Labor Market
Highlights The cyclical recovery in global earnings will trump, so to speak, ongoing political developments. Unlike the last three recessions, which resulted from burst asset bubbles, the next U.S. recession will be more akin to those of the 1970s and early 1980s. Those "retro" recessions were caused by the Fed's decision to raise rates aggressively in response to rising inflation. The good news is that it will take a while for inflation to accelerate, suggesting that the next recession will not occur until 2019 at the earliest. The bad news is that once inflation does start rising in earnest, the Fed is likely to find itself flat-footed. Remain overweight global equities for now, favoring European and Japanese stocks over U.S. equities in currency-hedged terms. Look to reduce exposure in the second half of next year. Feature After Charlottesville Political developments continued to cast a pall over markets this week. Last week's worries about escalating tensions in the Korean peninsula subsided on comments from the North Korean regime that it would not launch a preemptive strike against Guam. As that issue moved off the radar screen, a new one emerged. President Trump's comments about the violent protests in Charlottesville generated outrage in many quarters, leading to the disbandment of two of the President's business advisory councils. We agree with those who argue that this latest incident will have far-reaching consequences. However, we disagree about the timeframe over which they will manifest themselves. As with most Trump scandals, this one is likely to fizzle into the background. Republicans in Congress would love nothing more than to change the subject. Plowing ahead with tax cuts is one way to do that. A limited infrastructure bill also remains a possibility - and unlike most issues up for debate, this one could actually attract bipartisan support. The market has essentially priced out any meaningful progress on either taxes or infrastructure, so the bar for success here is fairly low (Chart 1). While the implications of recent events in the U.S. are unlikely to put much strain on markets over the next year or so, the longer-term ramifications could be profound. The Democrats' "Better Deal" agenda moves the party to the left on most economic issues. Historically, the Republicans have been champions of small government. Increasingly, however, many Trump voters are asking themselves why exactly they should support lower business taxes when most companies seem openly hostile to the populist agenda that got Trump elected. In this respect, it is noteworthy that support for free trade among Republican voters has collapsed over the past 10 years (Chart 2). Wall Street, Silicon Valley, and the rest of the business establishment tends to be liberal on social issues and conservative on economic ones. The problem is that very few voters share this configuration of views (Chart 3). This contradiction cannot be ignored indefinitely. Chart 1The Markets Have Given Up On Infrastructure And Taxes Chart 2Republican Support For Free Trade Has Collapsed Chart 3An Absence Of Libertarians We predicted that "The Trumpists Will Win" back in September 2015 when most pundits were still scoffing at the idea that Trump could win the Republican nomination, let alone the election. This prediction was based on the view that "Trumpism" would resonate with American voters more forcefully than most experts thought possible. If the Republican Party does move to the left on economic issues, this could lead to more economic instability and larger budget deficits - and ultimately, much higher inflation. We discussed the reasons why inflation is heading higher over the long haul several weeks ago and encourage readers to review that report.1 Still Chugging Along Over a shorter-term horizon of one or two years, however, things still look reasonably bright. Earnings are in a solid uptrend. The profit recovery has been broad-based across countries and sectors. Our global leading economic indicator is trending higher, as are estimates of global growth (Chart 4). Chart 4Global Growth Estimates Accelerating Despite Stalled U.S. Growth The current economic recovery in the U.S. has now lasted over eight years, making it the third-longest on record. If it continues until July 2019, it will take the top spot from the 1990s expansion. The fact that this expansion has endured for so long is not too surprising. The Great Recession was one of the deepest in history, while the recovery that followed has been fairly drawn out. Such "slow burn" recoveries are typical following financial crises, and this one has not been any different. However, now that the U.S. unemployment rate has returned to pre-recession levels, the question arises whether the curtain may finally be closing on this expansion. Our answer is "not yet." While this expansion is starting to get long in the tooth, the next recession probably won't roll around until 2019 - and perhaps even later. This means that a cyclically bullish stance towards risk assets is still appropriate. Searching For The Smoking Gun As the old saying goes, "Expansions don't die of old age. They are murdered by the Fed." Such a verdict is too harsh, but it does get to an underlying truth: Fed rate hikes have almost always preceded past U.S. recessions (Chart 5). Broadly speaking, post-war recessions can be broken down into two categories. The first consists of recessions that resulted from the bursting of asset bubbles. In those cases, Fed rate hikes were more the instigator of the recession than the cause of it. The second category consists of recessions where the Fed found itself behind the curve in normalizing monetary policy and was forced to raise rates aggressively in response to rising inflation. The last three recessions were all of the first variety. The 1990-91 recession stemmed from the commercial real estate bust and the ensuing Savings and Loan crisis. The 2001 recession was caused by the bursting of the dotcom bubble. And, of course, the Great Recession was largely the product of the housing bust and weak mortgage underwriting standards. Today's financial landscape is far from pristine. Corporate debt is close to record high levels as a share of GDP and asset valuations are stretched across the board (Chart 6). However, while these imbalances are bad enough to exacerbate a recession, they do not appear severe enough to cause one. This suggests that the next downturn may look less like the last three recessions and more like the "classic" or "retro" recessions of the 1960s, 70s, and early 80s. Chart 5Who Kills Economic Expansions? Chart 6Debt Is Rising, As Are Asset Values Inflation Remains Benign ... For Now If we are heading for a retro recession, investors should keep a close eye on inflation. This is simply because the Fed is unlikely to turn very hawkish until inflation starts accelerating. The good news is that inflation should remain dormant for at least the next 12 months. In fact, most measures of consumer price inflation have decelerated since the start of the year (Chart 7). Producer prices also fell unexpectedly in July, the first outright decline in 11 months. The St. Louis Fed's Price Pressures index remains near rock-bottom levels (Chart 8). Chart 7Consumer Inflation Has Decelerated Of Late Chart 8Price Pressures Are Muted... For Now Inflation expectations are still reasonably well anchored and trade unions have less clout than they once did. Shale producers also have the ability to ramp up production in response to higher oil prices. Past episodes of rapidly rising inflation were often accompanied by supply disruptions that led to spiraling energy costs. Moreover, at least for the time being, higher imports can absorb some of the excess in U.S. aggregate demand. The bad news is that once inflation does start rising in earnest, the Fed is likely to find itself flat-footed. Inflation is a highly lagging indicator. As we have noted before, inflation typically does not peak until well after a recession has begun and does not bottom until well after it has ended (Chart 9). Trying to infer the true level of economic slack from today's inflation rate is like trying to read the speedometer of an automobile when there is a 30-second delay between what the dial says and when you step on the accelerator. Chart 9Inflation Is A Lagging Indicator Timing Matters Too Doesn't a very low neutral real rate reduce the risk that the Fed will find itself behind the curve? The answer is "yes," but only to a limited extent. Suppose, for the sake of argument, that the Fed knew the exact level of the neutral real rate. It would still be the case that a major delay in bringing interest rates up to that magic number would cause the unemployment rate to fall below NAIRU, leading to an overheated economy. Such an economy may not generate inflation immediately, but both history and simple logic suggest that a situation where aggregate demand continues to outstrip supply will eventually produce upward pressure on prices. The lesson here is that successful monetary policy does not just require that central banks bring rates to the correct level. They also have to bring rates to the correct level at the right time. That is difficult to do, which is why soft landings following monetary tightening cycles are few and far between. Fed Dots Too Optimistic About Labor Force Growth And Productivity The Fed "dots" foresee the unemployment rate ending the year at the current level of 4.3% and falling marginally to 4.2% in 2018. The Fed also expects real GDP to grow by 2.2% in Q4 of 2017 and 2.1% in Q4 of 2018 over the previous year. This is similar to the average rate of GDP growth since the start of the recovery, a period where the unemployment rate fell by over five percentage points. Thus, the only way the Fed's math can add up is if labor force growth accelerates or productivity growth increases. Neither outcome is likely. The labor force participation rate has been flat for the past four years, despite the fact that an aging population has pushed more people into retirement. Chart 10 shows that the participation rate has fallen by three percentage points since 2008, only 0.3 points less than one would expect based solely on changes in the age distribution of the population. Much of the remaining gap can be explained by the secular decline in participation rates within young-to-middle age cohorts, offset in part by higher participation among the elderly (Chart 11). In particular, the downward trend in participation among less-educated workers appears to be more structural than cyclical in nature (Chart 12). As we noted last week, the growing shortage of workers is already visible in employer surveys and rising wage pressures at the lower end of the skill distribution.2 Thus, far from accelerating, chances are that labor force growth will decelerate as the economy runs out of people who can be persuaded to seek out gainful employment. This could cause the unemployment rate to fall further than the Fed expects. Chart 10Demographic Shifts Explain Most Of The Decline In Participation Rates Chart 11Participation Rates Across Age Cohorts Chart 12Labor Force Participation Has Fallen ##br##The Most Among The Less-Educated Productivity is also unlikely to make a significant rebound. The drop in productivity growth has been broad-based across industries and countries. Moreover, it began several years before the financial crisis, suggesting that the Great Recession was not the main culprit. All this points to underlying structural factors - such as a weaker pace of innovation and flagging educational achievement - as being the key drivers of the productivity slowdown.3 What Goes Down Must Come Up If labor force growth fails to accelerate and productivity growth remains weak, then the current pace of GDP growth of around 2% will push the unemployment rate down from current levels. Needless to say, if GDP growth accelerates above 2%, unemployment will drop even more. Such an outcome is, in fact, quite likely given the significant easing in financial conditions that the U.S. has experienced over the past few months. All this means that the unemployment rate may be on its way to falling below its 2000 low of 3.8% by next summer. This would leave it close to a full percentage point below the Fed's estimate of NAIRU. At that point, the unemployment rate would have nowhere to go but up. And, unfortunately, history suggests that once unemployment starts rising, it keeps rising. In fact, the U.S. has never averted a recession in the post-war era when the three-month average of the unemployment rate has risen by more than one-third of a percentage point (Chart 13). Chart 13Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle The Not-So-Prescient Stock Market If the U.S. does succumb to a recession in 2019 or 2020 because the Fed is forced to hike rates aggressively in response to rising inflation, how quickly will the market sniff out an impending downturn? Chart 14 plots the value of the S&P 500 around the time of past recessions. On average, the stock market has peaked six months before the beginning of a recession. However, there is quite a bit of variation from one episode to the next (Table 1). The S&P 500 peaked only two months before both the Great Recession and the 1990-91 recession. It peaked seven months before the 2001 recession, but that downturn was arguably more the product of the stock market bust than the cause of it. Chart 14Profile Of U.S. Stocks Around Recessions Table 1Stocks And Recession: Case By Case On the whole, the stock market is not particularly good at anticipating recessions triggered by financial sector imbalances. The stock market is more adept at predicting downturns caused by excessively tight monetary policy - although even here, it is difficult to know how much of the weakness in equities leading up to such recessions was due to rising expectations of a downturn and how much was simply the result of higher interest rates. From this, we conclude that the stock market will likely peak a few months before the next recession. If we are correct about the timing of our recession call, this implies the cyclical bull market has another 12-to-18 months left. Cyclical Leading Indicators Still Benign The bond market has generally done a better job of anticipating economic downturns than the stock market. This is especially the case for the yield curve, which has inverted in the lead-up to every single recession over the past 50 years, with only one false positive (Chart 15). While the 10-year/3-month spread has compressed over the past few years, it is still above the level that has warned of recessions in the past. Most other forward-looking cyclical indicators continue to point to an economic expansion that has further room to run. The Conference Board's Leading Economic Indicator (LEI) has consistently fallen into negative territory on a year-over-year basis leading up to past recessions (Chart 16). The LEI has accelerated since last summer, suggesting little risk of a near-term downturn. Chart 15The Yield Curve Has Called 8 Of The Last 7 Recessions Chart 16LEI Also Good At Signaling Recessions A decline in the ISM new orders component in relation to the inventory component has warned that final demand is softening while the stock of unsold goods is piling up (Chart 17). The current gap stands at 10.4, consistent with a robust expansion. Likewise, initial unemployment claims have usually risen going into past recessions (Chart 18). Neither the current level of claims nor hiring intention surveys are signaling trouble ahead. Chart 17Economic Momentum Is Still Positive Based On The ISM Chart 18Initial Claims Claim Everything Is Okay Changes in financial conditions tend to lead GDP growth by around 6-to-12 months. Thus, it is not surprising that recessions have often occurred in the wake of a tightening in financial conditions (Chart 19). As noted above, U.S. financial conditions have eased sharply since the start of the year. Chart 19Recessions Tend To Occur When Financial Conditions Are Tightening Investment Conclusions Historically, recessions and equity bear markets have gone hand in hand. As my colleague Doug Peta likes to emphasize, it simply does not pay to be underweight stocks unless one has legitimate reasons for thinking that another economic downturn is just around the corner (Chart 20).4 Our analysis suggests that another recession is still at least 18 months away. This is confirmed by a variety of recession-timing models, all of which are signaling low risks of an impending downturn in growth (Chart 21). As we noted last week, wage growth is likely to accelerate over the next few quarters. This will prop up consumer spending. July's blockbuster retail sales report was no fluke - there are plenty more where it came from. Stronger U.S. growth will force the market to revise up the miserly 41 basis points in rate hikes that it has priced in over the next two years. This will push up Treasury yields and give the dollar a boost. The greenback has usually strengthened whenever an overheated labor market has caused labor's share of income to rise (Chart 22). We expect the broad trade-weighted dollar to appreciate by about 10% over the next 18 months. Chart 2050 Years Of Recessions And Bear Markets Chart 21No Imminent Risk Of A Recession Chart 22Historically, A Rising Labor Share Has Pushed Up The Dollar A stronger dollar is necessary for tilting U.S. consumption towards foreign-made goods, thereby allowing domestic spending to rise in the face of tighter supply constraints. This is good news for foreign producers in developed economies, but could cause trouble for firms in emerging markets which have taken out large amounts of dollar-denominated debt. We continue to prefer European and Japanese stocks over their U.S. counterparts in currency-hedged terms. In the EM space, Chinese H-shares are our preferred market. Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017. 2 Please see Global Investment Strategy Weekly Report, "What's The Matter With Wages?," dated August 11, 2017. 3 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016; and The Bank Credit Analyst Special Report, "Taking Off The Rose-Colored Glasses: Education and Growth In The 21st Century," February 24, 2011. 4 Please see Global ETF Strategy Special Report, "A Guide To Spotting And Weathering Bear Markets," dated August 16, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Duration: An environment characterized by strong global growth and a weak dollar is very bearish for U.S. bonds. According to our model, fair value for the 10-year Treasury yield is 2.6%. Stay at below-benchmark duration. The Fed & The Dollar: A weak dollar eases financial conditions and supports higher core goods inflation. All else equal, this will strengthen the Fed's hawkish resolve in the near term. However, a rebound in core services (excluding shelter and medical care) inflation will be necessary for core inflation to reach the Fed's target on a sustained basis. USD Sovereigns: USD-denominated sovereigns are not attractive compared to domestic Baa-rated U.S. credit. At the country level, Finland, Mexico and Colombia offer the most attractive spreads and Finnish debt offers the best risk/reward trade-off. Feature Please note there will be no U.S. Bond Strategy report next week. Our regular publishing schedule will resume on August 29, 2017. Chart 1Firm Growth, Despite Weaker $ Escalating tension between the U.S. and North Korea captured the market's attention during the past week, causing investors to ignore what in our view is a more important economic development: Global growth has managed to stay firm even in the face of significant dollar depreciation. Not only does this break the pattern of the past few years when periods of substantial dollar weakness were associated with slowing global growth (Chart 1), but in our view it sends a very bearish signal for U.S. bonds. Above all else, a weak dollar amidst strong global growth suggests that the breadth of the economic recovery is improving. This intuition is confirmed by the fact that our Global Manufacturing PMI Diffusion Index, which measures the net percentage of countries with PMIs above the 50 boom/bust line, is fast approaching 90% (Chart 2). Not only that, but PMIs from the four most important economic blocs are all showing signs of strength. Both the Eurozone and Japanese PMIs are holding firm at high levels, while the U.S. and Chinese PMIs have recently reversed their year-to-date downtrends (Chart 2, bottom two panels). Why is the breadth of the global recovery important? Precisely because a more synchronized recovery prevents the dollar from appreciating too quickly. All else equal, a stronger dollar causes investors to reduce their forecasts for future U.S. growth and inflation. This implies a slower expected pace of rate hikes and lower Treasury yields. Conversely, a weaker dollar causes investors to revise up their growth and inflation forecasts, leading to a quicker expected pace of rate hikes and higher yields. To capture the importance of both global growth and the exchange rate we turn to our 2-factor Treasury model (Chart 3). This is a simple model of the 10-year Treasury yield based on the Global PMI and bullish sentiment toward the dollar. A stronger Global PMI pressures the model's fair value higher, as does increasingly bearish dollar sentiment. Chart 2Synchronized Global Growth Chart 310-Year Treasury Yield Fair Value At present, the model pegs fair value for the 10-year Treasury yield at 2.6%, meaning the current 10-year Treasury yield of 2.22% is 38 bps below fair value. This is the most expensive Treasuries have appeared on our model since the immediate aftermath of last year's Brexit vote. Political Uncertainty & Flights To Quality While our 2-factor model does a good job, there is one important driver of Treasury yields it does not capture. That is the tendency for political events to drive a flight to safety into Treasuries (Chart 4). Typically, if it is possible to identify a purely politically-driven flight to safety - one that is unlikely to exert a meaningful economic impact during the next 6-12 months - then the correct strategy is to heed our model's message and position for higher yields. This strategy worked out perfectly following the Brexit vote, and we anticipate it will work again this time around. Chart 4Policy Uncertainty Is A Driver Of Bond Yields With regards to the catalyst for last week's flight to safety, our Geopolitical Strategy service wrote in a recent Special Report1 that a pre-emptive strike by the U.S. on North Korea is extremely unlikely. The theatrics of the past week demonstrate only that the U.S. needs to establish a "credible threat" if it wants to eventually open a new round of negotiations over North Korea - not unlike the Iranian nuclear negotiations of the past decade. Looking further down the road, if those talks eventually fail then the potential for military conflict is high. We therefore conclude that there is not much potential for U.S. / North Korean tensions to exert a meaningful economic impact during the next 6-12 months, and view the recent bond rally as an opportunity to position for sharply higher yields in the near-term. Bottom Line: An environment characterized by strong global growth and a weak dollar is very bearish for U.S. bonds. According to our model, fair value for the 10-year Treasury yield is 2.6%. Stay at below-benchmark duration. How The Fed Views A Weaker Dollar Financial Conditions Chart 5Weak $ Eases Financial Conditions The Fed views the 7% year-to-date depreciation of the dollar as a significant easing of financial conditions. In fact, most broad indicators of financial conditions have eased this year, even though the Fed has lifted rates by 75 bps since December (Chart 5). In the Fed's framework, this means that the pace of rate hikes might need to increase in order to tighten financial conditions as much as desired. New York Fed President William Dudley summed up this approach in a 2015 speech:2 All else equal, if financial conditions tighten sharply, then we are likely to proceed more slowly. In contrast, if financial conditions were not to tighten at all or only very little, then - assuming the economic outlook hadn't changed significantly - we would likely have to move more quickly. In the end, we will adjust the policy stance to support financial market conditions that we deem are most consistent with our employment and inflation objectives. Of course, all else is not equal. Core inflation has disappointed so far this year and our current assessment of monetary policy is that while the Fed will take action to start shrinking its balance sheet next month, rate hikes are on hold until inflation turns higher. We remain optimistic that inflation will show sufficient strength in time for the Fed to lift rates in December.3 Inflation Chart 6Weak $ = Higher Inflation A weaker dollar also increases the Fed's confidence that inflation will head higher. Although so far we have not seen much evidence that this is occurring. Last Friday's July CPI report showed that core CPI rose only 0.1% month-over-month, while the year-over-year growth rate held flat at 1.7%. However, evidence is mounting that core inflation will soon put in a bottom. Our CPI diffusion index bounced back into positive territory in July (Chart 6) and our PCE diffusion index is at its highest level since last October.4 Both of these measures have excellent track records capturing the near-term swings in core inflation. The year-to-date weakness in the dollar has led to a surge in import prices. Stronger import prices will soon translate into higher core goods inflation (Chart 6, panels 2 and 3). Unfortunately, any increase in core goods inflation is unlikely to be sustained beyond the next 12 months. If the year-to-date dollar weakness starts to reverse, as our currency strategists anticipate,5 then import prices will decline anew. Eventually, this will translate into a deceleration in core goods inflation. For core inflation to sustainably reach the Fed's target, improvement in the lagging core services (excluding shelter and medical care) component will be required. Historically, this component is the most tightly linked to wage growth (Chart 6, bottom panel). A Rising Wage Growth Environment Two related methods do an excellent job predicting the direction of wage growth on a cyclical horizon. First, wages accelerate when the unemployment rate is falling, and second, wages accelerate when the prime-age (25-54) employment-to-population ratio is increasing. The top two panels of Chart 7 show the relationship between wage growth and the unemployment rate. The shaded regions in both panels correspond to periods when the unemployment rate is falling. As can be seen, wage growth always rises during these periods. That being the case, we calculate that non-farm employment needs to grow by more than 125k per month (on average) for the unemployment rate to continue its downtrend, assuming the labor force participation rate remains flat. Chart 7A Rising Wage Environment Of course it is not guaranteed that the labor force participation rate will stay flat. In a recent report we discussed the risk that a large cyclical increase in the participation rate might cause the unemployment rate to rise even as the economy continues to recover.6 This is why we also look at the shaded regions in the bottom two panels of Chart 7 and see that wages always rise during periods when the prime-age employment-to-population ratio is rising. By looking at the employment-to-population ratio instead of the unemployment rate we do not need to make an assumption about the trend in labor force participation. Using this method, we calculate that monthly employment growth must exceed 140k (on average) for the prime-age employment-to-population ratio to keep increasing. Non-farm payroll growth has averaged 184k per month so far in 2017 and averaged 187k per month in 2016. In other words, the U.S. jobs machine is running at a fairly steady pace, well above the thresholds we see as necessary for the recovery in wage growth to continue. Bottom Line: A weak dollar eases financial conditions and supports higher core goods inflation. All else equal, this will strengthen the Fed's hawkish resolve in the near term. However, a rebound in core services (excluding shelter and medical care) inflation will be necessary for core inflation to reach the Fed's target on a sustained basis. Sovereigns Not Buying The Weak Dollar USD-denominated sovereign bonds should benefit from a falling dollar. A weaker U.S. dollar makes the debt obligation cheaper in the issuing nation's local currency. However, the USD Sovereign index has actually underperformed the duration-matched Baa U.S. Credit index during the past six months, despite a depreciating U.S. currency (Chart 8). The duration-matched Baa-rated U.S. Credit index is the closest comparable we can find for the Sovereign index. It matches the Sovereign index in terms of duration and average credit rating, although historically it also delivers less excess return volatility (Chart 8, bottom panel). The two main factors we consider when deciding whether to add USD-denominated sovereigns to our portfolio at the expense of domestic U.S. credit are relative valuation and the outlook for the dollar. Historically, spread differential has been an important driver of relative returns. Attractive starting valuations even allowed sovereigns to outperform credit in 2014 and 2015 despite the dollar's surge. But at the moment, relative value is skewed heavily in favor of domestic U.S. credit (Chart 8, panel 1). Chart 8Sovereigns Too Expensive Added to that, with U.S. growth likely to remain strong and U.S. inflation poised to rebound, we think there is a high likelihood that the Fed will deliver more rate hikes than are currently priced in. This will make it difficult for the dollar to decline further from current levels. Taken together, poor relative valuation and a bullish outlook for the dollar lead us to continue underweighting USD-denominated sovereigns in our portfolio. The Sovereign Index: Country Breakdown Even though the overall index is unappealing, opportunities might still exist at the country level. Chart 9 shows a risk/reward picture for each country in the Bloomberg Barclays Sovereign index. The upper panels show the option-adjusted spread for each country relative to its duration and credit rating. The lower panels show a risk-adjusted spread on the y-axis. This risk-adjusted spread is the excess spread that remains after we adjust for differences in credit rating and duration using a cross-sectional model. What sticks out immediately is that Finland, Colombia and Mexico all offer compelling spreads after adjusting for differences in credit rating and duration. The outlook for each country's currency versus the U.S. dollar is obviously also important. And in fact, the lower-right panel of Chart 9 shows that exchange rate volatility is positively correlated with the risk-adjusted spreads from our cross-sectional model. This implies that the extra compensation available in Mexican and Colombian sovereigns is probably compensation for assuming highly volatile currency risk. By this measure, Finland looks even more attractive given the euro's slightly lower volatility. Chart 9USD Sovereign Index: Country Breakdown Bottom Line: USD-denominated sovereigns are not attractive compared to domestic Baa-rated U.S. credit. Remain underweight. At the country level, Finland, Mexico and Colombia offer the most attractive spreads and Finnish debt offers the best risk/reward trade-off. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Geopolitical Strategy Special Report, "North Korea: Beyond Satire", dated April 19, 2017, available at gps.bcaresearch.com 2 https://www.newyorkfed.org/newsevents/speeches/2015/dud150605 3 For further details on our outlook for the near-term path of monetary policy please see U.S. Bond Strategy Portfolio Allocation Summary, "On Hold, But Not For Long", dated August 8, 2017, available at usbs.bcaresearch.com 4 For a chart of the PCE diffusion index please see page 11 of U.S. Bond Strategy Portfolio Allocation Summary, "On Hold, But Not For Long", dated August 8, 2017, available at usbs.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "Fade North Korea, And Sell The Yen", dated August 11, 2017, available at fes.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights The GOP can bolster its case for re-election in 2018 by passing tax cuts and rolling back regulation. With U.S. equity valuations stretched, prolonged uncertainty in Northeast Asia may be a catalyst for a pullback. The global economic outlook is brightening and will be a tailwind for U.S. economic growth and equities. Rising wage pressure will be another headwind for EPS growth in 2018, although wages appear quite benign at the moment. Wages are not always a good leading indicator for the inflation cycle. Indeed, sometimes upturns in wage growth lags that of consumer prices. Feature Safe haven assets caught a bid last week while risk assets sold off as investors weighed geopolitical tensions in Northeast Asia and more uncertainty over fiscal policy in Washington. Last week's U.S. economic data highlighted the disconnect between a tighter labor market and a lack of wage pressures. Meanwhile, the data suggest that growth outside the U.S. is accelerating. Nonetheless, history shows that investors should be patient while waiting for an upturn in inflation. Next Up: Tax Cuts The GOP will deliver on tax cuts this year despite disarray at the White House and an incompetent Congress, but fiscal stimulus may fail to live up to its hype. Furthermore, a fiscal lift from infrastructure spending is unlikely anytime soon. Republicans need a win ahead of the 2018 mid-term elections and they have already laid the groundwork for tax reform via the budget reconciliation process. Moreover, cutting taxes is easier to justify politically than removing an entitlement program (i.e. Obamacare). Tax rates probably will not be lowered by as much as originally promised because conservative Republicans in the House will demand "revenue offsets" to pay for tax cuts. Internal GOP battles over how to fund tax cuts could spill over into some tension regarding raising the debt ceiling. However, it is in neither political party's interests to create another "fiscal cliff" out of thin air. The GOP needs Democratic votes to pass this legislation in the Senate and the Democratic leadership has indicated it is willing to support it. At what price? House Minority leader Nancy Pelosi and Senate Minority leader Chuck Schumer may link the debt ceiling and spending bill to tax reform, and push for the tax cuts to extend to the middle class and to be revenue neutral. There is a chance that both parties will agree to temporarily eliminate the debt ceiling, perhaps beyond the 2018 mid-term elections. In any event, we expect a last minute resolution to both the U.S. debt ceiling and the potential government shutdown in September. Thus, there should be no lasting impact on financial markets from the debt ceiling debate. Turning to government regulation, the NFIB survey shows that small businesses are pleased with the Trump administration's attack on red tape. President Trump has made progress on slowing regulation and is on track to enact one-tenth the amount of economically significant regulation1 passed by the Obama administration (Chart 1). By this metric, Trump is even more frugal than Reagan. Trump and the GOP-held Congress have rolled back Obama-era rules and delayed others. Still, regulatory change is slow to impact the economy and it may take years for the regulatory rollback to provide any meaningful lift to growth. Accordingly, the "Trump Put"2 is still in place. U.S. politics will remain a mess for much of the year, delaying any progress on populist economic policies that would have buoyed U.S. nominal GDP growth and given the Fed a reason to hike interest rates more aggressively (Chart 2). Chart 1Trump Has Had Success In Slowing Regulation Chart 2The Trump Put Bottom Line: Trump will not be impeached until after the 2018 mid-term election, and only then if the Democrats manage to take control of the House. The GOP can bolster its case for re-election in 2018 by passing tax cuts and rolling back regulation. The intensifying Mueller investigation and White House incompetence will only fuel the "Trump Put", which has been positive for U.S. equities, neutral for Treasuries, and bad for the dollar, all else equal. A significant uptick in inflation could overwhelm the "Trump Put" and spark a dollar rally. As such, investors should focus on inflation prospects rather than on White House politics. Fire And Fury Investors are on high alert and with the Q2 earnings season over, may look beyond the positive news on corporate profits for direction. Our colleagues in the BCA Geopolitical Strategy service have long maintained that Northeast Asia is ripe for economic/political risk.3 The underlying driver of uncertainty on the Korean Peninsula is the Sino-American rivalry. China is an emerging "great power" that threatens the global dominance of the U.S. and its allies. The immediate consequence is mounting friction in China's periphery. That is why Taiwan, the South China Sea, and North Korea, are all heating up. North Korea's regime is highly unpredictable as evidenced by events in the past few weeks. In that sense, it is more significant than the other "proxy battles" between the U.S. and China. In essence, North Korea is no longer merely an object of satire. A new round of negotiations over North Korea's nuclear and missile programs is about to begin. The potential for a military conflict is high unless diplomacy succeeds in convincing North Korea to freeze its weapons programs. The events on the Korean peninsula are unfolding as we expected they would. North Korea has a history of rational action. It wants a nuclear deterrent and a peace treaty, but not a regime change. The U.S. has forsworn regime change as an intention and China has recommitted to new sanctions. South Korea is pro-engagement. Moreover, we are seeing the U.S. establish a credible military as part of the "arc of diplomacy," comparable to U.S.-Iran relations 2010-15. Bottom Line: We do not expect a pre-emptive strike by the U.S. on North Korea, as the constraints to conflict are extremely high and not all diplomatic options have been exhausted. Nonetheless, with U.S. equity valuations stretched, prolonged uncertainty in the region may be a catalyst for a pullback. A Rosy Global Picture The global economic outlook is brightening and will be a tailwind for U.S. economic growth and equities. Global real GDP estimates continue to move higher, a welcome departure from years past when estimates slid relentlessly lower (Chart 3). Since the start of 2017, global GDP estimates for this year have increased from 2.8% to 3%, while 2018 forecasts have accelerated from 2.7% to 2.9%. This upward trajectory has occurred despite a recalibration by many major central banks away from accommodative policies. Aggressive central bank actions or escalating tensions in Northeast Asia, or both, may halt the improving growth forecasts. Falling oil prices would also challenge a quickening of global growth, but our view is that oil prices will move higher in the coming months.4 Chart 3Global Growth Estimates Accelerating Despite Stalled U.S. Growth Global leading indicators are on the upswing (Chart 4). The BCA Global Leading Indicator Index (excluding the U.S.) in July 2017 was the strongest since 2010 when it slowed after a sharp rebound from the global financial crisis. The increase in growth still has room to run. Admittedly, the LEI's diffusion index has dipped below 50%. It would be a warning sign for global growth if the diffusion index does not soon turn up. Nominal global GDP growth is speeding up, boosted by improving consumer and business confidence, rising capital spending and declining policy uncertainty (Chart 5). The global economic surprise index is also climbing, which provides additional support. Investors may be concerned that the global PMIs have peaked (Chart 6), but they remain at levels consistent with above-trend GDP growth and we see no reason why they should drop below 50. Chart 4LEIs Pointing Higher Chart 5Supports For Global Growth In Place Chart 6Global Economic Activity Brightening Industrial production (IP) overseas is expanding nearly twice as fast as in the U.S. (Chart 5). This suggests that U.S. economic activity will be pulled up by foreign demand. A stronger dollar (as much as a 10% appreciation in the next year) may dampen U.S. exports and earnings, but this will be more a problem for 2018 than 2017. Bottom Line: Improving economic activity outside the U.S. is a tailwind for both U.S. economic growth and profits of U.S. firms with significant business abroad. Solid foreign demand will help the economy hit the Fed's GDP target and also support additional, but gradual, tightening by the central bank. Stay overweight U.S. equities and remain short duration. Waiting For Wages Rising wage pressure will be another headwind for EPS growth in 2018, although wages appear quite benign at the moment. Both primary and secondary indicators point to a tighter U.S. labor market. The July jobs report (released in early August) was yet another sign that the slack in the jobs market is vanishing.5 Data released last week on job openings (JOLTS) and the National Federation of Independent Business (NFIB) further supported this trend, and indicated that the labor market may tighten even more. Job openings rose to a new all-time high along with BCA's quit rate less layoffs indicator (Chart 7). The hire rate remained at a cycle peak. The NFIB data was equally impressive, with hiring plans and job openings surging in July. Small businesses are also finding it increasingly difficult to find quality labor. (Chart 7, panel 4) The strength in the labor market has not yet translated into accelerating wages, but patience is required. The July NFIB survey noted that "while a tight job market may point to higher wages and rising consumer spending down the road, which is also good for small businesses, the current expansion efforts by small business owners are being choked by their difficulties in hiring and keeping workers." The NFIB's compensation plans (Chart 7) provided quantitative support for the group's qualitative assessment. However, the latest readings on labor compensation from the Q2 productivity report, the tepid July average hourly earnings data and the Atlanta Fed wage tracker suggest that the labor market is still not tight enough to generate much wage pressure (Chart 8). Chart 7Widespread Evidence That##BR##Labor Market Is Tightening Chart 8Not Much Wage##BR##Pressure Yet Inflation And Long-Expansion Dynamics That said, wages are not always a good leading indicator for the inflation cycle. Indeed, sometimes upturns in wage growth lag that of consumer prices. In previous research we split U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from medium and long expansions is the speed at which the most cyclical parts of the economy accelerated, and the time it took unemployment to reach a full employment level. Long expansions were characterized by a drawn-out rise in the cyclical parts of the economy and a very slow return to full employment, similar to what has occurred since the Great Recession. Chart 9 compares the current cycle to the average of two of the long cycles (the 1980s and the 1990s). We excluded the long-running 1960s expansion because the Fed delayed far too long and fell well behind the inflation curve. We define the 'late cycle' phase to be the time period from when the economy first reached full employment to the subsequent recession (shaded portions in Chart 9). The average late-cycle phase for these two expansions lasted almost four years, highlighting that reaching full employment does not necessarily mean that a recession is imminent. Inflation pressures are slower to emerge in 'slow burn' recoveries, allowing the Fed to proceed slowly. The Fed waited an average of 25 months to tighten policy after reaching full employment in these two long expansions, in part because core CPI inflation was roughly flat. The result was an extended late-cycle phase that was very rewarding for equity investors because the economy and earnings continued to grow. Of course, inflation eventually did turn higher, signaling the beginning of the end for the expansion and equity bull phase. In Chart 10, we compare the core PCE inflation rate in the current cycle with the average of the previous two long expansion episodes (the inflection point for inflation in the previous cycles are aligned with June 2017 for comparison purposes). The other panels in the chart highlight that, in the 1980s and 1990s, wage growth gave no warning that an inflation upturn was imminent. Indeed, wages were a lagging indicator of consumer price inflation. Chart 9Labor Market, Inflation And Stocks##BR##In The Long 80's & 90's Expansions Chart 10In The 80's & 90's Wage Growth##BR##Gave No Early Warning On On Inflation Market commentators often assume that inflation is driven exclusively by "cost push" effects, such that the direction of causation runs from wage pressure to price pressure. However, causation runs in the other direction as well. Households see rising prices and then demand better wages to compensate for the added cost of living. Chart 11Leading Indicators Of Inflation##BR##In "Slow Burn" Recoveries This is not to say that we should totally disregard wage information. But it does suggest that we must keep an eye on a wider set of data. Indicators that provided some leading information for inflation in the previous two long cycles are shown in Chart 11. To this list we would also add the St. Louis Fed's Price Pressure index, which is not shown in Chart 11 because it does not have enough history. All of these indicators have moved higher over the past 18 months, after bottoming at extremely low levels in 2015 and early 2016. However, they have all pulled back to some extent in recent months. This year's pipeline inflation "soft patch" continued into July, according to last week's release of the Producer Price Index. The easing in cost pressures at the producer level has been broadly based (i.e. one cannot blame special factors). These indicators suggest that consumer price inflation, according to either the CPI or the PCE, will struggle to rise in the next few months. The July CPI report revealed another tepid 0.1% monthly rise in the core price index, while the year-over-year rate remained at 1.7%. Rising prices for health care goods and services were offset by price declines for new and used cars. The diffusion index for the CPI moved up to the zero line in July, indicating that disinflation was a little less broadly based in the month. Bottom Line: Our base case is that core PCE inflation edges higher in the coming months, which will be enough for the FOMC to justify a rate hike in December. We also expect that inflation will be high enough in 2018 for the Fed to hike rates by more than is discounted in the bond market. Nonetheless, the warning signs of an inflation upturn are mixed at best. It would flatter our stocks-over-bonds recommendation if we are wrong on the inflation outlook, but our short duration stance would not be profitable in this case. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Office of Information and Regulatory Affairs (OIRA) of Office of Management and Budget (OMB): https://www.reginfo.gov/public/do/eAgendaMain and https://www.reginfo.gov/public/do/eoCountsSearchInit?action=init 2 Please see Geopolitical Strategy Weekly Report, "How Long Can The Trump Put Last" dated June 14, 2017, available at gps.bcaresearch.com. 3 Please see Geopolitical Strategy Weekly Report, "North Korea: Beyond Satire, dated April 18, 2017, available at gps.bcaresearch.com. 4 Please see Commodity & Energy Strategy Weekly Report, "KSA's Tactics Advance OPEC' 2.0's Agenda," dated August 10, 2017, available at ces.bcaresearch.com. 5 Please see U.S. Investment Strategy Weekly Report, "Stay The Course" dated August 7, 2017, available at usis.bcaresearch.com.
Highlights Strong corporate earnings growth will drown out worries about North Korea. Stay cyclically overweight global equities. Underlying wage growth in the U.S. is stronger than the official data suggest. Surveys point to a further acceleration in U.S. wages, as do pay gains at the lower end of the income distribution. Labor's share of income will resume its cyclical recovery. This will lead to more consumer spending, and ultimately, higher price inflation. Wage growth elsewhere in the world will also pick up as labor slack declines. Global fixed-income investors should underweight duration and increase exposure to inflation-linked securities. Feature Focus On Corporate Earnings, Not Korea Chart 1EPS Estimates Have Remained ##br##Resilient This Year Global equities dropped over the past few days on the back of rising risks of conflict in the Korean peninsula. Our geopolitical strategists believe that neither the U.S. nor North Korea will launch a preemptive strike.1 Despite its bluster, North Korea has a history of rational action. It wants a nuclear deterrent and a peace treaty. The U.S. has forsworn regime change as a policy goal. China has recommitted to new sanctions and the South is pro-engagement. This raises the likelihood that a diplomatic solution will be found. Unfortunately, getting from here (open hostilities) to there (negotiated solution) will take time, which leaves the door open to increased market volatility. Nevertheless, we expect any selloff to be short-lived, owing to the positive earnings picture. More than anything else, strong profit growth has underpinned the cyclical bull market in stocks, and we expect this to remain the case over the coming months. More than 80% of S&P 500 companies have reported Q2 results. Based on these preliminary numbers, EPS appears to have increased by 11% over the previous year, marking the fourth consecutive quarter of margin expansion. The strength has been broad based, with all eleven sectors reporting positive growth. U.S. earnings estimates for both 2017 and 2018 have remained steady since January, bucking the historic pattern of downward revisions throughout the course of the year (Chart 1). The picture is even more impressive outside the U.S., where earnings estimates continue to move higher. The Euro STOXX 600 is now expected to deliver EPS growth of 12.6% this year. EPS of stocks listed on the Japanese Topix is expected to rise 14.8% this year and 7.3% next year, giving them an attractive 2018E P/E of 13.6. We recommend overweighting euro area and Japanese stocks over their U.S. counterparts in currency-hedged terms. EM stocks have seen the strongest positive earnings revisions this year. We continue to worry about some of the structural headwinds facing emerging markets (high debt levels, poor governance, etc.). However, the cyclical picture remains more upbeat. Chinese H-shares remain our favorite EM market, trading at just 7.5 times 2017 earnings estimates. The U.S. Labor Market Gets A JOLT, But Where's The Wage Growth? The Job Openings and Labor Turnover Survey (JOLTS) released on Tuesday provided more good news about the state of the U.S. labor market (Chart 2). The number of job openings rose to 6.2 million in June. There are now 28% more unfilled jobs in the U.S. than at the prior peak in April 2007. The number of unemployed workers per job opening fell to 1.1, the lowest level in the history of the series. One might think that with numbers like these, wage growth would be skyrocketing. Yet, it is not. While monthly average hourly wages did surprise to the upside in the June payrolls report, the year-over-year change remained stuck at 2.5%. This week's productivity report showed that compensation per hour increased by only 1% in Q2 relative to the same period in 2016. Other measures of wage growth generally point to some softening this year (Chart 3). Chart 2More Good News For The U.S. Labor Market Chart 3U.S. Wage Growth Remains Soft Many commentators regard the lackluster pace of wage inflation - coming at a time when the unemployment rate has fallen below its 2007 lows - as a "mystery" that needs to be solved. As we argue in this report, there is less to this mystery than meets the eye. Properly measured, underlying wage growth in the U.S. has been rising for some time, and may actually be stronger than the "fundamentals" warrant. Wage inflation elsewhere in the world is more subdued. However, this is largely because progress towards restoring full employment has been slower outside the U.S. Is Wage Growth Being Mismeasured? How can U.S. wage growth be characterized as "strong" when it is still so weak by historic standards? Part of the answer has to do with that old bugbear: measurement error. Low-skilled workers have been re-entering the labor force en masse over the past few years, after having deserted it during the Great Recession. This has put downward pressure on average wages, arithmetically leading to slower wage growth. Most of the official wage series, including the Employment Cost Index, do not adjust for this statistical bias.2 In a recent research report, economists at the San Francisco Fed concluded that "correcting for worker composition changes, wages are consistent with a strong labor market that is drawing low-wage workers into full-time employment."3 In addition to cyclical factors, demographic shifts have depressed official measures of wage inflation. Historically, population aging has pushed up average wages because older workers tend to earn more than younger ones. The retirement of millions of well-paid baby boomers over the past few years has reversed this trend, at least temporarily. Chart 4 shows that the median age of employed workers has fallen for the past three years, the first time this has happened since the 1970s. Weak Productivity Growth Dragging Down Wages Unfortunately, there is more to the story than measurement error. Today's young workers are not better skilled or educated than those of previous generations. This, along with other factors that we have discussed extensively in past reports, has dragged down productivity growth.4 Nonfarm productivity has increased at an average annualized pace of less than 1% over the past few years, down from 3% in the early 2000s (Chart 5). Slower productivity growth gives firms less scope to raise wages. In fact, for all the talk about how wages are stagnant, real wages have risen by more than productivity since 2014. This has pushed labor's share of income off its post-recession lows. Chart 4Median Age Of Workers No Longer Rising Chart 5Real Wages Have Increased Faster ##br##Than Productivity Over The Past Few Years It remains to be seen whether the structural downtrend in the share of income going to labor will be reversed. One can make compelling arguments for both sides of the issue.5 But over a cyclical horizon of one-to-two years, it is highly likely that labor's share will rise. Labor's share of income is fairly procyclical. It increased significantly in the late 1990s and rose again in the years leading up to the Great Recession. Considering how low unemployment is today, it is not unreasonable to assume that it will maintain its cyclical uptrend. If so, this will lead to more consumer spending, and ultimately, higher inflation. Surveys Point To Faster Wage Growth... Surveys such as those conducted by the National Federation of Independent Business, Duke University/CFO Institute, National Association for Business Economics, and various regional Federal Reserve banks suggest that employers are becoming increasingly willing to raise compensation in order to fill vacancies (Chart 6). Workers, in turn, are becoming more choosy. This can be seen in an improving assessment of job availability and a rising quits rate. Both of these measures lead wage growth (Chart 7). Chart 6ASurveys Show Employers More Willing To Raise Compensation Chart 6BSurveys Show Employers More Willing To Raise Compensation Chart 7Workers Are Feeling More Confident ...As Do Wage Gains Among Low-Income Workers Median weekly earnings of low-income workers have accelerated this year, even as wage gains among higher-income workers have hit an air pocket (Chart 8). For example, restaurant workers have seen pay hikes of nearly 5% this year, up from 1% in 2014. Wage growth among lower-income workers tends to be less noisy than for higher-income workers. The incomes of better-paid workers are often influenced by bonuses and other variables that may be driven more by industry-specific or economy-wide profit trends rather than labor slack per se. Less-skilled workers are usually the first to get fired and the last to get hired. Thus, wage pressures at the lower end of the skill distribution often coincide with an overheated labor market. This makes the trend in lower-income wages a more reliable gauge of underlying labor market slack. Wage Inflation Will Slowly Pick Up As Global Slack Diminishes We expect U.S. wage growth to rise over the next few quarters by enough to allow the Fed to raise rates in line with the dots. However, a more rapid acceleration - one that forces the Fed to raise rates aggressively - is improbable, at least over the next 12 months. This is mainly because the relationship between domestic labor market slack and wage growth is not as tight as it once was. Trade unions have less clout these days, which means it takes longer for a tight labor market to produce larger negotiated pay hikes. The labor market has also become less fluid, as evidenced by the structural decline in both the rate of job creation and job destruction (Chart 9). Wages tend to adjust more slowly when there is less hiring and firing going on. Chart 8Better Pay For Low-Wage Earners: ##br##A Sign Of A Tighter Labor Market Chart 9Structural Declines In Job Creation##br## And Destruction Perhaps most importantly, an increasingly globalized workforce has given firms the ability to move production abroad in response to rising wages at home. This suggests that wage growth in the U.S. is unlikely to increase significantly until falling unemployment begins to push up wages abroad. Wage Growth Around The World For now, wage growth in America's trading partners remains subdued. Euro area wage inflation is stuck between 1% and 1.5%, although with important regional variations (Chart 10). Wage inflation has accelerated to over 2% in Germany, but is still close to zero in Italy and Spain. Considering that unemployment in both countries remains well above pre-recession levels, it will be difficult for the ECB to tighten monetary policy to any great degree over the next few years. Japanese wage growth has picked up since 2010, but is still below the level consistent with the BoJ's 2% inflation target (Chart 11). Wage inflation is likely to ratchet higher over the next few years, now that the ratio of job openings-to-applicants has risen to the highest level since 1974 (Chart 12). In a sign of the times, Yamato Transport, Japan's largest parcel delivery company, recently told Amazon that it would not be able to make same-day deliveries due to a shortage of available drivers. Chart 10Euro Area Wage Growth Remains ##br##Weak Outside Of Germany Chart 11Modest Pickup In Japanese Wages Wage growth in Canada has actually declined since 2014. However, that is likely to change given that the unemployment rate has fallen close to nine-year lows. Falling unemployment rates should also boost wage inflation in the U.K., Australia, and New Zealand. Chinese wage growth also remains brisk. Chart 13 shows that urban household future income confidence has picked up notably of late, as growth has improved and the labor market has tightened. Chart 12Job Openings Ratio Will Push Wages Higher Chart 13Optimism Over The Labor Market In China Faster Wage Growth Will Ultimately Lead To Higher Inflation Chart 14The Decline In Inflation Expectations ##br##Have Weighed On Wage Growth Going forward, the combination of falling labor slack abroad and an overheated labor market at home will cause U.S. wage inflation to increase more rapidly starting in the second half of 2018. This will be a break from the past. Lower longer-term inflation expectations have tempered nominal wage growth over the past eight years (Chart 14). Both market-based inflation expectations and inflation expectations 5-to-10 years out in the University of Michigan's survey have fallen by about half a point since the financial crisis. The recent decline in headline CPI inflation from 2.7% in February to 1.6% in June may also explain why wage growth has dipped this year even as payroll gains have rebounded. Rising wage growth could begin to feed on itself. As we have discussed before, the Phillips curve tends to steepen once an economy reaches full employment (Chart 15). If the unemployment rate falls from 7% to 6%, this is unlikely to have a huge effect on wages. But if it falls from 4.5% to 3.5%, the effect could be substantial. A recent Fed paper concluded that "evidence strongly suggests a non-linear effect of slack on wage growth and core PCE price inflation that becomes much larger after labor markets tighten beyond a certain point."6 The implication is that once inflation does start rising, it could rise more quickly than investors (or the Fed) expect. Concluding Thoughts The past three U.S. recessions were all caused by the unravelling of financial sector and asset market excesses: The housing bust lay the groundwork for the Great Recession; the collapse of dotcom stocks ushered in the 2001 recession; and the failure of hundreds of banks during the Savings and Loan crisis paved the way for the 1990-91 recession. Unlike the last few recessions, the next one may end up being more akin to those of 1960s, 70s, and 80s. Those earlier recessions were generally triggered by aggressive Fed rate hikes in the face of an overheated economy and rising inflation (Chart 16). Chart 15The Phillips Curve Appears To Be Non-Linear Chart 16Are We Heading Towards A "Retro-Recession"? The good news is that neither wage nor price inflation is likely to soar over the next 12 months. This means that the bull market in global equities can continue for a while longer. The bad news is that complacency about inflation risk is liable to cause central bankers to fall increasingly behind the curve. Rising inflation will force the Fed to pick up the pace of rate hikes in the second half of 2018. This is likely to lead to a stronger dollar and higher Treasury yields. The resulting tightening in U.S. financial conditions could trigger a recession in 2019 or 2020. Investors should remain overweight risk assets for now, but prepare to scale back exposure next summer. Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Geopolitical Strategy Special Report titled "North Korea: Beyond Satire," dated April 19, 2017. 2 Unlike the widely followed average hourly wage series published every month in the payrolls report, the quarterly Employment Cost Index (ECI) does control for shifts in the weights of different industries in total employment. Thus, an increase in the relative number of low-paid hospitality workers would depress average hourly wages, but would not affect the ECI. Nevertheless, the ECI does not control for the possibility that the composition of the workforce within industries may change over time. The Atlanta Fed's Wage Tracker does overcome this bias because it uses the same sample of workers from one period to the next. However it, too, is subject to a number of methodological problems. 3 Mary C. Daly, Bart Hobijn, and Benjamin Pyle, "What's Up with Wage Growth?" FRBSF Economic Letter 2016-07 (March 7, 2016). 4 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016; and The Bank Credit Analyst Special Report, "Taking Off The Rose-Colored Glasses: Education and Growth In The 21st Century," February 24, 2011. 5 Please see Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?" dated May 31, 2017; and The Bank Credit Analyst Special Report, "Rage Against The Machines: Is Technology Exacerbating Inequality?" dated June, 2014. 6 Jeremy Nalewaik, "Non-Linear Phillips Curves With Inflation Regime-Switching," Federal Reserve Board, Finance and Economics Discussion Series 2016-078 (August 2016). Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights July jobs report friendly for risk assets. Q2 earnings and July ISM confirm bullish profit environment. The Fed acknowledges softer inflation, but remains determined to tighten policy. 1H economic growth is just enough for the Fed. Housing weakness in Q2 is not a concern. Feature Chart 1Labor Market Conditions Favor Risk Assets The July jobs report suggests that the environment of solid economic growth and still muted wage pressures remains in place, a positive backdrop for equity markets. The report showed that the economy added 209,000 jobs in July, well above the consensus forecast of 178,000. Prior months were also revised higher by 2,000 pushing the 3-month moving average up to 195,000 jobs per month. Monthly job gains thus far in 2017 are nearly identical to the 187,000 jobs per month averaged in 2016. Despite an uptick in the participation rate to 62.9% from 62.8%, the unemployment rate dipped by 0.1% to 4.3%. At two decimal points, the dip in the jobless rate was from 4.36% to 4.35%. Although the monthly increase ticked up to 0.3%, the annual increase in average hourly earnings was flat at 2.5% for the fourth consecutive month (Chart 1). Nonetheless, the reacceleration in the 3-month change in average hourly earnings from 1.9% in January 2017 to 2.8% in July supports the Fed's view on inflation. Bottom Line: The July employment report paints a fairly stable picture of the U.S. economy. Job gains are continuing at a pace consistent with the 2% GDP growth rate of recent years. Meanwhile, wage gains remain modest and consistent with muted inflation. We still expect the Fed to announce the process of running down its balance sheet at the September FOMC meeting. The next rate hike will likely come at the December FOMC meeting, if inflation rebounds in the second half of the year. Steady growth, low inflation and a gentle Fed should continue to underpin U.S. risk assets. Q2 Earnings Update: Margin Expansion In Place EPS and sales growth in Q2 are running well ahead of consensus expectations as forecasted in our July 3 preview. Moreover, the counter trend rally in profit margins is still in place. More than 80% of companies have reported results so far with 73% of companies beating consensus EPS projections, just above the long-term average of 70% (Chart 2). Furthermore, 68% have posted Q2 revenues that exceeded expectations. The surprise factor for Q2 stands at 6% for EPS and 1% for sales. We anticipate the secular mean-reversion of margins to ultimately re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, over the nearer term, results thus far imply that Q2 will see another quarter of margin expansion. Average earnings growth (Q2 2017 versus Q2 2016) is strong at 12% with revenue growth at just 5%. The BCA Earnings model predicts EPS growth to hit roughly 24% later this year on a 4-quarter moving total basis, before moderating in 2018 (Chart 3). Measured on this basis, S&P 500 EPS growth in Q2 would be 20%, compared with 13% in Q1. Chart 2Positive Earnings Surprises Continue Chart 3Strong EPS Growth Ahead Importantly, the strength in earnings and revenues is broadly based (Table 1). Earnings per share are higher in Q2 2017 versus Q2 2016 in all 11 sectors. Results are particularly strong in energy, technology and financials. Energy revenues surged by 15.7% in Q2 versus a year ago. Sales gains in technology (8.2%), materials (7.2%) and utilities (5.7%) are notable. Since the start of 2017, the trajectory of EPS estimates for 2017 and 2018 (Chart 4) has been encouraging. The forecast for 2017 is 12%, up from 11% at the outset of the Q2 reporting season and unchanged from the start of the year. The 2018 estimate (11%) is also little changed from estimates made in January 2017. In a typical year, earnings estimates tend to move lower as the year progresses. Table 1S&P 500:##BR##Q2 2017 Results* Chart 4Stability In '17 & '18 EPS##BR##Estimates Supports U.S. Equities BCA's U.S. Equity Strategy service noted1 that the lagged effect from a softening U.S. dollar will also likely underpin EPS in the back half of the year. We are surprised that mentions of the greenback are absent from Q2 conference calls; the domestic market appears front of mind for both investors and management teams. We are inclined to see fading concerns about the dollar from the next Beige Book (due in early September) as evidence in favor of our colleagues' view. The July reading of the ISM manufacturing Index supports our case for accelerating profits in the second half of 2017. From the perspective of risks to our stance, industrial production (IP) has historically been a good proxy for sales of S&P 500 companies (Chart 5); and a rollover in the 12-month change in IP would challenge our constructive view towards earnings. However, strong readings on the ISM, which tracks IP, suggest that IP should accelerate in the next six months (Chart 5, panel 1). Chart 5Favorable Macro Backdrop For Earnings And Sales At 56.3 in July, the ISM has rebounded from its recent low of 47.9 in 2015, but ticked down from the 57.8 reading in June. For many investors, the risk is that the index has peaked and will soon roll over. While a decline is certainly possible given that the index is already elevated, the leading components of the ISM, including the new orders index and the new orders-to-inventory ratio, indicate that the ISM will remain above 50 in the months ahead (Chart 6). Moreover, the new export orders component of the ISM has also surged. The implication is that foreign demand (rather than domestic consumer or business spending) is leading the U.S. manufacturing sector. Consistent with this perspective, the 3- and 12-month changes in the industrial production indices in advanced economies outside the U.S. have outpaced domestic growth (Chart 7). Chart 6IP Poised To Accelerate##BR##And Support EPS Growth Chart 7U.S. IP Growth Still##BR##Other Developed Markets Bottom Line: EPS growth will continue to accelerate through the end of 2017 and into early 2018, aided by a period of margin expansion and decent top-line growth. The elevated level of ISM sets the stage for EPS growth to gather momentum in the second half of 2017. Firm readings on ISM indicate that our bullish profit story for 2017 is still intact, supporting an overweight stance towards stocks versus bonds. Fed Still On Track The July FOMC statement supports our view that the Fed will announce plans to shrink its balance sheet at the September FOMC meeting and hold off until December for the next rate hike. Policymakers upgraded their views of the labor market and downgraded their assessments of inflation. The reference to job gains moderating was dropped; instead, the Fed noted that employment growth has been robust. On inflation, the Fed stated that it is "running below" 2%, as opposed to "somewhat below" 2% in the June statement. These are only small tweaks and do not suggest any deviation from the Fed's plan to raise rates one more time this year as per its latest "dot plot" published in June. We still see the next rate hike in December if inflation begins to turn higher and shows signs of heading towards the 2% target. While the Fed is on the sidelines regarding rate hikes until the final meeting of 2017, it is creeping closer to begin shrinking its balance sheet. The July FOMC statement announced that the balance sheet normalization process will begin "relatively soon." The Fed had previously stated that the process would commence "this year." We view this shift in language as a signal that the balance sheet announcement will be made at the September meeting. Hesitation on tapering by the ECB, persistently weak readings on U.S. inflation or a tightening of U.S. financial conditions, would also give the Fed reason to reassess its plan. Bottom Line: Slight variations in the FOMC's statement indicate that rates are on hold at least until December. This will give the Fed time to determine whether inflation is moving back to its target and to assess the market impact of shrinking its balance sheet. 1H GDP: Just Enough U.S. GDP grew by 2.6% in Q2, following a revised 1.2% advance in Q1 (Chart 8). Given the potential distortions to the quarterly data from residual seasonality issues, an average of the first two quarters gives a better reading on the underlying trend in the economy. In the first half of this year, growth averaged 1.9%. On a year-over-year basis, the economy grew by 2.1%, and while that is only in line with the Fed's 2.1% forecast for 2017, it is above the central bank's view of 1.8% GDP growth in the "longer run." In addition, the NY Fed's Nowcast for Q3 is 2.0% and the Atlanta Fed's GDP now reading for Q3 is 3.7%. Moreover, in years when Q1 GDP is weak, 2H growth is faster than 1H growth 70% of the time.2 Quarterly GDP has averaged 2.2% since the current expansion started in the second half of 2009. Chart 8GDP Growth Remains Below Average, But Above Fed's Long Run Target Looking beyond the quarterly fluctuations, the U.S. economy has been relatively stable at about 2% growth for nearly 10 years. This advance has been sufficient to lower unemployment, with trend GDP growth slowing due to weak productivity gains and demographics. However, the expansion has not yet led to a material acceleration in wage growth or inflation. Inflation, a lagging indicator, warrants more attention from investors. BCA's Global Investment Strategy,3 team recently argued that both cyclical and structural forces will boost inflation in the next year and far into the next decade. In making this assessment, it was noted that inflation typically does not peak until well after a recession has begun and does not bottom until well after it has ended. The implication is that inflation could stay subdued for the next 12 months as the labor market slowly overheats, before moving higher in the second half of 2018. This also suggests that the central bank already may be behind the curve on raising rates. The implication for investors is to stay below-benchmark overall portfolio duration and favor corporate credit over government bonds over the rest of 2017. Bottom Line: Despite historically weak readings on economic growth, the U.S. economy is advancing quickly enough to reduce slack and ultimately, push up inflation. We agree with the Fed that gradual increases will forestall more aggressive hikes later in the cycle. Strong Housing Sector Dips In Q2 We expect housing to continue to add to GDP growth in 2017 and beyond. Housing - as measured by residential fixed investment - subtracted 0.27% from GDP growth in Q2 2017. However, since early 2011, the sector has contributed to growth in 20 of 25 quarters. Moreover, the Q2 decline appears to be a one off, with all of the weakness coming in "other structures," which measures broker commissions, manufactured housing and home improvement. The more economically sensitive single-family sector added 0.31% to GDP in Q2. There are few signs of the severe imbalances in housing and housing-related debt that sparked the 2007-2009 global financial crisis. Chart 9 shows that housing investment is running behind other long "slow burn" recoveries.4 These recoveries lasted well beyond the point at which the economy hit full employment, and inflationary pressures were also slower to emerge. The housing sector's lag is not surprising given the bloated inventory of vacant, unsold and foreclosed homes that needed to be absorbed in the early part of this recovery. Chart 10 shows the overhang has disappeared. Moreover, recent anecdotal reports suggest that the limited supply of homes in areas where people want to live is hurting sales. Chart 9We Are In A "Slow Burn" Expansion Chart 10Solid Housing Fundamentals In Place Other positive factors for housing include: A rise in FICO scores, which indicates that more renters now qualify for loans and could move from a rental unit to a single family house. We highlighted this factor in a recent Special Report on housing.5 Housing affordability: although off its all-time high, it remains favorable and the cost of owning remains cheap relative to renting. The rate of home ownership is now well below its long-term average (Chart 10, panel 2). If the pre-Lehman bubble in the homeownership rate has been unwound, it removes a headwind for construction activity because renting favors multi-family construction that produces less GDP per unit compared with single-family homes. The supply of foreclosed homes on the market is almost nil. While this may not directly impact home construction and GDP directly, it supports higher home prices. Lending standards have not eased much in this cycle, and accordingly, have not been a net plus for the housing market. Nonetheless, more selective mortgage lending by banks in this cycle stands in sharp contrast to the lax lending in the last cycle, with the net result being better credit quality for bank mortgage portfolios and less systemic risk in the banking sector. This is an area the Fed is paying close attention to in this cycle.6 That said, with lending standards tight, there is room for them to loosen and provide an additional boost to housing in the future. Household formation is still recovering from a period in which young adults stayed home with their parents for longer than normal for economic reasons. Although mild by historical standards, the tightening labor market and cyclical rebound in disposable incomes have allowed millennials to move out of their parents' basements, which has boosted housing demand (Chart 11). Chart 12 estimates the remaining pent up demand for housing, based on the deviation from its 1990-2007 trend in the ratio of the number of households to the total population. A closing of the remaining gap implies an extra 540,000 housing units. The equilibrium number of housing starts needed to cover underlying population growth, plus the units lost to scrappage, is estimated at about 1.4 million annually. If the household formation 'catch up' occurs during the next two years, adding another 250,000 units per year, then total demand could be 1.6 to 1.7 million in each of the next two years. This compares with the July housing starts level of 1.2 million. If starts rise smoothly from today's level to 1.7 million at the end of 2018, then the housing sector will contribute about 0.25 percentage points and 0.52 percentage point to real GDP growth in 2017 and 2018, respectively (Chart 13). Chart 11Household Formation##BR##Following Incomes Higher Chart 12A Catch Up In Housing Construction##BR##Will Occur If This Gap Narrows Chart 13Housing Catch Up##BR##Will Boost GDP Growth The implication for the economy is that this already-aged expansion phase could persist for a couple of more years as long as it is not hit by an adverse shock and inflationary pressures remain muted, which would allow the Fed to proceed slowly. Bottom Line: Housing starts remain well below the equilibrium level implied by underlying household formation and a "catch up" phase could stoke the current "slow burn" expansion in the coming years. Residential investment will continue to add to GDP growth in 2017 and beyond, and keep economic growth on track to hit the Fed's modest target. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see U.S. Equity Strategy Weekly Report "Growth Trumps Liquidity", dated July 31, 2017, available at uses.bcarearch.com. 2 Please see U.S. Investment Strategy Weekly Report "Waiting For The Turn", dated June 26, 2017, available at usis.bcarearch.com. 3 Please see Global Investment Strategy Weekly Report "A Secular Bottom In Inflation", dated July 28, 2017, available at gis.bcarearch.com. 4 Please see The Bank Credit Analyst Monthly Report, dated November 24, 2016, available at bca.bcarearch.com. 5 Please see U.S. Investment Strategy Special Report "U.S. Housing: What Comes Next?", dated March 27, 2017, available at usis.bcarearch.com. 6 Please see U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate", dated July 24, 2017, available at usis.bcaresearch.com.
Highlights EUR/USD is likely to correct over the course of the coming weeks, however, the picture remains too murky to be aggressive. The dollar move since 2015 is still in line with previous sideways consolidations. Economic developments suggest that the USD is more likely to break out than breakdown over the next 12 months. Inflation will hold the keys to the next big trend. The RBA is hampered by a high degree of labor underutilization, and the roll-over in the Chinese Keqiang index bodes poorly for the AUD. Feature The euro's recent strength has been nothing short of stunning. Abandoning our "dollar correction" stance at the end of May was clearly a mistake.1 Now that EUR/USD has punched back above its 2015 high, it is time to reflect whether this year's dollar decline was indeed a correction or whether the euro's bear market is over, in which case EUR/USD could move back above its PPP fair value of 1.33. A Dollar Move Chart I-1The Dollar Is Weak Against Everything The rally in EUR/USD has been more than just a period of euro strength: it has been reflective of a broad-based decline in the USD. As Chart I-1 illustrates, the plunge in the dollar's advance/decline line indicates the greenback has been weak against pretty much everything out there. While the White House's failures and its lack of action on the fiscal stimulus front have played a role in explaining the dollar's weakness, the Federal Reserve's absence of credibility among market participants has been an even greater factor. Weak U.S. inflation, with core CPI at 1.7% and core PCE at 1.4%, implies that the Fed is not achieving its 2% inflation target. Thus, the probability of another rate hike in December has now fallen below 50%, and the OIS curve only anticipates one interest rate hike per year for the next two years. We can add color by looking at specific contracts. At the end of 2016, the December 2019 Eurodollar futures sported a nearly 2.6% implied rate. Today, the same contract trades below 2%. This seems too complacent. For one, U.S. financial conditions have massively eased in response to the collapse in the dollar and the rally in risk assets. This suggests U.S. growth should perk up toward 3% for the remainder of 2017 (Chart I-2). Chart I-2Financial Conditions Will Support Growth Moreover, this is not happening in a vacuum. The official U.S. output gap is more or less closed, and our Composite Capacity Utilization Gauge - which incorporates both the traditional capacity utilization measure along with the unemployment gap - has now moved decisively into "no slack" territory. Under such circumstances, accelerating growth is likely to put heightened pressures on existing resources, raising the risk of a resumption in inflation. Also, in and of itself, this indicator has historically displayed long leads on inflation. Based on this measure, inflation should bottom during the third quarter of 2017 (Chart I-3). With the narrative that inflation is low forever well-entrenched in the market, an inflation surprise in the fall is a growing threat that would prompt a violent repricing of the Fed's path toward something closer to the "dots." This would support a rebound in the DXY. Would this rebound be playable? Our bias is to say yes. The U.S. labor market is still much tighter than the rest of the G10. The U.S. unemployment remains 2.7 percentage points below its 10-year moving average, versus 0.3 percentage points for the rest of the G10 (Chart I-4). Hence, U.S. rates have more upside relative to other advanced economies. This suggests that peak monetary divergences have yet to be seen. Moreover, from a technical perspective, it is far from clear that the dollar bull market is over. While the dollar A/D line has swooned, it has yet to break down - a pattern reminiscent of the second half of the 1990s, when the dollar bull market also experienced a long pause before powering ahead again (Chart I-5). Chart I-3The Trough In Inflation Is Coming Chart I-4The U.S.: In A Tighter Spot Chart I-5Too Early To Tell If The Greenback Is Dead Bottom Line: The euro's strength has been a reflection of generalized weakness in the USD. So far, the USD's weakness in 2017 continues to look and smell like a correction, similar to the action in the late 1990s. However, we cannot be dogmatic: the USD will remain under the thralls of inflationary dynamics in the U.S. The easing in U.S. financial conditions, along with the elevated level of resource utilization, suggests U.S. inflation will pick up this fall, which should prompt a repricing of the Fed's path by investors. The Euro Specifics When it comes to that specifics of the euro, the economic fundamentals are in favor of the dollar right now. First, it is undeniable the euro area inflation has been surprising to the upside relative to that of the U.S. However, this is principally a reflection of the lagging stimulative impact of the 25% collapse in the euro from April 2014 to March 2015. Its 12% appreciation since then points to a reversal of this dynamic (Chart I-6). Second, aggregate relative financial conditions (FCI) tell a similar story. The tightening in euro area FCI relative to the U.S. also points to a slowdown in relative growth in favor of the U.S. Most crucially though, this tightening in relative FCI also portends a change in relative inflation dynamics. As Chart I-7 illustrates, the change in relative FCI has been a reliable leading indicator of comparative inflation dynamics. At this juncture, it argues that inflation in Europe should slow down relative to the U.S. Chart I-6Inflation Surprises Will Move##br## From Europe To The U.S. Chart I-7FCIs Point To A Reversal ##br##Of Inflation Fortunes This makes sense. The U.S. has had trouble generating much inflation despite the U6 unemployment rate standing at 8.5% - a level at which wages and inflation accelerated in previous cycles. Meanwhile, the euro area's labor underutilization remains very high, especially outside Germany. This suggests that euro area inflation could be vulnerable to the tightening in financial conditions that has materialized in the wake of the euro's rally. In other words, the euro's strength is doing the ECB's job while the dollar's weakness is undoing some of the Fed's tightening. Third, the trading action around the release of the German Ifo survey this past Tuesday was very interesting. The Ifo came in at 116, another record reading and substantially above market expectations, yet the euro fell on the news until it was rescued by the Fed. What is fascinating is that, while the German Ifo is near record highs, the Belgian Business Confidence (BCC) survey has begun to sag (Chart I-8). Because Belgium is a logistical center deeply intertwined within European supply chains, the BCC has been an even better leading indicator of European growth trends than the Ifo. The current extreme gap between the Ifo and the BCC confirms that Europe owes a lot of its current health to Germany's boom - and indicates that the rest of the euro area is already suffering blowbacks from the euro's rally. Fourth, euro area equities have eradicated all of their gains for the year relative to U.S. equities. This is happening exactly as the euro area economic surprise index has rolled over against its U.S. counterpart (Chart I-9). This corroborates the economic risks created by the tightening of FCI in Europe versus the U.S. Fifth, the EUR/USD is trading at its greatest premium to our preferred intermediate-term fair value measure since December 2009 (Chart I-10). This measures incorporate real rate differentials at both the short end and long end of the curve, global risk aversion, and commodity prices, suggesting that the EUR/USD has dissociated from most reasonable guides.2 Chart I-8European Growth Is About Germany Chart I-9Stocks Are Sending A Dark Omen For The Euro Chart I-10Euro And Fair Value Bottom Line: European financial conditions have tightened considerably, especially relative to the U.S. This suggests European inflation will once again lag that of the U.S. Moreover, the pain of tighter FCIs is rearing its head: European stocks are once again underperforming the U.S., and the relative economic surprise index has markedly rolled over. We are thus experiencing a euro overshoot. Timing Chart I-1Skewed Positioning In EUR/USD These fundamental considerations do point to a weaker EUR/USD, but they provide little guidance in terms of timing the end of the euro bull run. Most metrics we follow are in fact pointing to trouble ahead. As we highlighted, euro longs are at all-time highs, while euro shorts have been massively purged. This suggests that chasing any further gains in the euro could be a high-risk proposition (Chart I-11). Additionally, the euro's fractal dimension is fully indicative of massive groupthink, and warns that both short-term and long-term investors are both positioned on the long side of the trade (Chart I-12). While the paucity of willing sellers in the market has been a key ingredient bidding up the euro, this also makes the currency vulnerable to a buying exhaustion phase as potential future buyers are already in the market, and will not be there to support it in the coming months. However, because of this very scarcity of sellers, only a few new buyers are necessary to bid up the euro further. Therefore, with the euro having broken above its 2015 high, a rally toward 1.2 could materialize in the blink of an eye. Because of this risk, we have been shorting the euro through the EUR/SEK, EUR/CAD, and EUR/NOK pairs, a strategy that has paid off. This week, for traders with greater liquidity needs, we recommend a tactical speculative short EUR/USD bet, with a tight stop at 1.182 and a target 1.12. Chart I-12Groupthink In Action Bottom Line: The euro is displaying signs of massive groupthink on the long side. Moreover, speculators are excessively long. Our preferred strategy is still to play a euro correction on its crosses, where the risk reward ratio seems more attractive. However, we are opening a tactical short EUR/USD bet this week with a tight stop. The Almighty AUD In a Special Report published four weeks ago, we positioned Australia in the middle of the pack within G10 central banks in terms of hiking sequence.3 Essentially, while Australia does not suffer from as much slack as the euro area and Switzerland, and from as much uncertainty as the U.K., or as severely entrenched inflation expectations as Japan, it still suffers from much more labor underutilization than Canada, Sweden, or New Zealand. As Chart I-13 illustrates, labor underutilization in Australia is still hovering near 20-year highs, underpinning low wage growth and policy rates. This weakness in wages is likely to continue to weigh on core inflation (Chart I-14). Chart I-13The Root Cause Of The RBA's Dovishness Chart I-14Wages Continue To Weigh On Core CPI Furthermore, while being deeply embedded in the Asian business cycle has helped Australia avoid a recession since 1991, this also means that Australian inflation has been greatly influenced by regional dynamics. Thus, based on recent trends, Aussie headline inflation could endure another down leg, especially as the AUD has rallied 16% since January 2016 (Chart I-15). This means that on all fronts, Australian inflationary pressures will remain muted. The recent speech by Governor Philip Lowe focusing on the flatness of the Australian Philips curve highlights that all these concerns are at the forefront of the Reserve Bank of Australia's mind. As a result, we continue to expect Australian interest rates to lag those in the U.S. As Chart I-16 illustrates, when the unemployment gap - as measured by the difference between unemployment and its 10-year moving average - is greater in Australia than in the U.S., the RBA lags the Fed. This also highlights that the AUD is at risk of a sharp correction once the broad USD rally resumes, especially as its recent strength is completely out of line with policy differentials. Chart I-15The Asian Inflation Anchor Chart I-16The Labour Market Points To A Weaker AUD Beyond the USD's own weakness, the rebound in the Chinese economy has been the main reason behind the Australian dollar's rally - despite the continued dovish bias of the RBA. Australian exports expressed in U.S. dollar terms have surged in response to the Chinese mini boom in late 2016/early 2017 (Chart I-17). However, this positive for the Australian economy and Australian profits is dissipating: the Chinese Keqiang index has rolled over, and Beijing is likely to continue to limit speculative excesses in Chinese real estate - a key source of demand for Australian exports. Chart I-17China's Boost Is Dissipating Moreover, the Australian dollar is trading 10% above its PPP, has moved out of line with interest rate differentials, and investors are massively long this currency; yet Australia still sports a negative international investment position of 60% of GDP. This combination makes the Aussie's strength untenable. When EM stocks break, a view espoused by our Emerging Market Strategy sister service, the AUD should prove the greatest victim within the G10 FX space. Bottom Line: Inflationary pressures in the Australian economy remain muted as labor underutilization remains plentiful. As a result, the RBA is likely to keep a dovish tone at least until the end of the year. The rebound in Chinese activity has been the key factor that has supported the AUD this year. However, the recent rollover in China's Keqiang index indicates this pillar of support to growth and profits is vanishing. The AUD will prove the greatest victim of any EM weakness or risk-off event. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled, "Bloody Potomac", dated May 19, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report titled, "In Search Of A Timing Model", dated July 22, 2016, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy and Global Alpha Sector Strategy Special Report titled, "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. Dollar U.S. data was somewhat mixed recently: Continuing and initial jobless claims both came in higher than expected; New home sales also increased at a lesser-than-anticipated pace, with home prices also fairing worse than investors hoped for; However, durable goods increased by very solid 6.5%; Building permits and housing starts, however, are also growing robustly. The DXY has hit a crucial point. It has given up all of its gains since 2015 and even from mid-2016. The greenback has previously fared well at this level, and a buying opportunity should emerge when U.S. inflation picks up as positioning is skewed against the dollar. Report Links: Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Data in core Europe is still firm, although it is becoming increasingly mixed: Headline inflation is staying at the consensus figure of 1.3% and core inflation came in higher than expected at 1.2%; PPI is increasing at a 2.4% pace annually; The IFO survey was robust, with the current assessment, business climate and expectations all beating expectations; However, ZEW survey was weaker than expected; PMIs were also weaker across the board. The recent strength in the euro was also compounded by weakness in the U.S. The euro has failed to appreciate nearly as much against commodity currencies due to higher global growth. Given its much lofty momentum, we are reluctant to bet on more euro upside. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Japanese trade balance worsened as exports and imports grew at 9.7% and 15.5% respectively; However, the all-industry activity index declined by 0.9% in May; The Leading Economic Indicator increased by only 0.4 to 104.6; The Coincident Index, however, declined to 115.8 from 117.1; USD/JPY has been declining recently due to softer U.S. data and lower bond yields. However, we remain yen bears as the absence of inflation remains the key challenge facing the Japanese economy. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Updating Our Intermediate Timing Models - April 28, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Data out of the U.K. was mixed: Real retail sales expanded at a 2.9% annual pace, with the 'ex-Fuel' measure expanding at 3%; PPI managed to increase by 2.9%; However, CPI came in at 2.6%, falling short of the 2.9% expected. GBP/USD has managed to appreciate close to 10% since the beginning of the year, while depreciating around 5% against EUR in the same time period. We still believe the pound has more short-term downside against the euro, and longer-term downside against the greenback. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The economic data flow in Australia saw a somewhat softer patch this week: RBA trimmed-mean CPI increased at a 1.8% pace, in line with consensus but below the previous data point; Headline CPI, however, increased by 1.9%, which was less than expected; Both the export price index and the import price index contracted 5.7% and 0.1% quarterly. Weaker data from the U.S. is helping the AUD sustain its gains, however, external pressures from China are proving to be even more paramount to the Aussie's strength. Domestically, however, the Australian economy remained challenged by persistent underemployment. We therefore believe the RBA is unlikely to follow the Bank of Canada in 2017. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Data out of New Zealand has been mixed: Visitor Arrivals increased at a 17.3% annual pace; The trade balance improved slightly, and both exports and imports also increased; The Global Dairy Trade price index increased by 0.2%; However, CPI came in at 1.7%, disappointing consensus by 0.2%, and falling short of the previous 2.2% figure. While the NZD has strengthened against the USD, it has lagged the euro and the rest of the commodity currency complex. WHile the RBNZ is better placed than the RBA to increase rates, it will continue to lag the BoC and the Fed this year. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The Canadian economy continues to exhibit signs of strength: Wholesale sales increased at a 0.9% monthly pace in May; Manufacturing shipments increased at a 1.1% monthly pace; Foreign portfolio investment in Canadian securities also increased to USD 29.46 bn; The CAD has experienced an unbelievable couple of months, appreciating more than 9% in the process. Weak U.S. data, a hawkish BoC, and somewhat stronger oil, have all added to the CAD's gains. We believe that the BoC will stay hawkish and Saudi Arabia will remain adamant in reducing oil inventories to their 5-year average by the end of the year. While these factors will limit the CAD downside this year, it is now vulnerable to a short-term pullback. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Swiss data has been mixed: Trade balance disappointed at 2,813 mn; UBS Consumption Indicator improved to 1.38 from 1.32; However, the ZEW Survey's Expectations increased to 34.7 from 20.7. EUR/CHF has appreciated more than 2% this past week, while USD/CHF has also been strong. This weakness is welcomed by the SNB, but more softness is needed before durable inflation trend can emerge in the Alpine Confederation. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Norway's recent labor force survey showed that the unemployment rate fell to 4.3%, better than the consensus 4.5%. Along with rebounding oil prices, this has been a key source of support for the NOK. BCA Energy Strategists continue to believe that oil inventories will be reduced to their 5-year average by the end of the year, which should warrant a healthy degree of downside for EUR/NOK. Against the dollar, the picture will become less positive once U.S. inflation picks up again. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 This week's data in Sweden has been somewhat weak: PPI increased at a 4.8% annual pace, less than the previous 7.2%; Consumer confidence decreased to 102.2, below the expected 103.1, and less than the previous 102.6; Unemployment rate increased to 7.4% from 7.2; However, the trade balance increased by 4.2 bn from the previous month. These explain the recent softness in the krona in recent days, however, we doubt that this represents the end of the period of weakness in EUR/SEK. The SEK's appreciation has been the result of an aggregate strengthening in Swedish data, especially on the inflation front, which has prompted a hawkish switch in the Riksbank's rhetoric. Report Links: Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights The Fed is behind the curve in raising rates, as is the Bank of Canada, the Reserve Bank of Australia, the Reserve Bank of New Zealand, and the Swedish Riksbank. In contrast, the Bank of Japan, the ECB, and the Swiss National Bank have little need to tighten monetary policy. Accordingly, investors should favor USD, CAD, SEK, NZD, and to a lesser extent, AUD. EUR, CHF, and JPY will weaken. GBP will trade sideways. Short-term momentum could push EUR/USD to 1.18, but the euro will ultimately reach parity against the dollar next year, as the Fed is forced to accelerate the pace of rate hikes. Stay structurally long DXY. Go long SEK/CHF. We are closing our longstanding overweight positions in Australian and New Zealand government bonds for a handsome profit. Remain overweight global equities for now, but be prepared to turn bearish in the second half of 2018. Feature The Fed: It's Time To Get A Bit More Hawkish In our December 2015 report "The Fed Makes An Unforced Error," we made the case that the Federal Reserve would regret its decision to tighten monetary policy.1 Subsequent events validated this view: U.S. growth sagged in the first half of 2016, leading to a sharp flattening in the yield curve. It would be another 12 months before the Fed raised rates again. As bond prices and the economic data evolved over the course of 2016, our recommendations changed accordingly. On July 5th, we published a note entitled "The End Of The 35-Year Bond Bull Market" arguing that it was time to take profits on long duration positions.2 As luck would have it, this was the exact same date that the 10-year Treasury yield hit a record closing low of 1.37%. Fast forward to the present and investors are once again debating the next steps that central banks are likely to take. However, unlike in 2015, a strong case can be made that the Fed is now behind the curve in raising rates, rather than ahead of it. There are three reasons for this: There is less slack now than in 2015. The unemployment rate stands at 4.4%, down from 5% in December 2015. The broader U-6 unemployment rate has fallen even more, from 9.9% to 8.6%. Other measures of labor market slack are also closing in on their past business-cycle lows (Table 1). Table 1Comparing Current Labor Market Slack With Past Cycles The neutral interest rate has likely risen somewhat over the past 18 months (Chart 1). Household debt has continued to decline as a share of disposable income. The share of national income going to labor has increased. Wage growth among lower-income workers who tend to spend most of their paychecks has accelerated. All this should give consumers the wherewithal to spend more, warranting higher interest rates. Bank balance sheets have also continued to improve, as evidenced by the recent stress test results. In addition, fiscal policy has eased modestly and could ease even more if Congress is able to pass legislation cutting taxes later this year or in early 2018. Financial conditions have eased significantly since the start of the year, which should boost growth in the second half of this year (Chart 2). This is in sharp contrast to 2015, a year when financial conditions tightened sharply. Easier financial conditions are boosting credit growth. The annualized 3-month change in bank credit has accelerated from 1.1% in April to 4.2% at present. (Chart 3). Chart 1Households Have The Wherewithal To Spend More Chart 2Financial Conditions Have Eased Chart 3Credit Growth Has Picked Up The prospect of stronger growth over the next few quarters implies that the unemployment rate is likely to fall below 4% early next year, possibly breaking through the 2000 low of 3.8%. If that were to happen, the unemployment rate would end up being nearly a full percentage point below the Fed's estimate of NAIRU. It is possible, of course, that the true value of NAIRU is lower than official estimates suggest. Older workers change jobs less frequently, and so an aging workforce tends to produce less frictional unemployment. The internet has also improved the ability of companies to fill vacancies with suitable workers. On the flipside, declining geographical mobility and falling demand for low-skilled labor may have raised structural unemployment. On balance, we are skeptical that the current estimate of NAIRU of 4.7% - already one percentage point below its post-1960 average (Chart 4) - is significantly overstated. A tighter U.S. labor market will put upward pressure on wages. While recent wage data has been on the soft side, our wage tracker is still growing twice as fast as in 2010 (Chart 5). Indeed, for all the talk about how wage growth is "inexplicably" slow, real wages have been rising more quickly than productivity for three straight years now - the longest stretch since the late 1990s (Chart 6). Chart 4NAIRU Is Low By Historic Standards Chart 5A Stronger Labor Market Will Lead To Faster Wage Growth Chart 6Real Wages Now Increasing Faster Than Productivity Inflation: A Lagging Indicator When will accelerating wage growth translate into sharply higher price inflation? Probably not this year. Historically, inflation has been the mother-of-all lagging indicators. Core inflation peaked at 2.5% in August 2008, eight months after the start of the recession. In fact, core inflation has topped out in every single business cycle over the past 40 years only after the expansion has ended and the recession begun (Chart 7). Likewise, core inflation typically bottoms several years after the economic recovery is underway. This suggests that inflation could stay subdued for the next 12 months as the labor market slowly overheats, before moving higher in the second half of 2018. Chart 7Inflation Is A Lagging Indicator If the Fed drags its feet in raising interest rates, it will be difficult to achieve a soft landing. Stabilizing the economy is akin to landing a plane: You don't just need to know the speed at which you have to hit the runway, you also have to time your descent in order to touch the ground at precisely the right speed. Even if the Fed knew where the neutral interest rate stood (which it doesn't), tightening monetary policy too late could end up pushing the unemployment rate to such a low level that it has nowhere to go but up. And as we have shown before, once the unemployment rate starts rising, it generally keeps rising, owing to the presence of numerous negative feedback loops.3 The Fed has arguably already fallen into the trap of waiting too long. If so, gradual rate hikes this year will give way to more aggressive hikes late next year, setting the stage for a recession in 2019. The Bank Of Canada Turns Hawkish On the other side of the 45th parallel, the Bank of Canada raised rates last week and signaled that further hikes lie in store. The BoC revised up its GDP growth forecasts for 2017 and 2018. It also indicated that the output gap would close later this year, rather than next year as it had earlier projected. The Bank of Canada's newfound optimism was bolstered by the most recent Business Outlook Survey, which pointed to accelerating growth, dwindling spare industrial capacity, and an increasingly tight labor market (Chart 8). The moose in the living room is the Canadian housing market (Chart 9). Central bankers are generally reluctant to use the blunt tool of tighter monetary policy to target excessive property prices. However, when stricter macroprudential regulations fail to do the job, the standard prescription is to tighten monetary policy slowly but early. The Bank of Canada has done the former but not the latter. Consequently, as my colleague Jonathan LaBerge argued in last week's Special Report, the coming housing bust is likely to be a nasty affair.4 This will be the price the Bank of Canada pays for being behind the curve. Chart 8Canadian Growth Picture Is Upbeat Chart 9Housing Bubbles Abound For now, we remain long the Canadian dollar in our currency recommendations. We are expressing this view by being long CAD/EUR, a trade that has gained 3.5% in the nine weeks since we initiated it. We also recommend being underweight Canadian government bonds within a global fixed-income portfolio. It is important to stress, however, that these are 12-month views. Most Canadian mortgages are floating rate. Higher borrowing costs will likely trigger a housing bust late next year or in 2019, forcing the Bank of Canada to slow or even reverse the pace of rate hikes. The RBA And RBNZ ... Behind The Curve Too Australia and New Zealand have also been grappling with dangerously overvalued housing markets, and just as in Canada, the RBA and RBNZ have been behind the curve in responding to the brewing excesses. That is starting to change. The Reserve Bank of Australia struck a hawkish tone in the July 4 meeting minutes released this week, sending the Aussie dollar to a 26-month high against the greenback. The RBA highlighted the improvement in business conditions and a tightening labor market. It also indicated that the "neutral cash rate" was 3.5%, two points higher than the rate of 1.5%. Australia's terms of trade have been recovering of late and this should support the economy as well as the Aussie dollar (Chart 10). The RBNZ is even further behind the curve than the RBA (Chart 11). Nominal GDP is growing at over 6% and retail sales are expanding at nearly 8%. Population growth has risen sharply in recent years due to increased immigration, leading to greater demand for housing. The government has increased infrastructure spending and cut taxes. The unemployment rate has fallen back to an 8-year low of 4.9%, while the terms of trade is approaching record-high levels. Chart 10RBA Behind The Curve... Chart 11... And RBNZ Too? With all this in mind, we are closing our longstanding overweight positions in Australian and New Zealand government bonds for gains of 59.5% and 74.2%, respectively.5 Riksbank: End Of NIRP? The Swedish repo rate stands at -0.5%, despite the fact that the output gap has moved into positive territory (Chart 12). Inflation is still slightly below target, but is moving higher. The Riksbank is taking notice of the changing economic environment. The central bank backed away from its easing bias at its most recent policy meeting. The facts on the ground support this decision. Sweden's GDP is now 0.7% above potential and the economy continues to strengthen. The Riksbank's resource utilization indicator points to a sharp acceleration in Swedish inflation in the coming quarters. Nonfinancial private credit has reached 237% of GDP, up from 106% in 2000. If the Riksbank falls too far behind the curve, it will be forced to jack up rates very aggressively down the road, reviving the specter of the debt crisis of the early 1990s. The ECB, SNB, And BoJ: Take It Easy Whereas a strong case can be made that the central banks discussed above are behind the curve in normalizing monetary policy, the same cannot be said for the ECB, Swiss National Bank, or Bank of Japan. Labor market slack across the euro area as a whole is still 3.2 percentage points higher than in 2008 and 6.7 points higher outside of Germany (Chart 13). Moreover, as we discussed two weeks ago, the neutral rate in the euro area remains very depressed.6 Thus, even if the euro area economy were close to full employment, the ECB would still not have much scope to raise rates. Chart 12NIRP In Sweden: R.I.P. Chart 13Euro Area: Labor Market Slack Still High Outside Of Germany In this light, investors have gotten too optimistic about the ability of the ECB to tighten monetary policy. While the ECB will further taper asset purchases as early as this autumn, sustained rate hikes are still a few years away. Mario Draghi explicitly said during his press conference yesterday that "the last thing that the governing council may want is actually an unwanted tightening of the financing conditions." This is in sharp contrast to the Fed, which is trying to tighten financial conditions by raising rates. Swiss monetary conditions are far from accommodative, despite a policy rate that remains buried in negative territory (Chart 14). Core inflation is close to zero and wage growth is anemic. An overvalued currency has offset the benefits from lower interest rates. Given the SNB's policy of intervening in the currency markets to keep EUR/CHF within a reasonably tight range, the recent appreciation of the euro will further add to the deflationary pressures weighing on the Swiss economy. Investors should position for a weaker franc (and euro) in the months ahead. Go long SEK/CHF (Chart 15). Chart 14The Swiss Economy Still Needs Low Rates Chart 15Long SEK/CHF Similar to the ECB and the SNB, the Bank of Japan is in no position to tighten monetary policy. Core inflation has fallen back to zero and medium-to-long-term inflation expectations have dipped so far this year (Chart 16). The annual shunto wage negotiations this summer produced little in the way of salary hikes. And even if inflation were to rise, the government would likely want to tighten fiscal policy before contemplating removing the monetary punch bowl. The Bank Of England: A Tough Call If one didn't know what transpired last June, the case for tighter monetary policy in the U.K. would be fairly straightforward. The unemployment rate is at a 9-year low and inflation is well above target. The trade-weighted pound has weakened by 21% since November 2015, which in most cases, would translate into stronger growth in the years ahead. Reflecting these points, our Central Bank Monitors show that the U.K. is more in need of tighter money than any other major developed economy (Chart 17). Chart 16BoJ: In No Position To Tighten Chart 17The Message From Our Central Bank Monitors Brexit negotiations are likely to cast a pall over the economy, however. The EU will be forced to take a tough line with the U.K., for fear that the Brexit vote could prompt other countries to follow's Britain's lead. BCA's geopolitical strategists ultimately expect a "hard Brexit" to be averted, but things may need to be brought to the precipice before that happens. The pound is cheap and so we do not expect it to weaken significantly from current levels. Nevertheless, the upside for both sterling and gilt yields will remain constrained until political uncertainty abates. Investment Conclusions As a rule of thumb, investors should favor currencies in economies whose central banks are behind the curve. Such central banks are likely to find themselves in a position where they have to scramble to tighten monetary policy. We noted on July 7th that short-term momentum favors the euro and that we would not be surprised if EUR/USD reaches 1.18 over the coming weeks. Looking further ahead, the appreciation of the euro in the first half of this year will weigh on growth in the remainder of 2017 and into early 2018. This will force the ECB to cool its heels. In contrast, U.S. growth should accelerate. Against the backdrop of diminished spare capacity, this will prompt the Fed to turn more hawkish. We expect EUR/USD to fall to 1.05 by year-end, and reach parity next year as the Fed ramps up the pace of rate hikes. The market is betting that the Fed will deliver fewer rate hikes than implied by the 'dots'. Our hunch is that the Fed will deliver more hikes than what its forecast suggests, especially starting early next year when inflation is liable to accelerate. Bullish sentiment towards the dollar has collapsed. Investors should turn contrarian and position for a stronger greenback over the next 12 months. In addition to the dollar, we like the Swedish krona, Canadian dollar, and New Zealand dollar. The Aussie dollar should also perform reasonably well, provided that the Chinese economy continues to hold up, as we expect it will. The Japanese yen remains our least favorite currency. Despite the dollar selloff, USD/JPY has managed to gain 3% since mid-April. As the Fed and a number of other central banks raise rates, the spread in yields between foreign government bonds and JGBs will widen. This will push down the yen, helping Japanese stocks in the process. As far as overall risk sentiment is concerned, another rule of thumb says that stocks rarely fall on a sustained basis outside of recessions (Chart 18). We do not expect a recession in the U.S. or elsewhere until 2019. This implies that investors should maintain an overweight position in global equities for now, favoring cyclical sectors over defensive ones. Chart 18Stocks Rarely Fall On A Sustained Basis Outside Of Recessions Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Fed Makes An Unforced Error," dated December 18, 2015, available at gis.bcaresearch.com. 2 Please see Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com 3 Please see Global Investment Strategy Weekly Report, "When Doves Cry," dated June 9, 2017, available at gis.bcaresearch.com. 4 Please see Global Investment Strategy Special Report, "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at gis.bcaresearch.com. 5 Calculated as the total excess return on the 10-year bond index relative to global government benchmark since inception in 2009, foreign-currency hedged since 2014. The 10-year yield for New Zealand government bonds has dropped from 4.28% at the time of inception to 2.94% today. The 10-year yield for Australian government bonds has fallen from 4.10% to 2.74% over this period. 6 Please see Global Investment Strategy Weekly Report, "Draghi's Dilemma," dated July 7, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades