Economy
Highlights President Trump has the opportunity to influence the Fed much more than past presidents, by virtue of the number of FOMC seats to fill and due to the likelihood that his nominations are likely to be confirmed. It would not be unprecedented for monetary policy to become politicized. In the current environment, the risk is that any loss of independence/politicization of the Fed would lead to higher inflation. Monitoring Trump's nominations will be the best way to gauge whether this is a legitimate worry for financial markets. Inflation will stay sufficiently benign in 2017 so that no more than three rate hikes occur in 2017. Feature Last week, a series of hawkish FOMC speeches caused expectations for a Fed rate hike in March to spike (Chart 1). On Friday, Yellen confirmed that a rate hike is likely in March as long as the data remains sufficiently strong. And Fed Governor Lael Brainard also signaled that a rate hike in mid-March is a high-probability outcome. What makes Brainard's hawkish comments particularly noteworthy is that she is well known to have very dovish leanings. She joins Fed Presidents Dudley and Williams, who also raised the prospect of raising rates this month earlier in the week. Chart 1March Rate Hike Expectations Surge In light of the recent Fed commentaries, our U.S. Bond Strategists now believe that a rate hike in March has a high likelihood. It will take a weak nonfarm payrolls report on Friday to stay the Fed's hand on March 15. As we note on page 7, the sudden hawkish shift to the Fed's rhetoric is somewhat at odds with the recent data, which do not call for any increased urgency to raise interest rates. For this reason, we believe it is premature to revise up the number of rate hikes likely to occur in 2017: we do not expect that economic and inflation performance will warrant a rate hike each quarter. Thus, we do not expect that overly tight monetary policy will be a risk to financial markets this year. This week, we focus on a longer-term threat to the monetary backdrop: the possibility of a more politicized Fed, and the implications for inflation. There has long been a healthy dose of suspicion in Congress about the Fed's role and conduct. But throughout Trump's campaign and now as president, the volume has been turned higher. There are several legislative proposals in recent years that have the potential to be advanced/passed during the next Presidential term: Audit The Fed: Audit the Fed legislation would require the Government Accountability Office (GAO) to audit the Fed's monetary policy decisions. The Fed's financial statements are already audited, and the GAO can examine most other Fed operations, but monetary policy decisions are currently exempt from needing Congress approval. This is the legislation that would be potentially most transformative for monetary policy, since it would subject the Fed to political pressure on monetary policy. Please see discussion below. The FORM Act: A main feature of the Fed Oversight Reform and Modernization Act (FORM) is the so-called Taylor Rule requirement, which would require Fed officials to establish a mathematical formula to guide their interest-rate decisions, and require them to report to Congress if they deviate from the rule. We discussed the Taylor rule and the FORM Act in Detail in the February 13th Weekly Report (Chart 2). The bill also would allow the GAO to audit the Fed's policy decisions; widen membership of the Fed's rate-setting committee; require the Fed Chair to testify more frequently; and place new restrictions on the Fed's emergency lending powers. Chart 2 landscapeA "Rules-Based" Fed Would Be A Tighter Fed Following a mechanical rule would severely limit the Fed's flexibility in determining the appropriate path of monetary policy. Bailout Prevention Act: This measure is designed to curtail the Fed's powers to lend to financial firms in an emergency. The 2010 Dodd-Frank law put some restrictions in place, but lawmakers on both sides of the aisle aren't satisfied the Fed has taken the necessary steps to implement those restrictions. Chart 3WWII Policy Expansion The Fed's ability to respond during crisis would henceforth be limited. Fed Capital Stock: This measure aims at requiring the Fed to pay back capital that banks paid to be members of the Fed system. The bill was introduced in 2015 after Congress voted to lower the dividend the Fed pays banks on that capital to help pay for federal highway programs. All of the above legislation will, if passed, have an impact on financial assets. However, Audit The Fed threatens to be by far the most transformative: as we discuss below, a slippage of independence of the U.S. monetary authority would have long-term consequences for the ability of policymakers to control inflation. At The Intersection Of The Fed And The Treasury: Inflation The Federal Reserve is part of the public sector. Its "chief executive" is a government appointee, and politicians have the power to legislate changes to central banks' structure, responsibilities, and mandates. Independence generally is interpreted as meaning that central bankers are free to conduct day-to-day monetary policy without any interference or influence from politicians, i.e. they have operational independence, not legal independence. It was not until The Banking Act of 1935 that the Treasury Secretary and the Comptroller of the Currency were removed from the Fed's governing board.1 The main argument for an independent central bank is that money supply decisions should be made independent of the political process. In other words, monetary policy should not be influenced by short-term political considerations. This is especially true for indebted economies: when debt/GDP levels are rising, the temptation for governments to fix government balance sheets via inflation grows. Indeed, it is not a coincidence that episodes of proximity between centrals and government coincide with periods of inflation, and that these periods almost always occur after periods of fiscal largesse (Chart 3). It would not be unprecedented for monetary policy to become politicized. During WWII, the Fed played an important role in financing defense-bloated budget deficits. And during the Nixon era, Chairman Arthur Burns was justifiably accused of running an overly-expansionary policy to aid the re-election prospects of the President (Chart 4). At a speech last week to a joint session of Congress, President Trump took a more conciliatory tone than in the past on all facets of governing, and did not even mention the Federal Reserve. There were few details on his plans, but the President's repeated mention of infrastructure and "national rebuilding" highlights that an infrastructure spending bill will happen. A major jump in defense spending also appears assured, as are tax cuts for the corporate and household sector. Of primary concern is how the current Administration will choose to finance its fiscal expansion. The temptation to finance higher deficit spending with easy money may be too great. Moreover, with so many vacant spots to fill on the FOMC, it might be far easier to align the Fed with Trump's interests than passing new legislation. Chart 4Impact Of Monetary Shifts Diluting Independence Through The Back Door The discussion on pages 2-3 focused on a potential loss of independence of the Fed via the legislative process. But passing Audit The Fed and other similar bills require a supermajority (60 votes) in the Senate. In January of last year, the Audit the Fed bill could not cross that hurdle. The easier route to bringing the Fed closer in line with the Treasury may simply involve staffing decisions. Recall that the FOMC committee is made up of seven Federal Reserve governors plus five regional Fed Presidents. FOMC members are nominated by the U.S. President and confirmed by the Senate. The full term of a Governor is 14 years and appointments are staggered so that one term expires each even-numbered year. In theory, only one new voting member should be replaced every second year. However, over the course of 2015/16, Obama delayed making nominations. Subsequently, his nominations were not approved by the (Republican) Senate. There are currently three Governor positions available (out of the possible seven). Two vacancies have existed since 2014, and Daniel Tarullo has resigned, effective April 5, 2017. Of the voting regional Fed Presidents, two (Atlanta and Richmond) will be replaced by mid-2018. Regional Fed Presidents are chosen by the Federal Reserve Bank's board of directors and these directors are representatives from member banks. Thus, the President does not have sway over the two Regional bank replacements. However, it is quite likely that the current Vice-Chair Stanley Fischer will retire at the end of his term in June 2018, as possibly Janet Yellen will as well, thus giving President Trump the opportunity to choose a majority of FOMC voting members by the middle of 2018. There is tremendous potential for Trump to put his stamp on the Federal Reserve. What could a Trump-induced Fed look like? There are plenty of names that are circulating. In the Box 1 on page 9, we provide a shortlist of possible candidates. Note that the candidates we list are what we classify as "typical" FOMC nominations. That is, their backgrounds and CVs fit the profile of recent FOMC members. Of course, these members range in hawkishness/dovishness, and so picking a few that rate more hawkishly (dovishly) could speed up (slow down) the march toward higher rates. It is worth noting that our list of candidates are Republican and, based on their track record, would favor a more hawkish bias. A bigger risk to financial markets is that Trump chooses multiple members outside of this pool of candidates, as this would mark a departure from the status quo/inject uncertainty. After all, the President has not shown a particular appreciation for economists in general. For example, President Trump has delayed appointing a Chair to the Council of Economic Advisers and has made it clear that in any case, the Chair will not be part of the President's cabinet (breaking the seven-decade tradition). A diversity of thinking could be a good thing, as one or two new voices would surely bring new ideas and perspectives to the Fed. But we see two major issues. First, six new board members over the next year or so will represent a tremendous changing of the guard at one time. If the President chooses to look outside traditional candidates to fill the majority of the vacant seats, then the FOMC committee is likely to lack experienced policymakers. Politics aside, by 2018, it is possible that only four of the twelve voting FOMC members will be veterans on the committee. Second, as we mentioned above, past presidents have not had to deal with the same temptation to meddle in monetary policy: Trump has been handed the opportunity to influence the Fed much more than past presidents, by virtue of the unprecedented number of FOMC seats to fill and the likelihood that his nominations are likely to be confirmed. Whether he decides to do so is unclear, but it is a risk that investors should bear in mind. A melding of powers between the Treasury and the Federal Reserve, should it occur, would be a very powerful structural inflationary force and would be a regime shift from the past couple of decades. Monitoring upcoming appointments over the next several months will help to understand to what extent this is a legitimate risk. Note, however, that for the year ahead, our view of inflation is unchanged; we simply do not believe that the U.S. economy is facing enough supply constraints to generate meaningful inflation pressures. Last week's data reinforces our view. Economy Update: Goldilocks, Continued Last week's major data releases supports our view of an economy that is running neither too hot nor too cold. True, the monthly rise in core PCE (0.3%) was strong, but once again, was driven by only a few components and does not represent broad-based inflation pressures (Chart 5). In particular motor vehicle and apparel prices shot higher, but our diffusion indicator, which measures the number of components with rising versus falling inflation rates, fell into negative territory. It is now widely known that over the past three years, U.S. government statistics softened systematically in the first quarter of the calendar year, while inflation reports tend to be strong in the opening months of the year. Recent consumer spending data continue to follow this yearly trend; PCE spending was on the soft side. We are not overly worried about this weak number, as the bulk of data from other sources continues to paint a much more upbeat picture. For example, the ISM manufacturing and services surveys ticked higher again in February (Chart 6). Respondents' comments were very upbeat. 17 out of 18 industries reported growth, and importantly, the more forward looking component of the survey - new orders - shot higher to near cyclical highs. Chart 5Benign Inflation Outlook Intact Chart 6Economic Momentum Intact In sum, the recent economic data reports continue to point to continued economic expansion. Q1 data disappointments have become the norm, but we continue to expect the economy to achieve real GDP growth greater than 2.5% in 2017. The bond market now expects the Fed to raise interest rates in March; Fed communication has certainly turned in that direction over the past few days. Although the timing of the next rate hike could indeed be pushed forward to March, our economic forecast for 2017 implies that more than three rate hikes this year is still unlikely. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 For more historical background on the politicization of monetary policy, please see Bank Credit Analyst Special Report "The Politicization Of Monetary Policy: Should We Care?," April 15, 2013. Box 1 Potential New FOMC Members President Trump's view of the Fed appears to be flexible - he has expressed a wide range of opinions about the central bank and its Chair. Unlike Trump's inconsistent views about interest rates, he has been more steady in his belief that Fed positions should be filled by Republicans. Our bias is to expect President Trump's Federal Reserve nominations to be a greater mix of traditional versus non-traditional central banking profiles. Below, we present a shortlist of mainstream Republican economists that may fill a vacancy on the FOMC. It is worth highlighting that a majority of these names have a hawkish bias, which could help mitigate the risk of a more politicized Fed being inherently more inflationary. Our list is by no means exhaustive. John Taylor (Hawkish bias): Taylor is most widely known for The Taylor Rule. He has recently criticized the Fed for being behind the curve, although has not explicitly advocated for a policy change. He also served as Under Secretary of Treasury for International Affairs from 2001 to 2005. Kevin Warsh (Hawkish bias): A former Morgan Stanley banker (and BCA Conference speaker!) has been forthright with his views that higher interest rates would actually be good for the U.S. economy. Glenn Hubbard (Neutral): Hubbard is Dean of Columbia Business School and has advocated a "wait and see" approach for monetary policy in face of current fiscal uncertainty. Hubbard headed the Council of Economic Advisers under the Bush Administration. Tom Hoenig (Hawkish bias): Hoenig is current FDIC Vice-Chair and former Kansas City Fed President. In the latter position, he was a voting member of the FOMC. Throughout 2010, Hoenig was the lone dissenter on the committee, voting always in favor of a rate hike and for the Fed to move away from ultra-accommodative policy. He is also a harsh critic of "too big to fail".
Highlights In this week's report, we update the "Three Controversial Calls"1 we made at BCA's New York Investment Conference held on September 26-27th, 2016. Call #1: "Trump Wins, And The Dollar Rallies." We still see 5% more upside for the greenback. Call #2: "Japan Overcomes Deflation." Inflation expectations have moved higher over the past five months, while the yen has weakened. This trend will persist. Call #3: "Global Banks Finally Outperform." Bank shares have beaten their global benchmark by 14% since we made this prediction. European financials have finally turned the corner. Feature Call #1: "Trump Wins, And The Dollar Rallies" Chart 1From Unrealistic To Even More Unrealistic We never bought into the notion that a Trump victory would cause investors to flee the dollar. On the contrary, we argued that most of Trump's policies were bond bearish/dollar bullish. In particular, we reasoned that Trump's attempts to browbeat companies into moving production back home would help reduce the U.S. trade deficit, boosting aggregate demand in the process. Efforts to curb illegal immigration would also push up the wages of low-skilled workers. Meanwhile, fiscal stimulus would fire up the labor market at a time when it was already approaching full employment. Fiscal Deficit On Upward Path With nearly four months having passed since the election, what have we learned? First, and foremost, a big increase in the budget deficit still looks likely. As Trump's address to the joint session of Congress on Tuesday night underscored, the president has plenty of specific areas in mind where he would like to increase spending (more money for defense, infrastructure, etc.) and a long list of taxes he would like to cut (corporate and personal income taxes, estate taxes, a new childcare tax credit,2 etc.). We do not take seriously Trump's pledge to pay for increased military spending by cutting annual nondefense discretionary spending by $54 billion relative to the existing CBO baseline. Chart 1 shows that under current budgetary rules, nondefense discretionary spending is set to decline from 3.3% of GDP in 2016 - already close to a historic low - to only 2.7% of GDP in 2026. Cutting that portion of the budget above and beyond what has already been legislated is unrealistic. There simply aren't enough programs like the National Endowment for the Arts that Republicans can take to the woodshed without facing a severe political backlash (Chart 2). As long as big ticket entitlement programs such as Social Security and Medicare remain unscathed - which Treasury Secretary Steven Mnuchin confirmed would be the case earlier this week - overall government spending will rise, not fall. Chart 2Nondefense Discretionary Spending: Where The Money Goes Trump And Trade The one category where Trump would be more than happy to see taxes go up is on imports. The constraint here is political. A unilateral move to legislate large-scale import duties would be in gross violation of WTO rules and could spark a global trade war. Many of Trump's Republican colleagues, as well as a fair number of Democrats, also favor free trade and would resist such an effort. One solution that Trump vaguely alluded to in his speech is to raise duties on imports within the context of a broader tax reform bill. A border adjustment tax, for example, would bring in $1.2 trillion in revenues over ten years.3 As we argued in a Special Report earlier this year, the introduction of a BAT would be highly dollar bullish.4 Pulling Back The Welcome Mat? On immigration, Trump has sent mixed messages. On the one hand, he continues to insist that he will build "the wall" and has maintained his hardline stance on refugee policy. On the other hand, he has backed off his campaign promise to reverse Obama's executive order protecting the so-called "dreamers." This order allows immigrants who came to the U.S. illegally as children to remain in the country indefinitely, provided they do not commit a serious criminal offence. During his speech, Trump signaled a willingness to shift the U.S. immigration system towards one based on merit, similar to what countries such as Canada and Australia already have. This is an excellent idea, but it raises the question of what will happen to the 11 million illegal aliens currently residing in the country, the vast majority of whom are poorly educated. It is important to remember that U.S. immigration laws are already very strict. Trump has given the U.S. Immigration and Customs Enforcement agency (ICE) greater leeway in enforcing these laws, while also pledging to hire 5,000 more border agents and 10,000 additional ICE officers. As such, a "status quo immigration policy" under Trump could prove to be much more restrictive than the one under Obama even if no new legislation is passed. A key implication is that labor shortages in areas such as construction and hospitality services may intensify. Solid U.S. Growth Outlook Favors A Stronger Dollar Meanwhile, the U.S. growth picture remains reasonably bright (Chart 3). This may not be obvious from current Q1 tracking estimates, which are pointing to real GDP growth of below 2%. However, the weak Q1 numbers are mainly due to an unexpectedly large jump in imports and a sharp decline in inventory accumulation. According to the Atlanta Fed's model, taken together these two factors have shaved a full percentage point off growth. Real private final demand is still rising at nearly 3% (Chart 4). If U.S. growth stays solid as we expect, the Fed will raise rates three or four times this year, starting in March. This is slightly more than the market is currently pricing in, which should be enough to ensure that the trade-weighted dollar strengthens by another 5% or so over the remainder of the year (Chart 5). We see the greatest upside for the dollar versus EM currencies, and as we discuss next, against the yen. Chart 3U.S. Economic Data Are Upbeat Chart 4Trade And Inventories Detract From ##br##A Bright Q1 Growth Picture Chart 5Real Rate Differentials Are ##br##Driving UpThe Dollar Call #2: "Japan Overcomes Deflation" Many of the forces that have exacerbated deflation in Japan, such as corporate deleveraging and falling property prices, have run their course (Chart 6). The population continues to age, but the impact that this is having on inflation may have reached an inflection point. For most of the past 25 years, slow population growth depressed aggregate demand by reducing the incentive for companies to build out new capacity. This generated a surfeit of savings relative to investment, helping to fuel deflation. Now, however, as an ever-rising share of the population enters retirement, the overabundance of savings is disappearing. The household saving rate currently stands at 2.8% - down from 14% in the early 1990s - while the ratio of job openings-to-applicants has soared to a 25-year high (Chart 7). Chart 6Japan: Easing Deflationary Forces Chart 7Japan: Low Household Saving Rate ##br##And A Tightening Labor Market Chart 8Investors Still Not Entirely ##br##Convinced Japan Is Eradicating Deflation Government policy is finally doing its part to slay the deflationary dragon. The Abe government shot itself in the foot by tightening fiscal policy by 3% of GDP between 2013 and 2015. It won't make the same mistake again. The Bank of Japan's efforts to pin the 10-year yield to zero also seem to be bearing fruit. As bond yields in other economies have trended higher, this has made Japanese bonds less attractive. That, in turn, has pushed down the yen, ushering in a virtuous circle where a falling yen props up economic activity, leading to higher inflation expectations, lower real yields, and an even weaker yen. Stay Short The Yen Consistent with this narrative, market-based inflation expectations have risen over the past five months. But with inflation swaps still pricing in inflation of only 0.6% over the next 20 years, there is plenty of scope for real rates to fall further (Chart 8). This implies that investors should maintain a structurally short position in the yen. A weaker yen will help boost Japanese stocks, at least in local-currency terms. As a relative play, investors should consider overweighting Japanese exporters versus domestically-exposed sectors. Multinational manufacturers stand to gain the most, as they will benefit from increased overseas sales, while the highly automated, capital-intensive nature of their operations will limit the burden of rising real wages. Call #3: "Global Banks Finally Outperform" Global bank shares have risen by 25% since we made this call, outperforming the MSCI All Country World Index by 14% (Chart 9). The thesis that we outlined five months ago still remains intact (Charts 10 and 11): Chart 9Global Bank Shares Have Bounced Chart 10Factors Supporting Bank Stocks Chart 11Global Banks Are Still Fairly Cheap Improving business and consumer confidence should continue to support credit demand. Stronger economic growth will reduce nonperforming loans. Capital ratios have improved significantly, reducing the risk of further equity dilution. Yield curves have steepened since last summer, which should flatter net interest margins. Despite the run-up in share prices over the past five months, valuations remain attractive. Looking across regions, European banks stand out as being particularly attractive over a cyclical horizon of about 12 months. BCA's European Corporate Health Monitor continues to improve, foreshadowing further progress in mending loan books (Chart 12). The ECB's lending survey indicates that a majority of banks are seeing stronger loan demand (Chart 13). This suggests that credit growth is not about to stall anytime soon. Meanwhile, euro area banks are trading at a miserly 0.8-times book value, which gives valuations plenty of upside. Chart 12Euro Area: Improving Corporate Health Chart 13Euro Area: Banks See Rising Loan Demand Political Risks Chart 14This Will Not Get Le Pen Into The Elysee Palace The risk is that European political developments sabotage this thesis. Our view here is "near-term sanguine, long-term cautious." We continue to think that populism is in a long-term secular bull market. However, unlike in the case of Brexit or Trump, populist leaders in continental Europe will have to wait until the next economic downturn (probably in two or three years) before they seize power. To that extent, the prevailing - though admittedly rather myopic - consensus view is correct: Marine Le Pen will not become president this year. Keep in mind that the National Front underperformed during regional elections in December 2015, just weeks after the terrorist attacks in Paris. Despite a recent uptick in the polls, support for Le Pen is actually lower now than it was back then (Chart 14). As long as the French economy continues to show signs of tentative improvement, the establishment parties will succeed in keeping Le Pen out of power. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. 2 Despite the populist sounding nature of this proposal, the Tax Policy Center estimates that 70% of the childcare credits will go to households earning $100,000 and up. See Lily L. Batchelder, Elaine Maag, Chye-Ching Huang, and Emily Horton, "Who Benefits from President Trump's Child Care Proposals?" Tax Policy Center (February 27, 2017) for details. 3 James R. Nunns, Leonard E. Burman, Jeffrey Rohaly, Joseph Rosenberg, and Benjamin R. Page, "An Analysis of the House GOP Tax Plan," Tax Policy Center (September 16, 2016). 4 Please see Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The supply of U.S. dollar outside America has been curtailed, yet there is large pent-up demand for dollars. This warrants another upleg in the greenback. The Trump administration's desire to shrink America's current account deficit will be very deflationary for the rest of the world, and mildly inflationary for the U.S. Such policies, if adopted, will exaggerate the paucity of U.S. dollars beyond America's borders and lead to notable dollar appreciation. The RMB is at risk because Chinese banks have created too many yuan, and deposit rates in real terms have turned negative as inflation has risen. Our negative view on EM has been and continues to be driven by our outlook on EM/China domestic demand, commodities prices and the U.S. dollar - not growth in advanced economies. Feature In recent weeks we met with clients in Asia and Australia. This week's report addresses some of the more common questions that we were asked to address. Question: You have written about "global U.S. dollar liquidity shortages." Why have these "global dollar shortages" occurred given the Fed expanded its balance sheet enormously from 2008 until 2014? How does one measure "global dollar shortages," and what does it mean for financial markets? By "global U.S. dollar shortages," we refer to deficiency in U.S. dollars outside the U.S., where U.S. dollar supply growth has fallen short of growth in demand for the greenback. We have the following pertinent observations on this issue: U.S. dollar shortages in the global banking system (eurodollar market) can be represented by U.S. banks' and other financial firms' claims on foreigners. This measure has been shrinking since early 2015 (Chart I-1). This corroborates the fact that U.S. banks, prime money market funds and other financial institutions have been unable/unwilling to supply dollars to the eurodollar market. This is consistent with rising LIBOR rates, which still continue to climb. U.S. non-financial entities' foreign assets have also fallen in the past year and a half but they are much smaller than banks and other financial institutions claims. As to U.S. banks' and other financial firms' claims on EM, they have also been shrinking since early 2015 (Chart I-2). Chart I-1Weak Supply Of U.S. Dollars To Rest ##br##Of World By U.S. Financial Institutions Chart I-2Shrinking Supply Of U.S. Dollars ##br##To EM By U.S. Financial Institutions Another way that the U.S. emits dollars to the rest of the world is by running a current account deficit. The U.S. current account deficit as a share of global GDP is now much smaller now than it was before the Great Recession (Chart I-3). This also means a smaller U.S. dollar supply relative to the size of the world economy. On the demand side, the widening in cross currency basis swaps indicates structural demand for U.S. dollar funding among euro area and Japanese investors (Chart I-4). Chart I-3The U.S. Emits Less ##br##Dollars To World Via Trade Chart I-4Pent-Up Demand For Dollars From Japanese ##br##And European Fixed-Income Investors These investors have been opting for exposure to dollar assets due to the higher yield on U.S. dollar fixed-income instruments - but they have been reluctant to take on exchange rate risk. In brief, they have avoided getting long exposure to the U.S. dollar. The reluctance to accept the exchange rate risk by European and Japanese investors means they are not bullish on the dollar. This goes against the widespread opinion among