time the PEG ratio has sunk to one standard deviation below the mean, at least a reflex rebound ensued. Table 2 summarizes the five most recent iterations we included in the analysis since 1985. While we cannot rule out a steep undershoot, if history at least rhymes, the S&P should be higher in the subsequent 12 months (Chart 5). Chart 5SPX Cycle-On-Cycle Return Profile When The PEG Ratio Gets Depressed Table 2S&P 500 Yearly Returns* This week we are removing an early cyclical index from our high-conviction call list, locking in handsome profits, and updating a high-beta energy sub-index. Put Banks On Downgrade Watch Despite a blockbuster earnings season, banks have come under pressure recently. Worrisomely, they have not followed the 10-year Treasury yield higher and that is cause for concern. We first cautioned last October that banks would shatter their near one-to-one relationship with the 10-year UST yield and re-establish it with the yield curve likely in the back half of 2018 as the Fed would further lift the fed funds rate away from the zero lower bound.2 This positive correlation shift from interest rates to the yield curve slope is important as it will likely squeeze banks' net interest margins, a key profit driver (Chart 6). Charts 7 & 8 show that there is increasing empirical evidence that banks have already started making this transition away from the 10-year UST yield and toward the 10/2 yield curve, and we are thus compelled to book profits of 6% and remove this early cyclical index from the high-conviction overweight call list. The S&P banks index is now also on downgrade alert. Chart 6NIM Trouble? Chart 7Monitoring Shifting... Chart 8...Correlations What would cause us to change our yearlong cyclical constructive view and move to a benchmark allocation, is a lack of relative price outperformance in the next 10-year Treasury yield jump. Crudely put, if banks fail to best the market when the bond market further sells off roughly to 3.25%, as BCA's fixed income strategists expect, we will pull the trigger and downgrade to a neutral stance. Another reason we are likely to become more wary of bank relative performance in the coming quarters is the stage of the business cycle. Importantly, we wanted to test our hypothesis that in the late/later stages of the expansion early cyclicals, banks included, fare poorly. Therefore, at some point we should move away from our sanguine view on this index and not overstay our welcome as the current expansion has become the second longest on record according to the NBER designated recessions. In more detail, what we did to test this hypothesis was to document relative bank performance from when the ISM manufacturing peaked for the cycle until the recession commenced going back to the 1960s (Chart 9). Table 3 aggregates the results using monthly data. What is clear is that if the recession is a financial crisis related recession, then shy away from banks. But, in 4 out of the 7 last cycles dating back to the 1960s, banks outperformed the broad market in the later stages of the business cycle. Chart 9Banks Tend To Slump In Later Stages Of The Cycle Table 3Late Cycle Analysis Nevertheless, breaking down the results in two periods is instructive. One period recalibrates the bank relative returns from the ISM peak until the SPX peak, and the second one from the SPX peak until the recession commences (Table 3). Banks clearly underwhelm 4 out of the 7 iterations as the SPX crests, confirming our negative return hypothesis. Subsequently, as the SPX deflates when the economy heads into recession, relative bank performance significantly improves with the caveat that during financial crises, banks continue to bleed (in an upcoming Special Report we will be performing the same analysis on the GICS1 U.S. equity sectors, stay tuned). Two weeks ago we lifted our peak SPX target to 3200,3 and the implication is that banks' best days have likely passed, if history at least rhymes. Bottom Line: Stay overweight banks for now, but lock in gains of 6% and remove the S&P banks index from the high-conviction overweight call list, as our confidence is not as high as in late-November.4 Further, we are putting this key financials sub index on downgrade alert reflecting the negative implication from our later stages of the business cycle analysis. We are closely monitoring the yield curve slope and interest rate correlation with bank performance, and if banks refrain from participating in the next leg up in interest rates it will serve as a catalyst to prune exposure to neutral. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, SIVB. Energy Servicers: The Phoenix Is Rising Quarter-to-date the S&P energy services index is up 12% compared with the 2% rise in the broad market. Even year-to-date, oil servicing companies have bested the market by 600bps. The steep rebound in oil prices primarily lies behind such stellar outperformance, and BCA's Commodity & Energy Strategy still-upbeat crude oil view is a harbinger of even brighter days ahead for this high-beta energy sub sector (Chart 10). While we are exploring our capex upcycle theme via a high-conviction overweight in the broad S&P energy index, oil services companies are also a prime beneficiary of our synchronized global capital outlays upcycle theme. In fact, relative share price momentum does not yet fully reflect the rebound in industry investment (using national accounts) that remains in a V-shaped recovery since the Q1/2016 oil market trough (second panel, Chart 11). Importantly, OPEC 2.0 and $70/bbl oil prices have resulted in a semblance of normality in the E&P space (a key industry client) that has lifted spending budgets (bottom panel, Chart 11). The upshot is that energy services revenues will continue to expand (Chart 11). Energy related capital spending budgets are not only rising in the U.S. (primarily in shale oil), but also globally. The global rig count is breaking out, and declining OECD oil stocks suggest that drilling activity will remain robust (top and second panel, Chart 12). Chart 10Catch up Phase Chart 11Capex Upcycle... Chart 12...Beneficiary Taking the pulse of oil services industry slack is extremely important for profitability. Our global idle rig proxy is also making a breakout attempt following a massive two year plus retrenchment phase (top panel, Chart 13). Keep in mind that energy servicers have only recently exited deflation, that wreaked havoc in the sector's financial metrics. Now as a renormalization period is unfolding with higher underlying commodity prices breathing life into industry new order growth, even a modest pricing power rebound will go a long way in lifting depressed profits. In fact, new orders-to-inventories are in a reflex rebound. While such an exponential rise is unsustainable, firming oil services demand should continue to remove excess slack, a boon for industry selling prices and profits (middle and bottom panels, Chart 13). Sentiment toward this energy sub-index remains bombed out and there is widespread disbelief that this rebound is sustainable. Rather, the risk of a deflationary relapse has kept investors at bay pushing relative valuations deep into undervalued territory. Both our composite relative Valuation Indicator (VI) and relative price-to-book are hovering near all-time lows (bottom panel, Chart 12). Technicals are not as depressed as the VI reading, with the recent relative share price bounce lifting our relative Technical Indicator to the neutral zone (Chart 14). Chart 13Deflation Is Over Chart 14Unloved And Underowned In sum, there are more gains in store for the S&P energy services index. Firming industry demand at a time when global energy capital spending budgets are renormalizing, along with rising crude oil prices, signal that high-beta energy services equities have more running room. Bottom Line: Stay overweight the S&P energy service index. The ticker symbols for the stocks in this index are: BLBG: S5ENRE -NOV, SLB, FTI, BHGE, HAL, HP. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 The freight transportation services index consists of: For-hire trucking (parcel services are not included); Freight railroad services (including rail-based intermodal shipments such as containers on flat cars); Inland waterway traffic; Pipeline movements (including principally petroleum and petroleum products and natural gas); and Air freight. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Later Cycle Dynamics," dated October 23, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Lifting SPX Target," dated April 30, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights Chart 1Interest Rate Expectations Last week the Federal Reserve made some necessary tweaks to the language in its statement. Namely, with the year-over-year core PCE deflator now up to 1.88%, the Fed was forced to upgrade its assessment of inflation and note that it has "moved close" to the 2 percent target. To assuage concern that such a change might lead to a quicker pace of rate hikes, the statement also emphasized that the inflation target is "symmetric" and noted that its policy of "gradual increases in the federal funds rate" will continue. While the recent increase in inflation is not sufficient to nudge the Fed away from "gradualism", the more important observation is that yields are still not high enough to discount the Fed's gradual approach (Chart 1). The Fed has tightened policy once per quarter since December 2016, tapering asset purchases in place of a rate hike in September 2017. It should be obvious that, absent an economic shock, one rate hike per quarter is the Fed's definition of "gradual". And yet, the market is still priced for barely more than two hikes for the balance of 2018, and not even two rate hikes for all of 2019! Maintain a below-benchmark duration stance until the market comes to grips with the Fed's gradualism. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 4 basis points in April, bringing year-to-date excess returns up to -77 bps. The Corporate index option-adjusted spread tightened somewhat in the first half of April, but widened anew during the past couple of weeks and recently made a new high for the year. Despite this sell-off, valuation remains expensive for investment grade corporates. The 12-month breakeven spread for an A-rated bond has only been tighter 27% of the time since 1989 (Chart 2). The same measure for a Baa-rated bond has only been tighter 28% of the time. We are preparing to cyclically scale back our corporate bond exposure, and will start the process once TIPS breakeven inflation rates reach our target range, signaling that monetary conditions are sufficiently restrictive. Our target range is 2.3% to 2.5% for both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates. Those rates currently sit at 2.16% and 2.23%, respectively. In a recent report we noted that corporate bond excess returns fall sharply once the 2/10 Treasury yield curve flattens to below 50 bps, though they typically remain positive until the curve actually inverts.1 The 2/10 Treasury slope currently sits at 45 bps. That same report also notes that while the outlook for corporate revenue growth is strong, rising employee compensation costs will likely soon put a dent in profit margins and cause gross leverage to resume its uptrend (panel 4). This will apply further widening pressure to spreads later in the year. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 121 basis points in April, bringing year-to-date excess returns up to 102 bps. The average index option-adjusted spread tightened 16 bps on the month, and currently sits at 343 bps. The 12-month trailing speculative grade default rate moved higher for the second consecutive month, hitting 3.92% in March. Moody's baseline forecast still calls for it to fall to 1.7% by March of next year. Based on Moody's default rate projection and our estimate of the recovery rate, we forecast High-Yield default losses of 0.85% for the next 12 months. This translates to a 12-month excess return of 257 bps for the High-Yield index versus Treasuries, assuming an unchanged junk spread (Chart 3). One hundred basis points of spread widening would lead to an excess return of -140 bps during this time horizon, and 100 bps of spread tightening would lead to an excess return of +654 bps. However, such a large spread tightening is almost certainly over-optimistic. As inflation continues to rise and the Fed applies the brakes, a floor will likely remain under the VIX index of implied equity volatility and this will prevent junk spreads from recovering their cyclical lows (top panel). This would be consistent with behavior typically seen late in the cycle, once the 2/10 Treasury slope flattens to below 50 bps.2 MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 18 basis points in April, bringing year-to-date excess returns up to -22 bps. The conventional 30-year zero-volatility MBS spread tightened 4 bps on the month, split between a 1 bp tightening of the option-adjusted spread (OAS) and a 3 bps decline in the compensation for prepayment risk (option cost). While mortgages are no longer excessively cheap compared to corporate credit (Chart 4), we still see limited potential for spread widening during the next 6-12 months. Rising interest rates should serve to limit mortgage refinancing, and muted refis are closely linked to tight MBS spreads (bottom panel). We also view extension risk as relatively limited for conventional 30-year MBS. Using a model of excess MBS returns that we introduced in February, we estimate that despite the 25 bps increase in duration-matched Treasury yields that occurred in April, extension risk trimmed only 2 bps off monthly excess returns.3 Our excess return Bond Map also shows that conventional 30-year MBS require far fewer days of average spread tightening to earn 100 bps of excess return than most other Aaa-rated structured products (Non-Agency Aaa-rated CMBS being the exception), although they are also more likely to deliver losses. But given the benign refinancing back-drop, we remain reasonably positive on the sector.4 Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 9 basis points in April, dragging year-to-date excess returns down to -7 bps. Sovereign debt underperformed the Treasury benchmark by 37 bps on the month, while Foreign Agencies underperformed by 15 bps and Domestic Agencies underperformed by 14 bps. Local Authorities delivered 14 bps of outperformance and Supranationals bested duration-equivalent Treasuries by 5 bps. Dollar strength hurt the performance of Sovereign debt last month, and relative valuation continues to show that Sovereigns are expensive relative to similarly-rated U.S. corporate bonds (Chart 5). We remain underweight USD-denominated Sovereign debt. Conversely, Foreign Agencies and Local Authorities continue to offer very attractive spreads, especially considering the duration and spread volatility characteristics of those sectors. Our excess return Bond Map shows that both sectors offer a superior risk/reward trade-off than the Barclays Aggregate and almost all of its components.5 The large presence of state-owned energy companies in the Foreign Agency sector means it should also benefit from higher oil prices in the coming months. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 65 basis points in April, bringing year-to-date excess returns up to 94 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio declined 2% in April as fund inflows returned to the sector (Chart 6). Persistently low visible supply is also contributing to the strong technical environment for yield ratios. The tax-adjusted yield for a 10-year municipal bond is now about 46 bps below the yield offered by an equivalent-duration corporate bond. As we have shown in prior research, investors typically get an opportunity to shift out of corporates and into munis at a positive spread differential before the end of the cycle.6 We will await this more attractive entry point before aggressively shifting our allocation in favor of munis. In a recent report we noted that state and local governments are still working to repair their budgets.7 More states enacted tax increases than decreases in fiscal year 2018 and the projected nominal budget increase across all states is a paltry 2.3%. Fortunately, our Municipal Health Monitor indicates that the hard work is paying off, and suggests that ratings upgrades should continue to outpace downgrades for the time being (bottom panel). Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve rose considerably in April, steepening a touch out to the 5-year maturity point and flattening thereafter. The 2/10 Treasury slope flattened 1 basis point in April, and currently sits at 45 bps. The 5/30 slope flattened 9 bps on the month and currently sits at 34 bps. The trade-off between the pace of Fed rate hikes on the one hand, and the re-anchoring of long-dated TIPS breakeven inflation rates on the other will dictate the slope of the yield curve during the next six months. With the 10-year TIPS breakeven inflation rate at 2.16%, it remains slightly below the range of 2.3% to 2.5% that is consistent with well-anchored inflation expectations. It will be difficult for the yield curve to flatten aggressively until that target is met. After that, curve flattening becomes much more likely. We continue to recommend a position in the 5-year bullet versus the duration-matched 2/10 barbell, primarily due to extremely attractive starting valuation. Our model suggests that the 2/5/10 butterfly spread is priced for 17 bps of 2/10 curve flattening during the next six months (Chart 7). With long-maturity TIPS breakevens still below target, we think that is too high a bar. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 93 basis points in April, bringing year-to-date excess returns up to 161 bps. The 10-year TIPS breakeven inflation rate rose 12 bps on the month and currently sits at 2.16%. The 5-year/5-year forward TIPS breakeven inflation rate increased 6 bps and currently sits at 2.23%. As we explained in a recent report, we view the first stage of the bond bear market as being driven by the re-anchoring of inflation expectations.8 We will consider inflation expectations well anchored when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are in a range between 2.3% and 2.5%, where they were the last time that inflation was well anchored around the Fed's target. If the recent trend in inflation continues, then this re-anchoring will occur relatively soon. The annualized 6-month rate of change in the trimmed mean PCE deflator has already returned to the Fed's target, and the annual rate of change jumped from 1.71% to 1.77% in March (Chart 8). Pipeline measures of inflation pressure also continue to strengthen. Our Pipeline Inflation Indicator is in a strong uptrend and the prices paid component of the ISM manufacturing survey is closing in on 80, a level last seen in 2011 (panel 4). ABS: Neutral Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 13 basis points in April, bringing year-to-date excess returns up to -6 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 4 bps on the month and now stands at 40 bps, 7 bps above its pre-crisis low. Our recently introduced excess return Bond Map shows that both Aaa-rated credit card and Aaa-rated auto loan ABS exhibit lower risk and less potential for gains than the Barclays Aggregate index.9 It also confirms that credit card ABS are somewhat more attractive than auto loan ABS, offering approximately the same potential for excess return with less risk. Compared to other fixed income sectors, Aaa-rated ABS offer greater potential return and higher risk than Agency CMBS, Domestic Agencies and Supranationals. But the ABS sector also has a less attractive risk/reward profile than the Foreign Agency, Local Authority and Investment grade corporate sectors. Fundamentally, while consumer delinquencies remain low, they are heading higher alongside a rising household debt service coverage ratio (Chart 9). The persistent (though mild) deterioration in credit quality causes us to maintain a neutral allocation to the sector, despite reasonably attractive valuations. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 60 basis points in April, bringing year-to-date excess returns up to 71 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 4 bps on the month and currently sits at 69 bps, close to one standard deviation below its pre-crisis mean. Our excess return Bond Map shows that Aaa-rated non-Agency CMBS offer greater potential reward, but also greater risk, than the majority of other high-rated spread products. The exception is conventional 30-year Agency MBS, which offer a less attractive risk/reward trade-off.10 That being said, the fundamental picture for commercial real estate is less appealing than on the residential side. CMBS spreads continue to diverge from commercial property prices (Chart 10). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 26 basis points in April, bringing year-to-date excess returns up to 12 bps. The index option-adjusted spread was flat on the month and currently sits at 47 bps. According to our Bond Map, Agency CMBS offer greater potential excess return and less risk than both the Supranational and Domestic Agency sectors. We continue to view the Agency CMBS space as an attractive low-risk spread sector. Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.70%. The drop in the model's fair value stems from a decline in the global PMI to 53.5 from a recent peak of 54.5. While global growth has undoubtedly lost momentum in recent months, we also suspect that our 2-factor model is finally breaking down. The 2-factor model does not contain a variable to capture the degree of resource utilization in the economy. Logically, as slack dissipates in the economy and inflationary pressures mount, then the same level of global growth should be associated with a higher Treasury yield, all else equal. This means that at some point, as we approach the end of the cycle, the model will break down and consistently produce fair value readings that are too low. We suspect that we may be reaching this point. When we augment our model with an additional variable to measure the degree of resource utilization, in this case the employment-to-population ratio, we find that the new model projects a fair value of 3.28% for the 10-year Treasury yield (Chart 11). This 3-factor model would not have worked as well as our 2-factor model during the zero-lower bound period, as can be seen by looking at how rolling regression betas from each of the three variables moved sharply following the recession (bottom three panels). However, as we move further away from the zero-lower bound we expect the regression coefficients to return to pre-crisis levels, meaning that it will be important to monitor both trends in global growth and the amount of resource slack in the economy. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "On The MOVE", dated February 13, 2018, available at usbs.bcaresearch.com 4 For details on the Bond Map please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Profiting From A Higher LIBOR", dated March 20, 2018, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)
Highlights The global 6-month credit impulse is now indisputably in a mini-downswing phase. Stick with underweights in the classically cyclical sectors: banks, basic materials and industrials. The strategy has worked well since the start of the year, and it is too early to exit. For bonds, the implication is that yields can move only slightly higher before stronger headwinds to risk-assets and/or the economy provide a tradeable reversal in yields. The trade-weighted euro has some support given that the BoE and/or the Fed have tightening expectations that can be priced out, while the ECB doesn't. We have a slight preference for the FTSE100 and S&P500 over the Eurostoxx50. Feature Entering the fifth month of the year, one puzzle for investors is the conflicting messages coming from banks and bonds. While banks' relative performance is close to its 2018 low, bond yields are not far from their year-to-date high (Chart of the Week). Chart of the WeekBanks Or Bonds: Which One Is Right? This poses a puzzle because the performances of banks and bond yields are usually joined at the hip. The underperformance of the economically sensitive banks would suggest that global growth is decelerating, whereas the performance of bond yields would suggest that global activity is holding up well. Which one is right? The Global 6-Month Credit Impulse Is Indisputably In A Mini-Downswing Looking at the other classically cyclical sectors, the mystery seems to deepen. Industrials and basic materials are also in very clear downtrends this year, which corroborates the message from the banks. But the oil and gas sector is close to a year high, which corroborates the message from bond yields (Charts I-2-I-4). Chart I-2Industrials Have Underperformed... Chart I-3...And Basic Materials Have Underperformed Chart I-4...But Oil And Gas Has Outperformed... The conflicting messages from banks, basic materials and industrials on one side and bond yields and oil and gas equities on the other side reflect the disconnect between non-oil commodity prices which have drifted lower this year and oil prices which have moved sharply higher (Chart I-5). This disconnect, resulting from differing supply dynamics in the different commodity markets, points us to a likely solution to our puzzle. Chart I-5...Because Oil Has Disconnected ##br##From Other Commodities The classically cyclical sectors are taking their cue from global growth and industrial activity, which does appear to be losing momentum. The global 6-month credit impulse is now indisputably in a mini-downswing phase. In contrast, bond yields are taking their cue from the oil price, given its major impact on headline inflation, inflation expectations, and thereby on central bank reaction functions. Based on previous mini-cycles, we can confidently say that mini-downswing phases last at least six to eight months and that the usual release valve is a decline in bond yields. In this regard, the apparent disconnect between decelerating activity and un-budging bond yields risks extending this mini-downswing phase. Therefore, for the next few months, it is appropriate to stick with underweights in the classically cyclical sectors: banks, basic materials and industrials. The strategy has worked well since we initiated it at the start of the year, and it is too early to exit. This sector strategy necessarily impacts regional allocation as explained in the next section. For bonds, the implication is that yields can move only slightly higher before stronger headwinds to risk-assets and/or the economy provide a natural cap and a tradeable reversal in yields. Even More Investment Reductionism Imagine a world in which all the global commodity firms decided to get their stock market listings in London; all the global financials decided to list on euro area bourses; all the major tech companies listed in New York; and all the industrials listed in Tokyo. Clearly, each major stock market would just be a play on its underlying global sector and nothing more. Our imagined world is an exaggeration, but it does illustrate an important truth. A quarter of the market capitalisation of each major stock market is in one dominant sector, and this gives each equity index its defining fingerprint: for the FTSE100 it is commodity firms; for the Eurostoxx50 it is financials; for the S&P500 it is technology; and for the Nikkei225 it is industrials (Table I-1). Table I-1Each Major Stock Market Has A Defining Fingerprint There is another important factor to consider: the currency. A global oil company like BP receives its revenue and incurs its costs in multiple major currencies, such as euros and dollars. In this sense, BP's global business is currency neutral. But BP's stock price is quoted in pounds. This means that if the pound strengthens, the company's multi-currency profits will decline relative to the stock price and weigh it down. Conversely, if the pound weakens, it will lift the BP stock price. So the currency is the channel through which the domestic economy can impact its stock market, albeit it is an inverse relationship: a strong currency hinders the stock market; a weak currency helps it. The upshot is that the defining fingerprints for the major indexes turn out to be: FTSE100: global commodity shares expressed in pounds. Eurostoxx50: global banks expressed in euros. S&P500: global technology expressed in dollars. Nikkei225: global industrials expressed in yen. And that's pretty much all you need to know for regional equity allocation! The charts in this report should leave you in no doubt. True to our Investment Reductionism philosophy, the relative performance of the regional equity indexes just reduces to their defining fingerprints: FTSE100 versus S&P500 reduces to global commodity companies in pounds versus global tech companies in dollars, Eurostoxx50 versus Nikkei225 reduces to global banks in euros versus global industrials in yen. And so on (Charts I-6-I-11). Chart I-6FTSE 100 Vs. S&P 500 = Global Commodity##br## Equities In Pounds Vs. Global Tech In Dollars Chart I-7FTSE 100 Vs. Nikkei 225 = Global Commodity ##br##Equities In Pounds Vs. Global Industrials In Yen Chart I-8FTSE 100 Vs. Euro Stoxx 50 = Global Commodity##br## Equities In Pounds Vs. Global Banks In Euros Chart I-9Euro Stoxx 50 Vs. S&P 500 = Global Banks In ##br##Euros Vs. Global Tech In Dollars Chart I-10Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In##br## Euros Vs. Global Industrials In Yen Chart I-11S&P 500 Vs. Nikkei 225 = Global Tech In ##br##Dollars Vs. Global Industrials In Yen The Right Way To Invest In The 21st Century One important implication of Investment Reductionism is that the head-to-head comparison of stock market valuations is a meaningless and potentially dangerous exercise. Two sectors with vastly different structural growth prospects - say, banks and technology - must necessarily trade on vastly different valuations. So the sector with the lower valuation is not necessarily the better-valued sector. By extension, the stock market with the lower valuation because of its sector fingerprint is not necessarily the better-valued stock market. Another implication is that simple 'value' indexes may not actually offer better value! In reality, they comprise a collection of sectors on the lowest head-to-head valuations which, to repeat, does not necessarily make them better-valued. Some people suggest comparing a valuation with its own history, and assessing how many 'standard deviations' it is above or below its norm. The problem is that the whole concept of standard deviation assumes 'stationarity' - meaning, no step changes in a sector's valuation through time. Unfortunately, sector valuations are 'non-stationary': they undergo major step changes when they enter a vastly different economic climate. For example, the structural outlook for bank profits undergoes a step change when a credit boom ends. Therefore, comparing a bank valuation after a credit boom with the valuation during the credit boom is like comparing an apple with an orange. Pulling together these complexities of sector effects, currency effects, and step changes in sector valuations, we offer some strong advice on how to sequence the investment process: 1. Make your asset class decision at a global level. This is because asset classes tend to move as global entities, not regional entities. And also because at a global level, asset class valuation comparisons are less distorted by sector and currency effects. 2. Make your sector decisions. Given that the companies that dominate European (and all major) indexes are multinationals, the sector decision should be based on the direction of the global economy. 3. Make your currency decisions. 4. You do not need to make any more major decisions! The main regional equity allocation, country allocation and value/growth allocation just drop out from the sector and currency decision. With the global 6-month credit impulse now indisputably in a mini-downswing phase (Chart I-12), the classically cyclical sectors are likely to continue underperforming for the next few months; the rise in bond yields faces resistance; and the euro - at least on a trade-weighted basis - has some support given that the BoE and/or the Fed have tightening expectations that can be priced out, while the ECB doesn't. Chart I-12The Global 6-Month Credit Impulse Is Indisputably In A Mini-Downswing Finally, in terms of regional equity allocation, Investment Reductionism implies a slight preference for the FTSE100 and S&P500 over the Eurostoxx50. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* In addition to the fundamental arguments in the main body of this report, fractal analysis finds that the outperformance of Oil and Gas relative to other commodity equities is technically extended. Hence, this week's trade recommendation is to underweight euro area Oil and Gas versus global Basic Materials. Set a profit target of 5%, with a symmetrical stop-loss. In other trades, we are pleased to report that long USD/ZAR hit its 6% profit target, and is now closed. This leaves us with five 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 I-13 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 Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations
GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of April 30, 2018. There are no significant changes in the model's allocation this month, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD, %) As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 20 bps in April, largely driven by the Level 2 model which outperformed by 44 bps while the Level 1 model outperformed only by 2 bps. Since going live, the overall model outperformed the MSCI World by 156 bps, due to the 493 bps of outperformance from the Level 2 model which allocates funds among 11 non-U.S. countries. The Level 1 model (which allocates funds between U.S. and the non-U.S.) is on par with the MSCI world benchmark.Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Text below For more details on the models, please see Special Report, "Global Equity Allocation: Introducing The Developed Markets Country Allocation Model," dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of April 30, 2018. For the third consecutive month, the model maintains a defensive positioning generating an alpha of 60 bps for the month of April. Following the end of trade threats (for now), the growth component of the model has stabilized. But, overall the model maintains the same weights from last month with an aggregate tilt of 1.3% towards defensive sectors. Energy remains the only cyclical sector with an overweight on the back of favorable valuations and improving momentum. Among defensive sectors, utilities maintains a large overweight of 5% on the back of better momentum. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," dated July 27, 2016, available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Aditya Kurian, Senior Analyst adityak@bcaresearch.com
Looking Beyond The Next Few Months The next couple of months could remain tricky for equity markets. But, with economic growth set to remain above trend for another year or so and central banks cautious about the pace of monetary tightening, we continue to expect risk assets to outperform over the 12-month horizon. To begin, our short-term concerns. Global growth has clearly slowed in recent months, with Q1 U.S. GDP growth coming in at 2.3%, well below the 2.9% in Q4; global PMIs have also come down from their recent peaks, led by the euro zone and Japan (Chart 1). Inflation has begun to spook investors, with a sharp pick-up in core U.S. inflation, including a rise to 1.9% YoY in the core PCE inflation measure that the Fed watches most closely (Chart 2). Geopolitics will dominate the headlines over the next six weeks, with the waiver on Iran sanctions expiring on May 12, the end of the 60-day consultation for U.S. tariffs on China on May 21, the possible imposition of tariffs on $50 billion of Chinese goods starting on June 4, and likely developments with North Korea and NAFTA. Recommended Allocation Chart 1Global Growth Has Slowed Chart 2...And Inflation Picked Up Investors inclined to make short-term tactical shifts might, therefore, want to reduce risk over the next one to three months. For most clients of the Global Asset Allocation service with a longer perspective, however, we continue to recommend an overweight on equities and other risk assets. In the U.S., in particular, fiscal stimulus will, according to IMF estimates, boost GDP growth by 0.8 percentage points this year and 0.9 percentage points next (Chart 3). U.S. corporate earnings should grow by almost 20% this year and around 12% next and, while this is already in analysts' forecasts, it is hard to imagine equity markets struggling against such a strong backdrop. Not one of the recession/bear market warning signals we are watching (inverted yield curve, rising credit spreads, Fed policy in restrictive territory, significant decline in PMIs, peak in cyclical spending) is yet flashing. Neither do we see any signs that higher interest rates or expensive energy prices are slowing growth. Lead indicators of capex have come off a little, but still point to robust growth (Chart 4). The housing market tends to be the most vulnerable to rising rates and the average rate on a 30-year U.S. fixed mortgage has risen to 4.5% (from 3.7% at the start of the year and a low of 3.3% in late 2016). But housing data still look strong, with a continued rise in house prices and mortgage applications steady (Chart 5). Perhaps the sector most vulnerable to rising U.S. rates in this cycle is emerging markets, where borrowers have grown foreign-currency debt to $3.2 trillion, according to the BIS - one reason for our longstanding caution on EM assets (Chart 6). With crude oil rising to $75 a barrel, U.S. retail gasoline prices now average $2.80 a gallon, up from below $2 in 2016, and transportation companies are complaining of rising costs. But, historically, oil prices have needed to rise by 100% YoY before they triggered recession (Chart 7). Chart 3U.S. Stimulus Will Boost The Economy Chart 4Capex Remains Robust Chart 5No Signs Of Higher Rates Hurting Housing Chart 6Could EM Be Most Affected By Higher Rates? Chart 7Oil Hasn't Risen Enough To Cause Recession Eventually, however, strong growth, especially in the U.S., will become a headwind for risk assets. There is still some slack in the labor market, with another 500,000 people likely to return to work eventually (Chart 8). When that happens, perhaps early next year, the currently sluggish wage growth will begin to accelerate. Fiscal stimulus is likely to prove inflationary, since it is unprecedented for a government to stimulate the economy so aggressively when it is already close to full capacity (Chart 9). These factors will push inflation expectations back to their equilibrium level, and the market will then need to adjust to the Fed accelerating the pace of rate hikes to choke off inflation, which will push up real bond yields (Chart 10). Chart 8Still 500,000 Who Could Return To Work Chart 9Stimulus Unprecedented In Such A Strong Economy Chart 10Eventually Real Rates Will Need To Rise When that starts to happen - perhaps late this year or early next year - the yield curve will invert, and investors will start to price in the next recession. That will be the time to turn defensive, but it is still too early now. Fixed Income: Markets are currently pricing only a 50% probability of three more Fed hikes this year, and only two hikes next year. As markets start to anticipate further tightening, long rates are also likely to rise (Chart 11). We see 10-year U.S. Treasury yields at 3.3-3.5% by year-end, and so recommend an overweight in TIPs and a short duration position. The ECB is unlikely to need to rush rate hikes, however, given the slack in the euro zone (Chart 12), and so the spread between U.S. and core euro yields should widen further. Corporate credit spreads are unlikely to contract further but, as long as growth continues, we see U.S. high-yield bonds, in particular, providing attractive returns within the fixed-income bucket. Our bond strategists find that between the 2/10 yield curve crossing below 50 BP and its inverting, high-yield debt has since 1980 given an annualized 368 BP of excess return.1 Chart 11Fed Expectations Drive Long Rates Chart 12Still Plenty Of Slack In The Euro Zone Equities: Our preference remains for developed equities over emerging, and for more cyclical, higher-beta markets such as euro zone and Japan. The risk of a stronger yen over the coming months is a concern for Japanese equities in local currency terms but, as our recommendations are expressed in U.S. dollars, the currency effect cancels out, and so we keep our overweight for now. At this stage of the cycle our preference is for value stocks (especially financials) over growth stocks (especially IT): value/growth usually performs in line with cyclicals/defensives, but the relationship has moved out of sync in the past year or so (Chart 13), mostly because of the performance of internet stocks, whose premium valuation makes them very vulnerable to any bad news. Currencies: A widening of interest-rate differentials between the U.S. and euro zone is likely to push down the euro against the U.S. dollar over the next few months, especially given how crowded the long-euro trade has become. The vulnerability of EM currencies to rising U.S. rates has been seen in the past few weeks, with sharp falls in currencies such as the Turkish lira, Brazilian real, and Russian ruble. We expect this to continue. Overall, we expect a moderate appreciation of the trade-weighted U.S. dollar over the next 12 months. Commodities: The crude oil price continues to rise in line with our forecasts, and we expect to see Brent crude above $80 a barrel before the end of the year. The price next year will depend on whether the OPEC agreement is extended, and how much U.S. shale oil production reacts to the higher price. On the assumption of a moderate increase in supply from both OPEC and the U.S., the crude price is likely to fall back moderately in 2019. We see the long-term equilibrium crude price in the $55-65 range, the level where global supply can be increased enough to satisfy around 1.5% annual growth in demand. We remain more cautious on industrial commodities, and see the first signs coming through of a slowdown in China, which will dent demand (Chart 14). Chart 13Value Stocks Look Attractive Chart 14Signs Of China Slowing Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt," dated 24 April, 2018, available at usbs.bcaresearch.com GAA Asset Allocation
Highlights Portfolio Strategy Reviving global machinery end-demand alongside a global capex upcycle, are the key pillars of our high-conviction overweight call in the S&P construction machinery & heavy truck index. The current macro backdrop is unforgiving for defensive insurance stocks. Leading indicators of pricing power warn that softening prices coupled with expanding headcount will weigh on insurance profits in the coming quarters. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Equities moved laterally last week and continued to consolidate the early-February tremor, unimpressed by better than expected profit growth across the board. The SPX has been oscillating in a 10% range over the past three months and has been a trader's (and bank's) paradise. There are high odds that this trading range will stay in place and the market will churn until the summer before breaking out (Chart 1). Chart 1Breakout Looming? Nevertheless, the anemic equity market response to solid earnings is slightly unnerving. Soft EPS guidance and perky input cost inflation are two thorny issues revealed this earnings season. With that in mind, we have identified three key brewing equity market headwinds: EPS growth deceleration toward 10%. Rising interest rates. U.S. dollar reflex rebound. Chart 2Monitoring The Correlation 20% profit growth is this cycle's peak rate, and we have been flagging in recent research1 that, beneath the surface, investors are slowly starting to revise expectations lower toward the 10% growth projection for calendar 2019 EPS. Simultaneously, interest rates continue their ascent and may cause some consternation in stocks. Not only does a higher discount rate weigh on valuations, but also the Fed's tightening cycle will eventually slam the brakes on the economy, with housing and the consumer feeling the higher interest rate knock-on effects most intensely. As we highlighted recently,2 we are closely monitoring the correlation between stocks and the 10-year Treasury yield and looking out for a collapse into negative territory to signal an economic (and market) choke point (Chart 2). Finally, recent ECB and BoJ chatter of easy monetary policies for as far as the eye can see, may have put a floor on the greenback, at least temporarily, with the Fed going it alone and lifting the fed funds rate into 2019 and beyond. While all three headwinds suggest that the market may have trouble breaking out of its funk in the next few months, on a cyclical 9-12 month horizon we remain upbeat on equity return prospects. Any U.S. dollar advance is likely a bear market rally and will take time to filter negatively through to earnings. Rising interest rates are also a consequence of higher economic growth which is a positive, i.e. real rates are rising alongside inflation expectations. And, if the SPX attains 10% EPS growth in 2019 as we expect, that is an above trend EPS growth rate and twice as high as nominal GDP growth, an impressive feat at this stage of the cycle. This week we are updating our SPX target to 3,200. We first came up with our SPX end-of-cycle target last July using three different methods:3 a traditional dividend discount model (DDM), EPS and multiple sensitivity analysis and forward equilibrium equity risk premium (ERP) analysis. As a reminder, this 3,200 SPX level is a peak number before the next recession hits and Table 2 summarizes our updated results (if you would like to receive the excel spreadsheet with the three models so you can tweak our inputs/assumptions please click here). In our DDM, our discount rate assumptions remain intact and very conservative. We use an up-to-date annual dividend per share number and back out dividends in U.S. dollars via the updated SPX divisor and make a conservative assumption of no buybacks in the coming years. The recession-related 10% dividend cut has moved to 2020, in line with BCA's view. Finally, we rolled over our estimates to 2023 resulting in a roughly 3,200 SPX peak value estimate. Our EPS and multiple sensitivity analysis starting point is $191 EPS in 2020 (this is in line with the sell-side bottom up estimate according to IBES data) and a 16.5 multiple. That equates to an SPX ending value of near 3200. Table 2SPX Target Using Three Different Methods With regard to the ERP analysis (Chart 3), our forward ERP equilibrium remains at 200bps. 2020 EPS come in at $191, and we also pencil in 100bps selloff in the bond market, resulting in an SPX 3,200 estimate. Chart 3ERP Has Room To Fall This week we are updating a high-conviction overweight call in a deep cyclical index, and reiterate a below benchmark allocation in a financials sub-index. The CAT Is Roaring, Is The Market Listening? Early last October we upgraded the S&P construction machinery & heavy truck (CMHT) index to overweight, and two months later we added it to the high-conviction overweight call list. On January 29th, right after the broad market hit its all-time highs, we managed to book impressive 10% relative gains as we introduced a risk management tool and instituted trailing stops to the high-conviction calls that cleared the 10% relative return mark. Subsequently, we reinstated the S&P CMHT index to the high-conviction overweight call list, at a deflated price point, as our constructive cyclical backdrop never wavered. Currently, our thesis remains intact: reviving global machinery end-demand alongside a global capex upcycle are a harbinger of sustained profit outperformance. While some leading indicators of global growth have recently crested, global output will remain brisk and above trend. When global growth is expanding, machinery demand typically demonstrates its high beta characteristics. Our global machinery exports proxy is firing on all cylinders rising to multi-year highs and sell side analysts have taken notice: S&P CMHT net earnings revisions are as good as they get (bottom panel, Chart 4). Encouragingly, the softening dollar suggests that U.S. exports have the upper hand and are grabbing market share. BCA's global machinery new orders proxy corroborates the trade data and underscores that machinery profits will overwhelm (middle panel, Chart 4). Dissecting global machinery demand is revealing. Importantly, previously moribund Chinese loan demand has reversed course and is now gaining traction. Tack on the recent steep fall in interest rates and factors are falling into place for a durable pick up in Chinese machinery consumption. Indeed, hypersensitive Chinese excavator sales continue to expand at a breakneck pace (Chart 5). Elsewhere in Asia, highly-cyclical Japanese machine tool orders likewise defy gravity vaulting to fresh all-time highs (Chart 5). The commodity complex also confirms the enticing global machinery end-demand backdrop. The broad commodity index in general and crude oil prices in particular have been reaccelerating of late. The energy space is a key end-customer for the machinery industry and $75/bbl global oil prices have reignited a fresh drilling cycle (Chart 6). Chart 4Global Machinery End-Demand Is Upbeat... Chart 5...And Asia Is Leading The Pack Chart 6Commodities Give The All Clear Sign Even the U.S. machinery demand backdrop is vibrant. The V-shaped recovery in U.S. machinery order books remains intact. Fiscal easing is reviving animal spirits and CEOs are voting with their feet: overall capital outlays are rising at a healthy clip, positively contributing to GDP growth, with machinery fixed capital formation growth recently clearing the 20%/annum hurdle (Chart 7). Capex intentions according to the regional Fed surveys are also holding near recent cyclical highs, and were Congress to pass an infrastructure bill that would be an additional boon to machinery top and bottom line growth (Chart 7). On the domestic operating front, machinery factories are humming and given that capacity is contracting, the industry is regaining its pricing power footing (Chart 8). The upshot is that this high-operating leverage industry should continue to enjoy outsized profit gains. Chart 7Even U.S. Machinery Demand Is Firming Chart 8Operating Metrics Flashing Green Nevertheless, there are two key risks to our otherwise bullish machinery thesis that we are closely monitoring. First, input costs are on the rise both in terms of labor and raw commodities (bottom panel, Chart 9). If the industry fails to pass this input cost inflation down the supply chain, then a margin squeeze is likely. Second, and most importantly, a hard landing in China would put our constructive machinery view offside, but we assign low odds to a gap down in Chinese economic activity (middle panel, Chart 9). Finally, given the recent consolidation phase, the S&P CMHT index has a valuation cushion as per the neutral reading in our relative valuation indicator. Similarly overbought conditions have been worked out and our technical indicator is also hovering near the neutral zone offering a compelling entry point to commit fresh capital (Chart 10). Chart 9Two Risks To Bullish View Chart 10Compelling Entry Point Bottom Line: We reiterate our high-conviction overweight call in the S&P construction machinery & heavy truck index. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR. Insurance Expiry Notice While we continue to recommend a core portfolio overweight in the S&P financials index via the banks (high-conviction), asset managers and investment banks sub-indexes, the S&P insurance index remains our sole underweight. Unlike its financials brethren, the insurance industry is defensive rather than cyclical and thrives when the economy is slowing. Fairly stable, recurring and, most of the time, predictable revenue streams are sought after attributes when economic growth is scarce. Currently, the U.S. and global economies are expanding above trend, the global capex upcycle is running at full steam and CEOs and consumers alike exude confidence. Under such a backdrop, investors have historically avoided insurance equities. Chart 11 drives this point home. Over the past four decades the greenback and relative share prices have been positively correlated. The U.S. dollar peaked in December 2016 and since then it has been goosing global output, and simultaneously weighing on insurance stocks. Similarly, a rising 10-year Treasury yield reflecting improving economic growth also anchors insurance stocks (10-year Treasury yield shown inverted, Chart 12). While higher interest rates are positive for investment portfolio income, they also imply mark-to-market losses on bond portfolios. Higher interest rates also incent insurers to underwrite at a faster pace with more lenient standards, which is often a precursor to increased competition and diminishing pricing power, eventually sapping profits. Chart 11Insurance Is Defensive Chart 12Higher Yields Hurt More Than Help On the pricing front, there seems to be a bifurcated market. Auto insurance pricing is hardening, but home insurance is moving in the opposite direction (Chart 13). The slingshot recovery in auto loans versus residential real estate loans partially explains the big delta in pricing as subprime auto loans excesses have, at the margin, boosted new and used vehicle sales. This is not sustainable and there are high odds that this extra demand will level off in the coming months as the subprime auto credit screws inevitably tighten, eventually dampening car insurance prices. Worrisomely, the latest Fed Senior Loan Officer Survey revealed that not only is demand for auto loans waning, but also bankers are no longer willing extenders of auto related credit. Taken together, momentum in housing and auto sales is nil, warning that insurance top line growth will trail the broad market (Chart 14). Unsurprisingly, relative consumer outlays on insurance remain moribund, and a far cry from the previous cyclical peak, warning that it is premature to expect a valuation re-rating (second panel, Chart 15). Chart 13Margin Trouble? Chart 14Softening Demand Chart 15Insurance Indicator Message: Shy Away With regard to input costs, insurance labor additions continue unabated, trumping overall non-farm payrolls and the broad financial services industry since the GFC trough. Our insurance wage bill proxy is closing in on 4%/annum (bottom panel, Chart 13), warning that a margin squeeze looms. Our Insurance Indicator does an excellent job encapsulating all of these different signals and has recently taken a turn for the worse (third panel, Chart 15), underscoring that the path of least resistance is lower for relative share prices in the coming months. Bottom Line: We reiterate our underweight stance in the S&P insurance index. The ticker symbols for the stocks in this index are: BLBG: S5INSU - AIG, CB, MET, MMC, PRU, TRV, AFL, AON, ALL, PGR, WLTW, HIG, PFG, L, CINF, LNC, XL, AJG, UNM, TMK, AIZ, RE, BHF. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "SPX 3,000?" dated July 10, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Stay neutral small over large caps (downgrade alert)
Highlights Global equities are poised for a "blow-off" rally over the next 12-to-18 months. Long-term return prospects, however, are poor. The final innings of the 1991-2001 economic expansion saw a violent rotation in favor of value stocks and euro area equities. We expect history to repeat itself. After sagging by as much as 7% in the second half of 1998 and going nowhere in 1999, the dollar rose by 13% between January 2000 and February 2002. The greenback today is similarly ripe for a second wind. The correlation between the dollar and oil prices was fairly weak in the late 1990s. The correlation is likely to weaken again now that U.S. crude imports have fallen by about 70% from their 2006 highs thanks to the shale boom. The U.S. 10-year Treasury yield peaked at 6.79% in January 2000. Thus far, there is scant evidence that the recent increase in bond yields is having a major effect on either U.S. capital spending or housing demand. This suggests yields can go higher before they enter restrictive territory. Feature Learning From The Past The theme of this year's BCA annual Investment Conference - which will be held in Toronto in September and will feature a keynote address by Janet L. Yellen - is, appropriately enough, entitled "Investing In A Late-Cycle Economy."1 In the spirit of our conference, this week's report looks back at the market environment at the tail end of the 1991-2001 expansion in order to distill some lessons for today. The mid-to-late 1990s was a tale of contrasts. The U.S. was thriving, spurred on by accelerating productivity growth, falling inflation, and a massive corporate capex boom. Southern Europe was also doing well, aided by falling interest rates and optimism about the coming introduction of the euro. On the flipside, Germany - dubbed by many pundits at the time as the sick man of Europe - was still coping with the hangover from reunification. Japan was mired in deflation. Emerging markets were melting down, starting with the Mexican peso crisis in late 1994, followed by the Asian crisis, and finally the Russian default. In the financial world, the following points are worth highlighting (Chart 1): Chart 1AFinancial Markets In The Late 1990s (I) Chart 1BFinancial Markets In The Late 1990s (II) Russia's default and the implosion of Long-term Capital Management (LTCM) led to a gut-wrenching 22% decline in the S&P 500 in the late summer and early fall of 1998. This was followed by a colossal 68% blow-off rally over the subsequent 18 months. The collapse of LTCM marked the low point for EM assets for the cycle. The combination of cheap currencies, rising commodity prices, and a newfound resolve to enact structural reforms paved the way for a major EM boom over the following decade. The VIX and credit spreads trended upwards during the late 1990s, even as U.S. stocks climbed higher. Rising equity volatility and wider spreads were partly a reaction to problems abroad. However, they also reflected the deterioration in U.S. corporate health and heightened fears that stock market valuations had reached unsustainable levels. The U.S. stock market peaked in March 2000. However, that was only because the tech bubble burst. Outside of the technology sector, the S&P 500 actually increased by 9.2% between March 2000 and May 2001. Value stocks finally began to outperform growth stocks in 2000, joining small caps, which had begun to outperform a year earlier. European equities also surged towards the end of the bull market, outpacing the U.S. by 34% in local-currency terms and 21% in dollar terms between July 1999 and March 2000. The strong U.S. economy during the late 1990s ushered in a prolonged period of dollar appreciation that lasted until February 2002. That said, the greenback did not rise in a straight line. The dollar fell by as much as 7% in the second half of 1998 as the Fed cut rates in response to the LTCM crisis. It went sideways in 1999 before resuming its upward trend in early 2000. The correlation between the dollar and oil prices was much weaker in the 1990s compared to the first 15 years of the new millennium. After falling from a high of 6.98% in April 1997 to 4.16% in October 1998, the 10-year U.S. Treasury yield rose to 6.79% in January 2000. The Fed would keep raising rates until May of that year. The recession began in March 2001. Now And Then Just as in the tail end of the 1990s expansion, the global economy is doing reasonably well these days. Growth has cooled over the past few months, but should remain comfortably above trend for the remainder of the year. After struggling in 2014-16, Emerging Markets are on the mend, thanks in part to the rebound in commodity prices. During the 1990s cycle, the U.S. was the first major economy to reach full employment. The same is true today. The headline unemployment rate has fallen to 4.1%, just shy of the 2000 low of 3.8%. The share of the working-age population out of the labor market but wanting a job is back to pre-recession levels. The same goes for the share of unemployed workers who have quit - rather than lost - their jobs (Chart 2). One key difference concerns fiscal policy. The U.S. federal budget was in great shape in 2000. The same cannot be said today. Chart 3 shows that the fiscal deficit currently stands at 3.5% of GDP. The deficit is on track to deteriorate to 4.9% of GDP in 2021 even if growth remains strong. Federal government debt held by the public is also set to rise to 83.1% of GDP in 2021, up from 33.6% of GDP in 2000. Unlike in the past, the U.S. government will have less scope to ease fiscal policy when the next recession rolls around. Chart 2An Economy At Full Employment Chart 3The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Further Upside For Global Bond Yields Deleveraging headwinds, excess spare capacity, slow potential GDP growth, and chronically low inflation have all conspired to keep a lid on global bond yields. That is starting to change. Credit growth has accelerated, while output gaps have shrunk. The structural outlook for productivity growth is weaker than it was in the 1990s, but a cyclical pickup is likely given the recent recovery in capital spending. Chart 4 shows that there is a reasonably strong correlation between business capex and productivity growth. On the inflation side, the 3-month annualized change in U.S. core CPI and core PCE has reached 2.9% and 2.8%, respectively. The prices paid component of the ISM manufacturing index hit a seven-year high in March. The New York Fed's Underlying Inflation Gauge has zoomed to 3.1% (Chart 5). The market has been slow to price in the prospect of higher U.S. inflation (Chart 6). The TIPS 10-year breakeven rate is still roughly 20 bps below where it traded in the pre-recession period, even though the unemployment rate is lower now than at any point during that cycle. As long-term inflation expectations reset higher, bond yields will rise. Higher inflation expectations will also push up the term premium, which remains in negative territory. Chart 4Pickup In Capex Brightens ##br##The Cyclical Productivity Outlook Chart 5Inflation##br## Is Coming... Chart 6...Which Could Take ##br##Bond Yields Higher The upward pressure on yields could be amplified if the market revises up its assessment of the terminal real rate. Perhaps in a nod to what is to come, the Fed revised its terminal fed funds projection from 2.8% to 2.9% in the March 2018 Summary of Economic Projections. However, this is still well below the median estimate of 4.3% shown in the inaugural dot plot in January 2012. The U.S. Economy Is Not Yet Succumbing To Higher Rates For now, there is little evidence that higher rates are having a major negative effect on the economy. Business capital spending has decelerated recently, but that appears to be a global phenomenon. Capex has weakened even more in Japan, where yields have barely moved. In any case, the slowdown in U.S. investment spending has been fairly modest. Core capital goods orders disappointed in March, but are still up 7% year-over-year. Likewise, while our capex intention survey indicator has ticked lower, it remains well above its historic average. And despite elevated corporate debt levels, high-yield credit spreads are subdued and banks continue to ease lending standards for commercial and industrial loans (Chart 7). In the household realm, delinquency rates are rising and lending standards are tightening for auto and credit card loans. However, this has more to do with excessively strong lending growth over the preceding few years than with higher interest rates. Particularly in the case of credit card lending, even large movements in the fed funds rate tend to translate into only modest percent changes in debt service payments because of the large spreads that lenders charge on unsecured loans. The financial obligation ratio - a measure of the debt service burden for the average household - is rising but is still close to the lowest levels in three decades. Mortgage debt, which accounts for about two-thirds of all household credit, is near a 16-year low as a share of disposable income (Chart 8). As Ed Leamer perceptively argued in his 2007 Jackson Hole address entitled "Housing Is The Business Cycle," housing is the main avenue by which monetary policy affects the real economy.2 Similar to business capital spending, while the housing data has leveled off to some extent, it still looks pretty good: Building permits and housing starts continue to rise. New and existing home sales rebounded in March. Home prices have accelerated. The S&P/Case Shiller Home Price Index saw its strongest month-over-month gain in February since 2005. The MBA Mortgage Applications Purchase Index is up 11% year-over-year. The percentage of households looking to buy a home in the next six months is at a cycle high. Homebuilder sentiment has dipped slightly, but it remains at rock-solid levels (Chart 9). Chart 7Capital Spending ##br##Still Quite Robust Chart 8Household Debt Load And Financial Obligations##br## Are At Pre-Housing Bubble Levels Chart 9The Housing Sector##br## Is Doing Fine Fixed-Income: Hedged Or Unhedged? Bond positioning is quite short, so a temporary dip in yields is probable. However, investors should expect bond yields to rise more than is currently discounted over the next 12 months. BCA's fixed income strategists favor cyclically underweighting the U.S., Canada, and core Europe, while overweighting Australia, the U.K., and Japan in currency-hedged terms. Table 1 shows that the hedged yield on U.S. 10-year Treasurys is only 20 bps in EUR terms, and 38 bps in yen terms. Table 1Global Bond Yields: Hedged And Unhedged The low level of hedged U.S. yields today means that Treasurys are unlikely to enjoy the same inflows as in the past from overseas investors. This could push yields higher than they otherwise would go. To gain the significant yield advantage that U.S. government debt now commands, investors would need to go long Treasurys on a currency-unhedged basis. For long-term investors, this is a tantalizing investment. The current spread between 30-year Treasurys and German bunds stands at 192 bps. The euro would have to appreciate to 2.15 against the dollar for buy-and-hold investors to lose money by going long Treasurys relative to bunds.3 Such an overshoot of the euro is unlikely to occur, especially since the structural problems haunting Europe are no less daunting than those facing the United States. A Pop In The Dollar? Admittedly, the near-term success of a strategy that buys Treasurys, currency-unhedged, will hinge on what happens to the dollar. As occurred at the turn of the millennium, the dollar could find a bid as the Fed is forced to raise rates more aggressively than the market is pricing in. In this regard, large-scale U.S. fiscal stimulus, while arguably bearish for the dollar over the long haul, could be bullish for the dollar in the near term. My colleague Jennifer Lacombe has observed that flows into U.S.-listed European equity ETFs, such as those offered by iShares (EZU) and Vanguard (VGK), have reliably led the euro-dollar exchange rate by about six months (Chart 10).4 Recent outflows from these funds augur poorly for the euro. Rising hedging costs could also prompt more investors to buy U.S. fixed-income assets currency-unhedged, which would raise the demand for dollars (Chart 11).5 Chart 10ETF Flows Point To Lower EUR/USD Chart 11The Dollar Could Bounce The Oil-Dollar Correlation May Be Weakening Investors are accustomed to thinking that the dollar tends to be inversely correlated with oil prices. That relationship has not always been in place. Brent bottomed at just over $9/bbl in December 1998. Crude prices tripled over the subsequent 20 months. The broad trade-weighted dollar actually rose by 5% over that period. The dollar has strengthened by 2.8% since hitting a low on September 8, 2017, while Brent has gained 37% over this period. This breakdown in the dollar-oil correlation harkens back to late 2016: Brent rose by 26% between the U.S. presidential election and the end of that year. The dollar appreciated by 4% during those months. We are not ready to abandon the view that a stronger dollar is generally bad news for oil prices. However, the relationship between the two variables seems to be fading. Chart 12 shows that the two-year rolling correlation coefficient of monthly returns for Brent crude and the broad trade-weighted dollar has weakened in recent years. Chart 12The Negative Dollar-Oil Correlation Has Weakened This is not too surprising. Thanks to the shale boom, U.S. oil imports have fallen by about 70% since 2006 (Chart 13). This has made the U.S. trade balance less sensitive to changes in oil prices. The recent surge in oil prices has also been strengthened by OPEC 2.0's decision to reduce the supply of crude hitting the market, ongoing turmoil in Venezuela, and the possibility that Iranian sanctions could take 0.3-0.8 million barrels a day off the market. A reduction in oil supply is bad for global growth at the margin. However, weaker global growth is good for the dollar (Chart 14). OPEC's production cuts also increase the scope for U.S. shale producers to gain global market share over the long haul, which should help the greenback. As such, while a modestly strong dollar over the remainder of the year will be a headwind for oil, it may not be a strong enough impediment to prevent Brent from rising another $6/bbl to reach $80/bbl, as per our commodity team's projections. Chart 13U.S. Oil Imports ##br##Have Collapsed Chart 14Slowing Global Growth Tends##br## To Be Bullish For The Dollar The Outlook For Equities Following the script of the late 1990s, stock market volatility has risen this year, as investors have begun to fret about the durability of the nine year-old equity bull market. Valuations are not as extreme as they were in 2000, but they are far from cheap. The Shiller P/E for U.S. stocks stands at 31, consistent with total nominal returns of only 4% over the next decade (Chart 15). On a price-to-sales basis, U.S. stocks have surpassed their 2000 peak (Chart 16). Such a rich multiple to sales can be justified if profit margins stay elevated, but that is far from a sure thing. Yes, the composition of the stock market has shifted towards sectors such as technology, which have traditionally enjoyed high margins. The explosion of winner-take-all markets has also allowed the most successful companies to dominate the stock market indices, while second-tier companies get pushed to the sidelines (Chart 17). Chart 15Long-Term Investors, Take Note Chart 16U.S. Stocks Are Pricey Chart 17Only The Best Nevertheless, there continues to be a strong relationship between economy-wide profits and the ratio of selling prices-to-unit labor costs (Chart 18). The latest data suggest that U.S. wage growth has picked up in the first quarter (Table 2). Low-skilled workers, whose wages tend to be better correlated with economic slack than those of high-skilled workers, are finally seeing sizable gains. Chart 18U.S. Profit Margins Could Resume Mean-Reverting... Table 2...If Wage Growth Continues Accelerating Even if productivity growth accelerates, unit labor costs are likely to rise faster than prices, pushing profit margins for many companies lower. Bottom-up analysts expect annual EPS growth to average more than 15% over the next five years, a level of optimism not seen since 1998 (Chart 19). The bar for positive surprises on the earnings front is getting increasingly high. Go For Value Historically, stocks tend not to peak until about six months before the start of a recession. Given our expectation that the next recession will occur in 2020, global equities could still enjoy a blow-off rally after the current shakeout exhausts itself. But when the music stops, the stock market is heading for a mighty fall. Given today's lofty valuations and the uncertainty about the precise timing of the next recession, we would certainly not fault long-term investors for taking some money off the table. For those who feel compelled to stay fully invested, our advice is to shift allocations towards cheaper alternatives. Value stocks have massively underperformed growth stocks for the past 11 years (Chart 20). Today, value trades at a greater-than-normal discount to growth. Earnings revisions are moving in favor of value names. Just like at the turn of the millennium, it may be value's turn to shine. Chart 19The Bar For Positive Earnings Surprises Has Risen Chart 20Value Stocks: An Attractive Proposition Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 For more information about our Investment Conference, please click here or contact your account manager. 2 Edward E. Leamer, "Housing Is The Business Cycle," Proceedings, Economic Policy Symposium, Jackson Hole, Federal Reserve Bank of Kansas City, (2007). 3 To arrive at this number, we multiply the current exchange rate by the degree to which EUR/USD would have to strengthen, on average, every year for the next 30 years in order to nullify the carry advantage of holding Treasurys over bunds. Thus, 1.217*(1.0192)^30=2.15. Granted, investors expect inflation to be about 45 bps lower in the euro area than in the U.S. over the next three decades. However, this would only lift the Purchasing Power Parity (PPP) value of EUR/USD from its current level of 1.32 to 1.51. This would still leave the euro 42% overvalued. 4 Please see Global ETF Strategy Special Report, "Do ETF Flows Lead Currencies?" dated April 18, 2018. 5 When a foreign investor buys U.S. bonds currency-hedged, this entails two transactions. First, the investor must purchase the bond, and second, the investor must sell the dollar forward (which is similar to shorting it). The former transaction increases the demand for dollars, while the latter increases the supply of dollars. Thus, as far as the value of the dollar is concerned, it is a wash. In contrast, if foreign investors buy bonds currency-unhedged, there is no offsetting increase in the supply of dollars, and hence the dollar will tend to strengthen. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Our base case outlook is unchanged. We do not see a recession in the U.S. before 2020, and the U.S. equity market could reward investors with high single-digit total returns this year and next. Nonetheless, the cycle is well advanced and, given current valuations, the long-term outlook for returns in the major asset classes is far less appealing. The risk/reward balance is unfavorable. Investors should therefore separate strategy from forecast. U.S. unemployment is very low and we are beginning to see hints of late-cycle inflation dynamics. Core inflation could soon be at the Fed's 2% target, which means that the FOMC will have to consider becoming outright restrictive in order to slow growth and raise the unemployment rate. The risks facing equities, EM assets and spread product will escalate at that point. The advanced stage in the cycle and our bias for capital preservation requires us to heed the recent warnings from our growth indicators and 'exit' timing checklist. The geopolitical calendar is also stacked with risk for markets over the next month at least. The implication is that we are tactically trimming risk asset exposure to benchmark. We expect to shift back to overweight once our indicators improve and/or the geopolitical tensions fade. This month we provide total return estimates for the major U.S. asset classes under our base case outlook and two alternative scenarios. We place the odds at 50% for the base case, 20% for the optimistic scenario and 30% for a recession in 2019. We also review the U.S. fiscal outlook, which is clearly unsustainable over the long-term. While we do not see a dollar crisis anytime soon, the prospect of large and sustained federal budget deficits supports the view that the dollar will continue on a long-term downtrend (although it is likely to buck the trend in the coming months). It also supports our view that the multi-decade Treasury bull market is over. U.S. consumers will not be particularly sensitive to rising borrowing rates, although there are pockets of excessive borrowing that will no doubt result in a spike in defaults in selected sectors when the next economic downturn arrives. Feature It was the summer of 2009. Risk assets were bombed out, investor sentiment was deeply depressed, business leaders were shell-shocked, the Fed was easing and some 'green shoots' of recovery were emerging. Plentiful economic slack also meant that there was a long potential runway for the economy and earnings to grow. Given that backdrop, it was appropriate to begin rebuilding risk portfolios and ride out any additional turbulence in the markets. Today's situation is almost the mirror image. The economic expansion is well advanced, there is little slack, the Fed is tightening, risk assets are expensive, and investor equity sentiment is frothy. The long-term outlook for returns in the major asset classes is underwhelming to say the least. Table I-1 updates the long-run return expectations we published in the 2018 BCA Outlook. Some technical adjustments make the numbers look a little better but, still, a balanced portfolio will deliver average returns over the long-term of only 3.8% and 1.8% in nominal and real terms, respectively. Table I-110-Year Asset Return Projections For stocks, the expected returns are poor by historical standards because we assume a mean-reversion in multiples and a decline in the profit share of total income. These assumptions may turn out to be too pessimistic if there is no redistribution of income shares from the corporate sector back to labor and/or P-E ratios remain at historically high levels. Equities obviously would do better than our estimates in this case, but the point is that it is very hard to see returns in risk assets anywhere close to their 1982-2017 average over the long haul. On a two-year horizon, our base case outlook still sees decent equity returns. Nonetheless, the risk/reward balance has become quite unfavorable because the cycle is so advanced. It is therefore prudent to focus on capital preservation and be quicker to trim risk exposure when the outlook becomes cloudier. Losing Sleep Investors have cheered some easing in the perceived risk of a trade war in recent weeks. Nonetheless, a number of items have made us more nervous about the near term. First, our Equity Scorecard has dropped to one, well below the critical value of three that is consistent with positive equity returns historically (Chart I-1). Table I-2 updates our Exit Checklist of items that we believe are important for the equity allocation call. Five of the nine are now giving a 'sell' signal, pointing to at least a technical correction. Chart I-1Our Equity Scorecard Turned Negative Table I-2Exit Checklist For Risk Assets Moreover, we highlighted last month that global growth appears to be peaking (Chart I-2). Our Global Leading Economic Indicator is still bullish, but its diffusion index has plunged below zero. The Global ZEW index and our Boom/Bust indicator have fallen sharply and the global PMI index ticked down (albeit, from a high level). Industrial production in the major economies has eased. Korean and Taiwanese exports, which are a barometer of global industrial activity, have decelerated as well. Chart I-2Economic Indicators Have Softened While we expect global growth to remain at an above-trend pace for at least the next year, the peaking in some coincident and leading indicators is worrying nonetheless. Other items to keep investors up at night include the following: Loss Of Fed Put: With inflation likely to reach the Fed's target in the next couple of months, and policymakers worried about froth in markets, the FOMC will be less predisposed to ease at the first hint of economic softness (see below). Inflation Surge: There is a lot of uncertainty around estimates of the level of the unemployment rate that is consistent with rising wage and price pressures. Inflation could suddenly jump if unemployment is far below this critical level, leading to a blood bath in the bond market that would reverberate through all other assets. The fact that long-term inflation breakevens have surged along with the 10-year Treasury yield in the past couple of weeks is an ominous sign for risk assets. Neutral Rate: We agree with the Fed that the neutral fed funds rate is rising, but nobody knows exactly where it is at the moment. If the neutral rate is lower than the Fed believes, then the economy could suddenly stall as actual rates rise above the neutral level. Trade War: President Trump's popularity among Republican voters is rising, which gives him the ability to weather turbulence in the stock market while he 'gets tough' on trade. The fact that U.S. Treasury Secretary Mnuchin will visit China is a hopeful sign. Nonetheless, we do not believe that we have seen peak pessimism on trade because the President needs to placate his supporters in the mid-west that are in favor of protectionism. The summer months could be volatile as market confusion grows amidst a plethora of upcoming event risks.1 Iran: This year's premier geopolitical risk is the potential for renewed U.S.-Iran tensions. Ahead of the all-important May 12 deadline - when the White House will decide whether to end the current waiver of economic sanctions against Iran - President Trump has staffed his cabinet with two hawks (Bolton and Pompeo). Meanwhile, tensions in Syria are building with the potential for U.S. and Iranian forces to be directly implicated in a skirmish. Russia: Tensions between the West and Russia are also building again. Stroke Of Pen Risk: There is a rising probability that the current administration decides to up the regulatory pressure on Amazon. Other technology companies like Facebook and Google also face "stroke of pen" risks. On a positive note, first quarter earnings season is off to a good start in the U.S. Earnings have surprised to the upside by a wide margin, which is impressive given that analysts bumped up their Q1 assessments in 10 of 11 sectors between the start of 2018 and the beginning of the Q1 reporting season. Analysts' estimates typically move lower as a quarter unfolds, which has the effect of lowering the bar for results to beat expectations. That said, a lot of good news is already discounted in the U.S. market. Chart I-3 highlights that bottom-up analysts' expected annual average EPS growth for the S&P 500 over the next five years has shot up to more than 15%, a level not seen since 1998! This is excessive even considering that the estimates include the impact of the tax cuts. History teaches that investors should be wary during periods of earnings euphoria. Chart I-3Five-Year Bottom-Up EPS Growth Estimates Are Impossibly High Given these risks, market pricing and our checklist, we adjusted the tactical (3-month) House View recommendation on risk assets to benchmark in April. We see this shift as tactical, and expect to move back to overweight once our growth indicators bottom and the geopolitical situation calms down a little. Our base case outlook remains constructive for risk assets on a cyclical (6-12 month) view. Three Scenarios This month we consider two alternative scenarios to our base case outlook and provide estimates of how several key asset classes would perform between now and the end of 2019: Base Case: U.S. real GDP growth accelerates to 3.3% year-over-year by the end of 2018 on the back of fiscal stimulus and improving animal spirits in the corporate sector. Growth is expected to decelerate in 2019, but remain above trend. Profit margins are squeezed marginally by rising wage pressure. The recession we expect to occur in 2020 is beyond the horizon of this exercise. Optimistic Case: The multiplier effects of the fiscal stimulus could be larger than we are assuming if consumers decide to spend most of the tax windfall, and the corporate sector cranks up capital spending due to accelerated depreciation, the tax savings and repatriated overseas funds. We assume that real GDP growth is about a half percentage point higher than the base case in both 2018 and 2019. This is only modestly stronger than the base case because, given that the economy is already at full employment, the supply side of the economy will constrain growth. Even more margin pressure partially offsets stronger top line growth for corporations. Pessimistic Case: The fiscal multiplier effects turn out to be smaller than expected, compounded by the growth-sapping impact of a tariff war and a spike in oil prices due to tensions in the Middle East. The corporate and consumer sectors are more sensitive to rising interest rates than we thought (see below for more discussion of U.S. consumer vulnerabilities). Growth begins to slow toward the end of 2018, culminating in a recession in the second half of 2019. Margins are squeezed initially, but then rise as labor market slack opens up next year. This is more than offset, however, by declining corporate revenues. Chart I-4 presents the implications for S&P 500 EPS growth in the three scenarios, according to our top-down model. Four-quarter trailing profit growth comes in at a respectable 15% and 8½%, respectively, in 2018 and 2019 in our base case. The optimistic scenario would see impressive profit growth of 20% and 13%. Trailing EPS expands by 9% this year in the pessimistic case, but contracts by about the same amount next year. Chart I-4Three Scenarios For S&P 500 EPS Growth In order to use these EPS forecasts to estimate expected S&P 500 returns, we made assumptions regarding an appropriate 12-month forward P/E ratio (Table I-3). We also translated our trailing EPS forecasts into 12-month forward estimates based on historical cyclical patterns. The 12-month forward P/E ratio is 17 as we go to press (based on Standard and Poors figures). We assume the ratio is flat this year in the base case, before edging lower in 2019 due to rising interest rates. The forward P/E is assumed to edge up in the optimistic case in 2019, but then falls back in 2019 as rates rise. In the recession scenario, we conservatively assume that this ratio falls to 15 by the end of this year, and to 13 by the end of 2019. We incorporate a 2% dividend yield in all scenarios. Over the next two years, the S&P 500 delivers an 8% annual average return in our baseline, and 13% in the optimistic case. As would be expected, investors suffer painful losses of 13% this year and roughly 20% next year in the case of recession, as the drop in multiples magnifies the earnings contraction. Table I-4 presents total return estimates for the 10-year Treasury under the three scenarios. The bond will provide an average return of close to zero in our base case. It suffers heavy losses in 2018 if growth turns out to be stronger than we expect, because a faster acceleration in inflation would spark a sharp upward revision to the path of short-term rates. Long-term inflation expectations would rise as well. The 10-year yield finishes 2019 at 3.5% in the base case, and at 3.75% in the optimistic growth scenario. In contrast, total returns are hefty in the recession case as the 10-year yield drops back below 2%. Table I-3S&P 500 Return Scenarios Table I-410-year Treasury Return Scenarios We believe the risk/reward profile is less attractive for corporate bonds than it is for equities (Table I-5). Strong profit growth in the base and optimistic cases is positive for corporates, but this is offset by deteriorating financial ratios as interest rates rise in the context of high leverage ratios. We expect investment-grade (IG) spreads to widen modestly even in the base case, providing a small negative excess return. We see spreads moving sideways at best in our optimistic scenario, giving investors a small positive excess return of about 100 basis points. In the case of a recession, we could see the option-adjusted spread of the Barclay's IG index surging from 105 basis points today to 250 basis points. Excess returns would obviously be quite negative. Table I-5U.S. Investment Grade Corporate Bonds All of these projected returns are only meant to be suggestive because they depend importantly on several key assumptions. Still, we wanted to provide readers with a sense of the risks for returns around our base case outlook. We place the odds at 50% for the base case, 20% for the optimistic scenario and 30% for a recession. U.S. Fiscal Policy: Good And Bad News The probabilities attached to the baseline and optimistic scenarios are supported by the U.S. fiscal stimulus that is in the pipeline. The IMF estimates that the tax cuts and spending increases will provide a fiscal thrust of 0.8% in 2018 and 0.9% in 2019, not far from the estimates we presented last month (Chart I-5).2 This represents a powerful tailwind for growth for the next two years. We must turn to the Congressional Budget Office (CBO) projections to gauge the longer-term implications. On a positive note, the CBO revised up its estimate of the economy's long-run potential growth rate on account of the supply-side benefits of lower taxes and the immediate expensing of capital outlays. Faster growth over the long run, on its own, reduces the projected cumulative budget deficit over the 2018-2027 period by $1 trillion. However, this positive impact is swamped by the direct effect on the budget of the tax breaks and increased spending. The CBO estimates that the net effect of the fiscal adjustments will be a $1.7 trillion increase in the cumulative budget deficit over the next decade, relative to the previous baseline (Chart I-6). The annual deficit is projected to surpass $1 trillion in 2020, and peak as a share of GDP at 5.4% in 2022. Federal government debt held by the private sector will rise from 76% this year to 96% in 2028 in this scenario. Chart I-5U.S. Fiscal Stimulus Will Support Growth Chart I-6U.S. Federal Budget: A Lot More Red Ink The deficit situation begins to look better after 2020 because a raft of "temporary provisions" are assumed to sunset as per current law, including some of the personal tax cuts and deductions included in the 2017 tax package. As is usually the case, the vast majority of these provisions are likely to be extended. The CBO performed an alternative scenario in which they extend the temporary provisions and grow the spending caps at the rate of inflation after 2020. In this more realistic scenario, the deficit reaches 6% of GDP by 2022 and the federal debt-to-GDP ratio hits almost 110% of GDP in 2028. This is not a pretty picture and investors are wondering what it means for government bond yields and the dollar. We noted in the March 2018 Bank Credit Analyst that academic studies published before 2007 suggested that every percentage point rise in the government's debt-to-GDP ratio added roughly three basis points to the equilibrium level of bond yields. If this is correct, then a rise in the U.S. ratio of 25 percentage points over the next decade would lift the equilibrium long-term bond yields by 75 basis points. This estimated impact on yields should not be thought of as a default risk premium because there is no reason to default when the Fed can simply print money in the event of a funding crisis. Rather, a worsening fiscal situation could show up in higher long-term inflation expectations if investors were to lose confidence in the Fed's inflation target. Higher real yields could also come about through the 'crowding out' effect; since growth is limited in the long run by the supply side of the economy, a larger government sector means that some private sector demand needs to be crowded out via higher real interest rates. Deficits And The Dollar We discussed the potential debt fallout for the U.S. dollar from an economic perspective in the April 2018 Special Report. While the fiscal stimulus means that the U.S. twin deficits are set to worsen, the situation is not so dire that the U.S. dollar is about to fall off a cliff because of sudden concerns regarding U.S. debt sustainability among international investors. The U.S. is not close to the point where investors will begin to seriously question America's ability to service its debt. Nonetheless, with President Donald Trump's overt calls for American geopolitical retrenchment from global commitments, investors have asked whether the end of the dollar as the global reserve currency is nigh. This month's Special Report beginning on page 22 examines this issue. There is no evidence at the moment that the U.S. dollar is losing any market share and we do not foresee any sudden shifts away from the U.S. dollar as a reserve currency. However, cracks are beginning to form, especially with regard to the RMB. We also believe that the euro is likely to benefit from a structural tailwind as global reserve managers increase the share of the euro in their reserves. A trade war would accelerate the diversification away from the dollar. Chart I-7Economic Slack: U.S./Eurozone Comparison The conclusions of this month's Special Report support those of last month's analysis; the dollar will continue on its long-term downtrend, although there is still room for a counter-trend rally this year. We do not see much upside against the yen in the near term, but we expect some of the euro's recent strength to be unwound. A debate is raging within the halls of the European Central Bank regarding the amount of Europe's economic slack. On this we side with President Draghi, who believes that there is still plenty of excess capacity in the labor market. The Eurozone's unemployment rate has reached the level of full employment as estimated by the OECD. However, Chart I-7 shows various measures of hidden unemployment, including discouraged workers and those that have been out of work for more than a year. In all cases, the Eurozone appears to be behind the U.S. in terms of getting back to full employment. This, along with the recent softening in some of the Eurozone's economic data, will keep the ECB wedded to low interest rates even as it terminates the asset purchase program this autumn. Long-dated forward rate differentials are beginning to move back in favor of the dollar relative to the Euro. Dollar strength will also be at the expense of most of the EM currencies. The Long-Term Consequences Of Government Debt While it is somewhat comforting that the U.S. twin-deficits are unlikely to spark financial panic in the short- to medium term, the U.S. and global debt situations are not without consequences. The latest IMF Fiscal Monitor again sounded the alarm over global debt levels, especially government paper. The Fund argues that debt sustainability becomes increasingly questionable once the general government debt/GDP ratio breaches 85%. The IMF points out that more than one-third of advanced economies had debt above 85% in 2017, three times more countries than in 2000. And this does not include the implicit liabilities linked to pension and health care spending. The good news is that the IMF expects that most of the major economies will see a reduction in their general government debt/GDP ratios between 2017 and 2023. The big exception is the U.S., where the average deficit is expected to far exceed the other major countries (Charts I-8A and I-8B). The U.S. cyclically-adjusted budget deficit is projected to be almost 7% of GDP in 2019! Including all levels of government, the IMF estimates that the U.S. debt/GDP ratio will rise by about nine percentage points, to almost 117%, between 2017 and 2023. Chart I-8AIMF Projections (I) Chart I-8BIMF Projections (II) U.S. fiscal trends are clearly unsustainable in the long-term. Taxes will have to rise or entitlement programs will have to be slashed at some point. The question is whether Congress administers the required medicine willingly, or is forced to do so by rioting markets. We do not believe that the dollar's 'day of reckoning' will happen anytime soon, but growing angst over the U.S. fiscal outlook supports our view that the multi-decade Treasury bull market is over. In the near term, the main threat to the global bond market is a mini 'inflation scare' in the U.S. Fed Will Soon Reach 2% Goal Chart I-9Inflation May Soon Reach The Fed's Target The 10-year Treasury yield is testing the 3% support level as we go to press. In part, upward pressure on yields likely reflects some calming of tensions regarding global trade and the news that the U.S. will hold face-to-face discussions with North Korea. Moreover, long-term inflation expectations have been rising in most of the major countries. Investors appear to be waking up to how strong U.S. inflation has been in recent months, driven in part by an unwinding of base effects that temporarily depressed the annual inflation rate. U.S. core CPI inflation has already quickened from 1.8% in February to 2.1% in March (Chart I-9). This acceleration will also play out in the core PCE deflator, the Fed's preferred inflation metric. Even if the core PCE deflator rises only 0.1% month-over-month in March, year-over-year core PCE inflation will increase to 1.85%. This would be above Bloomberg and Fed estimates for the end of the year. If the core PCE deflator rises 0.2% m/m in March - a reading more consistent with recent trends - then year-over-year core PCE inflation will almost reach the Fed's 2% target. The FOMC will not be alarmed even if inflation appears set to overshoot the 2% target. Nonetheless, Fed officials will be forced to adjust the communication language because they can no longer argue that "accommodative" monetary policy is still appropriate. In other words, policymakers will have to openly admit that policy will have to become outright restrictive. The Fed's "dot plot" could then be revised higher. The policy risks facing equities, EM assets and spread product will escalate once it becomes clear that the FOMC is actively targeting slower economic growth and a higher unemployment rate. As for Treasurys, the surge in the 10-year yield to 3% has been quick and we would not be surprised to see another consolidation period. Eventually, however, we expect the yield to reach 3.5% before the bear phase is over. How Vulnerable Are U.S. Households? The ultimate peak in U.S. yields will depend importantly on the economy's sensitivity to rising borrowing costs. Our research on excessive borrowing in recent months has focussed on the U.S. corporate sector. Next month we will review corporate vulnerabilities in the Eurozone. But what about U.S. consumers? Overall debt as a ratio to GDP or personal income has fallen back to pre-housing bubble levels, underscoring that the household sector has deleveraged impressively (Chart I-10). Household net worth has surpassed the pre-Lehman peak and our "wealth effect" proxy suggests that the rise in asset prices and recovery in home values provide a strong tailwind for spending (Chart I-11). The proxy likely overstates the size of the tailwind due to the lack of cash-out refinancing. Chart I-10U.S. Consumers Have Deleveraged Chart I-11'Wealth Effect' Is A Tailwind The financial obligation ratio (FOR) - a measure of the debt service burden for the average household - is rising but is still close to the lowest levels in three decades (Chart I-12). Chart I-13 shows a broader measure of the burden that households face when paying for essentials; interest payments, food, medical care and energy. These are all expenses that are difficult to trim. Spending on essentials has increased over the past couple of years to a little under 42% of disposable income due to rising interest rates and a continuing uptrend in out-of-pocket medical care costs. However, the ratio is below the post-1980 average level and has only risen back to levels that existed in 2011/12. From this perspective, it is difficult to believe that rising gasoline prices will dominate the benefits of the tax cuts on household spending. Chart I-12Past The Peak Of U.S. Consumer Credit Quality Chart I-13Spending On Essentials Is Not Onerous The labor market is clearly supportive for consumer spending. Wage growth has been disappointing so far in this recover, and real personal disposable income has slowed over the past year. Nonetheless, the economy continues to produce new jobs at an impressive pace, unemployment claims are close to all-time lows, and households are feeling confident about their future income and job prospects. Some market pundits have pointed to the falling household savings rate as a warning sign that consumers are 'tapped out' (Chart I-14). We are less concerned. The savings rate tends to decline during economic expansions and rises almost exclusively during recessions. All else equal, one could make the case that U.S. households should save more over their lifetimes. Nonetheless, a falling savings rate is consistent with strong, not weak, economic activity. That said, some signs have emerged that not all consumer lending in recent years has been prudent. Bank and finance company loan delinquency rates are rising, especially for credit cards and autos (Chart I-15). While the FOR is still low, it is rising and it tends to lead bank loan delinquency rates (Chart I-12). These trends usually occur just prior to a recession. Chart I-14Savings Rate Falls During Expansions Chart I-15Some Signs Of Excessive Lending There has also been an alarming surge in credit card charge-off rates, which have reached recession levels among banks that are outside of the top 100 (Chart I-15, top panel). Anecdotal evidence suggests that large banks offered lush cash rewards and points to attract higher-quality customers. Smaller banks could not compete on cash rewards, and instead had to loosen credit requirements for card issuance. The deterioration in the credit-quality composition of these banks' loan portfolios helps to explain why delinquencies have increased despite a robust labor market. The Fed's senior loan officer survey shows that expected delinquencies and charge-offs are rising even among large banks. One risk is that, while overall credit growth has been weak in this expansion, it has been concentrated in lower-income households. However, the Fed's Survey of Consumer Finances does not flag a huge problem. Various measures of credit quality have not deteriorated for lower income households since 2007 (latest year available; Chart I-16). Chart I-16Credit Quality For Lower ##br##Income U.S. Households The bottom line is that there are pockets of excessive borrowing that will no doubt result in a spike in defaults in selected sectors when the next economic downturn arrives. Nonetheless, the backdrop for consumer health has not deteriorated to the point where the U.S. household sector will be ultra-sensitive to higher interest rates on a broad scale. Investment Conclusions Our base case outlook is unchanged this month. We do not see a recession in the U.S. before 2020, and the U.S. equity market could reward investors with high single-digit total returns this year and next. Nonetheless, one must separate strategy from forecast at this point in the cycle. U.S. unemployment is very low and we are beginning to see hints of late-cycle inflation dynamics. Core inflation could soon be at the Fed's 2% target, while rising energy and base metal prices add to the broader inflationary backdrop. Strong global oil demand growth and the OPEC/Russia production cuts are draining global oil inventories and supporting prices. Sanctions against Iran and/or Venezuela that further restrict supply could easily send oil prices to more than US$80/bbl this year. Investors should remain overweight energy plays. The implication is that the Fed may have to tighten into outright restrictive territory. The advanced stage in the cycle and our bias for capital preservation requires us to heed the warnings from our indicators and timing checklist. The geopolitical calendar is also stacked with risk for markets over the next month at least. Thus, we are tactically trimming risk asset exposure to benchmark until our indicators improve and/or geopolitical tensions fade. Investors should also be more cautious in their equity sector allocation for the very near term. We continue to favor Eurozone stocks over the U.S. (currency hedged), since the threat from monetary tightening is greater in the latter market and we expect the dollar to appreciate. We are neutral on the Nikkei because the risk of a rising yen offsets currently-strong EPS growth momentum. Stay short duration within global bond portfolios, and remain underweight the U.S., Canada and core Europe (currency hedged). Overweight Australia and the U.K. The Aussie economy will continue to underperform, and the U.K. economy will not allow the Bank of England to hike rates as much as is currently discounted. Mark McClellan Senior Vice President The Bank Credit Analyst April 26, 2018 Next Report: May 31, 2018 1 For a list of these events, see Table 2 in the BCA Geopolitical Strategy Weekly Report "Expect Volatility... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. 2 The fiscal thrust is the change in the cyclically-adjusted budget balance as a share of GDP. It is a measure of the initial impetus to real GDP growth, but the actual impact on growth depends on fiscal "multipliers". II. Is King Dollar Facing Regicide? This month's Special Report is a joint effort by BCA's Geopolitical and Foreign Exchange strategists, along with contributing editors Mehul Daya and Neels Heyneke (Strategists at Nedbank CIB Research). It is a companion piece to last month's Special Report, in which I discussed the short- and long-term outlook for the U.S. dollar from a purely economic perspective. This month's analysis takes a geopolitical perspective, focusing on the possibility that the U.S. dollar will lose its reserve currency status and weaken over the long term. I trust that you will find the Report as insightful as I did. Mark McClellan Reserve currencies are built on a geopolitical and macroeconomic foundation. For the U.S. Dollar, these foundations remain in place, but cracks are emerging. Relative decline in American power, combined with a loss of confidence in the "Washington Consensus" at home, are eroding the geopolitical foundations. Meanwhile, threats to globalization, a slower pace of petrodollar recycling, and stresses in the Eurodollar system are eroding the macroeconomic foundations. The Renminbi is not an alternative to King Dollar, but the euro remains a potential challenger in the coming interregnum years that will see the world transition from American hegemony... to something else. In the long run, we envision a multipolar currency regime to emerge alongside a multipolar geopolitical world order. In this report, BCA's Geopolitical and Foreign Exchange strategies join efforts with contributing editors Mehul Daya and Neels Heyneke (Strategists at Nedbank CIB Research) to examine the conditions necessary for the decline of a reserve currency. Specifically, we seek to answer the question of whether the U.S. dollar is at the precipice of such a decline. With President Donald Trump's overt calls for American geopolitical retrenchment from global commitments, investors have asked whether the end of the dollar as the global reserve currency is nigh. After all, King Dollar has fallen by 9.7% since President Trump's inauguration on January 20, while alternatives of dubious value, such as a slew of cryptocurrencies, have seen a rally of epic proportions (Chart II-1). Professor Barry Eichengreen, a world-renowned international economics historian,1 has recently penned an insightful paper proposing a link between the robustness of military alliances and currency reserve status.2 According to the analysis, reserve currency status reflects both economic fundamentals - safety, liquidity, network effects, and economic conditions - and geopolitical fundamentals. In the case of close U.S. military allies, such as South Korea and Japan, the choice of the dollar as store of value is explained far more by the geopolitical links to the U.S., rather than the importance of the dollar for their economies. The authors warn that if the U.S. "withdraws from the world," the impact could be as large as an 80 basis points rise in the U.S. long-term interest rate. Intriguingly, some of what Professor Eichengreen posits could happen has already happened. For example, the share of foreign holdings of U.S. Treasuries by military allies has already declined by a whopping 25% (Chart II-2). And yet the demand for King Dollar assets was immediately picked up by non-military allies, proving the resiliency of greenback's status as the reserve currency. Chart II-1Is Trump Guilty Of Regicide? Chart II-2Geopolitics Is Not Driving ##br##Demand For Treasuries When it comes to global currency reserves, the U.S. dollar continues to command 63%, roughly the same level it has commanded since 2000 (Chart II-3). Interestingly, alternatives remain roughly the same as in the past, with little real movement (Chart II-4). The Chinese renminbi remains largely ignored as a global reserve currency and its use across markets and geographies appears to have declined since the imposition of full capital controls in October 2015 (Chart II-5). Chart II-3Dollar Remains King Chart II-4The Euro Is The Only Serious Competitor To King Dollar... Chart II-5...The Renminbi Is Not However, some cracks in the foundation are emerging. A recent IMF paper, penned by Camilo E. Tovar and Tania Mohd Nor,3 uses currency co-movements to determine which national currencies belong to a particular reserve currency bloc.4 Their work shows that the international monetary system has already transitioned from a bi-polar system - consisting of the greenback and the euro - to a multipolar one that includes the CNY (Chart II-6). However, the CNY's influence does not extend beyond the BRICS and is scant in East Asia, the geographical region that China already dominates in trade (Chart II-7), albeit not yet geopolitically (Map II-1). Chart II-6Renminbi Does Command A Large Currency 'Bloc'... Chart II-7...But Despite China's Dominance Of East Asia... Map II-1...Renminbi's 'Bloc' Is Not In Asia! Our conclusion is that the geopolitical and economic tailwinds behind the greenback's status as a global reserve currency are shifting into headwinds. This process, as we describe below, could increase the risk of a global dollar liquidity shortage, buoying the greenback in the short term. In the long term, however, a transition into a multipolar currency arrangement could rebalance some of the imbalances created by the collapse of the Bretton Woods System and is not necessarily to be feared. The Geopolitical Fundamentals Of A Reserve Currency Nothing lasts forever and the U.S. dollar will one day join a long list of former reserve currencies that includes the Ancient Greek drachma, the Roman aureus, the Byzantium solidus, the Florentine florin, the Dutch gulden, the Spanish dollar, and the pound sterling. All of the political entities that produced these reserve currencies have several factors in common. They were the geopolitical hegemons of their era, capable of controlling the most important trade routes, projecting both hard and soft power outside of their borders, and maintaining a stable economy that underpinned the purchasing power of their currency. Table II-1 illustrates several factors that we believe encapsulate the necessary conditions for a dominant international currency. Table II-1Insights From History: What Makes A Reserve Currency? Geopolitical Power As Eichengreen posits, geopolitical fundamentals are essential for reserve currency status. Military power is necessary in order to defend one's national and commercial interests abroad, compel foreign powers to yield to those interests, and protect allies in exchange for their acquiescence to the hegemonic status quo. An important modern world example of such "gunboat diplomacy" was the 1974 agreement between the U.S. and Saudi Arabia.5 In exchange for dumping their petro-dollars into U.S. debt, Riyadh received an American commitment to keep the Saudi Kingdom safe from all threats, both regional (Iran) and global (the Soviet Union). It also received special permission to keep its purchases of U.S. Treasuries secret. Chart II-8The Exorbitant Privilege In One Chart As with all the empires surveyed in Table II-1, allies and vassal states were forced to use the hegemon's currency in their trade and investment transactions as a way of paying for the security blanket. To this day, there is no better way to explain the "exorbitant privilege" that the dollar commands. Chart II-8 illustrates that the U.S. enjoys positive net income despite a massively negative net international investment position. It is true that the U.S.'s foreign assets are skewed toward foreign direct investment and equities, investments that have higher rates of returns than the fixed-income liabilities the U.S. owes to the rest of the world. But the U.S.'s positive net income balance has been exacerbated by the willingness of foreigners to invest their assets into the U.S. for little compensation, something illustrated by the fact that between 1971 and 2007, the ex-post U.S. term premium has been toward the lower end of the G10. Additionally, as foreigners are also willing holders of U.S. physical cash, the U.S. government has been able to finance part of its budget deficit with instruments carrying no interest payments. This is what economists refer to as seigniorage, a subsidy to the U.S. government equivalent to around 0.2% of GDP per annum (or roughly $39.5 bn in 2017). In essence, American allies are paying for American hegemony through their investments in U.S. dollar assets, and this lets the U.S. live above its means. But ultimately, the quid pro quo is perhaps as much geopolitical as economic. There is one, non-negligible, cost for U.S. policymakers. The greenback tends to appreciate during periods of global economic stress due to its reserve currency status.6 This means that each time the U.S. needs a weak dollar to reflate its economy, the dollar moves in the opposite direction, adding deflationary pressures to an already weak domestic economy. Compared to the benefits, which offer the U.S. a steady-stream of seigniorage income and low-cost financing, the cost of reserve currency status is acceptable. Chart II-9U.S. Naval Strength Still Supreme... Economic Power Aside from brute force, an empire is built on commercial and trade links. There are two reasons for this. First, trade allows the empire to acquire raw materials to fuel its economy and technological advancement. Second, it also gives the "periphery" a role to play in the empire, a stake in the world system underpinned by the hegemonic core. This creates an entire layer of society in the periphery - the elites enriched by and entrenched in the Empire - with existential interest in the status quo. For the past five centuries, commercial dominance has been underpinned by naval dominance. As the Ottoman Empire and the Ming Dynasty closed off the overland routes in the fourteenth and fifteenth centuries, Europeans used technological innovation to avoid the off-limits Eurasian landmass and establish alternative - and exclusively naval - routes to commodities and new markets. This has propelled a succession of largely naval empires: Portuguese, Spanish, Dutch, French, British, and finally American. Several land-based powers tried to break through the nautical noose - Ottoman Turks, Sweden, Hapsburg Austria, Germany, and the Soviet Union - but were defeated by the superiority of naval-based power. Dominance of the seas allows the hegemonic core to unite disparate and far-flung regions through commerce and to call upon vast resources in case of a global conflict. Meanwhile, the hegemon can deny that commerce and those resources to land-locked challengers. This is how the British defeated Napoleon and how the U.S. and its allies won World War I and II. The U.S. remains the supreme naval power (Chart II-9). While China is building up its ability to push back against the U.S. navy in its regional seas (East and South China Seas), it will be decades before it is close to being able to project power across the world's oceans. While the former is necessary for becoming a regional hegemon, the latter is necessary for China to offer non-contiguous allies an alternative to American hegemony. Bottom Line: The foundation of a global reserve currency status is geopolitical fundamentals. The U.S. remains well-endowed in both. American Hegemony - From Tailwinds To Headwinds Chart II-10...But Overall Hegemony Is In Decline The U.S. is already facing a relative geopolitical decline due to the rise of major emerging markets like China (Chart II-10). This theme underpins BCA Geopolitical Strategy's view that the world has already transitioned from American hegemony to a multipolar arrangement.7 In absolute terms, the U.S. still retains the hard and soft power variables that have supported the USD's global reserve status and will continue to do so for the next decade (which is the maximum investment horizon of the vast majority of our clients). However, there are three imminent threats to the status quo that may accentuate global multipolarity: Populism: The global hegemon could decide to withdraw from distant entanglements and institutional arrangements. In the U.S., an isolationist narrative has emerged suggesting that America's status as the consumer and mercenary of last resort is unsustainable (Chart II-11). President Obama was elected on the promise of withdrawing from Iraq and Afghanistan; his administration also struck a major deal with Iran to reduce American exposure to the Middle East. Donald Trump won the presidency on an even more isolationist platform and he and several of his advisors have voiced such a view over the past 15 months. The appeal of isolationism could resurface as it is a potent political elixir based on a much deeper rejection of globalization among the American public than the policy establishment realized (Chart II-12). Chart II-11Trump Is Rebelling Against The Post-Cold War System Chart II-12Americans Are Rebelling Against The 'Washington Consensus' Return of the land-based empire: While the U.S. remains the preeminent naval power, its leadership in military prowess could be wasted through a suboptimal grand strategy. The U.S. has two geopolitical imperatives: dominate the world's oceans and ensure the disunity of the Eurasian landmass.8 Eurasia has sufficient natural resources (Russia), population (China), wealth (Europe), and geographical buffer from naval powers (the seas surrounding it) to become self-sufficient. Hence any great power that managed to dominate Eurasia would have no need for a navy as it would become a superpower by default. Why would America's European allies abandon their U.S. security blanket for an alliance with Russia and China? First, stranger shifts in alliance structure have occurred in the past.9 Second, because a mix of U.S. mercantilism and isolationism could push Europe into making independent geopolitical arrangements with its Eurasian peers, even if these arrangements were informal. The advent of the cyber realm: Finally, the advent of the Internet as a new realm of great power competition reduces the relative utility of hard power, such as a navy. Great empires of the past struggled when confronted with new arenas of conflict such as air and submarine. New technologies and new arenas can yield advantages in traditional battlefields. Today, the U.S. must compete for hegemony in space and cyber-space with China, Russia, and other rivals. In these mediums, the U.S. does not have as great of a head start as it has in naval competition. Bottom Line: The U.S. remains the preeminent global power. However, its status as a hegemon is in relative decline. Domestic populism, suboptimal grand strategy, and the advent of cyber and outer-space warfare could all accelerate this decline on the margin. The Economic Fundamentals Of U.S. Dollar Reserve Status One unique aspect of the U.S. dollar as a reserve currency is that it is a fiat currency, i.e. paper money limited in supply only by policy. Throughout human history, most dominant currency reserves were based on commodities that were rare or difficult to acquire, like silver or gold.10 When the U.S. dollar was decoupled from gold prices in 1971, it became the only recent example of a global reserve currency backed by nothing but faith (the pound was for most of its period of dominance backed by gold). Money serves three functions in the economy. It is a means of payment, a unit of account, and a store of value. The last comes into jeopardy when the reserve currency has to supply the world with more and more liquidity, also known as the "Triffin dilemma". By definition, as the global reserve currency, the USD has to be plentiful enough for the global economy and financial system to function adequately. The U.S. government must constantly supply dollars to this end. Chart II-13 illustrates the timeline of global dollar liquidity, which we define as the total U.S. monetary base in circulation (U.S. monetary base plus holdings of U.S. Treasury securities held in custody for foreign officials and international accounts). The world has seen an ever-expanding U.S. dollar monetary base since 1988. Only during periods where the price of money (i.e. the Federal funds rate) has increased, has the money creation process slowed. Now that the expansion of the global USD monetary base is slowing, overall dollar liquidity is as important as the price, if not more (Chart II-14). Chart II-13Global Dollar Liquidity... Chart II-14...Drives Global Asset Prices The constant increase of dollar liquidity has made the greenback the "lubricant" of today's global financial system. There are three major forces at work beneath this condition: Recycling of petrodollars into the global financial system; Globalization and the build-up of - mainly USD-denominated - FX reserves; Deregulation of the Eurodollar system.11 Petrodollars Commodity exporters, mainly oil producers, sell their products in exchange for U.S. dollars. In addition, most Middle Eastern producers recycle their profits into U.S. dollars due to the liquidity and depth of U.S. capital markets. By 1980, the majority of oil producers were trading in U.S. dollars and were similarly investing their surpluses into the U.S. financial system in the form of U.S. government debt securities. The growth in petrodollars has allowed the world's dollar monetary base to grow substantially. This was both enabled by direct issuance of U.S. debt securities funded by petrodollar purchases and also through the Eurodollar system whereby banks outside the U.S. held large deposits of surplus dollar earnings from Middle East oil producers. Globalization The contemporary wave of globalization began in the mid-1980s, when it became evident that the Soviet Union was in midst of a deep economic malaise. This prompted the new Soviet Premier Mikhail Gorbachev to launch perestroika ("restructuring") in 1985, throwing in the proverbial towel in the contest between a statist planned economy and a free market one. Alongside the rise in global trade, financial globalization rose at a very rapid pace as cross-border capital flows more than doubled as a percentage of global GDP from 1990 onward. In the U.S., the economic boom of the 1990s was the longest expansion in history, with growth averaging 4% during the period. The U.S. trade deficit ballooned, providing the world with large amounts of dollar liquidity in the process. The flipside of the massive current account deficit was the accumulation of FX reserves in Europe and Asia, largely denominated in U.S. dollars. These insensitive buyers of U.S. debt indirectly financed the U.S. trade deficit, and also indirectly fuelled the debt super cycle and asset inflation as the "savings glut" compressed the world's risk-free rate and term premium. In other words, financial globalization combined with excess international savings morphed into a global quid pro quo. The world economy needed liquidity to finance growth and capital investment. In a system where the greenback stood at the base of any liquidity build up, this meant that the world needed dollars to finance its development. The world was thus willing to finance the U.S. current account deficit at little cost. The Eurodollar System The Eurodollar system was originally a payment system introduced after World War II as a result of the Marshal Plan. Because global trade was dominated by the U.S. - the only country that retained the capacity to produce industrial goods - foreigners had to be able to access U.S. dollars where they were domiciled in order to buy capital goods. The U.S. current account deficit played a role in growing that Eurodollar market. While a lot of the dollars supplied to the rest of the world through the U.S. current account deficit ended up going back to the U.S. via its large capital account surplus, a significant portion remained in offshore jurisdictions, providing an important fuel for the Eurodollar markets. In fact, more than two-thirds of U.S.-dollar claims in the Eurodollar market can be traced back to U.S. entities. After this original impetus, the Eurodollar market grew by leaps and bounds amid a number of regulatory advantages introduced in the 1980s. These changes in regulations not only deepened the participation of European and Japanese banks in the offshore markets, it also allowed U.S. banks to shift capital to Europe, harvesting a lower cost of capital in the process.12 The next growth phase in the Eurodollar system came with the evolution of shadow banking, in which credit was created off balance sheet by lending out collateral more than once, thus enabling banks to obtain higher gearing. This process is known as "re-hypothecation." In the U.S. there was a limit to which banks were allowed to gear collateral, which was not the case in Europe. Hence, to take advantage of this regulatory leniency, global banks grew further through the offshore market, causing an additional expansion in the Eurodollar market.13 Ultimately, this implies that over the past 30 years, the growth of the Eurodollar system has mainly been a consequence of the architecture of the international financial system. Headwinds To Dollar Liquidity The forces contributing to the extraordinary growth in dollar liquidity have begun to fade. In brief: Protectionism and populism: A slowdown in global trade has occurred for a number of structural, non-geopolitical reasons, especially if one controls for the recovery of energy prices (Chart II-15).14 This slowdown implies a slower accumulation of international FX reserves and a reduction of the "savings glut." If protectionism were to compound the effects - by shrinking the U.S. trade deficit - the result for global dollar liquidity would be negative. The consequence would be a certain degree of "quantitative tightening" of global dollar liquidity. Energy prices: Despite the recovery in energy prices, oil producers continue to struggle to rein in their budget deficits. Deficits blew out during the high-spending era buoyed by high oil prices (Chart II-16). Today, oil producing countries have less oil revenues to spend on the Treasury market, as their cash is needed at home. Meanwhile, the U.S. is slowly moving towards partial energy independence, further shrinking its trade deficit. Chart II-15Global Trade Growth Has Moderated Chart II-16Petrodollars Are Scarce Eurodollar system: The monetary "plumbing" has become clogged since 2014 after the Fed stopped growing its balance sheet and sweeping Basel III bank regulations took effect. The cost of acquiring U.S. dollars in Eurodollar markets currently stands at a premium. This extra cost cannot be arbitraged away due to the restrictive capital rules imposed under Basel III, which have raised the cost of capital for banks. This can be seen in the persistent widening of USD cross-currency basis-swap spreads and more recently, in the rise of the Libor-OIS spread (Chart II-17). The introduction of interest on excess reserves by the Federal Reserve is further draining dollars from the Eurodollar system. The velocity of dollar usage in international markets is unlikely to return to the pace experienced from 1995 to 2008, when the shadow banking system grew rapidly. To complicate matters, dollar-denominated debt issued outside of the U.S. by non-U.S. entities such as banks, governments, and non-financial corporations has grown substantially. This could exacerbate the scramble for dollars in case of a global shortage. For example, the stock of outstanding dollar debt issued by foreign nonfinancial corporations currently stands at US$10 trillion (Chart II-18). Chart II-17Mounting Stress In The Eurodollar System Chart II-18Foreign Dollar Debt Is At $10 Trillion Why is the Eurodollar system so important? Today is the first time in the world's history that this much debt has been accumulated in the global reserve currency outside of the country that issues that currency. The Eurodollar system is thus a key source of liquidity for global borrowers. It is also necessary to ensure that these borrowers can access U.S. dollars when the time comes to repay their USD-denominated obligations. The U.S. trade deficit is effectively the source of the growth of the monetary base in the Eurodollar system, and the stock of dollar-denominated debt issued by non-U.S. entities is the world's broad money supply. With the money multiplier in the offshore USD markets having fallen in response to the regulatory tightening that followed the Great Financial Crisis, broad USD money supply in the Eurodollar system will be hyper sensitive to any decline in the U.S. current account deficit. Less global imbalances would therefore result in a further increase in USD funding costs in the international system, and potentially into a stronger U.S. dollar as well, making this dollar debt very expensive to repay. This raises the likelihood of a massive short-squeeze in favour of the U.S. dollar, challenging the current downward trajectory in the U.S. dollar, at least in the short term. Another consequence of a higher cost of sourcing U.S. dollars in the Eurodollar market tends to be rising FX volatility (Chart II-19). An increase in FX volatility should represent a potent headwinds for carry trades. This, in turn, will hurt liquidity conditions in EM economies. Hence, EM growth may be another casualty of problems in the Eurodollar system. Chart II-19Eurodollar Stress Produces FX Volatility Thus, the risks associated with U.S. protectionism go well beyond the risks to global trade. If severe enough, protectionism can threaten the plumbing system of the global economy. Bottom Line: The global economy has been supplied with dollar-based liquidity through the Eurodollar market. At the base of this edifice stands the U.S. trade-deficit, which was then magnified by the issuance of U.S. dollar-denominated debt by non-U.S. entities. This system is becoming increasingly tenuous as Basel III regulations have increased the cost of capital for global money-center banks, resulting in a downward force on the money multiplier in the offshore dollar funding system. In this environment, the risk to the system created by protectionism rises. If Trump and his administration can indeed scale back the size of the U.S. trade deficit, not only will the growth of the U.S. dollar monetary base be broken, but since the monetary multiplier of the Eurodollar system is also impaired, the capacity of the system to provide the dollars needed to fund all the liabilities it has created will decline. This could result in a serious rise in dollar funding costs as well as a tightening of global liquidity that will hurt global growth and result in a dollar short squeeze. This implied precarious situation raises one obvious question: Could we see the emergence of another reserve asset to complement the dollar, alleviating global liquidity risk? If Something Cannot Go On Forever, It Will Stop A global shortage of dollars is not imminent but could result from the forces described above. Even so, it is unlikely that the U.S. dollar faces any sudden end to its role as the leading global reserve currency. However, the world is unlikely to abide by a system that limits its growth potential either. The demise of the Bretton Woods system is important to keep in mind. The Bretton Woods system tied the supply of global liquidity to the supply of U.S. dollars. Initially this was not a problem as the U.S. ran a trade surplus. But it became a significant issue when the rest of the world began to question the U.S. commitment to honouring the $35/oz price commitment amidst domestic profligacy and money printing. Ultimately, the system broke down for this very reason. The strength of the global economy, along with the size of the U.S. current account deficit, was creating too many offshore dollars. Either the global money supply had to shrink, or gold had to be revalued against the dollar. The unpegging of the dollar from gold effectively resulted in the latter. However, the 1971 Smithsonian Agreement that replaced the gold standard with a dollar standard retained the dollar's hegemony. There was simply no alternative at the time. Today, it is unlikely that the global economy will stand idle in the face of a potentially sharp tightening of global liquidity conditions. We posit that this rising dollar funding costs will be the most important factor to decrease the importance of the dollar in the global financial system. Since the demand for the USD as a reserve currency is linked to its use as a liability by banks and financial systems outside of the U.S., if the USD gets downgraded as a source of financing by global banks, the demand for the greenback in global reserves will decline.15 As the share of dollars in foreign reserve coffers decreases, the dollar will likely depreciate over time as it will stop benefiting from the return-inelastic demand from reserve managers. Profit-motivated private investors will demand higher expected returns on dollar assets in order to finance the U.S. current account deficit. Despite this important negative, the dollar will still be the most important reserve asset in the world for many decades. After all, the decline of the pound as the global reserve asset in the interwar period was a gradual affair. Nonetheless, the share of reserves concentrated in USD assets as well as the share of international liabilities issued in USD will decrease, potentially a lot quicker than is thought possible. Chart II-20Reserve Currency Status ##br##Can Diminish Quickly For example, Eichengreen has shown that the pound sterling's share of non-gold global currency reserves fell from 63% in 1899 to 48% in 1913, just 14 years later (Chart II-20). It is instructive that this pre-World War I era coincides with today's multipolar geopolitical context. It similarly featured the decline of a status quo power (the U.K.) and the emergence of a rising challenger (the German Empire). What are the alternatives to the dollar? Obviously, the euro will have a role in this play. The euro today only represents 20% of global reserve assets, and considering the size of the Euro Area economy as well as the depth of its capital markets, the euro's place in global reserves has room to increase. In fact, the share of euros in global reserves is 15% smaller than that of the combined continental European national currencies in 1990 (see Chart II-4 on page 25). The CNY can also expect to see its share of international reserves increase. While China does not have the same capital-market depth as the Euro Area, it is gaining wider currency. The One Belt One Road project is causing many international projects to be financed in CNY and China's economic and military heft is still growing fairly rapidly. Nevertheless, China's closed capital account continues to weigh against the CNY's position. As Chart II-21 illustrates, there is a relationship between a country's share of international global payments and inward foreign investment. Essentially, investors want to know that they can do something (buy and sell goods and services) with the currency that they use to settle their payments. In particular, they want to know that they can use the currency in the economy that issues it. As long as it keeps its capital account closed, China will fail to transform the CNY into a reserve currency. Chart II-21A Reserve Currency With A Closed Capital Account? Forget About It! This means that for at least the next five years, the renminbi's internationalization will be limited. If U.S. protectionism is severe enough, China's economic transition is less likely to be orderly and capital account liberalization could be delayed further. In terms of investment implications, this suggests that for the coming decade, the euro is likely to benefit from a structural tailwind as global reserve managers increase their share of euro reserves. The key metric that investors should follow to gauge whether or not the euro is becoming a more important source of global liquidity is not just the share of euros in global reserves, but also the amount of foreign-currency debt issued in euros by non-euro area entities in the international markets. In all likelihood, before the world transitions toward a unit of account other than the USD, tensions will grow severe, as they did in the late 1960s. It is hard to know when these tensions will become evident. This past winter, the USD basis-swap spread began to widen along with the Libor-OIS spread, but while the Libor-OIS spread remains wide, basis-swap spreads have normalized. Nonetheless, by the end of this cycle, we would expect a liquidity event to cause stress in global carry trades and EM assets. It is important that investors keep a close eye on basis-swap and Libor-OIS spreads to gauge this risk (Chart II-22). Chart II-22Are We Nearing A Global Liquidity Event? Additionally, the more protectionist the U.S. becomes, the larger the diversification away from the dollar by both global reserve managers and international bond issuers could become. This is because of two reasons: First, if the U.S. actually manages to pare down its trade deficit, this will accentuate the decline in the supply of base money in the international system. Second, rising trade protectionism out of the White House gives the world the impression that economic mismanagement is taking hold of the U.S., raising the spectre of stagflation. Finally, the next global reserve asset does not have to be a currency. After all, for millennia, that role was fulfilled by commodities such as gold, silver, or copper. Thus, another asset may emerge to fill this gap. At this point in time it is not clear which asset this may be. Bottom Line: A severe liquidity-tightening caused by a scarcity of U.S. dollars would create market tumult around the world. We worry that such a risk is growing. However, it is hard to envision the global economy falling to its knees. Instead, the global system will likely do what it has done many times before: evolve. This evolution will most likely result in new tools being used to increase the global monetary base. At the current juncture, our best bet is that it will be the euro, which will hurt the USD's exchange rate at the margin on a secular basis. This brings up the very important question of whether the euro is politically viable. We have turned to this question many times over the past seven years. Our high conviction view is still that the euro will survive over the foreseeable time horizon.16 Marko Papic, Senior Vice President Chief Geopolitical Strategist Mathieu Savary, Vice President Foreign Exchange Strategy Mehul Daya Consulting Editor Neels Heyneke Consulting Editor 1 And an erstwhile member of BCA's Research Advisory Board. 2 Please see Eichengreen, Barry et al, "Mars or Mercury? The Geopolitics of International Currency Choice," dated December 2017, available at nber.org. 3 Please see Tovar, Camillo and Tania Mohd Nor, 2018 "Reserve Currency Blocks: A Changing International Monetary System?," IMF Working Paper WP/18/20, Washington D.C. 4 The authors are essentially examining the extent to which national currencies are anchored to a particular reserve currency. 5 Please see David Shapiro, The Hidden Hand Of American Hegemony: Petrodollar Recycling And International Markets, New York: Columbia University Press. Also, Andrea Wong, "The Untold Story Behind Saudi Arabia's 41-Year Secret Debt," The Independent, dated June 1, 2016, available at independent.co.uk. 6 Please see The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, and Geopolitical Strategy Strategic Outlook, "We Are All Geopolitical Strategists Now," dated December 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "The Trump Doctrine," February 1, 2017, available at gps.bcaresearch.com. 9 Entente cordiale being particularly shocking at the time it was formalized in 1904. Other examples of ideologically heterodox alliances include the USSR's alliance first with Nazi Germany and then with Democratic America during World War II; the notorious alliance of Catholic France with Muslim Turks against its Christian neighbors throughout the seventeenth and eighteenth centuries; or Greek alliances with the Carthaginians against Rome in the third century BC. 10 Another exception to this rule was the Yuan Dynasty, established by Mongol ruler Kublai Khan, which issued fiat money made from mulberry bark. In fact, the mulberry trees in the courtyard at the Bank of England serve as a reminder of the origins of fiat money. 11 Eurodollar system simply refers to U.S. dollars that are outside the U.S. 12 Firstly, the absence of Regulation Q in offshore markets meant that regulatory arbitrage was possible, i.e. there was no ceiling imposed on interest rates on deposits at non-U.S. banks. Then, in the late 1990s, the Eurodollar system had another jump start with the amendment to Regulation D, which meant that non-U.S. banks were exempted from reserve requirements. 13 European banks specifically, but also U.S. banks with European branches, were aggressive buyers/funders of exotic derivatives products, such as CDO, MBS, SIVS. Most of these activities were off-balance sheet and took place in the Eurodollar system because a number of regulatory arbitrages existed. This is one of the main reasons that the Federal Reserve's bailout programs were largely focused towards foreign banks. The Fed's swap lines were heavily used by foreign central banks in order to clean up the operations of their own financial institutions. 14 Please see BCA Global Investment Strategy Special Report, "Why Has Global Trade Slowed?," dated January 29, 2016, available at gis.bcaresearch.com 15 Shah, Nihar, "Foreign Dollar Reserves and Financial Stability," December 2015, Harvard University. 16 Please see BCA Geopolitical Strategy Special Report, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011; "No Apocalypse Now?," dated October 31, 2011; "The Draghi 'Bait And Switch," dated January 9, 2013; "Europe: The Euro And (Geo)politics," dated February 11, 2015; "Greece After The Euro: A Land Of Milk And Honey?," dated January 20, 2016; "After BREXIT, N-EXIT?," dated July 13, 2016; "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017. III. Indicators And Reference Charts A key divergence has emerged between the U.S. corporate earnings data and our equity-related indicators. The divergence supports our tactical cautiousness on risk assets. Forward earnings have soared on the back of the U.S. tax cuts and upgrades to the growth outlook. Earnings are beating expectations by a wide margin so far in the Q1 earnings season, which is reflected in very elevated levels for the net revisions ratio and net earnings surprises. However, the S&P 500 has failed to gain any altitude on the back of the positive earnings news, in part because bond yields have jumped. Our Monetary Indicator moved further into bearish territory, and our Equity Technical indicator is below its 9-month moving average and is threatening to break below the zero line (which would be another negative signal). Valuation has improved marginally, but is still stretched, according to our Composite Valuation Indicator. Our Speculation Indicator does not suggest that market frothiness has waned at all, although sentiment has fallen back to neutral level. It is also worrying that our U.S. Willingness-to-Pay indicator took a sharp turn for the worse in April. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. U.S. flows have clearly turned negative for equities, although flows into European and Japanese markets are holding up for now. Finally, our Revealed Preference Indicator (RPI) for stocks flashed a 'sell' signal in April. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. As for bonds, oversold conditions have emerged but valuation has not yet reached one standard deviation, the threshold for undervaluation. This suggests that there is more upside potential for Treasury yields. The U.S. dollar broke out of its recent tight trading range to the upside in April, although this has only resulted in an unwinding of oversold conditions according to our Composite Technical Indicator. The dollar is expensive on a PPP basis, but we still expect the dollar to rally near term. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst