Fixed Income
Highlights Chart 1Waiting For A Signal TIPS breakeven inflation rates are fast approaching our end-of-cycle targets (Chart 1). The 10-year and 5-year/5-year rates are currently 2.14% and 2.36% respectively, only slightly below our target range of 2.4% to 2.5%. If this trend continues it is highly likely that we will start to slowly reduce the credit risk in our portfolio in the coming weeks. Already, we find that some lower risk spread products (Foreign Agency bonds and Munis) are attractively valued relative to corporates. But there are also risks to exiting credit too early. First and foremost is that the recent widening in TIPS breakevens might reverse before it bleeds into higher core inflation. As we noted in last week's report, the St. Louis Fed's Price Pressures Measure is still supportive of an overweight allocation to corporate bonds (Chart 1, bottom panel) and core PCE inflation has only just risen to 1.5% year-over-year.1 Investors should maintain below-benchmark duration and an overweight allocation to corporate bonds for now, but be wary that the time to make end-of-cycle preparations is drawing nearer. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 72 basis points in January. The average index option-adjusted spread tightened 7 bps on the month, and currently sits at 85 bps. Investment grade corporate bond spreads continue to tighten, and with each additional basis point the evidence of extreme overvaluation grows. As of today, the 12-month breakeven spread for an A-rated corporate bond has only been tighter 3% of the time since 1989 (Chart 2). The same measure for a Baa-rated bond has only been tighter 4% of the time (panel 3). Further, the average spread on the Foreign Agency bond index is now 3 bps greater than the average spread of an equivalent-duration corporate bond, despite having an average credit rating that is three notches higher (Aa2/Aa3 versus A3/Baa1). Even a 10-year Aaa-rated Municipal bond now offers 7 bps greater after-tax yield than a duration-equivalent corporate bond for investors in the top marginal tax bracket (see page 9). The bottom line is that with such poor value in investment grade corporate spreads, we only need to see a stronger signal from our inflation indicators before reducing exposure.2 Depending on how inflation (and TIPS breakevens) evolve, that time could come relatively soon. The Federal Reserve's Senior Loan Officer Survey, released yesterday, showed that lending standards for commerical & industrial (C&I) loans eased somewhat in the fourth quarter of 2017, and also noted that banks expect to ease standards further on C&I loans to large and middle-market firms in 2018. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 149 basis points in January. The average index option-adjusted spread tightened 24 bps on the month, and currently sits at 324 bps. Last week's equity sell-off and spike in the VIX suggest that some near-term junk spread widening could be in the cards (Chart 3). However, we expect it is still a bit too soon to move out of junk bonds for the cycle. That decision will be made based on whether our inflation indicators continue to rise in the coming weeks and/or months, suggesting that the monetary policy back-drop is becoming less accommodative. In terms of value, high-yield corporates offer better risk-adjusted value than their investment grade brethren. The 12-month breakeven spread for a Ba-rated high-yield bond has currently been tighter than it is today 14% of the time since 1995. The same figure comes in at 25% for a B-rated bond and 31% for a Caa-rated bond. Similar measures for investment grade corporates are significantly lower (see page 3). Further, assuming a default rate of 2.35% for the next 12 months and a recovery rate of 51%, we calculate that a position in high-yield bonds will return 209 bps in excess of Treasuries if spreads stay flat at current levels. Another 100 bps of spread tightening would imply an excess return of just over 6%, but this would bring junk spreads to all-time tight valuations and is probably too optimistic. Remain overweight high-yield for now. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 15 basis points in January. The conventional 30-year zero-volatility MBS spread narrowed 2 bps on the month, all concentrated in the compensation for prepayment risk (option cost). The option-adjusted spread (OAS) was flat on the month, and currently sits at 29 bps. After having widened for most of last year, the OAS for a conventional 30-year mortgage bond is now more attractive relative to an equivalent-duration investment grade corporate bond than at any time since 2014 (Chart 4). This makes MBS a reasonably attractive sector for investors looking to shift away from corporate bonds and de-risk their spread product portfolios. Further, there would appear to be very little risk of spread widening in the MBS sector. First, the schedule of run-off from the Fed's mortgage portfolio is already well known, and likely in the price. Second, mortgage refinancings are likely to stay contained in a rising interest rate environment (bottom panel). Finally, the risk of duration extension in MBS only becomes material when Treasury yields spike higher very quickly - on the order of 72 bps or more in a month - as we showed in last week's report.3 Investors should stay at neutral on MBS for now, but stand ready to increase exposure when the time comes to move out of corporate bonds for the cycle. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 42 basis points in January. Sovereign bonds outperformed by 118 bps, Local Authorities by 67 bps, Foreign Agencies by 54 bps, Domestic Agencies by 8 bps and Surpranationals by 3 bps. USD-denominated Sovereign bonds continue to look expensive compared to Baa-rated U.S. Credit (Chart 5), yet they still managed to deliver almost identical excess returns during the past 12 months because of the U.S. dollar's large depreciation. Going forward, with the dollar's rapid decline unlikely to accelerate, we would avoid Sovereign bonds in favor of U.S. corporates. Valuation is more attractive elsewhere in the Government-Related index. Foreign Agency bonds now offer greater spreads than equivalent-duration U.S. corporate bonds, despite benefitting from higher credit quality (panel 4). Local Authority spreads also look attractive compared to recent history (bottom panel). We continue to recommend overweight allocations to both sectors. We remain underweight Domestic Agency and Supranational bonds. Though both sectors offer low risk and high credit quality, they also only offer 12 bps and 16 bps of option-adjusted spread, respectively. We much prefer Agency-backed MBS and CMBS which are also relatively low risk and offer option-adjusted spreads of 29 bps and 40 bps, respectively. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 53 basis points in January (before adjusting for the tax advantage). The average AAA-rated Municipal / Treasury (M/T) yield ratio was flat on the month. Two market technicals spurred Muni outperformance in January. First, supply plunged after many advance refunding issues were pulled forward in anticipation of the U.S. tax bill (Chart 6). Second, the repeal of the state and local tax deduction led to increased demand for Munis, as evidenced by the recent jump in fund inflows (panel 3). In terms of credit quality, state and local government net borrowing as a percent of GDP likely fell to 0.9% in 2017 Q4 - assuming that corporate tax revenues are held constant. This is consistent with current low yield ratios (panel 4). Meanwhile, tax revenue growth should stay strong in the coming quarters due to recent increases in property prices and retail sales. While M/T yield ratios remain low compared to history, excessive valuations in investment grade corporate bonds mean that Munis are starting to look attractive by comparison. For example, for investors in the top marginal tax bracket, we calculate that the after-tax yield on a Aaa-rated municipal bond is 7 bps higher than the duration-equivalent yield offered by the investment grade corporate bond index, even though the corporate bond index offers an average credit rating of only A3/Baa1. While the bottom panel shows that this yield differential has been higher in the past, it is nevertheless an indication that we are approaching the end of the credit cycle. Stay underweight Munis for now, though an upgrade is likely when it comes time to exit our corporate bond overweights. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear steepened out to the 10-year maturity point in January, as bond markets started to price-in a rebound in inflation. The 2/10 slope steepened 7 basis points on the month and the 5/30 slope flattened 11 bps. The 2/10 slope steepened even further in the first five days of February and currently sits at 69 bps, up from its recent low of 50 bps. More near-term curve steepening is possible if long-maturity TIPS breakeven inflation rates continue to widen, especially since the Fed's median projected rate hike path for the next 12 months is already fully discounted (Chart 7). However, the yield curve is much more likely to be flatter by the end of the year than it is today. In large part because the upside in long-maturity yields will be limited once TIPS breakeven inflation rates reach our target fair value range of 2.4% to 2.5%. In terms of positioning, we continue to advocate a long position in the 5-year bullet versus a short position in a duration-matched 2/10 barbell. The 5-year continues to look very cheap on the curve (panel 3), or put differently, our model suggests that the 2/5/10 butterfly spread is currently priced for 29 bps of 2/10 curve flattening during the next six months (panel 4).4 This seems excessive for the time being. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 75 basis points in January. The 10-year TIPS breakeven inflation rate increased 15 bps on the month. At 2.14% and 2.36%, respectively, the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are still below our target range of 2.4% to 2.5%, but only modestly so. The big run-up in TIPS breakeven rates coincided with a jump in oil prices and, as we discussed in a recent report, this is no coincidence (Chart 8).5 The Fed has an asymmetric ability to influence inflation - it has an unlimited ability to tighten policy but its ability to ease policy is restricted by the zero-lower bound on interest rates. It is for this reason that when TIPS breakeven inflation rates become un-anchored to the downside, they also become much more sensitive to swings in commodity prices. In these environments the market sees inflation as increasingly determined by price pressures in the economy and not by the Fed's reaction function. The logical conclusion is that we should expect the tight correlation between oil prices and long-maturity TIPS breakeven rates to persist until breakevens reach our target fair value range of 2.4% to 2.5%. At that point, it is unlikely that further increases in commodity prices would filter through to long-maturity breakevens, because the market would anticipate a tightening response from the Fed. Stay overweight TIPS versus nominal Treasury securities for now. We will reduce exposure when our fair value target of 2.4% to 2.5% is achieved. ABS: Neutral Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 4 basis points in January. The index option-adjusted spread (OAS) for Aaa-rated ABS tightened 2 bps on the month and now stands at 33 bps, only 6 bps above its all-time low (Chart 9). All in all, a 33 bps spread is still reasonably attractive for a sector that is Aaa rated with an average duration of 2. By way of comparison, the intermediate maturity Aaa Credit index offers an OAS of only 17 bps and has an average duration above 3. However, credit trends are clearly shifting against the Consumer ABS sector. The consumer credit delinquency rate has put in a bottom, albeit from a very healthy level, and the trend in the household debt service ratio suggests that delinquencies will continue to rise (panel 3). Further, the Federal Reserve's Senior Loan Officer Survey shows that lending standards on auto loans have tightened on net in each of the past 7 quarters, while credit card lending standards have tightened for 3 consecutive quarters. Even though lending standards on both auto loans and credit cards moved slightly closer to net easing territory in the fourth quarter of 2017, the reading from lending standards is still consistent with a rising delinquency rate (bottom panel). We retain a neutral allocation to consumer ABS due to still attractive spreads for a low-duration, high credit quality sector. However, if the uptrend in consumer delinquencies is sustained then our next move will probably be to reduce allocation to this sector. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 60 basis points in January. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 7 bps on the month and currently sits at 59 bps. The spread is now only 8 bps above the lowest level seen since the inception of the index in 2000 (Chart 10). Much like in the Consumer ABS sector, historically low CMBS spreads are observed at a time when lending standards are tightening in the commercial real estate (CRE) sector. The Federal Reserve's most recent Senior Loan Officer Survey shows that lending standards for nonfarm nonresidential CRE loans have tightened for 10 consecutive quarters, though they have been tightening less aggressively of late (panel 3). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 14 basis points in January. The index option-adjusted spread narrowed 1 bp on the month and currently sits at 40 bps. With an average spread of 40 bps and an average duration of around 5, this sector is not quite as attractive as Consumer ABS on a spread per unit of duration basis. However, it still offers greater expected compensation than a position in Conventional 30-year residential MBS which has an option-adjusted spread of 29 bps and a similar duration. Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 3.01% (Chart 11). Our 3-factor version of the model (not shown), which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 3.06%. The Global PMI actually ticked down in January, but only slightly from 54.5 to 54.4. This small decline was more than offset in our model by the large drop in dollar sentiment, which just moved into "net bearish" territory (bottom panel). Of the four major economic blocs, PMIs increased in the U.S. and Japan, ticked down from an extremely high level in the Eurozone and held steady in China. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com. At the time of publication the 10-year Treasury yield was 2.84%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com Jeremie Peloso, Research Assistant jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 4 For further details on our model please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "It's Still All About Inflation", dated January 16, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)
Highlights Market participants should be asking why yields are higher, and not worry about how much they have climbed. While the bond market has begun to price in higher inflation (via the move in the TIPS breakeven rate), wage and price inflation remains muted for now. Sentiment has deteriorated more than valuations or technicals as the S&P 500 climbed to fresh all-time highs in December and January. Our U.S. Equity Strategy service downgraded small caps to neutral from overweight. Feature Chart 1The January Jobs Report Keeps The Fed##BR##On Track For Gradual Hikes This Year Last week marked Janet Yellen's final FOMC meeting and the first week in many years that the U.S. Treasury and equity markets worried about inflation. The strongest year-over-year reading in average hourly earnings in 9 years (+2.9% in January) added to the market's inflation concerns (Chart 1). The 10-year Treasury yield climbed 15 bps to 2.84%, while the S&P 500 moved lower by 2.5% as of midday on Friday, February 2. It was the worst week for the stock market since September 2016. Individual investor sentiment on the equity market has surged recently, and valuations are at extremes. However, BCA's technical indicator for U.S. stocks is not at an extreme. BCA's stance is that while the risk/reward for stocks over bonds has narrowed, it is too soon to call an end to the bull market. However, we are monitoring real yields closely. At 2.13% on Friday morning, February 2, the 10-year TIPS breakeven yield was still below the 2.4 to 2.5% range where markets should begin to worry about the Fed falling behind the curve. While the acceleration in average hourly earnings in January cements the case for continued gradual Fed rate hikes this year, inflation is not about to spiral higher. Wage inflation remains muted, and patience is still required as market participants await signs of a pickup in broader measures of consumer price inflation. The market is now fully priced for three rate hikes this year. Also, longer-term rate expectations have moved close to the Fed's estimate of the terminal rate. It would be reasonable to expect some short-term pause to recent near-relentless uptrend in rate expectations. For the market to price tightening beyond the Fed's dots, the economy and inflation would need to outperform the Fed's forecasts (which are 2.5% GDP growth, 1.9% core inflation and 3.9% unemployment for 2018). For now at least, it's not clear that is the case. Why Rates Are Rising Matters The relentless increase in 10-year Treasury yields spooked investors early last week, but it is too soon for equity investors to worry about an overly aggressive Fed. At 2.84%, the 10-year Treasury yield is above the FOMC's view of the neutral Fed funds rate, and has moved nearly 80 bps higher since early September. Market participants should be asking why yields are higher, and not worry about how much they have climbed. Chart 2Breaking Down The Rise In Yields BCA's U.S. Bond Strategy service noted in mid-January1 that in the current environment, it is useful to split the nominal 10-year yield into its two main components - the compensation for inflation protection and the real yield (Chart 2). The 10-year TIPS breakeven inflation rate has moved from 1.66% last June to 2.13% late last week, but is still too low. Historically, the 10-year TIPS breakeven rate has traded in a range between 2.4 and 2.5% when inflation is well-anchored near the Fed's 2% target. BCA's stance is that inflation will move back to the Fed's target soon. The implication is that there is still another 25 to 35 bps of upside in the 10-year breakeven rate. The reason why this threshold is important is because a rise in inflation expectations to that level would be a signal that the FOMC will need to become more aggressive in slowing economic growth. This could occur even if actual inflation is below the 2% target, as long as it is rising toward the target. This will be especially true if the unemployment rate is heading to 3.5%, as we suspect. BCA's U.S. Bond strategists' model of real yields2 projects that real yields will rise 4 bps by the end of the year to 0.61%, but it could be more depending on how quickly the Fed wants to slow growth. Bottom Line: BCA expects that the nominal Treasury yield should move into a range between 3.0 and 3.25% by the time inflation reaches the Fed's target. BCA's stance is that risk assets will get into trouble once inflation expectations rise above 2.4%. Bond yields will presumably be moving higher along with inflation expectations. However, investors should not ignore higher Treasury yields rates. That said, equity investors do not need to be too concerned until inflation expectations hit that 2.4% threshold. Inflation itself may not be at 2% as this occurs, but if inflation is climbing and the unemployment rate is still falling, then the market will believe that the Fed is behind the curve. That is a bearish environment for equities. Inflation: Still A Waiting Game While the bond market has begun to price in higher inflation (via the move in the TIPS breakeven rate), wage and price inflation remains muted for now. Chart 3 illustrates various measures of wage inflation. Panel 1 shows that the Employment Cost Index (ECI) is in a clear uptrend. The acceleration in the wages and salaries component of ECI is broad-based across geography and industry (Chart 4, panel 1). Moreover, at 86%, the percentage of states reporting unemployment rates below NAIRU suggests that wage gains are imminent (Chart 4, panels 2 and 3). Chart 3Most Wage Metrics Are Rolling Over Chart 4The Employment Cost Index Is In A Definitive Uptrend... Although the year-over-year increase in average hourly earnings accelerated to 2.9% in January, many other wage indicators have stalled out recently (Chart 3, panel 4). The Atlanta Fed Wage Tracker rolled over recently along with weekly usual earnings (Chart 3, panels 2 and 3). In short, despite a robust global economy, a U.S. economy running above its long term potential and the unemployment rate (4.1% in January) below NAIRU (4.6%), labor shortages are not yet strong enough to push up wage inflation. Chart 5Shift Towards Service Economy Led##BR##To Shift Away From Capacity Utilization That said, the historical evidence suggests that once the labor market tightens, inflation eventually does accelerate. However, wages do not always lead inflation at bottoms and may be a lagging indicator in this cycle.3 In long economic cycles (1980s and 1990s), wage inflation was a lagging indicator. BCA recommends that investors should monitor a broad range of inflation indicators. Most of these indicators show that inflation pressures are building, but only gradually. The low readings on manufacturing capacity utilization suggest low odds of a rapid acceleration in inflation. Furthermore, the shift in composition of the U.S. economy in the past three decades suggests that the metric is no longer an accurate measure of wage or price bottlenecks in the economy (Chart 5, panels 1 and 2). Manufacturing capacity utilization hit a post WWII low in mid-2009 at 63.5%, before recovering to a well below average 75%-76% range for the past half-decade. In December 2017, utilization hit a 9-year high at 77%. Chart 5, (panels 3 and 4) shows that prior to 1980, inflation accelerated and the output gap closed as utilization breached 80%. Since early 1990s, the relationship is not as clear. Is 5% The Magic Number On Rates? History suggests that rising rates are not an impediment to higher stock prices, as long as rates remain below 5%. Chart 6 is a reminder that the 10-year yield and stock prices climbed together in the 1950s. The rise in yields in the 50s primarily reflected better economic growth rather than fears of inflation. Nonetheless, investors are concerned that a rise in yields will flip the positive correlation between bond yields and stock prices. Table 1 shows that since 1980, long treasury yields and stock prices move in the same direction until the 10-year moves above 5%. Chart 7 shows the relationship between the level of nominal bond yields and stock to bond yield correlations back to 1874. Moreover, since 1980, a move from 2 to 3% on the 10-year is accompanied by an average gain for the S&P 500 of 1.2%, with a median move of 1.8%. On average, the S&P 500 posts a modest decline (24 bps) as the 10-year Treasury elevates from 3 to 4%, but the median return (98 bps) is still positive. Our July 2016 Special Report provides an in-depth discussion of the impact of rates and inflation on equity prices. Historically, even the move from 4 to 5% on the 10-year is not an impediment to higher stock prices.4 Moreover, in a 2016 report our Global ETF Strategy service provides a detailed overview of equity returns in various phases of the Fed cycle.5 Chart 6Stock Can Rise##BR##With Bond Yields Table 13-Year Correlation* Between Stock Prices##BR##And Bond Yield Level (1980-2018) BCA's stance is that the stock-to-bond ratio will climb this year. However, the risk/reward embedded in that stance has shifted given the move in both bond yields and stock prices in the past few months. Our U.S. bond strategists peg fair value for the 10-year Treasury yield at 3.0%, just 18 bps above the yield last Friday morning. Chart 8 illustrates this point across three time horizons given our view of fair value on the 10-year Treasury yield (3.0%). Our analysis assumes a 1.75% annualized dividend yield on the S&P 500. Panel 1 illustrates that the ratio between now and mid-year will remain positive if stocks are flat. The same holds true though September 2018 and year end. Just a 5% drop in the S&P 500 by year-end 2018 signals a localized peak in the stock-to-bond ratio. Declines of 10 or 20% indicate a reversal of the uptrend in stocks versus bonds that has been in place since early 2016. Chart 7Stock To Bond Correlations Remain Positive With Nominal Yields Below 4.25% Chart 8Scenarios For Stock-To-Bond Ratio Bottom Line: BCA's view is that Treasury yields will top out at around 3 to 3.25% in this cycle, as inflation returns to the Fed's 2% target. Our base case is that stocks will do well in 2018, and will not be subject to concerns over an aggressive Fed until 2019. However, investors should closely monitor the 10-year TIPs spread, as noted above. We do not expect to breech 2.4% this year, but the timing is unclear. Moreover, we may take profits on our overweight stance well before the market senses the Fed is behind the curve, earlier than that, especially given stretched valuation and stretched market sentiment. Seismic Sentiment Shift Rising rates are not the only concern for U.S. equities. In late November, we noted6 that our technical and sentiment indicators are not flashing red as in previous bear markets, but neither are they giving an all-clear for U.S. equity investors. Sentiment levels are a bigger concern than technical indicators, and investors should monitor both for signs of an equity sell-off. These indicators have become even more stretched since we highlighted them in November and more clearly since the most recent equity market lull in late August 2017. BCA's technical indicator deteriorated since our late November report, but remains below levels that, in the past, have preceded bear markets (Chart 9, panel 1). The S&P 500 is testing the top end of the recovery trend channel in place since 2009 (Panel 2). A break above that level suggests more upside to stocks. However, a definitive failure to breakout may signal a period of consolidation for equities. BCA's equity valuation metric pushed further into extreme overvalued territory. Stretched valuations say more about medium- and long-term returns than near-term performance.7 However, the shift in the equity sentiment indicators we track is notable. BCA's investor sentiment composite index is at an all-time high (Chart 10, panel 1). Moreover, the surge in sentiment is led by individual investors and advisors who serve them (panels 2 and 4). Traders are a bit more complacent. Furthermore, individuals' optimism toward stocks is at an all-time high in surveys conducted by the Conference Board and the University of Michigan (Chart 11, panels 1 and 2). Chart 9Technical Picture For##BR##Equities Still Looks OK Chart 10Investor Sentiment##BR##Is Flashing Red Chart 11Surge In Consumer Optimism##BR##Toward Year Ahead Returns For Equities A similar survey from Yale University suggests that consumers' expectations about future equity market returns remains subdued. However, this may be due to the fact that the Yale survey is only available to December, and thus misses the equity 'melt up' in January that followed the news of the U.S. tax cuts. The other surveys mentioned are up to January. Notably, the Yale panel includes wealthy individual investors and a sample of institutions. The respondents in the Michigan and Conference Board surveys are more representative of the average U.S. household. Despite elevated attitudes toward equities, readings from the Fed's Flow of Funds on household ownership of stocks suggest that individuals may still have room in their portfolios for equities. Chart 12 shows that as of Q3 2017, equity holdings as a share of total household financial assets remains below prior peaks. As the U.S. stock market soared in the late 1990s, equities accounted for 31% of assets at the peak. Just before the global financial crisis, the figure was 23%. Today, equities account for just 25% of households' financial portfolios. The bottom panel of Chart 12 illustrates that individuals have allocated away from debt securities in the past half-decade. Chart 12Household Holdings Of Equities Still Below Prior Peaks Bottom Line: Sentiment has deteriorated more than valuations or technicals as the S&P 500 climbed to fresh all-time highs in December and January. While we are sticking with our stance that stocks will beat bonds in 2018, we are concerned about small caps. BCA's U.S. Equity Strategy service notes8 that rising interest rates and a flattening yield curve, coupled with increasing relative indebtedness and lack of relative profit growth, signal that the time is right to shift from overweight to neutral on U.S. small caps. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Bond Strategy Weekly Report "The Long And Short Of It", published January 23, 2018. Available at usbs.bcaresearch.com. 2 Please see BCA Research's U.S. Bond Strategy Weekly Report "Ill Placed Trust?", published December 19, 2017. Available at usbs.bcaresearch.com. 3 Please see BCA Research's The Bank Credit Analyst "Monthly Report", published September 2017. Available at bca.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Special Report "Stock-To-Bond Correlation: When Will Good News Be Bad News?", published July 6, 2015. Available at usis.bcaresearch.com. 5 Please see BCA Research's Global ETF Strategy Special Report "Equity Factors And The Fed Funds Rate Cycle", published December 21, 2016. Available at getf.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report "Technically Speaking", published November 27, 2017. Available at usis.bcaresearch.com. 7 Please see BCA Research's Global Asset Allocation Special Report "What Returns Can You Expect?", published November 15, 2017. Available at gaa.bcaresearch.com. 8 Please see BCA Research's U.S. Equity Strategy Weekly Report "Too Good To Be True?", published January 22 , 2018. Available at uses.bcaresearch.com.
Highlights Global equities are technically overbought, making them highly vulnerable to a correction. The cyclical picture for stocks still looks good, thanks to strong economic growth and rising corporate profits, but the recent spike in bond yields is becoming a headwind. Valuations are highly stretched, particularly in the U.S. This points to subpar long-term returns. On balance, we recommend staying overweight global equities. However, investors should consider buying some insurance against a market selloff. The VIX has probably bottomed for this cycle and high-yield spreads are unlikely to move much lower. This makes long volatility and short credit positions attractive hedges. Going short AUD/JPY is also an appealing hedge, given the yen's defensive characteristics and the Aussie dollar's vulnerability to slower Chinese growth. We were stopped out of our long global industrials versus utilities trade for a gain of 12%. We are also raising our stop on our short fed funds futures trade to 70 bps. Feature A Cloudy Picture As a rule of thumb, technical factors drive stocks over short-term horizons of one-to-three months, business cycle developments and financial conditions drive stocks over horizons of one-to-two years, and valuations drive stocks over ultra long-term horizons of five years and beyond. Occasionally, all three sets of signals line up in the same direction. In March 2009, the combination of bombed-out sentiment, cheap valuations, green shoots in the economy, and the expansion of the Fed's QE program all aligned to mark the beginning of a powerful bull market in stocks. Unfortunately, today the calculus is not so simple. Stocks Are Technically Overbought Technically, the stock market has gotten ahead of itself. The S&P 500 Relative Strength Index hit a record high earlier this week, while our Technical Indicator reached a post-recession high (Chart 1). The S&P has now gone 310 days without a 3% drawdown and 402 days without a 5% drawdown - both records (Chart 2). Chart 1U.S. Equities Are Technically Overbought Chart 2It's Been A Long Time Since U.S. Stocks Corrected Irrational exuberance is back. Our Composite Sentiment Indicator has jumped to the highest level since right before the 1987 crash (Chart 3). Retail investors are also flooding back into the market. Discount brokers such as E*TRADE and Ameritrade have seen a flurry of activity (Chart 4).The latest monthly survey conducted by the American Association of Individual Investors showed that respondents had the largest allocation to stocks since 2000 (Chart 5). Chart 3Equity Investors Are Mega-Bullish Chart 4Retail Investors Have Piled In (Part I) Chart 5Retail Investors Have Piled In (Part II) The Economy And Earnings Still Paint A Bullish Backdrop Chart 6Economic Outlook Remains Solid In contrast to the ominous technical picture, the cyclical outlook for stocks looks reasonably solid (Chart 6). The Citigroup Economic Surprise Index for major advanced economies has risen to near record-high levels. Goldman's Global Current Activity Indicator stands close to a cycle high of 5%, up from 2.2% at the start of 2016. Our Global Leading Indicator has decelerated somewhat, but is still pointing to above-trend growth this year. Growth in the euro area remains strong. The economy grew by 2.5% in 2017, the fastest pace since 2007. U.S. growth is gathering steam. Real private final demand increased by 4.6% in Q4. The Atlanta Fed's GDPNow model is signaling growth of 5.4% in the first quarter, while the New York Fed Staff Nowcast is pointing to a more plausible growth rate of 3.1%. Reflecting the strong economy, corporate profits are ripping higher. 45% of S&P 500 companies have reported 2017 Q4 results. 80% have beaten consensus EPS projections, above the long-term average of 69%. 82% have beaten revenue projections, which also exceeds the long-term average of 56%. The fact that earnings and revenue have surprised so strongly to the upside is all the more impressive given the sharp increase in EPS estimates over the past few months (Chart 7). Moreover, the improvement in earnings has been broad-based across sectors (Table 1). Chart 7Analysts Scramble To Revise 2018 Earnings Estimates Higher Table 1Estimated Earnings Growth For 2018 Financial Conditions Are Supportive, But Rising Bond Yields Are A Risk Financial and monetary conditions remain accommodative, as judged by an assortment of financial conditions indices (Chart 8). The global credit impulse has surged (Chart 9). Chart 8Financial Conditions Have Eased Chart 9Global Credit Impulse Is Positive The recent rapid ascent in global bond yields complicates matters. So far, much of the increase in yields has been driven by higher inflation expectations. This has kept real yields down. Indeed, real 2-year yields have actually declined in the euro area and Japan over the last several months. In absolute terms, yields are still low by historic standards (Chart 10). As my colleague Doug Peta, who heads our Global ETF Strategy service, has documented, rising bond yields pose a bigger problem for the economy and risk assets when they move into restrictive territory (Table 2). We are not there yet (Chart 11). Stronger global growth and diminished spare capacity have pushed up the pain threshold for when rising bond yields begin to bite. In the U.S., fiscal stimulus and a cheaper dollar have also caused the neutral rate to rise. Chart 10Yields Are Still Low ##br## By Historic Standards Table 2Aggregate Real S&P 500 Returns ##br## During Rate Cycle Phases From August 1961 Chart 11Rates Not Hurting ... Yet Nevertheless, equities often struggle to digest rapid increases in bond yields. Although the late 2016 episode stands out as an exception, stocks have typically floundered following an increase in global bond yields of around 50 bps (Table 3). The yield on the JP Morgan Global Government Bond index has risen by 27 bps since last autumn. If yields continue their swift ascent, stocks could come under pressure. Table 3What Happens When Bond Yields Spike? Valuation Concerns Chart 12Demanding U.S. Valuations Point To Low Long-Term Returns Valuations are not much use for timing the stock market, but they are the most important driver of returns over the long haul. Chart 12 shows the close correlation between the Shiller P/E ratio in the U.S. and the subsequent 10-year total return for stocks. Even though realized earnings growth tends to be higher following periods when the P/E ratio is elevated, this is more than offset by a lower dividend yield and the compression of P/E multiples. Today's Shiller P/E ratio of 34 presages subpar returns over the next decade. The picture is somewhat better outside the U.S. Our composite valuation measure - which combines trailing P/E, price-to-sales, price-to-book, Tobin's Q, and market capitalization-to-GDP - suggests that most stock markets outside the U.S. will see returns in the low-to-mid single-digit range over the next ten years (Appendix 1). Nevertheless, this is still well below the historic average return for these markets. What To Do? Our cyclical overweight in global equities has worked out well, and barring evidence that the global economy is tipping into recession, we intend to maintain this recommendation. Nevertheless, the discussion above suggests that stocks are vulnerable to a near-term correction and that long-term returns are likely to be lackluster at best. As such, it is sensible to take out some insurance against a market selloff. The question, as always, is how to guard against a drop in equity prices without suffering too much of a drag if global bourses continue to grind higher. We noted three weeks ago that today's equity bull market is starting to look increasingly like the one in the late 1990s.1 Back then, rising equity prices were accompanied by both higher volatility and wider credit spreads (Chart 13). History seems to be repeating itself. The VIX bottomed on November 24 at 8.56 and ended last week at 11.08, even as the S&P 500 hit another record high. Investors should consider buying volatility futures on any major dip in the VIX. Junk bonds have also underperformed equities year-to-date, which has benefited our long S&P 500/short high-yield credit recommendation. As we go to press, the Barclays high-yield total return index is flat for the year, while the S&P 500 has gained 5.7%. Given the deterioration in our Corporate Health Monitor, and the likelihood that rising inflation will keep Treasury yields in an uptrend, investors should consider hedging equity risk by shorting junk bonds. Chart 13Volatility Can Increase And Spreads Can Widen As Stock Prices Rise Chart 14Chinese Growth Is Decelerating Moderately Go Short AUD/JPY Chart 15Iron Ore Stockpiles Are Hitting New Highs In China Going short the Australian dollar versus the Japanese yen is also an appealing hedge against a broad-based retreat from risk assets. The yen is a highly defensive currency. Japan has a healthy current account surplus of 4% of GDP. Its accumulated foreign assets outstrip foreign liabilities by a whopping 65% of GDP. When Japanese investors get nervous about the world and start repatriating funds back home, the yen invariably strengthens. The Aussie dollar is highly levered to the Chinese economy. While we do not expect a steep deceleration in Chinese growth this year, we do think that growth will fall from last year's heady pace. This can already be seen in the deterioration in the Li Keqiang index (Chart 14). The growth rate of railway freight, one of the index's components, has fallen from above 20% in early 2017 to -1%. Crucially for Australia, iron ore stockpiles in Chinese ports are hitting record highs (Chart 15). Meanwhile, the Reserve Bank of Australia's commodity index has rolled over. The year-over-year change in the index has dropped from a high of 47% six months ago to -1%. Domestically, the output gap stands at 2% of GDP. Both core CPI inflation and wage growth remain subdued (Chart 16). The household saving rate has dropped to 3%, while debt levels have reached nosebleed levels (Chart 17). This will limit consumer spending. Business confidence has dipped recently, as has the PMI new orders index (Chart 18). Mining capex has been trending lower, falling from over 6% of GDP in 2012 to 2.1% of GDP in 2017. The Australian government expects mining capex to sink further to 1.3% of GDP in 2018 (Chart 19). All this will limit the RBA's ability to hike rates. Chart 16Australian Core CPI Inflation And Wage Growth Remain Subdued Chart 17Australian Household Debt At Unsustainable Levels Chart 18Australia: Business Confidence And Orders Have Dipped Chart 19Mining Capex To Fall Further From a valuation perspective, AUD/JPY currently trades at a 27% premium to its Purchasing Power Parity exchange rate, having traded at a discount of as much as 50% back in 2000 (Chart 20). Speculators are heavily short the yen right now. As my colleague Mathieu Savary has noted, this could supercharge any short covering rally.2 Higher asset market volatility should also weaken the Aussie dollar. Chart 21 shows that AUD/JPY tends to be inversely correlated with the CVIX, an index of currency volatility. Chart 20AUD/JPY Trading At A Premium Chart 21Higher Vol Will Weaken AUD With this in mind, we are opening a new tactical trade recommendation to go short AUD/JPY. As a housekeeping matter, we are closing our long AUD/NZD trade for a loss of 1.8%. We were also stopped out of our long global industrial stocks versus utilities trade for a gain of 12%. Lastly, we are raising our stop on our short fed funds futures trade to 70 bps. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Will Bitcoin be Defanged," dated January 12, 2018, available at gis.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, "Yen: QQE Is Dead! Long Live YCC!," dated January 12, 2018, available at fes.bcaresearch.com Appendix 1 Chart A1Long-Term Return Prospects Are Slightly Better Outside The U.S.Long-Term Return Prospects Are Slightly Better Outside The U.S.Long-Term Return Prospects Are Slightly Better Outside The U.S. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Watch Inflation Expectations How much longer can this go on? Global equities were up 6% in January alone (the 15th consecutive month of positive returns), and investors are increasingly asking how much further this bull market has to run. There are no signs we can see that suggest it will end imminently. Our watch-list of key recession indicators (decline in global PMIs, inverted yield curve, rise in credit spreads - Chart 1) is sending no warning signals. U.S. GDP growth was a little weaker than expected in Q4, at 2.6% QoQ annualized, but this was mainly due to inventories and strong imports: final private demand, a better guide to future growth, was strong at 4.3%. Fed NowCasts for Q1 growth point to 3.1-4.2%. The euro zone grew even faster than the U.S. last year, and even Japan probably saw 1.8% GDP growth. Corporate earnings expectations have accelerated sharply over just the past few weeks - particularly in the U.S. as a result of the tax cuts (Chart 2) - with analysts now expecting 16% EPS growth for the S&P 500 this year. BCA U.S. Equity Strategy service's earnings models suggest that this forecast may still be too cautious (Chart 3). Recommended Allocation Chart 1No Recession Signals Flashing Chart 2A Dramatic Rise In Earnings Forecasts... Chart 3...But Forecasts May Still Be Too Cautious While it is true that equity valuations are stretched, particularly in the U.S. (with BCA's Composite Valuation Index having just tipped into the "Extremely Overvalued" zone - Chart 4), valuations are not usually a good timing tool. Investor euphoria seems not yet to have reached the extremes that usually characterize a bull-market peak. The message we hear consistently from wealth managers is that their clients who missed last year's rally are now looking to get into risk assets. The American Association of Individual Investors' latest weekly survey shows 45% bulls to 24% bears - not especially optimistic by past standards (Chart 5). Flows into equity funds have started to accelerate, but have been weaker than bond flows over the past year (Chart 6). Chart 4U.S. Equities Now 'Extremely Overvalued' Chart 5Investors Are Not Particularly Bullish Chart 6Flows Into Equities Starting To Accelerate Chart 7Key: Inflation Expectations Getting to 2.5% We think the key to timing the top lies in inflation expectations. With the U.S. economy at full capacity and unemployment at 4.1%, well below the NAIRU of 4.6%, the Fed believes that a pick-up in inflation is just a matter of time - an analysis we agree with. The market has started to come round to this view too, with implied inflation rising by about 40 BPs over the past two months (Chart 7). The market has now priced in a 65% probability of the Fed's projected three rate hikes this year, and even a 27% probability of four. Inflation expectations hitting 2.5% (which would be compatible with the Fed's 2% PCE inflation target - CPI inflation is typically 50 BPs higher) could be the tipping-point. This is because it would remove the Fed put - with inflation expectations elevated, the Fed would no longer be able to back off from tightening in the event of a global risk-off event such as a stock-market correction or a slowdown in China. Such a rise in inflation expectations would also push the 10-year U.S. Treasury yield above 3%, which would increase the attraction of fixed income, and represent a threat to highly indebted borrowers, especially in emerging markets. This is how bull markets typically end: with the Fed having to raise rates to choke off inflation, and either making a policy mistake or tightening monetary policy enough to slow growth. But all this is probably quite a few months away. We expect to turn more defensive perhaps late this year, ahead of a recession that we have for some time now penciled in for the second half of 2019. Given how advanced the cycle is, conservative investors primarily concerned with capital preservation might look to dial down risk or hedge exposure now. But investors focused on quarterly performance should ride the bull market until some of the warning signals mentioned above begin to flash. For now, therefore, we continue to recommend an overweight in equities relative to bonds on the 12-month investment horizon, and mostly pro-risk and pro-cyclical tilts. Equities: We continue to prefer developed over emerging equities. EM will be hurt by the slowdown likely in China (where money supply and credit growth have fallen in response to the authorities' tighter policies - Chart 8), rising U.S. interest rates, sluggish productivity growth, and valuations that are no longer particularly cheap (Chart 9). Within DM, we are overweight euro zone and Japanese equities, which should benefit from their higher beta, more cyclical earnings, still accommodative monetary policy, and cheaper valuations than the U.S. Our sector bets are tilted to late-cycle value sectors such as financials, industrials and energy. Chart 8Tighter Monetary Conditions in China Chart 9EM No Longer Cheap Fixed Income: Rising inflation expectations should push the 10-year U.S. Treasury bond yield up to 3% this year, with German Bunds rising by a similar amount. We recommend an underweight on duration, and a preference for inflation-linked over nominal bonds, in these markets. In the U.K. and Australia, however, central banks are unlikely to tighten as quickly as futures markets have priced in and so we prefer their government bonds. While the expansion continues, spread product should continue to outperform in the fixed-income bucket. The default-adjusted spread on U.S. high-yield bonds remains over 200 BP and, though we see little further spread contraction, carry alone makes this attractive. Currencies: BCA was correct last year to predict a widening of interest-rate differentials between the U.S. and the euro zone, but wrong to conclude that this would lead to a stronger dollar (Chart 10). The drivers of currencies can undergo regime shifts, and it seems now that valuation (both the euro and yen are cheap compared to their purchasing power parity, 1.32 and 99 to the U.S. dollar respectively), current account surpluses (3.3% for the euro zone and 3.7% for Japan), and other factors have become more important. Tactically, the euro, in particular, looks very overbought. Speculative investors are very long euros, the ECB is likely to remain dovish relative to the Fed, and the strong euro could put some downward pressure on growth in the short-term. However, if the dollar were to rebound by 5% or so we would be likely to end our dollar bull call. Chart 10Rate Differentials No Longer Moving Currencies Chart 11Oil Supply To Increase In 2019 Commodities: Oil prices have risen on the back of strong global demand, OPEC discipline, and a lag in the response of U.S. shale oil producers. We forecast an average of $67 a barrel for Brent crude this year, with spikes to as high as $80 in the event of disruptions in producer countries such as Venezuela. However, with one-year forward crude prices around $62, shale producers (whose marginal costs average about $52 a barrel) are likely to pick up production soon. OPEC, too, should be happy with crude around $50-60. Our energy team forecasts a pick-up in supply next year (Chart 11), which should bring the crude price down to an average of $55 in 2019. Industrial commodities are a product of Chinese demand, global growth, and the U.S. dollar. These drivers look likely to be mixed over the coming months and so we remain neutral. Gold has risen, in the face of rising interest rates, because of the weak dollar - it remains an excellent hedge against inflation, recession, and geopolitical risks and so should be a modest part of any balanced portfolio. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com GAA Asset Allocation
Highlights A potential rise in U.S. inflation and China's growth slowdown represent formidable headwinds to EM risk assets. A manifestation of these tectonic macro shifts will be a U.S. dollar rally and weakening commodities prices. These two will dent the EM risk asset rally. Strong DM growth will not offset the impact of a slower Chinese economy on EMs and commodities. A new fixed-income trade: bet on a steeper swap curve in Mexico relative to Canada. Feature The global macro landscape in 2018 will be shaped by the two tectonic shifts: U.S. fiscal stimulus amid vigorous growth, and policy tightening in China amid lingering credit and money excesses. The former will grease the wheels of the already robust U.S. economy, generating a whiff of inflation and fueling a further selloff in the U.S. bond market. China's tightening will in turn weigh on commodities prices and curtail the emerging market (EM) economic recovery. A manifestation of these tectonic macro shifts will be a U.S. dollar rally and weakening commodities prices producing formidable headwinds to EM risk assets. As such, we are reiterating our recommendation to underweight EM risk assets versus their DM peers. As to the absolute performance, we believe EM risk assets are close to a major market top. A Whiff Of U.S. Inflation Strong U.S. growth could in fact be damaging to EM financial markets, as it will likely augment U.S. consumer price inflation. Investors are currently extremely sanguine on U.S. inflationary pressures. An upside surprise to inflation will lift U.S. interest rate expectations further, supporting the greenback and hurting EM carry trades. There is some evidence that U.S. inflation is about to pick up: The New York Federal Reserve underlying inflation gauge is rising, signaling higher inflation ahead (Chart I-1). The nascent revival in the MZM (money of zero maturity) impulse presages a trough in inflation (Chart I-2). Chart I-1Fed Price Pressure Gauge Signifies Higher Inflation Chart I-2U.S. Money Growth And CPI The weak U.S. dollar will also help augment inflation in America. U.S. import prices from emerging Asia and Mexico have been rising - even before the latest carnage in the U.S. dollar (Chart I-3). This will filter through into higher domestic price pressures. Chart I-3U.S. Import Prices Are Rising In brief, fiscal stimulus amid buoyant growth as well as overwhelming optimism among consumers and businesses is creating fertile ground for companies to raise prices. This will amplify corporate profit growth but will also lead to higher inflation. We are not making a case that U.S. inflation is about to surge. Our thesis is that market participants are very complacent on inflation. The money market is pricing in only 96 basis points in rate hikes in 2018-'19. In the meantime, the term premium in the U.S. yield curve is extremely depressed. Therefore, even modest inflation surprises will likely produce an additional meaningful selloff in U.S./DM bond markets. Will global share prices rise in response to strong corporate profit growth, or sell off in the face of higher U.S. inflation? Our hunch is that share prices will suffer as rising bond yields cause multiples to shrink. Rising bond yields will overpower the profit growth impact on share prices. The basis is that multiples are disproportionately and inversely linked to percentage change interest rates but are proportionately and positively linked to EPS.1 At still-low yields, a 50-basis-point rise in bond yields constitutes a sizable percentage change in the bond yield, likely leading to a meaningful P/E de-rating. Current sky-high bullish sentiment towards equities combined with elevated valuations and overbought conditions will mean that even a modest rise in inflation readings will likely trigger equity market jitters. EMs will underperform DMs amid such a selloff, as the former has benefited much more than the latter from low interest rates. Bottom Line: U.S. fiscal stimulus is arriving at a time when final demand is robust, the labor market is tight and business and consumer confidence is buoyant. This will encourage companies to raise prices, resulting in a whiff of U.S. inflation. The latter will rattle markets in the months ahead. China: Tightening Amid Credit/Money Excesses Inflation in China has already been steadily rising (Chart I-4). Interest rates adjusted for inflation remain low. Rising inflation along with still-lingering credit and money excesses necessitates policy tightening. We have written extensively about China's ongoing tightening trifecta - liquidity tightening, increased regulatory oversight and clampdown as well as an anti-corruption crackdown in the financial industry.2 Regulatory tightening in particular could inflict a particular bite as it outright constrains banks' ability to originate credit. This tightening has already led to record low broad money growth, and credit growth is downshifting too (Chart I-5). The cumulative impact of this tightening will play out in the months ahead, weighing further on money and credit growth and ultimately on final demand. Chart I-4China: Inflation Is In Steady Uptrend Chart I-5China: Broad Money And Credit Growth On the fiscal front, local government spending has languished in recent months (Chart I-6, top panel) and general (central plus local) government spending growth has been lackluster (Chart I-6, bottom panel). In 2017, local government annual spending amounted to RMB 19 trillion, or 22% of nominal GDP. Central government expenditures are about 6-fold smaller. Local governments rely on land sales to replenish their coffers, but timid money growth points to weaker land sales ahead (Chart I-7). In the meantime, their annual borrowing is restricted by the central government. Overall, this will constrain local government expenditures in 2018. Chart I-6China: Government Expenditures Chart I-7China: Land Sales To Slump The combined credit and fiscal spending impulse heralds a relapse in mainland imports of goods and commodities (Chart I-8). This constitutes a major threat to commodities prices, and consequently to EM. A pertinent question is whether financial markets will react to rising U.S. inflation or a slowdown in Chinese growth. Clearly, one could argue that strong U.S. growth would offset a mainland growth slump, resulting in a stable global macro environment. However, financial markets are an emotional discounting mechanism, and they do not always follow rational thinking. For example, in the first half of 2008 - just a few months ahead of the Global Financial Crisis - global financial markets were preoccupied with mounting global inflation due to strong growth in EM/China. At the time, oil and many other commodities prices were literally surging, and U.S. bond yields were climbing (Chart I-9). Global financial markets were not concerned with the ongoing U.S. recession, shrinking bank loans and deflating house prices. Chart I-8China's Impact On Rest Of The World Chart I-92008: An Inflation Scare Just ##br##Before Deflationary Bust In retrospect, financial markets traded on the theme of rising global inflation in the first half of 2008 even though the U.S. was already in a recession, and was heading into the most severe deflationary bust of the past 80 years. Similarly, the financial markets today could trade on the U.S. inflation theme for a couple months, even though China will be slowing. Bottom Line: China's policy tightening is particularly dangerous because it is occurring amid substantial and still-lingering credit, money and property market excesses. Won't Strong DM Growth Support China And Other EMs? Our investment stance on EM has been and remains negative, despite our positive view on U.S. and European growth. The key rationale for this stance is that EMs are much more leveraged to China than to the U.S. and Europe. Hence, our view assumes de-synchronization of growth between EM and DM. In our opinion, an EM slowdown will be largely due to China's deceleration and the latter's impact on commodities prices and non-commodity economies in Asia via trade. South America, Russia, South Africa, Malaysia and Indonesia are commodities producers, and as such are sensitive to fluctuations in commodities prices. The rest of Asia - Korea, Taiwan, Singapore, Thailand and the Philippines - are still exposed to the mainland economy as the latter is their largest export destination. Thus out of the EM sphere, China's dynamics will have a limited impact on only Mexico, India, and Turkey. However, Mexico is at risk of a NAFTA abrogation, while Turkey is at risk of runaway inflation and monetary profligacy. India on the other hand has its own problems and its bourse is unlikely to do well, given it is overbought and expensive. Furthermore, while we are bullish on the growth outlook in central European economies, they are too small to matter from an EM benchmark perspective. It might be useful to contemplate the late 1990s macro dynamics when major decoupling occurred between DM and EM. The booming economies of the U.S. and Europe did not prevent recurring crises in EM in the second half of the 1990s. Chart I-10 illustrates that U.S. and European imports growth was surging at that time, but EM stocks and currencies collapsed. What's more, despite the economic boom in DM during that period - U.S. and euro area real GDP growth rates averaged 4.2% and 2.6%, respectively, between 1996 and 1998 - commodities prices were in a bear market (Chart I-11). Chart I-10EM Crises In 1997-98: U.S. And ##br##Europe's Imports Were Booming Chart I-11Booming DM GDP And ##br##Falling Commodities Prices One might suspect that EM crises in the second half of the 1990s occurred because booming DM growth led to rising U.S. bond yields. However, Chart I-12 portrays that U.S. bond yields actually fell in 1997 and 1998 due to the deflationary shock stemming from the EM turmoil. Chart I-12EM Crises Occurred Amid ##br##Falling U.S. Bond Yields By and large, the 1997-98 EM crises occurred despite buoyant DM growth and falling DM bond yields. Nowadays, advanced economies carry much smaller weight in global trade and GDP than they did 20 years ago. Furthermore, EMs are much less dependent on exporting to DMs than they were two decades ago. In addition, China was not an economic powerhouse 20 years ago like it is today, and it did not buy as much from the rest of EMs as it does today. Presently, China holds the key to the EM outlook, and the link is through Chinese imports of goods and commodities. As China's credit and fiscal spending impulse suggests, mainland imports are likely to slow, weighing on commodities prices (refer to Chart I-8 on page 6). To be sure, we are not suggesting that EMs are facing crises similar to what transpired in 1997-98. The point of this comparison is to highlight that robust DM growth in of itself is not sufficient to head off an EM downturn if the latter faces a negative shock from China. With respect to DM growth benefiting China itself, it is critical to realize that China's exports to the U.S. and EU together account for only 6.6% of Chinese GDP (Chart I-13). By far, the largest component of the mainland economy is capital spending, constituting 42% of GDP. Construction and infrastructure are an integral part of capital expenditures, and they are very sensitive to money/credit cycles. Finally, from a global trade perspective, China and the rest of EM account for 46% of global imports, while the U.S. and EU account for 20% and 15%, respectively (Chart I-14). Hence, the total import bill of EM including China is larger than that of the U.S.'s and EU's imports combined. This entails that the pace of global trade growth is set to moderate if EM/China domestic demand decelerates. Chart I-13What Drives Chinese Economy: ##br##Capex Not Exports To DM Chart I-14Important Of EM/China In Global Trade Bottom Line: Strong DM growth will not offset the impact of a slower Chinese economy on EMs and commodities. Investment Conclusions A manifestation of the above-discussed tectonic macro shifts - a rise in U.S. inflation and China's slowdown - will be a U.S. dollar rally and weakening commodities prices. These two macro shifts will produce a perfect storm for EM risk assets. As a harbinger of a forthcoming selloff in EM exchange rates and DM commodities currencies (AUD, NZD and CAD), their implied volatility measures are already picking up (Chart I-15). As to a China/Asia slowdown, Korean, Taiwanese and Singaporean manufacturing output volume growth rates have already relapsed (Chart I-16). Their exports and corporate profits still appear robust because of rising prices. This certifies that there are inflationary pressures, even in Asia. Chart I-15Currency VOLs Are Rising Chart I-16Asian Manufacturing Output Volume All in all, we maintain a negative stance on EM risk assets in absolute terms and recommend underweighting them versus their DM peers. Within the EM universe, our equity market overweights are Taiwan, India, Korean technology, Thailand, Russia, central Europe and Chile. Our underweights are South Africa, Turkey, Brazil, Peru and Malaysia. Among currencies, our favorite shorts are the TRY, the ZAR, the MYR and the BRL. For investors who prefers relative EM currency trades, we recommend the following longs for crosses: RUB, TWD, THB, CNY and INR. For fixed-income trades, please refer to our open position table on page 18. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Mexico: Bet On A Steeper Swap Curve Relative To Canada For Mexican financial markets, the key uncertainty at the moment is the outcome of the ongoing NAFTA negotiations. Mexico's macro backdrop argues for considerable central bank easing, as inflation is about to roll over and domestic demand is extremely weak. However, if the U.S. pulls out of NAFTA - the odds of which are considerable, as our Geopolitical Strategy team has argued3 - the peso will sell off and interest rates are likely to rise. How should investors position themselves in Mexican fixed-income markets given this binominal outcome from the NAFTA negotiations and uncertainty over its timing? One way is to position for a swap curve steepening in Mexico, and hedge it by betting on a swap curve flattening in Canada by entering the following pair trades (Chart II-1): Chart II-1Mexico, Canada And Their ##br##Relative Swap Curve Receive 6-month and pay 10-year swap rates in Mexico Pay 6-month and receive 10-year swap rates in Canada In A Scenario Where The U.S. Withdraws From NAFTA: The Mexican swap curve would invert due to short-term rates going up more than long-term rates. In Canada, potential risks from NAFTA abrogation and tightening monetary policy amid frothy property markets and high household debt will cap upside in its long-term interest rates. With its long-term bond swap rates at par with those in the U.S., it seems as though the Canadian fixed income market is underpricing the risk of potential growth disappointments beyond the near run. In essence, should the U.S. withdraw from NAFTA, the loss realized on the Mexican steepener leg would partially be offset by the potential gain on the Canadian flattener leg. In A Scenario Where The U.S. Does Not Withdraw From NAFTA: The Mexican swap curve would start steepening. The rationale is that domestic dynamics suggest inflation has peaked and Banxico should begin its easing cycle soon. Monetary and fiscal policies have been extremely restrictive in Mexico, and considerable monetary easing is justified going forward: A significant part of the rise in inflation in 2017 was caused by peso depreciation in 2016. Last year's peso rally suggests that inflation should start to roll over soon (Chart II-2). Besides, one-off effects on inflation - such as the gasoline subsidy removal that took place at the end of 2016 - will subside as the base effect it has caused fades. In brief, the consumer inflation rate will rapidly decline, justifying substantial monetary easing. Banxico's 425 basis points in rate hikes since the end of 2015 are still filtering through the economy. The persistent slowdown in money and credit growth will continue to weigh on domestic demand for the time being. Notably, retail sales volume and gross fixed capital formation are both contracting while domestic vehicles sales are shrinking sharply (Chart II-3). Chart II-2Mexico: Inflation Is Set To Drop Chart II-3Mexico: Consumer And Business ##br##Spending Are Extremely Weak Due to currently high inflation, real wage growth remains weak. This will continue to weigh on consumer spending (Chart II-4). Fiscal policy has been tightening. Fiscal expenditures, excluding interest payments, are contracting in nominal terms (Chart II-5). Chart II-4Mexico: Real Wage Growth Is Very Timid Chart II-5Mexico: Fiscal Policy Is Super Tight Canada is currently on the opposite side of the business cycle spectrum relative to Mexico. The Canadian economy is very strong, being led by domestic demand. Real consumer spending is growing at its fastest pace in nearly 10 years, while the unemployment rate is at 40-year lows. Moreover, a record proportion of Canadian firms are having difficulty meeting demand because of capacity constraints and a tight labor market (Chart II-6, top and middle panel). Chart II-6Canadian Economy Is ##br##Above Full-Employment As such, the output gap is positive and growing, which has historically led to rising inflation (Chart II-6, bottom panel). Robust growth and rising inflation will force the Bank of Canada to hike rates further. In the meantime, real estate and consumer credit in Canada are overextended, leaving the Canadian consumer at risk from much higher interest rates. The threat that monetary tightening will hurt domestic demand in the future will cap the swap curve in Canada relative to Mexico. On the whole, in the scenario where the U.S. remains in NAFTA, the potential for swap curve steepening in Canada is less than in Mexico. Investment Recommendations We have been recommending that investors maintain a neutral stance across all asset classes in Mexico and wait for clarity on NAFTA negotiations before going overweight the country's currency, fixed-income markets and possibly equities relative to their EM peers. In the face of lingering NAFTA uncertainty, fixed-income investors should contemplate the following relative trade: Receive 6-month and pay 10-year swap rates in Mexico / pay 6-month and receive 10-year swap rates in Canada. Overall, this trade is exposed to minimal losses in the scenario where the U.S. withdraws from NAFTA but is exposed to considerable gains where the U.S. remains in NAFTA, making the overall risk/reward attractive. Provided the NAFTA negotiations could drag till year-end, this trade offers a reasonable risk-reward for traders. It offers a profitable opportunity to profit from Mexico's swap curve steepening, while limiting downside in case NAFTA is terminated before year-end. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 This is due to the fact that interest rates are in the denominator of the Gordon Growth model while EPS/dividends are in the numerator. 2 Please refer to Emerging Markets Strategy Weekly Report, titled "Questions For Emerging Markets," dated November 29, 2017, the link is available on page 19. 3 Please refer to the Geopolitical Strategy Special Report, titled "Nafta - Populism Vs. Pluto-Populism," dated November 10, 2017, the link is available at gps.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Duration Checklist: Our Duration Checklists continue to point to a bearish backdrop for global bond yields. A continued below-benchmark overall portfolio duration stance is warranted. There is not enough of a difference between the U.S. & European portions of the Checklist to suggest a big imminent move in the U.S. Treasury-German Bund spread is in the cards. UST-Bund Spread: A big cyclical turn in the Treasury-Bund spread is coming, but not before the ECB begins to seriously signal an end to its asset purchases and the Fed delivers a few more rate hikes. There will be better levels to move to a long Treasury/short Bund position by the summer. Feature Chart of the WeekUST-Bund Gap Still##BR##Reflects Policy Differences With the 10-year yield on both U.S. Treasuries and German Bunds hitting new cyclical highs on an intraday basis yesterday (2.72% and 0.70%, respectively), it is clear that the backdrop for global government bond markets is still bearish. The yield differential between the two markets remains quite wide, however, with the cyclical European economic performance rapidly catching up to that in the U.S. This is raising the odds that European Central Bank (ECB) will have to soon begin signaling a move to a less accommodative policy stance that will raise European bond yields further away from historically low levels. The continued strength of the Euro versus the U.S. dollar is a sign that investors are already expecting a big compression in U.S. bond yields versus European equivalents (Chart of the Week). Should investors position now for an eventual tightening of the Treasury-Bund spread? Or is it possible that the spread widens even further, thus providing a better entry point to profit from a spread tightening move? In this Weekly Report, we investigate the drivers of the Treasury-Bund spread to provide some clues as to its future direction. Our conclusion is that, from a medium-term strategic perspective, a narrowing of the Treasury-Bund spread is highly probable, but there is still potential for widening in the next few months. Checking In On Our Duration Checklist: Still Bearish, But With No Big Signal For U.S.-German Spreads In early 2017, we introduced a list of indicators to monitor in order to determine if our strategic below-benchmark duration stance on U.S. Treasuries and German Bunds should be maintained.1 This list, which we dubbed our "Duration Checklist", contained elements focused on economic growth, inflation, central bank policy biases, investor risk appetite and bond market technicals. The vast majority of indicators in the Checklist have accurately pointed to a cyclical backdrop for rising yields throughout the past year, despite the surprising drop in global inflation witnessed in 2017 (Table 1). Table 1The Message From Our Duration Checklist Is Still Bearish For Both USTs & Bunds With bond yields hitting fresh cyclical highs this week, it is a good time to provide another update of our Duration Checklist to see how conditions have changed since our last update in September. Specifically, we are looking for any differences in the individual U.S. and European components of the Checklist that can inform our view on the UST-Bund spread. Global growth momentum is accelerating to the upside. The global leading economic indicator (LEI) continues to climb steadily higher, even with global growth already in a solid uptrend (Chart 2). The global ZEW index, measuring investor sentiment towards growth in the major developed economies, has started to accelerate. The Citigroup Global Data Surprise index is at the highest level since 2004 (!), while our global credit impulse indicator has picked up sharply - both of which should keep global bond yields under upward pressure. We are giving a "check" to all these elements of our Duration Checklist, indicating that a defensive stance on overall duration exposure should be maintained. The only indicator in the "global" section of our Duration Checklist that is not pointing to higher bond yields is our global LEI diffusion index, which has fallen to just below the 50 line. This suggests a potential narrowing of the breadth of the current global upturn, which warrants an "x" in the Checklist. Domestic economic growth in both the U.S. and Euro Area remains solid. Manufacturing PMIs in both the U.S. (the ISM index) and Europe remain high and are rising, as is consumer and business confidence on both sides of the Atlantic (Charts 3 & 4). Corporate profit growth is solid both in the U.S. and Europe, with our models suggesting that earnings should expand at a double-digit pace again in 2018. All these indicators earn a "check" in our Duration Checklist. Chart 2Majority Of Global Growth Indicators##BR##Still Pointing To Higher Yields Chart 3U.S. Growth##BR##Remains Solid Chart 4A Booming European##BR##Economy Is Bearish For Bunds Inflation signals are mixed both in the U.S. and Europe. This remains the portion of our Checklist that has the greatest number of conflicting signals. While the rapid rise in oil prices over the past several months is putting upward pressure on headline U.S. inflation (Chart 5), the equally fast increase in the EUR/USD exchange rate is helping offset much of that increase in the Euro Area (Chart 6). Unemployment is below the OECD's estimate of the full employment NAIRU rate in the U.S., yet both Average Hourly Earnings growth and the Atlanta Fed Wage Tracker are decelerating. Unemployment in the Euro Area is now back to the OECD'S NAIRU level for the first time since the Great Recession, but wage inflation has only risen modestly. Chart 5U.S. Inflation Still Subdued,##BR##Despite Higher Oil & Low Unemployment Chart 6A Puzzling Lack Of##BR##Euro Area Core Inflation For the U.S. inflation side of our Checklist, we are giving a "ΓΌ" to the accelerating oil price (in U.S. dollar terms) and the unemployment gap, but an "x" to decelerating wage inflation. In the Euro Area, we give a "check" to the unemployment gap and a weak "check" to wage inflation which is in a mild uptrend. The stable momentum in the Euro-denominated Brent oil price earns an "x" in the Checklist, however. Both the Fed and ECB Are Looking To Tighten Monetary Policy. The Fed remains in a tightening cycle and with U.S. growth strong, core inflation bottoming out and the labor market still tight, there is no reason why the Fed should not deliver on its projected three rate hikes in 2018. The ECB just reduced the size of its monthly asset purchases in response to the robust Euro Area economic growth and modest pickup in inflation. The latest comments from various ECB officials suggests that, if core inflation rebounds after the recent unusual dip, then additional moves to less accommodative monetary policy (tapering first, rate hikes later) should be expected. So for both the U.S. and Europe, we place a "check" in this portion of the Duration Checklist. Investors risk appetite remains strong. The surge in global stock markets seen so far in 2018 has definitely played a role in the backup in global bond yields, as investors have been allocating out of fixed income into equities. Within our Duration Checklist framework, a bearish signal for bonds occurs if the percentage deviation of equity indices from their 200-day moving average is positive but is not yet at 10% - a stretched level that has typically preceded significant equity corrections. The S&P 500 index is now 14% above its 200-day average, and thus earns an "x" in that element of the Duration Checklist. The other parts of the U.S. side of the Checklist - tight corporate bond spreads and a low level of the VIX volatility index - both warrant a "check" as an indication of intense investor risk appetite that lessens the appeal of government bonds (Chart 7). In the Euro Area, the Stoxx 600 index is only 4% above its 200-day moving average, but with tight credit spreads and a low level of the VStoxx volatility index (Chart 8). All these elements earn a "check" in our Duration Checklist. Chart 7High Risk Appetite In the U.S.,##BR##But Risk Assets Look Stretched Chart 8Still A Pro-Risk Bias##BR##Among Euro Area Investors Bond market momentum is not overly stretched, although short positioning is an issue. In the U.S., the 10-year Treasury yield is only 35bps above its 200-day moving average, well below the 90-100bps levels seen at previous yield peaks (Chart 9). Price momentum for the 10-year is right on the zero line, suggesting no stretched extreme that would precede a reversal. Both of those indicators earn a "check" in the Checklist. Positioning is a problem in the U.S., however, with the CFTC data on Treasury futures showing a net short position on the 10-year contract among speculators. From the point of view of our Duration Checklist, a big net short is a bullish signal for bonds from a contrarian perspective. Thus, positioning warrants an "x" in the U.S. side of the Checklist. In Europe, the 10-year Bund yield is now 22bps above its 200-day moving average. This is below the previous peaks around the 50bps level. Price momentum is also hovering just above the zero line and is no impediment to a move higher in yields (Chart 10). Both of these pieces of the Duration Checklist score a "check". Note that due to a lack of available data, we do not include a positioning component on the European side of the Checklist. Chart 9USTs Not Oversold,##BR##But Positioning Getting Stretched Chart 10Bunds Not Yet At##BR##Oversold Extremes The net conclusion from our Duration Checklist is that the majority of indicators continue to point to upward pressure on U.S. Treasury and German Bund yields. Thus, a below-benchmark duration stance is still warranted for both markets. There are only a few potentially bullish signals in the Checklist. The overshoot in U.S. equity markets and the large net short position in Treasury futures are both sending a more positive signal for Treasuries, while the more stable momentum in the Euro denominated oil price is also a positive for Bunds. None of those is enough to prompt a change in our recommended below-benchmark duration stance. At the same time, there is not enough of a difference between the U.S. and European sides of the Checklist to provide a signal for the future direction of the Treasury-Bund spread. For that, we must dig a bit deeper into the drivers of that spread, which we cover in the next section. Bottom Line: Our Duration Checklists continue to point to a bearish backdrop for global bond yields. A continued below-benchmark overall portfolio duration stance is warranted. There is not enough of a difference between the U.S. & European portions of the Checklist to suggest a big imminent move in the U.S. Treasury-German Bund spread is in the cards. How To Play The Treasury-Bund Spread - Tactically Wider, Structurally Narrower The Treasury-Bund spread, like most cross-country bond yield spreads, is driven mostly by economic growth and inflation differentials. In the past, the U.S. and European economic cycles have rarely been in sync, which creates gaps in growth, inflation and monetary policy between the two regions. This usually leads to the Fed and ECB (and the Bundesbank before it) rarely having interest rates at similar levels, or moving at a similar pace, thus creating large cyclical swings in the Treasury-Bund spread. At the moment, however, the 200bp gap between 10-year Treasuries and German Bunds mostly reflects the 4.6 percentage point gap between the unemployment rates in the U.S. and Europe. The spread has been far less correlated to the difference in inflation rates between the two economies. Reported headline inflation in the U.S. is only 30bps above the same measure in Europe, with core inflation only 60bps higher in the U.S. (Chart 11). The latter may be more critical for the future direction of the Treasury-Bund spread, however. The dip in Euro Area core inflation back below the 1% level at the end of 2017 was a surprise given the strength of European growth last year, with real GDP reaching a well-above potential pace of 2.8%. Core inflation must rise from the current 0.9% level for the ECB to consider any move to a tighter monetary policy stance, as this would give the central bank confidence that its 2% inflation target would be reached in the medium-term. The markets seem to be pricing in a recovery of Euro Area core inflation in the coming months. Our Euro Area months-to-hike indicator, which measures the number of months until the first full 25bp rate hike is priced into the EUR Overnight Index Swap (OIS) curve, is now down to 17 months. As the interest rate markets have pulled forward the date of the next ECB rate hike to June 2019, the currency markets have followed suit with the euro rallying to a 3-year high last week (Chart 12). Chart 11Big Gaps Between Yields & Unemployment,##BR##Small Gaps In Inflation Chart 12Markets Are Acting Like##BR##Core Inflation Will Rebound In Europe A rebound in Euro Area core inflation is the first step towards seeing a convergence of the Treasury-Bund spread. The key is how the ECB responds to that move. Looking across the full spectrum of maturities, the moves in the yield gap between U.S. Treasuries and German government bonds have historically occurred alongside changes in relative inflation expectations (Chart 13). This makes sense, as to the extent that inflation expectations were climbing at a faster rate in the U.S. than in Europe, the market would price in a higher future Fed funds rate relative to European policy rates and, thus, widen the Treasury-Bund spread (and vice versa). That correlation between relative inflation expectations and the Treasury-Bund spread has broken down in recent years. The specific timing of that breakdown can be traced back to the August 2014 speech given by Mario Draghi at the Fed's Jackson Hole conference, marked by the vertical line in Chart 13. In that speech, Draghi introduced the idea that the ECB could begin buying government bonds to fight deflation pressures in Europe. That sent a powerful signal to the markets not to expect any movement in European policy rates for some time - the typical response seen in recent years to an announcement by a central bank that it was ramping up asset purchases. If Euro Area core inflation begins to rise in the coming months, the ECB's "forward guidance" can start to work in reverse. The ECB will be forced to signal further reductions in its asset purchases, likely all the way to zero in a full taper scenario. Markets will then begin to price in both higher inflation expectations and ECB rate hikes, resulting in a normalization of the Treasury-Bund spread through higher Bund yields. Until that inflation upturn happens in Europe, however, it will be difficult to get much of a tightening of the Treasury-Bund spread. In Chart 14, we present the spread versus the difference between policy rates in the U.S. and Europe (top panel), the ratio of the U.S. and Euro Area unemployment rates (middle panel), and the gap between U.S. and European headline inflation (bottom panel). At the moment, the Treasury-Bund spread is being held at an elevated level by the relative unemployment rates, with the spread looking wide versus the inflation differential. The much lower U.S. unemployment rate, which is driving the Fed to continue slowly hiking interest rates while the ECB keeps policy rates near zero, is preventing any meaningful decline in the Treasury-Bund spread. Chart 13UST-Bund Spread Has Divorced##BR##From Inflation During ECB QE Chart 14UST-Bund Spread Reflects Policy##BR##& Unemployment Differentials We have combined these three variables into a simple econometric model to explain the Treasury-Bund spread (Chart 15). We also added the size of the balance sheets of the Fed and ECB as separate variables, to account for the impact of bond purchases from each central bank. This model shows that a) the predicted value of the spread continues to steadily rise and b) the current spread is below one standard deviation away from that predicted value - a level equal to 237bps on the spread. That implies that there is still room for Treasury yields to climb higher versus Bunds before the spread becomes "too wide". Additional spread widening will be much harder to come by in the near-term, however. The gap between data surprise indices between the U.S. and Euro Area - which correlates well to the momentum in the Treasury-Bund spread - is relatively stretched, at a time when U.S. bond managers are already very underweight duration exposure (Chart 16). Yet with the forward curves already pricing in some mild tightening over the next year (top panel), betting on Treasury-Bund spread widening is a positive carry trade. One final point in favor of a wider Treasury-Bund spread is that the spread momentum is not yet close to the extremes seen in previous cycles (Chart 17). The big cyclical peaks in the spread typically occur when spreads are 50bps above the 200-day moving average, which is well above current levels. Chart 15Our New Model Suggests##BR##UST-Bund Spread Not Overstretched Chart 16Relative Data Surprises & UST##BR##Positioning May Limit Additional Spread Widening Chart 17UST-Bund Spread Momentum##BR##Not Yet At Stretched Extremes Our conclusion after looking at all these indicators is that the major cyclical peak in the Treasury-Bund spread is not yet on the immediate horizon, but is likely to unfold later this year - after one final move higher in Treasury yields versus Bunds. Bottom Line: A big cyclical turn in the Treasury-Bund spread is coming, but not before the ECB begins to seriously signal an end to its asset purchases and the Fed delivers a few more rate hikes. There will be better levels to move to a long Treasury/short Bund position by the summer. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "A Duration Checklist For U.S. Treasuries & German Bunds", dated February 15th 2017, available at gfis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Corporate Bonds & Inflation: The perception of accommodative monetary policy is the sole support for corporate bond performance. But this support will fade as inflationary pressures mount. Our first trigger to reduce exposure to corporate bonds will be when the 10-year TIPS breakeven inflation rate returns to a range between 2.4% and 2.5%. Corporate Debt & Buybacks: New tax legislation incentivizes firms to carry less debt in an optimal capital structure, but this is not likely to alter the current cyclical path of corporate sector re-leveraging. Share buybacks are also once again rising, an unambiguous negative for corporate balance sheet health. MBS: Absent a major monetary policy miscommunication that causes Treasury yields to spike dramatically, extension risk is not likely to be a significant driver of Agency MBS excess returns. We estimate that a monthly increase in yields exceeding 72 bps is required before extension risk becomes material. Feature Chart 1Watch This Space Inflation drives everything in the current environment. If the market comes to expect that inflation will return to the Fed's target, then Treasury yields have further upside. A relapse in inflation would likewise cause yields to fall. Elsewhere, with corporate balance sheets already in disrepair, accommodative monetary policy remains the sole support for spread product excess returns. Once inflation rises this support will also vanish, bringing an end to the credit cycle. With that in mind there is one chart we are tracking more closely than any other. It is the 10-year TIPS breakeven inflation rate and it has moved up significantly in recent months, from a mid-2017 low of 1.66% to its most recent reading of 2.11% (Chart 1). In last week's report we discussed why the 10-year breakeven rate will likely converge to a range between 2.4% and 2.5% before the end of the cycle, applying 29 bps to 39 bps of additional upward pressure to the nominal 10-year Treasury yield.1 This week, we focus on why this chart is so important for our spread product call. Specifically, we explain why a return of the 10-year TIPS breakeven rate to its fair value range between 2.4% and 2.5% will also likely trigger a reduction in our recommended allocation to corporate bonds. Trigger Warning: TIPS Breakevens & The Credit Cycle The range of 2.4% to 2.5% for the 10-year TIPS breakeven inflation rate represents where it has traded in prior periods when inflation is well anchored around the Fed's target. When it is below this range the assumption is that the Fed must respond dovishly whenever credit spreads widen or financial conditions tighten more generally.2 Why? Because when inflation is low the Fed needs the recovery to continue. It cannot allow tighter financial conditions to derail economic growth. Market participants know that this "Fed put" is in place and this makes it very difficult for spreads to gap meaningfully wider. For some context, let's consider the most recent period of significant spread widening between 2014 and 2016 (Chart 2). The initial catalyst for the sell-off was certainly the collapse in commodity prices and defaults in the energy sector, but why was the poor performance so broad based across the entire corporate bond universe? It is because the market assumed that the Fed would not respond dovishly to what was purely a commodity price shock. Notice that our 24-month Fed Funds Discounter, the number of rate hikes the market expects during the next two years, held steady at an elevated level throughout the entire period of spread widening (Chart 2, top panel). It was not until after the Fed capitulated in early 2016, and the discounter fell, that spreads started to recover. We therefore conclude that in order to see another significant sell-off in spread product we need to re-create the conditions that prevailed between 2014 and 2016. Specifically, we need a sense in the market that the Fed will not respond dovishly even if financial conditions tighten. The most likely catalyst for such a shift in market psychology is if inflation pressures are higher. The Fed would be less concerned about maintaining strong growth, and more concerned about containing inflation. Our sense is that a return to the range of 2.4% to 2.5% on the 10-year TIPS breakeven inflation rate will be the earliest signal of such a shift. Chart 2Wider Spreads Need A Hawkish Fed Chart 3Inflation Not Yet A Constraint The Empirical Evidence The link we have drawn between inflation and the end of the credit cycle is not pure theory. The historical record also shows that corporate bond excess returns are highest when inflationary pressures are lowest, and vice-versa. The readings from the Federal Reserve Bank of St. Louis' Price Pressures Measure (PPM) and from core PCE inflation have proven to be particularly useful in this regard (Chart 3).3 Table 1 shows that a level of 15% on the PPM has been a key threshold between positive and negative corporate bond excess returns. Monthly corporate bond excess returns have averaged +24 bps when the PPM is below 15%, but have averaged -5 bps when the PPM is between 15% and 30%. A PPM between 30% and 50% has historically been met with average monthly corporate bond excess returns of -17 bps. The PPM is currently at 7%, still supportive of our overweight allocation to corporate bonds. Table 2 repeats the exercise from Table 1, but this time for year-over-year core PCE inflation. The best periods for corporate bond performance have been when core PCE inflation is below 1.5%. In those periods monthly excess returns have averaged +25 bps. An inflation rate between 1.5% and 2% has led to more balanced corporate bond performance, with average monthly excess returns coming in at zero. Core PCE above 2% typically sends a negative signal for corporate bonds, with average monthly excess returns coming in at -13 bps when core PCE inflation is between 2% and 2.5%. Data released yesterday show that year-over-year core PCE inflation just ticked above 1.5% in December. It is therefore just starting to signal that the environment for corporate bond outperformance is becoming less favorable. Table 1Investment Grade Corporate Bond Excess Returns* Under Different Ranges ##br##Of Price Pressures Measure** (January 1990 To Present) Table 2Investment Grade Corporate Bond Excess Returns* Under Different Ranges##br## Of Year-Over-Year Core** PCE (December 1993 To Present) Bottom Line: The perception of accommodative monetary policy is the sole support for corporate bond performance. But this support will fade as inflationary pressures mount. Our first trigger to reduce exposure to corporate bonds will be when the 10-year TIPS breakeven inflation rate returns to a range between 2.4% and 2.5%. Corporate Debt, Buybacks & Tax Reform The preceding section takes for granted that corporate balance sheets are highly levered. Therefore, spreads will start to widen once inflationary pressures mount and monetary policy turns more restrictive. However, if firms suddenly started paying down debt and shoring up their balance sheets, then a significant enough improvement in corporate health could challenge our conclusions. On that note, the recently passed U.S. tax package does include a few incentives for firms to carry less debt in the capital structure: Lower corporate tax rates reduce the tax benefit from debt financing. Limiting the corporate interest tax deduction to 30% of earnings accomplishes the same thing. The ability to repatriate off-shore cash might also incentivize firms to pay off debt they had taken out to finance previous dividend and buyback programs. It is definitely conceivable that the first two provisions might incentivize less corporate debt issuance in the long run, but we doubt they will alter the cyclical picture. Chart 4 shows that the ratio of non-financial corporate debt to sales only tends to peak once the economy enters recession. In other words, firms in aggregate do not pay down debt unless prompted by slowing demand. As for repatriation, it is also possible that some firms might use repatriated cash to pay down debt, but we also doubt this effect will be large enough to alter the cyclical re-leveraging of the corporate sector. The temptation to use repatriated cash to boost share buybacks even further might be too great for firms to resist, and in fact we already see evidence of surging buyback announcements since the tax bill was introduced (Chart 5). Share buybacks obviously pose a significant risk to corporate bonds because they reduce the equity cushion in corporate capital structures. And in fact, aggregate share buybacks do tend to peak just prior to turns in the credit cycle. However, buyback activity is not a very reliable indicator of when the credit cycle is about to turn. Simply because it peaks at a different level in each cycle. Chart 4The History Of Corporate Leverage Chart 5Cue The Buyback Surge? The more reliable correlation is that periods when buybacks are declining have tended to coincide with periods of corporate bond underperformance (Chart 5, panel 2). This is most likely because tighter lending standards cause both corporate spreads to widen and buyback activity to decline, as banks make debt financing less available. This explains why the most recent decline in buyback activity did not coincide with corporate bond underperformance, because bank lending standards remained supportive and were not the driving force behind the reduction in buybacks (Chart 5, bottom panel). Bottom Line: New tax legislation incentivizes firms to carry less debt in an optimal capital structure, but this is not likely to alter the current cyclical path of corporate sector releveraging. Share buybacks are also once again rising, an unambiguous negative for corporate balance sheet health. Extension Risk In MBS Once the 10-year TIPS breakeven inflation rate reaches our trigger range of 2.4% to 2.5%, one of the beneficiaries of the reduction in our allocation to corporate bonds will likely be Agency MBS. These securities have become much more attractive relative to investment grade corporate bonds during the past year, as corporate bond option-adjusted spreads (OAS) narrowed and MBS OAS widened a tad (Chart 6). In fact, the OAS differential between a conventional 30-year Agency MBS and an investment grade corporate bond is only 19 bps away from its all-time high (Chart 6, panel 2). Chart 6An Attractive Option For De-Risking Last year's widening in MBS OAS is most likely due to the market pricing-in the run-off of the mortgages on the Fed's balance sheet. Now that the schedule for MBS run-off is well known, we think it is probably already reflected in current spreads. That is, we think current MBS OAS present an attractive opportunity to shift some allocation out of corporate bonds and into MBS, in the context of de-risking a U.S. fixed income portfolio. As was stated above, we think it is still a bit too soon to take risk off the table, but that will change once inflationary pressures are more pronounced. Another reason why we view Agency MBS as attractive is that the risk of future spread widening appears to be low. Mortgage refinancings, the main driver of MBS spread widening, should stay low as long as we remain in a rising rate environment. Further, with so much burn-out already in existing mortgage pools, even a decline in mortgage rates is not likely to cause a surge in refi activity (Chart 6, bottom panel). This leaves duration extension as the main risk for excess MBS returns. The opposite of refinancing risk, extension risk in MBS comes from the fact that the duration of these negatively convex securities rises when yields rise, thus leading to greater losses in a rising rate environment. A typical positively convex bond will see its duration decline as yields rise, damping the negative impact of rising rates. How worried do we need to be about the impact of extension risk on excess MBS returns? To answer this question we performed a regression of monthly excess MBS returns (relative to duration-matched Treasury securities) on three factors: The monthly change in duration-equivalent Treasury yields. The squared monthly change in duration-equivalent Treasury yields. The monthly change in OAS. As is shown in Table 3, the first factor is positively related to MBS returns. This is because it proxies for refinancing risk. Lower yields lead to more refinancing and wider MBS spreads, while higher yields lead to less refinancing and tighter MBS spreads. The squared yield factor is included as a proxy for extension risk, and it enters the model with a negative coefficient. For example, a small increase in yields is positive for MBS returns since it leads to less refi activity, but a large increase in yields eventually becomes negative for returns once it causes MBS duration to extend. The change in OAS is also a significant driver of MBS returns, but is un-correlated with the change in yields and so operates independently from the factors that drive refinancing and extension risk. The main message from our excess return model is illustrated in Chart 7. If we assume that the OAS remains flat, then the relationship between monthly excess MBS returns (relative to Treasuries) and the monthly change in Treasury yields can be illustrated with the following quadratic equation: Table 3Model Of Monthly Excess (%) Returns For Conventional ##br##30-Year Agency MBS (2000 - Present) Chart 7Model Of Monthly Excess (%) Returns For Conventional ##br##30-Year Agency MBS (2000 - Present) The chart shows that, all else equal, a monthly change in the duration-matched Treasury yield between -35 bps and +72 bps is consistent with positive excess MBS returns relative to Treasuries. It is only when the monthly change in yields exceeds +72 bps on the upside, or -32 bps on the downside, that negative convexity starts to bite. As is shown in Chart 8, monthly changes in Treasury yields of this magnitude - especially spikes of more than 72 bps - are quite rare. Chart 8Extension Risk Rarely Bites Bottom Line: Absent a major monetary policy miscommunication that causes Treasury yields to spike dramatically, extension risk is not likely to be a significant driver of Agency MBS excess returns. We estimate that a monthly increase in yields exceeding 72 bps is required before extension risk becomes material. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Long And Short Of It", dated January 23, 2018, available at usbs.bcaresearch.com 2 Wider credit spreads, a stronger dollar, a rising VIX and falling equity prices all signal tighter financial conditions. 3 For further details on the Price Pressures Measure please see: https://research.stlouisfed.org/publications/economic-synopses/2015/11/06/introducing-the-st-louis-fed-price-pressures-measure/ Fixed Income Sector Performance Recommended Portfolio Specification