Currencies
Highlights Chinese growth will slow next year, but underlying momentum remains strong. Jerome Powell is the most likely choice for Fed chair. However, no matter who is selected, the general thrust of monetary policy will not change radically next year. The transatlantic interest rate spread is not particularly wide considering that the output gap is larger in the euro area, while the neutral rate and expected inflation are lower. U.S. growth should surprise on the upside over the next few quarters, as already evidenced by the rebound in the economic surprise index. This will give the Fed greater scope to raise rates. We expect EUR/USD to reach $1.15 by the end of the year. Feature China: Let's Get This Party Congress Started China's 19th National Congress of the Communist Party of China kicked off this week. As widely expected, President Xi Jinping lauded the successes that China has enjoyed over the past few years in his opening speech, but cautioned that more must be done to reduce corruption, clean up the environment, and expedite market reforms.1 We expect Chinese growth to slow modestly in 2018 from the current above-trend pace, as the government pares back stimulus efforts. Nevertheless, the underlying trend in growth will remain reasonably solid. Chart 1 shows that real-time measures of economic activity such as electricity production, excavator sales, and railway freight traffic are all growing at a healthy pace. Despite the introduction of some tightening measures this spring, the housing market remains resilient. The share of households planning to buy a new home is close to record high levels, while the amount of land purchased by developers - a good leading indicator for housing starts - has continued to accelerate (Chart 2). Chinese property developer stocks have been on a tear this year, outperforming even the red-hot tech sector. With housing inventory levels at multi-year lows, home prices should stay firm. In the industrial sector, rampant producer price deflation last year has given way to modest inflation this year. This has boosted industrial profits, which should support corporate spending in the months ahead (Chart 3). Chart 1Chinese Economy: No Need To Be Pessimistic Chart 2Chinese Housing Market Remains Resilient Chart 3Boost In Industrial Profits Bodes Well For Corporate Spending Both money and credit growth surprised on the upside in September. As we have argued before, copious private-sector savings will forestall a credit crunch and, at least for the foreseeable future, permit the government to run large off-balance sheet budget deficits in an effort to support aggregate demand (Chart 4). Indeed, for all the talk about slowing credit growth, medium- and long-term bank lending to nonfinancial corporations - probably the best single measure of credit flows to the real economy - has continued to accelerate this year (Chart 5). Investors should continue to overweight Chinese stocks relative to the EM aggregate. Chart 4China's Fiscal Deficit Has Been Increasing Chart 5Credit To Real Economy Accelerating Musical (Fed) Chairs News reports indicate that President Trump has winnowed down the list of candidates for Fed chair to five individuals: Chief economic advisor Gary Cohn, current Fed Governor Jerome Powell, former governor Kevin Warsh, Stanford university economist John Taylor, and current chair Janet Yellen. We suspect that Cohn will not make the cut, given his apparent falling out with Trump following the President's remarks about the Charlottesville protests. Warsh and Taylor are likely to be seen as too hawkish. That just leaves Powell and Yellen. Chair Yellen's relatively dovish views on monetary policy would likely sit well with Trump, but she has two major strikes against her. One, she has generally been in favor of more financial sector regulation, which is anathema to Trump. Two, Trump accused her of abetting Hillary Clinton during the election campaign. Keeping her as Fed Chair (assuming she would actually want the job) might convey the message that he is no longer interested in shaking up the existing institutional order in Washington DC. This just leaves Powell as the default candidate, who reportedly has received the blessing of Treasury Secretary Steven Mnuchin. The prevailing wisdom is that Powell is a moderate who is only slightly more hawkish than Yellen. But the truth is that we don't really know where he stands because he has no academic publication record and has generally steered clear of taking bold views on monetary policy. Such a potentially malleable mind may be exactly what Trump is seeking! Still, the organizational structure of the Fed makes it impossible for the chair to run roughshod over other FOMC members. This suggests that no matter who is selected, the general thrust of monetary policy will not change radically next year. Thoughts On The Transatlantic Yield Spread I have been visiting clients in Europe this week and questions about the relative stance of monetary policy between the U.S. and the euro area have come up in almost every meeting. The gap between U.S. and euro area rate expectations has narrowed since the start of the year, helping to push the euro higher. Nevertheless, most interest rate spreads remain elevated by historic standards. This has led many commentators to speculate that they will continue to shrink, putting further upward pressure on EUR/USD. For example, the U.S. 5-year Overnight Index Swap rate currently stands at 1.82%. This compares to only 0.02% in the euro area. The current level of spreads can be partly explained by the fact that labor market slack is still substantially higher in the euro area than in the U.S. Outside of Germany, labor underutilization is still 6.3 percentage points higher across the euro area than in 2008 (Chart 6). In contrast, our work suggests that the U.S. labor market has returned to full employment.2 Chart 6Euro Area: Labor Market Slack Still High Outside Of Germany This is not to say that transatlantic interest rate spreads won't narrow over the coming years. They will. But what matters for investors is how spreads evolve relative to market expectations. The market is already pricing in roughly 50 basis points of spread compression in five-year rates between now and 2022. If one looks further out to 2027, the spread in expected policy rates stands at 94 basis points.3 That may still seem like a lot, but keep in mind that inflation expectations in the euro area are well below those of the U.S. The CPI swap market is predicting that U.S. inflation will exceed euro area inflation by 67 basis points over the next decade. All things equal, lower inflation in the euro area implies that nominal interest rates should be lower there too. Moreover, many euro area government bond markets trade at a discount due to country-specific default/denomination risks. While these risks have faded, they have not gone away. As such, GDP-weighted euro area government bond yields - which are arguably what the ECB cares most about - are generally higher than swap rates of the same maturity. In Search Of Fair Value Chart 7The Neutral Rate Is Lower In The Euro Area A reasonable estimate is that the market currently sees the real terminal rate in the U.S. as being roughly 40 basis points higher than in the euro area. As it happens, this is almost identical to the gap in the neutral rate between the two regions that Williams, Laubach, and Holston have calculated (Chart 7). Does that mean that the current transatlantic spread is close to fair value? Not quite. One of things that has become apparent over the past eight years is that euro area membership comes at a high price. When countries such as Italy and Spain are hit by adverse economic shocks, they are limited in how they can respond. They cannot devalue their currency because they do not have a currency to devalue; and they cannot loosen fiscal policy for fear of being attacked by the bond vigilantes. All they can do is suffer from grinding deflation in the hopes of regaining competitiveness through weak wage growth. This means that over the long haul, unemployment in the euro area is likely to be above NAIRU more often than in the U.S. This, in turn, implies that euro area policy rates will, on average, be below their neutral value more often than in the U.S. Thus, even if the gap in the real neutral rate between the two regions were 40 basis points, the expected gap in policy rates should be larger than that. Modest Downside For EUR/USD The discussion above suggests that the transatlantic interest rate spread is not especially wide if one looks further out in time. If U.S. growth surprises on the upside over the coming months, while euro area growth flatlines, spreads will widen again. Such an outcome is, in fact, quite likely. U.S. financial conditions have eased significantly relative to those of the euro area since the start of the year (Chart 8). To the extent that changes in financial conditions lead growth by about 6-to-9 months, the U.S. could start outperforming the euro area as we enter 2018. The fact the Goldman's Sachs' U.S. Current Activity Indicator has hooked higher and the economic surprise index has rebounded smartly is early evidence that this process may have already begun (Chart 9). We see EUR/USD falling to 1.15 by the end of the year. Chart 8Diverging Financial Conditions ##br##Favor U.S. Over The Euro Area Chart 9Early Evidence That U.S. May ##br##Outperform Euro Area Next Year Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Geopolitical Strategy / China Investment Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017. 2 Please see Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017; and "What's the Matter With Wages?" dated August 11, 2017. 3 We estimate the expected policy rates ten years out by looking at one-month, 10-year forward OIS rates (i.e., the market's expectation of where one-month OIS rates will be ten years from today). Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights U.S. credit growth is set to improve as capex has more upside and households benefits from a positive backdrop. The U.S. has substantially more room to increase leverage than the rest of the G10, pointing toward further monetary divergences. The euro is not very cheap and is trading at a significant premium to forward rate differentials. It is thus at risk if U.S. rates can rise vis-à-vis Europe. Chinese underlying inflation is becoming elevated, which could prompt additional tightening by the PBoC. Moreover, Xi Jinping's speech this week suggests a move away from the debt-fueled, investment-led growth model. The AUD is at risk. Feature A general lack of credit growth has been one of the key factors hampering both broader growth and inflation in the U.S. Not only has this muted activity and weak pricing pressure kept the Federal Reserve on the easier side of policy, the absence of lending growth has further depressed real rates as demand for loanable funds remains low. Can credit pick up from here, and what are the implications for the USD? Room For Optimism There are good reasons to lean a bit more on the positive side regarding the U.S. credit growth outlook. As Chart I-1 illustrates, U.S. commercial and industrial loan growth seems to be rebounding. Confirming that this impulse could gain momentum, it follows an easing in lending standards and a pick-up in durable goods orders - two leading indicators of business borrowings. Household debt is also showing some signs of revival. While the annual growth rate of household borrowings from banks has yet to trough, the annualized quarterly growth rate has picked up significantly - a development that tends to precede accelerations in the yearly measure. Moreover, this improvement is broad based among all the key components of household borrowings (Chart I-2). Chart I-1Upside For U.S. C&I Loans... Chart I-2... And For Household Debt As Well This has positive implications for U.S. nonfinancial private credit, which has been in the process of forming a shallow bottom relative to GDP. Moreover, based on the low level of debt servicing costs for both households and businesses, this trend has room to develop (Chart I-3). However, most of the increase in the debt-to-GDP since 1994 has been caused by financial engineering, with firms swapping equity for debt in their capital structure, and has therefore not lifted domestic demand nor created inflationary pressures. However, we posit that this phenomenon is toward its tail end, and that additional debt accretion could have a meaningful impact on growth. Why? On the business front, capex - an essential but volatile component of aggregate demand - is set to accelerate further. Business investment is led by firms' capex intentions, a series that has surged since the summer of 2016 (Chart I-4, top panel). Confirming the message from this indicator, profits from U.S.-listed businesses have also sharply rebounded, a signal that leads capex by a year, as highlighted last Monday by Anastasios Avgeriou, who heads BCA's U.S. Equity Sector Strategy service (Chart I-4, bottom panel).1 Chart I-3The U.S. Has Room To Relever Chart I-4Capex Outlook Looks Good On the household front, three factors support our assessment: First, household nominal and real wages and salaries should enjoy further upside as the labor market remains very healthy. This means more consumption and more capacity to accumulate debt, especially as household financial obligations remain near multi-generational lows (Chart I-5). In fact, U.S. real median household income already hit an all-time high in 2016. Chart I-5Supports To Household Consumption Second, household confidence is still near record-high levels, a factor which tends to lead credit growth and consumption. Optimistic households are more likely to spend their income gains and buy durable goods like houses or apartments, especially as the household formation rate has regained vigor. Third, U.S. net wealth has hit 430% of disposable income, a record, which will keep supporting consumption. As households see their net worth increase, they can boost consumption and debt as their leverage ratios improve, especially when financial obligation ratios are as low as they are today. These factors point toward a continued increase in the indebtedness of the U.S. private sector, one which this time we anticipate will add to demand through investments, real estate purchases and general consumption. This also means that real rates are likely to experience upside. More debt-fueled aggregate demand implies more demand for loanable funds, and thus higher real rates. In an economy operating near full capacity, it can also lift inflation. Tax cuts and fiscal stimulus would only be a bonus in this environment. This should give the Fed room to increase interest rates in line with its dot plot, or more than the two-and-a-half hikes priced into the OIS curve over the next two years. However, as 2017 has vividly demonstrated, movements in U.S. rates alone are not enough to make a call on the U.S. dollar. One needs to have a sense of how U.S. rates could evolve vis-à-vis the rest of the world. In the context of debt accumulation, we are optimistic that the U.S. could experience a re-leveraging relative to the rest of the G10, putting upward pressures on U.S. real rates relative to the rest of the world. To begin with, U.S. non-financial private credit stands at 150% of GDP, a drop of 20% of GDP since its peak in 2009. The rest of the G10 has not experienced the same extent of post-financial crisis deleveraging, and nonfinancial private credit there still hovers around 175% of GDP (Chart I-6). Today, the indebtedness of the U.S. relative to other advanced economies is near its lowest levels of the past 50 years. Debt levels are obviously not the only consideration; the ability to service that debt also must enter the equation to judge the capacity of an economy to accumulate debt relative to the rest of the world. Currently, according to the BIS, the debt-service ratios of the U.S. nonfinancial private sector still stand well below the GDP-weighted average of the rest of the G10 (Chart I-7). This also highlights that the U.S. has plenty of room to have both higher debt accumulation and higher real rates than the rest of the G10. Chart I-6U.S. Vs. G10: Debt Upside Chart I-7Lower Private Sector Debt-Servicing Costs In The U.S. This should support the dollar in 2018. As Chart I-8 shows, 10-year bond yield differentials between the U.S. and other large advanced economies lead tops in the dollar by one year. To highlight this relationship, this chart de-trends the DXY by plotting it as a deviation from its 10-year moving average. Not only does the current trend in real rate differentials already point to a higher dollar, but room for more debt accumulation in the U.S. relative to the rest of the G10 supports the notion that the elevated level of spreads could even expand, implying the era of monetary divergence has yet to end. As we highlighted last week, the dollar may not be as expensive as seems at first glance. We have expanded on our 'modelization' exercise this week, using methods employed by the Swiss National Bank to incorporate the Balassa -Samuelsson effect.2, 3 This metric, which incorporates the relative price of manufactured goods in each economy, further confirm our assessment from last week that the dollar is not expensive enough to warrant a sell-signal (Chart I-9). Thus, with competitiveness a non-issue for the dollar for now, the USD is likely to be able to take advantage of potentially supportive real interest rate spreads. Chart I-8Real Rates Point To A Higher Peak For The USD Chart I-9U.S. Only Sightly Expensive On the technical side, our U.S. Dollar Capitulation Index hit very depressed levels earlier this year, but is now rebounding. Crucially, it has moved meaningfully back above its 13-week moving average, an event which normally characterizes uptrends in the dollar (Chart I-10). Chart I-10Dollar: From Bearish To Bullish Mood Bottom Line: The U.S. economy looks set to enjoy an episode of rising debt supporting increasing economic activity and higher rates as capex should grow further and a supportive backdrop continues to emerge for households - whether or not tax cuts happen. Because the U.S. private sector has comparatively healthy balance sheets relative to the rest of the G10, this means that U.S. re-leveraging should outpace the rest of the world. Even if this U.S. re-leveraging is only a cyclical phenomenon and not a resumption of the debt super-cycle, it would imply that monetary policy divergences have yet to reach their apex, and thus the dollar could experience additional upside. Even Against The Euro? We tend to view the euro as the anti-dollar. It is the main vehicle to play both uptrends and downtrends in the dollar and it is also the most liquid instrument, backed with an economy similarly sized as the U.S. Thus, the views expressed above would imply a negative slant on EUR/USD. Such a framework can give an impetus to a EUR/USD view, but is also not enough. Indeed, factors more specific to this pair argue that EUR/USD does have downside. When it comes to valuations, using the SNB's methodology, the EUR/USD is more or less the mirror image of the DXY. This pair is slightly cheap, essentially within the statistical definition of fairly valued (Chart I-11). Thus, valuations alone are fully neutral for the euro. This means EUR/USD remains prisoner to relative interest rate dynamics. On this front, a key driver of this pair paints a risky picture for euro bulls. The 1-year/1-year forward risk-free rate spread between the euro area and the U.S. has been a reliable guide of the EUR/USD's trend for the past 12 years. Yet, the euro's rally has not been matched by a similar move in this spread. As a result, the gap between the currency pair and its rates-implied fair value is at its highest since the summer of 2014 (Chart I-12). Chart I-11Euro: Not That Cheap Chart I-12Forward Interest Rates Point To Euro Risk But then again, the differential between the European and U.S. 1-year/1-year forward risk-free rate is at its lowest ever over the time frame of this chart. However, it was even lower than current levels in 1999 and 1997. This suggests that if the U.S. can re-leverage relative to the rest of the G10, the spread could grow as negative as it was in these two previous instances. Supporting this assessment, we anticipate U.S. inflation to outperform euro area measures going forward. Last week, we explored the reasons why we see an upcoming uptick in U.S. inflation next year: U.S. financial conditions have eased, American velocity of money has increased, pipeline inflationary pressures are growing and underlying wage growth seems to be improving.4 Meanwhile, European financial conditions have tightened, especially against the U.S., which historically leads to an underperformance of European inflation measures. Very importantly, the euro area core CPI diffusion index has rolled over and is now below 50%, suggesting that euro area core CPI has limited upside (Chart I-13). This means potential downside vis-à-vis the U.S. and room for upside in U.S. rates relative to the euro area, especially as the European Central Bank is likely to craft its message carefully next week when it announces the tapering of its asset purchases, to prevent quick upward movement in interest rate expectations. Additionally, the dollar is still quite under-owned by speculators relative to the euro. Our favorite positioning measure, which sums long bets in the euro with short bets on the DXY - two equivalent wagers - continues to hover near record-high levels, suggesting potential downside in EUR/USD (Chart I-14). This continues to highlight the risks to the euro created by a repricing of the Fed. Chart I-13Euro Area CPI Peaking? Chart I-14Excess Bullishness In Euro Intact Bottom Line: The euro is obviously at risk if the dollar gets lifted by rising economic activity and indebtedness in the U.S., even if this cyclical upswing in debt does not represent a resumption of the debt super-cycle. Moreover, 1-year/1-year forward rates differentials point to heightened EUR/USD vulnerability, especially if U.S. inflation bottoms relative to the euro area. Moreover, long euro bets have yet to be washed out, deepening the EUR/USD's vulnerability. A Few Words On China Chart I-15China: Good Reasons For Policy Tightening Despite a marginal slowdown in Chinese real GDP growth and slightly disappointing industrial production and fixed asset investment numbers for the third quarter, some key Chinese economic activity metrics have been very robust. Imports are growing at a 19% annual pace, credit growth continues to outperform expectations and electricity production and excavator sales remain robust. Should this make investors bullish on China plays? In our view, two key risks lurk on the horizon. The first is monetary tightening. Pricing pressures in China are growing and are looking increasingly genuine. As Chart I-15 shows, core CPI is clocking in at 2.3%, the highest level since 2010-2011, a level which in the past prompted monetary tightening by the Chinese authorities. Additionally, services inflation - a purely domestic sector and thus one reflective of domestic inflationary pressures - is now above 3% and accelerating. Also, PPI has re-accelerated to 6.9%, pointing to a paucity of deflationary forces in the Chinese economy that could potentially give the People's Bank of China the green light to tighten further. We would expect the rise in the Shibor 7-day rate to continue and monetary conditions, which have been tightening since the end of 2016, to become an even bigger handicap in the future. The second risk lies around the Communist Party Congress underway in Beijing. Xi Jinping's marathon speech highlighted his vision for Chinese socialism in a new era. Xi is very clearly dedicated to the primacy of the Chinese communist party. He did highlight, however, that the new principal problem for the Chinese population is the need for a better life, with less imbalances, less inequalities. This fits with his previously revealed policy preferences. As Matt Gertken, who heads the Asian efforts on our Geopolitical Strategy team, has shown, Xi's administration has massively increased spending to protect the environment and increased financial regulation (Table 1).5 These preferences fit in the optic of addressing China's new principal problems: too much pollution and too much debt. Table 1Fiscal Priorities Of Recent Chinese Presidents Moreover, the continued fight against corruption also fits into that mold. It is a key tool to maintain the legitimacy of the Communist party, and a popular way to address some of the inequalities and imbalances plaguing China today. What does this mean? China has continued to accumulate debt over the past 10 years, with debt to GDP increasing by nearly 120% between 2008 and 2017 (Chart I-16). If a window is opening to tighten monetary policy because inflationary pressures are growing while there is political will to combat inflation and imbalances, it is likely that investment - which pollutes heavily - and debt - a byproduct of large capex programs - could be curtailed. Moreover, the Chinese government still has the wherewithal to support aggregate economic activity through fiscal stimulus. In addition, in the context of the above, much fiscal stimulus could be deployed to fight pollution and decrease inequalities by supporting households. This means that while Chinese GDP growth is unlikely to weaken substantially, the capex intensity of the economy could decrease. So would imports of raw materials and capital goods. As a result, this could be a very negative environment for metals. Metals prices have rebounded sharply since 2016 as Chinese investment has increased. But now that policy could be tightened further and that Xi's new administration has more freedom to move away from an investment-heavy, deeply polluting growth model, the rally in metals could be at risk. Copper, a bellwether for the metals complex, has surged nearly 70% since 2016, and bullish sentiment on the red metal is now at levels historically associated with imminent corrections (Chart I-17). Chart I-16Is This What Deleveraging Looks Like? Chart I-17Tighter Policy And A Reform Push Put Metal At Risk This means that currencies for which metals prices are a key driver of terms of trade are at great risk, specifically the BRL, the CLP and the AUD. Moreover, the latter is expensive, having recently been buoyed by some positive economic numbers, and is now widely owned by very bullish investors. We have a short sell AUD/USD at 0.79 and our short AUD/NZD trade at 1.11 was triggered following the Labor/NZ First/Green coalition announced Thursday in New Zealand. Bottom Line: Chinese authorities are set to tighten monetary conditions further as domestic inflationary pressures are growing. Moreover, while short on details, this week's speech by Xi Jinping at the opening of the 19th Communist Party Congress in Beijing seemed to confirm that addressing imbalances, inequalities, and environmental problems will be a key objective of this administration. This points toward a less debt-/investment-driven economic model - at least until deflationary problems re-emerge. While overall GDP growth could be supported by targeted fiscal support, investment plays linked to Chinese capex and real estate could suffer. The AUD is at risk, and we are entering our proposed short AUD/NZD trade. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see U.S. Equity Strategy Special Report, titled “Top 5 Reasons To Favor Cyclicals Over Defensives” dated October 16, 2017, available at uses.bcaresearch.com 2 The Balassa Samuelson effect is an empirical observation that countries with higher productivity tend to experience an appreciating trend in there real exchange rate. Please see Foreign Exchange Strategy Weekly Report, titled “Is The Dollar Expensive?”, dated October 13, 2017, available at fes.bcaresearch.com 3 Samuel Reynard, “What Drives the Swiss Franc?” Swiss National Bank Working Papers (2008 – 14). 4 Please see Foreign Exchange Strategy Weekly Report, titled “Is The Dollar Expensive?”, dated October 13, 2017, available at fes.bcaresearch.com 5 Please see Geopolitical Strategy Weekly Report, titled “How To Read Xi Jinping’s Party Congress Speech”, dated October 18, 2017, available at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1 Chart II-2 U.S. data was mixed: Last week's CPI releases showed that inflation disappointed in September, with headline CPI increasing by only 2.2%, below the expected 2.3%; and Core CPI coming in at 1.7%, in line with expectations; However, long-term TIC data showed a large inflow of funds of USD 67.2 bn, much larger than the expected USD 14.3 bn. The labor market continues to tighten with initial jobless claims and continuing claims dropping to 222,000 and 1.888 million respectively. The DXY has rebounded this week on this news, and also helped by a somewhat disappointing ZEW survey from the euro area, but pared its gains on Wednesday. Regardless, positive developments in the U.S. fiscal space and disappearing slack will provide a tailwind for the greenback. 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-3 Chart II-4 Data from the euro area has been mixed: Industrial production grew at an annual rate of 3.8% in August; The trade balance contracted to EUR 16.1 bn from EUR 23.2 bn on a non-seasonally-adjusted basis, but improved on a seasonally-adjusted basis. The final estimate for core CPI hit 1.1%, in line with expectations; The ZEW Survey dropped and underperformed expectations; Despite largely weak data, the euro has pared all of last week's losses. Markets may be pricing in Catalan developments as a bullish case. The Spanish government has threatened to enact Article 155 of the constitution if Catalonia does not comply, which will give Spain the authority to take measures to ensure compliance by the rogue region. 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-5 Chart II-6 Recent data in Japan has been mixed: Bank lending outperformed expectations, growing at a 3% year-on-year pace. Machinery orders yearly growth also outperformed to the upside, coming in at 4.4% However, the annual growth of both imports and exports underperformed expectations and declined significantly from last month, coming in at 12% and 14.1% respectively. The yen has remained relatively flat these past two weeks. Overall, we expect USD/JPY to have additional upside, given that the U.S. OIS curve is not pricing in enough rate hike over the next 2-years. Ultimately, the driver of USD/JPY will simply be U.S. rates as Japanese 10-year rates are capped near 0%. This situation is not likely to change any time soon, as the Japanese economy is still hampered by very low inflation. 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-7 Chart II-8 Recent data in the U.K. has been mixed: Average hourly earnings outperformed expectations, growing at a 2.2% pace from a year ago. Both headline and core inflation came in line with expectations at 3% and 2.7% respectively. However, both retail sales and retail sales ex-fuel growth underperformed expectations, coming in at 1.2% and 1.6% respectively. Overall, we do not expect much more upside for the pound relative to the U.S. dollar, given that there is already a hike priced for November. At this point, the economic situation does not warrant any more hikes beyond just removing the emergency measures implemented after the Brexit fallout. Furthermore inflation has stopped climbing, and could start to come down in the coming months as the effects of the currency dissipate. Finally, Brexit negotiations have hit a bit of a temporary impass. 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-9 Chart II-10 The AUD has not seen much action this week. The RBA minutes highlighted that "slow growth in real wages and high levels of household debt were likely to be constraining influences". This is largely in line with our argument that spare capacity is limiting wage growth and inflation in the economy. Going forward, China remains a risk to our view, with the most recent import figures having provided a welcomed fillip to the AUD. Nevertheless, remarks by RBA Governors will limit the upside in the AUD. Expectations of a rate hike by the RBA depend upon growth numbers, which are unlikely to be achieved given the current trajectory of wages and consumer spending. Furthermore, high underemployment in the economy also remains a drag on spending, dampening the positive effect of a strong job report. 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-11 Chart II-12 Recent data in New Zealand has been mixed: Electronic card retail sales year-on-year growth declined form 4.4$ to 2.9%. Business NZ PMI softened from 57.9 to 57.5. However, headline inflation came in at 1.9%, rising from the previous month reading of 1.7% and outperforming expectations. The kiwi sold off by almost 2% yesterday, as Jacinda Ardern was elected as the new prime minister of New Zealand. The market is now pricing the risk that the Labor party, which Ardern leads, could change the mandate of the central bank from just targeting inflation to also seeking full employment. Moreover, Labor and its coalition partner, NZ First, want to curtail immigration, one of the tailwind to New Zealand growth. These development would structurally limit the upside for kiwi rates, acting as a headwinds to the New Zealand dollar. 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-13 Chart II-14 The CAD has been somewhat strong recently due to developments in the oil market. KSA-Russia support for an extension of supply cuts to OPEC 2.0, as well as developments in Iraq, have pointed to an increase in prices. While the path for Canadian interest rates seem fairly priced, oil prices could buoy the CAD. Risks surrounding NAFTA remain, as President Trump stays inflexible with regards to tariffs, although this is likely to have a greater effect on Mexico than on Canada. Furthermore, albeit still in its infancy Morneau's tax plan, which is anticipated to mostly affect the richest of small business, could have an effect on investment intentions. 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-15 Chart II-16 Recent data in Switzerland has surprised to the upside: The unemployment rate decreased from 3.2% and 3.1%, outperforming expectations. Producer and import prices yearly growth came in at 0.8%, also surprising to the upside. Finally, the trade balance also outperformed, coming in at 2.918 billion dollars for September. It seems that the fall in the franc has been very positive to the Swiss economy. Overall, it would be difficult to see much more upside in EUR/CHF, as the euro already reflects euro area positives. That being said, we are reticent to be outright bearish on this cross as the economic data is still too weak for the SNB to change its monetary policy stance. 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-17 Chart II-18 Recent data in Norway has been negative: Manufacturing yearly output growth underperformed expectations, contracting at 5.7%. Both core and headline inflation also surprised to the downside, coming in at 1% and 1.6% against expectations of 1.2% and 1.7% respectively. Finally, the Norwegian trade balance declined from 12.4 billion dollars to 9.2 billion dollars USD/NOK has risen 3% since September, even as oil prices have continued their path upward. This was first and foremost reflective of the higher probability of rate hikes in the U.S. in December. Additionally, the recent Norwegian inflation and trade balance numbers are showing that the krone rebounds has tightened monetary conditions in this Scandinavian economy. Overall, we remain bullish on USD/NOK and bearish on EUR/NOK. 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-19 Chart II-20 The most recent inflation data was slightly weak, with CPI increasing by 0.1% monthly, and 2.1% yearly. Unemployment worsened as the rate rose to 6.2% from 6%. The krona depreciated against the euro on the news, but was flat against the dollar. Despite this temporary setback, PMIs are still perky across the board, and credit is hooking up. China and Europe's recent performance has likely provided a tailwind for growth, which should translate into higher inflation as capacity utilization is extremely tight. Furthermore, the depreciation of the SEK since the beginning of September has eased monetary conditions, making way for the central bank to begin a tightening process in the wake of the ECB's tapering program. 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 The uptick in world oil demand in the wake of a strengthening global upturn - the first since the Global Financial Crisis (GFC) - coupled with continued production discipline by OPEC 2.0, will accelerate inventory draws, and lift prices above our previous expectation. Even though we expect - and model for - U.S. shale producers to step up drilling as a result, we are lifting our base case forecast for 2018 Brent and WTI to $65.15/bbl and $62.95/bbl, respectively. These estimates are up $5.51 and $5.98/bbl from our forecast last month.1 Energy: Overweight. Given our view (discussed below), we are taking profits on the long Dec/17 WTI call spread we recommended June 15 - long $50/bbl calls vs. short $55/bbl calls - on the close tonight. This position was up 116% Tuesday. We will replace this spread with long $55/bbl WTI calls vs. short $60/bbl WTI calls in Jul/18 and Dec/18. Base Metals: Neutral. We closed our short Dec 2016 copper trade last week, after our trailing-stop of $3.10/lb was elected, with a 0.75% return. Our trade was up 6% by the end of September, however bullish data in October - including an earthquake in Chile and worries over a potential metal shortage in China - lifted prices back up. Chinese copper import data showed a 26.5% year-on-year (yoy) jump in September. Even so, we expect copper imports to end 2017 with a yoy decline. Precious Metals: Neutral. Palladium continues to trade premium to platinum following its breakout at the end of September. We expect this to continue, given the supply-demand fundamentals we highlighted in June.2 Ags/Softs: Neutral. The USDA's latest World Agricultural Supply and Demand Estimates (WASDE) is supportive of our grains view - projections for 2017/18 wheat ending inventories were revised upward, while corn and soybeans stock estimates were lowered. Our long corn vs. short wheat position recommended October 5 is up 1.5% (please see p. 8 for further discussion.) Feature The global uptick in GDP growth noted this month by the IMF, along with continued production discipline from OPEC 2.0 - the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia - will lift 2018 average Brent and WTI prices to $65.15/bbl and $62.95/bbl, respectively. These estimates are up $5.51 and $5.98/bbl from our forecast last month (Chart of the Week). Chart of the WeekHigher Demand, Lower Supply,##BR##Tighter Inventories Lift Prices We expect the fortuitous combination of fundamentals - for oil producers, that is - to accelerate the drawdown in oil inventories globally, which also will be supportive for prices (Chart 2). This, in turn, will set off a new round of U.S. shale-oil production, which will temper the price rise we expect, but still force inventories to draw harder than expected (Chart 3). Our base case calls for OPEC 2.0 to extend its 1.8mm b/d production cutting deal to end-June 2018, and for compliance within the KSA-Russia-led coalition to remain strong. OPEC 2.0 member states compliance with self-imposed quotas stood at 106% of agreed cuts, according to a state-by-state tally published by S&P's Global Platts earlier this month.3 Iraq continues to flaunt its OPEC 2.0 production quota, at 4.54mm b/d by our estimate, or 153k b/d over its quota. OPEC as a whole is producing 32.74mm b/d of crude oil, by our reckoning, vs. Platts' estimate of 32.66mm b/d. We have Libya and Nigeria, which are not parties to the OPEC 2.0 Agreement, producing 930k b/d and 1.71mm b/d last month, vs. Platts' estimates of 910k b/d and 1.84mm b/d, respectively (Table 1). KSA and Russia continue to lead OPEC 2.0 by example, with the former's crude oil production coming in at 9.97mm b/d in September, vs. 9.95mm b/d in August; the latter's total liquids production was 11.12mm b/d, vs. 11.13mm in August (Chart 4). Chart 2Market Will Get##BR##Tighter Sooner Chart 3BCA Expects Sharper##BR##Inventory Draw Than EIA Chart 4KSA And Russia Continue##BR##Providing Leadership To OPEC 2.0 Global GDP, Oil Demand Growth Strengthens The IMF earlier this month raised its forecast for global GDP growth this year to 3.6% and to 3.7% for next year, up 0.1% for each year vs. previous forecasts. In its analysis, the Fund drew attention to: Notable pickups in investment, trade, and industrial production, coupled with strengthening business and consumer confidence, are supporting the recovery. With growth outcomes in the first half of 2017 generally stronger than expected, upward revisions to growth are broad based, including for the euro area, Japan, China, emerging Europe, and Russia. These more than offset downward revisions for the United States, the United Kingdom, and India.4 On the back of the IMF's revised global growth estimates, we lifted our 2017 and 2018 oil demand expectation to just under 47.5mm b/d on average for the OECD and to just under 52mm b/d for non-OECD economies (Table 1). This translates into global demand growth of 1.65mm b/d in 2017 and 1.69mm b/d in 2018. Notably, we expect global demand to exceed 100mm b/d on average next year in our base case. Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Our estimated demand is driven by global growth projections, particularly for EM economies, which make up the bulk of demand and growth in our balances estimates (Table 1). And, as before, our estimates remain above the EIA's (Chart 5). The indicators we look at to confirm or refute our demand assessment - global trade, particularly EM imports, and manufacturing - remain strong. Global trade continues to expand, particularly in EM ex-Middle East and Africa, as does manufacturing globally, both of which supports the IMF's assessment of growth generally (Charts 6 and 7). Rising incomes lead to rising trade, and also to increased oil and base metals consumption in EM economies. Chart 5We Continue To##BR##Estimate Higher Demand Than The EIA Chart 6Rising Trade Volumes##BR##Support Growth Story ... Chart 7... Expanding Manufacturing##BR##Does, Too Higher Prices, Greater USD Risk Expected In 2018 Given the upward revisions to global growth and our expectation OPEC 2.0 compliance will remain fairly stout, our baseline forecast now calls for WTI prices to average $56.40/bbl in 4Q17 and $62.95/bbl in 2018. Brent is expected to average $58.40/bbl in 4Q17 and $65.15/bbl next year (Chart 1 and Table 2). These estimates are up from last month's averages of $54.89 and $57.44/bbl for 4Q17 and 2018 WTI, and $56.67 and $59.17/bbl for 4Q17 and 2018 Brent.5 Our increasing bullishness is tempered by the risk of a stronger USD, particularly the broad trade-weighted USD index, which captures EM currency weakness. With the Fed set on a course to lift rates - our House view anticipates a Dec/17 rate hike and two or three hikes next year - and the oil market getting fundamentally tighter, we have seen the oil-USD linkage being re-established recently (Chart 8). Table 2Upgrading Our##BR##Price Forecasts Chart 8Expect The USD To Be Less##BR##Determinant For Oil Prices The persistent negative correlation between oil prices and the USD broke down following the global asset sell-off in 1Q16. However, this relationship converged to its long-term equilibrium in recent months. In our view, this reflects market participants' increasing conviction - expressed in market-cleared prices - that OPEC 2.0 will maintain its supply-management accord for an extended period, and that supply is now stabilizing. With demand remaining robust as the global synchronized upturn continues, the fundamental side of price determination has stabilized, and financial variables once again will strongly influence oil prices at the margin. Given our view the USD will trade off interest-rate differentials going forward, and our expectation that U.S. rates are set to increase relative to other systemically important rates, the USD likely will appreciate over the next 12 months. This will be a headwind for oil prices, and may be an additional factor OPEC 2.0 member states have to account for in 2018. Bottom Line: We are raising our price forecast for 4Q17 and 2018 in line with our expectation for stronger global growth and continued strong compliance from OPEC 2.0. With markets getting tighter, we expect the USD to become more important to the evolution of oil prices in 2018. Ag Update: Stay Long Corn, Short Wheat Global grain fundamentals continue to be supportive to our long corn vs. short wheat position, recommended October 5. The USDA's latest WASDE are projecting higher 2017/18 ending wheat inventories, while corn and soybeans stock estimates were lowered (Chart 9).6 Chart 9Fundamentals Support Long Corn##BR##Vs. Short Wheat Trade The USDA lowered its expected global corn stocks-to-use ratio, and increased its wheat stocks-to-use ratio for the current crop year. Revisions to the estimates for the 2016/17 crop year also reflect similar dynamics. We expected this going into the WASDE report at the beginning of the month when we published our Special Report on the Ag markets, and got long corn vs. short wheat. December 2017 corn futures traded on CME are up 0.14% since October 5, while wheat futures are down 1.36%. This brings the return on our long corn/short wheat trade to 1.5%, to date. Highlights from the current WASDE include: Upward revisions to wheat production from India, the EU, Russia, Australia, and Canada more than offset greater projected global demand, most notably from India and the EU. Overall, global ending stocks were revised up by 4.99mm MT, and are projected to stand at 268mm MT by the end of the 2017/18 marketing year. Greater projected corn demand, most notably from the U.S. and China, more than offset the ~ 6mm MT upward revision to global production in the USDA's estimates. Higher projected Chinese demand reflects greater food and seed demand, and higher expected industrial use. Corn stocks are expected to end 2017/18 at 200.96mm MT - 1.51mm MT below September projections. Similarly, in its October Chinese Agricultural Supply and Demand Estimates, China's Agriculture Ministry increased its forecast for the 2017/18 corn deficit to 4.31mm MT from 0.89mm MT projected last month. The Ministry expects lower output and greater consumption on the back of stronger demand from ethanol plants.7 Furthermore, in a move towards market pricing, Heilongjiang - China's top corn province - will be reducing the subsidy it gives corn farmers from 153.92 yuan/mu last year to 133.46 yuan/mu. The province will reorient its subsidies to incentivize more soybean production.8 In soybean markets, USDA projections for ending stocks were reduced by 1.48mm MT to 96.05mm MT by end-2017/18, largely on the back of lower expected U.S. and Brazilian inventories in 2016/17. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Assistant HugoB@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report "OPEC 2.0 Will Extend Cuts To June 2018," published September 21, 2017. It is available at ces.bcaresearch.com. 2 Please see "Precious Metals Update," in the June 29, 2017 issue of BCA Research's Commodity & Energy Strategy Weekly Report "EM Trade Volumes Continue Trending Higher, Supporting Metals". It is available at ces.bcaresearch.com. 3 Please see S&P Global Platts OPEC Guide published October 6, 2017. 4 Please see Chapter 1 of the IMF's World Economic Outlook for October 2017, which is available online at https://www.imf.org/en/Publications/WEO/Issues/2017/09/19/world-economic-outlook-october-2017. 5 Our base case continues to call for an end-June 2018 extension of the OPEC 2.0 production deal. Should the deal be extended to end-December 2018, we estimate 2018 WTI prices would average $67.35/bbl, while Brent prices would average just under $70.00/bbl. We are becoming increasingly confident OPEC 2.0 will become a durable production-management coalition, given the increasing cooperation and mutual investment between KSA and Russia. We will be exploring this further in future research. Please see "King Salman Goes To Moscow, Bolsters OPEC 2.0," published October 11, 2017, by BCA Research's Energy Sector Strategy. It is available at nrg.bcaresearch.com. 6 Please see Commodity & Energy Strategy Special Report titled "Ags In 2017/18: Move To Neutral," dated October 5, 2017, available at ces.bcaresearch.com. 7 Please see "China Raises Forecast For 2017/18 Corn Deficit On Lower Output," dated October 12, 2017, available at reuters.com. 8 Please see "Top China Corn Province Cuts Subsidy For Farmers Growing the Grain," dated October 16, 2017, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016
Highlights It is often argued that the U.S. dollar is expensive, but models do not offer a unanimous picture. The U.S. current account, exports share, and cyclical inflation do not point to an obvious dollar overvaluation either. Without a clear valuation signal, the dollar will continue to trade off rate differentials. An increasing body of evidence points toward a rebound in U.S. inflation. As such, U.S. rates are likely to move up relative to the rest of the world, lifting the USD over the next 12 months. Feature We are sending you a shorter regular bulletin this week as we are also publishing a follow up to our joint Special Report titled, "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors," released with the Global Asset Allocation team two weeks ago. In this follow-up, my colleague Xiaoli Tang expands on the same methodology, testing various FX-hedging strategies for international investors - but this time looking at portfolios based in the CHF, the SEK, and the NOK. In this week's regular bulletin, we take a closer look at the U.S. dollar's valuations. The consensus view is that the dollar is expensive. We explore how this claim stacks up against the facts. At this juncture, the U.S. economy is not exhibiting some of the key consequences typical of an economy burdened by an expensive currency. Valuation Models The main argument used by some investors to show that the U.S. dollar is expensive is the traditional purchasing power parity model. This indicator does indeed flag a large 17% overvaluation for the greenback (Chart I-1). However, this is only one metric based on producer price indices. We also like to look at measures that focus on the true determinant of competitiveness: the cost of labor. When we deflate the U.S. dollar's exchange rate using unit labor costs, the dollar is neither a screaming sell nor a screaming buy. It is in line with its long-term average (Chart I-2). The same IMF real effective exchange rate model based on unit labor costs also shows the euro as fairly valued. Thus, on this metric, valuations do not seem to provide a compelling argument to go long or short the dollar, which challenges the universally bearish take on the dollar's perceived overvaluation. Chart I-1An Argument For An###br## Expensive USD Chart I-2But Not All Valuation Approaches ##br##Are That Clearcut We can also double-check the result of this metric using our own long-term fair value model, which incorporates long-term relative productivity trends. This model tries to capture the so-called Balassa-Samuelson effect. This effect is an empirical observation that countries with superior long-term labor productivity trends tend to experience a secular upward bias on their real exchange rates. The perceived overvaluation of the U.S. dollar may in fact be an illusion, because when the Balassa-Samuelson effect is taken into account, the dollar currently trades in line with its fair value (Chart I-3). Chart I-3Another Global Approach With USD At Fair Value Bottom Line: Valuing currencies is always an exercise to be approached with plenty of circumspection. It is easy to look at simple PPP models and argue that the dollar looks very expensive. However, when one takes into account labor market costs and productivity trends, the dollar seems fairly valued. A Look At The Symptoms Chart I-4The U.S. Current Account##br## Shows Little Dollar Strain Models are only as good as their inputs. It is important to try to corroborate their insights with economic reality. An expensive currency should produce three major outcomes: the country's current account position should be deteriorating, its market share of global exports should be falling, and it should be experiencing deep deflationary pressures relative to the rest of the world. Let's begin with the current account. Despite a 17% increase in the U.S. dollar since 2014, the U.S. current account has remained stable (Chart I-4). It is undeniable that this reflects an improvement in the energy trade balance of the U.S., itself a byproduct of the shale revolution. Nonetheless, it also highlights that there is little balance-of-payments strains in the U.S. In fact, the move away from energy imports in itself should point to a higher level of equilibrium for the dollar. The export share of the U.S. also does not point to too much stress created by the dollar bull market. As Chart I-5 illustrates, in contrast to the early 1980s or late 1990s-early 2000s, U.S. exports has been faring well when compared to the rest of the world. This exercise needs to be conducted by comparing U.S. exports to the rest of the world excluding China. China has been grabbing global market share from everyone for 30 years. As an aside, the continued rise of China, as well as its still-large current account surplus of more than US$155 billion, supports the idea that the RMB is indeed cheap and remains attractive on a long-term basis - a message also flagged by our long-term fair value model for the CNY (Chart I-6). Chart I-5Growing U.S. Market Share Chart I-6The Yuan Is Clearly Cheap Finally, there is little evidence that the U.S. dollar is depressing U.S. inflation on a cyclical basis. Changes in financial conditions can temporarily redistribute inflationary pressures between the U.S. and the rest of the world, but an expensive dollar should depress U.S. inflation for an extended period of time on a global relative basis. An expensive U.S. dollar makes the U.S. uncompetitive, and should force some degree of internal adjustment on the U.S. economy. So far, the two-year moving average of U.S. core inflation relative to the OECD does not show the same kind of swoon as in the 1980s or late 1990s. In fact, even after this year's inflation slowdown in the U.S., American inflation remains in an uptrend relative to the rest of the OECD (Chart I-7). One source of worry remains the U.S. net international investment position (NIIP). The U.S.'s NIIP currently stands at -41% of GDP, and despite stabilizing for the past two years, has been in a pronounced downtrend over the past 35 years. Historically, countries like Switzerland or Japan with strong NIIPs have tended to experience long-term upward pressure on their exchange rates, while those with poor NIIPs such as South Africa tend to experience negative secular trends, even in real terms. For the time being, what keeps the negative impact of the NIIP on the USD at bay is that the U.S. continues to earn a positive net income - despite negative net assets abroad (Chart I-8). This reflects the willingness of investors to hold the U.S. dollar for its reserve currency status. For the time being, with a lack of alternative to challenge the U.S. dollar's reserve status, the NIIP should not represent a key hurdle for a few more years. Chart I-7The U.S. is Not Experiencing##br## An Internal Devaluation Chart I-8The Exorbitant ##br##Privilege Bottom Line: The U.S. economy is currently exhibiting few of the signals that would be associated with an expensive dollar: the current account remains well behaved, the country is not losing export market shares to its main competitors, and U.S. inflation remains well behaved relative to the rest of the OECD on a cyclical basis. A key risk remains the U.S.'s net international investment position, but so long as the USD can maintain its unchallenged role as the key reserve in the global financial system, the U.S. is likely to continue to run an income surplus vis-à-vis the rest of the world. So What? When it comes to the FX space, long-term valuations only become binding constraints when they are in the extreme. Right now, there is enough conflicting evidence to suggest that if the dollar is indeed expensive, it is not expensive enough to flash a bright sell signal. In this case, the U.S. dollar's dynamics are likely to be dominated by interest rate differentials. Interest rate curves outside of the U.S. seem currently fairly priced, but this is not the case in the U.S. Thus, with only two full hikes priced in over the next 24 months, one needs to see upside for U.S. interest rates if one is to be bullish on the greenback. Despite last month's very poor employment numbers, a consequence of hurricanes Harvey and Irma, the labor market remains strong enough to justify the Federal Reserve's desire to hike rates. The ISM surveys also remains very strong, with the headline numbers and new order components pointing toward robust growth. The only factor that could impede the Fed is inflation. On this front, we remain optimistic that inflation will not deteriorate much further and that, in fact, it is likely to pick up over the next six months, giving the Fed a green light to increase rates in line with its own forecast: First, in the past, we have highlighted that velocity of money - based on the money of zero maturity and nominal GDP - has been a very reliable leading indicator of inflation over the past 20 years, and is pointing toward a rebound in core inflation measures toward year-end.1 Moreover, the easing in U.S. financial conditions over the past 18 months also points toward upside risks to both U.S. growth and inflation. Second, the strength in the Prices-Paid component of both ISM surveys further increases our optimism. Moreover, the recent vigor of the Supplier Delivery subcomponent - a measure of bottlenecks in the system - also points to pipeline inflationary pressures. It is true that some of the recent spike is most likely skewed by the devastating impact of the hurricanes, but this improving trend began much earlier this year. Historically, a combined improvement in both the Prices-Paid and the Supplier Delivery components of the ISM survey tends to provide long leads on core inflation (Chart I-9). Third, the New York Fed has recently started publishing an underlying inflation trend estimate. This measure has also been rebounding sharply, hitting its highest level in 10 years, also pointing toward higher core inflation (Chart I-10). Chart I-9Pipeline Inflationary Pressures##br## Are Growing In The U.S. Chart I-10Underlying Inflationary ##br##Pressures Are Growing Fourth, the behavior of inflation itself is somewhat encouraging. While the recent core PCE year-over-year numbers have been disheartening, the three-month annualized rate of change has picked up robustly. Historically, this has also led to turning points in the year-on-year number (Chart I-11). Finally, there are signs of underlying vigor in wages. Last week's U.S. average hourly earnings number clicked in at 2.9%.It was likely overinflated by the effect of the hurricanes, which have temporarily dropped workers in low-paid industries out of the sample used by the U.S. Bureau of Labor Statistics to compute this data. However, the median average hourly earnings across the key sectors covered by the BLS has been in an uptrend since the beginning of the year (Chart I-12), pointing to some faint but real early signs of rising underlying wage growth. Moreover, while much ink has been spilled regarding whether or not the Philips curve is flat, there remain a well-defined tight relationship between the U.S. employment cost index (ECI) and the level of employment-to-population ratio in the U.S. (Chart I-13). Our view that employment growth will likely continue to tick in north of 120,000 jobs for the next 12 months, implies further improvement in the employment-to-population ratio, and thus a growing ECI. This will both support household income and consumption as well as our inflation view. Chart I-11Sequential Inflation Pointing ##br##To A Turning Point Chart I-12Cross-Sectional Median ##br##Of Wages Improving Chart I-13The Cross-Sectional Median##br## Of Wages Improving Bottom Line: With no clear message from long-term valuation, the key driver of the dollar is likely to remain interest rate differentials. At this point, U.S. interest rates need U.S. inflation to be able to rise by more than what is implied in the OIS curve and lift the dollar. Signs continue to accumulate that U.S. inflation is likely to turn the corner over the next six months, thanks to an easing in U.S. financial conditions and the pick-up in the velocity of money: the Prices-Paid and Supplier Deliveries components of the ISM have hooked up significantly, the NY Fed's underlying inflation measure is strong, the sequential growth rate in core inflation is improving, and there are growing signs that wage growth in the U.S. is picking up. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled "Fade North Korea, And Sell The Yen", dated August 11, 2017, or Foreign Exchange Strategy Weekly Report, titled "Conflicting Forces For The Dollar", dated September 8, 2017, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Closed Trades
Highlights Tipping points tend to occur when too many long-term value investors are uncharacteristically behaving like short-term momentum traders. Long IBEX35 versus Eurostoxx50 constitutes a good tactical trade. The underperformance of Spanish equities appears excessively pessimistic. Euro/dollar is technically extended by about 4 cents. The near term event risk is the ECB meeting on October 26, when a taper of asset purchases which extends well beyond 12 months might be regarded as dovish. But in the medium term, euro/dollar will head well north of 1.30. Underweight Basic Materials equities relative to the market as a tactical trade. Feature Spain: Red Herring Or Red Flag? Long Spanish equities is an excellent tactical trade provided that the imbroglio in Catalonia turns out to be a red herring. The IBEX35 index is at a classic tipping point of excessive short-term (negative) groupthink and herding (Chart of the Week). Chart Of The WeekThe Underperformance Of Spanish Equities Seems Excessive But is the imbroglio in Catalonia a red herring? Most likely, yes. As my colleague Marko Papic, BCA Chief Geopolitical Strategist points out, any unilateral declaration of independence from Catalonia would be vacuous if it lacked international legitimacy, or the ability to enforce it with arms. German sociologist Max Weber famously defined a nation's sovereignty as a "monopoly over the use of legitimate force." Unlike the Basque separatists, Catalan separatists have never resorted to force. A descent into violence remains unlikely because the Catalan independence movement is mainly a bourgeois, middle and upper class intellectual vision. The majority of Catalonia's working class are neither Catalan, nor support independence. Any unilateral declaration of independence would also lack political credibility because the opponents of independence largely boycotted the recent referendum to avoid giving it legitimacy. The vote for independence comprised only 37% of the electorate, meaning that popular support for independence remains questionable. The real (and unspoken) reason for the independence referendum was that it was the only glue holding together the Junts Pel Si (Together For Yes) four party coalition forming Catalonia's regional government. Without this glue, the two nationalist parties from opposite sides of the ideological spectrum would not be in bed with each other. And it is unclear whether this unholy alliance can stay entwined. To sum up, Catalan independence is an intellectual vision which at the moment lacks political and implementation credibility. For the imbroglio to become a full-blown crisis, the Catalan government, or militant groups, or the Spanish government would have to escalate tensions with the use of force. We do not expect this to happen. So the underperformance of Spanish equities appears excessively pessimistic, and long IBEX35 versus Eurostoxx50 constitutes a good 3-month trade (Chart I-2 and Chart I-3). Chart I-2The IBEX 35 And Euro Stoxx 50 Have Parted Company Chart I-3The IBEX 35 Has Catch-Up Potential Identifying Tipping Points Of Price Trends Let's take this opportunity to review how we identify such tipping points of excessive groupthink and herding. Tipping points tend to occur when too many long-term value investors are uncharacteristically behaving like short-term momentum traders. Instead of dispassionately investing on the basis of value, long-term investors get sucked into chasing a price trend, and thereby amplify it. These price trends reach exhaustion when there are no more value investors left to suck in, and at the margin, someone wants to get out. The following analysis describes the tipping point of a price uptrend, but exactly the same analysis applies in reverse to the tipping point of a price downtrend. When a financial asset price starts to rise, the momentum trader's natural inclination is to chase the price rise, and buy. Conversely, the long-term value investor's natural inclination, ordinarily, is to lean against the price rise, and sell. The two investors interpret the same information in polar opposite ways because they have very different time horizons. Importantly, their different interpretations of the same information - stemming from their different time horizons - allow the momentum trader and the value investor to trade with one another in very large volume at the current price. This is what creates a healthy market with plentiful liquidity. Now consider what happens when a long-term value investor flips out of character and acts like a momentum trader. With the numerical balance shifting to the momentum traders, the price has to move up to balance buy and sell orders. As more and more value investors defect to momentum trading, the price uptrend gathers steam. This uptrend is exhausted when the long-term value investors have all joined the trend. Regular readers know that we identify these tipping points by comparing the behaviour of investors with 'short-term' 1-day horizons and investors with 'long-term' 65-day horizons. For any financial asset, a near term price reversal is likely to occur when its 65-day fractal dimension hits a lower limit of 1.25 (Chart I-4), which we have found to be the 'universal constant of finance'.1 Chart I-4When The Valuation Framework Changes, It Is More Difficult To Assess Tipping Points At this remarkably consistent limit, the long-term investor reverts back to character, realises the stock is now overvalued and wants to sell. The trouble is that everybody has already joined the trend. To sell, there needs to be a buyer. But who will buy at the current price? Usually, the answer is nobody. The marginal buyer will be a new category of investor: an 'ultra-long term' value investor - let's say, with a 130-day horizon - who stayed true to character and refused to join the uptrend. As this investor knows that the stock is overvalued at the current price, he will only provide liquidity at the 'correct' lower price. So this is the tipping point at which the price trend reverses. Occasionally, there is another possibility. The ultra-long term value investor could also join the trend at the current price. This might happen when the valuation framework for an investment is especially uncertain, leaving long-term value investors extremely disoriented and unable to assess the 'correct' price. An important conclusion is that when the valuation framework for an investment is undergoing a major change, it is much more difficult to assess the tipping point of a price trend. Which brings us to the euro. Is The Euro Overbought? Through the second half of 2014 and early 2015, the euro was in a major downtrend as the ECB first signalled and then implemented its QE program. On several occasions, the 65-day downtrend seemed technically exhausted but after only minor reversals, the downtrend continued (see Chart I-4 again). Even after the 130-day downtrend seemed exhausted at the start of 2015, it persisted into the spring (Chart I-5). The reason was that as the ECB moved into the uncharted territory of QE, ZIRP and NIRP, the valuation framework for the euro also moved into uncharted territory. Without a reliable valuation anchor, longer and longer term investors jumped on the euro bear bandwagon. Chart I-5The Euro Is Overbought, But The Reversal Might Be Minor Today, we face the mirror-image situation. The euro has been in a major uptrend for most of 2017 as the ECB has signalled a recalibration of its extraordinary monetary easing. But though the 65-day uptrend seemed exhausted in the early summer, the uptrend continued as longer term investors joined the trend. Just as in 2014-15, the question today is: at a major turning point in ECB policy, what is the most reliable valuation anchor? For us, the best explanatory model for euro/dollar is the expected difference in ECB versus Fed policy rates 5 years ahead. As this differential compressed from -230 bps to -160 bps, euro/dollar rallied in perfect lockstep from 1.03 to 1.15. However, the subsequent rally has deviated from the expected policy rate differential, suggesting that the euro's uptrend is indeed overdone by about 4 cents. But in the medium term, the much bigger question is: what will happen to the expected policy rate differential? As we explained in Positioning For A Sea-Change2 the differential must eventually compress to around -40 bps, because this is the mid-point of a very well established multi-decade cycle (Chart I-6 and Chart I-7). In which case, euro/dollar must eventually head well north of 1.30 (Chart I-8). Chart I-6The Euro Area - U.S. Average ##br##Interest Rate Differntial = -40 bps... Chart I-7...Because The Euro Area-U.S. ##br##Inflation Differential = -40 bps Chart I-8An Expected Interest Differential ##br##Of -40 bps Means EUR/USD Goes North Of 1.30 To be clear, north of 1.30 is the medium term direction of travel, and the journey will not be a straight line. The near term event risk is the ECB meeting on October 26, when the central bank will very likely announce a recalibration of its monetary policy. A taper of asset purchases which extends well beyond 12 months might be regarded as dovish, as it would delay the timing of policy rate normalisation. In which case, euro/dollar could retest 1.15. Finally, and very briefly, Chart I-9 shows the major equity sector most at risk of a price trend reversal is Basic Materials. Although global growth seems healthy and synchronized, materials equities seem to have run much too far ahead, especially relative to other cyclical equity sectors. We recommend tactically underweighting Basic Materials relative to the market. Chart I-9Tactically Underweight Basic Materials Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Special Report, "The Universal Constant Of Finance," September 25 2014, available at eis.bcaresearch.com. 2 Published on September 7 2017 and available at eis.bcaresearch.com. Fractal Trading Model* As decribed in the main body of this report, this week’s new trade recommendation is to go long Spain’s IBEX35 versus the Eurostoxx50 with a profit target/stop loss of 2.5%. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights EM currencies are fairly valued at the moment - they are neither cheap nor expensive. Unit labor cost-based REER is a superior currency valuation measure to those based on consumer and producer prices. Based on this measure, the U.S. dollar is not expensive - rather its valuation is neutral. When valuations are neutral, directional market indicators are more imperative than valuations. We expect directional indicators to favor the U.S. dollar and the euro versus EM currencies. In Turkey, inflation is breaking out - the currency, stocks and bonds will be under assault (page 9). The Philippines economy is overheating warranting policy tightening. Share prices are at risk (page 16). Feature EM currencies have recently begun to sell off. Does this represent a major reversal, or just a pause in a bull market? Our bias is that it is the former. In this week's report, we discuss the valuation aspect of foreign exchange markets. One of the oft-cited bullish arguments for EM currencies is that they are cheap. Similarly, the contention goes that the U.S. dollar is expensive. Our exchange rate valuation measures do not support these claims. According to our most favored currency valuation measure - the real effective exchange rate (REER) based on unit labor costs - the U.S. dollar is currently fairly valued (Chart I-1). More specifically, the greenback is not cheap, per se, but it is not expensive either. Meanwhile, the euro is at its fair value and the yen is undervalued (Chart I-2). The source of this data is the IMF. Below we elaborate in detail why we believe the unit labor cost-based REER valuation measure is superior to those based on consumer or producer prices. Chart I-1The U.S. Dollar Is Neither Cheap Nor Expensive Chart I-2The Euro Is Fairly Valued, The Yen Is Cheap As to EM currencies, there is no data on REER based on unit labor costs across all EM countries. The IMF and OECD have data for only a few developing countries, shown in Chart I-3A and Chart I-3B. With the exception of the Mexican peso and the Polish zloty, EM currencies shown in these charts are not cheap. Chart I-3AEM Currencies Are Not Universally Cheap Chart I-3BEM Currencies Are Not Universally Cheap In the absence of unit labor cost-based REER for EM, we deduce EM currency valuations in a number of ways: First, if the U.S. dollar, the euro and yen are not expensive, EM currencies by definition cannot be cheap. Second, provided exchange rates of commodities-producing advanced countries such as Australia, New Zealand, Canada and Norway are still expensive, according to unit labor cost-based REER (Chart I-4A and Chart I-4B), it is fair to argue that currencies of commodities-producing EM economies probably are not cheap as well given they move in tandem with their advanced countries peers. Chart I-4ACAD Is At Fair Value, NOK Is Slightly Expensive Chart I-4BAUD & NZD Are Expensive Third, Chart I-5 illustrates consumer and producer prices-based REER for EM. Excluding China, Korea and Taiwan, the equity market cap-weighted EM REER based on the average of consumer and producer prices is at its historical mean (Chart I-5). This denotes that EM currencies are by and large fairly valued. Notably, the BRL is slightly above its fair value, according to the REER based on average of consumer and producer prices (Chart I-6, top panel). Similarly, the same measure for the RUB and ZAR is no longer depressed after the appreciation witnessed in both currencies over the past 18 months (Chart I-6, middle and bottom panels). Chart I-5EM Ex-China, Korea And Taiwan: ##br##Exchange Rates Valuations Are Neutral Chart I-6EM High-Yielding ##br##Currencies Are Not Cheap All in all, we conclude that EM currencies are fairly valued at the moment - they are neither cheap nor expensive. This message is also corroborated by current account profiles across EM economies. In many developing countries, current account balances have improved, but are still in deficit. Consistently, the U.S. current account deficit excluding oil is at 1.75%, and with oil is at 2.4% of GDP - not wide at all. So, the current account does not presage that the greenback is expensive. Importantly, when valuations are neutral, they do not necessarily prevent the market from either rallying or selling off. Neutral valuations in any market have little impact on the market outlook. Thereby, we conclude that valuations are not an impediment for both EM currencies and the U.S. dollar to move in any given direction. When valuations are neutral, directional market indicators are more imperative than valuations. The best directional indicators for EM currencies have been commodities prices and the EM business cycle. Chart I-7 illustrates the EM aggregate currency index has historically correlated with commodities prices and EM industrial production. If commodities prices relapse and the EM business cycle slows down, as we expect, EM currencies will depreciate. As to U.S. bond yields and the greenback, we believe U.S. interest rate expectations will rise and the U.S. dollar will strengthen, at least, relative to EM currencies. That said, there has been no historical correlation between high-yielding exchange rates such as the BRL and ZAR and their interest rate differential over the U.S. (Chart I-8). Chart I-7These Factors Drive ##br##EM Exchange Rates Chart I-8Interest Rate Differential And ##br##Exchange Rates: No Correlation The euro and European currencies have the least downside versus the U.S. dollar. Hence, we expect EM currencies to weaken materially versus both the dollar and the euro (Chart I-9). Bottom Line: EM currencies are neither cheap nor expensive. We expect commodities prices to relapse and U.S. interest rate expectations to rise. This warrants a material down leg in EM currencies. We continue recommending a short position in a basket of the following currencies: ZAR, TRY, BRL, MYR and IDR versus the U.S. dollar. Investors, who are not comfortable being long the U.S. dollar, can short these same EM currencies versus the euro. Our overweights within the EM currency space are the TWD, THB, RMB, RUB, MXN, PLN and CZK. The Superior Currency Valuation Measure Unit labor cost-based REER is a superior currency valuation measure to those based on consumer and producer prices. The key idea behind currency valuation measures in general is to gauge competitiveness. Rising consumer and producer prices relative to trading partners signifies deteriorating competitiveness, and usually entails more expensive currency valuations. However, nowadays, labor costs in many economies, especially advanced ones, represent the largest cost component, even for manufacturing businesses. Therefore, it makes sense to compare wages across trading partners, not consumer and producer prices. However, rising wages in a country relative to its trading partners do not always signify worsening competitiveness. Wages might be rising, but productivity of employees may well be growing faster than wages. Therefore, true labor costs for businesses are not wages, but unit labor costs. Unit labor costs equal wages divided by productivity. They show the labor cost per unit of output. To estimate an economy's true competitiveness, one should compare its unit labor costs relative to its trading partners. REER based on unit labor cost does that. Hence, this measure captures two critical variables to competitiveness: wages and productivity. On the whole, unit labor costs measure competitiveness better than consumer and producer prices. Therefore, we argue that REER based on unit labor costs is superior to those based on consumer and producer prices. For comparison purposes, Chart I-10 illustrates the two REER measures for the U.S. dollar. Chart I-9EM Currencies Versus The USD And Euro Chart I-10U.S. Dollar: Two Valuation Measures Based on the above analysis, we conclude that the greenback and the euro are fairly valued, while the Japanese yen is cheap. In addition, EM currency valuations are neutral and currencies of commodities producing advanced countries are modestly expensive. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Turkey: Ride The Sell-Off Turkish stocks were among the best performing equity markets worldwide in the January-August period of this year before relapsing by 16% in U.S. dollar terms since September 1st (Chart II-1). We remain bearish/underweight Turkish financial markets. A Genuine Inflation Breakout Despite the currency being stable since the beginning of the year, inflation has been rising. Core consumer price inflation has surpassed 10% for the first time in the past 14 years (Chart II-2). Chart II-1Turkish Stocks Have More Downside Chart II-2Turkey: Inflation Is Breaking Out The country's double-digit wage growth is not supported by productivity gains. The latter has been stagnant (Chart II-3, top panel). Consequently, unit labor costs have surged in both the manufacturing and services sectors (Chart II-3, bottom panel). This combination of strong wage growth paired with low productivity growth depresses companies' profit margins. This in turn will force businesses to raise prices. Provided stimulus-propelled domestic demand is robust, businesses will succeed in raising their prices leading to escalating inflation. Typically, when a country is witnessing heightening inflationary pressures, the natural policy response should be monetary and/or fiscal tightening. However, Turkish authorities have been doing the opposite - running loose monetary and fiscal policies: Government expenditure excluding interest payments have accelerated significantly (Chart II-4). The rise in government spending has been partially funded by commercial banks - the latter's holdings of government bonds have been growing, boosting money supply, as a result. Chart II-3Turkey: Surging Unit Labor Costs Chart II-4Turkey: Fiscal Expenditures Are Booming This year the Turkish authorities have been able to generate growth through the recapitalization of the Credit Guarantee Fund. The aim of this fund is to incentivize banks to lend by essentially assuming credit risk on loans extended to small and medium enterprises. Under this scheme, the government has effectively given a green light to flood the economy with credit, in turn, boosting economic growth. So far, the scheme has been responsible for the creation of TRY 200 billion, or 7% of GDP, worth of new credit out of the TRY 250 billion limit. This TRY 250 billion is considerable as it compares with a total of TRY 367 billion worth of loan origination by commercial banks last year. Turkey's banking system has been relying on enormous amounts of liquidity provisions by the central bank (Chart II-5, top panel) to sustain its ongoing credit boom and strong economic growth. On the whole, the central bank's net liquidity injections into the banking system continue to increase rapidly. Interestingly, the nature of the central bank's funding of commercial banks has increasingly shifted away from open market operations and more towards direct lending to banks (Chart II-5, bottom panel). Adding all the liquidity facilities - the intraday, overnight and late window facilities - the Central Bank Of Turkey's outstanding funding to banks is TRY 86 billion, or 3% of GDP, abnormally elevated relative to the data series' history. This entails that monetary policy is loose even though the price of liquidity provided by the central bank to banks has been rising. Consistently, local currency bank loan growth stands at 25% (Chart II-6, top panel). Chart II-5Central Bank Of Turkey's Liquidity Injections Chart II-6Turkey Is Experiencing A Credit Binge On the whole, commercial banks are requiring more and more liquidity, and the CBT is continuously supplying it. These injections maintain liquidity in the banking system to a sufficiently high level that allow money/credit creation by commercial banks to continue mushrooming (Chart II-6, bottom panel). Fiscal and monetary policies are overly simulative and the country's twin - fiscal and current account - deficit is widening (Chart II-7). The widening current account deficit - which is a form of hidden inflation - substantiates the case of an inflation outbreak in Turkey. Remarkably, despite extremely strong exports due to the robust growth in the Euro Area, Turkey's current account deficit has been unable to narrow at all. This confirms excessive growth in domestic demand. In regard to currency valuation, Chart II-8 demonstrates that the lira is not cheap, especially according to unit labor cost-based REER. It is therefore questionable how long Turkish exports can remain competitive if unit labor costs continue mushrooming at a rapid pace. Chart II-7Turkey: Widening Twin Deficit Chart II-8The Lira Is Not Cheap Bottom Line: Despite high inflation, the Turkish authorities have opted to stimulate the economy further, aiming to boost short-term growth at all costs. The outcome will be an inevitable inflation outbreak. The Monetary Regime And Exchange Rate Chart II-9Excessive Money Printing Is Bearish For Lira The monetary regime in Turkey will lead to a major lira depreciation: The money multiplier - calculated as broad local currency money divided by banks' excess reserves at the central bank - has been rising sharply since 2012 (Chart II-9, top panel). This measure illustrates the degree of leverage banks have assumed. Also, the money multiplier reveals how much broad money/purchasing power banks have created per unit of liquidity provided by the central bank. To put into perspective the vast amount of money that has been created, the bottom panel of Chart II-9 demonstrates that the current net level of foreign exchange reserves (currently US$ 32 billion) covers only 11% of broad local currency money M3. Not only is excessive money creation bearish for the currency but it is also highly inflationary. As inflation rises, residents' desire to convert their deposits from local to foreign currency will increase, further exerting downward pressure on the lira. In fact, this is already happening - households' foreign currency deposits - measured in U.S. dollars - are growing at rapid annual pace of 13%. Given this inflationary backdrop and the risk of further depreciation, interest rates will have to rise. This will inevitably trigger another NPL cycle. Banks are very under-provisioned for non-performing loans (NPL). NPLs have not risen, and NPL provisions are also very low (Chart II-10). Both are set to rise considerably, and banks' capital and ability to expand credit will be severely undermined. Lastly, higher interest rates will be negative for loan growth and bank's profitability. Bank stocks are starting to roll-over. Given the extent to which they have decoupled from interest rates, we believe there is much more downside (Chart II-11). Chart II-10Turkey: A New NPL Cycle Will Start Chart II-11Turkish Bank Stocks Have Considerable Downside The current monetary policy stance is unsustainable. Inflation is breaking out and this is bearish for Turkish financial markets. Box 1 on page 15 addresses the geopolitical dimension of Turkey's recent spat with the U.S. Investment Conclusions We expect policy makers to remain behind the curve amid rising inflation and this will weigh on the lira. As such, we suggest currency traders who are not shorting the lira to do so at this time. We remain short the lira versus the U.S. dollar but the lira will continue to plummet versus the euro too. A weaker lira will undermine U.S. dollar and euro returns on Turkish stocks and domestic bonds. Dedicated EM equity investors as well as those overseeing EM fixed income and credit portfolios should continue to underweight Turkish assets within their respective EM universes. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com BOX 1 Turkey's Unstable Geopolitical Position On the political front, the recent spat with the U.S. over visas is just another sign of how far Turkey has descended into the geopolitical unknown. The U.S. has closed its visa offices as a response to the detention of a Turkish national working for the U.S. consulate in Istanbul by the local authorities. The arrest was made over alleged links to Fethullah Gulen, the cleric that Turkish authorities blame for the July 2016 botched coup. That Gulen remains the obsession of Turkish authorities is a clear sign that President Recep Tayyip Erdogan continues to feel threatened. Whether the Gulen threat is real or imagined is not for us to determine. But it is clear that Turkey remains a deeply divided country. The April 2017 constitutional referendum giving the president greater powers barely passed, despite numerous reports of irregularities. As BCA's Geopolitical Strategy posited following the vote, the referendum did nothing to reinforce Erdogan's power or reduce domestic tensions.1 It would only deepen his instinct to use "rally-around-the-flag" strategy by emphasizing external threats to quell domestic opposition. Now Turkey finds itself at the crossroad on three different fronts: Iraq: Neighboring Kurdistan Regional Government (KRG) has just held an independence referendum, prompting Erdogan to threaten military action against the Iraqi Kurds. Although no regional or global power overtly supports KRG's moves towards independence, Turkey is under pressure to respond in order to snuff out any secessionist ambitions by the Kurds in Turkey and Syria. Syria: President Erdogan has also threatened invasion of the self-declared Kurdish canton of Afrin in northwestern Syria. The enclave is held by the U.S.-allied People's Protection Units (YPG), which fought against the Islamic State in Syria. According to various news reports, Turkish troops are amassing on the border with Syria for the intervention. This could put the Turkish military in direct contact with Russian troops, which have a presence in Afrin. The West: Relations with the West, with whom Turkey remains in a formal military alliance (NATO) remain in the doldrums. Aside from the visa spat with the U.S., Turkey's relations with Europe, and Germany in particular, are at their lowest point in years. Bottom Line: In a month's time, Turkey may have invaded both Syria and Iraq while simultaneously hitting a low point in its relationship with traditional Western allies. At the very least, this complicated geopolitical environment will make it difficult for Ankara to focus on the economy. At its greatest, it is a recipe for geopolitical overreach, military disaster, domestic crisis, or any combination of all three. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "What About Emerging Markets?," dated May 3, 2017, available at gps.bcaresearch.com. The Philippines: An Overheating Economy Requires Policy Tightening Since early 2016, the Philippine stock market has been massively lagging the EM benchmark (Chart III-1, top panel). Similarly, the Philippine peso has been extremely weak, recording new lows versus the U.S. dollar, despite the broad-based EM currency rally (Chart III-1, bottom panel). In fact, the symptoms of this economy and its financial markets are consistent with an overheating economy that is expanding above potential, and where inflationary pressures are heightening. Going forward, inflation will keep rising and the central bank will have to tighten monetary policy meaningfully. These developments will weigh on Philippine growth and financial markets. Consumer price inflation, both headline and core, are rising briskly and currently stand at 3% - in the middle of the central bank's 2-4% target (Chart III-2). With the policy rate at 3%, this entails that real rates have dropped to zero. Chart III-1Philippine Stocks Relative ##br##To EM Have Underperformed Chart III-2Philippine Inflation ##br##Is Creeping Higher The Central Bank of the Philippines (BSP) has kept monetary policy too easy for too long. It injected liquidity into the banking system on various occasions in 2013-2014 and 2016-2017 via its banking liquidity management tool - the Special Deposit Account (Chart III-3, top panel). These liquidity injections incentivized commercial banks to create enormous amounts of credit in the economy (Chart III-3, middle and bottom panels). Booming credit growth in turn is creating excessive purchasing power in the economy, resulting in a current account deficit for the first time since 2000. In addition, the fiscal deficit is now widening (Chart III-4). Chart III-3Credit Growth Is Rampant Chart III-4Philippines Twin Deficit On the wage front, non-agriculture workers' salaries are accelerating, pushing unit labor costs higher (Chart III-5). Remarkably, despite real GDP growth of about 6.5% since 2014, consumer staples EPS growth is on the verge of contracting. It seems that costs (including wages) have been mushrooming while productivity gains have been lagging. This also corroborates the overheating thesis. With Philippines' inflationary dynamics intensifying, the BSP will have to tighten monetary policy. In fact, the top panel of Chart III-3 shows that the BSP has already begun its tightening cycle by withdrawing some banking liquidity via its Special Deposit Account. In addition, interest rate hikes by the central bank are also an option. Monetary tightening amid very strong loan growth will lead a meaningful slowdown in the economy. Loan growth deceleration will affect primarily capital spending and the property market. Both segments are cooling off (Chart III-6). Chart III-5Philippines: Wages Are Accelerating Chart III-6Cyclical Slowdown On The Horizon Importantly, banks' net interest margins have been falling - a trend that will likely continue due to potential liquidity tightening and higher policy rates (Chart III-7, top panel). This, along with slow loan growth and rising NPL provisions, will intensify banks' EPS contraction (Chart III-7, bottom panel). Chart III-8 illustrates that both NPL and NPL provisions as a percent of total loans are at their lowest level since 1997. Higher borrowing costs following a decade-long lending boom, necessitates higher NPL provisions. Chart III-7Banks' Interest Rate Margins And Profits Chart III-8Bank NPLs To Rise Along With Provisions NPLs are likely to emanate from the real estate and construction sectors. Loans to these two sectors account for 20% of total bank loans. Hence, higher interest rates are negative for banks and real estate stocks which, together, account for 40% of the Philippines MSCI index market cap. If the central bank decides not to tighten, however, the economy will continue to overheat and bond yields - as well as the currency - will sell-off. Such a scenario is equally bearish for the equity market. Philippines equity valuations are elevated and, hence, are not priced for any of these scenarios. For dedicated EM equity investors, we continue recommending a neutral allocation to this bourse. We are reluctant to underweight this stock market because the Philippines remains less leveraged to China and the commodities cycle vis-à-vis other emerging markets (EM). Besides, it has already considerably underperformed the EM equity benchmark. Therefore, it might not underperform substantially relative to other EM countries - if and when commodities start selling off as a result of a growth slowdown in China. Within ASEAN, we favor Thailand, underweight Malaysia and are neutral on the Philippines, Indonesia, and India relative to the EM equity benchmark. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Duration: The global economic recovery is more synchronized than at any time since 2011. This suggests that foreign demand will be less of an impediment to the bond bear market and that Treasury yields will rise once U.S. data start to surprise on the upside. Stay at below-benchmark duration. MBS: Agency MBS option-adjusted spreads have widened significantly and no longer look expensive. With Treasury yields moving higher and mortgage refinancings likely to stay depressed, we advise upgrading MBS from underweight to neutral. Economy & Inflation: The U.S. economic data are starting to outperform beaten-down expectations. Survey data point to further GDP acceleration in the second half of this year and we expect inflation will soon follow growth higher. Feature Chart 12-Factor Treasury Model The relationship between the global breadth of economic growth, the value of the dollar and the outlook for Treasury yields has been a running theme in this publication.1 To summarize, stronger global growth pressures bond yields higher (and vice-versa). But how that growth is distributed across different countries matters as well. For example, if global growth is mostly concentrated in the U.S., then yield spreads will widen between the U.S. and the rest of the world and the dollar will appreciate as money pours in from overseas. Investors then respond to a stronger dollar by downgrading their U.S. growth and rate hike expectations. This caps the upside in long-dated U.S. Treasury yields. Conversely, if global growth is more evenly spread out throughout the world, then the dollar will come under less upward pressure when U.S. growth accelerates and Treasury yields can rise further. We developed a simple two-factor model to show how the trade-off between global growth and the exchange rate impacts the U.S. 10-year Treasury yield (Chart 1). The model uses the Global Manufacturing PMI as its proxy for global growth and a survey of bullish sentiment toward the dollar as its proxy for growth synchronization. So far this year, the Global PMI has moved higher and sentiment toward the dollar has become less bullish. Both developments have bond-bearish implications and our model now pegs fair value for the 10-year Treasury yield at 2.65%, 28 bps above the current 10-year yield. In Sync The Global PMI came in at 53.2 in September, the same as in August, but still a strong reading compared to recent history (Chart 2). But the most stunning detail of the September PMI releases is that 33 out of the 36 countries we track had PMIs above the 50 boom/bust line. As a result, our Global PMI Diffusion Index hit 90% for only the second time since 2011 (Chart 2, panel 1). The elevated reading of our diffusion index leads us to two market related observations. First, stronger growth outside of the U.S. explains why the 10-year Treasury yield is only 8 bps lower than at the start of the year despite U.S. economic data that have severely undershot expectations (Chart 2, bottom panel). Second, it suggests that when U.S. economic data inevitably start to surprise on the upside - a process which is only now beginning (see Economy & Inflation section below) - the dollar will appreciate by less than it would have when our PMI diffusion index was near 50. This removes a huge impediment from the bond bear market. In Chart 3 we see that the recent peak in 7-10 year U.S. bond yields occurred at 2.54% on Dec 16th. On that same date the spread between 7-10 year U.S. bond yields and average 7-10 year yields in the rest of the world was 178 bps, and bullish sentiment toward the dollar was above 80%. With the global recovery now more synchronized than it was last year, we anticipate that by the time U.S. yields take out that prior peak, the yield spread and dollar bullish sentiment will still be lower than they were last December. This means that less foreign capital will be encouraged into the U.S. and yields will rise even further. Chart 2Broad Based Recovery Chart 3Spreads Less Of A Constraint Where Is Growth Coming From? Considering the major economic blocs, the biggest change during the past year has been the surging Eurozone PMI (Chart 4). The U.S. PMI is still firmly above the 50 boom/bust line but has actually moderated in 2017. The Japanese PMI is similarly entrenched above 50 and while the Chinese PMI was weak earlier this year, it has rebounded during the past four months. At roughly 20%, China carries the largest weight in the Global PMI. The outlook for the Chinese economy is therefore crucial for the path of bond yields. On that note, while the Chinese PMI has been strong in recent months, a couple of warning signs are beginning to flash (Chart 5). Chart 4Global Manufacturing PMIs Chart 5Chinese Monetary Conditions Commodity prices - which correlate strongly with Chinese PMI - have declined since early September, although they remain above levels seen last year and do not yet pose a major risk. What's more important is that monetary conditions are starting to tighten (Chart 5, panel 2). If tighter monetary conditions persist, then we should expect growth to slow. The mild tightening in monetary conditions that has already occurred will probably lead to some near-term moderation in Chinese growth. But our China Investment Strategy service thinks it's unlikely that monetary conditions will tighten enough to cause a meaningful slowdown.2 Our China strategists note that with GDP growth within the government's target range, inflation exceedingly low and signs that financial excesses have been reigned in, there should not be much appetite for draconian policy tightening. We would also add that the causes of this year's tightening in monetary conditions have been relatively benign. The monetary conditions index shown in Chart 5 has fallen because the trade-weighted RMB is no longer depreciating and because real interest rates have moved a tad higher. Crucially, the RMB has only stabilized, it is not appreciating in trade-weighted terms. Also, the nominal policy rate remains flat at a low level. The increase in real interest rates resulted purely from weaker consumer price inflation. Bottom Line: The global economic recovery is more synchronized than at any time since 2011. This suggests that foreign demand will be less of an impediment to the bond bear market and that Treasury yields will rise once U.S. data start to surprise on the upside. Stay at below-benchmark duration. Buy The News In MBS Last week we upgraded our allocation to Agency MBS from underweight to neutral, noting that spreads had become more attractive during the past few months. In all likelihood this is the result of the market pricing in the wind-down of the Fed's balance sheet.3 With the Fed's plans now well known (and unlikely to change), there is an opportunity to increase MBS exposure from a more attractive starting point. After having sold the rumor, we think it's time to buy the news. The Value Proposition Chart 6OAS Look Attractive To be clear, we are not forecasting stellar excess returns from Agency MBS. But with spreads compressed across the entire U.S. fixed income universe, we would note that the option-adjusted spread (OAS) differential between conventional 30-year Agency MBS and investment grade corporate bonds (in duration-matched terms) has risen back to levels last seen in 2014 (Chart 6). The lagged OAS differential is a decent predictor of relative returns between MBS and corporate credit, and at current levels it suggests that MBS could even outperform corporate bonds at some point during the next 12 months (Chart 6, panel 2). This year's decline in Treasury yields has also biased OAS differentials between MBS and corporate bonds wider. Because of negative convexity, MBS duration is positively correlated with yields (Chart 6, bottom panel). If yields rise from here, as we expect they will, then MBS duration will also extend. This means that MBS OAS will start to appear less and less attractive relative to duration-matched comparables. In other words, MBS are less likely to cheapen relative to other spread product in an environment of rising Treasury yields. The Drivers Of MBS Spreads A simplified formula for excess MBS returns, relative to duration-matched Treasuries, could be written as follows: Excess Return = Starting OAS - Duration*(Change in nominal spread) + 0.5*Convexity*(Change in yield) 2 That is, OAS is the correct measure of MBS carry because it adjusts for expected losses due to prepayments. However, it is the change in the nominal spread (not the OAS) that will determine capital gains and losses during the investment horizon. On that note, we observe that nominal MBS spreads have rarely been tighter during the past 30 years (Chart 7). However, it is also hard for us to see a catalyst for significantly wider nominal spreads during the next 6-12 months. The two factors that correlate most closely with nominal MBS spreads are credit spreads and mortgage refinancings. Chart 7Nominal MBS Spreads Are Driven By Credit Spreads And Refinancings On credit spreads, we have repeatedly outlined why they are unlikely to widen materially in the absence of more significant inflationary pressure.4 As for refis, we are also hard pressed to see much upside for three main reasons: First, changes in mortgage rates are the number one driver of refinancings (Chart 8). Refis only increase when mortgage rates fall, making the proposition of refinancing more attractive. As yields rise during the next 6-12 months, refis will stay low. Second, the distribution of outstanding mortgages across the coupon stack impacts how sensitive refis are to changes in rates. The second panel of Chart 8 shows our measure of "moneyness", aka the dispersion of outstanding mortgages around the current coupon rate.5 Given today's dispersion levels we can calculate that even if the current coupon mortgage rate falls back to its recent low of 2.24%, our measure of moneyness would not get back to its late-2016 peak. For our moneyness indicator to rise back to 2013 levels the current coupon mortgage rate would have to fall all the way to 1.68%. Needless to say, we would characterize that risk as low. Third, the final factor that can impact the pace of mortgage refinancing is the seasoning of outstanding mortgages. Typically, we think of mortgages between 30 and 60 months old as being the most likely to refinance. Given that net mortgage origination was close to zero between 30 and 60 months ago and that mortgage purchase applications were at multi-year lows (Chart 9), most of the outstanding mortgage universe probably falls outside of this zone. Chart 8Refis Will Stay Low Chart 9Most Mortgages Are Not Yet Seasoned Bottom Line: Agency MBS option-adjusted spreads have widened significantly and no longer look expensive. With Treasury yields moving higher and mortgage refinancings likely to stay depressed, we advise upgrading MBS from underweight to neutral. Economy & Inflation Bring On The Upside Surprises As was alluded to in the opening section of this report, after have disappointed expectations year-to-date, we are just now starting to see U.S. economic data surprise to the upside (see Chart 2). The most recent datapoints that caught our eye were the ISM manufacturing and non-manufacturing PMIs.6 Our inclination is to mostly ignore last Friday's employment report as an outlier due to the recent hurricanes.7 The ISM non-manufacturing survey jumped to 59.8 in September, its highest level since 2005. Taken together with other survey indicators that tend to track GDP growth - the BCA Beige Book Indicator and the BCA Composite New Orders Indicator - the case is quite strong for further GDP acceleration in the third and fourth quarters (Chart 10). Of course the pressing issue for bond markets is whether that growth acceleration translates into higher inflation. On that note, we would suggest that the weak inflation we have seen during the past six months was a reaction to the growth slowdown witnessed in 2015 and the first half of 2016. The stronger ISM manufacturing index, in particular, sends a powerful signal that inflation is poised to put in a bottom (Chart 11). Chart 10Survey Indicators Of U.S. Growth Chart 11Inflation Lags Growth Bottom Line: The U.S. economic data are starting to outperform beaten-down expectations. Survey data point to further GDP acceleration in the second half of this year and we expect inflation will soon follow growth higher. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: Another Update", dated January 31, 2017, available at usbs.bcaresearch.com 2 Please see China Investment Strategy Special Report, "On A Higher Note", dated October 5, 2017, available at cis.bcaresearch.com 3 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Return Of The Trump Trade", dated October 3, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down", dated September 26, 2017, available at usbs.bcaresearch.com 5 For each coupon bucket in the Bloomberg Barclays Conventional 30-year Agency MBS index we calculate the squared deviation between its coupon and the current coupon rate. We then weight those squared differences by the market capitalization of each coupon bucket. 6 These are different than the Markit PMI that is included in our 2-factor Treasury model. 7 Please see BCA Daily Insights, "U.S. Jobs Report: All Noise, No Signal", dated October 6, 2017, available at din.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification