Policy
Highlights BCA's Geopolitical Power Index (GPI) confirms that we live in a multipolar world; Most of President Trump's policies are designed to strike out against this structural reality; Trade war with China is real and presents the premier geopolitical risk in 2018; President Trump's aggression towards G7 allies boils down to greater NAFTA risk; We remain bullish USD, bearish EM, maintain our short U.S. China-exposed equities and closing all our "bullish" NAFTA trades; Remain short GBP/USD, Theresa May's days appear numbered. Feature "We're going to win so much, you're going to be so sick and tired of winning." Candidate Donald Trump, May 26, 2016 In 2013, BCA's Geopolitical Strategy introduced the concept of multipolarity into our financial lexicon.1 Multipolarity is a term in political science that denotes when the number of states powerful enough to pursue an independent and globally relevant foreign policy is greater than one (unipolarity) or two (bipolarity). At the time, the evidence that U.S. global hegemony was in retreat was plentiful, but the idea of a U.S. decline was still far from consensus. By late 2016, however, President Donald Trump was overtly campaigning on it. His campaign slogan, "Make America Great Again," promised to reverse the process by striking out at the perceived causes of the decline: globalization, unchecked illegal immigration, and the ineffective foreign policy of the D.C. establishment. How can we quantitatively prove that the world is multipolar? We recently enhanced the classic National Capability Index (NCI) with our own measure, the Geopolitical Power Index (GPI). The original index, created for the Correlates of War project in 1963, had grown outdated. Its reliance on "military personnel" and "iron and steel production" harkened back to the late nineteenth century and overstated the power of China (Chart 1). Chart 1The National Capability Index Overstates China's Power Our own index avoids these pitfalls, while retaining the parsimony of the NCI, by focusing on six key factors: Population: We adapted the original population measure by penalizing countries with large dependency ratios. Yes, having a vast population matters, but having too many dependents (the elderly and youth) can strain resources otherwise available for global power projection. Global Economic Relevance: The original index failed to capture a country's relevance for the global economy. Designed at the height of the Cold War, the NCI did not foresee today's globalized future. As such, we modified the original index by introducing a measure that captures a country's contribution to global final demand. The more an economy imports, the greater its bargaining power in terms of trade and vis-à-vis its geopolitical rivals. Arms Exports: Having a large army is no longer as relevant now that wars have become a high-tech affair. To capture that reality, we replaced the NCI's focus on the number of soldiers with arms exports as a share of the global defense industry. We retained the original three variables that measure primary energy consumption, GDP, and overall military expenditure. Chart 2 shows the updated data. As expected, the U.S. is in decline, having lost nearly a third of its quantitatively measured geopolitical power since 1998. Over the same period, China has gone from having just 30% of U.S. geopolitical power to over 80%. Other countries, like Russia, India, Turkey, Iran, and Pakistan, have also seen an increase in geopolitical power over the same period, confirming their roles as regional powers (Chart 3). Chart 2BCA's Geopolitical Power Index Illustrates A Multipolar World Chart 3China Was Not The Only EM To Rise President Trump was elected with the mandate of changing the trajectory of American power and getting the country back on a "winning" path. Investors can perceive nearly all the moves by the administration - from protectionist actions against China and traditional allies, to applying a "Maximum Pressure" doctrine against North Korea and Iran - as a fight against the structural decline of U.S. power. Isn't President Trump "tilting at windmills"? Fighting a vain battle against imaginary adversaries? Yes. The decline of the U.S. is a product of classic imperial overstretch combined with the natural lifecycle of any global hegemon. U.S. policymakers have made decisions that have hastened the decline, but the overarching American geopolitical trajectory would have been negative regardless: Global peace brought prosperity which strengthened Emerging Markets (EM), particularly China, relative to the U.S. That said, Trump is not as crazy as the media often imply. Chaos is not necessarily bad for a domestically driven economy secured by two oceans. The U.S. tends to outperform the rest of the world - economically, financially, and geopolitically - amid turbulence. Our own updated GPI shows that both World Wars were massively favorable for U.S. hegemony (Chart 4), although this time around the chaos is mostly self-inflicted. Chart 4America Profits From Chaos Similarly, Trump's economic populism at home is buoying sentiment and assuaging the negative consequences - real or imagined - of his protectionism. Meanwhile, the threat of tariffs is souring the mood abroad. This policy mix is causing U.S. assets to outperform (Chart 5). Most importantly, the U.S. dollar is now up 2.7% since the beginning of the year, putting pressure on EM assets. When combined with continued counter-cyclical structural reforms in China, we maintain that the overall macro and geopolitical context remains bearish for global risk assets. This is not the first time that an American president has deployed both an aggressive trade policy and an aggressive foreign policy. The difference, this time around, is that the world is multipolar. A defining feature of multipolarity is that it is less predictable and more likely to produce inter-state conflict (Chart 6). As more countries matter - geopolitically, economically, financially - the number of "veto players" rises, making stable equilibria more difficult to produce. As such, bullying as a negotiating tactic worked when used by Presidents Nixon, Reagan, Bush Jr., and Clinton, but may not work today. Investors should therefore prepare for a long period of uncertainty this summer as the world responds to a U.S. administration focused on "winning." Chart 5U.S. Assets Outperform Chart 6Multipolarity Produces Uncertainty Bottom Line: There is a clear logic behind President Trump's foreign and trade policy. He is trying to reverse a decline in U.S. hegemony. The problem is that his policy decisions are unlikely to address the structural causes of America's decline. What is much more likely is that his policy will cause the rest of the world to react in unpredictable ways. The U.S. may benefit, but that is not a forgone conclusion. Investors should position themselves for a volatile summer. Below we review three key issues, two negative and one positive. The U.S. Vs. China: The Trade War Is Real The Trump administration has announced that it will go ahead with tariffs on $50 billion worth of Chinese imports in retaliation for forced technology transfer and intellectual property theft under Section 301 of the 1974 Trade Act. The tariffs will come in two tranches beginning on July 6. China will respond proportionately, based on both its statements and its response to the steel and aluminum tariffs (Chart 7). If the two sides stop here, then perhaps the trade war can be delayed. But Trump is already saying he will impose tariffs on a further $200 billion worth of goods. At that point, if Beijing re-retaliates, China's proportionate response will cover more goods than the entire range of U.S. imports (Chart 8). Retaliation will have to occur elsewhere. Chart 7Trump's Steel/Aluminum Tariffs Chart 8Trump's Tariffs On China We would expect the CNY/USD to weaken as negotiations fail. We would also expect tensions to continue spilling over into the South China Sea and other areas of strategic disagreement.2 The South China Sea or Taiwan could produce market-moving "black swan" geopolitical events this year or next.3 Chart 9Downside Risks Continue It is critical to distinguish between the U.S. trade conflict with China and the one with the G7. In the latter case, the U.S. political establishment will push against the Trump administration, encouraging him to compromise. With China, however, Congress is becoming the aggressor and we certainly do not expect the Defense Department or the intelligence community to play the peacemaker with Beijing. In particular, members of Congress are trying to cancel Trump's ZTE deal while expanding the powers of the Committee on Foreign Investment in the United States (CFIUS) to restrict Chinese investments.4 These congressional factors underscore our theme that U.S.-China tensions are structural and secular.5 Would China stimulate its economy to negate the effects of tariffs? We see nothing yet on the policy side to warrant a change in our fundamental view, which holds that any stimulus will be limited due to the agenda of containing systemic financial risk. Credit growth remains weak and fiscal spending has not yet perked up (Chart 9), portending weak Chinese imports and negative outcomes for EM. The risk to Chinese growth remains to the downside this year (and likely next year) as the government continues with the reforms. Critically, stimulus is not the only possible Chinese response to trade war. A trade war with the United States will provide Xi with a "foreign devil" on whom he can blame the pain of structural reforms. As such, it is entirely possible that Beijing doubles-down on reforms in light of an aggressive U.S. Bottom Line: The U.S.-China trade war is beginning and will cause additional market volatility and, potentially, a "black swan" event, especially ahead of the U.S. midterm elections. We do not expect 2015-style economic stimulus from Beijing. Stay long U.S. small caps relative to large caps; short U.S. China-exposed equities; and remain short EM equities relative to DM. The U.S. Vs. The G6: This Is About NAFTA There was little rhyme or reason to President Trump's smackdown of traditional U.S. allies at the G7 summit in Quebec. As our colleague Peter Berezin recently pointed out, the U.S. is throwing stones while living in a glass house.6 While the overall level of tariff barriers within developed countries is low, the U.S. actually stands at the top end of the spectrum (Chart 10). The decision to launch an investigation into whether automobile imports "threaten to impair the national security" of the U.S. - under Section 232 of the Trade Expansion Act of 1962 - falls into the same rubric of empty threats. The U.S. has had a 25% tariff on imported light trucks since 1964, a decision that likely caused its car companies to become addicted to domestic pickup truck demand to the detriment of global competitiveness. Meanwhile, only 15% of U.S. autos shipped to the EU were subject to the infamous European 10% surcharge on auto imports. This is because U.S. autos containing European parts are exempt from the tariff. Many foreign auto manufacturers have already adjusted to the U.S. market, setting up manufacturing inside the country (Chart 11). Tariffs would hurt luxury brands like BMW, Daimler, Volvo, and Jaguar.7 As such, we doubt the investment-relevance of Trump's threat against autos. Either way, the investigation is unlikely to be completed until the tail-end of Q1 2019. Chart 10Tariffs: Who Is Robbing The U.S.? Chart 11Car Imports? What Imports? Instead, investors should take Trump's aggressive comments from the G7 in the context of the ongoing NAFTA negotiations and the closing window for a deal. President Trump wants to get a NAFTA deal ahead of the U.S. midterms in November and prior to the new Mexican Congress being inaugurated on September 1.8 This means that a deal has to be concluded by late July, or early August, giving the "old" Mexican Congress enough time to ratify it before the new president - likely Andrés Manuel López Obrador - comes to power on December 1. This would conceivably give the U.S. Congress enough time to ratify a deal by December, assuming Republicans can remove some procedural hurdles before then. The rising probability of no resolution before the U.S. midterm election will increase the risk that Trump will trigger Article 2205 and announce the U.S.'s withdrawal. Trump has always had the option of triggering the six-month withdrawal period as a negotiating tactic to increase the pressure on Canada and Mexico. Withdrawing might fire up the base, while major concessions from Canada or Mexico might be presented as "victories" to voters. Anything short of these binary outcomes is useless to Trump on November 6. Therefore, if Canada and Mexico do not relent in the next month or two, the odds of Trump triggering Article 2205 will shoot up. The key is that Trump faces limited legal or economic constraints in withdrawing: Legal Constraints: Not only can Trump unilaterally withdraw from the agreement, triggering the six-month exit period, but Congress is unlikely to stop him. Announcing withdrawal automatically nullifies much of the 1993 NAFTA Implementation Act.9 Some provisions of NAFTA under this act may continue to be implemented, but the bulk would cease to have effect, and the White House could refuse to enforce the rest. Economic Constraints: The U.S. economy has far less exposure to Canada and Mexico than vice- versa (Chart 12). Certain states and industries would be heavily affected - ironically, the U.S. auto industry would be most severely impacted (Chart 13) - and they would lobby aggressively to save the agreement. But with the American economy hyper-charged with stimulus, the drag from leaving NAFTA is not prohibitive to Trump. Voters will feel any pocketbook consequences about three months late i.e., after the election. Chart 12U.S. Economy:##br## Largely Unaffected By NAFTA Chart 13NAFTA Has Made U.S. Auto ##br##Manufacturing More Competitive The potential saving grace for Canada is the Canada-U.S. Free Trade Agreement (CUSFTA), which took effect in 1989 and was incorporated into NAFTA. The U.S. and Canada agreed through an exchange of letters to suspend CUSFTA's operation when NAFTA took effect, but the suspension only lasts as long as NAFTA is in effect. However, reinstating CUSFTA is not straightforward. The NAFTA Implementation Act suspends some aspects of the CUSFTA and amends others (for instance, on customs fees), so there will not be an easy transition from NAFTA to a fully operational CUSFTA.10 Trump may well walk away from both CUSFTA and NAFTA in the same proclamation, or he could walk away from NAFTA while leaving CUSFTA in limbo. The latter would mitigate the negative impact on Canada, but it would still see rising tariffs, customs fees, and rising policy uncertainty. Bottom Line: We originally assigned a high probability to the abrogation of NAFTA.11 Subsequently, we lowered the probability due to positive comments from the White House and Trump's negotiating team. This was a mistake. As we initially posited, there are few constraints to abrogating NAFTA, particularly if President Trump intends to renegotiate the deal later, or conclude two separate bilateral deals that effectively maintain the same trade relationship. We are closing our trade favoring an equally-weighted basket of CAD/EUR and MXN/EUR. We are also closing our trade favoring Mexican local government bonds relative to EM. North Korea: A Geopolitical Opportunity, Not A Risk Not every move by the Trump administration is increasing geopolitical volatility. Trump's Maximum Pressure doctrine may have elevated risks on the Korean Peninsula in 2017, but it ultimately worked. The media is missing the big picture on the Singapore Summit. Diplomacy is on track and geopolitical risk - namely the risk of war on the peninsula - is fading. It is false to claim that President Trump got nothing in return for the summit. Since November 28, North Korea has moderated its belligerent threats, ceased conducting missile tests, released three U.S. political prisoners, and largely blocked off access to the Punggye-ri nuclear testing site. Now, North Korean leader Kim Jong-un has held the summit with Trump, reaffirmed his longstanding promise of "complete denuclearization," reaffirmed the peace-seeking April 2018 Panmunjom Declaration with South Korea, and pledged to dismantle a ballistic missile testing site and continue negotiations. In response, President Trump has given security guarantees to the North Korean regime and has pledged to discontinue U.S.-South Korea military drills for the duration of the negotiations. Trump has not yet eased economic sanctions and his administration has ruled out troop withdrawals from South Korea for now. There is much diplomatic work to be done. But the summit was undoubtedly a positive sign, dialogue is continuing at lower levels, and Kim is expected to visit the White House in the near future. Table 1 shows that the Singapore Summit is substantial when compared with major U.S.-North Korea agreements and inter-Korean summits - and it is unprecedented in that it was agreed between American and North Korean leaders. Table 1How The Singapore Summit Stacks Up To Previous Pacts With North Korea Because Trump demonstrated a credible military threat, and China enforced sanctions, the foundation is firmer than that of President Barack Obama's April 2012 agreement to provide food aid in payment for a cessation of nuclear and missile activity. It is much more similar to that of President Clinton and the "Agreed Framework" of 1994, which lasted until 2002, despite many serious failures on both the U.S. and North Korean sides. We should also bear in mind that it was originally U.S. Congress, not North Korea, which undermined the 1994 agreement. Aside from removing war risk, Korean diplomacy is of limited global significance. It marginally improves the outlook for South Korean industrials, energy, telecoms, and consumer staples relative to their EM peers (Chart 14). In the long run it should also be positive for the KRW. Chart 14Winners And Losers Of Inter-Korean Engagement We maintain that a U.S.-China trade war will not be prevented because of a Korean deal. But we do not expect China to spoil the negotiations. Geopolitically, China benefits from reducing the basis for U.S. forces to be stationed in South Korea. Bottom Line: Go long a "peace dividend" basket of South Korean equity sectors (industrials, energy, consumer staples, and telecoms) and short South Korean "loser" sectors (financials, IT, consumer discretionary, and health care), both relative to their EM peers. Stick to our Korean 2-year/10-year sovereign bond curve steepener trade. Brexit Update: A New Election Is Now In Play Prime Minister Theresa May is fending off a revolt within her Conservative Party this week that could set the course for a new election this year. May reneged on a "compromise" with soft-Brexit/Bremain Tory backbenchers on an amendment that would have given the House of Commons a meaningful vote on the final U.K.-EU Brexit deal. According to the press, the compromise was killed by her own Brexit Secretary, David Davis. There is a fundamental problem with Brexit. The current path towards a hard Brexit, pushed on May by hard-Brexit members of her cabinet and articulated in her January 2017 speech, is incompatible with her party's preferences. According to their pre-referendum preferences, a majority of Tory MPs identified with the Bremain campaign ahead of the referendum (Chart 15). That would suggest that a vast majority prefer a soft Brexit today, if not staying in the EU. We would go further. The current trajectory is incompatible with the democratic preferences of the U.K. public. First, polls are showing rising opposition to Brexit (Chart 16). Second, most voters who chose to vote for Brexit in 2016 did so under the assumption that the Conservative Party would pursue a soft Brexit, including continued membership in the Common Market. Boris Johnson, the most prominent supporter of Brexit ahead of the vote and now the foreign minister, famously stated right after the referendum that "there will continue to be free trade and access to the single market."12 Chart 15Westminster MPs Support Bremain! Chart 16Bremain On The Rise So what happens now? We expect the government to be defeated on the crucial amendment giving Westminster the right to vote on the final EU-U.K. deal. If that happens, PM May could be replaced by a hard-Brexit prime minister, most likely Davis. Given the lack of support for an actual hard-Brexit outcome - both in Westminster and among the public - we believe that a new election remains likely by March 2019. Bottom Line: Political risk remains elevated in the U.K. A new election could resolve this risk, but the potential for a Jeremy Corbyn-led Labour Party to win the election could add additional political risk to U.K. assets. We remain short GBP/USD. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013; and "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Pyongyang's Pivot To America," dated June 8, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Taiwan Is A Potential Black Swan," dated March 30, 2018, available at gps.bcaresearch.com. 4 The Senate has passed a version of the National Defense Authorization Act with a rider that would boost CFIUS and maintain stringent restrictions on ZTE's business with the U.S. These restrictions have crippled the company but would have been removed under the Trump administration's snap deal in June. The White House claims it will remove the rider when the House and Senate hold a conference to resolve differences between their versions of the defense bill, but it is not clear that the White House will succeed. Congress could test Trump's veto. If Trump does not veto he will break a personal promise to Xi Jinping and escalate the trade war further than perhaps even he intended. 5 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 6 Please see BCA Global Investment Strategy Weekly Report, "Piggy Bank No More? Trump And The Dollar's Reserve Currency Status," dated June 15, 2018, available at gis.bcaresearch.com. 7 We do not include Porsche in this list as we would gladly pay the 25% tariff on top of its current price. 8 Mexican elections for both president and Congress will take place on July 1, but the new Congress will sit on September 1 while the new president will take office on December 1. 9 Please see Lori Wallach, "Presidential Authority to Terminate NAFTA Without Congressional Approval," Public Citizen's Global Trade Watch, November 13, 2017, available at www.citizen.org. 10 The National Customs Brokers and Forwarders Association of America, "Issues Surrounding US Withdrawal From NAFTA," available from GHY International at www.ghy.com. See also Dan Ciuriak, "What if the United States Walks Away From NAFTA?" C. D. Howe Institute Intelligence Memos, dated November 27, 2017, available at www.cdhowe.org. 11 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 12 Please see "U.K. will retain access to the EU single market: Brexit leader Johnson," Reuters, dated June 26, 2016, available at uk.reuters.com. Geopolitical Calendar
Highlights Fed: The Fed delivered a confidently hawkish rate hike last week, but its projections for growth and, more importantly, inflation appear too cautious. With the market still not fully priced to the Fed's interest rate "dots", and with inflation expectations likely to continue rising to levels consistent with the Fed's inflation target, Treasury yields will remain under upward pressure. Maintain a defensive, below-benchmark U.S. duration stance. ECB: The ECB finally signaled the end of its current Asset Purchase Program, while sticking with its message that interest rate hikes are not likely until at least September 2019. The ECB's optimistic growth and inflation forecasts for the next couple of years may not be realized, but that will not prevent euro area bond yields from drifting higher as the ECB stops buying. Stay below-benchmark on euro area duration exposure. Feature Chart Of the WeekFed Vs. ECB: Still Diverging Central bank watching used to be a fairly black and white endeavor for investors and analysts. Policies were either "hawkish", "dovish" or perhaps "neutral". New buzzwords have entered the lexicon in the post-crisis era, however, as central banks have often struggled to adjust policy settings without upsetting financial markets. Now, the combination of action on interest rates and central bank communications can create additional types of policy moves, like a "hawkish hold" or a "dovish hike". With the Federal Reserve and the European Central Bank (ECB) announcing policy moves last week, we dedicate this Weekly Report to our assessment of the actions taken by each bank, while trying to throw a few more monetary policy buzzwords into the mix to describe their decisions. Our conclusion is that while there is a need to see tighter monetary conditions on both sides of the Atlantic, the Fed is still delivering a combination of rate changes and language that is creating more upside for bond yields in the U.S. than in Europe (Chart of the Week). The Fed: Hawkishly Hawkish The Fed sounded a confident tone at last week's policy meeting, delivering another 25bp rate hike while also upgrading its growth and inflation forecasts for 2018. In the press conference following the FOMC meeting, Fed Chairman Jerome Powell expressed a very upbeat view on the state of the economy and even sounded a bit surprised as to how resilient growth has been. Yet it appears that the Fed is still erring a bit on the cautious side when it comes to its economic growth projections and, by association, its inflation forecast. The Fed now expects U.S. real GDP growth of 2.8% in 2018, up a mere 0.1 percentage point from its projection from last March. Yet the economy has accelerated in the recent months and the Atlanta Fed's GDPNow model is calling for growth to hit a whopping 4.8% in the second quarter. While that model tends to over-predict actual growth outcomes, it does underscore how strong the current run of U.S. data has been and how the risks on the economy are tilted to the upside. That strength is also manifesting itself in robust business confidence, as evidenced by the latest read on small business optimism from the National Federation of Independent Business (NFIB) that was released last week.1 The overall NFIB Optimism Index reached the second highest level in its 45-year history in May, while a record number of respondents felt that now was a "good time to expand" (Chart 2). Reports of positive earnings trends also hit a record high, while reports of positive sales growth were the highest since 1995. At the same time, concerns about labor quality hit the second highest level in the history of the NFIB survey, while reports of compensation increases hit a record high. This booming economy is also impacting price-setting behavior, with reports of actual and planned price increases hitting the highest levels in a decade. Against this backdrop of very robust growth, the Fed did lower its forecast for the unemployment rate for 2018 (now 3.6%), 2019 (3.5%) and 2020 (3.5%). Yet its 2018 projections for headline and core PCE inflation were only nudged up by 0.2 percentage points (to 2.1%) and 0.1 percentage points (to 2.0%), respectively. Inflation is expected to remain around those levels in 2019 and 2020. Does the Fed still believe that NAIRU in the U.S. is 4.5%? If so, there is a serious disconnect between its unemployment and inflation forecasts - one that is more likely to be resolved via higher inflation, especially if those readings from the NFIB data are to be taken at face value. The FOMC did send a mildly hawkish message last week through its interest rate projections (the "dots"). They added one more expected rate increase to 2018, which would bring the total amount of hikes this year to 100bps. However, no cumulative additional increases were added beyond 2018, which means that the Fed merely pulled forward a rate hike that would have occurred in 2020. We still anticipate that a 25bps-per-quarter pace of hikes is the most likely outcome for the Fed over the next year, especially now that the inflation-adjusted funds rate is hovering around the Fed's own estimate of the neutral "r-star" level. That path of rates is still not fully discounted in U.S. money markets (Chart 3), however, which suggests that Treasury yields will remain under upward pressure from a higher front-end of the yield curve. Chart 2U.S. Economy Is On Fire Chart 3Market Still Not Fully Converged To Fed Dots The Fed will likely err on the side of caution regarding the pace of rate increases, however, given the fact that a) wage growth is still relatively subdued given how tight the labor market is; b) TIPS breakevens are not yet at levels consistent the with the market believing that the Fed has achieved its inflation target; c) the rising U.S. dollar is tightening monetary conditions at the margin; and d) the growing threat of a U.S.-vs-The-World trade war may pose a more serious risk to global growth. Yet all those factors are likely not enough to derail the booming U.S. growth locomotive. Only a move to an outright restrictive Fed monetary policy will make that happen. However, at the moment, the Fed seems more willing to tolerate a potential overshoot of its inflation target than to try and slow an overheating economy. This means that Treasury yields will likely rise through higher inflation expectations, as well as through a convergence of market pricing to the Fed's interest rate projections. Stay below-benchmark on U.S. Treasury market duration exposure. Bottom Line: The Fed delivered a confidently hawkish rate hike last week, but its projections for growth and, more importantly, inflation appear too cautious. With the market still not fully priced to the Fed's interest rate "dots", and with inflation expectations likely to continue rising to levels consistent with the Fed's inflation target, Treasury yields will remain under upward pressure. Maintain a defensive, below-benchmark U.S. duration stance. The ECB: Dovishly Hawkish The ECB announced last week what had widely been expected by the market - that there would be no net new bond buying in its Asset Purchase Program (APP) after December of this year. Yet at the same time, the central bank was able to convey a dovish signal on the timing and pace of rate hikes after the bond purchases stop. Financial markets latched onto the latter message, triggering a rally in euro area bond markets and a daily decline of two big figures on EUR/USD. The central bank sounded a very confident tone - perhaps, surprisingly so - on both the growth and inflation outlook. ECB President Mario Draghi described the deceleration of the euro area economy in the first quarter as a "soft patch" and that the 0.4% (non-annualized) growth in real GDP was "still high growth". Draghi went even further in his description of the strong economy seen last year, and the slowing seen so far in 2018, as being largely driven by external demand: "Basically, it's a pullback from the very high levels of growth in 2017, mostly justified by an extraordinary pickup in exports, which is unlikely to repeat itself now, compounded by an increase - an undeniable increase in uncertainty - and for a variety of reasons really, mostly geopolitical reasons, and some temporary and supply-side factors at both the domestic and the global level as well as weaker impetus from external trade." That assessment for the cause of the Q1/2018 growth slowdown is accurate, as the peak in euro area data such as the manufacturing PMI, industrial confidence and the OECD's leading economic indicator all occurred alongside a slowing of export growth (Chart 4). Yet the ECB may be too optimistic in thinking that the softening in export demand will prove to be "temporary". In the ECB's updated macroeconomic projections, the forecast for real GDP growth in 2018 was revised down from 2.4% to 2.1%, largely due to a reduction in expected export growth from 5.3% to 4.2%. Yet the GDP forecasts for 2019 (+1.9%) and 2020 (+1.7%) were unchanged, and the export growth projection for 2019 was upgraded from 4.1% to 4.4%. That is a view that may prove to be too optimistic. Global trade activity is slowing fast at the moment, primarily on the back of diminished Chinese demand (bottom panel), and leading economic indicators (outside of the U.S.) have rolled over. With U.S. President Donald Trump now turning his protectionist trade rhetoric into actual tariff actions - aimed not just at China but also Europe - the risks are all to the downside for the ECB's growth projections. We find it a bit surprising that the market reacted so strongly to the ECB's indication that interest rates would be kept at current levels "at least through the summer of 2019".2 That language is consistent with the message that the ECB had been signaling prior to last week that any rate hikes would not take place soon after the net new bond purchases end. Taking the ECB's statement at face value, it would suggest that September 2019 is the first possible "live" meeting where a rate hike could occur. According to a survey of economists taken in early June by Bloomberg, the consensus view was that the net bond purchases would stop in December, the ECB would raise the deposit rate in the second quarter of 2019, and then raise the main refinancing rate (the ECB's primary policy rate) from 0% in the third quarter of 2019.3 This is broadly consistent with the pricing we see in our own "months-to-hike" indicator for the euro area, which shows that a 10bp rate increase is priced into the euro Overnight Index Swap (OIS) curve by August 2019, but with a full 25bps of increases not discounted until March 2020 (Chart 5). That date for the 10bp hike was at June 2019 on the day prior to last week's policy meeting, so the market repriced more or less in line with the ECB's messaging on the potential timing of that first hike. Chart 4Is The ECB Too Optimistic On Growth? Chart 5Market & ECB Are In Agreement Draghi gave no specific indication as to which of the ECB's policy rates would be moved first - when the ECB finally does decide to move - nor what the size of that first move could be. Yet even if the ECB "goes small" on that first move and does not move in 25bp increments like the Fed has been doing, that outcome has now been largely been discounted in the money market yield curve. Our view remains that there will be no rate hikes from the ECB until euro area core inflation and, more importantly, inflation expectations are much higher (Chart 6). As a rough rule of thumb, the ECB's previous rate hikes during the mid-2000s tightening cycle, and even the much-criticized hikes in 2011 that played a role in triggering the European Debt Crisis, did not occur until market-based inflation expectations measures like the 5-year CPI swap, 5-years forward were above 2% (bottom panel). Realized core euro area inflation was pushing toward 1.5-2% during those prior two episodes, which the ECB is not projecting to occur until later in 2019. So with core inflation only at 1.1%, and with inflation expectations still mired at 1.7%, the market is correct to take the ECB at its word that it will not even consider raising rates until next September. So why did bond yields and the euro decline after last week's ECB meeting? Perhaps it was Draghi mentioning in his press conference that bond purchases could be restarted, if needed: "[...] APP is not disappearing; it remains part of the toolbox. It's a new instrument of monetary policy that will be used for contingencies that we don't see now, and that's what we anticipate. But it remains now as a normal instrument to monetary policy." This is not a provocative statement, of course. The Bank of England did exactly that - restarting its quantitative easing (QE) program after the shock of the 2016 Brexit vote - while the Fed has also stated that it could do more rounds of QE in the future if the situation required it (but only after the funds rate had been cut back to the zero once again). Perhaps by leaving the door open a crack to ramping up the APP again, at a time when euro area growth is decelerating and core inflation remains well below target, the ECB was seen by the market to be hedging its bets with regards to exiting the current extraordinarily accommodative monetary policy settings. The ECB has been trying to communicate consistently over the past few months that the decisions on stopping bond purchases and hiking interest rates should be treated separately. In other words, a decision on the former would not have any sort of immediate implications for the latter. We discussed the possibility of the ECB avoiding a Fed-style Taper Tantrum when it exited its APP program back in March.4 Our conclusion was that while the ECB had been absorbing a greater share of government bond issuance than the Fed ever did during its QE programs, the "flow effect" of the ECB buying fewer bonds as it exited the APP would still push up euro area bond yields through the normalization of negative term premia (Chart 7). The ECB has been arguing that the "stock effect" of it owning such a large share of the euro area bond market has created a scarcity of risk-free assets that will keep yields subdued. Yet as was shown in the U.S. experience, the bigger impact on U.S. Treasury yields from its QE program was the signaling effect on the expected path of interest rates post QE. That can be seen by the very tight correlation between the term premium on 10-year U.S. Treasury yields and our measure of the market's expectation for the neutral rate fed funds rate - the 5-year U.S. OIS rate, 5-years forward minus the 5-year U.S. CPI swap rate, 5-years forward (Chart 8). A similarly tight correlation exists in the euro area interest rate markets (bottom panel), suggesting that the ECB may have a tougher time keeping a lid on bond yields than they expect if the market starts to raise the expected path of interest rates at a faster pace than the ECB would like to see. Chart 6ECB Will Not Hike Until Inflation ##br##Expectations Are Much Higher Chart 7The 'Flow Effect' Of Less ECB Buying##br## Will Boost Bond Yields Chart 8Markets Do Not Treat Tapering ##br##& Rate Hikes Separately For now, the uncertainty of the current state of euro area economic growth, combined with core inflation that is still undershooting the ECB's target, suggests that euro area bond yields will remain subdued in the near term. Yet as the ECB begins to cut its pace of asset purchases after September of this year, a slow drift higher in euro area bond yields is still the most likely outcome. If the euro area economy rebounds as the ECB expects, then the risk of an even bigger move higher in yields would increase as the market reprices the ECB rate hike cycle, although only if accompanied by an acceleration in core inflation and inflation expectations. We are maintaining our strategic recommendation to stay below-benchmark on duration risk within euro area bond portfolios. In terms of country allocation, we are sticking with our modest underweight stance, however, although we do still prefer owning core European bonds over U.S. Treasuries (especially on a currency hedged basis into U.S. dollars), as the risks of higher bond yields are still much greater in the U.S. than in Europe. Bottom Line: The ECB finally signaled the end of its current Asset Purchase Program, while sticking with its message that interest rate hikes are not likely until at least September 2019. The ECB's optimistic growth and inflation forecasts for the next couple of years may not be realized, but that will not prevent euro area bond yields from drifting higher as the ECB stops buying. Stay below-benchmark on euro area duration exposure. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 https://www.nfib.com/surveys/small-business-economic-trends/ 2 http://www.ecb.europa.eu/press/pressconf/2018/html/ecb.is180614.en.html 3 https://www.bloomberg.com/news/articles/2018-06-07/draghi-s-bond-buying-era-seen-ending-as-ecb-gears-up-for-talks 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Bond Markets Are Suffering Withdrawal Symptoms", dated March 20th 2018, available at gfis.bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Monetary Policy: Position for rate hikes of 25 bps per quarter for the next 6-12 months and watch nominal GDP growth, cyclical spending and the price of gold for signals about the position of the fed funds rate relative to its equilibrium level. Yield Curve: Curve flattening will proceed as the Fed lifts rates, but some flattening pressure will be mitigated by the re-anchoring of long-dated inflation expectations. Against this back-drop, and given currently attractive valuations, a position long the 7-year bullet and short the duration-matched 1/20 barbell makes the most sense. IG Credit: Moving down-in-quality has a greater positive impact on the risk-adjusted performance of a credit portfolio when excess return volatility and index duration-times-spread are low. At present, down-in-quality allocations within investment grade credit are only marginally attractive. Feature "You just let the machines get on with the adding up," warned Majikthise, "and we'll take care of the eternal verities, thank you very much. [...] "That's right," shouted Vroomfondel, "we demand rigidly defined areas of doubt and uncertainty!" - The Hitchhiker's Guide To The Galaxy, By Douglas Adams Jerome Powell put his stamp on Fed communications at last week's FOMC meeting. He trimmed 100 words from the policy statement and began his post-meeting press conference with a concise "plain-English" summary of how the economy is doing. In short: "the economy is doing very well". But while he expressed confidence in the Fed's assessment of the economy, he was also keen to point out areas where the outlook is cloudier. His central theme seemed to be that we must delineate between those questions that can be addressed by the Fed's reading of the economic data and those that are better left to the philosophers in Douglas Adams' novel. The Chairman stressed the uncertainty surrounding two concepts in particular: the non-accelerating inflation rate of unemployment (NAIRU) and the neutral (or equilibrium) interest rate, even advising that "we can't be too attached to these unobservable variables." But what can we say about these traditionally important policy guideposts? And more importantly, how should we think about them when formulating an investment strategy? The Importance Of NAIRU Chart 1The Fed's Projections One issue that came up repeatedly in the Chairman's press conference was the seeming disconnect between the Fed's labor market projections and its inflation projections. The Fed expects the unemployment rate to fall far below NAIRU during the next two years, and yet it anticipates only a mild overshoot of its inflation target (Chart 1).1 Ultimately this disconnect will be resolved in one of two ways. Either the Fed is underestimating the inflation pressures that will result from running the unemployment rate so far below NAIRU and will be forced to hike rates more quickly than anticipated, or it will eventually revise its estimate of NAIRU downward. From an investment perspective, this disconnect will only matter if inflation starts to rise more quickly than anticipated and the Fed is forced to ramp up the pace of rate hikes. We discussed this possibility in a recent report and concluded that, on a 6-12 month horizon, the odds of the Fed hiking more quickly than its current 25 bps per quarter pace are low.2 This is principally because the Fed will likely tolerate a fairly substantial overshoot of its inflation target before it feels the need to tighten more quickly. The Importance Of The Neutral Rate For bond investors the theoretical concept of the neutral (or equilibrium) interest rate is much more important. This interest rate represents the threshold between accommodative and restrictive monetary policy. When the fed funds rate is above neutral we should expect the pace of economic growth to slow and inflation pressures to dissipate. At present, the majority of FOMC participants estimate that the neutral fed funds rate is between 2.75% and 3%. At the Fed's current 25 bps per quarter pace, the funds rate will reach neutral by the middle of next year (Chart 2). Chart 2The Federal Funds Rate Will Hit Neutral Next Year The important question for investors is whether the Fed will start to slow its rate hike pace at that time, or whether it will revise its estimate of the neutral rate based on trends in the economy. Chairman Powell's emphasis on uncertainty makes us lean toward the latter. In a recent report we outlined three factors to monitor that will help us determine whether monetary policy is accommodative (fed funds rate below neutral) or restrictive (fed funds rate above neutral).3 The first factor is the year-over-year growth rate in nominal GDP relative to the fed funds rate (Chart 3). Historically, the year-over-year growth rate in nominal GDP falling below the fed funds rate is a reliable (though often lagging) signal that monetary policy has turned restrictive. A more leading signal of restrictive monetary policy is the proportion of nominal GDP that comes from the most cyclical (or interest rate sensitive) sectors of the economy. Those sectors being consumer spending on durable goods, residential investment and investment on equipment & software. When cyclical spending declines as a proportion of overall growth it is often a sign that the fed funds rate is above its neutral level (Chart 3, panel 2). Finally, we also recommend monitoring the price of gold for clues about the neutral rate of interest. Gold tends to appreciate when the stance of monetary policy becomes more accommodative and depreciate when it becomes more restrictive. The steep decline in the gold price between 2013 and 2016 even preceded downward revisions to the Fed's estimate of the neutral rate (Chart 4). Going forward, an upside breakout in the price of gold would be a signal that we should revise our estimate of the neutral fed funds rate higher. Conversely, a large decline would suggest that monetary policy is turning restrictive and we should think about calling the cyclical peak in bond yields. Chart 3Tracking The Neutral Rate I Chart 4Tracking The Neutral Rate II Bottom Line: Rather than rely on current estimates of unobservable variables like NAIRU and the neutral rate of interest, investors should monitor developments in the economy and consider how those estimates might evolve over time. For now, investors should expect a rate hike pace of 25 bps per quarter and watch nominal GDP growth, cyclical spending and the price of gold for signals about the position of the fed funds rate relative to its equilibrium level. Gradualism And The Slope Of The Curve The Fed's fairly explicit guidance that rates will rise by 25 bps per quarter is quite helpful when formulating expectations about the slope of the yield curve. For example, we know that the current 1-year par coupon Treasury yield of 2.35% is priced for exactly 100 bps of rate hikes during the next 12 months with no term premium. In other words, investors today should be indifferent between an investment in cash and an investment in a 1-year Treasury note if they are 100% certain that the Fed will stick to its 25 bps per quarter hike pace for the next 12 months. We can also forecast where the 1-year Treasury yield will be six months from now under a few different scenarios (Table 1). The forward curve is consistent with a 1-year Treasury yield of 2.69% six months from now, and we calculate that it will be 2.83% if the market moves to fully discount a rate hike pace of 25 bps per quarter until the end of 2019. If the market only prices in the Fed's median funds rate projection, which calls for three hikes in 2019, then the 1-year Treasury yield will be between 2.62% and 2.81% six months from now, depending on which meetings in 2019 those three rate hikes are delivered. Table 1Forecasting The 1-Year Treasury Yield The main takeaway from these observations is that even in the most hawkish scenario the 1-year Treasury yield will only rise to 2.83%. This is 48 bps above its current level and a mere 14 bps more than what is already priced into the forward curve. Now let's consider the long-end of the curve. The 10-year and 20-year TIPS breakeven inflation rates currently sit at 2.12% and 2.10%, respectively. If inflation expectations become re-anchored around the Fed's 2% target during the next six months, which we expect they will, then both of these rates will reach a range between 2.3% and 2.5% (Chart 5). This alone will apply between 20 bps and 40 bps of upward pressure to the 20-year Treasury yield. The nominal 20-year Treasury yield is currently 2.98% and the forward curve is priced for it to rise to 3.01% in six months. In the most hawkish scenario where the Fed lifts rates 25 bps per quarter and long-maturity yields remain constant, the 1/20 Treasury slope will flatten by 48 bps during the next six months. In the more likely scenario where Fed rate hikes coincide with the re-anchoring of long-dated inflation expectations, the 1/20 slope will flatten by 28 bps or less. Meanwhile, our model of the 1/7/20 butterfly spread shows that it is priced for 55 bps of 1/20 flattening during the next six months (Chart 6). Or put differently, there is so much extra yield pick-up in the 7-year bullet relative to the duration-matched 1/20 barbell that being long the bullet and short the barbell will be profitable unless the 1/20 slope flattens by more than 55 bps. Chart 5Inflation Expectations Are Still Too Low Chart 6Butterfly Spread Fair Value Model Bottom Line: Curve flattening will proceed as the Fed lifts rates, but some flattening pressure will be offset by the re-anchoring of long-dated inflation expectations. Against this back-drop, and given currently attractive valuations, a position long the 7-year bullet and short the duration-matched 1/20 barbell makes the most sense. Risk Update On May 22 we initiated a tactical long duration position premised on extended net short positioning in the bond market and the high likelihood of negative near-term data surprises.4 We have seen considerable movement in our indicators during the past two weeks - positioning is now much closer to neutral (Chart 7) and our model no longer expects data surprises to turn negative (Chart 8). Therefore, this week we remove our tactical long duration recommendation. The biggest current risk to our below-benchmark duration stance is the large divergence that has opened up between U.S. growth and the rest of the world (Chart 9). This divergence is putting upward pressure on the U.S. dollar and, much like in 2015, is starting to hurt growth in emerging markets, as we discussed last week. Chart 7Bond Market Positioning Chart 8Data Surprises Should Remain Positive Chart 9Foreign Growth Is The Greatest Risk But dollar strength and emerging market weakness is not an imminent threat to higher U.S. yields. Using the 2015 experience as a template, we see in Chart 9 that U.S. yields did not fall until after emerging market financial conditions and global growth had already troughed. In fact, it was not until dollar strength and weak global growth culminated in a dramatic tightening of U.S. financial conditions that the Fed finally signaled a slower pace of rate hikes and Treasury yields declined (Chart 9, bottom panel). Similarly, we don't think the Fed will react to a strong dollar and weak foreign growth until the impact is felt by U.S. risk assets. With U.S. growth still elevated and the dollar having appreciated only modestly so far, we think Treasury yields will avoid this risk during the next few months. Nonetheless, the divergence between U.S. and foreign growth is a risk that bears close monitoring. We will not hesitate to alter our duration stance if the dollar continues to appreciate and the divergence appears close to a breaking point. The Best Time To Move Down In Quality In last week's report we reviewed our assessment of where we stand in the credit cycle. That assessment determines whether we should be overweight or underweight investment grade corporate bonds relative to a duration-equivalent position in Treasuries. This week we zero-in on our allocation to investment grade corporate bonds and consider how we should allocate between the different credit tiers (Aaa, Aa, A and Baa). In next week's report we will look at positioning across the different maturity buckets and industries. We begin our analysis with the four Bond Maps presented in Charts 10-13. These Bond Maps show risk-adjusted return potential on the y-axis. Specifically, the number of months of average spread tightening necessary to achieve the excess return threshold listed in each map's title. The risk-adjusted potential for losses is shown on the x-axis. In this case, it shows the number of months of average spread widening required to underperform Treasuries by the amount listed in the title. Chart 10Investment Grade Corporate Excess Return Bond Map:##br## +/- 50 BPs Threshold Chart 11Investment Grade Corporate Excess Return Bond Map: ##br##+/- 100 BPs Threshold Chart 12Investment Grade Corporate Excess Return Bond Map: ##br##+/- 200 BPs Threshold Chart 13Investment Grade Corporate Excess Return Bond Map:##br## +/- 300 BPs Threshold Credit tiers plotting closer to the bottom-left of the Bond Maps have less potential for return and less risk. Credit tiers plotting closer to the upper-right have greater potential for return and more risk. What we find particularly interesting is that when we set a low return threshold, such as +/- 50 bps, the credit tiers plot almost right on top of each other. In other words, an allocation to Baa-rated corporate bonds gives you a much greater chance of earning 50 bps with about the same risk of losing 50 bps as the other credit tiers. But as we increase the excess return threshold the risk/reward trade-off between the different credit tiers becomes more linear. In Chart 13 we see that Baa-rated bonds have a greater chance of earning 300 bps than the other credit tiers, but also carry a significantly greater risk of losing 300 bps. Chart 14Down-In-Quality Works ##br##Best When Vol Is Low This leads to an interesting conclusion. A macro environment where we would expect low excess return volatility is also one where moving down in quality within investment grade corporate bonds is most beneficial from a risk/reward perspective. Conversely, moving down in quality will improve the risk-adjusted performance of your portfolio by less (and might even hurt the risk-adjusted performance of your portfolio) in a highly volatile return environment. To test this theory, we first recognize that the excess return volatility of the investment grade corporate bond index is tightly linked with its duration-times-spread (DTS). Low DTS environments have lower excess return volatility, and also less of a spread differential between the lower and higher credit tiers (Chart 14). With this in mind we split the historical time series of monthly corporate bond excess returns into four quartiles based on the index DTS (Table 2). We also exclude recessions from our sample, meaning this analysis is only valid during periods of economic recovery. Not surprisingly, the results show that the standard deviation of monthly excess returns increases alongside index DTS. But we also see that the average return advantage in the Baa-rated credit tier is lower when the index DTS is higher. Table 2Investment Grade Corporate Bond Excess Returns By Credit Tier (1989-Present)* When the index DTS is between 3 and 4.5, the reward/risk ratio in the Baa-rated credit tier exceeds the average of the other three credit tiers by 0.13. This advantage falls to 0.07 when the DTS is between 4.5 and 6.7; and falls further to 0.04 when the DTS is between 6.7 and 9.7. In the highest DTS quartile, the Baa-rated credit tier provides a lower reward/risk ratio than the average of the other three credit tiers. At present the index DTS is 8.4. This puts us in the second highest quartile relative to history, and is consistent with a 12-month standard deviation of monthly excess returns of roughly 77 bps for the corporate bond index. In this environment we should expect down-in-quality allocations to positively impact the risk-adjusted performance of a credit portfolio, but not by as much as in lower DTS environments. Bottom Line: Moving down-in-quality has a greater positive impact on the risk-adjusted performance of a credit portfolio when excess return volatility and index duration-times-spread are low. At present, down-in-quality allocations within investment grade credit are only marginally attractive. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 In order to display a longer history, Chart 1 shows the Congressional Budget Office's estimate of NAIRU rather than the Fed's. At present both estimates are very close. The CBO estimates NAIRU to be 4.65% and the Fed's median projection calls for a NAIRU of 4.5%. 2 Please see U.S. Bond Strategy Weekly Report, "Breaking Points", dated May 29, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights As widely expected, the Fed raised the policy rate by 25bps last week. The central bank is also forecasting an additional rate hike for 2018, but one less for 2020. The labor market typically continues to improve after the economy reaches full employment, wage inflation begins to accelerate after the economy achieves full employment, while prices rise only gradually. Gold and Treasuries were the big winners and the dollar was the big loser in previous trade spats. Feature The dollar rose 1%, but gold, the S&P 500, and U.S. Treasury yields sunk last week amid a busy calendar of U.S. economic data and the Fed's new forecasts. The stats and the FOMC projections confirmed that the U.S. economy is already at full employment and that the market is underpricing the number of Fed hikes planned for this year. Meanwhile, U.S. President Trump's meeting with North Korea leader Kim Jong Un provided some relief on the geopolitical front, but there is still uncertainty on trade over impending tariffs on China. Chart 1Watch The 2.3% To 2.5% Level##BR##On TIPS Breakevens BCA's base case remains that U.S. equities will not be subject to an over-aggressive Fed until mid-2019 and that increasing bond yields are not a threat. That said, the timing is uncertain and depends importantly on how inflation and inflation expectations shift in the coming months. Inflation is only gradually moving higher at the moment and the Fed is willing to tolerate an overshoot of the 2% target. However, some inflation hawks at the Fed are worried given that the economy is already at full employment and expected to accelerate this year. The uptrend in inflation could suddenly become steeper in this macro environment. Alarm bells will ring when inflation hits 2.5% and the central bank will switch from normalizing policy to targeting slower growth, putting risk assets under pressure. We are also on the watch for a rise in the 10-year TIPS breakeven rate above 2.3% as a signal that the FOMC will become more aggressive in leaning against above-trend growth and a falling unemployment rate (Chart 1). That would be an important signal to trim exposure to risk assets. Although Trump's meeting with Kim lowered geopolitical risk, BCA's strategists note that the secular decline in U.S.-China ties and the "apex of globalization"1 are more relevant subjects than what happens on the Korean peninsula. While North Korea may still stir up concern, we recommend that investors monitor U.S.-China trade tensions, the East and South China Seas, and Taiwan. Elsewhere, U.S.-Iran tensions are the key understated geopolitical risk to markets. Moreover, BCA's Geopolitical Strategy service expects that trade-related uncertainty will persist at least until the U.S. mid-term elections in November.2 Two More In '18 As widely expected, the Fed raised the policy rate by 25bps last week. The central bank is also forecasting an additional rate hike for 2018, but one less for 2020 (Chart 2). Chart 2FOMC And Market Mostly##BR##Aligned On Economy And Rates Instead of three, the Fed now expects to deliver a total of four rate hikes in 2018. For 2019, the Fed continues to project a further three rate hikes. And for 2020, the Fed now believes only one rate hike will be warranted, down from two hikes in its previous forecast. What this means is that the Fed has simply brought forward one rate hike from 2020 to 2018. It left its median projection for the level of the Fed funds rate in 2020 unchanged at 3.375%. Moreover, the Fed kept its estimate of the neutral rate unchanged at 2.875%. In other words, the Fed is forecasting a marginally faster pace to rate hikes, but it has not changed its outlook for the full extent of the tightening cycle. This minor change to the policy outlook should not disrupt financial markets. Prior to last week's FOMC meeting, Fed funds futures were already pricing a 50% probability of a fourth rate hike this year. The bigger question is whether more upward adjustments to the interest rate outlook lie ahead. On this front, there are inconsistencies in the Fed's economic projections. In terms of the long-run steady state, the Fed believes the potential growth rate of the economy is 1.8% and NAIRU is 4.5%. Yet the Fed is forecasting real GDP growth of 2.4% and 2.0% (i.e. above-trend) for 2019 and 2020, respectively, but expects both the jobless rate and core inflation to remain steady at 3.5% and 2.1%, respectively. Above-trend growth should imply a further decline in the unemployment rate. And a jobless rate that's well below NAIRU should imply an acceleration in inflation. In turn, this should mean a higher path for interest rates. But rather than higher interest rates, the inconsistency in the Fed's economic forecasts can also be resolved in other ways. First, the Fed could simply be too optimistic on growth. If growth is weaker, then unemployment and inflation forecasts could be proven right. Second, the Fed's estimates of trend growth and NAIRU may be incorrect. If trend growth is higher and NAIRU is lower, the pressures on resource utilization and inflation will be less. Bottom Line: The tweaks to the Fed's interest rate projections are too small to have a material impact on financial market pricing. However, there is a risk that the inconsistencies in the Fed's economic forecasts will be resolved with more hawkishness in 2019. This could then prove problematic for global risk assets, depending on the evolution of inflation. Are We There Yet? The U.S. economy reached full employment in Q1 2017. The unemployment rate crossed below the Fed's measure of NAIRU in March 2017, a whopping 93 months after the start of the current expansion. Chart 3 shows that in the long expansions3 in the 1980s and 1990s, the economy reached full employment sooner; 54 months in the 1980s and 72 months in the 1990s expansion. After the economy attained full employment in the 1980s and 1990s, an average of another 27 months passed before the unemployment rate troughed. This means that the trough will occur in mid-2019 and our view is that the rate will bottom at around 3.5% in mid-2019.4 Moreover, the 1980s' economic recovery lasted another 34 months once the economy hit full employment and another 47 months once full employment was breached in the 1990s. If this historical pattern holds, then the next recession will begin in late 2020. This date is consistent with our prior work5 on the start date of the next downturn. Chart 3The Economy At Full Employment In Long Cycles The labor market typically continues to improve after the economy reaches full employment. Initial claims for unemployment insurance, as a share of the labor force, move lower for another two years, on average, after labor market slack disappears (Chart 4, panel 2). The monthly non-farm payrolls job count follows a similar pattern and it does not turn negative for another four years (panel 3). The Conference Board's jobs easy/hard to get shows that the labor market is hotter than in the previous long expansions (panel 4). The conclusion is that the labor market will continue to tighten for another year or so, consistent with our outlook. Wage inflation begins to accelerate after the economy achieves full employment. Chart 5 shows increases in the average hourly earnings (AHE), the Employment Cost Index (ECI), and compensation per hour after the unemployment rate fell below NAIRU in the 1980s and 1990s. However, unit labor costs (ULCs) did not accelerate in those years until well after the economy hit full employment. Many of these measures of wage inflation are also on the upswing today. However, none of the indicators are rising as quickly as they did in the 1980s and 1990s (See Appendix Table 1 for more details on performance of labor market, wage and inflation metrics after the economy reaches full employment). Inflation initially remained tame even after labor market slack was taken up in the previous two long expansions. Chart 6 shows that neither headline nor core CPI accelerated sharply after the economy arrived at full employment in the '80s and '90s. However, headline CPI inflation began rising not long after full employment was reached. It took a little longer for core inflation to perk up. Moreover, inflation tends to peak as the unemployment rate troughs. This occurs, on average, about three years after the unemployment rate crosses below NAIRU. Chart 4The Labor Market When##BR##The Economy Is At Full Employment Chart 5Wages And Compensation When##BR##The Economy Is At Full Employment Chart 6Inflation When The Economy##BR##Is At Full Employment Bottom Line: The U.S. economy has been at full employment since early 2017, but investors should be patient if they expect a marked acceleration in inflation. Inflation is already at the Fed's target and BCA expects two more rate hikes this year and at least three more increases in 2019 as inflation moves closer to 2.5%. Stay underweight duration. The labor market is as tight as it was at this point of the previous two long expansions. Moreover, the trends in inflation and wages are similar, although from a lower level. That said, while inflation is more muted today, interest rates are much, much lower, and the Fed does not want a major overshoot. If we follow the same path as the previous two long expansions, then inflation will rise only gradually, and the next recession is a ways off. But watch for an acceleration in ULC, because in the average of the last two long expansions, an acceleration in ULC coincided with an acceleration in core CPI inflation. That would cause the Fed to become more aggressive. Trump's Focus On China The U.S. is an old hand at trade wars and economic conflicts, with an endgame of dollar depreciation and compromises on trade.6 Since 1970 there have been seven major trade disputes involving tariffs, including the one that began in March of this year. Some were brief and several of those periods overlapped. Moreover, many other factors affected investment returns, including recessions, wars, major terrorist attacks, and financial crises. As a result, these periodic trade tiffs make it difficult to discern the implications for the financial markets. During episodes of trade-related uncertainty, stocks underperform Treasuries, the dollar falls both pre- and post-dispute, and gold performs much better both during and after. Treasuries are the most consistent performer, and this asset class beat stocks during five of the six periods. Meanwhile, the dollar fell during 5 of the 6 trade spats (Table 1). Chart 7 shows the performance of a wider set of U.S. financial assets before, during, and after trade tensions erupt. Table 1U.S. Stocks, Treasuries, The Dollar, Gold And Trade Disputes Chart 7U.S. Financial Assets And Trade Spats We begin our discussion of trade spats and their implication for financial markets in the early 1970s. In August 1971, with the dollar steeply overvalued, President Richard Nixon abandoned the gold standard and imposed a 10% surcharge on all dutiable imports. The purpose of the tariff was to force the U.S. allies to appreciate their currencies against the dollar. Some appreciation occurred as a result of the Smithsonian Agreement, but the effects were short-lived. The U.S. could not afford to alienate its allies amid the Cold War and removed the restrictions four months later. Table 1 shows that S&P 500 increased by nearly 40% in the year prior to the 1971 trade spat, but the economy was recovering from the 1969-70 recession. Equities easily beat Treasuries (+17%), the dollar declined by 3%, and gold jumped by 22%. However, during late 1971, the S&P 500 underperformed Treasuries, the dollar dropped by 5%, and gold was little changed. In the 12 months after the trade issue was resolved, U.S. stocks beat bonds, the dollar continued to move lower, and gold surged. This occurred as inflation ramped up. In a trade dispute episode during the 1980s, then President Reagan and a Democrat-leaning Congress became concerned with trade deficits and a sharply rising dollar. The Plaza Accord in 1985 consisted of a German and Japanese promise, once again, to appreciate their currencies. From 1985-89, a U.S.-Japan trade war was waged over Japan's growing share of the U.S. market and certain unfair trade practices affecting goods such as cars, semiconductors, and electronics (Chart 8). The combination of yen appreciation, voluntary export restraints and tariffs, resulted in compromises, and in the early 1990s the U.S. removed Japan from its list of targets. Chart 8The U.S.-Japan Trade Spat In The 1980s During the 1985-89 dispute, the U.S. stock market crashed, economic growth surged, inflationary pressures mounted, and the Fed hiked rates. Nevertheless, stocks crushed bonds as the dollar tumbled by 40% and gold soared by 30% (Table 1). Note that gold fell in the year before the trade dispute began and in the year after it ended. In the late 1990s, a series of trade disputes erupted between the U.S. and the European Union, most significantly on a tax device that allowed companies reduced taxes on profits derived from export sales. The EU won its case against the U.S. at the WTO and the U.S. eventually repealed the offending provisions in its tax code. At the same time, from 1999-2001, the U.S. contested EU policies on banana imports. Then in March 2002, President George W. Bush imposed steel tariffs affecting Europe, but these were subsequently reversed in December 2003 in the face of retaliatory threats. Trade tension in the late 1990s and early 2000s developed alongside the tech boom, the 2001 recession and recovery, and the first Gulf War. The 10-year Treasury outperformed the S&P 500 as Bush's steel tariffs were in effect, but the early part of this period coincided with the accounting scandals that buffeted U.S. equity markets. The U.S. dollar dropped nearly 25%, although the Fed cut rates in 2002 and 2003. Gold climbed 34% in this period, outpacing both stocks and bonds. President Trump's trade positions are reminiscent of both Nixon's and Reagan's policies and his trade team includes a notable veteran of the U.S.-Japan trade war, U.S. Trade Representative Robert Lighthizer. The focus, however, is not entirely the same. True, there is still a fixation on privileged manufacturing industries like steel and autos, both in the Section 232 actions on steel and aluminum and in the NAFTA renegotiation. But there is today a heightened focus on China's abuses of the international trade system, in particular its technology theft and intellectual property violations (the Section 301 actions). For investors, the critical issue is to separate the two areas of focus. The U.S. grievances with Europe, NAFTA, and Japan will cause more volatility this year and beyond, but are ultimately more manageable than those with China. U.S.-China trade tensions are caught up in a Great Power rivalry that will likely persist throughout this century, making trade tensions a permanent feature of the relationship going forward.7 China's rapid military growth and technological acquisition threaten U.S. global dominance. China will view any imposition of tariffs by the U.S., or demands for dramatic RMB appreciation, as a strategic attempt to derail China's rise. Moreover, while Congress will not attack President Trump for retreating from the trade war with the allies, it will attack President Trump for compromising on China. Recent U.S. elections have swung on Rust Belt Midwestern states that resent America's deindustrialization. In 2020, Democrats will attempt to reclaim their credibility as defenders of American workers and "fair trade," especially against China. President Trump stole their thunder with his protectionist platform. There is unlikely to be a "trade dove," and especially not a "China dove," in the White House from 2020-24. Bottom Line: The U.S. has historically used punitive trade measures to force its allied trading partners to appreciate their currencies versus the dollar. It has also sought to protect politically sensitive industries. Today, however, the trade war with China is inextricably tied to a strategic conflict that will play out over decades. Trump will likely impose Section 301 tariffs on China after June 15 and any deal to avoid confrontation will merely delay the decision on tariffs until after November's mid-term elections. Investors should recall that bonds beat stocks, the dollar fell, and gold rose during previous periods of trade tension. We also note that shifts in correlations between key U.S. asset classes tend to occur as trade spats begin and end, especially in the past 30 years (Chart 9). Moreover, gold usually continues to climb and the dollar falters even after these disputes are resolved. Chart 9U.S. Asset Class Correlations During Trade Disputes John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014. Available at gps.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," published April 4, 2018. Available at gps.bcaresearch.com. 3 Please see BCA Research's Bank Credit Analyst Monthly Report, published March 2017. Available at bca.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Tightening Up", published May 14, 2018. Available at usis.bcaresearch.com. 5 Please see BCA Research's Global Investment Strategy Weekly Report, "Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000," published March 30 2018. Available at gis.bcaresearch.com. 6 Please see BCA Research's Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," published April 12, 2017. Available at gps.bcaresearch.com. 7 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," published March 14, 2018. Available at gps.bcaresearch.com. Appendix Appendix Table 1Key Labor Market And Inflation Indicators At Full Employment
Highlights Global Inflation has upside on a cyclical basis, but this narrative is well known and investors have already placed their bets accordingly, buying inflation protection in a wide swath of markets. However, global growth has not yet found its footing, suggesting a mini-deflation scare, at least relative to expectations, is likely this summer. The U.S. dollar will benefit in such a scenario, and NOK/SEK will depreciate. While GBP/USD has downside, the pound should rally versus the euro. Weakness in EUR/CAD has not yet fully played out; the recent bout of strength was only a countertrend move. Feature Inflation is coming back, and this will obviously have major consequences for both asset and currency markets. However, macro investing is not just about forecasting fundamentals correctly; often, just as importantly, it is about understanding how other investors have priced in these expected economic developments. Therein lies the problem. While we understand why inflation could pick up, so too have most investors, and they have positioned themselves accordingly. With global growth currently looking shaky, we believe a better entry point for long-inflation plays will emerge in the coming months. In the meanwhile, a defensive, pro-U.S. dollar posture still makes sense. Investors Are Long Inflation Bets We have long argued that inflation was likely to make a cyclical comeback, a return that would begin in the U.S. before spreading to the rest of the globe. This story is currently playing out. However, in response these developments, investors have placed their bets accordingly, and the story currently seems well baked in. Prices of assets traditionally levered to inflation have already moved to discount a significant pick-up in inflation. The most evident dynamics can be observed in the U.S. inflation breakevens. Both the 10-year breakevens as well as the 5-year/5-year forward breakevens just experienced some of their sharpest two-year changes of the past 20 years, notwithstanding the pricing out of a post-Lehman, depression-like outcome (Chart I-1). Breakevens are not alone. Other assets have displayed similar behavior. In the U.S., investors have aggressively sold their holdings of utilities stocks, which have been greatly outperformed by industrial stocks. Traditionally, investors lift the price of XLI relative to that of XLU when they anticipate global inflation to pick up (Chart I-2). Chart I-1Markets Are Positioning Themselves##br## For Higher Inflation Chart I-2U.S. Sectoral Performance Suggests Investors ##br##Have Already Bet On Higher Inflation... It is not just intra-equity market dynamics that support this assertion. The behavior of the U.S. stock market relative to Treasurys further buttresses the idea that investors have already aggressively discounted an upturn in global consumer prices (Chart I-3). Potentially, the best illustration of investors' preference for inflation protection is currently visible in EM assets. A seemingly paradoxical phenomenon has been puzzling us: How have EM equities managed to avoid the gravitational pull that has caused EM bonds to nearly flirt with the nadir of early 2016? After all, EM equities, EM currencies and EM bonds are normally closely correlated, driven by investors' wagers on the direction of global growth. A simple variable can explain this strange dichotomy: anticipated inflation. As Chart I-4 illustrates, the performance of a volatility adjusted long EM stocks / short EM bonds portfolio tends to anticipate fluctuations in global inflation. The current price action in this basket indicates that investors have made their bets, and they think inflation is going up. Chart I-3...So Does The Stock-To-Bond Ratio Chart I-4Inflation Bets Explain Why EM Stocks And EM Bond Prices Have Diverged Anecdotal evidence suggests that in recent quarters, pension plans have been aggressive buyers of commodities - a move that normally coincides with these long-term investors putting in place some inflation hedges. Moreover, positioning in the futures markets corroborates these stories: speculators are still very long commodities like copper and oil - commodities traditionally perceived as efficient protectors against inflation spikes (Chart I-5). Finally, despite the potentially deflationary risks created by Italy three weeks ago, speculators remain short U.S. Treasury futures, bond investors are underweight duration, and sentiment toward the bond market remains near its lowest levels of the past eight years (Chart I-6). Again, this behavior is consistent with investors being positioned for an inflationary environment. Chart I-5Money Has Flown Into Resources Chart I-6Bond Market Positioning Is Still Very Short Bottom Line: There is a well-defined case to be made that a global economy that was not so long ago defined by the presence of deflationary risks is now morphing into a world where inflation is on the upswing. However, based on inflation breakevens, sectoral relative performance, equities relative to bonds in both DM and EM as well as on the positioning of investors in commodity and bond markets, this changing state has been quickly discounted by investors. The Decks Are Stacked, But Where Does The Economic Risk Lie? The problem facing investors already long inflation protection every which way they can be is that the global economy is slowing, which normally elicits deflationary fears, not inflationary ones. This seems a recipe for disappointment, albeit one that is likely to help the dollar. Our global economic and financial A/D line, which tallies the proportion of key variables around the world moving in a growth-friendly fashion, has fallen precipitously. This normally heralds a slowdown in global economic activity (Chart I-7). Chart I-7Global Growth Is Losing Traction In similar vein, global leading economic indicators have also begun to roll over - a trend that could gain further vigor if the diffusion index of OECD economies experiencing rising versus contracting LEIs is to be believed (Chart I-8). The global liquidity picture has also deteriorated enough to warrant caution. Currency carry strategies - as approximated by the performance of EM carry trades funded in yen - have sagged violently. This tells us that funds are flowing out of EM economies and moving back to countries already replete with excess savings like Japan or Switzerland (Chart I-9). Historically, these kinds of negative developments for global liquidity have preceded industrial slowdowns, as EM now accounts for the lion's share of global IP growth. Finally, China doesn't yet look set to bail out the world's industrial sector. This month's money and credit numbers were weaker than anticipated, and our leading indicator for the Li-Keqiang index - our preferred gauge of industrial activity in the Middle Kingdom - points to further weakness (Chart I-10). This makes it unlikely that China's imports will rise, lifting global growth. Additionally, China has re-stocked in various commodities, suggesting it is front-running its own domestic demand, highlighting the risk that its commodities intake could become even weaker than what domestic growth implies. Chart I-8More Weakness In LEIs Chart I-9Global Liquidity Tightening Chart I-10China Not Yet Set To Bail Out The World With this kind of backdrop, we expect the current slowdown in global growth to run further before ebbing, probably in response to what will be a policy move out some kind from China to put a floor under growth. As a result, the current infatuation with inflation hedges among investors may wane for a bit as slower growth could shock inflation expectations downward, especially in a global context that has been defined by excess capacity since the late 1990s. An environment where global inflation expectations could be downgraded in response to slower growth is likely to be an environment where the dollar performs well, particularly as U.S. growth continues to outperform global growth (Chart I-11). This also confirms our analysis from two weeks ago that showed that when bonds rally the dollar tends to outperform most currencies, with the exception of the yen.1 Moreover, with the Federal Open Market Committee upgrading its path for interest rates by one additional hike in 2018, this reinforces the message from our previous work noting that once the fed funds rate moves in the vicinity of r-star, the dollar performs well, nearly eradicating the losses it incurred when the fed funds rate rises but is well below the neutral rate (Table I-1). This is especially true if vulnerability to higher rates rests outside - not inside - the U.S., as is currently the case.2 Chart I-11The Dollar Likes Lower Global Inflation Table I-1Fed And The Dollar: Where We Stand Matters As Much As The Direction Beyond the dollar, one particular currency cross has historically been a good correlate to investors betting on higher inflation: NOK/SEK. As Chart I-12 illustrates, when investors buy inflation hedges such as going long EM equities relative to EM bonds, this generates a rally in NOK/SEK. These dynamics played in our favor when we were long this cross earlier this year. However, not only are EM equities extended relative to EM bonds, the current economic environment portends a growing risk of investors curtailing these kinds of bets. The implication is bearish for NOK/SEK, and we recommend investors sell this cross at current levels. Chart I-12NOK/SEK Suffers If Inflation Bets Are Unwound Bottom Line: Investors have quickly and aggressively positioned themselves to protect their portfolios against upside inflation risks. However, the global economy is still slowing - a development that has further to run. As a result, this current anticipation of inflation could easily morph into a temporary fear of deflation, at least relative to lofty expectations. This would undo the dynamics previously seen in the market. This is historically an environment in which the dollar performs well, suggesting the greenback rally is not over. Moreover, NOK/SEK could suffer in this environment. The Bad News Is Baked Into The Pound There is no denying that the data flow out of the U.K. has been poor of late. In fact, despite what was already a low bar for expectations, the U.K. economy has managed to generate large negative surprises (Chart I-13). One of the direct drivers of this poor performance has been the complete meltdown in the British credit impulse (Chart I-14). Additionally, the slowdown in British manufacturing can be easily understood in the context of slowing global growth (Chart I-15). Chart I-13Anarchy In The U.K. Chart I-14The Credit Impulse Has Bitten Chart I-15U.K. Exports Are Slowing Because Of Global Growth But, the bad new seems well priced into the pound, especially when compared to the euro. Not only is the GBP trading at a discount to the EUR on our fundamental and Intermediate-term timing models, speculators have accumulated near-record short bets on the pound versus the euro (Chart I-16). This begs the question: Could any positive factor come in and surprise investors, resulting in a fall in EUR/GBP? We think the answer to this question is yes. First, despite the negatives already priced in, incremental bad news have had little traction in dragging the pound lower versus the euro in recent weeks, suggesting that EUR/GBP buying has become exhausted. Second, a falling EUR/USD tends to weigh on EUR/GBP, as the pound tends to act as a low-beta version of the euro (Chart I-17). Chart I-16Investors Are Well Aware Of Britain's Problems Chart I-17EUR/GBP Sags When EUR/USD Weakens Third, the economic outlook for the U.K. is improving. It is true that in the context of slowing global growth, the manufacturing and export sectors are unlikely to be a source of positive surprises for Great Britain. However, the domestic economy could well be. As Chart I-14 highlights, the credit impulse has collapsed, but the good news is that outside of the Great Financial Crisis it has never fallen much below current levels, suggesting that a reversion to the mean may be in offing. Additionally, U.K. inflation is peaking, which is lifting British real wages (Chart I-18). In response, depressed consumer confidence is picking up. This is crucial as consumer spending, which represents roughly 70% of the U.K.'s GDP, has been the key drag on growth since 2016. Any improvement on this front will lift the whole British economy, even if the manufacturing sector remains soft. Fourth, Brexit is progressing. This week's vote in the House of Commons was confusing, but it is important to note than an amendment that gives Westminster the right to force a renegotiation between the U.K. and the EU if no deal is reached in 2019 has been passed. This also decreases the risk of a completely economically catastrophic Brexit down the road, but increases the risk that PM Theresa May could be ousted over the next 12 months. Our positive view on the pound versus the euro (or negative EUR/GBP bias) is not mimicked in cable itself. Ultimately, despite the GBP/USD's beta to EUR/GBP being below one, it is nonetheless greater than zero. As such, it is unlikely that GBP/USD will be able to rally if the DXY rallies and the EUR/USD weakens (Chart I-19). Therefore, while we recommend selling EUR/GBP, we are not willing buyers of GBP/USD. Chart I-18A Crucial Support To Growth Chart I-19Cable Will Not Avoid The Downward Pull Of A Strong Dollar Bottom Line: The British economy has undergone a period of weakness, which is already reflected in the very negative positioning of investors in the GBP versus the EUR. However, the bad data points are losing their capacity to push EUR/GBP higher, and the British economy may begin to heal as consumer confidence is rebounding thanks to improving real wages. The low beta of GBP/USD to the euro also implies that a falling EUR/USD will weigh on EUR/GBP. However, while the pound has upside against the euro, it will continue to suffer against the dollar if EUR/USD experiences further downside. What To Do With EUR/CAD? One weeks ago, we were stopped out of our short EUR/CAD trade. Has EUR/CAD finished its fall, or was the recent rally a pause within a downward channel? We are inclined to think the latter. Heated rhetoric on trade has hit the CAD harder than the EUR, as exports to the U.S. represent a much larger share of Canada's GDP than of the euro area, forcing the pricing of a risk premium in the loonie. However, even after a rather explosive G7 meeting, we do believe that a compromise is still feasible and that NAFTA is not dead on arrival. A deal is still likely because, as Chart I-20 demonstrates, Canadian tariffs on U.S. imports are not only marginally in excess of U.S. tariffs on Canadian imports, they are also in line with international comparisons. This suggests only a small push is needed to arrive to a deal that salvages NAFTA, which ultimately is much more important to Canada than the dairy industry. Chart I-20Canada And The U.S. Can Find A Compromise Despite this reality, we cannot be too complacent, U.S. President Donald Trump is likely to be playing internal politics ahead of the upcoming mid-term elections. U.S. citizens are distrustful of free trade (Chart I-21), a trend especially pronounced among his base. However, a good result for the GOP in November is contingent on the Republican base showing up at the polls. Firing this base up with inflammatory trade rhetoric is a sure way to do so. This means that risks around NAFTA are still not nil. Chart I-21America Belongs To The Anti-Globalization Bloc However, EUR/CAD continues to trade at a substantial premium to fair-value on an intermediate-term horizon (Chart I-22). Moreover, as the last panel of the chart illustrates, speculators remain massively short the CAD against the EUR. This creates a cushion for the CAD versus the EUR if global growth slows. Moreover, technicals are still favorable of shorting EUR/CAD. Not only is EUR/CAD still overbought on a 52-week rate-of-change basis, it seems to be in the process of forming a five-wave downward pattern, with the fourth one - a countertrend wave - potentially ending (Chart I-23). Chart I-22EUR/CAD Is Still Vulnerable Chart I-23Wave Pattern Not Completed Finally, EUR/CAD tends to perform poorly when the USD strengthens, which fits with our current thematic for the remainder of 2018. Bottom Line: The headline risk surrounding NAFTA has weighed on the loonie against the euro, stopping us out of our short EUR/CAD trade with a small profit. However, the valuation, positioning and technical dynamics suggest the timing is ripe to short this cross once again. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Rome Is Burning: Is It The End?", dated June 1, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "This Time Is NOT Different", dated May 25, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was stellar: NFIB Business Optimism Index climbed to 107.8, outperforming expectations; the price changes and good times to expand components are also very strong; Headline and core PPI both outperformed expectations, auguring well for future consumer inflation; Headline and core retail sales grew by 0.8% and 0.9% in monthly terms, beating expectations; Both initial and continuing jobless claims also came out below expectations, highlighting that the labor market is still tightening, and wage growth could pick up further. The Fed raised interest rates this week to 2%, and added one additional rate hike to its guidance for 2018. FOMC members once again highlighted the "symmetric" target, suggesting that the Fed expects the economy to overheat slightly. An outperforming U.S. economy relative to the rest of the world is likely to propel the greenback this year. Report Links: This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Economic data was largely disappointing: Italian industrial output contracted by 1.2% on a monthly basis, and grew only by 1.9% on a yearly basis; The German ZEW Survey declined substantially across all metrics; European industrial production increased by 1.7% annually, less than the expected 2.8% increase; However, Spanish headline inflation spiked up from 1.1% to 2.1%. Yesterday, ECB President Mario Draghi announced the ECB's plan to taper asset purchases to EUR 15 bn a month in September, and phase them out completely by year-end. Moreover, Draghi highlighted that the ECB was not anticipating to implement its first hike until after the summer of 2019. Furthermore, the ECB President highlighted the current slowdown in global growth, as well as the rising protectionist risk from the U.S. potentially negatively impacting the European economy and the ECB's decisions going forward, suggesting that the plans are not set in stone. 2018 is likely to remain a volatile year for the euro. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Japanese data has been strong this week: Machine orders increased on a 9.6% annual basis, and a 10.1% monthly basis, in April, outperforming expectations by a large margin; The Domestic Corporate Goods Price Index also increased by 2.7% annually, higher than the expected 2.2% increase. As political and economic risks in Europe and South America having subsided for now, the yen has lost some of its glitter. However, with ongoing uncertainty on trade and populism across the globe, we maintain our tactically bullish stance on the yen, especially against commodity currencies and the euro. However, beyond the short-term horizon, the BoJ will remain determined to cap any excess appreciation in the yen, as a strong JPY tightens Japanese financial conditions, weighing on the BoJ's ability to hit its inflation target. This will ultimately limit the yen's upside on a cyclical basis. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Data from the U.K. was somewhat disappointing: Manufacturing and industrial production both increased less than expected, at 1.4% and 1.8%, respectively; The goods trade deficit widened to GBP 14.03bn from GBP 12bn, and the overall trade deficit widened to GBP 5.28bn from GBP 3.22bn; Average earnings grew by 2.8%, less than the expected 2.9%; However, headline inflation came in at 2.4%, less than the expected 2.5%, while retail price inflation also underperformed expectations. This means that the uptrend in real wages continues. Given the limited movement in the pound, it seems that a lot of the bad news was already priced in by last month's depreciation. However, Theresa May's ongoing blunders in parliament represent a continued source of risk for the pound. While the GBP has downside against the EUR, it is unlikely to see much upside against the greenback. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Do Not Get Flat-Footed By Politics - March 30, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was weak: NAB Business Confidence and Conditions surveys both declined, also underperforming expectations; Australian employment grew by 12,000, less than expected. Moreover, full-time employment contracted. While the unemployment rate dropped as a result, this was largely due to a fall in the participation rate. RBA's Governor Lowe, in a speech on Wednesday, announced that any increase in interest rates "still looks some time away" as the slack in the labor market does not seem to be diminishing. Annual wage growth has been constant at 2.1% for the past three quarters, and did not pick up despite an improvement in full-time employment earlier this year. We remain bearish on the AUD. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The NZD is likely to face significant downside against the greenback along with the other commodity currencies as global growth slows down. However, due to its weaker linkages to Chinese industrial demand, the kiwi is likely to see less downside than the AUD. Nevertheless, it is likely to weaken against the CAD and the NOK as the NZD is expensive against these oil currencies, and oil's is likely to continue to outperform other commodities will support this view. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 USD/CAD has been on an uptrend given the greenback generally strong performance since February year, a force magnified by the volatile rhetoric surrounding NAFTA negotiations. However, the Canadian economy has been accelerating this year, thanks to robust growth in the U.S., to a strong Quebecer economy, and to a pickup in Alberta. In addition, the Canadian labor market is tightening further and wage growth is above 3%. Furthermore, risks surrounding NAFTA seem already reflected in the CAD's behavior and valuation. There is more clarity on the CAD versus its crosses than on the CAD versus the USD. Outperforming U.S. and Canadian growth relative to the rest of the world mean that the CAD should outperform most other G10 currencies. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data out of Switzerland was decent: Industrial production increased by 9% in annual terms, albeit less than the previous 19.6% growth; Producer and import prices increased by 3.2% year on year, in line with expectations, however the monthly increase underperformed markets anticipations. With global trade tensions rising, and Germany having entered President Trump's line of sight, the CHF could experience additional upside against the euro in the coming months. However, the SNB is unlikely to deviate from its ultra-accommodative stance, which means that any downside in EUR/CHF will proved to be short lived. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Both headline and core inflation underperformed, coming in at 2.3% and 1.2%, respectively. However, the Regional Network Survey hinted at a pickup in capacity utilization as expectations for industrial output remained robust, as well as at an additional strength in employment. This led to a forecast of a resurgence in inflationary pressures. We expect the NOK to outperform the EUR. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish inflation rose from 1.7% to 1.9%, coming in line with expectations. Additionally, Prospera 1-year inflation expectations survey rose to 1.9% from 1.8% in the March survey. This is likely to provide the Riksbank with reasons to turn gradually more hawkish, which should support the very cheap krona. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights The chaotic conclusion to last weekend's G7 summit in Charlevoix is a reminder that the specter of trade wars will not fade quietly into the night. A trade war would hurt the U.S., but would punish the rest of the world even more. The U.S. dollar typically strengthens when global trade slows. Despite President Trump's antics, the dollar is at little risk of losing its status as the world's premier reserve currency. Fiscal stimulus should keep U.S. growth above trend well into next year, allowing the Fed to maintain its once-per-quarter pace of rate hikes. We are currently overweight global equities, but we expect to shift to neutral before the end of the year. Feature Hit First, Ask Questions Later Donald's Trump's negotiating style - hit as hard as you can and then compromise - has worked well in dealing with tin-pot dictators, at least judging by the apparent outcome of this week's Singapore summit with Kim Jong-Un. It has also worked well throughout Trump's career as a real estate developer. However, as the breakdown of last weekend's G7 summit demonstrates, it is not clear if it is a winning strategy in the realm of international trade. Down-on-their-luck creditors may be willing to settle for twenty cents on the dollar when they had been promised one hundred, but governments have their citizens to answer to, and national pride often trumps (ahem) narrow financial interests in such matters. How Not To Fight A Trade War The U.S. is a fairly closed economy and hence a trade war probably would not have severe effects on growth. However, the way Trump is waging his war ensures that whatever impact it has on the domestic economy will be negative. This is not only because Trump's tariffs are certain to invite retaliation; it is also because Trump is targeting intermediate goods - goods that are used as inputs into production of final goods - for tariffs. Chart 1Rising Productivity In The Steel Sector ##br##Caused Employment To Decline Consider the case of steel. Today, the U.S. steel industry employs just 145,000 workers, down from 203,000 workers in 2000. In contrast, there are about two million workers employed in steel-consuming sectors of the economy.1 A reasonable rule-of-thumb from the international trade literature is that a one-percent increase in foreign prices causes domestic prices to rise by about half a percent. This is mainly because domestic producers end up capturing some of the gains from tariffs through higher profit margins. A 25% increase in steel tariffs would thus raise steel prices by around 12.5%. Higher steel prices will lead to higher prices for many American goods such as automobiles, some of which are exported abroad. It is actually quite conceivable that steel tariffs would reduce exports more than they would depress imports, leading to a wider trade deficit. Ironically, foreign competition probably explains only a small fraction of the decline in U.S. steel employment. The U.S. produces roughly as much steel now as it did in 2000 (Chart 1). What has changed is that output-per-worker in the steel industry has increased by a total of 43% since then. Blame technological progress, not trade. Trade Wars, The Fed, And The Dollar Chart 2The Dollar Tends To Strengthen ##br##When Global Trade Deteriorates Even if higher tariffs did produce a one-off increase in consumer and producer prices, slower GDP growth would likely prompt the Fed to moderate the pace of rate hikes. If the stock market declined in sympathy with slower growth and rising protectionist sentiment, the resulting tightening in financial conditions would further justify a go-slow approach to monetary normalization. All things equal, a more dovish-than-expected Fed would likely translate into a weaker dollar. All things are not equal, however. A trade war would probably hurt the rest of the world more than the U.S. This is partly because the rest of the world is more open to trade, but it is also because the rest of the world runs a trade surplus with the U.S., which makes it more vulnerable to a broad-based decline in trade volumes. Chart 2 shows that the dollar tends to strengthen when global trade is weakening. Reserve Currency Status In Jeopardy? An often-heard counterargument to the "protectionism is good for the dollar" view is that at some point, rising trade tensions could undermine the dollar's standing as the world's premier reserve currency. The U.S. has run a trade deficit almost continuously for 40 years, accumulating 40% of GDP in net liabilities to the rest of the world in the process (Chart 3). If foreign buyers decide to scale back their purchases of U.S. assets, the dollar could swoon. Chart 3U.S. External Deficit: 40 Years And Counting Trump's statement at the conclusion of the G7 summit that "We're like a piggy bank that everybody's robbing" seems to imply that he thinks that foreigners are living beyond their means by draining the U.S. of its wealth. The opposite is actually the case: The U.S. has been able to spend more than it earns for decades precisely because foreigners have been willing to deposit ever more money into the U.S. piggy bank. Fortunately for the greenback, America's status as the world's piggy bank of choice is unlikely to change any time soon. The euro area remains hopelessly divided. The Italian bond market - the biggest in Europe - has once again become the object of investor angst. Japan is drowning in a sea of government debt, with debt monetization probably the only viable solution. China would like to transform the renminbi into a global reserve currency, but opacity in government decision-making, and a still largely closed capital account, will limit any progress towards that goal for some time to come. China and other countries could try to "punish" the U.S. government by buying fewer Treasury bonds, but where would that get them? The average maturity of U.S. government debt is less than six years. The Fed, not China, largely sets rates at that portion of the yield curve. Granted, a decline in Treasury purchases would reduce the demand for dollars. However, that would just put upward pressure on the value of the renminbi. China does not want a stronger currency. For all the talk about how America's rivals are keen to reduce their dollar holdings, their share of global central bank reserves has actually climbed over the past two decades, largely because they have been gobbling up dollars to keep their own currencies from appreciating (Chart 4). Today, nearly two-thirds of global currency reserves are denominated in dollars, a higher proportion than when the Berlin Wall fell in 1989 (Chart 5). Chart 4Geopolitics Is Not Driving Demand For Treasurys Chart 5The Dollar Remains The Preferred Reserve Currency A Not So Exorbitant Privilege Chart 6The U.S. Term Premium Is ##br##Higher Than Elsewhere In any case, it's not clear how much the U.S. benefits from having a reserve currency. There is little evidence that U.S. long-term bond yields are lower than they would otherwise be because of foreign reserve accumulation. Chart 6 shows that the term premium - the difference between the yield on a long-term bond and the market's expectation of the average level of short-term rates over the life of the bond - is higher in the U.S. than in the rest of the world. If foreign central bank purchases were pushing down U.S. bond yields, one would expect to see the reverse pattern. The only tangible benefit the United States gets from having a reserve currency is that the U.S. Treasury can issue currency to foreigners who hold it as a store of value rather than spending it. This amounts to an interest-free loan to the U.S. government. This so-called "seigniorage revenue" is not trivial: Last year, foreigners increased their holdings of U.S. currency by $60 billion.2 However, this is still less than one-third of one percent of U.S. GDP. What Really Explains Why The U.S. Has A Current Account Deficit? It is often argued that the dollar's reserve currency status has allowed the U.S. to run large current account deficits. However, Australia has run even bigger current account deficits than the U.S., and it does not have a reserve currency. What matters in the end is whether people trust you to pay back your debts, not whether you have a reserve currency. The rate of return that a country offers investors is also important. As we explained in our weekly report on April 6th, an often-overlooked reason for why the U.S. and Australia run current account deficits is that both countries enjoy faster trend growth than most of their peers.3 Faster growth tends to push up the neutral real rate of interest, otherwise known as r-star. A country with a relatively low neutral rate needs to have an "undervalued" currency that is expected to appreciate over time in order to compensate investors for the subpar yield that its bonds provide. As sketched out in Chart 7, this results in current account surpluses for countries with low neutral rates, and current account deficits for countries with high neutral rates. Chart 7Interest Rates And Current Account Balances Commentators who claim that the euro is cheap are barking up the wrong tree. The euro needs to be cheap to entice investors into holding low-yielding German bunds and other safe-haven euro area bond markets. Indeed, one could argue that the euro is not cheap enough. Thirty-year U.S. Treasurys currently yield 3.07% while 30-year German bunds yield 1.16%, a difference of 191 basis points. Even if one allows for the fact that investors expect euro area inflation to be lower than in the U.S. over the next 30 years, EUR/USD would need to trade at a measly 84 cents today in order to compensate German bund holders for the inferior yield they will receive.4 The euro got a good clobbering yesterday following the release of the ECB's post-meeting statement, which established a timeline for ending asset purchases by the end of this year but promised no rate hikes for at least another 12 months. We continue to expect EUR/USD to hit 1.15, with a high likelihood that it goes even lower. Lessons From The Nixon Shock We are skeptical of the argument that threatening to raise tariffs is an effective tool for talking down one's currency. It is true that the Nixon Administration imposed an across-the-board 10% tariff in August 1971, which succeeded in forcing America's trading partners to revalue their currencies within the quasi-fixed exchange-rate Bretton Woods system that prevailed at that time. Such an arrangement would be difficult to orchestrate today. For one thing, the U.S. does not have the geopolitical sway that it once did. Moreover, when exchange rates are pegged, one can often revalue a currency to the upside while cutting interest rates (if investors expect a series of revaluations, they would be willing to hold government bonds even if they yielded less than those abroad). In today's world of flexible exchange rates, a country would need to be willing to tighten monetary policy to drive up its currency. Thus, it would get hit on two fronts: From a stronger currency and from higher interest rates. This additional cost to the economy lowers the odds that any country would voluntarily undertake such measures in the hope (probably futile anyway) of placating Trump. In any case, most of the dollar's weakness in the 1970s occurred after the December 1971 Smithsonian Agreement reversed Nixon's tariff hike. What followed was a period of trade liberalization on the back of successive GATT negotiation rounds. U.S. tariffs actually fell more in the 1970s than in the prior two decades (Chart 8). The fact that the dollar weakened during that period had more to do with the Fed, which permitted inflation to get out of hand by allowing real rates to remain in chronically negative territory. The dollar also suffered from the surge in oil prices, which produced a 35% deterioration in the U.S. terms of trade over the course of the decade (Chart 9). Chart 8Two Centuries Of U.S. Tarriffs Chart 9Dollar Weakness In the 1970s: Blame Deteriorating Terms Of Trade And A Dovish Fed It is possible that the Fed will repeat the mistakes of the 1970s, but this is more of a risk for the 2020s than a near-term concern. U.S. real yields have actually risen substantially relative to those abroad since last September (Chart 10). Chart 10The Dollar Is Once Again Responding ##br##To Real Rate Differentials The outcome of this week's FOMC meeting was on the hawkish side. The median number of dots in the newly released Summary of Economic Projections now point to four rate hikes this year, up from three hikes in the March projections. In addition, the Fed increased estimates for both growth and core inflation for this year. The decision to hold press conferences following every FOMC meeting will also give the Fed greater scope to expedite the pace of rate hikes. Investment Conclusions After panicking over every Trump tweet promising more protectionism earlier this year, markets have taken the recent news of escalating trade tensions in stride. Investors presumably think that Trump will water down his rhetoric, as he has periodically done over the past few months. Such a benign outcome is entirely possible. Trump left a fig leaf at the G7 summit in the form of a challenge to other members to eliminate their tariffs in exchange for the U.S. doing the same. Reaching such a deal would not be easy, but incremental progress towards this goal could be achieved. The overall level of tariff barriers within developed countries is already quite low. The U.S. actually stands at the top end of the spectrum -- average U.S. tariffs of 1.6% are double that of Canada, for example -- so the rest of the G7 would be wise to call Trump's bluff and agree to talks to further scale back trade barriers (Chart 11). This could give risk assets some breathing space for the next year or so. Yet, such a rosy outcome is far from guaranteed. Protectionism is popular among American voters, especially among Trump's base (Chart 12). Trump's obsession with the level of the stock market was a constraint on his protectionist rhetoric, but now that investors are content to look the other way, that constraint has loosened. Chart 11Tariffs: Who Is Robbing The U.S.? Chart 12Free Trade Is Not In Vogue In The U.S., And Is ##br##Especially Disliked Among Trump Supporters The fact that Trump's macroeconomic policies are completely at odds with his trade agenda does not help matters. Fiscal stimulus will boost aggregate demand, which will suck in more imports. An overheated economy will prompt the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. All this will result in a wider trade deficit. What will Trump tell voters two years from now when he is campaigning in Michigan and Ohio about why the trade deficit has widened rather than narrowed under his watch? Will he blame himself or America's trading partners? No trophy for getting that answer right. The effect of a trade war on the stock market would be grave. Multinational firms have large footprints abroad, the result of decades of investment in global supply chains. Equities represent a claim on the existing capital stock, not the capital stock that might emerge after a trade war has been fought. A trade war would result in a lot of stranded capital, forcing investors to mark down the value of the companies in their portfolios. In light of these risks, we expect to downgrade our recommendation on global equities from overweight to neutral before the end of the year. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Lydia Cox and Kadee Russ, "Will Steel Tariffs put U.S. Jobs at Risk?," EconoFact, February 26, 2018. Steel-consuming industries are defined as those that devote more than 5% of their total costs to steel. 2 Considering that 80% of U.S. currency in circulation consists of $100 bills, it is safe to say that much of this overseas stash of cash belongs to those who acquired it through ill-gotten means. 3 Please see Global Investment Strategy Weekly Report, "U.S.-China Trade Spat: Is R-Star To Blame?," dated April 6, 2018, available at gis.bcaresearch.com. 4 For this calculation, we assume that the fair value for EUR/USD is 1.32, which is close to the IMF's Purchasing Power Parity (PPP) estimate. The annual inflation differential of 0.4% is based on 30-year CPI swaps. This implies that the fair value for EUR/USD will rise to 1.49 after 30 years. If one assumes that the euro reaches that level by then, the common currency would need to trade at 1.49/(1.0191)^30=0.84 today. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The following four investment themes are likely to play out over the next couple of years: The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. The 10% undervaluation of the trade-weighted euro - as assessed by the ECB itself - will eventually correct. As the euro area's structural over-competitiveness gradually adjusts, euro area sectors that are domestically-oriented, like travel and leisure, will structurally outperform those that are export-oriented, like autos. Swedish real estate and Swedish real estate equities, which are both very richly valued, will underperform. Feature What connects last Sunday's dysfunctional G7 Summit with this week's ECB policy meeting? The answer is the euro area's €450 billion export surplus. Specifically, the €300 billion export surplus in Germany which equals 8% of its GDP - an export surplus that is squarely in President Trump's cross-hairs (Chart of the Week). Chart of the WeekECB Policy Has Driven Up Germany's Export Surplus The interesting thing is that the euro area hasn't always run an export surplus. Before 2012, the euro area's trade with the rest of the world was more or less in balance. Even Germany's export surplus was half of its current size. To put it in Trumpian terms, fewer Mercedes were "rolling down New York's Fifth Avenue." What caused the imbalance to surge in recent years? Was it punitive tariffs or restrictive trade practices in Germany? No, the answer is much simpler than that. ECB Policy Has Driven Up Germany's Export Surplus The export surplus in the euro area and in Germany is just a mirror-image of the euro exchange rate (Chart I-2). As the euro became undervalued, it made euro area exports more competitive and foreign imports into the euro area less competitive. This assessment of euro area over-competitiveness comes straight from the horse's mouth. The ECB's own indicators show that the euro area remains over-competitive by around 10%, meaning the euro is still undervalued by about 10%.1 In turn, the euro's substantial undervaluation is a near perfect function of the yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts (Chart I-3). It follows that the ultimate cause of the euro area's glaring imbalance is ECB policy itself - specifically, the extreme experiment with bond buying and negative interest rates. Chart I-2ECB Policy Has Driven Up The ##br##Euro Area's Export Surplus Chart I-3The ECB's Expansive Monetary Policy Is ##br##Responsible For The Euro's Undervaluation As Germany's former Finance Minister, Wolfgang Schäuble, explained: "When ECB chief Mario Draghi embarked on the expansive monetary policy, I told him he would drive up Germany's export surplus... I promised then not to publicly criticise this policy. But then I don't want to be criticised for the consequences of this policy." The ECB counters that it targets neither the euro exchange rate nor the trade balance; it sets policy to achieve its mandate for price stability. It argues that it is further from its mandate for price stability compared with the Federal Reserve because, ostensibly, the euro area is at a different point in the economic cycle compared with the U.S. This requires the ECB to set an ultra-accommodative policy compared with other central banks. The undervalued euro and trade surplus are the unavoidable spill-overs of this relative monetary policy. ECB Spill-Overs Felt Far And Wide However, one important reason that euro area inflation is underperforming U.S. inflation has nothing to do with the economic cycle. Rather, it is because the official measures of inflation in the euro area and the U.S. are defined differently (Chart I-4 and Chart I-5). The euro area's Harmonized Index of Consumer Prices (HICP) omits the consumption costs of owner-occupied housing, whereas the U.S. consumer price basket includes them at a very substantial 25% weight. Homeowners will testify that the cost of maintaining their homes constitutes one of their largest expenses, and that these costs tend to rise faster than other prices. Using the U.S. as a guide, we estimate that a euro area inflation measure that correctly included home maintenance costs would be running higher than HICP inflation by an average of 0.5 percentage points a year (Chart I-6). Chart I-4Euro Area Inflation##br## Is Underperforming... Chart I-5...Because Euro Area Inflation Omits ##br##Owner-Occupied Housing Costs Chart I-6Including Owner-Occupied Housing ##br##Costs Adds 0.5% To Inflation Just because the statisticians do not measure owner-occupied housing costs in the euro area HICP, it doesn't mean that homeowners do not feel these costs. In Germany, measured inflation is now running at 2.3%, so the true inflation that households feel is running closer to 3%. Meanwhile, interest rates on savings accounts are stuck near zero, which means that German savers are seeing the real value of their savings erode by 3% every year. As Der Spiegel magazine put it to ECB Chief Economist, Peter Praet: "Can you understand why so many Germans regard the ECB as the greatest threat to their personal wealth?" Spill-overs from the ECB's ultra-accommodative policy have also been felt across the Baltic Sea. The Riksbank and the Norges Bank have had to shadow the ECB to prevent a sharp appreciation of their currencies versus the euro. The trouble is that ultra-low and negative interest rates have been absurdly inappropriate for the booming Scandinavian economies. So ECB policy may have generated spill-over housing bubbles in Sweden and Norway (Chart I-7 and Chart I-8). Chart I-7ECB Spill-Overs Felt In Scandinavia Chart I-8Scandinavian Real Estate Appears Richly Valued Hence, a seemingly innocuous 'definitional' difference between the consumer price baskets in the euro area vis-à-vis the U.S. explains: the bulk of the shortfall in euro area inflation; the ECB's justification for ultra-accommodation; the undervalued euro; the euro area's €450 billion trade surplus; deeply negative real interest rates in Germany; and putative housing bubbles in Sweden and Norway. The main argument we hear in the ECB's defence is that the central bank is at the mercy of its treaty. If the treaty demands ultra-accommodation then the ECB must deliver it. But this argument is wrong. The ECB treaty only asks that the central bank delivers "price stability", leaving the ECB with substantial flexibility in how it precisely defines price stability. With this in mind, the ECB - and other central banks - should use this definitional flexibility to minimize differences with other central banks. Because in a world of integrated capital markets, the spill-overs from seemingly innocuous definitional differences are felt far and wide, resulting in political backlashes and economic imbalances. Imbalances Must Correct In The Long Run Ultimately though, economic imbalances must correct, and the corrective mechanism is economic, financial, or political feedback loops, or some combination of these. On this basis, we reiterate four investment themes that are likely to play out over the next couple of years: The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. The 10% undervaluation of the trade-weighted euro - as assessed by the ECB itself - will eventually correct. As the euro area's structural over-competitiveness gradually adjusts, euro area sectors that are domestically-oriented, like travel and leisure, will structurally outperform those that are export-oriented, like autos (Chart I-9). Chart I-9As The Euro's Undervaluation Corrects, It Will Help Euro Area Domestics And Hurt Exporters Swedish real estate and Swedish real estate equities, which are both very richly valued, will underperform. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see https://www.ecb.europa.eu/stats/balance_of_payments_and_external/hci/html/index.en.html The ECB uses three metrics to assess the euro area's competitiveness versus its major trading partners: GDP deflators, CPIs, and unit labour costs. The average of the three metrics suggests that the euro is undervalued by around 10%.The assessment of euro undervaluation assumes that the major euro area economies entered the monetary union at a broadly correct level of competitiveness against each other and against their other major trading partners. This assumption seems valid, given that the net external position of these economies were all in equilibrium at the onset of monetary union. Fractal Trading Model We are pleased to report that our long SEK/GBP currency position hit its profit target of 3% and is now closed. This week we note that the relative performance of two classically cyclical sectors, oil and gas versus financials, is technically stretched and at a 65-day fractal dimension which has accurately predicted the last two major reversals. Hence, our recommended trade is short euro area oil and gas versus euro area financials. Set a profit target of 6% with a symmetric stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations