UK
The Tactical Asset Allocation model can provide investment recommendations which diverge from those outlined in our regular weekly publications. The model has a much shorter investment horizon - namely, one month - and thus attempts to capture very tactical opportunities. Meanwhile, our regular recommendations have a longer expected life, anywhere from 3-months to a year (or longer). This difference explains why the recommendations between the two publications can deviate from each other from time to time. Highlights Chart 1Model Weights In October, the model outperformed global equities in USD and local-currency terms; it also outperformed the S&P 500 in local-currency terms, while performing in line with the S&P in USD terms. For November, the model trimmed its allocation to cash and stocks and boosted its weighting in bonds (Chart 1). The model increased its weighting in French, Dutch, and Swedish stocks at the expense of the U.S., Japan, Germany, Switzerland, New Zealand, and Emerging Asia. Within the bond portfolio, allocation to New Zealand and the U.K. was increased, while the allocation to U.S., Australian and Spanish paper was reduced. The risk index for stocks deteriorated in October, while the bond risk index improved noticeably. Feature Performance In October, the recommended balanced portfolio gained 0.6% in local-currency terms, and was down 1% in U.S. dollar terms (Chart 2). This compares with a loss of 1.4% for the global equity benchmark, and a 1% loss for the S&P 500 index. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we do provide recommendations from time to time. The higher allocation to EM stocks in October was timely, but the boost to bonds was a drag on the model's performance. Weights The model cut its allocation to stocks from 67% to 66% and increased its bond weighting from 21% to 26%. The allocation to cash was decreased from 12% to 8%, while commodities remain excluded from the portfolio (Table 1). The model reduced its allocation to New Zealand equities by 3 points, Emerging Asia by 2 points and U.S., Japan, Germany and Switzerland by 1 point each. Meanwhile, it increased allocation to Dutch, French and Swedish stocks by 4 points, 3 points and 1 point, respectively. In the fixed-income space, the allocation to U.K. and New Zealand paper was increased by 6 points and 5 points respectively, while allocation to Australia, Spain and the U.S. was cut by 3 points, 2 points and 1 point, respectively. Chart 2Portfolio Total Returns Table 1Model Weights (As Of October 27, 2016) Currency Allocation Local currency-based indicators drive the construction of our model. As such, the performance of the model's portfolio should be compared with the local-currency global equity benchmark. The decision to hedge currency exposure should be made at the client's discretion, though from time to time, we do provide our recommendations. The dollar appreciated in October and investors should position for additional dollar strength. Our Dollar Capitulation Index seems to be breaking out to the upside following a pattern of lower highs. Since 2008, such breakouts have been followed by a significant rally in the broad trade-weighted dollar (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation Capital Market Indicators Our model continues to exclude commodities from the portfolio. The risk index for this asset class remains at the highest level in over two years (Chart 4). For the first time since June 2014, the risk index for global equities is above the neutral line (Chart 5). The higher overall risk reflects deteriorating liquidity and momentum readings. Our model cut its weighting in equities for the third month in a row. Chart 4Commodity Index And Risk Chart 5Global Stock Market And Risk The value component of the risk index for U.S. stocks improved in October, but this was overshadowed by worsening liquidity and momentum readings. The model slightly trimmed its allocation to U.S. equities (Chart 6). Even after the latest small uptick in the risk index for Dutch equities, it remains one of the lowest among the model's universe. The allocation to this bourse was increased. (Chart 7). Chart 6U.S. Stock Market And Risk Chart 7Netherlands Stock Market And Risk The risk index for U.K. stocks declined slightly in October, but remains firmly in high-risk territory both compared to its own history and its global peers. This asset class remains excluded from the portfolio (Chart 8). The model slightly upgraded Swedish equities, despite a worsening risk index. The continued favorable liquidity backdrop remains a boon for Swedish stocks (Chart 9). Chart 8U.K. Stock Market And Risk Chart 9Swedish Stock Market And Risk After declining for four consecutive months, the overall risk index for bonds is not at extreme high-risk levels anymore. The increase in yields has helped completely unwind overbought conditions, as per our momentum indicator. The model used the latest selloff to increase its allocation to bonds (Chart 10). The risk index for U.S. Treasurys declined markedly in October, but a few other markets also feature improved risk readings. As a result, the model downgraded U.S. Treasurys (Chart 11). Chart 10Global Bond Yields And Risk Chart 11U.S. Bond Yields And Risk The selloff in New Zealand bonds has pushed the momentum indicator into oversold territory, boosting the allocation to this asset class (Chart 12). The risk index for euro area bonds remains firmly in the high-risk zone even after a notable decline. However, there are select bond markets in the common-currency area that have relatively more favorable risk readings (Chart 13). Chart 12New Zealand Bond Yields And Risk Chart 13Euro Area Bond Yields And Risk Within the euro area, Italian bonds feature a risk reading that has fallen below the neutral line. While the cyclical indicator continues to move into more bond-negative territory, it is currently being offset by the oversold reading on the momentum indicator (Chart 14). U.K. gilt yields moved up as the post-Brexit inflation backdrop became gilt-unfriendly and growth surprised on the upside. Now, with momentum moving from overbought to oversold over just a couple of months, any negative economic surprises could potentially weigh on gilt yields. The model has added this asset class to the portfolio (Chart 15). Chart 14Italian Bond Yields and Risk Chart 15U.K. Bond Yields And Risk A more hawkish Fed could push the dollar higher. The 13-week momentum measure for the USD remains above, but close to the neutral line. The recovery of the 40-week rate of change from mildly negative levels which have represented a floor since 2012 would suggest that a new leg in the dollar bull market is in the offing (Chart 16). Both the 13-week and 40-week momentum measures for the euro are below the neutral line (Chart 17). Growing monetary divergences could continue weighing on EUR/USD before the technical indicators are pushed into more oversold territory. Fears of hard Brexit knocked down the pound. The 13-week rate of change is now close to its post-Brexit lows, while the 40-week rate of change measure is at the most oversold level since 2000 (excluding the great recession). At these technical levels the pound seems overdue to find a temporary bottom (Chart 18). Chart 16U.S. Trade-Weighted Dollar* Chart 17Euro Chart 18Sterling Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com
Highlights The perceived shape of Brexit is the single most important driver of the pound and most U.K. assets. The U.K. Courts are due to deliver landmark legal rulings, which have huge implications for the perceived shape of Brexit. Expect an eventual soft Brexit if the Courts decide against the U.K. government and deem that triggering Article 50 requires parliamentary approval. Expect a much harder Brexit if the Courts decide in favour of the U.K. government. Tactical investors should consider owning some very short-term call options on pound/dollar or a combination of call and put options. Feature Within the next two weeks, the U.K. High Court will deliver a landmark legal ruling which will have huge implications for the future of the U.K. and Europe. Chart of the WeekDifferent Levels Of Brexit Mean Different Levels Of The Pound The U.K. High Court will rule whether Prime Minister Theresa May can start the legal process to exit the EU using the so-called 'royal prerogative' - the power granted to governments to make decisions without a vote from parliament. If May cannot use the royal prerogative, she will require an Act of Parliament to trigger Article 50 of the Lisbon Treaty. The High Court judgement hinges on a fundamental issue. Triggering Article 50 necessarily means that the current government will overturn previous parliamentary decisions - the European Communities Act (1972) and European Union Act (2011). Does the constitution permit a government to overturn parliamentary decisions, take away treaties, and remove the population's legal rights without obtaining parliamentary approval? Although we are not legal experts, the court could regard that as overstretching government authority. If the High Court's judgement does go against the U.K. government, expect pound/dollar to rally immediately by about 4-5 cents. Conversely, a judgement in favour of the government could see the pound sell off by about 1-2 cents. Given the possibility of this gapping, tactical investors should consider owning some very short-term call options on pound/dollar, or a combination of call and put options. Nevertheless, the story will not end with the High Court. Whichever side loses will appeal the decision and take the case to the Supreme Court, which is expected to respond by the end of the year. This ultimate pronouncement of law will have a landmark bearing on the shape of Brexit and, thereby, the future of the U.K. and the other EU 27. Where Is The Pound Headed Longer-Term? For investors, the spectrum of Brexit possibilities - no Brexit, 'soft' Brexit, 'hard' Brexit, or 'very hard' Brexit - will be the single-most important driver of the pound, and by extension, other U.K. assets. Of course, U.K. asset prices ultimately depend on economic and financial fundamentals. But Chart I-2, Chart I-3, Chart I-4, Chart I-5, Chart I-6, Chart I-7 illustrate that by far the most important fundamental for all U.K. assets right now is the perceived hardness of Brexit, as captured in the pound's value. Chart I-2Harder Brexit Means The Eurostoxx600 ##br##Underperforms The FTSE100... Chart I-3...And The FTSE250 ##br##Underperforms The FTSE100 Chart I-4Harder Brexit Means U.K. ##br##Goods Exporters Outperform... Chart I-5Harder Brexit Means ##br##Retailers Underperform... Chart I-6...Travel And Leisure Underperforms... Chart I-7...And Real Estate Underperforms Pound/dollar has (so far) traded at three distinct levels, based on three distinct levels of perceived Brexit severity: near 1.50 before the Brexit vote; near 1.30 after the Brexit vote but perceiving a soft Brexit; and near 1.20 after Theresa May announced that she would trigger Article 50 by next March and was contemplating a hard Brexit (Chart of the Week). Hence the (post-appeal) outcome of the legal case against the government carries great significance. If the government loses, and requires a parliamentary vote to trigger Article 50, several consequences follow. Theresa May's end-March deadline for firing the Brexit starting gun would become very difficult to meet, severely delaying the whole process. Would the government even win a parliamentary majority? If in doubt, would the government call a snap General Election to try and beef up its majority? The current batch of parliamentarians has a strong bias for staying in the EU, but it would be difficult to fly in the face of the referendum result. On the other hand, the checks and balances of parliament are there precisely to stop the country walking over the cliff-edge that a very hard Brexit would be. All the while, with investment slowing and higher inflation from the weaker pound squeezing household real incomes, the economic headwinds from the U.K.s limbo status would be becoming more apparent. Given the high stakes and likely irreversibility of the formal legal process, parliamentarians would rightfully want to examine and approve the U.K.'s negotiating hand. It seems that Parliament would almost certainly water down or delay Brexit before voting it through. Hence, if the government loses its legal case after appeal, Brexit will likely end up in a soft form. And pound/dollar will ultimately elevate to 1.35. Conversely, if the government wins its legal case after appeal, Theresa May will be on course to trigger Article 50 early next year, as promised. At which point, the EU 27's optimal game-theoretical first play is to be very aggressive - effectively opening with a very hard Brexit offer as described in the next section. Whereupon, pound/dollar would find its fourth, even lower, new level: near 1.10. Two Myths About Brexit It is important to debunk a couple of common myths about Brexit. First, that the U.K.'s current position as the EU 28's second largest economy will force the remaining EU 27 to give the U.K. a special status - allowing access to the three freedoms of goods, services, and capital but with controls on the fourth freedom of movement: people. This belief is misplaced. The biggest worry for the EU 27 is that a special status for Britain could catalyse other countries, under populist pressure, to ask for equivalent deals. The EU 27 does not want to give Marine Le Pen the opportunity to say "let's follow the Brits, they've negotiated a great deal." Hence, the U.K. will not get special treatment. Quite the contrary, it must be seen to be paying a substantial price for Brexit. Even for Anglophile Angela Merkel, protecting the indivisibility of the four freedoms and the integrity of the EU is the overriding priority. If the U.K. restricts free movement of people, it almost certainly means a hard Brexit: substantially restricted access to the single market. The U.K. would then have to negotiate a free trade agreement (FTA) with the EU. Given the current difficulty that Canada is experiencing in negotiating a FTA, this might not be a straightforward process for the U.K either. Furthermore, as a FTA does not usually cover services, it would handicap the services-heavy U.K. economy, while perfectly suiting the goods-heavy German economy. A second common belief is that the pound will act as an automatic economic stabilizer. That irrespective of a very tough deal from the EU 27, a weaker sterling will soothe the pain of a very hard Brexit by making British exports more competitive. Granted, the weaker pound will boost the demand for the U.K.'s goods exports. But total U.K exports are much less sensitive to devaluations compared to when the pound tumbled out of the Exchange Rate Mechanism in 1992. Then, just a quarter of the U.K's exports were services; today that proportion is approaching a half (Chart I-8) With the exception of tourism, these services tend to be high value-added financial and business services. Cutting their price will not significantly boost the demand for them. Chart I-8Almost Half Of U.K. Exports Are Services Meanwhile, U.K. consumers will feel distinctly poorer as the sterling prices of food and energy rise (Chart I-9), squeezing real household incomes and spending. In turn, this will leave the Bank of England with a major headache. How best to support real spending: defend the plunging pound to keep a lid on food and energy prices, or cut interest rates? Chart I-9Higher Sterling Prices For Food And Energy Will Squeeze Real Incomes Investment Reductionism For U.K. Assets The charts throughout this report show that the strategy for many U.K. investments reduces to an overriding question. Will the U.K largely retain access to the single market, defining a soft Brexit? Or will the U.K. largely lose access to the single market, defining a hard Brexit? In a soft Brexit: Sterling would rally 10%, taking pound/dollar to 1.35. The Eurostoxx600 and S&P500 would outperform the FTSE100. Within U.K. equities, sterling earners would outperform dollar earners, favouring small and mid-cap over large cap. The FTSE250 would outperform the FTSE100. The heavily domestic-focused retailers, travel and leisure, and real estate sectors would outperform the market. Goods exporters, such as the apparel sector would become less competitive and underperform the market. In a hard Brexit, expect the exact opposite of the above. Pound/dollar would slump 10% to 1.10, and so on. To determine which strategy to follow, await the post-appeal Supreme Court judgement on how Article 50 must be triggered, due at the end of the year. If Article 50 requires parliamentary approval, expect a soft Brexit. If it doesn't require parliamentary approval, expect the Brexit game theory to become hard and aggressive. Right now this is a coin toss, but forced to choose, we expect events may eventually prevent a damaging hard Brexit. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* This week's trade is another commodity pair trade: long copper / short tin. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart 10 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights Global Duration: The current mix of rising government bond yields, bear-steepening yield curves and rising inflation expectations is not surprising, given reduced political uncertainty and greater perceived tolerance of higher inflation by central banks. Maintain a below-benchmark portfolio duration stance, favoring low-inflation countries (core Europe, Japan) over higher-inflation countries (U.S., U.K.). U.K. Gilts: The selloff in Gilts looks similar to the path followed by U.S. Treasuries after the Fed's quantitative easing programs, only with a much larger currency decline. Yields have more upside in the near-term, especially against bond markets with lower inflation pressures. Downgrade U.K. allocations to below-benchmark (2 of 5) and upgrade core European exposure by upgrading France to neutral (3 of 5). U.K. Corporates: The Bank of England's corporate bond purchase program has made valuations quite expensive in the sectors where the central bank has been most active. We continue to recommend an above-benchmark stance on U.K. Investment Grade corporates versus nominal Gilts, but focusing on sectors that still over some relative value (mostly Communications). Feature Chart of the WeekA Rough Couple Of Months For Bonds There is not a lot of love for government bonds right now. Yields continue to grind higher, led by rising inflation expectations and bear-steepening moves in the core Developed market yield curves at a time when bond durations are extremely elevated (Chart of the Week). Bond investors may be starting to worry about monetary authorities falling behind the inflation-fighting curve, particularly with the heads of some major central banks openly expressing tolerance of inflation overshooting policy targets. It remains to be seen if the markets will start discounting significantly higher inflation. Within the major Developed economies, only in the U.K. are market-based inflation expectations currently above the central bank target level ... and only then after a historic currency collapse that has already caused a surge in U.K. import prices. The more important point is that the monetary authorities seem almost happy (relieved?) to see inflation expectations finally moving up and are unlikely to be very aggressive in trying to stop that trend. Only in the U.S. is there talk of a monetary tightening in the near term and, even there, little has been promised after a likely December rate hike with some Fed officials talking about letting the U.S. economy "run hot" for a while. The time for bond investors to start worrying more about inflation is when central banks begin to worry less about inflation. Favoring the bond markets with the lower rates of inflation seems like a reasonable investment strategy to pursue in the current environment. Global Duration - Stay Below-Benchmark In our previous Weekly Report,1 we revisited the reasons behind our current below-benchmark duration recommendation that has stood since July. We concluded that the case for higher yields was still intact. An additional factor that we did not discuss, but which has also had a significant influence on bond yields this year, has been the rise of political uncertainty on both sides of the Atlantic. Between the U.K. Brexit drama, and the rise of the protectionist Donald Trump in the U.S. Presidential election, investors have had to worry more about political risk than in previous years. This uncertainty created massive safe haven flows into core Developed market bonds, helping drive yields down to secular lows (Chart 2). Chart 2Uncertainty Fading, Yields Rising Yet the shock of the Brexit vote has not resulted in any noticeable slump in global growth, with even the U.K. economic data starting to show some improvement of late (more on that in the next section). As investors have come to realize that the Brexit vote was having no material effect on global growth, the political uncertainty premium on global bond yields has unwound, with yields in the major Developed bond markets now back to, or even surpassing, the pre-Brexit levels. In the case of the U.S. election, the recent decline in Trump's polling numbers has coincided with the rise in U.S. Treasury yields (Chart 3). Given the significant changes to all aspects of the U.S. government that Trump has proposed (foreign policy, immigration policy, tax policy, etc), his campaign represents the "greater uncertainty" choice in the U.S. election. So as his polling numbers decline, so should any impact on U.S. Treasury yields from political uncertainty. While this is hardly the only factor influencing Treasury yields, it is one piece of the puzzle that has turned a bit more bond bearish of late. So with less political uncertainty weighing on bonds, investors can turn their focus back to the usual drivers of yields - growth, inflation and monetary policy expectations. The news is not very bond bullish on those fronts either. Global economic indicators are not pointing to any material slowing of growth, with the OECD leading economic indicators (LEI) currently in the process of bottoming out or increasing (Chart 4). While absolute growth rates are hardly booming in the Developed world, the cyclical upturn in many Emerging economies this year has been a positive surprise. If the Emerging LEIs are to be believed, this pickup in growth can continue into next year. Chart 3Trump Really Is The 'King Of Debt' Chart 4Signs Of A Global Growth Upturn Meanwhile, inflationary pressures are potentially appearing in some of the Developed economies, most notably the U.S. and the U.K. The end of the disinflationary shock from the oil price collapse in 2014/15 has played a large role here. However, measures of spare economic capacity like the output gap or the unemployment gap2 have narrowed considerably in the major Developed economies (Chart 5), so it is perhaps no surprise that inflation expectations are starting to move higher in some of the those countries. Against this backdrop where the world might be a bit more inflationary than has been the case over the past several years, these comments last week from two prominent central bankers may have set off some alarm bells for bond investors: Bank of England Governor Mark Carney: "We're willing to tolerate a bit of overshoot in inflation over the course of the next few years in order [...] to cushion the blow [from Brexit]." U.S. Federal Reserve Chair Janet Yellen: "[...] it might be possible to reverse these adverse supply-side effects [from a deep recession] by temporarily running a 'high-pressure economy,' with robust aggregate demand and a tight labor market." This comes on top of the Bank of Japan's decision last month to move to deliberately target an overshoot of the 2% inflation target in order to raise depressed longer-term inflation expectations. The central banks may have a tough time convincing the markets that they would tolerate much of a rise in inflation above the policy targets. Already, interest rate expectations embedded in money market yield curves have either priced out additional rate cuts or, in the case of the U.S., priced in some modest rate hikes (Chart 6). This pricing appears correct, in our view. Chart 5The Gaps Are Closing Fast Chart 6Rate Expectations Have Turned Less Dovish We still see the Fed delivering on another rate hike in December but, even then, the median FOMC projection is only calling for two more rate hikes in 2017 following one increase this year. In the case of the Euro Area, our base case remains that the European Central Bank (ECB) will not end its asset purchase program in early 2017, as currently scheduled, but will also not push short-term interest rates deeper into negative territory. In the U.K., our expectation is that the BoE will not provide any new stimulus (i.e. cutting the policy rate to 0% or extending the current asset purchase program beyond March of next year), but will not move to quickly tighten policy either, even with U.K. inflation surging and the Pound collapsing. Chart 7Inflation Expectations Are Moving First The Bank of Japan (BoJ) may try another interest rate cut in the coming months to try and help weaken the yen, but given its new policy of yield curve "targeting", we do not expect longer-term Japanese government bond (JGB) yields to move in response to a rate cut, if it does occur. Meanwhile, we expect no policy moves from the Bank of Canada or the Reserve Bank of Australia over the next six months, even though the domestic economy looks in good shape in the latter. We continue to advise keeping a below-benchmark stance on overall portfolio duration, as the global growth and inflation backdrop has become a bit less bond-friendly at a time when longer-term bond yields remain generally overvalued. In terms of our country allocation, we recommend below-benchmark exposure where inflation expectations are rising the fastest and are most likely to continue doing so - the U.S. and, as of this week, the U.K. (see the next section). We also continue to recommend favoring inflation-linked bonds/swaps in the U.S. and U.K. over nominal government debt. Finally, we advise neutral allocations to the markets where inflation expectations are farthest from the central bank targets: Japan and core Europe (Chart 7). Bottom Line: The current mix of rising government bond yields, bear-steepening yield curves and rising inflation expectations is not surprising, given reduced political uncertainty and greater perceived tolerance of higher inflation by central banks. Maintain a below-benchmark portfolio duration stance, favoring low-inflation countries (core Europe, Japan) over higher-inflation countries (U.S., U.K.). U.K.: Monetary Overkill From The BoE? U.K. Gilts have suffered major losses over the past couple of months, with the benchmark 10-year yield up +30bps since the BoE cut rates and introduced a new round of quantitative easing (QE) back on August 4th. Reducing the policy rate and ramping up QE should, in theory, be supportive for the Gilt market. However, the BoE's actions may be causing the growth and inflation backdrop in the U.K. to become very unfriendly for Gilts: Domestic economic data have improved sharply higher in the months after the June Brexit vote, with retail sales and manufacturing in particular showing large improvements, even as business optimism took a hit following the vote to leave the European Union (Chart 8); U.K. realized inflation has started to move higher in response to the collapse of the Pound and higher import prices, which now are rising at a positive annual rate for the first time since 2011 (Chart 9 & Chart 10). Chart 8What Post-Brexit Slump? Chart 9Blame The Pound For Rising U.K. Inflation This type of response from Gilt yields to a QE announcement is not unprecedented; a similar pattern unfolded after the Fed's QE announcements earlier in the decade. In Chart 11, we show a "cycle-on-cycle" analysis of the U.K. and the U.S. financial markets around past QE announcements. The dotted lines in all panels of the chart represent the equally-weighted average of the three Fed QE announcements (in 2008, 2010 and 2012), while the solid line is the current U.K. cycle. The vertical line in the chart represents the day of the QE announcement, so in this chart we are "lining up" the U.K. now with the U.S. back then. Chart 10BoE QE: Good For Corporates, Bad For Inflation Chart 11Gilts Following The Post-Fed-QE Playbook The conclusion from Chart 11 is that Gilts are behaving in a similar fashion to Treasuries after the Fed announced its QE programs. Yields rose almost immediately, led by a wider term premium and higher inflation expectations. The initial response was modestly bullish for the currency, but then that was quickly reversed as inflation expectations continued to rise. Risk assets like equities and credit performed very well in response to the QE. The biggest difference between the U.K. now and the U.S. then is the magnitude of the currency decline. The Pound has fallen -17% since the Brexit vote, and the decline has accelerated in recent weeks on the back of increased worries about a possible "hard Brexit" - a more protectionist outcome than was originally feared after the June vote. With the U.K. having a massive current account deficit (-5.7% of GDP), any news that could stall capital inflows into the U.K. (like worries about greater protectionism) can trigger an outsized currency decline. With the Pound unlikely to rebound in the near-term, the inflationary effects of the weaker currency can continue to feed through into both realized and expected inflation. Already, the 10yr U.K. CPI swap rate has risen to 3.6% - the high end of the range of the post-2008 crisis era. We have recommended favoring inflation-linked Gilts over nominal Gilts since the BoE's QE announcement in August, and we continue to recommend owning U.K. inflation protection. If Gilts continue to follow the post-Fed-QE playbook shown in Chart 11, then Gilt yields will likely to rise until the end of the year. Chart 12Gilt Underperformance Will Continue We have maintained an overweight stance on Gilts since the BoE announcement, as we had expected the QE effect on the supply/demand balance in the Gilt market to dominate via an even more depressed Gilt term premium. A strong possibility of a final BoE rate cut to 0% was also a reason to favor Gilts over other Developed economy government bonds. But with the Pound continuing to plunge and inflation expectations soaring, and with little sign of a big downturn in the U.K. economy, it is difficult to argue that the BoE needs to easy policy again. Even if they did, the markets would likely interpret the next cut as being "monetary overkill" that was unnecessary and creates future inflation risks. This would likely exacerbate the current selloff in Gilts. The recent comments from BoE Governor Carney highlighted earlier in this report suggest that he is quite comfortable with the current monetary policy stance, and that he is not overly concerned about the inflationary effects of a weaker Pound. This suggests that the BoE will not be quickly reversing any of the August monetary easing measures, even as U.K. inflation continues to rise. Given this new policy of "benign neglect" towards rising inflation by the BoE, this week we are downgrading our recommended stance on U.K. fixed income from above-benchmark (4 of 5) to below-benchmark (2 of 5). As an offset, we are upgrading our allocation to core European bonds to neutral (3 of 5) - specifically in France, where we are currently below-benchmark (2 of 5). The spreads between U.K. Gilts and French debt have been widening as Gilt yields have increased (Chart 12), and we see the spreads returning to their pre-Brexit ranges in the months ahead. Bottom Line: The selloff in Gilts looks similar to the path followed by U.S. Treasuries after the Fed's quantitative easing programs, only with a much larger currency decline. Yields have more upside in the near-term, especially against bond markets with lower inflation pressures. Downgrade U.K. allocations to below-benchmark (2 of 5) and upgrade core European exposure by upgrading France to neutral (3 of 5). A Quick Update On U.K. Corporate Bonds The BoE's expanded QE program also included an increase in Investment Grade non-financial corporate bond purchases. The plan called for the BoE to purchase 10bn pounds worth of corporate debt over an 18-month period. The BoE has pursued a weighting scheme across sectors that differs from the market-capitalization based weightings of a traditional U.K. corporate bond benchmark index. For example, the BoE is buying far more debt from sectors like Electricity, Consumer Non-Cyclicals, Industrials and Transportation relative to the weights in the Barclays U.K. corporate bond index (Chart 13). Chart 13BoE Corporate Bond Purchases Are Not Following The Benchmark The impact of the BoE bond buying can be seen in current corporate bond spread valuations. The BoE's heavy focus on Utilities & Industrials issuers drove the spreads on the Barclays benchmark indices for those sectors down to the lows of the past few years (Chart 14). We can also see this in our own U.K. sector spread relative value framework, where the sectors that have the heaviest BoE involvement also have the most expensive spreads (Table 1). Chart 14U.K. Corporate Spreads Are Tight (Ex Financials) Table 1U.K. Investment Grade Corporate Sector Spread Valuations With the BoE becoming such a large marginal player in the U.K. corporate bond market, an overweight position versus nominal Gilts is still warranted. The weakness of the Pound is also supportive of the performance of U.K. non-financial corporates, as evidenced by the strong correlation of corporate bond excess returns, equity returns and the swings of the trade-weighted Pound over the past five years (Chart 15 & Chart 16). Chart 15U.K. Equities & Corps Are Both Performing Well... Chart 16...Thanks To The Plunging Currency In terms of individual sector recommendations, favor names in the Communications sectors (specifically, Cable & Satellite and Wireless), where spreads are cheap in our valuation framework and the BoE can potentially buy bonds as part of its QE program. One final note: U.K. Financials score the cheapest in our sector valuation model, and there is a case for shifting to an overweight in those sectors (most Banks and Insurers), even if the BoE is not buying those bonds. Financials will likely benefit from higher Gilt yields and a steeper Gilt curve, but could also require higher risk premiums as the Brexit process plays out and the business models of banks may need to be altered in a post-EU U.K. This likely makes U.K. Financials more of a riskier carry trade than an undervalued spread-compression trade. Bottom Line: The Bank of England's corporate bond purchase program has made valuations quite expensive in the sectors where the central bank has been most active. We continue to recommend an above-benchmark stance on U.K. Investment Grade corporates versus nominal Gilts, but focusing on sectors that still over some relative value where the central bank is buying (mostly in Communications). Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Bond Bear Phase Continues", dated October 11, 2016, available at gfis.bcaresearch.com 2 The unemployment rate minus the NAIRU or "full employment" level of unemployment The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Global liquidity conditions are set to tighten in the months ahead. This could add some fire to a dollar rally, especially against EM and commodity currencies. The GBP has become the new anti-dollar, reflected by its strong sensitivity to the greenback. Financing the U.K.'s large current-account deficit is a difficult task when global liquidity tightens, the layer of political uncertainty now makes it a herculean labor. While the pound is now attractive as a long-term play, it still possesses plenty downside risk. A quick look at EUR/SEK, NOK/SEK, GBP/CAD, and AUD/JPY. Feature Global liquidity conditions have begun to tighten. This development is likely to send the dollar higher and inflict serious damage on EM and commodity currencies. The pound's weakness fits nicely into this larger story. Not only is the current political climate in the British Isles prompting investors to think twice about buying British assets, but a tightening in global liquidity makes financing the U.K. current account deficit even more onerous. This adjustment demands a cheaper GBP. Global Yields: A Step Forward, Half A Step Backward The main reason why global liquidity conditions are tightening is the recent back up in global bond yields. In normal circumstances, a 39 basis-point (bp), a 24bp, and a 16bp back-up in 10-year Treasury yields, JGB yields, and bund yields, respectively, would not represent much of a problem. But today is anything but normal. The shift in global monetary policy has been behind the back-up in yields. In aggregate, global central banks are about to begin decreasing their purchases of securities. This will not only lift interest rates on government paper, but it will also raise rates for private-sector borrowing, especially as global risk premia have been depressed by an effect known as TINA - or "There Is No Alternative" (Chart I-1). The Fed too is in the process of lifting global bond yields. For one thing, U.S. labor market slack is dissipating and we are starting to witness rising wage pressures (Chart I-2). As such, we expect the Fed to raise its policy rate in December, and to further push rates higher in 2017 and 2018. Given that only 62 basis points of hike are priced in until the end of 2019, there is scope for U.S. bond yields to rise. Chart I-1Central Banks Are Contributing##br## To Tightening Liquidity Chart I-2U.S. Labor Market Is ##br##Showing Signs Of Tightening In terms of investor sentiment, despite the recent back-up in long bond yields, investors remain surprisingly upbeat on the outlook for T-bonds (Chart I-3). This, combined with their still-poor valuations, is another reason to be worried about the outlook for U.S. and global bonds for the remainder of the year. Finally, we expect U.S. real rates to have more upside than non-U.S. rates. Why? The U.S. output gap is arguably narrower than that of Europe or Japan. Moreover, the U.S. economy has deleveraged more than the rest of the G10. With U.S households enjoying strong real income growth, strong balance sheet positions, and with banks easing their lending standards to households, U.S. private-sector debt levels can expand vis-à-vis those of other developed economies. This will lift U.S. relative real rates (Chart I-4). Chart I-3Upside For ##br##Yields Chart I-4Real Rate Differentials Should ##br##Move In The Dollar's Favor What does this all mean for currency markets? As we highlighted last week, we expect the U.S. dollar to display more upside, potentially rising by around 10% over the next 18 months. We also expect more tumultuous times to re-emerge in the EM space. Rising real rates have been a bane for EM assets in this cycle. This is because EM growth has been dependent on EM financial conditions, which themselves, have been a function of global liquidity conditions (Chart I-5). Exacerbating our fear, the recent narrowing in EM spreads has not been reflective of EM corporate health. This suggests that EM borrowing costs and financial conditions are at risk of a shakeout (Chart I-6). Chart I-5Global Liquidity Conditions Will Hurt EM Chart I-6EM Spreads Are Priced For Perfection This obviously leads us to worry about commodity currencies as well. For one, they remain tightly linked with EM equities, displaying a 0.82 correlation with that asset class since 2000. Moreover, as Chart I-7 and Table I-1 illustrate, commodity currencies are tightly linked with the dollar and EM spreads. Thus, a combo of a higher dollar and deteriorating EM financial conditions could do great harm to the AUD, the NZD, and the NOK. Interestingly, SEK and GBP are also two potential big casualties of any such development. Chart I-7The GBP Has Become The Anti-Dollar Table I-1Currency Sensitivities To Key Factors, Since 2014 That being said, these dynamics contain the seeds of their own demise. As they are deflationary shocks, EM and commodity sell-offs are likely to elicit a dovish response from global policymakers. This will limit the upside for yields, implying that any tightening in global liquidity conditions is likely to prompt another reflationary push early in 2017. Bottom Line: Global rates still have more upside from here. U.S. real rates could rise the most as the Fed is now confronted with an increasingly tight labor market. Moreover, the U.S. economy possesses the strongest structural fundamentals in the G10. Together, this set of circumstances is likely to boost the dollar, especially at the expense of EM, commodity currencies, and the pound. GBP: Another Arrow In The Eye Nine hundred and fifty years ago to this day, King Harold, the last Anglo-Saxon King of England, died on the battlefield at Hastings from an arrow to the eye.1 The kingship of Norman William the Conqueror ushered a long and complex relationship between the British Isles and the rest of the continent. Over the past two weeks, the fall in the pound has been a dramatic story. The collapse of the nominal effective exchange rate to a nearly 200-year low, is a clear indication that the battle between the U.K. and the rest of the EU is inflicting long-term damage on the kingdom (Chart I-8). The key shock to the pound remains political. PM May made it clear that Brexit means Brexit. Additionally, elements of her discourse, such as wanting firms to list their foreign-born employees, are raising fears among the business community that the Conservatives are taking a very populist, anti-business slant that could weigh on the long-term prospects for British growth. True, these policies may never see the light of day. But across the Channel, the EU partners are taking a hardline approach to Brexit negations. Investors cheered the announcement on Wednesday that PM Theresa May will allow deeper scrutiny from parliament before triggering Brexit. Altogether, this mostly means that the cacophony over the future of the U.K. will only grow louder. Thus, we expect political headline risks to remain a strong source of uncertainty. These political games are poisonous for the pound. The U.K. is highly dependent on FDI inflows to finance it large current account deficit of nearly 6% of GDP (Chart I-9). Not knowing the status of the U.K. vis-à-vis the common market heightens any risk premium on investments in the U.K. Also, any shift of rhetoric toward a more populist discourse increases the risk that regulations could be implemented that either hurt the future profitability of British firms or increase their cost of capital. At the margin, this makes the U.K. less attractive to foreign investors. Chart I-8Something Evil This Way Comes Chart I-9The U.K. Needs Capital This has multiple implications. The pound remains highly sensitive to global liquidity trends, a fact highlighted by its extremely elevated sensitivity to EM spreads. The pound will also remain correlated with EM equity prices. This suggests that if a rising dollar acts as a lever to tighten global liquidity conditions, the pound will continue to be the currency with the largest beta to USD. In other words, investors will continue to express bullish-dollar views through the pound. Domestic dynamics are also problematic. The recent fall in the pound is lifting British inflationary pressures, a reality picked up by our Inflation Pressure Gauge (Chart I-10). In normal times, this could have lifted the pound as investors would have expected a response by the BoE. Today, however, the British credit impulse is very weak, in part reflecting the lack of confidence toward the future of the U.K. (Chart I-10, bottom panel). Hence, the BoE is not responding to these inflationary pressures. This combo is very bearish for the pound. It means that British real rates are falling, especially vis-à-vis the U.S. (Chart I-11). The U.K. is now in a vicious circle where the more the pound falls, the higher British inflation expectations go, which depresses British real rates and puts additional selling pressure on the pound. In other words, the U.K. is in the opposite spot of where Japan was in the spring of 2016. Chart I-10Stagflation Light! Chart I-11A Vicious Circle For GBP What is the downside for the pound? On a 52-week rate of change basis, the pound is not as oversold as it was at long-term bottoms like in 1985, 1993, or 2009. More concerning, long-term bottoms are also characterized by the 2-year rate of change staying oversold for a prolonged period, which again, has yet to be the case (Chart I-12). On the valuation front, GBP/USD is cheap, trading at a 25% discount to its PPP. However, in 1985, the pound was trading at a 36% discount to PPP (Chart I-13). The uncertainty around the future of the British economy is much higher today than in 1985. A move away from the pro-business Thatcherite policies of the 1980s, could result in a GBP discount similar to that of 1985. The sensitivity of the pound to the dollar amplifies the probability that such a scenario materializes. This could imply a GBP/USD toward 1.1-1.05 at its bottom. Chart I-12GBP/USD: Not Oversold Enough Chart I-13GBP/USD Valuation When is that bottom likely to emerge? With the strong downward momentum currently weighing on the pound, and the progressive un-anchoring of market based inflation expectations in the U.K., the bottom in the pound is a moving target. Moreover, Dhaval Joshi, who runs our European Investment Strategy service, has written about the fractal dimension as a tool to identify turning points in a trend. When the fractal dimension hits 1.25, a reversal in the trend is likely. Essentially, this metric measures group-think. When both short-term and long-term investors end up uniformly expressing the same views, liquidity dries up as there are fewer and fewer sellers for each buyer (or vice-versa).2 Currently GBP/USD's fractal dimension has not yet hit that stage. While the 3-6 months risk-reward ratio for the pound remains poor, the pound is now attractive as a long-term buy. The recent collapse in real rates and sterling has massively eased monetary conditions in the U.K. (Chart I-14). Also, even if valuations are a poor guide of near term returns, the 25% discount currently experienced by the pound suggests that on a one- to two-year basis, holding the GBP will be a rewarding bet. What about EUR/GBP? EUR/GBP has moved out of line with its historical link to real-rate differentials (Chart I-15). However, the pound's beta to the dollar is twice as high as that of the euro. Moreover, the pound is many times more sensitive to EM spreads than the euro. This suggests that our view of a strong dollar and tightening EM liquidity conditions are likely to weigh on GBP more than on the EUR for the next few months. Thus we believe it is still too early to short EUR/GBP. In fact EUR/GBP could flirt with 0.95. Chart I-14A Glimmer of Hope For The Long-Term Chart I-15EUR/GBP Has Overshot Fundamentals Bottom Line: While the pound is cheap, it can cheapen further. Not only is the pound being hampered by the political quagmire surrounding Brexit, but the strong sensitivity of the pound to the dollar and EM spreads are two additional potent headwinds for the British currency. Altogether, while the pound is most likely a long-term buy at current levels, it could still experience significant downside in the near term. We remain long gold in GBP terms. Four Chart Reviews Four long-term price charts caught our eye this week. First is EUR/SEK. As Chart I-16 shows, despite the valuation, economic momentum, and balance of payments advantages for the SEK, EUR/SEK broke out. We think this reflects the SEK's strong sensitivity to the dollar and brewing EM risks. A move to slightly above 10 on this cross is likely. Second, while we remain positive on NOK/SEK, the next few weeks may prove challenging. As Chart I-17 illustrates, NOK/SEK is about to test a potent downward sloping trend line, exactly as it is becoming overbought. With NOK being slightly more sensitive to the dollar than SEK, punching above this trend line will require much firmer oil prices. While our energy strategists see oil in the mid- to upper-$50s for next year, they worry that the recent rally to $52/bbl may have been too violent and is already eliciting a supply response from U.S. shale producers. Chart I-16EUR/SEK Can Rise Higher Chart I-17Big Ceiling Above Third, since the early 1980s, GBP/CAD has formed long-term bottom in the 1.5 region, a zone we expect to be tested again (Chart I-18). While CAD is more sensitive to commodity prices than the GBP, it is much less sensitive to the USD and EM spreads than the British currency. Also, the loonie does not suffer from a massive political handicap. That being said, each time the 1.5 zone has been hit, GBP/CAD slingshots higher. We recommend buying GBP/CAD at that level. Finally, since 1991, AUD/JPY has been strongly mean-reverting in a trading band between 60 and 110 (Chart I-19). Any blow-up in EM in the next few months is likely to prompt this cross to hit the low end of this band once again. Chart I-18GBP/CAD: Target 1.5 Chart I-19AUD/JPY: A Model Of Mean Reversion Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 This story of his death is now considered more a legend than an historical event, but we like this story. 2 Please see European Investment Strategy Special Report, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Policy Commentary: "We're at a point where the economic expansion has plenty of room to run. Inflation's a little bit below our target, rather than above our target... so, I think we can be quite gentle as we go in terms of gradually removing monetary policy accommodation" - Federal Reserve Bank of New York President William Dudley (October 12, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Policy Commentary: "Due to the role of global inflation, more stimulus is needed than in the past to deliver their domestic mandates; and where, due to the falling equilibrium interest rates, their ability to deliver that stimulus is more constrained" - ECB Executive Board Member Yves Mersch (October 12, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Clashing Forces - July 29, 2016) The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Policy Commentary: "Since the employment situation has continued to improve, no further easing of monetary policy may be necessary... at any rate, I would like to discuss this thoroughly with other board members at our monetary policy meeting" - BoJ Board Member Yutaka Harada (October 12, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 How Do You Say "Whatever It Takes" In Japanese? - September 23, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Policy Commentary: "If the MPC and other monetary authorities hadn't eased policy - if they had failed to accommodate the forces pushing down on the neutral real rate - the performance of the economy and equity markets, and the long-term prospects for pension funds, would probably have been worse" - BoE Deputy Governor Ben Broadbent (October 5, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Messages From Bali - August 5, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Policy Commentary: "Inflation remains quite low. Given very subdued growth in labor costs and very low cost pressures elsewhere in the world, this is expected to remain the case for some time" - RBA Monetary Policy Statement (October 3, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Messages From Bali - August 5, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Policy Commentary: "Interest rates are at multi-decade lows, and our current projections and assumptions indicate that further policy easing will be required to ensure that future inflation settles near the middle of the target range" - Reserve Bank Assistant Governor John McDermott (October 11, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Policy Commentary: "Policy is having its effects. And obviously we have room to maneuver but its not a great deal of room to maneuver and fortunately we have a different mix of policy today and the fiscal effects we talked about should be showing up in the data any time now" - BoC Governor Stephen Poloz (October 8, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Policy Commentary: "We feel [negative interest rates and currency market interventions] is actually how we can ensure our mandate, namely by making the Swiss franc less attractive" - SNB Vice President Fritz Zurbruegg (October 12, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Policy Commentary: "Review [of the monetary policy framework] is in order... I would, however, emphasise that our experience of the current framework is positive. This suggests a need for adjustments rather than a regime change" - Norgest Bank Governor Oeystein Olsen (October 11, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Policy Commentary: "We have all the tools but there are limits since the repo rate and additional bond purchases can produce undesired side-effects... We don't really know for how long future interest rate cuts will work in an effective way." - Riksbank Deputy Governor Cecila Skingsley (October 7, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Grungy Times - A Replay Of The Early 1990s? - June 10, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Hillary Clinton has a 65% chance of winning the election; she receives 334 electoral college votes according to our model. Trump still requires an exogenous shock to win. Meanwhile, the USD is poised to rally - and leftward-moving policymakers will applaud its redistributive effects while MNCs suffer the consequences.
Our <i>Fourth Quarter Strategy Outlook</i> presents the major investment themes and views we see playing out for the rest of the year and beyond.
This week, we are reviewing all of our active trades discussed in the last twelve months, which are intended to be an overlay to our recommended fixed income portfolio.
In a February <i>Special Report</i> titled "Assessing Fair Value In FX Markets" we introduced a set of long-term valuation models based on various fundamentals. We have updated the results and added KRW, INR, PHP, HKD, CLP and COP to our analysis. The dollar still remains expensive, albeit with no signs of a dangerous overvaluation. The yuan is now at its cheapest level since 2009.
In September, the model outperformed the S&P 500, while it underperformed global equities in both USD and local-currency terms. For October, the model trimmed its allocation to stocks and boosted its weightings in bonds and cash.