Consumer
Highlights Duration: As long as inflation shows signs of stabilizing during the next couple of months the Fed will lift rates again in December. Stay at below-benchmark duration and remain overweight TIPS versus nominal Treasuries. Credit Cycle: The process of corporate sector re-leveraging is well underway, but the corporate bond trade still has further to run. In fact, the second quarter decline in net leverage likely prolongs the length of time that overweight corporate bond positions will be profitable. Economy & Inflation: While households are no longer paying down debt, the pace of re-leveraging has so far been slow. With delinquency rates already starting to rise for certain classes of consumer credit, we see household debt growth as remaining tepid at best. Feature Janet Yellen struck a somewhat hawkish tone in her press conference following last week's FOMC meeting, as did the post-meeting statement and Summary of Economic Projections (SEP). Predictably, the bond market sold off and is now priced for 39 bps of rate hikes between now and the end of 2018 (Chart 1). While this is still well below the 100 bps predicted in the SEP, it proved sufficient to send the 2-year Treasury yield to a new cycle high (Chart 1, bottom panel). The Fed also announced the unwind of its balance sheet, as had been widely anticipated, and Yellen took great pains to stress that the pace of balance sheet reduction will not be altered unless the economy encounters a shock severe enough to send the fed funds rate back to zero. As was discussed in last week's report,1 this is a calculated move by the Fed meant to sever the link between the balance sheet and expectations about the future path of rate hikes. The SEP showed that most FOMC participants still expect to lift rates once more this year, and that only four out of 16 believe the Fed should stand pat, the same number as in June. However, expectations for one more hike this year are most likely contingent on inflation showing some further signs of strength. To see this, we note that the real fed funds rate is very close to at least one popular estimate of its equilibrium level (Chart 2). With inflation still below the Fed's target it is imperative that an accommodative monetary policy stance is maintained. Practically, this means keeping the real fed funds rate below equilibrium so that economic slack can be absorbed and inflation can rise. If inflation stays flat and the Fed hikes in December, then the real fed funds rate will move above the Laubach-Williams estimate of equilibrium. Chart 1Fed Pushes Yields Higher Chart 2Funds Rate Must Stay Below Neutral We calculate that if the Fed delivers a 25 basis point hike in December, then year-over-year core PCE inflation must rise from its current 1.41% to 1.63% for the real fed funds rate to stay below its neutral level (Chart 2, bottom panel). This squares with the Fed's central tendency forecast that calls for core PCE inflation between 1.5% and 1.6% by the end of the year. In our view, as long as inflation shows further signs of stabilizing and moves toward the Fed's central tendency range during the next couple of months, then the Fed will likely lift rates again in December. However, if inflation resumes its recent downtrend, then the Fed will take a pass. Inflation Expectations: Yellen vs. Brainard Perhaps the most interesting detail to emerge from last week's FOMC meeting is that the committee is so far rejecting Governor Lael Brainard's claim that inflation expectations have become unanchored to the downside. As we discussed in a recent report,2 inflation expectations are critical to the Fed's way of thinking about inflation. In the Fed's view, monetary policy can be used effectively in response to shifts in the cyclical drivers of inflation. However, if inflation expectations were to become unanchored, it would suggest that inflation's long run trend had been altered. This would make monetary policy much less effective, and a timely return of inflation to target much less likely. Governor Brainard views the recent weakness in inflation as suggesting that inflation expectations have in fact become unmoored. As evidence she points to the low levels of: TIPS breakeven inflation rates (Chart 3, top panel) Chart 3Inflation Expectations Household inflation expectations from the University of Michigan survey (Chart 3, panel 2) 5-year, 5-year forward CPI forecasts derived from the Survey of Professional Forecasters (SPF) (Chart 3, panel 3) In contrast, at her post-meeting press conference Chair Yellen pointed to median 10-year forecasts from the SPF as evidence that inflation expectations remain well-anchored (Chart 3, bottom panel). Although, she also admitted that she is unable to explain why inflation has fallen this year: I can't say I can easily point to a sufficient set of factors that explain this year why inflation has been this low. I've mentioned a few idiosyncratic things, but frankly, the low inflation is more broad-based than just idiosyncratic things. What matters for bond investors is that TIPS breakeven inflation rates, a measure of the compensation for inflation protection embedded in nominal bond yields, are well below levels that are usually seen when core inflation is well anchored around the Fed's target. At present, the 10-year TIPS breakeven inflation rate is 1.84%. We expect it will return to a range between 2.4% and 2.5% by the time that year-over-year core PCE inflation reaches 2%. In Yellen's view, inflationary pressures are strong enough for this process to play out with the Fed still being able to gradually lift rates, once more this year and then three more times in 2018. But the longer that inflation fails to rebound as Yellen expects, the more likely it becomes that the committee will come around to Brainard's view and scale back the pace of hikes. A slower expected pace of rate hikes will lend support to inflation and TIPS breakevens, and in either scenario we would expect TIPS breakevens to reach the 2.4% to 2.5% range by the end of the cycle. The uncertainty surrounds what level of real rates will be required to achieve that outcome. In that regard we are more inclined toward Yellen's view. Inflation will soon follow growth indicators higher,3 and the Fed will be able to deliver a pace of rate hikes similar to what it currently projects. But with so few rate hikes priced into the curve, we think the investment implications are the same in either scenario. Investors should stay at below-benchmark duration and remain overweight TIPS versus nominal Treasuries. Bonds In The Long-Run? The Fed's median projection for the level of longer-run interest rates also declined last week, from 3% to 2.75%. It is now only 8 bps above the 5-year, 5-year forward Treasury yield (Chart 4). Chart 4Fed Slowly Embracing A Low Neutral Rate In general, we think the 5-year, 5-year Treasury yield should be equal to the nominal interest rate expected to prevail in the longer-run plus a small risk premium. In that respect, the yield still looks a tad low compared to the Fed's forecast, although the gap has narrowed considerably. While we would not want to hinge our investment strategy on the accuracy of the Fed's longer-run interest rate forecast, it is notable that the Fed continues to price-in a future where the equilibrium interest rate remains depressed. Please see the Economy & Inflation section (below) for a discussion of the longer-run outlook for the fed funds rate. Corporate Credit Cycle Prolonged Second quarter Financial Accounts (formerly Flow of Funds) data were released last week, allowing us to update some of our credit cycle indicators. Chart 5 shows that, historically, three conditions must be met before the credit cycle turns and we experience a period of sustained corporate bond underperformance. Our Corporate Health Monitor (CHM) must be in "deteriorating health" territory, signaling that the corporate sector is aggressively taking on debt (Chart 5, panel 2). Monetary policy must be restrictive. This can be signaled by the real federal funds rate crossing above its equilibrium level (Chart 5, panel 3), or an inversion of the yield curve (Chart 5, panel 4). Banks must be tightening standards on commercial & industrial loans (Chart 5, bottom panel). So far this cycle only the first criterion has been met and while the CHM remains firmly in "deteriorating health" territory, it actually took a sizeable turn toward zero in Q2. The marginal improvement in corporate health was broad based across all six of our monitor's components (Chart 6). Even return on capital, which had been in free fall, managed to move higher (Chart 6, panel 3). Chart 5Credit Cycle Indicators Chart 6Corporate Health Monitor Components Box 1Corporate Health Monitor Components The slower pace of deterioration in corporate health can mostly be chalked up to surging profit growth. EBITD4 growth outpaced debt growth in Q2, sending our measure of net leverage lower (Chart 7). Year-over-year EBITD growth is now within striking distance of corporate debt growth for the first time since 2015 (Chart 7, bottom panel). Chart 7Can Leverage Reverse Its Uptrend? It is rare for corporate spreads to tighten while leverage is rising. So in that regard the tick lower in leverage probably extends the period of time we can remain overweight corporate bonds in a U.S. fixed income portfolio. Chart 8Profit Outlook Still Positive Since 1973, we calculate that investment grade corporate bonds have outperformed duration-equivalent Treasuries in 62% of six month periods, for an average annualized excess return of 45 bps. In prior research5 we showed that, during the same timeframe, when leverage rose for two consecutive quarters corporate bonds outperformed in only 45% of the following six month periods, for an average annualized excess return of -190 bps. This quarter's decline in leverage breaks a streak of two consecutive increases. But what about going forward? Further declines in leverage will depend on whether profit growth can sustain its recent strength. While some moderation is likely, our leading profit indicators suggest that growth will remain firm for the remainder of the year (Chart 8). Total business sales less inventories have hooked a tad lower, but are still consistent with solid profit growth (Chart 8, panel 1). Industrial production growth also rolled over last month, but that reflects temporary weakness related to Hurricane Harvey. Continued elevated readings from the ISM manufacturing index suggest that underlying demand is strong (Chart 8, panel 2). Meanwhile, dollar weakness continues to provide a tailwind for profit growth (Chart 8, panel 3), and our profit margin proxy has also ticked higher (Chart 8, bottom panel). Our profit margin proxy has risen due to weakness in unit labor costs. While tightening labor markets should cause the corporate wage bill to increase, a late-cycle rebound in productivity growth will ensure that unit labor cost growth stays muted compared to other wage growth measures. We made the case for a late-cycle rebound in productivity growth driven by stronger non-residential investment in a recent report.6 That being said, mounting wage pressures will likely cause margins to narrow next year, although a sharp margin-driven hit to profit growth is not likely in the next few quarters. Bottom Line: The process of corporate sector re-leveraging is well underway, but the corporate bond trade still has further to run. In fact, the second quarter decline in net leverage likely prolongs the length of time that overweight corporate bond positions will be profitable. Economy & Inflation: Household Re-leveraging Still A Slog As was noted above, both model-driven estimates and FOMC forecasts posit that the real equilibrium fed funds rate is very low by historical standards. One school of thought, secular stagnation, views the low equilibrium rate as a permanent state of affairs. While another, the "headwinds" thesis, claims that the fall-out from the financial crisis is keeping the equilibrium rate low for now, but that it will rise as the vestiges of the crisis start to fade. In this second theory, the major headwind keeping the equilibrium rate temporarily low would be the slow pace of household re-leveraging. Chart 9 shows the correlation between the Laubach-Williams estimate of the real equilibrium fed funds rate and growth in household debt. Household debt has only recently started to increase, and even today it is growing at a historically slow pace. So far this has not translated into strong enough growth to push the equilibrium interest rate higher, perhaps because the modest debt growth is occurring off quite a low base. Overall household debt is no longer falling relative to disposable income, but it has also not yet started to rise (Chart 9, panel 2). Whether you fall into the secular stagnation or headwinds camp, we would argue that the pace of household re-leveraging will remain tepid, keeping a lid on the equilibrium interest rate for quite some time. Household debt is dominated by housing, where still-tight lending standards and a lack of savings on the part of potential first-time homebuyers remain semi-permanent features of the economic landscape that will take a long time to disappear. Outside of housing, consumers have been adding debt fairly aggressively, especially in the non-revolving (auto loan and student loan) spaces (Chart 9, bottom panel). The problem is that in those areas where consumers have been adding debt (credit cards, auto loans and student loans), we are also seeing delinquency rates start to rise (Chart 10). Chart 9Household Debt & The Neutral Rate Chart 10Consumer Credit Delinquency Rates Delinquency rates are elevated compared to pre-crisis levels for both auto loans and student loans. For credit cards, where the re-leveraging is not as far advanced, delinquency rates remain low but have started to increase. It is only in the mortgage market, where re-leveraging has not occurred, that delinquencies remain low. The fact that delinquency rates have already started to increase for auto loans, student loans and credit cards suggests that there is limited scope to add further debt in those areas. Bottom Line: While households are no longer paying down debt, the pace of re-leveraging has so far been slow. With delinquency rates already starting to rise for certain classes of consumer credit, we see household debt growth as remaining tepid at best. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Great Unwind", dated September 19, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Open Mouth Operations", dated September 12, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Open Mouth Operations", dated September 12, 2017, available at usbs.bcaresearch.com 4 Earnings before interest, taxes and depreciation. 5 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Open Mouth Operations", dated September 12, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights The Fed will shrink its balance and is determined to raise rates. Implications of synchronized global growth and global NAIRU. Consumers are upbeat and ready to spend. What's the signal from record high consumer expectations for equities? Feature Risk assets and Treasury yields rose up to and after last week's Fed meeting, but late-week saber-rattling by North Korea left most asset classes little changed on the week. The U.S. economic data released last week continued to be impacted by Hurricanes Harvey and Irma, but the Fed notes that the storms are "unlikely to materially alter the course of the national economy beyond the next few months". The backdrop has turned more bearish for bonds even before the Fed's recommitment last week to raising rates gradually and shrinking its balance sheet. The Fed's hawkish stance short term and dovish stance long term will allow risk assets to outperform Treasury bonds and cash, but a sudden move higher in inflation would challenge that view. FOMC: Short Term Hawkish... The Fed sent a hawkish short-term signal on the outlook for monetary policy at its meeting last week. The vast majority of FOMC members, 12 out of 16, expect to raise rates again by December (Chart 1). A 0.2% downward revision to the Fed's 2017 core PCE inflation forecast was offset by an equal 0.2% upward revision to its GDP growth forecast. Moreover, Fed Chair Janet Yellen downplayed this year's soft inflation figures and stressed that inflation expectations remain "reasonably well anchored". Although the relationship may have weakened somewhat recently, the Fed is loath to throw the Phillips curve model into the dust bin just yet. The unemployment rate forecasts were lowered from 4.2% to 4.1% for 2018 and 2019, while the Fed kept its NAIRU estimate at 4.6%. The tightening labor market is expected to place upward pressure on wage inflation and push PCE inflation to the 2% target by 2019. Chart 1Market Expects A Hike In December Incoming data on actual inflation and inflation expectations will determine whether the Fed will be able to pull the trigger in December. Further softness in the core PCE inflation and CPI will raise doubts as to whether the inflation undershoot is indeed transitory. And especially worrisome will be a decline in inflation expectations. It is noteworthy that 10-year inflation breakevens fell nearly 4bps immediately following yesterday's FOMC announcement. At 1.85%, 10-year breakevens are already running below the 2.4-2.5% range that is consistent with the Fed's 2% target for PCE inflation. Any further decline in breakevens will call into question the Fed's view that inflation expectations remain well anchored. Further, with the decline in inflation expectations, the 2/10-year yield curve flattened following the Fed's announcement. This is could be considered a sign of a slight lowering in growth expectations. Finally, there was little surprise on the Fed's balance sheet announcement. For now, the Fed is committed to slowly unwinding its bond holdings. Janet Yellen said that the Fed will only resume full reinvestment of maturing bonds after it had cut the policy rate back to the zero bound. In other words, the Fed funds rate is now the primary tool to set monetary policy. The odds of another Fed rate hike by year-end have certainly increased (Chart 1). This need not upset risk assets if the incoming data justify higher rates. Only a policy error, where the Fed hikes rates even as inflation expectations decline and the yield curve flattens, will trigger a sizeable pullback in risk assets. This is not our baseline scenario. Softness in inflation and inflation expectations will force the Fed to back down. ...But Long Term Dovish Although the Fed signaled a greater probability of an interest rate hike in the near-term, it lowered the long-run outlook for policy rates. First, the median FOMC member now expects only two rate increases in 2019, down from three in the June forecast (not shown). Second, the estimate for the terminal rate was lowered to 2.75% from 3.0% (Chart 2, panel 4). With the long-run inflation target being 2% (Chart 2, panel 3), this means that the FOMC collectively believes the long-term neutral real Fed funds rate to be just 0.75%. Currently, the Laubach-Williams estimate of the neutral real Fed funds rate is near zero (Chart 3). Therefore, the FOMC sees it rising only modestly from current levels over the coming years. Chart 2The FOMC's "Long Run" Forecasts Since 2012 Chart 3Neutral Real Rate Near Zero For any given term premium, a lower short-term interest rate path will mean a lower 10-year yield. If estimates for the terminal policy rate outside the U.S. remain unchanged, the Fed's lower projection will mean narrower interest rate differentials, reducing the relative attractiveness of the dollar. As for equities, a lower estimate for the long-run policy rate would be a wash if it also reflected a lower estimate for long-term GDP growth. However, the Fed kept its longer run real GDP growth estimate unchanged at 1.8% (Chart 2, panel 1). If that proves accurate, lower interest rates and a weaker dollar will be more supportive for U.S. equities over the long-term. Notably, the Fed did not adjust its view of NAIRU, keeping it at 4.6%, where it has been since April (Chart 2, panel 2). Bottom Line: In terms of investment implications, the lower estimate of the long-run neutral rate is supportive for 10-year Treasuries, negative for the dollar and positive for equities. Stay overweight stocks versus bonds and short duration. Don't Downplay NAIRU Synchronous global growth remains in place in 2017 and will persist into 2018, but this growth alone may not be enough to push up inflation. BCA's OECD Real GDP Diffusion Index is at 100% after it dipped to 14% during the financial crisis. The index was also above 90% from 1994 through 1998, and then again from 2001 through 2007. Moreover, the OECD expects that GDP growth will climb above zero in all the member countries in BCA's diffusion index again in 2018. The broad-based global GDP growth has historically been associated with a rising stock-to-bond ratio, rising global trade flows, a narrowing output gap and accelerating industrial production (Chart 4). However, there is no consistent pattern on the dollar, the unemployment rate, or core inflation. Chart 5 shows that during prior periods of robust global growth, equities beat bonds, the U.S. output gap tightened and industrial production increased. U.S. exports tend to contribute more to GDP growth during these phases, but not in a uniform way. Meantime, the Fed has both raised and lowered rates during these periods. Chart 4Widespread##BR##Global Growth... Chart 5... Supports Risk Assets,##BR##Trade And A Narrower Output Gap Nonetheless, while the dollar jumped in the 1990s when BCA's OECD growth index was above 90%, it fell from 2001 to 2007, and it's performance since 2015 has been mixed. The unemployment rate declined in the mid-to-late 1990s, but initially rose in the 2001-2007 period and has dropped since 2010. The Fed both raised and lowered rates during the previous episodes, but has only boosted rates in the current phase. Core inflation slowed in the 1990s when 90% of countries saw positive GDP growth, but accelerated in the early 2000s. Since 2015, core inflation has both climbed and decelerated. What will trigger higher inflation if more than 90% of the globe is experiencing positive economic growth? BCA's Global Fixed Income Strategy service notes that1 67% of OECD nations have unemployment rates under the organization's assessment of "global NAIRU", a level not seen since before the Great Recession when inflation expanded in both the goods and service sectors (Chart 6). However, the link between inflation and NAIRU waned during and just after the 2007-2009 recession and only reconnected lately. The implication for investors is that there is a global NAIRU level (or global output gap), which is more important in determining worldwide inflation rates than individual country NAIRU measures. Chart 6The NAIRU Concept Is Not Dead Yet Bottom Line: Surging global growth is a precondition for higher inflation, but sustained improvement in the labor market is needed to drive up inflation and prompt more action from the Fed. Investors may be downplaying the NAIRU concept at a time when it is finally set to bite. If that is the case, inflation expectations around the world are too low, although it will take some evidence of faster realized inflation (especially in the U.S. and Europe) before the markets begin to discount that view in bond yields. Stay underweight duration. Flow Of Funds Update On Consumer And Corporate Health The latest readings on the health of household and corporate balance sheets from the Fed's flow of funds accounts reinforce BCA's stance that consumer spending will provide strong support for the U.S. economy through 2017 and 2018. Household net worth continues to rise and is well above average at this point in a long expansion (Chart 7). The total wealth effect for consumer spending is still lagging prior cycles, but remains supportive. Debt-to-income ratios are at multi-decade lows. The ongoing repair of consumer balance sheets has led to an all-time high in FICO scores (Chart 7, panel 4). Last week's U.S. flow of funds report also allows us to update BCA's Corporate Health Monitor (CHM) (Chart 8). The level of the CHM improved slightly between Q1 and Q2, but the overall level still suggests corporate balance sheets are deteriorating. The progress in Q2 was broadbased, as all the components improved, notably the net leverage component. Profit growth surged while debt moved up modestly in Q2, modestly reducing leverage. The Monitor has been a reliable indicator of the trend in corporate bond spreads. The upswing in the CHM in Q2 - and particularly the dip in leverage - supports our corporate bond overweight. On the consumer front, while the recent weakness in vehicle sales and overall retail sales are noteworthy, they do not signal the end of the business cycle. We found2 that a peak in vehicle sales leads the end of the economic cycle by two years. Moreover, Hurricane Harvey weighed on August's retail sales report and Irma will have the same impact on September's sales.3 Instead, the backdrop for consumer spending remains strong. For example, the most recent Fed Senior Loan Officer's Survey suggests that the banking sector is willing to lend to households and that consumers are open to borrowing, although household demand for loans has weakened in recent quarters (Chart 9). Chart 7Support For The Consumer##BR##Remains In Place Chart 8Improved A Bit In Q2##BR##But Still Deteriorating Chart 9Senior Loan Officers##BR##Survey Still Supportive In addition, consumer spending intentions remain in an uptrend and the decade-high readings on "plans to buy" a house and a car are telling (Chart 10, panels 1 and 2). Overall measures of consumer confidence remain at 16-year peaks (Chart 10, panel 3). Furthermore, the sturdy labor market, modest wage growth and low inflation are all factors that support a solid pace of real income growth, which reinforces the spending backdrop (Chart 10, panel 4). Student loan debt increased again in Q2 and investors are concerned by the risks posed by the upswing. The Bank Credit Analyst covered the topic in a comprehensive report in November 2016.4 The key message was that student debt is a modest drag on economic growth, but is not a threat to U.S. government finances and does not represent the next subprime crisis. Nearly a year later, BCA's conclusions remain unchanged. A recent report5 by the Federal Reserve Bank of New York provides data on student loans through Q2 2017. The report noted that while student debt levels were little changed between Q1 and Q2 2017, they are up $85B from a year ago and at record highs (Chart 11). Although student loan delinquencies ticked higher in Q2, and remain elevated by historical standards, they have moved sideways in recent years. We will continue to monitor all types of consumer indebtedness as we assess hazards in the U.S. economy. Student loans are only a mild economic headwind and do not represent a source of systemic financial risk. Chart 10Consumers Upbeat And Ready To Spend Chart 11Student Loan Debt Is Elevated Bottom Line: The consumer - a key driver of the U.S. economy and corporate earnings - will provide a solid backdrop for the economy through 2017 and beyond. This climate will allow the Fed to boost rates one more time this year and begin paring its balance sheet starting next month. The solid underpinnings for the consumer will sustain corporate earnings growth and, ultimately, higher stock prices. However, favorable consumer attitudes toward U.S. equity prices are a mild concern. Signals From Stock Sentiment Surveys Record U.S. consumer optimism - as measured by the University of Michigan (UM) - on forward stock returns does not necessarily signal a market top. On the other hand, it supports BCA's view that investors be prudent with risk allocations. Respondents to the UM Survey of Consumers assign a 65% probability that the U.S. stock market will move higher in the next 12 months, surpassing the previous zenith in mid-2004. Interestingly, before the 2014 high (60%), the top reading was in mid-2007 (62%), only three months prior to the October 2007 equity market peak. A cursory look at Chart 12, panel 1 shows that peaks on this metric line up with those in equities. We view it another way. Investors should not assume that stocks are peaking based on the UM data. The bottom panel of Chart 12 shows that at just 5.6%, the annual change in the percentage of respondents who expect stocks to move higher in the next 12 months is not at an extreme. The 12-month change was as high as 18% in early 2004 and again in March 2010. Stock returns in the 12 months after these peaks in sentiment were lower than in the 12 months prior. However, we are not yet in the danger zone based on this indicator. Furthermore, BCA's Investor Sentiment Composite Index (not shown) is not at an extreme, although it is at the top end of its bull market range. We expect the stock-to-bond ratio to move higher in the next 6-to-12 months, despite the elevated readings on households' expected return on stocks. Our position is driven more by our bearish stance on Treasury bond prices than on an overly bullish call on equity returns. Chart 13 illustrates this point across three time horizons given our view of fair value on the 10-year Treasury yield (2.67%).6 Our analysis assumes a 2% annualized dividend yield on the S&P 500. Panel 1 shows the ratio between now and year end will remain positive if U.S. equities dip by 5%. Looking ahead 6 and 12 months (Panels 2 and 3), the S&P 500 will have to drop by between 5% and 10% to signal a localized peak in the stock-to-bond ratio. Chart 12Consumers' Expectations For Equity Returns Are Elevated Chart 13Scenarios For Stock-To-Bond Ratio Bottom Line: Despite heightened consumer sentiment toward equities, we expect the stock-to-bond ratio to move higher in the next 6 to 12 months. Nonetheless, investors should be prudent with risk assets, paring back any maximum overweight positions and holding some safe-haven assets within diversified portfolios. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No.", September 12, 2017. Available at gfis.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report, "Disconnected," September 11, 2017. Available at usis.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Shelter From The Storm, "September 5, 2017. Available at usis.bcaresearch.com. 4 Please see The Bank Credit Analyst Special Report, "Student Loan Blues: Can't Replay What I Borrowed", November 2016. Available at bca.bcaresearch.com. 5 https://www.newyorkfed.org/medialibrary/interactives/householdcredit/data/pdf/HHDC_2017Q2.pdf 6 Please see BCA's U.S. Bond Strategy Portfolio Allocation Summary, "The Cyclical Sweet Spot Rolls On," September 5, 2017. Available at usbs.bcaresearch.com.
Highlights The ECB can talk down the euro, but not by much. The central bank has previously expressed comfort with EUR/USD at 1.15. The cyclical and structural direction of EUR/USD is higher... ...because the euro area versus U.S. long bond yield spread should ultimately compress to -40 bps from today's -130 bps. Remain neutral in Germany's DAX and underweight Sweden's OMX. Equity markets with a strong base currency and a large exposure to exporters will come under pressure. Overweight German consumer services equities versus German exporters and the DAX. Underweight U.K. consumer services equities versus the FTSE100. Feature When mariners know that a sea-change is coming, their concern is not whether it comes today, tomorrow or the day after tomorrow. The big issue is the sea-change itself - because it brings major implications for navigating the seas. In the same way, when currency markets know that a sea-change in monetary policy is coming, their concern is not whether the policy announcement comes on September 7, October 26 or December 141 - or indeed whether the sea-change will happen suddenly or gradually. At a sea-change, currency markets look much further ahead. Just as for mariners, the big issue is the sea-change itself. EUR/USD is now moving in lockstep with the expected differential between euro area and U.S. policy interest rates not next year, nor the year after next, but rather the differential five years out (Chart I-2). Chart I-1AA Strong Euro Is Good For ##br##German Consumer Services... Chart I-1B...A Weak Pound Is Bad For##br## U.K. Consumer Services Chart I-2EUR/USD Is Moving In Line With The Interest ##br##Rate Differential Expected In 2022 The ECB Can Talk Down The Euro, But Not By Much Chart I-3EUR/USD Might Find Support At 1.15 Therefore, if the ECB really wants to unwind the euro's sharp appreciation this year, the central bank must tell the market that the expectation for a sea-change is completely wrong. In other words, the ECB must indicate that it has no intention to dial back its emergency monetary accommodation. Such a volte-face is unlikely, for two reasons. First, the ECB likes to adjust market expectations incrementally rather than violently. The last policy meeting made the case "for proceeding gradually and prudently when approaching adjustments in the monetary policy stance and communication." Second, not to dial-back its emergency monetary accommodation flies in the face of a euro area economic expansion that is solid, broad, and among the strongest and best-established among major developed economies. "Postponing an adjustment for too long could give rise to a misalignment between the Governing Council's communication and its assessment of the state of the economy, which could (eventually) trigger more pronounced volatility in financial markets." Nevertheless, at the margin, dovish words from Draghi could pare back the euro. How much? Consider that at the last policy meeting EUR/USD stood at 1.15 and the ECB justified this level on the basis of the improved "relative fundamentals in the euro area vis-à-vis the rest of the world." (Chart I-3) Given that these relative fundamentals are still intact, 1.15 might provide a level of support in a technical retracement. Of course, EUR/USD also depends on the Federal Reserve and expectations for its policy rate five years out. EUR/USD would sink if the market became much more hawkish about where it sees the U.S. 'terminal' interest rate. However, for the terminal rate expectation to rise suddenly and sharply in the U.S. relative to the euro area would also fly in the face of the economic data on both sides of the Atlantic. Recently, there has been little difference in either economic growth or inflation rates. The 'Neutral' Real Interest Rates In The Euro Area And U.S. Are The Same More fundamentally, there is little difference in the so-called 'neutral' (or mid-cycle) real interest rates in the euro area and the U.S. Through the 19 years of the euro's life, the euro area versus U.S. long bond yield spread has averaged -40 bps2 (Chart I-4). Over this same period, the euro area versus U.S. annual inflation differential has also averaged -40 bps (Chart I-5). Ergo, the real interest rate differential has averaged zero. Meaning, the neutral real interest rates in the euro area and the U.S. have been exactly the same. Chart I-4Euro-U.S.: Average Interest ##br##Differential = -40bps Chart I-5Euro Area-U.S.: ##br##Inflation Differential = -40bps Bear in mind that the 19 year life of the euro captures multiple manias and crises, some centred in Europe, some in the U.S. Hence, 1999-2017 is a good representation of what the future holds, at least in relative terms if not in absolute terms. With little difference in the neutral real rates over the past two decades, is there any reason to expect a big difference in the future? Our starting assumption has to be no. Chart I-6If Composition Differences Were Removed, ##br##Euro Area And U.S. Inflation Would Be Near-Identical In fact, even the -40 bps annual inflation shortfall in the euro area is due to a compositional difference in the consumer price baskets. The euro area does not include owner occupied housing costs, whereas the U.S. does at a hefty weighting.3 If this compositional difference were removed, inflation would also be near-identical (Chart I-6). Still, each central bank must target inflation as it is defined in its respective jurisdiction, so let's assume the annual inflation differential continues to average -40 bps. In this case, the long bond yield spread should also ultimately compress to -40 bps from today's -130 bps. The biggest risk to this view is if the existential threat to the euro resurfaced. Looking at the political calendar, the German Federal Election on September 24 poses no such threat. Meanwhile, ahead of the Italian general election to be held no later than May 20 2018, even the non-establishment Five Star Movement and Northern League are toning down their anti-euro rhetoric. As my colleague Marko Papic, our Chief Geopolitical Strategist, puts it: "euro area politics are a red herring." On this basis, our central expectation is that the euro area versus U.S. yield spread has the scope to compress much further from its current -130 bps. This means that after a possible near-term retracement, we expect the cyclical and the structural rally in the euro to resume. German Consumers Are Winners, U.K. Consumers Are Losers When European currencies strengthen, the big winners are European consumers because they become richer in terms of the goods and services they can buy in international markets. This is significant because Europe imports its food and energy in large (and inelastic) volumes. Hence, their price decline in local currency terms significantly boosts the real spending power of consumers. And vice-versa (Chart I-7). As if to prove the point, German consumer services equities have rallied strongly this year (Chart I-8). And their outperformance has closely tracked euro strength (Chart of the Week, left panel). Across the English Channel, it is the mirror-image story. The pound has slumped. And the big losers are U.K. consumers, whose real spending power is evaporating as food and energy prices - in pound terms - rise. Again, to prove the point, U.K. consumer services equities have struggled to make any headway this year (Chart I-9). And their underperformance has closely tracked the trade-weighted pound's weakness (Chart of the Week, right panel). Chart I-7German Consumption Accelerating,##br## U.K. Consumption Decelerating Chart I-8German Consumer Services ##br##Have Rallied Chart I-9U.K. Consumer Services ##br##Have Struggled If the euro has more cyclical and structural upside - as we anticipate - then these equity performance trends have further to run. Chart I-10The Exporter Heavy DAX And##br## OMX Have Struggled Remain overweight German consumer services equities versus German exporters and the DAX. And remain underweight U.K. consumer services equities versus the FTSE100. At the same time, equity markets with a strong base currency and a large exposure to exporters will come under pressure. Mostly, this is because the translation of multi-currency international earnings into a strengthening base currency hurts index profits. For the time being, this influences our allocation to Germany's DAX - in which we have been neutral relative to the Eurostoxx600 - and Sweden's OMX - in which we have been underweight (Chart I-10). Next week, we will update our overall European country allocation. Given the large sector skews in European equity indexes, this country allocation is heavily dependent on the stance towards Healthcare and Banks. Hence, we await any incremental communication from the ECB. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 These are the dates of the ECB's three remaining monetary policy meetings in 2017. 2 Calculated from the over 10-year government bond yield: euro area average, weighted by sovereign issue size, less U.S. 3 The imputed cost of owner occupied housing (owners' equivalent rent of residences) comprises 25% of the U.S. consumer price basket but 0% of the euro area consumer price basket. Fractal Trading Model Basic materials equities are technically overbought. Initiate a short position relative to the broad market with a profit target / stop loss at 2.5%. In other trades, long Mediaset Espana / short IBEX35 hit its stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations
Highlights The GOP's failure to repeal Obamacare could rev up the Republicans' motivation to move forward on tax cuts. Fed policymakers are taking financial stability seriously. Constructive conditions for consumer spending. Margin expansion continues in early Q2 earnings results. Feature Tax Cuts Still On The Table The Republicans' failure to pass their health care legislation is leading the markets to doubt the prospect for tax cuts. This may be premature but, contrary to conventional wisdom, it may actually increase the chances of tax cuts. Ironically, the inability to jettison Obamacare may turn out to be a blessing for President Trump and the Republican Party. According to the Congressional Budget Office, by 2026, 22 million fewer Americans would have health care if the legislation had been enacted compared with the status quo. The Senate bill also would have led to substantial cuts to Medicaid and deep reductions to insurance subsidies for poor and middle-class families, many of whom voted for Trump. The failure to repeal Obamacare could actually increase the motivation of Republicans to move forward on tax cuts anyway. The chances for broad tax reform have certainly diminished, since that will be just as difficult to get passed as healthcare reform. The GOP also wanted to use the roughly $200 billion in savings from healthcare reform to fund reduced tax rates. However, tax cuts are something that all Republicans can easily agree too, and they will need to show a legislative victory ahead of next year's mid-term elections. The difficulty will be how to pay for these cuts. We expect them to be "fully funded" in the sense that there will be offsetting spending cuts, but these will be back-loaded toward the end of the 10-year budget window, whereas the tax cuts will be front-loaded. This would generate a modest amount of fiscal stimulus over the next few years. Implications For The Fed Expansionary fiscal policy next year would generate difficulties for the FOMC. The June CPI report underscored that inflation is not a problem for now. Nonetheless, we highlighted in last week's report that pipeline inflationary pressures are gradually building. The unemployment rate is already below the Fed's estimate of the full employment level. Chart 1Inside The Fed's Forecasts... Moreover, unemployment will continue to fall unless productivity picks up soon. We backed out the productivity growth rate implied by the Fed's latest Summary of Economic Projections, given its assumption that real GDP growth will be roughly 2% over the next couple of years and that the unemployment rate will stabilize near the current level. This combination implies that productivity growth will accelerate from the average rate observed so far in this expansion (0.7%) to about 1%, which is consistent with monthly payrolls of 135,000. If we instead assume that productivity does not accelerate (and real GDP growth is 2%), then payrolls must jump to 160,000 and the unemployment rate would fall below 4% next year (Chart 1). The implication is that, unless real GDP growth slows, the unemployment rate is soon likely to reach lows not seen since 2000. The FOMC hawks would become even more worried that the Fed is taking too large a risk with inflation and financial stability (see below). Fiscal stimulus in 2018 would place the FOMC even further behind the curve. Policymakers would be forced to tighten aggressively to bump up the unemployment rate. The Fed would hope for a soft landing, but the more likely result is a recession in 2019. That said, it is too early for investors to position for a recession.1 Bonds rallied and the dollar weakened anew following the collapse of the Senate's healthcare bill on the view that hopes for fiscal stimulus are all but dead. We still believe that bond yields and the dollar have more upside potential, even in the absence of fresh fiscal stimulus. Last week's report2 highlighted that a global monetary policy recalibration is under way because central bankers have decided that "emergency" levels of monetary accommodation are no longer required. Moreover, the maximum level of policy divergence has not yet been reached between the Fed and other major central banks, which means that the dollar will have one last leg higher. The U.S. stock market has weathered the fiscal disappointment, seemingly moving out of sync with dollar and bond market action in the past several months. The equity market appears to have been given a "free pass" because earnings have been very supportive. The combination of robust earnings growth, steady real GDP growth near 2%, and low bond yields, all have been bullish for stocks. It will be tougher sledding when profit growth peaks. Fortunately, the earnings backdrop is still constructive at the moment (see below). A Third Mandate? Financial stability has become a third mandate for the Fed, and is one of the reasons the hawks want to keep tightening despite the fact that the FOMC has not yet met the inflation target. The topic has been mentioned by either Fed staff or FOMC members in 27 of the 39 meetings since September 2012. Fed Chair Yellen has elevated financial stability during her tenure, leading discussions or staff briefings in 19 of the 27 meetings she has presided over. The topic merited only passing mention in Fed deliberations prior to 2012. At the June meeting, Fed staff characterized the "financial vulnerabilities of the U.S. financial system" as moderate on balance.3 This assessment has not changed since the Fed began to offer opinions on the health of the financial system at its September 2013 meeting. However, the Fed does not provide a financial stability grade at every meeting. In December 2013, Fed staff described financial conditions as moderate, but its next judgment (also moderate) was only in January 2016. Since then, Fed staff has provided an assessment of financial stability in half of the 12 subsequent meetings. Another indication that Fed policymakers are paying particular attention to financial market risk is that the issue has become a key part of the Monetary Policy Report (MPR).4 Before the onset of the GFC, financial stability warranted only a few paragraphs in the MPR, but since 2013 the report has included a special section on the topic. Chart 2FOMC Closely Monitoring Financial Stability The four primary areas that the Fed monitors to assess financial stability are: Vulnerabilities stemming from maturity and liquidity transformation in the financial sector (Chart 2, panel 1); Valuation pressures across a range of assets, including Treasury securities, equities, corporate bonds and commercial real estate (panel 2); Leverage in the household and business sectors (panel 5); and Regulatory burden (not shown). Some FOMC members are worried that if rates are not normalized soon, then valuation will become even more stretched in bond and equity markets, which could potentially lead to financial stability issues. This is a reason why a few of the central bankers want to hike rates even though inflation is still too low. This group believes it is better to tighten slowly, rather than wait and raises rates sharply in the future when financial valuations may be even more stretched. Nonetheless, others at the Fed are concerned that higher rates may trigger an equity correction, which if significant enough, would spark a slowdown in the U.S. economy via the wealth channel. In this case, greater financial instability would push the Fed to pause its rate hike regime prematurely. We intend to return to this scenario in a future Weekly Report. The monetary authority is also concerned by negative term premiums in the bond market. We expect only minimal impact on Treasury bond yields linked to the reduction in the Fed's balance sheet.5 That said, a big sell-off in bond prices that leads to a sudden correction in equity prices or a widening of credit spreads would tighten financial conditions, impact the real economy and prompt the Fed to rethink its path for the fed funds rate and its balance sheet. Bottom Line: The conditions that foster financial stability matter to the central bank almost as much as maintaining low and stable inflation, and full employment. The doves want to see inflation rise closer to the 2% target before tightening even more. The hawks worry that the relationship could be non-linear, which means that a further undershoot of unemployment below estimates of full employment could suddenly generate a surge in inflation. At a minimum, an undershoot could boost risks to financial stability by promoting excess risk-taking in the financial markets. Conditions Still Favor The Consumer June's reading on retail sales released in mid-July was disappointing, but the conditions that cultivated increased consumer spending are still in place. Core retail sales dipped by 0.1% month-over-month in June, and both the 3-month and 12-month rates of change have been on a downward trajectory since the start of the year (Chart 3, panel 1). Moreover, auto sales have stagnated near all-time highs in recent months, adding to the market's consumer concerns (panel 2). The only positive is that consumer spending looks better in real terms because inflation has moderated (panel 3). Nominal retail sales have softened, but inflation-adjusted spending is what feeds into the construction of GDP. Even so, conditions are in place for a rebound in spending in the coming months. Consumer confidence readings are still near cycle peaks; home values are elevated and rising; household net worth is at an all-time high and expanding rapidly, financial conditions are easy, and accelerating income growth is supported by the tightening labor market. When these economic circumstances prevailed in the past, consumer spending almost always sped up (Chart 4). Chart 3Soft Patch In Retail Sales##BR##And Inflation Continues Chart 4Conditions Conducive For##BR##Consumer Spending Bottom Line: The soft patch in consumer spending is lingering longer than expected, which challenges our view that U.S. economic growth will be stronger in the second half of the year relative to the first half average. Nevertheless, we anticipate that GDP growth will permit economic output to hit the Fed's low target for the year and keep the monetary authority on track to tighten policy at a faster pace than is discounted in the bond market. The resulting bond sell-off will not derail the equity bull run as long as profits remain supportive. Q2 Earnings Update: Margin Expansion Continues Chart 5Positive Earnings Surprises Continue The Q2 earnings reporting season is off to a strong start, with both EPS and sales running well ahead of consensus expectations as forecasted in our July 3 preview. Moreover, the counter trend rally in profit margins is still in place. Just under 20% of companies have reported results so far with 74% of companies beating consensus EPS projections, right at the long-term average of 70% (Chart 5). In addition, 74% have posted Q2 revenues that exceeded expectations. The surprise factor for Q2 stands at 5% for EPS and 1% for sales. We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, the initial results imply that Q2 will see another quarter of margin expansion. Average earnings growth (Q2 2017 versus Q2 2016) is strong at 9% with revenue growth at 5%. The BCA Earnings model predicts EPS growth to hit roughly 18% later this year on a 4-quarter moving total basis, before moderating in 2018 (Chart 6). Measured on this basis, S&P 500 EPS growth so far in Q2 is 18%, compared with 12% in Q1. The strength in earnings and revenue is broad based (Table 1). Earnings per share are up in Q2 2017 versus Q2 2016 in 10 of 11 sectors; the lone exception is the utilities sector. EPS results are particularly strong in energy, technology and financials. Energy revenues surged by 15% in Q2 versus a year ago. Sales gains in technology (7%), materials (6%), utilities (5%), and real estate (5%), are notable. The upward trajectory of EPS estimates for 2017 and 2018 (Chart 7) since the start of 2017 is encouraging. We will provide an update on the Q2 earnings season in the August 7 Weekly Report. Chart 6Strong EPS##BR##Growth Ahead Table 1S&P 500:##BR##Q2 2017 Results* Chart 7Estimates For '17 & '18 Have Moved##BR##Higher Since Start Of The Year Bottom Line: EPS growth will continue to accelerate through the end of 2017 and into early 2018, aided by a period of margin expansion and decent top-line growth. The elevated level of ISM sets the stage for EPS growth to gather speed in the second half of 2017. Firm readings on ISM are an indication that our bullish profit story for 2017 is still intact. Stay overweight stocks versus bonds. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA's U.S. Investment Strategy Weekly Report "Waiting For The Turn", dated June 26, 2017. Available at usis.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report "Global Monetary Policy Recalibration", dated July 17, 2017. Available at usis.bcaresearch.com. 3 https://www.federalreserve.gov/monetarypolicy/fomcminutes20170614.htm 4 https://www.federalreserve.gov/monetarypolicy/files/20170707_mprfullreport.pdf 5 Please see BCA's U.S. Bond Strategy Weekly Report "Two Challenges For U.S. Policymakers", dated May 23, 2017. Available at usbs.bcaresearch.com.
Highlights Rising equity prices, low and falling bond yields and stable credit spreads are all consistent with today's low growth and inflation backdrop, where the Fed can take its time raising rates. The FOMC is looking through the inflation shortfall for now and is sticking with its rate hike plan. Lower oil prices are the key driver of plunging market-based inflation expectations. We expect the Fed to begin to trim its balance sheet later this year, and be a modest negative for Treasury prices. The latest readings on the health of household balance sheet from the Fed's flow of funds accounts reinforce our view that the consumer sector will provide solid support for the U.S. economy through 2017; the student loan debt situation is not a source of financial systemic risk. Feature We first outlined our view that U.S. assets were in a policy sweet spot back in September 2016, noting that the monetary policy sweet spot won't end for risk assets until interest rates climb above the equilibrium rate. Nine months later, policy remains in the sweet spot, thanks to a beneficial combination of moderate economic growth, healthy corporate profit growth, stable margins and low inflation. Last week's CPI report was disconcerting, but did reinforce the notion that the Fed can take its time. Thus, when investors ask: "How can equity prices and bond prices both be moving higher?" Our answer is: "Because we are still in the sweet spot." Low And Slow Wins The Day Investors are wondering how the equity market can hold up given that the bond market and the dollar appear to be signaling sluggish economic growth. We look at it another way. Rising equity prices, low and falling bond yields and stable credit spreads are all consistent with today's low growth and inflation backdrop, where the Fed can take its time raising rates. The FOMC reaffirmed its intended path for rates at last week's meeting (see below). If the Fed's modest forecasts for growth and inflation are met, the central bank will raise rates gradually and begin to shrink its balance sheet. The implication for investors is that the recent outperformance of stocks over bonds accompanied by positive correlations between the two can persist for some time. Lessons from the 1950s and 1990s are helpful in illustrating this point. During the 1950s (Chart 1A, the Fed was gradually raising rates, but inflation and long rates remained low. Even as rates edged higher, stocks outperformed bonds, despite a booming economy that was near full employment. In the 1990s, long bond yields fell even as equity prices surged. Inflation was well contained for most of that decade (Chart 1B). Chart 1ABond Yields, Stocks, Inflation And The Fed In The 1950s... Chart 1B...And In The 1990s At what point will bond market become a problem for stocks? Charts 2 and 3 show that low inflation and low rates are both critical to keeping stock and bond yields positively correlated. The 4.25% level on the 10-year Treasury is a critical level to watch based on the historical relationship between Treasury yields and stock-bond correlations. However, the reason for rising bond yields is as important as the level of yields. An increase in long-dated Treasury yields associated with a pickup in real growth is less of a threat to equities than a rise in yields due to an uptick in inflation, because the latter invites a more aggressive Fed tightening cycle. Chart 3 shows that core inflation around or below 2% supports a positive correlation between stock and bond yields. As inflation begins to move from 2 to 3%, the relationship fluctuates, and above 3% there are very few periods of positive correlation. All signs point to a depressed inflation environment over the next year, which is one of the keys to keeping bond yields and stock prices positively correlated. We expect core CPI to move back up to 2% in the medium term, and the Fed agrees. The central bank's latest forecast puts inflation at just 2% for the next two years and in the long run. Bottom Line: Stocks can handle rising bond yields as long as higher yields are driven by better growth and not inflation. With inflation low and bonds yields at 2.15%, we are a long way from where bond yields become a problem for the stock market. FOMC: Sticking With The Roadmap For Now It was a wild ride in the Treasury market last week as bonds first rallied hard on the heels of some data releases, before selling off after the FOMC failed to deliver a fully "dovish hike". May retail sales were decent below the surface. The "control group" measure that feeds into the GDP figures was flat in May, but was revised up to a 0.6% gain in April (Chart 4). The result was a solid 4.3% annualized gain over the past three months. This suggests that, although not booming, consumer spending growth is solid in the second quarter. U.S. household balance sheets are in solid shape, as we highlight below. The FOMC was probably not swayed by this report. The CPI report was another story (Chart 5). The energy component pulled down the headline rate as expected, but the softening of inflation is widespread in the index. The annualized 3-month rate of change in the core rate fell virtually to zero in May. Disinflation can be seen in areas that have little to do with the output gap, such as shelter and medical care. But it is also showing up in other services, a segment of the CPI that is most highly correlated with wage growth and labor market pressure. The sudden broad-based change in direction is difficult to explain and, at a minimum, presents a challenge to the view that the U.S. economy is approaching its non-inflationary limits. Chart 4Consumer Spending##BR##Remains Solid Chart 5Disinflation In Core Services##BR##Is A Challenge To Fed's View Bonds rallied heading into the FOMC meeting on the view that the Fed would deliver a rate hike as promised, but would revise down the "dot plot" or, at a minimum, would play up concerns about the inflation undershoot. In the event, the Fed did neither. Chart 6Labor Market Continues To Tighten The statement acknowledged the disappointing inflation readings, but also revealed a determination to normalize interest rates in the face of a tight labor market. In the press conference, Chair Yellen downplayed the inflation shortfall, pointing to some one-off factors. She stressed that the FOMC makes policy for the "medium term," and should not over-react to short-term wiggles in the data. Given the tight labor market, the Fed Chair argued that the conditions are in place for inflation to move higher. Indeed, the median FOMC forecast for headline and core inflation was revised down for this year only; the outlook for 2018 and 2019 was left unchanged at 2%. Growth was revised up a little for 2017. We agree with the FOMC that the labor market is tight enough to gradually push up inflation. The underlying trend in wage growth has accelerated from 1.2% in 2010 to 2.4% today according to our wage tracker, in line with the narrowing of the unemployment gap over the period (Chart 6). The FOMC trimmed its estimate of the full-employment level of unemployment by 0.1 percentage points to 4.6%, but it revised down its forecast for the actual unemployment rate by a larger 0.3 percentage points over the next two years. This means that the projected amount of excess labor demand is now greater than in the March projection. By itself, this should make the FOMC more predisposed to tightening, especially since financial conditions have been easing. That said, the May CPI report was admittedly disconcerting due to the broad-based nature of the disinflationary pulse. This is contrary to Chair Yellen's assertion that the inflation disappointment reflects one-off factors. The May CPI report could be a head-fake, related to normal randomness in the data. But it is not clear why there would be a sudden and widespread moderation of inflation. Inflation Expectations Plunge A large portion of the decline in long-term Treasury yields since March reflected a decline in inflation expectations. The 10-year CPI swap rate has dropped by 35 basis points over the period. BCA's fixed-income strategists point out that the decline in long-term inflation expectations has been widespread across the major countries, irrespective of whether or not actual inflation is trending up or down.1 Given all these diverging signals within the national inflation data, it is odd that there has been such a uniform decline in inflation expectations across the major bond markets. That leads us to look to the oil price decline as the main driver. Weaker energy prices have been part of a broader move lower in commodity prices that is likely related to less reflationary monetary and fiscal policies out of the world's biggest commodity consumer, China. However, our commodity strategists have noted that export and import volumes in the emerging economies accelerated sharply in the first quarter of 2017. Given that there is a strong correlation between trade volumes and oil demand in the emerging markets, this bodes well for a rebound in global oil demand. Combined with the "OPEC 2.0" production cuts, the demand-supply balance in world oil markets is likely to turn positive in the months ahead, which will allow oil prices to return to a range close to $60/bbl by year-end. A move in oil prices back to that level would help arrest the downturn in overall commodity price indices, and stabilize goods CPI inflation in the developed economies in the latter half of 2017. This should also boost global inflation expectations and bond yields, especially since inflation expectations have fallen too far relative to underlying non-energy inflation pressures. This forecast also applies to the U.S. bond market, although one cannot blame the deceleration in inflation entirely on energy in this case. We expect inflation to move higher in line with the tight labor market, but we may have to change our view if service sector inflation continues to move lower in the next few of months. Balance Sheet News Chart 7Main Risk To Bond Yields Is To The Upside The Fed also provided some details on plans to shrink the balance sheet in terms of the size of the monthly "run off". If the economy evolves as the Fed expects, the balance sheet will start to shrink later this year. Reducing the Fed's balance sheet will be negative for Treasury prices as we argued in the May 22, 2017 Weekly Report, but the impact of this adjustment on its own will be modest. As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions get too tight, too quickly (i.e. the term premium would rise, but would be partly offset by a lower expected path for the fed funds rate). Thus, the path of short-term rates is dependent on the dollar and the reaction of the long end of the curve. The bottom line is that the FOMC is looking-through the inflation shortfall for now and is sticking with its rate hike plan. The evolution of inflation in the coming months will obviously be key. Nonetheless, given that only one more rate hike is expected over the next year, inflation expectations are back to U.S. pre-election levels, and that the 10-year U.S. term premium is well below zero again, it appears that the main risk for bond yields is to the upside (Chart 7). The equity market should benefit in the short-term to the extent that market expectations for a flatter rate hike cycle are driven by lower inflation expectations, rather than a slower growth outlook. If we are correct that inflation expectations will bounce later this year, the associated bond sell-off may present a small headwind for stocks. Nonetheless, we do not believe this will derail the rally in risk assets until inflation has reached the Fed's 2% target, and bond yields and the dollar are significantly higher. The Consumer Comeback Continues The latest readings on the health of household balance sheet from the Fed's flow of funds accounts reinforce our view that the consumer sector will provide solid support for the U.S. economy through 2017 and beyond. Household net worth continues to rise and is well above average at this point in a long expansion (Chart 8). While the total wealth effect for consumer spending is lagging behind prior cycles, it remains supportive. Debt to income ratios are at multi-decade lows. The result of the ongoing balance sheet repair is that FICO scores have hit an all time high (Chart 8, panel 4). The most recent Fed Senior Loan Officer's Survey also suggests that the banking sector is willing to lend to households and that consumers themselves are open to borrowing, although household demand for loans has weakened in recent quarters (Chart 9). Chart 8Support For Consumer Remains In Place Chart 9Senior Loan Officers Survey Still Supportive Consumer spending intentions also remain in an uptrend, and while consumers do not always do what they say, the 10-year high readings on "plans to buy" a house and a car are telling. (Chart 10, panels 1 and 2). Overall measures of consumer confidence also remain at 16 year highs (Chart 10, panel 3). Chart 10Consumers Are In A Good Mood The sturdy labor market, modest wage growth, and low inflation are all factors that support a solid pace of real income growth, adding another support to the spending backdrop (Chart 10, panel 4). Rising rates do not pose a threat to spending for two main reasons, at least in the early stages of the Fed tightening cycle. First, we expect Fed rate hikes to be gradual this year and next, putting only modest upward pressure on longer-dated Treasury yields that anchor consumer loan rates for mortgages, autos, and personal loans. Our colleagues in The Bank Credit Analyst concluded that household interest payment burdens will rise only modestly, and from a low level, in the next couple of years even if borrowing rates increase immediately by 100bps for today's levels. According to their analysis, it would require a much more significant shock, i.e. 300bps or greater, to move interest payments as a share of GDP back toward historical averages.2 We continue to receive many questions from clients on the risks posed by the rise in student debt levels. The Bank Credit Analyst publication covered the topic in a comprehensive report back in November 2016.3 The key takeaway from that report for investors was that student debt is a modest drag for economic growth, but is not a source of risk for U.S. government finances and does not represent the next subprime crisis. More than half a year later, our conclusions remain the same, though the concern among investors has not abated. A recent report4 by the Federal Reserve Bank of New York provides some data on student loans through Q1 2017. More specifically, the report noted that student debt levels continued to rise in Q4 2016 and Q1 2017, and that student loan delinquencies remain high by historical standards but moved sideways in recent years. We will continue to monitor the student loan and all other forms of consumer indebtedness as we assess the risks in the U.S. economy. However, the elevated level of student loan delinquencies does not change our overall assessment of the impact of student loans on the economy and the financial system. Student loans are only a mild economic headwind, and do not represent a source of financial systemic risk. Bottom Line: The consumer - a key driver of the U.S. economy and corporate earnings - will provide a solid backdrop for the economy through 2017 and beyond. This climate will allow the Fed to raise rates one more time this year and begin to pare its balance sheet. The solid underpinnings for the consumer will sustain corporate earnings growth and, ultimately, higher stock prices. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report "Alternative Facts In The Bond Market," dated June 13, 2017, available at gfis.bcaresearch.com. 2 Please see The Bank Credit Analyst Special Report "Global Debt Titanic Collides With Fed Iceberg?," dated February 2017, available at bca.bcaresearch.com. 3 Please see The Bank Credit Analyst Special Report "Student Loan Blues: Can't Replay What I Borrowed," dated October 2016, available at bca.bcaresearch.com. 4 Please see "Quarterly Report On Household Debt And Credit", dated May 2017, available at https://www.newyorkfed.org/medialibrary/interactives/householdcredit/data/pdf/HHDC_2017Q1.pdf
Highlights Monetary Policy: The Fed will deliver two rate hikes between now and the end of the year and will also begin the process of winding down its balance sheet. The market is only priced for 36 bps of rate hikes this year. Maintain below-benchmark duration. Economy: Weakness in Q1 GDP was concentrated in consumer spending and inventories. Both of these components are likely to strengthen in the months ahead. Inflation: The Fed is content to rely on Phillips Curve inflation forecasts, and does not need to see actual inflation rise in order to lift rates. However, if inflation does not rebound as expected, the Fed will become increasingly concerned about falling inflation expectations and could adopt a more dovish reaction function later this summer. We think inflation will be strong enough to avoid this outcome. Financial Conditions: The Fed strongly believes that financial conditions lead economic growth. Absent any major changes in the economic data, the pace of rate hikes will be determined by the Fed's targeting of financial conditions. Feature The market-implied probability of a June rate hike jumped sharply during the past two weeks (Chart 1), and stood at 81% as of last Friday's close. In all likelihood the fourth rate hike of the cycle, and the third in the past six months, will occur at the next FOMC meeting on June 14. In our view, the Fed will deliver two 25 basis point rate hikes between now and the end of the year and will also begin the process of winding down its balance sheet (see Box). With the market only priced for 36 bps of rate hikes during that timeframe, we continue to advocate a below-benchmark duration stance. Chart 1Still On For June The minutes from the May FOMC meeting, released last week, suggest that most Fed policymakers still maintain a forecast for two more hikes this year. The minutes also provide some useful insight about how FOMC participants think about the economy and what developments could cause their forecasts to change. This week we take a look at what the Fed believes, and consider whether those beliefs are well founded. Box Balance Sheet Strategy Revealed We wrote about the potential impact of the Fed’s balance sheet policy in last week’s report (please see U.S. Bond Strategy Weekly Report, “Two Challenges For U.S. Policymakers”, dated May 23, 2017, available at usbs.bcaresearch.com), but provide a brief update this week because of new information gained from the May FOMC minutes. Previously, it was unknown whether the Fed would cease the reinvestment of its securities holdings all at once, or whether it would “taper” the reinvestment by gradually increasing the amount of securities it allowed to run off. We now know that “nearly all policymakers expressed a favorable view” of a tapering strategy where the Fed will set a series of gradually increasing caps on the total amount of securities it allows to run off its balance sheet. The plan calls for the caps to be raised every three months, according to a schedule that will be set in advance. The only reason for this plan to not function smoothly would be if market participants start to view the reinvestment caps as an additional policy tool that the Fed will vary according to economic conditions. This would risk taking the focus off the fed funds rate as the main policy tool, and would make it difficult for the market to interpret the overall stance of monetary policy. The minutes show that the Fed plans to avoid this messy outcome by setting a fixed schedule for changing the reinvestment caps. If the market believes that the Fed will stick to this schedule, then the plan should work fine. The May minutes also showed that “nearly all policymakers” thought that it would be appropriate to begin the reinvestment process this year, as long as economic conditions do not deteriorate. While we still lack some important details, such as the Fed’s target for the ultimate level of reserves in the banking system, we now think it is very likely that these details will emerge at either the June or September FOMC meeting and that balance sheet run off will begin following either the September or December meeting. What The Fed Believes: Weak Q1 Growth Is Transitory Although the incoming data showed that aggregate spending in the first quarter had been weaker than participants had expected, they viewed the slowing as likely to be transitory.1 Even after last week's slight upward revision, at 1.2%, first quarter GDP growth came in well below its post-crisis average (Chart 2). However, a quick look at the major components of GDP reveals that the weakness was concentrated in consumer spending and the change in private inventories (Chart 2, bottom two panels). Growth contributions from residential and non-residential investment were actually considerably above their post-crisis averages, and the contributions from net exports and government spending were in-line with theirs (Chart 3). Chart 2The Consumer Was A Drag In Q1 Chart 3Investment Is A Bright Spot We know from history that large changes in inventories tend to mean-revert fairly quickly. In fact, we can model the inventory component of GDP growth based on the lagged change in inventories and the Backlog of Orders component of the ISM Manufacturing survey (Chart 4). Both of these factors suggest that inventories will bounce back strongly next quarter. In fact, the ISM survey shows the largest backlog of manufacturing orders since 2014. Likewise, weakness in consumer spending is unlikely to persist. The fundamental drivers of consumer spending all continue to paint a positive picture (Chart 5). Chart 4Big Backlog Of Orders Chart 5Consumer Spending Drivers: Part I Consumer confidence has hardly given back any of its post-election gains (Chart 5, panel 1). Personal income growth is already on the upswing, and income expectations point to further acceleration (Chart 5, panel 2). Employment is still growing at a reasonably robust pace, and the mild slowdown since early 2015 has been offset by stronger wage growth (Chart 5, bottom panel). Longer-run drivers of consumer spending are also solid. Households continue to accumulate wealth, and household leverage has returned to late 1990s levels. In other words, household balance sheets are the healthiest they have been since prior to the housing bubble (Chart 6). More broadly, indicators of overall GDP growth are also pointing toward an acceleration (Chart 7). The ISM Non-Manufacturing index increased to 57.5 in April from 55.2 in March, and the BCA Beige Book Monitor - an indicator based on the occurrence of certain keywords in the Fed's Beige Book2 - has gone vertical. It would be unusual for GDP growth to diverge from these two indicators for a prolonged period of time. Chart 6Consumer Spending Drivers: Part II Chart 7Overall Growth Indicators Bottom Line: Weakness in Q1 GDP was concentrated in consumer spending and inventories. Both of these components are likely to strengthen in the months ahead. The Fed is probably correct that weak Q1 growth will prove transitory. Recent Weak Inflation Readings Are Also Transitory Overall, most participants viewed the recent softer inflation data as primarily reflecting transitory factors, but a few expressed concern that progress toward the Committee's objective may have slowed.3 We dealt with the inflation outlook in last week's report,4 through the lens of our Phillips Curve inflation model. To recap, using our model we found it very difficult to craft a realistic set of economic assumptions that resulted in year-over-year core PCE inflation below 1.88% by the end of the year. In our base case economic scenario the model projects that core inflation will reach 2.11%. Because our model is based on one that Janet Yellen referred to in a 2015 speech,5 we assumed that the Fed would reach a similar conclusion with regards to the inflation outlook. Although it must be said that the May FOMC meeting occurred prior to the disappointing April CPI release, it is notable that the minutes from the May meeting say that only "one member view[ed] further progress of inflation toward the 2 percent objective as necessary before taking another step to remove policy accommodation." In other words, almost all Fed members are content to rely on Phillips Curve style inflation models, which suggest that inflation will rise in the near future, and are putting less weight on the current low level of actual inflation. Of course, that dynamic could change relatively quickly. Chart 8 shows the track record of our Phillips Curve model, and we can see that it is not unusual for large residuals - on the order of 0.5% - to persist for significant periods of time. This means that even if all of our forecasts of the independent variables in the model turn out to be correct, there is still a chance that actual inflation will not keep pace with the model. In light of current circumstances, one period in particular stands out. The period from late-1993 to mid-1994, denoted by the shaded region in Chart 8. Chart 8The Fed Still Believes In The Phillips Curve In that episode the fair value from our model suggested that inflation should trend higher. Instead, inflation fell quite sharply. Eventually the model's fair value also moved lower, driven by a declining contribution from the model's lagged inflation term,6 and also by falling inflation expectations. In our view, this latter point is particularly important. In 1993-94, the failure of inflation to keep pace with Phillips Curve forecasts eventually caused market participants to lose faith and revise their inflation expectations lower. In a worst case scenario, a large decline in inflation expectations can feed on itself, leading to a deflationary spiral from which the Fed would have difficulty escaping. Chart 9Inflation Expectations Are ##br##Tough To Measure The Fed is very worried about falling (or more specifically "un-anchored") inflation expectations. In her aforementioned 2015 speech,7 Chair Yellen cautioned that temporary fluctuations in import prices or resource utilization could lead to permanent changes in inflation if they also caused inflation expectations to shift. Also, the longer the Fed misses its inflation target, the more likely it is that inflation expectations will become un-tethered. This is a very real risk. For now, the FOMC continues to view inflation expectations as well anchored, although the May minutes showed that "some participants" expressed concern that "the public's longer-term inflation expectations may have fallen somewhat." One problem is that there is no perfect way to measure inflation expectations (Chart 9). Market-based measures of inflation compensation are well below levels that have been consistent with the Fed's 2% inflation target in the past (Chart 9, panel 1), but these measures are volatile and are often driven by market-specific factors unrelated to inflation expectations. Meantime, the inflation expectations of professional forecasters have been quite stable (Chart 9, panel 2), while the message from consumer inflation expectations is mixed (Chart 9, bottom panel). The University of Michigan consumer survey shows inflation expectations near an all-time low, but the New York Fed's survey shows them in an uptrend. In any event, the strong correlation between consumer inflation expectations and gasoline prices makes them questionable at best. Bottom Line: The Fed is content to rely on Phillips Curve inflation forecasts, and does not need to see actual inflation rise in order to lift rates. However, if inflation does not rebound as expected, the Fed will become increasingly concerned about falling inflation expectations and could adopt a more dovish reaction function later this summer. We think inflation will be strong enough to avoid this outcome and that the Fed is still on track for two more rate hikes this year. Financial Conditions Are Crucial [Some participants] noted variously that the decline in longer-term interest rates and the modest depreciation of the dollar over the intermeeting period would provide some stimulus to aggregate demand, that the Committee's recent policy actions had not resulted in a tightening of financial conditions, or that some of the decline in longer-term yields reflected investors' perceptions of diminished odds of significant fiscal stimulus and an increase in some geopolitical and foreign political risks.8 The above passage shows that the Fed believes that financial conditions lead growth, a result we have also shown in prior reports (Chart 10).9 In this context, the Fed would expect financial conditions to tighten as it lifts rates, eventually causing economic growth to moderate. If financial conditions fail to tighten it would suggest that monetary policy needs to become more restrictive, and vice-versa. Financial conditions tightened dramatically following the December 2015 rate hike (Chart 11) and the ensuing growth slowdown caused the Fed to postpone the next rate hike for 12 months. Then, financial conditions were relatively unchanged following the December 2016 rate hike, and this allowed the Fed to deliver another hike in March. The large easing in financial conditions since the March hike is telling the Fed that it needs to step up its pace. Chart 10The Fed Believes That Financial Conditions Lead Growth Chart 11A Big Easing Since March Ultimately, the Fed still needs inflation to increase. This means that it does not want financial conditions to tighten too much, and would likely prefer to keep the Chicago Fed's Adjusted Financial Conditions index below the zero line (Chart 11, top panel). A negative reading from the adjusted index signals that financial conditions are easy relative to the strength of the economy. That is, they should be sufficiently accommodative to allow the economic recovery to continue and cause inflation to rise. At the same time, levels that are deep in accommodative territory signal that the Fed can move more rapidly. Bottom Line: The Fed strongly believes that financial conditions lead economic growth. Absent any major changes in the economic data, the pace of rate hikes will be determined by the Fed's targeting of financial conditions. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Minutes of the Federal Open Market Committee May 2-3, 2017. https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20170503.pdf 2 For further details on the BCA Beige Book Monitor please see U.S. Investment Strategy Weekly Report, "The Great Debate Continues", dated April 17, 2017, available at usis.bcaresearch.com 3 Minutes of the Federal Open Market Committee May 2-3, 2017. https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20170503.pdf 4 Please see U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers", dated May 23, 2017, available at usbs.bcaresearch.com 5 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 6 One of the independent variables in our model is a 12-month lag of the year-over-year change in core PCE inflation. The lagged inflation variable pressures the model's fair value toward the level of actual inflation. If no other variables change, then over time the lagged inflation variable will ensure that the model fair value converges toward actual inflation. 7 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 8 Minutes of the Federal Open Market Committee May 2-3, 2017. https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20170503.pdf 9 Please see U.S. Bond Strategy Weekly Report, "Buy The Back-Up In Junk Spreads", dated March 14, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Politics will inject further volatility into risk assets, but stocks will outperform bonds and cash on a 6-12 month horizon. The health of the economy and earnings matter more than Trump's political woes for investors and the Fed. The consumer - a key driver of the U.S. economy and corporate earnings - will provide a solid backdrop for the economy through 2017 and beyond. The combination of balance sheet shrinkage and Fed rate hikes will lead to higher bond yields than are currently discounted in the market. It is a different story for the mortgage market, where spreads will be biased to widen during Fed runoff. Feature The Economy Matters More Than Politics The health of the economy and earnings matter more than Trump's political woes for investors and the Fed. When the economy and earnings backdrop was favorable during presidential scandals in the 1920s and the 1990s, the equity markets performed well. In the early 70s, amid soaring inflation and the worst recession since the Great Depression, there was a bear market in equities (Chart 1). Today, the backdrop for the economy and earnings - while not as robust as in the 1920s or late 1990s - provides support for higher stock prices, two more Fed rate hikes and higher Treasury bond yields. Trump's political woes may slow, but not completely halt the GOP's legislative agenda1. Support for Trump among his GOP base remains high at 85%, making impeachment a long shot until after the November 2018 mid-term elections (Chart 2). If the Democrats take the House, they are likely to impeach Trump in 2019. For the Trump and the Republicans in Congress, this means the impetus is even greater to make progress now on tax cuts, tax reform and infrastructure. However, the embattled White House will slow the process as the president's staff often acts as a coordinator among the various factions in Congress. With Trump's team preoccupied with political woes, they will not be effective in this role. Chart 1Economy Will Trump Politics ##br## For Financial Markets Chart 2GOP Base Not Yet Willing To ##br## Impeach Trump The Fed will look through the politics and focus on the health of the economy and will continue to raise rates gradually this year, with the next hike coming in June. Financial conditions have eased since the Fed's 25 basis point rate hike in December, and that alone should be enough to keep the Fed on track to tighten next month. As we have noted in recent reports, even without fiscal stimulus, the U.S. economy will still grow near its long-term potential, tighten the labor market and push up wages and inflation. The Fed has been reticent to include any impact from fiscal stimulus into their policy deliberations thus far. The minutes of the March FOMC meeting noted that "members continued to judge that there was significant uncertainty about the effects of possible changes in fiscal and other government policies". Bottom Line: The lack of progress on legislation may result in a pullback in U.S. equity prices, but absent a material weakening of the U.S. economy or profit picture, the pullback will not turn into a bear market. Checking In On The Consumer The consumer - a key driver of the U.S. economy and corporate earnings - will provide a solid backdrop for the economy through 2017 and beyond. This backdrop will allow the Fed to pursue two rate hikes this year. The weakness in several indicators has worried some investors that the economy may be on the verge of a slowdown or even a collapse. However, a firming economy should sustain corporate earnings growth and, ultimately, higher stock prices. Consumer spending's share of GDP is 68% and increasing (Chart 3). GDP growth excluding consumer spending is more volatile than overall GDP growth. The household sector has contributed 75% to growth since the end of the recession, which is the best performance of any sector. The key drivers of spending point to further gains in the sector, and the imbalances that were present ahead of prior downturns are not evident today. Chart 3Household Share Of GDP Is At An All Time High And Rising Chart 4Consumer Spending Remains In An Uptrend Household spending growth has softened but remains in an uptrend. Broad measures of consumer spending tend to peak two to four years prior to the start of a recession. The lead time is even longer in a long-cycle expansion.2 Investors should not dismiss the weakness altogether, but position portfolios for the late-cycle environment. Personal consumption expenditure growth peaked at 4% year-over-year in Q1 2015. Auto sales, a timelier measure of spending although not as comprehensive, peaked in December 2016 (Chart 4). Applying the 2 to 4 year lead time noted above - and making the assumption that spending has indeed peaked - this points to a recession commencing in the middle of 2019 at the earliest. Household net worth is at an all-time high, and the overall wealth effect on consumer spending has been positive for some time. Our forecast for financial markets and the housing market, though modest, imply that the positive wealth effect will continue. Debt-financed spending remains a viable option for consumers, which was not the case in late 2007 before the onset of the recession. Banks have not changed their lending standards for most consumer loans and demand for these loans will stay solid despite the Fed rate increases that we expect. The Bank Credit Analyst's March 2017 report showed that even a 100-basis point rate rise from the current levels would not lift the interest payments to burdensome levels by historical standards. Incomes will continue to climb and importantly, consumer income expectations have also hit new highs. With the economy at the Fed's assessment of full employment, wage growth is accelerating, albeit more modestly than in previous recoveries. Our recent report3 found that wages tend to rise about two years after the output gap has formed a bottom. A narrowing output gap leads to a tighter labor market and higher incomes. As measured by the quit rate, job security is at a fresh cycle high (not shown). Many consumer indicators are in better shape today than they were in 2007 or at similar points in the other long cycles4 (Charts 5 and 6). We define the long cycle economic expansions as those lasting 8-10 years. The two expansions that meet the definition are 1981-1990 and 1992-2001.5 Consumer spending is running in line with incomes, unlike in the mid-2000s. Chart 5Key Consumer Metrics ##br## Remain Favorable Chart 6There Is Still Plenty Of Support ##br## For Solid Consumer Spending Mortgage equity withdrawal, a crucial source of debt-fueled consumer spending prior to 2007, has been non-existent in this cycle. Spending on essentials are close to all-time lows. In 2007 they were at record highs and had moved up dramatically in the prior half-decade amid escalating debt levels, rising energy prices and consumer interest rates. We are concerned by the historically high percentage of household incomes (17%) dedicated to medical care. An aging population, ever rising healthcare costs and uncertainty surrounding the future of Obamacare may drive medical spending even higher. Household debt levels as a percentage of disposable income peaked in 2008 at over 120%, but are back under 100%, i.e. at the level that existed prior to the 2007-2009 recession. The level of household debt compares favorably to similar points in the long cycles of the 1980s and 1990s. Financial obligations are at multi-decade lows (Chart 6, bottom panel). Bottom Line: The fundamentals supporting consumer spending remain solid. A healthy consumer means the economy can meet the Fed's modest GDP forecast for 2017, keeping the central bank on track to tighten twice more in 2017. This outlook supports our view for stocks over bonds in the next 6-12 months. The Fed's Balance Sheet: It's Diet Time Chart 7Fed Set To Begin Tapering In Early 2018 The minutes from the March FOMC meeting indicated that a change in the Fed's reinvestment policy will likely be appropriate "later this year". The minutes suggested that the FOMC is split on whether to simply terminate all reinvestment for both Treasurys and MBS, or to "taper" reinvestment over time. Our base case is that the Fed will follow up a June rate hike with another one in September, at which point policymakers will provide some details on their plans for balance sheet runoff to begin in January of 2018. Investors are rightly concerned about the potential impact of the runoff, especially given that memories of the 2013 "taper tantrum" are still fresh. There is disagreement among academics about whether quantitative easing (QE) directly depressed bond yields by restricting the supply of high-quality fixed income assets, or whether the impact on yields was solely via the "signaling effect" (i.e. that QE implied that short-rates will be held at a low level for a very long time). Either way, balance sheet runoff will likely have some impact on bond yields. A good starting point is to employ an empirical estimate of the impact of QE. The IMF has modeled long-term Treasury yields based on a number of economic and financial variables, including inflation expectations, demographics, growth, current accounts and budget balances. The model also includes the stock of assets held by the Fed as a share of GDP. If the Fed were to begin running off its holdings of both Treasurys and MBS at the beginning of 2018 by terminating all reinvestment, then the amount of bank reserves held at the Fed would likely evaporate by 2021. This represents a fall of roughly 10 percentage points of GDP (Chart 7). Given the IMF interest rate model's coefficient of -0.9, it implies that long-term Treasury yields and mortgage rates would rise by 90 basis points from the "portfolio balance" effect alone. However, it is more complicated than that. The impact on yields is likely to be tempered by three factors: The Fed may opt to avoid going "cold turkey" on reinvestment, choosing instead to scale back gradually. Fed President William Dudley recently commented that the Fed wants balance sheet reduction to "run in the background", such that it is not a major event for markets. Some academic experts are recommending that the Fed maintain a fairly large balance sheet by historical standards because of the need in financial markets for short-term, risk-free assets that would diminish if there are fewer excess bank reserves available. Banks, for example, are required by regulators to hold more high-quality assets than they did in the pre-Lehman years. The implication is that the balance sheet may never fully revert to historic norms relative to GDP. As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions get too tight, too quickly (i.e. the term premium would rise, but would be partly offset by a lower expected path for the fed funds rate). Thus, the path of short-term rates is dependent on the dollar and the reaction of the long end of the curve. It is difficult to estimate how it will shake out, but a recent report from the Federal Reserve Bank of Kansas City estimated that a $675 billion reduction in the size of the Fed's balance sheet is equivalent to a 25 basis point increase in the fed funds rate (although the authors admit that the confidence band around this estimate is extremely wide).6 We expect that the impact of runoff alone will be much less than the 90 basis point estimate discussed above. Still, the combination of balance sheet shrinkage and Fed rate hikes will lead to higher bond yields than is currently discounted in the market. We could also see some upward pressure on global term premia when the ECB announces the next tapering of its QE purchase program, possibly this autumn. However, it will be years before the ECB will be in a position to reduce the size of its balance sheet. As for the Bank of Japan, we doubt that the central bank will ever shed its JGB holdings. What about the shape of the Treasury curve? Our fixed-income strategists believe that the shape of the curve will be determined by the normal cyclical dynamics we have seen in the past. We are still in a window in which the Treasury curve will steepen as yields rise. A little later in the Fed cycle, the curve will bear-flatten as the long-end begins to rise at a slower pace than the front end. We do not see balance sheet adjustment as changing these dynamics much. Similarly, with respect to credit spreads, the state of nonfinancial corporate sector balance sheets and the overall stance of monetary policy will continue to be the main drivers of the credit cycle. If unwinding the balance sheet leads to a premature tightening of financial conditions, then the Fed will proceed more slowly on rate hikes. The crucial indicator to watch is core PCE inflation. Credit spreads will remain fairly well contained until core PCE inflation reaches the Fed's 2% target. At that point, the pace of monetary normalization will ramp up, putting spreads at risk of widening. It is a different story for the mortgage market, where spreads will be biased to widen during Fed runoff. While spreads have already widened a bit, in our view they still do not adequately compensate for the additional MBS supply that will hit the market when the Fed takes a step back. Historically, there is a reasonably tight correlation between MBS spreads and the spread between mortgage rates and Treasury yields (Chart 8). Thus, it is reasonable to expect mortgage rates to rise by more than Treasury yields. Chart 8MBS Spreads Set To Widen As Fed Tapers While the Fed's balance sheet reduction by itself may not have a big impact on the dollar, we still believe the currency has more upside because of the divergence in the overall monetary policy stance between the U.S. on one side and the ECB and Bank of Japan (BoJ) on the other. The BoJ will hold the 10-year JGB near to zero for quite some time. The ECB will also not be in a position to tighten for a long time, outside of removing negative short rates and tapering QE purchases a bit further in 2018. Meanwhile, we think the Fed will tighten by more than is currently discounted. Admittedly, the economic data have disappointed so far in 2017 and CPI inflation has softened which, at the margin, would cause some FOMC members to back away from rate hikes. Nonetheless, policymakers are focused more on the labor market than GDP to gauge the health of the expansion and the amount of economic slack. Despite the dismal Q1 GDP figures, following unimpressive growth in 2016, the unemployment rate has already fallen below what the FOMC expected the rate will be at the end of this year! A tightening labor market means that the economy is still growing above a trend pace. Unless there is a clear deceleration in wage growth as measured by the ECI or the Productivity and Cost report, the FOMC will likely hike rates by more than the 38 basis points currently discounted over the next 12 months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 See Geopolitical Strategy Report, "Break Glass In Case Of Impeachment," May 17, 2017. Available at gps.bcaresearch.com 2 See The Bank Credit Analyst, March 2017. Available at bca.bcaresearch.com 3 See U.S. Investment Strategy Weekly Report, "Still Awaiting the Next Pullback", May 15, 2017. Available at usis.bcaresearch.com 4 See The Bank Credit Analyst, March 2017. Available at bca.bcaresearch.com 5 We did not include the 1960s in this analysis because the Fed waited too long to tighten and allowed inflation to get out of hand. 6 Forecasting the Stance of Monetary Policy Under Balance Sheet Adjustments. The Macro Bulletin, Federal Reserve Bank of Kansas City. Troy Davig and A. Lee Smith. May 10, 2017.