Canada
Highlights The euro doesn't have the key attributes of a funding or a risk-off currency. This means its behavior is not fixed. While in the past it has behaved as a risk-off currency, this year it has traded as a risk-on one, correlating with key risky assets. The current episode of market volatility will not help the euro. CAD/SEK will benefit if asset-market volatility continues. A global growth deceleration helps the CAD outperform the SEK, especially as this cross trades at a discount to rate differentials. Feature As markets have begun selling off, the euro has once again become well bid. Does this reaction makes sense, or is it a move that should be faded? We are inclined to look the other way, as it is highly unlikely that the euro will benefit from market weakness this time around. The Chameleon Currency Is the euro a risk-off or risk-on currency? We believe it is neither, and that its behavior evolves over time. The reason for this is that the euro is not underpinned by one of the key attributes that offer currencies like the Swiss franc or the yen their strong defensive characteristic: a large positive net international position (NIIP). While Switzerland or Japan have NIIPs in excess of 130% of GDP and 62% of GDP, respectively, the euro area owes the equivalent of 3% of GDP more to the rest of the world than the rest of world owes the Eurozone. This means the euro does not benefit from its investors repatriating funds at home when market turbulences emerge. In other words, unlike Japan or Switzerland, local investors' home bias does not come to the euro's rescue when markets vacillate. Moreover, unlike the USD, the euro is not the key reserve currency global investors seek when turmoil grips the market. The euro represents 20% of allocated global reserves, while the USD still garners 64% of these reserves. Rightly or wrongly, investors do not yet feel that the euro area has the permanence of the U.S., nor that it possesses the military might and the same capacity to control global sea lanes that the U.S. currently enjoys. Lacking these attributes, the euro is a bit of a chameleon. When investors are negative on the outlook for the European economy, the euro is used as a funding currency for carry trades. However, sometimes it is used as the vehicle to bet on a weaker dollar or an improving global economy. These two last bets are often one and the same, as the greenback remains a countercyclical currency, enjoying strength when the global economy weakens (Chart I-1). This is because the U.S. is low-beta economy as it is much less exposed to the vagaries of EM growth - a key source of variation in the global economy and the global industrial cycle - than the euro area is (Chart I-2). This is the case as the manufacturing sector is a much lower contributor to U.S. growth than to the euro area. Chart 1The Dollar Is Countercyclical Chart I-2The U.S. Is A Low-Beta Economy This time around, the euro seems to have been used to bet on stronger global growth and a weaker dollar. This makes sense. There is no doubt that the European economic upswing is based on domestic dynamics, but foreign factors have supercharged the European recovery this year. As Chart I-3 illustrates, French exports to Germany and China have tracked the Chinese Keqiang index - a key measure of Chinese industrial activity. More interestingly, French exports to Germany and China have been correlated with Chinese monetary conditions, suggesting China's economic rebound has filtered through a wide swath of the euro area. The action of the euro only agrees with the macroeconomic observations made above. The euro and copper - a key beneficiary of Chinese reflation - have both been moving together through most of 2017 (Chart I-4). The same holds true for EM stocks. As Chart I-5 shows, the euro has tracked the performance of EM equities relative to U.S. ones since August 2015. Both these observations make sense. A stronger China should benefit EM economies more than it benefits the U.S. A stronger China should help copper as it consumes three times as much of the red metal as the U.S., the euro area, and Japan combined. And stronger EM help Europe more than they help the U.S. Chart I-3The Positive Influence Of China Chart I-4EUR/USD Moves With Copper Chart I-5EUR/USD And EM Relative Performance Yet, as we highlighted last week, cracks are emerging in the global economy that should prove particularly painful for EM economies and EM assets.1 Behind some of these weaknesses lies China itself. After having eased fiscal and monetary conditions through most of 2015 and all of 2016, Chinese authorities are using elevated core CPI and producer price readings to reverse course. Aggregate fiscal spending is slowing massively - pointing to a negative fiscal impulse - and broad money supply is growing at its slowest pace ever (Chart I-6). The tightening in monetary conditions is bearing fruit. Chinese industrial production and retail sales disappointed this month, and the Chinese surprise index has now dipped into negative territory (Chart I-7). The boost to global growth, and EM growth especially, that was caused by Chinese imports lifted by domestic investment is now receding. Chart I-6China: Aggregate Fiscal Spending Growth##br## Is Also Weak China: Broad Money Growth Is At ##br##Record Low Chinese Policy Tightening Chart I-7Chinese Surprises Have ##br## Turned Negative EM assets are not ready for this, as they are priced for perfection. EM assets, which have traded in line with U.S. high-yield bond prices since 2008, are now very expensive relative to this already expensive asset (Chart I-8). A slowdown in Chinese and EM growth is likely to represent a substantially negative shock for EM equities, especially as the slowdown in EM M1 to 9.3% already portends a contraction in EM profit growth. The breakdown in U.S. and EM high-yield bond prices could easily catalyze these risks. Copper, too, is vulnerable. With an almost insatiable love for the red metal, investors are not positioned for a reversal of its bull market (Chart I-9). However, China already has near record-high inventories of copper; slowing public spending and money growth suggest that the construction industry is likely to decelerate, limiting China's intake over the next few quarters. A negative surprise is likely to come. Chart I-8EM Stocks Offer No Protection##br## Against A Slowdown Chart I-9Too Much Love For Copper Equals ##br##High Risk Of Disappointment Falling copper prices and underperforming EM equity prices will thus drive the euro lower, as they will be key symptoms of the waning of a crucial euro support. Moreover, the euro is now overbought, and as we have highlighted before, over-owned (Chart I-10). This picture alone should support the notion that the euro is unlikely to benefit from a short squeeze as global risk aversion rises. How could it? After all, investors did not sell the euro to fund carry trades when global growth was rising and global volatility was falling. They were buying it along with carry trades. Maybe the euro was buoyed by strong GDP prints out of Europe this week, with Germany growing at a 3.2% pace on an annualized basis in the third quarter, faster than the U.S. If this response of the euro were to be durable, it should be associated with a commensurate move in interest rate differentials. Neither the gap in 5-year risk-free rates or 1-year forward, 1-year risk free rates between Europe and the U.S. have moved in favor of the euro in the wake of the release (Chart I-11). However, in the face of the existing gap between the euro and interest rate differentials, to stay stable, the euro will need an increase in the pace of positive surprises relative to the U.S. over the coming months - something that is unlikely to materialize as European financial conditions have greatly tightened relative to the U.S. Chart I-10The Euro Has Not Been Used##br## To Fund Carry Trades Chart I-11If Growth Was The Current Driver, The Euro And ##br##Rate Differentials Would Be Moving Together Instead, we believe that worries regarding the U.S. tax plan may be playing a role in the euro's strength. Investors are worried of a repeat about the Obamacare repeal debacle. Now that Senators Cruz, Rand and Cotton want to add a provision to the tax bill that would eliminate Obamacare's individual mandates, investors worry that Senators McCain, Murkowski and Collins will down the bill. This is a valid concern, but we should not forget that this is only U.S. legal process, and that reconciliation of the House version and the Senate version of the bill will need to take place before it is finalized, suggesting the final bill proposed could be very different from the version currently being discussed. Bottom Line: The euro is unlikely to benefit from a risk-off environment if the current selloff in EM and high-yield bonds continues. The euro area's net international investment position is too small to suggest that fund repatriation by local investors will result in the euro being bid. In fact, the euro has rallied on a similar impulse that pushed EM assets and copper higher: Stronger global growth and Chinese stimulus. Thus, now that the euro is over-owned and overbought, any tightening in EM financial conditions is likely to hurt it as well. Long CAD/SEK: The Rationale Last week, we opened a long CAD/SEK trade. The rationale for this position is rather straightforward. To start, the SEK is a more pro-cyclical currency than the CAD. Our Global Growth Indicator has rolled over and, if history is any guide, when this global growth gauge weakens, this leads to a period of depreciation for the stokkie relative to the loonie (Chart I-12). Stefan Ingves's renewed leadership of the Riksbank makes this risk even more salient. Throughout his tenure, Governor Ingves has emphasized that the Swedish central bank would fight imported deflation. Weakening global growth should result in some deflationary forces in Sweden, even if the domestic economy is experiencing growing resource utilization pressures. Ingves will counterbalance these dynamics by keeping the SEK down. Also, over the past 10 years, when U.S. two-year rates have been rising relative to euro area short rates, CAD/SEK has appreciated (Chart I-13). This is simply because the Canadian economy is tied to the U.S., while Sweden's is tied to the euro area. Thus when U.S. rates rise, this tends to let the Bank of Canada hike as well without putting undue pressure on CAD/USD. The same relationship is true between Swedish and European rates. As such, the current upward bias in U.S. relative to euro area rates is creating an upward drift on Canadian relative to Swedish rates. Chart I-12Growth Rolling Over Leads ##br##To A Stronger CAD/SEK Chart I-13When The Fed Tightens Versus ##br##The ECB, CAD/SEK Rises Some key domestic factors are also favoring the CAD over the SEK. Canadian real retail sales have spiked, growing a record three percentage points faster than Sweden's. Moreover, this development has occurred despite a surge in the Swedish credit impulse relative to that of Canada. The relative credit impulse is now slowly moving in favor of the Canadian economy. If this continues, since the Canadian consumer is already roaring, it will support Canadian aggregate demand relative to Sweden's. With Canadian wages set to pick up as labor shortages intensify, this could stoke additional wage and inflationary pressures (Chart I-14). The BoC is thus likely to continue to hike even if Ingves is hampered by the ECB and EM. Finally, CAD/SEK is trading at a 5% discount to our relative intermediate-term timing model (Chart I-15). This kind of a discount has historically been associated with tradeable rebounds in the loonie relative to the stokkie. We believe that a risk-off period in global capital markets is the likely catalyst required to realize the good value currently present in this cross. Chart I-14Canada Will Experience Rising Wages Chart I-15CAD/SEK Trading At A Discount to Rates This trade is obviously not devoid of risks. The most salient one remains the renegotiation of NAFTA. As Marko Papic, our Chief Geopolitical strategist argues in a Special Report, large swaths of the U.S. population are not in favor of free trade, and feel they have not gained much from globalization. Low social mobility, high income inequality, stagnant middle-class wages and growing difficulty to access debt have fueled this sentiment.2 Since U.S. President Donald Trump and not Congress is ultimately in charge of trade relations between the U.S. and the rest of the world, Trump has much leeway to please his electorate. He can therefore repudiate NAFTA. Such a development would hurt Canada. Exports to the U.S. represent 20% of Canada's GDP. A large share of these exports, especially in the auto sector, could fall under a new trade regime. This means that net exports might become a drag on Canadian growth, but it also means that a lot of capex that should have materialized in Canada will instead be realized in the U.S. This would boost USD/CAD. However, as excess investment in the U.S. is a positive for U.S. rates, it would also lift the USD against the EUR. Considering EUR/USD has a negative 67.3% correlation with CAD/SEK, this would limit the damage to our long CAD/SEK trade created by NAFTA renegotiations. Bottom Line: CAD/SEK should benefit as global growth and global risk assets hit a snag in the coming months. Moreover, the Canadian economy continues to experience growing inflationary pressures, while the Riksbank is likely to prove ultra-sensitive to any weakness in EM. With CAD/SEK trading on the cheap side, such a development is likely to result in a tactical upswing in this cross. The biggest risk to this position is related to an adverse ending to NAFTA renegotiations. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Temporary Short-Term Risks", dated November 10, 2017, available at fes.bcaresearch.com 2 Please see Geopolitical Strategy Special Report, titled "NAFTA - Populism Vs. Pluto-Populism", dated November 10, 2017, available at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was generally positive: PPI measures beat expectations, with the headline measure coming in at 2.8% and the core at 2.4%; Core CPI beat expectations, coming in at 1.8%, while headline inflation remained steady at 2%; Continuing jobless claims decreased to 1.86 million, however initial jobless claims increased to 249,000; Net long-term TIC flows increased to USD 80.9 bn, while total net TIC flows are negative at USD -51.3 bn; NFIB Business Optimum Index and the Philadelphia Fed Manufacturing Survey underperformed expectations, coming in at 103.8 and 22.7, respectively; There was, however, a generally bearish rhetoric for the USD this week due to perceived inability of President Trump's administration to push through tax reform. Nevertheless, stronger inflation should lift the dollar in the coming months. Report Links: It's Not My Cross To Bear - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Euro area data was generally positive: German GDP accelerated greatly, hitting an annual rate of 2.3%, although this was in line with expectations. However, the quarterly measure of 0.8% beat expectations of 0.6%; European GDP grew in line with expectations of 2.5% on an annual basis; Industrial production increased by 3.3%, beating expectations of 3.2%; CPI across the euro area stayed steady and in line with expectations, with core inflation slowing to 0.9%. Importantly, the euro area core CPI diffusion index is decelerating sharply; As expected, French unemployment increased to 9.7% from 9.5%. The euro experienced a strong week following the release of these data points. However, as we have iterated in the past, the appreciation in the euro has tightened financial conditions, which means that inflation is unlikely to increase much from current levels. Report Links: Temporary Short-Term Rates - November 10, 2017 Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data has surprised to the upside in Japan: Industrial production monthly growth was not as weak as expected, only weakening -1%. Meanwhile, yearly growth came in at 2.6%, an acceleration relative to last month. Gross domestic product annual growth also outperformed expectations, coming in at 1.4%. However it is worth to point out that growth slowed from a 2.6% reading last quarter. The yen has appreciated slightly this week, with USD/JPY rising by about 0.4%. Overall we continue to bearish on the yen against the dollar, given that interest rate differentials will continue to be the main determinants of this cross. On the other hand we are more bullish on the yen against commodity currencies like the NZD, given that we expect a temporary growth downshift is likely to cause commodity and EM plays to experience some downside. Report Links: Temporary Short-Term Rates - November 10, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Consumer price inflation underperformed expectations, coming at 3%. Core inflation also surprised to the downside, coming in at 2.7%. However average hourly earnings surprised to the upside, coming in at 2.2%. It is important to note however, that this is a slowdown from last month's number of 2.3%. Moreover, retail sales growth outperformed expectations coming in at -0.3%. Nevertheless, this measure drop sharply from last month's reading of 1.3%. Overall, the GBP/USD has stayed relatively flat this week, while it has depreciated by about 1% against the euro. We believe that the upside for the pound against the dollar from here on is limited, as the BoE has very little incentive to hike any more than what is priced into the SONIA curve given that inflation seems to be stabilizing. Report Links: Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD has suffered this week following a slew of mixed data: NAB Business Conditions improved to 21 from 14, but Business Confidence remained steady at 8; Westpac Consumer Confidence was negative at -1.7%; Wage growth remains depressed at 2% annually and 0.5% quarterly, underperforming the expected 2.2% and 0.7%, respectively; Melbourne Institute's Consumer Inflation Expectations declined to 3.7% from 4.3% in November; The participation rate dropped 10 bps to 65.1% and employment grew by only 3,700, below the expected 17,500. However, this was because the decline in part-time employment of 20,700 was offset by the increase in full-time employment of 24,300. While there were some positive developments in the labor market, wages remain depressed, pointing to ongoing underemployment within the economy. This is likely to leave the RBA to stay cautious. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The New Zealand dollar has depreciated by almost 2% this week, as commodities and junk bonds have plunged. We continue to be bearish on this currency against both the dollar and then yen, as we expect a further deterioration in EM financial conditions. This is mainly due to 2 factors: First, monetary tightening in China should cause a worsening in financial conditions, which will weigh on growth and commodity producers. Moreover, market-based expectations of U.S. interest rates could experience some upside as U.S. inflation is slated to pick up. This will put upward pressure on the U.S. dollar, and thus, weigh on commodity prices. Nevertheless, we continue to be bullish on the NZD relatively to the AUD, as the Australian economy is much more sensitive to the dynamics described above. Report Links: Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data has been positive: Manufacturing shipments increased by 0.5% on a monthly basis, beating expectations of -0.3% but they were weaker than the previous release of 1.6%; Foreign portfolio investment in Canadian securities increased to CAD 16.81 bn, above the expected CAD 10.68 bn and also beating the previous figure of CAD 9.77 bn. However, oil weaknesses weighed on the CAD this week. Furthermore, a lack of Canadian data meant that USD/CAD traded mostly off positive U.S. data, which further handicapped the CAD. Report Links: Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The Swiss franc has continued to depreciate, with EUR/CHF surging by almost 1% this week. This cross is now roughly 2.5% away from the level at which it was when the Swiss National Bank took off its floor in early 2015. Overall we see very little indication that the SNB will let off their ultra-dovish monetary policy and currency intervention. Speaking with the government on Wednesday, the SNB's president Thomas Jordan said that the Franc is still "highly valued". Although there has been a slight improvement in price inflation and in economic activity, it still too tepid for central bankers to change policy significantly. Thus, the franc will continue to suffer downward pressure, due to FX market intervention. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Gross domestic product growth outperformed expectations, coming in at 0.7%. Moreover core inflation also surprised to the upside, coming in at 1.1%, and increasing from last month's reading of 1%. However headline inflation underperformed substantially, coming in at 1.2% and decreasing from last month's reading of 1.6%. The krone has depreciated slightly against the dollar, as USD/NOK has risen by almost 0.6% this week. In spite of our positive view on oil, we continue to be bullish on USD/NOK, given that this cross is more sensitive to interest rate differentials than it is to oil prices. The Norwegian economy is still plagued with plenty of slack, thus the spread between U.S. and Norwegian rates will continue to widen. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The SEK had a dismal week due to downbeat data: Inflation slowed greatly to 1.7% from 2.1%, even underperforming the expected slowdown of 1.8%. In monthly terms, it contracted by 0.1%; Capacity Utilization fell in Q3 to 0.2% from 0.5%, indicating slack in the economy; The unemployment rate also rose to 6.3%; EUR/SEK traded near 10.0000, appreciating to levels reached last October. These data points will certainly be taken into account by the Riksbank, and a dovish tilt has most likely been priced in by the market. Close EUR/SEK trade Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Jerome Powell takes the helm of the Federal Reserve at a time when both sides of the Fed's dual mandate are in conflict. The lagging nature of inflation explains why it has failed to rise even though the unemployment rate has fallen below NAIRU. U.S. growth should surprise on the upside over the coming quarters, with or without the passage of tax legislation. This should enable the Fed to raise rates four times by end-2018, which should give the dollar a boost. Higher oil prices will prop up the Canadian dollar. Brexit uncertainty will continue to weigh on the U.K. economy, but the pound has already priced in much of the bad news. Feature Chart 1The Dual Mandate Headache Jay Powell: You're Hired! Jerome Powell takes the helm of the Federal Reserve at a pivotal time. Under Janet Yellen's leadership, the Fed began running down its balance sheet. For all intents and purposes, that part of the normalization process has been put on autopilot. In contrast, the question of how much higher interest rates need to go remains up in the air. In normal times, the Fed would be guided by its dual mandate, which calls for maximum sustainable employment and low inflation. The Fed's predicament is that the two sides of this mandate are currently in conflict: While the unemployment rate has fallen more than the FOMC anticipated at the start of the year and is below the Fed's estimate of full employment, inflation has dipped further below the Fed's 2% target (Chart 1). Why Has Inflation Been So Low? There are four competing explanations for why inflation remains stubbornly low. The first is that the headline unemployment rate understates the true amount of labor market slack. There was considerable merit to this argument a few years ago, but it seems less plausible today. While some auxiliary measures of slack, such as involuntary part-time employment and the share of the working-age population that is out of the labor force but wants a job, are still elevated relative to pre-recession levels, others such as the job openings rate and household perceptions of job availability have reached levels consistent with an overheated economy (Table 1). Taken together, the U.S. labor market appears to be close to full employment. Table 1Comparing Current Labor Market Slack With Past Cycles The second explanation for why higher inflation has failed to materialize accepts the centrality of the unemployment rate as an accurate summary measure of labor market slack, but posits that NAIRU - the so-called Non-Accelerating Inflation Rate of Unemployment - is lower than widely believed. NAIRU cannot be observed directly, so in principal this argument could be true. That said, it is worth noting that official estimates of NAIRU are already well below their long-term average (Chart 2). While certain factors such as the aging of the workforce have reduced NAIRU - older people tend to change jobs less frequently, which reduces frictional unemployment - other factors have likely raised it. These include automation, globalization, and the opioid crisis, all of which have probably led to higher structural unemployment. The third explanation for why inflation has failed to rise in the face of falling unemployment is that the Phillips curve has broken down. Whether they realize it or not, people who make this argument are implicitly assuming that NAIRU no longer matters - that central banks can drive the unemployment rate down as far as they wish and not worry about runaway inflation. If true, this would seemingly revoke the law of supply and demand because it would imply that an economy can stay perpetually overheated without wages or prices ever having to rise. Alas, no such free lunch exists. Chart 3 shows that the relationship between wage growth and unemployment remains intact. The so-called "wage-Phillips curve" tends to steepen sharply once unemployment falls below 5%. The recent acceleration in average hourly wages, median weekly earnings, and the Employment Cost Index all suggest that we have reached the steep part of the Phillips curve (Chart 4). Chart 2NAIRU Estimates Are Historically Low Chart 3U.S. Economy Has Moved Into ##br##The 'Steep' Part Of The Phillips Curve Chart 4U.S. Wage Growth Is Accelerating Higher wage growth will push up real household disposable income, leading to more consumer spending. With the output gap now effectively closed, firms will find themselves running into more supply-side constraints, forcing them to raise prices. Just as in the past, "this time is different" explanations for why inflation will stay depressed, such as the overhyped "Amazon effect," will be proven wrong.1 This leads us to the fourth - and in our view, most cogent - explanation for why inflation has been low, which is that the Phillips curve has simply been dormant. History suggests that inflation is a highly lagging indicator (Chart 5). A variety of technical factors - ranging from a steep drop in cell phone data charges to a dip in prescription drug prices - have depressed inflation this year. As these wear off, inflation will slowly pick up. The recent increase in the ISM prices-paid component, along with producer price indices around the world, suggest that both domestic and external inflationary pressures are intensifying. Consistent with this, the NY Fed's "underlying inflation gauge" has reached an 11-year high of 2.8% (Chart 6). Chart 5Inflation Is A Lagging Indicator Chart 6Fed Sees Underlying Inflation Gathering Steam The Cost Of Waiting Admittedly, there is a lot of uncertainty about the degree to which inflation will accelerate over the next few years. With that in mind, many commentators have argued for a go-slow approach. "Wait to see the whites of inflation's eyes" as Larry Summers has colorfully stated. This perspective is not unreasonable, but we think most FOMC members will ultimately reject it. This is mainly because inflation is a highly lagging indicator. By the time it is obvious that inflation is getting out of hand, it is often too late to react. The unemployment rate is already half a percentage point below the Fed's estimate of NAIRU. If the labor market continues to firm up, the Fed will eventually have no choice but to tighten monetary policy by enough to bring the unemployment rate back up to NAIRU. This means that rates may have to rise above their neutral level for a considerable period of time. Such an outcome could lead to a significant re-rating of risk asset prices. It would also damage the economy. The U.S. has never avoided a recession in the post-war period whenever the three-month average level of the unemployment rate has risen by more than 0.3 percentage points (Chart 7). Chart 7What Goes Down Must Come Up? Already Behind The Curve The Fed has arguably already fallen behind the curve in normalizing monetary policy. As our models predicted, the easing in U.S. financial conditions earlier this year is helping to turbocharge growth (Chart 8). Real GDP rose by 3.0% in the third quarter. Growth would have been even higher had residential investment not fallen by 6% in the wake of the hurricanes. The Atlanta Fed's GDPNow model is pointing to growth of 4.5% in Q4. Chart 8U.S.: Easier Financial Conditions Are Boosting Growth Core capital goods orders are increasing at a solid pace. The Conference Board's index of consumer confidence rose to a 17-year high in October. Initial jobless claims have fallen to a four-decade low. Citi's economic surprise index has spiked into positive territory and Goldman's is nearing record highs (Chart 9). Given the recent acceleration in growth, the unemployment rate is likely to fall to 3.5% by the end of next year - well below the Fed's current end-2018 projection of 4.1%. If Congress delivers on its pledge to reduce corporate and personal income taxes, this would represent a further modest upward surprise to near-term growth prospects. Fiscal policy remains a wildcard. The "Tax Cut and Jobs Act" released by the House of Representatives yesterday seeks to reduce taxes by about $1.5 trillion over the next ten years, with two-thirds of that amount consisting of lower business taxes (Table 2). Negotiations with the Senate are likely to result in a scaling back of the magnitude of the cuts and a shifting of more of the benefits towards middle-class earners. Among other things, this probably means the proposed phase-out of the estate tax will be scrapped. Most empirical estimates suggest that the growth benefits from the legislation will be modest. Nevertheless, if taxes are cut early next year, as we think is likely, this will put a greater impetus for the Fed to raise rates. Chart 9U.S. Economy Surprising On The Upside Table 2U.S.: How Much Will The Tax Plan Cost? Aging Bull Stocks are likely to weather the impact of Fed hikes as long as rates are rising in an environment of stronger GDP growth. Chart 10 shows that equities tend to do well when the ISM manufacturing index is elevated. This leads us to think the cyclical bull market in stocks will continue for the next 12 months. Chart 10Stocks Fare Well When The ISM Is Strong Once inflation begins to rise in earnest in 2019, equities will buckle. Given that the United States accounts for over half of global stock market capitalization, a selloff in the U.S. will be quickly transmitted to the rest of the world. Short-term oriented investors should remain overweight global equities for now, but look to turn more defensive late next year. Long-term investors should consider paring back exposure already. U.S. Dollar: Stronger For Now, Weaker in 2019 Once the U.S. falls into a recession in late 2019 and the Fed starts cutting rates, the dollar will crumble. But until then, the odds are that the greenback strengthens. Our model suggests that the dollar is undervalued against the euro based on today's level of spreads (Chart 11). Hence, even if spreads remain unchanged, we would expect the dollar to strengthen somewhat. Keep in mind that 10-year German bunds yield nearly two percentage points less than U.S. Treasurys. The euro would have to strengthen to 1.42 against the dollar over the next ten years just to compensate for the lower interest rates that bunds offer. Granted, if spreads between Treasurys and bunds were to narrow significantly, the euro would appreciate. Such an outcome is probable in 2019, by which time investors will begin fretting about a looming U.S. recession and pricing in Fed rate cuts. However, it is not likely to occur over the next 12 months, given the prospect that U.S. growth will accelerate over this period. Chart 12 shows the market's expectation of where one-month OIS rates will be in the U.S. and euro area over the next ten years. The one-month transatlantic rate spread currently stands at 151 basis points and is expected to peak in February 2019 at 210 basis points. It then declines gradually, falling to 164 basis points in five years and 107 basis points in ten years. Chart 11Dollar Is Undervalued Based On Current Spreads Chart 12Rates Will Diverge More In 2018 Than Is Priced In Relative to current market expectations, the interest rate spread one-year out is likely to widen further over the coming months. The market is currently pricing in 54 basis points of Fed rate hikes between now and end-2018, well below the "dot" forecast of 100 basis points. For his part, Mario Draghi made it clear last week that the ECB's bond buying program will continue until September 2018, and that the central bank will not raise rates until "well past the horizon of our asset purchases." Chart 13The Euro Has Overshot Interest Rate Spreads There is less scope for spreads to widen if one looks at expected interest rates more than one year into the future. However, we don't see much room for spread compression in the near term, so long as U.S. growth continues to surprise on the upside. Long-term inflation expectations are about 55 basis points lower in the euro area than they are in the U.S. As such, the expected spread in real short-term rates ten years out stands at about 50 basis points (Chart 13). This is not much different from Laubach and Williams' estimate of the gap in the real neutral rate between the U.S. and the euro area. Moreover, as we noted two weeks ago, the actual gap in expected interest rates should be larger than what is implied by neutral rate estimates since unemployment is likely to be above NAIRU more often in the euro area than in the United States.2 On balance, we remain comfortable with our year-end target for EUR/USD of 1.15 and see further upside for the dollar against the euro in 2018. Bank Of Japan: Nowhere Near The Exit Door The yen should also continue to trade down against the greenback. Governor Kuroda dismissed speculation that the BoJ is considering dialing back monetary accommodation during his press conference following this week's Monetary Policy Meeting. The BoJ lowered its inflation outlook for both FY2017 and FY2018, but maintained its projection of reaching its 2% inflation target in FY2019. In perhaps a sign of the times, newly selected board member Goushi Kataoka cast a dissenting vote, arguing that monetary policy should be even more accommodative. Kataoka suggested that the BoJ consider extending its yield curve targeting regime to government bonds with maturities of up to 15 years. Currently, the government seeks to cap yields for maturities of up to ten years. As bond yields elsewhere in the world drift higher, JGBs will become increasingly unattractive. This will weigh on the yen. CAD: Fade The Recent Weakness The Canadian dollar has been on the back foot lately. Last week Governor Poloz mentioned that "a lot of things have to come together" for the Bank of Canada to raise rates in December. This week brought news that the economy shrank by 0.1% in August due to a decline in manufacturing output. The market has gone from fully pricing in a hike in December to only assigning a one-in-five chance that rates will rise. Worries that the Trump administration will pull out of NAFTA have also weighed on rate expectations. Still, one should keep things in perspective. Real GDP is up 3.5% year-over-year - well in excess of the BoC's estimate of trend growth - while the output gap has been fully closed. Canadian GDP growth has historically been closely correlated with U.S. growth, so it would be very surprising if Canada's economy were to flounder just as America's is gaining steam (Chart 14). Chart 14Canada Remains Linked To The U.S. Canadian And U.S. Growth Are Correlated Chart 15The Pound Is Cheap And while the risk of a NAFTA pullout is real, most of Trump's wrath has been focused on Mexico. If NAFTA were to fall apart, Canada would still be covered by preexisting Canada-U.S. trade agreements. We will discuss this and other trade-related issues in a Special Report to be published next week. Perhaps most critically for the loonie, crude prices remain in an uptrend. BCA's energy strategists now see Brent averaging $65.2/bbl and WTI averaging $62.9/bbl in 2018, which is $6.2/bbl and $8.9/bbl, respectively, above current market expectations. Stick with it. Bank Of England Delivers A Dovish Hike In a split 7-to-2 decision, the Bank of England's Monetary Policy Committee voted to raise rates by 25 basis points for the first time in ten years yesterday. In a nod to the concerns that some board members had about raising rates, the MPC noted that "any future increases in the Bank Rate would be expected to be at a gradual pace and to a limited extent." The Committee also removed language suggesting that future rate hikes would have to be in excess of what the market has been pricing in. The MPC's reluctance to sound hawkish is understandable. While the unemployment rate has fallen to a four-decade low, growth has lagged behind the rest of Europe. Consumer confidence has weakened and the CBI retailers survey suggests that British households are tightening their purse strings. House prices in London have fallen 7% since the U.K. government started the formal process of Brexit seven months ago. Inflation is running at 3%, but this mainly reflects the lagged effects from the depreciation in the currency. Still, with the market pricing in only two additional hikes through to mid-2020, it is doubtful that rate expectations will fall much from current levels. There is also a reasonably high probability that Brexit will not occur. At some point over the next few years, the U.K. government will call a new referendum to affirm whatever deal it reaches with the EU. Given that the contours of the deal will be less favorable than what many pro-Brexit voters had been promised, it is likely that a majority of the populace will decide that life inside the EU is better after all. As such, the odds are good that the pound - which is very cheap based on our valuation measures - will strengthen over the long haul (Chart 15). Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see The Bank Credit Analyst Special Report, "Did Amazon Kill The Phillips Curve?" dated September 1, 2017 and Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017. 2 Please see Global Investment Strategy Weekly Report, "China, The Fed, And The Transatlantic Interest Rate Spread," dated October 20, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Feature This week we are sending you a shorter-than-usual market update, as we are also publishing a Special Report exploring the outlook for USD cross-currency basis swap spreads. This report argues that USD basis swap spreads should widen over the next 12 months. Being a phenomenon associated with higher FX vols, this should hurt carry trades, including EM and dollar bloc currencies. It will also potentially create additional support for the USD. Also, next week, we will provide a deeper analysis of the fallout from the New Zealand government's dynamics. ECB Tapers? European Central Bank President Mario Draghi refused to call it "tapering," but he nonetheless announced that the ECB will be cutting back its asset purchases to EUR30 billion per month until at least September 2018. However, because the ECB will continue to proceed with re-investment of the stock of assets it holds, the monthly total presence of the ECB in European bond markets will stay above EUR 30 billion. Moreover, the ECB is keeping the door open to leaving its purchases in place beyond September 2019, if inflation does not keep track with the central bank's forecasts, and thus referred to the adjustment as being open-ended. Ultimately, the ECB does think that the recent rebound in inflation has been and remains a function of maintaining a very accommodative monetary setting. We think this option to keep the asset purchases in place beyond September 2018 is just this: an option. However, we do believe that yesterday's change in policy means the ECB will not increase interest rates until well into 2019. We also anticipate U.S. core inflation to begin outperforming euro area core inflation as U.S. financial conditions have eased significantly relative to the euro area - a key factor to redistribute inflationary pressures among these two economies (Chart I-1). As a result, because we anticipate that the Federal Reserve will increase the fed funds rate by more than the 67 basis points currently expected over the next two years, there could be some downside risk in EUR/USD. This downside risk is already highlighted by the large gap that has recently emerged between the 1-year/1-year forward risk-free rate spread between Europe and the U.S. versus the euro itself (Chart I-2). Chart I-1U.S. Inflation Set To Outperform Euro Area Prices Chart I-2Forward Interest Rates Point To A Lower Euro Moreover, the elevated long positioning right now further highlights the downside risk present in the euro (Chart I-3), probably explaining the European currency's rather violent reaction to what was a well-anticipated policy move. This means that EUR/USD could end 2017 in the 1.15 neighborhood, and fall further in 2018. Chart I-3Positioning Risk In EUR/USD Bottom Line: The ECB delivered exactly what was anticipated, yet the euro sold off. The ECB is unlikely to increase interest rates until well into 2019, suggesting the first anticipated rate hike in Europe is fairly priced. Thus, in order to justify any downside in the euro, one needs to be more positive on the Fed than what is currently priced into the U.S. interest rate curve. We fall into this camp. Moreover, positioning remains too long the euro. We expect EUR/USD to fall toward 1.15 by year end, and display more downside in 2018. Bank Of Canada The Bank of Canada (BoC) surprised the market this week by expressing a reversing of its recent pronounced hawkish bias, instead expressing a much more cautious tone. Where a closed output gap was once driving the need for tighter policy, residual labor market slack now warrants a more restrained approach to tightening. What has changed? NAFTA. The most recent and tenuous NAFTA negotiation round raised the specter of an end to the North American FTA. While NAFTA is still not dead, the rising probability that Canada-U.S. trade falls backs under the umbrella of the previous CUSFTA or even maybe something worse is causing a headache for Canadian policymakers. Some 20% of Canadian GDP is made up of products destined to be exported to the U.S., and this large chunk of GDP could be under some risk. Additionally, as the BoC highlighted, future investment decisions by firms in Canada may become investments in the U.S. to bypass regulatory uncertainty. Ultimately, if the Canada / U.S. trade relationship falls back under the CUSFTA umbrella, the impact on Canadian growth will be limited. Nonetheless, we think the BoC is correct to play its hand carefully, especially as the Canadian housing market is cooling. Moreover, a recent IPSOS survey revealed that around 40% of Canadian households would face financial difficulties if rates moved up significantly, which may justify a slower pace of hiking. With all this uncertainty looming, it is logical for the BoC to take its time before tightening policy anew. But in the end, we do anticipate the Canadian central bank to increase rates around two times next year, which is in line with the market's assessment: Canada's output gap is closing, and inflation is moving in the right direction. Thus, the outlook for the CAD is likely to be dominated by the outlook for oil. Robert Ryan, who runs BCA's Commodity And Energy Strategy service, expects WTI to move toward US$63/bbl next year, with upside risk to his forecast.1 This could help the CAD. However, the CAD does not seem particularly cheap against the USD when Canada's poor productivity performance is taken into account (Chart I-4), and speculators are now quite long the CAD (Chart I-5). As a result, our preferred medium to express positive views on the CAD is to be short AUD/CAD, where a valuation advantage is still present for the loonie (Chart I-6). Moreover, the AUD is more likely to suffer from China moving away from its investment-led growth model, while the CAD is less exposed to this risk. Chart I-4The CAD Is Not That Cheap Chart I-5Speculators Are Very Long The CAD Chart I-6Short AUD/CAD Bottom Line: The BoC is rightfully concerned that a breakdown of NAFTA would negatively affect the Canadian economy. While a return to CUSFTA would minimize any impact, the current high degree of uncertainty warrants that the BoC takes a more cautious stance. Ultimately, the BoC will increase rates next year, potentially two times. We continue to prefer to short AUD/CAD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report, titled "Upside Risks Dominate BCA's Oil Price Forecast", dated October 26, 2017, available at ces.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data has been strong: Manufacturing PMI came out at 54.5, stronger than expected; Services PMI came out at 55.9, also stronger than expected; Durable goods orders increased by 2.2%; New home sales increased by 18.9% monthly, the highest growth rate in 25 years; Initial jobless claims declined and beat expectations. Crucially, the DXY is above its 100-day moving average and has broken the reverse head-and-shoulders neckline, with momentum in the greenback's favor. The ECB's tapering weakened the euro by 1.4%. Further weakness in commodity currencies also allowed the dollar to gain momentum. We expect this momentum to continue as inflation in the U.S. re-emerges over the next six to twelve months. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The ECB's decision was largely in line with market consensus, but the euro nonetheless fell significantly. The ECB will halve its rate of purchases to EUR 30 bn a month starting next year until at least September 2018. However, President Mario Draghi stated that this could be extended beyond September, or even increased, if conditions warrant it. Draghi noted that "domestic price pressures are still muted overall and the economic outlook and the path of inflation remain conditional on continued support from monetary policy", also stating that rates would remain low for an extended period of time, and possibly even "past the horizon of the net asset purchases". Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: The Leading Economic Index increased from 105.2 to 107.2 in the month of August. Nikkei Manufacturing PMI surprised to the downside, coming in at 52.5, declining from 52.9 the month before. However, corporate service prices year-on-year growth came in at 0.9%, against expectations of 0.8%. Following the overwhelming victory of Prime Minister Shinzo Abe, the USD/JPY traded above 114, before stabilizing just below later in the week. Now that Abe has won the election, he is freer to implement loose fiscal policy in order to increase his chances to amend the pacifist Japanese constitution. This, accompanied by 10-year JGB rates anchored around zero, and a Federal Reserve that is likely to hike more than expected, should push USD/JPY higher. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in Britain has been mixed: Gross Domestic product yearly and quarterly growth surprised to the upside, coming in at 1.5% and 0.4% respectively. Moreover, public sector net borrowing was also lower than expected coming in at 5.236 billion pounds for the month of September. However, BBA mortgage approvals came below expectations, coming in at 41.584 thousand, which is lower than the month before. The pound has gone up following the positive GDP reading. As of now the market considers there is a 91% probability that the Bank of England hikes rates in November. However any hikes beyond that would require a significant improvement in economic activity. Thus, we would tend to fade any strength in GBP/USD, as the Fed is more likely to hike rates than the BoE on a sustainable basis. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD declined on weak consumer price numbers. The trimmed mean CPI remained steady at 1.8% annually, below the expected 2% rate, and weakened to 0.4% quarterly, down from 0.5%. The largest yearly decline was in communication (services or equipment) of 1.4%, although declines in food prices and clothing were also substantial at 0.9%. This is largely in line with our view that the consumer sector is handicapped with poor wage growth. We believe inflation is unlikely to move much higher; this will keep the RBA at bay. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been negative: Imports surprised to the upside, coming in at 4.92 billion dollars. This figure also increased form last month's reading. However exports underperformed expectations, coming in at 3.78 billion dollars for the month of September. Finally the trade balance, also underperformed expectations, coming in at -1.143 billion dollars. After the election of new Prime Minister Jacinda Ardern the kiwi has plunged, and now has a negative return year-to-date. The government is trying to implement three measures which significantly affect the value of the kiwi: a dual central bank mandate, restrictions on immigration, and a stop to foreign real estate purchases. All these measures lower the terminal rate for the RBNZ. With this being said, we are still shorting AUD/NZD given that commodity dynamics will dominate the movements of this cross. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 CAD had an eventful week as the Bank of Canada came out with a monetary policy decision. The decision was in line with the consensus, but the statement was not. The Bank was particularly concerned "about political developments and fiscal and trade policies, notably the renegotiation of the North American Free Trade Agreement". Additionally, it was also noted that "because of high debt levels, household spending is likely more sensitive to interest rates than in the past". The Bank also made a U-turn in its view of the labor market, stating that "wage and other data indicate that there is still slack in the labor market". These unexpected remarks dropped the CAD's value by 1% against USD. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The Franc continues to depreciate against the Euro, even as EUR/USD has gone down more than 2.5% since peaking early in December. Meanwhile, as the franc has depreciated, economic variables have improved. The KOF Industry Survey Business Climate indicator is now positive for the first time since 2011. Meanwhile, core inflation has reached 2011 highs as well. Additionally multiple components of PMI are at their highest level in the past 6 years. All of these factors bode well for the Swiss economy, and prove that the SNB's ultra-loose monetary policy and currency intervention is working. That being said, we would like to see more strength from key economic variables to consider shorting EUR/CHF, given that the recovery is still too fragile for the SNB to change policy. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The Norges Bank left their key policy rate unchanged at 0.5% yesterday. The central bank highlighted that capacity utilization was below normal levels and that inflation was expected to be below 2.5% in the coming years. Furthermore, the comittee highlighted that although the labor market appears to be improving, inflation has been lower than expected, while the krone is also weaker than projected. The bank has reassured our view that even in the face of strong oil prices, slack is still too big in the Norwegian economy for the Norges Bank to start raising rates. Furthermore, a hawkish fed will further put upward pressure on USD/NOK. Than being said, EUR/NOK should depreciate, given that this cross is much more sensitive to oil than it is to rate differentials. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The SEK has depreciated considerably in recent weeks owing to somewhat weaker inflation figures. It has weakened particularly against the EUR, as markets are expecting the Riksbank to follow the ECB in its rate path. This was confirmed by a particularly dovish tone from the recent monetary policy statement which exacerbated this decline, with the board expecting to maintain the current monetary policy until mid-2018, and even discussed a possible extension of asset purchase programs beyond December. The Board has "also taken a decision to extend the mandate that facilitates a quick intervention in the foreign exchange market". Finally, they lowered their inflation forecasts for both 2017 and 2018. Stefan Ingves is firmly in control. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights This week, we are reviewing all our current active trades in our Tactical Overlay. As a reminder, these positions (Table 1) are meant to complement our strategic GFIS Model Fixed Income Portfolio, typically with shorter holding periods and occasionally in smaller or less liquid markets outside our usual core bond market coverage (i.e. U.S. TIPS or Swedish interest rate swaps). This report includes a short summary of the rationale behind each position, as well as a decision on whether to continue holding the trade, close it out or switch to a new position that may more efficiently express our view. The trades are grouped together by the country/region that is most relevant for the performance of each trade. Table 1GFIS Tactical Overlay Trades Feature U.S. Short July 2018 Fed Funds futures (HOLD). Long 5-year U.S. Treasury (UST) bullet vs. 2-year/10-year duration-matched UST barbell (HOLD). Long U.S. TIPS vs. nominal USTs (HOLD). Short 10-year USTs vs. 10-year German Bunds (HOLD). The tactical trades that we have been recommending within U.S. markets all have a common theme - positioning for an expected rebound in U.S. inflation that will push up U.S. bond yields. We are maintaining all of them. The drift lower in realized inflation rates since the spring has been a surprise given the backdrop of above-potential growth, low unemployment and a weakening U.S. dollar. On the back of this, markets have priced out several of the Fed rates hikes that had been expected over the next year, leaving U.S. Treasury yields at overly-depressed levels. Back on July 11th, we initiated a recommendation to short the July 2018 fed funds futures contract (Chart 1). This was a position that would turn a profit if the market moved to once again discount multiple Fed rate hikes by mid-2018. The trade has a modest profit of 9bps, but with scope for additional gains if the market moves to discount 2-3 hikes by the middle of next year. Our base case scenario is that the Fed will lift rates again this December, and deliver additional increases next year amid healthy growth and with inflation likely to grind higher towards the Fed's 2% target. With the market discounting 46bps of rate hikes over the next year, there is scope for additional profits in our fed funds futures trade. Another tactical position that we've been recommending is a butterfly trade within the U.S. Treasury (UST) curve, long a 5-year UST bullet versus a duration-matched 2-year/10-year UST barbell. This is a position that would benefit from a bearish steepening of the UST curve as the market priced in higher longer-term inflation expectations (Chart 2). We have held that trade for a much longer period than a typical tactical trade, going back nearly a full year to December 20th, 2016. Yet while the UST curve has flattened since that date, our trade has delivered a return of +18bps. This outperformance can be attributed to the undervalued level of the 5-year bullet at the initiation of the trade. Chart 1Stay Short July 2018##BR##Fed Funds Futures Chart 2Stay Long The 5yr UST Bullet Vs.##BR##The 2yr/10yr UST Barbell While that valuation cushion no longer exists (bottom panel), longer-term TIPS breakevens are back to the levels seen last December (middle panel), thanks in no small part to much higher energy prices (top panel). This leaves the UST curve at risk of a bearish re-steepening on the back of rising inflation expectations. Add in a U.S. dollar that is -2.5% weaker from year-ago levels (Chart 3, middle panel), and a solid U.S. economic expansion that should eventually translate into rising core inflation momentum (bottom panel), and the case for a steeper UST curve over the next 3-6 months is a strong one. The above logic also supports our trade recommendation to go long U.S. TIPS vs. nominal USTs, which is up +248bps since inception on August 23, 2016. We have been holding this trade for much longer than our usual tactical recommendations, but we will not look to take profits until we see the 10-year breakeven (now at 186bps) return back to levels consistent with the Fed's 2% PCE inflation target (i.e. headline U.S. CPI inflation back to 2.5%). One final tactical trade that will benefit from higher UST yields is our recommendation to position for a wider spread between 10-year USTs and 10-year German Bunds. This trade was initiated on August 9th of this year, and has delivered a profit of +9bps. Yet the UST-Bund spread still looks too low relative to shorter-term interest rate differentials that favor the U.S. (Chart 4, top panel). With U.S. data starting to surprise more on the upside than Euro Area data (middle panel), and with UST positioning still quite long (bottom panel), there is potential for additional near-term UST-Bund spread widening. The upcoming decision by the European Central Bank (ECB) on potential tapering of its asset purchases next year represents a potential risk for the long Bund leg of our recommended trade. Any hawkish surprises on that front would be a likely catalyst for us to close out this position. Chart 3Stay Long U.S. TIPS Vs. Nominal USTs Chart 4Stay Short 10yr USTs Vs. German Bunds Euro Area Long 10yr Euro Area CPI swaps (HOLD). Long 5-year Spain vs. 5-year Italy in government bonds (HOLD). We have two recommended tactical trades that are specifically focused on developments in the Euro Area. We are maintaining both of them. As a way to position for an eventual pickup in European inflation, we entered a long position in 10-year Euro Area CPI swaps back on December 20th, 2016. That trade is now estimated to have a profit of +29bps, as market-based inflation expectations have drifted higher in the Euro Area. The simple reason for that increase is that realized inflation has moved higher on the back of rising energy costs, as there is a very robust correlation between the annual growth rate of oil prices (denominated in euros) and headline Euro Area inflation (Chart 5). More importantly, the booming Euro Area economy, which has eaten up much of the spare capacity in the Europe, has boosted wage growth and core inflation to levels seen prior to the disinflation shock from the 2014/15 collapse in oil prices (bottom panel). With no signs of any imminent slowing of Euro Area growth that could raise unemployment and slow underlying inflation pressures, the trend for inflation expectations in Europe is still upward. The current 10-year Euro Area CPI swap at 1.5% is still well beneath the ECB's inflation target of "just below" 2% on headline CPI, so there is room for inflation expectations to continue drifting higher. ECB tapering of asset purchases is not an immediate threat to this trade, as the central bank is still likely to keep buying bonds next year (at a slower pace), while holding off on any interest rate increases until late 2019. In other words, the ECB will not be looking to act to slow economic growth to bring down Euro Area inflation anytime soon. Our other tactical trade recommendation in Europe is a relative value spread trade, long 5-year Spanish government debt versus 5-year Italian bonds. This trade was initiated on December 13th, 2016 and currently has only a modest gain of +9bps, although the profits were much larger earlier this year. Italian bonds have been outperforming on the back of improving Italian economic growth (Chart 6, top panel) and, recently, a generalized sell-off in Spanish financial assets on the back of the political uncertainty in Catalonia. Chart 5Stay Long 10yr##BR##Euro Area CPI Swaps Chart 6Stay Long 5yr Spanish Government Bonds Vs.##BR##5-Year Italian Debt Our colleagues at BCA Geopolitical Strategy have been downplaying the threat to Spanish political stability from the Catalonian independence movement, given that the polling data shows only 35% for outright independence from Spain. At the same time, the poll numbers in Italy for the upcoming parliamentary elections are much closer, with parties favoring less integration with Europe holding a slight lead over more "establishment" parties (bottom two panels). With the bulk of the cyclical convergence between Italian and Spanish growth now largely completed, and with a greater potential for future political instability in Italy compared to Spain, we expect that Spain-Italy spreads will tighten further back to the lows seen at the beginning of 2017 (-64bps on the 5-year spread). That is a level we are targeting on our current tactical trade recommendation. Canada Short 10-year Canadian government bonds vs. 10-year USTs (TAKE PROFITS). Long Canada/U.K. 2-year/10-year government bond yield curve box, positioning for a relatively flatter Canadian curve (TAKE PROFITS). Short 5-year Canada government bond versus a duration-matched 2-year/10-year barbell (TAKE PROFITS). We have three different Canadian fixed income trades in our Tactical Overlay, all of which were biased towards tighter monetary policy in Canada: a Canada-U.S. bond spread widener, a yield curve box trade versus the U.K. and a curve flattener expressed as a barbell trade (Chart 7) All three positions are in the money, but we now recommend taking profits. We had initiated these recommendations in a very timely fashion earlier in the year at a time when the Bank of Canada (BoC) was sending a relative dovish message. In our view, the Canadian economy was building significant upward momentum that would eventually force the central bank to shift its policy bias. This would especially be true with the Fed also in a tightening cycle, given the typical tendency for the BoC to follow the Fed's policy actions. Several members of the BoC monetary policy committee began to sing a more hawkish tune over the summer, particularly after the release of the Q2 BoC Business Outlook Survey. That robust report, which was confirmed by a 2nd quarter GDP growth rate of nearly 4% (Chart 8), led the BoC to deliver not one by two unexpected interest rate hikes in July and September. Markets reacted accordingly, driving Canadian bond yields higher and flattening the yield curve. Chart 7Take Profits On Bearish Canadian Bond Trades Chart 8Canadian Growth Set To Cool Off A Bit Now, we see the market pricing as having gone a bit too far, too quickly. The Q3 Business Outlook Survey, released yesterday, was still positive but with readings softer than the booming Q2 report. Meanwhile, the commentary from the BoC has become more balanced, with BoC Governor (and BCA alumnus) Stephen Poloz describing the central bank as being more "data dependent" after the recent rate hikes. Markets are now pricing in another 72bps of rate hikes over the next year, even with our own BoC Monitor off the peak (Chart 9). Chart 9Our BoC Monitor Is Peaking From a tactical perspective, the repricing of the BoC that we expected earlier this year is now largely complete. Thus, we are taking profits on all three Canadian trades: Canada-U.S. spread trade: initiated on January 17th, profit of +43bps. Canada/U.K. box trade: initiated on May 16th, profit of +67bps. Canada 2yr/5yr/10yr butterfly trade: initiated on December 6th, 2016, profit of +95bps. From a strategic perspective, we still see a case where the BoC can deliver additional rate hikes and keep upward pressure on Canadian bond yields. The output gap in Canada is now closed, according to BoC estimates, and additional strength in the economy now has a greater chance in translating to higher inflation. Strong global growth, especially in the U.S., will also support Canadian export growth and feed into rising capital spending. While the rate hikes have help boost the value of the Canadian dollar (CAD), the exchange rate (on a trade-weighted basis) also largely reflects a rising value of energy prices and is, therefore, should provide an additional boost to growth via stronger terms-of-trade (bottom panel). In other words, the rising CAD will not prevent additional BoC rate hikes if oil prices remain strong. Thus, we are maintaining our underweight recommendation on Canadian government bonds in our strategic model bond portfolio, even as we take profits on our bearish Canadian tactical trades. Australia Long a 2-year/10-year Australia government bond curve flattener (SELL AND SWITCH TO NEW TRADE). On July 25th of this year, we entered into a 2-year/10-year curve flattener trade for Australia. Though employment was improving and house prices were booming in Australia, the wide output gap, high level of consumer indebtedness and lack of real wage growth was keeping the Reserve Bank of Australia (RBA) inactive. In our view, nothing has changed since then; the RBA remains in a very difficult position. While the yield curve flattened substantially following the initiation of our trade, the global rise in long-term yields since mid-September lifted Australian longer-maturity yields, and the yield curve with it (Chart 10). Now, Australian long-term yields are not reflecting domestic fundamentals but are instead driven by improving global growth. As such, we are closing the trade and initiating a new position - long Dec 2018 Australian Bank Bill futures - as a more focused way to express the view that the RBA will stay on hold for longer than markets expect. Markets are currently pricing in 30bps of RBA rate hikes over the next twelve months. We believe this will be unlikely, for several reasons. Macroprudential measures on the Australian housing market will continue to dampen credit growth. Core inflation is slowly rising but still far below the central bank's target. Additionally, there is plenty of slack in the labor market despite the spike in employment growth. This is evidenced in anemic real wage growth, stubbornly high underemployment rate, low hours worked and high percentage of part-time to full-time workers (Chart 11). Chart 10Close Australian Government##BR##Bond 2yr/10yr Flattener Chart 11RBA Unlikely To Deliver##BR##Discounted Rate Hikes The biggest risk to our new trade would if signs of a tighter Australian labor market started to feed through into faster wage growth, which would likely coincide with faster underlying price inflation and a more hawkish turn by the RBA. New Zealand Long 5-year NZ government bonds vs. 5-year USTs (currency hedged). Long 5-year NZ government bonds vs. 5-year Germany (currency unhedged). Chart 12Stay Long 5yr NZ Government Bonds##BR##Vs. U.S, & Germany We entered two New Zealand (NZ) tactical bond trades on May 30th, going long 5-year government bonds vs. U.S. and Germany (Chart 12). We expected NZ spreads to tighten faster than the forwards based on our more hawkish views on the Fed and, to a lesser extent, the ECB relative to the more dovish view on the Reserve Bank of New Zealand (RBNZ). The outright bond spreads have tightened and, on a currency-hedged basis, both trades are in the money. Our dovish view on the RBNZ came from the central bank's own forecasts, which called for slowing headline inflation on the back of softer "tradeables" inflation and a sharp cooling of domestic "non-tradeables" inflation through a slowing housing market (Chart 13, bottom two panels). Our own RBNZ Monitor has been calling for the need for higher interest rates in NZ, mostly from the strength in the labor market. Yet we have been ignoring that signal, as has the market which has priced out one full expected RBNZ rate hike since the beginning of the year. With business confidence rolling over, and with the trade-weighted NZ dollar still staying at stubbornly strong levels, the case for the RBNZ to deliver even a single rate hike is not a strong one - especially given the soft inflation forecasts of the central bank. Thus, we are sticking with our tactical spread trades for NZ versus the U.S. and Germany. We are maintaining the currency hedge on the U.S. version of the trade, as we typically do for the vast majority of our cross-country spread trade recommendations. Occasionally, however, we will make an active decision to do a spread trade UN-hedged if we felt very strongly about a currency move. We did that for our NZ-Germany spread trade and this has cost us in the performance of the trade, which is down -3.4%. This is because of a surprisingly large decline in the New Zealand dollar (NZD) versus the euro since the inception of our trade. Yet a review of the technical indicators on the NZD/EUR currency cross shows that the currency pair is now very stretched versus its medium-term trend (the 40-week moving average), with price momentum also at some of the most negative levels of the past decade (Chart 14). These measures suggest that the worst of the downturn in the currency is likely over. The relative positioning on the two individual currencies is now neutral, as long positions on the NZD have been reduced (bottom panel). Chart 13RBNZ Dovishness Is Justified Chart 14Keep NZ/Germany Position Currency Unhedged Given these technical indicators, and from these current levels, we see greater upside potential for NZD/EUR in the months ahead. This leads us to maintain our unhedged currency position on the NZ-Germany spread trade so as not to realize the current mark-to-market losses on the trade. Sweden Pay 18-month Sweden Overnight Index Swap (OIS) rate (TAKE PROFITS). We entered into a bearish Swedish rates position back on November 22nd, 2016, paying Sweden 18-month Overnight Index swap rates (Chart 15). At the time, we expected the Riksbank to begin hiking interest rates earlier than what was priced in the markets IF inflation reached the central bank target faster due to a weaker Swedish krona. We also believed that the economy would continue to expand at a robust pace when the economy had no spare capacity, creating additional upside inflation surprises. According to the Riksbank's latest Monetary Policy Statement (MPS), the central bank will likely keep the repo rate at -0.5% until mid-2018, while continuing its asset purchase program until the end of this year - even with an overheating economy. This is because realized inflation has remained below the Riksbank target for a long period of time and, although current inflation is above target, it was not necessary to immediately tighten conditions. More likely, the Riskbank is worried about the potential for the krona to appreciate - especially versus the euro - if rate hikes are delivered. It will only be a matter of time before the central bank is forced to tighten policy with the economy likely to strengthen further, led by solid domestic demand, strong productivity growth, and improving exports. Consumption is also expected to increase as households have scope to cut back their high level of savings. Combining the Riksbank's easing policy with the current strength of the economy and the tightness of the labor market, inflation is very likely to return to the 2% target in the next year or two (Chart 16). Chart 15Close Sweden OIS Trade Chart 16Riksbank More Worried About SEK Than Inflation However, if the Riskbank remains too concerned about the currency versus the euro, as we suspect, then this will prevent any shift to a more hawkish stance before any change from the ECB. That is unlikely to happen over the next year, at least, even if the ECB slows the pace of asset purchases as we expect. Thus, we are closing out our Sweden 18-month Overnight Index Swap position at a small profit of 12bps. We have already kept this trade for longer than the typical investment horizon for one of our tactical overlay trades. We will investigate the potential for more profitable trade opportunities in the Swedish fixed income markets in a future report. Korea Long a 2-year/10-year Korean government bond yield curve steepener (HOLD). We recommended entering into a 2-year/10-year steepening trade in the Korean government bond yield curve on May 30th, 2017. Since then, the yield curve has flattened by 7bps, which was mainly caused by an unexpected rise in the 2-year yield, rather than a decline in 10-year yield (Chart 17). Korea is currently enjoying a solid business cycle upturn. Leading economic indicators are rising, the year-over-year growth in exports has risen to a 7-year high and previously sluggish private consumption has also rebounded recently. The Bank of Korea (BoK) is of the view that the recovery will continue and consumer price inflation will stabilize at the target level over the medium-term. This recovery should cause the 2/10 curve to steepen as longer-term inflation expectations rise. Based on South Korean President Moon's aggressive fiscal plans to increase welfare spending and create jobs in the public sector, at a time when the economy is good shape, we still believe that long-end of the curve (10-year) will rise. In addition, as shown in Chart 18, the 26-week rolling beta of changes in the 10-year UST yield and Korean 10-year bond is very high, nearly 1. Given our bearish view on USTs, this implies Korean yields can follow suit. On the other hand, the correlation between the 2-year UST yield and equivalent maturity Korean yields is much lower (4th panel), as Korean rate expectations have not been following those of the U.S. higher - even with a stronger Korean economy. Most likely, this is due to investors downplaying the potential for the BoK to match Fed rate hikes tick-for-tick given the heightened tensions between the U.S. and North Korea. Chart 17Stay In Korea 2yr/10yr##BR##Government Bond Steepener Chart 18Long-Term Korean##BR##Yields Are Too Low We still believe the Korean curve can steepen as longer-term yields rise, although we will be monitoring the behavior of shorter-dated Korean yield as the situation between D.C. and Pyongyang evolves. If investors begin to demand a higher risk premium on Korean assets, particularly the Korean won, then 2-year Korean yields may rise much faster and our curve trade may not go our way. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Economic Outlook: Global growth will stay strong over the next 12 months, with the U.S. surprising on the upside. Unfortunately, the global economy will succumb to a recession in 2019. Stagflation will become a major problem in the 2020s. Portfolio Strategy: We are sticking with our pro-risk stance for the time being, but are trimming our overweight recommendations to global equities and high-yield credit. Fixed Income: Maintain below benchmark duration exposure over the next 12 months. Underweight U.S., euro area, and Canadian government bonds; stay neutral the U.K., Australia, and New Zealand; overweight Japan. Equities: Favor cyclicals over defensives, but look to turn outright bearish on stocks late next year. For now, stay overweight the euro area and Japan relative to the U.S. in local-currency terms. In the EM universe, Chinese H-shares will outperform. Currencies and Commodities: While the recent dollar rebound has further to run, oil-sensitive currencies and the yuan will hold their ground against the greenback. It is too early to buy gold. Feature I. Global Macro Outlook: Reflation, Recession, And Stagflation The economic outlook over the coming years can be summarized in three words: reflation, recession, and stagflation. Reflation A Broad-Based Recovery Global growth is firing on all cylinders. The OECD estimates that all 46 of the economies that it tracks will see positive growth this year, the first time this has happened since 2007. Most leading economic indicators remain upbeat (Chart 1). This has left analysts scrambling to revise up their global GDP growth forecasts (Chart 2). Chart 1Most Leading Economic Indicators Remain Upbeat Chart 2Global Growth Has Accelerated The acceleration in global growth has occurred against the backdrop of tame inflation, which has allowed most central banks to keep interest rates at exceptionally low levels. Not surprisingly, risk assets have reacted positively. These goldilocks conditions should remain in place for the next 12 months. While most economies are growing at an above-trend pace, there is still plenty of spare capacity around the world. This means that inflation in countries such as the U.S. - where the labor market has returned to full employment - is likely to rise only gradually, as excess demand is satiated through higher imports. Such a redistribution of demand from countries with low levels of spare capacity to those with high levels is a win-win outcome for the global economy. Recession Running Out Of Room Unfortunately, all good things must come to an end. Weak productivity growth across most of the world is likely to cause bottlenecks to emerge over time, and this will cause inflation to move higher (Chart 3). Output gaps in the main developed economies would actually be higher today than at the height of the Great Recession had potential GDP grown at the rate the IMF projected back in 2008 (Chart 4). This is a testament to just how exceptionally weak potential growth has been. Chart 3Productivity Growth Has Slowed Across The Globe Chart 4Weak Supply Growth Has Narrowed Output Gaps U.S. growth will surprise to the upside over the next 12 months, leading to an unwelcome burst of inflation in late 2018 or early 2019. Financial conditions have eased sharply this year thanks to lower bond yields, narrower credit spreads, a weaker dollar, and a surging stock market. Changes in financial conditions lead growth by around 6-to-9 months, implying that U.S. growth could reach 3% early next year (Chart 5). This could take the unemployment rate down to 3.5% by end-2018, more than a full point below the Fed's estimate of full employment and even lower than the 2008 low of 3.8%. The unemployment rate could fall even further if Congress succeeds in passing legislation to cut taxes, as we expect it will. Our geopolitical team estimates that the GOP proposal would reduce federal revenues by $1.1-to-$1.2 trillion over ten years, or about 0.5% of GDP.1 In order to appease moderates, the final bill is likely to scale back the size of the tax cuts and shift more of the benefits to middle class households. Under the current proposal, the top 1% of taxpayers would receive 50% of the tax benefits (Chart 6). Our best bet is that the legislation will be enshrined into law in early 2018. Chart 5Easier Financial Conditions Will Boost U.S. Growth Chart 6Republican Tax Would Disproportionately Benefit The Top 1% Welcome To The Steep Side Of The Phillips Curve The so-called Phillips curve, which depicts the relationship between unemployment and inflation, tends to become quite steep once unemployment falls to very low levels (Chart 7). It is easy to see why: When spare capacity is high, a modest decline in slack will still leave many workers idle. In such a setting, inflation is unlikely to rise. However, once the output gap is fully closed, any further decline in slack will cause bottlenecks to emerge, pushing wages and prices higher. The 1960s provide a useful lesson in that regard. Just like today, inflation hovered below 2% during the first half of that decade, even though unemployment was trending downward over this period. To most observers back then, the Phillips curve would have also seemed defunct. However, once the unemployment rate fell below 4%, core inflation took off, rising from 1.5% in early 1966 to nearly 4% in 1967 (Chart 8). The kink in the Phillips curve had been reached. Inflation ultimately made its way to 6% in 1970, four years before the first oil shock struck. Chart 7U.S. Economy Has Moved Into The 'Steep' Side Of The Phillips Curve Chart 8Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Many commentators have questioned the relevance of the sixties template on the grounds that the U.S. economy was less open to the rest of the world back then, trade unions had greater bargaining power, inflation expectations were not as well anchored, and the deflationary effects of new technologies were not as pervasive. We discussed these arguments in a report published earlier this month, concluding that they are not nearly as persuasive as one might think.2 The Difficulty Of Achieving A Soft Landing Rising inflation will compel the Fed to hike rates aggressively starting late next year in order to push the unemployment rate back towards NAIRU. A turn towards hawkishness is especially likely if Janet Yellen is replaced by someone such as former Fed Governor Kevin Warsh, whom betting markets now think has a 40% chance of becoming the next Fed chair (Chart 9). The problem for whoever ends up running the Fed is that it is very difficult to raise the unemployment rate by just a little bit. Modern economies are subject to massive feedback loops. When unemployment begins rising, households lose confidence and reduce spending. This prompts firms to slow hiring, leading to even less spending. The U.S. has never averted a recession in the post-war era whenever the unemployment rate has increased by more than one-third of a percentage point (Chart 10). Chart 9Who Will The Next Fed Chair Be? Chart 10Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Lofty valuations are likely to exacerbate the adverse feedback loop described above during the next downturn. As growth slows, risk asset prices will tumble. This will cause business investment spending to dry up. Given America's dominant role in global financial markets, the U.S. recession will spread like wildfire to the rest of the world. Stagflation The Doves Reassert Control The next recession will probably be more painful for Wall Street than for Main Street. Fed-induced downturns tend to be swift but short-lived. The subsequent recoveries are usually V-shaped, rather than the elongated U-shaped recoveries that follow financial crises. Nevertheless, central banks around the world will undoubtedly start slashing rates again, perhaps even restarting their QE programs. Traumatized by the Great Recession, central bankers will overreact. The hawks will be blamed for the recession and forced to turn tail. The doves will reassert control. Fiscal policy will be significantly eased. This will be particularly the case if the next recession coincides with Trump's re-election campaign, brewing populism in Europe, and the spectre of military conflict in a variety of hotspots around the planet. Structural Forces Will Boost Inflation Meanwhile, millions of baby boomers will be in the process of leaving the workforce. This will lead to slower income growth, but not to slower spending growth - spending actually rises late in life due to spiraling health care costs (Chart 11). An increase in spending relative to income tends to push up prices. A recent IMF research report estimated that population aging has been highly deflationary over the past few decades, but will be very inflationary over the coming years (Chart 12). Chart 11Savings Over The Life Cycle Chart 12Demographic Shifts: From Highly Deflationary To Highly Inflationary All this suggests that the dip in inflation during the next recession will be fleeting. As the recovery from the shallow recession unfolds, inflation will reaccelerate. Of course, at that point, central banks could step in to aggressively quell inflationary pressures. However, they are unlikely to do so. After the next recession-induced burst of fiscal stimulus, debt levels will be even higher than they are now. The temptation to inflate away this debt will intensify. And, in an environment of anemic real potential GDP growth, the means to generate inflation will become available: Central banks will simply need to keep rates below their "neutral" level. Central bankers will rationalize their actions on the grounds that higher inflation will allow them to bring real interest rates deeper into negative territory in the event of another economic downturn. A growing chorus of eminent economists has begun to argue that a 2% inflation target is too low. For example, just this week, Larry Summers stated that "I think we probably need to adjust our monetary policy framework ... to [one] that provides for higher nominal rates during normal times, so there's more room to cut rates during downturns."3 II. Financial Markets As with the economic outlook, the three words reflation, recession, and stagflation guide our views of where financial markets are heading over the coming years. We continue to maintain a pro-risk stance, but are trimming our overweight recommendation to equities and high-yield credit due to the fact that valuations have gotten stretched and we are entering the last innings of the business-cycle expansion (Table 1). Table 1BCA's Tactical Global Asset Allocation Recommendations* Equities Sticking With Bullish ... For Now Recessions and bear markets tend to go hand-in-hand (Chart 13). None of our recession timing indicators are warning of an imminent downturn, suggesting that the cyclical global equity bull market has further room to run (Chart 14). Chart 13Recessions And Bear Markets Usually Overlap Chart 14AThis Business Cycle Has Further To Run Chart 14BThis Business Cycle Has Further To Run Strong growth in corporate earnings continues to underpin the rally in equities. The MSCI All-Country World index has increased by 11.9% in the first 9 months of the year, only slightly more than the 9.1% gain in earnings. As a result, the forward P/E ratio has only risen from 15.7 at the start of the year to 16.1 (Table 2). Table 2Earnings-Backed Price Appreciation Favor Cyclicals Over Defensives Above-trend global growth should boost profits over the next 12 months. We favor cyclical sectors over defensives, and are expressing this view through our long global industrial stocks/short utilities trade recommendation. The trade is up 0.9% since we initiated it last Friday and up 2.3% since I previewed it at BCA's annual New York Investment Conference earlier the same week. Capital spending tends to accelerate in the mature phase of business-cycle expansions, as a growing number of firms realize that they have insufficient capacity to meet rising demand. Our model predicts that global capex will grow at the fastest pace in six years (Chart 15). This should benefit industrial stocks. On the flipside, rising global yields will hurt rate-sensitive utilities (Chart 16). Chart 15Global Capex On The Upswing Chart 16Higher Bond Yields Will Hurt Utilities Financials should also outperform. Banks, in particular, will benefit from steeper yield curves, faster credit growth, and ongoing declines in nonperforming loans. Energy stocks are also attractive. As discussed below, we continue to maintain a generally upbeat view on the direction of oil prices. Prefer DM Over EM, Europe And Japan Over The U.S. While it is a close call, we see more upside for DM than EM stocks, as the former are less vulnerable to a dollar rebound and an increasingly hawkish Fed. Emerging market equities have had a good run over the past year, and are due for a breather. Our favorite EM equity idea for the fourth quarter is to be long Chinese H-shares. H-shares are heavily tilted toward financials and deep cyclicals, two sectors that we like. They also trade at a mere seven-times forward earnings and one-times book value (Chart 17). Within the DM space, European and Japanese equities should outperform U.S. stocks in currency-hedged terms. The sector composition of both the European and Japanese market is tilted toward stocks that will gain the most from strong global growth and increased capital spending. As our European strategists have documented, the European stock market is dominated by large multinationals whose fortunes are tied more to the global economy than to domestic prospects. This is largely true for the Japanese stock market as well. If our prediction for a somewhat weaker euro and yen comes to pass, profits in both regions will benefit from the currency translation effect. Valuations in Europe and Japan are also generally more attractive than in the U.S, even if one adjusts for different sector weights (Chart 18). Chart 17Chinese H-Shares: A Valuation Snapshot Chart 18U.S. Stocks Look Pricey Small Cap Value Trumps Large Cap Growth Style-wise, we prefer small cap value over large cap growth. Value stocks generally do better in environments where cyclicals are outperforming defensives, while small caps tend to be high-beta bets on global growth (Chart 19). U.S. small caps will disproportionately benefit from cuts to statutory corporate taxes, since smaller companies typically have less ability to game the tax code in their favor. Timing The Next Bear Market As one looks beyond the next 12 months, the skies begin to darken for global equities. The stock market usually sniffs out recessions before they happen, but the lead time is quite variable and generally not that long (Table 3). For example, the S&P 500 peaked only two months before the start of the Great Recession in December 2007. Chart 19Favor Cyclicals And Value Plays Table 3Stocks And Recessions: Case-By-Case Chart 20Stagflation Was Devastating For Stocks Stagflation Is Not A Stock-Friendly Environment If the next recession begins in the second half of 2019, global equities will probably peak earlier that year or in late 2018. Given the starting point for valuations, U.S. equities are likely to fall 20%-to-30% peak-to-trough. While other global bourses are generally not as expensive, their higher-beta nature means that they will probably face similar if not worse declines. The fact that correlations tend to rise during risk-off episodes will only add to the bloodshed. Stocks And Stagflation If the experience of the 1970s is any guide, equities perform poorly in stagflationary environments (Chart 20). Investors tend to see stocks as a riskier substitute for bonds. When nominal bond yields rise, the dividend yield offered by stocks becomes less attractive. In theory, the increase in the nominal value of corporate net worth resulting from higher inflation should generate enough capital gains over time to compensate for the wider gap between dividend yields and bond yields. In practice, due to "money illusion" and other considerations, that does not fully occur, requiring that stocks become cheaper so that their expected return can rise. The Long-Term Outlook For Profit Margins A complicating factor going into the next decade will be what happens to profit margins. S&P 500 operating margins are close to their all-time highs (Chart 21). While margins will undoubtedly fall during the next recession, their subsequent recovery is likely to be encumbered by a number of shifting structural forces. A slew of labor-saving technological innovations depressed labor's share of income over the past few decades. So did the entry of over one billion new workers into the global labor force following the collapse of the Berlin Wall and China's transition to a capitalist economy. The fixation of central banks on bringing down inflation may have led to higher unemployment than what would otherwise have been the case, thereby undermining the bargaining power of workers. All this may change during the next decade. China's labor force has peaked and is on track to decline by over 400 million workers by the end of the century - a larger decline than the entire U.S. population (Chart 22). A shift towards persistently more expansionary monetary policy could also keep the labor market fairly tight. Chart 21U.S. Profit Margins Are Close To All-Time Highs Chart 22China On Course To Lose More Than 400 Million Workers Technological innovation will persist, but the firms that benefit from it are likely to attract more scrutiny from regulators. Republican voters - the traditional defenders of corporate America's God-given right to make a buck - are growing increasingly wary of big business. Wall Street, Silicon Valley, and the rest of the corporate establishment tend to be liberal on social issues and conservative on economic ones. Very few voters actually share this configuration of views (Chart 23). The Democratic Party's "Better Deal" moves it to the left on many economic issues. This runs the risk of leaving the U.S. without any major party actively pushing a pro-business agenda. That can't be good for profit margins. Bottom Line: Investors should stay overweight global equities, but trim exposure from moderate overweight to small overweight due to rising business-cycle risk, and look to get outright bearish late next year. The long-term outlook for equities is poor, especially in the U.S. where valuations are highly stretched. Chart 24 presents a stylized sketch of how we think the major stock market indices will evolve over the coming years. Chart 23An Absence Of Libertarians Chart 24Market Outlook: Equities Fixed Income Above-trend GDP growth and rising inflation are likely to push up long-term bond yields in most economies over the next few quarters, as flagged by our Central Bank Monitors (Chart 25). Bond yields will fall during the next recession and then begin to inexorably rise higher as stagflationary forces intensify (Chart 26). Looking out over the next 12 months, our regional allocation recommendations are as follows: Chart 25Our Central Bank Monitors Point To Growing Pressures To Tighten Chart 26Market Outlook: Bonds Underweight The U.S., Euro Area, And Canada Chart 27Canada Enjoys Robust Growth We remain underweight U.S. Treasurys in a global fixed-income portfolio. The market is pricing in only 44 basis points in Fed hikes between now and the end of next year, well below the 100 basis points of hikes implied by the dots in the Summary of Economic Projections. The U.S. yield curve has flattened since the start of the year. This should change over the next 12 months, as inflation expectations rebound from currently depressed levels. The yield curve in the euro area should steepen more than in the U.S., since the ECB has pledged not to raise rates until well after its asset purchase program is complete - something that is unlikely to happen until the end of next year. This implies that the 2-year spread between the two regions will widen in favor of the U.S., which should be bullish for the dollar. Canadian bond yields are likely to rise further (Chart 27). The unemployment rate has fallen to a nine-year low and the Bank of Canada expects the output gap to be fully closed by the end of this year. The economy grew by 3.7% year-over-year in the second quarter, well above the BoC's estimate of potential real GDP growth of 1.5%. The Bank's most recent Business Outlook Survey points to continued robust growth ahead. The bubbly housing market remains a concern, but delaying withdrawal of monetary accommodation risks exacerbating the problem. Neutral On Gilts And Aussie And Kiwi Bonds In contrast to most other developed economies, leading indicators point to slower U.K. growth in the months ahead (Chart 28). This undoubtedly reflects the ongoing uncertainty over Brexit negotiations, which are likely to drag on for quite some time. Core inflation has surged to 2.7% on the back of the sharp depreciation of the pound, but market expectations suggest that it is about to roll over. Nevertheless, with 10-year gilts fetching just 1.35%, the downside for yields is limited. The cheap pound should also prop up exports, partly offsetting the impact of diminished market access to the rest of the EU. The unemployment rate stands at 4.3%, slightly below the Bank of England's estimate of NAIRU. One way or another, the uncertainty over Brexit will fade, allowing gilt yields to move higher. As with gilts, the outlook for Australian and New Zealand bonds is mixed. Strong global growth should boost commodity prices. This will help the Australian economy. The unemployment rate in Australia has fallen to 5.6%, but involuntary part-time employment is high and wage growth has been stagnant. Industrial capacity utilization remains low, as reflected in a fairly large output gap (Chart 29). The market expects the RBA to deliver 38 basis points in rate hikes over the next 12 months. We think that's about right. New Zealand's 10-year yield stands at a relatively generous 2.96%, which makes it difficult to be too bearish on kiwi bonds. However, we do not see much scope for yields to fall from current levels. Nominal GDP is growing at over 5% and retail sales are expanding at nearly 7% (Chart 30). The terms of trade have risen to their highest level since the 1970s. The output gap is now fully closed and core inflation is edging higher. Despite this good news, the policy rate remains at a record low of 1.75%. We concur with market expectations that the RBNZ will start raising rates next year. Chart 28U.K. Growth Is Slowing Chart 29There Is Still Slack In The Australian Economy Chart 30New Zealand: Upbeat Indicators Overweight JGBs CPI swaps predict that inflation in Japan will average only 0.5% over the next twenty years. As we argued last week, this is far too low.4 The secular drivers of deflation are fading and inflation will begin to surprise to the upside over the coming years (Chart 31). However, the path between here and there will be a choppy one. Considering that deflationary expectations remain deeply entrenched, the Bank of Japan is unlikely to abandon its yield curve targeting regime for at least the next few years. As government bond yields rise elsewhere in the world, 10-year JGBs will be the default winners. Investors thinking of going short Japanese government bonds should focus on 20-year or 30-year maturities, which are not subject to the BoJ's cap. Credit: Still Overweight, But Trimming Back Exposure High-yield credit spreads have fallen back near their post-recession lows after widening in the wake of the global manufacturing recession (Chart 32). We see little scope for further spread compression. Our U.S. Corporate Health Monitor remains in deteriorating territory (Chart 33), and higher Treasury yields will put downward pressure on corporate bond prices even if spreads remain constant. Nevertheless, the default-adjusted spread on U.S. high-yield debt of 212 basis points is still large enough to warrant a modest overweight to credit, especially since banks have started to loosen lending standards again. Chart 31Japan: Fading Deflationary Forces Chart 32High-Yield Spreads Have Narrowed Chart 33U.S. Corporate Health Continues To Deteriorate Our Global Fixed Income Strategists prefer U.S. over European credit, given that spreads are lower in Europe, and the tapering of ECB asset purchases could reduce the demand for spread product. Currencies And Commodities The Dollar: Comeback Kid? Charts 34 and 35 show our expectations about the future path of the major currencies and commodities. Chart 34Market Outlook: Currencies Chart 35Market Outlook: Commodities BCA's Global Investment Strategy service went long the dollar in October 2014. We reiterated our bullish stance before the U.S. presidential elections, controversially arguing that "Trump Will Win And The Dollar Will Rally."5 Unfortunately, we remained long the dollar over the course of this year, which turned out to be a mistake. Strong growth abroad, weaker-than-expected inflation readings in the U.S., and the fizzling of the "Trump Trade" all contributed to dollar weakness. Technicals also played a role. Sentiment was extremely bullish towards the dollar at the start of the year, but extremely bearish towards the euro (Chart 36). The reversal of these technical trends helps explain why the euro appreciated a lot more than what one would have expected based simply on changes in interest rate differentials (Chart 37). Chart 36Euro: Long Positions Are Getting Stretched Chart 37The Euro Has Overshot Interest Rate Spreads Of course, if the spread between U.S. and euro area interest rates continues to narrow, it is likely that EUR/USD will strengthen. We are skeptical that it will. For one thing, financial conditions have eased sharply in the U.S. since the start of the year, but have tightened in the euro area (Chart 38). This suggests that U.S. growth will surprise on the upside whereas euro area growth could begin to disappoint. Chart 38U.S. Versus Euro Area Diverging Financial Conditions The five-year, five-year forward OIS spread between the two regions stands at 87 basis points in nominal terms, and 25 basis points in real terms. The five-year forward spread is even lower if one calculates a GDP-weighted bond yield for the euro area rather than looking at the expected path of interbank rates. Such a small spread is inconsistent with the fact that the neutral rate is substantially higher in the U.S.6 We expect EUR/USD to fall to $1.15 by the end of 2017, and potentially decline further in 2018 as the Fed picks up the pace of rate hikes. The dollar is also likely to strengthen against the yen, as Treasury yields rise relative to JGB yields. We see less downside for the British pound and the Swedish krona against the greenback. This is reflected in our long GBP/EUR and long SEK/CHF trade recommendations, both of which remain in the black. Upside For Oil-Sensitive Currencies Our energy strategists still see further upside for crude oil prices, owing to favorable supply and demand conditions. They point to the fact that official forecasts by the EIA have consistently underestimated oil demand. They also note that compliance with OPEC 2.0 production cuts has been remarkably good, and that estimates of how much new shale output will hit the market over the next 12 months are too optimistic. Additionally, they believe that the decline in production from conventional oil fields around the world - especially offshore fields, where there has been a dearth of new investment in recent years - could be larger than expected.7 Geopolitical risks in Iraq, Libya, and Venezuela could also adversely affect supply. Firmer demand and lackluster supply will lead to further drawdowns in OECD oil inventories, which should be supportive of prices (Chart 39). We recently took profits of 13.8% on our recommendation to go long the December-2017 Brent oil futures contract, but are maintaining exposure to oil through our long CAD/EUR and RUB/EUR positions, as well as through our bias towards cyclical equities. Resilient Chinese Economy Should Support Metal Prices And The RMB Recent Chinese data have been on the soft side, giving rise to fears that the economy is heading towards a major slowdown. We are more optimistic. While growth has clearly slowed since the start of the year, it remains at an above-trend pace, as evidenced by numerous real-time measures of economic activity (Chart 40). Chart 39Falling Oil Inventories Should Lead To Higher Crude Prices Chart 40Chinese Economy: No Need To Be Pessimistic Even the housing market has managed to stay resilient, despite widespread predictions of imminent doom (Chart 41). The share of households planning to buy a new home remains close to all-time highs. The amount of land purchased by developers - a good leading indicator for housing starts - is accelerating. Reflecting these developments, property stocks are surging. Financial conditions have tightened, but so far this has largely bypassed the real economy. In fact, long-term bank lending to nonfinancial institutions has accelerated since the start of the year (Chart 42). The recently announced cuts to reserve requirements for small business loans should facilitate this trend. Chart 41Chinese Housing Market Remains Resilient Chart 42Credit To Real Economy And Profit Rebound Bode Well For Capex Meanwhile, industrial profits have rebounded, as rampant producer price deflation last year has given way to modest price gains this year. Increased retained earnings will give Chinese companies the wherewithal to spend more on capital equipment. A recovery in global trade should also help stoke export growth. (Chart 43). Despite strengthening this year, our indicators suggest the yuan is still in undervalued territory (Chart 44). Buoyant economic growth should alleviate capital flight and reduce the pressure on the authorities to engineer a further depreciation of the currency. This, in turn, should help support metal prices and other EM currencies, even in a setting where the dollar remains well bid. Chart 43Positive Global Trade Momentum: A Tailwind For Chinese Exports Chart 44The Chinese Yuan Is Undervalued Chart 45Gold: Waiting For Drivers Of Sustained Price Appreciation Buy Gold ... But Not Yet Lastly, a few words on gold. Gold does well in situations where real rates are falling and the dollar is weakening (Chart 45). That's not the environment we find ourselves in today. Gold will have its day in the sun, but probably not before the stagflationary era begins in earnest after the next recession. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 This revenue loss is measured against a baseline where a number of tax breaks, which are currently set to expire, are extended. Please see BCA Geopolitical Strategy Weekly Report, "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 2 Please see Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017. 3 Summers, Lawrence, H. (@LHSummers). "Great piece by @jasonfurman in today's @WSJ: The U.S. can no longer afford deficit-increasing tax cuts." 01 Oct 2017. Tweet. 4 Please see Global Investment Strategy Weekly Report, "Three Tantalizing Trades," dated September 29, 2017. 5 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016. 6 Please see Global Investment Strategy Weekly Report, "Central Bank Showdown," dated September 8, 2017. 7 Please see Commodity & Energy Strategy, "OPEC 2.0 Will Extend Cuts to June 2018," dated September 21, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Recommendation Allocation The global growth outlook remains strong, with corporate earnings likely to beat expectations for a couple more quarters. Inflation and Fed policy are key to asset allocation. We expect inflation to recover, which will push up interest rates and the dollar. But uncertainty is rising too: for example the composition of the FOMC next year, Chinese policy post the Party Congress, Geopolitics. We keep our pro-risk tilts, particularly overweights in euro area and Japanese equities, U.S. high-yield bonds, private equity, and cyclical sectors. But we reduce portfolio risk by bringing some allocations closer to benchmark, for example downgrading U.S. equities to neutral and reducing the underweight in EM. Feature Overview Growth Is Picking Up - But So Is Uncertainty The outlook for global economic growth remains almost unarguably positive (Chart 1). The key for asset allocation, then, comes down to whether inflation in the U.S. will rebound, and whether therefore the Fed will continue to tighten monetary policy in line with its current projections. This would likely cause long-term interest rates to rise and the dollar to appreciate, which would be positive for developed market equities and credit, but negative for government bonds, emerging market equities and commodities. This scenario has been our expectation - and the basis of our recommendations - for some time, and it remains so. In September, the market started coming around to our view - after months of pricing in that inflation would stay sluggish (which, therefore, had caused the euro and yen, government bonds, EM equities and commodities to perform well). In just a couple of weeks, the futures-market-priced probability of a December Fed hike has moved from 31% to 75%. This was triggered by little more than stabilization of core CPI (Chart 2), due mainly to shelter inflation, which anyway has a low weight in the core PCE inflation data that the Fed most closely watches. To us, this demonstrates just how sensitive the market is to any slight pickup in inflation, due to the fact that its expectations of Fed rate hikes over the next 12 months are so far below what the FOMC is signaling (Chart 3). Chart 1Lead Indicators Looking Good Chart 2Is The Softness In Inflation Over? Chart 3The Market Still Doesn't Believe The Fed However, a risk to BCA's view is that the Fed turns dovish. Even Janet Yellen, in the press conference after the FOMC meeting on 20 September, admitted that the Fed needs "to figure out whether the factors that have lowered inflation are likely to prove persistent". If they do, she said, "it would require an alteration of monetary policy." FOMC member (and notable dove) Lael Brainard, in an important speech earlier in September, laid out the argument that, since inflation has missed the Fed's 2% target for five years, inflation expectations have been damaged (Chart 4) and that only a period during which inflation overshot could repair them. With Yellen's term due to expire next February and four other vacancies on the FOMC, personnel changes could significantly change the Fed's direction. Online prediction sites give a somewhat high probability to President Trump's replacing Yellen, with (the rather more hawkish) Kevin Warsh, a Fed governor in 2006-11 (Chart 5). However, presidents tend to like loose monetary policy - President Trump has said as much himself - which raises the possibility of his trying to steer the Fed in a direction that is more tolerant of rising inflation. A possible scenario, then, is of an accommodative Fed which allows equities markets to have a final meltup for this cycle, similar to 1999. Chart 4Have Inflation Expectations Been Damaged? Chart 5Who Will Trump Choose To Lead The Fed? Another current source of uncertainty is China. Money supply growth there has slowed sharply this year, after being pushed upwards by the government's reflationary policies in late 2015. This historically has been a good lead indicator of growth and, indeed, many cyclical indicators have surprised to the downside recently (Chart 6). It is also hard to predict whether, after October's five-yearly Communist Party congress, newly re-elected President Xi Jinping will move ahead with implementing structural reforms, even at the expense of a short-term slowdown of growth.1 We continue to think that risk assets have further upside for this cycle. Growth is likely to remain strong, the probability of a U.S. tax cut is rising, and corporate earnings should surprise to the upside for another couple of quarters (Q3 S&P500 EPS consensus forecasts remain cautious at 5% YoY, versus our model which suggests double-digit growth). Nonetheless, the cycle is now mature, global equities have already produced a total return of almost 40% since their recent bottom in February last year, and valuations in almost every asset class are stretched (Chart 7). Moreover, geopolitical risks - such as that from North Korean missiles - will not disappear quickly. We continue to pencil in the possibility of a recession in 2019 or 2020, caused by a sharp rise in inflation, especially in the U.S., which the Fed - whoever is running it - would have to stamp on by raising rates above the equilibrium level. Chart 6Is A Downturn Coming In China? Chart 7Nothing Looks Cheap Therefore, on the 12-month horizon we continue to recommend pro-risk and pro-cyclical positioning, for example an overweight in equities versus fixed income. However, given the rising uncertainty, we are reducing the scale of our bets a little and so, for example among our equity country and regional recommendations, move a little closer to benchmark by lowering the U.S. to neutral and reducing the degree of our underweight in EM. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking How worried should we be about North Korea? Chart 8Threats - But Eventually A Diplomatic Solution President Obama reportedly warned President Trump just prior to inauguration that North Korea would be his biggest headache. After 15 missile launches and a nuclear test this year (Chart 8, panel 1), investors are beginning to think the same. How big is the risk that the tension turns into warfare? BCA's Geopolitical strategists have written about the subject extensively.2 They conclude that military action is unlikely. An U.S. attack on North Korean missile or nuclear sites would simply provoke an attack with conventional weapons on Seoul, which is only 50 km from the border. Kim Jong-un undoubtedly knows that if he were to attack Guam or Japan, his country would be wiped out. In the end, then, a diplomatic solution is likely - but this will only be achieved after tension has risen sufficiently to force the two sides to the negotiating table. The analogy is Iran in 2012-15, where sanctions finally forced it to agree to a 10-year freeze in its nuclear plans. For the moment, sanctions seem unlikely to bite. North Korea's trade with China is not yet notably slowing (Chart 8, panel 2) and its GDP growth actually accelerated last year, albeit from stagnating levels, according to estimates from the Bank of Korea (Chart 8, panel 3). So the cycle of new threats and tougher sanctions will continue for a while. Historically, North Korean provocations caused related markets (such as South Korea stocks) to fall sharply for a few days, but this always represented a buying opportunity (Chart 8, panel 4). Given the likelihood of a diplomatic outcome, we think this remains a good rule of thumb. What will happen after China's 19th Party Congress, and will there be a slowdown in the economy? China's twice-a-decade National Party Congress will be held October 18-25. The outcome of the meeting could have important economic and market consequences. The key purpose of the Congress is to rotate China's political leaders. The 19th Party Congress is crucial because it marks the passing of a generation: President Xi Jinping will receive a second five-year term, but is predicted to consolidate his power by placing a younger generation of leaders who support his structural reforms into key positions. When Xi came to power, his reform agenda included de-emphasizing GDP targets; injecting private capital, competition and market discipline into the state-owned corporate sector; and fighting pollution. This agenda has since been compromised, with Xi reverting to infrastructure spending and credit growth to avoid painful adjustments. However, recently, there have been signs of a pullback in reflationary policies (Chart 9). Financial tightening is a key to reviving reform. Tighter controls on banks and leverage will translate into greater market discipline, and will put pressure on the sector most in need of change: SOEs. During the twice-a-decade National Financial Work Conference In late July, Yang Weimin, a key economic policymaker who is close to Xi, said, "The nation can't let leverage rise for the purpose of boosting economic expansion," signaling that the administration is willing to tackle difficult reform issues. He also mentioned the potential risks in the economy such as shadow banking, property bubbles, high leverage in SOEs, and local government debt, adding that the nation should set out its priorities and tackle them. Though it is impossible to predict the precise outcome of the Congress, the leadership reshuffle is likely to benefit Xi's reform agenda. The new leadership is likely to work on rebalancing growth toward consumption and services while encouraging private entrepreneurship and cutting back state-owned enterprises and, most importantly, deleveraging corporate debt. If China's credit impulse rolls over, the recent improvement in industrial profits and domestic demand will come under threat (Chart 9). As a result, China's cyclical growth is set to slow in 2018 as Xi reboots reform. Although economic risks will rise as the reform takes place, we still believe China H shares are attractive relative to other EM markets. In the long run, Xi's renewed reform drive should help China to get out of the "middle income trap'', which could help Chinese stocks to outperform EMs such as South Africa, Turkey and Brazil, where reforms are absent.3 Are Indian equities still a buy? In the three years since Prime Minister Narendra Modi's election, Indian stock prices have outperformed their emerging market peers by more than 20%. But the underlying growth dynamics do not justify this performance. We are turning cautious on India and downgrade Indian equities to neutral for the following reasons. India's GDP growth rate fell to a three-year low of 5.7% yoy in the April-June quarter. The administration's "Make In India" campaign is having limited impact, as seen in the near-zero growth of the manufacturing sector. Capital spending by firms has been dismal, further weighing on the outlook for productivity. Increasing layoffs and business shutdowns have produced considerable slack in the economy. Non-performing loans in the banking system have reached 11.8% of assets. As a result, credit growth to business has fallen almost to zero. This has slowed infrastructure development, as seen in the high level of stalled capital projects. The Reserve Bank of India has only just started the process of pushing banks to raise provisioning for distressed assets. The negative impact of last year's demonetization program is finally showing through. Less than 10% of Indians have ever used non-cash payment methods, and so demand for cyclical goods is slowing. Finally, Indian stocks have risen significantly in recent years, making them expensive relative to EM peers. In addition, profit growth has slowed, and return on equity converged with the EM average. Indian equities have been riding on expectations of reforms from the Modi administration. But, with the exception of the Goods & Services Tax (GST), the reform progress has been disappointing. We are turning cautious on Indian equities until we see improvements in the macro backdrop (Chart 10). Chart 9Sign of slowdown in Chinese Economy Chart 10India: Loosing Steam? How should global equity investors hedge foreign currency exposures? Chart 11Dynamic Hedging Outperforms Static Hedging There have been many conflicting views on how to hedge foreign currency exposures in a global equity portfolio. Full hedge,4 no hedge,5 or simply 50% hedge?6 Or should all investors hold the reserve currencies (USD, euro and Swiss Franc), avoid commodities currencies (AUD and CAD) while being neutral on GBP and JPY?7 As published in a Special Report 8 on September 29, 2017, our research has found that not only should investors with different home currencies manage their foreign currency exposures differently, but also a dynamic hedging framework based on the indicators from BCA's Foreign Exchange Strategy service's Intermediate Timing Model (ITTM)9 outperforms all the static hedging strategies for all investors with six different home currencies (USD, EUR, JPY, GBP, AUD and CAD) (Chart 11). A few key observations from Chart 11 Static hedges reduces risk with little impact on returns for the USD and JPY investors only. Unlike the CAD investors, the AUD investors are much better off to hedge than not to, on a risk adjusted basis, even though AUD is also a commodity currencies, like the CAD. The 50% "least regret" hedge ratio has lived up to its reputation as it reduced risk by more than 50% without severely jeopardizing returns. And for the USD based investors, the 50% static hedge has a similar risk/return profile as the dynamic hedge. For all other five home currencies, however, the 50% static hedge underperforms the dynamic hedge. Global Economy Overview: Globally growth has accelerated, with inflation quiescent. We expect growth to continue to be strong, but U.S. inflation will start to normalize, which should trigger further Fed hikes and a rise in long-term rates. Japanese and euro zone growth will be less inflationary, given continued slack in these economies. U.S.: Growth has rebounded sharply after the seasonally weak Q1 and excessive expectations following the presidential election. The Citi Economic Surprise Index (Chart 12, panel 1) shows strong upward surprises. First-half GDP growth came in at 2.2% (above trend, which is estimated at 1.8%), and the manufacturing ISM reached 57.7 in September. The two big hurricanes will probably knock around 0.5 points off Q3 growth but the lesson from previous disasters is that this will be more than made up over the following three quarters. Rebounding capex, and consumption aided by a probable acceleration in wages, should keep GDP growth strong. Euro Area: Due to Europe's greater cyclicality and dependence on the global cycle, growth momentum is unsurprisingly even stronger than in the U.S., with Q2 GDP growth 2.3% YoY and the manufacturing PMI at 57.4. German growth has been particularly robust with the IFO index at 115.9, close to an all-time high, and German manufacturing wages growing by 2.9% YoY. The credit impulse suggests that the strong growth should continue, although the euro appreciation this year (and consequent tightening of financial conditions) might dampen it a little. Japan: Growth continues to be good in the external sector (with exports rising 18% YOY and industrial production 5%), but weak in the domestic economy, where household spending and core inflation continue to flatline. We do, though, see some first tentative signs of inflation: the Bank of Japan's estimate suggests the output gap has now closed, and the tight labor market is showing through in part-time hourly wages, which are rising 2.9%. Emerging Markets: China's PMI has oscillated around 50 all year (Chart 13, panel 3), as the authorities tried to stabilize growth ahead of October's Party Congress. But money supply and credit growth have been slowing all year, and this is now showing through in downside surprises in fixed asset investment and retail sales data. Especially if the congress moves towards structural reform and short-term pain, growth may slow further. This would be negative for other emerging markets, which depend on China for growth. Bank loan growth and domestic consumption generally remain weak throughout EM ex China. Chart 12Global Growth Is Accelerating... Chart 13...Propelling Europe And Japan Interest Rates: Inflation has been soft this year in the U.S. but is likely to pick up in coming months reflecting stronger economic growth and dollar depreciation. We expect the Fed to raise rates in December and confirm its three hikes next year. That should be enough to push the 10-year Treasury yield up to close to 3%. In Japan and the euro area, however, underlying inflationary pressures are much weaker. So we expect the Bank of Japan to stick to its yield curve control policy, and for the ECB to emphasize, when it announces in October next year's (reduced) asset purchase program, that it will be cautious about raising rates. Global Equities Chart 14Earnings Have Been Strong... Q3 2017 was the second quarter in a row when the price appreciation in global equities was driven entirely by earnings growth, since the forward price-to-earnings ratio contracted by 2% compared to Q2 (Chart 14). Chart 15No Compelling Reasons To Make Large Bets The scope of the improvement in earnings so far in 2017 has been wide. Not only are forward earnings being revised up, but 12-month trailing earnings growth has also been very strong, with all 10 top-level sectors registering positive earnings growth. Margins have steadily improved globally from the lows in early 2016. Despite the slight multiple compression in Q3, equity valuations are not cheap by historical standards. As an asset class, however, equities are still attractively valued compared to bonds, especially after the recent safe-haven buying drove global bond yields to very depressed levels. We remain overweight equities versus bonds on the 9-12 month horizon. Within equities, however, we think it's prudent to reduce portfolio risk by bringing allocations closer to benchmark weighting because 1) equities are not cheap, 2) volatility is low, 3) geopolitical tension is rising, and 4) year-on-year earnings growth over coming quarters may not be as strong as it has been so far this year because earnings in the first half of the 2016 were very depressed. As such, we downgrade the U.S. to neutral from overweight (+3 percentage points), and reduce the underweight in EM (to -2 from -5). We remain overweight the euro area and Japan (but hedge the yen exposure). Within EM, we have been more positive on China and remain so on a 6-9 month horizon. Sector-wise, we maintain our pro-cyclical tilt. Country Allocations: Downgrade U.S. To Neutral We started the year being "cautiously optimistic" with a maximum overweight (+6 ppts) in U.S. equities.10 We added risk at the end of the first quarter by reducing by half the U.S. overweight in order to upgrade the higher-beta euro area to overweight (+3) from neutral.11 The change has worked well, as the euro area outperformed the U.S. by 542 basis points (bps) in Q2 and then by 370 bps in Q3 in unhedged USD terms. Our DM-only quant model also started the year with a maximum overweight in the U.S., but the overweight was gradually reduced each month until July when the model indicated a benchmark weight for the U.S. The model continued its shift away from the U.S. in August and September, and now the U.S. is the largest underweight in the model. As we have previously stated, we use the quant model as one key input into our decision-making process, but we do not follow it slavishly because 1) no model can capture all the ever-changing driving forces in the market, and 2) the model moves more often than we prefer. In light of the rising geopolitical risks and low levels of volatility in all asset classes, we conclude that there are no longer compelling reasons to make large bets among the countries (Chart 15). Valuation in the U.S. is stretched, but neither is it cheap in EM anymore; both trailing and forward earnings growth in the U.S. are below the global average. Forward earnings in the EM look likely to outpace the global average, but EM trailing earnings growth seems to be losing steam. As such, we recommend investors to be neutral in the U.S. and use the funds to reduce the underweight in EM. Sector Allocation: Stay Underweight Global Utilities Overall, our sector positioning retains its tilt towards cyclicals and against defensives (see Table 1). Our global sector quant model, however, in September reduced its underweight in defensives by upgrading utilities to overweight from underweight, mainly due to the momentum factor. We have decided to overwrite the model result and maintain our underweight recommendation for the following reasons. In October, the model again downgraded utilities to underweight. In the most recent cycle post the Global Financial Crisis (GFC), the relative performance of utilities has been closely correlated with the performance of bonds vs. equities (Chart 16, top panel). This is not surprising given the bond-like nature of the sector. The sector enjoys a higher dividend yield than the global average: other than during the GFC, the excess yield has been in the range of 1-2%. In a low bond-yield environment, this yield pick-up is no doubt attractive. However, our house view is for global bond yields to rise over the next 9-12 months and we maintain our overweight on equities vs. bonds. As such, underweight utilities is in line with our overall risk/return assessment. In addition, even though the utilities sector has a higher dividend yield, the current reading is not particularly attractive compared to the five-year average (panel 4); valuation measures such as price to book (panel 3) show a neutral reading as well. The other sector where we override our quant model is Healthcare, which we favor as a long-term play because of favorable demographic trends, while the quant model points to an underweight due to short-term factors such as momentum and valuation. Smart Beta Update Year-to-date, the equal-weighted multi-factor portfolio has outperformed the global benchmark by 54 basis point (bps). (Table 1 and Chart 17) Among the five most enduring factors - size, value, quality, minimum volatility, and momentum - momentum is the only factor that has prevailed in both DM and EM universes, while quality has outperformed in the DM, but underperformed in EM. (Table 1) Chart 16Maintain Underweight Utilities Chart 17MSCI ACW: Factor Relative Performance Value has underperformed growth across the board (Table 1). The size performance, however, has large regional divergences in both value and growth spaces. Small cap has outperformed large cap consistently in both the value and growth spaces in the higher-beta euro area, Japan and U.K., while underperforming in the lower-beta U.S. (Table 2) We maintain our neutral view on styles and prefer to use sector positioning to implement the underlying factors given the historically close correlation between styles and cyclicals versus defensives (Chart 17, bottom two panels). Year-to-date cyclicals have outperformed defensives (Table 1). Table 1YTD Relative Performance* Table 2YTD Total Returns* (%) Small Cap - Large Cap Government Bonds Maintain Slight Underweight Duration. U.S. bond yields declined significantly in Q3 to below fair-value levels in response to heightened geopolitical risks and hurricanes (Chart 18, top panel). This safe-haven buying spread globally, despite ample evidence of faster global growth (middle panel) and less accommodative monetary policies from the major central banks. There is now considerable upside risk for global bond yields from these current low levels. Maintain Overweight TIPS Vs. Treasuries. The fall in nominal U.S. Treasury yields, however, was concentrated in the real yields, as 10-year break-even inflation widened in Q3 (Chart 18, panel 3). In terms of relative value, TIPS are now fairly valued vs. nominal bonds. However, our U.S. Bond Strategy's core PCE model, which closely tracks the 10-year TIPS breakeven rate (Chart 18, panel 3), is sending the message that inflationary pressures are building in the economy and that core PCE should reach the Fed's 2% target by the end of this year. This suggests that the bond markets are not providing adequate compensation for the inflationary economic backdrop. Underweight Canadian Government Bonds. The Bank of Canada (BOC) delivered another surprise 25 bps rate hike in September, due to "the impressive strength of the Canadian economy" and "the more synchronized global expansion that was supporting higher industrial commodity prices." BCA's Global Fixed Income Strategy has been underweight Canada in its hedged global portfolio and recommends investors not to fight the BOC despite little inflation pressure in the Canadian economy (Chart 19). Chart 18Poor Value in Nominal Government Bonds Chart 19Bank of Canada: Shock Hawks Corporate Bonds As inflation recovers and the Fed moves ahead with rate hikes, we expect long-term risk-free rates to rise moderately. Fair value for the 10-year U.S. Treasury yield is currently close to 2.7%. In the context of rising rates and continued economic expansion, we continue to prefer spread product over government bonds. Investment grade bonds in the U.S. trade at an average option-adjusted spread over Treasuries of 110 bps. While Aaa corporate spreads are expensive, other investment grade credit tiers appear fairly valued. Given the deterioration in our U.S. Corporate Health Monitor (Chart 20), amid a rise in leverage, over the past two years (Chart 21) we do not expect the spread to contract further or fall back close to historic lows. However, investors should still be moderately attracted by the carry in a low interest rate environment. Our preference is for U.S. investment-grade corporate bonds over European ones, since the latter could be negatively impacted when the ECB announces its tapering of asset purchases in October. High-yield bonds look attractive after a small rise in spreads and an improvement in the cyclical outlook over the past quarter. The current spread of U.S. high-yield, 360 bps, translates into a default-adjusted yield (assuming a 2.6% default rate and 49% recovery rate over the next 12 months) of 250 bps - close to the long-run average (Chart 22). European junk debt looks less attractive from a valuation perspective. Chart 20Corporate Health Is A Worry In The U.S. Chart 21IG Spreads Unlikely To Contract Further Chart 22High-Yield Debt Valuations Look Attractive Commodities Chart 23Mixed View Towards Commodities Secular perspective: Bearish We hold a bearish secular outlook for commodities, mainly due to our view on China's slowing economic growth and the increasing shift from traditional energy sources to alternatives. Cyclical perspective: Neutral Our short-term commodities view remains neutral since oil inventory drawdowns will push up the crude oil price further, and because low real interest rates will keep gold from falling this year. But industrial metals are likely to react negatively to the winding down of China's reflation after the Party Congress in mid-October. Precious metal: Short-term bullish, long-term bearish. We expect the Fed to tighten rates only slowly which, over time, will mean the central bank finds itself behind the curve on inflation. Real rates are expected to remain relatively low for the foreseeable future, which will be supportive of gold. Rising tension between North Korea and the U.S. could also give gold a lift. Industrial metals: Bearish The copper price has rallied by 10% during Q3 2017, thanks to supply-side disruptions at some of the world's largest copper mines, along with better-than-expected performance of the Chinese economy. However, mine interruptions will be transitory, and the world copper market is already back in balance (Chart 23, panel 3). Although the rebound in the Chinese PMI is keeping metal prices up, we believe China after the Party Congress will try to reengineer its economy towards being more consumption and services-led, which will temper demand for industrial metals. Energy: Bullish We believe that market has been overly pessimistic on oil, and that this will change due to declining inventories and better demand and supply dynamics. (Chart 23) The U.S. Energy Information Administration revised down its shale production forecast for 2H 2017 by 200,000 barrels/day, which should lower investors' concerns over shale overproduction. Libyan oil production, the biggest threat to our bullish oil view, faltered by 300,000/day in August, keeping OPEC in compliance with its promised cuts. Currencies U.S. Dollar: Year to date, the dollar is down by 8% on a trade-weighted basis (Chart 24). However, after a period of underperformance, the U.S. economy is improving relative to its G10 peers, as seen by the strong rebound in the U.S. ISM manufacturing index. Additionally, the pick-up in money velocity points to a recovery in core inflation. As inflation starts to pick up again, markets will discount additional Fed rate hikes. Stay bullish U.S. dollar over the next 12 months. Chart 24U.S. Dollar Recovery? Pound: After a weak start to the year, sterling has recovered all its losses. Strong net FDI inflows have pushed the basic balance back into positive territory. However, Brexit negotiations will impact the financial sector, the largest target for FDI. Additionally, the recent sharp increase in inflation came from the pass-through effect of the weaker currency, and is not reflective of domestic economic activity. We expect increased political uncertainty to weigh down on future growth, forcing the Bank of England to maintain a dovish stance. Stay bearish over the next 12 months. Dollar: On a trade-weighted basis the currency is up 4% year to date, primarily driven by the rally in select metal prices. OECD's measure of output gap still points to substantial slack in the domestic economy, as seen in the downtrend in core inflation and nominal retail sales. However, despite improvements in global trade and domestic real estate activity, the Reserve Bank of Australia will keep policy easy in response to volatile commodity markets. Stay bearish over the next 12 months. Canadian Dollar: Driven by net portfolio inflows near record highs, the currency is up 6% on a trade-weighted basis so far this year. With improving economic activity, as seen in strong retail sales, the Bank of Canada expects the output gap to close in 2018. However, going forward, oil prices are unlikely to double again, and the combination of elevated indebtedness, bubby house prices and rising rates will create headwinds for the household sector. Stay bearish over the next 12 months. Alternatives Chart 25Favor PE, Real Assets Return Enhancers: Favor private equity vs. hedge funds In 2017 so far, private equity has returned 9%, whereas hedge funds have managed only a 3.5% return (Chart 25). Given their strong performance, private equity firms are raising near-record amounts of capital from investors starved for yield. By contrast, hedge funds continue to underperform both global equities and private equity, as is typical outside of recessions or bear markets. However, increasing concerns about valuations in private markets have pushed private equity dry powder to new highs of $963 billion. We continue to favor private equity over hedge funds, albeit with a more cautious outlook. Within the hedge fund space, we favor event-driven funds over the cycle, and macro funds heading into a recession. Inflation Hedges: Favor direct real estate vs. commodity futures In 2017 to date, direct real estate has returned 3.3%, whereas commodity futures are down over 10%. With energy markets likely to continue to recover lost ground over the coming months, we stress the structural nature of our negative recommendation on commodities. Depressed interest rates will keep financing cheap, making the spread between real estate and fixed income yields attractive. However, the slowdown in commercial real estate has made us more cautious on the overall real estate space. With regards to the commodity complex, the long term transition of China to a service-based economy will continue the structural decline in commodity demand. Continue to favor direct real estate vs. commodity futures. Volatility Dampeners: Favor farmland & timberland vs. structured products In 2017 to date, farmland and timberland have returned 2.2% and 1.5% respectively, whereas structured products have returned 1.4%. Farmland continues to outperform timberland given the latter's lower correlation with growth. Timberland returns have also lagged farmland given the weak recovery in the U.S. housing market. Investors can reduce the volatility of a multi-asset portfolio with the inclusion of farmland and timberland. With regards to structured products, rising rates and deteriorating credit quality in the auto loan market will weigh on returns. Given the Fed's plans to start unwinding its balance sheet this year, increased supply will put upward pressure on spreads. Risks To Our View Our pro-risk positioning would be incorrect if global growth were to slow sharply. But we see little sign that this is a significant risk over the next six to 12 months. Of our three favorite indicators of recession risk, global PMIs remain strong, and the U.S. 10-minus-2 year yield curve is still solidly positive at around 80 BP. Only a small blip up in junk bond spreads in August (Chart 26) is of any concern, and it was probably caused just by geopolitical tensions. With U.S. and European consumption and capex looking strong, probably the biggest risk to global growth would come from China, similar to 2015, if October's Party Congress signals a shift to short-term pain to achieve structural reforms. Perhaps more likely is an upside surprise to growth, with BCA's models - based on consumer and business sentiment - pointing to around 3% real GDP growth in the U.S. and 2½% in the euro area over the coming couple of quarters (Chart 27). Such an acceleration of growth would raise the risk of upside surprises to inflation, which could cause a bigger sell off in bond markets than we currently anticipate. Chart 26Any Need To Worry About Credit Spreads? Chart 27Could Growth Surprise On The Upside? Chart 28Suppose Inflation Stays Stubbornly Low Our positioning is not based on inflation remaining chronically low. But structural changes in the economy could cause this. While the Philips curve has not broken down completely, wage growth in the U.S. is 1-1½% lower than in previous expansions when the unemployment gap was at its current level (Chart 28). Could the Nairu be lower than the Fed's estimate of 4.6%? Has the gig economy somehow changed worker and employer behavior? 1 Please see What Our Clients Are Asking: "What Will Happen After China's 19th Party Congress, And Will There Be A Slowdown In The Economy?" of this report. 2 For their most comprehensive analysis, please see Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 3 Please see Geopolitical Strategy Special Report "China: Looking Beyond The Party Congress'' dated July 19, 2017. available at gps.bcaresearch.com). 4 Perold, A and E. Schulman, 1988, "The free lunch in currency hedging: Implications for investment policy and performance standards," Financial Analyst Journal 44, 45-50. 5 Froot K., 1993, "Currency hedging over long horizons," NBER working paper 4355. 6 Michenaud, S., and B., Solnik, 2008, "Applying Regret Theory to Investment Choices: Currency Hedging Decisions," Journal of International Money and Finance 27, 677-694. 7 Campbell, J., K. de Medeiros and L. Viceira, 2010, "Global Currency Hedging," Journal of Finance LXV, 87-122. 8 Please see Global Asset Allocation Special Report, "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors," dated September 29, 2017, available at gaa.bcaresearch.com. 9 Please see Foreign Exchange Strategy "In Search of A Timing Model," dated July 22, 2016, available at fes.bcaresearch.com. 10 Please see Global Asset Allocation, "Quarterly - December 2016," dated December 15, 2016. 11 Please see Global Asset Allocation, "Quarterly - April 2017," dated April 3, 2017. GAA Asset Allocation
Highlights In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors - one of our favorite and long-standing indicators to assess the potential for monetary policy changes. The broad conclusion - the Monitors are all at or above the threshold signaling that tighter monetary policy is required, validating the recent hawkish shift by policymakers. Feature September has been an active month for central bankers. The Bank of Canada hiked rates again, the European Central Bank gave strong hints that a tapering of its asset purchase program will soon be announced, and the Bank of England warned that tighter policy might soon be required. Just last week, the Federal Reserve began the process of reducing its massive balance sheet while also making no changes to its plans to hike interest rates several times over the next year. This is setting up a potential nasty surprise for bond markets. Investors have became deeply skeptical about the possibility of policymakers shifting in a more hawkish direction without an obvious trigger from faster inflation. Yet the global economy is in a synchronized expansion with the largest share of countries operating at (or beyond) full employment since the pre-crisis years. Inflation is in the process of stabilizing, or grinding higher, in most of the major economies. In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors - one of our favorite indicators to assess the potential for monetary policy changes. The broad conclusion - the Monitors are all at or above the threshold signaling that tighter policy is required, validating the recent hawkish shift by policymakers (Chart of the Week). Chart of the WeekGrowing Pressures To Tighten, According To Our Central Bank Monitors An Overview Of The BCA Central Bank Monitors Chart 2Upward Pressure On Global Bond Yields The BCA Central Bank Monitors are composite indicators designed to measure the cyclical growth and inflation pressures that can influence future monetary policy decisions. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, exchange rates, etc). The data series are standardized and combined to form the Monitors. Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the Developed Markets (Chart 2). Currently, the Monitors are all near or above the zero line, providing context for why central bankers have shifted towards a more hawkish bias of late. Actual rate hikes are still not likely over the next few months outside of the Fed and BoC (we remain skeptical on the potential for the BoE to realistically tighten policy). More importantly, the underlying growth and inflation pressures indicated by the Monitors suggest that policymakers will maintain a hawkish bias (or, at best, a neutral tone) in their communications with the markets. One new addition to the individual country sections in this Chartbook are charts showing the Monitors, broken into growth and inflation components. The conclusion from these new charts is that the current level of the overall Monitors is a reflection of strong economic growth in all countries, with the inflation components giving more mixed signals. The Fed Monitor: Neutral For Now, Likely To Head Higher Again Our Fed Monitor has drifted lower over the past several months, and now sits just slightly above the zero line, calling for no imminent need to change U.S. monetary policy (Chart 3A). FOMC members have been sending more balanced messages in their recent speeches, specifically noting the confusing mix of what appears to be a U.S. economy operating at full employment but with slowing core inflation (Chart 3B). Chart 3AU.S.: Fed Monitor Chart 3BNo Spare Capacity In The U.S. When looking at the breakdown of our Monitor into its main inputs (Chart 3C), the growth component remains in a steady grinding uptrend. The inflation component had softened since the peak earlier this year, but the latest reading shows a slight uptick. Chart 3CPressure On The Fed From U.S. Growth. Is Inflation Next? Looking ahead, we expect realized U.S. inflation, which looks to be stabilizing after the downturn since the spring, to grind higher alongside a steadily expanding U.S. economy. With corporate profits and household incomes expanding, and with leading indicators steadily climbing, there is little reason to expect much sustained slowing of U.S. growth in the next few quarters. The next move in our Fed Monitor will likely be upward. The historical correlations between changes in our Fed Monitor and changes in U.S. Treasury yields suggest that any renewed increase in the Monitor should put more upward pressure on the front end of the yield curve than the back end (Chart 3D). This suggests that Treasury curve would bear-flatten as the market priced in more Fed rate hikes. However, we see a greater near-term risk of a bear-steepening of the curve given the low level of market-based inflation expectations. The Fed will want to see those rise - which will require signs of realized inflation rebounding - before delivering another rate hike, perhaps as soon as December. Chart 3DThe Fed Monitor Is Most Correlated To Shorter-Maturity USTs BoE Monitor: The Window Is Closing For A Rate Hike Our Bank of England (BoE) Monitor has been in the "tight money required" zone since the end of 2015 and has not signaled a need for easier monetary policy since 2012 (Chart 4A). This is unsurprising with the U.K. economy running beyond full employment for over three years alongside a steady rise in inflation (Chart 4B). Chart 4AU.K.: BoE Monitor Chart 4BTight Capacity In The U.K. The after-effects of the Brexit vote last year are still an issue for the U.K. economy and the BoE. The central bank eased monetary policy (rate cuts and QE) after the Brexit shock as insurance against the massive economic uncertainty. Yet that not only provided stimulus to an economy that was already operating beyond full employment, but also resulted in a 16% peak-to-trough decline in the British Pound. The result: a surge in headline U.K. inflation to 2.9%, well above the BoE's 2% target. The BoE sent a hawkish message at the policy meeting earlier this month, signaling that interest rates would have to rise if growth evolves in line with their forecasts. We are skeptical on that front: U.K. leading economic indicators have rolled over, real income growth has stagnated due the high inflation, and business confidence continues to be dragged down by Brexit uncertainties. Also, the greater stability in the trade-weighted Pound - now essentially flat versus year-ago levels - should result in some cooling off of the currency-driven surge in inflation, which the inflation component of our BoE Monitor is already signaling (Chart 4C). Chart 4CThe Inflation Component Of The BoE Monitor Has Collapsed We remain neutral on Gilts, as we expect the BoE to remain on hold and not follow through on their recent hawkish commentary (Chart 4D). Chart 4DThe Gilt/BoE Monitor Correlations Are Higher At The Long-End ECB Monitor: On Course For A 2018 Taper Our European Central Bank (ECB) Monitor has steadily climbed over the course of 2017 and now sits right on the zero line (Chart 5A). The solid and broad-based economic expansion in the Euro Area has soaked up spare capacity. The unemployment rate has fallen to an 8-year low of 9.1%, suggesting that the Euro Area economy is very close to full employment for the first time since the Great Recession (Chart 5B). Chart 5AEuro Area: ECB Monitor Chart 5BExcess Capacity In Europe Dwindling Fast Against that strong growth backdrop, core inflation has been grinding higher off the lows, but at 1.4% remains below the ECB 2% target for headline inflation. When looking at the components of our ECB Monitor, however, rising inflation pressures have been as important a reason behind the pickup in the Monitor as stronger growth (Chart 5C). Chart 5CGrowth Has Pushed The ECB Monitor Higher This Year The deflation threat that prompted the ECB to begin its own asset purchase program in 2015 has passed, and we expect the ECB to announce a tapering of the bond buying starting in January 2018. If growth and inflation evolve according to the ECB's forecasts - which is likely barring an additional major surge in the euro from current elevated levels - then there is a good chance that the asset purchase program will be wound down by the end of 2018. Interest rate hikes are still some time away, though. The market is currently discounting a first 25bp ECB rate hike around October 2019. We agree with that pricing, as the ECB will "follow the Fed playbook" and not begin rate hikes until well after the end of the asset purchase program. We remain underweight Euro Area government debt, with a bias towards bear-steepening of yield curves as inflation expectations should steadily climb higher and the ECB keeps policy rates unchanged (Chart 5D). Chart 5DStronger Bond/ECB Monitor Correlations At The Short-End BoJ Monitor: Creeping Higher, Surprisingly The Bank of Japan (BoJ) Monitor has steadily climbed throughout 2017 and now sits right on the zero line (Chart 6A). While overall inflation rates remain well below the 2% BoJ target, the steady economic expansion has absorbed spare economic capacity, with the unemployment rate now down to a mere 2.8% (Chart 6B). Both the growth and inflation components of our BoJ Monitor have been rising (Chart 6C). Chart 6AJapan: BoJ Monitor Chart 6BTight Labor Market, But Still No Inflation While the pickup in inflation off the lows is a welcome sight for the BoJ, there is no immediate pressure to shift to a less accommodative policy stance (Chart 6D). In fact, the central bank has already done its own version of a "taper" by moving to a 0% yield target on JGBs one year ago. Maintaining that yield level has required a slower pace of asset purchases by the central bank, which are running at an annualized pace of 70 trillion yen so far in 2017, below the 80 trillion yen target for the current QE program. Chart 6CTight Labor Market, But Still No Inflation We do not see the BoJ abandoning the 0% yield target anytime soon. By depressing JGB yields, the BoJ hopes to engineer additional weakness in the yen which will feed through into faster inflation and rising inflation expectations. This appears to be the only way to generate any inflation in Japan, even with such a low unemployment rate. Chart 6DLow Correlations Between the BoJ Monitor & JGB Yields It will require a rise in Japanese core inflation back towards 2% before the BoJ will even begin to discuss any real tapering of its QE program. Thus, JGBs will remain a low-beta "safe-haven" among Developed Market government bonds, where there is greater risk of central bank tightening actions that will push yields higher. Remain overweight. BoC Monitor: More Tightening To Come The Bank of Canada (BoC) Monitor has been comfortably above the zero line throughout 2017 (Chart 7A). The Canadian economy has shown robust growth, which has soaked up spare capacity (Chart 7B). The BoC is projecting that the output gap in Canada will likely be fully closed before the end of this year. The surprising surge in growth is likely to continue given the strength in the leading economic indicators and the robust readings from the BoC's own Business Outlook Survey. Chart 7ACanada: BoC Monitor Chart 7BStill Not Much Inflation In Canada The central bank has already responded to the faster-than-expected pace of growth with two 25bps rate hikes since July. This took place even without much of a pick-up in realized inflation or in the inflation component of our BoC Monitor (Chart 7C). Clearly, the BoC is focusing more on the rapidly accelerating economy, with real GDP growth surging to a 3.7% year-over-year pace in Q2. With the BoC Overnight Rate still at a very low level of 1%, well below the central bank's own estimate of the neutral "terminal" rate of 3%, there is room for additional rate hikes as long as growth remains robust. Chart 7CRising Growth Pressures On The BoC, Still No Inflation The surging Canadian dollar is not yet a concern for the BoC, as this reflects both the improving Canadian economy and the Fed taking a pause on its own rate hiking cycle. With the latter poised to resume in December and continue into 2018, the appreciation of the "Loonie" is likely to cool off, even if the BoC keeps raising rates. We have maintained an underweight stance on Canadian bonds, with a curve flattening bias, since mid-year (Chart 7D). We are sticking with that stance, even with the market now priced for nearly 70bps of additional rate hikes over the next year. If the Canadian economy continues to grow rapidly, and the Fed returns to hiking rates, the BoC can tighten to levels beyond current market pricing. Chart 7DA Rising BoC Monitor Typically Leads To A Flatter Canadian Yield Curve RBA Monitor: Conflicting Forces Our Reserve Bank of Australia (RBA) Monitor remains in "tighter policy required" territory (Chart 8A). Core inflation has picked up slightly, dragging market expectations along with it, but headline price growth has declined below 2% (Chart 8B). However, commodity prices continue to ease, survey-based measures of inflation expectations have pulled back and the inflation component of the RBA Monitor has retreated from the highs (Chart 8C). Chart 8AAustralia: RBA Monitor Chart 8BNo Inflation Pressures On The RBA The RBA is facing conflicting forces of an improving labor market and booming house prices, combined with high consumer indebtedness and nonexistent real wage growth. Though employment growth has recently spiked, part time employment as a percentage of total is just starting to roll over and underemployment remains elevated. Labor market conditions will need to tighten considerably for wages to rise and consumer confidence to recover. A wide output gap, mixed employment backdrop and a lack of inflation pressure will likely keep the policymakers on hold for longer than the market expects. Chart 8CRBA Facing Surging Growth Pressures & Cooling Inflation Pressures We are currently at a neutral stance on Australian government bonds, given the mixed economic backdrop. Instead, we prefer to maintain our 2yr/10yr yield curve flattener trade. The short end will remain anchored by an inactive RBA, with the long end facing downward pressure from soft inflation expectations and macro-prudential measures in the housing market dampening credit growth. Even if the RBA were to tighten policy as markets expect, the yield curve would flatten. Additionally, negative correlations between Australian yield curves and the RBA monitor have been more robust in the post-crisis era (Chart 8D). As labor markets continue to improve, the other components of the Monitor, such as wages, retail sales and consumer confidence, will follow. Chart 8DThe Entire Australian Curve Is Highly Correlated To Our RBA Monitor RBNZ Monitor: Rate Hikes Are Needed Our Reserve Bank of New Zealand (RBNZ) Monitor has been the strongest of all our Monitors, and is currently well into "tight money required" territory" (Chart 9A). The solid New Zealand economic expansion has fully absorbed spare capacity, and both headline core inflation are accelerating towards the RBNZ target (Chart 9B). Both the inflation and growth components are surging, contributing to the overall sharp rise in the RBNZ Monitor (Chart 9C). Chart 9ANew Zealand: RBNZ Monitor Chart 9BFull Employment & Rising Inflation In NZ So with growth and inflation looking perkier, why has the RBNZ not delivered on rate hikes this year? They central bank has highlighted "international uncertainties" related to geopolitical risks as well as trade tensions between China and the U.S. that could spill over into New Zealand exports to Asia. The central bank has also shown caution in its own growth and inflation forecasts, despite the signs of strength. Chart 9CHow Much Longer Can The RBNZ Ignore This? More likely, the RBNZ has been actively trying to avoid an unwanted surge in the currency that could derail the economy. Given the elevated geopolitical tensions with North Korea, it is likely that the RBNZ will stick with a dovish message - especially given the recent pickup in the currency. We have been running long positions in New Zealand government debt versus U.S. Treasuries and German Bunds in our Tactical Overlay portfolio since May. We've been heeding the commentary of the central bank rather than our own RBNZ Monitor, although the divergence between the two is becoming unsustainable (Chart 9D). The Q3 CPI inflation report due in October will be critical to assess the RBNZ's next move. We are sticking with our recommended trades, for now. Chart 9DNZ Bonds Are Vulnerable To Current Cyclical Growth & Inflation Pressures Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns