Emerging Markets
Highlights U.S. Treasuries: EM market declines have, so far, shown no signs of impacting U.S. economic growth. The underlying acceleration of U.S. growth and inflation in the face of the EM turmoil suggests that bond investors should remain strategically underweight U.S. Treasuries with a below-benchmark duration stance. EM Contagion: The current EM turmoil has not yet spilled over into U.S. financial markets, as occurred during the 2013 and 2014/2015 EM selloffs, because the U.S. economy is in a much stronger position now. It will take a bigger tightening of U.S. financial conditions, likely through higher U.S. interest rates and a larger increase in the U.S. dollar, before U.S. risk assets suffer the type of decline that could trigger a pause in the Fed rate hike cycle. Feature Chart of the WeekBond Yields Following Inflation & QT, Not EM Have investors become too complacent? The selloff in emerging market (EM) assets is intensifying. The White House is threatening to slap tariffs on virtually all Chinese imports in the U.S. Accelerating wage and price inflation in the U.S. is keeping Fed rate hikes in play. The divergence between the strong U.S. economy and the rest of the world is growing wider, keeping the U.S. dollar elevated. Yet despite all that, non-EM markets show a surprising lack of concern over the EM volatility. U.S. equity indices remain close to all-time highs, while corporate bond spreads in the major developed markets are generally stable. Government bond yields remain well above levels implied by measures of economic sentiment like the global ZEW expectations index (Chart of the Week). For yields, the big issue remains, as always, the outlook for inflation and monetary policy. On that note, yields are being supported by inflation expectations, which have been boosted by faster realized inflation, tight labor markets and high oil prices. These trends are most pronounced in the U.S., where the Fed is not only hiking rates but also slowly reducing the size of its swollen balance sheet. This comes on top of the diminished pace of asset purchases by the European Central Bank (ECB) and Bank of Japan (BoJ), with the former still on track to end its net new buying of bonds at the end of the year. Against that backdrop of rising inflation and tightening global liquidity conditions, it is incorrect to solely make comparisons between today and the most recent period of EM weakness in 2014/15 that eventually spilled back violently into non-EM markets and caused the Fed to pause after only its first post-QE rate hike. The current backdrop also has similarities to the 2013 "Taper Tantrum", when the Fed surprised the markets by signaling that it was considering ending QE, triggering a spike in Treasury yields and a selloff in global risk assets. Chart 2China Remains The Key To Global Growth Then, global growth was accelerating and inflation expectations were at levels consistent with policymaker targets in the U.S. and Europe, yet central bank liquidity was slowing rapidly (mostly due to a contracting ECB balance sheet at a time when the Fed's balance sheet growth had already slowed). EM markets sold off alongside the rapid rise in U.S. Treasury yields during the Taper Tantrum. Yet with global growth accelerating and the U.S. dollar staying relatively stable, the EM selloff ended when the Fed delayed the start of the taper into 2014, providing a monetary boost to a global economy that did not need it. Today, realized inflation is even faster and central bank liquidity is again slowing rapidly. Yet market-based inflation expectations are still a bit below central bank targets, while non-U.S. growth expectations are slowing. Worries about the impact on the world economy from the brewing U.S.-China trade war are clearly weighing on the latter. The wild card will be how China responds to the tariff threat through policy stimulus. Already, China's policymakers have allowed some depreciation of the renminbi, along with some modest easing of monetary and fiscal policies, to counteract the growth threat from the Trump tariffs. BCA's China experts do not expect anything close to the massive 2015/16 package of fiscal/monetary stimulus, given the stated goal of President Xi Jinping to crack down on systemic financial risk.1 Yet the most recent figures on Chinese import growth, and higher-frequency data incorporated in the Li Keqiang index, are showing some reacceleration after the 2017 slowdown (Chart 2). At the same time, the most recent data point on the OECD's global leading economic indicator is potentially stabilizing (middle panel). A continuation of these trends could help reverse the cooling of non-U.S. growth seen so far in 2018 (bottom panel). Given all the uncertainties surrounding the U.S.-China trade battle, EM volatility and Chinese growth - at a time when global QE has turned into "QT", or "quantitative tightening", with an associated reduction in global capital flows - we continue to recommend only a neutral stance on global spread product, favoring U.S. corporates vs non-U.S. equivalents (especially avoiding EM credit). We also are maintaining our strategic recommended underweight stance on overall developed market duration, but favoring countries where monetary tightening will be more difficult to deliver (overweight U.K., Japan and Australia versus underweight U.S., euro area and Canada). A Quick Update On U.S. Treasuries: Stay Defensive Chart 3Stronger U.S. Growth = UST Underperformance The main U.S. data releases last week, the ISM surveys and the Payrolls report for August, came as a big surprise for the U.S. Treasury market. The headline ISM Manufacturing index hit a 17-year high of 61, led by increases in both the growth and inflation sub-components of the index (Chart 3), while the U.S. economy added another 200k jobs. The big shock came from the wage data in the Payrolls report, with Average Hourly Earnings rising by 0.4% in August, pushing the year-over-year growth rate to 2.9%, the highest since 2009. The Treasury market responded to data as expected, with the 10-year yield rising back to 2.94%. One of our favorite chart relationships shows the ISM Manufacturing index as a leading indicator of the momentum (12-month change) of core CPI inflation in the U.S. (Chart 4). The recent acceleration of U.S. core inflation can be explained as a lagged response to the U.S. economic growth acceleration since the start of 2016. If the relationship in this chart holds up, the current levels of the ISM are consistent with core CPI inflation accelerating to the 2.5-3% range next year. That outcome would keep the Fed on its planned rate hike path in 2019. At the moment, the market pricing of Fed rate expectations in the Overnight Index Swap (OIS) curve remains below the latest FOMC projections for the funds rate for the next two years (Chart 5). The 10-year TIPS breakeven inflation rate, which now sits at 2.1%, is still priced below the 2.3-2.5% levels that, in the past, have been consistent with inflation expectations staying well-anchored around the Fed's 2% inflation target. A combination of accelerating U.S. growth, faster wages, and a market that has not fully discounted the likely outcome for inflation and the funds rate is not a bullish one for U.S. Treasuries. We acknowledge that there could be a short-term flight-to-quality bid for Treasuries if the EM turbulence becomes more violent and finally spills over into the U.S. markets (likely through a rapid rise in the U.S. dollar). Yet without any signs of a meaningful slowing of U.S. growth or inflation, such a move would prove to be a short-lived trading opportunity rather than a true change in the rising trend for bond yields. Chart 4U.S. Inflation Acceleration Will Continue Chart 5Market Still Underpricing Fed Rate Hikes Bottom Line: EM market declines have, so far, shown no signs of impacting U.S. economic growth. The underlying acceleration of U.S. growth and inflation in the face of the EM turmoil suggests that bond investors should remain strategically underweight U.S. Treasuries with a below-benchmark duration stance. EM Turmoil, Then & Now, In Charts As discussed earlier, we see signs today of both of the most recent EM selloffs in 2013 and 2014/15 that were fueled by rising U.S. interest rates and a higher U.S. dollar. In the sets of charts beginning on Page 7 we present "cycle-on-cycle" analyses of several economic and financial indicators during those episodes, as well as this year. The charts are set up so that the blue lines represent the current EM selloff and the dotted lines in each panel represent how the same data series responded in 2013 (top panel of each chart) and 2014/15 (bottom panel of each chart). The vertical line represents the date of the trough in the U.S. dollar for each episode, which occurred in February 2018 for the current cycle. By looking at these charts, we can see how the current backdrop is evolving versus those prior episodes. The goal is to try to determine where things are similar, and different, to EM market declines in recent history. We are focusing on the areas where we believe there is the greatest concern over the potential spillovers from the current bout of EM stress - U.S. economic growth, Chinese economic growth and U.S. financial markets. We present the charts in a rapid "chartbook" format, with our overall conclusions at the end. Leading Economic Indicators: The OECD's leading economic indicator for the U.S. (Chart 6A) is currently off the high seen at the beginning of the year, following a path similar to 2014/15, but the latest data point has ticked higher. More importantly, the level is higher than at the same point in the 2013 and 2014/15 cycles. Meanwhile, the OECD (ex-U.S.) global leading economic indicator (Chart 6B) is following the depressed path of the 2014/15 episode, rather than the acceleration seen during the 2013 Taper Tantrum. Chart 6AU.S. Leading Indicator Following 2014/15 Path Chart 6BGlobal Leading Indicator Following 2014/15 Path U.S. Dollar: The rising dollar of 2018 (Chart 7A) looks more like the 2014/15 episode in terms of magnitude, although the greenback is at a lower level than during that earlier cycle (note that all lines are indexed to 100 at the date of the trough in the dollar at the vertical line). In 2013, the increase in the dollar was fairly mild, even with U.S. bond yields soaring higher, due to fact that non-U.S. growth was improving at the time. Chart 7AU.S. Dollar Following 2014/15 Path...So Far Chart 7BU.S. Investment Grade Returns Matching 2014/15 Path U.S. Corporate Bonds: The path of excess returns for U.S. investment grade corporate debt (Chart 7B) is tracking extremely tightly to the 2014/15 experience, with larger losses compared to this similar point during the Taper Tantrum. EM Equities & Credit: The widening in USD-denominated EM sovereign credit spreads in 2018 (Chart 8A) is in line with the 2014/15 cycle and has already surpassed the 2013 episode. The decline in EM equities (Chart 8B) has been worse than both prior EM selloffs. Chart 8AEM Equities Worse Than Both 2013 & 2014/15 Chart 8BEM Spreads Matching 2014/15 Path U.S. Interest Rates: Our 12-month fed funds discounter, which measures the amount of Fed rate hikes expected by the market over the next year, is higher than the 2014/15 episode and much higher than 2013 (Chart 9A). 10-year Treasury yields are at the same level as occurred at this point during the Taper Tantrum, and well above the levels seen in 2014/15 (Chart 9B). Chart 9AMore Fed Hikes Expected Than 2013 & 2014/15 Chart 9BUST Yields Following 2013 Path U.S. Labor Markets: Perhaps the biggest difference between the current backdrop and the prior EM selloffs is state of the U.S. labor market. The unemployment rate of 3.9% is much lower than the 5.6% rate seen during the 2014/15 cycle and the 7.6% level seen at this point during the Taper Tantrum (Chart 10A). That is translating to a faster pace of U.S. wage growth, measured by the annual percentage change in Average Hourly Earnings, than in either of the previous episodes of USD strength and EM turmoil (Chart 10B). Chart 10AMuch Lower U.S. Unemployment In 2018... Chart 10B...With Faster U.S. Wage Growth U.S. Inflation: Realized U.S. inflation, using core CPI, is higher now than in either of the previous episodes (Chart 11A). That can also been seen in the ISM Prices Paid index, which is far above the levels seen in both 2013 and 2014/15 (Chart 11B). Chart 11AHigher U.S. Inflation In 2018... Chart 11B...With Greater Inflation Pressures U.S. Economy: We can obviously show many charts here, but we think the most relevant are those related to signs that non-U.S. market turmoil and slowing growth is spilling back into the U.S. On that note, we show the ISM New Orders index in Chart 12A and the annual growth rate of total U.S. exports in Chart 12B. The New Orders index today is as strong as it was at this point during the Taper Tantrum, and much healthier compared to 2014/15 when New Orders were falling sharply. U.S. export growth is faster than both prior episodes, especially 2014/15 when exports contracted outright. Chart 12AStronger ISM New Orders In 2018... Chart 12B...With Healthier Export Demand China Economy: Again, we could use any number of data series in these charts, but we are keeping it simple and choosing indicators that show the impact of Chinese growth on the world economy. Chinese nominal GDP growth, currently at 9.8%, is the same as it was at this point in the 2013 cycle but much faster than during the 2014/15 period (Chart 13A). Importantly, however, China nominal GDP growth is decelerating now as it was in both of the prior episodes. Chinese annual import growth, up 19% in RMB terms, is faster now than in both prior periods of EM stress, especially compared to the contraction seen during the 2014/15 episode (Chart 13B). Chart 13AFaster, But Still Slowing, China GDP Growth Chart 13BStronger China Import Growth In 2018 U.S. Corporate Profits: Here is perhaps the biggest difference between today and the previous EM stress episodes. The annual growth in earnings-per-share for the S&P 500 rose to 18% in the 2nd quarter of this year, far above the zero growth rate seen at this point of the 2013 and 2014/15 cycles (Chart 14A). A big reason for the difference is the impact of the Trump corporate tax cuts this year, which has boosted operating margins well beyond levels seen in the prior two episodes (Chart 14B). Chart 14AFaster U.S. Profit Growth In 2018... Chart 14B...With Wider Margins Thanks To Tax Cuts EM Growth: An aggregate of EM Purchasing Managers Indices (PMIs) shows that the current bout of softer EM growth looks similar to the slowdowns in 2013 and 2014/15 (Chart 15A). In both prior cases, the PMIs eventually fell below 50, signifying economic contraction. In the 2013 episode, however, the PMI rebounded around the same point in the cycle as we are at today. Chart 15AEM Growth Slowing Similar To 2013 & 2014/15 Chart 15BU.S. Financial Conditions Tightening Like 2014/15 U.S. Financial Conditions: U.S. financial conditions are tighter now than the level seen at this point in the 2013 cycle and are as tight as witnessed at this point in the 2014/15 period (Chart 15B). After looking through all these charts, we can come up with the following conclusions: Chart 16Is It All Just "Q.T."? EM financial stress today is worse than 2013 and 2014/15 The U.S. economy is stronger today than in 2013 and 2014/15 U.S. external demand and corporate profits are both more robust today than in 2013 and 2014/15 U.S. inflation pressures are greater today than in 2013 and 2014/15 China's economy today, while slowing, is still growing faster than in 2013 and 2014/15 EM economic growth is slowing at the same pace as in 2013 and 2014/15. In terms of "benchmarking" where we are now compared to the previous two EM big EM selloffs, the fact that U.S. and Chinese economic growth is stronger today, and U.S. inflation is faster today, are the most important differences. This may even explain why U.S. markets are not reacting more negatively to the growing protectionist threats from the White house. Against this backdrop, it will require higher U.S. interest rates and a much stronger dollar before U.S. equities and credit markets finally suffer a serious pullback. In the end, though, the fact that U.S. and Chinese growth is better today does not suggest that a cautious investment stance is unwarranted. For the best correlation can be seen in our final chart (Chart 16), which shows the growth rate of the major developed market central bank balance sheets as a leading indicator of EM equity returns and developed market credit returns (and as a coincident indicator of government bond yields). If one were to only look at this chart, the weaker returns from global risk assets in 2018 can be fully explained by "quantitative tightening" and the resulting pullback in risk-seeking global capital flows compared the 2016/17. Bottom Line: The current EM turmoil has not yet spilled over into U.S. financial markets, as occurred during the 2013 and 204/15 EM selloffs, because the U.S. economy is in a much stronger position now. It will take a bigger tightening of U.S. financial conditions, likely through higher U.S. interest rates and a larger increase in the U.S. dollar, before U.S. risk assets suffer the type of decline that could trigger a pause in the Fed rate hike cycle. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy/China Investment Strategy Special Report, "China: How Stimulating Is The Stimulus?", dated August 8th 2018, available at gps.bcaresearch.com and cis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Last week's View Meeting underlined the point that BCA's take on the macro backdrop hasn't changed. Decelerating global growth and the potential for a nasty EM debt episode still argue for slightly cautious asset allocation. Global desynchronization is in full swing, with the U.S. leading the other major DM economies by a wide margin. The growth disparity will be dollar-positive while it lasts, but the deteriorating U.S. budget position will weigh on the dollar in the long run. S&P 500 performance across the earnings cycle reveals that decelerating earnings growth is not a problem for stocks as long as earnings are still growing year-on-year. Acceleration beats deceleration, but peaking earnings growth is not a signal to trim equity exposures. The U.S. is not impervious to a meaningful EM credit event, but its direct exposures are very limited. Post-crisis banking regulations have meaningfully reduced the banking system's vulnerabilities and make it very unlikely that another LTCM-like event might occur. Feature BCA researchers convened last week for our monthly View Meeting with the explicit goal of taking stock of our strategy teams' macro views. The nine-year-plus U.S. expansion is well advanced, and we are carefully monitoring the business cycle, the credit cycle, and the policy cycle for early warning of inflections in the rates, credit, and equity markets. In addition to the regular cyclical movements, we also have to gauge the impact of the ongoing reversal of extraordinary monetary accommodation and a raft of geopolitical issues. The investment outcome of the many crosscurrents continues to be subject to spirited debate, but the warily constructive house view, in place since mid-June, was not challenged. Decelerating global growth was a key driver of our June downgrade to neutral on equities. The U.S. economy may be surging as two years of fiscal stimulus makes its presence felt, but the other major developed-world economies are softening, and the emerging-market bloc faces considerable pressure. Although the S&P 500 has since made new highs (Chart 1, top panel), the MSCI All-Country World Index ("ACWI") has gone nowhere (Chart 1, second panel). Within the ACWI, DM equities (Chart 1, third panel), have handily outperformed struggling EM equities (Chart 1, bottom panel). We continue to expect more of the same. Tax cuts will keep corporate profits growing at better than 20% for the rest of the year, and federal spending will boost the U.S. economy through the end of 2019. The pickup in aggregate demand will strain dwindling spare capacity, feeding inflation pressures, and keeping the Fed from easing up on its rate-hiking campaign. A resolute Fed will ratchet up the pressure on EM borrowers, while increasing trade barriers pose a headwind for the many DM and EM economies that are more open than the U.S. Chinese policymakers could provide some respite to the global economy, but our China and EM strategists aren't counting on it. Easing monetary and/or fiscal policy would run counter to the Party's ongoing deleveraging and anti-corruption campaigns (Chart 2). Though China's rulers have demonstrated a tendency to overreact when acting to offset adverse economic events, our in-house experts think conditions will have to get a good bit worse to provoke meaningful stimulus of any sort. The strike price on a Chinese policy put may be considerably out of the money. Chart 1So Far, So Good Chart 2Will They Swim Against The Tide? Bottom Line: Overindebtedness, rising trade barriers, and a U.S. economy with the potential to overheat will keep the pressure on the EM bloc and cast a shadow over global growth. The Chinese policy cavalry may not feel any particular urgency to ride to the rescue. Leading The Pack There was no dispute about the U.S. growth outlook, absolute or relative. The U.S. economy is flying high, and will continue to outdistance its DM peers for the rest of this year and next. S&P 500 EPS growth will maintain its better than 20% pace in the third and fourth quarters. Next year's 10% consensus may be ambitious, given that this year's dollar appreciation probably hasn't shown up in earnings data, but corporate management teams have not yet expressed much in the way of dollar concerns. Decoupling cannot go on forever in the 21st-century global economy, but the comparatively closed U.S. economy has room to run in the near term. Last week's August ISM Manufacturing survey reached a 14-year high while the global PMI continued to hook lower (Chart 3). The gap between the U.S. LEI index and the global ex-U.S. LEI index has been widening for over a year (Chart 4), and would seem to herald additional dollar strength (Chart 4, bottom panel). Our corporate earnings models see U.S. EPS growth widening its lead on Europe and Japan over the rest of the year (Chart 5). Chart 3You Go Your Way And I'll Go Mine Chart 4Dollar Strength... Chart 5...Hasn't Gotten In Earnings' Way Yet Bottom Line: The U.S. is outgrowing its developed market peers, and there is nothing on the immediate horizon that suggests a reversal is in store. Superior corporate earnings growth and dollar strength should allow U.S. equities to outperform their major DM peers on a common-currency basis well into 2019. The Change, Or The Change Of The Change? Deceleration has been at the heart of BCA's managing editors' concerns, and there is an intuitive appeal to the idea that equity markets prize the change of the change (the second derivative) over the first-order move itself. It has the potential to clash, however, with the empirical fact that stocks typically rise unless earnings are contracting. To determine the degree to which decelerating earnings growth has historically presented a challenge to the S&P 500, we posit a four-phase earnings cycle based on the interaction between earnings-estimate growth and acceleration (Diagram 1), as follows: Diagram 1The Earnings Cycle Phase I begins when the worst part of the cycle has ended. Earnings estimates are contracting on a year-over-year basis, but at a slowing rate. Because earnings typically grow, and the bounce off the bottom is typically swift, this phase has occurred just 8% of the time. In Phase II, year-over-year earnings are growing at an accelerating rate. In Phase III, year-over-year earnings are still growing, but at a slowing rate. Phase II and Phase III are the de facto default phases, each accounting for 39% of all observations. In Phase IV, year-over-year earnings are contracting at an accelerating rate. Phase IV is more common than Phase I because the decline to the bottom tends to unfold more slowly than the bounce off of it, but it still occurs just 14% of the time. Table 1 shows annualized S&P 500 price returns for each phase of the cycle and then groups the phases by acceleration/deceleration and expansion/contraction. Stocks perform better when the rate of earnings growth is accelerating than they do when it's decelerating, but they also perform better when earnings are growing on a year-over-year basis than they do when they're declining. Stocks perform terribly when earnings are falling year-on-year at an increasing rate (Phase IV), and do great when the pace at which they're falling slows (Phase I), but those occurrences are few and far between. Earnings grow four-fifths of the time, and when they do, the differences between accelerating and decelerating growth aren't all that big a deal (Chart 6). Table 1Acceleration Is Better, But Deceleration Isn't All Bad... Chart 6...As It's Not A Problem As Long As Earnings Still Grow Bottom Line: Deceleration in the rate of earnings growth is not a signal to abandon stocks as long as earnings are still growing year-on-year. Investors have fared well for 40 years when earnings estimates expand, regardless of whether the rate of expansion is accelerating. 2018 Is Not 1997-98 In the wake of August's wobbles, several clients have been eager to explore various EM economies' vulnerabilities1 in more detail. We have fielded several questions relating to U.S. banks' EM exposures and how they compare to their exposures to the Asian Tigers on the cusp of the Asian Crisis. Per data from the Bank for International Settlements and the FDIC, U.S. claims on Thailand, Indonesia, the Philippines, Singapore, Malaysia, South Korea and Taiwan amounted to about 14% of all U.S. bank credit at the end of 1996. That exposure is very similar to the U.S. banking system's current exposure to Argentina, Turkey, Brazil, Colombia, Mexico, Chile, South Africa, and Indonesia. Direct exposure to fragile EM economies did not drive the S&P 500's 19% decline across July and August of 1998, however, nor did it inspire a consortium of fourteen major global financial institutions to come together to attempt to ring-fence the U.S. banking system. Those outcomes can be laid to the brokers' and investment banks' indirect exposure to the massively leveraged investment portfolio of the Long-Term Capital Management hedge fund (LTCM). To gauge the system's fragility back then, we perform a simple comparison of LTCM's debt to the publicly traded U.S. investment banks' total equity. In our back-of-the-envelope analysis (Table 2), we assume that the four investment banks, which contributed a quarter of the funds to rescue LTCM, had provided at least a quarter of LTCM's financing.2 Per our assumptions, LTCM claims accounted for 82% of the four banks' total equity. Losses given default would not have been anywhere near 100%, but a disorderly exit from LTCM's positions would surely have forced several of LTCM's creditors to conduct urgent capital raisings of their own. Fortunately for investors, today's banking system is nowhere near as vulnerable. Investment bank leverage ratios of 30 or more, commonplace in the late '90s, are a practical impossibility today. While lenders are no less likely to chase business late in the cycle today, post-crisis regulation makes it far more difficult to indulge their folly. Today's investment banks operate with a third of the leverage of 20 years ago (Table 3). The odds that another overextended investor, or group of investors, could imperil the U.S. banking system are much longer today than they were then. It's considerably harder to come by leverage via the regulated banking system, and leverage is the essential contagion ingredient. Table 2Enormous Leverage Made The Banking System Unstable In The Summer Of 1998 ... Table 3... But It's Not A Problem Anymore Bottom Line: Basel III, Dodd-Frank and the Volcker Rule save lenders from their own worst impulses. The odds of another LTCM crisis are far slimmer than they were in the late '90s. Investment Implications We continue to have a constructive view of the business, market and policy cycles in the U.S., but there's more to the global investing backdrop than just the U.S. Global investors should overweight U.S. equities versus equities in the rest of the world and U.S. investors should be sure to be at least equal weight equities, but the environment is sufficiently risky to inspire caution. We join our colleagues in continuing to recommend a benchmark equity allocation, while underweighting bonds and overweighting cash. August's employment report supports our economic and investment takes. The labor market remains tight, with the broader U-6 definition of unemployment (including involuntary part-time and discouraged workers) making a second straight 17-year low (Chart 7, top panel), and average hourly earnings extending their slow march higher (Chart 7, bottom panel). With the three-month moving average of payrolls (185,000) expanding at a rate well above the 110,000-per-month pace required to absorb new entrants to the labor market, qualified candidates are going to become even more difficult to find. The upshot is that the Fed remains firmly on a path to hike rates more than the market consensus currently expects. Despite the potential for a near-term flight-to-safety bid for Treasury bonds, we are sticking with our below-benchmark duration call. Chart 7As Slack Is Absorbed, Wages Will Rise Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Please see the August 20, 2018 U.S. Investment Strategy Weekly Report, "Rude Health," available at usis.bcaresearch.com. 2 Lehman did not contribute to the bailout, but it is highly improbable that it had not lent to LTCM.
Highlights Fed policy and U.S. interest rates are not irrelevant to EM, but they are of secondary importance. The most vital factors that drive EM financial markets - the direction of global trade, domestic demand, corporate profits, and borrowing costs - do not currently indicate a sustainable bottom. Stay short/underweight EM risk assets. Feature How long and how deep will the selloff in emerging markets (EM) be? There are many factors that investors should be watching to gauge potential for further downside in the EM universe, and to exercise judgement about a bottom. These include the business cycle trajectory, policy actions and shifts, market technicals, liquidity, valuations and other fundamental variables. Not all of preconditions typically need to be satisfied before a major bottom emerges. What's more, not all bottoms are identical and contingent on the same factors. Hence, there is no magical formula for calling a bottom or top in any financial market. Today we revisit some of the variables that, in our opinion, are worth monitoring in terms of gauging a bottom. To begin, we address a currently popular narrative within the investment industry, which contends the following: EM woes are primarily being driven by Federal Reserve tightening. According to this view, when the Fed halts its tightening campaign, the skies will clear for EM risk assets. By and large, we disagree with this narrative. EM And The Fed: Let's Get Things Straight Fed policy and U.S. interest rates are not irrelevant to EM, but they are of secondary importance. The primary drivers of EM economies are domestic fundamentals and the overall global business cycle. Historically, the correlation between EM risk assets and the fed funds rate has been mixed (Chart 1). On this chart, we shaded the periods in which EM stocks rallied, despite a rising fed funds rate. Chart 1EM Equity Prices And Fed Funds Rate: Mixed Correlation There were only two episodes when EMs crashed amid rising U.S. interest rates: the 1982 Latin America debt crisis and the 1994 Mexican Tequila crisis. Yet, it is vital to emphasize that these crises occurred because of poor EM fundamentals: elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits, pegged exchange rates, and so on. Importantly, EM stocks and currencies did well during other periods of a rising fed funds rate: in 1983-1984, 1988-1989, 1999-2000 and 2017, as illustrated by the shaded periods in Chart 1. Hence, statistically there is no case that EMs plunge when the Fed is tightening policy. Why did the behavior of EM risk assets during various Fed tightening episodes differ? The key was EM fundamentals at the time: When fundamentals were healthy, EM managed to rally, despite Fed tightening; when fundamentals were flawed, EM markets relapsed regardless of the Fed's policy stance. Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-1998. However, these late-1990s EM crises occurred without much in the way of Fed tightening or rising U.S. bond yields. Notably, U.S. and EU growth were booming and U.S. bond yields were dropping in 1997-'98. Specifically, U.S. and EU import volumes were growing at double-digit rates but this did not preclude EM crises, including in export-dependent Asian economies such as Korea, Malaysia and Thailand (Chart 2). It is critical to emphasize that China was not an economic superpower in the late 1990s. EM economic dependence on the U.S. and European economies was much greater than it is today. Yet neither booming demand in the U.S. and EU nor falling U.S. government bond yields prevented the Asian/EM crises from rolling across the globe in 1997-'98 (Chart 3A). Moreover, the S&P 500 was in a bull market in the second half of 1990s, as it is today (Chart 3B), but it did not help EM either. Chart 2Asian/EM Crises In 1997-98 Occurred Amid Booming Growth In U.S. And EU Chart 3AAsian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Chart 3BAsian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Hence, we can safely conclude that the EM fallout in 1997-'98 was due to EM domestic fundamentals - not developed market dynamics in general and Fed tightening in particular. An essential question is: Why are EM risk assets currently plunging while U.S. stocks and credit markets are holding up just fine? The U.S. economy is much more exposed to rising U.S. borrowing costs than EM. Despite this, the American economy, U.S. share prices and corporate bonds have been performing very well. In our view, this also stipulates that the core root for the current EM bear market is EM fundamentals. As we have repeatedly noted in various reports,1 EM fundamentals have been very frail, and the end of easy Fed monetary policy has not helped. The Fed's tightening can be regarded as the trigger - not the cause - of the EM bear market. The cause is weak EM fundamentals, such as credit excesses, low return on capital, weakening productivity growth and, in some cases, inflation and dependence on external funding. Importantly, the dependence of EM countries on the Chinese economy is presently greater than their dependence on the U.S. as shown in Table 1. Further, mainland growth is decelerating. Adding it all up, it is not surprising to us that EM financial markets are in turmoil. Table 1Many Emerging Economies Sell More##br## To China Than to The U.S. Our bearish view on EM has not been based on a negative view on U.S./EU growth. On the contrary, we have been bearish on EM/China and positive on domestic demand in the U.S. and the EU. Early this year, we promoted the theme of tectonic macro shifts,2 arguing that China/EM growth would slump and the U.S. economy would accelerate - and that such dynamics would propel the U.S. dollar higher. In turn, a firm dollar would inflict substantial pain on EM. Bottom Line: Rising U.S. interest rates, in and of itself, is neither a necessary nor a sufficient condition for EM to sell off. Consequently, the Fed adopting an easier policy stance or lower U.S. Treasury yields may not, in and of themselves, create sufficient conditions for a reversal in EM financial markets, unless they coincide with a turnaround in other variables that matter for EM. What Matters For EM? As of now, we do not think sufficient conditions exist for a bottom in EM financial markets because of several pertinent factors: The most important factor for EM assets in the medium term is the direction of the business cycle in EM in general, and in China in particular. The EM business cycle is still decelerating, as evidenced by falling manufacturing PMI indexes in EM ex-China and China (Chart 4). Consistently, corporate earnings growth is decelerating for EM non-financial companies and Chinese non-financial A-share corporates (Chart 5). The rationale for our focus on non-financial corporate earnings is that non-performing loans are usually not recognized and provisioned for by banks in a timely way to reflect their true profitability. Typically, banks' earnings cycle lags the real economy. When the real economy is slowing, banks' profits typically deteriorate with a time lag. Chart 4Manufacturing Is Slowing In China And EM Ex-China Chart 5EM/China Corporate Profit Growth Is Decelerating Corporate profits in China and in EM have not yet contracted, but our view is that there will be a meaningful profit contraction in this downturn. As and when corporate earnings shrink, share prices will sell off. In brief, we are not out of the woods yet. In China, the industrial part of the economy continues to weaken, as evidenced by the slump in the total freight index and electricity consumption by manufacturing and resource sectors (Chart 6). So far, the cumulative impact of policy easing in China has not been sufficient to reverse its business cycle. As we discussed in our prior report,3 money/credit impulses lead China's industrial sector by nine months or so. Even if the government's recent stimulus initiatives cause money/credit impulses to improve materially today (which we still doubt), the impact on growth will be felt only next year. While financial markets are forward-looking, they are unlikely to bottom a full six months before the bottom in the real economy. Hence, we are currently in the window where China plays in financial markets remain at risk. Global trade is also weakening, as evidenced by falling semiconductor prices (Chart 7) and industrial metals. Similarly, the container freight index at Chinese ports is sluggish, and broader Asian export volumes are slowing (Chart 8). Chart 6Signs Of Industrial Slowdown In China Chart 7Semiconductor Prices Are Plunging Chart 8Asian Export To Slow Further Regarding liquidity, there are various definitions and ways to measure liquidity. One measure of EM liquidity is EM local interest rates. Chart 9A and 9B shows that interbank rates in various EM countries are rising due to the ongoing currency weakness. EM benchmark local currency bond yields are also under upward pressure (Chart 10, top panel). These are all signs of tightening liquidity. The ramifications of higher interest rates will be a slowdown in money and credit, and consequently a slump in domestic demand. Chart 9AEM: Interbank Rates##br## Are Rising Chart 9BEM: Interbank Rates##br## Are Rising Chart 10EM: Local Currency Bonds Yields##br## And Narrow Money Growth Chart 10 illustrates that local bond yields negatively correlate with narrow money growth in EM ex-China, Korea, Taiwan and India. These four markets are not included in the EM GBI local bond index; to maintain consistency, we have removed them from the money supply aggregate. EM sovereign and corporate bond yields continue to rise. As we have shown numerous times in previous reports, EM share prices do not bottom until EM corporate and sovereign bond yields roll over on a sustainable basis. Finally, we discussed EM equity and currency valuations in our August 23 report. We maintain that aggregate EM equity and currency valuations are not yet cheap enough to warrant bottom-fishing. Bottom Line: The most vital factors that drive EM financial markets - the direction of global trade, domestic demand, corporate profits, and borrowing costs - do not currently indicate a sustainable bottom. Stay short/underweight EM risk assets. 6 September 2018 The list of our trades and country allocation is always presented at the end of each report (please see page 10-11). Specifically, we continue shorting BRL, CLP, ZAR, IDR and MYR versus the U.S. dollar. Within the equity space, our overweights are Taiwan, Korea, Thailand, Chile, India, Mexico and central Europe; and underweights are Brazil, Peru, Malaysia, Indonesia, and South Africa. Among local currency bonds we are overweight Russia, Korea, Mexico, Thailand, and central Europe and underweight Brazil, South Africa, Turkey, Malaysia, and Indonesia. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see BCA Emerging Markets Strategy Weekly Report, "Understanding The EM/China Cycles," July 19, 2018. 2 Please see BCA Emerging Markets Strategy Weekly Report, "Two Tectonic Macro Shifts," January 31, 2018. 3 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Do Note Catch A Falling Knife," August 23, 2018. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights The primary trend for both Chinese stock prices and CNY-USD remains captive to negative surprises related to the trade war between the U.S. and China. Considerable uncertainty remains on this front, but our outlook is that the situation is likely to get worse, not better. It remains too early to forecast a durable stabilization in the exchange rate. It is an open question whether the PBOC will be forced to change short-term interest rates in order to guide the currency in their preferred direction. There is some evidence to suggest that China can control both the interest and exchange rate should it choose to do so, but analyzing the issue is significantly complicated by the approach Chinese policymakers are using to manage the impossible trinity. There is room for Chinese short-term interest rates to rise modestly if the worst of the U.S./China trade war does not materialize. This would be consistent with the goal of avoiding significant releveraging of China's private sector. For now, investors should maintain no more than a benchmark allocation towards Chinese investable stocks within a global equity portfolio, and should continue to favor low-beta sectors within the investable universe. Feature We noted in our August 22 Weekly Report that the persistent weakness of the RMB appeared to be one important factor weighing on Chinese stocks, particularly the domestic market.1 We presented some tentative evidence that part of the decline in CNY-USD since mid-June has been policy-driven (despite the PBOC's statements that it had not been depreciating the currency), but also noted that the RMB had now likely fallen outside the comfort zone of policymakers. The PBOC's re-introduction of its "counter-cyclical factor" when fixing the yuan's daily mid-point supports this view, and suggests that monetary authorities are now aiming for a broadly stable exchange rate (or are aiming to limit further downside). Chart 1 highlights that there have been some, albeit modest, signs of success. Whether they succeed will, first and foremost, be largely determined by what appears to be an imminent decision by the Trump administration to levy tariffs on an additional $200 billion in imports from China. Our previous analysis of potential equilibrium levels for CNY-USD suggests that investors have already priced in the imposition of a second round of tariffs, but the key factor for markets will be whether the tariff rate applied is 10% or 25%. In the first case it is possible that the RMB has overshot to the downside; in the latter case, CNY-USD will very likely come under renewed pressure that would be difficult for the PBOC to fully counter. Chart 1Some Modest Signs Of Currency Stability Chart 2Interest Rate Differentials And CNY-USD: A Tight Link But an additional question is whether the PBOC will be forced to change short-term interest rates in order to guide the currency in their preferred direction. Both our Global Investment Strategy and Emerging Markets Strategy services have highlighted that USD-CNY has broadly tracked the one-year swap differential between the U.S. and China over the past few years (Chart 2). This suggests that, at a minimum, there is some link between the interbank market and the exchange rate, despite the fact that capital controls are still tight in the Chinese economy. It also seems to imply, ominously, that the PBOC may have to choose between potentially significant releveraging and a significant re-appreciation in the exchange rate. Revisiting The Impossible Trinity "With Chinese Characteristics" The exact nature of this interest/exchange rate link is difficult to analyze, because of how China has chosen to manage the "impossible trinity" following the August 2015 devaluation of the yuan. The upper portion of Chart 3 illustrates the standard view of the impossible trinity, which posits that policymakers must choose one side of the triangle, foregoing the opposite economic attribute. For example, most modern economies have chosen "B", allowing the free flow of capital and independent monetary policy by giving up a fixed exchange rate regime. Hong Kong has chosen "A", meaning that its monetary policy is driven by the Fed in exchange for a pegged exchange rate and an open capital account. Chart 3The Possible Trinity? China historically has chosen "C", an economy with a closed capital account, a fixed exchange rate, and independent monetary policy. There is no causal link between interest and exchange rates in the world of option C, but following the PBOC's move in 2015 towards a more market-oriented approach for the exchange rate, it was accused by many market participants of trying to pursue all three goals simultaneously. In short, market participants have not been able to clearly discern what option China has chosen following over the past few years. China, in effect, answered these criticisms by arguing that it was not bound by the standard view of the impossible trinity, but rather one "with Chinese characteristics". The lower portion of Chart 3 presents this theory, which posits that policymakers must distribute a 200% adoption rate among three competing choices. The chart depicts a possible scenario where policymakers are relatively tolerant of capital flow, partially adopting two measures in addition to fully independent monetary policy: quasi-floating exchange rates highly subject to the interest rate dynamics shown in Chart 2, and loosely enforced capital controls. The chart also shows what ostensibly occurred in response to significant capital flight in 2014 and 2015, i.e. a crackdown on capital control enforcement and a less market-driven exchange rate. To the extent that this framework still applies, Charts 4 - 7 suggest that this capital flow crackdown has not abated and that the PBOC may be able to prevent significant further weakness in the currency without dramatically raising interest rates: China tightened scrutiny on trade invoicing verifications in 2016 to crack down on "fake" international trades, such as imports from Hong Kong (local firms fabricated import businesses to move money offshore). Based on the recent trend, these restrictions remain in effect (Chart 4). In addition, quarterly net flows of currency and deposits, which turned sharply negative in Q3 2015, have risen back into positive territory (Chart 5). Chart 4Blocking Capital Leakage In Trade... Chart 5...And Cash Chart 6 presents Chinese foreign reserves measured in SDRs, and highlights that reserves have been stable for the better part of the past two years. This stability is in sharp contrast to the material decline that occurred in 2015, and is supportive of the view that China can control both the interest and exchange rate, should it choose to do so. Chart 7 highlights that there are a few precedents for a divergence between interbank rates and CNY-USD. One divergence in 2012-2013 is particularly noteworthy: CNY-USD trended higher, but interbank interest rates remained flat for some time. Crucially, this does not appear to have been driven by falling U.S. interest rates, as the 2-year Treasury yield had already fallen close to zero in 2011 and did not begin to rise until mid-2013. Chart 6China Has Stabilized Its ##br##Foreign Reserves Chart 7Short-Term Interest Rates And ##br## CNY-USD Have Diverged Before Interest Rates And Moderate Releveraging Despite the evidence presented in Charts 4 - 7, the bottom line is that it is not clear whether the PBOC would be forced to raise short-term interest rates (and by how much) if it chooses to stabilize the currency. Would doing so be a death-knell for the Chinese economy? In our view, the answer is no, unless the trade war does indeed metastasize further. We have argued that the magnitude of the decline in the 3-month repo rate has been excessive, and is not currently consistent with a moderately reflationary scenario. We have argued that the repo rate decline is a side-effect of the PBOC's heavy liquidity injections, which were more likely aimed at ensuring financial system stability against the backdrop of struggling small banks. Chart 8Lending Rates Will Decline Substantially ##br## If Repo Rates Don't Rise But the current level of liquidity support carries risks to the objective of controlling private-sector leveraging. Chart 8 suggests that unless the PBOC raises the benchmark lending rate (which would be interpreted very hawkishly by the market), the magnitude of the decline in the repo rate will push the weighted average lending back to its 2016 low (when the monetary authority had turned the policy dial to "maximum reflation"). Last week's Special Report explained in detail why this would carry significant risks to China's financial stability.2 We noted that most of the private sector leveraging that has occurred in China since 2010 has occurred on the balance sheet of state-owned enterprises (SOEs) and the household sector. While the household debt-to-GDP ratio is still low, it is rising rapidly and may accelerate even further if lending rates fall significantly. The picture for SOEs is even more dire: leverage is extremely elevated, and a comparison of adjusted return on assets to borrowing costs suggests that the marginal operating gain from debt has become negative. This suggests that further leveraging of SOEs could push them into a debt trap and/or shackle the monetary authority's ability to meaningfully raise interest rates. As such, it is actually our expectation that short-term interest rates will rise modestly following a 10% rate on the second round of tariffs (instead of 25%), or if it becomes clear that there will be no third round. If the trade war escalates, however, short-term interest rates would not be expected to rise at all, and the drive to control leverage could be downshifted yet again. Investment Conclusions Chart 9Stay Neutral Towards Chinese Stocks, ##br##And Favor Low-Beta Sectors What does this all mean for our view on the RMB, and what are the implications for Chinese stocks? For now, we can draw the following conclusions: The primary trend for both stock prices and the exchange rate remains captive to negative surprises related to the trade war between the U.S. and China. We would expect further financial market weakness in response to a 25% rate on the second round of tariffs, and especially if President Trump moves forward with plans to tariff the remaining $250 billion of imports from China (the "third round"). Conversely, a 10% second-round tariff rate, or convincing signs that there will be no third round, could soon put a floor under the RMB and stock prices. On this front, the lead-up to a possible meeting between Presidents Trump and Xi in November will be important to monitor. But for now, given our view that the trade war between the U.S. and China is likely to get worse, not better, it remains too early to forecast a durable stabilization in the exchange rate, and an overweight stance towards Chinese equities in absolute terms remains premature. A-shares are deeply oversold and we are watching closely for signs to time a reversal, relative to investable stocks (at least at first). Higher Chinese short-term interest rates are not necessarily negative for stock prices, as long as the rise is modest and not in the context of a further, material uptick in trade tensions between the U.S. and China. While a moderate releveraging scenario would clearly imply a weaker earnings growth outlook than if credit accelerated strongly, earnings growth is still positive and yet Chinese equities are 20-30% off of their 1-year high in local currency terms. Modestly higher interest rates, in the context of durable RMB stability and an end to the escalation of trade threats, is likely to be equity-positive. As we wait for more clarity on the trade outlook, we reiterate our core equity investment recommendations: Investors should maintain no more than a benchmark allocation towards Chinese investable stocks within a global equity portfolio, and should continue to favor low-beta sectors within the investable universe (Chart 9). As always, we will be monitoring developments related to the timing and magnitude of the upcoming export shock, as well as further policymaker responses continually over the coming weeks and months. Stay tuned! Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see China Investment Strategy Weekly Report "In Limbo", dated August 22, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Special Report "Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging", dated August 29, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Feature Desynchronization To Continue This year has been characterized by strong growth and asset performance in the U.S., and weakness everywhere else. While U.S. stocks are up by 10% year-to-date, those in the rest of the world have fallen by 3% in dollar terms (Chart 1). GDP growth in Q2 was 4.2% QoQ annualized in the U.S., compared to 1.6% in the euro area and 1.9% in Japan. Leading economic indicators point to this continuing and, therefore, to the U.S. dollar strengthening further (Chart 2). This has already put significant pressure on emerging markets, where equities have fallen by 7% this year in USD terms. Recommended Allocation Chart 1U.S. Has Outperformed Chart 2...And Leading Indicators Suggest This Will Continue There are many reasons why the desynchronization is likely to continue: U.S. growth continues to be boosted by tax cuts and increased fiscal spending which, according to IMF estimates, will add 0.7% to GDP growth this year and 0.8% next. The peak impact from the stimulus will not come until around Q1 next year. Further protectionist tariff increases. Despite August's tentative agreement between the U.S. and Mexico, the Trump administration still plans to implement 10-25% tariffs on $200 billion of Chinese imports, and also possibly 25% tariffs on auto imports, in September. This will - initially at least - be more negative for global exporters, such as China, the euro area and Japan, than for the U.S. China is unlikely to implement the sort of massive stimulus that it carried out in 2009 and 2015.1 It has recently cut interest rates and brought forward fiscal spending to cushion downside risk. But, given the Xi administration's focus on deleveraging and structural reform, we do not expect to see a substantial increase in credit creation (Chart 3). This indicates that emerging markets, and capital goods and commodities exporters, will continue to struggle. European banks will stay under pressure because of the problems in Italy (which will fight this fall with the European Commission over its fiscal stimulus plans) and Turkey. Euro zone equity relative performance is heavily influenced by the performance of financials, even though the sector is only 18% of market cap (Chart 4). The euro zone and Japan are also far more sensitive to a slowdown in EM growth: exports to EM are 8.4% and 6.4% of GDP in the euro zone and Japan respectively, but only 3.6% in the U.S. Chart 3China Unlikely To Repeat 2009 and 2015 Chart 4Banks Drive European Equity Performance Eventually, however, strong growth in the U.S. will become a headwind for U.S. assets too. Already, there are some signs of wage growth ticking up (Chart 5), suggesting that the labor market is finally becoming tight. Fed chair Jerome Powell, in his speech at Jackson Hole last month, reiterated that a "gradual process of normalization [of monetary policy] remains appropriate", suggesting that the Fed will continue to hike by 25 basis points a quarter. But the futures market is pricing in only 75 basis points in hikes over the next two years (Chart 6). And, if core PCE inflation were to rise above the Fed's forecast of 2.1% (it is currently 2.0%), the Fed would need to accelerate the pace of tightening. This all points to further dollar strength which will hurt emerging markets, given the consistent inverse correlation between U.S. financial conditions and EM asset performance (Chart 7). Chart 5Is Wage Growth Finally Accelerating? Chart 6Markets Pricing In Only Three More Fed Hikes Chart 7Tightening Financial Conditions Are Bad For EM We continue for now, therefore, to remain overweight U.S. equities in USD terms within a global multi-asset portfolio, despite their strong performance this year. We are neutral on equities overall and expect to move to negative perhaps early next year, when we will see some of the classic warning signs of recession (inverted yield curve, rise in credit spreads, peak in profit margins) starting to flash. Profit expectations are one key to the timing of this. Analysts forecast 22% YoY EPS growth for S&P 500 companies in Q3 and 21% in Q4, slowing to 10% in 2019. Those are strong numbers. But if companies are unable to beat these forecasts, what would be the catalyst for stocks to continue to rise? Moreover, analysts' expectations for long-term earnings growth are more optimistic currently than any time since 2000 (Chart 8). It would not take much of a downside earnings surprise - perhaps caused by the strength of the dollar, or regulatory change for internet companies - to disappoint the market. Equities: Our strongest conviction call remains an underweight on emerging markets. Emerging markets are entering what is likely to be a prolonged period of deleveraging, given their elevated levels of debt relative to GDP and exports (Chart 9). That makes them very vulnerable to the stronger U.S. dollar and higher interest rates that we expect. While EM equities have already fallen significantly, they are not yet cheap and investors have mostly not capitulated: outflows from EM funds have been small relative to inflows in previous years (Chart 10). Among developed markets, we keep our overweight on the U.S.: not only does its lower beta mean it should outperform in the event of a sell-off, but if markets were to see a last-year-of-the-bull-market "melt-up" (similar to 1999), this would likely be led by tech and internet stocks, where the U.S. is overweight. Chart 8Analysts Too Optimistic About Long-Term Earnings Growth Chart 9Long Period Of Deleveraging Ahead For EM Chart 10No Signs Of Capitulation In EM Yet Fixed Income: Higher inflation, and more Fed tightening than the market is pricing in, suggest that long-term rates have further to rise. Fed rate surprises have historically been a good indicator of the return from U.S. Treasury bonds (Chart 11). We expect to see the 10-year yield reach 3.3-3.5% by early next year. We therefore remain underweight duration, and prefer TIPS over nominal bonds. We recently lowered our weighting in corporate credit to neutral (within the underweight fixed-income category). Junk bonds have continued to perform well, thanks to their 250 basis point default-adjusted spread over Treasuries. But spreads typically start to widen one to two quarters before equities peak, so we think caution is already warranted, particularly in the light of the higher leverage, longer duration, and falling average credit rating which currently characterize the U.S. corporate credit market. Currencies: As described above, mainly because of divergent growth and monetary policy, we expect the U.S. dollar to strengthen further, but more against emerging market currencies than against the yen or euro. Short-term, however, the dollar may have overshot and speculative positions are significantly dollar-long (Chart 12), so a temporary pullback would not be surprising. Chart 11More Fed Hikes Means Higher Long-Term Rates Chart 12Are Investors Too Dollar Bullish? Chart 13Dollar And China Hurting Commodities Commodities: Industrial metals prices have declined sharply over the past few months, on the back of the stronger dollar and slowdown in China (Chart 13). We expect this to continue. Gold, we have long argued, has a place in a portfolio as an inflation hedge. But it is also negatively impacted by rises in the dollar and real interest rates, and these are likely to continue to be a drag on performance. The oil price is currently being driven by supply dynamics: How much more oil will Saudi Arabia produce? Will the E.U. and Japan follow the U.S. in imposing sanctions on Iran? Will Venezuelan production fall further? These will make the crude oil price more volatile, but our energy strategists see Brent softening a little to average $70 in H2 this year, but with potential upside surprises taking it up to an average of $80 in 2019. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 For details on why we think massive stimulus is unlikely, please see BCA Geopolitical Strategy Special Reports, "China: How Stimulating Is The Stimulus?" Parts One and Two, dated 8 August 2018 and 15 August 2018, available at gps.bcaresearch.com GAA Asset Allocation
Highlights We remain bullish on the dollar, but no longer think that being long the greenback is the "slam-dunk" trade that it was earlier this year. A reacceleration in growth outside the U.S. and an overly dovish Fed represent the biggest risks to our constructive dollar view. China is likely to stimulate its economy, but concerns about high debt levels and malinvestment will limit the scale of any fiscal/credit stimulus. Letting the RMB slide may prove to be the preferable option. Worries about debt sustainability in Italy and EM contagion to European banks will constrain credit growth in the euro area, thus keeping the ECB in a highly dovish mode. For the time being, we favor developed market stocks over their EM peers. At the sector level, we would overweight defensives relative to deep cyclicals. U.S. stocks will outperform European stocks in dollar terms, although the performance is likely to be much more balanced in local-currency terms. The longer-term path for Treasury yields is to the upside. Nevertheless, a stronger dollar, coupled with safe-haven flows into the Treasury market, could temporarily push the 10-year yield down to 2.5% over the next few months. Feature The Dollar At A Crossroads After surging by 10% between February 1st and August 15th, the broad trade-weighted dollar has fallen by 0.9% over the past two weeks. Despite the latest setback, the greenback is still 23.2% above its 2014 lows and only 2.8% below its December 28, 2016 high (Chart 1). BCA continues to maintain a bullish view on the dollar. However, given recent market action, it is useful to stress-test our thesis in order to explore what could go wrong with it. As we discuss below, a key risk to the dollar is that global growth reaccelerates, with the U.S. once again going from leader to laggard in the global growth horserace. Global Growth And The Dollar The dollar tends to strengthen when global growth is deteriorating. Since the U.S. is a "low-beta" economy dominated by services rather than manufacturing and primary industries, an environment in which the global economy is slowing is usually one where the U.S. is outperforming the rest of the world. Chart 2 shows that there is a strong correlation between the value of the trade-weighted dollar and the difference between The Conference Board's U.S. Leading Economic Indicator (LEI) and the non-U.S. LEI. The gap between the U.S. and the non-U.S. LEI is still quite large. However, it has started to shrink recently, reflecting both a dip in the U.S. LEI as well as a small improvement in the non-U.S. LEI. The implication is that the U.S. economy is outshining the rest of the world, but the magnitude of outperformance has begun to narrow. Looking forward, the fate of the dollar will hinge on whether growth in the rest of the world can catch up with the United States. By definition, this can happen either if U.S. growth falls or non-U.S. growth rises. We examine each possibility in turn. Chart 1Despite Recent Pullback, ##br##The Dollar Is Still Close To Its 2016 High Chart 2The U.S. Economy Is Still Outperforming The Rest Of The World, But The Gap Is Starting To Narrow U.S. Growth: As Good As It Gets? The second quarter was probably the high watermark for U.S. growth for the rest of this cycle. Real GDP expanded by 4.2%, more than double most estimates of trend growth. The deceleration in payroll growth in July, a string of weak housing data releases, and the drop in the national ISM surveys alongside declines in a number of regional surveys such as the Philly Fed PMI, all point to a somewhat softer third quarter GDP growth reading. How worried should dollar bulls be? We see three reasons to downplay the negative impact on the dollar from the recent string of softer economic data. While the U.S. economy has slowed, it is still quite strong. The Bloomberg consensus forecast suggests that real GDP will increase by 3% in Q3. The Atlanta Fed's GDPNow model predicts 4.1% growth, while the New York Fed's Nowcast anticipates a more modest growth rate of 2%. The underlying drivers of aggregate demand remain supportive. U.S. financial conditions have loosened recently, thanks mainly to narrower credit spreads and higher equity prices (Chart 3). The effects of fiscal stimulus have also yet to make their way fully through the economy, especially with respect to government spending. The consumer is in great shape. The unemployment rate is near a 20-year low and the savings rate stands at a comfortable 6.7%, well above the level that the current ratio of household net worth-to-disposable income would predict (Chart 4). The housing vacancy rate is close to all-time lows, which limits the downside risk both to home prices and construction activity (Chart 5). Chart 3U.S. Financial Conditions Have Eased Recently Chart 4The Savings Rate Has Room To Fall Some of the apparent slowdown in U.S. growth appears to be due to intensifying supply-side constraints rather than faltering demand (Chart 6). This is important because slower growth resulting from weaker demand should, in principle, cause the Fed to moderate the pace of rate hikes, whereas slower growth resulting from an overheated economy should prompt the Fed to accelerate the pace of rate hikes. The latter is much better for the dollar than the former. Chart 5Low Housing Inventories Will ##br##Support Home Prices And Construction Chart 6U.S. Economy Is Hitting Supply-Side ##br##Constraints The Fed's Fate Is In The Stars What is true in principle, however, does not always match what happens in practice. In his Jackson Hole address, Jay Powell invoked a Draghi-esque phrase when saying that the FOMC would "do whatever it takes" to keep inflation expectations from becoming unmoored.1 Nevertheless, he also said that "there does not seem to be an elevated risk of overheating" at the moment. This is a curious statement considering the abundant evidence that U.S. firms are struggling to find qualified workers. To his credit, Powell stressed the inherent difficulty of "navigating by the stars," that is, of setting monetary policy based on highly imprecise estimates of the natural rate of unemployment, u*, and the neutral real rate of interest, r*. What he did not say is that the Fed's current estimates of these "stars" stand at record lows, which introduces a dovish bias into monetary policy should these estimates prove to be too low. Our baseline view is that the Federal Reserve will raise rates more than the market is currently discounting. We also doubt the Fed will succumb to President Trump's pressure to keep rates low or to accommodate any effort by the Treasury to intervene in the foreign exchange market with the aim of driving down the value of the dollar. That said, the risk to this view is that the Fed reacts too slowly to rising inflation. This could cause real rates to drift lower, with adverse consequences for the dollar. The China Policy Wildcard The discussion above suggests that the dollar would suffer either if U.S. growth slows significantly or if the Fed falls too far behind the curve in normalizing monetary policy. An additional risk to the dollar is that growth outside the U.S. picks up. This would suck capital away from the U.S. and into the rest of the world, with adverse consequences for the greenback. At present, the biggest question mark around the global growth outlook concerns China. The Chinese economy has struggled of late, with trade tensions adding to the misery (Chart 7). The stock market is down in the dumps. On-shore corporate yields for low-quality borrowers continue to rise. Industrial production, retail sales, and fixed asset investment all disappointed in July, following a further drop in the PMIs. The economic surprise index remains in negative territory. Only the housing market is showing renewed vigour, with both starts and sales rebounding (Chart 8). Chart 7China: Some Signs Of A Struggling Economy... Chart 8...With Housing Being The Main Exception The central bank has responded by easing liquidity. Interbank rates fell from a peak of 5.9% in late 2017 to 2.9% today. The authorities have also instructed local governments to expedite their spending plans, while ordering state-owned banks to expand lending to the export sector and for infrastructure-related projects. Fiscal/credit stimulus of the sort the authorities engaged in both 2009 and 2015 carries significant risks, however. Debt levels have reached stratospheric levels and concerns about excess capacity and malinvestment abound. We suspect these facts will cause policymakers to be more guarded than they would otherwise be. What's Next For The RMB? Letting the RMB weaken offers an alternative way to stimulate the economy - and one, crucially, that does not require piling on evermore debt. In contrast to more roads and bridges, a cheaper Chinese currency would not be welcome news for the rest of the world. A weaker RMB makes it more difficult for other economies to compete against China. A weaker currency also increases the costs to Chinese firms of importing raw materials, thus putting downward pressure on commodity prices. Despite efforts by emerging markets to diversify their economies, EM earnings remain highly correlated with industrial metals prices (Chart 9). Despite the presence of capital controls, the USD/CNY exchange rate has broadly tracked the one-year swap differential between the U.S. and China over the past few years (Chart 10). The differential has dropped from close to 300 basis points at the beginning of this year to less than 100 basis points today. Given that prospect of further Fed rate hikes, the only way the Chinese authorities will be able to keep the interest rate differential from falling even more is by tightening monetary policy themselves. This could slow credit growth and thus weaken the economy. The failure to raise rates, however, would probably cause the RMB to fall further. Both outcomes would be problematic for the rest of the world. Chart 9EM Earnings Are Correlated ##br##With Industrial Metal Prices Chart 10USD/CNY Tracks China-U.S. ##br##Interest Rate Differentials Our bet is that the authorities will ultimately choose to keep domestic monetary conditions fairly easy - leading to a weaker RMB - but will use administrative controls to prevent credit growth from accelerating too rapidly. That said, we would not rule out the possibility that the authorities succeed in stimulating the economy in a way that precludes further currency weakness. If this stimulus coincides with a thawing in trade tensions, it could lead to a burst in optimism about China specifically, and global growth in general. Such an outcome would hurt the dollar. The Euro Area: Keeping The Recovery On Track After putting in a strong performance in 2017, the economy in the euro area has struggled to maintain momentum this year. Growth is still above trend, but the overall tone of the data has been lackluster at best, with the risks to growth increasingly tilted to the downside. Weaker growth in China and other emerging markets certainly has not helped. However, much of the problem lies closer to home. The election of a populist government in Italy renewed concerns about debt sustainability in the euro area's third largest economy. The 10-year yield reached a four-year high of 3.2% this week. It is now 150 basis points above its April 2018 lows (Chart 11). The resulting tightening in Italian financial conditions will continue to weigh on growth in the months ahead. Bank credit remains the lifeblood of the euro area economy. Chart 12 shows that the 12-month credit impulse - defined as the change in credit growth from one 12-month period to the next - tends to move closely with GDP growth. Euro area credit began to moderate this year even before the Italian imbroglio and worries about the exposure of European banks to vulnerable emerging markets came on the scene. It will be difficult for euro area GDP growth to accelerate unless credit growth revives. In the absence of faster credit growth, the ECB will have little choice but to remain firmly in dovish mode. Chart 11Italian Populism Meets The Bond Market Chart 12Euro Area Credit Growth Has Flatlined The best-case scenario for the common currency is that EM stresses subside, and the Italian government reaches a friendly agreement with the European Commission over next year's budget. The thawing in Brexit negotiations would also help. We are skeptical that any of these three things will happen, but if one or a number of them did occur, this would benefit the euro at the expense of the dollar. Investment Conclusions We are not as bullish on the dollar as we were earlier this year. Sentiment towards the greenback has clearly improved (Chart 13). The narrative about a "synchronized global growth recovery" that was all the rage last year has also given way to a more sober appreciation of the problems facing emerging markets. In short, markets have moved a long way towards our view of the world. Still, we are not ready to abandon our strong dollar view. Chinese stimulus or not, the structural challenges facing emerging markets - high debt levels, poor productivity growth - will not go away. The same goes for Europe and its litany of political and economic travails. Even if the dollar did manage to weaken again, this would constitute an unwelcome easing in U.S. financial conditions at a time when the Fed wants to tighten financial conditions in order to keep the economy from overheating. From this perspective, a weaker dollar just means that the Fed would need to hike rates even more than it otherwise would. Since more rate hikes will buttress the dollar, the extent to which the dollar can weaken is self-limiting. In short, interest rate differentials between the U.S. and its trading partners should continue to favor the greenback. Assuming the dollar does strengthen from here, emerging markets will be the main casualties. While EM assets have cheapened considerably, Chart 14 shows that neither EM equities, credit, nor currencies are at levels that have marked past bottoms. Global investors should continue to favor developed market stocks over their EM peers. At the equity sector level, investors should overweight defensives over deep cyclicals. Regionally, this posture implies that U.S. stocks will outperform European stocks in dollar terms, although the performance is likely to be much more balanced in local-currency terms. Chart 13Investors Have Turned More Bullish On The Dollar Chart 14EM Assets Are Not Very Cheap As we recently discussed in a two-part Special Report,2 the longer-term path for Treasury yields is to the upside. Nevertheless, a broad-based appreciation in the value of the dollar, coupled with safe-haven flows into the Treasury market, could temporarily push the 10-year yield down to 2.5% over the next few months. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Jerome H. Powell, "Monetary Policy in a Changing Economy," Speech at "Changing Market Structure and Implications for Monetary Policy," a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 24, 2018. 2 Please see Global Investment Strategy Special Reports, "1970s-Style Inflation: Could It Happen Again? (Part 1)," dated August 10, 2018; "1970s-Style Inflation: Could It Happen Again? (Part 2)," dated August 24, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Two key issues will remain important drivers of global financial markets in the coming quarters: the direction of the dollar and Chinese policy stimulus. Policy and growth divergences will remain tailwinds for the dollar and there is little the Trump Administration can do to reverse the upward trend. Dollar strength is exposing poor macro fundamentals in many emerging market economies. The problems facing EM economies run deep, and will not disappear anytime soon. Expect more EM fireworks. EM market turmoil could pause the Fed's tightening campaign, but this would require evidence that the U.S. economy and/or financial markets are being negatively affected. Chinese stimulus is a risk to our base-case outlook. A growth impulse might keep the RMB from weakening further, boost commodity prices and support EM exports. However, we believe that Chinese stimulus will not be a 'game changer', and might even cause more problems if the authorities push the RMB lower. The U.S. economy and financial system are less exposed to emerging markets than in the Eurozone. An excellent profit backdrop also provides U.S. risk assets with a strong tailwind. Nonetheless, the U.S. is not immune to EM woes. Poor valuation implies a meaningful correction in U.S. risk assets on any flight-to-quality event. Stay cautious on asset allocation. Fed Chair Powell is willing to wait for the "whites of the eyes" of inflation before becoming alarmed, almost ensuring that the FOMC will fall behind the inflation curve. Evidence of labor market overheating is accumulating. Bond yields will rise as the FOMC tries to catch up and long-term inflation expectations bounce. We believe that investors are underestimating the upside in U.S. inflation risks over the medium term. We recommend below-benchmark duration, although government bonds would temporarily rally if EM turbulence sparks a flight-to-quality. We still expect the supply/demand balance in the world oil market to tighten later this year. Stay positioned for higher oil prices. Japanese corporate profits have been stellar, but that will soon change. EPS growth is likely to soften in the Eurozone too. Favor the U.S. market in unhedged terms. Feature There are numerous key issues on the investment landscape, but two stand out at the moment because they both have wide-ranging global implications: (1) Will the U.S. dollar continue to appreciate; and (2) Will Chinese policymakers place structural reform on the back burner and 'go for growth' in the near term? The latest U.S. economic and profit data provide a strong tailwind for American risk assets. Nonetheless, the mighty U.S. dollar is casting a dark shadow over the heavily-indebted emerging market economies, sparking comparisons with the late 1990s. Could Turkey be the start of a 'domino' effect, similar to Thailand's plunge into financial crisis in 1997 that eventually spread to Brazil and Russia, and finally contributed to the demise of Long-Term Capital Management in the fall of 1998? On the global growth front, the story has not changed much from our assessment last month. Growth is solid, but slowing, in part due to a deceleration in developed-economy capital spending. The global expansion has become less synchronized and relative growth dynamics are pointing to more upside for the greenback (Chart I-1). Chart I-1Cyclical Divergence Is Still Dollar Bullish As in the late 1990s, the Fed is likely to ignore turbulence in EM financial markets and will continue on its tightening path until it begins to affect the U.S. economy or asset prices. The path of least resistance for the dollar is up until something breaks. A major policy impulse from China could alter the feedback loop between the strengthening dollar and EM asset prices. A growth pickup would lift China's imports and commodity prices, both of which would support emerging market economies and asset prices. There is plenty of uncertainty regarding the size of the recently-announced Chinese stimulus measures, but our take is that they are likely to underwhelm because a major growth push would undermine the authorities' structural initiatives. The implication is that the global backdrop will remain unfriendly to emerging market assets at a time when they are more vulnerable than the consensus believes. The risk of a financial accident is escalating. The good news is that the U.S. earnings picture remains excellent, which precludes us from being underweight on risk assets. Nonetheless, investors should have no more than a benchmark allocation to equities and corporate bonds in the major advanced economies. We are upgrading government bonds to neutral at the expense of cash on a tactical basis, to reflect the rising possibility of a global flight-to-quality. The First Domino Turkey has had all the hallmarks of a crisis for a long while. Erdogan's slim hold on power has motivated several populist policy decisions that have stretched Turkey's macro fundamentals. The central bank has been forced to provide large injections of liquidity into the banking system, despite double-digit inflation readings. The country suffers from a classic "twin deficit" problem. Turkish private sector external debt stands at 40% of GDP, of which 13% of GDP is short-term, the highest among EM countries. Erdogan wants economic growth at all costs, but has done little in terms of the structural reforms necessary to lift the country's growth potential. The Lira has lost almost 26% of its value versus the dollar since August 1 and Turkish spreads have blown out. It appears that a lot of bad news has been discounted, but our EM strategists do not see this as a buying opportunity. One risk is that Erdogan imposes capital controls next. Our emerging market team's long held caution on EM is rooted in concern for failing fundamentals.1 They emphasize that Turkey was the catalyst, not the main cause, for the broader financial stress observed across EM assets in August. BCA has highlighted for some time that EM debt is a ticking time bomb. Chart I-2 shows that EM dollar-denominated debt is now as high as it was in the late 1990s as a share of both GDP and exports. Chart I-3 highlights the most vulnerable EM economies in terms of the foreign currency funding requirement, and the foreign debt-servicing obligation relative to total exports. Turkey stands out as the most vulnerable, along with Argentina, Brazil, Indonesia, Chile, and Colombia. Chart I-2Debt Makes EM Vulnerable Chart I-3EM Debt Exposure In all previous major EM selloffs, any decoupling between different EM regions proved to be unsustainable. And it certainly does not help that the Fed remains on its tightening path; EM equities usually fall when U.S. financial conditions tighten (Chart I-4). The combination of a strong dollar and weak RMB is a deadly combination for highly-indebted emerging market economies. Chart I-4EM Highly Sensitive To U.S. Financial Conditions... Investors should expect contagion to intensify. China To The Rescue? Some investors are hoping that China will 'save the day' by providing a major dose of policy stimulus, as it did in 2015, the last time that EM was close to a tipping point. We doubt China will be able to play the same stabilizing role. The Chinese authorities are committed to their long-term structural goals. They have been trying to reorient the economy toward consumption and away from investment and exports, as well as undertake other reforms to reduce financial risk, pollution, poverty and corruption. China kept policy on the tight side until recently, which resulted in a gradual growth slowdown. The Li Keqiang index (LKI) is a good coincident indicator for economic growth (Chart I-5). This index has ticked up in recent months, along with imports, but this likely reflects industrial activity designed to fill foreign orders before the new U.S. tariffs take effect. Our LKI model, based on money and credit, points to further economic weakness ahead. Chart I-5China: Watch Credit And Fiscal Impulse The escalation of the trade war with the U.S. is forcing the Chinese authorities to provide some short-term policy stimulus in order to pre-empt any resulting economic damage. A flurry of policy announcements over the past month has given investors the impression that Beijing has cranked up the policy dial, including cuts to short-term interest rates, a decrease in reserve requirements, liquidity provision to the banking system, and promises of various forms of fiscal stimulus. Chinese stimulus has historically been positive for commodity prices and EM assets. However, we are less sanguine this time. First, the authorities are not abandoning structural reforms, which means that the associated growth headwinds will not disappear. Second, our China experts believe that Chinese policy is only turning moderately reflationary; this is not the 'big bang' that followed the Great Recession in the late 2000s, or the same level of stimulus provided following the 2015-16 global manufacturing downturn. There will no doubt be some fiscal stimulus, but we do not expect a major expansion in bank credit to the private sector because of the government's crackdown on shadow banking, excessive leverage and growing non-performing loans. The change in the policy stance amounts to 'taking the foot off the brake' rather than pressing firmly on the accelerator.2 Third, and perhaps most importantly, the authorities may rely even more on the currency lever to do the heavy lifting if the economy continues to slow and/or the tariff war escalates further. This would be negative for commodity demand because a weaker RMB will make commodities dearer for Chinese producers. Metals prices are particularly at risk. China's competitors will also feel the sting of a cheaper RMB. It will be critical to watch the Chinese money and credit data in the coming months to gauge whether our view on the policy stimulus is correct. We will also be watching the combined credit and fiscal impulse which, at the moment, points to continued weakening in import growth in the near term (Chart I-5, bottom panel). Slower EM growth and/or more financial market turbulence is likely to take a larger toll on the euro area than the United States. Exports to emerging markets account for only 3.6% of GDP for the U.S., compared to 9.7% of GDP for the euro area. Euro area banks also have more exposure to emerging markets than U.S. banks (Chart I-6). Notably, Spanish banks - BBVA in particular - has sizable exposure to Turkey. Meanwhile, Italian assets have come under pressure as the rift between the European Commission and the new populist government widens and Italian banks become increasingly wary of financing their government. Chart I-6DM Bank Exposure To EM European growth will therefore likely continue to trail that of the U.S. Our base case does not see euro area growth falling below a trend pace in the coming quarters, but relative growth momentum and the ongoing policy divergence will favor the dollar over the euro. FOMC: No Urgency The key message from the latest FOMC Minutes and Chairman Powell's Jackson Hole speech is that policymakers are sticking with the "gradual" approach to tightening, despite the late-cycle acceleration in economic growth. The blowout second-quarter GDP report supports the view that fiscal stimulus is stoking the economy at a time when there is little slack. Evidence that the labor market is overheating is not simply anecdotal anymore. In past cycles, an acceleration in growth at a time when inflation is already at target and unemployment is below estimates of full employment would have sparked aggressive Fed action. But the Minutes and Powell's speech revealed no sense of urgency. Powell made the case that the Fed must proceed carefully in an environment where there is much uncertainty about the level of the neutral policy rate, the natural rate of unemployment and the slope of the Phillips curve. Moreover, long-term inflation expectations are still hovering below a level that is consistent with meeting the 2% target over the medium term. Some FOMC policymakers believe that this fact justifies taking chances with an inflation overshoot in the coming quarters. Another reason for the FOMC to proceed cautiously is the wage picture, which is confusing even to economic experts because the official measures paint a mixed picture (Chart I-7). The Employment Cost Index for private sector workers continues to march higher. However, growth in compensation per hour, average hourly earnings (AHE) and unit labor costs have all eased a little this year. The Atlanta Fed Wage Tracker, one of the cleanest measures of wages, reveals an even more significant pullback. The softening in wage growth has been fairly widespread across age cohorts, educational attainment and regions, according to the Atlanta Fed data (Chart I-8). Part-time workers appear to be the only segment that has bucked the trend. It is not clear why workers in the 16-24 age group, as well as those with bachelor's degrees (of any age), have seen the most pronounced softening in wage growth this year. Chart I-7Mixed U.S. Wage Data Chart I-8U.S. Wage Slowdown Broadly-Based Which measure is telling the correct story: the ECI or the Atlanta Wage Tracker? Both are a relatively clean measure of wages and it is difficult to tell based on the relative merits of each index alone. Nonetheless, there is little doubt that the labor market is now very tight by historical standards. Small business owners' compensation plans remained near record levels in July, while concerns about the "quality of labor" have never been higher (Chart I-9). Chart I-10 shows that the ratio of the level of job openings to unemployed workers has surpassed the pre-recession level in all but one sector according to the Jolts survey. Indeed, in most cases this ratio is well above the previous peak. Unemployment is now below the estimated level of full-employment in more than 80% of U.S. states. Chart I-9U.S. Labor Shortage Is Growing Chart I-10JOLTS Signals Very Tight Jobs Market No Evidence Of U.S. Overheating? Labor shortages first appeared for skilled workers, helping to explain why highly-skilled workers have enjoyed the fastest wage gains in recent years. But this year's Fed Beige Books have noted that many businesses are now having trouble finding low- and middle-skilled workers, as listed in Table I-1. These industries roughly line up with the ones that reveal above-average growth in average hourly earnings, and with the ones where labor market tightness is the most acute according to the Jolts survey (second and third columns in the table). The shortages appear to be broadly based, ranging from truck transportation to financial services, manufacturing and construction. This makes it all the more curious that Chairman Powell finds that there is no evidence of overheating in the labor market. The evidence seems pretty conclusive to us and it even features in the Fed's own Beige Book. Keep in mind that inflation is not always the 'cost push' type, beginning in the labor market and traveling to consumer prices. Sometimes inflation can begin in the market for goods and services, and then affect wage demands. U.S. consumer price inflation appears to be headed higher based on the New York Fed's Underlying Inflation Gauge (Chart I-11). Our CPI diffusion index shows that inflation is accelerating in a majority of categories. Other measures of underlying inflation, such as the Sticky Price Index, the Trimmed Mean, and the Median inflation rate are all in a solid uptrend. Dollar strength this year will eventually put downward pressure on core goods inflation, but that will take some time; non-energy goods inflation is more likely to rise in the near term as it catches up to the previous acceleration in imported goods prices (Chart I-11, bottom panel). Table I-1Labor 'Shortages' Identified In The Beige Book Chart I-11U.S. Underlying Inflation Is Rising U.S. Inflation To Surprise On Upside We believe that the market is underestimating the risk of a meaningful inflation overshoot over the medium term. Investors still do not believe that the Fed will be able to consistently meet the 2% target over the long-term, based on CPI swaps and TIPS breakeven rates. BCA's Chief Global Strategist, Peter Berezin, penned a two-part Special Report in August on the potential for upside inflation surprises over the coming years.3 First, increasing political pressure on the major central banks is worrying. Second, policymakers are coming around to the idea that there may be an exploitable trade-off between higher inflation and lower unemployment. This was a mistake last made in the inflationary 1970s. Finally, the pressure to keep monetary policy accommodative until the "whites of the eyes" of inflation are visible will remain strong. Bonds are in for some trouble if we are correct on the inflation outlook. We recommend that investors with a 6-12 month investor horizon remain short in duration and overweight TIPS versus conventional Treasurys. That said, we cannot rule out a flight-to-quality episode at some point, possibly reflecting trade tensions and/or EM turmoil, which would send Treasury yields temporarily lower. The Fed may be forced to place rate hikes on hold if financial conditions tighten too quickly. No Margin Peak Yet In The U.S.... The S&P 500 was unfazed by the turmoil in emerging markets and the re-widening in Italian bond spreads in August, likely because of continuing good news on the profit front. Corporate earnings remained in a sweet spot in the second quarter. Nominal GDP grew by a whopping 5.4% from a year ago, helping to boost the top line for the corporate sector. The lagged effect of previous dollar depreciation is still flattering earnings, although this only accounts for about two percentage points according to our model (Chart I-12). Meanwhile, equity buybacks have kicked into overdrive (Chart I-13). Chart I-12U.S. Dollar Impact On EPS Growth Chart I-13U.S. Equity Buyback In Overdrive Margins continued their impressive ascent in the second quarter to well above the pre-Lehman peak (Chart I-14). A lot of the increase is related to the tax cuts; EBITDA margins are still substantially below the 2007 peak according to the S&P data. It is disconcerting that all of the surge in S&P 500 margins is due to the Tech sector (Chart I-14, bottom panel). Excluding Tech, S&P after-tax margins have simply moved sideways since 2010. Looking ahead, the tailwind from previous dollar depreciation will shift to a headwind by mid-2019. Chart I-12 shows that the contribution from changes in the dollar to EPS growth will shift from a positive two percentage points to a drag of 1½ percentage points if the dollar is flat from today's level in broad trade-weighted terms. If the dollar rises by another 5% this year, then next year's drag on EPS growth will reach three percentage points. Moreover, the impact of the tax cuts on after-tax profits will fade next year. Wage pressures are building and this should eventually squeeze profit margins. That said, a margin peak does not appear to be imminent. Last month we introduced some macro indicators for profit margins (Chart I-15). Most appeared to be rolling over a month ago, but they have all since ticked up. Chart I-14Tech And Taxes Driving Profit Margins Chart I-15U.S. Margin Indicators Have Turned Up The bottom line is that we continue to expect a mean reversion in U.S. profit margins in the coming years, but this is not a risk for at least the rest of 2018. ...But Profit Outlook Darkening In Japan Second quarter earnings season was also a good one for Japanese companies. Twelve-month forward earnings estimates have been in a steep incline and margins have been rising (Chart I-16). Despite this, the Nikkei has only managed to move sideways this year in local currency terms. Concerns over trade and global growth have perhaps weighed on Japanese stock performance. Company profits have a high beta with respect to global growth. Things are looking shaky on the domestic front too. Domestic demand growth is decelerating, consistent with a weakening Economy Watcher's Survey. Some of the weakness may be related to poor weather, but the LEI suggests that this trend will continue in the coming quarters (Chart I-17, bottom panel). Chart I-16Japan: Trailing Earnings Are Solid... Chart I-17...But Profit Margins Will Narrow Chart I-17 presents some of the variables that have helped to explain historical trends in Japanese EPS. Industrial production growth, a good proxy for top line growth, is decelerating. Nominal GDP growth has fallen to just 1.1% year-over-year, at a time when total labor compensation has surged by more than 4%. The difference between these two, a proxy for profit margins, has therefore plunged. Previous shifts in the yen have not had a large impact on EPS growth over the past year and we do not expect that to change much in 2019. On a positive note, Japanese stocks are attractively valued now that the 12-month forward P/E ratio has fallen below 13 (Chart I-16, bottom panel). It is also constructive that the Bank of Japan is the only central bank that is not backing away from monetary stimulus. The recent widening of the trading band for the 10-year JGB yield was a technical change meant to give the central bank more flexibility, not a signal that policymakers are planning to change tack. Nonetheless, we believe that earnings growth and margins will disappoint market expectations over the next year. The story is much the same for the Eurozone. Both trailing and forward profit margins have been in a strong uptrend. Twelve-month forward EPS growth has been holding at a solid 9%. Nonetheless, the data that feed into our Eurozone profit model point to some softening ahead, including industrial production and the difference between nominal GDP and the aggregate wage bill (not shown). The Eurozone's credit impulse turned negative even before concerns about EM and Italian politics exploded onto the scene. Thus, home-grown profit generation is likely to moderate along with foreign-sourced earnings. For the moment, the BCA House View remains at benchmark on Japanese and Eurozone stocks in currency-hedged terms. In unhedged terms, we prefer the U.S. market to these other bourses because of our bullish dollar bias. Investment Conclusions: Two key issues will remain important drivers of global financial markets in the coming months and quarters: the direction of the dollar and Chinese policy stimulus. We believe that the U.S. dollar has additional upside potential due to growth and policy divergences. There is some speculation in the financial community that President Trump might resort to currency intervention. However, any intervention would be sterilized by the Fed. The only way to shift currencies on a sustained basis would be to organize a coordinated change in monetary or fiscal policies among the U.S. and its main trading partners. This is highly unlikely. Thus, the path of least resistance is up for the U.S. dollar. Dollar strength is exposing poor macro fundamentals in many emerging market economies. The problems facing EM economies run deep, and will not disappear anytime soon because high debt levels make these economies vulnerable to any weakness in global growth, commodity prices or global liquidity conditions. EM financial market turmoil could cause the Fed tightening campaign to go on hold, but this would require evidence that the former is negatively affecting the U.S. economy and/or financial markets. In other words, we need to see some pain before the Fed blinks. Chinese stimulus is a risk to our base-case EM outlook. Policy stimulus might keep the RMB from weakening further, boost commodity prices and support EM exports. This would not change the EM debt situation, but would at least give emerging economies a temporary reprieve. Careful analysis suggests that Chinese stimulus will not be a 'game changer', and might even cause problems if the authorities push the RMB lower. But it will be critical to monitor the next couple of money and credit reports. The U.S. economy and financial system are less exposed to further EM turmoil than in the Eurozone. But as the LTCM event demonstrated in 1998, the U.S. is not immune. Moreover, U.S. equity prices are more expensive than they were during previous EM selloffs that have occurred since the Great Recession. This could mean a larger equity re-rating on any flight-to-quality. This is not to say that we expect a bear market in DM risk assets to get underway in the near future. A U.S./global recession before 2020 is unlikely. Nonetheless, the risk of a meaningful correction is elevated enough that caution is warranted, especially at a time when all risk assets appear expensive. Chart I-18 updates our valuation measures for some major asset classes. All appear to be expensive, especially U.S. equities, raw materials and gold. EM sovereigns and equities are at the cheaper end of the spectrum, but are still not cheap in absolute terms even after the recent selloff. Chart I-18Major Asset Valuation Comparison Treasurys rallied briefly after Chairman Powell signaled that he is not willing to accelerate the pace of rate hikes in light of the U.S. economy's growth acceleration. He is willing to wait until he sees the "whites of the eyes" of inflation before becoming alarmed, almost ensuring that the FOMC will fall behind the inflation curve. Bond yields will rise as the FOMC tries to catch up and long-term inflation expectations bounce. Over the medium term, we believe that investors are underestimating the upside in U.S. inflation risks. We recommend below-benchmark duration, although bonds may temporarily rally if EM turbulence sparks a flight-to-quality. We still expect the supply/demand balance in the world oil market to tighten later this year. Stay positioned for higher oil prices. Finally, as we go to press, the U.S. is trying to force Canada to sign on to the U.S./Mexico 'agreement in principal' by August 31. A framework deal with Canada would likely leave many tough issues unresolved. There is also a chance that Canada misses the deadline and that the existing trilateral deal will not survive. It is technically possible that Canada's refusal to join the U.S.-Mexico bilateral deal will delay its ratification well into next year. In the meantime, Trump could raise the stakes for Canada by boosting tariffs on Canadian autos and/or by suspending NAFTA altogether. As a result, we decided to go ahead and publish our Special Report on U.S. equity sector implications if NAFTA is not ratified and tariffs rise to WTO levels. The report begins on page 20. Mark McClellan Senior Vice President The Bank Credit Analyst August 30, 2018 Next Report: September 27, 2018 1 Please see BCA Emerging Market Strategy Weekly Report "What's Really Driving The EM Selloff?"dated June 28, 2018, available on ems.bcaresearch.com 2 Please see BCA China Investment Strategy Weekly Report "China is Easing Up On The Brake, Not Pressing The Accelerator," dated July 26, 2018, available on cis.bcaresearch.com 3 Please see BCA Global Investment Strategy Special Reports: "1970s-Style Inflation: Could It Happen Again? Parts I and II," dated August 10 and 24, 2018, available on gis.bcaresearch.com II. What If NAFTA Is Not A Done Deal? U.S. Equity Implications This Special Report examines the impact of a NAFTA cancelation on 21 level-three GICs industries. While the latest news on the NAFTA renegotiation with Mexico is positive as we go to press, there is still a non-negligible risk that the existing trilateral deal will not survive. The U.S.-Mexico bilateral deal is an "agreement in principle" and will take time to ratify. Meanwhile, a framework deal with Canada would leave many thorny issues to be resolved. President Trump can still revert to his tough tactics on Canada ahead of the U.S. mid-term elections. If the President does not gain major concessions that can be presented as "victories" to voters, he is likely to take an aggressive stand in order to fire up his political base. The probability of Trump triggering Article 2205 and threatening to walk away from the suspended U.S.-Canada free trade agreement is still not trivial, despite the deal with Mexico. By itself, the cancelation of NAFTA would not be devastating for any particular U.S. industry because the size of the tariff increases would be fairly small as long as all parties stick with MFN tariff levels. That said, the impact would not be trivial, especially for those industries that have extensive supply lines that run between the three countries involved (especially Autos). We approached the issue from four different perspectives; international supply chains, a model-based approach, and an analysis of foreign revenue exposure and input cost exposure. The broad conclusion is that there are no winners from a NAFTA cancelation for the U.S. manufacturing GICs industries. Pharmaceuticals, Health Care Equipment & Supplies, Personal Products and Construction Materials are lower on the risk scale, but cannot be considered beneficiaries of a NAFTA collapse. The remaining industries are all moderately-to-highly exposed. Considering the four perspectives as a group, the most vulnerable industries are Automobiles, Automobile Components, Metals & Mining, Food Products, Beverages, and Textiles & Apparel. Our U.S. equity sector specialists recommend overweight positions in Defense and Financials; while neither stands to benefit from a NAFTA abrogation, they should at least be relative outperformers. They recommend underweight positions on Auto Components, Steel and Electrical Components & Equipment as relative (and probably absolute) underperformers should NAFTA disappear. While the latest news on the renegotiation of the North American Free Trade Agreement (NAFTA) is positive as we go to press, there is still a non-negligible risk that President Trump could revert to his tough tactics ahead of the U.S. mid-term elections.1 Even if Canada signs on to a framework deal, a lot of thorny details will have to be worked out. A presidential proclamation triggering Article 2205 of the NAFTA agreement (as opposed to tweeting that the U.S. will withdraw) would initiate a six-month "exit" period. Trump could use this deadline, and the threat of canceling the underlying U.S.-Canada FTA, to put pressure on Canada (if not Mexico) to concede to U.S. demands, just as he could revoke his exit announcement anytime within the six-month period. While some market volatility would ensue upon any exit announcement, even a total withdrawal at the end of the six months would have a limited macro-economic impact as long as the U.S. continued to respect its WTO commitments and lifted tariffs only to Most Favored Nation (MFN) levels. Nonetheless, a modest tariff hike is not assured given the Administration's "America First" policy, its looming threat of Section 232 tariffs on auto imports, its warnings against the WTO itself, and the steep tariffs it has already imposed on Canada, including a 20% tariff on softwood lumber and the 300% tariff on Bombardier CSeries jets. Moreover, even a small rise in tariffs to MFN levels would have a significant negative impact on industries that are heavily integrated across borders. Our first report on the evolving U.S. trade situation analyzed the implications of the U.S.-China trade war for the 24 level two U.S. GICs equity sectors. This Special Report examines the impact of a NAFTA cancelation on 21 level three GICs industries (finer detail is required since NAFTA covers mostly goods industries). We find that there are no "winners" among the U.S. equity sectors because the negative impact would outweigh any positive effects. The hardest hit U.S. industries would be Autos, Metals & Mining, Food Products, Beverages, and Textiles and Apparel, but many others are heavily exposed to a failure of the free trade agreement. Out Of Time President Trump is seeking a new NAFTA deal ahead of the U.S. midterms in November. While this timing may yet prove too ambitious, the U.S. has made progress in recent bilateral negotiations with Mexico, raising the potential that Trump will be able to tout a new NAFTA framework deal by November 6. Yet, investors should be prepared for additional volatility. There are technical issues with the bilateral U.S.-Mexico deal that could delay ratification in Congress until mid-2019. The new Mexican Congress must ratify the deal by December 1 if outgoing President Enrique Peña Nieto is to sign off. Otherwise, the incoming Mexican President Andrés Manuel López Obrador may still want to revise any deal he signs, prolonging the process. Meanwhile, it would be surprising if the Canadians signed onto a U.S.-Mexico deal they had no part in negotiating without insisting on any adjustments.2 The important point is that President Trump's economic and legal constraints on withdrawing from NAFTA have fallen even further with the Mexican deal. If Trump does not get major concessions that can be presented as "victories" to voters, he is likely to take an aggressive stand in order to fire up his political base, as a gray area of "continuing talks" will not inspire voters. This could mean imposing the threatened auto tariffs or threatening to cancel the existing trade agreements with Canada. Thus, the risk of Trump triggering Article 2205 is still not trivial. A bilateral Mexican trade deal is not the same as NAFTA. Announcing withdrawal automatically nullifies much of the 1993 NAFTA Implementation Act. Some provisions of NAFTA under this act may continue, but the bulk would cease to have effect, and the White House could refuse to enforce the rest. The potential saving grace for trade with Canada was that the Canada-U.S. Free Trade Agreement (CUSFTA), which took effect in 1989, was incorporated into NAFTA. The U.S. and Canada agreed to suspend CUSFTA's operation when NAFTA was created, but the suspension only lasts as long as NAFTA is in effect. However, Trump may walk away from both CUSFTA and NAFTA in the same proclamation. In that event, WTO rules for preferential trade would require the U.S. and Canada to raise tariffs on trade with each other to Most Favored Nation (MFN) levels. These tariff levels are shown in Charts II-1A and II-1B. The Charts also show the maximum tariff that could potentially be applied under WTO rules. The latter are much higher than the MFN levels, underscoring that the situation could get really ugly if a full trade war scenario somehow still emerged among these three trading partners. Chart II-1AU.S.: MFN Tariff Rates By GICS Industry (2017) Chart II-1BMexico & Canada: MFN Tariff Rates By GICS Industry (2017) Current tariffs are set at zero for virtually all of these GICs industries, which means that the MFN levels also indicate how much tariffs will rise at a minimum if NAFTA is cancelled. Tariffs would rise the most for Automobiles, Textiles & Apparel, and Food Products (especially agricultural products), and Beverages. U.S. tariffs under the WTO are not significantly higher than NAFTA's rates; the average MFN tariff in 2016 was 3½%, which compares to 4.1% for the average Canadian MFN tariff. Would MFN Tariffs Be Painful? An increase in tariff rates of 3-4 percentage points may seem like small potatoes. Nonetheless, even this could have an outsized impact on some industries because tariffs are levied on trade flows, not on production. A substantial amount of trade today is in intermediate goods due to well-integrated supply chains. Charts II-2A and II-2B present a measure of integration. Exports and imports are quite large relative to total production in some industries. The most integrated U.S. GICs sectors include Automobiles & Components, Materials, Capital Goods and Electrical & Optical Equipment. Higher tariffs would slam those intermediate goods that cross the border multiple times at different stages of production. For example, studies of particular automobile models have found that "parts and components may cross the NAFTA countries' borders as many as eight times before being installed in a final assembly in one of the three partner countries."3 Tariffs would apply each time these parts cross the border if NAFTA fails. Chart II-2AU.S./Canada Supply Chain Integration Chart II-2BU.S./Mexico Supply Chain Integration Appendix Tables II-1 to II-4 show bilateral trade by product between the U.S. and Canada, and the U.S. and Mexico. In 2017, the U.S. imported almost $300b in goods from Canada, and exported $282b to that country, resulting in a small U.S. bilateral trade deficit. The bilateral deficit with Mexico is larger, with $314b in U.S. imports and $243b in exports. The largest trade categories include motor vehicles, machinery, and petroleum products. Telecom equipment and food products also rank highly. As mentioned above, the impact of rising tariffs is outsized to the extent that a substantial portion of trade in North America is in intermediate goods. Box II-1 reviews the five main channels through which rising tariffs can affect U.S. industry. Box II-1 Trade Channels There are at least five channels through which rising tariffs can affect U.S. industry: (1) The Direct Effect: This can be positive or negative. The impact is positive for those industries that do not export much but are provided relief from stiff import competition via higher import tariffs. The impact is negative for those firms facing higher tariffs on their exports, as well as for those firms facing higher costs for imported inputs to their production process. These firms would be forced to absorb some of import tariffs via lower profit margins. Some industries will fall into both positive and negative camps. U.S. washing machines are a good example. Whirlpool's stock price jumped after President Trump announced an import tariff on washing machines, but it subsequently fell back when the Administration imposed an import tariff on steel and aluminum (that are used in the production of washing machines). NAFTA also eliminated many non-tariff barriers, especially in service industries. Cancelling the agreement could thus see a return of these barriers to trade; (2) Indirect Effect: The higher costs for imported goods are passed along the supply chain within an industry and to other industries that are not directly affected by rising tariffs. This will undermine profit margins in these indirectly-affected industries to the extent that they cannot fully pass along the higher input costs. There would also be a loss of economies-of-scale and comparative advantage to the extent that firms are no longer able to use an "optimal" supply network that crosses borders, further raising the cost of doing business; (3) Foreign Direct Investment: Some U.S. imports emanate from U.S. multinationals' subsidiaries outside the U.S., or by foreign OEM suppliers for U.S. firms. NAFTA eliminated many national barriers to FDI, expanded basic protections for companies' FDI in other member nations, and established a dispute-settlement procedure. The Canadian and Mexican authorities could make life more difficult for those U.S. firms that have undertaken significant FDI in retaliation for NAFTA's cancellation; (4) Macro Effect: The end of NAFTA, especially if it were to lead to a trade war that results in tariffs in excess of the MFN levels, would take a toll on North American trade and reduce GDP growth across the three countries. Besides the negative effect of uncertainty on business confidence and, thus, capital spending, rising prices for both consumer and capital goods will reduce the volume of spending in both cases. Moreover, corporate profits have a high beta with respect to economic activity. The macro effect would probably not be large to the extent that tariffs only rise to MFN levels; (5) Currency Effect: To the extent that a trade war pushes up the dollar relative to the Canadian dollar and Mexican peso, it would undermine export-oriented industries and benefit those that import. However, while we are bullish the dollar due to diverging monetary policy, the dollar may not benefit much from trade friction given that tariffs would rise for all three countries. Chart II-3 is a scatter chart of GICs industries that compares the average MFN tariff on U.S. imports to the average MFN tariff on Canadian and Mexican imports from the U.S. A U.S. industry may benefit if it garners significant import protection but does not face a higher tariff on its exports to the other two countries. Unfortunately, there are no industries that fall into the north-west portion of the chart. The opposite corner, signifying low import protection but high tariffs on exports, includes Beverages, Household Durables, Household Products, Personal Products and Machinery. Chart II-3Import And Export Tariffs Faced By U.S. GICS Industries Model-Based Approach The C.D. Howe Institute has employed a general equilibrium model to estimate the impact of a NAFTA failure at the industrial level.4 The model is able to capture the impact on trade conducted through foreign affiliates. The study captures the direct implications of higher tariffs, but also includes a negative shock to business investment that would stem from heightened uncertainty about the future of market access for cross-border trade. It also takes into consideration non-tariff barriers affecting services. Table II-1Impact Of NAFTA Cancellation By Industry As with most studies of this type, the Howe report finds that the level of GDP falls by a relatively small amount relative to the baseline in all three countries - i.e. there are no winners if NAFTA goes down. Moreover, the U.S. is not even able to reduce its external deficit. While the trade barriers trim U.S. imports from NAFTA parties by $60b, exports to Canada and Mexico fall by $62b. At the industry level, the model sums the impacts of the NAFTA shock on imports, exports and domestic market share to arrive at the estimated change in total shipments (Table II-1). It is possible that an industry will enjoy a boost to total shipments if a larger domestic market share outweighs the damage to exports. However, the vast majority of U.S. industries would suffer a decline in total shipments according to this study, because the estimated gain in domestic market share is simply not large enough. Beef, Pork & Poultry and Dairy would see a 1-2% drop in total shipments relative to the baseline forecast. Next on the list are textiles & apparel, food products and automotive products. Even some service industries suffer a small decline in business, due to indirect income effects. Foreign-Sourced Revenue And Input Cost Approach Another way to approach this issue is to identify the U.S. industries that garner the largest proportion of total revenues from Mexico and Canada. Unfortunately, few companies provide much country detail on where their foreign revenues are derived. Many simply split U.S. and non-U.S. revenues, or North American and non-North American revenues. Table II-2 presents the proportion of total revenues that is generated from operations outside the U.S. for the top five companies in the industry by market cap (in some cases the proportion that is generated outside of North America was used as a proxy for foreign- sourced revenues). While this approach is not perfect, it does provide a good indication of how exposed a U.S. industry is to Canada and Mexico. This is because any company that has "gone global" will very likely be doing substantial business in these two countries. Table II-2Foreign Revenue Exposure At the top of the list are the Metals & Mining, Personal Products, and Auto Component industries. Between 62% and 81% of revenues in these three industries is derived from foreign sources. Following that is Household Durables, Leisure Products, Chemicals and Tobacco. Indeed, all of the level three GICs industries we are analyzing are moderately-to-highly globally-oriented, with the sole exception of Construction Materials. Table II-3Import Tariff Exposure U.S. companies are also exposed to U.S. tariffs that boost the price of imported inputs to the production process. This can occur directly when firm A imports a good from abroad, and indirectly, when firm A then sells its intermediate good to firm B at a higher price, and then on to firm C. In order to capture the entire process, we used the information contained in the Bureau of Economic Analysis' Input/Output tables. We estimated the proportion of each industry's total inputs that would be affected by a rise in tariffs to MFN levels. We then allocated the industries contained in the input/output tables to the 21 GICs level 3 industries we are considering, in order to obtain an import exposure ranking in S&P industry space (Table II-3). All 21 industries are significantly vulnerable to rising input costs, which is not surprising given that we are focusing on the manufacturing-based GICs industries and NAFTA focused on trade in goods. The vast majority of the industries could face a cost increase on 50% or more of their intermediate inputs to the production process. The Automobile industry is at the top of the list, with 72% of its intermediate inputs potentially affected by the shift up in tariffs (Automobile Components is down the list, at 56%). Containers & Packaging, Oil & Gas, Aerospace & Defense, Textiles and Food Products are also highly exposed to tariff increases. The automobile industry is a special case because of the safeguards built into NAFTA regarding rules-of-origin and the associated tracing list. The U.S. is seeking significant changes in both in order to tilt the playing field toward U.S. production, but this could severely undermine the intricate supply chain linking the three countries. Box II-2 provides more details. Box II-2 Automotive Production In NAFTA; Update Required We are focused on two key aspects to the renegotiation of the NAFTA rules that could have far reaching implications for automakers and the auto component maker supply base: the tracing list and country of origin rules. Regarding the first of these, the Trump administration has a legitimate gripe when it comes to automotive production. A tracing list was written in the early-1990's to define automotive components such that the rules of origin (ROO) could be easily met; anything not on the list is deemed originating in North America. As anyone who has driven a vehicle of early-1990's vintage and one of late-2010's vintage can attest, high tech components (largely not included on the tracing list) have grown exponentially as a percentage of the cost of the vehicle and, at least with respect to electronic and display components, are sourced mostly from overseas. Updating the tracing list would force auto makers to source a significantly greater amount of components domestically, almost certainly raising the cost of the vehicle and either hurting margins or hurting competitiveness through higher prices. The current NAFTA ROO require that 62.5% of the content of a vehicle must be sourced in North America, with no distinction between any of the member nations. The result of this legislation has been the creation of a highly integrated supply base that sees components move back and forth across borders through each stage of the manufacturing process. Early proposals from the Trump administration for a NAFTA rework included a country of origin provision for as much as 50% U.S. content. Such a provision would certainly cause a massive disruption in the automotive supply chain with components manufacturers forced to relocate or automakers electing to source overseas and pay the 2.5% MFN tariff on exports within North America. Either scenario presents a headwind to the tightly woven auto components base, underscoring BCA's U.S. Equity Strategy's underweight recommendation on the sector. The recently announced bilateral trade deal with Mexico raises the ROO content requirements to 75% from the 62.5% contemplated under NAFTA but, importantly, no country of origin provisions appear in the new deal. Still, given how quickly this is evolving, a final NAFTA deal could be significantly different. Chart II-4 presents a scatter diagram that compares import tariff exposure (horizontal axis) with foreign revenue exposure (vertical axis). The industries in the north-east corner of the diagram are the most exposed to NAFTA failure. The problem is that there are so many in this region that it is difficult to choose the top two or three, although Metals & Mining stands out from the rest. It is easier to identify the industries that face less risk in relative terms: Pharmaceuticals, Construction Materials, Health Care & Supplies, Leisure Products and, perhaps, Machinery. The rest rank highly in terms of both foreign revenue exposure and import tariff exposure. Chart II-4Foreign Revenue And Import Tariff Exposure Conclusions: By itself, a total cancelation of NAFTA would not be devastating for any particular U.S. industry because the size of the tariff increases would be fairly small as long as all parties stick with MFN tariff levels. That said, the impact would not be trivial, especially for those industries that have extensive supply lines that run between the three countries involved. The negative impact on GDP growth would likely be worse for Canada (and Mexico if its bilateral somehow fell through), but U.S. exporters would see some loss of business. We approached the issue from four different perspectives; international supply chains, a model-based approach, and an analysis of foreign revenue exposure and import tariff exposure. The broad conclusion is that there are no winners from a NAFTA cancelation for the U.S. manufacturing GICs industries. Pharmaceuticals, Health Care Equipment & Supplies, Personal Products and Construction Materials are lower on the risk scale, but cannot be considered beneficiaries of a NAFTA collapse. The remaining industries are all moderately-to-highly exposed. Considering the four perspectives as a group, the most vulnerable industries are Automobiles, Automobile Components, Metals & Mining, Food Products, Beverages, and Textiles & Apparel. Our U.S. equity sector specialists recommend overweight positions in Defense and Financials; while neither stands to benefit from a NAFTA abrogation, they should at least be relative outperformers. They recommend underweight positions on Auto Components, Steel and Electrical Components & Equipment as relative (and probably absolute) underperformers should NAFTA disappear. As we go to press, rapid developments are taking place in the NAFTA negotiations. The U.S. and Mexico have completed a bilateral agreement in principle and a Canadian team is looking into whether to sign onto the agreement by a U.S.-imposed August 31 deadline. This deadline would enable the current U.S. Congress to proceed to ratification before turning over its seats in January, though it is not a hard deadline. It is possible that the negotiations will conclude this week and the crisis will be averted. But the lack of constraints on President Trump's trade authority gives reason for pause. If Canada demurs, Trump could move to raise the cost through auto tariffs or announcements that he intends to withdraw from existing U.S.-Canada agreements in advance of November 6. While Mexico has now tentatively secured bilaterals with both countries through the new U.S. deal and the Trans-Pacific Partnership (which includes Canada), it still stands to suffer if a trilateral agreement is not in place. Moreover it is technically possible that Canada's refusal to join the U.S.-Mexico bilateral could delay the latter's ratification well into next year. Therefore, we treat Mexico the same as Canada in our analysis, despite the fact that Mexican assets stand to benefit in relative terms from having a floor put under them by the Trump Administration's more constructive posture and this week's framework deal. If Trump does not pursue a hard line with Canada, then it will be an important sign that he is adjusting his trade policy to contain the degree of confrontation with the developed nations and allies and instead focus squarely on China, where we expect trade risks to increase in the coming months. Mark McClellan Senior Vice President The Bank Credit Analyst Matt Gertken Associate Vice President Geopolitical Strategy Chris Bowes Associate Editor U.S. Equity Strategy APPENDIX TABLE II-1 U.S. Imports From Canada (2017) APPENDIX TABLE II-2 U.S. Exports To Canada (2017) APPENDIX TABLE II-3 U.S. Imports From Mexico (2017) APPENDIX TABLE II-4 U.S. Exports To Mexico (2017) 1 Please see BCA Geopolitical Strategy Special Report, "A Mexican Standoff - Markets Vs. AMLO," dated June 28, 2018, and Weekly Report, "Are You 'Sick Of Winning' Yet?" dated June 20, 2018, available at gps.bcaresearch.com 2 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com 3 Working Together: Economic Ties Between the United States and Mexico. Christopher E. Wilson, November 2011. 4 The NAFTA Renegotiation: What if the U.S. Walks Away? The C.D. Howe Institute Working Paper. November 2017. III. Indicators And Reference Charts Our equity indicators continue to signal that caution is warranted, but U.S. profits have been so strong recently as to dominate any negative market forces. Our Monetary Indicator is hovering at a low level by historical standards, suggesting that liquidity conditions have tightened. It is constructive that our Composite Technical Indicator has hooked up, narrowly avoiding a technical break below the zero line. It is also positive that our Composite Sentiment Indicator is rising, but not yet to a level that would signal trouble for stocks from a contrary perspective. However, our U.S. Willingness-to-Pay (WTP) indicator continues to erode, and the Japanese WTP appears to be rolling over. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Flows into the U.S. stock market are waning, and those into the Japanese market are wavering. Flows into European stocks have flattened off. Moreover, our Revealed Preference Indicator (RPI) for stocks remained on a 'sell' signal in August. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. Our indicators thus suggest that the underlying health of the U.S. equity bull market is fraying at the edges. Nonetheless, robust U.S. profits figures have sparked a euphoric late-cycle blow-off phase. The net revisions ratio is still in positive territory, and the net earnings surprises index has surged to an all-time high. Not much has changed on the U.S. Treasury front. The 10-year bond is slightly on the cheap side according to our model, and oversold conditions have not yet been worked off. This month's Overview section discusses the potential for upside inflation surprises in the U.S. that will place the FOMC "behind the curve". The term premium and long-term inflation expectations are still too low. This year's dollar rally has taken it to very expensive levels according to our purchasing power parity estimate. The long-term trend in the dollar is down, but economic and policy divergences vis-à-vis the U.S. and the other major economies suggests that the dollar is likely to continue moving higher in the near term. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst