Labor Market

Productivity growth is experiencing a cyclical rebound, but remains structurally weak. The end of the deepening of globalization, statistical hurdles, and the possibility that today’s technological advances may not be as revolutionary as past ones all hamper productivity. On the back of rising market power and concentration, companies are increasing markups instead of production. This is depressing productivity and lowering the neutral rate of interest. For now, investors can generate alpha by focusing on consolidating industries. Growing market power cannot last forever and will meet a political wall. Structurally, this will hurt asset prices.   “We don’t have a free market; don’t kid yourself. (…) Businesspeople are enemies of free markets, not friends (…) businesspeople are all in favor of freedom for everybody else (…) but when it comes to their own business, they want to go to Washington to protect their businesses.” Milton Friedman, January 1991. Despite the explosion of applications of growing computing power, U.S. productivity growth has been lacking this cycle. This incapacity to do more with less has weighed on trend growth and on the neutral rate of interest, and has been a powerful force behind the low level of yields at home and abroad. In this report, we look at the different factors and theories advanced to explain the structural decline in productivity. Among them, a steady increase in corporate market power not only goes a long way in explaining the lack of productivity in the U.S., but also the high level of profit margins along with the depressed level of investment and real neutral rates. A Simple Cyclical Explanation The decline in productivity growth is both a structural and cyclical story. Historically, productivity growth has followed economic activity. When demand is strong, businesses can generate more revenue and therefore produce more. The historical correlation between U.S. nonfarm business productivity and the ISM manufacturing index illustrates this relationship (Chart II-1). Chart II-1The Cyclical Behavior Of Productivity The Cyclical Behavior Of Productivity The Cyclical Behavior Of Productivity Chart II-2Deleveraging Hurts Productivity Deleveraging Hurts Productivity Deleveraging Hurts Productivity Since 2008, as households worked off their previous over-indebtedness, the U.S. private sector has experienced its longest deleveraging period since the Great Depression. This frugality has depressed demand and contributed to lower growth this cycle. Since productivity is measured as output generated by unit of input, weak demand growth has depressed productivity statistics. On this dimension, the brief deleveraging experience of the early 1990s is instructive: productivity picked up only after 1993, once the private sector began to accumulate debt faster than the pace of GDP growth (Chart II-2). The recent pick-up in productivity reflects these debt dynamics. Since 2009, the U.S. non-financial private sector has stopped deleveraging, removing one anchor on demand, allowing productivity to blossom. Moreover, the pick-up in capex from 2017 to present is also helping productivity by raising the capital-to-workers ratio. While this is a positive development for the U.S. economy, the decline in productivity nonetheless seems structural, as the five-year moving average of labor productivity growth remains near its early 1980s nadir (Chart II-3). Something else is at play. Chart II-3 The Usual Suspects Three major forces are often used to explain why observed productivity growth is currently in decline: A slowdown in global trade penetration, the fact that statisticians do not have a good grasp on productivity growth in a service-based economy, and innovation that simply isn’t what it used to be. Slowdown In Global Trade Penetration Two hundred years ago, David Ricardo argued that due to competitive advantages, countries should always engage in trade to increase their economic welfare. This insight has laid the foundation of the argument that exchanges between nations maximizes the utilization of resources domestically and around the world. The collapse in new business formation in the U.S. is another fascinating development. Rarely was this argument more relevant than over the past 40 years. On the heels of the supply-side revolution of the early 1980s and the fall of the Berlin Wall, globalization took off. The share of the world's population participating in the global capitalist system rose from 30% in 1985 to nearly 100% today. Generating elevated productivity gains is simpler when a country’s capital stock is underdeveloped: each unit of investment grows the capital-to-labor ratio by a greater proportion. As a result, productivity – which reflects the capital-to-worker ratio – can grow quickly. As more poor countries have joined the global economy and benefitted from FDI and other capital inflows, their productivity has flourished. Consequently, even if productivity growth has been poor in advanced economies over the past 10 years, global productivity has remained high and has tracked the share of exports in global GDP (Chart II-4). Chart II-4The Apex Of Globalization Represented The Summit Of Global Productivity Growth The Apex Of Globalization Represented The Summit Of Global Productivity Growth The Apex Of Globalization Represented The Summit Of Global Productivity Growth This globalization tailwind to global productivity growth is dissipating. First, following an investment boom where poor decisions were made, EM productivity growth has been declining. Second, with nearly 100% of the world’s labor supply already participating in the global economy, it is increasingly difficult to expand the share of global trade in global GDP and increase the benefit of cross-border specialization. Finally, the popular backlash in advanced economies against globalization could force global trade into reverse. As economic nationalism takes hold, cross-border investments could decline, moving the world economy further away from an optimal allocation of capital. These forces may explain why global productivity peaked earlier this decade. Productivity Is Mismeasured Recently deceased luminary Martin Feldstein argued that the structural decline in productivity is an illusion. As the argument goes, productivity is not weak; it is only underestimated. A parallel with the introduction of electricity in the late 19th century often comes to mind. Back then, U.S. statistical agencies found it difficult to disentangle price changes from quantity changes in the quickly growing revenues of electrical utilities. As a result, the Bureau Of Labor Statistics overestimated price changes in the early 20th century, which depressed the estimated output growth of utilities by a similar factor. Since productivity is measured as output per unit of labor, this also understated actual productivity growth – not just for utilities but for the economy as a whole. Ultimately, overall productivity growth was revised upward. Chart II-5Plenty Of Room To Mismeasure Real Output Growth Plenty Of Room To Mismeasure Real Output Growth Plenty Of Room To Mismeasure Real Output Growth In today’s economy, this could be a larger problem, as 70% of output is generated in the service sector. Estimating productivity growth is much harder in the service sector than in the manufacturing sector, as there is no actual countable output to measure. Thus, distinguishing price increases from quantity or quality improvements is challenging. Adding to this difficulty, the service sector is one of the main beneficiaries of the increase in computational power currently disrupting industries around the world. The growing share of components of the consumer price index subject to hedonic adjustments highlight this challenge (Chart II-5). Estimating quality changes is hard and may bias the increase in prices in the economy. If prices are unreliably measured, so will output and productivity. Pushing The Production Frontier Is Increasingly Hard Chart II-6A Multifaceted Decline In Productivity A Multifaceted Decline In Productivity A Multifaceted Decline In Productivity Another school of thought simply accepts that productivity growth has declined in a structural fashion. It is far from clear that the current technological revolution is much more productivity-enhancing than the introduction of electricity 140 years ago, the development of the internal combustion engine in the late 19th century, the adoption of indoor plumbing, or the discovery of penicillin in 1928. It is easy to overestimate the economic impact of new technologies. At first, like their predecessors, the microprocessor and the internet created entirely new industries. But this is not the case anymore. For all its virtues, e-commerce is only a new method of selling goods and services. Cloud computing is mainly a way to outsource hardware spending. Social media’s main economic value has been to gather more information on consumers, allowing sellers to reach potential buyers in a more targeted way. Without creating entirely new industries, spending on new technologies often ends up cannibalizing spending on older technologies. For example, while Google captures 32.4% of global ad revenues, similar revenues for the print industry have fallen by 70% since their apex in 2000. If new technologies are not as accretive to production as the introduction of previous ones were, productivity growth remains constrained by the same old economic forces of capex, human capital growth and resource utilization. And as Chart II-6 shows, labor input, the utilization of capital and multifactor productivity have all weakened. Some key drivers help understand why productivity growth has downshifted structurally. Let’s look at human capital. It is much easier to grow human capital when very few people have a high-school diploma: just make a larger share of your population finish high school, or even better, complete a university degree. But once the share of university-educated citizens has risen, building human capital further becomes increasingly difficult. Chart II-7 illustrates this problem. Growth in educational achievement has been slowing since 1995 in both advanced and developing economies. This means that the growth of human capital is slowing. This is without even wading into whether or not the quality of education has remained constant. This is pure market power, and it helps explain the gap between wages and productivity. Human capital is also negatively impacted by demographic trends. Workers in their forties tend to be at the peak of their careers, with the highest accumulated job know-how. Problematically, these workers represent a shrinking share of the labor force, which is hurting productivity trends (Chart II-8). Chart II-7 Chart II-8Demographics Are Hurting Productivity Demographics Are Hurting Productivity Demographics Are Hurting Productivity   The capital stock too is experiencing its own headwinds. While Moore’s Law seems more or less intact, the decline in the cost of storing information is clearly decelerating (Chart II-9). Today, quality adjusted IT prices are contracting at a pace of 2.3% per annum, compared to annual declines of 14% at the turn of the millennium. Thus, even if nominal spending in IT investment had remained constant, real investment growth would have sharply decelerated (Chart II-10). But since nominal spending has decelerated greatly from its late 1990s pace, real investment in IT has fallen substantially. The growth of the capital stock is therefore lagging its previous pace, which is hurting productivity growth. Chart II-9 Chart II-10The Impact Of Slowing IT Deflation The Impact Of Slowing IT Deflation The Impact Of Slowing IT Deflation Chart II-11A Dearth Of New Businesses A Dearth Of New Businesses A Dearth Of New Businesses   The collapse in new business formation in the U.S. is another fascinating development (Chart II-11). New businesses are a large source of productivity gains. Ultimately, 20% of productivity gains have come from small businesses becoming large ones. Think Apple in 1977 versus Apple today. A large decline in the pace of new business formation suggests that fewer seeds have been planted over the past 20 years to generate those enormous productivity explosions than was the case in the previous 50 years.   The X Factor: Growing Market Concentration The three aforementioned explanations for the decline in productivity are all appealing, but they generally leave investors looking for more. Why are companies investing less, especially when profit margins are near record highs? Why is inflation low? Why has the pace of new business formation collapsed? These are all somewhat paradoxical. Chart II-12Wide Profit Margins: A Testament To The Weakness Of Labor Wide Profit Margins: A Testament To The Weakness Of Labor Wide Profit Margins: A Testament To The Weakness Of Labor This is where a growing body of works comes in. Our economy is moving away from the Adam Smith idea of perfect competition. Industry concentration has progressively risen, and few companies dominate their line of business and control both their selling prices and input costs. They behave as monopolies and monopsonies, all at once.1 This helps explain why selling prices have been able to rise relative to unit labor costs, raising margins in the process (Chart II-12). Let’s start by looking at the concept of market concentration. According to Grullon, Larkin and Michaely, sales of the median publicly traded firms, expressed in constant dollars, have nearly tripled since the mid-1990s, while real GDP has only increased 70% (Chart II-13).2 The escalation in market concentration is also vividly demonstrated in Chart II-14. The top panel shows that since 1997, most U.S. industries have experienced sharp increases in their Herfindahl-Hirshman Index (HHI),3 a measure of concentration. In fact, more than half of U.S. industries have experienced concentration increases of more than 40%, and as a corollary, more than 75% of industries have seen the number of firms decline by more than 40%. The last panel of the chart also highlights that this increase in concentration has been top-heavy, with a third of industries seeing the market share of their four biggest players rise by more than 40%. Rising market concentration is therefore a broad phenomenon – not one unique to the tech sector. Chart II-13 Chart II-14     This rising market concentration has also happened on the employment front. In 1995, less than 24% of U.S. private sector employees worked for firms with 10,000 or more employees, versus nearly 28% today. This does not seem particularly dramatic. However, at the local level, the number of regions where employment is concentrated with one or two large employers has risen. Azar, Marinescu and Steinbaum developed Map II-1, which shows that 75% of non-metropolitan areas now have high or extreme levels of employment concentration.4 Chart II- Chart II-15The Owners Of Capital Are Keeping The Proceeds Of The Meagre Productivity Gains The Owners Of Capital Are Keeping The Proceeds Of The Meagre Productivity Gains The Owners Of Capital Are Keeping The Proceeds Of The Meagre Productivity Gains This growing market power of companies on employment can have a large impact on wages. Chart II-15 shows that real wages have lagged productivity since the turn of the millennium. Meanwhile, Chart II-16 plots real wages on the y-axis versus the HHI of applications (top panel) and vacancies (bottom panel). This chart shows that for any given industry, if applicants in a geographical area do not have many options where to apply – i.e. a few dominant employers provide most of the jobs in the region – real wages lag the national average. The more concentrated vacancies as well as applications are with one employer, the greater the discount to national wages in that industry.5 This is pure market power, and it helps explain the gap between wages and productivity as well as the widening gap between metropolitan and non-metropolitan household incomes. Chart II-16 Growing market power and concentration do not only compress labor costs, they also result in higher prices for consumers. This seems paradoxical in a world of low inflation. But inflation could have been even lower if market concentration had remained at pre-2000s levels. In 2009, Matthew Weinberg showed that over the previous 22 years, horizontal mergers within an industry resulted in higher prices.6 In a 2014 meta-study conducted by Weinberg along with Orley Ashenfelter and Daniel Hosken, the authors showed that across 49 studies ranging across 21 industries, 36 showed that horizontal mergers resulted in higher prices for consumers.7 While today’s technology may be enhancing the productive potential of our economies, this is not benefiting output and measured productivity. Instead, it is boosting profit margins. In a low-inflation environment, the only way for companies to garner pricing power is to decrease competition, and M&As are the quickest way to achieve this goal. After examining nearly 50 merger and antitrust studies spanning more than 3,000 merger cases, John Kwoka found that, following mergers that augmented an industry’s concentration, prices increased in 95% of cases, and on average by 4.5%.8 In no industry is this effect more vividly demonstrated than in the healthcare field, an industry that has undergone a massive wave of consolidation – from hospitals, to pharmacies to drug manufacturers. As Chart II-17 illustrates, between 1980 and 2016, healthcare costs have increased at a much faster pace in the U.S. than in the rest of the world. However, life expectancy increased much less than in other advanced economies. Chart II-17 In this context of growing market concentration, it is easy to see why, as De Loecker and Eeckhout have argued, markups have been rising steadily since the 1980s (Chart II-18, top panel) and have tracked M&A activity (Chart II-18, bottom panel).9 In essence, mergers and acquisitions have been the main tool used by firms to increase their concentration. Another tool at their disposal has been the increase in patents. The top panel of Chart II-19 shows that the total number of patent applications in the U.S. has increased by 3.6-fold since the 1980s, but most interestingly, the share of patents coming from large, dominant players within each industry has risen by 10% over the same timeframe (Chart II-19, bottom panel). To use Warren Buffet’s terminology, M&A and patents have been how firms build large “moats” to limit competition and protect their businesses. Chart II-18Markups Rise Along With Growing M&A Activity Markups Rise Along With Growing M&A Activity Markups Rise Along With Growing M&A Activity Chart II-19How To Build A Moat? How To Build A Moat? How To Build A Moat?   Why is this rise in market concentration affecting productivity? First, from an empirical perspective, rising markups and concentration tend to lead to lower levels of capex. A recent IMF study shows that the more concentrated industries become, the higher the corporate savings rate goes (Chart II-20, top panel).10 These elevated savings reflect wider markups, but also firms with markups in the top decile of the distribution display significantly lower investment rates (Chart II-20, bottom panel). If more of the U.S. output is generated by larger, more concentrated firms, this leads to a lower pace of increase in the capital stock, which hurts productivity. Second, downward pressure on real wages is also linked to a drag on productivity. Monopolies and oligopolies are not incentivized to maximize output. In fact, for any market, a monopoly should lead to lower production than perfect competition would. Diagram II-I from De Loecker and Eeckhout shows that moving from perfect competition to a monopoly results in a steeper labor demand curve as the monopolist produces less. As a result, real wages move downward and the labor participation force declines. Does this sound familiar? Chart II-20 Chart II-   The rise of market power might mean that in some way Martin Feldstein was right about productivity being mismeasured – just not the way he anticipated. In a June 2017 Bank Credit Analyst Special Report, Peter Berezin showed that labor-saving technologies like AI and robotics, which are increasingly being deployed today, could lead to lower wages (Chart II-21).11 For a given level of technology in the economy, productivity is positively linked to real wages but inversely linked to markups – especially if the technology is of the labor-saving kind. So, if markups rise on the back of firms’ growing market power, the ensuing labor savings will not be used to increase actual input. Rather, corporate savings will rise. Thus, while today’s technology may be enhancing the productive potential of our economies, this is not benefiting output and measured productivity. Instead, it is boosting profit margins.12 Unsurprisingly, return on assets and market concentration are positively correlated (Chart II-22). Chart II-21 Chart II-22     Finally, market power and concentration weighing on capex, wages and productivity are fully consistent with higher returns of cash to shareholders and lower interest rates. The higher profits and lower capex liberate cash flows available to be redistributed to shareholders. Moreover, lower capex also depresses demand for savings in the economy, while weak wages depress middle-class incomes, which hurts aggregate demand. Additionally, higher corporate savings increases the wealth of the richest households, who have a high marginal propensity to save. This results in higher savings for the economy. With a greater supply of savings and lower demand for those savings, the neutral rate of interest has been depressed. Investment Implications First, in an environment of low inflation, investors should continue to favor businesses that can generate higher markups via pricing power. Equity investors should therefore continue to prefer industries where horizontal mergers are still increasing market concentration. Second, so long as the status quo continues, wages will have a natural cap, and so will the neutral rate of interest. This does not mean that wage growth cannot increase further on a cyclical basis, but it means that wages are unlikely to blossom as they did in the late 1960s, even within a very tight labor market. Without too-severe an inflation push from wages, the business cycle could remain intact even longer, keeping a window open for risk assets to rise further on a cyclical basis. Third, long-term investors need to keep a keen eye on the political sphere. A much more laissez-faire approach to regulation, a push toward self-regulation, and a much laxer enforcement of antitrust laws and merger rules were behind the rise in market power and concentration.13 The particularly sharp ascent of populism in Anglo-Saxon economies, where market power increased by the greatest extent, is not surprising. So far, populists have not blamed the corporate sector, but if the recent antitrust noise toward the Silicon Valley behemoths is any indication, the clock is ticking. On a structural basis, this could be very negative for asset prices. An end to this rise in market power would force profit margins to mean-revert toward their long-term trend, which is 4.7 percentage-points below current levels. This will require discounting much lower cash flows in the future. Additionally, by raising wages and capex, more competition would increase aggregate demand and lift real interest rates. Higher wages and aggregate demand could also structurally lift inflation. Thus, not only will investors need to discount lower cash flows, they will have to do so at higher discount rates. As a result, this cycle will likely witness both a generational peak in equity valuations as well as structural lows in bond yields. As we mentioned, these changes are political in nature. We will look forward to studying the political angle of this thesis to get a better handle on when these turning points will likely emerge. Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1       A monopsony is a firm that controls the price of its input because it is the dominant, if not unique, buyer of said input. 2       G. Grullon, Y. Larkin and R. Michaely, “Are Us Industries Becoming More Concentrated?,” April 2017. 3       The Herfindahl-Hirschman Index (HHI) is calculated by taking the market share of each firm in the industry, squaring them, and summing the result. Consider a hypothetical industry with four total firm where firm1, firm2, firm3 and firm4 has 40%, 30%, 15% and 15% of market share, respectively. Then HHI is 402+302+152+152 = 2,950. 4       J. Azar, I. Marinescu, M. Steinbaum, “Labor Market Concentration,” December 2017. 5     J. Azar, I. Marinescu, M. Steinbaum, “Labor Market Concentration,” December 2017. 6     M. Weinberg, “The Price Effects Of Horizontal Mergers”, Journal of Competition Law & Economics, Volume 4, Issue 2, June 2008, Pages 433–447. 7     O. Ashenfelter, D. Hosken, M. Weinberg, "Did Robert Bork Understate the Competitive Impact of Mergers? Evidence from Consummated Mergers," Journal of Law and Economics, University of Chicago Press, vol. 57(S3), pages S67 - S100. 8    J. Kwoka, “Mergers, Merger Control, and Remedies: A Retrospective Analysis of U.S. Policy,” MIT Press, 2015. 9     J. De Loecker, J. Eeckhout, G. Unger, "The Rise Of Market Power And The Macroeconomic Implications," Mimeo 2018. 10     “Chapter 2: The Rise of Corporate Market Power and Its Macroeconomic Effects,” World Economic Outlook, April 2019. 11     Please see The Bank Credit Analyst Special Report "Is Slow Productivity Growth Good Or Bad For Bonds?"dated May 31, 2017, available at bca.bcaresearch.com. 12     Productivity can be written as: Image 13     J. Tepper, D. Hearn, “The Myth of Capitalism: Monopolies and the Death of Competition,” Wiley, November 2018.

Highlights We are searching for evidence of an imminent end to this business cycle, … : Investors who recognize the onset of the recession in a timely fashion will have a leg up on the competition all the way through the intermediate term. … but the data do not support the increasingly popular conclusion that it is nearly at hand, … : The U.S. economy is doing quite well and contradicts the message from the inverted yield curve, which may well be a less powerful signal than it has been in the past. … and it’s hard to see the end of the expansion when the Fed’s trying its utmost to sustain it: Restrictive monetary policy is a necessary, if not sufficient, condition for a recession. Last week’s FOMC meeting pushed that eventuality beyond the visible horizon. Maintain a pro-risk portfolio positioning. Feature What if you gave a party and nobody came? The U.S. economy is finding out as we speak. The expansion that began in July 2009 turns ten years old at the end of the week, and no one seems to care. An expansion and bull market that have been derided from the get-go as “artificial,” “manufactured,” and “propped up by money printing” continue to be unloved, yet manage to keep chugging along like the Energizer bunny. The expansion has been no more pleasing to the eye than the famous toy in the battery commercials, plodding along at an often sluggish pace, but that may be the secret to its longevity. It has never been able to achieve a high enough rate of speed to give rise to unsustainable activity in the most cyclical segments of the economy. Ditto the bull markets in equities and spread product. Held in check by a deficiency of animal spirits, they have failed to breed valuation excesses. In the absence of a clearly approaching catalyst for reversal, internal or external, there is no reason to expect that the U.S. economy cannot continue to expand at its meandering post-crisis pace. An increasing number of market participants, including some within BCA, cite the inverted yield curve, disappointing May employment report, and weakening manufacturing activity at home and abroad as ill portents for the economy. On the face of it, these factors are surely inauspicious. Upon further examination, though, they aren’t as bad as they’ve been made out to be. An investor who sniffs out the next recession, and shifts asset allocation aggressively in line with that recognition, will have a very good chance of outperforming over both the near and intermediate term. Timely recognition of inflection points is how macro analysis most clearly benefits money managers. Since equity bull markets tend to be highly potent in their final stages, however, crying wolf can be especially damaging to relative performance. In our view, the available evidence does not support the conclusion that the end of the cycle is at hand and that investors should de-risk their portfolios. The Yield Curve Isn’t What It Used To Be We do not know how many basis points can dance on the head of a pin, and neither do the battalions of central bank economists who have been unable to settle exactly how large-scale asset purchases hold down interest rates. Those purchases’ flow effect (the share of newly-issued bonds purchased by a central bank), stock effect (the share of outstanding bonds held by a central bank), and forward guidance’s muzzling of bond and inflation volatility may all play a role. At the end of the day, it appears quite likely that QE has depressed the term premium on the 10-year Treasury bond, which recently made 50-year lows. The term premium is the compensation investors receive for tying up their money in a longer-maturity instrument, and it is a whopping 250 basis points below its long-run mean (Chart 1). Chart 1The Bombed-Out Term Premium ... The Bombed-Out Term Premium ... The Bombed-Out Term Premium ... Yield curve has been a reliable, if often early, leading indicator of recessions for the last 50 years. The unprecedentedly low 10-year term premium renders the definitive 3-month/10-year segment of the yield curve considerably more prone to invert. The only sustained yield-curve inversion that issued a false recession signal in the 57-year history of the Adrian, Crump and Moench term-premium estimate occurred in late 1966/early 1967,1 when the term premium skittered around both sides of the zero bound (Chart 2). If investors had received no additional compensation for holding the 10-year Treasury over the last five decades, an inverted curve would be a regular feature of the investment landscape (Chart 3). Chart 2... Is Distorting The Signal From The Yield Curve, ... ... Is Distorting The Signal From The Yield Curve, ... ... Is Distorting The Signal From The Yield Curve, ... Chart 3... Which Wouldn't Slope Upward Without It ... Which Wouldn't Slope Upward Without It ... Which Wouldn't Slope Upward Without It Leading Data Do Not Confirm The Yield Curve’s Signal Chart 4Only Manufacturing Looks Recession-ish Only Manufacturing Looks Recession-ish Only Manufacturing Looks Recession-ish Investors ignore the yield curve at their own risk. It has been a reliable, if often early, leading indicator of recessions for the last 50 years. We view its current inversion as a yellow light, and it is making us more vigilant about seeking out evidence of a slowdown. Given that the negative term premium weighs heavily on long-dated yields, however, investors should not de-risk portfolios unless the flow of data corroborates its signal. Our Global Fixed Income Strategy colleagues sought that corroboration by performing a cycle-on-cycle analysis of a selection of data series with leading properties – the Conference Board’s LEI, initial unemployment claims, the manufacturing ISM’s new-orders-to-inventories ratio and the Conference Board’s consumer confidence index. The analysis compares the current position of each indicator with its average position in the run-up to the last five recessions (January-July ’80 through December ’07-June ’09). With the exception of the weak new-orders-to-inventories ratio (Chart 4, third panel), none of the indicators are in a position that suggests trouble lies ahead (Chart 4). For the time being, the incoming data flow only confirms the concerns about the weak manufacturing outlook. Is Economic Activity Really Slowing? The course of GDP growth makes it appear as if the U.S. is slowing pretty quickly. After the first quarter’s surprisingly strong 3.1% growth, consensus second-quarter estimates are hovering around 1.75%. Viewed alongside the sizable shortfall in May payroll gains, uninspiring housing activity and a sharp global manufacturing downturn, the deceleration in GDP growth seems to confirm the notion that the U.S. economy is weakening fast. We are not overly concerned about the labor market, housing or manufacturing, however, and the GDP trend is not what it appears to be at first blush. Real final domestic demand growth at 3% is well above the economy’s long-run potential and is hardly the sign of an economy that’s gasping for air, or staggering under the weight of an overly high fed funds rate. To get the best read on the underlying state of the domestic economy, we adjust GDP data to back out net exports and inventory adjustments. Backing out net exports puts the focus on domestic conditions, while removing inventory adjustments isolates sales to end consumers. The result is real final domestic demand, and according to the Atlanta Fed’s GDPNow model, it accelerated sharply between the first and second quarters. The first quarter was flattered by a 60-basis-point (“bps”) inventory build and a highly-unlikely-to-be-repeated 100-bps contribution from net exports. After backing those components out of the headline 3.1% gain, first quarter growth slips to 1.5%. That may not look like much against 2-2.25% trend growth, but it was not at all bad given the body blows the economy sustained in the first quarter: the federal government shutdown that stretched across nearly all of January, and the severe tightening in financial conditions resulting from the fourth quarter’s sharp sell-offs in equities and risky bonds. Following last week’s stronger-than-expected May retail sales report (and upwardly revised April data), the GDPNow model is projecting 2% growth in the second quarter. Per the model’s detailed projections, the headline gain is being held back by a 100-bps inventory runoff. Removing the inventory adjustment, real final domestic demand is projected to grow at 3% (net exports are projected to make zero contribution). 3% growth is well above the economy’s long-run potential and is hardly the sign of an economy that’s gasping for air, or staggering under the weight of an overly high fed funds rate. Per the current GDPNow projections, real final domestic demand growth is above the expansion’s mean growth rate, casting some doubt on whether the yield curve’s signal has been overwhelmed by a pickup in risk aversion and the factors that have flipped the term premium on its head. 3% real final domestic demand represents a quickening in the pace of growth that has prevailed across the 40 quarters of the expansion (Chart 5), and is incompatible with the message from the New York Fed’s yield curve-based recession probability indicator (“RPI”). To evaluate the current warning, we compared the standardized value of real final domestic demand growth during the previous quarters of the expansion when the New York Fed’s RPI was above the 33% level that has accurately foretold every recession over the last 50 years (Chart 6). When all of the previous RPI warning signals were issued, real final domestic demand growth was slower than its expansion average (z-score less than zero), and in all but one case considerably slower, clustering around one standard deviation below the mean (Table 1). Per the current GDPNow projections, real final domestic demand growth is above the expansion’s mean growth rate, casting some doubt on whether the yield curve’s signal has been overwhelmed by a pickup in risk aversion and the factors that have flipped the term premium on its head. Chart 5Real Final Domestic Demand Is Still Vigorous Real Final Domestic Demand Is Still Vigorous Real Final Domestic Demand Is Still Vigorous Chart 6The New York Fed's Yield-Curve-Based Recession Model Is Flashing Red The New York Fed's Yield-Curve-Based Recession Model Is Flashing Red The New York Fed's Yield-Curve-Based Recession Model Is Flashing Red The Labor Market Is Still Roaring Table 1New York Fed Recession Warnings And Economic Conditions Everybody Into The Pool! Everybody Into The Pool! Consumption plays an outsized role in the U.S. economy, accounting for over two-thirds of GDP. As macro analysts are well aware, if you have an accurate read on consumption, you’ll know where the U.S. economy is headed. Extending the relationship to encompass household income’s impact on spending, and employment’s impact on income, the expression can be rewritten as: If you get the labor market right, you’ll get consumption right. The May employment situation report was roundly disappointing, as May net hirings fell short of expectations by about 100,000 and March and April gains were revised down by 75,000. Chart 7Employees Are Gaining The Upper Hand Employees Are Gaining The Upper Hand Employees Are Gaining The Upper Hand     The three-month moving average of net payroll additions slipped to just over 150,000. 110,000 monthly net additions is all it takes to keep the unemployment rate at a steady state, however, and there is some evidence that Midwestern flooding held down the May figure. With the job openings rate at a series high well above the 2006-07 peak and (most likely) above the peak in 1999-2000 (Chart 7, top panel), there is quite a lot of demand for new workers, as confirmed by the sizable margin of consumers who report that jobs are plentiful over those who report they’re hard to get (Chart 7, middle panel). The elevated quits rate (Chart 7, bottom panel) indicates that employers are competing fiercely to fill that demand. Given that almost no one quits a job unless s/he already has another one lined up, the quits rate reveals that employers are poaching employees from each other. When Employer A, after losing an employee to Employer B, plucks a replacement away from Employer C or Employer D, a self-reinforcing cycle quickly springs up that endows employees with some bargaining power. The budding dynamic is good for household income and good for consumption. Manufacturing’s Softness Isn’t Such A Big Deal The weakness in manufacturing PMI surveys around the world reveals that there has clearly been a significant global manufacturing slowdown, if not a full-on global manufacturing recession. The steep slide in the U.S. manufacturing PMI shows that it has not been immune. Manufacturing only accounts for about one-sixth of U.S. output and employment, however, and the level of the PMI series, which has simply returned to its mean level across the last three complete cycles, is not a cause for concern (Chart 8). The trend is worrisome, though, and we are watching to see if it breaks through the 50 boom-bust line. Manufacturing is weakening, but it’s not in dire straits yet. Chart 8Manufacturing Is Weakening, But It's Not In Dire Straits Yet Manufacturing Is Weakening, But It's Not In Dire Straits Yet Manufacturing Is Weakening, But It's Not In Dire Straits Yet Refilling The Punch Bowl This week’s FOMC meeting delivered on the change in tone intimated by Fed speakers at the beginning of the month. It appears that a couple of rate cuts may be forthcoming, whether the economy needs them or not. We had advised clients that the chances of a July rate cut were slightly more than fifty-fifty, but the probability now appears to be much higher. A follow-up cut in September also seems likely. The Fed’s move to insure against an economic shock pushes out our recession timetable yet again. If the fed funds rate is headed to 2% from its current 2.5%, the road to a restrictive policy setting in the mid-3s just got longer. The good news for our recommendations is that they were already decidedly risk friendly, on the grounds that there’s no need to de-risk until a recession is around six months away. Assuming no exogenous event intrudes on U.S. economic activity, neither the expansion nor the bull markets in risk assets will end until the Fed takes away the punch bowl. Right now, it seems intent on refilling it. As a client in Western Canada put it in a meeting with us last week, “Game on!” Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 On the basis of monthly rate/yield data, the 1998 false positive comprised just one observation (September).

Highlights A resurfacing of trade tensions could weigh on risk sentiment in the near term. A somewhat less dovish tone from the FOMC this month could further rattle risk assets. While we would not exclude the possibility of an “insurance cut,” the Fed is probably uncomfortable with the amount of easing that markets now expect. That being said, a trade truce is still more likely than not, and while the Fed will resist cutting rates this year, it will not raise them either. The neutral rate of interest in the U.S. is higher than widely believed, which means that monetary policy will remain accommodative. That’s good news for global equities. Investors should maintain a somewhat cautious stance over the next month or so. However, they should overweight stocks, while underweighting bonds, over a 12-month horizon. The equity bull market will only end when U.S. inflation rises to a level that forces the Fed to pick up the pace of rate hikes. That is unlikely to occur until late-2020 at the earliest. Feature Stocks Bounce Back We turned positive on global equities in late December after a six-month period on the sidelines. While we have remained structurally bullish over the course of this year, we initiated a tactical hedge to short the S&P 500 on May 10th following what we regarded as an overly complacent reaction by investors to President Trump’s decision to increase tariffs on Chinese imports. Our reasoning at the time was that a period of market pressure would likely be necessary to forge an agreement between the two sides. Our thesis was looking prescient for a while. However, the rebound in stocks since last week has brought the S&P 500 close to the level where we initiated the trade. Is it time to drop the hedge? Not yet. First, market internals do not inspire much confidence. Even though the S&P 500 is just below its year-to-date (and all-time) high, the Russell 2000 is 5.1% below its May highs, and 11.8% below where it was last August (Chart 1). The S&P mid cap and small cap indexes are 6.8% and 16.2%, respectively, below their highs reached last August. Such weak breadth is disconcerting. Chart 1U.S. Stocks: Not As Strong As They Appear U.S. Stocks: Not As Strong As They Appear U.S. Stocks: Not As Strong As They Appear Second, President Trump’s decision to suspend raising the tariffs on Mexican imports may have had less to do with his desire to seek a more conciliatory tone, and more to do with pressure from Congressional Republicans. Various news reports suggested that Mitch McConnell and other Republican leaders opposed the action, and threatened to revoke the President’s authority to unilaterally impose tariffs.1 In the end, the deal with Mexico contained many of the same measures that the Mexicans had already agreed to implement months earlier. Our geopolitical team remains skeptical of a grand bargain in trade talks with China.2 In the United States, protectionist sentiment is politically more popular towards China than it is towards other countries (Chart 2). A breakthrough is still probable, but again, it may take a stock market selloff to produce a trade truce. Chart 2 Chart 2   Third, we have become increasingly concerned that the market has gotten ahead of itself in pricing in Fed easing. While we would not rule out the possibility that the Fed takes out an “insurance cut” to guard against downside risks to the economy, the 80 basis points of easing that the market has priced in over the next 12 months seems excessive to us. Chart 3Financial Conditions Have Not Tightened Much Financial Conditions Have Not Tightened Much Financial Conditions Have Not Tightened Much Unlike late last year, U.S. financial conditions have tightened only modestly over the past nine weeks (Chart 3). The economy is also performing reasonably well. According to the Atlanta Fed GDPNow model, real final sales to domestic purchasers3 are set to grow by 2.5% in the second quarter, up from 1.5% in Q1 (Chart 4). Real personal consumption expenditures are on track to rise by 3.2%. Gasoline futures have tumbled, which will support discretionary spending over the next few quarters (Chart 5).   Chart 4 Chart 5Lower Gasoline Prices Should Bode Well For Discretionary Spending Lower Gasoline Prices Should Bode Well For Discretionary Spending Lower Gasoline Prices Should Bode Well For Discretionary Spending Granted, the labor market has cooled down. Payrolls increased by only 75K in May. However, the Council of Economic Advisers estimated that flooding in the Midwest shaved 40K from payrolls. And even with this adverse impact, the three-month average for payroll growth still stands at 151K, well above the 90K-to-100K or so that is needed to keep up with labor force growth. Meanwhile, initial unemployment claims remain muted and the employment component of the nonmanufacturing ISM hit a seven-month high in May. Chart 6Trimmed Mean PCE Inflation Back To 2% Trimmed Mean PCE Inflation Back To 2% Trimmed Mean PCE Inflation Back To 2% Inflation expectations are on the low side, but actual inflation is proving to be reasonably sturdy. The core PCE index rose by 0.25% month-over-month in April. Trimmed mean PCE inflation increased above 2% on a year-over-year basis for the first time in seven years (Chart 6). According to a recent Fed study, the trimmed mean calculation is superior to the core PCE index as a summary measure of underlying inflationary trends.4 Ultimately, the fact that the U.S. economy is holding up well is a positive sign for equity returns over the next 12 months. In the short term, however, it does create the risk that the Fed will sound less dovish than investors are anticipating, leading to a temporary selloff in stocks. Hence our view: near-term cautious, longer-term bullish. Who Determines Interest Rates? Central banks decide where rates will go in the short run, but it is the economy that determines where interest rates will go in the long run. The neutral rate of interest is the rate that corresponds to full employment and stable inflation. One can also think of it as the rate that aligns the level of aggregate demand with the maximum potential output the economy is capable of achieving without overheating. Both the Fed dots and the widely-used Laubach Williams model suggest that rates are close to neutral. But are they really? If a central bank keeps rates below their neutral level for too long, inflation will eventually break out, forcing the central bank to raise rates. Conversely, if a central bank raises rates above their neutral level, growth will slow, inflation will decline, and the central bank will be forced to cut rates. The problem is that changes in monetary policy typically affect the economy with a lag of 12-to-18 months. Inflation is also a highly lagging indicator. It usually peaks well after a recession has begun and troughs long after the recovery is under way (Chart 7). Thus, central banks have to make an educated guess as to where the neutral rate lies and try to steer the economy towards that rate in a way that achieves a soft landing. Needless to say, this is easier said than done. Chart 7 Today, both the Fed dots and the widely-used Laubach Williams model suggest that rates are close to neutral (Chart 8). Chart 8The Fed Thinks Rates Are Close To Neutral The Fed Thinks Rates Are Close To Neutral The Fed Thinks Rates Are Close To Neutral But are they really? That’s the million dollar question. Not only will the answer determine the medium-term path of interest rates, it will also determine how long the current U.S. economic expansion will last. Recessions rarely occur when monetary policy is accommodative, and equity bear markets almost never happen outside of recessionary periods (Chart 9). Thus, if rates are currently well below neutral, investors should maintain a bullish equity tilt. Chart 9Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Chart 10U.S.: Federal Fiscal Policy Has Been Expansionary U.S.: Federal Fiscal Policy Has Been Expansionary U.S.: Federal Fiscal Policy Has Been Expansionary Where Is Neutral? The neutral rate of interest is a function of many variables, most of which are not in the Laubach Williams model. Let us consider a few: Fiscal Policy A larger budget deficit boosts aggregate demand, while higher interest rates lower demand. Thus, once an economy has achieved full employment, an easing of fiscal policy must be counterbalanced by an increase in interest rates, which is another way of saying that looser fiscal policy raises the neutral rate of interest. The U.S. cyclically-adjusted budget deficit has risen by about 3% of GDP since 2015. Both tax cuts and increased federal discretionary spending have contributed to the deterioration in the fiscal balance (Chart 10). Standard “Taylor Rule” equations suggest that a 1% of GDP increase in aggregate demand will raise the appropriate level of the fed funds rate by 0.5-to-1 percentage points.5 This implies that easier fiscal policy has lifted the neutral rate of interest by 1.5-to-3 percentage points over the past five years. Labor Market Developments A tight labor market tends to increase the share of national income accruing to workers (Chart 11). Workers generally spend more of every dollar of income than businesses. Thus, a shift of income from businesses to workers raises the neutral rate of interest. The fact that a tight labor market usually generates the biggest gains for workers at the bottom of the income distribution – who have the highest marginal propensity to spend – further amplifies the positive effect on aggregate spending. Chart 11Workers Garner A Larger Piece Of The Income Pie When The Labor Market Is Tight Workers Garner A Larger Piece Of The Income Pie When The Labor Market Is Tight Workers Garner A Larger Piece Of The Income Pie When The Labor Market Is Tight Chart 12 The labor share of income has rebounded since reaching a record low in 2014. The lowest-paid workers have also seen the largest wage increases during the past 12 months (Chart 12). Neither of these nascent developments have come close to unwinding the beating that labor has suffered in relation to capital over the past four decades, but if the unemployment rate keeps falling, workers are going to start gaining the upper hand. Thus, one would expect the neutral rate of interest to rise further as the labor market continues to tighten. Credit Growth The Great Recession ushered in a painful deleveraging cycle. Household debt fell from 86% of GDP in 2009 to 70% of GDP in 2012. The household debt-to-GDP ratio has edged slightly lower since then due to continued declines in mortgage debt and home equity lines of credit. A return to the rapid pace of credit growth seen before the financial crisis is unlikely. Nevertheless, a modest releveraging of household balance sheets would not be surprising. Some categories such as student and auto loans have seen fairly robust debt growth (Chart 13). Housing-related debt could also stage a modest comeback due to rising home prices and buoyant consumer confidence. Conceptually, the rate of credit growth determines the level of aggregate demand.6 Thus, if household credit growth picks up at the margin, this would push up the neutral rate of interest. Corporate debt levels also have scope to rise further. Net corporate debt is only modestly higher than it was in the late 1980s, a period when the fed funds rate averaged nearly 10% (Chart 14). Chart 13U.S. Housing Deleveraging Has Slowed U.S. Housing Deleveraging Has Slowed U.S. Housing Deleveraging Has Slowed Chart 14U.S. Corporate Debt (I): No Cause For Alarm U.S. Corporate Debt (I): No Cause For Alarm U.S. Corporate Debt (I): No Cause For Alarm   Thanks to low interest rates and rapid asset accumulation, the economy-wide interest coverage ratio is above, while the ratio of debt-to-assets is below, their respective long-term averages (Chart 15). The corporate sector financial balance – the difference between what businesses earn and spend – is still in surplus. Almost every recession in the post-war era has begun when the corporate sector financial balance was in deficit (Chart 16). Chart 15U.S. Corporate Debt (II): No Cause For Alarm U.S. Corporate Debt (II): No Cause For Alarm U.S. Corporate Debt (II): No Cause For Alarm Chart 16U.S. Corporate Debt (III): No Cause For Alarm U.S. Corporate Debt (III): No Cause For Alarm U.S. Corporate Debt (III): No Cause For Alarm     The Value Of The U.S. Dollar A stronger dollar reduces net exports. This drains demand from the economy, which lowers the neutral rate of interest. The real broad trade-weighted dollar index has risen 10% since 2014. According to the New York Fed’s econometric model, this would be expected to reduce the level of real GDP by 0.5% in the first year and by a further 0.2% in the second year, for a cumulative decline of 0.7%, equivalent to a decrease in the neutral rate of 0.35%-to-0.7%. The New York Fed model assumes an “all things equal” environment. All things have not been quite equal, however. The U.S. has benefited from a modest improvement in its terms of trade7 over the past five years (Chart 17). The shale boom has also significantly cut into oil imports. As a result, the trade deficit has fallen from 5.9% of GDP in 2005 to 2.9% of GDP at present. Chart 17The Dollar Has Appreciated Since 2014 The Dollar Has Appreciated Since 2014 The Dollar Has Appreciated Since 2014 Chart 18The Savings Rate Has (A Lot Of) Room To Drop, Judging From The Historical Relationship With Wealth The Savings Rate Has (A Lot Of) Room To Drop, Judging From The Historical Relationship With Wealth The Savings Rate Has (A Lot Of) Room To Drop, Judging From The Historical Relationship With Wealth Asset Prices An increase in asset values – whether they be equities, bonds, or homes – makes people and businesses feel wealthier, which leads to more consumption and investment spending. As such, higher asset prices raise the neutral rate of interest. Today, U.S. household net worth stands near a record high as a percent of disposable income (Chart 18). The personal savings rate, in contrast, still stands at an elevated 6.4%. If the savings rate falls over the coming months, this would further boost aggregate demand. Demographics Slower labor force growth has led to a decline in trend GDP growth in the U.S. and most other economies. Slower economic growth tends to reduce the neutral rate of interest. The Bureau of Labor Statistics expects labor force growth to be broadly stable over the next 5-to-10 years, with immigration compensating for the withdrawal of baby boomers from employment (Chart 19). Chart 19 Chart 20Savings Over The Life Cycle Savings Over The Life Cycle Savings Over The Life Cycle In the current political climate, there is quite a bit of uncertainty over how many immigrants will settle in the United States. On the one hand, less immigration would reduce labor force growth, thus lowering the neutral rate. On the other hand, a decline in immigration would lead to an even tighter labor market, thus potentially raising the neutral rate. An additional question is how population aging, which will continue even if immigration remains elevated, will affect the neutral rate. Older people work less, but consume more than younger people, once health care spending is accounted for (Chart 20). If overall national output falls in relation to consumption, national savings will go down. This will raise the neutral rate of interest. The Shift To A Capital-Lite Economy Firms increasingly need less physical capital to carry out their activities. Larry Summers has labeled this the “demassification” of the economy. Lower investment spending would translate into a lower neutral rate. While plausible, it is not clear how important this phenomenon is. Companies may need less physical capital, but they need more human capital. Instead of more lending to businesses to finance purchases of machinery, we get additional lending to students. If our thesis that the neutral rate of interest is higher than widely believed turns out to be correct, this means that the Fed will eventually need to start hiking rates again. The question is when. The share of R&D and other intangibles in business investment has risen from around 14% in the 1960s to 33% today (Chart 21). Importantly, the depreciation rate for intangible investment is much higher than for other forms of capital spending. As intangible investment has increased, the overall depreciation rate for the economy has risen (Chart 22). Conceptually, an increase in the depreciation rate should lead to a higher neutral rate of interest.8 Chart 21A Larger Share Of Business Investment Is Intangible... A Larger Share Of Business Investment Is Intangible... A Larger Share Of Business Investment Is Intangible... Chart 22...And That Puts Upward Pressure On The Depreciation Rate ...And That Puts Upward Pressure On The Depreciation Rate ...And That Puts Upward Pressure On The Depreciation Rate   Watch Housing And Business Capex The discussion above suggests that the neutral rate of interest is probably higher than widely believed. That said, there is significant uncertainty around any estimate of the neutral rate. As such, we recommend that investors track the more interest-rate sensitive sectors of the economy to gauge whether monetary policy is becoming restrictive. Housing, and to a lesser extent, business capital expenditures are the key indicators to watch. As a long-lived asset, housing is very sensitive to mortgage rates. Chart 23 shows that changes in mortgage rates tend to lead residential investment and home sales by about six months. Chart 23Housing Is Interest-Rate Sensitive Housing Is Interest-Rate Sensitive Housing Is Interest-Rate Sensitive If the decline in mortgage rates since last fall fails to spur housing, this would support the claim that monetary policy turned restrictive last year. Fortunately, the jump in homebuilder confidence, the outperformance of homebuilder stocks, and the surge in mortgage applications for purchases all suggest that the housing sector remains on firm ground (Chart 24). Despite the broad-based weakness in the global manufacturing sector, U.S. capex intentions remain reasonably buoyant (Chart 25). This week’s release of the May NFIB small business survey, which showed that the share of firms citing “now is a good time to expand” jumped five points to a seven-month high, provides further evidence in support of this view. Chart 24Some Positives For U.S. Housing Some Positives For U.S. Housing Some Positives For U.S. Housing Chart 25U.S. Capex Intentions Remain Solid U.S. Capex Intentions Remain Solid U.S. Capex Intentions Remain Solid   A Two-Stage Fed Cycle Chart 26Inflation Expectations Are Not Where The Fed Wants Them To Be Inflation Expectations Are Not Where The Fed Wants Them To Be Inflation Expectations Are Not Where The Fed Wants Them To Be If our thesis that the neutral rate of interest is higher than widely believed turns out to be correct, this means that the Fed will eventually need to start hiking rates again. The question is when. Right now, the Fed has the luxury of time on its side. Even though some measures of core inflation such as the trimmed mean calculation discussed above have reached the Fed’s 2% target, this follows a prolonged period of below-target inflation. A few years of above-trend inflation would hardly be the worst thing in the world. The Fed’s failure to reach its inflation target has pushed long-term inflation expectations below the central bank’s comfort zone (Chart 26). Given the asymmetric risks created by the zero lower bound on interest rates - if inflation rises too fast, the Fed can always hike rates; but if inflation falls too much, it may be impossible to ease monetary policy by enough to avert a recession - the Fed can afford to remain patient. Thus, while the Fed is unlikely to cut rates as much as investors currently expect, it is also unlikely to raise them this year. Thanks to a cyclical revival in productivity growth, unit labor cost inflation has actually declined over the past 12 months (Chart 27). However, as we get into late next year and 2021, circumstances may change. If an increasingly tight jobs market continues to push up wage growth, unit labor costs will start to reaccelerate. Cost-push inflation will kick in. At that point, the Fed may have no choice but to pick up the pace of monetary tightening. All this suggests that Fed policy will evolve in two stages: an initial stage lasting for the next 12-to-18 months where the Fed is doing little-to-no tightening (and could even cut rates if the trade war heats up), followed by a second stage where the central bank is scrambling to raise rates to cool an overheated economy. U.S. Treasury yields are likely to rise modestly during the first stage in response to stronger-than-expected economic growth. We see the 10-year yield clawing its way back to the high-2% range by early next year. Yields could rise more precipitously, to around 4%, in the second stage once inflation begins to move decisively higher. The dollar is unlikely to strengthen during the first stage. Indeed, our baseline forecast calls for a period of modest dollar weakness stretching into late next year driven by a reacceleration in European and Chinese/EM growth. The sharp rebound in Chinese real estate equipment purchases from -18% on a six-month basis late last year to +30% in April suggests that the government’s stimulus efforts are working (Chart 28). Chart 27No Imminent Threat Of A Wage-Price Inflationary Spiral No Imminent Threat Of A Wage-Price Inflationary Spiral No Imminent Threat Of A Wage-Price Inflationary Spiral Chart 28China: A Sign That Stimulus Is Finding Its Way Into The Economy China: A Sign That Stimulus Is Finding Its Way Into The Economy China: A Sign That Stimulus Is Finding Its Way Into The Economy   The greenback will likely appreciate, perhaps significantly so, once the Fed picks up the pace of rate hikes in late 2020. The accompanying tightening in global financial conditions is likely to sow the seeds for a worldwide downturn in 2021. The combination of faster global growth and a weaker dollar will support global equities over the next 12 months. European and EM bourses will benefit the most. Investors should begin derisking in the second half of next year. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Footnotes 1      Patricia Zengerle, “U.S. Lawmakers Seek To Block Trump On Tariffs,” Reuters, June 5, 2019. 2      Please see Geopolitical Strategy Weekly Report, “Is Trump Ready For The New Long March?” dated May 24, 2019. 3      Final sales to domestic purchasers is equal to gross domestic product (GDP) excluding net exports of goods and services, less the change in private inventories. 4      Jim Dolmas and Evan F. Koenig, “Two Measures Of Core Inflation: A Comparison,” Federal Reserve Bank Of Dallas, Working Paper 1903, February 25, 2019. 5      Depending on which specification of the Taylor Rule one uses, a one percent of GDP increase in aggregate demand will increase the neutral rate of interest by half a point (John Taylor’s original specification) or by a full point (Janet Yellen’s preferred specification). John B. Taylor's 1993 specification is based on the following equation: rt = 2 + pt + 0.5(pt - 2) + 0.5yt. Janet Yellen's preferred specification is based on the following equation: rt = 2 + pt+ 0.5(pt - 2) + 1.0yt. Please note: For both specifications above, rt is the federal funds rate; pt is core PCE expressed as a year-over-year percent change; and yt is the output gap (as approximated using the unemployment gap and Okun's law). For further discussion, please see Janet L. Yellen, "The Economic Outlook And Monetary Policy," April 11, 2012. 6      Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. 7      Ratio (multiplied by 100) of the price index for exports of goods and services to the price index for imports of goods and services. 8      The higher the depreciation rate, the more investment is necessary to maintain the existing capital stock. More investment demand for any given level of savings implies a higher interest rate. One can see this in the Solow growth model, which posits that the neutral rate of interest (r*) should be equal to: Image Where a is the output elasticity of capital, s is the savings rate, n is labor force growth, g is the growth in total factor productivity, and d is the depreciation rate. The equation implies that the neutral rate of interest will increase if capital intensity increases, the savings rate declines, the rate of labor force growth picks up, technological progress accelerates, or the depreciation rate increases.     Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 29 Tactical Trades Strategic Recommendations Closed Trades

Highlights 10-year real Spanish and Portuguese bond yields have already fallen below the neutral rate of interest for the entire euro zone. This suggests monetary conditions could now be favorable for all euro zone countries. Should external demand pick up, this will also help lift the equilibrium rate for the monetary union, which will be a tailwind for the EUR/USD. Falling U.S. rate expectations relative to policy action have historically been bearish for the dollar, with a lag of about six to 12 months. A risk to this view is further deterioration in the U.S.-China trade war, or a rollover in Chinese stimulus. Remain long EUR/CHF, with a tight stop at 1.11. Our bias is that the Swiss National Bank will continue to use the currency as a weapon to defend the economy. Feature The standard dilemma for the euro zone is that interest rates have always been too low for the most productive nation, Germany, but too expensive for others such as Spain and Italy. As such, the euro has typically been caught in a tug-of-war between a rising equilibrium rate of interest for Germany, but a very low neutral rate for the peripheral countries. Over the years, the impasse has been resolved from time to time through a combination of internal devaluation, currency depreciation and a successively accommodative European Central Bank. This has helped prevent a collapse of the monetary union, but in the process generated tremendous volatility in the currency. Since the onset of the Great Recession, the EUR/USD has seen five boom/bust cycles of about 20% to 25%. For both domestic policymakers and global investors alike, this has been an untenable headache. The silver lining is that the ECB may now have finally lowered domestic interest rates and eased policy to the point where they are accommodative for almost all euro zone countries: 10-year government bond yields in France, Spain and even Portugal now sit at 11bps, 54bps and 65bps respectively, much below the neutral rate. This is severely easing financial conditions in the entire euro zone, with huge implications for European assets in general and the euro in particular. In short, the EUR/USD may be very close to a floor (Chart I-1). Chart I-1How Much Lower For Relative R-Star*? How Much Lower For Relative R-Star*? How Much Lower For Relative R-Star*? Structural Reforms Have Progressed The neutral rate of interest is simply the market price at which both the supply of savings and the demand for them clear. In academic parlance, this means the interest rate at which the economy is at full employment, but inflationary pressures are relatively contained. At this critical interest rate level, the economy tends to be in balance. The difficulty arises because most indicators of either full employment or inflation tend to be lagging. As such, steering interest rates toward the neutral level becomes a very difficult task for any one country and/or central bank to achieve in real time. For the euro zone as a whole, where member countries can have vastly diverging economic outcomes at any point in time, the task becomes even more arduous.   This is why since the introduction of the euro, most of the economic imbalances from the region have stemmed from the standard contradiction of a common currency regime. For most of the early 2000s, Spanish and Irish long-term rates were too low relative to the potential of their respective economies, and the reverse was true for Germany. As a result, Spanish real estate took off in what culminated to be one of the biggest booms in recent history, while it stagnated in Germany. And after the Great Recession, the reverse was true: rates became too low for the most productive nation, Germany, and too high for Ireland and Spain (Chart I-2). In a normal adjustment process, the exchange rate always tends to play a key role. In a common-currency regime, there is not such a possibility.  In a normal adjustment process, the exchange rate always tends to play a key role, since countries with lower productivity growth require a lower neutral rate, and as such see currency depreciation. This tends to ease financial conditions, alleviating the need for an internal adjustment process. However, in a common-currency regime, there is not such a possibility. The result is a painful process of internal devaluation, as was very vivid in the European peripheral countries from 2009-2012 (Chart I-3). Chart I-2The Common-Currency Dilemma The Common-Currency Dilemma The Common-Currency Dilemma Chart I-3Internal Devaluation In The South... Internal Devaluation In The South... Internal Devaluation In The South... The good news is that for the euro zone, it forced businesses to restructure and jumpstarted the process of structural reform. In the early 2000s, the German economy had to restructure in order to improve its competitiveness. As a result, unit labor costs began to lag in 2001. Over the same period, the German government began to reform the labor market. The Hartz IV labor market reforms implemented minimized safety nets for the unemployed, encouraging them to accept market-determined wages. This dramatically increased the flexibility of the labor market. The same script has been replayed over the last decade with the European periphery. Labor market reforms in Mediterranean Europe have seen unit labor costs in Greece, Ireland, Portugal and Spain collectively contract by almost 10%. This has effectively eliminated the competitiveness gap that had accumulated over the past two decades (Chart I-4). Italy remains saddled with a rigid and less productive workforce, but overall adjustments have still come a long way to closing a key fissure plaguing the common currency area. At the same time, other factors also suggest the neutral rate for individual countries should also have converged higher to that of Germany. Peripheral sovereign borrowing costs have plummeted from their prohibitive 2012 levels. As a result, interest payments as a share of GDP have become more manageable. Most southern European countries now run primary surpluses, reducing the need for external funding. Fortunately, the improvement in structural budget balances has diminished the need for any additional austerity measures, meaning government spending should no longer be a net drag on GDP growth. Increased integration continues to sustain a steady stream of cheap migrant workers to Germany.  On the labor market front, the unemployment rate in Germany remains well below that in other regions, but increased integration continues to sustain a steady stream of cheap migrant workers to Germany. Over the last decade, there has been a surge of migrant workers into Germany from countries such as Portugal or Spain (Chart I-5). This will help redistribute aggregate demand within the system. Chart I-4...Has Realigned Competitiveness ...Has Realigned Competitiveness ...Has Realigned Competitiveness Chart I-5The Unemployment Gap Is Closing The Unemployment Gap Is Closing The Unemployment Gap Is Closing The bottom line is that the various forces that may have been keeping the neutral rate of interest artificially low in the euro area are ebbing. The proverbial saying is that a chain is only as strong as its weakest link. This means that if these forces pressuring equilibrium rates in the periphery are slowly dissipating, that should lift the neutral rate of interest in the entire euro zone. Over a cyclical horizon, this should be bullish for the euro (previously referenced Chart I-1). Manufacturing Recession May Soon End With the rising specter of a full-blown trade war and a global manufacturing recession, it is possible that euro zone policy settings have become even more appropriate for Germany than the rest of Europe. For example, the latest PMI releases suggest that Germany is the weakest link in the euro zone on the manufacturing front (Chart I-6). The implication is that if the ECB’s monetary settings are now being calibrated for Germany, they may also now be appropriate for all euro zone countries. For example, since 2015, peripheral country exports have increased to 28% of GDP, from a low of 16%, despite strength in the trade-weighted euro. This contrasts favorably with Germany, where the export share of German GDP has essentially been flat over this period (Chart I-7). In fact, it is entirely possible that the German economy may have already 'maxed out' its export market share gains, given its externally driven growth model over the last decade. If so, further currency weakness can only lead to inflation and wage pressures in Germany, redistributing demand from exports to the domestic sector, while benefitting the periphery. Chart I-6Germany Is Once Again The Sickman Germany Is Once Again The Sickman Germany Is Once Again The Sickman Chart I-7GIPS Are Gaining Export Share GIPS Are Gaining Export Share GIPS Are Gaining Export Share Over the past few years, corporate profits as a share of GDP in both Portugal and Spain have overtaken German levels. And with the output gap is still open in these countries, it will take a while before the unemployment rate moves below NAIRU and begins to generate wage pressures. This will allow companies to continue reaping a labor dividend while gaining export market share. It is not easy to tell if and when the trade war will end sans escalation, but there remain a number of green shoots in the European economy: While the German PMI is currently one of the weakest in the euro zone, forward-looking indicators suggest we are on the cusp of a V-shaped bottom over the next few months or so (Chart I-8). A rising Chinese credit impulse is usually bullish for European exports, and this time should be no different (Chart I-9). This also follows improvement in the European credit impulse. Most European growth indicators relative to the U.S. hit a nadir at the beginning of this year, and have been steadily improving since.1 Chart I-8German Manufacturing Could Soon Bottom German Manufacturing Could Soon Bottom German Manufacturing Could Soon Bottom Chart I-9A Pick Up In Global Demand Will Help A Pick Up In Global Demand Will Help A Pick Up In Global Demand Will Help The bottom line is that investors are currently too pessimistic on Europe’s growth prospects at a time when policy settings have become appropriate for the weakest link. If, in fact, European growth and inflation improve relative to the U.S., this will give investors an opportunity to reassess interest rate expectations for the euro area versus the U.S. Implications For The Euro The euro tends to be largely driven by pro-cyclical flows. Fortunately for investors, European equities, especially those in the periphery, remain unloved, given they are trading at some of the cheapest cyclically adjusted price-to-earnings multiples in the developed world. Analysts began aggressively revising up their earnings estimates for euro zone equities verus the U.S. earlier this year. If they are right, this tends to firmly lead the euro by about nine to 12 months, suggesting we are due for a pop in the coming quarters (Chart I-10).  Chart I-10Rising Earnings Revisions Are Bullish For The Euro Rising Earnings Revisions Are Bullish For The Euro Rising Earnings Revisions Are Bullish For The Euro The euro’s bounce after the ECB’s latest meeting suggests its dovish shift is paradoxically bullish for the common currency. If a central bank eases financing conditions at a time when growth is hitting a nadir, it is tough to argue that it is bearish for the currency. This in combination with easier fiscal policy should boost aggregate demand and lift the neutral rate of interest in the euro zone. Dollar weakness could be the catalyst that triggers a EUR/USD rally. Markets are usually wrong about Federal Reserve interest rate expectations, and this time is likely to be no different. However, the current divergence between market expectations and policy action is the widest since the Great Recession. Falling rate expectations relative to policy action have historically been bearish for the dollar with a lag of about nine to 12 months (Chart I-11). The basic balance in the euro area is on the verge of hitting fresh highs. Finally, positioning, valuation and balance-of-payments dynamics remain favorable for the euro (Chart I-12). The basic balance in the euro area is on the verge of hitting fresh highs on the back of improvement in FDI flows. With a large number of short positions on the euro, this could trigger a significant short-covering rally. Chart I-11The Dollar Might ##br##Soon Peak The Dollar Might Soon Peak The Dollar Might Soon Peak Chart I-12A Favorable Balance Of Payments ##br##Backdrop For The Euro A Favorable Balance Of Payments Backdrop For The Euro A Favorable Balance Of Payments Backdrop For The Euro   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, titled “A Contrarian Bet On The Euro,” dated March 1, 2019, available at fes.bcaresearch.com.  Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. have been mostly negative, but a few one-time factors were at play: On the labor market front, nonfarm payrolls fell to 75 thousand in May, but this was dragged down by flooding in the Midwest. Average hourly earnings grew by 3.1% year-on-year and the unemployment rate was stable at 3.6%. Headline and core consumer price inflation came in slightly lower at 1.8% and 2% year-on-year, but remain on target. Export prices fell by 0.7% year-on-year in May, and import prices contracted by 1.5% year-on-year, giving the greenback a terms-of-trade boost. On a positive note, the NFIB Small Business Optimism survey rose to a 5-month high of 105 in May. On another positive note, mortgage applications jumped by 26.8% this week. DXY index rose by 0.3% this week. Our bias is that the dollar is in the final innings of its rally, amid narrowing interest rate differentials, portfolio outflows, and easing liquidity strains.  Should global growth benefit from the dovish pivot by central banks, this could be the catalyst for dollar downside. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 President Trump And The Dollar - May 9, 2019 Take Out Some Insurance - May 3, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 There has been tepid data out of the euro zone this week: Sentix investor confidence fell to -3.3 in June. Industrial production contracted by 0.4% year-on-year in April. This is an improvement compared with the last reading of -0.7% and the consensus of -0.5%. EUR/USD fell by 0.3% this week. The front section this week is dedicated to the euro, since it has begun to tick many of the boxes for a counter-trend rally. The euro is trading below its fair value, easy financial conditions within the euro area will help, and Chinese stimulus could boost European exports, lifting the growth potential for the entire union. Report Links: Take Out Some Insurance - May 3, 2019 Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been mixed: The leading economic index fell to 95.5 in April, while the coincident index increased to 101.9. Annualized GDP growth was 2.2% year-on-year in Q1. Quarter-on-quarter growth also improved to 0.6%. The current account balance came in at 1.7 trillion yen in April. This was lower than the previous 2.9 trillion figure, but an improvement over consensus. Machine tool orders contracted by 27.3% year-on-year in May, while machinery orders increased by 2.5% year-on-year in April. It is worth noting that the pace of deceleration in machine tool orders is ebbing. USD/JPY has been flat this week. We continue to recommend the yen as an insurance against market turbulence. Even though the yen might weaken on the crosses in a scenario where global growth picks up later this year, it still has upside potential against the U.S. dollar. Report Links: Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much - May 31, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been mixed: Halifax house prices increased by 5.2% year-on-year in May. Industrial production contracted by 1% year-on-year in April. Manufacturing production also contracted by 0.8% year-on-year. The trade deficit narrowed to 2.74 billion pounds in April. The ILO unemployment rate was unchanged at 3.8% in April, while average earnings growth keeps holding firm, though it fell slightly to 3.1%. GBP/USD fell by 0.4% this week, now oscillating around 1.268. We will respect the stop loss for our long GBP/USD position if triggered at 1.25. While cheap valuation and favorable fundamentals support the pound on a cyclical basis, the implied volatility remains elevated amidst political uncertainties. The official kickoff for a new Conservative party leader is poised to ratchet up “hard Brexit” rhetoric, which will be negative for the pound. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Not Out Of The Woods Yet - April 5, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have shown a steady labor market: Consumer inflation expectations were unchanged at 3.3% in June. On the labor market front, the participation rate increased to 66% in May; unemployment rate was stable at 5.2%; 42.3 thousand new jobs were created in May but the mix was unfavorable, with a combination of 2.4 thousand full-time jobs and 39.8 thousand part-time jobs. AUD/USD fell by 1.3% this week. Clearly, the Australian jobs report was interpreted negatively by the market, given the boost from temporary election hiring. As such, markets are continually pricing in further rate cuts from the RBA, a negative for interest rate differentials between Australia and the U.S. Over the longer term, easier financial conditions could help to lift the economy, and stabilize the housing sector by reducing the interest payment burdens.  Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 There was scant data out of New Zealand this week: Manufacturing sales were unchanged at 2% in Q1. Electronic card retail sales growth grew by 3.2% year-on-year in May, higher than the consensus of 1.6%. Immigration remains a tailwind for domestic demand, but is slowly fading. NZD/USD fell by 1.4% this week. We introduced a long SEK/NZD trade last Friday, which is now 0.3% in the money. We believe that the Swedish krona will benefit more than the New Zealand dollar once global growth picks up.  Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been positive: The labor market remains robust with 27.7 thousand new jobs created in May. This pushed the unemployment rate to a low of 5.4%. The participation rate fell slightly to 65.7% but average hourly wages increased by 2.6% year-on-year. The mix was also positive, with all of the jobs generated as full-time employment. Housing starts came in at 202.3 thousand in May, while building permits increased by 14.7% month-on-month in April. USD/CAD initially fell by 1% on the labor market data last Friday, then recovered gradually, returning flat this week. While the labor market remains strong and the housing sector is showing signs of a recovery, the recent weakness in energy prices has been a headwind for the loonie. Moreover, a rate cut by BoC has become increasingly likely following the dovish shift by the Fed. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There has been little data out of Switzerland this week: The unemployment rate was unchanged at 2.4% in May. Foreign currency reserves fell slightly to 760 billion CHF in May. Producer and import prices contracted by 0.8% year-on-year in May. USD/CHF appreciated by 0.4% this week. The Swiss National Bank maintained  interest rates at -0.75% this week. The policy remains expansionary, in order to stabilize price developments and support economic activity. As a technicality, the SNB will also stop targeting Libor rates in favor of SARON (Swiss Average Rate Overnight). More importantly for the franc, the SNB stated that they will “remain active in the foreign exchange market as necessary, while taking the overall currency situation into consideration.” This suggest the SNB will weaponize the franc against deflationary pressures. Remain long EUR/CHF. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have softened: Manufacturing output increased by 2.2% month-on-month in April. Headline and core inflation both fell to 2.5% and 2.3% year-on-year in May. This has nudged the core measure below the central bank’s target. Producer price inflation fell to 0.4% year-on-year in May. USD/NOK rose by 0.6% this week. The recent plunge in oil prices caused by the U.S. inventory buildup has been a headwind for the Norwegian krone. However, we expect U.S. shale-oil production to eventually slow as E&P companies exercise greater capital discipline as marginal profit decreases. Moreover, irrespective of the oil price direction, we expect the Norwegian krone to outperform other petro-currencies, such as the Canadian dollar. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been positive: PES unemployment rate fell further to 3.4% in May. Household consumption increased by 0.2% month-on-month in April, but was unchanged on a year-on-year basis. USD/SEK appreciated by 0.9% this week. We favor the krona due to its cheap valuation, and its higher β to global growth (the potential to benefit more from a global economy recovery). We initiated the long SEK/NZD position last week, based on improving relative fundamentals between Sweden and New Zealand. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Treasury yields have tumbled despite a solid U.S. economy: The 10-year Treasury bond yielded just under 3% when we started beating the below-benchmark-duration drum last summer; now it’s hovering around 2.3%. The golden rule of bond investing argues against positioning for further declines, … : The returns to duration strategies hinge on the difference between actual and expected moves in the fed funds rate. With the money market looking for two cuts over the next twelve months, the fed funds rate is more likely to surprise to the upside than the downside. … but could a lack of borrowing keep yields low?: If debt-fueled spending has gone out of fashion in the U.S., global savings could overwhelm investment, and rates might have to fall further to bring them back into balance. Feature The ride has gotten bumpier as the trade tensions between the U.S. and China have heated up, but our recommendations have held up well since last summer. Equal-weighting equities, underweighting bonds and overweighting cash helped preserve capital during the fourth-quarter selloff, while our early and late January upgrades of equities (while downgrading cash) and spread product (while further downgrading Treasuries), respectively, have proven to be beneficial.1 On a total return basis, the S&P 500 is up over 12% since our upgrade, and the Barclays Bloomberg Corporate and High Yield Indexes have generated excess returns over Treasuries of around 175 and 75 basis points (“bps”), respectively, despite ceding much of their previous leads.2 Even the TIPS ETF (TIP) has held its own with the equivalent-duration nominal-Treasury ETF (IEF). The below-benchmark duration call has eroded some of the overall outperformance, however, and there has been some debate within BCA about whether or not we should change the view. We still do not believe the monetary policy outlook merits a duration-view change. We remain constructive on the outlook for global growth, despite the escalation in tensions between U.S. and Chinese trade negotiators, and therefore do not see a fundamental reason to expect lower real rates. The idea that soft credit growth could hold rates down is interesting, but one would have to believe the spendthrift U.S. leopard really has changed its spots to position a portfolio in line with it. Fed Policy Chart 1Caution: Falling Rate Expectations Caution: Falling Rate Expectations Caution: Falling Rate Expectations As of Thursday’s close, the money market was pricing in a 100% chance of a 25-bps rate cut by Thanksgiving, a 100% chance of a 50-bps rate cut by this time next year, and a 45% chance of a third cut by Thanksgiving 2020 (Chart 1, bottom panel). The FOMC has paused its rate-hiking campaign, to be sure, but the idea that it will soon embark on a rate-cutting campaign seems like a stretch. The minutes from the FOMC’s April 30th-May 1st meeting, released last week, painted a picture of a fundamentally solid economy. The balance between hawks and doves remained roughly equal, with “a few participants” calling for a coming need to firm policy, given the swiftness with which inflation pressures can build in a tight labor market, while “a few other participants” noted that the unemployment rate is not the be-all and end-all measure of resource utilization. From an investment strategy perspective, we think our U.S. Bond Strategy service’s golden rule provides the best insight. Below-benchmark-duration positioning will outperform if the Fed cuts less (or hikes more) over the next twelve months than markets expect; above-benchmark-duration will win if the Fed cuts more (or hikes less) than markets expect. Some strategists within BCA have raised the possibility that market expectations could force the Fed’s hand. The reason that the Fed is especially loath to disappoint markets in what might be called the forward-guidance era of central banking, but we think there’s an important distinction between taking care not to surprise markets and surrendering one’s free will to them, as parents of young children can attest. Bottom Line: We think the money markets are significantly overestimating the possibility that the Fed will soon cut the fed funds rate, increasing the potential returns from below-benchmark-duration positioning. The Rates Checklist Table 1Rates View Checklist Is America Not Borrowing Enough? Is America Not Borrowing Enough? We developed our rates checklist3 to provide a list of real-time measures that bear on our rates view. Of the eleven items on the list, only three have met our threshold for reassessing our bearish rates call at any point over the last eight months, so we have stayed the course (Table 1). The checked boxes indicate that the evidence has been moving against us, though we would argue that the stingy 10-year Treasury yield has gotten overly carried away with discounting that evidence (Chart 1, top panel).  Policy Perceptions The spread between our monetary policy expectations and the markets’ remains wide, so the prospective returns from our Fed call remain ample, and the first box remains unchecked. Thanks to last week’s two-day, 11-bps decline in the 10-year Treasury yield, we have again checked the inverted yield curve box, which first inverted for five days near the end of March, and has inverted for four days so far in May. Our empirical study of the inverted curve’s recession-signaling properties used month-end closes for the 10-year Treasury yield and the 3-month Treasury Bill rate, and found that an inverted curve had called the seven recessions that have occurred over the last 50 years with just one false positive (Chart 2). Now that the curve has inverted over a couple of daily stretches, clients have asked us just what constitutes bona fide inversion. Chart 2Accurate Yield Curve Signals Tend To Last Accurate Yield Curve Signals Tend To Last Accurate Yield Curve Signals Tend To Last Per the curve’s moves over the last 50 years, we would say inversion doesn’t issue an actionable signal until it persists for at least a few months (Table 2). 1998’s false alarm encompassed just seven days between late September and early October, and covered just one month end. The intuition behind the inverted yield curve’s predictive power is that the bond market sniffs out economic weakness before the Fed officially changes course. Recognizing that the Fed will have to begin cutting rates soon, bond investors buy longer-maturity instruments to reap the biggest rewards. Investors shouldn’t overreact to tentative inversions of the yield curve. Table 2Yield Curve Inversions Is America Not Borrowing Enough? Is America Not Borrowing Enough? We have argued that the next recession will not occur until the Fed has hiked the fed funds rate to a level above the equilibrium fed funds rate. Since we cannot observe the equilibrium rate in real time, we have looked to interest-rate-sensitive segments of the economy to gauge if higher rates are beginning to bite. Housing is on the front line of interest-rate sensitivity, and it remains quite affordable relative to history, suggesting that monetary policy has not yet become restrictive. Every time the inverted curve preceded a recession, the affordability index was below its long-run mean or rapidly making its way there (mid-1973); when the yield curve briefly inverted in September 1998, homes remained more affordable than average (Chart 3). Chart 3If Higher Rates Aren't Squeezing The Economy, The Yield Curve May Be Crying Wolf If Higher Rates Aren't Squeezing The Economy, The Yield Curve May Be Crying Wolf If Higher Rates Aren't Squeezing The Economy, The Yield Curve May Be Crying Wolf Inflation We concede that realized inflation measures (Chart 4), and inflation expectations as proxied by the difference in TIPS and nominal Treasury yields (Chart 5), have lost momentum since last summer. Washington’s unexpected grant of six-month waivers for importing Iranian oil caused crude prices to plunge, taking headline inflation measures and inflation expectations down with them (Chart 6). Given our Commodity And Energy Strategy team’s view that oil prices will extend their rebound across the rest of this year and into next, we expect that they will again move higher. Chart 4Consumer Price Indexes, ... Consumer Price Indexes, ... Consumer Price Indexes, ... chart 5... And Inflation Breakevens, ... ... And Inflation Breakevens, ... ... And Inflation Breakevens, ... Chart 6... Are Joined At The Hip With Oil Prices ... Are Joined At The Hip With Oil Prices ... Are Joined At The Hip With Oil Prices The Labor Market And Imbalances At Home And Abroad The labor market remains tight, so none of the labor market indicators argue for easier monetary policy and lower rates across the term structure. As far as the instability indicators go, there is as yet no sign of unsustainable activity in the economy’s key cyclical sectors. The Fed has stopped emphasizing the idea that financial sector imbalances alone might justify tighter policy, but anecdotal reports about lending standards suggest that potential vulnerabilities remain. There has not yet been an outbreak of major international distress that could deter the Fed from tightening policy, but worsening trade tensions and continued dollar strength would seem to make it slightly more likely. Bottom Line: We have checked a few boxes on our rates checklist, but the available evidence does not support adopting a more constructive view on rates. Hey, Big Spender The American consumer has long been a punching bag for Austrian School adherents and other moralists. As much as they scorn American households for living beyond their means, U.S. consumption has long played a symbiotic role in the global economy. As the engine powering the world’s largest economy, it makes an essential contribution to global aggregate demand, and provides an outlet for export powerhouses like China and Germany. An economy can only run a current account surplus provided that there are other economies running current account deficits capable of offsetting it. Measured inflation and inflation expectations were beginning to get some traction before oil collapsed upon the issuance of Iranian import waivers. In a recent blog post, former BCA Editor-in-Chief Francis Scotland posited that interest rates may not go anywhere as long as American households embrace their nascent post-crisis frugality. Using U.S. household demand as a proxy for global aggregate demand, Francis argues that if households don’t borrow and spend the way they did throughout the pre-crisis postwar era, global aggregate demand will suffer unless another profligate spender emerges to pick up the slack. Add China to the mix, and global savings could swamp global investment. Against that backdrop, savings and investment would only realign if rates fell. Newly frugal U.S. households may be helping to cap interest rates, but it’s too early to declare the end of the Debt Supercycle. Broadening the scope to include all public- and private-sector U.S. borrowing, the nominal 10-year Treasury yield has taken some cues from growth in aggregate borrowing (Chart 7). The relationship with real yields is not as strong (Chart 8), but if borrowing has some relationship to inflation, as under the guns-and-butter fiscal policy of the late sixties, nominal yields might well be a better measure. We can easily go along with the supply-and-demand intuition behind the observed relationship: when there’s stronger demand for credit, rates have to rise to entice savings and discourage investment to bring them back into balance, and vice versa. Chart 7Nominal Treasury Yields Have Been Tightly Linked With The Pace Of Loan Growth, ... Nominal Treasury Yields Have Been Tightly Linked With The Pace Of Loan Growth, ... Nominal Treasury Yields Have Been Tightly Linked With The Pace Of Loan Growth, ... Chart 8... And Real Yields Have Broadly Followed The Pattern As Well ... And Real Yields Have Broadly Followed The Pattern As Well ... And Real Yields Have Broadly Followed The Pattern As Well Government borrowing filled the void left by retrenching households and corporations in the immediate aftermath of the crisis. Household and corporate loan demand has been choppy since, however, and growth in aggregate borrowing has bumped around its mid-1950s lows throughout the expansion. We are not ready to declare that Americans have turned over a new, parsimonious leaf. The federal budget deficit soared following the passage of the stimulus package, and the CBO projects that it will continue to widen. Household debt growth is at its pre-crisis lows, but it has been accelerating ever since 2010 (Chart 9), and with debt service as a share of disposable income at its lowest level in at least 40 years, households have plenty of capacity to borrow. Chart 9Don't Count Consumers Out Just Yet Don't Count Consumers Out Just Yet Don't Count Consumers Out Just Yet Bottom Line: Interest rates have moved directionally with aggregate loan growth across the postwar era. Tepid loan demand growth may well keep a lid on rates, but we are not convinced that the Debt Supercycle has really breathed its last. Investment Implications Now that the 10-year Treasury yield has drifted back down to 2.3%, we believe the distribution of potential rate outcomes a year from now is skewed to the upside. We are thereby sticking with our recommendation that investors underweight Treasuries and maintain below-benchmark-duration positioning in all fixed-income portfolios. Even if there is not a clear catalyst on the immediate horizon for higher rates, we do not think that either the U.S. or the global economy is so fragile that investors should position for further rate declines. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the January 7 and January 28, 2019 U.S. Investment Strategy Weekly Reports, “What Now?” and “Double Breaker,” available at usis.bcaresearch.com. 2 All return data calculated as of the Thursday, May 23rd close. 3 Please see the September 17, 2018 U.S. Investment Strategy Weekly Report, “What Would It Take To Change Our Bearish Rates View?” available at usis.bcaresearch.com.

Highlights Duration: We see current bond market behavior as very similar to mid-2016, when heightened political uncertainty obscured the economy’s true strength and kept bond yields lower for longer than was justified by the economic fundamentals. The correct strategy at that time was to sell into the bond market’s strength, and we advocate a similar strategy today. China: Any attempt by the Chinese government to retaliate in the trade war by selling U.S. Treasury securities would be either self-defeating or ineffective, depending on the exact strategy employed. In either case, U.S. Treasury yields will be unaffected. Fed: At least part of the Fed’s dovish turn might represent a desire to send the labor share of national income higher. We introduce a new data series for Fed Watchers to track. Feature The Trump Administration fired the latest salvo in the trade war two weeks ago, expanding tariffs to a broader swathe of Chinese imports. Then last week, the escalation of tensions spilled over to the bond market, sending global yields abruptly lower. Chart 1Flight To Safety Flight To Safety Flight To Safety The 10-year U.S. Treasury yield bounced off 2.35% last Thursday and has since settled at 2.39% (Chart 1). Meanwhile, the overnight index swap curve is now priced for 44 bps of Fed rate cuts over the next 12 months (Chart 1, bottom panel). It is possible, and even likely, that geopolitical tensions will keep yields low during the next month or two. In fact, our Geopolitical Strategy service places the odds of a complete breakdown in trade negotiations by the end of June at 50%.1  But we would encourage investors to sell into rallies, positioning for higher yields on a 6-12 month horizon. To see why, we return to a Weekly Report from early April where we walked through different factors that would be useful in the creation of a macroeconomic model for the 10-year U.S. Treasury yield.2 We consider what has changed during the past six weeks and what those developments mean for bond yields going forward. Back In The Bond Kitchen In early April, we ran through four different factors that should be included in any bond model and suggested macroeconomic indicators that best capture the trends in each. The four factors are: Global Growth: Best proxied by the Global Manufacturing PMI and Bullish Dollar Sentiment Policy Uncertainty: Best proxied by the Global Economic Policy Uncertainty Index Output Gap: Best proxied by Average Hourly Earnings Sentiment: Best proxied by the U.S. Economic Surprise Index We consider each factor in turn. Global Growth Chart 2Monitoring Global Growth Monitoring Global Growth Monitoring Global Growth The Global Manufacturing PMI, our preferred series for tracking global growth, ticked down during the past month, continuing the free-fall that has been in place since the end of 2017 (Chart 2). At 50.3, it is now only slightly above the 50 boom/bust line and is close to where it was in mid-2016, when the 10-year yield hit its cyclical low. But on a positive note, several leading indicators have hooked up in recent months, suggesting that the Global PMI could soon trough and move higher in the second half of the year. Specifically, the ZEW survey of global economic sentiment is off its lows, as is the BCA Global Leading Economic Indicator (LEI). Meanwhile, the Global LEI Diffusion Index has surged, indicating that 74% of the 23 countries in our sample are seeing improvement in their LEIs. Historically, the Global LEI Diffusion Index leads changes in both the Global LEI and the Global Manufacturing PMI (Chart 2, panel 3). Financial market prices that are highly geared to global growth had been singing a similar tune, but they rolled over as trade tensions flared during the past two weeks. For example, cyclical equity sectors recently started to underperform defensive sectors (Chart 2, bottom panel), and the important CRB Raw Industrials index took a nosedive. We place particular importance on the CRB Raw Industrials index as a timely indicator of global growth, because the ratio between the CRB index and gold correlates nicely with the 10-year Treasury yield (Chart 3).3 Unsurprisingly, the ratio’s recent dip coincides with last week’s drop in the 10-year. Several leading indicators have hooked up in recent months, suggesting that the Global PMI could soon trough and move higher in the second half of the year.  In addition to the Global Manufacturing PMI, we recommend including a survey of bullish sentiment toward the U.S. dollar in any bond model. More bullish dollar sentiment coincides with lower Treasury yields, and vice-versa. Our preferred survey shows that dollar sentiment remains elevated, but hasn’t changed much since April (Chart 4). The dollar itself, however, has begun to appreciate during the past two weeks (Chart 4, bottom panel). Chart 3A Falling CRB/Gold Ratio... A Falling CRB/Gold Ratio... A Falling CRB/Gold Ratio... Chart 4...And The Greenback Is On The Rise ...And The Greenback Is On The Rise ...And The Greenback Is On The Rise Bottom Line: The coincident global growth indicators that correlate best with bond yields – the Global Manufacturing PMI and Dollar Bullish Sentiment – are sending a similar message as in April. Meanwhile, leading economic indicators continue to suggest that we should expect improvement in the second half of the year. The biggest change from April is that global growth indicators derived from financial market prices – cyclical versus defensive equities, the CRB Raw Industrials index and the trade-weighted dollar – have responded negatively to heightened political risk. If this weakness persists and eventually infects the economic data, then it could prevent a second-half rebound in global growth, keeping Treasury yields low for even longer.   Policy Uncertainty Spikes in the monthly Global Economic Policy Uncertainty Index often cause capital to seek out the safety of U.S. Treasuries, and we recommend including this index in any macroeconomic bond model (Chart 5A). Spikes in the monthly Global Economic Policy Uncertainty Index often cause capital to seek out the safety of U.S. Treasuries. While there have been no updates to the monthly index since the trade war’s recent escalation, one of its components – a daily index that tracks the number of relevant news stories – has surged during the past two weeks (Chart 5B). This clearly illustrates that a sharp increase in political uncertainty has been the catalyst for the bond market rally. Investors are obviously concerned that an ongoing and intensifying trade war might derail the economic recovery, and they are seeking out Treasuries as a hedge. Chart 5AGlobal Uncertainty Set To Spike Global Uncertainty Set To Spike Global Uncertainty Set To Spike Chart 5BMarkets Are Concerned Markets Are Concerned Markets Are Concerned In such situations, the traditional playbook is to fade any purely uncertainty-driven rally, on the view that markets tend to overreact to headline risk. This strategy worked well following the mid-2016 Brexit vote. The uncertainty shock from the vote sent the 10-year quickly down to 1.37%, but it then increased in the second half of the year when it became apparent that the economic recovery would continue. While higher tariffs will certainly be a drag on growth going forward, accommodative Fed policy and a probable increase in Chinese economic stimulus will mitigate the impact, keeping the economic recovery intact.4 Output Gap Chart 6Wages Are Headed Higher Wages Are Headed Higher Wages Are Headed Higher The output gap is a concept that represents where the economy is operating relative to its peak capacity, and its progress during the past three years is the main reason why bond yields will not re-test 2016 lows. We have found that wage growth is the most reliable way to measure the output gap: higher wage growth signals less spare capacity, and less spare capacity coincides with higher bond yields. We recommend Average Hourly Earnings as the best wage measure to include in any bond model. Since April, average hourly earnings growth has been roughly flat, but leading indicators suggest that further acceleration is highly likely in the coming months (Chart 6). While the Fed is keen to let wage growth accelerate, rising wage growth also makes a rate cut difficult to justify. The combination of rising wage growth and an on-hold Fed should put a rising floor under long-maturity bond yields. Sentiment The final factor that should be included in any bond model is sentiment. In April, we suggested that the U.S. Economic Surprise Index is the best measure of sentiment. When the surprise index has been deeply negative for a long time, it usually means that investors are downbeat on the economy and that the bar for a positive surprise is low. This has actually been the case in recent months, and our simple auto-regressive model suggests that the surprise index is biased higher (Chart 7). Positioning data confirm this message, and in fact show that investors are taking as much duration risk as they were when yields troughed in mid-2016 (Chart 8). Chart 7Low Bar For Positive Surprises Low Bar For Positive Surprises Low Bar For Positive Surprises Chart 8Similar Positioning As In Mid-2016 Similar Positioning As In Mid-2016 Similar Positioning As In Mid-2016 The overall message is that bond investors have a very dim view of the economy, and it will not take much positive news to send yields higher. Investment Strategy We see current bond market behavior as very similar to mid-2016, when heightened political uncertainty obscured the economy’s true strength and kept bond yields lower for longer than was justified by the economic fundamentals. The correct strategy at that time was to sell into the bond market’s strength, and we advocate a similar strategy today. Timing when the next move higher in bond yields will occur is difficult, but we take some comfort in the fact that the flatness of the yield curve makes it less costly than usual to carry below-benchmark duration positions. In fact, the average yield on the Bloomberg Barclays Cash index is 7 bps higher than the average yield on the Bloomberg Barclays Treasury Master Index. Bond investors have a very dim view of the economy, and it will not take much positive news to send yields higher. To further mitigate the cost of keeping duration low, we advocate taking duration-neutral positions that are short the belly (5-year & 7-year) part of the yield curve and long the very long and very short ends of the curve. Such trades are also provide a positive yield pick-up, and will earn capital gains when Treasury yields move higher.5 A Quick Note On China’s Treasury Purchases Chart 9Do Not Expect Treasuries To Be Used As A Weapon In This War Do Not Expect Treasuries To Be Used As A Weapon In This War Do Not Expect Treasuries To Be Used As A Weapon In This War The trade war’s recent escalation has led some to speculate that China could retaliate against higher tariffs by dumping U.S. Treasury securities onto the open market. The speculation only increased when the TIC data revealed that Chinese net Treasury purchases totaled -$24 billion in March, the most deeply negative figure since October 2016 (Chart 9).   We see low odds that China will employ this tactic in the trade war, and no meaningful impact on Treasury yields in any case. To see why, let’s consider two possible scenarios. In the first scenario, China sells a large amount of U.S. Treasury securities and keeps the proceeds from the sales in its domestic currency. Assuming the amounts in question are sufficiently large, these transactions would cause the RMB to appreciate and lead to a tightening of Chinese monetary conditions. Tighter monetary conditions are exactly what the Chinese government does not want as it seeks to counteract the negative economic impact from tariffs. In fact, China is much more likely to engineer a further easing of monetary conditions, much like in 2015/16 (Chart 9, bottom panel). In the second scenario, China could sell U.S. Treasuries and purchase other foreign bonds (German bunds, for example). This would nullify any impact on Chinese monetary conditions, but it would not have much impact on U.S. Treasury yields. With Chinese money still flowing into global bond markets, the re-balancing would only push other investors out of non-U.S. bond markets and into U.S. Treasuries. Without changing the overall demand for global bonds, it is difficult to envision much of an impact on U.S. yields. Bottom Line: Any attempt by the Chinese government to retaliate in the trade war by selling U.S. Treasury securities would be either self-defeating or ineffective, depending on the exact strategy employed. In either case, U.S. Treasury yields will be unaffected. A New Data Series For Fed Watchers: Rich’s Ratio A number of recent Fed speeches have referred to the time series plotted in Chart 10: The share of national income going to labor, as opposed to corporate profits. Chart 10Introducing Rich's Ratio Introducing Rich's Ratio Introducing Rich's Ratio Vice-Chair Richard Clarida brought this analysis to the Fed, and the data series was actually once dubbed “Rich’s Ratio” by Clarida’s old PIMCO colleague Paul McCulley. The idea behind Rich’s Ratio is that while some late-cycle wage gains are passed through to prices, a portion also eat into corporate profits. Notice in Chart 10 that Rich’s Ratio has a tendency to rise late in the economic recovery. Based on his past writings, we would not be surprised if at least part of the Fed’s recent dovish turn represents a desire to send Rich’s Ratio higher, even if that goal might entail a modest overshoot of the Fed's 2 percent inflation target. We will have more to say about Rich’s Ratio in the coming weeks. For now, we simply want to make Fed Watchers aware that they have a new series to track. Stay tuned. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see Geopolitical Strategy Weekly Report, “How Trump Became A War President”, dated May 17, 2019, available at gps.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019, available at usbs.bcaresearch.com 3 The rationale for why the CRB/Gold ratio tracks the 10-year Treasury yield is found in U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com 4 Please see Global Investment Strategy Weekly Report, “Tarrified”, dated May 16, 2019, available at gis.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights We were on the road last week, discussing our economic and market outlooks: We met with a range of Midwestern clients who focus primarily on the U.S. A majority of our meetings were with fixed-income teams. The Fed will ultimately decide the fate of the expansion, … : Nearly everyone wanted to get a read on how much longer the expansion will last. We offered the view that the Fed will induce the next recession, provided that an exogenous event doesn’t beat it to the punch. … and inflation will be the catalyst that prompts the Fed to act: Inflation was typically far from investors’ minds, and several of our meetings centered on what will drive it, and where and when we expect it will show up. Feature We traveled throughout the Midwest last week, discussing our outlook for financial markets and the economy with a range of investors. We got the sense that our clients are constructive about the economy and are generally open to tilting portfolios in a risk-friendly direction, albeit somewhat grudgingly. They recognized the challenge that worsening U.S.-China trade relations would pose to a constructive call, but were content to wait for more information before adjusting their views or their portfolios. Our views continue to follow the outline we’ve laid out in our written reports. In the absence of economic or financial market excesses, or an exogenous shock that induces a material slowdown, we expect the expansion to roll on until the Fed begins to fear that it’s gone too far and imposes restrictive monetary policy settings to rein it in. Until it does, we expect that the equity bull market will continue and spread product will deliver positive excess returns over Treasuries. The investment strategy takeaway is that it is too early to de-risk portfolios. De-risking will become the order of the day once the Fed resumes tightening monetary conditions via rate hikes. There is currently no sign that the Fed is contemplating a meaningfully hawkish shift, but we expect that inflation pressures will eventually force its hand. Ten years of subdued inflation have made a mockery of recurring post-crisis inflation warnings, and clients have developed a robust immunity to them. What, they wanted to know, has changed enough to resuscitate inflation? Steroid-Fueled Demand Aggregate demand crashed during the crisis and was far short of the economy’s capacity when it bottomed in mid-2009. In economics lingo, that meant that the U.S. economy faced a sizable negative output gap when it embarked on the recovery/expansion. Although the economy grew at a tepid 2% rate over the ensuing decade, capacity grew even more slowly, held back by consistently weak capital expenditures, and the output gap finally closed around the beginning of 2018 (Chart 1), removing a stout inflation-absorbing buffer. Chart 1The Excess Capacity Cushion Is Gone The Excess Capacity Cushion Is Gone The Excess Capacity Cushion Is Gone The United States then poured fuel on the fire by injecting a significant quantity of stimulus into an economy that was already operating at capacity. Corporations and other businesses that viewed the pickup in aggregate demand as a one-off event refrained from expanding capacity to meet that demand, as it appeared as if it would be a poor use of capital. Imported goods from economies that still have excess capacity can relieve some of the pressure of inadequate domestic supply, but they’re unlikely to absorb all of the pressure from excess demand, even in the absence of new tariff barriers. The aggregate 2018-19 stimulus shapes up as a catalyst for higher prices. Capacity vastly exceeded demand when the economy began to turn around ten years ago, but the stimulus package has made it look a little thin. The trouble is that no one can pinpoint exactly when upward price pressures will reveal themselves. Inflation is the mother of all lagging indicators, peaking and bottoming well after business cycle transitions suggest it should (Chart 2). All we can say is that the steroid injection from the stimulus planted the seeds of inflation. Just when they’ll begin to sprout is uncertain, but we believe the Fed’s pause will give them a chance to take root. Chart 2 Wage Inflation The labor market is so tight that it squeaks. The unemployment rate has fallen to a 49-year low; baby boomer retirements will cap the labor force participation rate around its current level (Chart 3, top panel); and discouraged workers (Chart 3, middle panel) and involuntary part-time workers are few and far between (Chart 3, bottom panel). Now that it has been absorbed, the glut of idled workers will no longer serve as a buffer neutralizing upward wage pressures. The labor market is tight as a drum. The pool of discouraged workers and involuntary part-timers is smaller than it was at the last two cyclical peaks, while employer demand is more robust. Employees are starting to gain bargaining power. The Job Openings and Labor Turnover Survey (JOLTS) indicates that demand for new workers is intense. As a share of total filled positions, job openings are at an all-time high in the 18-year history of the series (Chart 4, middle panel). No one quits a job unless s/he has another one lined up, and it almost always requires higher pay to induce an employee to jump from Employer A to Employer B. The elevated quit rate thus reveals that employers are poaching workers from each other to meet that demand (Chart 4, bottom panel). After Employer B lures an employee away from Employer A, Employer A hires a worker from Employer C or Employer D, which now has an opening it needs to fill. The employment merry-go-round creates a self-reinforcing cycle pushing wages higher and endowing employees with newfound bargaining power. Chart 3With Fewer Workers On The Sidelines … With Fewer Workers On The Sidelines ... With Fewer Workers On The Sidelines ... Chart 4… Employers Have Turned To Poaching ... Employers Have Turned To Poaching ... Employers Have Turned To Poaching Self-sustaining wage gains could produce price-level increases via a demand-pull or a cost-push mechanism. In a demand-pull framework, businesses observing steady payroll expansions and increased household income may well attempt to push through selling price increases. Under cost-push, corporations raise prices in an attempt to offset increased labor costs. Then again, the pass-through from wage inflation to price inflation might not occur at all, as the dynamics of inflation are not fully understood. What The Fed Believes Investors may be frustrated by the lack of a clear connection between wages and prices, but they should not be put off by a little ambiguity – there would be no alpha without uncertainty. An absence of realized inflation does not eliminate the prospect of rate hikes. Our Inflation → Rate Hikes → Restrictive Monetary Policy → Recession → Bear Market roadmap may still come to pass. The first step in the chain would simply have to be perceived inflation as opposed to realized inflation, and it’s the Fed’s perception that drives monetary policy, not the public’s. As we stressed in our Special Report on the Phillips curve,1 there is no alternative explanation in mainstream economics connecting the dots between the elements of the Fed’s dual mandate. Every mainstream economic model posits an inverse relationship between inflation and the unemployment rate. Every economist learned about the expectations-augmented Phillips curve multiple times in the course of his or her undergraduate and graduate studies. Until the profession settles on an alternative narrative, the Fed and other major central banks will be beholden to the Phillips curve. The connection between wages and prices is a mystery, but the Phillips curve’s place in mainstream economics remains secure. It’s easy to talk of patience when inflation has been hibernating for ten years, even with the unemployment rate at 49-year lows, but once wage gains begin to exceed 3.5% and 4%, we expect the Fed will change its tune. Wages do not respond to changes in the unemployment rate when there’s ample slack in the labor market, but they do once it becomes difficult to find employees. The varying sensitivity of changes in wages at different levels of unemployment explains the kink in the Phillips curve, but we found the NAIRU-based unemployment gap2 to be a reliable proxy for identifying the point at which the labor market meaningfully tightens (Chart 5). Chart 5NAIRU, … NAIRU, ... NAIRU, ... The natural rate of unemployment is only a concept, however, and the CBO series we use to calculate the unemployment gap is subject to retroactive adjustments intended to better match the CBO’s estimates with real-world observations. We therefore incorporated two alternative measures of labor market slack to test the robustness of the unemployment-gap framework. The first is the Jobs Plentiful/Jobs Hard To Get responses from the Conference Board’s consumer confidence survey. The top panel of Chart 6 calculates the difference between Jobs Hard To Get and Jobs Plentiful; when it’s positive (negative), survey respondents are indicating that the labor market is soft (tight). The disparity in wage growth between the soft and the tight states, as estimated by the hoi polloi, is a little larger than under the CBO’s revised NAIRU estimates, suggesting Main Street may be better positioned to evaluate labor-market dynamics than D Street (the CBO’s address). Chart 6… The Consumer Confidence Survey, … ... The Consumer Confidence Survey, ... ... The Consumer Confidence Survey, ... To get away from the arbitrariness of the unemployment rate and the uncertainty of NAIRU estimates, we considered the employment gap from the perspective of the prime-age (non-)employment-to-population ratio (Chart 7). It also supports the conclusion that wage gains are a function of the degree of labor market slack, but the outlier results from the crisis render the mean non-employment ratio since 1985 a less-than-perfect boundary between tightness and slack. The prime-age (non-)employment-to-population ratio better fits the standard Phillips curve framework, producing a solidly linear relationship (Chart 8). It points to further wage gains as prime-age employment increases. Chart 7… And Prime-Age (Non-)Employment All Point To Faster Wage Gains ... And Prime-Age (Non-)Employment All Point To Faster Wage Gains ... And Prime-Age (Non-)Employment All Point To Faster Wage Gains Chart 8 If productivity continues to grow by leaps and bounds – the fourth-quarter gain was impressive, the first-quarter’s was eye-popping – the Fed won’t feel much pressure to hike rates. Productivity is a function of capital expenditures; workers are able to increase output when they’re provided with more and better tools. Capex has been extremely weak ever since the crisis in the U.S. and the rest of the world, however, and we do not think that investors should count on productivity remaining much above its low 1%-plus trend level of the last several years. Investment Implications The ultimate effect of the Fed’s pause will be to extend the duration of the expansion, assuming that an exogenous shock does not pull the plug on it. Extending the expansion will have the effect of extending the equity bull market, and the period in which spread product generates positive excess returns over Treasuries. There is no free lunch, and dovishness now will be offset by hawkishness later. Larger bull-market gains will ultimately be countered by larger bear-market losses. That is a concern for another day, however, and we continue to recommend that investors remain at least equal weight equities and spread product in balanced portfolios. We do not see a recession until the second half of 2020 at the earliest. Our best guess is that it will begin around the middle of 2021, so it is too early to de-risk portfolios or shift to a more defensive asset allocation profile.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 Please see the U.S. Investment Strategy Special Report,  “The Phillips Curve: Science Or Superstition?”, published February 26, 2019. Available at usis.bcaresearch.com. 2 The unemployment gap in the top panel of Chart 5 is calculated by subtracting the Congressional Budget Office’s estimate of NAIRU from the official unemployment rate. NAIRU, or the natural rate of unemployment (u*), is the minimum unemployment rate that would exist even in a full-employment economy. It results from structural factors like skill and geographic mismatches. The CBO currently estimates that NAIRU is 4.7%; the Fed’s dots suggest that it estimates u* is around 4.6%.