Policy
Highlights The best recession indicators are not flashing red, but volatility is rising as the end of the cycle approaches; U.S. fiscal policy is surprising to the upside, as we expected; The next recession will usher in an inflationary political paradigm shift, with wealth transferred from Baby Boomers to Millennials; Expect a new U.K. election ahead of March 2019, but do not expect a second referendum unless popular opinion swings decisively against Brexit; Stay short U.S. 10-year Treasuries versus German bunds; short Fed Funds Dec 2018 futures; and initiate a short GBP/USD trade. Feature February has been tough for global markets, with the S&P 500 falling by 5.9% since the beginning of the month. Several clients have pointed out that the market may be sniffing out a recession and that the "buy the dip" strategy is therefore no longer applicable. It is true that markets and recessions go together (Chart 1), but it is not clear from the data that the equity market alone predicts recessions correctly. Chart 1Bear Markets & Recessions: Unclear Which One Leads The Other BCA's House View is that a recession is likely at the end of 2019.1 This view is in no small part based on our political analysis.2 President Trump ran on a populist electoral platform and populist policymakers globally have a successful track record of delivering higher nominal GDP growth than their non-populist counterparts (Chart 2). We assume that the Powell Fed will respond to such higher growth and inflation prospects no differently from the Yellen Fed and that it will restrict monetary policy to an extent that will usher in a mild recession by the end of next year. Chart 2Populists Deliver (Nominal) GDP Growth Of course, predicting recessions is extraordinarily difficult. Being six months early or late would still be an achievement, but the implications for the equity market would likely be considerably different. If our "late 2019" call is actually an "early 2019" recession, then equity markets may indeed be at or near their cyclical peaks. A "buy on dips" strategy may work for the next quarter or so, but superior returns over the course of the year may be achieved with a bearish strategy. To help guide clients through the uncertainty, our colleague Doug Peta, chief strategist of BCA's Global ETF Strategy, has recently updated BCA's methodology for identifying the inflection points that usher in a recession.3 In our 70-year history as an investment research house, we have picked up two definitive truths: valuation and technical indicators cannot call a recession. So what can? We encourage clients to pick up a copy of Doug's analysis.4 The report highlights the three BCA Research recession indicators: the orientation of the yield curve, the year-over-year change in the leading economic indicator (LEI),5 and the monetary policy backdrop. Charts 3, 4, and 5 show how successful the three indicators are in calling recessions. In our 50-year sample period, the yield curve has successfully called all seven recessions with just one false positive. However, it tends to be overly eager, preceding the onset of a recession by an average of nearly twelve months. When we combine the yield curve indicator with the LEI, the false positives go away. Chart 3The Yield Curve Has Called Seven Of The Last Eight Recessions... Chart 4... And So Has The Leading Economic Indicator To confirm the recession signal and make it more robust, we also consider the monetary policy backdrop. Over the nearly 60 years for which BCA's equilibrium fed funds rate model has calculated an estimate of the equilibrium policy rate, every recession has occurred when the fed funds rate exceeded our estimate of equilibrium. In other words, recessions only occur when monetary policy settings are restrictive. Today, none of the indicators are even close to pointing to a recession, with the LEI at a cyclical peak. However, the yield curve and monetary policy are directionally moving towards the end of the cycle. Taken together, they suggest that the only controversy about our late 2019 recession call is that it is so early. So why the market volatility? Because wage growth in the U.S. has begun to pick up in earnest (Chart 6), revealing that BCA's concerns about inflation may at last be coming true. Investors, after more than a year of rationalizing weak inflation by means of dubious concepts (Amazon, AI, robots, etc.), may be reassessing their forecasts in real time, causing market turbulence. Chart 5Tight Policy Is A Necessary,##br## If Not Sufficient, Recession Ingredient Chart 6Wages Picking##br## Up In Earnest There is of course a political explanation as well. Our colleague Peter Berezin correctly called the end of the 35-year bond bull market on July 5, 2016.6 The timing of the call - mere days after the U.K. EU membership referendum - was not a coincidence. As Peter mused at the time, "the post-Brexit shock running through policy circles leads to a further easing in fiscal and monetary policy." He was not speaking about the U.K. alone, but in global terms. Indeed, the populists have begun to deliver. Ever since President Trump's election, we have cautioned clients not to doubt the White House's populist credentials.7 After a surge in bond bearishness immediately following the election, investors lost faith in the populist narrative due to the failure of Congress to pass any significant legislation, as if Congress has ever been a nimble institution under previous presidents. But investors are beginning to realize that their collective political analysis was extremely wrong. Not only have profligate tax cuts been passed, as we controversially expected throughout 2017, but Congress is now on the brink of a monumental two-year appropriations bill that will add nearly 1% of GDP worth of fiscal thrust in 2018 higher than what the IMF expected for the U.S. (Chart 7). In addition, Congress has set in motion the process to re-authorize the use of "earmarks" - i.e. legislative tags that direct funding to special interests in representatives' home districts (Chart 8).8 Chart 72018 Fiscal Thrust Was Unexpected Chart 8Here Comes Pork! By our back-of-the-envelope accounting, Congress is about to authorize just shy of $400bn in extra spending over the next two years.9 If earmarks are allowed back into the legislative process, we could see up to another $50bn in spending. An infrastructure deal, which now also looks likely given that the Democrats have realized that their "resistance"/ "outrage" strategy does not work against the Trump White House, could add significantly to that total. We are already positioned for these political developments through two fixed-income recommendations. We are short U.S. 10-year Treasuries vs. German Bunds, a recommendation that has returned 27.7 bps since September 2017. In addition, we are short the Fed Funds December 2018 futures, a recommendation that has returned 43.17 bps since the same initiation date. In addition, we went long the U.S. dollar index (DXY) on January 31, right before the stock market correction and precisely when the greenback appeared to bottom. Should investors prepare for runaway inflation this cycle? Is it time to load up on gold? We do not think so. The fiscal impulse from the two-year budget deal will become negative in 2020. The capex incentives from the tax cut plan are also front-loaded. The paradigm-shifting impact on inflation will require a policy paradigm shift. And we expect such a shift only after the next recession. To put it bluntly, U.S. voters elected a TV game show host due to angst at a time when unemployment stood at 4.6% (the rate on November 2016). Who will they elect with unemployment rising to 6% in the aftermath of the next recession, or God forbid if that next recession is worse than we think it will be? Policymakers are unlikely to sit around and wait for an answer to that question. Extraordinary measures will be taken to prevent the median voter from lashing out against the system when the next recession hits. Inflation, which is a redistributive mechanism, will be employed to transfer wealth from savers (mainly well-to-do retirees) to consumers (their children). In large part, this will be a generational wealth transfer between Baby Boomers (or at least those with some savings) and their Millennial children. Given that Millennials have become the largest voting bloc in the U.S. as of the 2016 election, this will be a populist policy with firm backing in the electorate. The next recession will therefore usher in the inflationary era of the next decade, regardless of how painful the actual recession is. In the meantime, we recommend that clients with a 9-to-12 month horizon continue to "buy on dips," given that a recession is not on the horizon. However, with the U.S. 10-year yield approaching 3%, China moderately slowing down (with considerable risk to the downside), and the U.S. dollar slide arrested, we think that the outperformance of EM equities is over. Brexit: We Can't Work It Out10 The EU agreed on January 29 to its negotiation guidelines for the temporary transition period after the U.K. officially leaves the bloc in March 2019.11 The British press predictably balked at the conditions - the term "vassal state" has been liberally bandied about - which in our view included absolutely nothing out of the expected. The EU conditions for the transition period are not the fundamental problem. Rather, the problem is that the "Vote Leave" campaign was never honest with its promises. Boris Johnson, the most prominent supporter of Brexit ahead of the vote and now the foreign minister in Prime Minister Theresa May's cabinet, famously quipped after the referendum that "there will continue to be free trade and access to the single market."12 The problem with that promise, however, was that it was predicated on using London's "superior negotiating position" vis-à-vis the EU in order to force the Europeans to redefine what membership in the Common Market means. As we pointed out in our net assessment ahead of the Brexit referendum, the problem with exiting the EU but remaining in the Common Market is that the issue of sovereignty is not resolved (Diagram 1).13 As such, Johnson and other Brexit supporters argued that they could change the relationship by forcing the EU to change how the Common Market works. Diagram 1Common Market Membership Is Illogical Except for one problem: the U.K.'s negotiating position is not, never was, nor ever will be, superior. Anyone with a rudimentary understanding of how trade works can understand this. For example, the U.K. is a significant market for Germany, at 6% of German exports (right in line with the 6% of total EU exports that go to the U.K.). However, the EU is a far greater destination for British exports, with 47% of all exports going to the bloc.14 As we expected, the EU has surprised the conventional wisdom by remaining united in the face of negotiations. And as we also predicted, the Tories are now completely divided.15 PM May will attempt to hammer out an internal deal on how to approach the transition deal. But her political capital is so drained by the disastrous early election results that there is practically no way that she can produce a set of negotiating guidelines that will not be pilloried in the press. As such, we expect a new election to take place in the U.K. ahead of March 2019, perhaps sooner. We do not see how May's negotiating position will satisfy all wings of the Conservative Party. In addition, we see no scenario by which the ultimate exit deal with the EU gets enough votes in Westminster. Investors betting on that election replacing a second Brexit referendum would be wrong. A Jeremy Corbyn-led, Labour government will only turn against Brexit once the polls definitively turn against it. This has not yet happened, as the gap between supporters and opponents of Brexit in the polls, while widening in favor of opponents, remains within a margin of error (Chart 9). As such, Corbyn would scrap the Tory-led negotiations with the EU and ask Brussels for even more time - and thus more market uncertainty! - in order to produce a Labour-led Brexit deal.16 In order for the probability of Brexit to definitively decline, the polls have to show that "Bregret" or "Bremorse" is setting in. Without a move in the polls, U.K. politicians will continue to pursue Brexit, no matter how flawed their tactics may be. Policymakers are ultimately not the price makers but the price takers. On the issue of Brexit, the U.K. median voter is only slightly miffed regarding the outcome. Current polls suggest that Labour could win the next election, albeit needing to rule with a coalition (Chart 10). This would prolong the uncertainty facing the economy. Not only is Corbyn the most left-leaning politician in a major European economy since François Mitterand, but also his coalition would likely include the Scottish National Party and potentially the Liberal Democrats. Keeping all their priorities aligned could be even more difficult than the balancing act PM May is performing between soft-Brexiters, hard-Brexiters, and the Democratic Unionist Party. Chart 9Bremorse: Rising, But Not Definitive Chart 10Anti-Brexit Forces On The Rise Meanwhile, on the economic front, the situation is not much better. Our colleague Rob Robis, BCA's chief bond strategist, recently penned a critical assessment of the U.K. economy.17 As Rob pointed out, the OECD leading economic indicator is decelerating steadily and pointing to a real GDP growth rate below 2% in 2018 (Chart 11). The biggest factors that will weigh on growth will be a sluggish consumer and softer capex. Household consumer growth has been slowing since early 2017, driven by diminishing consumer confidence (Chart 12, top panel). High realized inflation, which has sapped the purchasing power of U.K. workers who have not seen matching increases in wages, is weighing on confidence (third panel). Consumers were able to maintain a decent pace of spending during a period of stagnant real income growth by drawing on savings, but that looks to be tapped out now with the saving rate down to a 19-year low of 5.5% (bottom panel). Chart 11U.K. Growth Set To Slow Chart 12The U.K. Consumer Looks Tapped Out Making matters worse, U.K. consumers are not seeing much of a wealth effect from the housing market. The January 2018 readings of the year-over-year growth rate of U.K. house prices from the Halifax and Nationwide indexes came in at 1.9% and 3.1% respectively (Chart 13). In addition, the net balance of national house price expectations from the Royal Institution of Chartered Surveyors (RICS) has steadily declined since mid-2016 and now sits just above zero (i.e. equal number of respondents expecting higher prices and falling prices). The same indicator for London was a staggering -47% in January 2018. Apparently, foreigners are no longer interested in a Brexit discount. Our global bond team goes on to point out that political uncertainty is also weighing on U.K. business investment spending. Capital expenditure growth slowed to 4.3% year-over-year in nominal terms in Q3 2017 and is even lower in real terms (Chart 14). Chart 13No Wealth Effect ##br## From Housing Chart 14Brexit Gloom Trumps ##br##Export Boom For U.K. Companies Putting all of this together, neither our global bond team nor our foreign exchange team expect the Bank of England to raise interest rates, despite the market pricing in 36 bps of rate hikes over the next twelve months. As Chart 15 illustrates, inflation across a broad swath of components is likely to slow sharply in the coming months as the trade-weighted pound has stopped depreciating. Thus, the pass-through from a lower exchange rate is beginning to dissipate.18 In the long-term, we understand why investors are itching to bet on Brexit never happening. But to get from here to there, the market will have to riot. And that means more downside to U.K. assets. Chart 15U.K. Inflation:##br## Less Pass-Through From The Pound Chart 16GBP:##br## Stuck In A Rut Bottom Line: BCA's FX strategist, Mathieu Savary, has pointed out that the trade-weighted pound is testing the upper bound of its post-Brexit trading range (Chart 16). As our FX and bond teams show in their respective research, the economics currently at play make it unlikely that the pound will be able to punch above the ceiling of this range. Our political assessment adds to this view. In fact, we expect that the coming political uncertainty, including an early election prior to March 2019, is likely to take the pound back to the floor of its trading range. As such, we are recommending that clients short cable, GBP/USD. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," June 16, 2017, available at gis.bcaresearch.com. 2 Please see BCA Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, and "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017, available at bcaresearch.com. 3 Please see BCA Special Report, "Timing The Next Equity Bear Market," dated January 24, 2014, and "Timing Equity Bear Markets," dated April 6, 2011, available at bcaresearch.com. 4 Please see BCA Global ETF Strategy Special Report, "A Guide To Spotting And Weathering Bear Markets," dated August 16, 2017, available at etf.bcaresearch.com. 5 The ten components of leading economic index for the U.S. include: 1. Average weekly hours, manufacturing; 2. Average weekly initial claims for unemployment insurance; 3. Manufacturers' new orders, consumer goods and materials; 4. ISM® Index of New Orders; 5. Manufacturers' new orders, nondefense capital goods excluding aircraft orders; 6. Building permits, new private housing units; 7. Stock prices, 500 common stocks; 8. Leading Credit Index TM; 9. Interest rate spread, 10-year Treasury bonds less federal funds; and 10. Index of consumer expectations. Source: The Conference Board. 6 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications," dated November 9, 2016, and "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 9 We are referring to the Senate deal struck last week to authorize additional military spending ($80bn in FY2018 and $85bn in FY2019) and discretionary spending ($63bn in FY2018 and $68bn in FY2019), as well as to provide disaster relief in the amount of $45bn for both fiscal years. 10 Life is very short, and there's no time ... For fussing and fighting, my friend ... 11 Please see European Council, "Brexit: Council (Article 50) adopts negotiating directives on the transition period," dated January 29, 2018, available at consilium.europa.eu. 12 Please see "UK will retain access to the EU single market: Brexit leader Johnson," Reuters, dated June 26, 2016, available at uk.reuters.com. 13 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 14 This is not a coincidence. The whole point of the EU is that it is the world's richest consumer market. As such, it has massive negotiating leverage with all trade partners. As a side note, this throws into doubt the logic that the U.K. can get better trade deals by leaving the bloc. The first test of that premise will be its negotiations with the EU itself. 15 Please see BCA Special Report, "Break Glass To Brexit: A Fact Sheet," dated June 17, 2016, available at bca.bcaresearch.com. 16 Investors should remember that Westminster voted decisively 319 to 23 to reject the Liberal Democrats' amendment seeking a referendum on the final Brexit agreement. Only nine Labour MPs voted in favor of the amendment after Jeremy Corbyn instructed his party to abstain. 17 Please see BCA Global Fixed Income Strategy Weekly Report, "A Melt-Up In Equities AND Bond Yields?" dated January 23, 2018, available at gfis.bcaresearch.com. 18 Please see BCA Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot," dated February 2, 2018, available at fes.bcaresearch.com.
Highlights The spike in volatility last week led to a sharp correction in equities. However, the bull market in equities is not over yet. The Fed's response to the selloff will be critical. Policymakers will closely monitor financial conditions. The most overvalued assets are at greatest risk during a selloff. Feature Financial markets did not give new Fed Chair Jay Powell a warm welcome last week. Volatility spiked, and risk assets fell sharply. Nonetheless, BCA's view is that strong economic growth and stout earnings growth will keep the bull market intact. The selloff is reminiscent of the 7% drop in the S&P 500 in May of 2006.1 Back in the spring of 2006, then Chairman Ben Bernanke had just taken the helm at the Federal Reserve. Global growth was strong, the U.S. dollar was selling off and global share prices were surging and overbought. From May through June 2006, markets sold off because of the then-prevailing narrative that Chairman Bernanke would be too dovish, allowing U.S. inflation to get out of hand. U.S. bond yields spiked, inflicting particular damage on EM assets. The February 2018 may not play out exactly like May 2006. That said, there are enough similarities to draw parallels. Global growth is robust and inflationary pressures are accumulating. Bond yields are rising, and the greenback is selling off. A new Fed Chairman just took over the reins, and there are growing odds that U.S. inflation will soon begin to rise, justifying more Fed rate hikes. The Fed's response to the tighter financial conditions will be crucial. The May 2006 selloff turned out to be just a correction in a bull market that lasted another 18 months. Still, investors today are also concerned about what to sell first as the end of the expansion draws closer. A Shake Up BCA strategists believe that the market turmoil since last week reflects a technical correction from overbought and over complacent levels, but the cyclical bull run is not yet over.2 Nonetheless, investors should note that the bull market is entering its late stages. The low inflation and low volatility era is ending as the U.S. economy begins to face late-cycle, supply-side constraints, especially in the labor market. Therefore, the equity advance will be associated with higher volatility than in the past few years. Chart 1 shows that the VIX soared by roughly four times more on February 5 than expected, based on the decline in equity prices. This suggests that the spike in volatility caused the stock market plunge, rather than the other way around. The relatively muted reaction in the past few days of other risk gauges, such as junk bonds, EM stocks, and gold prices, is consistent with this thesis. Chart 1Last Monday's VIX Spike Was Abnormally Large Importantly, the implosion of volatility funds is unlikely to reverberate across the global financial system in the same way as it did during the 2007-2009 financial crisis. The mortgage crisis a decade ago was so toxic that the losses were concentrated in the books of highly leveraged financial institutions. However, that does not appear to be the current case with volatility funds. The cyclical underpinnings for the bull market in equities is intact. The odds of a recession remain low (Chart 2). Corporate earnings continue to come in above expectations, aided by a wave of share buybacks linked to the U.S. Tax Cut and Jobs Act (Chart 3). Global economic growth remains upbeat as well. Chart 2Odds Of A Recession##BR##Remain Low Chart 3Buybacks, Surging Capex##BR##Raising The Bar For 2018 EPS Growth Chart 4U.S. Equities And Vol##BR##Climbed Through The 1990s This does not mean that everything will be smooth sailing. Last week's selloff marked an inflection point in the low-volatility world that has prevailed in the past few years. The VIX Humpty-Dumpty has been irrevocably broken. Volatility will stay elevated relative to what investors have come to anticipate. As the experience of the 1990s shows, stocks can still climb when volatility trends higher (Chart 4), but this is going to make for a more challenging investment environment. Bottom Line: Rising volatility does not mean the end of the bull market or the economic expansion. Bear markets outside of recessions are rare, and our view remains that the odds of a recession this year or next remain low. Moreover, the additional dose of fiscal stimulus passed by Congress late last week may extend the expansion into 2020. Stay overweight stocks versus bonds.3 The Policy Response The Fed's reaction to this new regime will be critical. The 7.2% drop in equities last week occurred on Jay Powell's first as Chairman of the Fed. Chart 5 shows that it is not unusual for the equity markets to be in turmoil in the early months of a new Fed Chair's tenure. BCA expects that Powell and his FOMC colleagues will adopt Janet Yellen's gradual approach to raising rates this year. Nonetheless, the January readings on average hourly earnings suggest that supply-side constraints are beginning to bite. The runway for low inflation and easy monetary policy may not be as long as some had hoped. Just like Yellen, Jay Powell will seek a consensus among his colleagues. The composition of the FOMC will probably shift in a more hawkish direction, but the evolution will be slow. In the meantime, the recommendations of career Fed staff will represent an important and often underappreciated source of continuity. Last week, several Fed speakers reinforced that the central bank will continue to monitor incoming economic and financial data, and react accordingly. The stock market rout has led to some tightening in financial conditions, but FCIs in the U.S. remain more expansionary than they were six months ago (Chart 6). As a result, U.S. economic growth is poised to accelerate even more in the first half of the year (Chart 7). This will push the unemployment rate further below NAIRU and ultimately force up wage and price inflation. Chart 5New Fed Chairs##BR##And The Equity Market Chart 6Decline In Equity Market##BR##Tightened Financial Conditions However, at 2.1% on February 8, the 10-year TIPS breakeven yield was still below the 2.4 to 2.5% range where markets need to worry about the Fed falling behind the curve (Chart 8). A shift above 2.4% would be consistent with the Fed's 2% target for the PCE measure of inflation. This would signal that the FOMC will have to boost the pace of rate hikes and aggressively slow economic growth. We expect the Fed to tighten four times in 2018. We will likely take some money off the table if core inflation rises, even if it is still below 2%, when the TIPS breakeven reaches 2.4%. Chart 7Lagged Effect Of Easier##BR##Monetary Conditions Will Boost Growth Chart 8Breaking Down##BR##The Rise In Yields A sustained move above 3% on the nominal 10-year Treasury yield will require a more durable increase in inflation. Ultimately, we think core inflation will move4 above 2%, forcing the Fed to lift interest rates into restrictive territory. However, this probably will be a story for 2019 rather than 2018. Stocks tend to peak about six months before the start of a recession (Table 1). If the next recession occurs in late 2019, as we forecast, the equity bull market could last a while longer. The additional fiscal impulse from the spending bill passed by Congress last week may extend the expansion into early 2020. A modest overweight on global risk assets is warranted for now, but investors should consider reducing their risk exposure later this year. Table 1Too Soon To Get Out Bottom Line: The Fed and the market are now in agreement on rate hikes in 2018. BCA's U.S. Bond Strategists' stance is that the 2/10 curve will flatten from here, as the upside in long maturity yields will be limited once the TIPS breakeven inflation rates reach our target fair value range of 2.4-2.5%. Nonetheless, at that point, the nominal 10-year yield5 is likely to be between 3.0 and 3.25%. Stay underweight duration for now. Where Do We Go From Here? Clients have asked our view on the appropriate order in which to reduce risk assets. One way to approach the question is to compare valuation across asset classes. Presumably, the most over-valued ones are at greatest risk, and thus profits should be taken here first. It is difficult to compare valuation across asset classes. Should one use fitted values from models or simple deviations from moving averages? Over what time span? We include multiple measures because there is no widely accepted approach. More than one time period was used in some cases to capture regime changes. Table 2 provides our best approximation for nine asset classes. The approaches range from sophisticated methods6 developed over many years (i.e. our equity valuation indicators), to regression analysis on the fundamentals (i.e. oil), to simple deviations from a time trend (i.e. real raw industrial commodity prices and gold). Table 2Valuation Levels For Major Asset Classes We averaged the valuation readings where there were multiple estimates for a single asset class. The results are shown in Chart 9. Chart 9Valuation Levels For Major Asset Classes By far, U.S. equities stand out as the most expensive at 1.8 standard deviations above fair value. Gold, raw industrials and EM equities are next at one standard deviation overvalued. EM sovereign bond spreads follow at 0.7, tracked closely by U.S. Treasuries (real yield levels) and investment-grade corporate (IG) bonds (expressed as a spread). High-yield (HY) is only about 0.3 sigma expensive, based on default-adjusted spreads over the Treasury curve. That said, both IG and HY are very expensive in absolute terms based on the fact that government bonds are pricey. Oil is sitting very close to fair value, despite the rapid price run up in the past couple of months. This makes oil exposure doubly attractive because the fundamentals point to higher prices when the underlying asset is not expensive. Historical analysis around equity market zeniths provides an alternative approach to the sequencing question. Table 3 presents the number of days that various asset classes peaked before or after the past major five tops in the S&P 500. A negative number indicates that the asset class peaked before U.S. equities, and a positive number means that it peaked after. Table 3Asset Class Leads & Lags Vs. Peak In S&P 500 Unfortunately, there is no consistent pattern observed for EM equities, raw industrials, U.S. cyclical stocks, tech stocks or small-cap versus large-cap relative returns. Sometimes they reached their zenith before the S&P 500, and sometimes after. The EM sovereign bond excess return index peaked about 130 days in advance of the 1998 and 2007 U.S. equity market tops, although we only have three episodes to analyze due to data limitations. Oil is a mixed bag. A peak in the price of gold led the equity market in four out of five episodes, but the lead time was long and variable. The U.S. corporate bond market offers the most consistent lead/lag relationship. Both investment- and speculative-grade excess returns relative to government bonds peaked in advance of U.S. stocks in four of the five episodes. High-yield excess returns provided the most lead time, peaking on average 154 days in advance. Excess returns to high-yield were a better signal than total returns. This leading relationship is one reason why we plan to trim exposure to corporate bonds within our bond portfolio before we scale back on equities. Base metal prices will be hit particularly hard if the 2019 U.S. recession spills over as expected to the EM economies. We may downgrade base metals from neutral to underweight around the time that we downgrade equities, but much depends on the evolution of China's economy in the coming months. Oil is a different story. OPEC 2.0 will likely cut back on supply in the face of an economic downturn, which will help keep prices elevated.7 Therefore, we may not trim energy exposure this year. In terms of equities, our recommended portfolio is still overweight cyclicals for now. Our themes of a synchronized global capex boom, rising bond yield, and firm oil price means we will stay overweight in the industrials, energy and financial sectors. Utilities and homebuilders are underweight. Tech is part of the cyclical sector, but poor valuation keeps us underweight. Our U.S. Equity Strategists have already started a gradual shift away from cyclicals toward defensives. This transition will continue in the coming months as we reduce risk. We will also shift small caps to neutral on earnings disappointments and elevated debt levels.8 Bottom Line: The economic expansion is not over, but investors are already wondering what to sell first as the next peak in equities nears. Market participants should look to trim credit exposure before scaling back on equities, and BCAs' U.S. Equity Strategy service is already scaling back on cyclicals and reduced small caps to neutral from overweight last month. At under $60/ barrel WTI, oil is 5% below our Commodity & Energy Strategy's target of $63/bbl. Moreover, global inventories will continue to draw on the back of OPEC supply restraint as shale production growth alone will not satisfy stronger global demand driven by stronger global economic growth. If prices hit the low $70 range, supply restraint and demand growth will ebb, capping incremental upside. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA Research's U.S. Equity Strategy Insight "Buy The Dip," published February 8, 2018. Available at uses.bcaresearch.com. 2 Please see BCA Research's Global Investment Strategy Special Report "The Return Of Vol," published February 6, 2018. Available at gis.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report "Watching Five Risks," published January 24, 2018. Available at gps.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy PAS "Warning Signals," published February 6, 2018. Available at usbs.bcaresearch.com. 5 Please see BCA Research's U.S. Bond Strategy PAS "Warning Signals," published February 6, 2018. Available at usbs.bcaresearch.com. 6 Please see BCA Research's The Bank Credit Analyst Monthly Report, published January 25, 2018. Available at bca.bcaresearch.com. 7 Please see BCA Research's Commodity & Energy Strategy Weekly Report "OPEC 2.0 Vs. The Fed," published February 8, 2018. Available at ces.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 This week's global equities sell-off spilled into oil markets, taking Brent and WTI down 2.7% and 3.7% as of Tuesday's close, in line with the S&P 500 decline, which began Friday. In line with our House view, we do not believe this will, in and of itself, deter the Fed from raising overnight rates four times this year. Nor do we believe oil-price weakness earlier this week reflects a breakdown in fundamentals. Any demand-dampening effects coming from a stronger USD in the wake of Fed rate hikes will have a muted effect on oil prices, provided OPEC 2.0 can maintain production discipline, and, critically, keep the Brent and WTI forward curves backwardated.1 Likewise, any demand stimulation coming from a weaker USD in the wake of a more measured Fed policy - e.g., two or three hikes - also will be muted by backwardation. Energy: Overweight. Fundamentally, we cannot see anything that warrants a change in our average-price forecast of $67 and $63/bbl for Brent and WTI this year. Our long Jul/18 WTI vs. short Dec/18 WTI calendar spread, put on in expectation of continued backwardation in oil forward curves, is up 81.5% since Nov 2/17, when we recommended it. Base Metals: Neutral. Base metals also were caught up in the equities sell-off, with spot copper trading ~ $3.15 - $3.20/lb on the COMEX. As with oil, we do not see the equities sell-off as a harbinger of a bearish shift in base metals fundamentals. Precious Metals: Neutral. Gold returns were relatively flat amid the equities sell-off with only a 0.6% loss. Our long gold portfolio hedge is up 7.9% since it was recommended on May 4/17. Ags/Softs: Underweight. China opened an anti-dumping and anti-subsidy investigation into U.S. sorghum imports, which the country's foreign ministry insisted was not related to recent U.S. tariffs on solar panels and washing machines. China accounts for ~ 80% of U.S. sorghum exports. Feature The global equity sell-off spilled into oil markets, with Brent and WTI prompt futures down 2.7% and 3.7% over the past week when the equity slide began (Chart of The Week). The proximate cause of the equities down leg appears to be the stronger-than-expected U.S. wage growth reported last week, suggesting inflationary pressures continue to build in the U.S. This prompted speculation the Fed would be inclined to increase the number of rate hikes it executes this year - going from a consensus view of three hikes to four - and that financial conditions would tighten. The equities sell-off this prompted then led to speculation the Fed would dial back the number of rate hikes it executes this year. We believe the Fed will look through the recent equity-market volatility, and will lift rates four times this year, in line with BCA's once-out-of-consensus House view. Chart of the WeekOil Prices Caught Up In Equities Sell-Off Chart 2Fundamentals Support Backwardation As far as oil markets are concerned, as long as the Brent and WTI forward curves remain backwardated (Chart 2), any impact from U.S. monetary policy on oil prices - chiefly through currency effects - will be muted. Demand-dampening effects coming from a stronger USD in the wake of Fed rate hikes will be dissipated in backwardated markets. Likewise, any demand stimulation coming from a weaker USD in the wake of fewer rate hikes policy at the Fed - e.g., two or three hikes - will be muted by backwardation. Fundamentals Dominate Oil-Price Evolution Chart 3Strong Fundamentals##BR##Force Inventories Lower Fundamentals point to continued tightening of crude oil markets in 1H18, the period we have the greatest visibility on: OPEC 2.0's production cuts are pretty much locked in to end-June, when the producer coalition again will meet to assess market conditions, and global demand growth will remain robust. Even with U.S. shale-oil output increasing, OECD inventories will continue to draw during this period (Chart 3). OPEC 2.0's goal of reducing OECD inventories to five-year average levels likely will be met late in 1H18 or early in 2H18, based on our global balances model. While it is possible OPEC 2.0 will extend its production cuts to year-end 2018, we don't believe it is likely. Voluntary production cuts by Russia and Gulf OPEC nations, combined with decline-curve losses in non-Gulf OPEC producers have removed ~ 1.4mm b/d from the market since January 2017. The bulk of these cuts have been made by KSA and Russia, which account for close to 1.0mm b/d of OPEC 2.0 production cuts. Based on our fundamentally driven econometric model, extending OPEC 2.0's cuts to year-end would lift average prices in 2018 from our current expectation of $67/bbl for Brent and $63/bbl for WTI to $71 and $67/bbl, respectively. Counterintuitively, we believe maintaining prices at this level for the entire year is not the desired outcome of OPEC 2.0's production-cutting strategy. Higher price levels will incentivize larger-than-expected shale-oil production gains than we currently are forecasting - ~ 1.0mm b/d in 2018 and 1.2mm b/d in 2019. In addition, they would breathe life into marginal production around the world, particularly in provinces where break-evens and services costs have fallen - e.g., the North Sea, Barents Sea and offshore Brazil. OPEC 2.0's Long Game KSA's and Russia's oil ministers, the leaders of OPEC 2.0, have stated they would prefer to see their coalition endure beyond end-2018, when their production-cutting deal expires. Be that as it may, they have yet to publicly articulate an agreed strategy for OPEC 2.0, either in terms of a preferred price level or price band, or a strategy that builds on the gains they've made in backwardating oil forward curves. Chart 4Stakes Are High For OPEC 2.0##BR##If No Post-2018 Strategy Emerges Russian Energy Minister Alexander Novak recently suggested a preferred range for prices of $50 to $60/bbl for Brent, the international crude-oil benchmark. In the short term, KSA likely prefers a higher price - between $60 and $70/bbl for Brent - to support the IPO of Saudi Aramco, which probably will occur later this year. As we near the end of 1H18, OPEC 2.0's leaders will have to provide some indication they are converging on a common production-management strategy. They will, we believe, have to begin behaving more like a central bank - i.e., providing the market forward guidance - and less like a loose alliance of like-minded producers lurching between stop-gap measures to support prices. Importantly, when they do provide such guidance, they will have to follow through on publicly stated goals, or risk losing credibility with markets. The stakes are fairly high. If, as we've modeled in our unconstrained case, OPEC 2.0 returns ~ 1.1 - 1.2 mm b/d of actual production cuts (ex-decline-curve losses) to the market beginning in 2H18, and U.S. shale and other producers respond to 2018's higher prices with aggressive production growth that carries through 2019, Brent and WTI prices could be pushing toward $40/bbl by the end of 2019 (Chart 4). Also note that if prices start to moderate in H2 2018, 2019 shale production growth may ultimately be less than the 1.2 MMb/d we have forecast, softening the decline in prices during 2019. Longer term, we believe KSA and Russia are aligned with Russia's preference, if for no reason other than to keep U.S. shale-oil production from realizing the run-away growth sustained higher prices almost surely would provoke. Such growth would accelerate the development of U.S. crude oil export capacity - already hovering around ~ 2mm b/d - and the competition for market share in markets OPEC 2.0 members are keen to defend. Higher prices also would improve the competitive position of non-hydrocarbon-based transportation - e.g., electric vehicles and hybrids - which works against OPEC 2.0's long-term goals. Backwardation Matters For OPEC 2.0 Price levels always will be an important policy variable for OPEC 2.0. Equally important, we believe, will be having a strategy that maintains a backwardated forward curve in the Brent and WTI markets. This is because OPEC 2.0 member states sell oil at spot-price levels - the highest point of a backwardated forward curve - while shale-oil producers hedge their revenues over a 1- to 2-year interval. Other than allowing prices to collapse once again, this is the most viable way of constraining U.S. shale production growth longer term. The steeper the backwardation in the WTI forward curve, in particular, the lower the average price level of the hedges producers are able to lock in when they hedge forward revenues. This translates directly into lower output, since producers cannot afford to field as many rigs at lower prices over the life of the hedge as they would be able to field at higher prices. The extent to which OPEC 2.0 can keep forward curves backwardated will determine the extent to which the USD influences oil prices, as well. Our recently concluded research reveals backwardation can mitigate FX effects on oil prices induced by U.S. monetary policy. There is a long-term equilibrium between the level of the USD's broad trade-weighted index (TWIB) and crude oil prices (Chart 5). Indeed, the USD TWIB is one of the key variables we use in our demand, supply and price models. A weak dollar spurs consumption - USD/bbl prices ex-U.S. are cheaper in local-currency terms, especially for fast-growing emerging markets - while production costs ex-U.S. are higher, which limits output growth at the margin. A stronger dollar restrains consumption and encourages production ex-U.S., at the margin. However, this long-term equilibrium is asymmetric. The strength of the correlation between the level of the USD and crude oil prices is such that as oil inventories fall - and backwardation becomes more pronounced - the USD becomes less important to the evolution of oil prices.2 This can be seen in the month-on-month (m-o-m) rolling correlation between prompt WTI futures and the USD TWIB plotted against the spread between 1st nearby WTI futures and 12th nearby WTI futures (Chart 6). Chart 5Long-Term Inverse Correlation##BR##Between USD TWIB And Crude Prices Chart 6Backwardated Forward Curves##BR##Limit USD's Effect On Oil Prices With the exception of the Global Financial Crisis (GFC), the higher the backwardation in crude oil forward curves, the smaller the USD-WTI correlation becomes.3 This suggests that, if OPEC 2.0 can maintain the backwardation in WTI and Brent in 2018, the correlation between crude oil prices and the USD TWIB likely will not go back to the large negative correlation typical of previous cycles. In other words, sustained backwardation will weaken the inverse relationship between WTI prices and the USD TWIB vs. the long-term average in place since 2000, which is roughly when oil prices became random-walking variables. We also looked at year-on-year change in U.S. commercial inventories vs. the USD-WTI prices correlation (Chart 7). Our analysis indicates that when inventories are building, the correlation between USD and WTI prices becomes negative, and when they are falling the correlation goes to zero or positive. This supports our earlier observation that when crude inventories fall, the USD becomes less important to the evolution of WTI prices, particularly spot prices. One more point that we should note: the inverse relationship between the USD and oil prices is a two-way street. In addition to a weaker USD helping to support higher oil prices, higher oil prices have also tended to weaken the USD by inflating the U.S. trade deficit through more expensive petroleum imports. However, over the past decade, the U.S. has reduced its volumes of petroleum imports by roughly 75%, from 12-13 MMB/d in 2007 to only 3-4 MM b/d today (Chart 8). Therefore, this feedback loop of higher oil prices weakening the USD, and lower oil prices strengthening the USD, is greatly reduced. Chart 7Tighter Inventories Limit##BR##USD's Effect On Oil Prices Chart 8Lower Imports Of Petroleum Help##BR##Insulate USD From Oil Price Moves The USD's influence on the evolution of oil prices essentially is an exogenous variable out of OPEC 2.0's control. To the extent it can minimize these effects by backwardating oil forward curves, the coalition reduces the impact of an essentially exogenous USD risk from its production-management strategy. Bottom Line: The Fed likely will view the equity sell-off as a transitory event, and proceed with four overnight-rate hikes this year, in line with our House view. Any read-through from Fed policy decisions to the USD TWIB will be muted by continued backwardation in crude oil forward curves. To the extent OPEC 2.0 can maintain backwardated forward oil curves, it reduces the impact of an essentially exogenous USD risk from its production-management strategy. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 Jargon recap: OPEC 2.0 is the moniker we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. Its historic production-cutting Agreement to remove 1.8mm b/d of production from the market - via a combination of outright cuts and decline-curve run-off - has largely held, despite wide-spread skepticism. "Backwardation" is a term of art in commodities describing a forward curve in which prompt-delivered crude oil trades at a higher price than crude delivered in the future - e.g., a year hence. This is a reflection of a tight market - i.e., refiners are willing to pay more for oil delivered tomorrow or next month than they are willing to pay for oil delivered next year. The opposite of a backwardated market is a "contango" market, another term of art. 2 Generally, falling commodity inventories put a premium on prompt-delivered supply. As inventories fall, there is less readily available supply in place to meet unexpected supply outages. Under such conditions, refiners will attempt to conserve inventory and bid for flowing supply more aggressively, either to replace consumption out of inventory or to keep inventories at safe levels so as to minimize stockout risks. Either way, prompt-delivered supply becomes more valuable than deferred supply. Backwardation reflects this dynamic by keeping prompt-delivered prices above prices for deferred delivery. Backwardation is the market's way of incentivizing storage holders to release inventory to the market. It also is the source of returns for long-only commodity index products. 3 The GFC of 2008 - 09 was a global liquidity event, in which correlations between most tradeable assets went to 1.0 as prices collapsed. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Highlights Global Bond Rout: Overheated financial markets are going through a much needed correction with higher bond yields being the immediate trigger. The cyclical rise in global bond yields is not yet complete, however. Monetary policy settings remain accommodative in almost all major economies, while global growth momentum is showing no signs of slowing. The current turbulence is an early indication of how the investment backdrop will become much more challenging later in 2018 as global inflation continues to rise. Fixed Income Strategy: Returns on global spread product are still expected to beat those on sovereign debt in the coming months, particularly after the latest market correction restored some value through spread widening. There is no sign yet that the sell-off is damaging future global growth expectations that can stall the move to less accommodative monetary policy. Maintain an overall below-benchmark duration stance, favoring corporate credit over sovereign debt - especially in the U.S. - for now. Feature Risk assets worldwide are finally correcting after the relentless run-up seen in January, with the trigger being the steady rise in global bond yields seen since the beginning of the year. The big decline in U.S. equity markets, particularly after the release of last Friday's U.S. employment data which featured the highest year-over-year growth rate in wages seen in almost a decade, suggests that investors are growing increasingly worried about accelerating inflation and a more aggressive tightening response from central banks (NOTE: markets were undergoing another bout of selling yesterday as this publication went to press, but the conclusions reached in this report are unchanged). Chart of the WeekThe Cyclical Rise In Yields##BR##Has Room To Run However, taking a step back to look at the big picture, nothing has really changed in the past few days. Global growth remains strong, which has already steadily increased pressure on policymakers to raise interest rates according to our own BCA Central Bank Monitors (Chart of the Week). In the U.S. - the epicenter of the latest bout of market angst - financial conditions remain highly accommodative and supportive for future growth, while bond volatility remains low by historical standards even after the most recent upward blip. Credit spreads and equity valuations in non-U.S. markets, from Europe to the emerging world, are also no impediment to future growth in those regions. We have been expecting global bond yields to rise in 2018 as markets adjust to both a normalization of global inflation expectations and a shift to a less aggressive pace of bond buying by the Fed, European Central Bank (ECB) and Bank of Japan (BoJ). As we described in our 2018 Outlook report published last December:1 The current low volatility regime will end when higher inflation and less accommodative central banks raise interest rate volatility and, eventually, future growth uncertainty. We see that inflection point occurring sometime next year, leading to a more challenging environment for global fixed income "carry trades" that are also focused on global growth, like developed market corporate bonds and emerging market debt. The current market sell-off is likely too soon to be the ultimate realization of that forecast. Monetary policy settings remain accommodative and inflation is still below central bank targets in almost all major economies, while global growth momentum is showing no signs of slowing. This is an early indication, however, of how the investment backdrop will become much more challenging later in 2018 as global inflation continues to rise. We continue to recommend a pro-growth fixed income investment strategy, staying below-benchmark overall duration, focusing on lower-beta government bond markets, overweighting corporate debt over sovereign debt, and prioritizing inflation protection in bond portfolios. In the coming weeks, however, we will begin to discuss strategies to play for the shift to a more hostile investment backdrop that we expect later in 2018. The U.S. Bond Vigilantes Are Back In Charge Global monetary policies that remain "too" accommodative given robust growth and some pickup in realized inflation have prompted bond markets to reprice, through both higher inflation expectations and real yields. Rising yields have triggered a spike in market volatility measures like the U.S. VIX index, although there were also several bouts of higher volatility in 2017 (Chart 2). Growth-sensitive financial assets shrugged off those higher volatility episodes, mainly because growth expectations were not impacted. We see no reason why this current bout of market turbulence should differ from last year's volatility spikes, and have any meaningful impact on forecasts for future economic growth (and, by extension, corporate profits). At least, not without a more meaningful tightening of global monetary policy, particularly in the U.S. where inflation pressures are gaining steam. The December Payrolls report released last week may finally contain that missing piece of the inflation puzzle - faster wage growth. Headline Average Hourly Earnings expanded 2.9% on a year-over-year basis, with the 3-month annualized growth rate surging to pre-crisis levels above 4% (Chart 3). Coming at a time when the U.S. labor market remains tight by any measure (top panel), a pickup in wage growth supports the other evidence indicating that U.S. inflation is on the upswing, like the modest acceleration in core PCE inflation (3rd panel) and steady climb in TIPS breakevens (bottom panel).2 Chart 2This Is A Correction,##BR##Not A Reversal, In Risk Assets Chart 3U.S. Wage Inflation##BR##Finally Appears A faster inflation backdrop is making the Fed's current monetary policy plans more credible for investors. The U.S. Overnight Index Swap (OIS) curve is now fully pricing in the Fed's three planned interest rate hikes for 2018, and has almost priced in the additional 50bps of hikes the Fed is projecting for 2019 (Chart 4). Rate expectations even further out the curve have been climbing, as well. Our measure of the market's expectation for the so-called "terminal rate" - the 5-year U.S. OIS rate, 5-years forward - is now up to 2.66%, only 9bps below the current median projection ("dot") for the terminal rate. Markets have been highly skeptical that the Fed would ever be able to raise rates as high as its projections in recent years - justifiably so, given that U.S. realized inflation has been persistently falling short of the Fed's 2% inflation target. Now, with core inflation having clearly bottomed out and shorter annualized rates of change closing in on 2%, markets are coming around to the idea that the Fed inflation forecasts will be realized. If that happens, then the Fed should be expected to follow through on its published projections, not only for 2018 but for the remainder of the current tightening cycle. On that basis, there is not a lot more room for the market's pricing of the expected path of U.S. interest rates to converge to the Fed's projections. That suggests that the shorter-end of the U.S. Treasury curve may be approaching a cyclical peak - unless the Fed were to begin revising up its "dots" in response to a faster pace of U.S. economic growth and inflation. That would require the Fed to start believing that a faster pace of rate hikes, or a higher equilibrium real interest rate, was required in the U.S. The current real interest rate remains around 0% (subtracting core PCE inflation from the fed funds rate), as the Fed's rate hikes since beginning the tightening cycle in December 2015 have matched the increase in realized inflation. Measures of the so-called "r-star" equilibrium rate, like the Williams-Laubach measure, are also indicating that the real fed funds rate should be around 0% (Chart 5). The real fed funds rate has historically been highly correlated to the employment/population ratio in the U.S., and the current level of that ratio (60%) suggests that the Fed does not have to target a real funds rate above 0%. The conclusion is that it would take a sign of even greater U.S. labor market utilization - i.e. a rising employment/population ratio - for the Fed to conclude that it must raise its interest rate projections. Chart 4Market Pricing Has Caught Up##BR##To The Fed's Forecasts Chart 5A 0% Real Fed Funds Rate##BR##Is Still Appropriate Without such a boost to the Fed's expected path of interest rates, any remaining increases in U.S. Treasury yields will have to come from higher inflation expectations. On that front, the current level of the 10-year TIPS breakeven at 2.14% remains 30-40bps below the 2.4-2.5% range that is consistent with the Fed's 2% inflation target (adjusting for the typical gap between CPI and PCE inflation and allowing for a small inflation risk premium). That suggests that the 10-year nominal Treasury yield can rise to the 3.10-3.25% range to fully discount a sustainable return of inflation to the Fed's target, with the Fed delivering on its interest rate projections in response. That target range is also not far from the current fair value from our 2-factor 10-year U.S. Treasury yield model, which has risen to 3.01% (Chart 6).3 It will be critical to watch the future behavior of the parts of the U.S. economy that are most sensitive to interest rates, like consumer durables and housing, for signs that the latest rise in U.S. bond yields is having any negative effect on U.S. growth. A slowing trajectory for U.S. growth in response to higher interest rates would certainly give the Fed some second thoughts on moving ahead with its rate hike plans. On that note, the year-over-year change in the 10-year Treasury yield is now in positive territory, which has typically led to a slower contribution to U.S. real GDP growth from consumer durables (Chart 7, top panel). The rise in U.S. mortgage rates should also lead to slower growth in residential investment, although housing has already been providing very little marginal contribution to U.S. growth over the past two years (2nd panel). Chart 6Fair Value On The 10-Year##BR##UST Yield Is 3%...And Rising Chart 7Rising U.S. Capex Should Offset##BR##Slowing Interest-Sensitive Spending The potential offset to any slowdown in interest-sensitive spending, however, is capital spending by businesses, which is being boosted by easy financial conditions (bottom panel), loosening bank lending standards and a rise on the expected after-tax return on investment following the Trump corporate tax cuts. It will likely take higher interest rates, and much tighter financial conditions, before the capex cycle peaks out. Bottom Line: Overheated financial markets are going through a much needed correction, with higher bond yields, most notably in the U.S., being the immediate trigger. The cyclical rise in global bond yields is not yet complete, however, and monetary policies will need to tighten further in response to strong growth and rising inflation pressures. The cyclical interest rate tipping point for risk assets has not yet been reached, even in the U.S., but is getting incrementally closer. Don't Forget The Other Factor Driving Global Bond Yields - Reduced Central Bank Buying Amidst all the worries about higher inflation and the related impact on global bond yields, it should not be forgotten that the major developed market central banks have been cutting back on their bond purchases. Global bond yields have been correlated to the growth rate of the combined balance sheet of the "G-4" central banks (Fed, ECB, BoJ and Bank of England) since the ECB started its bond buying program in 2015 (Chart 8). The current rise in global yields has been in line with the projected slower pace of aggregate bond buying by those central banks. Based on our projection for the year-over-year growth rate of the G-4 central bank balance sheets - which incorporate the Fed letting maturing bonds run off its balance sheet and cutbacks in the pace of buying of new bonds by the ECB and BoJ - there is still more room for bond yields to rise over the course of 2018. A slower pace of central bank "liquidity" creation is something that we anticipated to weigh on risk asset returns in 2018. By driving down the yields on safe assets like government debt to highly unattractive levels, central banks induced huge inflows into global equity and credit markets, both in the developed and emerging worlds. As central banks are now buying fewer bonds, however, there is not only reduced downward pressure on government bond yields but also diminished scope for additional inflows into riskier assets. Looking at the growth rate of the G-4 central bank balance sheet versus the rolling 12-month returns on global equities and credit, the current pullback in overheated risk assets is merely bringing returns back down to levels consistent with central banks taking their foot off the monetary accelerator (Chart 9). Chart 8The Central Bank Impact On##BR##Bond Yields Is Slowly Unwinding... Chart 9...Which Impacts Risk Asset##BR##Returns, As Well For global fixed income markets, we had anticipated that 2018 would be a year of much lower expected returns on spread product like global corporate debt, although those would still beat the returns likely from government debt - at least until government bond yields reached our cyclical targets. Our view has not changed, even in light of the current pullback in risk assets and yesterday's decline in government bond yields. For now, we continue to recommend an overweight stance on global corporate debt, but favoring U.S. Investment Grade and High-Yield debt over European equivalents (and over Emerging Market hard currency debt). We will discuss our eventual recommended exit strategy in upcoming reports, but for now, our advice is to sit tight and ride out this current bout of market turbulence. Bottom Line: Returns on global spread product are still expected to beat those on sovereign debt in the coming months, particularly after the latest market correction restored some value through spread widening. There is no sign yet that the sell-off is damaging future global growth expectations that can stall the move to less accommodative monetary policy. Maintain an overall below-benchmark duration stance, favoring corporate credit over sovereign debt - especially in the U.S. - for now. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "2018 Key Views: BCA's Outlook & What It Means For Global Fixed Income Markets", dated December 5th, 2017, available at gfis.bcaresearch.com. 2 It is interesting to note that it took a sharp pickup in the Average Hourly Earnings measure to get the market's attention about wage inflation. Many Fed officials and market commentators (including here at BCA!) have consistently pointed out the inherent flaws in looking at Average Hourly Earnings as an accurate measure of wage pressures in the U.S. Yet the big market response to the latest surge in Average Hourly Earnings is a sign that investors still look at that indicator as the "true" measure of wage inflation. 3 The standard deviation of the fair value estimate from that model is 17bps, which means that yields could rise as high as 3.18% before reaching an "undervalued" level for U.S. Treasuries - assuming no further increases in fair value, of course. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
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.