investors that the overwhelming majority of global investors are bullish on the U.S. currency. By hedging the exchange rate risk - in this case the risk of potential greenback depreciation - these investors are giving up a considerable portion of higher yield that they obtain in U.S. fixed-income market. In fact, if these basis swaps continue to widen or remain wide it might make sense for European and Japanese fixed-income investors to buy U.S. fixed-income securities and not hedge the currency risk. If and when these investors stop hedging their exchange rate risk, the U.S. dollar will appreciate versus the euro and the yen. Provided European and Japanese fixed-income investors are sizable players in global fixed income and hence currency markets, they have the potential to make a difference in exchange rate markets. In short, there is potential pent-up demand for U.S. dollars from these European and Japanese institutions. Such a widening in basis swaps is also consistent with the above observations that U.S. banks have been reluctant to take the other side of this trade - i.e., offer U.S. dollars to European and Japanese investors - even though it is a very profitable opportunity. Finally, the drop in EM central banks' foreign exchange reserves reflects demand for U.S. dollars in their economies, primarily in China (Chart I-5). The Chinese central bank has sold U.S. securities to meet mushrooming demand for U.S. dollars from Chinese households and companies. This entails there has been and remains considerable pent-up demand for dollars by mainland companies and households. With respect to the supply of currency, it is important to note that it is up to commercial banks - not the central bank - to create money. Central banks provide liquidity for commercial banks, but it is the latter that creates money.1 In a nutshell, by undertaking QE, the Fed provided reserves for U.S. commercial banks (Chart I-6), yet the latter have been reluctant to create too much money. Banks create money by originating loans and other types of claims. Chart I-5China: Selling U.S. Securities To ##br##Meet Domestic Demand For Dollars Chart I-6The Fed's Balance ##br##Sheet In Perspective U.S. banks have been very conservative in money creation especially outside America. In the U.S., banks shrunk their balance sheets and loans in the 2009-2011 period. That is why the Fed's QE programs have not led to inflation. Notably, U.S. banks' total assets - including bank loans - and broad money (M2) growth have lately rolled over (Chart I-7). This worsens the lingering dollar scarcity outside the U.S., which should in turn prop up the value of the dollar. The reasons why U.S. banks and financial institutions have been conservative is due to their own deleveraging objectives and because of regulatory changes in the financial industry. In regard to interest rates, U.S. nominal and real (inflation-adjusted) interest rates are very low yet they are high relative to European and Japanese real rates (Chart I-8). Given a relatively tight labor market, odds are that U.S. interest rate expectations will rise further in both absolute and relative terms. This will cause the dollar to appreciate. Chart I-7U.S. Banks Control ##br##The Supply Of U.S. Dollars Chart I-8U.S. And German ##br##Inflation-Adjusted Interest Rates Bottom Line: The pace of supply of dollars beyond the U.S. is falling short of growth in demand for this currency. Typically, this warrants greenback appreciation. Question: What about the U.S. administration's preference for a weaker dollar to improve America's trade position? Won't the greenback depreciate as the Trump administration expresses its desire for a weaker currency? Certainly U.S. officials can verbally influence the exchange rate and drive markets for a (short) period of time. Yet fundamentals and flows will re-assert themselves and the greenback will ultimately appreciate even if its rally is delayed by policymakers. The new U.S. administration intends to run mercantilist policies to create jobs in America and doing so will shrink the current account deficit. Nevertheless, a narrowing U.S. current account deficit ultimately entails diminishing flows of U.S. dollars to the rest of the world, which is bullish for the greenback. In brief, the U.S. administration can delay the dollar rally, but it will not be able to prevent it if and when it shrinks the U.S. current account deficit. This will be enormously deflationary for the rest of the world and ultimately for the global economy. The supply of dollars outside U.S. borders will become even more dearth. As their exports tumble, manufacturing-heavy Asian and European economies will have to run even more stimulative policies - reduce their real interest rates further - to offset such a deflationary shock to their economies. In the case where the Trump administration successfully manages to weaken the U.S. dollar, the ensuing boost to U.S. manufacturing and employment will be mildly inflationary given the already relatively tight labor market. Thereby, trade protectionism or policy-driven currency depreciation, if these occur, will lift U.S. inflation and U.S. interest rates will go up. Rising U.S. interest rates and lower interest rates throughout the rest of the world will propel the dollar's value higher. On the whole, in the case of U.S. trade restrictions, the exchange rates have to adjust to mitigate deflation in the rest of world and cap inflation in America. This ultimately entails a stronger U.S. dollar and weaker currencies abroad. A final note on exchange rates valuation. Based on unit labor costs, the U.S. dollar is not yet expensive (Chart I-9A). The same measure for other currencies is also shown in Chart I-9A and Chart I-9B. Chart I-9AReal Effective Exchange ##br##Rates Based On Unit Labor Costs Chart I-9BReal Effective Exchange ##br##Rates Based On Unit Labor Costs Financial markets tend to overshoot and undershoot before a major trend reversal. We believe the U.S. dollar is in a genuine bull market and will likely become more expensive before topping out. Bottom Line: The U.S.'s desire to shrink its current account deficit is very deflationary for the rest of the world. Such policies, if adopted in the U.S., will exaggerate the scarcity of U.S. dollars beyond America's borders and lead to notable dollar appreciation. Question: The RMB/USD exchange rate has been stable lately. Does this mean the authorities have reasserted their control over the exchange rate and will not allow it to depreciate? The authorities in China have partial and temporary control over the exchange rate. Ultimately, it will be Chinese households and companies that drive the exchange rate, barring full-out government controls over all export/import transactions, money transfers as well as financial and capital account flows. If mainland households and companies opt to convert a small portion of their liquid savings (deposits at banks) into foreign currency, there is little the authorities can do to defend the RMB, barring a complete closing of balance-of-payments transactions to companies and households. The primary risk to the yuan exchange rate is not currency valuation but an overflow of yuan in the system - i.e., excess supply of RMBs is the main factor that will cause currency depreciation. Unlike U.S. banks, Chinese banks have created too many yuan. Broad money (M2) in China has risen from RMB 48 trillion as of December 2008 to RMB 158 trillion currently - i.e., it has surged by 3-fold. M2 has risen from 150% to 210% of GDP in the past eight years (Chart I-10). In the meantime, the ratio of foreign exchange reserves to M2 has dropped to 14% (Chart I-11). Chart I-10Chinese Banks Have ##br##Created Too Many Yuan Chart I-11China: Foreign Reserves Are ##br##Small Relative To Money Supply The latter ratio implies that if Chinese companies and households decide to convert 14% of their deposits at banks into foreign currencies and the People's Bank of China (PBoC) sells its international reserves to offset it, the latter will simply evaporate. We are not suggesting this will actually happen. The point to emphasize is that mainland banks have created so much money that even the country's US$ 3 trillion foreign exchange reserves are not sufficient to back those deposits up. Chinese households and companies may already be sensing there is too much in the way of RMBs floating around, and intuitively may not trust the currency. They have paid astronomical multiples for real assets like property in China, and have recently been willing to shift assets into foreign currencies/assets. Importantly, the one-year deposit rate at banks is 1.5% in nominal terms but in real terms it has now become negative as inflation has picked up. Chart I-12 (top panel) demonstrates that the deposit rate deflated by core inflation is negative for the first time in the past 10 years. The bottom panel of Chart I-12 shows that the deposit rate deflated by headline CPI inflation is also negative. Interestingly, any time the real deposit rate turned negative in the past, the central bank hiked interest rates. It is impossible to know whether the latest pick up in China's inflation represents a temporary spike or is the beginning of a major and lasting uptrend (Chart I-13). We are surprised by how fast and sharply inflation has risen lately, given the growth improvement has so far been modest. Chart I-12China: Real Deposit ##br##Rates Have Turned Negative Chart I-13China: Inflation ##br##Is Rising, For Now The trillion- dollar question is what is the true output gap in China and, correspondingly, whether the latest rise in inflation is genuine and lasting or simply a statistical aberration. No one including Chinese policymakers knows the answers to these very essential questions. What type of adjustment China embarks on depends on monetary policy and banks in China. As and if Chinese banks slow down money creation, economic growth will tumble and deflationary tendencies will resurface. This scenario is good for creditors - households and companies with large amounts of deposits - because deposit rates in real terms will rise again. Yet this is a bad outcome for indebted companies, capital spending and employment. If mainland banks continue to create money at a double-digit pace as they have been doing, inflation will likely become persistent and durable. These dynamics are positive for debtors as real borrowing costs will drop further/stay negative, and growth will hold up. However, in such a case, negative real rates will buttress capital outflows and pressure the value of the RMB. By and large, the Chinese authorities are facing a profound choice: Policymakers can choose to help debtors (indebted companies) by accommodating continuous money supply expansion by banks, i.e., opt for negative real interest rates. The outcome will be much stronger downward pressure on the RMB. The latter will depreciate at a double-digit pace annually in the next several years. They can opt to force the banking system to slow down the pace of money/credit creation. This will lead to some sort of debt deflation. Money growth and inflation will drop and the currency will not be at a risk of major depreciation. Yet, economic growth/profits/employment will tumble. A third choice for the authorities is to resort to full-out government controls over all trade, transfers as well as financial and capital account transactions - i.e., take the country back to socialism. Only in such a case can the authorities control the exchange rate and interest rates simultaneously - i.e., they can inflate the credit bubble away while preventing households from converting their liquid savings into foreign currency. In brief, this entails financial repression, and it will erode the real value of Chinese deposits. It is not clear to us whether this is a politically more viable option than allowing some bankruptcies/layoffs and debt deflation. Besides, this will devastate China's vibrant private sector as businessmen and high-income employees become reluctant to invest and expand as they observe the real value of their savings/wealth decline. Chart I-14U.S. Dollar And Commodities ##br##Prices Unusual Decoupling As if there were not enough domestic challenges, Chinese policymakers are also facing a hawkish Trump administration on the issue of trade and the exchange rate. Putting it all together, we conclude it will be extremely difficult for the Chinese authorities to navigate through these challenges. One area where we disagree with many investors is that the Chinese authorities have a viable plan and strategy. Given the above constraints, there are no easy choices and it is hard to know which route the Chinese government will take. The latest bout of stability in the RMB has been due to a notable shutdown in outflows. Yet this is a temporary solution. The inability to convert liquid savings into foreign currency will only make households and companies more set on converting their yuan. Odds are that capital outflows will skyrocket on any relaxation of recent harsh restrictions. Bottom Line: In any country, the monetary authorities cannot simultaneously control the price of money (interest rates), the quantity of money, and thereby the exchange rate. This will prove to be true in China too. We continue betting on further RMB depreciation. Question: Why do you not think this commodities rally has further to go, given supply has been curtailed and demand is picking up as global growth improves? The strength in commodities prices in recent months when the U.S. dollar has been firm is a major departure from historical correlations (Chart I-14). Remarkably, oil forward prices have recently dropped and global energy share prices have relapsed in absolute terms, even though the spot price has held up (Chart I-15). This foretells that the marketplace does not believe in the sustainability of the current spot price level of crude. As to industrial metals, our hunch is that Chinese demand will weaken again as the nation's credit and fiscal impulse relapses (Chart I-16). Besides, the recent resilience in copper has been due to supply disruptions that may be temporary. Chart I-15Has Sell Off In Oil Market Begun? Chart I-16China's Growth To Peak Later This Year Notably, hopes that U.S. infrastructure spending - even if such spending turns out to be considerable - will boost demand for industrial metals are misplaced, because the U.S. is a small consumer of metals. China consumes six to seven times more copper, nickel, zinc, aluminum, tin and lead than the U.S. Hence, we view industrial metals as a pure play on China's capital spending. Bottom Line: We expect a combination of a stronger dollar, weaker Chinese growth and elevated oil inventories to produce a major reversal in industrial metals and oil prices. Chart I-17EM Stocks And U.S. ##br##TIPS Yields: Negative Correlation Question: Is your negative stance on EM contingent on weakness in DM growth? No, our negative stance on EM is not contingent on a relapse in DM growth. Some combination of the following key factors will trigger and drive weakness in EM risk assets: Higher U.S. real rates or a stronger U.S. dollar. Chart I-17 demonstrates the strong negative correlation between higher U.S. TIPS yields and EM share prices in the recent years. Lower commodities prices. Renewed weakness in China's economy. Our negative view on EM has and continues to be driven by our views on EM/China domestic demand/credit cycles, commodities and the U.S. dollar. Investment Conclusions Chart I-18EM/China Plays Are At Critical Juncture Exchange rates have been critical to financial market dynamics in recent years. This is unlikely to change. Odds favor another upleg in the U.S. dollar and a weaker RMB. As such, the outlook for EM risk assets is poor. EM currencies will be driven by a stronger dollar, a weaker RMB and lower commodities prices. EM share prices as well as global mining, and machinery stocks are at a critical juncture (Chart I-18). China-plays may soon start reacting to the PBoC's recent modest tightening as well as regulatory credit curtailment and begin to sell off in anticipation of weaker growth later this year. Global equity portfolios should continue underweighting EM stocks. Similarly, global credit (corporate bonds) portfolios should underweight EM sovereign and corporate credit. Finally, the outlook for weaker currencies does not bode well for EM local currency bonds. However, for fixed income investors we have several swap rate trades, relative value recommendations and yield curve positions that are published regularly in our Open Position Table on page 16. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to Trilogy of Special Reports on money/loan creation, savings and investment, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, and "China's Money Creation Redux And The RMB," dated November 23, 2016, links available on page 17. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Tensions are still high between the U.S. and China; China's neighbors are in the line of fire; Korea and Taiwan stand to suffer; We are bullish Thailand, Vietnam, and the Philippines; We are bearish Indonesia and Malaysia. Feature Over the past two weeks we have taken clients on a tour through Europe, where we think political and geopolitical risks are generally overstated in the short term. This provides ample room for European financial assets to outperform this year.1 This week we turn to Asia Pacific, where the situation is quite different. We see this region as the chief source of geopolitical "Black Swans," mainly due to rising U.S.-China tensions, which we have highlighted since 2012.2 While U.S. President Donald Trump and Chinese President Xi Jinping have recently reassured the world that relations will be cooperative and stable, it is far too soon to declare that the two have resolved anything substantial. While we have addressed U.S.-China relations before, it is essential to watch the rest of EM Asia, where proxy battles between the U.S. and China continue to play out.3 If the Philippines shocked the world in 2016 by pivoting away from the U.S. and toward China, South Korea is the country that will do the same in 2017. In this report, we review the opportunities and risks afforded by this regional dynamic. I. Will Trump And Xi Cool Their Heels? Fundamentally, geopolitical risk in Asia Pacific is driven by the "Thucydides Trap," a struggle between the established regional and global power (the United States), and an emerging power that seeks to rewrite the region's geopolitical order (China).4 This dynamic emerged well before President Donald Trump's election.5 Trump is an unpredictable agent thrown into a structural dynamic. His election on an avowed platform of protectionism, his comments singling out China as a U.S. threat, and his break with the U.S. foreign policy establishment all suggest that the secular rise in Sino-U.S. tensions is about to get worse.6 Yet, since taking office, Trump has sent mixed signals. On the one hand, he threatens a policy of isolationism that would see the U.S. withdraw from its global security commitments. On the other hand, he has threatened to escalate geopolitical conflicts in order to get what he wants on business and trade. Table 1Market Implications Of ##br##Trump's Options Toward China As Table 1 illustrates, it is extremely important for investors which of these foreign policies Trump ultimately pursues - nationalist or isolationist - and whether he combines it with the trade protectionism (or mercantilism) that he has threatened. In the short term, the most bullish combination would be the economic status quo with a scaled-down U.S. presence. The most bearish would be mercantilism combined with nationalist foreign policy. Trump's recent interchanges with Xi were notable because for once he adhered to diplomatic protocol. He and Xi gave some initial - and we would add tentative - assurances to the world that Sino-U.S. relations will not explode in a ball of flames this year: Taiwan - Trump reaffirmed the One China Policy, i.e., that Taiwan has no claim to independence from the mainland. Trump's phone call with the Taiwanese President Tsai Ing-wen in December, and subsequent comments, had put this principle in doubt, raising the prospect of a new Cold War or actual war. North Korea - China has offered to enforce a stringent new set of economic sanctions on North Korea, namely barring coal imports for 2017. This is significant, given the short duration of China's previous punitive measures against the North and the hit that North Korean exports have already suffered from China's slowing economic growth (Chart 1). The Obama administration had begun sanctioning China as a result of its unwillingness to enforce, so with enforcement may come the Trump administration's deactivation of such threats for a time. The RMB - Trump did not accuse China of currency manipulation on "day one" of his administration as he had promised during his campaign, though he has informally called the Chinese the "grand champions" of manipulation.7 This strongly suggests that he will allow the Treasury Department's semi-annual foreign exchange review process to run its course (Diagram 1). On that time frame, the U.S. would issue a warning in the April report and then begin negotiations that legally should take a year. Of course, China does not qualify by the usual measures. Since 2015 it has been propping up its currency rather than suppressing it (Chart 2), and its current account surplus has dropped sharply from 10% to 2% of GDP over the past ten years (though still massive in absolute terms). Diagram 1Calling China A Currency Manipulator: The Process The Trans-Pacific Partnership (TPP) - Trump yanked the U.S. out of the major multilateral trade initiative of the Obama administration, which was an advanced trade deal that excluded China and primarily benefited smaller Chinese competitors like Vietnam and Malaysia. Though Trump acted unilaterally - and therefore cannot have gotten any real concessions from China in exchange for killing an "anti-China" trade deal - he avoided the frictions with China that would have resulted over the coming years from implementing the deal. Chart 1Will China Cut Imports From Here? Chart 2The 'Grand Champions' Of Currency Manipulation In addition, the Trump administration is already embroiled in domestic politics with a number of its early actions. Thus it would not surprise us if Trump - exactly like Ronald Reagan, Bill Clinton, Barack Obama, and George W. Bush - needed to pacify relations with China despite his early tough talk. Meanwhile President Xi wants stability even more than usual this year as the Communist Party holds its "midterm" five-year National Party Congress. We will return to the party congress in an upcoming report, but for now we will simply reiterate that stability means neither excessive stimulus nor excessive reform (Chart 3). Chinese policymakers could trigger unintended consequences with their financial tightening, but that's why we think they will be exceedingly cautious.8 If Trump does not try to sabotage this politically sensitive year, China should be relatively stable. Chart 3China Wants Stability, Not Speed, Ahead Of Five-Year Party Congress So have U.S.-China ties become bullish all of a sudden? No. At least, not yet. Consider the following: South China Sea still a powder keg - On both sides, the idea of excluding "access" to the sea is being openly discussed, if disavowed.9 While there is conceivably a path for both sides to de-escalate, it will take very tough negotiations, and we are not there yet. Trade fight hasn't even begun - Though previous presidents got sidetracked, Trump was the first to campaign aggressively on a protectionist, anti-China platform, and to put a team in place to pursue that platform.10 We think he will get tough. We also think he will endorse the House Republicans' plan of a Border Adjustment Tax - a tax on imports - which would hurt China most of all as the country with the biggest trade surplus with the U.S.11 Japan is proactive - Japan has virtually no domestic political constraints and has an incentive to play up security threats. Why? Because Prime Minister Abe wants a nationwide popular referendum on revising the constitution to legitimize the Japanese Self-Defense Forces.12 And this is not even to mention that Taiwan and the Koreas are still major risks. Structurally, we still see Sino-U.S. tensions as the chief source of geopolitical risk and "Black Swan" events this year that could rattle markets in a very big way. Bottom Line: A modus vivendi between Trump and Xi is conceivable, but the U.S. and China are not out of the woods yet. II. What About The Neighbors? Short of the formidable "left-tail" risk of direct U.S.-China conflict, China's periphery is the chief battlefield and source of risk for investors. Asian EM economies have the most to risk from the reversal of the past decade's trade globalization (Chart 4). Investors also tend to underrate the fact that they are in the thick of the geopolitical risk arising from Sino-U.S. tensions and global "multipolarity" more broadly.13 A look across the region suggests that most Asian EM economies are shifting their policy to become more accommodative with China. This should reduce their geopolitical risk in the short term, though it is too soon to sound the "all clear." We remain strategically short EM stocks relative to DM. Within the EM space, we are bullish on Thailand, less so on the Philippines and Vietnam, and neutral-to-bearish on Taiwan, South Korea, Malaysia, and Indonesia. Chart 4De-Globalization Hurts Asia Pacific Most Of All Koreas - Here Comes The Sunshine Policy South Korea is at the center of the U.S.-China struggle as it faces a domestic political crisis, economic pressure from China, rising North Korean nuclear and missile capabilities, and a likely clash with the new U.S. administration. First, the Constitutional Court must decide the fate of impeached President Park Geun-hye. The market has rallied since the ruling Saenuri Party turned against her in early December, paving the way for her December 9 impeachment in the assembly. However, the politics of the court makes her removal from office less likely than the market expects, especially if the court does not rule by March 13, when a second judge this year retires from the bench.14 If the impeachment falters, it will lock South Korea into greater political instability throughout the year, at least until the scheduled election on December 20. Chart 5Leftward Policy Shift In South Korea ... However, it is virtually impossible for the Saenuri Party candidate, Acting President Hwang Kyo-Anh, to win the election, despite his fairly strong polling (Chart 5). His party has been discredited and split, and there are now calls for his impeachment as he defends Park from further investigation. The leading contenders are all left-of-center. They are contending in a primary election over how to redistribute wealth, crack down on the Chaebol (corporate conglomerates), engage North Korea, and improve relations with China. These policies are receiving a tailwind because Korean society has seen the economic system shocked by the end of the debt supercycle in the United States and the slowdown in China. Moreover, inequality has been rising in Korea (Chart 6). As in neighboring Taiwanese elections last year, the election is shaping up to be a backlash against the pro-trade and globalization policies of the preceding decade. Korea's share of global exports has increased, and its tech companies are profitable, but the government has engaged in conservative fiscal policies, its workers are overworked and underpaid, and its social safety net is non-existent (Chart 7). Redistribution and reforming the Chaebol could bring serious benefits over the long run, but both will negatively affect corporate profits on the margin. Internationally, improving relations with North Korea and China will mean that the new South Korean government, in H2 of this year or H1 of next, could be on a collision course with the United States and especially Japan. We expect Korea to go its own way for a time, giving the impression globally that another American ally is "pivoting to China" (after the Philippines in 2016).15 While this may seem bullish for Korea, as it did for the Philippines due to the fact that China is a growing economy, Korean exports to the U.S. and Japan are still a significant portion of its total exports (Chart 8). Korea is also constrained by the fact that China is increasingly a trade competitor, and Korea's exports to China mainly consist of goods that China wants to make itself: high-end electronic manufacturing, cars, and car parts. Thus, China will welcome greater ties as it looks for substitutes for the increasingly protectionist West in acquiring technology and expertise, but Korea's new government will see rising fears of economic "absorption" as it attempts to improve access to Chinese markets. Chart 6... As Inequality Has Risen Sharply Chart 7Workers Want More Largesse Chart 8Korea's Balancing Act What are the market implications? South Korea is in a decent place in the short run. Global growth, exports, and corporate earnings are improving, and stock valuations have come down, especially relative to EM. Over the long run, however, we are turning bearish. Korean labor productivity is in a downtrend (Chart 9), its population is not growing, and there is no reservoir of young people left to tap. There are three basic options for securing future growth. First, Korea could become a net investor nation like Japan (Chart 10). However, it is not yet wealthy enough to do so, and needs to build the aforementioned social safety net. Second, South Korea could reunify with the North, which would alleviate its labor force problems, though the costs of reunification would be extreme (Chart 11). Chart 9Reforms On Hold Until New Government Sits Chart 10Korea's Japanese Dream Chart 11Reunification Would Increase Labor Force Third, it could continue on its current path of trying to secure large markets like the U.S. and China, while conducting a balancing act between them as geopolitical tensions rise. The problem right now is that the first two options are not ready and the balancing act is getting too hard, too soon. The South stands to suffer from both protectionism and multipolarity, i.e., being sandwiched between resurgent Sino-U.S. and Sino-Japanese tensions. Furthermore, the Trump administration has not yet decided whether its North Korea policy will be one of engagement, aggression, or continued neglect. Yet the U.S. defense and intelligence establishment's threat assessment is reaching a level that will cause greater public concern and more demand for action. Until Trump's policy is clear, South Korea's attempts to launch a new "Sunshine Policy" toward eventual reunification will be extremely vulnerable. Over time, North Korea is likely to become more of a black swan than the red herring it has been in the past (Chart 12). Chart 12North Korean Incidents: Mostly Red Herrings Bottom Line: Now is ostensibly a good entry point for Korean stocks relative to EM stocks, but we remain reluctant due to the political and geopolitical factors. Also, the path of least resistance for the Korean won is down, so we recommend going long THB/KRW, discussed further below. Taiwan - "One China" Or More? Our prediction that China-Taiwan relations would deteriorate dramatically, and that Taiwan could be one of five "Black Swans" of 2016, has essentially played out.16 The two sides cut off formal contact, Trump accepted a phone call from the Taiwanese president in a sharp break with U.S.-China convention, and the Taiwanese navy accidentally fired a missile toward the mainland during a drill on the Chinese Communist Party's 95th birthday on July 1. Despite the tensions, hard data coming out of Taiwan have been strong. Its export-oriented economy is buoyed by strong global growth. Both its equities and currency are the few bright spots in the EM universe and investors have been responding positively to the strong data (Chart 13). Yet Taiwan remains highly vulnerable to geopolitical tensions, as its economy is "too open," especially to China. China has imposed discrete economic sanctions, as we expected. The number of mainland tourists to Taiwan have dropped by 50% (Chart 14). This trend will continue, hurting consumer sentiment. While Trump has backed away from his threat to break the One China Policy, a move markets view as very reassuring, he cannot unsay his words and China will not forget them. Moreover, his administration will attempt to shore up the U.S.-Taiwan alliance in traditional ways, including with new arms sales that will provoke angrier responses than in the past from Beijing (Chart 15). Chart 13Investors Do Not Fear Independence Talk Yet Chart 14China's Silent Sanctions Chart 15Plenty More To Come Crucially, Taiwan's domestic politics are not a major constraint on its actions, which heightens the risks of a cross-strait "incident." The Democratic Progressive Party (DPP) is in control at almost every level of government on the island. President Tsai Ing-wen and the DPP swept to power on a popular mandate to stall and roll back trade liberalization with China, which the public felt had gone too far under the previous Kuomintang government. Perhaps if Trump had never entered the picture, Taiwan and China would have found a new equilibrium in which Taiwan distanced itself while assuring the mainland it did not seek independence. Now, however, the odds of that solution are declining. Taipei may become overly aggressive if it believes Trump has its back, and this dynamic will ensure continuous Chinese pressures and sanctions, all negative for Taiwanese assets. Bottom Line: Despite the fact that Taiwan's economy has some bright spots (exports, capital formation), we are sticking with our "One China Policy" trade of going long Chinese equities / short Taiwanese and Hong Kong equities. BCA's China Investment Strategy agrees with this call and is shorting Taiwanese stocks relative to its mainland counterparts.17 We expect China to penalize these territories for expressing the desire for greater autonomy. We also suggest going short the Taiwanese dollar versus the Philippine peso, to be discussed further below. Thailand - The Junta's Persistence Is Bullish For most of the past fifteen years, the death of Thailand's King Bhumibol Adulyadej, which occurred on October 13 of last year, was feared as a catalyst for a total breakdown of law and order due to the deep socio-political and regional division in Thai politics that has pitted an urban royalist faction against a rural populist faction. But the 2014 coup was intended to preempt the king's death and ensure that the royalist, pro-military faction held firm control over the country during the risky succession period. The market responded positively during the coup in 2014 and upon the king's death last year (Chart 16). We recommended going long Thai stocks and THB last October, in a joint report with BCA's Emerging Markets Strategy, and both trades are in the black.18 Chart 16Thailand: Investors Cheered The Succession Crisis The junta's strategy has been to root out the leaders of the populist movement and rewrite the constitution to legitimize its ability to intervene in the future. The new monarch has cooperated with the military so far, upholding the status quo, but if at any point he favors the populists to the detriment of the military, political uncertainty will spike from its current historically low levels (Chart 17). The junta is fully in charge for the time being. It has pushed back elections to February 2018 or later, delaying the re-introduction of political instability into the Thai market. It is also surging public spending and transfers to the rural poor to ensure social stability. Historically, strong public capital investment and global exports coincide with strong Thai manufacturing output (Chart 18). Favorable domestic and external macro environments should be bullish for Thai equities, creating a near-term buying opportunity in the Thai market. Chart 17Junta Keeps A Lid On Politics... Chart 18... And Buys Friends With Public Money Thailand is distant from China's quarrels with its neighbors over the South China Sea. It was the first of the U.S. allies to hedge against President Obama's pivot and seek better relations with China instead, a strategy that has paid off. Thailand, like many regional actors, may be forced to choose between China and U.S. at some point, but for now it enjoys the best of both worlds. With a fundamentally strong macro-backdrop, including a large current account surplus of 12% of GDP, we are bullish on Thai assets relative to EM. Bottom Line: Thailand is the most attractive Asian EM economy right now from an investment-oriented geopolitical point of view. It is not too late to go long THB/KRW or long Thai stocks relative to EM. Philippines - The War On Drugs Is A Headwind The Philippines continues to display strong macro-fundamentals and market momentum in the EM universe. However, domestic political risks are significant and prevent us from returning to an overweight stance relative to EM.19 The inauguration of populist southerner Rodrigo Duterte as president of the Philippines in July of last year led the country into a bloodbath that has since claimed over 7,000 lives in a "war on drugs." Only recently has it shown any sign of abating, and it is not clear that it will. The political backlash is gradually building. Duterte's policy preferences are left-leaning and mark a partial reversal of the pro-market, reform orientation of the preceding Aquino government.20 As a result, foreign investment has dropped off from its sharp rise, though it remains elevated (Chart 19). The Philippines may also fall victim to its own success. Due to the booming economy under the Aquino presidency, bank loans and deposits have enjoyed strong growth in recent years. However, the loan-to-deposit ratio is getting overextended and the economy is showing signs of heating up with inflation creeping above 2% in 2016 (Chart 20). Populist policies and the advanced cyclical expansion may add more heat. Thus, it is becoming more likely that monetary policy will tighten as the economy moves into the advanced stage of its cyclical expansion. Duterte could create a problem if at any point he decides to interfere with the central bank or technocratic management of the economy more broadly. In terms of geopolitical risk, Duterte is engineering a pivot away from the United States toward Russia and China, aggravating relations with the former, its chief ally (Chart 21). As relations with China improve, they will bring some investment in infrastructure and a calming of the near seas. Chart 19Duterte Marked The Top Chart 20Credit Is Strong, Inflation Creeping Back Chart 21Duterte's 'Pivot' To Asia Ultimately, however, we view this calming as temporary, since China's assertiveness is a long-term phenomenon. We also think that the fundamental U.S.-Philippine alliance will survive any major disagreements of the Duterte era. Duterte is constrained by his weakness in the Philippine Senate and the popularity of the United States among Filipinos, which is among the highest in the world. In essence, the public is not anti-American but "anti-colonialist" - many feared that the U.S. "Pivot to Asia" of the Obama and Aquino administrations would put the Philippines into a subordinate "colonial" role highly vulnerable to Chinese aggression. Like other U.S. allies in the region, the Philippines wants to be a partner of the U.S. and not just a naval base. Thus, for now, we see the Philippines in a gray area of frictions with the U.S. yet disappointing hopes with regard to China. Until Duterte removes the headline risk to internal stability from his belligerent law and order policies - and compromises on his more anti-market economic stances - we are at best open to tactical possibilities. Bottom Line: Considering its strong macro-fundamentals, advanced cyclical expansion, and politically driven uncertainty, we are only willing to entertain short-term, tactical opportunities in the Philippines. Now is a decent entry point for equities relative to EM. Also, our colleagues at BCA's Foreign Exchange Strategy point out that the peso is currently trading at a 10% discount.21 We recommend going long the peso versus the Taiwanese dollar to capitalize on the dynamics outlined for both countries above. Indonesia - A Dream Deferred Indonesia outperformed our expectations throughout 2016.22 President Joko Widodo ("Jokowi") managed to corral his party behind him despite an internal leadership struggle. And the large bureaucratic party, Golkar, joined his coalition in parliament, creating a strong legislative majority. These were our two preconditions for a more effective government; Jokowi has also found allies within the military, as we surmised. As a result, he managed to make some progress on his tax-raising, union-restraining, and infrastructure-building initiatives. Nevertheless, the market has sniffed out the difference between a pro-reform government and the enormous difficulties of pulling off reform in Indonesia. Long-term investment has fallen even as short-term portfolio investment has rallied on the back of the EM reflation trade (Chart 22). While Jokowi reduced the size of costly domestic fuel subsidies in his first year, it was easy to do so amid the oil-price collapse in 2014. Since then, Indonesian retail gasoline prices have remained subdued, indicating that subsidies are still significant. As the global oil prices continue increasing, so will the subsidy (Chart 23), adding to the country's budget deficit. Jokowi also put forth minimum-wage reforms in 2015, introducing a formula which requires the minimum wage to be adjusted every year based on inflation and economic growth (rather than ad hoc negotiations with local unions and governments). Predictably, wages have skyrocketed since the indexing policy was implemented, which is negative for profit margins (Chart 24). Chart 22Investors Skeptical Of Jokowi's Reforms Chart 23Fuel Subsidies Still In Effect Chart 24No Wage Rationalization Yet Indonesia is on the outskirts of China's claims in the South China Sea and has a domestically driven economy that should suffer less than that of its neighbors in a context of de-globalization. In that sense, we are inclined to view it favorably. However, its currency is at risk from twin deficits - current account and budgetary reforms have stalled, and the credit impulse is weakening. If Jokowi's favored candidate wins the heavily contested gubernatorial run-off in Jakarta in April, it will not be very bullish, but a loss would be bearish for Jokowi's reform agenda ahead of the 2019 elections. Bottom Line: We are still short Indonesia within the EM space - its underperformance since the second half of last year can persist. Vietnam - No American Guarantee Vietnam is highly vulnerable to a geopolitical conflict with China which would impact markets. Unlike the Philippines and Thailand, it cannot count on an underlying bedrock of American defense to anchor its pivot toward China - and yet, it has the greatest historical and territorial conflicts with China of all the Southeast Asian states. Chart 25Fighting In The Teeth Of The Dragon Nevertheless, in the short term, geopolitical risks are abating. Relations have improved since a recent low point in 2014.23 And Vietnamese leaders, having invested heavily in the TPP as the trade pact's biggest potential beneficiaries, are trying to make amends with China now that it is canceled. Thus, we remain long Vietnamese equities relative to EM. This is mostly due to the country's strong domestic demand and export competitiveness (Chart 25), attractive environment for foreign investment, and ability to capitalize on diversification away from China. The country's reforms are not perfect, but it has at least recognized NPLs and begun privatizing some SOEs. Bottom Line: We are sticking with long Vietnamese equities versus EM, though downgrading it to a tactical trade due to our wariness of a turn for the worse in China relations or the broader trade environment. Malaysia - Going To The Pawnshop Malaysia, with Vietnam, was to be the top beneficiary of the TPP. It, too, has lost greater access to the U.S. market that the deal would have provided and must now make amends with China. The latter process has already begun, as Malaysia's government has turned to China for a $33 billion deal in exchange for energy assets and valuable land in the state of Johor. The general election of 2013 and the economic slowdown have catalyzed domestic political divisions, especially ethnic and religious ones, igniting a drastic push over the past two years to have Prime Minister Najib Razak ousted for his alleged embezzlement of funds from the state-owned 1MDB corporation. Najib chose to crack down on the opposition and ride out the storm, which he has managed so far, causing unprecedented political instability. Najib's decision to sell land to the Chinese will not sit well with much of the Malay population. Many will see it as undignified; and historically, there is much animosity toward the local Chinese. Najib already faces an intense political struggle due to the exodus of high-ranking politicians from his ruling United Malay National Organization (UMNO). Former strongman leader Mahathir Mohammad and ex-Deputy Prime Minister Muhyiddin Yassin are leading the defectors to form a new Malay party that will pose a serious challenge in the 2018 elections. Recent flirtation between the ruling UMNO and the Islamist Pan-Malaysia Islamic Party (PAS) also injected new uncertainty into the already turbulent domestic political environment. In essence, the one-party state that investors once knew (and loved) is forming new factions that will contest the upcoming elections with abandon. Chart 26Growth Slowing, Credit Drying Up This struggle over the 2018 election promises to be emphatically unfriendly to investors. And until Najib gets a new mandate, he can do very little to arrest the economic breakdown. As long as the support and continuity of Najib's policies are in question, it is difficult to take a directional view of Malaysian assets. A victorious UMNO does not mean that investors should be bullish, but it will resolve the question of "Who is in charge?" At that point, we can reassess the market attractiveness based on the higher "certainty" of the policy preferences of the country. Meanwhile the constraints to Malaysia's economy are clear from a host of weak data, from domestic trade to the property market to the current account and the currency, along with a rise in NPLs that will undermine the inadequately provisioned banks' willingness to lend (Chart 26). While palm oil and petroleum prices have recovered, which is positive for Malaysian markets, this is not enough to outweigh the negative factors. Bottom Line: We are bearish on Malaysian assets and currency. Matt Gertken, Associate Editor mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, and BCA Geopolitical Strategy Weekly Report, "A Fat-Tails World," dated February 22, 2017, available at gps.bcaresearch.com. 2 Please see BCA Global Investment Strategy Special Report, "The Looming Conflict In The South China Sea," dated May 29, 2012, available at gis.bcaresearch.com, and BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 Please see Graham Allison, "The Thucydides Trap: Are The U.S. And China Headed For War?" The Atlantic, September 24, 2015, available at www.theatlantic.com. 5 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Underestimating Sino-American Tensions," dated November 6, 2015, available at gis.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 8 Please see BCA China Investment Strategy Weekly Report, "Be Aware Of China's Fiscal Tightening," dated February 16, 2017, available at cis.bcaresearch.com. 9 In the short time since Trump's and Xi's phone call, the U.S. has announced that it intends to intensify the Freedom of Navigation Operations around the rocks in the South China Sea to assert its rights of navigation and overflight. Meanwhile Chinese lawmakers have revealed that they want to pass a new maritime law by 2020 that would encourage maritime security forces to bar foreign ships from passing through Chinese "sovereign" waters if they are ill-intentioned. 10 Trump's Treasury Secretary Steve Mnuchin was only just confirmed by the Senate and could not have taken any significant action yet. His appointees, notably Commerce Secretary Wilbur Ross, National Trade Council chief Peter Navarro, and U.S. Trade Representative Robert Lighthizer, are China hawks. If not currency, Trump's team will rotate the negotiations to focus on China's capital controls and failure to liberalize the capital account, its lackadaisical cuts to industrial overcapacity, and the negative business environment for U.S. firms. 11 Please see BCA Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?" dated February 8, 2017, available at gps.bcaresearch.com, and Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. 12 The first nationwide evacuation drill in the event of a North Korean missile attack will take place sometime in March of this year. 13 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 14 Bringing the total number of judges from nine to seven, and thus reducing the threshold for a vote in favor of retaining Park in office from four to two, for constitutional reasons. All but one of the judges were appointed by Park or her party's predecessor. 15 For instance, if the new administration reverses the deployment of the U.S. Terminal High Altitude Area Defense (THAAD) system, it will provoke a crisis with the U.S., but if it does not, China will continue its underhanded economic sanctions on the South, and the new South Korean president's North Korean policy will be stillborn. 16 Please see BCA Geopolitical Strategy Special Reports, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, and "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 17 Please see BCA China Investment Strategy Weekly Report, "Taiwan's 'Trump' Risk," dated February 2, 2017, available at cis.bcaresearch.com. 18 Please see "Thailand: Upgrade Stocks To Overweight And Go Long THB Versus KRW," in BCA Emerging Markets Strategy Weekly Report, "The EM Rally: Running Out Of Steam?" dated October 19, 2016, available at ems.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 20 For instance, he is imposing controls on the mining sector that will scare away investors, in an echo of Indonesia's mining fiasco implemented since 2013, and he is working on eliminating a "contract worker" system that enables employers to avoid the costs of full-time hiring. Please see BCA Geopolitical Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 21 Please see BCA Foreign Exchange Strategy Special Report, "Updating Our Long-Term FX Value Models," dated February 17, 2017, available at fes.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "Stick To Long Modi / Short Jokowi," dated November 23, 2015, available at gps.bcaresearch.com. 23 Vietnam has moved toward better crisis management with China since the HYSY-981 incident in 2014, when a clash broke out over a mobile Chinese oil rig in the South China Sea. Significantly, the Vietnamese Communist Party's leaders removed former Prime Minister Nguyen Tan Dung, the highest-ranked China hawk and pro-market reformer on the Politburo, in the January 2016 leadership reshuffle.
How Long Is The Sweet Spot? Table 1Recommended Allocation The sweet spot on a baseball bat, scientists find,1 is the small area about two inches (5 cm) long, some six inches from the tip. The sweet spot for global risk assets may not be much bigger. The 22% rise in global equities since February last year has been driven by a "goldilocks" combination of recovering economic activity, quiescent inflation, and still-accommodative monetary policy. But, after such a strong rally, markets must walk a fine line - no slowdown in growth and no surprising tightening of monetary conditions - for prices to rise further. Our analysis suggests that they can, but the risk of a correction is rising. A lot of the better news of the past year has already been priced in. The price-to-sales ratio for U.S. stocks is close to an all-time high, and even the plain-vanilla 12-month forward PE ratio has reached 17.5x, the highest since 2002 (Chart 1). Volatility has fallen to a low level, with the VIX not rising above 12 over the past month, and the S&P500 index going 98 days without a one-day decline of 1% or more, the longest such period since 1995 (Chart 2). To a degree, this is justified by the recent strong pick-up in global growth. Sentiment indicators have accelerated since the election of President Trump, and even hard data is now showing the first signs of recovery (Chart 3) with, for example, U.S. retail sales rising 5.6% year-on-year in January, and core durable goods orders starting to follow the rise in companies' capex intentions (Chart 4). Similar positive economic surprises are visible in Europe, Japan, China and elsewhere. The problem is that further upside surprises are likely to be limited. Regional Fed NowCast surveys for Q1 real GDP growth are already at 2.5-3.1%. Consensus forecasts for S&P500 earnings growth in 2017 look about right at 10.5% but, with a stronger dollar and rising wages, are unlikely to be beaten. Chart 1Historically High Valuations Chart 2Time For A Pull-Back? Chart 3Hard Data Starting To Recover Too Chart 4Orders To Follow Capex Intentions Headline inflation has picked up (to 2.5% in the U.S. and 1.9% in the Eurozone), mainly because of higher oil prices, but core inflation remains sufficiently under control that central banks don't need to slam on the brakes. The rise in unit labor costs in the U.S. suggests that core PCE inflation will gradually move up to 2% during the year (Chart 5). The latest FOMC minutes revealed that members want a further rate hike "fairly soon", and BCA expects the Fed to raise three times this year (to which the futures market ascribes only a 36% probability). But Fed policy remains very accommodative (Chart 6), the European Central Bank is unlikely to end its asset purchases soon on account of political and banking system concerns, and the Bank of Japan remains committed to its 0% yield target for 10-year government bonds until inflation is well above 2%. Absent a powerful fiscal stimulus in the U.S. or a move by the "hard money" advocates in the Trump administration to change the Fed's modus operandi, we think its unlikely that a tightening of monetary policy will drag down asset prices. Chart 5Labor Costs Putting Pressure On Prices Chart 6Fed Policy Still Accomodative Risks certainly abound. The Trump administration could start a trade war with China. Its proposals for corporate and personal tax cuts could disappoint both in terms of their details and the timing of Congress's passing them. European politics remain a concern, with the probability of Marine Le Pen becoming French President increasing recently (though it remains small). But risk markets tend to rise on a wall of worry. Investor sentiment is not particularly bullish at the moment, with the bull/bear ratio among individual investors barely above 1 (Chart 7) and flows into equity funds in recent months not reversing the outflows of last year (Chart 8). Chart 7Retail Investors Not So Bullish Chart 8Equity Flows Are Still Tepid After a year of a strong cyclical risk-on rally, progress from now on will get tougher. A short-term change of direction is quite possible (and has already happened in some assets, with the yen moving back to 112 and the 10-year Treasury yield to 2.3%). But we expect economic growth to remain robust this year - with U.S. real GDP growth likely to come in close to 3% on the back of surprises in capex - which will push the 10-year Treasury yield above 3% by year-end. In this environment, we continue to favor equities over bonds, and maintain our pro-risk tilt in equity sectors, credit and alternative assets. Equities: U.S. equities have outperformed Eurozone ones by 5% year-to-date, mainly because of worries about Europe's political risk and the fragility of its banking sector. Though we think the political risks are overstated (except perhaps in Italy), we continue to prefer the U.S. in common currency terms because of our expectations of further dollar appreciation and because the lower volatility of the U.S. helps reduce the beta of our recommended portfolio. Emerging markets have outperformed global equities by 3% YTD, mainly on the back of stronger commodities prices. But we remain underweight EM because of the risks from a stronger dollar and rising global rates, concerns about protectionism and debt refinancing, and because of the likelihood that China's rebound will run out of steam over the next 12 months (Chart 9). Fixed Income: Rates have pulled back recently: long-term institutional investors have begun to find attraction in the long end of the U.S. Treasury yield curve at 2-3%, though speculative investors remain short (Chart 10). With the Fed likely to raise rates three times this year, inflation expectations to pick up further, and nominal GDP growth in the U.S. to reach 4.5-5%, we expect the U.S. 10-year yield to rise above 3%. We therefore remain underweight duration and prefer inflation-linked over nominal bonds. In the improving economic environment, we continue to like credit, but find valuations more attractive for investment-grade bonds than for high-yield. Currencies: Dollar appreciation has been on hold since January but we think the long-term trend remains in place because of the probable direction of relative interest rates. Neither Japan nor the Eurozone is likely to move towards monetary tightening over the next 12 months. Even if the Trump administration were to want a weaker dollar, a few tweets would not be enough to offset monetary fundamentals. And, while it is true that sentiment towards the dollar is already bullish, this has historically not precluded further appreciation, for example in the late 1990s (Chart 11). Chart 9EM Equities Correlated With China PMIs Chart 10Divergent Views On U.S. Bonds Chart 11Optimism Need Not Stop USD's Rise Commodities: The oil price remains close to its equilibrium level at around $55 a barrel, with the OPEC agreement largely holding but being offset by a production increase from the U.S. shale drillers, whose rig count has doubled since last May. We are neutral on industrial commodities: Chinese demand resulting from last year's reflationary policy is likely to be offset by the stronger dollar. Gold remains a useful portfolio hedge in a world of elevated geopolitical worries and inflation tail-risk, but is also negatively correlated with the U.S. dollar. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see, for example, "The Sweetspot of a Hollow Baseball or Softball Bat", by Daniel A. Russell, Pennsylvania State University, available at www.acs.psu.edu/drussell/bats/sweetspot.html Recommended Asset Allocation Model Portfolio (USD Terms)
Highlights U.S. Treasuries - Fair Value: The 10-year U.S. Treasury yield now appears 7 bps expensive on our model. Investors should maintain below-benchmark duration and continue to monitor bullish sentiment toward the U.S. dollar for signals about the breadth of the global economic recovery. U.S. Treasuries - Technicals: Large net short bond positions are in the process of being unwound. A more balanced technical picture removes one of the key impediments to the bond bear market and possibly sets the stage for another leg higher in yields. China: Chinese monetary policy that is sufficiently accommodative to spur economic growth, but not so accommodative that it causes undue strength in the trade-weighted U.S. dollar, is the most bearish outcome for U.S. bonds. Feature Bonds rallied strongly late last week without any obvious economic catalyst. Now that the dust has settled we find the 10-year U.S. Treasury yield trading at 2.34%, 7 bps below our estimate of fair value (Chart 1). Chart 12-Factor U.S. Treasury Model Updating Our U.S. Treasury Model That fair value estimate comes from our 2-factor U.S. Treasury model, based on the Global Manufacturing PMI and bullish sentiment toward the U.S. dollar. In our view, these two factors capture the most important macro drivers of U.S. bond yields. Stronger global growth, as proxied by the Global Manufacturing PMI, tends to push yields higher. However, to the extent that stronger global growth coincides with an appreciating U.S. dollar, the amount of monetary tightening that needs to be achieved through higher interest rates is limited. This caps the upside in long-dated U.S. bond yields. Put differently, it is not just the magnitude of the global growth impulse that matters for U.S. bond yields, but also the breadth of the recovery. The more broad-based the recovery, the less upward pressure on the U.S. dollar and the higher U.S. Treasury yields can rise. Last week we received Flash PMI estimates for the U.S., Eurozone and Japan that we can use to estimate the Global PMI for February. According to the Flash estimates, the U.S. PMI declined slightly in February, but this was more than offset by accelerations in both the Eurozone and Japan. Altogether, these three regions account for 48% of the Global PMI and, assuming PMIs in all other countries remain flat, we can calculate that the global PMI will nudge higher from 52.7 in January to 52.9 in February. Of course one month of data is much less important than the longer run trend. Taking a step back, we see that manufacturing PMIs are trending higher in every major economic bloc (Chart 2). Our diffusion index also shows that the global manufacturing recovery is more broadly based than at any time during the past three years (Chart 2, top panel). The synchronized nature of the recovery is also reflected in the behavior of the U.S. dollar, which has not appreciated during the past month even though Fed rate hike expectations have shifted up (Chart 3). The message from the survey of bullish dollar sentiment - the series that is included in our Treasury model - is more mixed. Bullish dollar sentiment plunged from elevated levels in January but has recovered somewhat during the past few weeks (Chart 3, panel 2). Meantime, U.S. Treasury spreads over German bunds and JGBs are also sending mixed signals. Short-maturity spreads have widened alongside increased U.S. rate hike expectations, while long-maturity spreads have been well contained (Chart 3, bottom 2 panels). Chart 2Synchronized Global Recovery Chart 3Keep Watching The Dollar Global bond investors should closely monitor trends in the U.S. dollar, bullish sentiment toward the dollar, and U.S. Treasury spreads over bunds and JGBs. Each of these indicators provides information about the breadth of the economic recovery. If Fed rate hike expectations remain firm, or even move higher, and that trend is not matched by a stronger dollar or wider Treasury spreads, then that would signal that the global recovery is becoming more synchronized, suggesting additional upside for bond yields. Bottom Line: The 10-year U.S. Treasury yield now appears 7 bps expensive on our model. Investors should maintain below-benchmark duration and continue to monitor bullish sentiment toward the U.S. dollar for signals about the breadth of the global economic recovery. Chart 4Positioning Becoming More Balanced Treasury Technicals Less Stretched This brings us back to last Friday's bond rally. Puzzlingly, the 2-year U.S. Treasury yield declined 6 bps and the 10-year yield fell 7 bps on a day without any significant economic or political news. In fact, Treasury yields managed to decline even though rate hike expectations embedded in the overnight index swap curve were unchanged and the probability of a March rate hike priced into fed funds futures actually increased from 31% to 33%! The unusual disconnect between Treasury yields and rate hike expectations is probably related to the expiry of the March bond futures contracts. Last week, traders had to decide whether to let their March contracts expire or roll them over into June. Positioning data show that speculators carried large net short positions into last week (Chart 4), so it is possible that it was the capitulation of these large short positions that drove yields lower on Friday. More timely data from the skew between payer and receiver swaptions show that swaption investors are no longer betting on rising rates (Chart 4, panel 4). Net speculative positions in Treasury futures could follow suit when the data are released later this week. In addition, our composite sentiment indicator has just recently ticked back above the zero line (Chart 4, panel 2). Bottom Line: Large net short bond positions are in the process of being unwound. A more balanced technical picture removes one of the key impediments to the bond bear market, and possibly sets the stage for another leg higher in yields. China's Bond Market Balancing Act Chart 5Easy Money Spurs Chinese Growth In the context of the 2-factor U.S. Treasury model presented above, there are two reasons why developments in China matter for U.S. bond markets. The first is that China accounts for the single largest weighting in the Global Manufacturing PMI, so stronger growth in the Chinese manufacturing sector will pressure bond yields higher, all else equal. But the Chinese economy can also influence U.S. bond yields if changes in the RMB exert meaningful influence on the trade-weighted U.S. dollar. For example, faster Chinese growth pressures U.S. bond yields higher, but some of that upward pressure could be mitigated if that strong growth is engineered through a rapid depreciation of the RMB relative to the U.S. dollar. On the first point, China's manufacturing PMI is in a clear uptrend although the recent contraction in the government's fiscal expenditures is a potential warning sign (Chart 5). Our China Investment Strategy service views the fiscal contraction as a risk but still expects the Chinese economy to remain buoyant this year.1 This is because Chinese monetary conditions remain supportive of further gains in the manufacturing sector, and the rebound in China's PMI that began early last year is more tied to easing monetary conditions - a weaker exchange rate and falling real interest rates - than to increased fiscal spending. On the second point, while a weaker trade-weighted RMB has helped spur the recovery in Chinese manufacturing, the impulse from a weaker RMB has so far not been potent enough to move the needle on the trade-weighted U.S. dollar (Chart 6). From the perspective of U.S. fixed income markets a continuation of this trend would be the most bond-bearish outcome. Chinese monetary policy remains easy enough to spur economic growth but not so easy that it causes the U.S. dollar to spike. For the time being at least, China has been actively selling Treasuries in order to mitigate the extent of its currency depreciation (Chart 7). If China were to suddenly stop selling Treasuries, then the RMB would likely depreciate sharply. This would actually have an ambiguous impact on U.S. Treasury yields since it would probably lead to both a stronger U.S. dollar and faster global growth. Chart 6USD So Far Not Impacted By RMB Chart 7China Is A Treasury Seller More likely, however, is that China will continue to manage the gradual depreciation of its currency unless it is forced to take more dramatic action in the face of a negative growth shock. Our China Investment Strategy team notes that the annual People's Congress in early March should offer some important clues about the Chinese government's growth priorities and policy direction going forward. Bottom Line: Chinese monetary policy that is sufficiently accommodative to spur economic growth, but not so accommodative that it causes undue strength in the trade-weighted U.S. dollar, is the most bearish outcome for U.S. bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Be Aware Of China's Fiscal Tightening", dated February 16, 2017, available at cis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Portfolio Strategy The market has quietly adopted a less cyclical sectoral tone since yearend, a trend that could amplify over the coming months, even if overall appreciation persists. Defense stocks have grown into previously extended valuations, warranting ongoing above-benchmark exposure. The opposite is true for aerospace equities. Data processing shares are more likely to roll over than break out and we recommend paring positions to underweight. Recent Changes S&P Data Processing - Downgrade to underweight from overweight. Table 1 Feature The stock market has cheered the broad-based rebound in earnings and improvement in corporate sector pricing power (Chart 1). Unbridled optimism about growth friendly policy tilts including potential tax reform and select regulatory relief combined with an easing in financial conditions have encouraged investors to make large down payments against expected future profit gains. Indeed, extreme economic and earnings bullishness is evident in record setting price/sales (P/S) multiples: Chart 1 shows that on a median basis, the industry group (P/S) ratio is far above the 2000 peak, providing yet another metric in a long list of yardsticks signaling that greed is the overriding market emotion. Nosebleed valuation levels are cause for significant cyclical concern, but as discussed last week, momentum and a valuation-agnostic transition from fixed income to equities are the dominant tactical forces at the moment. Since it is difficult to reconcile valuations at odds with realistic expectations about future earnings growth, we remain focused on sub-surface positioning to indemnify against disappointment. Since late last year, the market has adopted a more defensive than cyclically-oriented tenor. Defensive sectors have troughed at extremely attractive relative valuation levels, based on our models (Chart 2). Conversely, cyclical sectors have rolled over, meeting resistance at very demanding valuation levels of more than two standard deviations above normal (Chart 2). Chart 1Future Growth Has Been Paid For Already Chart 2The Market Tone Is Changing Contrarians should take note. These nascent trend changes have developed even though economic data have generally surprised on the upside, which may be an indication that a more forceful response will occur once the string of upside surprises loses momentum. The global PMI has been very strong, but any hint of a reversal would provide a catalyst for a full-fledged recovery in defensive vs. cyclical stocks (Chart 3). The contraction in U.S. bank lending growth may be heralding slippage in hard economic data (Chart 3), to the benefit of defensive vs. cyclical sectors. Keep in mind that the market is priced for non-inflationary growth nirvana, such that even modest economic disappointment could short circuit the buying binge. The yield curve has stopped widening and financial conditions are no longer easing (Chart 3), providing additional confirmation that the defensive vs. cyclical equity sector trough is more likely a budding trend change than a pause in a downtrend. A trend change is also consistent with the relentless downgrading in emerging market vs. developed country GDP growth expectations (Chart 4). Chart 3Forward Looking Yellow Flags Chart 4No EM Confirmation For Cyclicals The lack of a durable and credible growth thrust in EM is confirmed by regional share price performance, as EM equities have significantly lagged their developed country counterparts (Chart 4). Now that China's fiscal stimulus impulse has rolled over amidst ongoing currency depreciation, EM lacks a catalyst for incremental growth outperformance vs. developed markets. Adding it up, evidence of a sub-surface trend change continues to materialize, even in the face of upward momentum in the broad market. We expect a mostly defensive along with select interest rate-sensitive exposure to provide optimal portfolio performance in the next 3-6 months. Defense Stocks Will Continue To Protect Portfolios... A Special Report sent to clients on October 31 outlined the long-term appeal of defense stocks, prior to the installment of a new, bellicose U.S. Administration. If anything, the latter threatens to exacerbate the decline in globalization that was already in progress (as discussed since 2014 by BCA's Geopolitical Strategy Service), potentially creating a leadership vacuum that will raise the specter of open military conflict. More nationalistic foreign policies in a number of countries, i.e. moving away from collaboration and cooperation and toward isolationism and self-sufficiency, is a recipe for increased geopolitical instability. China's challenge to the status quo is also likely to motivate a boost to defense spending globally. The recent World Economic Forum estimates of global military spending by 2030 cite both China and India planning to quadruple military outlays over this time frame (Table 2). The U.S. Administration is already pressuring other NATO members to boost defense spending after a long contraction (Chart 5), which should eventually spillover into rising defense contractor sales. Reportedly, only 5 out of 28 NATO members reached the targeted goal of spending 2% of GDP on defense. Ergo, there is room for an increase, especially in some larger countries with fiscal room to maneuver. More imminently, the conditions that have created the gap between aerospace and defense relative performance are growing even stronger (Chart 6). Table 2A New Arms Race Underway Chart 5Lots Of Upside Chart 6A Growing Gap While U.S. defense spending has been through a soft patch for the past several years, new orders for defense goods have been one of the strongest components of overall durable goods orders (Chart 6). The unfortunate reality is that the incentive to boost defense and security spending has never been higher. Terrorist activity continues to proliferate around the world (Chart 7), raising a sense of geopolitical uncertainty and mistrust. With defense new orders continuing to make new cyclical highs, factory output should run at levels flattering operating margins. Shipments of defense goods are outpacing inventories by a wide margin, which is consistent with solid pricing power. Even exports of military goods are booming (Chart 7), despite the strong U.S. dollar, reflecting a strong undercurrent of global demand. Domestic defense spending has room to expand. Real defense outlays are only just starting to recover (Chart 8). President Trump ran on a campaign to protect the U.S. from terrorism. That should make it comparatively easy to increase defense spending in the years to come. It is normal for defense stocks to retain momentum as defense spending growth accelerates (Chart 8, top panel). Increased staffing at the U.S. Department of Defense (DOD) implies that purse strings may already be loosening in anticipation of heightened activity. DOD employment growth often provides a good leading indication for real defensive spending trends (Chart 8, bottom panel). Thus, while share prices have been on a tear and valuations are not cheap, rapid earnings growth has pushed down forward multiples to manageable, below-market, levels (Chart 9, shown as an average of the companies in the BCA Defense Index). Chart 7Powerful Momentum... Chart 8... With Long-Term Durability Chart 9Growing Into Valuations Prospects for strong multiyear growth should support a move to a premium valuation as margins expand (Chart 9), similar to what occurred during past defense spending booms, as chronicled in our October 31 Special Report. ...But Aerospace Stocks Are Out Of Fuel In terms of aerospace equities, the outlook is more challenging. New orders have been sinking steadily, reflecting a downturn in the commercial aerospace cycle. While long lead times and lengthy delivery schedules offer some earnings protection, dwindling order backlogs will ultimately undermine confidence in the long-term outlook. Chart 10 shows that aerospace unfilled orders are contracting, an environment typically associated with share price underperformance, or at least elevated volatility. Shipments of aerospace goods are falling, a rare occurrence (Chart 10). The implication is that aerospace industrial production is also shrinking (Chart 10). With a heavily unionized labor force, it will be difficult to maintain profitability. Will increased global growth translate into a recovery in aerospace new orders? Doubtful. Aerospace cycles tend to be long and are not always correlated with the business cycle. Aerospace new order growth has little correlation with the global leading economic indicator. In fact, if anything, it is more countercyclical. Ominously, there are signs of excess capacity. Our global airline consumer price index, a composite of airline pricing power in a number of major countries, is in negative territory. A negative CPI reflects excess capacity, and warns of grim prospects for a recovery in new airplane orders (Chart 11). Chart 10Running On Empty Chart 11Too Much Capacity Against this backdrop, aerospace profits will become increasingly reliant on maintenance, repair and consumables activity. However, weak pricing power suggests that this source of revenue is soft (Chart 11). Aerospace valuations are close to a par with those of defense stocks. Divergent profit outlooks imply that the latter should expand while the former get squeezed. Bottom Line: We remain confident that the BCA defense index (LMT, GD, RTN, NOC, LLL) will continue to generate above market returns, whereas the BCA aerospace index (BA, UTX, HON, TXT) exhibits asymmetric downside risk. Data Processors Are Losing Their Allure After a consolidation phase that restored value to a more neutral level, we upgraded the S&P data processing index to overweight in late-September, because it fit into our consumption vs. capital spending theme, outperforms in disinflationary environments and would benefit from a recovery in industry sales growth. While several of those factors still exist, the share price ratio has been unable to gain traction and the window for outperformance may be closing. The economic backdrop is no longer conducive to capital inflows. Data processing companies enjoy hefty recurring revenue and high returns on equity, warranting persistent above market valuations (Chart 12). However, the flipside of predictability is lower operating leverage than many other industries and a pattern of underperformance during periods of rising inflation expectations. Indeed, cyclical share price momentum tends to take its cue, inversely, from inflation expectations (inflation expectations shown inverted, middle panel, Chart 12). Renewed traction in global economic growth, as evidenced by the upturn in the global leading economic indicator (GLEI, shown inverted, top panel, Chart 13), represents a headwind to capital inflows and relative multiple expansion. The improvement in business sentiment has also boosted our capital spending model, albeit we are doubtful as to whether increased animal spirits will translate into much of a capital spending cycle in a world of deficient final demand and soft free cash flow. Still, any rise in capital spending would put the services-based data processing group at a disadvantage, in relative terms. The downturn in the ISM services index compared with the ISM manufacturing index reinforces that the external environment has become more challenging (Chart 13). All of these factors could be overcome if operating trends were set to improve. Data processing revenue trends are tightly linked with consumer spending (Chart 14). The personal savings rate has room to fall, facilitating an increase in outlays, particularly now that the labor market has tightened. Rising job security has buoyed consumer confidence, which has historically augured well for data processing sales growth. Chart 12The Window Has Closed Chart 13Sell Signals Chart 14Margin Squeeze But top-line growth has been in a funk of late, even with firming pricing power (second panel, Chart 14). Companies have made a significant investment to boost marketing, as evidenced by the surge in SG&A, but so far, this has sapped margins more than stoked revenue. Importantly, Visa has recently provided a fee break to retailers, who are increasingly banding together to put pressure on the industry to lower fees. Amidst increased competition on the payments processing side, this trend is likely to be structural and put downward pressure on profit margins. Thus, we are reluctant to embrace the jump in the producer price index, as future readings could be much weaker. The implication is that operating performance will not overcome macro hurdles. Bottom Line: Reduce the S&P data processing index (V, MA, PYPL, ADP, FIS, FISV, PAYX, ADS, GPN, WU, TSS) from overweight to underweight. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).
Highlights Since the 1950s, the trends in margins and earnings growth have been one and the same: as profit margins decline, so does earnings growth. The decline in profit margins that began in early 2015 has gone on hiatus for the past two quarters. But this rebound in margins is unlikely to be sustained. However, even if profit margins turn lower on a sustained basis, there is scope for equity returns to stay positive, based on historical precedent. Similar to a broad-based profit margin decline, further currency strength will be an earnings headwind, but not a show-stopper for profit growth. All in all, with forward multiples now at multi-decade highs, there is lots of room for earnings growth to disappoint, but the conditions for an equity bear market are not in place. Feature Equity prices continue to march higher and the S&P 500 made another all-time high last week. Q4 earnings reporting is now nearly complete, with about two-thirds of companies surprising to the upside. According to FactSet, the share of Q4 surprises is below the 5-year average, while the size of surprises (2.9% above the estimate) is also a smaller margin than the "average surprise" in the past five years (Chart 1). Nonetheless, that has not stopped analysts from getting even more bulled up about 2017 earnings. Analysts' consensus for S&P 500 operating earnings is 10.2% for the calendar year, and the forward multiple now stands at 17.5x, its highest level since 2004 (Chart 2). Chart 1Q4 Earnings Surprises: Better, ##br##But Not That Surprising Chart 2Forward P/E At ##br##Decade Highs A 10% rise in earnings within the year would not be an unprecedented move - there are numerous historical re-accelerations of operating earnings of that size. However, it would be unprecedented for earnings growth to move consistently higher over the next year without an upward trend in profit margins. As Charts 3A and 3B shows, the turning points in earnings growth always correspond with turning points in profit margins. True, there have been 13 minor episodes whereby profit margins have declined but earnings growth accelerated. But these periods were very short-lived, never lasting more than three months at a time. In the majority of these episodes, equity investors saw through the blip down in margins; equity prices continued to rally higher and returns for the year were larger than average. Chart 3AProfit Growth And Margins: An Iron Link Chart 3B There have been far more one-quarter episodes whereby earnings growth decelerates and profit margins continue to rise (39 times since 1951). In these cases, equities exhibit below average returns. Chart 4Slow Growth Will Stay A Profit Headwind The key takeaway is that when profit margins and earnings growth temporarily fail to pull in the same direction, investors have tended to focus on earnings growth. However, the caveat to the above analysis is that we rely on data going back to 1951. The current cycle is unique in that potential GDP growth has never been this low (Chart 4). In a low-growth environment, it is harder for volume expansion to compensate for any fall in margins. We believe that understanding the profit margin backdrop in this environment will remain particularly important. The Outlook For Profit Margins The trend in profit margins is determined largely by the relative growth rates of selling prices, compensation and productivity. Unit labor costs (ULC), which is compensation divided by productivity, account for about 60% of production expenses: the ratio of selling price to unit labor costs is a good proxy for profit margins (Chart 5). In terms of the denominator, unit labor costs have been choppy, but have nonetheless been on a rising trend since the beginning of the recovery. Since the early 1990s, unit labor costs tended to rise throughout the business expansion, and then fall sharply once businesses retrenched during recessions. If this cycle follows historical patterns, then unit labor costs could push higher toward 3%. In other words, labor expenses may not accelerate quickly, but it is highly unlikely that profits will benefit from a fall in ULC growth at this stage of the expansion. In a recent Special Report,1 we made the case that the economy is at full employment and there would be cyclical pressure for wages to rise, despite some structural headwinds. We do not anticipate a surge in labor costs, rather a slow creep higher. Chart 5Can Selling Prices ##br##Catch Up To Labor Cost? Chart 6Businesses Will Find It Hard ##br##To Pass On Price Increases Our major concern is whether or not selling prices (i.e. the numerator in our proxy) can keep up with even mild cost pressures. Traditionally, the conditions that allow companies to raise prices are also associated with rising costs of inputs and labor, and higher inflation prompts the Fed to impose monetary restraint. Thus, profit margins - and therefore equity prices - have generally done better when price inflation is low. However, the concern today is that inflation (corporate selling prices) is too low and that it is difficult for firms to pass on rising input costs, i.e. that a margin squeeze occurs because businesses cannot sufficiently pass on rising labor costs, as consumers have become conditioned to entrenched deflation, particularly at the retail level. We have written extensively in recent publications about inflation. Our bias is to expect broad-based inflation (PCE and CPI measures) as well as corporate selling price inflation (i.e. businesses pricing power) to rise slowly this cycle. The key points are as follows: Inflation expectations are extremely well anchored (Chart 6). True, there is a gap that has opened between survey and market-based inflation expectations. But as we explained in our January 9 Weekly Report, there are several reasons why market-based measures are likely overstating the rise in inflation expectations. Even so, these measures remain well below historic averages and continue to signal that even if the trend is up, the rate of inflation remains very benign. If survey-based inflation expectations are correct, then this business cycle could be a mirror opposite of the 1970s/80s. In that cycle, strong inflation expectations became self-fulfilling/self-reinforcing and lead to higher realized inflation. Today, after a long period of fearing deflation and experiencing massive price discounting at the retail level (Chart 6), consumers have become conditioned to expect prices will never go up. Even once the output gap is fully closed, it could take several years for inflation to gain traction. A strong dollar argues for constant drag on 30% of consumer price inflation (i.e. tradable goods and services). This will keep a lid on inflation for the foreseeable future. Overall, wage costs have outpaced pricing power since 2014, with the exception of the prior two quarters. We do not have a strong view on whether profit margins are finally in a sustained mean-reverting phase, but the above framework suggests that due to a very solid anchoring of inflation expectations, businesses could be faced with a tough pricing backdrop much later than is typical in the business cycle. Flat/falling margins are historically not enough to derail the bull market at this stage of the expansion. However, as we highlighted above, equities are now trading at sky-high forward valuations and have become extremely vulnerable to earnings disappointment. What About The Dollar? A frequent question from clients is about the role of the dollar in U.S. earnings and how enthusiastic can one be about earnings growth if the dollar is rising? As our U.S. Equity Strategy team has pointed out in the past, there are two distinct camps on the impact of U.S. dollar strength on equities.2 Bulls believe that dollar strength will depress commodity and import prices, tamping down inflation pressures and allowing the Fed to avoid monetary tightening. Therefore, the net monetary conditions impact will be positive for the U.S., which is a relatively closed economy. Under these conditions, capital would continue to flow into stocks. Bears see the currency as undermining profitability, given that foreign translation will take a hit along with income from foreign affiliates selling into weaker demand abroad (Chart 7). In other words, the rest of the world is exporting deflationary pressures to the U.S. via currency depreciation. This threatens the earnings outlook, particularly relative to still lofty growth expectations. Chart 7Dollar Headwind Our take is somewhere in between these two extremes. It is certainly true that a strong dollar helps contain inflation pressures, and allows for a prolonged business cycle. But as highlighted above, in an economy still struggling to grow much above 2%, inflation pressures are not an overly large concern to begin with. Meanwhile, hedging means that the currency translation effect on financial performance is not immediate. And the impact of any dollar strength surely depends on the conditions under which it is strengthening: dollar strength in a period of weak global growth will be more detrimental to returns than a dollar that is rising due to exceptionally strong domestic conditions. We are currently at neither one of these extremes (Chart 8). Chart 8U.S. And Global Economy: Not Hot, Not Cold Our Bank Credit Analyst service recently presented a matrix of different scenarios for the dollar and economic growth applied to a model for EPS growth. The key finding was that the effect of even small changes in growth assumptions dominate the effect of much larger moves in the dollar. A 10% dollar appreciation from current levels would shave about 2% from profits, assuming no change to the GDP growth outlook. The bottom line is that the recent improvement in margins has helped earnings recover from last year's profit recession. However, it is unlikely that margins have entered a lasting uptrend; firms lack pricing power and the labor market is now tight enough that unit labor costs will rise on a sustained basis. As profit margins trend lower in the coming years, this will present a headwind for profit growth. Similarly, our expectation that the currency will continue to appreciate over the next 12-18 months is a headwind to earnings growth. Current sky-high equity valuations leave little room for these risks. We expect that disappointments will eventually cause an equity price reset, but timing is uncertain. As we wrote last week, technical indicators do not currently suggest an important pullback is imminent. Looking further out, the overall backdrop of slowly building inflation, a go-slow Fed, and a mild pickup in nominal GDP growth, is a positive backdrop for long-term stocks. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see U.S. Investment Strategy Special Report "U.S. Wage Growth: Paid In Full?", dated November 28, 2016, available at usis.bcaresearch.com 2 Please see U.S. Equity Strategy Service Special Report, “Equity Sectors And The Soaring U.S. Dollar,” dated November 3, 2014, available at uses.bcaresearch.com