Asset Allocation
Highlights Portfolio Strategy Looming inflation, the synchronized global capex upcycle and rising real Treasury yields all argue for preferring oil-related to gold-exposed equities. Recent Changes Initiate a long S&P oil & gas exploration & production / short global gold miners pair trade today. Table 1 Feature Chart 1No Contagion Yet Stocks recovered smartly from the Turkey induced pullback last week, and continue to flirt with all-time highs. While the risk of contagion remains acute, three key high-frequency financial market metrics suggest that the SPX will likely escape unscathed. The second panel of Chart 1 shows that both the Japanese yen and the Swiss franc, the two ultimate safe havens, have barely budged vis-a-vis the U.S. dollar and also the junk bond market remains extremely calm (third panel, Chart 1). We will continue to closely monitor these indicators to gauge the risk of contagion in U.S. equities. The greatest risk, however, is China's economic footing, particularly its foreign exchange policy (bottom panel, Chart 1). Any further steep devaluation in the renminbi will prove destabilizing and bring back memories of August 2015 when Chinese policy easing caused the dollar to spike and short-circuited SPX EPS growth. Relatedly, there is also a risk that China moves forward more aggressively on capital account liberalization, likely leading to a renminbi devaluation at least initially. Re-reading this Bank For International Settlements paper (starting on page 35 penned by Mitsuhiro Fukao, an ex-Director of Economic Research at the Bank of Japan) and taking a cue from Japan's experience was insightful.1 But, it remains difficult to predict what China's ultimate reaction function to Trump's trade rhetoric will be (Mathieu Savary, BCA's foreign exchange strategist, will be addressing this in one of his upcoming reports). While a tactical 5-10% pullback cannot be ruled out as the seasonally weak month of September is nearing, from a cyclical perspective our strategy would be to "buy the dip" if one were to materialize. Importantly, this bulletproof equity market that refuses to go down has two stealthy allies on its side: pension plans that are forced into equities and corporate treasurers that execute buybacks. Granted, EPS have delivered and suggest that upbeat fundamentals remain the key market support pillars. As a result, the S&P 500 is on track to register a tenth consecutive positive total return year, which is unprecedented in previous expansions. The only other time that the (reconstructed) SPX rose every year for 10 years in a row was in the late 1940s, however, two recessions occurred during that equity market run (Chart 2). While we are undoubtedly in the later stages of the bull market and the business cycle, there is a big difference between "late-cycle" and "end-of-cycle". Keep in mind that the current backdrop is unusual. A large fiscal package has hit late in the game likely extending the cycle. Thus, gauging where we are in the cycle is important. Chart 3 shows a stylized liquidity cycle and our sense is that we are in the early innings of the inflation stage. The handoff from reflation to inflation has happened and during this stage excesses take root eventually morphing, more often than not, into a mania. Chart 2Impressive Streak Continues Chart 3Liquidity Cycle From a macro perspective inflation is slated to rear its ugly head. Nominal GDP is far exceeding the 10-year Treasury yield, and this yield curve type steepening is bullish for SPX top line growth (Chart 4). As a reminder, in Q2 the GDP deflator jumped to 3.35% pushing nominal GDP growth to 7.41%. Money velocity2 is also enjoying a slingshot recovery. Nominal GDP growth is outpacing M2 money supply growth by roughly 150bps. The U.S. money multiplier (M2 over the monetary base, not shown) is also at a 5-year high. This is an inflationary backdrop (bottom panel, Chart 5) and should also boost SPX revenues and thus continue to underpin the broad equity market. Similarly, the NY Fed's Underlying Inflation Gauge (UIG) is firing on all cylinders and is a harbinger of a further pickup in core inflation in the coming months. As a result, SPX sales growth remains on a solid foundation (Chart 6). Chart 4SPX Sales Rest On Solid Foundations Chart 5A Little Bit Of Inflation... Chart 6...Is A Boon For The SPX This week we are initiating a market and asset class neutral pair trade to benefit from the inflationary backdrop. Initiate A Long Oil & Gas E&P / Short Gold Miners Pair Trade One way to benefit from this onset of the inflation stage/mania phase is to go long oil & gas exploration & production/short global gold miners. On the underlying commodity front, the handoff from reflation to inflation has historically been a boon to the oil/gold ratio (OGR). Importantly, the prices paid subcomponent of the ISM manufacturing survey has gone parabolic compared with the new order sub index, roughly doubling since the 2016 nadir. This depicts an inflationary backdrop and is signaling that the OGR will play catch up in the coming months (Chart 7). Chart 7CHART 7 Reflation To Inflation Handoff Similarly, another surging inflation indicator also suggests that the OGR has ample room to run. The GDP deflator has recently eclipsed the 3% mark and since exiting deflation following the end of the recent global manufacturing recession it is up over 370bps. Chart 8 shows that if this multi-decade positive correlation were to hold then the OGR could double from current levels. Chart 8GDP Deflator On The Rise Finally, the NY Fed's UIG is also closely correlated with OGR momentum, corroborates the other firming inflation signals and hints that more gains are in store for the OGR (bottom panel, Chart 9). Global macro tailwinds are also clearly in favor of oil at the expense of gold. BCA's global industrial production gauge of 40 DM and EM countries continues to expand at a healthy clip. Oil is a global growth barometer, whereas gold represents one of the few true safe havens in times of duress. Taken together, the implication is that a catch up phase looms for the OGR (middle panel, Chart 9). The relative commodity backdrop is the most important determinant of relative share prices as it dictates the direction of relative profitability (middle panel, Chart 10). Therefore, as the OGR goes so do relative share prices. Chart 9Enticing Global Macro Backdrop Chart 10Buy Oil & Gas E&P... Beyond this enticing relative commodity complex outlook, the synchronized global capex upcycle, one of BCA's key themes for the year, is underpinning the relative share price ratio. U.S. capex in particular is outpacing GDP growth and oil & gas investment is the key driver. The V-shaped recovery in the Baker Hughes oil & gas rig count data (bottom panel, Chart 10) confirms this upbeat energy capital outlay backdrop. Moreover, capex intentions from the Dallas Fed survey point to more upside in relative share prices (bottom panel, Chart 11). Meanwhile, keep in mind that the U.S. has been at full employment for 18 months now (in other words the unemployment gap closed in February of 2017) and the economy is firing on all cylinders. Real rates have also shot the lights out recently. In fact the 5-year real Treasury yield is perched near 1%, a multi-year high. Given that gold does not yield any income, it suffers when real yields rise and vice versa (for additional details on the relationship between gold and interest rates, please refer to the early-May piece penned by our sister publication U.S. Bond Strategy titled "A Signal From Gold?").3 Similarly, relative share prices thrive when real yields advance and retreat when the TIPS yield sinks (top panel, Chart 12). Chart 11...At The Expense Of Gold Miners Chart 12Bullion TIPS Over Unsurprisingly, the Fed has been tightening monetary policy since December 2015. Nevertheless, the "Fed Spread" (2-year Treasury yield compared with the fed funds rate) is steepening and continues to point to additional gains in the share price ratio (bottom panel, Chart 12). Given that both the ECB and the BoJ have remained ultra-accommodative, a hawkish Fed has boosted the U.S. dollar. However, most commodities are priced in greenbacks, thus the currency effect is a washout and is neither closely correlated to the OGR nor to the share price ratio. Two risks to this high octane, high momentum pair trade are: an EM accident induced risk off phase and a global recession likely due to a flare up in the global trade war (policy uncertainty shown inverted, top panel, Chart 9). In either of these scenarios, investors will likely seek the refuge of bullion's perceived safety as the bond market will almost immediately start pricing in easier monetary policy with investors flocking into the ultimate safe haven asset, U.S. Treasurys. Netting it all out, an enticing macro backdrop with the onset of the inflation stage, the synchronized global capex upcycle and rising real Treasury yields all argue for preferring oil-related to gold-exposed equities. Bottom Line: Initiate a market- and currency-neutral long S&P oil & gas exploration & production/short global gold miners pair trade today. The ETF ticker symbols the S&P oil & gas exploration & production and the global gold mining index are: XOP and GDX, respectively. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 BIS Papers No 15 "China's capital account liberalisation: international perspectives", Monetary and Economic Department, April 2003. 2 "The velocity of money is the frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy". Source: Federal Reserve Bank of St. Louis. 3 Please see BCA U.S. Bond Strategy Weekly Report, "A Signal From Gold?" dated May 1, 2018, available at usbs.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights The Turkish economy is in disarray, ... : The lira's plunge has reminded some investors of the Thai baht's in 1997, but we do not foresee a replay of the Asian Crisis. ... highlighting emerging markets' vulnerability to external factors: EM economies may be on firmer footing than they were 20 years ago, but the vicissitudes of dollar-denominated debt remain their Achilles' heel. Fraught times around the world justify paring back portfolio risk, ... : Increased caution is appropriate in the face of potential EM distress. Multiples are elevated and spreads are tight, leaving stocks and bonds susceptible to a pickup in risk aversion. ... even if domestic data indicate that the U.S. expansion is alive and well: Global concerns did nothing to dim small businesses' rosy outlook, but the dirty little secret within the July NFIB survey is that rising cost pressures will keep the Fed from backing off of its tightening plans. Feature Dear Client, This is our final report for the month of August. We will resume our regular publication schedule the first week of September. We wish everyone an enjoyable rest of the summer. Best regards, Doug Peta, Chief U.S. Investment Strategist What a difference a year makes. If 2017 was all about synchronized global growth, 2018 has been a study in desynchronization. While the list of sputtering international economies grows longer with every passing month, the U.S. economy continues to gather steam. The fact that it is leaving the laggards choking on its exhaust as it speeds by, trampling the conventions of the postwar international order the U.S. itself established, and tightening the screws on dollar borrowers, is bruising feelings from Ankara and Beijing to Ottawa and Brussels. There is nothing on the horizon to indicate that the desynchronization trend is about to end. Surreal as it may be for baby boomers and other pre-millennials, trade barriers are an essential plank in the Republicans' midterm election platform. Our geopolitical strategists caution that there is little reason to expect the anti-trade rhetoric out of Washington to die down before November. The associated headwinds for multinational corporations and economies more reliant on global trade are likely to persist for at least a few more months. The other global policy irritant comes from the Fed. Although it is not blind to the impact of its policies on other economies, its America First mandate is firmly entrenched. Confronted with a domestic economy that is being force-fed stimulus when it is already showing signs of bumping up against supply constraints, the Fed has very little room to relax its vigilance. Investors counting on an "EM put" to alter the course of rate hikes should recognize that that put is way out of the money: it will take a great deal of EM pain for the Fed to back away from its projected course. Turkey's Tenuous Model Before the Asian Crisis, the growth of the Asian Tiger economies was the envy of the world. The formula was simple and effective: take ample supplies of cheap labor, mix with developed-world capital to finance a buildup of manufacturing capacity, and watch eye-popping growth ensue. All was well until too much excitement led to hard-currency-debt-financed investment in overcapacity. When exchange-rate pegs fell, domestic borrowers became unable to meet their obligations and the Asian Miracle imploded. The Turkish lira's plunge has put many investors in mind of the Thai baht's 1997 collapse that set the Asian Crisis in motion. The EM contagion eventually found its way to Russia in the summer of 1998, felling hedge fund titan Long-Term Capital Management (LTCM) and thoroughly rattling several of its Wall Street enablers. Investors would be foolish to ignore the problems in Turkey, which could well ripple out into other EM economies and the developed world. However, our current base-case scenario does not call for anything on the order of the Asian Crisis. Chart of the WeekTurkey Is A Clear Outlier Today ... Chart 2... But It Would Have Been In The Thick Of Things In 1997 Turkey's dependency on external capital flows is reminiscent of the Asian Tigers', but it is an outlier in today's more conservative context (Chart of the Week). On the eve of the Asian Crisis, Turkey's external financing profile, on both a flow (current-account balance as a share of GDP) and a stock (external private debt as a share of GDP) basis, would have placed it squarely within the smart set (Chart 2). In retrospect, the Asian Miracle template of the early and mid '90s was an accident waiting to happen. Currency pegs are seen as a naïve relic, and exporters assiduously build up reserve war chests to prevent currency panics from taking root. Chart 3U.S. Banks Have Modest EM Exposure The key issue for U.S. investors is the potential for contagion to the U.S. banking system and its markets. It is almost impossible to identify an LTCM in advance, but the fact that the banking system is on a much tighter leash following the crisis means that it is far less vulnerable than it was in the late '90s. As our f/x strategists point out,1 European banks (especially Spain's BBVA) have considerably more exposure to Turkey and other fragile EM economies (Chart 3). Sentiment is the most likely transmission mechanism, and U.S. assets would seem to be last in line for multiple de-rating and spread widening, given the strength of the U.S. economy and its comparative remove from the rest of the world. Bottom Line: The magnitude of Turkey's financing excesses is not representative of the entire EM complex. U.S. investors should operate with a heightened sense of caution, but they should not panic. Emerging Markets' Achilles' Heel The magnitude of Turkey's reliance on external financing is unusual, but the direction is common. The vast bulk of the world's wealth is held in developed economies, and EM projects necessarily source capital from DM investors. Over 90% of all EM corporate debt is denominated in hard currency, of which the vast majority is denominated in U.S. dollars. For EM corporates with mainly domestic revenues, moves in the dollar exchange rate exert disproportionate influence over how comfortably they can service their debt. Exchange rates are determined by many factors, but real interest rate differentials are among the most prominent drivers. When the Fed hikes the fed funds rate while other central banks are easing policy or standing pat, the dollar tends to appreciate. A rising dollar pressures EM corporate borrowers, and hasn't been good for EM stock prices, either (Chart 4). If the Fed were to lift the fed funds rate all the way to 3.5% by the end of 2019, as we expect, several EM borrowers could find themselves in the crosshairs. Chart 4Tighter Fed Policy Squeezes EM Equities, Too Meaningful Chinese stimulus could go a long way to offsetting Fed tightening pressures. A more robust Chinese economy would trade more and consume more natural resources. Increased export volumes and higher commodity prices would boost EM exports and commodity prices, helping to support exchange rates. Unfortunately for Asian and Latin American EMs, the jury is still out as to whether or not the Chinese cavalry will ride to the rescue. Our China strategists have observed that a sizable stimulus injection would run counter to policy makers' commitment to reining in shadow banking excesses and cooling off the property market. If the trade war with the U.S. really starts to bite, however, reform may become a lesser priority. The powers that be have been circumspect with stimulus so far (Chart 5), weakening the currency to defend exports (Chart 6) rather than attempting to boost domestic activity via government spending. We will keep a close eye on Chinese policy developments as they unfold. Chart 5Instead Of Helping The EM Bloc With Reflation,... Chart 6...China Has Been Exporting Deflation Bottom Line: Chinese stimulus could help cushion the blow from a stronger dollar, but policy makers have yet to show their hand. Stay tuned. The View From Main Street Despite the global challenges, the July NFIB survey underlined the point that the U.S. economy is flying high. The headline Optimism Index is a single tick below its all-time high (Chart 7, top panel), the Hiring Plans (Chart 7, second panel) and Job Openings components (Chart 7, third panel) are at or near all-time highs, and the Good Time to Expand component is just off the high it set in May (Chart 7, bottom panel). All in all, the view from Main Street is the best it's ever been over the survey's 44-year history. All of the readings in Chart 7 are so good (two-plus standard deviations above the mean), that there is little scope for improvement. Mean reversion may well begin to assert itself, but it is likely to be a slow process. Overall optimism peaks well ahead of downturns, and tends to take its time deteriorating. It lends support to the message from our recession indicator2 that the expansion has at least another year to run. All good things come to an end, however, and the downside to the gangbusters survey results is that they foreshadow the expansion's eventual demise. Respondents' reports of price changes and future intentions to raise them correlate closely with PCE inflation (Chart 8). Record strength in job openings and hiring intentions indicates the labor market is tight enough to squeak, suggesting that firms will soon have to bid up wages to attract new employees. Taken together, the inflation-related measures imply that the Fed will not be able to let up, supporting the house view that the fed funds rate will surprise to the upside. Chart 7A Roaring Economy... Chart 8...Carries The Seeds Of Its Own Demise Bottom Line: The end of the expansion is not at hand, but its strength will eventually compel the Fed to step in to cut it off. Investment Implications Fiscal stimulus and monetary policy still support the expansion and the bull markets in equities and corporate debt, but they will not do so indefinitely. Stimulus is not sustainable from a budgetary standpoint, and gathering inflationary pressures will eventually inspire the Fed to wield its policy tools to bring the curtain down on the business cycle. The shift to restrictive policy will mark an inflection point in risk-asset performance, and investors should pursue more defensive portfolio positioning when it arrives. Although the cyclical inflection point is not yet upon us, the uncertain outcome of trade tensions and emerging market vulnerabilities merit dialing back portfolio risk in the near term. In line with the BCA house view, we recommend overweighting cash and underweighting bonds, while maintaining benchmark positioning in equities. Treasuries will likely outperform if the EM rumblings turn into something more serious, but we would view any decline in yields as a temporary respite from a Treasury bear market that has already been in place for two years. Depending on when, or if, the current global pressures abate, the equity bull market may still have some juice, and we are keeping an open mind about moving stocks back to overweight for the final push. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Please see the August 17, 2018 Foreign Exchange Strategy Special Report, "The Bear And The Two Travelers," available at fes.bcaresearch.com. 2 Please see the August 13, 2018 U.S. Investment Strategy Special Report, "How Much Longer Can The Bull Market Last?" available at usis.bcaresearch.com.
We published a Special Alert report titled Turkey: Book Profits On Shorts yesterday. The link is available on page 18. This report is Part 2 of an overview of the cyclical profiles of emerging market (EM) economies. This all-in-charts presentation illustrates the business cycle conditions of various developing economies. The aim of this report is to provide investors with a quick assessment of where each EM economy stands. In addition, we provide our view on each market. The rest of the countries were covered in Part 1, published last week (the link to it is available on page 18). Chart I-1 Malaysia: Keep Underweight For Now As... Malaysia: Keep Underweight For Now As...Malaysia: Keep Underweight For Now As... Malaysia: Keep Underweight For Now As... ...Bank Shares Have Significant Downside ...Bank Shares Have Significant Downside ...Bank Shares Have Significant Downside...Bank Shares Have Significant Downside Indonesia: Underweight Equities & Bonds Indonesia: Underweight Equities & Bonds Indonesia: Underweight Equities & Bonds Indonesia: Underweight Equities & Bonds Indonesia: Underweight Equities & Bonds Indonesia: The Sell-Off Is Not Over Yet Indonesia: The Sell-Off Is Not Over Yet Indonesia: The Sell-Off Is Not Over Yet Indonesia: The Sell-Off Is Not Over Yet Indonesia: The Sell-Off Is Not Over Yet Thailand: Stay Overweight Thailand: Stay Overweight Thailand: Stay OverweightThailand: Stay Overweight Thailand: Better Positioned To Weather The EM Storm Thailand: Better Positioned ##br##To Weather The EM Storm Thailand: Better Positioned ##br##To Weather The EM Storm Thailand: Better Positioned ##br##To Weather The EM Storm Thailand: Better Positioned ##br##To Weather The EM Storm Philippines: Inflation Breakout Philippines: Inflation BreakoutPhilippines: Inflation Breakout Philippines: Inflation Breakout Philippines: Neutral On Equities Due To Oversold Conditions Philippines: Neutral On Equities ##br##Due To Oversold Conditions Philippines: Neutral On Equities ##br##Due To Oversold ConditionsPhilippines: Neutral On Equities ##br##Due To Oversold Conditions Central Europe: Labor Shortages & Wage Inflation Central Europe: Labor Shortages & Wage Inflation Central Europe: Labor Shortages & Wage Inflation Central Europe: Robust Growth - Overweight Central Europe: Robust Growth - Overweight Central Europe: Robust Growth - OverweightCentral Europe: Robust Growth - Overweight Chile: Robust Growth - Overweight Equities Chile: Robust Growth - Overweight Equities Chile: Robust Growth - Overweight Equities Chile: No Inflationary Pressures Chile: No Inflationary PressuresChile: No Inflationary PressuresChile: No Inflationary Pressures Chile: No Inflationary Pressures Colombia: Currency Will Be A Release Valve Colombia: Currency Will Be A Release Valve Colombia: Currency Will Be A Release Valve Colombia: Currency Will Be A Release Valve Colombia: Currency Will Be A Release Valve Colombia: Credit Growth Remains A Headwind For Economy - Neutral Colombia: Credit Growth Remains ##br##A Headwind For Economy - Neutral Colombia: Credit Growth Remains ##br##A Headwind For Economy - NeutralColombia: Credit Growth Remains ##br##A Headwind For Economy - Neutral Peru: Vulnerable To External Developments Peru: Vulnerable To External Developments Peru: Vulnerable To External Developments Peru: Vulnerable To External Developments Peru: Vulnerable To External Developments Peruvian Equities - Underweight Peruvian Equities - Underweight Peruvian Equities - UnderweightPeruvian Equities - Underweight
Highlights Chart 1Yield Curve Suggests GDP Growth Has Peaked Last month we learned that the U.S. economy grew 4.1% in the second quarter, the fastest pace since 2014. The gap between year-over-year nominal GDP growth and the fed funds rate - a reliable recession indicator - also widened considerably (Chart 1). However, our sense is that this might be as good as it gets for the U.S. economy. With fewer unemployed workers than job openings and businesses reporting difficulties finding qualified labor, strong demand will increasingly translate into higher prices rather than more output. Higher interest rates and a stronger dollar will also start to weigh on demand as the Fed responds to rising inflation. For bond investors, it is still too soon to position for slower growth by increasing portfolio duration. Markets are priced for only 83 basis points of Fed tightening during the next 12 months, below the current "gradual" pace of +25 bps per quarter. Maintain below-benchmark portfolio duration and a neutral allocation to spread product. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 133 basis points in July, bringing year-to-date excess returns up to -50 bps. The index option-adjusted spread tightened 14 bps on the month, and currently sits at 109 bps. Corporate bonds remain expensive with 12-month breakeven spreads for both the A and Baa credit tiers near their 25th percentiles since 1989 (Chart 2). Further, with inflation now close to the Fed's target, monetary policy will provide much less support for corporate bond returns going forward. These are two main reasons why we downgraded our cyclical corporate bond exposure to neutral near the end of June.1 Recent revisions to the U.S. National Accounts reveal that gross nonfinancial corporate leverage declined in Q4 2017 and Q1 2018, though from an elevated starting point (panel 4). While strong Q2 2018 profit growth should lead to a further decline when the second quarter data are reported in September, the downtrend in leverage will probably not last through the second half of the year. A rising wage bill and stronger dollar will soon drag profit growth below the rate of debt growth. At that point, leverage will rise. Historically, rising gross leverage correlates with rising corporate defaults and widening corporate bond spreads. The Fed's Senior Loan Officer Survey for the second quarter was released yesterday, and it showed that banks continue to ease standards on commercial & industrial loans (bottom panel). Rising corporate defaults tend to coincide with tightening lending standards (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 128 basis points in July, bringing year-to-date excess returns up to +205 bps. The average index option-adjusted spread tightened 27 bps on the month, and currently sits at 334 bps. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses is currently 213 bps, below its long-run mean of 247 bps (Chart 3). This tells us that if default losses during the next 12 months are in line with our expectations, we should expect excess high-yield returns of 213 bps over duration-matched Treasuries, assuming also that there are no capital gains/losses from spread tightening/widening. However, we showed in a recent report that the default loss expectations embedded in our calculation are extremely low relative to history (panel 4).2 Our assumption, derived from the Moody's baseline default rate forecast and our own forecast of the recovery rate, calls for default losses of 1.2% during the next 12 months. The only historical period to show significantly lower default losses was 2007, a time when corporate balance sheets were in much better shape than today. While most indicators suggest that default losses will in fact remain low for the next 12 months, historical context clearly demonstrates that the risks are to the upside. It will be critically important to track real-time indicators of the default rate such as job cut announcements, which declined last month but remain above 2017 lows (bottom panel), for signals about whether current default forecasts are overly optimistic. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 20 basis points in July, bringing year-to-date excess returns up to -4 bps. The conventional 30-year zero-volatility MBS spread tightened 3 bps on the month, driven by a 2 bps decline in the compensation for prepayment risk (option cost) and a 1 bp tightening of the option-adjusted spread (OAS). The excess return Bond Map shows that MBS offer a relatively poor risk/reward trade-off, particularly compared to Aaa-rated non-Agency CMBS, High-Yield and Sovereigns. However, our Bond Map analysis does not account for the macro environment, which remains very favorable for the sector. In a recent report we showed that the two main factors that influence MBS spreads are mortgage refinancing activity and residential mortgage bank lending standards.3 Refi activity is tepid (Chart 4) and will likely stay that way for the foreseeable future. Only 5.8% of the par value of the Conventional 30-year MBS index carries a coupon above the current mortgage rate, and even a drop in the mortgage rate to below 4% (from its current 4.6%) would only increase the refinanceable percentage to 38%. As for lending standards, yesterday's second quarter Senior Loan Officer Survey showed that they continue to ease (bottom panel), though banks also reported that they remain at the tighter end of the range since 2005. The still-tight level of lending standards suggests that further gradual easing is likely going forward. That will keep downward pressure on MBS spreads. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 37 basis points in July, bringing year-to-date excess returns up to +2 bps. Sovereign debt outperformed the Treasury benchmark by 179 bps on the month, bringing year-to-date excess returns up to -35 bps. Foreign Agencies outperformed by 24 bps on the month, bringing year-to-date excess returns up to -22 bps. Local Authorities outperformed by 33 bps on the month, bringing year-to-date excess returns up to +61 bps. Supranationals outperformed by 6 bps on the month, bringing year-to-date excess returns up to +13 bps. Domestic Agency bonds broke even with duration-matched Treasuries in July, keeping year-to-date excess returns steady at -1 bp. The strengthening U.S. dollar is a clear negative for hard currency Sovereign debt (Chart 5) and valuation relative to U.S. corporates remains negative (panel 2). Maintain an underweight allocation to Sovereigns. In contrast, the Foreign Agency and Local Authority sectors continue to offer a favorable risk/reward trade-off compared to other fixed income sectors (please see the Bond Maps on page 15). Maintain overweight allocations to both sectors. The Bond Maps also show that while the Supranational and Domestic Agency sectors are very low risk, expected returns are feeble. Both sectors should be avoided. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 66 basis points in July, bringing year-to-date excess returns up to +187 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio fell 3% in July to reach 83% (Chart 6). This is more than one standard deviation below its post-crisis mean and only slightly higher than the average of 81% that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. The total return Bond Map shows that municipal bonds still offer an attractive risk/reward profile for investors who are exposed to the top marginal tax rate. For investors who cannot benefit from the tax exemption there are better alternatives - notably Supranationals, Domestic Agency bonds and Agency CMBS. While value is dissipating, the near-term technical picture remains positive. Fund inflows are strong (panel 2) and visible supply is low (panel 3). Fundamentally, revisions to the GDP data reveal that state & local government net borrowing has been fairly flat in recent years, and in fact probably increased in the second quarter (bottom panel). At least so far, ratings downgrades have not risen alongside higher net borrowing, but this will be crucial to monitor during the next few quarters. Stay tuned. Treasury Curve: Buy The 5/30 Barbell Versus The 10-Year Bullet Chart 7Treasury Yield Curve Overview The Treasury curve's bear flattening trend continued in July. The 2/10 Treasury slope flattened 4 bps and the 5/30 slope flattened 2 bps, as yields moved higher. Despite the curve flattening, our position long the 7-year bullet and short the 1/20 barbell returned +8 bps on the month and is now up +30 bps since inception.4 The trade's outperformance is due to the extreme undervaluation of the 7-year bullet versus the 1/20 barbell. As of today, the bullet still plots 12 bps cheap on our model (Chart 7), which translates to an expected 42 bps of 1/20 flattening during the next six months. We view that much flattening as unlikely.5 Table 4 of this report shows that curve steepeners are also cheap at the front-end of the curve, particularly the 2-year bullet over the 1/5 and 1/7 barbells. Meanwhile, barbells are more fairly valued relative to bullets at the long-end of the curve. The 5/30 and 7/30 barbells look particularly attractive relative to the 10-year bullet. We recommend adding a position long the 5/30 barbell and short the 10-year bullet. The 5/30 barbell is close to fairly valued on our model (panel 4), which implies that the 5/10/30 butterfly spread is priced for relatively little change in the 5/30 slope during the next six months. This trade should perform well in the modest curve flattening environment we anticipate, and it provides a partial hedge to our 1/7/20 trade that is geared toward curve steepening. Table 4Butterfly Strategy Valuation (As Of August 3, 2018) TIPS: Overweight Chart 8Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 10 basis points in July, bringing year-to-date excess returns up to +139 bps. The 10-year TIPS breakeven inflation rate increased 1 bp on the month and currently sits at 2.12%. The 5-year/5-year forward TIPS breakeven inflation rate increased 8 bps on the month and currently sits at 2.24% (Chart 8). Both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates remain below the 2.3% to 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed's 2% target. We expect breakevens will return to that target range as investors become increasingly convinced that the risk of deflation has faded. Consistent inflation prints at or above the Fed's 2% target will be the deciding factor that eventually leads to this upward re-rating of inflation expectations. In that regard, core PCE inflation was relatively weak in June, growing only 0.11% month-over-month. That pace is somewhat below the monthly pace of 0.17% that is necessary to sustain 2% annualized inflation (panel 4). Nevertheless, 12-month core PCE inflation at 1.9% is only just below the Fed's target, and the 6-month rate of change is above 2% on an annualized basis. These readings are confirmed by the Dallas Fed's trimmed mean PCE inflation measure (bottom panel). Maintain an overweight allocation to TIPS relative to nominal Treasury securities for now. We will reduce exposure to TIPS once both the 10-year and 5-year/5-year forward breakeven rates reach our target range of 2.3% to 2.5%. ABS: Neutral Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in July, bringing year-to-date excess returns up to +9 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 5 bps on the month and now stands at 38 bps, only 11 bps above its pre-crisis low. The Bond Maps show that consumer ABS continue to offer relatively attractive return potential compared to other low-risk spread products. However, we maintain only a neutral allocation to this space because credit quality trends have started to move against the sector. Despite the large upward revision to the personal savings rate that accompanied the second quarter GDP report, the multi-year uptrend in the household interest coverage ratio remains intact (Chart 9). This will eventually translate into more frequent consumer credit delinquencies, and indeed, the consumer credit delinquency rate appears to have put in a bottom. The Fed's Senior Loan Officer Survey for Q2 was released yesterday and it showed that average consumer credit lending standards tightened for the ninth consecutive quarter (bottom panel). Credit card lending standards tightened for the fifth consecutive quarter, while auto loan standards eased after having tightened in each of the prior eight quarters. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 37 basis points in July, bringing year-to-date excess returns up to +98 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 5 bps on the month and currently sits at 71 bps (Chart 10). In a recent report we showed that the macro picture for CMBS is decidedly mixed.6 A typical negative environment for CMBS is characterized by tightening bank lending standards for commercial real estate loans and falling demand. Yesterday's Q2 Senior Loan Officer Survey reported that both lending standards and demand for nonresidential real estate loans were very close to unchanged (bottom two panels). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 24 basis points in July, bringing year-to-date excess returns up to +31 bps. The index option-adjusted spread tightened 5 bps on the month and currently sits at 47 bps. The Bond Maps show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this defensive sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of August 3, 2018) Chart 12Total Return Bond Map (As Of August 3, 2018) Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem", dated July 17, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem", dated July 17, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)
Highlights Global QE has made bonds as risky as equities. Thereby, global QE has forced investors to accept identically depressed returns from equities and from bonds, requiring equity and other risk-asset valuations to surge. The good news is that record high valuations of risk-assets are fully justified if global bond yields remain at current levels or fall. The bad news is that risk-asset valuations will become dangerously unstable if global bond yields march much higher. The 'rule of 4' for equity/bond allocation: sum the three 10-year yields - the German bund, the U.S. T-bond, and the JGB. Above 3.5 means a neutral stance in equities... ... Above 4 means it's time to go underweight equities and overweight bonds. Feature Chart of the WeekAt Higher Bond Yields, The Correlation With Equity Prices Has Flipped From Positive To Negative The end is nigh for QE. The ECB will exit its asset purchase program at the end of the year. In doing so, it will mark the end of an epoch which began in the aftermath of the global financial crisis, a ten year period in which at least one of the world's major central banks has been buying a defined quantity of assets every month (Chart I-2). Approaching the end of the epoch, it is fitting to ask: how did the global QE stimulant work, and what will be the withdrawal symptoms? Chart I-2The End Is Nigh For QE As far back as 2011, in a provocative report titled QE And Riots we predicted that: "QE... will exacerbate already extreme income inequality and the consequent social tensions that arise from it" Events in the subsequent seven years have fully vindicated our prediction. Simply put, QE has front-loaded asset returns which would ordinarily have accrued in the distant future to the here and now - in the form of sharply higher capital values. So if you were invested in the financial markets or most housing markets, congratulations, you have received a bonanza; if you weren't, bad luck, there's not much left for you (Chart I-3). Chart I-3Equities Are Now Priced To Generate A Measly Long-Term Return To understand why, we need to delve deeper into behavioural economics. QE: Why The Stimulant Was So Powerful Central banks admit that there is a lower bound for interest rates below which there would be an exodus of bank deposits. Once policy rates hit the lower bound, central banks can unleash a 'plan B': a commitment to keep policy rates at this lower bound for an extended period. QE is simply a powerful signalling tool for this commitment. As ECB Chief Economist Peter Praet explains: "There is a signalling channel inherent in asset purchases, which reinforces the credibility of forward guidance on policy rates. This credibility of promises to follow a certain course for policy rates in the future is enhanced by the asset purchases, as these asset purchases are a concrete demonstration of our desire (to keep policy rates at the lower bound)" The credible commitment to keep policy rates near the lower bound for an extended period depresses bond yields towards the lower bound too (Chart I-4). Chart I-4The Credible Commitment To Keep Policy Rates##br## Low Pulls Down Bond Yields Now comes the part of the story that is not well understood, even by central bankers, because it derives from recent breakthroughs in behavioural economics. When bond yields approach the lower bound, the asymmetry in their future direction makes bonds very risky investments. The short-term potential for capital appreciation - nominal or real - vanishes, while the potential for vicious losses increases dramatically (Chart I-5). The technical term for this unattractive asymmetry is negative skew. Years of research in behavioural economics has led Nobel Laureate Professor Daniel Kahneman to conclude: negative skew is the measure that best encapsulates our perception of an investment's risk. Chart I-5Bonds Become Much Riskier ##br## At Low Bond Yields Professor Kahneman's work reveals a profound truth: global QE has made bonds as risky as equities (Chart I-6). The ramification is that equities and other risk-assets no longer need to lure investors with an excess return over bond returns. QE has forced investors to accept identically depressed returns from equities and from bonds, requiring equity and other risk-asset valuations to surge.1 Chart I-6Global QE Has Made Bonds ##br##As Risky As Equities One counterargument we hear is that bonds offer investors a diversification benefit and, because of this, investors will still accept a lower return from bonds. But this argument is flawed. Just as bonds are a diversifier for equity investors, equities are a diversifier for bond investors. Indeed in recent years, equities have protected bond investors during vicious sell-offs in the bond market such as after Trump's shock victory in 2016. So we could equally argue that equities require the lower return. In fact, with the same negative skew and symmetrical diversification properties, both assets must offer the same prospective return. The breakthroughs in behavioural economics provide some good news and some bad news. The good news is that record high valuations of risk-assets are fully justified if bond yields remain at current levels or fall. The bad news is that risk-asset valuations will become dangerously unstable if bond yields march much higher (Chart I-7). Chart I-7At Low Bond Yields The Required Return On ##br##Equities Plunges, So Equity Valuations Surge Financial Markets Dwarf The World Economy One common misunderstanding about QE is that it has been the bond purchasing itself that has held down bond yields. This seems a natural assumption because we connect the act of buying with higher prices (lower yields). Moreover, the $10 trillion of bonds that the 'big four' central banks have bought is not far short of the size of the euro area economy. But let's put this into context. The global bond market exceeds $100 trillion. Long-term bank loans amount to something similar. In this $217 trillion2 global fixed income market, $10 trillion of QE is peanuts. To reiterate, QE's impact came not from the $10 trillion of central bank purchases in itself, but from the signal that interest rates would remain at the lower bound for a long time, mathematically requiring bond yields to approach the lower bound too;3 and from the consequent equalization of negative skew on bonds and risk-assets, mathematically requiring an exponential rerating of all risk-asset valuations (Chart I-8). Chart I-8Equities Are Now Priced To Generate A Measly Long-Term Return Now note that the combination of equities and correlated risk-assets such as corporate and EM debt is worth around $160 trillion, and real estate is worth $220 trillion. World GDP is worth much less, around $80 trillion. So if returns from these richly valued risk-assets were reallocated from the here and now back to the distant future, through lower capital values today, there would be a very real risk that current spending could take a dive. Supporting this broad thesis, central bank measures of 'financial conditions easiness' are just tracking the level of the stock market (Chart I-9). Chart I-9Financial Conditions Are Just##br## Tracking The Stock Market The 'Rule Of 4' For Equities And Bonds On February 1 this year, we advised that the big threat to risk-asset valuations "comes from the global 10-year bond yield rising to 2% - broadly equivalent to the German 10-year bund yield rising to 1% or the U.S. 10-year T-bond yield rising to 3%." This advice has proved to be remarkably prescient. Whenever bond yields have been at the lower end of recent ranges, the correlation with equities has been positive, meaning equities have risen in tandem with bond yields. But whenever bond yields have moved to the upper end of recent ranges, the correlation has abruptly flipped to negative, meaning equities have fallen as bond yields have risen (Chart of the Week). While many strategists and commentators are fixated on the risks from trade wars and/or the global economy, our non-consensus call is that the biggest threat to risk-assets comes from rich valuations which will become dangerously unstable if bond yields march much higher. In this regard the bond yield that matters is the global bond yield. Previously we defined this in terms of the German 10-year bund yield and the U.S. 10-year T-bond yield. But today for completeness, we would like to add another important component: the Japanese 10-year government bond yield. The global bond yield is a weighted average of the three components. But for a useful rule of thumb, just sum the three 10-year yields - the German bund, the U.S. T-bond, and the JGB. A sum above 3.5 means a neutral stance to equities. A sum above 4 - which broadly equates to the global yield rising above 2% - means it's time to go underweight equities and overweight bonds. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Consider what happens to valuations when bond yields decline from 4% to 2%. At a 4% bond yield, equities possess significantly more negative skew than 10-year bonds. So investors will demand a comparatively higher return from equities, let’s say 8% a year. Whereas, at a 2% bond yield, equities and 10-year bonds possess the same negative skew. So investors will demand the same return from equities as they can get from bonds, 2% a year. At the lower bond yield, the bond must deliver 2% a year less for ten years compared to previously, meaning its price must rise by 22%. But equities must deliver 6% a year less for ten years, so the equity market must surge by 80%. 2 Source: The Institute of International Finance (IIF) https://www.iif.com/publication/global-debt-monitor/global-debt-monitor-june-2017 3 In contrast, if the market feared bond purchases would cause inflation and thereby imply a higher path of interest rates, QE would push up bond yields! Fractal Trading Model* This week we note that the underperformance of emerging market versus developed market equities is technically stretched and ripe for at least a brief countertrend reversal. The 65-day trade is long EM versus DM with a profit target of 2.5% and a symmetrical stop-loss. 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 I-10 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. * 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 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
Feature GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of July 31, 2018. The quant model lifted its U.S. allocation to be in line with the benchmark weight at the expense of Spain. No major changes in other country weights, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 59 bps in July, largely driven by Level 2 model which outperformed its benchmark by 146 bps. Level 1 model slightly unperformed its MSCI world benchmark by 5 bps in July. Since going live, the overall model has outperformed its benchmarks by 132 bps, driven by the Level 2 outperformance of 375 bps offset by the 2 bps of Level 1 underperformance. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, "Global Equity Allocation: Introducing The Developed Markets Country Allocation Model," dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Mode (Chart 4) is updated as of July 31, 2018. Following the developments on the trade front and increasing worries of a growth slowdown, the model continues to maintain a defensive bias with an aggregate overweight of 5.8% relative to cyclical sectors. The relative tilts within cyclicals and defensives remain the same as the previous month. However, both discretionary and financials are going through unfavorable technical and momentum indicators. Energy remains the only resource based sector with an overweight, primarily driven by attractive long-term valuations. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," dated July 27, 2016, available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Aditya Kurian, Senior Analyst adityak@bcaresearch.com
Feature Downside Risks Haven't Gone Away We downgraded risk assets to neutral in last month's Quarterly Portfolio Outlook,1 citing an increasing number of risks to the equity bull market. Specifically, we warned about the slowdown and desynchronization of global growth, rising U.S. inflation, further deterioration in the trade war, and the ongoing slowdown in China. Markets - particularly in the U.S. - have stabilized somewhat over the past few weeks on the expectation that these risks are not particularly grave, that global growth remains robust, and that central banks will be slow to tighten. We accept that there remain upside risks (which is why we are neutral, not underweight, equities) but think many investors remain too sanguine about the downside risks. On desynchronized growth, it is true that the slowdown in the euro zone seems to have bottomed. The Citi Economic Surprise Indexes (Chart 1) suggest that downward surprises to euro zone and Japanese growth have ended, and that the U.S. is no longer surprising significantly to the upside. However, the likely path of inflation in the two regions looks very different, with U.S. core PCE inflation likely headed towards 2.5% over the next few quarters, while euro zone core inflation is stuck around 1% (Chart 2). Table 1Recommended Allocation Chart 1A Resynchronization Of Growth? Chart 2Core Inflation: Higher In The U.S. Than In The Euro Zone In particular, we think it is only a matter of time before U.S. wages start to accelerate. Unemployment has not been this low since the late 1960s. As happened then, there is typically a lag between the labor market becoming tight and inflation emerging (Chart 3). With the employment/population ratio for the key working-age demographic now back close to its 2007 level (Chart 4), and 601,000 new entrants to the labor force last month alone, that point is probably not far away. Note, too, that people switching jobs are now seeing large wage rises; those staying are not (Chart 5). With strong corporate profit growth, companies will soon start to raise wages to keep staff and fill vacancies. Chart 3Just A Matter Of Time Before Inflation Accelerates Chart 4Little Slack Left In The Labor Market Chart 5Switchers Getting Wage Rises; Stayers Not This all suggests that markets are too nonchalant about the risk of further Fed tightening. The futures market is pricing in only four rate hikes from the Fed over the next 24 months (Chart 6). We think it likely that the Fed will continue to hike by 25 basis points a quarter until something gives. By contrast, the ECB has clearly signaled that it will wait until at least September next year before raising rates; when it does so, it may hike by only 10 basis points. The futures market is close to pricing this correctly (Chart 6, panel 2). We remain concerned about further exacerbation of the retaliatory tariff war. In late July, the European Union and President Trump seemed to agree a truce, especially with regard to auto tariffs. But, even if this proves more than transitory, it is unlikely to be repeated between the U.S. and China. Both sides have raised the stakes so much that it will be politically difficult for either to back down. Further aggressive moves are likely, including a 10% tariff on all USD500 billion of Chinese imports into the U.S, and the Chinese authorities engineering a further depreciation of the Chinese yuan, and making life difficult for U.S. companies that manufacture and sell in China (where their sales total USD350 billion). Businesses around the world have woken up to this risk: capex intentions among U.S. companies have slipped recently and, in the Global ZEW survey, future expectations are now the lowest relative to current conditions since 2007, a bearish indicator (Chart 7). Chart 6Fed Is Likely To Hike more Than This Chart 7Businesses Expect Things To Get Worse Moreover, we don't see China launching a massive reflationary stimulus, as it did in 2009 and 2015. In the past few weeks, it has announced some minor easing of monetary policy, targeted tax cuts, and an acceleration of this year's fiscal spending. This will be enough to cushion the downside. But interest rates have not fallen anything like as much as in previous episodes (Chart 8). The authorities have reiterated that structural reform remains the priority. Given the significant slowdown in credit growth over the past year, we expect a further deceleration in the Chinese industrial economy (and, therefore, in imports) through the end of the year. If our macro outlook is correct, it is likely to have the following consequences for financial markets: further rises in long-term interest rates (we forecast 3.3-3.5% for the 10-year U.S. Treasury bond yield by early 2019), a further appreciation of the U.S. dollar (as monetary policy divergences with the euro area and Japan widen further), and negative performance for emerging market assets (hurt by higher U.S. rates, the rising USD, and the slowdown in China). This points to small negative returns from global government bonds over the next 12 months. Equities are more complicated. Earnings growth remains strong. If S&P500 companies really achieve the 20% EPS growth this year and 10% next year that analysts (and BCA's models) are forecasting, the forward multiple will fall from 16.5x now to 14.0x by end-2019. We would expect to see low single-digit positive returns from global equities over the rest of the year. We accordingly remain neutral on equities, where we can see both upside and downside risks. One key is the timing of the peak in profit margins. This has typically come a few quarters before the start of a recession. Currently margins continue to improve (Chart 9). They are likely to peak around the end of this year, when wages (and input prices, partly because of higher import tariffs) begin to rise faster than sales. We expect to move underweight equities around that time, when this and other recession indicators start to flash warning signals. Chart 8Not 2015 Redux In China Chart 9Watch For The Peak In Profit Margins Currencies: The outlook for the USD remains the key to the performance of other asset classes, particularly emerging markets and commodities. We see the risk of a short-term pullback, since long speculative positions in the dollar have recently built up (Chart 10). But differences in growth, inflation, monetary policy, and long-term rates between the U.S. and other developed economies suggest further moderate dollar appreciation over the coming 12 months. We remain very negative on EM currencies. Central banks in many emerging markets have been forced to raise rates sharply in recent weeks to defend their currencies. This is likely to slow growth over coming quarters. Those central banks that have resisted hiking (for example, Turkey and Brazil) are likely to see sharp rises in inflation. Equities: We prefer developed market equities over emerging ones. Our two overweights are the U.S. and Japan. The U.S. is a defensive market, with a beta to global equities of only 0.9 over the past 20 years. But, if there were to be a last-year equity market melt-up (along the lines of 1999), it is likely to be led by internet stocks, in which the U.S. is particularly overweight, and so the U.S. overweight also acts as a hedge against this upside risk. Our overweight in Japan is based on our view that the Bank of Japan will continue its ultra-accommodative monetary policy (bolstered by the recent tweaks to the operation of the policy), even while other DM central banks are moving towards tightening. There are also some signs of wage growth picking up, which should be positive for consumer sectors. Fixed Income: We remain underweight bonds and, within the asset class, are neutral between government bonds and spread product. U.S. junk bonds continue to have some attraction as long as economic growth remains strong (and the oil price does not fall). But junk bonds typically peak one or two quarters before equities. And, in this cycle, U.S. corporate leverage began to rise rather early, which suggests that at the start of the next recession leverage will be worryingly high (Chart 11) and that junk bonds will, therefore, perform particularly poorly. Chart 10Dollar Long Positions Building Up Again Chart 11Leverage Is High For This Stage Of The Cycle Commodities: Oil has become much harder to forecast in recent weeks, with downside risk to the price of crude coming from the recently announced OPEC production increases, but upside risk from Iran (which is threatening to close the straits of Hormuz in the face of renewed U.S. sanctions) and the collapse in Venezuelan production. BCA's energy strategists see Brent falling a little to average USD70 a barrel in 2H, and at USD75 on average next year, with greater risk of upside surprises than downside.2 Industrial metals prices are likely to remain under pressure if the USD appreciates and China slows further, as evidenced by significant downside moves in copper, iron ore and other metals over the past few weeks. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Global Asset Allocation Quarterly Portfolio Review, "Lowering Risk Assets To Neutral," dated 2 July 2018, available at gaa.bcaresearch.com 2 Please see Commodity & Energy Strategy Special Report, "U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic," dated 19 July 2018, available at ces.bcaresearch.com GAA Asset Allocation