High-Yield
Highlights Chart 1Upside Risks & Uncertainty The evidence of economic acceleration continues to pile up and we maintain our view that bond yields will be higher than current forwards by the end of 2017. In the near-term, however, the bond market has been too quick to discount a more positive growth outlook, especially considering still-elevated levels of economic policy uncertainty. Our cautious optimism is echoed by the readings from our global PMI models and also by the Fed. The minutes from December's FOMC meeting revealed that more participants saw upside risks to growth and inflation than saw downside risks, but also that this improved economic forecast was judged to be more uncertain than any Fed forecast since 2013 (Chart 1). We remain bond bears on a 12-month horizon, but advocate a benchmark duration stance in the near term. A period of flat bond yields is the most likely outcome until elevated uncertainty levels revert to a more normal range (see the global economic policy uncertainty index). Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 82 basis points in December and by 478 basis points in 2016. The index option-adjusted spread tightened 6 bps on the month and 42 bps on the year. At 122 bps, the spread is currently well below its historical average (134 bps). Corporate spreads have tightened substantially since last February despite elevated gross leverage (Chart 2).1 As we pointed out in our end-of-year Special Report titled "Seven Fixed Income Themes For 2017",2 it is very rare for spreads to tighten when leverage is in an uptrend. While a rebound in profit growth will likely cause the uptrend in leverage to abate this year, spreads have already moved to discount a significant reversal. Although valuations are by no means attractive, accelerating economic growth and still-accommodative Fed policy will keep spreads at tight levels during the first half of this year. This sweet spot will persist at least until TIPS breakeven inflation rates return to pre-crisis levels, which would likely presage a hawkish shift in Fed policy. Energy sector debt returned 12.5% in excess of duration-equivalent Treasuries in 2016, compared to excess returns of under 5% for the overall corporate index. Despite this large outperformance, energy credits still appear attractive according to our model (Table 3), and should continue to outperform into the New Year. Table 3ACorporate Sector Relative Valuation##br## And Recommended Allocation* Table 3BCorporate Sector##br## Risk Vs. Reward* High-Yield: Underweight Chart 3High-Yield Market Overview High-yield outperformed the duration-equivalent Treasury index by 188 basis points in December and by 1539 basis points in 2016. The index option-adjusted spread narrowed 46 bps on the month and 251 bps on the year. At 383 bps, it is currently 137 bps below its historical average. As we highlighted in our year-end Special Report,3 the uptrend in defaults is likely to reverse this year, mostly due to recovery in the energy sector. However, still-poor corporate health and tightening monetary policy will lead to a resumption of the uptrend in 2018 and beyond. Given the improving default backdrop, we are actively looking to upgrade our allocation to high-yield debt. However, valuations do not present a sufficiently compelling opportunity at the moment. Our estimate of the default-adjusted high-yield spread - the average spread of the junk index less our forecast of 12-month default losses - is below 150 bps (Chart 3). This is close to one standard deviation below the long-run average. Historically, we have found that a default-adjusted spread between 100 bps and 200 bps is consistent with positive 12-month excess returns 65% of the time, but with an average 12-month excess return of close to zero. With the spread in this range, a 90% confidence interval would place 12-month excess returns between -3% and +4%. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in December, but underperformed by 11 bps in 2016. The conventional 30-year MBS yield rose 5 bps in December, completely driven by a 5 bps increase in the rate component. The compensation for prepayment risk (option cost) and option-adjusted spread were both flat on the month. In 2016, the conventional 30-year MBS yield rose 6 bps. This was driven by a 12 bps increase in the rate component that was partially offset by a 9 bps decline in the option-adjusted spread. The option cost increased 3 bps on the year. Our underweight in MBS is predicated upon very low option-adjusted spreads, relative both to history and other comparable spread product (Chart 4). Historically, the option-adjusted spread is correlated with net MBS issuance and eventually we expect rising net issuance to lead the option-adjusted spread wider. Importantly, purchase applications have remained firm in the face of higher mortgage rates even though refinancings have collapsed (bottom panel). Another tail risk for the MBS market is the possibility that the Fed ceases the reinvestment of its mortgage portfolio. While we do not expect this to occur in 2017, with two rate hikes now in the bank the fed funds rate is approaching levels where the Fed might begin to consider it. A new Fed Chair in early 2018 might also be more inclined to wind down the balance sheet. Government Related: Overweight Chart 5Government Related Market Overview The government-related index outperformed the duration-equivalent Treasury index by 27 basis points in December. Foreign Agency and Sovereign bonds outperformed by 84 bps and 83 bps respectively, while Local Authorities outperformed by 22 bps. Domestic Agency bonds and Supranationals were a drag on performance during the month, underperforming the Treasury benchmark by 10 bps and 7 bps respectively. The government-related index outperformed the duration-equivalent Treasury benchmark by 150 bps in 2016. The best performing sub-sectors for the year were Sovereigns (outperformed by 322 bps), Local Authorities (outperformed by 286 bps) and Foreign Agencies (outperformed by 258 bps). Domestic Agency bonds outperformed Treasuries by 38 bps, while Supranationals underperformed by 11 bps. Foreign Agency bonds and Local Authority bonds continue to appear attractive relative to U.S. corporate credit, after adjusting for credit rating and duration. We recommend focusing our government related allocation in these two sectors. In contrast, Sovereigns and Supranationals both appear expensive relative to U.S. corporate credit, and we recommend avoiding these sectors. Spreads on Domestic Agency debt have room to tighten in the near-term (Chart 5). Spreads widened to the top of their recent range last month on rumors that the new government could seek to speed up the process of GSE reform. We view these concerns as premature. This week we also remove our recommendation to favor callable agencies over bullets. Bullets have tended to outperform when the 2/5 Treasury slope steepens (bottom panel). We expect the 2/5 curve to be biased steeper in the first half of this year. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 134 basis points in December, but underperformed the index by 103 basis points in 2016 (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio fell 8% in December, but increased 13% during 2016. At present the average M/T ratio is 98%, only slightly below its post-crisis average (Chart 6). Although M/T ratios moved higher last year, trends in issuance and fund flows suggest they are still too low. As we noted in our year-end Special Report,4 our tactical model of the M/T yield ratio - based on issuance, fund flows, ratings changes and economic policy uncertainty - pegs current fair value for the average M/T yield ratio at 112%. Further, as was also highlighted in our year-end report, the municipal credit cycle is likely to take a turn for the worse in late 2017, with muni downgrades starting to outpace upgrades. This analysis is based on indicators of state & local government budget health that tend to follow our indicators of corporate sector health with a two year lag. Just last month Moody's downgraded $1.6 billion worth of the City of Dallas' general obligation debt from Aa3 to A1. The downgrade was justified based on the city's poorly funded public safety pension plan. Attention will increasingly turn to underfunded public pensions when state & local government budget health starts to deteriorate later this year. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve shifted higher and flattened in December. The 2/10 slope flattened by 1 basis point on the month and the 5/30 slope flattened 6 bps. For 2016 as a whole, the Treasury curve bear-steepened out to the 10-year maturity. The 2/10 slope steepened 4 bps and the 5/30 slope flattened 12 bps. In our year-end Special Report,5 we detailed how the combination of accelerating economic growth and still-accommodative Fed policy will cause the Treasury curve to bear-steepen in the first half of 2017. This steepening will be driven by continued, but gradual, recovery in long-dated TIPS breakeven inflation back to pre-crisis levels (2.4% to 2.5%). Once inflation expectations return to pre-crisis levels, it is possible that the Fed will shift to a monetary policy that is focused more on tamping out inflation than supporting growth. At that point the curve will shift from a bear-steepening to a bear-flattening regime. A steepening curve environment will cause bullet trades to outperform barbells. On top of that, the 5-year bullet is currently extremely cheap on the curve (Chart 7). For these reasons we recommended entering a long 5-year bullet, short 2/10 barbell trade on December 20. This trade has already returned 8 bps since initiation, even though the 2/10 slope has flattened 10 bps during this period. A resumption of curve steepening will cause our long 5-year bullet, short 2/10 barbell trade to perform even better in the months ahead. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 6 basis points in December, and by 331 bps in 2016. The 10-year TIPS breakeven rate increased by 1 bp in December and by 41 bps in 2016. At present it sits at 1.96%, still well below the 2.4% to 2.5% range that is consistent with the Fed's 2% inflation target. As we explained in our year-end Special Report,6 the Fed will be keen to allow TIPS breakevens to rise toward levels more consistent with its inflation target, and will quickly back away from a hawkish policy stance should breakevens fall. But while breakevens will continue to trend higher, the rate of increase should moderate to be more in line with the shallow uptrend in realized inflation. It is difficult for the Fed to drive long-dated inflation expectations higher while it is in the midst of a tightening cycle. For this reason, trends in actual inflation will be a more important determinant of TIPS breakevens than in the past. And while there are indications that the uptrend in realized inflation will persist, notably recent accelerations in wage growth and survey measures of prices paid (Chart 8). There is currently no indication that core and trimmed mean inflation are breaking out to the upside (bottom panel). We remain overweight TIPS relative to nominal Treasuries on the expectation that long-dated breakevens reach the 2.4% to 2.5% range in the second half of 2017, and that core PCE inflation reaches the Fed's 2% target by the end of the year. ABS: Maximum Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 17 basis points in December but outperformed the Treasury benchmark by 94 bps in 2016. Aaa-rated ABS underperformed Treasuries by 21 bps in December but outperformed by 75 bps in 2016, while non-Aaa ABS outperformed the benchmark by 13 bps in December and by 257 bps in 2016. The index option-adjusted spread for Aaa-rated ABS widened by 11 bps in December, but tightened by 10 bps in 2016. Further, the spread differential between Aaa-rated auto ABS and Aaa-rated credit card ABS narrowed substantially in 2016. The option-adjusted spread for Aaa-rated auto loan ABS has tightened by 20 bps since the end of 2015, while the option-adjusted spread for Aaa-rated credit card ABS has tightened by 10 bps. We have previously noted that, after adjusting for spread volatility, Aaa-rated auto loan ABS no longer offer an attractive opportunity relative to Aaa-rated credit cards (Chart 9). We continue to favor Aaa-rated credit cards over Aaa-rated auto loans, given the low spread differential and divergences in collateral credit quality (bottom panel). As was noted in the Appendix to our year-end Special Report,7 consumer ABS provided better volatility-adjusted excess returns than all fixed income sectors except for Baa-rated corporates and Caa-rated high-yield in 2016. With spreads still elevated relative to other similarly risky fixed income sectors, we expect this risk-adjusted performance to continue. Non-Agency CMBS: Underweight Agency CMBS: Overweight Chart 10CMBS Market Overview Agency CMBS underperformed the duration-equivalent Treasury index by 40 basis points in December, but outperformed by 117 bps in 2016. The index option-adjusted spread for Agency CMBS widened 10 bps in December but tightened 6 bps in 2016. Agency CMBS still offer 50 bps of option-adjusted spread. This is similar to what is offered by Aaa-rated consumer ABS (51 bps) and greater than what is offered by conventional 30-year MBS (26 bps) for a similar amount of spread volatility. We continue to recommend an overweight position in Agency CMBS. Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 19 basis points in December, but outperformed by 313 bps in 2016. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 7 bps in December but tightened 48 bps in 2016. It has recently moved well below its average pre-crisis level (Chart 10). Rising CMBS delinquency rates and tightening commercial real estate lending standards make us cautious on non-agency CMBS. This caution has only intensified now that spreads are at their tightest levels since prior to the financial crisis. Treasury Valuation Chart 11Global PMI Model The current reading from our 2-factor Global PMI model (which includes the global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.31% (Chart 11). Our 3-factor version of the model, which also incorporates the global economic policy uncertainty index, places fair value at 2.02%. The lower fair value is the result of a large spike in the global economic policy uncertainty index in November that barely reversed in December (bottom panel). Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we would be inclined to view the fair value reading from our 2-factor model as more indicative of true fair value at the moment. However, unusually high uncertainty is one reason we are reluctant to adopt a below benchmark duration stance for the time being even though we expect yields to be higher in 12 months. At the time of publication the 10-year Treasury yield was 2.37% For further details on our Global PMI models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com. Monetary Conditions And Rate Expectations The BCA Monetary Conditions Index (MCI) combines changes in the fed funds rate with changes in the trade-weighted dollar using a 10:1 ratio. Historically, economic downturns have been preceded by a break in this index above its equilibrium level - calculated using the Congressional Budget Office's estimate of potential GDP growth (Chart 12). With the MCI having just reached this estimate of equilibrium, the shaded region in Chart 13 shows the expected path of the federal funds rate assuming that the MCI remains at its equilibrium level. The upper-end of the shaded region corresponds to a scenario where the trade-weighted dollar depreciates by 2% per year and the lower-end of the shaded region corresponds to a scenario where the dollar appreciates by 2% per year. The thick line through the middle of the region corresponds to a flat dollar. Chart 12Monetary Conditions Vs. Equilibrium Chart 13Fed Funds Rate Scenarios As can be seen in Chart 13, both the market and Fed are discounting a move in the MCI above its equilibrium level. This would be consistent with behavior witnessed in past cycles when the MCI broke above its equilibrium level several years before the next recession. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com 1 Defined as total debt divided by EBITD. 2 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)
Highlights The U.S. dollar will continue to appreciate while the RMB will depreciate further. This is a bad omen for EM risk assets, commodities, and global late cyclical equity sectors. Gold often leads oil and copper prices. Investors should heed the current downbeat message from gold. EM credit spreads have become detached from fundamentals and are unreasonably tight. Continue overweighting the Indian bourse within an EM equity portfolio. A new equity trade: long Indian software stocks / short the EM overall index. Feature There are several major discrepancies in financial markets that in our view are unsustainable. 1. The gap between EM equity breadth, USD, RMB and EM share prices One way to measure equity market breadth is to compare performance of equal-weighted versus market cap-weighted stock price indexes. Based on this measure, EM stock market breadth has been deteriorating. Poor breadth often heralds a major selloff (Chart I-1). Chart I-1Poor EM Equity Breadth Heralds A Major Selloff Remarkably, the same measure for the U.S. stock market shows improving breadth. The relative performance of equally-weighted EM stocks against U.S. equity indexes - a measure of breadth in relative performance - can also be a reliable marker for the relative performance of market cap-weighted indexes. It has plummeted to a new low pointing to new lows in EM versus U.S. relative share prices. In addition, a surging U.S. dollar has historically meant lower EM share prices (Chart I-2). We doubt this time is different. Finally, EM risk assets have decoupled from the RMB/USD exchange rate as well. The RMB has been depreciating and China's domestic corporate and government bond yields have spiked. As a result, the on-shore bond prices in RMB terms have plummeted (Chart I-3). Chart I-2A Rising U.S. Dollar Is ##br##A Bad Omen For EM Chart I-3China's On-Shore Corporate Bond##br## Prices Have Crashed Experiencing considerable losses on their favorite financial investment of the past year, bonds, Chinese investors, as well as households and companies, could opt to switch into U.S. dollars. The stampede into the U.S. dollar could start as early as January when the annual US$ 50,000 quota per person becomes available. It is hard to see what the government will do to preclude this rush and massive flight towards U.S. dollars. In China, households' and corporates' RMB deposits in the banking system amount to RMB 122 tn or US$17.5 tn. Hence, the PBoC's foreign exchange reserves including gold at US$ 3.2 tn are only equal to 18.5% of these deposits at the current exchange rate. Bottom Line: The U.S. dollar will appreciate and the RMB will depreciate. This is a bad omen for EM share prices and other risk assets. 2. Oil and copper prices deviating from gold prices Historically, when gold and oil prices have diverged, gold in most cases has proven more forward looking, with oil prices ultimately converging toward gold prices. Chart I-4A and Chart I-4B illustrate past episodes of gold and oil decoupling (in the 1980, 1990s and 2008), each of which were resolved via oil prices gravitating toward gold prices. Chart I-4AGold Led Oil Prices Chart I-4BGold Led Oil Prices In short, if history is any guide, the current gap between gold and oil prices will likely close via lower oil prices (Chart I-5, top panel). The same holds true for the recent divergence between gold and copper prices (Chart 5, bottom panel). We identified four historical periods when gold and copper prices diverged. In each case, it was copper prices that amended their trajectory and aligned with the direction of gold prices (Chart I-6A and 6B). Chart I-5Divergence Between Oil, Copper And Gold Chart I-6AGold Led Copper Prices Too Chart I-6BGold Led Copper Prices Too In sum, historically there have been a number of episodes when gold has led both oil and copper prices. Investors should heed the current downbeat message from gold. Chart I-7China: Dichotomies The underlying rationale could be that gold responds to monetary/liquidity conditions (gold is very sensitive to U.S. TIPS (real) yields) while oil and copper are more sensitive to growth conditions. Tightening in monetary/liquidity conditions often precedes a growth relapse. This could be the reason why gold has led oil and copper prices on several occasions in the past. 3. Dichotomies in China's industrial economy There are two types of dichotomies underway within China's industrial economy: The first is between industrial activity and industrial commodities prices. Commodities prices have surged, but the pace of manufacturing production has not improved at all (Chart I-7). There have been major discrepancies among various segments of China's industrial economy, with utilities surging and the technology sector remaining robust, and many others stagnating. The decoupling between industrial activity and industrial commodities prices can be explained by financial speculation and supply cutbacks. The former is unsustainable, while the latter is reversing as the government is gradually lifting restrictions on supply for coal and steel. The second is between the private- and state-owned parts of the industrial sector. The state-owned segment has experienced a meaningful improvement in output, while private companies in the industrial sector have seen their output growth weaken, albeit the growth rate is higher than in the SOE sector. (Chart I-7, bottom panel). As China's fiscal and credit impulses wane,1 activity in the state-owned industrial segment will relapse anew. 4. EM credit spreads diverging from EM currencies and credit fundamentals EM sovereign and corporate credit spreads (credit markets) are once again proving very resilient, despite the renewed selloff in EM currencies (Chart I-8). EM credit markets have defied deteriorating EM credit fundamentals in the past several years. Below we identify several divergences and anomalies within the EM credit space that give us confidence that EM credit markets have become detached from fundamentals, and that their risk-reward profile is poor. Chart I-8EM Credit Markets And EM Currencies:##br## A Widening Dichotomy Chart I-9EM Corporate Financial Health:##br## Not Much Improvement The EM Corporate Financial Health (CFH) Indicator has stabilized, but remains at a very depressed level (Chart I-9, top panel). This amelioration is largely due to the profit margin component. The other three components have not improved (Chart I-9, second panel). The valuation model based on the EM CFH indicator shows that EM corporate spreads are far too tight (Chart I-10). Chart I-10EM Corporate Bonds Are Expensive The strong performance of EM credit markets in recent years has been justified by the persistence of low bond yields in developed markets (DM). Yet the latest spike in DM bond yields has so far not caused EM credit spreads to widen. We expect U.S./DM government bond yields to rise further, and the U.S. dollar to continue to strengthen. This, along with potential broad-based declines in commodities prices, should lead to material widening in EM sovereign and corporate credit spreads in early 2017. With respect to unsustainable discrepancies, the case in point is Brazil. The country's sovereign and corporate spreads have tightened a lot this year, even though economic activity continues to shrink. The country has had numerous boom-bust cycles in the past 100 years, yet this depression is the worst on record. In fact, the nation's economic growth and public debt dynamics are worse than at any time during the past 20 years. Yet, at 300 basis points, sovereign spreads are well below the 1000-2500 basis point trading range that prevailed in the second half of 1990s and early 2000s (Chart I-11). Remarkably, the economy's pace of contraction has lately intensified (Chart I-12). This will likely worsen government revenues and lead to further widening in the fiscal deficit - making debt dynamics unsustainable. Another absurd credit market divergence is between China's sovereign CDS and Chinese offshore corporate spreads. Sovereign CDS spreads have been widening, but corporate credit spreads remain very tight (Chart I-13). Chart I-11Brazil: Dichotomy Between Sovereign ##br##Spreads And Fundamentals Chart I-12Brazil's Economy: ##br##No Improvement At All Chart I-13Chinese Sovereign CDS And ##br##Off-Shore Corporate Spreads Yet there is much more risk in Chinese corporates than in government debt. The corporate sector commands record leverage of 165% of national GDP, while public debt stands at 46% of GDP. Besides, the central government in China will always have immediate access to domestic or foreign debt markets, while some corporations could lose access to financing if creditors question their creditworthiness and decide to tighten credit. There is no rational case to support the rise in sovereign CDS when corporate spreads are tame. The only feasible explanation is that investors - who are invested in Chinese corporate bonds, and are not interested in selling them - are buying sovereign CDS to tactically hedge their credit exposure. If and when market sentiment sours sufficiently, and credit spread widening is perceived durable and lasting, real money will sell corporate bonds, resulting in a major spike in corporate spreads. 5. Divergence between global late cyclicals and the U.S. dollar Another area where we detect that financial markets have lately become overly optimistic is in global late cyclicals - materials, machinery and energy stocks. Typically, the absolute share prices in these sectors correlate with the U.S. dollar exchange rate but they have lately diverged (Chart I-14). Furthermore, global machinery stocks in general, and Caterpillar's share price in particular, have lately staged significant gains, while their EPS and sales continue to plunge (Chart I-15). Notably, Caterpillar's sales have not improved, even on a rate-of-change basis. Chart I-14Global Late Cyclicals And The U.S. Dollar: ##br##Unsustainable Decoupling Chart I-15Global Machinery Sales And##br## Profits Continue Plunging EM including China capital spending in real terms is as large as the U.S. and EU capital spending combined (Chart I-16). If the EM and China capex cycle does not post a recovery, which is our baseline view, it will be hard for global late cyclical stocks to continue rallying based solely on the positive outlook for U.S. infrastructure spending and potential U.S. tax reforms. In short, global late cyclicals such as machinery, materials and energy stocks that performed quite well in 2016 are vulnerable to a major pullback as EM/Chinese capital spending disappoints on the back of credit growth deceleration. Notably, these global equity sectors have reached a major technical resistance that will likely become a ceiling for their share prices (Chart I-17). Chart I-16EM/China's Capex Is As Large As ##br##U.S. And Euro Area Combined Chart I-17Global Late Cyclicals Are ##br##Facing Technical Resistance 6. Decoupling between the South African rand and precious metals prices The South African rand's recent resilience - despite the considerable drop in precious metal prices - is unprecedented (Chart I-18, top panel). Similarly, the rand has also decoupled from the exchange rate of another major metals producer: Australia (Chart I-18, bottom panel). We cannot think of any reason why these discrepancies can or should persist. Rising global bond yields and a broadening selloff in commodities prices should hurt the rand. In fact, the trade-weighted rand is facing a major technical resistance (Chart I-19) and will likely relapse sooner than later. Chart I-18Rand, AUD And ##br##Precious Metals Chart I-19Trade-Weighted Rand Is ##br##Facing Technical Resistance We reiterate our structural short position in the rand versus the U.S. dollar, and on October 12, 2016 initiated a short ZAR / long MXN trade. Traders should consider putting on these trades. Investment Strategy Chart I-20EM Relative Equity Performance ##br##Is Heading To New Lows Emerging markets share prices and currencies have been doing poorly since October, despite U.S. equity shares breaking out to new highs. In fact, almost all relative outperformance has been wiped out (Chart I-20). BCA's Emerging Markets Strategy team expects further declines in EM share prices and currencies, as well as a selloff in domestic bonds and a widening of sovereign and corporate spreads. Absolute return investors should stay put, while asset allocators should maintain underweight positions in EM risk assets within respective global portfolios. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com India: Demonetization And Opportunities In Equities On November 8, India launched a demonetization program with the goal of removing the two most used banknotes - the 500 INR and 1000 INR banknotes - from circulation. Both banknotes accounted for roughly 85% of currency in circulation, which itself accounts for 13% of India's broad money supply. Moreover, almost 90%2 of retail transactions in India are cash-reliant. While around INR 13 trillion of notes (US$ 190 billion) have been deposited in the banking system as of December 10, only INR 5 trillion of new notes have been issued by the Reserve Bank of India (RBI). India is unlikely to turn cashless overnight. According to a Harvard Business Review article,3 less than 10% of Indians have ever used non-cash payment instruments. Likewise, less than 2% of Indians have used a cellular phone to receive a payment. This implies cash shortages could persist for a while and will have a significant impact on short-term economic activity. There are numerous reports that layoffs and business shutdowns have ensued in several industries, particularly in the informal economy (Chart II-1). The service sector PMI already dipped below 50 in November and the manufacturing PMI fell as well (Chart II-2). Chart II-1Very Weak Employment Outlook Chart II-2Indian PMIs Are Sinking Having boomed over the past year, motorcycle sales growth is now waning. Similarly, passenger and commercial vehicle sales - that have been anemic - will now dip. However, the consumption slowdown should not continue beyond the next couple of months. As more currency is supplied by the RBI, economic activity will rebound - particularly household spending. Pent-up demand will be unleashed as money circulation is restored. Nevertheless, investment expenditures are the key factors for improving productivity and, hence, as non-inflationary growth potential. Capital spending had been anemic in India well before the demonetization program was announced (Chart II-3). The reason for such lackluster investment expenditure lies in the fact that past investment projects taken on by highly leveraged Indian conglomerates have delivered poor performance. This translated into ever rising non-performing loans (NPLs) at state banks. Without debt restructuring and public bank recapitalization, a new capex cycle is unlikely in India. Consistently, credit to large industries is now contracting (Chart II-4) and foreign lending to Indian companies is declining. Chart II-3Indian Capex Is Anemic Chart II-4Banks Prefer Consumers We expect the demonetization program to hurt capital spending only mildly in the coming months, but do not expect a material bounce in investment afterward, unlike the one slated for household consumption. Indian share prices have more downside in absolute terms, as the market is still expensive and growth is slumping. Nevertheless, India will likely outperform the EM equity benchmark going forward (Chart II-5). Chart II-5Indian Share Prices: A Tapering Wedge The rationale for our overweight on Indian equities within the EM stock universe is due to the nation's much better macro fundamentals relative to those in many other EM. In particular, deleveraging and NPL write-offs are more advanced, the current account deficit is small, and India will benefit from potentially lower commodities prices. Within the Indian bourse, we recommend overweighting software stocks that will benefit from a revival in advanced economies' growth and a weaker currency. Besides, Indian software stocks are not exposed to the currently weak domestic consumption cycle and in fact might benefit from the push toward digitalization in banking. Bottom Line: Indian consumption will weaken in the coming three months or so, but will rebound thereafter. The capex cycle is weak and will remain subdued. Continue overweighting the Indian bourse within an EM equity portfolio. A new equity recommendation: long Indian software stocks / short the EM overall index. Ayman Kawtharani, Research Analyst aymank@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Key EM Issues Going Into 2017," dated December 14, 2016, available at ems.bcaresearch.com 2 Chakravorti, B., Mazzotta, B., Bijapurkar, R., Shukla, R., Ramesha, K., Bapat, D., &Roy, D. (2013). The cost of cash in India. Institute of Business in the Global Context, Fletcher School, Tufts University. 3 Chakravorti, B. (2016, December 14). India's Botched War on Cash. Retrieved from https://hbr.org Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Duration: An easing of financial conditions is likely necessary for recent improvements in U.S. economic growth to continue. As such, the uptrend in Treasury yields will pause in the near-term before resuming early next year. Corporate Bonds: The macro back-drop is turning marginally more positive for corporate spreads. C&I lending standards are no longer tightening and bank stocks have rallied significantly. Corporate Bonds: Spreads are too tight at the moment, even for an improving economic environment. Remain neutral (3 out of 5) on investment grade and underweight (2 out of 5) on high-yield for now. We are actively looking to add exposure to corporate credit from more attractive levels. Feature There is no question that the U.S. economy is on a firm footing heading into the New Year. Third quarter real GDP growth came in at a robust 3.2%, and the Atlanta and New York Fed tracking models currently forecast fourth quarter growth of 2.6% and 2.7%, respectively. This represents a marked acceleration from the average growth rate of 1.1% witnessed during the first two quarters of 2016. Forward-looking survey data are also pointing in the right direction. The ISM non-manufacturing survey reached 57.2 in November, its highest level since October 2015, while the expectations component of the University of Michigan Consumer Sentiment survey reached 88.9 in December, its highest level since January 2015 (Chart 1). The question for bond investors is how much of this good news is already reflected in Treasury yields. Higher Treasury yields and a stronger dollar have already led to a material tightening in some broad indexes of financial conditions, enough to exert a meaningful drag on U.S. growth (Chart 2). In fact, according to the Fed's FRB/US model, the recent interest rate and dollar moves could be expected to shave 1% from GDP over the next eight quarters. Chart 1Economic Tailwinds Chart 2Financial Conditions Must Ease The natural conclusion is that while some upside in Treasury yields is justified by an improving economic outlook, the bond selloff has proceeded too quickly and must pause in the near-term to prevent financial conditions from exerting an excessive drag on growth. Sentiment and positioning indicators also confirm that the uptrend in yields appears stretched (Chart 2, bottom two panels). As such, last week we tactically shifted our recommended portfolio duration allocation from 'below benchmark' to 'at benchmark'.1 We expect Treasury yields will grind higher next year, reaching a range of 2.8% to 3% by the end of 2017, but the selloff will proceed more gradually, in line with the acceleration in economic growth. A More Uncertain World The premise that the bond selloff has proceeded too quickly is confirmed by our Global PMI models of the 10-year Treasury yield. We track two versions of our Global PMI model. One is a 2-factor model based only on the Global PMI index and a survey of bullish sentiment toward the U.S. dollar. The intuition behind this model is that improving global growth contributes to a higher fair value Treasury yield. However, for a given level of global growth, increasingly bullish dollar sentiment applies downward pressure to yields. This is because a stronger dollar represents a tightening of monetary conditions, so that all else equal, a stronger dollar means we should expect fewer Fed rate hikes. The current fair value reading from this 2-factor model is 2.26%, meaning that the 10-year Treasury yield at 2.49% appears somewhat cheap (Chart 3). The second version of our Global PMI model is a 3-factor model which adds the Global Economic Policy Uncertainty Index (EPUI) as a third independent variable. All else equal, an increase in uncertainty about the economic outlook should depress the term premium in long-dated Treasury yields. The data appear to back-up this assertion, as the EPUI is negatively correlated with the 10-year Treasury yield over time. With the addition of the EPUI, our 3-factor model explains 84% of the variation in the 10-year Treasury yield since 2010, compared to 80% from our 2-factor model. The EPUI spiked last month, and as such, this version of the model suggests that fair value for the 10-year Treasury yield is only 1.82% (Chart 4). Chart 32-Factor Global PMI Model Chart 43-Factor Global PMI Model There are probably good reasons to overlook last month's spike in policy uncertainty. For one, the EPUI, created by Baker, Bloom and Davis,2 is largely constructed from algorithms that scan newspaper articles for keywords. They do not attempt to distinguish between economic news with bond-bearish or bond-bullish implications. Second, we have found that large spikes in uncertainty that do not coincide with deterioration in economic growth tend to mean-revert fairly quickly. This past summer's Brexit vote being a prime example. As a counterpoint, however, the negative correlation between the EPUI and the 10-year Treasury yield is quite robust (Chart 5), and historically, incidents of spiking policy uncertainty and rising Treasury yields have been few and far between. Since 1991, there have been 42 instances when the monthly increase in the EPUI exceeded one standard deviation. In those 42 months, the 10-year Treasury yield increased only 36% of the time, with last month's 53 basis point rise being by far the largest on record. We tend to view the reading from the 2-factor model as the more reasonable assessment of fair value in the current environment. But the spike in policy uncertainty does underscore why we should view the recent bond selloff skeptically. The recent selloff has, to a large extent, been predicated upon promises of fiscal stimulus that have yet to be delivered, from a President-elect who has shown himself to be highly unpredictable. In this environment, near-term caution is clearly warranted. Of course, this week the market's focus will at least temporarily turn away from fiscal policy and toward the Fed. We expect that the Fed will announce a 25 basis point increase in the fed funds rate tomorrow, but also that participants' interest rate projections will not change meaningfully. The FOMC will likely be much slower to react to promises of fiscal stimulus than the market. With the Fed's projected near-term path for interest rates already mostly discounted by the market (Chart 6), we could see a "dovish hike" from the Fed tomorrow coinciding with the near-term top in Treasury yields. Chart 5Economic Policy Uncertainty & Treasury Yields Chart 6A "Dovish Hike" Is In The Price Bottom Line: An easing of financial conditions is likely necessary for recent improvements in U.S. economic growth to continue. As such, the uptrend in Treasury yields will pause in the near-term before resuming early next year. A More Favorable Environment For Credit We frequently point to three main indicators that we use to assess the current stage of the credit cycle: Our Corporate Health Monitor (CHM) Monetary conditions relative to equilibrium C&I bank lending standards In a report3 published earlier this year we found that the performance of bank stocks relative to the overall market is another useful indicator (Chart 7). While the credit cycle is still very much in its late stages, recently, our indicators have been sending marginally more positive signals. The CHM remains deep in 'deteriorating health' territory and non-financial corporate balance sheets continue to lever-up aggressively. However, the indicator did inch slightly closer to 'improving health' territory in the third quarter due to an improvement in all six of its components (Chart 8). Make no mistake, trends in corporate balance sheet leverage are not supportive for corporate spreads. In fact, as we will explore in a future report, the recent divergence between rising leverage and tightening spreads is nearly unprecedented during the past 40 years. But at the margin, recent trends are less worrisome. Chart 7Credit Cycle Indicators Chart 8Corporate Health Monitor Components Box1: Corporate Health Monitor Components The BCA Corporate Health Monitor is a normalized composite of six financial ratios, calculated for the non-financial corporate sector as a whole. These six ratios are defined as follows: Profit Margins: After-tax cash flow as a percent of corporate sales Return on Capital: After-tax earnings plus interest expense, as a percent of capital stock Debt Coverage: After-tax cash flow less capital expenditures, as a percent of all interest bearing debt Interest Coverage: EBITDA (Earnings before interest, taxes, depreciation & amortization) divided by the sum of interest expense and dividends Leverage: Total debt as a percent of market value of equity Liquidity: Working Capital, excluding inventories, as a percent of market value of assets Second, although monetary conditions appear very close to our estimate of equilibrium, the recent steepening of the yield curve suggests that the market is revising its estimate of monetary equilibrium higher, leading to a de-facto easing of monetary conditions. In the long-run, with the Fed in the midst of a hiking cycle, this sort of easing is unlikely to persist. But, as we argued in a recent report,4 the bear steepening curve environment could continue in the first half of next year as the Fed is slow to respond to an improving economy. Third, C&I bank lending standards have fallen back to unchanged after having tightened for four consecutive quarters. This likely reflects less stress in the energy sector now that oil prices have rebounded. Fourth, bank stocks have rallied strongly alongside the steepening yield curve. To the extent that higher bank stock prices reflect lower future commercial loan delinquencies, then this trend should be viewed positively from the perspective of credit investors. To test the idea that bank stock performance might help us trade the corporate bond market, we take a look at the past six credit cycles, going back to 1975 (Chart 9). The bottom panel of Chart 9 shows the percent drawdown in relative bank equity performance from its peak during the most recent credit cycle. We define credit cycles as the periods between when the CHM crosses into 'improving health' territory. For example, we define the most recent credit cycle as beginning when the CHM fell into 'improving health' territory in 2002 and ending when it fell into 'improving health' territory in 2009. Shaded regions in Chart 9 show periods when the CHM is in 'deteriorating health' territory. Chart 9Bank Equity Drawdown & Corporate Bond Performance If we construct a trading strategy using the CHM alone, we can get fairly good results. We find that investment grade corporate bonds underperform duration-equivalent Treasury securities in 3 out of 6 instances, over a 12-month investment horizon, following the time when the CHM first crosses into deteriorating health territory, for an average excess return of -1.2% (Table 1). Table 1Corporate Bond Trading Rules: 12-Month Investment Horizon However, we find that this result can be improved if we also incorporate bank stock price performance. If we were to only reduce corporate bond exposure when the CHM was in deteriorating health territory and after the drawdown in bank equities exceeded 20%, then the position is still profitable in 3 out of 6 instances, but for a more negative average return of -1.9%. Further, if we were to wait for the drawdown in bank equities to surpass 30%, then the hit rate on our position improves to 3 out of 5 and the average return falls to -4.6%. We find similar results if we use a 6-month investment horizon (Table 2). In the current cycle, the drawdown in bank stocks breached 25% in February but has since reversed course, and it has not yet reached the 30% threshold. Our analysis suggests that corporate bond underperformance tends to persist for some time even after the drawdown in bank stocks exceeds 30%. Table 2Corporate Bond Trading Rules: 6-Month Investment Horizon Chart 10Corporate Spreads Are Too Low Bottom Line: The macro back-drop is turning marginally more positive for corporate spreads. We remain neutral (3 out of 5) on investment grade and underweight (2 out of 5) on high-yield for now, due to poor starting valuation (Chart 10). But we are looking for an opportunity to upgrade from more attractive spread levels in the next couple of months. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Too Far Too Fast, But The Bond Bear Is Still Intact", dated December 6, 2016, available at usbs.bcaresearch.com 2 For further details on the construction of this index please see www.policyuncertainty.com 3 Please see U.S. Bond Strategy Weekly Report, "Lighten Up On Duration", dated February 16, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Chart 1More Upside From Inflation We moved to below benchmark duration on July 19, when the 10-year Treasury yield was 1.56%. As of last Friday's close, the 10-year Treasury yield was 2.4% and above the fair value reading from our global PMI model. While our economic outlook still justifies higher Treasury yields on a 12-month horizon, the selloff in bonds has moved too far, too quickly. We recommend tactically shifting to a benchmark duration stance. Longer run, the upside in Treasury yields will be concentrated in the inflation component. The cost of 10-year inflation compensation can rise another 49 bps before it is consistent with the Fed's target. But that adjustment will proceed gradually next year, alongside a shallow uptrend in realized inflation (Chart 1). Higher inflation compensation can occasionally be offset by lower real yields, but this only occurs when the increase in inflation compensation results from an easing of Fed policy, as in 2011-2012. With the Fed in the midst of a hiking cycle, the downside in real yields is limited. We would not be surprised to see the 10-year Treasury yield re-visit the 2%-2.2% range during the next month or two. At that point we would re-initiate a below benchmark duration stance, on the view that the 10-year yield will reach 2.80%-3% by the end of 2017. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 52 basis points in November. The index option-adjusted spread tightened 3 bps on the month and, at 129 bps, it is now slightly below its historical average (134 bps). Spread per unit of gross leverage1 for the nonfinancial corporate sector is slightly above its historical average (Chart 2). But unusually, spreads have been tightening this year despite sharply rising gross leverage. Since 1973, there has only been one other period when spreads tightened despite rising gross leverage. That was in 1986-88 when, similar to today, spreads were tightening from extremely oversold levels. Much like today, elevated spreads in 1986 resulted from distress in the energy sector that dissipated as oil prices recovered. This caused corporate spreads to widen dramatically and then tighten, while in the background gross leverage persistently climbed higher. The current recovery in oil prices could lead to further corporate spread tightening early next year. Indeed, energy sector credits still appear cheap on our model and we continue to recommend overweighting those sectors. This month we also upgrade Paper from neutral to overweight (Table 3). Table 3Corporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* However, corporate credit fundamentals are deteriorating rapidly and spreads will be at risk when the Fed adopts a more hawkish policy stance, possibly as early as the second half of next year.2 High-Yield: Maximum Underweight Chart 3High-Yield Market Overview High-yield outperformed the duration-equivalent Treasury index by 128 basis points in November. The index option-adjusted spread tightened 23 bps on the month and, at 450 bps, it is 71 bps below its historical average. A model based on lagged spreads and default losses explains more than 50% of the variation in 12-month excess junk returns. This model currently forecasts excess junk returns of close to zero during the next 12 months (Chart 3), a forecast that is based on our expectation of a modest improvement in default losses (bottom panel). In a recent report,3 we examined the relationship between default-adjusted spreads and excess junk returns in more detail. We showed that a model based purely on ex-ante estimates of default losses explains around 34% of the variation in excess junk returns. We also showed that, historically, negative excess returns to junk bonds are only likely if the ex-ante default-adjusted spread is below 100 bps. Our current ex-ante default-adjusted spread is 201 bps. Historically, when the ex-ante default-adjusted spread is between 200 bps and 250 bps, junk earns positive excess returns 81% of the time. However, junk earns positive excess returns only 65% of the time if the spread is between 150 bps and 200 bps. Although our economic outlook for next year is fairly optimistic, high-yield valuations are stretched and we expect to get a better entry point from which to upgrade the sector during the next couple of months. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 47 basis points in November. Other than municipal bonds, MBS has been the worst performing fixed income sector relative to Treasuries, earning year-to-date excess returns of -17 bps. The conventional 30-year MBS yield rose 53 bps in November, driven by a 59 bps increase in the rate component. The compensation for prepayment risk (option cost) declined 10 bps, while the option-adjusted spread widened by 4 bps. Prior to the election, we had been tactically overweight MBS on the view that higher Treasury yields would lead to a lower option cost, benefitting MBS in the near term. Now that Treasury yields have moved substantially higher, our focus returns to the extremely depressed levels of MBS option-adjusted spreads (Chart 4). Extremely low option-adjusted spreads coupled with a housing market that should continue to recover - leading to steadily increasing net supply (bottom panel) - make for a poor risk/reward trade-off in MBS relative to other fixed income sectors. Against this back-drop, MBS are only worth a tactical trade if you have high conviction that Treasury yields are about to rise and option costs about to tighten. We do not expect the Fed to cease the reinvestment of its MBS purchases in 2017. But, if Janet Yellen is replaced as Fed Chair in early 2018, then it is possible that the new Fed will seek to end its involvement in the MBS market. This is a tail risk for MBS in 2018. Government Related: Overweight Chart 5Government Related Market Overview The government-related index underperformed the duration-equivalent Treasury index by 19 basis points in November (Chart 5). Domestic Agency bonds and Local Authority bonds outperformed the Treasury index by 2 bps and 61 bps, respectively. Sovereign debt underperformed by 122 bps, Foreign Agency debt underperformed by 54 bps and Supranationals underperformed by 6 bps. More than half of the underperformance in the Foreign Agency sector came from Mexico's state oil company, Pemex, in the aftermath of Donald Trump's election win. Losses in the Sovereign debt sector were similarly concentrated in Mexican issues. Strength in oil prices should permit Foreign Agency debt to outperform going forward, while the strong U.S. dollar will remain a drag on Sovereign debt. Local Authority and Foreign Agency debt both continue to offer attractive spreads relative to U.S. investment grade corporate bonds, after adjusting for duration and credit rating. In contrast, Supranationals and Sovereigns both appear expensive. We continue to recommend an underweight allocation to Sovereign debt within an otherwise overweight allocation to the government related sector. Bullet Agency issues outperformed callable Agency bonds in November, despite the large increase in Treasury yields (bottom panel). We expect this trend will soon reverse, and remain overweight callable versus bullet Agencies. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration equivalent Treasury index by 83 basis points in November (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio rose from 99% to 107% in November, and is now above its post-crisis average (Chart 6). We downgraded municipal bonds to underweight on November 15,4 following Donald Trump's election victory. Lower tax rates under the new administration will undermine the tax advantage in municipal bonds, leading to outflows and higher M/T yield ratios. ICI data show that outflows have already begun. Net outflows from Muni funds have exceeded $7 billion in the four weeks since the end of October (panel 4). There are also longer-run concerns related to supply and state & local government credit quality. Depending on how it is structured, increased infrastructure spending next year could lead to a large increase in municipal bond supply. Also, state & local government downgrades are likely to increase later next year, following the lead of the corporate sector. Both of these issues are discussed in more detail in a recent Special Report.5 In October, the SEC finalized new liquidity management standards for open-ended investment funds. Funds must now determine a minimum percentage of net assets that must be invested in highly liquid securities, and no more than 15% of assets can be invested in securities deemed illiquid. At the margin, the new rule could limit funds' appetites for municipal bonds. Treasury Curve: Laddered Chart 7Treasury Yield Curve Overview November's bond rout was concentrated in the belly (5-10 years) of the Treasury curve. The 2/10 Treasury slope steepened 28 basis points on the month, while the 5/30 slope flattened by 8 bps. We believe that the yield curve has room to steepen further in 2017, based largely on the expectation that the Fed will maintain an accommodative stance of monetary policy at least until TIPS breakeven inflation rates are at levels more consistent with the Fed's 2% inflation target (Chart 7). In our view, this level is between 2.4% and 2.5% for long-dated TIPS breakevens. However, we are reluctant to initiate a curve steepener one week before the Fed is poised to lift rates. Although we view a "dovish hike", i.e. an increase in the fed funds rate with no upward revision to the Fed's interest rate forecasts, as the most likely outcome. If we are wrong, an upward revision to the Fed's forecasts would cause the curve to bear-flatten on the day. At present, the market expects 55 bps of rate hikes during the next 12 months (panel 1). If expectations remain at these levels until after next week's FOMC meeting they will be consistent with the Fed's median forecast, assuming there are no upward revisions. Also, as we pointed out on the front page of this report, the selloff at the long-end of the Treasury curve appears stretched relative to fundamentals and is likely to take a pause. This should provide us with a more attractive level from which to enter curve steepeners heading into next year. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 148 bps in November. The 10-year breakeven rate increased 21 bps on the month, and currently sits at 1.91%. The 5-year, 5-year forward TIPS breakeven inflation rate has risen to 2.06% from its early 2016 trough of 1.41%. However, it still has room to rise before it returns to levels that are consistent with the Fed's 2% target for PCE inflation (Chart 8). As economic growth improves next year the Fed will be keen to allow TIPS breakevens to rise toward its target, and will be slow to shift to a less accommodative policy stance. As such, we maintain our recommendation to overweight TIPS relative to nominal Treasuries, with a target of 2.4% to 2.5% for the 5-year, 5-year forward TIPS breakeven rate. While breakevens will continue to trend higher, the rate of increase should moderate to be more in line with the shallow uptrend in realized inflation. With the Fed in the midst of a tightening cycle, it will be difficult for the Fed to lead inflation expectations sharply higher as in past cycles. Trends in realized inflation will be more important for long-dated breakevens this time around. Core and trimmed mean PCE inflation continue to grind slowly higher, a trend that is supported by the PCE diffusion index (panel 4). Assuming the current trend remains in place, core PCE inflation should finally reach the Fed's 2% target before the end of next year. ABS: Maximum Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 10 basis points in November, bringing year-to-date excess returns up to +111 bps. Aaa-rated ABS outperformed the Treasury benchmark by 11 bps on the month, while non-Aaa issues outperformed by 5 bps. Credit card ABS outperformed by 14 bps, while auto ABS outperformed by 7 bps. The index option-adjusted spread for Aaa-rated ABS tightened 4 bps in November and, at 43 bps, it is well below its average pre-crisis level. Last month we observed that after adjusting for trailing 6-month spread volatility, Aaa-rated auto loan ABS no longer offer a compelling spread pick-up relative to Aaa-rated credit card ABS. We calculate that it will take 12 days of average spread widening for Aaa-rated auto ABS to underperform Treasuries on a 6-month horizon and 9 days of average spread widening for Aaa-rated credit card ABS to underperform (Chart 9). This spread cushion is not sufficient to compensate for the fact that credit card quality metrics are in much better shape than those for auto loans. The auto loan net loss rate has entered a clear uptrend, while credit card charge-offs are still near all-time lows (bottom panel). CMBS: Underweight Chart 10CMBS Market Overview Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 74 basis points in November, bringing year-to-date excess returns up to +269 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 16 bps in November, and has now fallen below its average pre-crisis level (Chart 10). Rising delinquency rates and tightening lending standards make us cautious on non-agency CMBS. This caution has only intensified now that spreads are at their tightest levels since prior to the financial crisis. Further adding to our caution is that more than 6000 commercial real estate loans backing public conduit CMBS deals are set to mature in 2017. This is almost 5x the number that matured last year, according to data from Trepp. Agency CMBS outperformed the duration-equivalent Treasury index by 52 basis points in November, bringing year-to-date excess returns up to +158 bps. Agency CMBS still offer 45 bps of option-adjusted spread. This is similar to what is offered by Aaa-rated consumer ABS (43 bps) and greater than what is offered by conventional 30-year MBS (22 bps) for a similar amount of spread volatility. We continue to recommend an overweight position in Agency CMBS. Treasury Valuation Chart 11Global PMI Model The current reading from our 3-factor Global PMI model (which includes global PMI, dollar sentiment and global policy uncertainty) places fair value for the 10-year Treasury yield at 1.82%. However, the low reading mostly reflects a large spike in global policy uncertainty in November. Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we would be inclined to view the fair value reading from our 2-factor Global PMI model (which includes only global PMI and dollar bullish sentiment) as more representative of 10-year Treasury yield fair value at the moment. The fair value reading from our 2-factor model is currently 2.26% (Chart 11). At the time of publication the 10-year Treasury yield was 2.4%. For further details on our Global PMI model please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com. Monetary Conditions And Rate Expectations The BCA Monetary Conditions Index (MCI) combines changes in the fed funds rate with changes in the trade-weighted dollar using a 10:1 ratio. Historically, economic downturns have been preceded by a break in this index above its equilibrium level - calculated using the Congressional Budget Office's estimate of potential GDP growth (Chart 12). Using assumptions for the time until the MCI converges with equilibrium and the annual appreciation of the trade-weighted dollar, it is possible to calculate the expected change in the fed funds rate for the cycle. The shaded region in Chart 13 shows the expected path for the federal funds rate assuming that the MCI reaches equilibrium at the end of 2019. The upper-end of the region corresponds to a scenario where the trade-weighted dollar depreciates by 2% per year and the lower-end of the region corresponds to a scenario where the dollar appreciates by 2% per year. The thick line through the middle of the region corresponds to a flat dollar. Chart 12Monetary Conditions Vs. Equilibrium Chart 13Fed Funds Rate Scenarios Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com 1 Defined as total debt divided by EBITD. 2 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, "The Fourth Tantrum", dated November 29, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Secular Stagnation Vs. Trumponomics", dated November 15, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)
Highlights U.S. bond yields and the U.S. dollar will rise further. Consistently, EM currencies and local bonds will continue selling off. There is meaningful downside in EM exchange rates. We recommend short positions in the following basket of EM currencies versus the U.S. dollar: KOR, MYR, IDR, TRY, ZAR, BRL, COP and CLP. Within domestic bond portfolios, overweight low-beta defensive markets as well as Russia and Mexico. Our underweights are Turkey, South Africa, Malaysia and Indonesia. The latest exponential rise in commodities prices on Chinese exchanges is an unsustainable speculative frenzy. Feature Emerging market (EM) risk assets will likely continue to be driven by both rising U.S. bond yields and a strong U.S. dollar over the next two months or so. Beyond the next couple of months, the focus of the markets will likely switch to China: renewed weakness in growth and possible instability in its financial markets, with negative implications for China plays globally and for commodities prices in particular. The combination of these two negative forces will lead to a considerable drop in EM currencies in the next six months or so. In turn, EM currency depreciation will trigger broad liquidation of EM risk assets. BCA's Emerging Markets Strategy service believes that EM risk assets will continue to sell off in absolute terms, and underperform their DM/U.S. peers. EM Local Bonds The total return (including carry) index of JPM GBI-EM1 local currency bonds in U.S. dollar terms has rolled over at a critical resistance level (Chart I-1). The total return index of EM local bonds has also relapsed relative to the total return of 5-year U.S. Treasurys, failing to break above its long-term moving average (Chart I-1, bottom panel). Consistently, domestic bond yields have troughed at important technical levels in several key countries such as Brazil, Turkey, Colombia, Russia, South Africa and Malaysia (Chart I-2A and Chart I-2B). Chart I-1EM Local Bonds' Total ##br##Return In US$: Failed Breakout Chart I-2AHave EM Domestic ##br##Bond Yields Bottomed? Chart I-2BHave EM Domestic ##br##Bond Yields Bottomed? In short, EM local bonds are exhibiting negative technical dynamics that corroborate our downbeat fundamental analysis. Consequently, we believe the total return JPM GBI-EM index in U.S. dollar terms will drop to new lows for the following reasons: Currency swings are responsible for most of the fluctuations in EM local bond total returns. As we have elaborated numerous times and re-assert in this report, the outlook for EM exchange rates remains gloomy. Foreign holdings of EM local currency bonds are substantial (Table I-1). Even though there have been improvements in a few countries, current account and fiscal deficits generally remain wide in the majority of developing nations (Chart I-3A and Chart I-3B). In other words, a number of EM economies are still at risk from a slowdown in foreign funding. Table I-1Foreign Holdings Of EM Local Bonds Chart I-3ACurrent Accounts And Fiscal Deficits Chart I-3BCurrent Accounts And Fiscal Deficits Chart I-4U.S. And EM Local Yields Notably, the bar for exchange rate depreciation is very low in EM economies with current account deficits. It takes only a reduction in net capital and financial inflows - i.e., net outflows are not necessary - for these countries' currencies to depreciate significantly. As net foreign funding diminishes, exchange rates of countries with current account deficits should weaken and interest rates should rise in order to compress domestic demand, which in turn would equalize the current account deficit to net inflows in capital and financial accounts. Finally, the spread of EM local bonds (the yield for GBI-EM global diversified index) over duration-matched (5-year) U.S. Treasury yields has not risen much (Chart I-4). Heightened risks in EM currencies warrant higher local bond yield spreads over U.S. Treasurys. Bottom Line: Absolute return investors should stay away from EM local currency bonds. U.S. Bond Yields And The Dollar: More Upside We expect U.S./DM bond yields to keep rising as re-pricing in global fixed income markets continues. The decline in DM bond yields in recent years until the latest selloff was enormous, and some sort of mean reversion should not come as a surprise. Our bias is that this selloff will likely continue until sometime in January, when U.S. President-elect Donald Trump takes office. This riot in the bond market could, in retrospect, resemble a typical "sell the rumor, buy the news" pattern. In other words, by the time President-elect Trump takes office, a lot of bad news will already be priced into the U.S. bond markets, creating a buying opportunity. In our July 13 Weekly Report,2 we argued that: "In the U.S., the combination of a healthy labor market and a heavily overbought fixed-income market have created the backdrop for a material rise in U.S. interest rate expectations/bond yields. As U.S. rate expectations climb, the U.S. dollar should gain support. This in turn will create headwinds for EM currencies and other EM risk assets." Then, we reiterated this view in our July 27 Weekly Report: "Nowadays, there is little talk in the investment community about a bond bubble and the potential for much higher bond yields. Indeed, "lower for longer" has begun to dominate the investor lexicon. This is a sign that many G7 bond bears have likely capitulated. Investor consensus on bonds has become quite bullish, and many investors are long duration. When many bears capitulate, the odds of a market selloff inevitably rise. "Importantly, the increase in G7 bond yields might not be gradual as many expect because of the following: with yields at such low levels, bonds' duration is high and price changes become very sensitive to changes in yield... Such (large) price changes (drops) would amount to large losses for bond investors, and forced selling could intensify. As a result, the unwinding of long positions could be abrupt and volatile." For now, odds are that U.S. bond yields will rise further. Given global bond funds have seen massive inflows in recent years, the latest drop in prices of various bonds has been substantial and will likely trigger withdrawals and redemptions from bond funds, prompting forced selling. This is true for all types of bond portfolios, including DM government and corporates, EM credit (U.S. dollar bonds) and EM local currency bonds. U.S. bond yields are still low, even from the perspective of the past several years, and the market-implied terminal fed funds rate is still 80 basis points below the median projection of the Federal Open Market Committee's longer-run rate (Chart I-5). Given that U.S. interest rate expectations are not high at all, they will rise further (Chart I-6) as the uptrend in U.S. wages persists - driven by an already reasonably tight labor market (Chart I-7). Chart I-5U.S. Interest Rate Expectations Are Still Low Chart I-6U.S. Wage Growth Is Accelerating Chart I-7More Upside In U.S. Treasurys Yields Finally, the U.S. dollar will continue to be buoyed by rising U.S. interest rate expectations. Our composite momentum indicator for the broad trade-weighted U.S. dollar has bounced off the zero line (Chart I-8). This constitutes a strong technical confirmation of the durable bullish market trend in the dollar. Bottom Line: Odds are that the rise in U.S. bond yields is not over. As U.S. bond yields rise further, EM currencies and bonds will sell off. Long-Term EM Currency Trends We have several observations on the long-term performance of EM currencies and financial markets: In the long run, there is no guarantee that the majority of EM currencies will appreciate in real terms (adjusted for inflation differentials). In fact, even countries such as Korea and Taiwan - which have been very successful in their economic development and have tremendously grown their income per capita - have seen their real (inflation-adjusted) exchange rates depreciate over the past several decades (Chart I-9). The case for long-term appreciation in real terms is even weaker for exchange rates in countries that exhibit chronically high inflation rates and/or current account deficits. This has been true for many non-Asian EM currencies (Chart I-10). Chart I-8The U.S. Dollar Is ##br##In A Genuine Bull Market Chart I-9Long-Term Currency ##br##Downtrends In Korea And Taiwan Chart I-10EM Currency Trends: ##br##A Long-Term Perspective Importantly, most losses to foreign investors in EM financial markets often occur via currency depreciation. This is even truer in the current bear market downtrend. The JPM ELMI+ currency total return index (including cost of carry) seems to be about to break down (Chart I-11). In EM ex-China, the real effective exchange rate is still elevated (Chart I-12). Given their poor productivity growth outlook, the real effective exchange rates will be inclined to depreciate. Chart I-11EM Currency Return With Cost ##br##Of Carry Versus U.S. Dollar Chart I-12Weak Productivity Means ##br##Further Currency Depreciation To limit the upside in domestic interest rates - both in bond yields and interbank rates - many developing nations' central banks will inject more local currency liquidity into their respective systems.3 This might help cap local interest rates, but is bearish for their currencies. The Turkish central bank has been among the most aggressive in this disguised money printing, and not surprisingly the value of its currency has collapsed (Chart I-13). There is no long-term history for EM currencies, as before 1998 most developing nations' exchange rates were pegged. Yet when one examines EM equities' relative performance against the S&P 500, it emerges that there is no single EM bourse that has outperformed U.S. stocks on a consistent basis in the very long run. Chart I-14A and Chart I-14B demonstrate that among 11 EM equity markets that have a long-term history, none have outperformed the S&P 500 over the past 30-35 years. Chart I-13Turkey's Central Bank Has Been ##br##Pumping Local Currency Into The System Chart I-14AEM Equities Versus The S&P 500: ##br##A Long-Term Perspective Chart I-14BEM Equities Versus The S&P 500: ##br##A Long-Term Perspective This goes to reveal that the starting point of underdevelopment and the mark "emerging" does not guarantee consistent outperformance even in the long run. In fact, EM's relative performance against the U.S. has followed multi-year cycles, and we believe the current bear market and underperformance is not yet over. While EM underperformance is long in duration, economic and financial adjustments remain incomplete. DM QE programs and China's still-growing credit bubble have delayed the adjustment. As a rule, the longer a financial or economic imbalance/excess lingers, the more protracted the adjustment will be. Bottom Line: EM exchange rates will continue depreciating. We recommend short positions in the following basket of EM currencies versus the U.S. dollar: KRW, MYR, IDR, TRY, ZAR, BRL, COP and CLP. For a complete list of our open currency and fixed-income trades please refer to page 18. Country Allocation For EM Local Bond Portfolios Chart I-15 demonstrates the relationship between developing countries' foreign funding requirements and their real (inflation-adjusted) local bond yields. The foreign funding requirement is calculated as the sum of the current account deficit and foreign debt service obligations over the next 12 months. We use inflation-linked (real) bond yields for markets where they are available. In other cases, we subtract the headline inflation rate from nominal bond yields to derive the real one. Chart I-15Real Bond Yields And Foreign Funding Requirements: A Cross Country Comparison The higher the foreign funding requirement, the higher the real yield must be to attract foreign capital, all else equal. On this diagram, the value pockets are Brazil (its real yield of 6.3% offers the best value by far), Indonesia, Russia and India. Domestic real yields in these countries are relatively high compared to their foreign funding requirements, which is a proxy for exchange rate risk. In contrast, Turkey, Chile, Colombia, Hungary and Malaysia have low real yields relative to their large foreign funding requirements. However, there are other factors that are shaping local yields. For example, Brazilian real yields look very attractive on this matrix because the latter does not account for public debt dynamics. The fiscal dynamics in Brazil are dreadful.4 On the contrary, Chilean local bonds appear expensive, but the country's fiscal outlook is very healthy. After considering all factors that affect local bond yields as well as incorporating the currency outlook, we recommend the following allocations: Overweight Korea, Thailand, Poland, Hungary, the Czech Republic, Russia and Mexico (Chart I-16). For investors who can invest in Chinese, Taiwanese and Indian local bonds, we also recommend overweighting these markets within an EM domestic bond portfolio. Underweight Turkish, South African, Malaysian and Indonesian local currency bonds (Chart I-17). We will publish our analysis on Indonesia soon. Stay neutral on domestic bonds' total return in U.S. dollar terms in Brazil (with a negative bias because of the considerable currency risk), Chile and Colombia (Chart I-18). Chart I-16Our Recommended ##br##Overweights In Local Bonds Chart I-17Our Recommended ##br##Underweights In Local Bonds Chart I-18Local Bonds ##br##Warranting A Neutral Allocation A Word On China's Commodities Frenzy Speculative fever is running high in Chinese commodities exchanges. Frenetic commodities trading in China has seen prices skyrocket of late (Chart I-19). Prices often rise a limit during a day. We have the following observations: This stampede into commodities is a reflection of rotating bubbles in China. Mania forces rotated from property to stocks, then to corporate bonds, and then back to housing, again. It seems to be shifting into commodities now. While the mainland's industrial sector and real demand for commodities have registered gradual improvement in recent months, the sharp spike in commodities prices largely reflects speculative activity much more than real demand. In fact, net imports of base metals have been flat for the past six years (zero growth in six years), and all swings have most likely been related to inventory cycles (Chart I-20). Chart I-19The Spike In Commodities ##br##Prices Trading In China Chart I-20China: Net Import Of Base Metals Like any speculative frenzy, this is momentum-driven and will one day crash. Timing the reversal is impossible. A lot depends on policymakers' willingness to confront this speculative bubble and investor psychology. Notably, onshore corporate bond yields and swap rates have recently begun rising. As in DM bonds, the rise in yields from very low levels is causing large price drops. As and if yields rise further, losses in corporate bonds will become considerable and investors (especially ones managing retail investors' money) will head for the exits, triggering liquidation. This, along with the eventual unraveling of commodities speculation poses substantial potential risk to global, or at least EM, financial markets. Bottom Line: The latest exponential rise in commodities prices on Chinese exchanges is an unsustainable speculative frenzy that will end badly. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com 1 The JPMorgan Government Bond Index-Emerging Markets (GBI-EM) indices are emerging market debt benchmarks that track local currency bonds issued by Emerging Market governments. 2 Please see Emerging Markets Strategy Weekly Report, titled "Risks To Our Negative EM View," dated July 13, 2016. 3 Please see "EM: Is The Liquidity Upturn Genuine And Sustainable?" Parts I & II, dated November 25, 2015 and December 2, 2015, respectively. 4 Please refer to the Emerging Markets Strategy Special Report, "Brazil: The Honeymoon Is Over," dated August 3, 2016. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Duration: The odds of further bond bearish catalysts emerging during the next 6-12 months are still quite elevated. Maintain below benchmark duration. Global Bond Strategy: The most likely candidates for another bond bearish catalyst would be an announcement of substantial fiscal stimulus from Japan and/or a hawkish policy shift from the Fed. Investors should remain overweight core Europe, underweight U.S. Treasuries and neutral on JGBs. U.S. High-Yield: Given current spread levels and our default loss expectations, valuation in the U.S. high-yield market sends neither a strong buy nor sell signal. Feature In a U.S. Bond Strategy Special Report1 published in August we observed that, since the financial crisis, material increases in global bond yields have all been associated with a policy catalyst (Chart 1). We identified three such catalysts: the Fed's 2010 announcement of QE2, the Fed signaling its willingness to slow the pace of asset purchases in 2013, and the European Central Bank's (ECB) announcement of its own QE program in 2015. Now we can add the election of Donald Trump as a fourth catalyst that has spurred a tantrum in global bond markets. Chart 1The Four Post-Crisis Bond Tantrums The common factor that links all of these catalysts is that each causes the market to quickly re-assess its expectations about the future pace of monetary tightening. Interestingly, this re-assessment can be caused by either the announcement of a program that is perceived to be extremely stimulative or the announcement that monetary stimulus will be scaled back. Examples of the former include both the Fed's and ECB's QE announcements as well as the recent U.S. election. An example of the latter would be the 2013 taper tantrum. As in August, the goal of this report is to perform a quick survey of the major global economies in order to assess the likelihood that another bond-bearish catalyst emerges during the next 6-12 months. While we find it difficult to see a catalyst of the same scale as those shown in Chart 1, we assign high odds to the possibility that the announcement of fiscal easing in Japan will add to the bearish pressure on global bonds. We also assign high odds to the possibility that upside inflation surprises in the U.S. cause the Fed to adopt a more hawkish forward guidance, further increasing the bearish pressure on global bonds. We assign low odds to the possibility that ECB policy will contribute to the global bond selloff. U.S. Chart 2Fed Wants Breakevens To Head Higher The recent "Trump Tantrum" has sent yields sharply higher, and expectations priced into the U.S. bond market are now not far from the Fed's median rate hike expectations, especially at the short-end of the curve (Chart 2). In the U.S., the next most likely catalyst for sharply higher global bond yields would be the Fed signaling that it will adopt a quicker pace of rate hikes. Specifically, the Fed would need to cease revising its funds rate forecasts lower - which has been the pattern for the last few years - and start revising them higher. While the market was quick to price-in the likelihood of greater fiscal stimulus and rising deficits under the incoming government, the Fed will take a more cautious approach. In fact, with inflation still below target (Chart 2, bottom panel) and market-based measures of inflation compensation still depressed, the Fed will be in no rush to signal a more hawkish policy stance. We expect the Fed will follow through with an expected rate increase in December, but that the median expectation will continue to call for only two more hikes in 2017. The Fed is only likely to shift toward a more hawkish policy stance once inflation expectations are more firmly anchored around levels consistent with the Fed's inflation target. This corresponds to a range of 2.4% to 2.5% on the 5-year, 5-year forward TIPS breakeven inflation rate (Chart 2, second panel). Assuming that U.S. economic growth continues to accelerate into next year, as we expect, then the 5y5y TIPS breakeven rate could reach this target sometime in the middle of 2017. At that point, a more hawkish Fed policy becomes more likely. In the meantime, while the "Trump Tantrum" is likely to take a pause in the near-term (next 1-2 months), it may not have run its course just yet. If U.S. growth is strong in 2017 and the Trump administration appears to be making progress implementing its more stimulative policies, then the Treasury curve will likely resume its bear-steepening trend in the first half of next year.2 Euro Area Chart 3Strong Growth, But Plenty Of Slack According to the OECD and others, including the European Commission and ECB, trend GDP growth in the Eurozone is below 1%. In fact, most estimates center around 0.7%. This means that as long as GDP growth is maintained above these levels we should expect the labor market to continue to tighten. At least for now, the data suggest that growth is likely to remain well above trend. Led by gains in both the services and manufacturing indexes, the euro area's composite PMI jumped from 53.3 to 54.1 in November. The composite PMI has a good track record of leading European GDP growth (Chart 3), and the current reading is consistent with GDP growth of 2%. Despite strong growth, the ECB's policy stance is likely to remain accommodative for quite some time and is unlikely to spur a global bond tantrum within our 6-12 month investment horizon. The fact that core inflation remains below 1% (Chart 3, panel 3) tells us that the output gap in the euro area is still very wide. It will take a prolonged period of strong growth for the output gap to close and for inflationary pressures to mount. In prior cycles inflation has not begun to accelerate until the unemployment rate was below 9% (shaded regions in Chart 3). An announcement from the ECB that it will cease its asset purchase program because the economy has made adequate progress toward its economic and inflation goals would likely spur a large rise in global bond yields. However, this is unlikely to occur until the unemployment rate is below 9% and inflation is in an uptrend. As we argued in a recent Global Fixed Income Strategy report,3 the ECB will be able to alter the rules regarding the quantity of bonds available for purchase as is necessary to keep the program in place. Japan The Bank of Japan (BoJ) recently switched to a policy framework that involves targeting a level of yields as opposed to a quantity of purchases. In our view, this sends a pretty strong signal that monetary policy is close to being exhausted and that fiscal policy must take up the baton of Abenomics. While the timing and amount of any additional fiscal spending is not clear, it is probably necessary if policymakers are serious about reaching their 2% inflation goal. Chart 4Policy Action Required In Japan At present, the Japanese Diet is currently deliberating the third revision to the second supplementary budget and government officials have signaled that there will be more coordination between monetary and fiscal policy in the future. The government is also debating ways to boost household income, including raising government wages, lifting the minimum wage and providing tax incentives for the private sector to be more generous on the wage front. While any fiscal measures would not spur an increase in nominal JGB yields (because the BoJ will retain the cap), they would spur an increase in inflation expectations and a decline in real yields (Chart 4). We also think that the reflationary impulse would be felt by bond markets in the rest of the world, and that large enough fiscal stimulus from Japan would pressure global bond yields higher even though JGBs remain capped. Admittedly, the cap on nominal JGB yields would limit the contagion from Japanese fiscal stimulus to the rest of the global bond market. As would the impact of a depreciating yen relative to the euro and U.S. dollar. However, we also suspect that the shift toward greater fiscal stimulus in both the U.S. and Japan would cause investors to revise their global growth expectations higher, and that this impact would dominate in terms of the impact on global bond yields. Investment Conclusions The odds of further bond bearish catalysts emerging during the next 6-12 months remain quite elevated. The most likely candidates would be an announcement of substantial fiscal stimulus in Japan and/or a hawkish policy shift from the Fed. The ECB is unlikely to contribute to the bearish pressure on global bonds during the next 6-12 months. As such, we continue to recommend a below benchmark duration stance on a 6-12 month horizon. In global bond portfolios, investors should remain overweight core Europe, underweight U.S. Treasuries and neutral JGBs. Valuation & Expected Returns In U.S. High-Yield A commonly used tool for assessing value in the high-yield bond market is a default-adjusted spread. That is, we formulate an expectation for default losses during our investment horizon and compare it to the spread that is currently on offer. If the current spread is elevated compared to our expectation for default losses then the default-adjusted spread is high and we would see good value in high-yield bonds relative to equivalent-duration Treasuries. This week we examine two different formulations of a default-adjusted spread for the U.S. high-yield market and test how well each corresponds to excess junk returns. The first measure we look at is a true ex-ante measure. It relies only on data that are available in real time, and can therefore be used as part of a trading strategy. Specifically, our ex-ante default-adjusted spread is calculated as the average option-adjusted spread from the Bloomberg Barclays U.S. High-Yield index less an expectation of default losses for the subsequent 12 month period. Expected default losses are calculated by taking the Moody's baseline forecast for the U.S. speculative grade default rate during the next 12 months and multiplying it by 1 minus our forecast of the recovery rate for this same period. We forecast the recovery rate based on its historical relationship with the default rate. The second measure we examine is an ex-post default-adjusted spread. In this case we look at the average spread of the index less actual default losses that are realized during the subsequent 12 months. As such, this measure can only be calculated after the fact. Comparing the ex-ante and ex-post measures, we see that both tend to reside within a range of 200 to 300 basis points. However, the ex-post measure periodically shows a negative value while the ex-ante measure is more often above 300 bps (Chart 5). This tells us that when forecasting default losses it is more common to underestimate default losses, rather than overestimate them. Chart 5Distribution of Default-Adjusted Spreads Over Time The next thing we look at is how closely each measure aligns with high-yield excess returns (Charts 6 & 7). Our ex-ante measure explains 34% of the variation in high-yield excess returns since 2002 (when our sample begins). Predictably, the ex-post measure, which removes the error surrounding the default loss forecast, explains a greater proportion of the variation in excess junk returns (53%). Our sample period is also longer for the ex-post measure, beginning in 1995. Chart 612-Month Excess High-Yield Returns Vs.##br## Ex-Ante Default-Adjusted Spread (2002 - Present) Chart 712-Month Excess High-Yield Returns Vs. ##br##Ex-Post Default-Adjusted Spread (1995 - Present) The current average option-adjusted spread for the High-Yield index is 459 bps. If we incorporate the Moody's baseline forecast for the default rate during the next 12 months (4.1%) and our forecast for the recovery rate (39%), then we calculate an ex-ante default-adjusted spread of 210 bps. Using the relationship in Chart 6, this translates into an expected 12-month excess return of -26 bps. If we assume there is no error in our forecast then we can use the relationship in Chart 7. In that case, our expected 12-month excess return would be +55 bps. Of course, that exercise imposes a linear relationship between excess returns and the default-adjusted spread and doesn't consider that there is considerable variation in actual excess returns around this trendline. For that reason, in Charts 8 & 9 we split both our default-adjusted spread measures into intervals of 50 basis points. For each interval we display the average 12-month excess return along with a 90% confidence interval for where those returns are likely to fall. Chart 812-Month High-Yield Excess Returns & 90% Confidence Intervals: ##br##Ex-Ante Default-Adjusted Spread Chart 912-Month High-Yield Excess Returns & 90% Confidence Intervals:##br## Ex-Post Default-Adjusted Spread Specifically, the blue dots in Charts 8 & 9 show the 12-month excess return that is earned on average when the default-adjusted spread falls into a particular interval. The top and bottom edges of the vertical lines correspond to the upper and lower limits of the 90% confidence interval. More statistics related to the 12-month excess returns that have been observed when the default-adjusted spread falls into a specific interval can be found in the Appendix to this report. The main message from these charts is that a default-adjusted spread below 100 bps is a powerful sell signal, while a default-adjusted spread above 350 bps is a powerful buy signal. Between those two thresholds the signal is less clear. Bottom Line: Given current spread levels and our default loss expectations, valuation in the U.S. high-yield market sends neither a strong buy nor sell signal, but is consistent with small positive excess returns. Our inclination is to remain cautious on U.S. high-yield for the time being, but to look for opportunities to upgrade from more attractive valuations. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "The Tantrum Theory Of Global Bond Yields", dated August 16, 2016, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com 3 Please see Global Fixed Income Strategy Weekly Report, "The ECB's Next Move: Extend & Pretend", dated October 25, 2016, available at gfis.bcaresearch.com Appendix Table 112-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Table 212-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Treasury Yields: The uptrend in Treasury yields has run into extreme technical resistance and is likely to abate during the next few weeks. Beyond that, a cyclical sweet spot of improving growth and accommodative monetary policy will open up during the first half of 2017 that will cause the Treasury curve to bear-steepen. Spread Product: Poor valuations and a probable Fed rate hike next month keep us cautious on spread product in the near term. But the environment for credit markets will turn more positive in the first half of 2017. Leveraged Loans: The combination of Fed rate hikes and elevated defaults should allow leveraged loans to outperform fixed rate junk bonds on a 12-month horizon. High-Yield Munis: An examination of spreads alone suggests that high-yield munis are attractive compared to high-yield corporate debt, but the attractiveness is not sufficient to compensate for lower tax rates under President Trump. Avoid high-yield municipal debt. Feature Several Fed speakers last week, including Fed Chair Janet Yellen, affirmed the case for a December rate hike, and the market has taken full notice of that message. We calculate that the market-implied odds of a rate hike next month rose to 84% as of the close of business on Friday.1 But just as critical for the path of Treasury yields is that the Fed will be taking a "wait and see" approach when it comes to the prospect of increased fiscal stimulus under the Donald Trump administration. Right now there is so much uncertainty about what the Congress will pass or not pass, what the president will propose. As a baseline, assuming a continuation of current fiscal policy has probably as good a chance as any other forecast that we are going to make up. Minneapolis Fed President Neel Kashkari2 This leads us to believe that the Fed will lift rates next month, but will also not revise its fed funds rate forecasts (dots) higher. We also expect that the Fed will be slow to respond to any pick-up in growth expectations as we head into 2017. This sets up a two-phase outlook for Treasury yields. During the next month, the uptrend in yields will meet resistance as both the market and Fed turn a more skeptical eye toward Trump's fiscal promises. But if growth picks up in early 2017, as we expect, and the Fed maintains its dovish bias, then we could enter a sweet spot where the Treasury curve resumes its bear-steepening and risk assets rally. Near-Term Pull-Back Two factors make us think it is likely that Treasury yields will at least level-off, and perhaps decline a bit, during the next month. First, market pricing has already mostly converged with the Fed's rate expectations, especially at the short-end of the curve (Chart 1). Our sense is that the Fed's dots provide a reasonable valuation anchor for yields in the absence of more concrete evidence that growth is accelerating. Second, technical measures and positioning data suggest that the rapid rise in yields is due for a pause. The fractal dimension for long-maturity Treasuries, a measure of groupthink developed by our Chief European Strategist Dhaval Joshi rests at 1.25, a level at which a trend reversal - even if only a temporary one - tends to emerge (Chart 2).3 Additionally, our composite sentiment indicator, based on the 13-week rate of change in prices, investor sentiment, and net speculative positions, is deeply oversold, highlighting the risk of a near-term reversal (Chart 3). Chart 1The Market & Dots Converge Chart 2Treasuries Face Technical Resistance Chart 3Bond Sentiment At A Bearish Extreme Cyclical Sweet Spot Once the December FOMC meeting has passed, we expect investor attention will turn toward U.S. economic growth, which should accelerate as we head into 2017 (Chart 4). Chart 4U.S. Growth: Poised To Accelerate Consumer confidence has been resilient at high levels, which supports continued strong consumer spending (Chart 4, panel 1). According to trends in public sector employment, government spending is poised to increase, even in the absence of new fiscal stimulus (Chart 4, panel 2). Inventories were an unusually large drag on growth in 2016. This drag will continue to unwind (Chart 4, panel 3). Survey measures suggest that non-residential investment will reverse its downtrend (Chart 4, panel 4). The supply of new residential housing remains tight, which will support increased construction even in the face of higher rates (Chart 4, bottom panel). On top of this, we can potentially tack on any newly enacted fiscal stimulus once Trump takes office in January. Our political strategists expect that the Trump administration will not face meaningful opposition from the Republican-controlled Congress, and will be able to enact - in relatively short order - a more stimulative fiscal policy in the form of lower taxes and increased spending for infrastructure and defense.4 A quicker pace of Fed tightening would be a powerful offset to this rosy growth outlook. In fact, Chair Yellen alluded to the notion that a large fiscal impulse would probably be counteracted by tighter monetary policy in her Congressional testimony last week: "The economy is operating relatively close to full employment at this point, so in contrast to where the economy was after the financial crisis when a large demand boost was needed to lower unemployment, we're no longer in that state."5 In essence, with the economy close to full employment it is more likely that a sufficiently large growth impulse will result in rising inflation, which the Fed will lean against. However, we believe this is a story for the second half of 2017. At least initially, the Fed will be in no rush to deviate from the dovish bias embedded in its current forecasts. Market-based measures of inflation compensation have increased strongly in the past few weeks, but remain below levels that are consistent with the Fed hitting its 2% PCE inflation target (Chart 5). The 5-year, 5-year forward TIPS breakeven inflation rate is currently 2.06%, and needs to rise another 34bps before it is consistent with its average pre-crisis level. The Fed will be extremely cautious about tightening monetary policy until TIPS breakevens are more firmly anchored around pre-crisis levels. This opens a window in the first half of 2017 when improving economic growth will be met with still-accommodative monetary policy. In this environment we would expect the Treasury curve to bear-steepen and spread product to outperform. All else equal, we are likely to shift our recommended portfolio allocation in that direction (initiate curve steepeners, increase allocation to spread product) once the near-term risk of a Fed rate hike is behind us. The major risk to the view that a cyclical sweet spot opens up in the first half of 2017 is that any improvement in growth might be quickly cut-off by overly restrictive financial conditions, specifically in the form of a much stronger dollar (Chart 6). The pace of dollar appreciation has increased since the election and overall indexes of financial conditions have tightened, but so far the tightening has not been as sharp as that which occurred around the time of last year's Fed rate hike. We anticipate that this time around, due to the improved trajectory of growth outside of the U.S., tightening of overall financial conditions will not be as severe. A second related risk is that the recent surge in bond yields will harm cyclical sectors of the economy such as housing and consumer spending on durable goods (Chart 7). This is undoubtedly true, but it is important to recall that this process is self-limiting. If yields rise too far, then growth will decelerate and yields will reverse course. Then lower yields will cause growth to re-accelerate, leading to higher yields. As long as the Fed is perceived to be "behind the curve" on inflation then the underlying trend will be one of improving growth and a bear-steepening of the Treasury curve. Chart 5Breakevens Still Too Low Chart 6A Strong Dollar Is The #1 Risk Chart 7Higher Yields Also A Drag On Growth Bottom Line: The uptrend in Treasury yields has run into extreme technical resistance and is likely to abate during the next few weeks. Beyond that, a cyclical sweet spot of improving growth and accommodative monetary policy will open up during the first half of 2017. This will cause the Treasury curve to bear-steepen and will be positive for spread product. Leveraged Loans: Still A Buy We recommended that investors favor leveraged loans over fixed-rate junk bonds on July 19.6 In large part, this recommendation was predicated on a high conviction view that Treasury yields were poised to increase, thus benefitting floating rate loans over fixed rate bonds. Since July 19, the S&P/LSTA Leveraged Loan 100 index has returned +196bps, compared to +176bps of total return from the Bloomberg Barclays High-Yield bond index, and flows into the largest leveraged loan ETF (BKLN) have outpaced flows into the largest junk bond ETF (HYG) since August (Chart 8). Historically, there are two reasons that leveraged loans might be expected to outperform fixed rate junk bonds (Chart 9). The first is that 3-month LIBOR is rising, causing loan coupons to reset higher. The second is that the default rate is elevated. Loans tend to benefit relative to bonds when the default rate is elevated because their senior position in the capital structure means they earn a higher recovery rate (Chart 10). Chart 8Loan Performance Is Lagging Fund Flows Chart 9Leveraged Loans Will Outperform Chart 10Loans Benefit From Higher Recoveries Taking a closer look at Chart 9 we can see that the above two factors have only led to two periods of sustained leveraged loan outperformance since 1991 (denoted by shaded regions). In 1994, loans outperformed bonds because the pace of Fed tightening surprised markets to the upside and 3-month LIBOR moved sharply higher. In this instance higher coupons were sufficient for loans to outperform even though corporate defaults were low. Loans also outperformed bonds between 1997 and 2002. In this case it was a prolonged uptrend in corporate defaults that drove the outperformance. Loans benefitted from higher LIBOR in the early stages of this period, but then the Fed began cutting rates in 2001. Loans did not outperform bonds during the 2004-2006 rate hike cycle, as defaults were very low and the rate hikes were well telegraphed - meaning that asset prices already reflected the up-move in 3-month LIBOR before it occurred. Likewise, loans did not outperform bonds during the 2008 default episode because the Fed was cutting rates sharply and, unlike in the 1990s, the spike and reversal in the default rate occurred over a relatively short period of time. The good news for loans is that the current environment very much resembles the early part of the 1997-2002 period insofar as the Fed is in the early stages of a rate hike cycle - so 3-month LIBOR can be expected to move higher - and corporate defaults have already started to increase. So far loans have only benefitted marginally from the rise in 3-month LIBOR because most have LIBOR floors. This means that the loan's coupon is only reset higher once 3-month LIBOR is increased above the stated floor. Bloomberg calculates that $221 billion of outstanding leveraged loans have LIBOR floors of 75bps and $690 billion of outstanding loans have LIBOR floors of 100bps. With 3-month LIBOR at 91bps currently, it will only take one more Fed rate hike before the floors on most loans are breached. Bottom Line: The combination of Fed rate hikes and elevated defaults should allow leveraged loans to outperform fixed rate junk bonds on a 12-month horizon. High-Yield Munis: Stay Away We detailed our longer-term outlook for municipal bonds in a recent Special Report,7 and then downgraded our muni allocation to underweight (2 out of 5) following Trump's surprise election win. Our expectation is that the combination of lower tax rates and increased infrastructure spending will be toxic for municipal debt. That analysis, however, focused on investment grade municipal debt. This week we investigate the relative value in high-yield municipal bonds relative to high-yield corporates. The starting point of our analysis is an examination of the spread differential between high-yield munis and high-yield corporates (Chart 11). The second panel of Chart 11 shows that, compared to history, munis offer a sizeable spread advantage over similarly-rated corporate debt. However, this comparison does not adjust for differences in duration and convexity between the two indexes. In the bottom panel of Chart 11 we show the residual from a model where the spread differential between high-yield munis and high-yield corporates has been regressed against differences in duration and convexity. We see that high-yield munis look even more attractive after making these adjustments. These simple adjustments reveal that high-yield munis are attractive relative to high-yield corporates, but they do not consider the impact of a macro environment that is about to turn extremely negative for municipal debt. To control for this we created an augmented model of the spread differential between high-yield munis and corporates, adjusting for duration, convexity, the effective personal tax rate, relative ratings migration and several other factors (Chart 12). Chart 11High-Yield Muni Valuation I Chart 12High-Yield Muni Valuation II High-yield munis still appear quite attractive based on this model, but if we assume that the effective personal income tax rate reverts even to 2011 levels, then the a good chunk of the spread advantage vanishes (Chart 12, panel 2). This is an extremely conservative assumption. In reality, we expect the effective personal tax rate will fall much below 2011 levels under the new administration. Bottom Line: An examination of spreads alone suggests that high-yield munis are attractive compared to high-yield corporate debt, but the attractiveness is not sufficient to compensate for lower tax rates under President Trump. Avoid high-yield municipal debt. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our internal calculation differs somewhat from the widely reported probability that is available on Bloomberg terminals. The reason is that the Bloomberg calculation assumes a baseline fed funds rate of 37.5 bps (the midpoint of the Fed's current target range), while we use the current effective fed funds rate which has recently been stable at 41 bps. 2 http://www.bloomberg.com/news/articles/2016-11-16/fed-s-kashkari-says-election-hasn-t-changed-economic-outlook-yet 3 Please see European Investment Strategy Special Report, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com 4 Please see BCA Special Report, "U.S. Elections: Outcomes And Investment Implications", dated November 9, 2016, available at www.bcaresearch.com 5 https://www.c-span.org/organization/?63944 6 Please see Global Fixed Income Strategy / U.S. Bond Strategy Weekly Report, "Six Reasons To Tactically Reduce Duration Exposure Now", dated July 19, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification