Geopolitics
Highlights An Italian referendum 'no' is not really revolting. Some people are voting no for no change to the current constitution's vital checks and balances. Lean against any knee-jerk widening of the Italian sovereign yield spread versus France that followed a no vote. Lean against any knee-jerk rally in Italian banks that followed a yes vote. A 50bps spike in the JPM Global Government Bond Yield in just 3 months is normally a bad omen for risk-asset performance. Retain a cautious stance to risk-assets on a 3-month horizon. Feature After shock victories for Brexit and Donald Trump at the polls, a 'no' vote in Italy's December 4 referendum on constitutional reform would be the next worrying sign of a growing grassroots revolt against the establishment. Or would it? An Italian 'No' Is Not Really Revolting The votes for Brexit or Donald Trump were clearly votes for change. At first glance, an Italian no would also look like a revolt, with the potential to trigger political uncertainty and instability in the euro area's third largest economy. Chart of the WeekItalian Banks Are Tracking Japanese 'Zombie' Banks The truth is more nuanced. Clearly, some Italians are voting no to reject Prime Minister Renzi. But others - including former Prime Minister Mario Monti - are voting no for no change. These voters want to leave in place the current constitution's vital checks and balances. If Italians vote yes to constitutional reform, the upper house of parliament - the Senate - would be relegated to an advisory chamber. Meanwhile, an already approved new electoral law for the lower house of parliament - the Chamber of Deputies - hands an automatic 55 percent majority of seats to the largest party. Some people fear that this combination would amount to excessive executive power. So they are voting no to mitigate the danger. Granted, a no vote might also force Renzi to resign, but this would not necessarily trigger new elections. President Sergio Mattarella would likely explore options for a new government - perhaps a technocratic government - which the parties in the current governing coalition have a strong incentive to support until the next elections are due in 2018. Even if there were early elections, it is improbable that they would result in a government led by the populist 5 Star Movement. If 5 Star was the largest party, it would hold a 55 percent majority of seats in the lower house, but only 30 percent in the upper house, in proportion to its popular vote share (Chart I-2). Therefore, it could not form a government. Under the current constitution, the government needs the support of both houses. The irony is that a yes vote - by giving the executive excessive powers - would make it more likely for a populist party like 5 Star to form a government in 2018 or beyond. Still, even this might prove a tall order. Italy's constitutional court is reviewing the electoral law change that gives 55 percent of lower house seats to the largest party. The court will likely demand more proportionality, making it hard for any one party to win an outright majority. This means more coalition governments, which 5 Star rejects. Hence, an Italian no will not be the equivalent of the Brexit vote or U.S. election of Donald Trump. Fears that it will unleash a dangerous phase of populism and political instability in Italy are overblown. Yet in the last three months, the Italian sovereign yield spread has widened sharply versus France (Chart I-3). Note also that the 65-day fractal dimension of the Italy versus France sovereign bond performance is close to its technical limit, indicating excessive pessimistic groupthink. Chart I-2The 5 Star Movement Could Not Form A ##br##Government Under The Current Constitution Chart I-3Italy's Political Risk Premium Has ##br##Increased, But Is It Justified? If December 4 brings a no vote in the Italian referendum combined with the election of a far-right President of Austria - whose role is largely ceremonial - the knee-jerk market response might still be fright. In which case, a further widening in the Italy/France yield spread would be a tactical entry opportunity, given that political risk is overstated. Fixing Italian Banks Needs A 'Deep-V' Or A 'Long-L' The real question in Italy is not about an imminent populist backlash. The real question is what does the cure for Italy's banking malaise look like? The answer is either a 'deep-V', meaning a banking crisis forces a quick workout; or a 'long-L', meaning no banking crisis but a very long struggle back to normal health. As an investor, neither seems particularly appealing. Italy's banking malaise has built up stealthily, generating frequent financial tremors but without an outright crisis. In contrast, the housing-related credit booms in Ireland, Spain, the U.K. and the U.S. did eventually cause housing busts and full-blown financial crises - requiring urgent government-led and central bank-led bailouts. Today, Italian banks' non-performing loans (NPLs) account for 18% of gross lending, and NPLs net of provisions equal 85% of equity capital. A few years ago, Irish banks looked even worse. Irish NPLs peaked at 25% of gross lending in 2013 and net NPLs peaked at 100% of equity capital. Following government bailouts Irish banks have recovered well (Chart I-4 and Chart I-5). Likewise, the Spanish government created a 'bad bank' in 2012 to offload bank NPLs. Subsequently, Spanish banks' NPLs as a share of gross lending has almost halved. Chart I-4Ireland Looked Worse Than Italy##br## For NPLs As A Share Of Loans Chart I-5Ireland Looked Worse Than Italy ##br##For NPLs As A Share Of Capital Compared to Ireland and Spain, Italy's avoidance of outright crisis (thus far) appears a blessing. Unfortunately, it is now a curse. In waiting so long, Italy cannot follow Ireland, Spain, the U.K. and the U.S. in their escapes from their banking woes. The EU Bank Recovery and Resolution Directive (BRRD), which came into full force on January 1 2016, has blocked the bailout escape route. The BRRD does allow state intervention in a banking crisis. But the overarching aim is to protect banks' critical functions and stakeholders, specifically: payment systems, taxpayers and depositors. Therefore, in a banking crisis "other parts may be allowed to fail in the normal way... after shares in full... then evenly on holders of subordinated bonds and then evenly on senior bondholders." For bank investors, this would constitute the 'deep-V' cure: likely intense pain up-front albeit with much better long-term prospects thereafter. Alternatively, without a crisis, the process to recognise and expunge NPLs would be largely up to the private sector and markets. But a long chain of events from the repossession of assets under bankruptcy law, to valuation, to full divestment from the banks' balance sheets could take years. Indeed, the Chart of the Week shows a striking parallel between Italian bank profits and Japan's 'zombie' bank profits, if we lag the Japanese experience by 17 years. Japan perfectly illustrates this alternative 'long-L' cure: no outright crisis, just a long and seemingly never-ending struggle back to normal health. Either way, absent any further information, we would lean against any knee-jerk rally in Italian banks that followed a yes vote on December 4. What Happens When Bond Yields Spike? Turning to the broader financial markets, a bigger concern is the impact that sharply higher bond yields will have on growth and/or on risk-asset valuations. Higher long-term borrowing costs depress credit growth as captured in the credit impulse (Chart I-6 and Chart I-7). A depressed credit impulse then almost always drags down subsequent GDP growth. The recent spike in U.S. 15-year and 30-year mortgage rates has already caused mortgage refinancing applications to plunge by 40% since July (Chart I-8). Chart I-6Higher Bond Yields Depress##br## Credit Growth In Europe... Chart I-7...And In ##br##The U.S. Chart I-8Mortgage Applications##br## Have Plunged Prior to the current incidence, a 50bps rise in the JPM Global Government Bond Yield in just 3 months has occurred only eight times this century (Chart I-9). Table I-1 lists those eight occasions and the subsequent 3-month performance of the equity market. On three out of the eight occasions, the equity market rose modestly, but on the other five it fell. Chart I-9The Bond Yield Has Spiked Table I-1What Happens When Bond Yields Spike? But perhaps the most interesting finding is that on all eight occasions, the equity market's subsequent 3-month performance consistently deteriorated, on average by -7%, compared to the preceding 3-month performance. For reference, today's preceding 3-month performance is just 0.7%. Given this evidence, it is prudent to retain a cautious stance to risk-assets on a 3-month horizon. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* The Italy versus France sovereign bond underperformance indicates excessive pessimistic groupthink. However, in this instance we would wait until after Italy's December 4 referendum on constitutional reform before initiating the countertrend trade. 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 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations
Recommended Allocation The Meaning Of Trump Sudden large shocks in markets are rare. But the election of Donald Trump as U.S. President is one such. After a shock of this magnitude, markets tend initially to overreact, then correct, before settling on a new course. Market action since November 9th has caused many asset prices to overshoot short term. It is likely that U.S. bond yields, inflation expectations, the performance of bank and materials stocks, and the U.S. dollar (Chart 1) will correct over the next month or so, perhaps triggered by the Fed's likely rate hike on December 14th or simply by shifting expectations for Trump's economic policies. But what is the likely long-term course, which should set our asset allocation for the next 6 to 12 months? We think investors should take Trump at least partly at his word when he says he will enact tax cuts and increase infrastructure investment. BCA's Geopolitical Strategy service sees few constraints on Trump from Congress in the short term.1 The OECD in its latest Economic Outlook has given its imprimatur, arguing that "a stronger fiscal policy response is needed," and estimating that U.S. fiscal stimulus could add 0.1 percentage point to global growth next year and 0.3 points in 2018.2 If such a policy boosted growth and inflation, it would be negative for bonds. The only question, with 10-year U.S. Treasury bond yields having already risen by almost 100 bps since July, is how much of this is priced in. In the long run, government bond yields are broadly correlated with nominal GDP growth (Chart 2). In H1 2016, U.S. nominal GDP growth was 2.7%, and for 2016 as a whole probably about 3.2%. If it picks up to 4-5% in 2017 (2.5-3% real, plus inflation of 1.5-2%), an additional rise of 50-100 bps in the 10-year yield would not be surprising (though ECB and BoJ asset purchases might somewhat limit the rise in yields). Moreover, growth was already accelerating before Trump's victory. The effects of 2015's commodity shock and industrial and profits recessions have passed, with U.S. Q3 GDP growth revised up to 3.2% and the Fed's NowCasting models suggesting 2.5%-3.6% for Q4. The Citi Economic Surprise Index has surprised on the upside in recent weeks both in the U.S. and Europe - though not in emerging markets (Chart 3). And the Q3 earnings season in the U.S. was well above expectations, with EPS coming in at +3.3% YoY (compared to a consensus forecast pre-results of -2.2%). Analysts' forecasts for 2017 EPS growth are a comparatively modest 11%. Chart 1Some Short-Term Overshoots Chart 2Bond Yields Relate To Nominal Growth Chart 3Growth Was Already Surprising On The Upside But whether this new world will be positive for equities is harder to answer. Trump's unpredictability raises policy uncertainty: how much emphasis, for example, will he put on trade protectionism or confrontational foreign policy? This should raise the risk premium. The Fed's response will also be key. Futures have now priced in the rate hike in December and (almost) the two further rate hikes in the Fed's dots for 2017 (Chart 4). But the market still sees the long-term equilibrium rate (as expressed in five-year five-year forwards) as only just over 2%, compared to the Fed's 2.9%. And, although Janet Yellen has suggested that the Fed will act only after Trump's policies take effect ("We will be watching the decisions that Congress makes and updating our economic outlook as the policy landscape becomes clearer," she said), if core PCE inflation continues to pick up in 2017 beyond the current 1.7% and a strong stimulus package is implemented, the Fed might accelerate its rate hikes. More worryingly, Trump's fundamental views on monetary policy are unknown: does he, as a businessman, like low rates, or will he listen to his "hard money" advisers who believe the Fed has been too lax? Since he can appoint six FOMC governors in his first year in office, he will be able to influence monetary policy. Too fast a rise in Fed rates would be negative for equities. On balance, in this environment we see equities outperforming bonds over the next 12 months. It is unusual for the stock-to-bond ratio to decline outside of a global recession (Chart 5) - and, with the extra boost from fiscal policy (with Trump possibly joined by Japan, the U.K., China and others), a recession is unlikely over our forecast horizon. Chart 4Market Has Priced In 2017 Fed Hikes - ##br##But Not The Long-Term Chart 5Stocks Don't Often ##br##Underperform Outside Recession Accordingly, we are raising our recommendation for global equities to overweight, and lowering bonds to underweight. The problem is timing: we recognize that there may be a better entry point over the next couple of months. Some investors may, therefore, want to implement the change gradually. In addition, some recent market moves are not fundamentally justified: for example, we cannot see how the materials sector would be a significant beneficiary from a Trump fiscal stimulus. We plan to make further detailed adjustments to our equity country and sector recommendations and bond-class recommendations in the next Quarterly Portfolio Update, to be published on December 15th. Currencies: Stronger U.S. growth and tighter monetary policy suggest that the USD will continue to appreciate. The dollar looks somewhat expensive but is still well below the peak of overvaluation at the end of previous bouts of strength in 1985 and 2002. The Bank of Japan's policy of capping the 10-year JGB yield at 0% has worked well (pushing the yen down by 12% against the dollar in the past two months) and, as rates elsewhere rise, this implies further long-run yen weakness. The euro is likely to weaken less, with eurozone growth recently surprising on the upside and the ECB therefore likely to reconsider the amount of asset purchases at some point next year, though probably not at its meeting on December 8th. Emerging market currencies continue to look particularly vulnerable. Equities: In common currency terms, U.S. equities are more attractive than European ones. In local currency terms, however, the call is closer since the strong dollar will depress U.S. earnings relative to those in Europe, and an acceleration of global economic growth should help the more cyclical eurozone stock market. On the other hand, Europe faces structural issues, such as the chronically poor profitability of its banking system, and political risk from a series of upcoming elections (starting with the Italian referendum on December 4th). We continue to like Japan (on a currency hedged basis) and expect that the BoJ's policy will be bolstered by government fiscal and employment policies. We remain underweight on emerging markets. They have always been vulnerable during periods of dollar strength, and political side-effects from their bout of economic weakness in 2011-5 are starting to spread, recently to Turkey, Malaysia, India, Brazil, Korea and South Africa. Fixed Income: The risk of tighter Fed policy and higher yields suggest investors should remain underweight duration. We have liked U.S. TIPS over nominal bonds all year and, with 10-year breakeven inflation still only at 1.8%, they remain attractive in the current environment. We reduced high-yield bonds to neutral on September 30th, on the grounds that investors were no longer being sufficiently compensated for default risk: they have subsequently given -3% return, while equities rallied. We recommend investment grade credits for those investors who need to pick up yield (Chart 6). Commodities: After the OPEC agreement on production cuts, we expect the oil price to move towards $55 in the first few months of 2017 as inventories are drawn down. Over the longer run the risk is to the upside as a dearth of new projects, following cancellations last year, will tighten the supply/demand balance. Metals prices have strengthened since Trump's victory, with the CRB Raw Industrials Index up sharply (Chart 7). This makes little sense. Trump's stimulus will be centered on tax, not infrastructure. China remains a far more important factor: the U.S. represented only 7% of global steel consumption in 2015, for example, compared to 43% for China. And China's recent stimulus is running out of steam. Chart 6Yield On Investment Grade Credits ##br##Still Attractive Chart 7Trump Shouldn't Have ##br##This Much Effect On Metals Prices Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Geopolitical Strategy Special Report,"U.S. Election: Outcomes and Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 2 Please see OECD Global Economic Outlook, November 2016, available at http://www.oecd.org/economy/outlook/economicoutlook.htm. Recommended Asset Allocation
Highlights The pace of globalization is slowing, reflecting the culmination of a decades-long process of integrating China and other emerging economies into the international trading system. Most commentators overstate the benefits of globalization, while glossing over the increasingly large distributional effects. A modest retreat from globalization would not irrevocably harm global growth, but a full-fledged trade war certainly would. Investors are underestimating the likelihood of disruptive trade measures from a Trump administration. Tactically underweight global equities. U.S. large cap tech stocks will suffer the most from a turn towards trade protectionism and from the curtailment of H-1B visa issuance under Trump's immigration plan. EM stocks could also come under pressure. Treasurys are oversold, but the structural trend for bond yields remains to the upside. The trade-weighted dollar could rally another 5% from current levels. And Take Your Damn Trump Hat With You If there is one sure way to get thrown out of a Davos party, it is by telling the assembled guests that globalization is not all that it is cracked up to be. After all, don't all cultured people know that globalization has made the world vastly richer? Well, maybe it has, but the evidence is not nearly as clear-cut as most people might imagine. Twenty years ago, the consensus among economists and policymakers was that international capital mobility should be strongly encouraged. Poor countries had a myriad of profitable investment opportunities, but lacked the savings to finance them, so the argument went. The solution, they were told, was to borrow from wealthier countries, which had a surfeit of savings. In the early 1990s, everything seemed to be going to plan. Emerging markets were running large current account deficits, using the proceeds from capital inflows to finance all sorts of investment projects. And then the Peso Crisis struck. And then the Asian Crisis. And just as quickly as the money came in, it came straight out. The result was mass defaults and depressed economies. Since then, most emerging economies have been trying to maintain current account surpluses - exactly the opposite of what theory would predict. Not to worry, the experts reassured us. What happened in emerging markets could not happen to developed economies with their strong institutions and sophisticated methods for allocating capital. The global financial crisis and later, the European sovereign debt crisis, put these claims to shame. Faced with this reality, the IMF published an official report in 2012 acknowledging that "rapid capital inflow surges or disruptive outflows can create policy challenges." It concluded that "there is ... no presumption that full liberalization is an appropriate goal for all countries at all times."1 This was a stunning about-face for an institution that, among other things, had sharply criticized Malaysia for imposing capital controls in 1998. Diminishing Returns To Globalization In contrast to capital account liberalization, the case for free trade in goods and services stands on sturdier ground. That said, proponents of free trade tend to overstate the benefits. As Paul Krugman has noted, the widely-used Eaton-Kortum model suggests that only about 5% of the increase in global GDP since 1990 can be attributed to higher trade flows.2 Moreover, it appears that the benefits to middle class workers in advanced economies from globalization have fallen over time. This is partly because trade liberalization, like most aspects of economic life, is subject to diminishing returns. Chart 1 shows that each succeeding round of trade liberalization has resulted in ever-smaller declines in average tariff rates. With tariffs on most tradeable goods now close to zero in the U.S. and most other advanced economies, there is less scope to liberalize trade further. As a result, proposed trade deals such as the Trans-Pacific Partnership (TPP) have focused on harmonizing business regulations and expanding patent and copyright protections. To call these deals "free trade agreements" is a stretch. Chart 1Tariffs Have Little Room To Decline Further Granted, many "invisible" barriers continue to stymie trade. John Helliwell has documented that a typical firm in Toronto generates roughly ten times as much sales from customers in Vancouver as it does from a similarly-sized, equidistant city in the U.S. such as Seattle.3 As it turns out, differences in legal systems and labor market institutions across countries, as well as differing social networks, can be as important an obstacle to trade flows as tariffs and quotas. But think about what this implies: If globalization were the key to economic development, then Canada, as a small economy situated next to a much larger neighbour, could prosper by dismantling these massive invisible trade barriers. However, we know that this proposition cannot be true: Canada is already a very rich economy, so any further trade liberalization would only boost incomes at the margin. What's Behind The Trade Slowdown? The analysis above helps put the much-discussed slowdown in global trade into context (Chart 2). As the IMF concluded in its most recent World Economic Outlook, while much of the deceleration in trade growth is attributable to cyclical factors, structural considerations also loom large.4 In particular, the boost to global trade over the past few decades stemming from the collapse of communism, the progressive elimination of most trade barriers, and the decision by most developing economies to abandon import-substitution policies appears to have run its course (Chart 3). In addition, the regional disaggregation of the global supply chain is slowing. These days, motor vehicle parts are shipped across national borders many times over before the final product rolls off the assembly line. The manufacturing process can only be broken down so much before diminishing returns set in. Chart 2Global Trade ##br##Growth Is Slowing Chart 3The Low-Hanging Fruits Of ##br##Globalization Have Been Picked Productivity gains in the global shipping industry are also moderating. As Marc Levinson argued in his book "The Box," the widespread adoption of containerization in the 1970s completely revolutionized the logistics and transportation industry. As a consequence, the days when thousands of longshoremen toiled in the great ports of Baltimore and Long Beach are long gone. Nowadays, huge cranes move containers off ships and place them into waiting trucks or trains. To the extent that there are still technological advances on the horizon - think self-driving trucks - these are likely to reduce intranational transport costs more than international costs. This could result in even slower trade growth by encouraging onshoring. Trade And Income Distribution Chart 4China's Rise Came Partly At ##br##The Expense Of U.S. Rust Belt Workers As every first-year economics student learns, David Ricardo's Theory of Comparative Advantage predicts that real wages will rise when countries specialize in the production of goods that they can manufacture relatively well. Students who stick around (and manage to stay awake) for second-year economics might learn about the Heckscher-Ohlin model. This model qualifies Ricardo's findings. Yes, free trade raises average real wages, but there can be large distributional effects. In particular, low-skilled workers could actually suffer a decline in real wages when rich countries increase trade with poorer countries. As trade ties between advanced and developing countries have grown, these distributional issues have become more important. David Autor has documented that increasing Chinese imports have had a sizable negative effect on manufacturing employment in the U.S. (Chart 4).5 It is thus not surprising that voters in Rust Belt states were especially receptive to Donald Trump's protectionist rhetoric. A Tale Of Two Globalizations: China Versus Mexico Most economists agree that trade liberalization has disproportionately benefited developing economies. Nevertheless, there too the benefits are often overstated. China, of course, is frequently cited as an example of a country that has prospered by integrating itself into the global economy. But what about Mexico? It also made a massive push to liberalize trade starting in the mid-1980s, which culminated in NAFTA in 1994. As a consequence, the ratio of Mexican exports-to-GDP rose from 13% in 1994 to 35% at present. Yet, as Chart 5 shows, GDP-per-hour worked has actually declined relative to the U.S. over this period. One key reason why China benefited more from globalization than Mexico is that China had a much better educated workforce. This allowed it to quickly absorb technological know-how from the rest of the world, setting the stage for the spectacular growth of its own domestic industries. Sadly, when it comes to human capital, China is more the exception than the rule across developing economies (Chart 6). Chart 5Trade Liberalization Has Not ##br##Improved Mexico's Relative Productivity Chart 6Educational Achievement ##br##In Emerging Economies: China Stands Out Noble... And Not So Noble Lies To be clear, the discussion above should not be interpreted as arguing that globalization is bad for growth. Trade openness does matter for economic development. However, other things, such as the level of human capital and the quality of domestic economic institutions, matter even more. How can one reconcile this view with the near-apocalyptic terms in which many commentators discuss the anti-globalization sentiment sweeping across many developed economies? Let me suggest two explanations: one noble, one less so. The noble explanation goes beyond economics. Proponents of trade liberalization often argue that the 1930 Smoot-Hawley Tariff Act was a leading cause of the Great Depression. On purely economic grounds, this argument makes little sense. Exports accounted for less than 6% of U.S. GDP in 1929. While trade volumes did fall rapidly between 1929 and 1932, this was mainly the result of the economic slump, rather than the cause of it. In fact, trade volumes actually fell more in the immediate aftermath of the 2008 financial crisis (Chart 7). Yet, from a political perspective, the importance of Smoot-Hawley is hard to deny. At a time when Nazi Germany was on the rise, the U.S. and its allies were squabbling over trade issues. As such, the main problem with Smooth-Hawley was not that it pushed the U.S. into a Depression, but that it sabotaged diplomatic coordination at a time when it was most needed. One suspects that something similar underlies much of the angst over Trump's trade policies. The Global Trade Alert, currently the most comprehensive database for all types of trade-related measures imposed since the global financial crisis, shows an increase in protectionist measures over the last few years (Chart 8). The risk is that this trend will accelerate after Donald Trump is sworn in as President. Chart 7Global Trade Fell More ##br##During The Great Recession Chart 8Protectionist Measures ##br##Are On The Rise Considering that globalization ran into diminishing returns some time ago, a modest unwinding of globalization would probably not have the calamitous impact that many fear. However, just like a plane that fails to fly sufficiently fast will fall to the ground, a "modest unwind" may prove difficult to achieve in practice. Globalization, in other words, may be approaching stall speed. And given the large number of issues that require global cooperation - terrorism, migration, climate change - that is a risk which requires attention. Money Talks If that were all to the story, it would be easy to forgive those who overstate the economic benefits from globalization in order to preserve the political ones. One suspects, however, that there may also be a self-serving motive at work. The integration of millions of workers from China and other developing economies into the global labor market has put downward pressure on wages, boosting profit margins in the process. Not surprisingly, CEOs, hedge fund managers, and other titans of industry have benefited greatly from this development. Chart 9 shows that most of the increase in income equality since 1980 has occurred not at the 99th percentile, but at the 99.99th percentile and higher. It would be naïve to think that the colossal gains that some have enjoyed from globalization would not color what they say on the subject. Chart 9The (Really) Rich Got Richer Investment Conclusions U.S. equities have been in rally mode since the election. Many aspects of Trump's agenda are good for stocks - corporate tax cuts, deregulation, and fiscal stimulus, just to name a few. These factors make us somewhat constructive on equities over a long-term horizon. Chart 10Tech Stocks Are Heavily ##br##Exposed To Globalism Nevertheless, it cannot be denied that Trump's anti-globalization rhetoric represents a direct threat to corporate earnings. While some of Trump's protectionist proposals will undoubtedly be watered down, investors are underestimating the likelihood of disruptive trade measures. Unlike on most issues where he has flip-flopped repeatedly, Trump has consistently espoused a mercantilist view on trade since the 1980s. He is also the sort of person that strives to reward his supporters while disparaging those who slight him. Rust Belt voters awarded Trump the presidency. Their loyalty will not be forgotten. This means the stock market's honeymoon with Donald Trump may not last much longer. We remain tactically cautious global equities and are expressing that view by shorting the NASDAQ 100 futures. Globally-exposed large cap tech stocks will suffer the most from a turn towards trade protectionism and from the curtailment of H1-B visa issuance under Trump's immigration plan (Chart 10). Emerging market equities are also likely to feel the heat from rising protectionist sentiment in developed economies. A stronger dollar will only add to EM woes by putting downward pressure on commodity prices and making it more expensive for EM borrowers to service dollar-denominated loans. As we discussed in "A Trump Victory Would Be Bullish For The Dollar" and "Three Controversial Calls: Trump Will Win, And The Dollar Will Rally," the three key elements of Trump's policy agenda - fiscal stimulus, tighter immigration controls, and higher tariffs - are all inflationary, and hence are likely to prompt the Fed to raise rates more than it otherwise would.6 Higher U.S. rates, in turn, will keep the greenback well bid. We expect the real trade-weighted dollar to strengthen another 5% from current levels. The flipside of a stronger dollar is increasing monetary policy divergence between the U.S. and the rest of the world. U.S. bond yields have risen significantly since the election. Tactically, we would not be adding to short duration positions at current levels. Structurally, however, the 35-year bond bull market is over. As we discussed in our latest Strategy Outlook,7 weak potential GDP growth is eroding excess capacity around the world, which is bad news for bonds. Population aging could also shift from being bullish to bearish for bonds, as more people retire and begin to draw down their savings. Meanwhile, central banks are looking for ever more creative ways to boost inflation, while the populist wave is forcing governments to abandon austerity measures. Lastly, and most relevant to this week's discussion, globalization - an inherently deflationary force - is in retreat. This, too, suggests that the longer-term risks to inflation are to the upside. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see "The Liberalization And Management Of Capital Flows: An Institutional View," IMF Executive Summary, November 14, 2012. 2 Paul Krugman, "The Gains From Hyperglobalization (Wonkish)," The New York Times, October 1, 2013. 3 John F. Helliwell and Lawrence L. Schembri, "Borders, Common Currencies, Trade And Welfare: What Can We Learn From The Evidence?" Bank of Canada Review, Spring 2005. 4 Please see "Global Trade: What's behind the Slowdown?" in "Subdued Demand: Symptoms and Remedies," IMF World Economic Outlook (October 2016). 5 David Autor, David Dorn, and Gordon Hanson, "The China Syndrome: Local Labor Market Effects Of Import Competition In The United States," The American Economic Review, Vol. 103, No. 6, (2013): pp. 2121-2168. 6 Please see Global Investment Strategy Weekly Report, "A Trump Victory Would Be Bullish For The Dollar," dated June 3, 2016, and Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com 7 Please see Global Investment Strategy, "Strategy Outlook Fourth Quarter 2016: Supply Constraints Resurface," dated October 7, 2016, available at gis.bcaresearch.com Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Investors are betting that Trump's expansionary agenda will not be torpedoed by his less market-friendly policies such as trade protectionism. We have some sympathy for this view, but believe that investors should remain cautious on risk assets until we receive more clarity on the sequencing of Trump's wish list and how aggressively he will pursue fiscal expansionism relative to trade and immigration reform. We doubt that Trump's fiscal and regulatory plan will place the U.S. economy on a permanently higher growth plane. Many of the growth headwinds that existed in the U.S. before the election remain in place. We expect that Trump will find most common ground with Congress on the fiscal side. It will be difficult, politically, for Republicans in the Senate and House to stand in Trump's way given that he has just been elected on a populist platform. We expect a meaningful fiscal stimulus package to be passed in the U.S. that will boost growth temporarily. We cannot rule out a trade war that more than offsets the fiscal impulse. Nonetheless, Trump's desire for growth means that he may tread carefully on protectionism. A window may open next year that will favor risk assets for a period of time. A temporary U.S. growth acceleration in late-2017/early 2018 would lift the equity and corporate bond boats. Our bias is to upgrade risk assets to overweight, but poor value means that the risk/reward tradeoff is underwhelming until we get more visibility on the new Administration's policy intentions. In the meantime, remain at benchmark in equities, overweight the dollar and below-benchmark duration in fixed-income portfolios. The bond selloff is likely to pause until there is more concrete evidence that Congress will accept tax cuts and infrastructure spending, but global yields eventually have more upside potential. Value and relative monetary policies favor the Japanese and European stock markets versus the U.S., at least in local currencies. We are less bearish on high-yield bonds in relative terms, although we are still slightly below-benchmark. Feature Initial fears that a Trump victory would be apocalyptic for the economy and financial markets quickly morphed into an equity celebration on hopes that the Republican sweep would usher in policies that will shift American growth into high gear. Major U.S. stock indexes have broken above recent trading ranges, despite the surge in the dollar and the devastation in bond markets. Investors are betting that Trump's expansionary policies will not be torpedoed by his less market-friendly policies such as trade protectionism. We have some sympathy for this view, but believe that investors should remain cautious on risk assets until we receive more clarity on the sequencing of Trump's wish list and how aggressively he will pursue fiscal expansionism relative to trade and immigration reform. In the meantime, investors should remain long the dollar and short duration within bond portfolios, although a near-term correction of recent market action appears likely. Our geopolitical strategists argued through the entire campaign that Trump had a better chance of winning than the consensus believed because he was riding a voter preference wave that is moving left. Trump campaigned as an unorthodox Republican, appealing to white, blue collar voters by blaming globalization for their job losses and low wages, and by refusing to accept Republican (GOP) orthodoxy on fiscal austerity or entitlement spending. Chart I-1Big Government Is Only ##br##A Problem For The Opposition The polarization of U.S. voters and comparisons with the U.K. Brexit vote are well trodden themes that we won't rehash here. The important point is that the GOP now holds both the White House and Congress. The investment implications hinge critically on how friendly Congress is to Trump's policy prescriptions. Many pundits argue that House and Senate Republican's will block Trump's ambitious tax cut and infrastructure spending plan because it would blow out the budget deficit. The reality is more complex. It will be difficult politically for Republicans in the Senate and House to stand in Trump's way given that he has just been elected on a populist platform; it would be seen as thwarting the will of the people. Our post-election Special Report pointed out that, over the past 28 years, each new president has generally succeeded in passing their signature items.1 Moreover, the GOP is less fiscally conservative than is widely believed. Fiscal trends under the Bush and Reagan administrations highlighted that Republicans do not always keep spending in check (Chart I-1). The key pillars of Trump's campaign were renegotiating trade deals, immigration reform, increased infrastructure and defense spending, tax cuts, protecting entitlements, repealing Obamacare and reducing regulations. However, there is a big difference between election promises and what can actually be delivered. It is early going, but our first Special Report, beginning on page 19, presents a Q&A from our geopolitical team on what we know in terms of political constraints and possible outcomes in the coming year. Common Ground On Fiscal Policy We expect that Trump will find most common ground with Congress on the fiscal side. Infrastructure spending has bipartisan support, as highlighted by last year's highway funding bill. Democratic senators and House Republicans have promised to work with the new President on infrastructure spending. Trump is likely to offer tax reform in exchange for his infrastructure plan. Trump wants to cut the top marginal corporate tax rate (from 39.6% to 33%), repeal the Alternative Minimum Tax, and slash the corporate tax rate (from 35% to 15%). His plan also includes increased standard deduction limits and a full expensing of business capital spending. The Tax Policy Center estimates that Trump's tax plan alone would increase federal debt by $6.2 trillion over the next ten years (excluding additional interest).2 An extra $1 trillion in infrastructure outlays over the next decade, together with a growing defense budget, could add another $100-$200 billion to total federal spending per year. The problem, of course, is that few sources of new revenue have been suggested to cover the costs of these policy changes. The Tax Policy Center's scoring of the Trump plan implies a jump in the U.S. debt/GDP ratio from 77% today to 106% in 2026. Other studies claim that the budget damage will be far less than this because government revenues will boom along with the economy. We doubt that will be the case. The outlook for U.S. trade policy is even more nebulous. Trump has threatened to kill the Trans-Pacific Partnership (TPP), renegotiate the North American Free Trade Agreement (NAFTA) and potentially place tariffs of 35% and 45%, respectively, on imports from Mexico and China (among other protectionist measures). He has even threatened to take the U.S. out of the WTO.3 These threats are no more than posturing ahead of negotiations, but Trump needs to show his base of support that he is working to "make America great again". Protectionism will probably generate more pushback from Republicans in the House and Senate than Trump's fiscal measures. The Economic Implications Of Trumponomics Table I-1Ranges For U.S. Fiscal Multipliers In terms of the overall economic impact, there are many moving parts and it is unclear how much the Trump Administration will push fiscal stimulus versus trade protectionism. As discussed in the Special Report, it is possible that the tax cuts will be implemented as quickly as the second quarter of 2017, while infrastructure spending could begin ramping up in the second half of the year. However, we cannot rule out a lengthy bargaining process that would delay the economic stimulus into 2018. We doubt that Trump will get everything on his wish list. Moreover, the multiplier effects of tax cuts, which will benefit the upper-income classes the most, are smaller than for direct government spending (Table I-1). Nevertheless, even if he gets one quarter of what he is seeking, it could be enough to boost aggregate demand growth by up to 1% per year over a two year period. In terms of trade, Trump will undoubtedly kill the TPP immediately following his inauguration to show he means business. The President also has the power to implement tariffs without Congressional consent. It is unclear whether he can also cancel NAFTA unilaterally, but at a minimum he can impose higher tariffs and trade restrictions on Canada and Mexico. Nonetheless, comments from his advisors suggest that president-elect Trump wants stronger growth above all else. This means that he may tread carefully to avoid the negative growth effects of a trade war. Some high-profile studies of the impact of the Trump economic plan paint a grim picture. The Peterson Institute points out that "withdrawal from the WTO would lead to the unraveling of all tariff negotiations and the reversion of rates to the MFN level of a preexisting agreement, conceivably all the way back to the Smoot-Hawley rates that were in effect in 1934." Another Peterson study reported the results of a simulation of the impact of returning to the Smoot-Hawley tariff levels, using a large general equilibrium global model.4 They find that U.S. real GDP would contract by about 7½%, or roughly $1 trillion. Thus, a "doomsday trade scenario" is possible, but it seems inconceivable that Trump would withdraw from the WTO given his desire for growth. More likely, he will settle for higher tariffs placed on Mexico and China. Such tariffs would undermine U.S. growth on their own, but we believe that some recent studies discussed in the press overstate the negative impact of these tariffs. Back-of-the-envelope estimates suggest that the tariff increases would reduce U.S. real GDP by roughly 1.2%, including retaliation by Mexico and China in the form of higher tariffs on U.S. exports (see Box I-1 for more details). The negative shock would likely be stretched over a couple of years.5 Box 1 Importantly, not all of any tariff increase would be "passed-through" to U.S. businesses and households. Studies show that, historically, the pass-through of tariff increases into U.S. prices was actually quite low, at about 0.5. A large portion of previous tariff hikes have been absorbed by foreign producers as they endeavored to protect market share. This means that a 35% tariff on Mexican imports would result in a roughly 17½% rise in import prices from Mexico. A 45% tariff on Chinese goods would result in a 22½% rise in import prices from China. Moreover, the import price elasticity of U.S. demand, or the sensitivity of U.S. demand to a change in the price of imported goods, is estimated to be about 1. That is, a 22½% rise in import prices from China leads to a 22½% drop in import volumes from that country. Roughly one-half of the drop in imports is replaced by purchases from other countries and one-half from U.S. sources. This so-called "expenditure switching" effect actually boosts U.S. real GDP on its own. Of course, this lift is more than offset by the fact that households and businesses suffer a loss of purchasing power due to higher import prices. Chinese and Mexican imports represent 2.7% and 1.7%, respectively, of U.S. GDP. With these figures and the elasticities discussed above, we can calculate a back-of-the-envelope estimate of the impact of the Trump tariffs. The expenditure switching effect would boost U.S. real GDP by about 0.4%. This is offset by the purchasing power effect of -0.7% (including a multiplier of 1.5), leaving a net loss of only 0.3%. Of course, China and Mexico will retaliate by imposing higher tariffs on U.S. exports. This has a larger negative impact on the U.S. because American export volumes decline and there is no offsetting expenditure-switching effect. We estimate that retaliation with equal tariffs on U.S. exports would reduce U.S. GDP by about 1% using reasonable elasticities. Adding it all up, the proposed Trump tariffs on China and Mexico would result in a roughly 1.2% hit to U.S. real GDP. This could overstate the negative shock to the extent that the tariff revenues are spent by the U.S. government.6 Moreover, some studies of the Trump agenda assume that business spending would wither under a stronger dollar, waning business confidence and higher interest rates. We are not so pessimistic. The threat of punitive measures is likely to dissuade some U.S. companies from moving production abroad. Ford announced that it had abandoned plans to shift production of its luxury Lincoln SUV from Kentucky to Mexico. On the flipside, the fear of losing access to the U.S. market might persuade some foreign companies to relocate production to the United States. Such worries were a key reason why Japanese automobile companies began to invest in new U.S. production capacity starting in the 1980s. Moreover, U.S. corporate capital spending has been lackluster since the Great Recession due to "offshoring". Higher tariffs would promote "onshoring", helping to lift capital spending within the U.S. economy. We are not arguing that trade protectionism will be good for the U.S. economy. We are merely pointing out that there are positive offsets to the negative aspects of protectionism, and that many studies are overly pessimistic on the impact on growth. That said, all bets are off if Trump does the unthinkable and cancels NAFTA outright and/or takes the U.S. out of the WTO. The Fed's Reaction The economic and financial market dynamics over the next couple of years depend importantly on how the Fed responds to the Trump policy mix. We are not worried about central bank independence or Janet Yellen's future. Donald Trump has, at various times, both praised and attacked the Fed Chair and current monetary policy settings. A review of the Fed may happen at some point, but we assert that an investigation will not be a priority early in Trump's mandate. Some have raised concerns that Trump could stack the FOMC with hawks when he fills the openings next year. More likely, he will opt for doves because he will not want a hawkish Fed prematurely shutting down the expansion. The studies that warn of a major U.S. recession under Trump's policies assume that the Fed tightens aggressively as fiscal stimulus lifts the economy's growth rate. For example, the Moodys' report assumes that the fed funds rate rises to 6½% by 2018!7 No wonder Moodys' foresees a downturn that is longer than the Great Recession. No doubt, it would have been better if fiscal stimulus arrived years ago when there was a substantial amount of economic slack. With the economy close to full employment today, aggressive government pump-priming could set the U.S. up for a typical end to the business cycle; overheating followed by a Fed-induced recession. Indeed, many investors are wondering if the U.S. is overdue for a recession anyway. The current expansion phase is indeed looking long-in-the-tooth by historical standards. However, the old adage is apt: "expansions don't die of old age, they are murdered by the Fed". In Charts I-2A, Chart I-2B and Chart I-2C, we split the U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from the medium and long expansions is the speed by which the most cyclical parts of the economy accelerate, and the time it takes for the unemployment rate to reach a full employment level. Long expansion phases were characterized by a drawn-out rise in the cyclical parts of the economy and a slow return to full employment in the labor market, similar to what has occurred since the Great Recession (Chart I-2C). Chart I-2ALong Chart I-2BMedium Expansions Chart I-2CA Short Expansion Of course, the Fed did not begin to tighten policy immediately upon reaching full employment in the past. The Fed began hiking rates an average of 13 months after reaching full employment in the short cycles, 30 months for medium cycles, and more than 60 months in the "slow burn" expansions (Table I-2). Even if we exclude the 1960s expansion, when the Fed delayed for too long and fell behind the inflation curve, the Fed has waited an average of 45 months before lifting rates in the other long expansions (beginning in 1982 and 1991). The longer delay compared to the shorter expansions reflected the slow pace at which inflationary pressures accumulated. During these periods, inflation-adjusted earnings-per-share (EPS) expanded by an average of 25% and the real value of the S&P 500 index increased by 28%. Table I-1U.S. Expansions Can Last Long After Full Employment Is Reached The lesson is that risk assets can still perform well for a long time after the economy reaches full employment. Admittedly, however, equity valuation is more stretched today than was the case at similar points in past long cycles. Before the U.S. election, the current expansion appeared to be heading for a similar long, drawn-out conclusion. Inflationary pressures are beginning to emerge, but only slowly, and from a low starting point. Moreover, evidence suggests that the Phillips curve8 is quite flat at low levels of inflation. This implies that the Fed has plenty of time to normalize interest rates because inflation is unlikely to surge. However, a sea change in trade and fiscal policy could change the calculus. To the extent that fiscal stimulus is front-loaded relative to trade protection, and that any trade restrictions add to inflation, Trump's policy agenda could force the Fed to normalize rates more quickly. The FOMC Will Wait And See Chart I-3Inflation Expectations Moving To Target Yellen's congressional testimony in November revealed that the Fed is not yet preparing for a more aggressive tightening cycle. There was nothing to suggest that the Fed is revising its economic forecasts following the election. Similarly, the Fed is not making any upward revisions to its estimate of the long-run neutral rate, which remains "quite low by historical standards." The implication is that the Fed will raise rates in December, but it will keep its "dot" forecast unchanged. The FOMC is prudently awaiting the details of the fiscal package before changing its economic and interest rate projections. We doubt that the Fed will be aggressive in offsetting the fiscal stimulus. We have argued in the past that the consensus on the FOMC would not follow the Bank of Japan and officially target a temporary overshoot of the 2% inflation target. Nonetheless, most Fed officials would not be upset if, with hindsight, they tighten too slowly and inflation overshoots modestly. The inflation target is supposed to be symmetric, which means that 2% is not meant to be a hard ceiling. Moreover, the Fed will be extremely cautious about tightening monetary policy until TIPS breakevens are more firmly anchored around pre-crisis levels. Market-based measures of inflation compensation have surged in the past few weeks, but remain below levels that are consistent with the Fed hitting its 2% PCE inflation target (Chart I-3).9 Investors should continue to hold inflation protection in the bond market. A window may open sometime in 2017 in which improving economic growth is met with a cautious Fed. In this environment, we would expect the Treasury curve to bear-steepen and risk assets to outperform. The window will likely close once inflation moves up and inflation expectations converge at a level consistent with the 2% target. Bond Strategy The implications of Trump's policy agenda are clearly bond bearish, although yields have shifted a long way in a short time. The gap between market rate expectations and the Fed's median expected path has narrowed considerably, both at the long-end and short-end of the curve (Chart I-4). The 5-year/5-year forward overnight index swap rate is now 2.1%, only 82 bps below the Fed's median estimate of the equilibrium fed funds rate. The U.S. 10-year yield has already converged with two measures of fair value, although yields remain well below fair value in the other major countries according to estimates of nominal potential output growth (Charts I-5 and I-6). The fact that the gap between the Fed's dots and market expectations has almost closed, means that a lot of bond-bearish news has been discounted in the U.S. We would not be surprised to see a partial retracement of the recent bond selloff. Investors will want to see concrete plans for substantial fiscal stimulus before the next leg of the bond bear market takes place. Speculators may wish to take profits on short bond plays, but investors with a 6-12 month horizon should remain short of duration benchmarks. Chart I-4Market Expectations Converging With Dots Chart I-5Bond Fair Value Method (I) Chart I-6Bond Fair Value Method (II) On a long-term horizon, the Trump agenda reinforces our view that the secular bull market in bonds is over. Larry Summers' Secular Stagnation thesis will be challenged and investors will come to question the need for ultra-low real interest rates in the U.S. well into the next decade. A blowout in the U.S. budget deficit will temper the excess global savings story to some extent. Tax cuts, infrastructure spending, full expensing of capital goods and reduced regulation may also boost the long-run potential growth rate in the U.S. All of this suggests that equilibrium interest rates and bond yields will shift higher. Nonetheless, poor demographic trends and other impediments to both the supply- and demand-sides of the U.S. and global economies have not disappeared. The ECB is likely to extend its bond purchase program beyond next March, while the Bank of Japan has capped the 10-year JGB yield at close to zero, both of which should limit the amount by which yields in the other developed markets can rise. We could even see global yields fall back to near previous lows if the Fed winds up tightening too aggressively and sparks the next recession. Is Trump Bullish For Stocks? Chart I-7Equity Market Breakouts Developed country stock markets cheered the U.S. election outcome, presumably betting that the positives will outweigh the negatives. The main indexes in the U.S. and Japan have broken out of their trading ranges (Chart I-7). Bourses in Europe have also moved higher, but have not yet broken out. On the plus side, deregulation and stronger growth are bullish for U.S. corporate profits. Trump's proposal for a major corporate tax cut is another positive for equities, although the effective corporate tax rate in the U.S. is already at multi-decade lows. Cutting the marginal rate will thus not affect the effective rate much for large corporations. Any lowering of the marginal rate will benefit small and medium enterprises, as well as domestically-oriented S&P 500 corporations. On the negative side, dollar strength will be a headwind given that about a third of S&P 500 earnings are sourced from abroad. This raises the question of which factor will dominate profit growth over the next year; better economic growth or dollar strength? Table I-3 presents a matrix of different scenarios for the dollar and economic growth applied to our U.S. EPS model. Our base-case assumptions, implemented before the election, generated 5-6% earnings growth in 2017. We assumed that real and nominal GDP growth would be on par with the conservative IMF forecast. The bullish case assumes that real GDP growth is about a percentage point stronger, with modestly higher inflation. The opposite is assumed in the bear case. These three cases are combined with various scenarios for the dollar. The key point of Table I-3 is that the growth assumptions dominate the dollar effects. If growth is significantly stronger than the base case, then it would require a massive dollar adjustment to offset the positive impact on earnings. For example, our EPS estimate rises from 5-6% in the base case to almost 13% in the strong growth scenario, even if the dollar appreciates by 5%.10 The elephant in the room is the prospect of a trade war. Anti-globalization polices are negative for equities generally, although the boost for domestically-oriented firms provides some offset. As we argued above, higher tariffs on Mexico and China alone would not fully counteract a major fiscal push next year, especially if the trade impediments are implemented with a lag. Nonetheless, a broader anti-trade initiative that draws retaliation from many of America's trading partners cannot be ruled out. This is the main reason why we remain tactically cautious on equities. Table I-3U.S. Earnings Scenarios Country Equity Allocation In common currency terms, the U.S. equity market has a lot going for it relative to Japan and Europe. There will be spillovers from stronger U.S. growth to other countries, but the U.S. will benefit the most from Trump's fiscal stimulus plan. Continuing policy divergence will prop up the dollar, boosting returns in common-currency terms. The dollar has appreciated by about 4% in trade-weighted terms since we first predicted a 10% rise, suggesting that there is another 6% to go. Chart I-8Eurozone Still Has Lots Of Slack However, it is a tougher call in local currency terms. Monetary policy will remain highly accommodative in both Japan and Europe. As we highlighted in last month's Overview, we still expect Japan to implement a major fiscal stimulus plan. In the context of the Bank of Japan's fixing of the 10-year yield, government spending will amount to a helicopter drop policy that could generate a substantial yen depreciation. The central bank will continue to hold the yield curve down even when growth picks up, to drive real yields lower via rising inflation expectations. In the Eurozone, the ECB is likely to extend its asset purchase program beyond next March because it cannot credibly argue that inflation is on track to meet the target on any reasonable timetable. While the Eurozone economy has been growing well above trend this year, the fact that wage growth is languishing highlights that significant labor market slack persists (Chart I-8). Easy-money policies in Europe and Japan will be bullish for stocks in both markets in absolute terms and relative to the U.S. Stocks are also cheaper in Japan and the Eurozone. Earlier this year, we presented a methodology for valuing Eurozone stocks relative to the U.S. from a top-down perspective. The methodology accounted for different sector weightings and the fact that European stocks generally trade at a discount to the U.S. This month's second Special Report, beginning on page 27, applies the same methodology to Japanese/U.S. relative valuation. Combining seven relative valuation measures into a single composite metric, we find that both the Eurozone and Japanese equity markets are about one standard deviation cheap relative to the U.S. (Chart I-9). History shows that investors would have made substantial (currency hedged) excess returns if they had favored Eurozone and Japanese stocks to the U.S. on a six-month or longer investment horizon whenever our composite valuation index reached one standard deviation on the cheap side. Our recommended (hedged) overweight in Europe and Japan has not worked out yet, as tepid global growth has instead flattered the lower-beta U.S. market. That tide should turn, however, if the rise in global bond yields reflects a credibly reflationary growth pulse in the U.S. A stronger dollar would redistribute some of that growth to other countries. Chart I-10 shows that higher beta markets like Europe and Japan can outperform the U.S. when bond yields rise. The financial sectors in both Europe and Japan, so punished relative to the broad market as a result of deleveraging and negative interest rates, would then be poised to outperform as well. Chart I-9Equity Valuation Chart I-10U.S. Equities ##br##Underperform When Yields Rise Investment Conclusions: Hopes are running high that fiscal stimulus and a more business-friendly regulatory framework will stir animal spirits, rekindle business investment and lift the U.S. economy out of its growth funk. The violent reaction in financial markets to the election has probably gone too far in discounting a transformative policy change. We doubt that Trump's fiscal and regulatory agenda will place the U.S. economy on a permanently higher growth plane. Many of the growth headwinds that existed in the U.S. before the election remain in place, such as: the end of the Debt Supercycle; deteriorating demographics; elevated corporate leverage; and nose-bleed levels of government debt. A lot of good (policy) news is already discounted in equity prices, implying that the market is vulnerable to policy or economic disappointments. That said, a window may open next year that would favor risk assets for a period of time. A temporary growth acceleration in late-2017/early 2018 would lift the equity and corporate bond boats. Markets will front-run the growth pulse (some of it is admittedly already discounted). Our bias is therefore to upgrade these asset classes, but poor value means that the risk/reward tradeoff is underwhelming until we get more visibility on the new administration's policy intentions. Until there is more clarity, remain at benchmark in equities, overweight the dollar and below-benchmark duration in fixed-income portfolios. EM assets appear to us like a lose-lose proposition. A trade war would obviously be disastrous for this asset class. But EM also loses if U.S. protectionism takes a back seat to growth initiatives to the extent that this results in a stronger dollar. EM risk assets have never escaped periods of dollar strength unscathed. The possibility of RMB depreciation versus the U.S. dollar adds to EM vulnerability. Our other investment recommendations include the following: avoid peripheral European government bonds within European bond portfolios due to Italian referendum risk; avoid U.S. municipal bonds, as tax cuts would devalue the tax advantage of muni debt; remain overweight inflation-linked bonds versus conventional issues within government bond portfolios, as inflation expectations have more upside potential; we are marginally less bearish on high-yield bonds since better growth will temper defaults. We also see less near-term risk of a Fed-driven volatility event. Nonetheless, concerns about corporate health still justify a slight underweight relative to Treasurys in the U.S. Overweight investment-grade corporates in Europe versus European governments due to ongoing ECB support; overweight European and Japanese equities versus the U.S. in currency-hedged terms. within the U.S. equity market, remain overweight small caps since Trump's corporate tax reform will benefit small firms disproportionately. Dollar strength also favors small versus large caps. Mark McClellan Senior Vice President The Bank Credit Analyst November 24, 2016 Next Report: December 20, 2016 1 Please see BCA Geopolitical Strategy, "U.S. Election: Outcomes and Investment Implications," November 9, 2016, available at gps.bcaresearch.com 2 Please see Jim Nunns, Len Burman, Ben Page, Jeff Rohaly, and Joe Rosenberg, "An Analysis Of Donald Trump's Revised Tax Plan," Tax Policy Center, October 18, 2016. 3 World Trade Organization. 4 Scott Bradford, Paul Grieco and Gary Clyde Hufbauer, "The Payoff to America from Global Integration," Peterson Institute for International Economics. 5 These calculations capture the demand-side effects of the tariffs. There will also be supply-side effects, in terms of reduced productivity, but this will be relatively small and affect the economy largely over the medium term. 6 The elasticities and methodology for these calculations are based on the report; "Trump's Tariffs: A Dissent," J.W. Mason, November 2016. 7 "The Macroeconomic Consequences of Mr.Trump's Economic Policies," Moody's Analytics, June 2016. 8 The short-term tradeoff between unemployment and inflation. 9 Inflation breakeven rates have historically exceeded 2% because of the presence of risk premia. 10 The impact of dollar appreciation on profits shown in Table 3 may seem too low to some readers given that S&P 500 companies derive a third of their earnings from abroad. However, some of these earnings are hedged, while dollar strength will benefit the earnings of domestically-oriented U.S. companies. II. A Q&A On Political Dynamics In Washington In this Special Report, BCA's Geopolitical Strategy service answers some key questions posed by clients surrounding the incoming Trump administration. The situation could evolve quickly in the coming months, but these answers convey our preliminary thoughts. What support will President-elect Trump's infrastructure plans have from Republicans in Congress? The support for infrastructure spending can be gauged by popular opinion and the bipartisan highway funding bill passed by Congress late last year. The $305 billion bill to fund roads, bridges and rail lines received support from both parties (83-16 vote in the Senate and 359-65 vote in the House). The dissenting votes included fiscal conservatives and Tea Party/Freedom Caucus members. And yet many of their voters supported Trump, whose victory shows the political winds shifting against "austerity." Moreover, new presidents normally receive support from their party on major initiatives early in their term. Democratic Senators and House Representatives have suggested they may work with Trump on infrastructure spending, most notably Bernie Sanders, Elizabeth Warren, Chuck Schumer and even Nancy Pelosi. This could mark an instance of bipartisanship in the context of still-growing polarization. The 2018 mid-term elections will be difficult for the Democrats, with 10 Democratic senators facing elections in states which Donald Trump won, including key "Rust Belt" swing states where the infrastructure argument is appealing (Michigan, Wisconsin, Pennsylvania, Ohio). Thus, there are political incentives for Democrats to cooperate with the White House on infrastructure. Trump owes his victory to swing voters who favor infrastructure. As we discuss below, he may give the GOP Congress some concessions (for instance, on tax reform) in exchange for cooperation on infrastructure spending. How many votes would he need to get an infrastructure bill passed in Congress? Trump will likely get the votes. He needs 218 votes in the House and 51 votes in the Senate, assuming his infrastructure plan is not so partisan (or so entwined with partisan measures like his tax cuts) as to draw a Senate filibuster. The GOP has 239 seats in the House and at least 51 in the Senate (Louisiana could make it 52). One way of overcoming any Democratic filibuster in the Senate is by "Reconciliation," a process for speeding up bills affecting revenues and expenditures. Under this process, which requires the prior passage of a budget resolution, a simple majority in the Senate is enough to allow a reconciliation bill to pass. The process can be used for passing tax cuts as well, after procedural changes in 2011 and 2015. If passed, what is the earliest we could expect more spending? Congress passed President Obama's $763 billion stimulus package, the American Recovery and Reinvestment Act (ARRA), in February 2009, the month after he was sworn in. About 20% of the investment outlays went out the door by the end of fiscal 2009 and 40% by the end of fiscal 2010.1 Today, infrastructure outlays are less urgent, as the country is not in the mouth of a financial crisis, but the roll-out could be expedited by the administration. Trump's plan calls for building infrastructure through public-private partnerships, which could involve longer negotiation periods but also faster completion once started. Trump's team claims they can accelerate the spending process by cutting red tape. What is a 'best guess' on the final amount of deficit-financed infrastructure spending? Trump is currently committed to $550 billion in new infrastructure investment, down from initial suggestions of $1 trillion over a decade. A detailed plan has not been released, however. Trump's campaign promised to induce infrastructure spending via public-private partnerships, with tax credits for private investors. The plan was said to be "deficit neutral" based on assumptions about revenue recuperated from taxing the labor that works on the projects and the profits of companies involved, taxed at Trump's proposed 15% corporate tax rate.2 The government tax credit would have amounted to 13.7% of the total investment. Earlier proposals can easily be revised or scrapped. Already, Trump has reversed his earlier opposition to Hillary Clinton's proposal of setting up an infrastructure bank, potentially financed by repatriated earnings of U.S. corporations. His potential Treasury Secretary, Steven Mnuchin, raised the possibility on November 16. Who are key players in this process and what are their backgrounds? The aforementioned leading Democrats could become key players, if they prove willing to work with Trump on infrastructure. Comments by Paul Ryan and the Congressional GOP should be monitored, as infrastructure spending was not a major part of their policy platform, called "A Better Way," released in June of this year.3 The only infrastructure that Ryan mentioned in the GOP policy paper was energy infrastructure. Not the "roads, bridges, railways, tunnels, sea ports, and airports" that President-elect Trump has promised repeatedly, in addition to energy. Asked during the Washington Ideas Forum in September whether he supports infrastructure spending, Ryan said it is not part of the GOP's proposal. Other notable personalities to watch: Wilbur Ross, an American investor and potential Commerce Secretary pick, was one of the authors of Trump's original, public-private infrastructure plan. Peter Navarro, UC-Irvine business professor and another economic advisor, co-authored that proposal. Also watch: Steven Mnuchin, Finance Chairman of the Trump campaign and former Goldman Sachs partner, and potential Treasury Secretary pick. Stephen Moore, a member of Trump's economic advisory team and the chief economist for the Heritage Foundation. John Paulson, President of Paulson & Co. Also watch fiscal hawks such as House Majority Leader Kevin McCarthy of California, who has recently softened on infrastructure spending, saying it could be "a priority" and "a bipartisan issue." Representative David Brat of Virginia, another ultra-conservative Freedom Caucus member, who has softened on infrastructure. House Appropriations Chairman Hal Rogers, and Representative Bill Flores, Chairman of the conservative Republican Study Committee, could also send signals. Chairman of the House Committee on ways and Means, Kevin Brady, has already admitted that some tax receipts from repatriated corporate earnings may go to infrastructure. Would deficit spending on infrastructure revive problems with the debt ceiling? The debt ceiling legislation is technically separate from the budget process. It is the statuary threshold on the level of government debt. It currently stands at $20.1 trillion. Congress voted last fall to "suspend" the debt ceiling until March of 2017. This means it will come due right around the time that negotiations over the fiscal 2018 budget resolution take place. But debt ceiling negotiating tactics are unlikely to recur in Trump's first year with his own party in control of Congress. Trump and the GOP could vote to "suspend" the debt ceiling indefinitely. Or, the GOP could set the debt ceiling limit so high that it no longer matters in the near term. Where do the GOP and Trump disagree on tax reform? Tax reform is a major GOP demand in recent years; it was also a focus, albeit less central, in Trump's campaign. Both want to flatten the personal income tax structure from 7 brackets to 3 brackets, with 12%, 25%, and 33% tax rates. Trump revised his initial tax plan, which called for 10%, 20%, and 25% rates, late in his campaign to be more compatible with the GOP. In terms of corporate taxes, President-elect Trump proposes a 15% rate for all businesses, with partnerships eligible to pay the 15% rate instead of being taxed under a higher personal income tax rate. By contrast, the GOP has called for a 20% corporate tax rate and a 25% rate for partnerships. How difficult is it to simplify the tax code? It is certainly not easy, but it can be done in 2017 given that the GOP controls both the White House and Congress. GOP leaders claim that a proposal will go public early in the year and a vote will occur within 2017. GOP leaders want a comprehensive law, including income and corporate tax reform, but there are rumors of splitting the two. Income tax reform may take longer to pass because it is more complex. There has not been comprehensive tax reform in the U.S. since Ronald Reagan signed the Tax Reform Act of 1986. The Republicans obtained lower tax rates in exchange for a broadening of the base that the Democrats favored. It would be difficult to strike a similar deal next year, given that Republicans seek to slash taxes on corporations and top earners, and Democrats are staunchly opposed. There is likely to be some horse trading between Trump and the GOP. The GOP may use tax reform as the price of their support for Trump's infrastructure investment. Alternatively, Trump could hold out his Supreme Court appointments in exchange for GOP acquiescence on taxes and infrastructure. He could, for example, threaten to appoint centrist justices if the GOP does not play ball on other matters. What are the obstacles and timeline to a repatriation tax on overseas corporate earnings? An estimated $2.5-$3 trillion in corporate earnings are currently held "offshore," which means that taxes on this income is deferred until it is repatriated to the U.S. There is growing bipartisan support for a deemed repatriation tax. This means a one-off tax imposed on all overseas income not previously taxed. Obama, Hillary Clinton, Trump, and GOP representatives have all presented proposals to tap this source of tax revenue. For that reason there are various avenues through which it could be legislated. Trump put forth a plan to tax un-repatriated earnings at a 10% rate for cash (4% for non-cash earnings), with the liability payable over a 10-year period. As mentioned, this could be combined with his infrastructure plan as a way to finance an infrastructure bank or encourage the same corporations to invest in infrastructure development via tax breaks. According to the Tax Policy Center, Trump's repatriation plan would raise $147.8 billion in revenue over 2016-2026. Overall, this is a paltry sum of $14 billion per year. In a similar vein, President Obama's plan called for a 14% rate on repatriated earnings and was projected to raise $240 billion. The GOP offers a different plan from Trump. The party supports a repatriation tax at an 8.75% rate, payable over eight years. The GOP's plan would raise an estimated $138.3 billion during the same period. The GOP proposes to overhaul the entire U.S. corporate taxation system, while Trump does not. The GOP would change it from the worldwide system (i.e. the same corporate tax rate for U.S. corporations on profits everywhere), to a more typical destination-based system, in which U.S. corporations would be exempt from U.S. taxes on profits earned overseas. The latter would reduce the incentive for offshoring and tax inversions, that is, moving head offices outside of the U.S. to take advantage of lower tax rates. The 2004 tax holiday was a disappointment. Findings from the Center on Budget and Policy Priorities, NBER, Congressional Research Service, and others, indicate that the repatriated earnings did not significantly improve long-term fiscal deficits, boost employment, or increase domestic investment. Will Trump accuse China of "currency manipulation" on his first day in office as promised? It seems likely that Trump will follow through with his pledge of naming China a "currency manipulator." The question is whether he does so through the existing, formal Treasury Department review process or whether he would bypass that system and take independent action as the executive. Adhering to the formal process would show that Trump wants to keep tensions contained even as he draws a tougher line on economic relations with China. The "currency manipulation" charge is a mostly symbolic act that does not automatically initiate punitive measures. The move will not be unprecedented, as the U.S. labeled China a manipulator from 1992-1994. The label requires bilateral negotiations and could lead to Treasury recommending that Congress, or Trump, take punitive measures. The 2015 update to the law specifies what trade remedies Treasury might suggest, but the remedies are not particularly frightful. The options might prevent the U.S. government from supporting some private investment in China, cut China out of U.S. government procurement contracts, or cut China out of trade deals. The latter point, however, will be overshadowed by Trump's withdrawing the U.S. from the Trans-Pacific Partnership, a net gain for China since that strategic trade initiative had excluded China from the beginning. The real risk - higher than ever before, but still low probability - is that Trump could act unilaterally to impose tariffs or import quotas under a host of existing trade laws (1917, 1962, 1974, 1977) which give him extensive leeway. Some of these would be temporary, but others allow him to do virtually whatever he wants, especially if he declares a state of emergency or invokes wartime necessity (his lawyers could use any existing overseas conflict for this purpose).4 Presidents have been unscrupulous about such rationalizations in the past. Congress and the courts would not be able to stop Trump for the first year or two if he proceeded independently by executive decree. WTO rulings would take 18 months. China would not wait to retaliate, leading to a trade conflict of some sort. Would Congressional Republicans support punitive measures against China? How would China respond? There are two possibilities. First, Trump is free to set his own executive timeline if his administration makes a special case and he acts through executive directives. Second, Trump could proceed under the Treasury Department's existing timeline. An investigation would be launched in the April Treasury report, leading to negotiations with China. If there is no satisfactory outcome of the negotiations, then the October Treasury Report could label China as a currency manipulator. Under the 2015 law, there would be a necessary one-year waiting period before punitive measures are implemented. But again, Trump could override that. China would cause a diplomatic uproar; it would level similar accusations at the U.S. of distortionary trade policies. China would likely respond unilaterally as well as go to the WTO to claim that the U.S. has abrogated the purpose of the agreement, giving it an additional path to retaliate within international law. China's unilateral sanctions could target U.S. high-quality imports, services, or production chains. Or China could sell U.S. government debt in an attempt to retaliate, though it is not clear what the net effect of that would be. However, China would suffer worse in an all-out trade war. Xi Jinping has been very pragmatic about maintaining stability, like previous Chinese presidents since Deng. He is tougher than usual, but as long as Trump proposes credible negotiations, rather than staging a full frontal assault, Xi would likely attempt to strike a deal, perhaps cutting pro-export policies while promising faster structural rebalancing, to avoid a full-blown confrontation. We have seen with Russia that authoritarian leaders can use external threats and economic sanctions as a way to rally the population "around the flag." Trump's campaign threats, combined with other macro-economic trends, pose the risk that over the next four years China could face intensified American economic pressure and internal economic instability simultaneously. That would be a volatile mix for U.S.-China relations and global stability. But, once in office, it remains to be seen how Trump will conduct relations with China. Most likely, the currency manipulation accusation will cause a period of harsh words and gestures that dies down relatively quickly. The two powers will proceed to negotiations over a "new" economic relationship, highlighting the time-tried ability of the U.S. and China to remain engaged and "manage" their differences. Nevertheless, any shot across the bow will point to Sino-American distrust that is already growing over the long run. That distrust is signaled by Trump's success in key swing states by pitching protectionism, specifically against China. Will Trump's border enforcement policies add to fiscal stimulus? Yes, it would add marginally to the fiscal thrust that we expect from other infrastructure and defense spending. How will Trump approach the deportation of illegal immigrants? Trump will probably maintain Obama's stance on illegal immigration and deportation. Obama has deported around 2.5 million illegals between 2009 and 2015, the most of any president. These are mostly deportable illegals and non-citizens with criminal convictions. Trump stated in an interview on 60 Minutes that he plans to deport 2 to 3 million undocumented immigrants. The execution of this order will be swift as the Department of Homeland Security (DHS) has already exhibited this capacity under Obama. It is difficult to gage the economic impact of deportation. A study done by the University of Southern California found that undocumented immigrants are paid 10% lower than natives with similar skills in California.5 About half of farm workers and a quarter of construction workers are undocumented immigrants. If this source of cheap labor is removed, the cost for business in these sectors will increase. Are there other policy areas where you see a significant divergence between Congressional Republicans and Trump? Trump and the GOP establishment obviously have an awkward relationship that is only beginning to heal. Both sides are making progress in bridging the gap, but on trade protectionism, infrastructure, immigration, entitlement spending, and foreign policy Trump will continue to sit uneasily with Republican orthodoxy. This will give rise to a range of disagreements, separate from those listed above, of which we note only two here that have caught our attention during the post-election transition. How to deal with Putin: Trump has received renewed criticism from Sen. John McCain over a possible thaw in relations with Russia. This could affect the sanctions on Russia imposed by the U.S. and EU after the intervention in Ukraine in 2014, as well as broader Russia-NATO relations. H1B Visa: Trump is in favor of expanding H1B1 visas and allowing the "best" immigrants to stay in the U.S. once they complete their university education. But his White House chief strategist Steve Bannon has vilified the GOP for doing this. Thus there could be disagreement between the GOP and Trump's team on the issue of highly skilled immigrants. The BCA Geopolitical Team 1 Please see the White House, "The Economic Impact Of The American Recovery And Reinvestment Act Five Years Later," in the "2014 Economic Report of the President," available at www.whitehouse.gov. 2 Please see "Trump Versus Clinton On Infrastructure," October 27, 2016, available at peternavarro.com. 3 Please see Paul Ryan, "A Better Way For Tax Reform," available at abetterway.speaker.gov. 4 Please see Marcus Noland et al, "Assessing Trade Agendas In The US Presidential Campaign," Peterson Institute for International Economics, PIIE Briefing 16-6, dated September 2016, available at piie.com. 5 Please see Manuel Pastor et al, "The Economic Benefits Of Immigrant Authorization In California," Center for the Study of Immigrant Integration, dated January 2010, available at dornsife.usc.edu. III. Japanese Equities: Good Value Or Value Trap? Japanese stocks have experienced a long stretch of underperformance versus the U.S. since the early 90's. The deflationary macro backdrop and poor corporate profitability are the main underlying factors, although there are many others. More recently, some corporate fundamentals have shifted in favor of Japanese stocks relative to the U.S., but investors remain skeptical, sending Japanese valuations to near all time lows in absolute terms and relative to the U.S. In this Special Report, we take a top-down approach to determine whether Japanese stocks are cheap versus the U.S. after adjusting for persistent differences in underlying profit fundamentals. Our mechanical and fundamental valuation indicators provide an impressive historical track record of "buy" and "sell" signals when the metrics reach extreme levels. The story is corroborated at the sector level. The implication is that there is plenty of "kindling" to drive a reversal in Japanese stock relative performance, but it needs a spark. We believe the catalyst could be a major fiscal push that would be like a "helicopter drop" under the current monetary regime. Unfortunately, the timing is uncertain. A major fiscal package may not occur until the spring. Japanese equities have been a perennial underperformer versus the U.S. for almost three decades, in both local- and common-currency terms (Chart III-1). There was a ray of light in the early years of Abenomics, when the aggressive three-arrow approach appeared to be finally lifting the Japanese economy out of Secular Stagnation. Yen weakness contributed to a surge in earnings-per-share (EPS) in absolute terms and relative to both the U.S. and world. Equity multiples also rose between 2012 and 2015. Unfortunately, Abe's honeymoon with equity markets has since faded. Yen strength, collapsing inflation expectations and weakening business confidence have caused investors to question the upside potential for Japanese corporate top-line growth (Chart III-2). EPS have fallen by 11% percent this year in absolute local currency terms, and are down by 10.7% versus the U.S. In turn, Japanese equities have dropped from the mid-2015 peak (Chart III-3). The decline in Japanese multiples this year is in marked contrast to a rise in the U.S. Chart III-1Japanese Equities ##br##Have Underperformed Chart III-2A Challenging ##br##Macro Backdrop Chart III-3Japanese EPS Growth ##br##Has Been Strong Until 2016 Japanese equities currently appear very cheap to the U.S. market based on standard valuation measures (Chart III-4). However, these ratios are always lower in Japan, except for price-to-forward earnings. Japanese companies generally have a much higher interest coverage ratio compared to Corporate America. Nonetheless, they tend come up short in terms of profitability. Operating margins in the U.S. have typically been double that of Japan (Chart III-5A). Japan's return-on-equity (RoE) has been dismal because of low levels of corporate leverage and loads of low-yielding cash sitting on balance sheets (Chart III-6). Table III-1 shows that Japan has a much larger sector weighting in consumer discretionary and a much lower weighting intechnology. Still, the story does not change much when we adjust financial ratios for differences in sector weights between the two markets (Chart III-5B). Chart III-4Japan Is Always Cheaper Chart III-5A...Adjusted For Common Sector Weights Chart III-5BJapanese Vs. U.S. Fundamentals... Chart III-6RoE Is Consistently Lower In Japan Table III-1Japanese Vs. U.S. Sector Weights The lower level of RoE by itself justifies a price discount on Japanese equities. But by how much? Are Japanese stocks still cheap once they are adjusted for structurally depressed profitability relative to the U.S.? This report assesses relative valuation, employing the same methodology used in our previous work on Eurozone equity valuation.1 While many cultural nuances make direct comparison of the Japanese market difficult, investment decisions are made within the scope of the available set of alternatives. With Japanese equity valuations at the lowest levels in recent history, the key question is whether this represents an opportunity to load up, or an example of a "value trap". We conclude that valuation justifies an overweight in Japanese equities (currency hedged), although the fiscal stimulus required to unlock the value may not arrive until February. Mechanical Approach We excluded the financial sector from our market valuation work since analysts use different fundamental statistics to judge profitability and value compared to non-financial companies. We also recalculated all of the Japanese aggregates using U.S. weights in order to avoid the problem that differing sector weights could bias measures of relative value for the overall market. The mechanical approach adjusts the valuation measures by subtracting the 5-year moving average (m.a.) from both markets. For example, the calculation for the price-to-sales ratio (P/S) is: VG = (US P/S - 5-year m.a.) - (EMU P/S - 5-year m.a.) Then we divided the Valuation Gap (VG) by the 5-year moving standard deviation of the VG. This provides a valuation indicator that is mean-reverting and fluctuates roughly between -2 and +2 standard deviations: Valuation Indicator = VG/(5-year moving standard deviation of VG) The same methodology is applied to the other valuation measures shown in Charts III-7A, 7B, 7C, 7D and III-8A, 8B, 8C. This approach suggests that the U.S. market is trading expensive to Japan in all seven cases except for the Shiller P/E. Japan is around 1-sigma cheap on most of the other valuation measures, with forward P/E the highest at almost 2 standard deviations. Chart III-7AMechanical Valuation Indicators (I) Chart III-7BMechanical Valuation Indicators (I) Chart III-7CMechanical Valuation Indicators (I) Chart III-7DMechanical Valuation Indicators (I) Chart III-8AMechanical Valuation Indicators (II) Chart III-8BMechanical Valuation Indicators (II) Chart III-8CMechanical Valuation Indicators (II) The underlying logic is that using a longer-term moving average should remove the structurally lower bias in Japanese valuations. Standardizing relative valuations in such a way should provide extreme valuation signals that can be used to gauge major trading opportunities. One potential pitfall of using a 5-year moving average to discount the structurally lower valuation of Japanese equities versus U.S. is that it fails to capture an extended period of either over- or under-valuation. For example, the U.S. may enter a bubble phase that does not occur in Japan. The 5-year moving average would move higher over time, eventually giving the false signal that the U.S. is back to fair value if the bubble persists. This is a fair criticism, although the track record of these valuation metrics shows that extended bubbles have not been a large source of false signals. Valuation By Sector We applied the same methodology at the sector level. Due to space constraints, we cannot present the 70 charts covering the seven relative valuation metrics across the 10 sectors. However, we present the latest reading for the 70 indicators in Table III-2, which reveals whether the U.S. is expensive (e) or cheap (c) versus Europe. A blank entry means that relative valuation is in the range of fair value. Table III-2Story Holds At The Sector Level The sector valuation indicators corroborate the message from the aggregate valuation analysis; over 60% of valuation metrics suggest that the U.S. is at least modestly expensive versus Japanese stocks. The U.S. is cheap in only 13% of the cases, with 26% at fair value. Value measures that most consistently place U.S. sectors in expensive territory are P/CF, P/B and EV/EBITDA. The U.S. sectors that are most consistently identified as expensive are financials, consumer discretionary, industrials, utilities, tech and basic materials. U.S. healthcare received a fairly consistent "cheap" rating while U.S. telecoms were consistently "cheap" or "fair" across all valuation measures. Predictive Value? Having a standardized tool of relative valuation is well and good but multiple divergence between regions is only useful if it translates into excess returns. Valuation is generally a poor timing tool but proves to be useful in predicting returns over a longer investment horizon. Theoretically, forward relative returns between Japanese and U.S. equities should be positively correlated with the size of the gap in their relative valuation metrics. In order to test the efficacy of the mechanical valuation indicator we calculated forward relative returns at points of extreme valuation divergences (in local currency). The trading rule is set such that, when the mechanical indicator reaches positive one or two standard deviations, we short the more expensive U.S. market and go long Japanese equities. Conversely, the opposite investment stance is taken for value readings of negative one and two standard deviations. Forward returns are calculated on 3, 6, 12, and 24 month horizons. Overall, the indicators performed well when the valuation gap between U.S. and Japanese multiples reached (+/-) 1 and 2 standard deviations from the long-term mean. Valuation measures exhibiting the highest returns were P/CF and forward P/E. For brevity, we present only these two measures in Table III-3. At two standard deviation extremes, the mechanical indicator produced a two-year forward return of 84% and 44% for P/CF and forward P/E, respectively. Table III-3 also presents the indicator's batting average. That is, the number of positive excess returns generated by the trading rule as a percent of the total number of signals. For P/CF, the batting average is between 50-60% for a 1 standard deviation valuation reading and mostly 100% for 2 standard deviations. The batting average for the forward P/E ranges from 53-92% for 1 standard deviation, and 83-100% for 2 standard deviations. Table III-3Select Mechanical Indictor Returns And Batting Averages Presently, all of the indicators are at or above the zero line signaling that the U.S. market is overvalued versus Japan. The valuation metric sending the strongest signal of U.S. overvaluation has interestingly been one of the better predictors of positive excess returns; the forward P/E mechanical indicator has just recently touched the +2 standard deviation level. Given the information provided by our back tested results above, investors are poised to enjoy strong positive returns by overweighting Japanese equities versus their U.S. peers. Fundamental Approach Chart III-9Japan Has A Lower Cost Of Debt Japanese companies trade at a discount relative to their U.S. peers due to more volatile Japanese profit fundamentals and a structurally depressed RoE. To compensate for structural differences in fundamentals we regressed U.S./Japanese value gaps on spreads in underlying financial statistics such as earnings-per-share growth, the interest coverage ratio, free-cash-flow growth, operating margins, and forward earnings-per-share growth. A dummy variable was used to exclude the "tech bubble" years in the late 90's to early 00's since the surge in tech stocks had an outsized effect on overall relative valuations, distorting the true underlying trend. The fundamental approach used in our previous Special Report comparing the U.S. and Eurozone did not work as well as hoped and we had an inkling that an analysis of Japan versus the U.S. might yield similar results. Once again we were underwhelmed by the results, although some valuation measures did produce decent outcomes. These included P/S, P/B, and P/CF. Unfortunately, fundamental models for EV/EBITDA, P/E and forward P/E either had low explanatory power or had coefficients with the wrong sign. The financial variable that appears most frequently as being significant in our fundamental models is the interest coverage ratio. Japanese firms have experienced a massive reduction in net debt post-GFC, while those in the U.S. have been taking advantage of lower rates to issue debt and perform share buybacks. Weak aggregate demand has dissuaded Japanese corporations from performing any sort of intensive capital expenditure programs and they have therefore been using free cash flow to build up cash reserves on their balance sheet and pay down debt. Not to mention, the more dramatic decrease in borrowing rates for Japanese firms has reduced their interest burden vis-à-vis U.S. corporates (Chart III-9). Chart III-10 presents the modeled fair values along with the corresponding valuation indicator. The U.S. market is expensive compared to Japan for all three models, with the most extreme cases being P/S and P/CF. Chart III-10AFundamental Valuation Indicators Chart III-10BFundamental Valuation Indicators Chart III-10CFundamental Valuation Indicators While the fundamental approach gave results that are less than spectacular, they still corroborate the message given by the mechanical approach. Japanese equities are undervalued compared to their U.S. peers and are reaching extreme levels, even after adjusting for structural trends in the underlying financials. Chart III-11Combined Fundamental Indicator Returns The next step is to verify the predictive power of our fundamental models. We analyzed forward returns implementing the same methodology used for the mechanical indicators. A (+/-) 1 standard deviation threshold was used as an investment signal to either overweight Japanese equities versus the U.S., if positive, or take the opposite stance if negative. Chart III-11 shows the returns categorized by time horizon and the number of valuation measures flashing a positive investment signal. The results were mixed; strong positive returns occurred when only one or two measures displayed valuation extremes, but excess returns were less than spectacular during periods when all three metrics provided the same signal. This is counter-intuitive, but when analyzing Chart III-10 it becomes apparent that the periods where all three indicators simultaneously entered extreme territory are concentrated in the last two years of history when U.S. market returns have trounced Japan. For periods during which our indicator flashed one or two positive signals, mostly before the past two years, returns were in line with those achieved by the mechanical indicators. Table III-4 shows the probability of success for the combined fundamental approach. Overall it has a batting average lower than that of the mechanical approach, with 60-89% for one signal and 70-86% for two signals. The batting average was generally poor when there were three signals for the reason discussed above.2 Since the beginning of 2015, all three indicators have been signaling that Japanese stocks are extremely cheap versus the U.S. Indeed, relative valuation continues to stretch as U.S. equity prices rise versus Japan, bucking the recent relative shifts in balance sheet fundamentals that favor the Japanese market. Table III-4Combined Fundamental Indicator Batting Averages Conclusion We are pleased with the results of the mechanical approach. The majority of valuation measures show that investors will make positive returns by overweighting and underweighting Japanese equities versus the U.S. when relative valuation reaches extreme levels. The consistency of these excess returns highlights that the indicators add value to global equity investors. We had hoped that a fundamentals based approach to valuation would have worked better. Conceptually, it would be more intellectually gratifying for company financials to better explain excess returns compared to technical measures. In a liquidity-driven world, this may be too much to ask. Although our fundamental models did not pan out perfectly, they still provided support for our underlying thesis that Japanese equities offer excellent value relative to the U.S. market. These models highlight that Japanese balance sheet and income statement trends favor this equity market versus the U.S. at the moment. Investors have been ignoring the fundamentals, frowning on Japanese equities in absolute terms and, especially, relative to the U.S. The sour view on Japan likely reflects disappointment in Abenomics. This includes not only fears that Abenomics is failing to lift the economy out of the liquidity trap, but also fading hopes for changes in corporate governance that would force firms to make better use of their cash hoards to the benefit of shareholders. All the valuation metrics presented above say that it is a good time to overweight Japan versus the U.S. in local currency terms. Of course, so much depends on policy these days. Our valuation metrics highlight that there is plenty of "kindling" in place for a reversal in relative performance given the right spark. As discussed in the Overview section, the catalyst could be a major fiscal stimulus package. When combined with a yield curve that is fixed by the Bank of Japan, it would amount to a "helicopter drop". Such a policy would drive up inflation expectations, push down real borrowing rates and dampen the yen. This self-reinforcing virtuous circle would be quite positive for growth in real and nominal terms, lifting the outlook for corporate profit growth and sparking a substantial re-rating of Japanese stocks. The timing is admittedly uncertain. A smaller fiscal package could be implemented as part of a third supplementary budget before year-end. A major fiscal push is most likely to occur only in February, when the next full budget is announced. Still, rock-bottom valuations make Japan an attractive market for longer-term investors, although the currency risk must be hedged. Michael Commisso Research Analyst 1 Please see The Bank Credit Analyst, "Are Eurozone Stocks Really Cheap?" July 2016, available at bca.bcaresearch.com 2 Except for the 24-month column, which shows a 100% batting average. However, this can be ignored. There was only a single episode of three positive signals that occurred more than 24 months ago, allowing a 24-month return calculation.
