Consumer
Highlights Portfolio Strategy Boost restaurant stocks to neutral, as same-store sales should improve next year. A further upgrade requires evidence of top-line traction. The exodus from health care stocks represents an overreaction rather than a downshift in fundamental forces. Stay long. Recent Changes S&P Restaurants Index - Upgrade to neutral for a profit of 9%. Table 1 Feature Equity market buoyancy remains a liquidity rather than an earnings story. Fed commentary and the trend in global bond yields, a reflection of the global central bank narrative, continue to exert an outsize influence on short-term price action and momentum. In the background, earnings are a wildcard. Companies may be surpassing beaten down third quarter estimates, but the path of profits over the next several quarters is by no means assured and will determine the durability of any stock market advance. Even excluding the persistent drag from narrowing profit margins, courtesy of falling productivity and increasing unit labor costs, it is dangerous to look at the corporate profit outlook through rose colored glasses. The low level of economic growth, both at home and abroad, represents a major hurdle to the corporate sector. Total business sales have climbed back up to zero, but it is premature to forecast meaningful growth ahead based on moribund global export growth (Chart 1), and/or leading economic indicators. After all, sales growth has been virtually non-existent for years, reinforcing that earnings per share have been driven by cost cutting and buybacks. While measured consumer price inflation has crept higher, corporate sector pricing power remains virtually non-existent. The producer price index is still deflating, despite the rally in oil prices. U.S. import prices are very weak (Chart 1). The negative global credit impulse warns that there is still no impetus to reinvigorate final demand, and by extension, global profits (Chart 1). It is hard to envision an economic reacceleration as long as the corporate sector is more inclined to retrench than expand, as heralded by stressed balance sheets and weak durable goods orders (Chart 2). Chart 3 shows BCA's two U.S. profit models. The first one is based on reflationary variables, such as the dollar, bond yields and oil prices. It is designed to predict the trend in forward earnings momentum. This model has troughed, but is not signaling any upside ahead in already exuberant analyst earnings estimates (Chart 3, second panel). Chart 1Without Sales Growth... Chart 2... And Rising Costs... Chart 3... How Much Can Profits Improve? The second model looks at macro data such as new orders, labor costs and productivity growth to forecast the trend in actual operating earnings. This model is slightly more optimistic (Chart 3, bottom panel), and signals a decisive end to the profit contraction, albeit not a growth rate sufficient to satisfy double-digit analysts forecasts or rich valuations. The U.S. dollar is a major wildcard, as any sustained strength would compromise earnings. Typically, major profit expansions only occur after the currency begins to depreciate and labor cost inflation ebbs (Chart 2). The late-1990s was an exception, as profits climbed alongside the currency and amidst rising wage inflation (Chart 2). However, that was during an economic and credit boom, two key factors that are conspicuously absent at the moment. Nevertheless, as discussed in past Weekly Reports, the flood of central bank liquidity could sustain the overshoot in equity prices for a while longer. Investors have demonstrated a willingness to look through soggy profits as long as the liquidity taps remain open. Despite the possibility of a stubbornly resilient broad market, we do not recommend interpreting it as a sign of economic vitality, and consider it high risk. Our portfolio strategy is based on expected sectoral earnings trends, as liquidity is subject to the whims of central bankers. We recommend a largely defensive sector portfolio, with some exceptions, as discussed in last week's Special Report. Our cyclical exposure remains confined to consumption-oriented plays; this week we are lifting our view on restaurants. Restaurants: Buying Into Weakness Investors have gravitated toward washed out deep cyclical sectors rather than consumption-oriented plays in recent months. However, we doubt this trend has staying power, as outlined in our Special Report last week. Consequently, it is time to revisit the outlook for shunned consumer sectors, such as restaurants. This year's exodus from casual dining stocks has been justified on the basis of overvaluation and deteriorating industry performance. The National Association of Restaurants (NAR) survey of current performance has dipped into negative territory (Chart 4), as restaurant operators have reported a decrease in traffic. One of the major drags on restaurant same-store sales has been the gap in restaurant inflation compared with the cost of food inflation for eating at home. Relative inflation has soared (Chart 5). That has caused relative spending growth at restaurants vs. at home dining to drop sharply, in real (volumes) terms. However, next year could be different. If the inflation gap falls, as predicted by the decline in relative spending (Chart 5), then restaurant traffic should stabilize. Importantly, the odds of budgets for dining out being pruned even further are low. As long as wages and salaries growth is decent and consumer income expectations are firm, consumers should still allocate a rising share to restaurants relative to eating at home (Chart 5). There is plenty of scope for relative restaurant spending to rise on a secular basis (Chart 5, bottom panel). Clearly, if relative spending were to reaccelerate too quickly, then the inflation gap would stay wide, and same-store sales growth would stay punk. That is a risk to an optimistic view of future restaurant traffic. But the good news is that cost structures are being realigned to a more subdued sales run rate. The NAR survey shows that staffing plans are on the wane. That leads restaurant labor cost inflation (Chart 4). As the largest source of expenses, any decline in headcount would be welcome given that minimum wages in a number of states are set to climb next year. In any case, the most potent profit elixir would be a recovery in top-line growth, sourced both domestically and from abroad. Restaurant sales growth has been unimpressive for the past several years. Subdued pricing power gains, and until recently, lackluster income growth among lower income consumers have weighed on revenue growth. The good news is that consumer confidence among low income earners is on the upswing (Chart 6), which bodes well for casual dining out in the coming quarters. If our bearish view on refiners and gasoline prices continues to pan out, then a windfall from lower fuel prices may further bolster the outlook. Chart 4Expenses Set To Ease Chart 5Inflation Gap Should Narrow Chart 6Sales Set To Stabilize... In addition, restaurant retail sales often follow the trend in the wealth effect (Chart 7). The latter has pulled back this year, owing to the equity market consolidation and house price correction. However, financial wealth gains are rebounding, and provided the stock market does not suffer a sustained swoon, consumers' feeling of affluence may soon be bolstered. Even marginal improvements in store traffic should be impactful to same-store sales. Restaurant chains have been in retrenchment mode since the Great Recession. Construction activity is historically low, which implies limited capacity expansion (Chart 7). Contribution from abroad may become less of a drag. The industry garners roughly 67% of sales from overseas. The strong U.S. dollar, particularly against emerging market currencies, has deprived the industry of sales strength. Moreover, even in domestic currency terms, emerging markets consumption has been through a difficult period, as the Asian Hotel and Restaurant Activity Proxy spent most of the last year in negative territory (Chart 8). But EM currencies have stabilized and Asian restaurant activity has climbed back into positive territory in recent months. The upshot is that foreign revenue could make up any lingering domestic sales slack. All of this suggests that leaning into share price weakness in anticipation of improved prospects next year makes sense. Nevertheless, the S&P restaurants index does not warrant a full shift from underweight to overweight. There could still be earnings/headline risk given lackluster readings in coincident activity indicators, despite McDonald's earnings beat last week. Valuations are not cheap. On a normalized basis, the relative forward P/E ratio has dropped below its average, but still trades at a premium to the broad market. A return to above average levels is possible if operating margins expand on the back of sales improvement (Chart 9), thereby sparking higher return on equity, but it may be too soon to position for such an outcome. Chart 7... Or Even Improve In 2017 Chart 8End Of Foreign Drag Chart 9Still Not Dirt Cheap Bottom Line: Lift the S&P restaurant index (BLBG: S5REST - MCD, SBUX, YUM, CMG, DRI) to neutral from underweight, locking in a profit of 9% since our underweight recommendation last November. Health Care Crunch: Buying Opportunity Or Trend Change? The speed at which the health care sector has sunk toward the bottom end of this year's trading range has unnerved many investors. In fact, the sector has dropped back down to the levels where we added it to our high conviction overweight list. The question now is whether our positive views still hold, and whether would we add here if we weren't long already, or if something more sinister is at work? The hit to health care stocks reflects a rise in risk premiums related to concerns that the U.S. government will exert more control over price setting if the Democrats win the election rather than any immediate downshift in relative forward earnings drivers. While it is impossible to forecast with any precision to what extent pricing models may or may not change, the political appetite may be low for another overhaul of the sector so soon after the Affordable Care Act was implemented. Regardless, several observations suggest that the sector may already be undershooting, i.e. a Democratic victory is already discounted. Relative performance has experienced a clear uptrend over the last forty years, with cyclical swings oscillating around its upward sloping trend-line (Chart 10). It would be extremely rare for a bull phase to peak prior to hitting at least one standard deviation above trend. Instead, the price ratio hit trend and is now not far above one standard deviation below trend, a level one would normally equate with an economic boom when capital flowed to high-beta sectors. Cyclical technical measures also point to an undershoot. Our Technical Indicator has hit an oversold extreme (Chart 11), signaling that the sell-off is in the late stages. Our relative advance/decline line has also stayed firm, suggesting that the decline in the overall sector has not been broad-based (Chart 11). Chart 10Time To Buy, Not Sell Chart 11Buying Opportunity Whether a wholesale flight from the sector, and all defensives in general, looms is largely contingent on the path of inflation expectations, which have been in a multiyear decline. This trend reflects anemic global final demand and the repercussions from over-indebtedness. Lately, inflation expectations have firmed, but that may largely reflect the rebound in oil prices courtesy of hopes for an OPEC production cut, given the lack of confirming indicators of growth acceleration and renewed strength in the U.S. dollar. The latter is testing the top end of its recent range (Chart 11, shown inverted, bottom panel), and it would be highly unusual for inflation expectations to rise concurrent with the U.S. dollar. In a world of zero interest rates and limited aggregate demand strength, a strong currency is deflationary, especially for corporate profits. Those conditions keep bond yields low, and push capital into long duration sectors. Once the election is over, attention will refocus on the relative forward earnings outlook. Our Indicators suggest that earnings momentum will stay positive. Our health care sector pricing power proxy has rebounded after cooling from red-hot levels, and is still much stronger than overall corporate sector pricing (Chart 12, second panel). That is confirmed by the pharmaceuticals producer price index, and employment cost index for health insurance, i.e. pricing strength is broad-based. There is still scant evidence of a downshift in consumer spending patterns in reaction to rising health care sector inflation. Real (volumes) personal spending on health care goods and services continues to grow at a mid-single digit rate, well in excess of the rate of overall consumption (Chart 12). That is consistent with ongoing earnings outperformance. As noted in past research, the time to forecast negative relative earnings momentum is when consumers balk at higher prices. So far, a few high profile cases of exorbitant drug price increases have grabbed the spotlight, but in aggregate, consumers are not voting with their wallets. The biggest tangible negative for the health care sector may be that shares outstanding are no longer falling (Chart 13). That mirrors overall buyback activity, which has cooled markedly on the back of balance sheet deterioration and waning free cash flow. We doubt the supply of health care stocks is going to rise much, however, because the sector is in good financial shape, earning healthy returns and is not dependent on external financing. Chart 12Demand Driven Pricing Power Gains Chart 13Buybacks Are Dwindling Bottom Line: Health care sector risk premiums have climbed in response to polling results, but an apolitical check on relative earnings drivers and valuations points to a buying opportunity. Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.
Highlights The path of the least resistance for the U.S. dollar is up; this has far-reaching implications for monetary policy, global growth dynamics and asset prices. Dollar strength reinforces our view to overweight defensives vs. cyclicals and is a headwind to overall S&P 500 profits. Most of the gap between core CPI and core PCE can be explained by the medical care component. Overall, core PCE is likely to reach 2% over the next several months; a strong dollar means core goods PCE deflation will be sustained, but rising wage costs will put upward pressure on service sector inflation. Feature Amid the ongoing U.S. elections and Q3 earnings uncertainty, one of our higher conviction views is the likelihood of U.S. dollar appreciation. Our reasoning is straightforward: interest-rate differentials are the strongest 12-18 month predictor of currency trends,1 and relative economic performance between the U.S. and the rest of the world suggests that the gap between U.S. monetary policy and elsewhere will stay wide, and perhaps even widen (Chart 1). Chart 1Interest Rates And The Dollar Moreover, as we showed last week, the trade-weighted dollar provides good insurance against a variety of downside equity risks, even when a financial calamity occurs on U.S. soil. We remain dollar bulls. However, that does not mean that the outlook is without risk. The implications of further dollar strength are wide-ranging: How does dollar strength impact inflation expectations and monetary policy? How does the rest of the world cope with a rising U.S. dollar? How does the S&P 500 stand up to further dollar appreciation? Monetary Policy And The Dollar We have discussed the ramifications of the Fed Policy Loop, the interplay between Fed policy and financial conditions, since September 2015 (Chart 2). Since last year, each hawkish move from the Fed has been met by a sharp upward adjustment in the trade-weighted dollar and a sell-off in equities and credit spreads. Tighter-than-expected financial conditions have then forced the Fed to lower its outlook for future economic growth and adopt a more dovish policy stance. A more dovish Fed then caused financial conditions to ease and the dollar to fall, and this easing eventually emboldened Fed policymakers to move in a more hawkish direction. The loop then repeats itself. The reason this loop has been in place is because U.S. monetary policy is so far in advance of other central banks. For example, the ECB and BoJ continue to try to find ways to stimulate their economies, while the Fed is gearing up for a second rate hike. The point is that this feedback mechanism means that monetary conditions tighten in the form of a rising dollar, even without the Fed hiking interest rates by very much (Chart 3). The implication for investors is also clear: for equities, even though overall monetary conditions can tighten, rate-sensitive, domestically-exposed sectors such as telecoms can still perform well, because the tightening is coming mainly through the currency, rather than interest rates. For bonds, the policy loop means that sell-offs are likely to happen in fits and starts: the Fed knows that the process of normalizing interest rates will trigger bouts of volatility, because their actions are being exaggerated by movements in the dollar. This is one reason why we are not more eager to move aggressively underweight duration. Chart 2The Fed Policy Loop Chart 3Dollar To Do The Fed's Lifting? ROW And The Dollar Dollar strength, in the context of a robust U.S. economy, can be a good thing for some parts of the world. For example, a strong dollar means that European and Japanese exports will be more competitive. In this benign context, currency strength acts a growth re-distributor, taking growth away from the U.S., but transferring it to others, where the currency has been devalued. Our concerns focus squarely on emerging markets. Since the early 1980s, there have been no periods when EM share prices rallied amid strength in the real broad trade-weighted U.S. dollar (Chart 4). Chart 4EM Stocks Don't Like Dollar Strength It is significant that financial markets panicked in August, 2015 when the RMB was devalued by 2% ahead of the Fed's warning about a rate rise, and amid broad based U.S. dollar strength. True, the RMB has weakened periodically since then, without any real fallout for risk assets. Nonetheless, it is hard to say that the global economy - and China for that matter - is in significantly better shape than when the Fed began televising the last rate hike. We do not offer a forecast on the likelihood of further RMB devaluation. However, recent history is a reminder that dollar strength risks creating volatility in global markets. The latter would be especially true if worries about the EM credit cycle resurface. S&P 500 And The Dollar In the last major dollar bull market (1994-2002), U.S. stocks strengthened alongside the rise in the currency, offering some historical support that dollar strength does not necessarily hinder stock market performance. However, the global backdrop during that era was distinctly different from today. During the last half of the 1990s, the entire global economy experienced a supply-side, disinflationary expansion and credit binge. The U.S. was at the forefront of that expansion, and pulled the rest of the world (ROW) along for the ride. In other words, the U.S. and ROW were all moving broadly in the same direction. Today, the global economic backdrop is starkly different. Europe, Japan and China are all battling deflation and the major distinguishing trait of this business cycle is deficient demand and the need to de-lever. As we highlighted above, the U.S. has embarked on a gradual rate hike path, but most other central banks are trying new ways to reflate. In this world, currency movements act to re-distribute growth: a stronger currency can become a headwind to externally sourced profits, rather than a reflection of strong domestic demand. Indeed, the S&P 500 may become even more vulnerable to dollar strength: globally sourced profits as a share of overall S&P 500 profits has been in a steady climb over the past twenty years. Chart 5 shows that net earnings revisions are especially sensitive to currency moves, suggesting that further dollar appreciation would undermine already very lofty earnings expectations and would be a headwind for the broad market. Chart 5Beware The Dollar Drag From a sector perspective, dollar strength has already become problematic and is a main reason why we continue to advocate for defensive stocks relative to cyclical plays. Our U.S. Equity Strategy service published a Special Report on this topic last week.2 The Report outlined a seven item checklist of factors needed before tilting positions in favor of cyclicals. The first item on the list is dollar weakness. The full checklist is here: Chart 6Stick With Defensives Broad-based U.S. dollar weakness, particularly against emerging market currencies in countries with large current account deficits. An end to Chinese manufacturing sector deflation. A decisive upturn in global manufacturing purchasing manager's indexes. A return to growth in global export volumes and prices. A resynchronization in global profitability such that U.S. profits were not the only locomotive. A rebound in global inflation expectations. China credibly addressing banking sector weakness to the point where economic growth can reaccelerate rather than move laterally. Most of the items remain unfulfilled and our U.S. equity strategists believe that over the past several weeks, a technical adjustment has occurred in equity markets, rather than a fundamentally-driven trend change. In fact, the cyclical vs. defensive share price ratio appears to now be overshooting after having undershot. We expect leadership to revert back to non-cyclical sectors once the current rotational correction has run its course, given the lack of confirmation from the bulk of the macro variables on our checklist (Chart 6). The bottom line is that the U.S. dollar's path of least resistance is to trend higher. Dollar strength has already become restrictive for some U.S. industries, and unlike the late 1990s, we are concerned that further currency appreciation will act to restrain profit growth, rather than be reflective of a stellar domestic backdrop. Still, the Fed and other central banks' actions have proven to so far be a powerful antidote to earnings concerns: as long as the liquidity taps remain open, investors are willing to look through profit disappointment. We continue to recommend benchmark weightings to equities, but are highly attuned to this profit risk. What Is The True Inflation Rate? The Fed's target is 2% inflation. Core CPI has been above this rate for eleven months, implying that if the Fed's target was based on this measure, policymakers would have been much more aggressive in hiking interest rates. But the Fed's preferred measure, core PCE, is still stuck below the target. The CPI and PCE usually move together. The correlation between the two series is about 98% and divergences tend to be short-lived (Chart 7). Thus, the choice between the two series is often irrelevant, although the recent gap raises an issue for the Fed and the bond market: which measure is currently telling the right story? First, there are many alternative measures of inflation and in Chart 8, we show a selection of them. The median CPI uses the middle or median price change as its estimate of the underlying rate of inflation, irrespective of its share of the overall basket. The trimmed mean CPI removes the most volatile components of the index. The market-based PCE measure of inflation addresses concerns about using "imputed" prices (such as financial services furnished without payment) by leaving them out. Incidentally, this latter series, which is currently somewhat weaker than core PCE, is giving a similar inflation signal to our corporate price deflator. Together, these two measures suggest that the business sector is faced with a much tougher pricing backdrop than the core PCE and core CPI suggest. Chart 7Core CPI And Core PCE Usually Say The Same Thing Chart 8Various Alternative Measures Unfortunately, none of these alternative measures offer reliable leading information and do not help in understanding the divergence between core CPI or core PCE. However, understanding how the indexes are constructed does uncover important differences. Core CPI And Core PCE Explained The core CPI is a fixed-weight index while the personal consumption expenditure is chain-weighted. A fixed-weight index uses a constant basket of goods and tries to determine how much more an individual pays for an identical basket today versus a base year. A chain-type index measures how much it costs to a constantly evolving basket. The latter should be more representative of consumers' evolving buying habits. Historically, the different weighting methodology explains most of the gap between CPI and PCE inflation rates. The remainder of the gap is accounted for largely by the difference in the size of the weights used for the medical and housing components. Housing accounts for 40% of core CPI and only 17% of core PCE. Medical care accounts for 7% of core CPI versus 18% of core PCE. Currently, the gap between core PCE and core CPI is mostly explained by the medical care component (both the relative weights, but also the underlying prices used). In the CPI, only the portion that consumers spend on health care is taken into account, but the PCE also includes the amount that government agencies spend on consumers' behalf. The pricing information on the government funded portion is estimated from the PPI, which sometimes gives a different signal than the data supplied to the CPI from the consumer expenditure survey. The gap between medical care PCE and CPI has become particularly pronounced in the past few years. There is a lot of confusion about what is driving the spike in CPI medical care costs, with some pundits trying to find a political angle. Some blame higher insurance rates, while others blame drug costs. In fact, as Chart 9 shows, all elements of medical care CPI have contributed to the surge. Meanwhile, core PCE shows that medical care inflation has in fact been contained, some say, due to the enactment of the Affordable Care Act (a.k.a. Obamacare). It is not clear that this is the full story and forecasting future rates of inflation specifically in this sector is beyond the scope of this report. Over the next six to twelve months, we would expect some convergence between the two inflation gauges, as CPI medical care inflation peaks. More specifically, we would not be surprised to see the core PCE move slightly above 2%, but we think it is unlikely that much of an overshoot of the Fed's target can occur. Chart 10 shows the major components of CPI and we note the following: Chart 9Medical Care##br## Inflation Is Tricky Chart 10Major Components Of##br## Inflation At Crosscurrents Goods prices continue to fall. If our strong dollar view proves correct, deflation in this sector may persist for years. Recall that throughout the economic recovery in the first half of the previous decade, core goods price deflation persisted; that was during a dollar bear market. This time, dollar strength is likely to keep an even tighter lid on imported prices. Non-shelter service price inflation appears to be rolling over, after a surge earlier this year. The key for core service price inflation is wage pressures, since labor costs are the most significant input cost to U.S. service businesses. For core service price inflation to sustainably break above 3%, i.e. to return to the pre-Great Recession range, recent wage trends will need to be sustained, if not accelerate. Shelter prices are the most difficult segment to forecast. Our model for shelter inflation has flattened out, owing to a decline in market-tightness in multi-family properties. A reasonable working assumption is that shelter inflation stays around 3%, which is roughly the rate of shelter inflation that persisted prior to the housing bubble of the previous decade. Adding it up, core inflation is likely to drift gradually up: service sector inflation will likely trend higher with wage growth, but deflation in the goods sector will provide somewhat of an offset. The Fed has initiated interest rate hikes in the past when core PCE was under 1.5%, so there is historic precedent for policymakers to hike rates before the 2% target is achieved. Of course, this cycle is very different and there has been much talk of the need for policymakers to err on the side of ease for even longer, i.e. allow inflation to run much higher than 2%. Recent Fed communication suggests that a December rate hike is most likely, unless the data significantly worsen in the meantime. Thereafter, if our inflation view is correct, the Fed will find little reason to hike more than twice in 2017. Note: Last week, I had the pleasure of participating in our Geopolitical Strategy service's webcast on the upcoming U.S. Elections. In addition to a well-rounded debate on the U.S. political situation, we also discussed the present economic and investment landscape. To listen to the replay, please go here: www.bcaresearch.com/webcasts/index/131 Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report "Dollar: The Great Redistributor", dated October 7, 2016, available at fes.bcaresearch.com 2 Please see U.S. Equity Strategy Special Report "Defensive Dominance Has Bent, But Will Not Break", dated October 17, 2016, available at uses.bcaresearch.com Appendix Monthly Asset Allocation Model Update Our Asset Allocation (AA) model provides an objective assessment of the outlook for relative returns across equities, Treasuries and cash. It combines valuation, cyclical, monetary and technical indicators. The model was constructed as a capital preservation tool, and has historically outperformed the benchmark in large part by avoiding major equity bear markets. Please note that our official cyclical asset allocation recommendations deviate at times from the model's recommendation. The model is just one input to our decision process. The model's recommended weightings for the major asset classes remained unchanged this month: neutral equity exposure at 60% (benchmark 60%), slightly overweight Treasury allocation at 40% (benchmark 30%) and underweight cash at 0% (benchmark 10%). The neutral portfolio recommendation for equities is in line with our qualitative defensive stance, in place since August 2015. Although the technical and monetary components of the equity model are still favorable, the earnings-driven component continues to warn that profits are likely to remain lackluster, especially relative to expectations. The allocation for a slight overweight in Treasuries continues to be supported by all three components of the bond model: valuation, cyclical and technical. While the valuation component continues trending towards expensive territory, a "buy signal" still exists for now. The cyclical and technical components of the bond model have retraced some of their bullish signals, but both still maintain a preference for Treasuries, especially relative to cash. Chart 11Portfolio Total Returns Chart 12Current Model Recommendations Note: The asset allocation model is not necessarily consistent with the weighting recommendations of the Cyclical Investment Stance. For further information, please see our Special Report "Presenting Our U.S. Asset Allocation Model", February 6, 2009. Market Calls
Highlights The U.S. is not yet a "high-pressure" economy, but slack is dissipating. U.S. growth, while not torrid, will remain high enough to push interest rates higher. The euro area continues to exhibit tepid domestic demand growth, and slack there remains higher than in the U.S. Monetary divergences will grow, weighing on EUR/USD. The Canadian economy displays underlying weaknesses which will prevent the BoC from hiking for an extended period of time. Stay long USD/CAD, but favor the CAD to the AUD and the NZD on a USD rally. Feature Following Janet Yellen's Boston speech last week, a new phrase has entered the lexicon of investors: "high-pressure economy". The speech was originally interpreted as a clarion call to let the economy overheat in order to absorb the slack created by the shock of 2008. However, Yellen still sees some slack in the economy. In her eyes, an easy monetary stance, at this point, will not cause an overheating, it will only bring back to the marketplace workers that had left the labor force. Chart I-1Drying Global Liquidity We have sympathy toward this view, especially when put in an international context where global capacity utilization remains depressed. Also, countries like China, Saudi Arabia, and Mexico have been intervening in the FX markets to preempt or limit downside to their currencies, tightening global liquidity conditions (Chart I-1). Nonetheless, the Fed Chair also highlighted that the FOMC did not want the U.S. economy to overheat as the domestic slack gets absorbed. Doing so would raise the risk that the Fed will have to then overcompensate by tightening rates very aggressively. This would prompt another recession. U.S.: Not High Pressure Yet, But... No indicator suggests that there is a burning need to quickly ratchet U.S. rates higher. However, domestic economic conditions are falling into place to justify a slow move toward higher rates. Our aggregate U.S. capacity utilization gauge is showing a dissipation of U.S. economic slack (Chart I-2, top panel). This is a side-effect of the tepid growth in the capital stock of U.S. businesses this cycle, which limits the expansion of the supply-side of the economy (Chart I-2, bottom panel). Meanwhile, household consumption should remain robust. Not only did 2015 register the strongest growth in the median household's real income since 1967, consumption is unlikely to slow much. In fact, vehicle-miles traveled and the Federal income tax receipts are both pointing toward healthy consumption (Chart I-3). Despite punky construction starts, housing activity shows signs of improvement. Housing inventories are near record lows and construction has underperformed household formation. Moreover, building permits are hooking upward, while housing affordability remains generous (Chart I-4). Additionally, the NAHB survey also points toward a rising share of residential activity in the economy (Chart I-4, bottom panel). Finally, capex intentions are slowly recovering. Moreover, the BCA House view is that the U.S. profit contraction is past its nadir. Going forward, capex and inventories are unlikely to subtract as much from growth as they did in 2015 and 2016. They may even become accretive to GDP growth. Chart I-2Vanishing U.S. Slack Chart I-3Positive Signs For The U.S. Consumer Chart I-4Residential Investment Will Improve Limited slack and a continued economic expansion imply a high likelihood of a Fed hike this year, and maybe two more next year if no shocks to financial conditions emerge. With markets currently pricing in 65 basis points of rate hikes by the end of 2019, this should lift rates across the curve. Higher interest rates on U.S. assets should drive private inflows into the country, pushing the U.S. dollar higher (Chart I-5). From a technical perspective, the U.S. capitulation index is breaking out to the upside following a pattern of lower highs. Since 2008, such breakouts have been followed by a significant rally in the broad trade-weighted dollar (Chart I-6). Thus, we continue to position ourselves for additional dollar strength this cycle. Chart I-5Flows Into The U.S. ##br##Are Set To Grow Chart I-6Favorable Technical ##br##Backdrop For The Greenback Bottom Line: The household sector remains healthy, and U.S. economic slack is dissipating. Hence, the Fed will try, rightfully or wrongly, to push rates higher this year and next, lifting the dollar in the process. Euro Area: Less Pressure A dollar rally could be painful for the euro. Yet, the euro is cheap and supported by a current account surplus of 3.3% of GDP (Chart I-7). What to do with this conflicting picture? For a currency to embark on a durable bull market, productivity growth needs to be stronger than that of its trading partners. A strong currency makes the tradeable-goods sector less competitive, hampering growth. A positive terms-of-trade shock, like that undergone by commodity producers during the previous decade can also do the trick. Neither of these statements currently describe the euro area. Another avenue for a country to withstand a strong currency is for growth to be domestically driven. If household consumption is the main locomotive, exporters' loss of market share do not hurt activity as much. This is true until the domestic economy enters a recession, an event usually driven by higher policy rates. This is why when the share of salaries in the U.S. economy expands, the dollar undergoes cyclical bull markets (Chart I-8). More salaries in the national income means more consumption. Chart I-7Euro ##br##Supports Chart I-8Domestically-Driven Growth##br## Is Good For A Currency In the euro area, GDP growth is above trend, but, in recent quarters, final private domestic demand has been weak (Chart I-9). In fact, last quarter, net exports were the main contributor to growth. This could explain why, since 2015, stronger European business surveys vis-Ã -vis the U.S. were unable to boost EUR/USD (Chart I-10). Chart I-9European Consumption##br## Isn't Strong Chart I-10If EUR/USD Could Not ##br##Rally Then, When Will It? We do expect eurozone final domestic demand to remain tepid. Yes, the credit impulse has improved, but this amelioration will prove temporary. The previous rebound in credit flows reflected the movement from a large contraction to a small expansion. Today, the dismal performance of euro area bank stocks - which have been a good leading indicator of European loan growth - points to slowing credit growth (Chart I-11). Fiscal policy is also moving from a small positive to a small negative. Work by the ECB staff shows that the cyclically adjusted budget balance in Europe fell by 0.3%, from -1.7% to -2.0% of GDP in 2016. Aggregate cyclically-adjusted budget balances are forecasted to improve to -1.8% and -1.6% of GDP in 2017 and 2018, respectively, representing a 0.2% fiscal drag each year. While a small number, we have to keep in mind that euro area trend growth is between 0.5% and 1%. This suggests that the European economy remains ill-equipped to handle a stronger euro. Moreover, the European economy exhibits much more slack than the U.S. economy. While total hours worked in the U.S. are 14% above Q1 2010 levels, in Europe, they are only 1.5% above such levels (Chart I-12), a gap much greater than demographics alone would have suggested. This means that monetary divergence will continue between Europe and the U.S. Chart I-11Euro Area Credit Impulse Will Weaken Chart I-12Less Capacity Pressures In Europe In fact, this week, the ECB did little to dispel this notion. Beyond trying to squash ideas of a sudden end to the QE program or any imminent tapering, president Draghi communicated that December will be the month when the real action occurs. Based on current trends, we expect the ECB to extend its QE program beyond March, but to hint at a tapering of purchases later in 2017. The ECB will also make it very clear that rates will remain as low as they currently are for an extremely long time. Thus, while the ECB might be slowly moving away from its hyper-stimulative stance, it will not do so as fast as the Fed. Therefore, policy divergences should continue to weigh on EUR/USD. Technicals are also pointing toward a lower euro. Not only has EUR/USD broken down its 1-year old series of higher lows, the euro's capitulation index, the intermediate-term momentum indicator, and the euro's A/D line are forming negative divergences with EUR/USD (Chart I-13). An interesting way to play the euro's weakness is to go short EUR/CZK, a position championed by our Emerging Market Strategy service.1 A floor at 27 has been set under EUR/CZK since November 2013. Yet, this floor looks increasingly untenable. Speculators are beginning to pile in. This week, 2-year Czech yields temporarily dipped below those of Swiss 2-year bonds, the current holder of the world's lowest yield. To fight appreciation pressures, the Czech National Bank (CNB) is accumulating a lot of reserves by buying euros, which is fueling a surge in the money supply (Chart I-14, top panel). Chart I-13Worrying Euro ##br##Technicals Chart I-14CZK: Reserves Expansion##br## Leading To Inflation This accumulation of reserves, in turn, is fanning inflationary forces in the Czech economy. The output gap is closing and core inflation already is increasing at a rate of 1.8% p.a. Easy financial conditions and expanding credit growth are likely to boost already-accelerating unit labor costs and wages (Chart I-14, bottom panel). This means that the 2% inflation target is likely to be hit as early as Q2 2017 according to the CNB. We expect this goal to be handily surpassed if the floor stays in place. Thus, we expect the CNB to abandon the floor within the next twelve months and we are shorting EUR/CZK. Finally, while we are bearish EUR/USD, we do believe that the euro will outperform the pound and commodity currencies. Moreover, despite poorer fundamentals, the euro could also temporarily outperform the SEK and the NOK if the dollar strengthens. The latter two are more sensitive to the USD than the euro is. Bottom Line: EUR/USD is at risk from the broad dollar rally. It is also likely to suffer from the tepid state of the euro area's final domestic demand, fueling monetary-policy divergences with the U.S. A speculative opportunity to short EUR/CZK is emerging, as the CNB's peg is outliving its usefulness. Canada: Falling Pressure USD/CAD has become more correlated with movements in rate differentials than with the vagaries of oil prices (Chart I-15). This puts the actions of the Bank of Canada in sharper focus. As expected, this week, the BoC left policy rates unchanged at 0.5%. More interesting was the quarterly monetary report. The economy has rebounded from the slump induced by the Q2 Alberta wildfires, and many key gauges of the Canadian economy have improved (Chart I-16). Yet, the BoC is looking the other way. Chart I-15CAD: Now More Rates Than Oil Chart I-16The BoC Is Looking The Other Way... The BoC is now forecasting the Canadian output gap to close in mid-2018; in July, this was expected to happen in the second half of 2017. This is because the BoC cut the expected Canadian growth rate by a cumulative 0.5% over the next two years. There have been some worrying developments warranting a more cautious forecast. While the Trudeau government's new childcare benefits are currently being rolled out and new infrastructure spending is to be implemented in 2017, the Canadian private sector's finances are increasingly shaky. The aggregate debt-servicing costs of the non-financial private sector is at record highs, with generous contributions from both households and the corporate sector (Chart I-17). The aggregate credit impulse has responded to this handicap, contracting by 7% of potential GDP, a move driven by the corporate sector (Chart I-18). While not as dramatic, the pace of debt accumulation by the household sector has also weakened. Recent administrative measures to cool the housing market - put in place by various provincial entities as well as the federal government - could accentuate this trend. Chart I-17...Rightfully So Chart I-18Collapsing Canadian Credit Impulse Another problem for Canada has been its loss of competitiveness. Non-oil Canadian exports have not responded as expected to the fall in the CAD. This is because many Canadian manufacturers have set up factories in Mexico and other EMs, or are competing with firms operating out of these nations. With these countries' currencies witnessing devaluations as deep as, or deeper than the loonie's, it is no wonder that Canada has lost market shares in the U.S. (Chart I-19). This means that Canadian rates will remain low for longer, making Canada another contributor to global monetary divergences vis-a-vis the U.S. The BoC is right to be worried that the Canadian economy will take longer than anticipated to close its output gap. With the pass-through to inflation of a lower CAD dissipating, the BoC expects Canadian core inflation to remain well contained for the next two years. We see little cause to disagree. This means that despite trading at a premium to PPP, USD/CAD has upside. Moreover, the Canadian dollar's A/D line is rolling over, another factor pointing to upside for USD/CAD (Chart I-20). At this point, the biggest risk to our view is oil. If WTI can breakout above $52 - perhaps in response to an as-yet negotiated OPEC/Russia oil-production cut or freeze - this could mitigate the downside for the CAD. Thus, while we like USD/CAD, we think the CAD has upside against the AUD and the NZD, especially as the loonie is less sensitive to the USD and EM spreads than the two antipodean currencies. Chart I-19Canada Is Losing Competitiveness Chart I-20Falling CAD A/D Line Bottom Line: The Canadian economy is showing surprising signs of underlying weakness. With the CAD having recently been more correlated to rate differentials than to oil, USD/CAD could rally on monetary divergences. That being said, on the back of a strong USD, CAD is likely to outperform the AUD and NZD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report, "Central European Strategy: Two Currency Trades", dated September 28, 2016, available at ems.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Policy Commentary: "The risks have changed in terms of overshooting what I think is full employment with implications for potential imbalances...Those imbalances might result in a reaction by the Fed that we end up having to tighten more quickly than I would like" - FOMC Voting Member Eric Rosengren (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Policy Commentary: "An abrupt ending to bond purchases, I think, is unlikely...We remain committed to preserving a very substantial degree of monetary accommodation" - ECB President Mario Draghi (October 20, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Policy Commentary: "Since the employment situation has continued to improve, no further easing of monetary policy may be necessary... at any rate, I would like to discuss this thoroughly with other board members at our monetary policy meeting" - BoJ Board Member Yutaka Harada (October 12, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Policy Commentary: "Our judgment in the summer was that we could have seen another 400,000-500,000 people unemployed over the course of the next few years...So we're willing to tolerate a bit of overshoot in inflation over the course of the next few years in order to avoid that situation, to cushion the blow" - BOE Governor Mark Carney (October 14, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Policy Commentary: "We have never thought of our job as keeping the year-ended rate of inflation between 2 and 3 percent at all times...Given the uncertainties in the world, something more prescriptive and mechanical is neither possible nor desirable" - RBA Governor Philip Lowe (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Policy Commentary: "There are several reasons for low inflation - both here and abroad. In New Zealand, tradable inflation, which accounts for almost half of the CPI regimen, has been negative for the past four years. Much of the weakness in inflation can be attributed to global developments that have been reflected in the high New Zealand dollar and low inflation in our import prices" - RBNZ Assistant Governor John McDermott (October 11, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Policy Commentary: "Given the downgrade to our outlook, Governing Council actively discussed the possibility of adding more monetary stimulus at this time, in order to speed up the return of the economy to full capacity" - BoC Governor Stephen Poloz (October 19, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Policy Commentary: "[On the effects of low interest rates on the housing market]...If you look at the recent past, the dynamics have been a bit more reassuring...[still]let's not forget, this disequilibrium that we have achieved remains very high" - SNB Vice-President Fritz Zurbruegg (October 12, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Policy Commentary: "A period of low interest rates can engender financial imbalances. The risk that growth in property prices and debt will become unsustainably high over time is increasing. With high debt ratios, households are more vulnerable to cyclical downturns" - Norges Bank Governor Oystein Olsen (October 11, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Policy Commentary: "[On Sweden's financial stability]...it remains an issue because we are mismanaging out housing market. Our housing market isn't under control in my view" - Riksbank Governor Stefan Ingves (October 27, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Our protector portfolio is a combination of assets that have a low or negative correlation with equities that give investors some downside protection. Replacing cash and/or Treasuries with our protector portfolio in 60-30-10 or 60-40 benchmark portfolios would have produced superior returns since 2011. We continue to advocate allocating investments to our protector portfolio in the near term as it represents an effective hedge against immediate risks such as a negative market reaction to the upcoming elections and/or disappointing third quarter profits. Feature Both equities and bonds are under pressure, as a higher likelihood of a December interest rate hike is beginning to be priced in at the same time as nervousness about Q3 earnings results has intensified. This confluence of factors - less liquidity and earnings disappointment - has been the central argument of our defensive portfolio stance for some time: any handoff from liquidity to growth would be shaky, and potentially premature. Indeed, as we wrote in the September 26 Weekly Report, liquidity conditions will largely remain favorable for risk assets for some time because even with a December rate hike, interest rates are well below equilibrium, i.e. are not restrictive. However, equity investors will suffer through bouts of earnings disappointments, similar to the chronic disappointment in GDP growth. As we show in Chart 1, throughout the economic recovery, expectations for economic growth have been revised lower and are only now finally in line with what we expect is close to reality. As highlighted in last week's report, investors' expectations about earnings are most likely to undergo the same fate because profit margins will remain a lasting headwind: investors have not yet adjusted to this new reality (Chart 2). That will hold equity gains to low single digits, at best. Chart 1Years Of One-Way (Down) Revisions Chart 2Earnings Set To Disappoint? Overall, our view is that the economic backdrop is stable as there are low odds of a recession-inducing monetary tightening occurring, and we do not see any other negative shocks that are concerning enough to trigger a recession. Still, above and beyond our worry about profit disappointments, many client queries are currently focused on U.S. election risks. On September 26, we warned of market volatility leading up to the election, since investors may continue to assign too low odds of a Trump Presidential win. However, we would expect markets to quickly recover - at least until Trump reveals his true policy colors. We took a page from the market reaction to Brexit as a possible guideline to the outcome of Trump winning the election, i.e. the election is ultimately won by a non-status quo candidate. Investors will recall that the post-vote U.K. equity market reaction to Brexit was short-lived but savage. However, the uncertainty around the upheaval of institutions and structures in the euro area and the U.K. are far greater than the election of a non-conformist U.S. President within an institutionally sound system with checks and balances. All of that said, we recognize that we could be wrong and that the U.S. election has taken over the pole position on investors' list of concerns. More specifically, investors are worried about negative financial market fallout from a Trump win.1 So, how should investors hedge the downside risk of these election results? And for that matter, what about other near-term risks? Protector Portfolio Explained This publication has been advocating for some time that investors hold some portion of their capital in a protector portfolio (currently a combination of TIPS, gold and the U.S. dollar). The goal is to find assets with a low or negative correlation to U.S. equities and offer a measure of protection against a steep selloff in stocks. As Chart 3 shows, a portfolio of 60/30/10, where 10% is placed in the protector portfolio, would have outperformed a traditional 60/30/10 allocation in which the 10% is held in straight cash since 2011 (in a ZIRP world). A 60/40 allocation where 40% is placed in the protector portfolio also beats a 60/40 stock/Treasury allocation since 2011. Chart 3Protector Portfolio Enhances Performance ##br## Since 2011 Chart 4Protector Components Are ##br## Negatively Correlated With S&P 500 The three assets included in our protector portfolio were chosen with specific risks in mind: USD: As the main global reserve currency, the U.S. dollar benefits when global risk aversion is on the rise. Admittedly, when fears have emanated from U.S. soil, the dollar has performed less well compared to other safe-haven assets, such as the Swiss franc and/or Swiss bonds. Nonetheless, for U.S. investors, investing in one's home currency can provide a natural hedge/advantage. In Chart 4, we show the one-year correlation between USD and S&P 500 equity returns. Since 2009, the correlation has been negative and the implication is that by holding USD, investors are already implicitly defensive. Gold: Gold traditionally does well in times of extreme geopolitical uncertainty and also as a hedge against inflation. More recently, gold has done less well as a hedge because the negative correlation between equity prices and gold broke down from 2011 until earlier this year (Chart 4). Gold has once again become negatively correlated with equity prices and we believe it will be an effective safe-haven asset should inflation become a concern. TIPS: Both 10-year TIPS and nominal Treasuries are negatively correlated with U.S. equity returns and both provide some measure of insurance in risk-off periods/phases of economic disappointment. Nonetheless, we prefer TIPS at the moment since they offer a measure of protection against a back-up in inflation expectations (also Chart 4). In sum, our protector portfolio is a combination of assets that are uncorrelated enough with equities to give investors some protection against a range of downside risks. Protector Portfolio: But Beware Buy And Hold Chart 5Protector Buy And Hold Will Not Work As Chart 2 has shown, our protector portfolio has outperformed both a 60-30-10 and 60-40 portfolio in recent years. However, longer -term performance has been less outstanding (Chart 5). Indeed, adding a constant proportion of safe-haven assets to a balanced portfolio over an extended period underperforms the balanced portfolio benchmark for long stretches of time: there are non-negligible costs associated with holding safe-haven assets over prolonged periods. The bottom line is that timing plays a critical part in investing in safe-haven assets. Owning a fixed share of protector portfolio assets over long horizons will not beat a traditional buy and hold strategy, although superior returns over cash offer a compelling case in a NIRP world. We continue to recommend that investors hedge against downside risk in the form of the protector portfolio - or simply by choosing the safe haven that most closely corresponds as a hedge to the specific risk at hand. However, it is important to know that safe-haven assets fall in and out of favor through time and the protector portfolio will at some point no longer be justified, and/or its components will need to be adjusted. For example, only after 2000 did Treasuries start providing a good hedge against equity corrections. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but then became correlated with S&P 500 total returns from 2012-early 2016. That said, gold's coefficient has turned negative again, and it should be viewed as an all-weather safe haven, especially if deflation risks begin to dissipate. The Most Relevant Safe Haven In Case Of A Policy Mistake Chart 6Fed Policy Mistake? Buy Protector Portfolio As we wrote above, our base investment case is that the prospect of less liquidity and the risk of an earnings disappointment mean that investors should keep a defensive portfolio stance and be prepared for pullbacks in equities in the single digits. However, the Minutes of the latest FOMC meeting highlight that a fairly low threshold has been set for a December interest rate rise. If financial market participants interpret incoming economic information more bearishly than the Fed, then a December rate hike risks being perceived by investors as a policy mistake. Under this scenario, risk assets could be set for a much greater fall, buoying the case for further portfolio insurance. Which safe havens will outperform? We take our cue from the market reaction to the December, 2015 rate hike. In that episode, equity prices fell 12%. The protector portfolio in its current configuration2 increased 10%. The bulk of the appreciation was due to a strong run in gold prices (surely helped in part by massive woes in China) and TIPS (Chart 6). We believe that this basket of assets would once again offer an important buffer against equity losses associated with a policy mistake. The Most Relevant Safe Haven For A Trump Win If a Trump win triggers a correction in risk assets, we would expect the U.S. dollar to rally due to Trump policy uncertainty and heightened geopolitical risk. We noted above that USD does not always rally when a stress event occurs on U.S. soil. However, in the past several weeks, the performance of the dollar as well as Treasury yields has been linked to Trump's probability of winning the election. Whenever the odds of a Trump presidency rise, these risk-off assets have appreciated. And The Most Relevant Lessons From The Election Cycle This month's Geopolitical Strategy Special Report 3 provides a final forecast and implications for the elections. As we note above, we agree that a Trump win is a red herring in terms of the key issues investors face. But we also agree with our geopolitical strategists that there are several important lessons from the election cycle that may have long term ramifications for investors. Below, we highlight the most relevant for financial market participants: The median voter has moved to the left on economic policy. Trump's victory over an army of seasoned, relatively orthodox GOP contenders in the primary exposed the fact that the party's grassroots voters no longer care deeply about fiscal austerity and no longer wish to tolerate the corporate incentive for importing cheap labor. Similarly, demographic trends favoring millennials and minorities (who tend to vote left on economic policies), portends a shift by which the GOP attempts to capture left-leaning voters. Fiscal conservatism (and social conservatism, for that matter) will have less to show by way of official party machinery. The 2016 election campaign has amplified the notion that the news media works in narratives. These narratives work as a filter that preempts and distorts the presentation and, to some extent, reception of facts. This phenomenon was influential in Trump's rise - the first "Twitter" candidacy - as well as his recent decline. Investors cannot be too wary of what the mainstream press or financial "smart money" says about any particular political trend or event. It is essential to separate the wheat from the chaff by using empirics and looking at macro and structural factors to identify the constraints rather than the preferences of candidates or politicians. U.S. Economy: Neither Hot Nor Cold The NFIB survey of small business survey ranks as one of our preferred indicators of U.S. business confidence. The employment related indicators serve as a key input into our payroll model; questions about the pricing environment often provide a good leading/coincident gauge about inflation trends, and; as Chart 7 shows, the labor cost versus pricing series provides an excellent leading indicator for the profit margin outlook. The latter remains in a downtrend, reinforcing our message that profit margins will remain a headwind to earnings growth for still some time. Overall, small business optimism has been generally flat this year, after peaking in late 2014. It is somewhat discouraging that "demand" as a most important problem is no longer falling. Consumption has been one of the more robust areas of growth in the past several years and we expect consumption to continue to outshine other areas of the economy. However, even here, the data should be monitored closely. Chart 7Small Business Concerns (Part 1) Chart 8Small Business Concerns (Part 2) Retail sales (excluding gasoline and autos) growth has been slowing throughout 2016 and September data did not buck this trend (Chart 8). Results among retailers varied substantially, with growth strongest at building supply stores, sporting goods stores, vehicle dealers and furniture stores. Laggards include electronics and appliance stores - segments that are still under siege from falling prices. The bottom line is that in aggregate, consumption is holding up reasonably well and should continue to do so, as long as employment gains and modest wage growth remain intact. Stay tuned. Lenka Martinek Vice President, U.S. Investment Strategy lenka@bcaresearch.com 1 Our Geopolitical Strategy service concurs that a Trump win is a red herring, i.e. is unlikely to occur and is a distraction from more relevant issues. For more insight, please see Geopolitical Strategy Monthly Report "King Dollar: The Agent Of Righteous Retribution", dated October, 2016, available at gps.bcaresearch.com 2 At the time, the protector portfolio performed slightly less well, as 30-year government bonds were used instead of TIPS. 3 Please see Geopolitical Strategy Special Report "U.S. Election: Final Forecast & Implications", dated October 12, 2016, available at gps.bcaresearch.com Market Calls
Highlights Recent U.S. economic data have surprised to the upside, raising the odds of a December rate hike. U.S. GDP growth is likely to accelerate further in 2017 on the back of stronger business capex, a turn in the inventory cycle, and a pickup in government spending. Faster wage growth should also support consumption. The real broad trade-weighted dollar will appreciate by 10% over the next 12 months, as the market prices in more Fed tightening. The stronger dollar will pose a headache for U.S. multinationals, as well as emerging markets and commodity producers. However, it will be a boon for Europe and Japan. Global equities are vulnerable to a near-term correction, but the longer-term outlook for developed market stocks outside the U.S. looks reasonably good. Investors should overweight euro area and Japanese equities in currency-hedged terms. Feature Why The Fed Hit The Pause Button When the FOMC decided to hike rates last December, it signaled to investors via its "dot plot" that rates would likely rise four times this year. Ten months later, the fed funds rate remains unchanged. What caused the Fed to stand down? External factors certainly played a role: Fears of a hard landing in China permeated the markets at the start of the year. And just as these worries were beginning to recede, the Brexit vote sent investors into a hurried panic. However, the more important reason for the Fed's decision to hit the pause button is that U.S. domestic activity slowed sharply, with real GDP growing by just 0.9% in Q4 of 2015 and by an average of 1.1% in the first half of 2016. Rays Of Light Fortunately, recent data suggest that the growth drought may be ending (Chart 1): Chart 1Some Bright Spots In the U.S. Data The ISM non-manufacturing index jumped 5.7 points in September, the largest monthly increase on record. The ISM manufacturing index also surprised to the upside, with the new orders index jumping six points to 55.1. Factory orders increased by 0.2% in August, against consensus expectations for a modest decline. Initial unemployment claims continue to decline, with the four-week average falling to a 42-year low this week. The Conference's Board's consumer confidence index hit a nine-year high in September. The University of Michigan's index also rose. The key question for investors is whether the recent spate of good data is just noise or the start of a more lasting improvement in underlying demand growth. We think it's the latter. As we expand upon below, the adverse lagged effects on growth from the dollar's appreciation between mid-2014 and early this year should dissipate, pushing aggregate demand higher. Energy sector capex appears to be stabilizing after plunging nearly 70% since its peak in 2014. Stronger wage growth should also keep consumption demand elevated, even as employment growth continues to decelerate. In addition, fiscal policy is likely to loosen somewhat regardless of who wins the presidential election. Lastly, the inventory cycle appears to be turning, following five straight quarters in which falling inventory investment subtracted from growth. To what extent will better U.S. growth translate into a stronger dollar? To answer this question, we proceed in three steps: First, we estimate the magnitude by which U.S. growth will exceed its trend rate if the Fed takes no action to tighten financial conditions. Our answer is "by around one percentage point in 2017," which we think is considerably above market expectations. Second, we assess the degree to which the Fed will need to tighten financial conditions - via higher interest rates and a stronger dollar - in order to keep inflation from significantly overshooting its target. Third, we consider how developments abroad will affect the dollar. Our conclusion is that the real trade-weighted dollar will likely rise by around 10% over the next 12 months. How Quickly Will Aggregate Demand Grow If The Fed Does Not Raise Rates? As detailed below, a bottom-up analysis of the various components of GDP suggests that real GDP growth could reach 2.5% in the second half of 2016 and accelerate to 2.8% in 2017 if financial conditions remain unchanged from current levels. This would represent a significant step up in growth from the average pace of 1.6% experienced between Q1 of 2015 and Q2 of 2016. While growth of 2.8% next year might sound implausibly high, keep in mind that real final sales to private domestic purchasers - the cleanest measure of underlying private-sector demand - has grown by an average of 3% since Q3 of 2014 and increased by 3.2% in Q2 of this year, the last quarter for which data is available. Consumption Assuming that interest rates and the dollar remain unchanged, we project that real personal consumption will grow by an average of 2.7% in Q4 of this year and over the course of 2017. This is equivalent to the average growth rate of real PCE between Q1 of 2015 and Q2 of 2016, but below the 3% pace recorded in the first half of this year. Granted, employment growth is likely to slow over the coming quarters, as labor market slack is absorbed. Nevertheless, real income growth should remain reasonably robust, as real wages accelerate in response to a tighter labor market. A rough rule of thumb is that a 1% increase in real wage growth boosts real household income by the equivalent of 120,000 extra jobs per month over one full year. Thus, it would not take much of a pickup in wage growth to ensure that consumption keeps rising at a fairly solid pace. In fact, one could see a virtuous circle emerging, where accelerating wage growth pushes up consumption, leading to a tighter labor market, and even faster wage growth. At some point the Fed would raise rates by enough to cool the economy, but not before the dollar had moved sharply higher. This may explain why there is such a strikingly strong correlation between the dollar and labor's share of national income (Chart 2). Households may also end up spending a bit more of their incomes. Faster wage growth, rising consumer confidence, continued home price appreciation, and negative real deposit rates have all given households even more incentive to spend freely. While we do not expect the savings rate to fall anywhere close to the rock-bottom levels seen before the financial crisis, even a 0.5 percentage point decline from the current level of 5.7%, spread out over six quarters, would add 0.4% to GDP growth. Residential Investment Real residential investment dropped 7.7% in Q2 after growing by an average of nearly 12% over the preceding six quarters. The Q2 dip was mainly due to the warm winter, which pulled forward home-improvement spending. Housing activity has recovered since then, with new home sales, single-family housing starts, and the NAHB homebuilders index all at or near post-crisis highs (Chart 3). Chart 2The Dollar Is Redistributing Income Chart 3U.S. Housing Remains Robust The underpinnings for housing continue to look good. The ratio of household debt-to-GDP has declined nearly 20 points from its 2008 high - the lowest figure since 2003 - while the debt- service ratio is back to where it was in the early 1980s (Chart 4). Excess inventories have also been absorbed. The homeowner vacancy rate has fallen to 1.7%, completely reversing the spike experienced during the Great Recession (Chart 5). With household formation picking up and housing starts still 20%-to-25% below most estimates of how much construction is necessary to keep up with population growth, it is likely that housing activity can increase at a reasonably brisk pace over the next two years. We assume that real residential investment will expand by 4% in both Q4 and 2017. Chart 4Household Debt Burdens Have Declined Chart 5The Excess Supply In Housing Has Cleared Business Capex Growth in business capital spending has been falling since mid-2014 and turned negative on a year-over-year basis in the first quarter of this year. Initially, the deceleration in capital spending was largely confined to the energy sector. Since late last year, however, non-energy capex has also weakened sharply (Chart 6). Chart 6Easing In Energy Sector Retrenchment The recent slowdown in business capex reflects three factors. First, the disaggregated data on corporate investment spending indicate that lower energy prices generated a second-round effect on businesses that are not officially classified as being part of the energy space, but that are nonetheless major suppliers to the sector. Second, the stronger dollar hurt the manufacturing sector more broadly, leading to a lagged decline in capital spending. Third, the backup in corporate borrowing spreads that began in May 2014 and the associated tightening in bank lending standards put further downward pressure on business capex. All three of these headwinds have waned over the past few months (Chart 7). The oil rig count has started to recover, suggesting that energy capex should stabilize and perhaps even improve. The dollar and corporate credit spreads have also come down, while loan growth remains robust (Chart 8). Reflecting these developments, core capital goods orders have risen for the past three months. Corporate capex intentions have also perked up (Chart 9). We project that real business capex will increase by 2.5% in Q4 and 3.5% in 2017 if the dollar and interest rates remain unchanged. Chart 7Borrowing Costs Have Fallen Chart 8Solid Loan Growth Chart 9Recent Signs Of Improving Corporate Capex Spending Intentions Inventories Lower inventory investment shaved 1.2 percentage points off Q2 growth. This marked the fifth consecutive quarter that inventories have been a drag on growth - the first time this has happened since 1956. Real inventory levels fell by $9.5 billion at a seasonally-adjusted annualized pace in the second quarter and are likely to be flat-to-slightly down again in Q3. However, since it is the change in inventory investment that affects growth, this should translate into a modestly positive contribution to Q3 GDP growth. Looking further out, firms are likely to start slowly rebuilding inventories as we head into 2017. The economy wide inventory-to-sales ratio is now back near its trend level (Chart 10). Durable goods inventories excluding the volatile aircraft component rose in the third quarter, as did the inventory component of the ISM manufacturing index (Chart 11). We expect inventory restocking to boost growth by 0.1 percentage points in Q4 and 2017, a big improvement over the drag of -0.6 percentage points between Q2 of 2015 and Q2 of 2016. Chart 10Room To Stock Up Chart 11Inventory Rebuilding Has Commenced Government Spending Real government consumption and investment declined by 1.7% in Q2 on the back of lower state and local spending and continued weakness in defense expenditures. The drop at the state and local levels should be reversed, given that tax revenues are trending higher. Federal government spending should also pick up regardless of who wins the presidency. There is now bipartisan support for removing the sequester and increasing infrastructure spending. We are penciling in growth in real government expenditures of 1.5% in Q4 and 2.5% in 2017. Net Exports Net exports shaved 0.8 percentage points off growth in the five quarters spanning Q4 of 2014 to Q4 of 2015. Net exports made a slight positive contribution to growth in the first half of this year. Unfortunately, this was mainly a consequence of sluggish import growth against a backdrop of decelerating domestic demand. Looking out, assuming no change in the dollar index, a rebound in import demand will lead to a modest widening in the trade deficit, which will translate into a 0.2 percentage-point drag from net exports over the remainder of this year and 2017. Putting It All Together The analysis above suggests that the U.S. economy will grow by around 2.5% in Q4 - close to the pace that Q3 growth is currently tracking at - with growth accelerating to 2.8% in 2017. This is a point above the Fed's estimate of long-term real potential GDP growth based on the latest Summary of Economic Projections. How Will The Fed React To Faster Growth? We tend to agree with most FOMC officials who think that the economy is now close to full employment. We also concur that the relationship between inflation and spare capacity is not linear. When spare capacity is high, even large declines in unemployment have little effect on inflation. In contrast, when the labor market becomes quite tight, modest declines in the unemployment rate can cause inflation to rise appreciably. As Chart 12 illustrates, the existence of such a "kinked" Phillips Curve is consistent with the data. Where this publication's view differs with the Fed's is over the question of how much of an inflation overshoot should be tolerated. Considering that the Fed has undershot its inflation target by a cumulative 4% since 2009, a strong case can be made that it should aim for a sizable overshoot in order to bring the price level back to its pre-crisis trend. Most FOMC members do not see it that way, however. This point was reinforced by Chair Yellen at her September press conference when she said that "We don't want the economy to overheat and significantly overshoot our 2 percent inflation objective."1 Chart 13 shows that many measures of core inflation are already above 2%. This suggests that the Fed is unlikely to stand pat if aggregate demand growth looks set to accelerate to nearly 3% next year, as our analysis suggests it will. Chart 12The Phillips Curve Appears To Be Non-Linear Chart 13Some Measures Of U.S. Core Inflation Are Already Above 2% How high will rates go? This is a tricky question to answer because it requires us to know the value of the so-called neutral rate - the short-term interest rate consistent with full employment. Complicating the matter is the fact that changes in interest rate expectations will affect the value of the dollar, and that changes in the value of the greenback, in turn, will affect the level of the neutral rate. This is because a stronger dollar means a larger trade deficit, which necessitates a lower interest rate to keep the economy at full employment. It is a "joint estimation" problem, as economists call it. One key point to keep in mind is that currencies tend to be more sensitive to changes in interest rate differentials when those differentials are expected to persist for a long time. Chart 14 makes this point using a visual example.2 The implication is that most of the tightening in financial conditions that the Fed will need to engineer is likely to occur through a stronger dollar rather than through higher interest rate expectations. Chart 14The Longer The Interest Rate Gap Persists, The Bigger The Exchange Rate Overshoot A back-of-the-envelope calculation suggests that the level of aggregate demand would exceed the economy's supply-side potential by 2% of GDP by end-2019 in the absence of any effort by the Fed to tighten financial conditions.3 We estimate that in order to keep the output gap at zero, the real trade-weighted dollar would need to appreciate by 10% and the fed funds rate would need to rise to 2% in nominal terms, or 0% in real terms. Despite this month's rally, the real broad trade-weighted dollar is still down more than 2% from its January high. Thus, a 10% appreciation would leave the dollar index less than 8% above where it was earlier this year, and well below past peaks (Chart 15). Chart 15Still Far From Past Peaks In terms of timing, a reasonable baseline is that the Fed will raise rates in December and twice more in 2017. This would represent a more rapid pace of rate hikes than what is currently discounted by markets, but would only be roughly half as fast as in past tightening cycles. How quickly the dollar strengthens will depend on how fast market expectations about the future path of short-term rates adjust. In past episodes such as the "taper tantrum," they have moved quite rapidly. This suggests that the dollar could also rise at a fairly fast clip. The Impact From Abroad Chart 16A Stronger Dollar Could Push Up EM Spreads Exchange rates are nothing more than relative prices. This means that developments abroad have just as much of an effect on currencies as developments at home. Given the size of the U.S. economy, better U.S. growth would likely benefit the rest of the world. Could this impart a tightening bias on other central banks that cancels out some of the upward pressure on the dollar? For the most part, the answer is no. Both the euro area and Japan have more of a problem with deflation than the U.S. The neutral rate is also lower in both economies. This implies that neither the ECB nor the BoJ are likely to raise rates anytime soon. Thus, to the extent that stronger U.S. growth buoys these economies, this will translate into somewhat higher inflation expectations and thus, lower real rates in the euro area and Japan. This is bearish for their currencies. The possibility that the ECB will start tapering asset purchases next March, as many have speculated, would not alter our bullish view on the dollar to any great degree. Granted, if the ECB did take such a step without introducing any offsetting measures to ease monetary policy, this would cause European bond yields to rise, putting upward pressure on the euro. However, anything that strengthens the euro would weaken the dollar, giving the U.S. a competitive boost. This, in turn, would prompt the Fed to raise rates even more than it otherwise would. The final outcome would be that the dollar would still appreciate, although not quite as much as if the ECB kept its asset purchases unchanged. As far as emerging markets are concerned, a hawkish Fed is generally bad news. Tighter U.S. monetary policy will reduce the pool of global liquidity that has pushed down EM borrowing costs (Chart 16). And given that 80% of EM foreign-currency debt is denominated in dollars, a stronger greenback could cause distress among some over-leveraged borrowers. To make matters worse, a stronger dollar has typically hurt commodities - the lifeblood for many emerging economies. All of this is likely to translate into weaker EM currencies, and hence, a stronger dollar. Investment Conclusions Today's market climate is similar to the one around this time last year. Back then, the Fed was also gearing up to hike rates. Initially, stocks held their ground even as bond yields edged higher. But then, shortly after the Fed raised rates, the floodgates opened and the S&P 500 fell 13% within the course of six weeks (Chart 17). We are nearing such a precipice again. And, in contrast to earlier this year when the 10-year Treasury yield fell by 70 basis points, there is less scope for the bond market to generate an easing in financial conditions in response to plunging equity prices. The 10-year Treasury yield stood at 2.30% on December 29, just before the stock market began to sell off. Today it stands at 1.74%. Investors should position for an equity correction that sends the S&P 500 down 10% from current levels. Looking out, if U.S. growth does begin to accelerate, that should provide some support to stocks. Nevertheless, a stronger dollar and faster wage growth will weigh on corporate earnings, while stretched valuation levels will limit any further expansion in P/E multiples (Chart 18). Investors should underweight U.S. stocks relative to their global peers, at least in local-currency terms. Chart 17Beware Of A Replay Of The Last Correction Chart 18U.S. P/E Ratios: High, Very High Turning to bonds, while an equity market correction would not cause Treasurys to rally as much as they did in January, the 10-year yield could still touch 1.5% if risk sentiment were to deteriorate. Once the dust settles, however, bond yields will resume their upward grind. Lastly, a stronger dollar will pose a significant headwind for commodities. That said, as we discussed in last week's Fourth Quarter Strategy Outlook, recent cuts to capital spending are likely to generate supply shortages in some corners of the commodity complex.4 BCA's commodity strategists prefer energy over metals and are particularly bullish on U.S. natural gas heading into 2017. Peter Berezin, Senior Vice President peterb@bcaresearch.com 1 Please see "Transcript of Chair Yellen's Press Conference September 21, 2016," Federal Reserve, September 21, 2016. 2 To understand this concept in words, consider two countries: Country A and Country B. Suppose rates in both countries are initially the same, but that Country A's central bank then proceeds to raise rates by one percentage point and pledges to keep them at this higher level for five years. Why would anyone buy Country B's short-term debt given that Country A's debt yields one percent more? The answer is that people would be indifferent between investing in Country A and Country B if they thought Country A's currency would depreciate by 1% per year over the next five years. To generate the expectation of a depreciation, however, Country A's currency would first have to appreciate by 5%. Now modify the example with the only difference being that Country A's central bank pledges to keep rates higher for ten years, rather than five. For interest rate parity to hold, Country A's currency would now have to overshoot its fair value by 10%. The implication is that the longer interest rates in Country A are expected to exceed those in Country B, the more "expensive" Country A's currency must first become. 3 For the purposes of this calculation, we assume that the output gap this year will be -0.5% of GDP and that aggregate demand growth will exceed potential GDP growth by 1% in both 2017 and 2018, with the gap between demand and supply growth falling to 0.5% in 2019 and stabilizing at zero thereafter. The New York Fed's trade model suggests that a 10% appreciation in the dollar would reduce the level of real GDP by a cumulative 1.2 percentage points over a two-year period. A slightly modified Taylor Rule equation implies that an 80 basis-point increase in interest rates on average across the yield curve would reduce the level of real GDP by 0.8 percentage points after several years. We assume that Fed tightening would lead to a flatter yield curve so that short-term rates rise more than long-term yields. 4 Please see Global Investment Strategy Strategy Outlook, "Fourth Quarter 2016: Supply Constraints Resurface," dated October 7, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Consumer products stocks are likely to move to an even larger valuation premium before the cyclical outperformance phase ends.
The August payrolls report did not change our view that a Fed rate hike is likely in December, but not before that.
Investors are being forced into riskier asset classes by the TINA effect, but the gaping macro disequilibria makes it difficult for investors to see how we move back to equilibrium in a benign way. Monetary policy on its own is limited in its ability to soften the adjustment, but the good news is that the political pendulum is swinging toward fiscal stimulus.
The major banks are more willing to lend to the consumer and less willing to lend to the corporate sector.