Fiscal
Highlights President Trump has little to do with the ongoing EM selloff; The macro backdrop is the real culprit behind Turkey's woes, particularly the strong dollar... ... Which is a product of global policy divergence, with the U.S. stimulating while China pursues growth-constraining reforms; Chinese stimulus is important to watch, as it could change the game, but we do not expect China to save EM as it did in 2015; Turkey's troubles are a product of its late-stage populist cycle and will not end with Trump's magnanimity; The positive spin on the EM bloodbath is that it may force the Fed to slow its rate hikes, prolonging the business cycle. Feature Chart 1EM: Bloodbath Markets are selling off in Turkey and the wider EM economies (Chart 1), with the financial media focusing on the actions taken by the U.S. President Donald Trump in the escalating diplomatic spat between the two countries. Investors should be very clear what it means to ascribe the ongoing selloff to President Trump's aggressive posture with Ankara in particular and trade in general. If President Trump started EM's troubles with his tweets, he can then end them with another late-night missive. This is not our view. Turkey is enveloped in a deep morass of populism and weak fundamentals since at least 2013. What is worse, the ongoing selloff is likely going to ensnare at least the other fragile EM economies and potentially take down EM as an asset class. In this Report, we recount the pernicious macro backdrop - both geopolitical and economic - that EM economies face today. We then focus on Turkey itself and show that President Trump has little to do with the current selloff. The Bloodbath Is Afoot, Again Every financial bubble, and every financial bust, begins with a compelling story grounded in solid fundamentals. The now by-gone EM "Goldilocks Era" (2001-2011) was primarily driven by exogenous factors: a generational debt-fueled consumption binge in DM; an investment-fueled double-digit growth rate in China that kicked off a structural commodity bull market; and the unleashing of pent-up EM consumption/credit demand (Chart 2).1 These EM tailwinds petered out by 2011. Subsequently, China and EM economies entered a major downtrend that culminated in a massive commodity rout that began in 2014. But before the bloodbath could motivate policymakers to initiate painful structural reforms, Chinese policymakers stimulated in earnest. In the second half of 2015, Beijing became unnerved and injected enormous amount of credit and fiscal stimulus into the mainland economy (Chart 3). The intervention, however, did not change the pernicious fundamentals driving EM economies but merely caused "a mid-cycle recovery, or hiatus, in an unfinished downtrend," as our EM strategists have recently pointed out (Chart 4).2 Chart 2Goldilocks Era##BR##Is Over For EM Chart 3Is China About To Cause Another##BR##EM Mid-Cycle Recovery? Take Brazil, for example. Instead of using the 2014-2015 generational downturn to double-down on painful fiscal and pension reforms, the country's politicians declared President Dilma Rousseff to be the root-cause of all evil that befell the nation, impeached her in April 2016, and then proceeded to unceremoniously punt all painful reforms until after this year's election (if ever). They were enabled to do so by the "mid-cycle recovery" spurred by Chinese stimulus. In other words, Brazil's policymakers did nothing to actually deserve the recovery in asset prices but got one anyway. The country now will experience "faceoff time" with the markets, with no public support for painful reforms (Chart 5) and hardly an orthodox candidate in sight ahead of the October general election.3 Chart 4Where Are China/EM In The Cycle? Chart 5Brazil's Population Is Not Open To Fiscal Austerity Could Brazilian and Turkish policymakers be in luck, as Chinese policymakers have blinked again?4 Our assessment is that the coming stimulus will not be as stimulative as in 2015. First, President Xi's monetary and fiscal policy, since coming into office in 2012, has been biased towards tightening (Chart 6). Second, Chinese leverage has plateaued (Chart 7). In fact, "debt servicing" is now the third-fastest category of fiscal spending growth since Xi came to power (Table 1). Third, the July 31 Politburo statement pledged to make fiscal policy "more proactive" and "supportive," but also reaffirmed the commitment to continue the campaign against systemic risk. Chart 6Xi Jinping Caps##BR##Government Spending And Credit Chart 7The Rise And Plateau##BR##Of Macro Leverage Whether China's mid-year stimulus will be globally stimulative is now the question for global investors. The key data to watch out of China will be August credit numbers, to be released September 9th through 15th. Is President Trump not to be blamed at all for the EM selloff? What about the trade war against China? If anything, tariffs against China have caused Beijing to "blink" and implement some stimulative measures this summer. If one must find fault in U.S. policy, it is the double dose of fiscal stimulus that has endangered EM economies. A key theme for BCA's Geopolitical Strategy this year has been the idea that global policy divergence would replace the global growth convergence.5 Populist economic stimulus in the U.S. and structural reforms in China would imperil growth in the latter and accelerate it in the former, forming a bullish environment for the U.S. dollar (Chart 8). Table 1Total Government Spending Preferences (Under Leader's General Control) Chart 8U.S. Outperformance Should Be Bullish USD As such, the White House is partly responsible for the EM selloff, but not in any way that can be changed with a tweet or a handshake. Furthermore, we do not see the upcoming U.S. midterm election as somehow capable of altering the global growth dynamics.6 It is highly unlikely that Democrats will seek to spend less, and they cannot raise taxes under Trump. Bottom Line: EM economies have never adjusted to the end of their Goldilocks era. A surge in global liquidity pushed investors further down the risk-curve, propping up EM assets despite poor macro fundamentals. China's massive 2015-2016 stimulus arrested the bear market, giving investors a perception that EM economies had recovered. This mid-cycle hiatus, however, has now been overtaken by the global policy divergence between Washington and Beijing, which is bullish USD. President Trump's trade tariffs and aggressive pressure on Turkey do not help. However, they are merely the catalyst, not the cause, of the selloff. As such, investors should not "buy" EM on a resolution of China-U.S. trade tensions or of the Washington-Ankara diplomatic dispute. Contagion Risk BCA's Emerging Market Strategy is clear: in all episodes of a major EM selloff, the de-coupling between different regions proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside (Chart 9).7 One reason to expect contagion risk among all EM markets is that the primary export market for China and other East Asian exporters are other EM economies, particularly the commodity producers (Chart 10). As such, it is highly unlikely that East Asian EM economies will be able to avoid a downturn. In fact, leading indicators of exports and manufacturing, such as Korea's manufacturing shipments-to-inventory ratio and Taiwan's semiconductor shipments-to-inventory ratio herald further deceleration in their respective export sectors (Chart 11). Chart 9Asian And Latin American Equities:##BR##Unsustainable Divergences Chart 10EM Trades##BR##With EM Chart 11Asia Export##BR##Slowdown Is Afoot In respect of foreign funding requirements of EM economies, our EM strategists have pointed out that there is a substantive amount of foreign currency debt coming due in 2018 (Table 2), with majority EM economies facing much higher foreign debt burdens than in 1996 (Table 3).8 Investors should not, however, rely merely on debt as percent of GDP ratios for their vulnerability assessment. For example, Malaysia's private sector FX debt load stands at 63.7% of GDP, the second highest level after Turkey. But relative to total exports (a source of revenue for its indebted corporates) and FX reserves (which the central bank can use to plug the gap in the balance of payments), Malaysia actually scores fairly well. Table 2EM: Short-Term (Due In 2018) FX Debt Table 3EM Private Sector FX Debt: 1996 Versus Today Chart 12 shows the most vulnerable EM economies in terms of foreign currency private sector debt exposure relative to FX reserves and total exports. Unsurprisingly, Turkey stands as the most vulnerable economy, along with Argentina, Brazil, Indonesia, Chile, and Colombia. Chart 12BCA's Emerging Markets Strategy Has Already Pinned Turkey As The Most Vulnerable EM Economy Will the EM selloff eventually ensnare DM economies as well, particularly the U.S.? We think yes. The drawdown in EM will bid up safe-haven assets like the U.S. dollar. The dollar can be thought of as America's second central bank, along with the Fed. If both the greenback and the Fed are tightening monetary conditions, eventually the U.S. economy will feel the burn. As such, it is dangerous to dismiss the ongoing crisis in Turkey as a merely localized problem that could, at its worst, spread to other EM economies. In 1997, Thailand played a similar role to that of Turkey. The Fed tightened rates in early 1997 and largely remained aloof of the developing East Asia crisis that eventually spread to Brazil and Russia, ignoring the tumult abroad until September 1998 when it finally cut rates three times. Fed policy easing at the end of 1998 ushered in the stock market overshoot and dot-com bubble, whose burst caused the end of the economic cycle. The same playbook may be occurring today. The Fed, motivated by the strong U.S. economy and fears of being too close to the zero-bound ahead of the next recession, is proceeding apace with its tightening cycle. It is likely to ignore troubles in the rest of the world until the USD overshoots or U.S. equities are impacted directly. At that point, perhaps later this year or early next year, the Fed will back off from tightening, ushering the one last overshoot phase ahead of the recession in 2020 - or beyond. Bottom Line: Research by BCA's EM strategists shows that EM contagion is almost never contained in just a few vulnerable economies. For investors who have to remain invested in EM economies, we would recommend that they go long Chinese equities relative to EM, given that Beijing policymakers are stimulating the economy to ensure that Chinese growth is stabilized. While this will be positive for China, it is likely to fall short of the 2015 stimulus that also stimulated non-China EM. An alternative play is to go long energy producers vs. the rest of EM - given our fundamentally bullish oil view combined with rising geopolitical risks regarding sanctions against Iran.9 We eventually expect EM risks to spur an appreciation in the USD that the Fed has to lean against by either pausing its tightening cycle, or eventually reversing it as it did in the 1997-1998 scenario. This decision will usher in the final blow-off stage in U.S. equities that investors will not want to miss. What About Turkey? Chart 13Turkey: Volatile Politics, Volatile Stocks In 2013, we called Turkey a "canary in the EM coal mine" arguing that its historically volatile financial markets would mean-revert as domestic politics became turbulent (Chart 13).10 Turkey is a deeply divided society equally split between the secularist cities, which are primarily located on the Mediterranean (Istanbul, Izmir, Bursa, Adana, etc.), and the religiously conservative Anatolian interior. This split dates back to the founding of the modern Turkish Republic in the post-World War I era (and in truth, even before that). The ruling Justice and Development Party (AKP), a religiously conservative but initially pro-free-market party, managed to appeal to the conservative Anatolia while neutering the most powerful secularist institution in Turkey, its military. Investors hailed AKP's dominance because it reduced political volatility and initially promised both pro-market policies and even accession to the EU. However, the AKP has struggled to win more than 50% of the popular vote in a slew of elections and referendums since coming to power (Chart 14), a fact that belies its supposed iron-grip hold on Turkish politics since it came to power in 2002. The vulnerability behind AKP's hold on office has largely motivated President Recep Tayyip Erdogan's attempt to consolidate political power. While we disagree with the consensus view that Erdogan's constitutional changes have turned Turkey into a dictatorship, some of his actions do suggest a deep fear of losing power.11 Populist leadership is characterized by a strategy of "giving people what they want" so that the policymakers in charge remain in office. Erdogan's perpetually slim hold on power has motivated several populist policy decisions that have stretched Turkey's macro fundamentals. First, Turkey's central bank has essentially been conducting quantitative easing since 2013 via net liquidity injections into the banking system (Chart 15). Notably, these injections began at the same time as the May 2013 Gezi Park protests, which saw a huge outpouring of anti-government sentiment across Turkey's large cities. Essentially, politics has been motivating Ankara's monetary policy over the past five years. Chart 14AKP's Stranglehold On Power Is Overstated Chart 15Turkey's Populist Policies Began##BR##With Gezi Park Protests Second, Turkey's current account balance has suffered under the weight of rising energy costs, with no attempt to improve the fiscal balance (Chart 16). The government has done little in terms of structural reforms or fiscal austerity, instead President Erdogan has continued to challenge central bank independence on interest rates, despite a clear sign that the country is experiencing a genuine inflationary breakout (Chart 17). Chart 16Populism Means No Austerity Is In Sight Chart 17Genuine Inflation Breakout Overall, Turkey is a classic example of how populism in a highly divided and polarized country can get out of control. Foreign investors have long assumed that Erdogan's populism was benign, if not even positive, given the presumably ample political capital at the president's disposal. However, with every election or referendum, the government did not double-down on pro-market structural reforms. Instead, the pressure on the central bank only increased while Turkey's expensive and extravagant geopolitical adventures in neighboring Syria accelerated. In this pernicious macro context, it has not taken much to knock Turkey's assets off balance. President Trump's threats to expand sanctions to Turkish trade are largely irrelevant, given that the vast majority of Turkey's exports and FDI sources are non-American (Chart 18). However, given past behavior - such as after the shadowy Gülen "plot" to take over power or the 2016 coup d'état - markets are by now conditioned to expect that Turkish policymakers will double-down on populist policies in the face of renewed pressure. Chart 18Turkey-U.S. Relationship Is Not Economic What of Turkey's membership in NATO? Should investors fear broader geopolitical instability due to the domestic crisis? No. Ankara has used its membership in NATO, and particularly the U.S. reliance on its Incirlik air base in southern Turkey, as levers in previous negotiations and diplomatic spats with Europe and the U.S. If Ankara were to renege on its commitments to the Western military alliance, it would likely face a united front from Europe and the U.S. As such, we would expect Turkey neither to threaten exit from NATO, which it has not done in the past, nor even to threaten U.S. operations in Incirlik, which Erdogan's government has threatened before. The most likely outcome of the ongoing diplomatic spat, in fact, would be to see Ankara give in to U.S. demands, given the accelerating financial and economic crisis. Such an outcome, however, will not arrest the downturn. Turkey's economy and assets are fundamentally under pressure due to the realization by investors that this year's main macro theme is not the resynchronized global growth recovery, but rather the global policy divergence between the U.S. and China, which has appreciated the U.S. dollar. No amount of kowtowing by Ankara will change this macro trend. Bottom Line: The list of Turkish policy sins is long. Erdogan's reign has been characterized by deep polarization and populism, leading to suboptimal policy choices since at least 2013. The latest U.S.-Turkey spat is therefore merely one of many problems plaguing the country. As such, its resolution will not be a buying opportunity for investors. Investment Implications Our main investment theme in 2018 was that the global policy divergence between the U.S. and China - emblematized by fiscal stimulus in the U.S. and structural reforms in China - would end the global growth resynchronization. As the U.S. economy outperformed the rest of the world, the U.S. greenback would appreciate, imperiling EM economies. The best cognitive roadmap for today is the late 1990s, when the U.S. economy continued to grow apace as the rest of the world suffered from an EM crisis. The problems eventually washed onto American shores in the form of a stronger dollar, forcing the Fed to back off from tightening in mid-1998. Policy easing then led to the overshoot phase in U.S. equities in 1999. Investors should prepare for a similar roadmap by being long DXY relative to EM currencies, long DM equities (particularly U.S.) relative to EM equities, and tactically cautious on all global risk assets. Strategically, however, it makes sense to remain overweight equities as a Fed capitulation would be a boon for risk assets. If the current selloff in EM gets worse, we would expect that the Fed would again back off from tightening as it did in 1998, ushering in a blow-off stage in equities ahead of the next recession. Once the dollar peaks and EM assets bottom, U.S. equities will become the laggard, with global cyclicals outperforming. A secondary conclusion is that President Trump's trade rhetoric in general, and aggressive policies towards Turkey in particular, are merely a catalyst for the selloff. As such, if President Trump changes his mind, we would fade any rally in EM assets. The fundamental policy decisions that have led to the greenback rally have already been taken in 2017 and early 2018. The profligate tax cuts and the two-year stimulative appropriations bill, combined with Chinese policymakers' focus on controlling financial leverage, are the seeds of the current EM imbroglio. Finally, a small bit of housekeeping. We are booking gains on our long Malaysian ringgit / short Turkish lira trade for a gain of 51.2% since May. We are also closing our speculative long Russian equities relative to EM trade for a loss of -0.9% as a result of the persistent headwind from U.S. sanctions. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, available at gps.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Weekly Report, "Understanding The EM/China Cycles," dated July 19, 2018, available at ems.bcaresearch.com. 3 Please see BCA Emerging Markets Special Report, "Brazil: Faceoff Time," dated July 27, 2018, available at ems.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "China: How Stimulating Is The Stimulus?" dated August 8, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, and Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 7 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Sustained Decoupling, Or Domino Effect?" dated June 14, 2018, available at ems.bcaresearch.com. 8 Please see BCA Emerging Markets Strategy Special Report, "A Primer On EM External Debt," dated June 7, 2018, available at ems.bcaresearch.com. 9 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic," dated July 19, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Monthly Report, "Turkey: Canary In The EM Coal Mine?" in "The Coming Political Recapitalization Rally," dated June 13, 2013, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Weekly Report, "Turkey: Deceitful Stability," in "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com.
Highlights Without a true banking union it is impossible to have a true monetary union. The result is a fragmented monetary policy. A fragmented monetary policy with an inflexibly rigid fiscal policy is a recipe for economic and political polarization. Until the banking union is complete, policymakers must permit a more fragmented fiscal policy as a crucial economic counterbalance. Expect a multi-year narrowing in core euro area long bond yield spreads versus their counterparts in the U.K. and U.S. Extremely loose monetary policy is inappropriate for Germany and France and ineffective for Italy. If Italy's banking system does recover to full functionality, the best long-term investment play will be Italy's real estate market. The equity play is Covivio. Feature The European Monetary Union is a contradiction because European monetary policy is not united; it is fragmented. Granted, the euro area has one policy interest rate, and one currency. But monetary policy works principally through accelerations and decelerations in the broad money supply, whose main component is bank credit. It follows that when the banking system is fragmented, a genuine monetary union is elusive. Italy Is 'Yin', The Rest Of Europe Is 'Yang' Economist Richard Koo distinguishes two distinct phases of an economy, a 'yin' phase and a 'yang' phase, with the key difference being the financial health of the private sector including the all-important banking system. In a yang economy, the private sector and the banks are solvent and functional. In such an economy, the smaller and less intrusive the government, the better. Fiscal policy is ineffective because it crowds out private investment. But monetary policy is highly effective because a forward-looking private sector generates a demand for bank credit which will accelerate or decelerate according to the policy interest rate. In a yin economy, the opposite is true. The private sector and/or the banks are insolvent and dysfunctional. In such an economy, monetary policy is ineffective. No amount of depressing interest rates, central bank liquidity injections, or bond buying is able to stimulate bank lending. This is because impaired balance sheets prevent the private sector from borrowing and/or the banks from lending. But in a yin economy, fiscal policy is highly effective. Because the private sector is single-mindedly paying down debt, the government can borrow and spend these private sector debt repayments and excess savings with no danger of crowding out. Indeed in a yin economy, if the government consistently applies an appropriately sized fiscal stimulus, the economy can continue to grow at a healthy pace. Chart I-1-Chart I-6 should make it crystal clear that while Germany and France have a yang economy, Italy has a yin economy. Chart I-1Italy Has A 'Yin' Economy: ##br##Monetary Policy Is Not Effective... Chart I-2...But Fiscal Policy##br## Is Effective Chart I-3France Has A 'Yang' Economy: ##br##Monetary Policy Is Effective... Chart I-4...But Fiscal Policy##br## Is Not Effective Chart I-5Germany Has A 'Yang' Economy:##br## Monetary Policy Is Effective... Chart I-6...But Fiscal Policy ##br##Is Not Effective A Monetary Union Needs A Banking Union In Germany and France, bank credit has surged in response to the ECB's ultra-accommodative monetary policy. But in Italy, bank credit growth is almost non-existent. Through the past ten years, no amount of depressing interest rates, central bank liquidity injections, or bond buying has been able to stimulate Italy's money supply (Chart I-7 and Chart I-8). Chart I-7Italian Banks Are ##br##Not Lending... Chart I-8...Because The Italian Banking System Has##br## Been Left Undercapitalised For A Decade Furthermore, when the ECB bought Italian government bonds from investors, where did Italian investors deposit the hundreds of billions of euros they received? Not in the local Italian banks, but in German banks, which they deemed to be much safer. Italian banks are not lending, and their depositors are still very wary, because the Italian banking system has been left undercapitalized for a decade. The irony is that the ECB's bond-buying was supposed to help Italy the most, but has probably helped it the least (Chart I-9). Chart I-9The ECB's Bond-Buying Has Exacerbated##br## The Target2 Imbalances Europe's full-fledged banking union is still years away. Europe has established a single supervisor for its 130 largest banks. It has also set up a single resolution fund (SRF) to wind down failing banks in an orderly fashion. Unfortunately, the SRF's coffers will not be full for another six years.1 Until then, the SRF will not be credible to the financial markets without a backstop. A candidate to provide such a backstop would be the European Stability Mechanism (ESM), but this is work in progress. Europe also lacks a common deposit insurance scheme. Knowing that the buck stops with the national government makes depositors wary, as has been the case recently in Italy. The large international banks are keen to implement a pan-European deposit insurance scheme. But this requires a clean-up of bank balance sheets in certain countries, notably Italy. Otherwise, the prudent banks will balk at the prospect of paying for the past mistakes of their less prudent competitors. Again, this is work in progress which may take several years to complete. A Fragmented Monetary Policy Requires A Fragmented Fiscal Policy If the entire euro area economy enters a yin phase, the constituent governments are allowed to use fiscal policy to support growth. For example, when the whole euro area went into a yin phase during the debt crisis, the European Commission relaxed the normal 3% cap on government deficits, and this fiscal stimulus helped the most troubled countries to weather the storm. But what if one country enters a yin phase, while the others are still in a yang phase? For example, a 'no-deal' Brexit would hit Ireland much harder than other euro area economies. The EU budget can help to an extent but, at just 1% of Europe's GDP compared to almost 20% in the U.S., the budget is small. This might still be sufficient to help Ireland, but it is insufficient for a large economy like Italy. The ESM can also help, but the assistance arrives too late - when the troubled country has already lost market access, and thereby is in, or close to, a recession. The unfortunate truth is that without a true banking union it is impossible to have a true monetary union. The result is a fragmented monetary policy, as is the case right now. A fragmented monetary policy with an inflexibly rigid fiscal policy is a recipe for economic polarization and thereby, political polarization. Therefore, until the banking union is complete, policymakers must permit a more fragmented fiscal policy as a crucial economic counterbalance. Because ultimately, a less economically polarized euro area will be a more successful and united euro area. An important test to this thesis has now arrived, as the new government in Italy prepares next year's budget. The government must agree its fiscal plan by September and present a draft to the European Commission by mid-October. Italy was projected to reduce its structural deficit by about 0.8 percent. But given that Italy will have one of the world's lowest structural deficits in the coming years, this reduction seems unnecessarily drastic (Table I-1). Because an increase in the deficit might unnerve the markets, the optimal outcome would be to leave the structural deficit close to its current level. Table 1Italy Will Have One Of The World's Lowest Structural Deficits We end with two brief thoughts for investors. The evidence clearly shows that the ECB's extremely loose monetary policy is wholly inappropriate for the euro area's mostly yang economy and largely ineffective for Italy's yin economy. On this premise, expect a multi-year narrowing in core euro area long bond yield spreads versus their counterparts in the U.K. and U.S. Finally, if Italy's banking system does gradually recover to full health and functionality, the best long-term investment play will be Italy's real estate market, in which prices have been bid down to depressed levels due to a lack of a lack of bank financing. On this premise, the long-term equity play is Covivio. Please note that I am taking a brief summer break, so the next weekly report will come out on August 23. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 The SRF will be gradually built up during 2016-2023 and shall reach the target level of at least 1% of the amount of covered deposits of all credit institutions within the Banking Union by December 31 2023. Fractal Trading Model* We have seven open positions, so we are not adding any new trades this week. 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 Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations
Highlights China is turning moderately reflationary, but Xi's reform agenda will remain a drag on the economy, as China will not entirely abandon the "Reform Reboot" that began last October. Fiscal spending, rather than a sharp acceleration in credit growth, will dominate China's reflationary efforts, and even a strong fiscal response would involve more "soft infrastructure" than in the past. Consequently, expectations that Chinese reflation will dramatically reverse both the looming export shock as well as the underlying slowdown in China's old economy are not likely to be met. The goal of policymakers is merely to prevent a substantial, uncontrolled downturn in domestic demand. Convincing signs that China is likely to end up overstimulating in a way that results in a net positive for the global economy would cause us to advocate a more pro-cyclical investment stance. There is a small chance this may occur, but it is far from our base case view. For now, stay neutrally positioned towards Chinese stocks within a global equity portfolio, and favor low-beta sectors within the Chinese investable universe. Feature Today's Weekly Report is abridged, as we are sending you part 1 of a 2-part report written by my colleague Matt Gertken, Associate Vice President of BCA's Geopolitical Strategy (GPS) service. Last year our geopolitical team made the case that China's General Secretary Xi Jinping would double down on his reform agenda in 2018, specifically the bid to control financial risk. This view has played out quite well, and today's report presents an assessment of the likely impact of China's recent stimulus announcements along with the implications for investors. Matt's report concludes that China is turning moderately reflationary: a substantial boost to fiscal thrust, and possibly a smaller boost to credit growth, is in the works. Yet Xi's reform agenda will remain a drag on the economy, as China will not entirely abandon the "Reform Reboot" that began last October. This will be discussed next week in the second-part of the two-part series. Today's GPS report is quite timely, as the intensity of China's reflationary efforts is at the forefront of investor attention. BCA's China Investment Strategy (CIS) argued in our July 26 Weekly Report that China is taking its foot off of the brake rather than pressing the accelerator,1 meaning that so far the stimulus announced has fallen short of a substantially reflationary response that would dramatically reverse both the looming export shock as well as the underlying slowdown in China's old economy. Chart 1 shows that market signals are so far consistent with this view, at least in terms of fiscal and/or infrastructure spending. The chart shows how domestic infrastructure stocks are outperforming the broad domestic market (in response to news two weeks ago of stepped up infrastructure spending), but that their performance remains anemic relative to global stocks. Presumably, "big bang" fiscal spending in China would cause the earnings outlook for domestic infrastructure stocks to brighten considerably relative to the global average. Matt notes in today's joint report that even a strong fiscal response would involve more "soft infrastructure" than in the past, and for now investors do not seem to be betting on an intense, "hard infrastructure" boom. Chart 1The Performance Of Infrastructure Stocks Does Not Herald "Big Bang" Stimulus Chart 2At First Blush, This Implies Maximum Reflationary Efforts However, one development that is not consistent with CIS' "foot off the brake" view is the extraordinary decline in interbank interest rates that has occurred over the past month. Chart 2 shows that the 3-month interbank repo rate (China's "de-facto" policy rate) has collapsed even further than it had when we published our July 26 report which, at first blush, suggests that the PBOC has turned the policy dial to maximum reflation. Chart 3 presents a stylized view of the possible PBOC reactions to the imposition of U.S. tariff imposition against China. In scenario 1, the PBOC eases policy in a way that is proportional to the tariff-induced deterioration in the growth outlook, which would stabilize the economy but not result in an acceleration in growth from conditions in place prior to the impact of tariffs on exports. In scenario 2, the PBOC stimulates disproportionately, giving investors license to expect that monetary easing will result in a growth outcome that is net positive. Chart 3A Proportional Monetary Response To A Deceleration In Growth Isn't A Net Positive For The World As Matt notes in his report, the decline in interbank interest rates may not feed through into significantly stronger credit growth if banks are afraid to lend, which could occur as long as the Xi administration remains even partially committed to its crackdown on the financial sector. The decline in the repo rate may not reflect the PBOC's intention to forcefully stimulate credit growth via lower borrowing rates, but rather is a necessary consequence of substantially increasing liquidity in the banking system to avoid any financial system instability stemming from a major shock to exports. We agree that the collapse in the 3-month repo rate is more consistent with scenario 2 than scenario 1, although there are two important counterpoints to consider: Chart 4Possibly Due To Rising NIMs, Rather Than A Significant Acceleration In Credit Growth On the second point, the crackdown on shadow banking over the past 18 months has substantially (negatively) impacted small Chinese banks, and it is conceivable that the PBOC has acted to prevent a liquidity problem from become an outright solvency problem for some financial institutions. If true, this suggests that the extent of the decline in the repo rate may be temporary, or that policymakers will employ other tools to limit the feedthrough from lower interbank borrowing costs to lending rates in the real economy in order to limit the resulting pickup in credit growth. The latter option would, in effect, purposely engineer an expansion in bank net interest margins, a scenario that could explain the recent uptick in domestic bank relative performance without resorting to a forecast of surging credit growth (Chart 4). What does this all mean for investors? Were we to see convincing signs that China is likely to end up overstimulating in a way that results in a net positive for the global economy, we would recommend a more pro-cyclical investment stance. This could likely include the constituent assets of the China Play Index presented by my colleague Mathieu Savary, Vice President of BCA's Foreign Exchange Strategy service in his last Weekly Report,2 and we plan on employing the index as a gauge of investors' stimulus expectations. But for now, we are comfortable with our existing recommendations: investors should remain neutrally positioned towards Chinese stocks within a global equity portfolio, and should favor low-beta sectors within the Chinese investable universe. We will be monitoring the upcoming export shock as well as further policymaker responses continually over the coming weeks and months, and invite investors to come along for the ride. Stay tuned! Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Research's China Investment Strategy Special Report "China Is Easing Up On The Brake, Not Pressing The Accelerator," published July 26, 2018. Available at cis.bcaresearch.com. 2 Please see BCA Research's Foreign Exchange Strategy Weekly Report "The Dollar And Risk Assets Are Beholden To China's Stimulus," published August 3, 2018. Available at fes.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights The 2018 dollar rally is principally the consequence of the slowdown in global industrial activity and global trade, itself a reverberation of China's efforts to de-lever and reform its economy. For China, reforms and deleveraging are here to stay, suggesting the dollar rally and EM rout are not over. However, in response to U.S. President Donald Trump's trade battling, China is stimulating its economy in order to limit its own downside. The chances of miscalculation on the part of Beijing are high. This raises the risk that investors begin pricing in a much more aggressive reflation campaign. Such a reflation campaign would cause a correction in the dollar and give more lift to the current rebound in EM assets. In order to track this risk and hedge it, investors should monitor and buy a portfolio made up of iron ore, Brazilian equities, AUD/JPY, Swedish industrial equities and EM high-yield bonds. Feature Many assign the strength in the dollar this year to the Federal Reserve increasing interest rates at a faster pace than other advanced economies. While monetary divergences seems like both a historically plausible and intuitive explanation, it rings hallow. The Fed was hiking rates at a much faster pace than the rest of the world last year, yet the dollar had a horrendous 2017, falling 10%. In our view, the trend in global growth has had a much more important role in explaining the dollar's performance. When global trade and global industrial production is strong, this normally leads to a period of weakness in the dollar. The opposite also holds true; soft global growth is associated with a strong dollar (Chart I-1). Behind this relationship lies the low-beta nature of the U.S. economy. Since its economy is not as levered to exports and manufacturing as the rest of the world is, the U.S. benefits less when global growth is improving (Chart I-2). As a result, when global growth is on the up and up, investors can upgrade the economic and inflation outlook for Europe faster than they can for the U.S. In the process, long-term rate expectations rise faster in Europe than the U.S., attracting money into Europe and out of the U.S. The process can be replicated across most economies outside the U.S. This hurts the dollar. Chart I-1The Dollar Likes ##br##Poor Global Growth Chart I-2The U.S. Economy Is Less##br## Sensitive To Global Growth To understand the outlook for the greenback, it is crucial to understand the outlook for global economic activity. Many commentators have pinned the blame of slowing global growth on the back of rising protectionism. The problem with this thesis is that global growth began slowing before investors took protectionist risks seriously. Instead, in our view, the key culprit behind the global growth slowdown has been policy tightening in China. Therein lies the issue. China has slowed, and President Xi Jinping is signaling that his administration will continue to push ahead with deleveraging the Chinese economy. This should imply weaker industrial growth in China and in the rest of the world and therefore a stronger dollar. However, with protectionism on the rise, the Chinese authorities are announcing virtually every day new measures to soften the blow to the Chinese economy. This stimulus could support global growth, and hurt the dollar, at least tactically. Our Geopolitical Strategy team believes the desire to reform and de-lever the Chinese economy will ultimately prevail, and thus so will a stronger dollar. However, the growing list of stimulus measures implemented in China supports our thesis, articulated last month, that a counter-trend correction in the dollar will first materialize before the greenback rally begins anew.1 As such, we continue to recommend investors hedge their long USD bets, and that traders with a short-term horizon take advantage of a portfolio we propose in this report. China Drives Growth And Returns Differentials We have long argued that China has a disproportionate role in determining what happens to growth outside the U.S. To some extent, this argument is almost tautological: at PPP exchange rates, China produces 24% of global GDP outside the U.S. But there is more than meets the eye to this argument. China is the world largest investor, with Chinese capital investment accounting for 26% of global capital formation, or 6.5% of the world's GDP. This means that the growth rate of Chinese investment has a large direct impact on global industrial good exports around the world. There is a second-round effect as well: China is also the largest consumer of industrial commodities globally. This implies that China is the marginal consumer and thus the price-setter of many natural resources. However, commodity producers account for a large share of global capex, 10.5% from 2004 to 2017. Thus, through its impact on commodity prices, China also impacts the demand for global industrial and capital goods via the capex needs of commodity exports. This large footprint can result in some counterintuitive relationships. For example, why is it that Chinese economic variables explain so well the gyrations of French exports to Germany, its largest export market (Chart I-3)? This conundrum is explained by the fact that German economic activity is deeply affected by Chinese growth. Since German growth is the key determinant of German imports, it follows that Chinese activity plays a large role in driving French exports. This pattern gets repeated across Europe, as Germany is the leading trading partner of most European nations. China does not have the same impact on the U.S. economy (Chart I-4) as total U.S. exports only represent 13% of GDP and exports to China, a measly 0.6% of GDP. Manufacturing also only represents 11% of U.S. GDP, again limiting the impact of secondary benefits of Chinese growth on the U.S. economy. Chart I-3What Drives French Exports To Germany: China Chart I-4Chinese Growth Has Little Impact On U.S. Growth Thanks to this difference, we can spot one very useful relationship that we have highlighted to our clients for more than a year: when the Chinese authorities stimulate their economy, European growth picks up sharply vis-a-vis the U.S. (Chart I-5).2 In this optic, the growth outperformance of Europe in 2017 made perfect sense; it was a consequence of China's aggressive push to reflate after 2015. 2018 is the mirror image of 2017; European growth is underperforming as a result of China's efforts to limit growth. This also means that wherever China goes going forward, so will the growth gap between the euro area and the U.S. Chart I-5AIf European Growth Beats That ##br##Of The U.S., Thank China (I) Chart I-5BIf European Growth Beats That ##br##Of The U.S., Thank China (II) Since Chinese growth affects the distribution of economic activity around the world, China affects the distribution of rates of returns around the world as well. Nowhere is the influence of China more evident than in the spread between U.S. and global bond yields. If we accept that Chinese growth exerts a limited influence on the domestically driven U.S. economy but exerts a large impact on the rest of the world, Chinese economic fluctuations should have an implication on the relative interest rate outlook between the U.S. and the rest of the world. This is indeed the case. As Chart I-6 shows, when the growth of China's nominal manufacturing GDP slows relative to the U.S., U.S. bond yields rise relative to yields in other major economies. Since money flows where it is best treated, the impact of China on relative rates of returns and interest rates around the world should be felt in the dollar. This is also the case. When Chinese nominal manufacturing GDP growth accelerates, the dollar tends to suffer as money leaves the U.S. and finds its way into Europe, Australia, Canada, EM and so forth to take advantage of rising marginal rates of returns relative to the U.S. (Chart I-7). Chart I-6Treasurys Vs. The World Equals U.S. Nominal GDP ##br##Vs. Chinese Manufacturing Chart I-7The DXY Moves In Opposition##br## To Chinese Manufacturing Bottom Line: The U.S. economy does not benefit as much from rising Chinese economic activity as the rest of the world does. This means that U.S. relative rates of return fall when China booms and rise when China busts. This also implies that China is just as important as the Fed in determining the trend in the dollar: A strong China is associated with a weak dollar, and vice-versa. Chinese Deleveraging Is Dollar Bullish, But... Despite its large debt load, China does not have a debt problem per se. With a savings rate of 46% of GDP and a limited stock of foreign currency debt, China does not exhibit the necessary conditions to end up like Argentina or Asian economies in the late 1990s. Instead, China's problem remains misallocated capital. China's debt load has increased by USD23.6 trillion since 2008. This is a lot of capital to invest in a short time span. Poor investments have been made, resulting in excess capacity in many industries, and most crucially a collapse in total factor productivity (Chart I-8). This decline in productivity represents a real threat to China's long-term viability, especially as China's labor force is set to begin declining and its leadership wants to avoid the middle-income trap that has plagued so many EM economies in the past. In order to avoid this trap, China's long-term growth is dependent on a sustained effort to de-lever and reform. Our Geopolitical Strategy team is adamant that Xi Jinping remains committed to this agenda. Long-term growth is his priority - a luxury now made possible by his "long-term" mandate.3 The impact of reforms is most evident through the evolution of credit growth. As Chart I-9 illustrates, total social financing has been slowing. The bottom panel of Chart I-9 also illustrates that the collapse in the Chinese credit impulse has followed the implosion of bond issuance by small financial institutions. This essentially tells us that the ongoing administrative and regulatory tightening of the shadow banking system is bearing fruit: Financial institutions are curtailing their issuance of exotic instruments, which is hurting overall credit growth - even if old-school bank loans are proving resilient. Chart I-8China: Labor Force And Total Factor ##br##Productivity The Need For Reforms Chart I-9Deleveraging In ##br##Action Since credit growth is so fundamental to generating investment and supporting the country's manufacturing sector, this implies that Chinese manufacturing activity has ample downside. As a result, we would anticipate that China will continue to be a drag on the rest of the world for many more quarters. This implies that the U.S. dollar has upside, and that EM plays as well as commodity currencies are especially vulnerable. While this view seems clear, and most investors now well understand the investment ramifications of Chinese reforms and deleveraging, sand has been thrown in the wheels of this narrative. As a result, the uptrend in the dollar and the downtrend in EM assets may take a pause. Bottom Line: China needs to de-lever further and reform its economy. Without this growth strategy, the country will be stuck in the dreaded middle-income trap, as its productivity has collapsed. Since deleveraging in China means less investment and slower manufacturing sector growth, this also means that the dollar should benefit, and EM-related assets should suffer, but... ... Stimulus Is A Potent Narrative The sand in the wheels of the dollar-bullish scenario created by Chinese reforms and their retardant effect on Chinese industrial growth is, paradoxically, President Trump's trade war with China. China decided to implement reforms last year because stronger growth out of the euro area and the U.S., its two largest export markets, should have buffeted its economy against some of the deflationary consequences of deleveraging. However, if President Trump tries to limit the growth of Chinese exports to the U.S., this create yet another shock that China does not need. This makes it much more difficult for China to deal with the deflationary consequences of its own reform efforts. As a result, not only have the Chinese authorities let the yuan depreciate by 8% since April, the fastest pace of decline since the 1994 devaluation, they have also begun announcing a slew of stimulus measures over the course of recent weeks: The People's Bank of China has engaged in RMB502 billion of liquidity injections, especially through its medium-term lending facility; Three reserve requirement ratio cuts have been implemented, freeing up RMB2.8 trillion of liquidity; Local governments have been allowed to increase net new bond issuance this year by up to RMB2.2 trillion; The issuance of special purpose bonds by local governments has been accelerated; Banks with high credit quality standards can reduce provisioning for NPLs; Individual income tax cuts have been announced; And modifications to the macro prudential assessment's structural component have been announced, which will free up new lending by commercial banks. These stimulus measures are not designed to cause growth to accelerate. In fact, as Jonathan LaBerge argues in our China Investment Strategy service, they pale in comparison to the total amount of stimulus implemented in 2015, especially as back then, RMB5 trillion in credit had also been injected into the economy.4 However, a problem remains for investors. Even if these measures are far from enough to cause Chinese growth to re-accelerate, they can easily foment the following narrative: Chinese policymakers are trying to calibrate their policy response in order to support growth. However, they are human beings, and do not know a priori how much stimulus will be needed to support growth without causing credit growth to actually surge. As a result, they will push stimulus into the system until the economy responds. But once the economy responds, it will be too late, and the lagged impact of stimulus will cause a sharp rebound in credit and capex. The opacity of Chinese policy and data raises the chance that this simplification will take over the investment community. Such reversion to simplicity in the face of ambiguity and intractable complexity is a well-documented phenomenon in sociology.5 Even if this narrative is mistaken and not based in actual reality, investors who view Chinese fundamentals as bullish to the dollar and bearish to EM and commodity plays need to be ready for this eventuality. We are reluctant to close our long dollar trade based on a narrative alone. Instead, we have purchased protection by selling USD/CAD as a hedge. However, we also offer investors a mean to observe if this narrative does take hold of the market, by tracking a portfolio of assets very sensitive to the outlook for Chinese growth, and thus very sensitive to Chinese reflation. These assets are: Chinese Iron ore prices, expressed in USD; Swedish industrial equities, expressed in USD; Brazilian equities, expressed in USD; AUD/JPY; And EM high-yield bond denominated in USD. Chart I-10 illustrates the performance of a portfolio composed of these assets, weighted in such a way that they contribute equally to the variance of the portfolio. As the chart illustrates, not only is this portfolio massively oversold, suggesting there is plenty of negatives already priced into China-linked assets, it has begun to rebound. Chart I-11 illustrates that the Chinese Li-Keqiang Index of industrial activity leads this index.6 The recent rebound in the LKI already supports the idea that this portfolio could have upside in the coming months. Moreover, if investors do extrapolate that additional stimulus measures are likely to come out of Beijing, this will support even greater upside to this portfolio. Chart I-10An Index To Monitor... Chart I-11...Or A Vehicle To Bet On Impactful Stimulus As a result, we would go one step beyond suggesting this portfolio as a tracker for Chinese reflation. Investors should buy it. If you are bearish on the Chinese growth outlook, buying this portfolio offers protection against countertrend moves that would hurt long-dollar and short-EM bets (our preferred strategy). If, however, you are bullish on Chinese reflation, this portfolio should prove a very rewarding vehicle to implement such views. Bottom Line: Chinese reforms are a tailwind for the dollar. However, they are now confronted with the reality of trade wars, which is causing the Chinese authorities to stimulate their economy to put a floor under growth. Nevertheless, this exercise is fraught with calibration errors - a risk that market participants can easily uncover. This raises the probability that a countertrend correction in the dollar will emerge. To monitor this risk, we recommend investors track a portfolio of assets heavily influenced by Chinese growth: Iron ore, Swedish industrial equities, Brazilian stocks, AUD/JPY, and EM high-yield bonds. Moreover, if one is already long the dollar, this portfolio can also be used as a hedge against the risk created by investors pricing in large-scale Chinese stimulus. If one disagrees with our view that reforms will ultimately take primacy on stimulus, one can also use this portfolio as a high-octane way to play Chinese reflation. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Reports, titled "Time To Pause And Breathe", dated July 6, 2018 and "That Sinking Feeling" dated July 13, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, "ECB: All About China?" dated April 7, 2017, available at fes.bcaresearch.com 3 Please see Geopolitical Strategy Special Reports, titled "China: Looking Beyond The Party Congress" dated July 19, 2017, and "China: Party Congress Ends...So What?" dated November 1, 2017, both available at gps.bcaresearch.com 4 Please see China Investment Strategy Weekly Report, "China Is Easing Up On The Brake, Not Pressing The Accelerator" dated July 26, 2018, available at cis.bcaresearch.com 5 Smelser, Neil J. "The Rational and the Ambivalent in the Social Sciences: 1997 Presidential Address." American Sociological Review, vol. 63, no. 1, Feb. 1998, pp. 1-16. 6 The Li-Keqiang index is based on railways freight traffic, bank credit, and electricity output. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Gross Domestic Product growth underperformed expectations slightly, coming in at 4.1%, reflecting a large decline in inventories. In fact, real final sales were strong, growing at a 5.1%. The ISM manufacturing survey also came in slightly below expectations, softening to 58.1 from 60.2 in July. It is still indicative of above-trend growth. However, the Chicago PMI surprised positively, coming in at 65.5. This measure also increased form last month's reading. While the DXY was able to rally this week thanks to growing tensions between the U.S. and China, we expect the dollar to have short-term downside, as the temporary stimulus by the Chinese authorities should give an ephemeral boost to global growth, a development that would hurt the dollar. That being said, impact should ultimately prove to be transient, and the dollar. Report Links: Rhetoric Is Not Always Policy - July 27, 2018 Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area has been mixed: The yearly growth of GDP underperformed expectations, coming in at 2.1%. This also represented a decrease relative to the previous quarter. However, both core and headline inflation surprised to the upside, coming in at 2.1% and 1.1% respectively. Moreover, the European Commission's economic sentiment indicator also outperformed to the upside, coming in at 112.1. However, this measure decreased from last month's reading. EUR/USD was relatively flat for most of the week until a wave of risk aversion prompted by worries of a Sino-U.S. trade war took hold of the market, lifting the dollar in the process. In a mirror image to our dollar view, we expect the euro to have upside in the next couple of months, but resume its downward trajectory by the end of the year. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Retail sales yearly growth beat expectations, coming in at 1.5%. Moreover, the jobs-to-applicants ratio also surprised to the upside, coming in at 1.62. However, the unemployment rate surprised negatively, coming in at 2.4% and increasing from last month's number. However, this reflected an increase in the participation rate. Finally, the consumer confidence index also underperformed expectations, coming in at 43.5. USD/JPY has risen by roughly 0.5% this week after it became clear that the BoJ only marginally adjusted its policy, in a way that only confirmed its highly dovish bias. Interestingly, while the spike in JGB yields has reverberated across global bond markets, it has not been able to provide a boost for the yen. While we expect the trade-weighted yen to appreciate by the end of this year as Chinese policymakers still want China to de-lever, a period of interim weakness is possible as the PBoC tries to buffet the Chinese economy against the impact of U.S. protectionism. Report Links: Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: The Nationwide house price index yearly growth rate outperformed expectations, coming in at 2.5%. This measure also increased relatively to last month's number. Moreover, PMI construction also surprised to the upside, coming in at 55.8, and increasing from last month's reading. However, Markit manufacturing PMI underperformed expectations, coming in at 54. GBP/USD was relatively flat this week, but ultimately experienced a large fall following the hike by the BoE as investors began to worry that the "old lady" is making a policy error that will need to be reversed. Overall, we remain negative on cable, as the ability for the BoE to continue on their hiking campaign will be limited given the current political turmoil in Britain. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been mixed: Building permit yearly growth outperformed expectations, coming in at 1.6%. Moreover, producer prices also surprised positively, coming in at 1.5%. However this measure decreased compared to last month's reading. Finally, the RBA Commodity Index SDR yearly growth surprised to the downside, coming in at 7.6%. AUD/USD fell this week as market wrestle with the risk to global growth created by the China-U.S. trade war. Overall, we continue to be negative on the Aussie on a cyclical basis, as this currency is the most exposed in the G10 to a slowdown in the Chinese industrial sectors. That said, a bout of stimulus in China could provide some short-term upside to AUD. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: Employment growth surprised to the upside, coming in at 0.5%. However, this measure slowed from last month's reading. Moreover, the participation rate outperformed expectations, coming in at 10.9% and increasing from last month's number. However, the unemployment rate underperformed expectations, coming in at 4.5% and increasing from last month's reading. NZD/USD experienced a large fall this week. We are negative on the NZD on a cyclical basis, as tightening by both China and the U.S. along with trade tensions will provide for a toxic cocktail for small open economies like New Zealand. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mixed: Industrial production month-mon-month growth outperformed expectations, coming in at 0.5%. Moreover, Monthly GDP growth also surprised positively, coming in at an annualized rate of 0.5%. However, the Markit Manufacturing PMI underperformed expectations, coming in at 56.9. This measure also declined relative to last month's number. The CAD is the only currency that managed to appreciate against the USD this week, despite a rather pitiful performance for crude oil. This dynamics comforts in our tactical bullish stance on the loonie. In fact, this pair is our preferred vehicle to play the countertrend correction in the U.S. dollar. Meanwhile, on a cyclical basis we are positive on the Canadian dollar within the commodity complex. Not only do supply constraint within OPEC will help oil outperform base metals, but also, the BoC is the only central bank within this group that is currently lifting interest rates. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: The KOF leading indicator underperformed expectations, coming in at 101.1, and declining relatively to last month's reading. However, retail sales yearly growth surprised to the upside, coming in at 0.3%. Finally, the SVME Purchasing Manager's Index also surprised positively, coming in at 61.9, and increasing from last month's number. EUR/CHF has been relatively flat this week. On a long term basis, we are bullish on this cross, as inflationary pressures are still very weak in Switzerland. Therefore, the SNB will maintain its ultra-dovish stance, hurting the franc in the process. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK rallied vigorously this week. While the generalized dollar strength has been key culprit behind the depreciation of the NOK, the fall in oil prices only added fuel to the fire. Overall, we expect this cross to go up by the end of the year, as the interaction of Chinese and U.S. policy will likely push up the USD and weigh on commodities. That being said, the NOK will probably outperform within the commodity space, given that it is cheap and that supply cuts by OPEC should help oil prices on a relative basis. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been mixed: Retail sales yearly growth surprised to the downside, coming in at 0.2%, and declining substantially, from 3.1% last month. However, the annual growth rate of GDP outperformed expectations, coming in at very strong 3.3%. This measure stayed flat relative to the first quarter. Finally, Manufacturing PMI came in at 57.4, increasing from last month's number. USD/SEK still rallied this week as the SEK is particularly sensitive to the outlook for global growth. We are positive on the Swedish Krona on a long-term basis, as Sweden is the country in the G10 where monetary policy is most misaligned with economic fundamentals. Thus, if the Sweden continues to show strength, the Riksbank will eventually have to respond. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights A flurry of policy announcements over the past month has given investors the impression that Beijing has turned the policy dial in the direction of supporting growth. We agree that China is easing at the margin, but several observations suggest that the stimulus proposed so far falls short of a "big bang" response that would reverse both the looming export shock as well as the underlying slowdown in China's old economy. Investors should remain neutrally positioned towards Chinese stocks within a global equity portfolio, and should favor low-beta sectors within the Chinese investable universe. Feature There have been several policy-related announcements over the past month in China. This has led many market participants to question whether China is in the process of entering full-blown stimulus mode, and if we are on the cusp of another upswing in Chinese economic activity. Our answer to both questions is, for now, no. China appears to merely be easing off the brake, rather than pressing hard on the accelerator. Given that export growth will certainly slow to some degree due to the imposition of import tariffs, and that an industrial sector slowdown was already underway in China prior to President Trump's protectionist actions, it is far from clear that any stimulus will be a net positive for the country's "old economy". In other words, stimulus may counteract an upcoming export shock, but we would need to see more evidence before concluding that it will lead to a renewed cyclical uptrend in China's economy. A Flurry Of Policy Announcements... Several policy actions, announcements, and signals have occurred over the past month: The RMB has fallen nearly 6% since mid-June, which we have argued has been at least partially policy-driven. As we highlighted in our June 27 report,1 the decline in CNY/USD has been large, has occurred very rapidly, and cannot be explained by its previous relationship with the U.S. dollar (Chart 1). The PBOC cut its reserve requirement ratio for both big and small banks at the end of June, following the cut in April (Chart 2). It also provided incentives for banks to buy speculative-rated corporate bonds, clarified that its new asset management rules would permit mutual funds to invest in non-standard assets, and recently injected 500 billion RMB of liquidity into the banking system via its medium-term lending facility (MLF). Chart 1An Enormous, At Least Partially Policy-Driven Move Chart 2A Second Cut To Bank Reserve Requirement Ratios The Ministry of Finance (MOF) signaled that it would speed up spending that was planned to occur later in the year, and the State Council signaled that it would accelerate the issuance of 1.4 trillion RMB in local government bonds to support infrastructure investment. It also green-lighted a comparatively small 6.5 billion RMB in tax cuts for corporate R&D. China's legislature released a draft version of proposed tax changes that would cut the rate paid for individuals. The flurry of policy announcements over the past month has given investors the impression that Beijing has turned the policy dial in the direction of supporting growth. We agree that China is easing at the margin, and that these policy announcements are important: without them, the Chinese economy would likely face a substantial deceleration that would risk a serious slowdown in global growth. ...That Will Not Cause A Material Re-Acceleration In The Economy But several observations suggest that the stimulus proposed so far falls short of a "big bang" response that would reverse both the looming export shock as well as the underlying slowdown in China's old economy: Fiscal Stimulus: Chart 3 shows that China's on-budget deficit expanded by 3 percentage points over an 18-month period from 2014 to 2016. An equivalent expansion today would imply a 2.6 trillion RMB rise in the budget deficit, meaning that the local government bond issuance announced on Monday is 40% smaller than the deficit expansion that occurred from 2014 to 2016. If the infrastructure projects financed by these bonds turn out to be multi-year initiatives tied to China's structural reform plans, the intensity of this round of fiscal stimulus will likely turn out to be less than half, or even a fraction, of what occurred previously. Fiscal Vs. Credit Expansion: While an increase in fiscal spending was important in catalyzing an economic recovery in 2014/2016, Chart 4 highlights that the expansion of credit was considerably larger. The chart shows on-budget fiscal spending and the change in adjusted total social financing (TSF) as a percent of GDP, and highlights that the latter dwarfs the former. By our calculations, adjusted TSF accelerated by 5 trillion RMB from 2015 to 2016, which from our perspective could only have been achieved by very aggressive monetary easing. Currency Depreciation: A simple framework that equates the equilibrium/required currency depreciation to the size of the tariffs imposed as a share of total exports to the U.S. suggests that a 6% decline in CNY/USD may be adequate at negating an export shock if the proposed tariffs stop after the recently proposed new round of 10% tariffs on $200 billion worth of goods. But first, this approach suggests that a further 6-7% decline may be needed if President Trump follows through with his threat to impose tariffs on all imports from China. Second, in either case the currency decline merely addresses the prospective export shock, not the underlying slowdown in China's old economy that has been occurring over the past year. Chart 3Bond-Financed Infrastructure Spending Unlikely To Match 2015's Fiscal Expansion Chart 4Three Years Ago, The Expansion In Credit Dwarfed That Of Fiscal Spending From our perspective, China's monetary policy actions have so far been the most convincingly stimulative developments in response to the threat to exports. We downplayed China's most recent reserve requirement ratio cut in our June 27 Weekly Report,1 and we acknowledge that this initial assessment was overly pessimistic. Chart 5 shows that the 3-month repo rate, China's de-facto policy rate, has broken meaningfully below the lower band that had prevailed since the beginning of 2017. This suggests that the targeted addition of liquidity, particularly to China's small banks, was at least somewhat effective at easing financial conditions. Chart 5The PBOC Has Successfully Lowered The 3-Month Repo Rate... Chart 6...But This Is Unlikely to Significantly Drop Average Lending Rates Still, we remain unconvinced that what has been announced so far is likely to generate an acceleration in credit growth even approaching what occurred three years ago. Chart 6 shows the weighted average lending rate in China, alongside a simple regression model for the rate based on the benchmark lending rate and the 3-month interbank repo rate (China's "old" and "de-facto new" policy rates, respectively). The chart highlights the likely minimal impact of the recent decline in the repo rate on the average lending rate. In fact, Chart 6 underscores an important point about China's stimulus in 2014-2016: a good portion of that episode's reflationary impact appears to have been caused by the PBOC's 170 bps cut to its benchmark lending rate, which has so far remained unchanged (without any hint from policymakers that it might be lowered). Finally, we are similarly underwhelmed by the PBOC's incentives to banks to buy "junk" corporate bonds: debt securities are a small (albeit fast growing) portion of China's total nonfinancial credit, and junk-rated bonds are a small fraction of that market. We thus see this announcement as an attempt to provide some marginal liquidity support for issuers of these bonds that have upcoming refinancing requirements, rather than a policy of any true macro significance. Conclusions And Investment Strategy Recommendations Two important insights emerge from our above analysis. The first is that the intensity and timing of the infrastructure projects alluded to by the State Council are important factors in determining the likely impact of increased government spending. We suspect that any boost to the economy over the coming year from infrastructure spending will be relatively small, but this will be an important element to monitor over the coming months. The second insight is that we would become considerably more constructive towards China's economy were the PBOC to cut its benchmark lending rate. This would be clear sign that the China is pressing on the accelerator, rather than attempting to simply "fine tune" the economy in the face of an external economic shock. For now, however, our view is that the stimulative measures that have been announced are not likely to lead to a renewed cyclical uptrend in China's economy. This implies that investors should remain neutrally positioned towards Chinese stocks within a global equity portfolio, and should favor low-beta sectors within the Chinese investable universe. Chart 7 shows that the latter position, which we initiated on June 27, has risen almost 1% in relative terms over the past month, and we expect further gains over the remainder of the year. Finally, we noted in our July 5 Weekly Report that the selloff in Chinese domestic stocks was advanced,2 and that we would consider implementing a long MSCI China A Onshore index / short MSCI China index trade in response to a 5% rally in relative common currency performance. It is conceivable that "easing off the brake" will be enough for A-shares to rally non-trivially relative to investable stocks, given how much they have fallen since the beginning of the year. Chart 8 shows that A-shares have approached this threshold in response to recent stimulus announcements, but have yet to break through. We will be watching relative A-share performance closely over the coming weeks for a green light to initiate the position. Stay tuned! Chart 7Low-Beta Sectors Are Outperforming China's Investable Market Chart 8Conditions May Soon Warrant A Pair Trade Favoring Domestic Stocks Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see China Investment Strategy Weekly Report "Now What?", dated June 27, 2018, available at cis.bcaresearch.com 2 Pease see China Investment Strategy Weekly Report "Standing On One Leg", dated July 5, 2018, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Highlights Subdued long-term inflation expectations and central bank bond purchases have suppressed the term premium. This is set to change, as quantitative easing turns into quantitative tightening and shrinking output gaps around the world start to push up inflation. The neutral rate in the U.S. is likely higher than the Federal Reserve realizes, which could leave the Fed behind the curve in normalizing monetary policy. A spike in the term premium is unlikely this year, given the prospect of a stronger dollar and ongoing stresses in emerging markets. Next year may be a different story, however. Fixed-income investors with a 12-to-18 month horizon should maintain duration risk at below-benchmark levels. Asset allocators should keep equity and credit exposure at neutral. Within the equity space, investors should favor developed market equities over their EM peers and defensive sectors over cyclicals. Feature The Mystery Of The Falling Term Premium The yield on a bond can be decomposed into the expected path of short-term rates and a term premium. Historically, the term premium has been positive, meaning that investors could expect to earn a higher return by purchasing a bond rather than by rolling over a short-term bill.1 More recently, the term premium has turned negative in many economies (Chart 1). Not only are investors willing to forego the extra return for taking on duration risk, but they are actually willing to sacrifice return when buying long-term bonds. Chart 1Term Premia Across Developed Markets Are Low There are two main reasons why the term premium has fallen: Long-term inflation expectations have been very subdued, which has made bonds a hedge against bad economic outcomes. Central bank purchases have depressed yields, while forward guidance has dampened interest-rate volatility. Bonds And Risk Some commentators like to describe the riskiness of a security by how volatile its price is, or if they want to get a bit more sophisticated, the skew of its returns. But this is not really the right way to think about risk. As Harry Markowitz first discussed in 1952 in his seminal paper "Portfolio Selection," investors ultimately care about their overall level of wealth. If the price of a certain security goes up when the prices of all others go down, investors should prefer to hold this particular security even if it offers a subpar expected return. Bonds today play the role of this safe security. Chart 2 shows the rolling correlation between monthly changes in the 10-year Treasury bond yield and the S&P 500. The correlation was generally negative between the late-1960s and late-1990s: Bond yields back then tended to rise whenever the S&P 500 was falling. This made bonds a bad hedge against lower equity prices. Chart 2Bond Yields Now Tend To Rise When Equity Prices Go Up Over the past two decades, however, bond yields have generally declined whenever the stock market has swooned. Since a lower bond yield implies a higher bond price, bonds have been a good hedge against equity risk in particular, and a weaker economy in general. As a consequence, investors are now willing to pay a premium to hold long-term bonds. This has bid up the price of bonds, so much so that the term premium has dipped into negative territory. Receding Inflation Fears Have Made Bonds Safer Why did the correlation between bond yields and stock market returns change? The answer has a lot to do with what happened to inflation. Bond yields can go up because of expectations of stronger growth or because of the anticipation of higher inflation. The former is good for equities, while the latter is typically bad for equities because it heralds additional monetary tightening. As inflation expectations became increasingly unhinged in the second half of the 1960s, inflationary shocks became the dominant driver of bond yields. When bond yields went up during that period, stock prices usually fell. That changed in the 1990s, as inflation stabilized at low levels and growth became the primary driver of yields once again (Chart 3). Chart 3Long-Term Inflation Expectations Have ##br##Remained Subdued For Over Two Decades Following the financial crisis, inflationary concerns were supplanted by worries about deflation. Falling inflation is generally good for bond investors. If inflation declines, the real purchasing power of a bond's interest and principal payments will go up. For investors who have to mark-to-market their portfolios, the benefits of lower inflation are especially clear. A decline in inflation will take the pressure off central banks to hike rates. This will cause the price of existing bonds to rise, delivering an immediate capital gain to their holders. Moreover, to the extent that falling inflation expectations typically accompany rising worries about the growth outlook, investors will benefit from a decline in the expected path of real interest rates. QE And The Term Premium While falling inflation expectations have been the most important driver of the decline in the term premium, central bank asset purchases have also lent a helping hand. In standard macroeconomic models, bond yields are determined at the margin by the willingness of private investors to hold the existing stock of debt. If a central bank buys bonds, this reduces the volume of bonds that the private sector can hold. To induce private investors to hold fewer bonds, bond yields must decline. There is no consensus about how much quantitative easing has depressed bond yields. A Fed study published in April of last year estimated that QE had depressed the 10-year yield by 100 basis points at the time of writing, a number that the authors expected to decline to 85 basis points by the end of 2017.2 Other studies found that the peak impact on yields has ranged from 90-to-200 basis points. One thing that is empirically undeniable is that there is a large international component to bond yields. The steep decline in the U.S. term premium in 2014 was mainly driven by the expectation - ultimately proven correct - that the ECB would launch its own QE program. Asset purchases by the Bank of Japan, along with its yield curve control policy, also contributed to lower bond yields in the rest of the world. Things are beginning to change, however (Chart 4). The Fed is now letting its balance sheet shrink by about $40 billion per month, a number that will rise to $50 billion in October. The Bank of England has kept its holdings of gilts and corporate bonds constant for over a year, while the ECB intends to start tapering asset purchases later this year. The Bank of Japan continues to buy assets, but even there, the pace of annual purchases has fallen from about 80 trillion yen in 2015-16 to 35 trillion at present. Meanwhile, the use of forward guidance - which was arguably even more instrumental in suppressing interest rate volatility and pushing down the term premium than QE - is likely to be scaled back, at least in the United States. Fed Chair Powell said on May 25: "I think [forward guidance] will have a significantly smaller role going forward." Incoming New York Fed President John Williams echoed this sentiment, noting in a Bloomberg interview that "I think this forward guidance, at some point, will be past its shelf life."3 Opening The Fiscal Spigots Just as central banks are purchasing fewer bonds in the open market, bond issuance is set to rise. Usually the U.S. budget deficit narrows whenever the unemployment rate declines, as strong economic growth draws in more tax revenue and spending on social programs drops (Chart 5). Things are different this time around. The Congressional Budget Office (CBO) expects the U.S. budget deficit to increase from 2.4% of GDP in 2015 to 4.6% of GDP in 2019. Chart 4From Quantitative Easing To ##br##Quantitative Tightening Chart 5Unlike In The Past, The U.S. Budget Deficit Is Set To Widen Even ##br##If The Unemployment Rate Continues To Decline The Trump tax cuts have imperiled the long-term fiscal outlook. Up until last year, the U.S. fiscal picture appeared much better than it once did. In 2009, the amount of federal debt held by the public was projected to exceed 250% of GDP in 2046. By 2016, that forecast had been reduced to 113% of GDP, thanks mainly to the economic recovery and slower projected spending growth on health care following the introduction of the Affordable Care Act (Chart 6). The Trump tax cuts have blown those forecasts out of the water. We estimate that government debt held by the public will increase to almost 190% of GDP in 2046 if current policies are maintained. Chart 6Trump Tax Cuts Have Put Debt Trajectory ##br##Back On An Unsustainable Path While the stock of debt, rather than the flow, determines bond yields in the standard bond pricing model, flows can still matter if they provide a reliable signal as to how large the stock of debt will be in the future. Given that changes in fiscal policy are often hard to reverse, the deterioration in the fiscal outlook suggests that the stock of government debt will be much larger than investors had expected a few years ago. This justifies a higher term premium today. Broken Accelerator? Subdued inflation expectations have kept the term premium in check, but the prospect of ill-timed fiscal stimulus raises doubts about whether this state of affairs will persist. What would happen to inflation if the economy found itself in an overheated state for a prolonged period of time? The truth is that no one really knows the answer to that question. Some prominent economists have contended that nothing terrible would transpire. They argue that the entire concept of the Non-Accelerating Inflation Rate of Unemployment (NAIRU) is passé. In their view, the magnitude of economic slack determines the level of inflation, not the rate of change in inflation. Recent data provides some support to their views. Shrinking output gaps in much of the world during the past eight years have failed to raise inflation by very much, let alone cause inflation to accelerate to the upside (Chart 7). If an overheated economy simply results in modestly higher inflation, rather than increasing inflation, central banks have little to fear. A bit more inflation would allow central bankers to target a higher nominal interest rate, thus giving them greater scope to cut rates in the event of an economic downturn. Higher inflation could also improve labor market flexibility by permitting real wages to fall in the presence of nominal wage rigidities.4 In addition, as we have argued in the past, modestly higher inflation could make the financial system less susceptible to asset bubbles.5 Unfortunately, the case for letting the economy overheat is not so straightforward. For one thing, the relationship between inflation and unemployment tends to be non-linear. As Chart 8 illustrates, an economy's aggregate supply curve is likely to be quite shallow when there is a lot of excess capacity but rather steep when most of the slack has been absorbed. We may simply have not yet reached the steep side of the aggregate supply curve. Chart 7Developed Markets: Inflation Has Remained ##br##Low Despite Shrinking Output Gaps Chart 8Inflationary Pressures Tend To Increase ##br##When Spare Capacity Is Absorbed The experience of the late 1960s illustrates this point. Core inflation was remarkably stable during the first half of the decade, even as the unemployment rate continued to drift lower. In economic parlance, the Phillips curve was very flat. However, once the unemployment rate fell below 4%, core inflation took off, rising from 1.5% in early 1966 to nearly 4% in 1967 (Chart 9). Inflation ultimately made its way to 6% in 1970, three years before the first oil shock struck. Anchors Away The upward trend in inflation observed during the 1970s underscores another point, which is that there is no unique mapping between the unemployment rate and inflation. To use a bit of economic jargon, not only does the slope of the Phillips curve vary depending on what the unemployment rate is, but the intercept of the curve could potentially move up or down in response to changes in long-term inflation expectations (Chart 10). Chart 9Inflation In The 1960s Took Off Once ##br##The Economy Began To Overheat Chart 10An Increase In Inflation Expectations Can ##br##Cause The Phillips Curve To Shift Upwards Chart 11Market Expectations Versus The Fed Dots This is a point that Milton Friedman and Edmund Phelps made more than fifty years ago. Friedman and Phelps argued that central banks could only stimulate the economy if they delivered more inflation than people were anticipating. Higher-than-expected inflation would push down real interest rates, leading to more spending. As the two economists correctly noted, however, such an outcome would only occur if people systematically underestimated what inflation would end up being. If people made inflation forecasts in a fairly rational manner, the apparent trade-off between higher inflation and lower unemployment would evaporate: Inflation would rise, but output would not be any greater than before. One of the errors that central banks made in the 1970s is that they kept interest rates too low for too long in the mistaken belief that slower growth was the result of inadequate demand rather than a decline in the growth rate in the economy's productive capacity and a higher equilibrium rate of unemployment. Today, the error may be in thinking that the neutral rate of interest is lower than it really is. As we argued several weeks ago, cyclical factors have probably pushed up the neutral rate quite a bit over the past few years.6 Neither the Fed dots nor market pricing are adequately discounting this possibility (Chart 11). Inflation is a notoriously lagging indicator. It typically does not peak until after a recession has begun and does not bottom until the recovery is well underway (Chart 12). By the time the Fed realizes it is behind the curve, inflation could already be substantially higher. The fact that the New York Fed's Underlying Inflation Gauge - which leads core CPI inflation by about 18 months - has risen to over 3% provides some evidence in support of this view (Chart 13). Chart 12Inflation Is A Lagging Indicator Chart 13Upside Risks To U.S. Inflation Investment Conclusions A sudden increase in the term premium could set in motion a vicious circle where bond yields rise and the stock market falls at the same. In such a setting, bonds would lose much of their appeal as a hedge against equity drawdowns. This could put even more upward pressure on the term premium, leading to even lower stock prices. Chart 14 shows that the MOVE index, a measure of implied volatility for the Treasury market, remains near historically low levels. Just as investors were too complacent about the possibility of an equity volatility spike earlier this year, they are too complacent about the possibility of an increase in bond volatility. Chart 14Investors Are Too Complacent Getting the timing of any change in the term premium is critical, of course. It often takes a while for an overheated economy to generate inflation. The unemployment rate fell nearly two percentage points below its full employment level in the 1960s before inflation took off. The U.S. economy is only now starting to boil over. Moreover, if the dollar continues to strengthen over the coming months, as we expect, this could put downward pressure on commodity prices. Thus, we do not foresee a major inflation-induced spike in the term premium this year. Next year may be a very different story. If inflation ratchets higher in 2019, the term premium could jump. The resulting tightening in financial conditions could pave the way for a recession in 2020. Fixed-income investors with a 12-to-18 month horizon should maintain duration risk at below-benchmark levels. We downgraded global equities and credit exposure to neutral last month. Within the equity space, investors should favor developed market equities over their EM peers and defensive sectors over deep cyclicals such as industrials and materials. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Note that the term premium and the slope of the yield curve are different concepts. The slope of the yield curve measures the difference in yields between two maturities at any given point in time. In contrast, the term premium measures the difference between the return on a long-term bond and the return an investor would receive by rolling over a short-term bill over the life of that bond. Unlike the slope of the yield curve, which can be observed directly, the term premium has to be estimated using market expectations of the future path of short-term rates. 2 Please see Brian Bonis, Ihrig, Jane, and Wei, Min, "The Effect of the Federal Reserve's Securities Holdings on Longer-term Interest Rates," FEDS Notes, Federal Reserve (April 20, 2017); Edison Yu, "Did Quantitative Easing Work?" Economic Insight, Federal Reserve Bank of Philadelphia Research Department (First quarter 2016); and "Unconventional Monetary Policies -- Recent Experience And Prospects," IMF (April 18, 2013). 3 Jeanna Smialek, "Powell Sees Significantly Smaller Role for Fed Forward Guidance," Bloomberg (May 25, 2018); and Jeanna Smialek, "The Incoming New York Fed Chief Talks About Inflation and the Yield Curve," Bloomberg (May 16 2018). 4 A low-inflation environment can have adverse economic consequences during economic downturns due to the presence of downward rigidity of nominal wages. Firms typically try to reduce costs when demand for their products and services declines, but employers tend to be unwilling or unable to cut nominal wages. In this context, higher inflation provides a potential way to overcome nominal wage rigidity as it helps real wages to adjust to negative shocks. When inflation is low, real wages become less flexible, making it more likely that firms will opt for job cuts as a means to decrease overall costs. 5 Please see Global Investment Strategy Weekly Report, "Tinbergen's Ghost," dated May 11, 2018. 6 Please see Global Investment Strategy Weekly Report, "U.S. Housing Will Drive The Global Business Cycle... Again," dated July 6, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades