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Highlights The 2018 dollar rally is principally the consequence of the slowdown in global industrial activity and global trade, itself a reverberation of China's efforts to de-lever and reform its economy. For China, reforms and deleveraging are here to stay, suggesting the dollar rally and EM rout are not over. However, in response to U.S. President Donald Trump's trade battling, China is stimulating its economy in order to limit its own downside. The chances of miscalculation on the part of Beijing are high. This raises the risk that investors begin pricing in a much more aggressive reflation campaign. Such a reflation campaign would cause a correction in the dollar and give more lift to the current rebound in EM assets. In order to track this risk and hedge it, investors should monitor and buy a portfolio made up of iron ore, Brazilian equities, AUD/JPY, Swedish industrial equities and EM high-yield bonds. Feature Many assign the strength in the dollar this year to the Federal Reserve increasing interest rates at a faster pace than other advanced economies. While monetary divergences seems like both a historically plausible and intuitive explanation, it rings hallow. The Fed was hiking rates at a much faster pace than the rest of the world last year, yet the dollar had a horrendous 2017, falling 10%. In our view, the trend in global growth has had a much more important role in explaining the dollar's performance. When global trade and global industrial production is strong, this normally leads to a period of weakness in the dollar. The opposite also holds true; soft global growth is associated with a strong dollar (Chart I-1). Behind this relationship lies the low-beta nature of the U.S. economy. Since its economy is not as levered to exports and manufacturing as the rest of the world is, the U.S. benefits less when global growth is improving (Chart I-2). As a result, when global growth is on the up and up, investors can upgrade the economic and inflation outlook for Europe faster than they can for the U.S. In the process, long-term rate expectations rise faster in Europe than the U.S., attracting money into Europe and out of the U.S. The process can be replicated across most economies outside the U.S. This hurts the dollar. Chart I-1The Dollar Likes ##br##Poor Global Growth Chart I-2The U.S. Economy Is Less##br## Sensitive To Global Growth To understand the outlook for the greenback, it is crucial to understand the outlook for global economic activity. Many commentators have pinned the blame of slowing global growth on the back of rising protectionism. The problem with this thesis is that global growth began slowing before investors took protectionist risks seriously. Instead, in our view, the key culprit behind the global growth slowdown has been policy tightening in China. Therein lies the issue. China has slowed, and President Xi Jinping is signaling that his administration will continue to push ahead with deleveraging the Chinese economy. This should imply weaker industrial growth in China and in the rest of the world and therefore a stronger dollar. However, with protectionism on the rise, the Chinese authorities are announcing virtually every day new measures to soften the blow to the Chinese economy. This stimulus could support global growth, and hurt the dollar, at least tactically. Our Geopolitical Strategy team believes the desire to reform and de-lever the Chinese economy will ultimately prevail, and thus so will a stronger dollar. However, the growing list of stimulus measures implemented in China supports our thesis, articulated last month, that a counter-trend correction in the dollar will first materialize before the greenback rally begins anew.1 As such, we continue to recommend investors hedge their long USD bets, and that traders with a short-term horizon take advantage of a portfolio we propose in this report. China Drives Growth And Returns Differentials We have long argued that China has a disproportionate role in determining what happens to growth outside the U.S. To some extent, this argument is almost tautological: at PPP exchange rates, China produces 24% of global GDP outside the U.S. But there is more than meets the eye to this argument. China is the world largest investor, with Chinese capital investment accounting for 26% of global capital formation, or 6.5% of the world's GDP. This means that the growth rate of Chinese investment has a large direct impact on global industrial good exports around the world. There is a second-round effect as well: China is also the largest consumer of industrial commodities globally. This implies that China is the marginal consumer and thus the price-setter of many natural resources. However, commodity producers account for a large share of global capex, 10.5% from 2004 to 2017. Thus, through its impact on commodity prices, China also impacts the demand for global industrial and capital goods via the capex needs of commodity exports. This large footprint can result in some counterintuitive relationships. For example, why is it that Chinese economic variables explain so well the gyrations of French exports to Germany, its largest export market (Chart I-3)? This conundrum is explained by the fact that German economic activity is deeply affected by Chinese growth. Since German growth is the key determinant of German imports, it follows that Chinese activity plays a large role in driving French exports. This pattern gets repeated across Europe, as Germany is the leading trading partner of most European nations. China does not have the same impact on the U.S. economy (Chart I-4) as total U.S. exports only represent 13% of GDP and exports to China, a measly 0.6% of GDP. Manufacturing also only represents 11% of U.S. GDP, again limiting the impact of secondary benefits of Chinese growth on the U.S. economy. Chart I-3What Drives French Exports To Germany: China Chart I-4Chinese Growth Has Little Impact On U.S. Growth Thanks to this difference, we can spot one very useful relationship that we have highlighted to our clients for more than a year: when the Chinese authorities stimulate their economy, European growth picks up sharply vis-a-vis the U.S. (Chart I-5).2 In this optic, the growth outperformance of Europe in 2017 made perfect sense; it was a consequence of China's aggressive push to reflate after 2015. 2018 is the mirror image of 2017; European growth is underperforming as a result of China's efforts to limit growth. This also means that wherever China goes going forward, so will the growth gap between the euro area and the U.S. Chart I-5AIf European Growth Beats That ##br##Of The U.S., Thank China (I) Chart I-5BIf European Growth Beats That ##br##Of The U.S., Thank China (II) Since Chinese growth affects the distribution of economic activity around the world, China affects the distribution of rates of returns around the world as well. Nowhere is the influence of China more evident than in the spread between U.S. and global bond yields. If we accept that Chinese growth exerts a limited influence on the domestically driven U.S. economy but exerts a large impact on the rest of the world, Chinese economic fluctuations should have an implication on the relative interest rate outlook between the U.S. and the rest of the world. This is indeed the case. As Chart I-6 shows, when the growth of China's nominal manufacturing GDP slows relative to the U.S., U.S. bond yields rise relative to yields in other major economies. Since money flows where it is best treated, the impact of China on relative rates of returns and interest rates around the world should be felt in the dollar. This is also the case. When Chinese nominal manufacturing GDP growth accelerates, the dollar tends to suffer as money leaves the U.S. and finds its way into Europe, Australia, Canada, EM and so forth to take advantage of rising marginal rates of returns relative to the U.S. (Chart I-7). Chart I-6Treasurys Vs. The World Equals U.S. Nominal GDP ##br##Vs. Chinese Manufacturing Chart I-7The DXY Moves In Opposition##br## To Chinese Manufacturing Bottom Line: The U.S. economy does not benefit as much from rising Chinese economic activity as the rest of the world does. This means that U.S. relative rates of return fall when China booms and rise when China busts. This also implies that China is just as important as the Fed in determining the trend in the dollar: A strong China is associated with a weak dollar, and vice-versa. Chinese Deleveraging Is Dollar Bullish, But... Despite its large debt load, China does not have a debt problem per se. With a savings rate of 46% of GDP and a limited stock of foreign currency debt, China does not exhibit the necessary conditions to end up like Argentina or Asian economies in the late 1990s. Instead, China's problem remains misallocated capital. China's debt load has increased by USD23.6 trillion since 2008. This is a lot of capital to invest in a short time span. Poor investments have been made, resulting in excess capacity in many industries, and most crucially a collapse in total factor productivity (Chart I-8). This decline in productivity represents a real threat to China's long-term viability, especially as China's labor force is set to begin declining and its leadership wants to avoid the middle-income trap that has plagued so many EM economies in the past. In order to avoid this trap, China's long-term growth is dependent on a sustained effort to de-lever and reform. Our Geopolitical Strategy team is adamant that Xi Jinping remains committed to this agenda. Long-term growth is his priority - a luxury now made possible by his "long-term" mandate.3 The impact of reforms is most evident through the evolution of credit growth. As Chart I-9 illustrates, total social financing has been slowing. The bottom panel of Chart I-9 also illustrates that the collapse in the Chinese credit impulse has followed the implosion of bond issuance by small financial institutions. This essentially tells us that the ongoing administrative and regulatory tightening of the shadow banking system is bearing fruit: Financial institutions are curtailing their issuance of exotic instruments, which is hurting overall credit growth - even if old-school bank loans are proving resilient. Chart I-8China: Labor Force And Total Factor ##br##Productivity The Need For Reforms Chart I-9Deleveraging In ##br##Action Since credit growth is so fundamental to generating investment and supporting the country's manufacturing sector, this implies that Chinese manufacturing activity has ample downside. As a result, we would anticipate that China will continue to be a drag on the rest of the world for many more quarters. This implies that the U.S. dollar has upside, and that EM plays as well as commodity currencies are especially vulnerable. While this view seems clear, and most investors now well understand the investment ramifications of Chinese reforms and deleveraging, sand has been thrown in the wheels of this narrative. As a result, the uptrend in the dollar and the downtrend in EM assets may take a pause. Bottom Line: China needs to de-lever further and reform its economy. Without this growth strategy, the country will be stuck in the dreaded middle-income trap, as its productivity has collapsed. Since deleveraging in China means less investment and slower manufacturing sector growth, this also means that the dollar should benefit, and EM-related assets should suffer, but... ... Stimulus Is A Potent Narrative The sand in the wheels of the dollar-bullish scenario created by Chinese reforms and their retardant effect on Chinese industrial growth is, paradoxically, President Trump's trade war with China. China decided to implement reforms last year because stronger growth out of the euro area and the U.S., its two largest export markets, should have buffeted its economy against some of the deflationary consequences of deleveraging. However, if President Trump tries to limit the growth of Chinese exports to the U.S., this create yet another shock that China does not need. This makes it much more difficult for China to deal with the deflationary consequences of its own reform efforts. As a result, not only have the Chinese authorities let the yuan depreciate by 8% since April, the fastest pace of decline since the 1994 devaluation, they have also begun announcing a slew of stimulus measures over the course of recent weeks: The People's Bank of China has engaged in RMB502 billion of liquidity injections, especially through its medium-term lending facility; Three reserve requirement ratio cuts have been implemented, freeing up RMB2.8 trillion of liquidity; Local governments have been allowed to increase net new bond issuance this year by up to RMB2.2 trillion; The issuance of special purpose bonds by local governments has been accelerated; Banks with high credit quality standards can reduce provisioning for NPLs; Individual income tax cuts have been announced; And modifications to the macro prudential assessment's structural component have been announced, which will free up new lending by commercial banks. These stimulus measures are not designed to cause growth to accelerate. In fact, as Jonathan LaBerge argues in our China Investment Strategy service, they pale in comparison to the total amount of stimulus implemented in 2015, especially as back then, RMB5 trillion in credit had also been injected into the economy.4 However, a problem remains for investors. Even if these measures are far from enough to cause Chinese growth to re-accelerate, they can easily foment the following narrative: Chinese policymakers are trying to calibrate their policy response in order to support growth. However, they are human beings, and do not know a priori how much stimulus will be needed to support growth without causing credit growth to actually surge. As a result, they will push stimulus into the system until the economy responds. But once the economy responds, it will be too late, and the lagged impact of stimulus will cause a sharp rebound in credit and capex. The opacity of Chinese policy and data raises the chance that this simplification will take over the investment community. Such reversion to simplicity in the face of ambiguity and intractable complexity is a well-documented phenomenon in sociology.5 Even if this narrative is mistaken and not based in actual reality, investors who view Chinese fundamentals as bullish to the dollar and bearish to EM and commodity plays need to be ready for this eventuality. We are reluctant to close our long dollar trade based on a narrative alone. Instead, we have purchased protection by selling USD/CAD as a hedge. However, we also offer investors a mean to observe if this narrative does take hold of the market, by tracking a portfolio of assets very sensitive to the outlook for Chinese growth, and thus very sensitive to Chinese reflation. These assets are: Chinese Iron ore prices, expressed in USD; Swedish industrial equities, expressed in USD; Brazilian equities, expressed in USD; AUD/JPY; And EM high-yield bond denominated in USD. Chart I-10 illustrates the performance of a portfolio composed of these assets, weighted in such a way that they contribute equally to the variance of the portfolio. As the chart illustrates, not only is this portfolio massively oversold, suggesting there is plenty of negatives already priced into China-linked assets, it has begun to rebound. Chart I-11 illustrates that the Chinese Li-Keqiang Index of industrial activity leads this index.6 The recent rebound in the LKI already supports the idea that this portfolio could have upside in the coming months. Moreover, if investors do extrapolate that additional stimulus measures are likely to come out of Beijing, this will support even greater upside to this portfolio. Chart I-10An Index To Monitor... Chart I-11...Or A Vehicle To Bet On Impactful Stimulus As a result, we would go one step beyond suggesting this portfolio as a tracker for Chinese reflation. Investors should buy it. If you are bearish on the Chinese growth outlook, buying this portfolio offers protection against countertrend moves that would hurt long-dollar and short-EM bets (our preferred strategy). If, however, you are bullish on Chinese reflation, this portfolio should prove a very rewarding vehicle to implement such views. Bottom Line: Chinese reforms are a tailwind for the dollar. However, they are now confronted with the reality of trade wars, which is causing the Chinese authorities to stimulate their economy to put a floor under growth. Nevertheless, this exercise is fraught with calibration errors - a risk that market participants can easily uncover. This raises the probability that a countertrend correction in the dollar will emerge. To monitor this risk, we recommend investors track a portfolio of assets heavily influenced by Chinese growth: Iron ore, Swedish industrial equities, Brazilian stocks, AUD/JPY, and EM high-yield bonds. Moreover, if one is already long the dollar, this portfolio can also be used as a hedge against the risk created by investors pricing in large-scale Chinese stimulus. If one disagrees with our view that reforms will ultimately take primacy on stimulus, one can also use this portfolio as a high-octane way to play Chinese reflation. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Reports, titled "Time To Pause And Breathe", dated July 6, 2018 and "That Sinking Feeling" dated July 13, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, "ECB: All About China?" dated April 7, 2017, available at fes.bcaresearch.com 3 Please see Geopolitical Strategy Special Reports, titled "China: Looking Beyond The Party Congress" dated July 19, 2017, and "China: Party Congress Ends...So What?" dated November 1, 2017, both available at gps.bcaresearch.com 4 Please see China Investment Strategy Weekly Report, "China Is Easing Up On The Brake, Not Pressing The Accelerator" dated July 26, 2018, available at cis.bcaresearch.com 5 Smelser, Neil J. "The Rational and the Ambivalent in the Social Sciences: 1997 Presidential Address." American Sociological Review, vol. 63, no. 1, Feb. 1998, pp. 1-16. 6 The Li-Keqiang index is based on railways freight traffic, bank credit, and electricity output. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Gross Domestic Product growth underperformed expectations slightly, coming in at 4.1%, reflecting a large decline in inventories. In fact, real final sales were strong, growing at a 5.1%. The ISM manufacturing survey also came in slightly below expectations, softening to 58.1 from 60.2 in July. It is still indicative of above-trend growth. However, the Chicago PMI surprised positively, coming in at 65.5. This measure also increased form last month's reading. While the DXY was able to rally this week thanks to growing tensions between the U.S. and China, we expect the dollar to have short-term downside, as the temporary stimulus by the Chinese authorities should give an ephemeral boost to global growth, a development that would hurt the dollar. That being said, impact should ultimately prove to be transient, and the dollar. Report Links: Rhetoric Is Not Always Policy - July 27, 2018 Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area has been mixed: The yearly growth of GDP underperformed expectations, coming in at 2.1%. This also represented a decrease relative to the previous quarter. However, both core and headline inflation surprised to the upside, coming in at 2.1% and 1.1% respectively. Moreover, the European Commission's economic sentiment indicator also outperformed to the upside, coming in at 112.1. However, this measure decreased from last month's reading. EUR/USD was relatively flat for most of the week until a wave of risk aversion prompted by worries of a Sino-U.S. trade war took hold of the market, lifting the dollar in the process. In a mirror image to our dollar view, we expect the euro to have upside in the next couple of months, but resume its downward trajectory by the end of the year. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Retail sales yearly growth beat expectations, coming in at 1.5%. Moreover, the jobs-to-applicants ratio also surprised to the upside, coming in at 1.62. However, the unemployment rate surprised negatively, coming in at 2.4% and increasing from last month's number. However, this reflected an increase in the participation rate. Finally, the consumer confidence index also underperformed expectations, coming in at 43.5. USD/JPY has risen by roughly 0.5% this week after it became clear that the BoJ only marginally adjusted its policy, in a way that only confirmed its highly dovish bias. Interestingly, while the spike in JGB yields has reverberated across global bond markets, it has not been able to provide a boost for the yen. While we expect the trade-weighted yen to appreciate by the end of this year as Chinese policymakers still want China to de-lever, a period of interim weakness is possible as the PBoC tries to buffet the Chinese economy against the impact of U.S. protectionism. Report Links: Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: The Nationwide house price index yearly growth rate outperformed expectations, coming in at 2.5%. This measure also increased relatively to last month's number. Moreover, PMI construction also surprised to the upside, coming in at 55.8, and increasing from last month's reading. However, Markit manufacturing PMI underperformed expectations, coming in at 54. GBP/USD was relatively flat this week, but ultimately experienced a large fall following the hike by the BoE as investors began to worry that the "old lady" is making a policy error that will need to be reversed. Overall, we remain negative on cable, as the ability for the BoE to continue on their hiking campaign will be limited given the current political turmoil in Britain. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been mixed: Building permit yearly growth outperformed expectations, coming in at 1.6%. Moreover, producer prices also surprised positively, coming in at 1.5%. However this measure decreased compared to last month's reading. Finally, the RBA Commodity Index SDR yearly growth surprised to the downside, coming in at 7.6%. AUD/USD fell this week as market wrestle with the risk to global growth created by the China-U.S. trade war. Overall, we continue to be negative on the Aussie on a cyclical basis, as this currency is the most exposed in the G10 to a slowdown in the Chinese industrial sectors. That said, a bout of stimulus in China could provide some short-term upside to AUD. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: Employment growth surprised to the upside, coming in at 0.5%. However, this measure slowed from last month's reading. Moreover, the participation rate outperformed expectations, coming in at 10.9% and increasing from last month's number. However, the unemployment rate underperformed expectations, coming in at 4.5% and increasing from last month's reading. NZD/USD experienced a large fall this week. We are negative on the NZD on a cyclical basis, as tightening by both China and the U.S. along with trade tensions will provide for a toxic cocktail for small open economies like New Zealand. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mixed: Industrial production month-mon-month growth outperformed expectations, coming in at 0.5%. Moreover, Monthly GDP growth also surprised positively, coming in at an annualized rate of 0.5%. However, the Markit Manufacturing PMI underperformed expectations, coming in at 56.9. This measure also declined relative to last month's number. The CAD is the only currency that managed to appreciate against the USD this week, despite a rather pitiful performance for crude oil. This dynamics comforts in our tactical bullish stance on the loonie. In fact, this pair is our preferred vehicle to play the countertrend correction in the U.S. dollar. Meanwhile, on a cyclical basis we are positive on the Canadian dollar within the commodity complex. Not only do supply constraint within OPEC will help oil outperform base metals, but also, the BoC is the only central bank within this group that is currently lifting interest rates. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: The KOF leading indicator underperformed expectations, coming in at 101.1, and declining relatively to last month's reading. However, retail sales yearly growth surprised to the upside, coming in at 0.3%. Finally, the SVME Purchasing Manager's Index also surprised positively, coming in at 61.9, and increasing from last month's number. EUR/CHF has been relatively flat this week. On a long term basis, we are bullish on this cross, as inflationary pressures are still very weak in Switzerland. Therefore, the SNB will maintain its ultra-dovish stance, hurting the franc in the process. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK rallied vigorously this week. While the generalized dollar strength has been key culprit behind the depreciation of the NOK, the fall in oil prices only added fuel to the fire. Overall, we expect this cross to go up by the end of the year, as the interaction of Chinese and U.S. policy will likely push up the USD and weigh on commodities. That being said, the NOK will probably outperform within the commodity space, given that it is cheap and that supply cuts by OPEC should help oil prices on a relative basis. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been mixed: Retail sales yearly growth surprised to the downside, coming in at 0.2%, and declining substantially, from 3.1% last month. However, the annual growth rate of GDP outperformed expectations, coming in at very strong 3.3%. This measure stayed flat relative to the first quarter. Finally, Manufacturing PMI came in at 57.4, increasing from last month's number. USD/SEK still rallied this week as the SEK is particularly sensitive to the outlook for global growth. We are positive on the Swedish Krona on a long-term basis, as Sweden is the country in the G10 where monetary policy is most misaligned with economic fundamentals. Thus, if the Sweden continues to show strength, the Riksbank will eventually have to respond. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Paradox 1: U.S. growth will slow, and this will force the Fed to raise rates MORE quickly. Paradox 2: China will try to stimulate its economy, and this will HURT commodities and other risk assets. Paradox 3: Global rebalancing will require the euro area and Japan to have LARGER current account surpluses. Feature Faulty Assumptions Investors assume that slower U.S. growth will cause the Fed to turn more dovish; efforts by China to stimulate its economy will boost market sentiment towards risk assets; and global rebalancing requires the euro area and Japan to reduce their bloated current account surpluses. In this week's report, we consider the possibility that all three assumptions are wrong. Let's start with the U.S. growth picture. U.S. Growth About To Slow? The U.S. economy grew by 4.1% in the second quarter, the fastest pace since 2014. The composition of growth was reasonably solid. Net exports boosted real GDP by 1.1 percentage points, but this was largely offset by a 1.0 point drag from a slower pace of inventory accumulation. As a result, domestic final demand increased at a robust rate of 3.9%, led by personal consumption (up 4.0%) and business fixed investment (up 7.3%). Unfortunately, the second quarter is probably as good as it gets for growth. We say this not because we expect aggregate demand growth to falter to any great degree. Quite the contrary. Consumer confidence is high and the labor market is strong, with initial unemployment claims near 49-year lows. The Bureau of Economic Analysis' latest revisions revealed a much higher personal savings rate than had been previously estimated (Chart 1). The savings rate is now well above levels that one would expect based on the ratio of household net worth-to-disposable income (Chart 2). This raises the odds that consumer spending will accelerate. Chart 1Households Are Saving More ##br##Than Previously Thought Chart 2Consumption Could Accelerate ##br##As The Savings Rate Drops Rising consumer demand will prompt businesses to expand capacity (Chart 3). Core capital goods orders surprised on the upside in June, with positive revisions made to past months. Capex intention surveys remain at elevated levels. So far, fears of a trade war have not had a major impact on business investment. Fiscal spending is also set to rise. Federal government expenditures increased by only 3.5% in Q2, far short of the 10%-plus growth rate that some forecasters were projecting. The effect of the tax cuts have also yet to make their way fully through the economy. Supply Matters Considering all these positive drivers of demand, why do we worry that growth could slow meaningfully later this year or in early 2019? The answer is that for the first time in over a decade, demand is no longer the binding constraint to growth - supply is. Today, there are fewer unemployed workers than job vacancies (Chart 4). The number of people outside the labor force who want a job is near all-time lows. Businesses are reporting increasing difficulty in finding qualified labor. Chart 3U.S. Companies Plan To Boost Capex Chart 4Companies Are Struggling To Fill Job Openings New business investment will add to the economy's productive capacity over time, but in the near term, the boost to aggregate demand from new investment spending will easily exceed the contribution to aggregate supply.1 The Congressional Budget Office estimates that potential real GDP growth is running at around 2%. What happens when the output gap is fully eliminated, and aggregate demand growth begins to eclipse supply growth? The answer is that inflation will rise. Instead of more output, we will see higher prices (Chart 5). Chart 5Inflationary Pressures Tend To Increase ##br##When Spare Capacity Is Absorbed Rising inflation will force the Fed to engineer an increase in real interest rates, even in the face of slower GDP growth. Such a stagflationary outcome is not good for equities, which is one reason why we downgraded our cyclical recommendation on risk assets from overweight to neutral in June. Higher-than-expected real interest rates will put upward pressure on the U.S. dollar. A stronger dollar will hurt U.S. companies with significant foreign exposure more than it hurts their domestically-oriented peers. If history is any guide, a resurgent greenback will also cause credit spreads to widen (Chart 6). Chinese Stimulus: Be Careful What You Wish For Chinese stimulus helped reignite global growth after the Global Financial Crisis and again during the 2015-2016 manufacturing downturn. With global growth slowing anew, will China once again come to the rescue? Not quite. China does not want to let its economy falter, but high debt levels, and an overvalued property market plagued by excess capacity, limit what the authorities can do (Chart 7). Chart 6A Stronger Dollar Usually Corresponds ##br##To Wider Corporate Borrowing Spreads Chart 7China: High Debt Levels Make ##br##Credit-Fueled Stimulus A Risky Proposition Granted, the government has loosened monetary policy at the margin and plans to increase fiscal spending. However, our China strategists feel these actions are more consistent with easing off the brake than pressing down on the accelerator.2 They note that the authorities continue to squeeze the shadow banking system, as evidenced by the continued deceleration in money and credit growth, as well as rising onshore spreads for the riskiest corporate bonds (Chart 8). The Specter Of Currency Wars If Chinese growth continues to decelerate, what options do the authorities have? One possibility is to double down on what they are already doing: letting the RMB slide. Chart 9 shows that the Chinese currency has weakened substantially more over the past six weeks than its prior relationship with the dollar would have suggested. Chart 8Chinese Credit Growth Has Been Slowing Chart 9The Yuan Has Weakened More Than Expected ##br##Based On the Broad Dollar Trend Letting the currency weaken is a risky strategy. Global financial markets went into a tizzy the last time China devalued the yuan in August 2015. The devaluation triggered significant capital outflows, arguably only compounding China's problems. This has led some commentators to conclude that the authorities would not make the same mistake again. But what if the real mistake was not that China devalued its currency, but that it did not devalue it by enough? Standard economic theory says that a country should always devalue its currency by enough to flush out expectations of a further decline. Perhaps China was simply too timid? Capital controls are tighter in China today than they were in 2015. This gives the authorities more room for maneuver. China is also waging a trade war with the United States. The U.S. exported only $188 billion of goods and services to China in 2017, a small fraction of the $524 billion in goods and services that China exported to the United States. China simply cannot win a tit-for-tat trade war with the United States. In contrast, China is better positioned to wage a currency war with the United States. The Chinese simply need to step up their purchases of U.S. Treasurys, which would drive up the value of the dollar. Efforts by China to devalue its currency would invite retaliation from the United States. However, since the Trump Administration seems keen on pursuing a protectionist trade agenda no matter what happens, the Chinese may see their decision to weaken the yuan as the least bad of all possible outcomes. Unlike traditional stimulus in the form of additional infrastructure spending and faster credit growth, a currency devaluation would roil financial markets, causing risk asset prices to plunge. Metal prices would take it on the chin, since a weaker RMB would make it more expensive for Chinese businesses to import commodities. China now consumes close to half of the world's supply of copper, zinc, nickel, aluminum, and iron ore (Chart 10). Investors should remain underweight emerging market equities relative to developed markets and shun the currencies of commodity-exporting economies. We are currently short AUD/CAD on the grounds that a China shock would hurt metal prices more than energy prices. The Canadian dollar is highly levered to the latter, while the Aussie dollar is more levered to the former. Global Rebalancing: It's Not About Getting To Zero We have argued before that China's high savings rate explains why the country has maintained a structural current account surplus, despite the economy's rapid GDP growth rate.3 Both the euro area and Japan also have an excessive savings problem, minus the mitigating effect of rapid trend growth. The euro area's excessive savings problem was masked during the nine years following the introduction of the euro by a massive credit boom across much of the region (Chart 11). Germany did not partake in that boom, but it was still able to export its excess savings to the rest of the euro area via a rising current account balance. Chart 10China Is A More Dominant Consumer ##br##Of Metals Than Oil Chart 11Germany Did Not Take Part ##br##In The Credit Boom Germany Needs A Spender Of Last Resort Chart 12 shows that Germany's current account surplus with other euro area members mirrored the country's increasing competitiveness vis-à-vis the rest of the region. In essence, the spending boom in southern Europe sucked in German exports, with German savings financing the periphery's swelling current account deficits. This is the main reason why German banks were hit so hard during the Global Financial Crisis: They were the ones who underwrote the periphery's spendthrift ways. That party ended in 2008. With the periphery no longer the spender of last resort in Europe, Germany had to find a way to export its savings to the rest of the world. But that required a cheaper currency, which Mario Draghi ultimately delivered in 2014 when he set in motion the ECB's own quantitative easing program. So where do we go from here? Germany's excess savings problem is not about to go away anytime soon. The working-age population is set to decline over the next few decades, which means that most domestically oriented businesses will have little incentive to expand capacity (Chart 13). The peripheral countries remain in belt-tightening mode. This will limit demand for German imports. Meanwhile, countries such as Spain have made significant progress in reducing unit labor costs in an effort to improve competitiveness and shift their current account balances back into surplus. Chart 12Competitiveness Gains In The 2000s Allowed ##br##Germany To Increase Its Current Account Surplus Chart 13Germans Need To Have More Children The ECB And The BOJ Can't Afford To Raise Rates The private sector financial balance in the euro area - effectively, the difference between what the private sector earns and spends - now stands near a record high (Chart 14). Fiscal policy also remains fairly tight. The IMF estimates that the euro area's cyclically-adjusted primary budget balance will be in a surplus of 0.9% of GDP in 2018-19, compared to a deficit of 3.8% of GDP in the United States (Chart 15). Chart 14Euro Area: Private Sector ##br##Balance Remains Elevated Chart 15The Euro Area's Fiscal Policy Is Tight If the public sector is unwilling to absorb the private sector's excess savings by running large fiscal deficits, those savings need to be exported abroad in the form of a current account surplus. Failure to do so will result in higher unemployment, and ultimately, further political upheaval. This means that the ECB has no choice other than to keep rates near rock-bottom levels in order to ensure that the euro remains cheap. Japan has been more willing than Europe to maintain large budget deficits, but the problem is that this has resulted in a huge debt-to-GDP ratio. The Japanese would like to tighten fiscal policy, starting with the consumption tax hike scheduled for October 2019. However, this may require the economy to have an even larger current account surplus, which can only be achieved if the yen weakens further. This, in turn, suggests that the Bank of Japan will not abandon its yield curve control policy anytime soon. We were not in the least bit surprised this week when Governor Kuroda poured cold water on the idea that the BoJ was contemplating raising either its short or long-term interest rate targets. The bottom line is that thinking about global imbalances solely in terms of current account positions is not enough. One should also think about the distribution of aggregate demand across the world. Countries with demand to spare such as the United States can afford to run current account deficits, while economies with insufficient demand such as the euro area and Japan should run current account surpluses. The key market implication is that interest rates will remain structurally higher in the United States, which will keep the dollar well bid. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 This is partly because it can take a while for additional capital spending to raise aggregate supply. For example, it may take a few years to build an office tower or a new factory. Corporate R&D investment may not generate tangible benefits for a long time, especially in cases where the research is focused on something complicated (i.e., the design of new computer chips or pharmaceuticals). And even if investment spending could be transformed into additional productive capacity instantaneously, aggregate demand would still rise more than aggregate supply, at least temporarily. Here is the reason: The nonresidential private-sector capital stock is about 120% of GDP in the United States. As such, a one percent increase in investment spending would raise the capital stock by four-fifths of a percentage point. Assuming a capital share of income of 40% of national income, a one percent increase in the capital stock would lift output by 0.4%. Thus, a one-dollar increase in business investment would boost aggregate demand by one dollar in the year it is undertaken, while increasing supply by only 4/5*0.4 = roughly 32 cents. 2 Please see China Investment Strategy Weekly Report, "China Is Easing Up On The Brake, Not Pressing The Accelerator," dated July 26, 2018. 3 Please see Global Investment Strategy Weekly Report, "U.S.-China Trade Spat: Is R-Star To Blame?" dated April 6, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights President Trump has expressed dissatisfaction with the Fed's policy tightening. However, we do not think he will be able to influence policy in a dovish fashion this cycle. Trump has suggested that many nations are manipulating their exchange rates to the detriment of the U.S. We do not see the U.S. as having the same capacity to force large exchange rate appreciation for its trading partners as it previously did. We expect instead this rhetoric to result in more favorable trade deals for the U.S. As a result, while we believe Trump's rhetoric was the catalyst for a much-needed correction in the dollar, his utterances do not mark the end of the dollar rally for 2018. We have been hedging the dollar's short-term downside by selling USD/CAD. We do not anticipate the BoJ to tweak its YCC policy next week. As a result, we fade the yen's recent strength against the dollar. However, we do believe the global economic outlook warrants staying long the yen against the euro and the Aussie for the remainder of the year. Feature U.S. President Donald Trump has begun to fight back against the impact of his stimulative fiscal policy. Obviously, it is not that he is displeased with the decent growth and job performance of the U.S. Instead, he is not happy that this increase in economic activity and build-up in inflationary pressures is causing the Federal Reserve to hike interest rates faster than he would like, and the dollar to be stronger as well. Despite President Trump's intentions, it is unlikely that he actually has enough levers to push the Fed to conduct easier monetary policy, and it is even more doubtful that he can push the dollar lower by pressuring the euro area, China, and other trading partners to revalue their currencies. The Fed Is No Pushover While BCA has argued that President Trump is unconstrained when it comes to his international agenda, there are certainly large constraints on his domestic agenda. When it comes to the Fed, this constraint is binding, as the Federal Reserve Act of 1913 clearly states that the U.S. central bank is a creature of Congress. Moreover, historically, the Fed has been a staunch defender of its independence. As Chart I-1 illustrates, through the post-war period, even when we include the 1970s when former U.S. President Richard Nixon's interferences temporarily eroded the Fed's independence, the U.S. central bank has been among the most fiercely independent monetary guardians in the G-10. Chart I-1The Fed Values Its Independence The 1970s offer a counter-argument to the view that the President has little influence on the Fed. However, Nixon chose Arthur Burns as Fed Chair in 1970 with the goal of maintaining very easy policy. Moreover, Burns continued to target full employment as his priority, which meant inflationary pressures only grew larger in response to the 1973 oil shock. This is in sharp contrast with today's Fed. In opposition to the period prior to the 1977 amendment of the Federal Reserve Act, which required the Fed to "promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates," the Fed is now much more focused on controlling inflation - even if this means more frequent large overshoots in unemployment (Chart I-2). Chart I-2Trump's Fed Is Not Nixon's Fed This means that in today's context, the Fed will continue to push rates higher in order to combat inflationary pressures in the U.S. (Chart I-3). Moreover, as Chart I-4 illustrates, our composite capacity utilization measure shows that the U.S. economy is experiencing its tightest conditions since the late 1980s. Historically, such a dearth of economic slack is accompanied by higher interest rates. Chart I-3Upside Risks To U.S. Inflation Budding Price Pressures Chart I-4Maximum Pressure... Capacity Pressures That Is This also means that it is highly unlikely the Fed will sit idly by in front of the large amount of fiscal stimulus implemented in the U.S. while the economy is at full employment (Chart I-5). Not since the late 1960s has the U.S. experienced this kind of a policy mix. While in the late 1960s it took some time for inflationary pressures to emerge, they ultimately did with much vigor by 1968. However, for inflation to become as pernicious a force as it was in the 1970s, the Fed had to maintain too-easy monetary policy. With its dual mandate that includes keeping inflation at bay, we doubt the Fed will allow the 1970s experience to repeat itself.1 Chart I-5Trump Will Push Rates Higher While this means that President Trump is unlikely to be able to affect policy this cycle, it does not mean that he has zero levers. He can ultimately change the Fed leadership to find a great dove; however, this will require that he waits until Fed Chairman Jerome Powell's term ends - something not in sight until 2020. And really, who can he find today that is that dovish; we doubt that Paul Krugman will make any Trump shortlist for Fed leadership anytime soon. In the meantime, we would anticipate President Trump to continue to voice his displeasure with the Fed's policy, as at the very least it will give him a culprit to blame in 2020 if the economy does not perform as he has promised. As a result, we remain confident that the Fed is likely to try to follow the path of rate hikes it currently envisions in its latest set of forecasts. As Chart I-6 illustrates, this path for policy remains above the path currently anticipated in the market. Moreover, we do not believe the Fed will tighten more than it currently anticipates only to assert its own independence. For the Fed to deviate from its current interest rate forecast, economic growth and inflationary pressures will also have to significantly deviate from current expectations, not for Trump to grow louder. Chart I-6U.S. Rate Pricing Has Upside Bottom Line: President Trump may express his unhappiness with the Fed's hiking campaign, but he can do little more than complain. For now, he cannot affect monetary policy directly, as the Fed is very independent and is very set on limiting the long-term upside to inflation. Since the White House's policies are inflationary, we expect the Fed to continue to tighten as per its current intended path. Trump will only be able to affect policy in a dovish fashion once he gets to change the Fed's leadership. In the meantime, blaming the Fed is an insurance policy for 2020: if the economy is not as strong as he promised, someone else will be responsible for it. Currency Manipulators? Another issue raised by President Trump has contributed to the recent decline in the dollar: His assertions that various currencies, including the euro, are being manipulated downward. Is there much to this assertion, and can the White House do anything to generate downward pressure on the dollar? Let's begin with China. We have argued that at the very least, the Chinese authorities are facilitating the recent slide in the RMB. As Chart I-7 illustrates, CNY/USD is much softer than implied by the level of the dollar itself. If we want to stretch the argument that one country is pushing down its currency today, it is China. Can President Trump do much about it? For the time being, we doubt it. The White House has announced a flurry of implemented and proposed tariffs on China (Chart I-8), and in the interim, the CNY has not strengthened; it has only weakened. Instead of letting the U.S. bully them on their exchange rate policy, it seems the Chinese authorities are finding other means to alleviate the pain created by U.S. tariffs. Chart I-7China Is Manipulating Its Currency... Chart I-8... And Is Already Facing An Onslaught Of Tariffs... To begin with, the People's Bank of China has injected RMB502 billion into the banking system in recent weeks in order to put downward pressure on overnight rates. Most importantly, earlier this week, it was revealed that the State Council in Beijing would accelerate the issuance of CNY1.4 trillion in local government bonds to support infrastructure. This significant amount of fiscal stimulus may not be enough to prevent China from slowing in response to its own deleveraging effort, it is nonetheless likely to soften the blow to the Chinese economy created by the Trump tariffs. Essentially, we believe that China wants to avoid the shock Japan suffered in the wake of the 1985 Plaza accord. In the 1980s, U.S. President Ronald Reagan and the American public were fed up with the growing Japanese trade surplus with the U.S. The White House started proposing tariffs on Japanese exports and ultimately got Japan to revalue the yen violently. However, this huge yen rally had massively deflationary consequences for Japan. At first, the Bank of Japan responded by cutting rates, inflating the Japanese bubble in the process. Once the bubble popped and the Japanese private sector debt burden was laid bare, the true deflationary impact of the sudden yen revaluation became evident (Chart I-9). To this day, Japan is still dealing with the consequences of these series of policy mistakes. Chart I-9... But It First And Foremost ##br##Wants To Avoid Japan's Fate Today, Chinese policymakers not only benefit from the insight of Japan's disastrous experience, but also they already face an enormous debt problem. China's corporate debt stands at 160% of GDP, versus Japan's corporate debt, which stood at 110% of GDP in 1985 when the yen began appreciating and 135% of GDP in 1989 just before the bubble burst. The deflationary consequences of a large FX revaluation are thus at least as dangerous in China today as they were in Japan in the 1980s. In fact, if China is serious about deleveraging and reforming its economy, it will need a cheap currency to ease the deflationary impact of these domestic economic adjustments. On the political front, the U.S. does not have the same levers on China today as it did on Japan in the 1980s. The U.S. is not a military ally; it does not defend the Middle Kingdom against foreign attacks. However, the U.S. was - and still is - Japan's most important military ally, its protector against the Soviet Union in the 1980s and China today. As a result, while Reagan was able to threaten Tokyo with the removal of the U.S. military umbrella, Trump does not have the same tool when it comes to China. Hence, we continue to expect that the outcome of the China-U.S. trade conflict to more likely result in a renegotiation of bilateral investments, tariffs and quotas than a sharply higher RMB. What about Trump's stance on the euro? After all, the U.S. does remain the EU's most important military ally, and the key financial contributor to NATO. This should count as leverage, no? Politically Europe is not as beholden to the U.S today as it was in the 1980s. As Marko Papic argues in BCA's Geopolitical Strategy service, the international political order has entered a multipolar state, with various regional powers vying for local dominance. In the 1980s, the world had two poles of power: the U.S. and the Soviet Union. Back then, Moscow constituted a real threat to Western Europe, as Warsaw Pact nations had tanks parked at the EUs border. Today, this is no longer the case. Russia has weakened, its army is technologically beleaguered, and, in fact, Russia is more dependent on the EU than a threat. As a result, the support of the U.S. is not as crucial to Europe as it once was. Moreover, as Marko also argues, global trade is not expanding as fast as it once was. This means that the U.S. allies are not as likely to tolerate a higher exchange rate as they once were. Essentially, in the 1970s and 1980s, Europe was willing to pushup its exchange rates and absorb an immediate negative shock in order to reap the benefits of growing trade later. This is not feasible anymore as future export growth will not be large enough to compensate for the immediate cost of a euro revaluation. This will limit the tolerance of Europeans to pushup the euro just because the U.S. asked them to do so.2 Nonetheless, President Trump is correct to insist that the euro is cheap, and that this is contributing to the huge trade surplus that Europe runs with the U.S. (Chart I-10). However, the euro area does not target a lower exchange rate, and the European Central Bank does not actively sell euros in the open market. Instead, the undervaluation of EUR/USD simply reflects the fact that the ECB continues to conduct very stimulative monetary policy, which is dragging European real rates lower versus the U.S. It is because of this domestic imperative that EUR/USD remains cheap (Chart I-11). Chart I-10European Exports Are ##br##Benefiting From A Cheap Euro.. Chart I-11... But This Cheapness Is A Consequence##br## Of Diverging Monetary Policies However, we think Europe does still need much easier monetary policy than the U.S. because: European growth is lagging that of the U.S. (Chart I-12); The European output gap remains negative, while the U.S.'s is now positive; The U.S. will receive a much larger dose of fiscal stimulus than Europe in 2018 and 2019 (Chart I-13). Chart I-12U.S. Growth Still##br## Outperforms Europe's... Chart I-13... And The Relative Fiscal Policy Points##br## To Continued Monetary Divergences This means that we do not expect the euro's long-term undervaluation to get anywhere near corrected this year. In fact, while we have argued that the dollar is likely to experience a correction in the very near term,3 we continue to anticipate that EUR/USD will make deeper lows later in 2018. As we have highlighted, the euro may be cheap on a long-term basis, but it continues to trade at a premium to its short-term drivers (Chart I-14). Moreover, relative inflation between the U.S. and the euro area has been a powerful driver of anticipated monetary policy shifts between these two economies. As a result, relative core inflation has been a good prognosticator of EUR/USD, and currently points to a lower euro (Chart I-15). Therefore, we are not closing our long DXY trade in the face of the dollar's anticipated correction. Instead, we prefer to hedge our risk through this countertrend move by selling USD/CAD. Chart I-14The Euro Is Not A Buy Yet... Chart I-15... And Will Not Become So Until Later This Year Bottom Line: President Trump can call China and Europe currency manipulators if he wants to, but this does not mean he has much leverage over these two economies. China already has a large debt load and is vulnerable to the kind of deflationary shock that Japan endured in the wake of the yen's appreciation following the 1985 Plaza Accord. This limits Beijing's willingness to let the CNY appreciate. Meanwhile, the euro is not manipulated per se; its undervaluation only reflects the fact that Europe needs much easier monetary policy than the U.S. This state of affairs is not changing this year. Thus, only once Europe is ready to withstand higher interest rates will the euro's undervaluation disappear. Japan: The End of YCC? Rumors have been circulating this week that the Bank of Japan may tweak its Yield Curve Control Strategy as soon as next week's Monetary Policy meeting. We are skeptical. First, it is true that Japanese wages have been accelerating in response to the tightest labor market conditions in 30 years (Chart I-16). However, Japanese inflation excluding food and energy has again weakened to 0.3%, pointing to the difficulty the country has in achieving its 2% inflation target. Second, economic numbers have been quite mixed. Japanese Manufacturing PMIs have weakened to 51.6 from as high as 54.8, five months ago. Moreover, industrial production has softened, heeding the message from the sagging shipments-to-inventories ratio (Chart I-17). As a result, capacity utilization will remain too low to be consistent with upward risk to core CPI. Chart I-16Strengthening Japanese ##br##Wages Are Inflationary... Chart I-17... But Capacity Utilization Concerns ##br##Cap The Upside To Inflation Third, money growth has also slowed significantly in Japan, and is now at the low end of the post-Abenomics experience (Chart I-18). This weighs on the outlook for both growth and inflation. Fourth, if there were a valid reason to removed YCC it would be if banks were in danger. After all, low rates and a flat yield curve hurt banks' profitability, potentially creating risks to the financial system. However, as Chart I-19 shows, Japanese regional banks have not experienced any meaningful downward pressure on their profits since YCC has been implemented, and are far from generating aggregate losses. Chart I-18Japanese Money Trends Do Not Justify Tweaking YCC Chart I-19YCC Does Not Yet Threaten Japanese Banks Health Fifth, it is customary in Japan policy circles to float trial balloons to test policy ideas. It is very likely that the recent rumors of a tweak to YCC were such a balloon. However, the market impact of this trial was clear: a rallying yen, rising yields and falling equity prices. All these market moves suggest that if YCC was indeed tweaked next week, Japan would experience a violent tightening in monetary conditions - exactly what the BoJ wants to avoid if it ever wishes to hit its 2% inflation target. Moreover, we do not read much into the decline of JGB purchases by the Japanese central bank. The BoJ does not need to buy many JGBs in order to cap Japanese bond yields. Instead, speculators can force JGB yields towards the BoJ's target, on the expectation that if JGB yields deviate too much from this target, the BoJ will force bond prices back to its objective. We think these dynamics are currently at play, explaining why the BoJ has not been buying JPY80 trillion of JGBs per annum. Instead, we think that the BoJ will stay the course with YCC. While Japanese wages are stronger than they have been for 20 years, they are still not consistent with 2% inflation. As such, the BoJ needs to engineer further labor market tightening for inflation to move to target. Even in the U.S., where the economy is not in the thralls of deep-seated deflationary pressures, the job-hoppers are the ones pocketing the lion's share of accelerating wages - not people staying in their current positions (Chart I-20). Since Japanese workers do not tend to switch jobs, the Japanese labor market needs to become a genuine pressure cooker before inflation can rise meaningfully. The BoJ will thus need to maintain very easy monetary policy. Chart I-20You Need To Leave Your Job To Get A Raise As a result, we are not buying into the current rally in the yen versus the dollar. We do believe the yen can continue to perform well this year versus the euro and the AUD, but this is because we expect the U.S. monetary policy to tighten along with China's efforts to de-lever to continue to weigh on EM asset prices, EM economic activity, and thus global trade. In the short term, the yen could correct against these currencies as we continue to foresee a temporary correction in "growth slowdown" trades. But ultimately we expect the yen to continue to rally against the more pro-cyclical euro and Australian dollar. Bottom Line: The BoJ will not adjust YCC next week. Japanese wages may have picked up, but inflation itself is not only still well below target, it has weakened of late. Additionally, economic growth is not strong enough to justify a removal of monetary accommodation, especially as YCC has not negatively affected the health of regional banks. As a result, we recommend investors fade the recent strength in the yen versus the dollar. The yen still has room to rally further against the EUR and AUD over the course of the next six to nine months, but this is a reflection of our stance on global growth and EM asset prices, not a consequence of any anticipated shift in YCC. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, "Trump: No Nixon Redux", dated December 2, 2016, available at fes.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "The Dollar May Be Our Currency, But It Is Your Problem", dated July 25, 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Reports, "Time To Pause And Breathe" dated July 6, 2018 and "That Sinking Feeling", dated July 13, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Recent data in the U.S. has been mixed: Markit Manufacturing PMI came in at 55.5, outperforming expectations. It also increased from last month's reading. However, both services and composite PMI underperformed expectations, coming in at 56.2 and 55.9 respectively. Finally, existing home sales surprised to the downside, coming in at 5.38 million. This measure also decreased compared to last month's reading. The DXY has declined by roughly 1.3% this week. We are bearish on the dollar on a tactical basis. Stretched positioning in the USD as well as a respite in the global growth slowdown due to Chinese easing will combine to temporarily weigh on the greenback. However, we believe the DXY will resume its uptrend before year-end, as a combination of fed tightening, slower global growth, and positive momentum will help the dollar on a cyclical basis. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The Euro Recent data in the Euro area has been mixed: Manufacturing PMI outperformed expectations, coming in at 55.1, and increasing from last month's reading. Moreover the German IFO, also outperformed expectations, coming in at 101.7. However, both Markit Composite PMI and Markit Services PMI underperformed expectations, coming in at 54.3 and 54.4 respectively, while also decreasing from last month's numbers. Finally, Belgian Business confidence showed a deceleration in the month of July. EUR/USD is flat this week, as the surge at the beginning of the week was counteracted by a relatively dovish announcement by the ECB yesterday. On a 6-month basis we are bearish on the euro, given that the cumulative tightening by both the People's Bank of China and the Fed will still combined in a toxic cocktail for global growth, and hence, drag the euro lower in the process. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The Yen Recent data in Japan has been mixed: The Nikkei Manufacturing PMI underperformed expectations, coming in at 51.6. It also decreased from last month's reading of 53. However, the All Industry Activity Index month-on-month growth outperformed expectations, coming in at 0.1%. USD/JPY has declined by roughly 1.5%, partly due to the fall in the U.S. dollar, but also because of the newly perceived hawkish tone by the BoJ. On a short-term basis, we continue to be bullish on the yen against the euro and the Aussie, as we expect Chinese deleveraging to add volatility to the markets. On a longer-term basis, however, we are bearish on the yen, as the BoJ will have to remains very accommodative in order to meet its inflation mandate. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 British Pound Recent data in the U.K. has been positive: Public sector net borrowing outperformed expectations, coming in at 4.530 billion pounds. This measure also increased relatively to last month's number. Moreover, mortgage approvals also surprised to the upside, coming in at 40.541 thousand. This measure also increased relatively to last month's number. Finally, the CBI Distributed Trades Survey also surprised positively, coming in at 20%. GBP/USD has risen by nearly 1.5% this week. Overall, we are cyclically bearish on the pound, as the uncertainty of the Brexit negotiations continue to weigh on capital flows into the U.S. Moreover, the rise in the dollar will add further downward pressure to cable. That being said, the pound could have some upside against the euro, given that the U.K. is less exposed to global trade and industrial activity than its continental counterpart. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Australian Dollar Recent data in Australia has been mixed: Headline inflation came in at 2.1%, underperforming expectations. However, this measure increased from 1.9% the month before. Meanwhile, the RBA trimmed mean CPI yearly growth came in at 1.9%, in line with expectations and with the previous' month number. AUD/USD has rallied by roughly 1.7%, in part due to the fall in the dollar, as well as in response to positive news in China concerning the issuance of infrastructure bonds. Despite these temporary positives, we continue to be cyclically bearish on the Aussie, as a slowdown in the Chinese industrial cycle will weigh heavily on this currency, given its high exposure to base metals, and given the continued presence of slack in the Australian labor market. Report Links: What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 New Zealand Dollar NZD/USD has risen by roughly 1.7% this week, as trade tensions have eased following the announcement by President Trump that the EU and the United States would collaborate to eliminate tariffs between the two economies. Moreover, Chinese authorities have implemented some easing at the margin, which should provide a temporary boost to high beta economies like New Zealand. However, on a cyclical basis, we remain bearish on the kiwi, as the tightening campaign in China is likely to continue. Moreover, a tightening fed will continue to put pressure on EM dollar borrowers, affecting New Zealand in the process, given its high exposure to global growth. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Canadian Dollar Recent data in Canada has been mixed: Headline inflation came in at 2.5%, surprising to the upside. It also increased from last month's reading. Moreover, retail sales and retail sales ex-autos month-on-month growth both outperformed expectations, coming in at 2% and 1.4% respectively. However, core inflation underperformed expectations, coming in at 1.3%. This measure stayed stable compared to last month's reading. USD/CAD has declined by roughly 1.4% this week. In our view, the best cross to play what we believe will be a temporary correction in the greenback is to short USD/CAD, as the Canadian dollar trades at a deep discount to fair value, while short positions are likely overextended. Moreover, the BoC is the only nation among the G10 commodity producers raising rates, adding another boon for the Lonnie. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Swiss Franc EUR/CHF is down roughly 0.5% this week, especially after the perceived dovish tone to the ECB's press conference on Thursday. On a short-term basis, we are bearish on this cross, given that tightening by the fed and a sluggish Chinese economy should cause a risk-off period in markets, creating a supportive environment for the franc. On the other hand, we are bullish on this cross on a longer-term basis, given that the SNB will likely continue with its ultra-dovish monetary policy, as well as currency intervention to make sure that an appreciating franc does not derail its campaign to reach its inflation target. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Norwegian Krone USD/NOK is down roughly 0.7% this week. Overall we continue to be bullish on this cross, given that the tightening of the fed should increase the interest rate differential between Norway and the U.S., counteracting any further appreciation in oil prices due to OPEC output cuts. That being said, we are positive on the NOK within the commodity complex, as Norway will likely be less affected than New Zealand or Australia by the tightening campaign in China, given that oil has a lower beta to Chinese growth than other commodities. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Swedish Krona EUR/SEK is down by slightly more than 1% this week, falling substantially after the interest rate decision by the ECB. We are bullish on the krona on a long-term basis, as inflationary pressures continue to be strong in Sweden, and the Riksbank has become progressively more hawkish. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights A flurry of policy announcements over the past month has given investors the impression that Beijing has turned the policy dial in the direction of supporting growth. We agree that China is easing at the margin, but several observations suggest that the stimulus proposed so far falls short of a "big bang" response that would reverse both the looming export shock as well as the underlying slowdown in China's old economy. Investors should remain neutrally positioned towards Chinese stocks within a global equity portfolio, and should favor low-beta sectors within the Chinese investable universe. Feature There have been several policy-related announcements over the past month in China. This has led many market participants to question whether China is in the process of entering full-blown stimulus mode, and if we are on the cusp of another upswing in Chinese economic activity. Our answer to both questions is, for now, no. China appears to merely be easing off the brake, rather than pressing hard on the accelerator. Given that export growth will certainly slow to some degree due to the imposition of import tariffs, and that an industrial sector slowdown was already underway in China prior to President Trump's protectionist actions, it is far from clear that any stimulus will be a net positive for the country's "old economy". In other words, stimulus may counteract an upcoming export shock, but we would need to see more evidence before concluding that it will lead to a renewed cyclical uptrend in China's economy. A Flurry Of Policy Announcements... Several policy actions, announcements, and signals have occurred over the past month: The RMB has fallen nearly 6% since mid-June, which we have argued has been at least partially policy-driven. As we highlighted in our June 27 report,1 the decline in CNY/USD has been large, has occurred very rapidly, and cannot be explained by its previous relationship with the U.S. dollar (Chart 1). The PBOC cut its reserve requirement ratio for both big and small banks at the end of June, following the cut in April (Chart 2). It also provided incentives for banks to buy speculative-rated corporate bonds, clarified that its new asset management rules would permit mutual funds to invest in non-standard assets, and recently injected 500 billion RMB of liquidity into the banking system via its medium-term lending facility (MLF). Chart 1An Enormous, At Least Partially Policy-Driven Move Chart 2A Second Cut To Bank Reserve Requirement Ratios The Ministry of Finance (MOF) signaled that it would speed up spending that was planned to occur later in the year, and the State Council signaled that it would accelerate the issuance of 1.4 trillion RMB in local government bonds to support infrastructure investment. It also green-lighted a comparatively small 6.5 billion RMB in tax cuts for corporate R&D. China's legislature released a draft version of proposed tax changes that would cut the rate paid for individuals. The flurry of policy announcements over the past month has given investors the impression that Beijing has turned the policy dial in the direction of supporting growth. We agree that China is easing at the margin, and that these policy announcements are important: without them, the Chinese economy would likely face a substantial deceleration that would risk a serious slowdown in global growth. ...That Will Not Cause A Material Re-Acceleration In The Economy But several observations suggest that the stimulus proposed so far falls short of a "big bang" response that would reverse both the looming export shock as well as the underlying slowdown in China's old economy: Fiscal Stimulus: Chart 3 shows that China's on-budget deficit expanded by 3 percentage points over an 18-month period from 2014 to 2016. An equivalent expansion today would imply a 2.6 trillion RMB rise in the budget deficit, meaning that the local government bond issuance announced on Monday is 40% smaller than the deficit expansion that occurred from 2014 to 2016. If the infrastructure projects financed by these bonds turn out to be multi-year initiatives tied to China's structural reform plans, the intensity of this round of fiscal stimulus will likely turn out to be less than half, or even a fraction, of what occurred previously. Fiscal Vs. Credit Expansion: While an increase in fiscal spending was important in catalyzing an economic recovery in 2014/2016, Chart 4 highlights that the expansion of credit was considerably larger. The chart shows on-budget fiscal spending and the change in adjusted total social financing (TSF) as a percent of GDP, and highlights that the latter dwarfs the former. By our calculations, adjusted TSF accelerated by 5 trillion RMB from 2015 to 2016, which from our perspective could only have been achieved by very aggressive monetary easing. Currency Depreciation: A simple framework that equates the equilibrium/required currency depreciation to the size of the tariffs imposed as a share of total exports to the U.S. suggests that a 6% decline in CNY/USD may be adequate at negating an export shock if the proposed tariffs stop after the recently proposed new round of 10% tariffs on $200 billion worth of goods. But first, this approach suggests that a further 6-7% decline may be needed if President Trump follows through with his threat to impose tariffs on all imports from China. Second, in either case the currency decline merely addresses the prospective export shock, not the underlying slowdown in China's old economy that has been occurring over the past year. Chart 3Bond-Financed Infrastructure Spending Unlikely To Match 2015's Fiscal Expansion Chart 4Three Years Ago, The Expansion In Credit Dwarfed That Of Fiscal Spending From our perspective, China's monetary policy actions have so far been the most convincingly stimulative developments in response to the threat to exports. We downplayed China's most recent reserve requirement ratio cut in our June 27 Weekly Report,1 and we acknowledge that this initial assessment was overly pessimistic. Chart 5 shows that the 3-month repo rate, China's de-facto policy rate, has broken meaningfully below the lower band that had prevailed since the beginning of 2017. This suggests that the targeted addition of liquidity, particularly to China's small banks, was at least somewhat effective at easing financial conditions. Chart 5The PBOC Has Successfully Lowered The 3-Month Repo Rate... Chart 6...But This Is Unlikely to Significantly Drop Average Lending Rates Still, we remain unconvinced that what has been announced so far is likely to generate an acceleration in credit growth even approaching what occurred three years ago. Chart 6 shows the weighted average lending rate in China, alongside a simple regression model for the rate based on the benchmark lending rate and the 3-month interbank repo rate (China's "old" and "de-facto new" policy rates, respectively). The chart highlights the likely minimal impact of the recent decline in the repo rate on the average lending rate. In fact, Chart 6 underscores an important point about China's stimulus in 2014-2016: a good portion of that episode's reflationary impact appears to have been caused by the PBOC's 170 bps cut to its benchmark lending rate, which has so far remained unchanged (without any hint from policymakers that it might be lowered). Finally, we are similarly underwhelmed by the PBOC's incentives to banks to buy "junk" corporate bonds: debt securities are a small (albeit fast growing) portion of China's total nonfinancial credit, and junk-rated bonds are a small fraction of that market. We thus see this announcement as an attempt to provide some marginal liquidity support for issuers of these bonds that have upcoming refinancing requirements, rather than a policy of any true macro significance. Conclusions And Investment Strategy Recommendations Two important insights emerge from our above analysis. The first is that the intensity and timing of the infrastructure projects alluded to by the State Council are important factors in determining the likely impact of increased government spending. We suspect that any boost to the economy over the coming year from infrastructure spending will be relatively small, but this will be an important element to monitor over the coming months. The second insight is that we would become considerably more constructive towards China's economy were the PBOC to cut its benchmark lending rate. This would be clear sign that the China is pressing on the accelerator, rather than attempting to simply "fine tune" the economy in the face of an external economic shock. For now, however, our view is that the stimulative measures that have been announced are not likely to lead to a renewed cyclical uptrend in China's economy. This implies that investors should remain neutrally positioned towards Chinese stocks within a global equity portfolio, and should favor low-beta sectors within the Chinese investable universe. Chart 7 shows that the latter position, which we initiated on June 27, has risen almost 1% in relative terms over the past month, and we expect further gains over the remainder of the year. Finally, we noted in our July 5 Weekly Report that the selloff in Chinese domestic stocks was advanced,2 and that we would consider implementing a long MSCI China A Onshore index / short MSCI China index trade in response to a 5% rally in relative common currency performance. It is conceivable that "easing off the brake" will be enough for A-shares to rally non-trivially relative to investable stocks, given how much they have fallen since the beginning of the year. Chart 8 shows that A-shares have approached this threshold in response to recent stimulus announcements, but have yet to break through. We will be watching relative A-share performance closely over the coming weeks for a green light to initiate the position. Stay tuned! Chart 7Low-Beta Sectors Are Outperforming China's Investable Market Chart 8Conditions May Soon Warrant A Pair Trade Favoring Domestic Stocks Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see China Investment Strategy Weekly Report "Now What?", dated June 27, 2018, available at cis.bcaresearch.com 2 Pease see China Investment Strategy Weekly Report "Standing On One Leg", dated July 5, 2018, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Highlights Chart of the WeekTrade Fears Weighing On Ag Complex Bearish sentiment in ag markets is overdone. We believe prices have bottomed. But we are not yet ready to get bullish, given the elevated trade-policy uncertainty dominating markets at present. The evolution of grains and bean prices from here will depend on whether ongoing trade disputes between the U.S. and some of its largest ag markets are transitory or permanent (Chart of the Week). Highlights Energy: Overweight. We closed our Dec18 Brent $65 vs. $70/bbl call spread last week with a net gain of 80%. We remain long call spreads along the Brent forward curve in 2019, which are down an average 2.7%, and the SP GSCI, which is up 12.1%. Base Metals: Neutral. Aluminum prices are down ~ 1.6% in the past week, following indications from U.S. Treasury Secretary Steven Mnuchin sanctions against Russian aluminum supplier Rusal could be removed. Precious Metals: Neutral. Gold prices recovered slightly over the past week, but remain under pressure, given continued strength in the broad trade-weighted USD and real U.S. interest rates. We remain long gold as a portfolio hedge, nonetheless. Ags/Softs: Underweight. Fundamentals support higher grain and bean prices. However, trade-policy uncertainty - particularly re Sino - U.S. relations - will keep them under pressure (see below). Feature Weather-related uncertainty typically is center stage when it comes to forecasting ag prices during the growing season. This year, trade-policy uncertainty emanating from Washington will contend with weather risk as the dominant influence on prices. We do not expect ag-related trade policies to become more hostile. This means the path of ag prices will be contingent on whether the current trade disputes - primarily between the U.S. and China - are transient or permanent features of international trade. Given what we've seen already, we can expect American farmers will fare poorly in the ongoing trade spats. U.S. agricultural exports have been disproportionately hard hit by tariffs from their most important foreign consumer markets, levied in retaliation against U.S. tariffs (Chart 2). BCA Research's Geopolitical Strategy analysts assign a high probability to the escalation of current tensions into a full-blown trade war.1 Nevertheless, we believe the negative sentiment in ag markets is overdone, and that there is not much further downside from here. It is unsurprising that agriculture is a natural first target in this trade dispute. More than a quarter of U.S. crops are exported, with the share rising above 50% in many cases (Chart 3). This provides foreign consumers with ammunition in the dispute. Furthermore, these exports account for a large chunk of global ag trade, in some cases making American exports price makers in the global market. Importantly, many farmers and farm-belt voters cast ballots for Donald Trump. Chart 2American Ags Hit Hard##BR##By Trade Barriers... Chart 3...Because They Are Exposed##BR##To Foreign Markets The USDA's plans announced earlier this week to spend as much as $12 billion between September and end of harvest to help soften the impact of tariff retaliations against U.S. farm states loyal to Trump are not unexpected. The measures will entail (1) direct payments to soybean, sorghum, cotton, corn, wheat, dairy and pork farmers, (2) the procurement and subsequent re-distribution of ag products to nutrition programs, and (3) working with the private sector to promote trade and develop new export markets.2 Trade Spats Hit Grain Markets Hard Grain markets have been especially hard hit in the cross-fire between the U.S. and some of its key trade partners (Table 1). China's retaliatory tariffs are especially consequential, due to its outsized role as a main ag demand market. Table 1Ags Caught In The Crossfire All in all, the Thomson Reuters Equal Weight Grains & Oilseeds Index is down ~ 10% since end-May on the back of these tariffs. Soybeans lead the decline with a 17% loss. We have been foreshadowing this since the beginning of the year.3 Now that it's played out consistent with our previous expectations, it leaves us wondering "now what?" We see three potential scenarios unfolding in the ongoing trade skirmish: Scenario 1: The current tariffs remain in place with no significant increase in ag-relevant trade barriers.4 Scenario 2: The disputes peak soon, and de-escalate. In this scenario, tariffs imposed since the beginning of the year are reversed, ultimately leading to a free and now-fairer global trade order. Scenario 3: A complete breakdown in global trade. This scenario can take on a soft outcome whereby tariffs are increased, or to a more aggressive scenario, resulting in a seismic collapse in world trade agreements. The first two scenarios are clearly more optimistic. In Scenario 1, near-term downside to prices would be restrained, contingent on the responses of major ag consumers. We discuss their four main options and potential courses of action below. Scenario 2 is the most bullish, with price formation once again a function of supply-demand-inventory fundamentals. In this scenario, exogenous risks primarily stem from weather and U.S. financial variables. However, Scenario 3, in which a prolonged trade war pushes the global economy into a recession, would intensify the pain. This would lead to a contraction in the global flow of goods and services, reducing access to foreign markets. Additionally, it would hurt ag demand through the income channel. Consumption growth of ags is correlated with income growth. If the trade war bears down on incomes, it will reduce per-capita demand for ag commodities, which ultimately depresses prices. This is especially true in the case of lower income and emerging economies, where demand is more elastic. Impact Of Tariffs In face of higher costs brought on by U.S. tariffs, foreign buyers are essentially faced with four options: Reduce imports from the U.S., and opt to purchase more from other major producers; Reduce consumption of particular crops by substituting with others; Consume out of inventory, or Continue purchasing U.S. crops, but at a higher price. Chart 4Soybean Farmers Are Most Vulnerable Given the heightened risks surrounding the Sino-American trade dispute, we analyze these possibilities with reference to China. In addition, since soybeans are the most vulnerable of the crops hit by the trade dispute, we focus on beans, arguing that in most cases similar courses of action can be taken for other crops (Chart 4). Chinese authorities have already communicated that they plan to use options 1 - 3, and, as such, have assessed the impact of these restrictions on Chinese buyers to be minimal. Furthermore, according to a comment earlier this month by Lu Xiaodong, deputy general manager of state stockpile Sinograin, China is capable of fully meeting its needs without importing soybeans from the U.S.5 The extent to which buyers are successful in doing so will ultimately determine the overall impact of the trade dispute on U.S. ag markets. We expect China's solution will be a mélange of these four options. Below we assess these possibilities. Option 1: Chinese Buyers Are Turning To Other Major Producers An oft-noted change in Chinese purchasing behavior in reference to U.S. soybeans has been cited as the rationale for the negative sentiment towards U.S. ags. While it is true that Chinese buyers have been shunning American beans, the conclusion fails to recognize a few key points (Chart 5). Chart 5U.S. Soybean Exports Down On Weak Sales To China First, due to the difference in crop calendars - South American beans are harvested in spring while the U.S. crop is harvested in the fall - there is a clear seasonal pattern in China's purchasing behavior (Chart 6). Thus, greater Chinese imports of Brazilian soybeans are typical for this time of year. In addition, agricultural commodities are fungible, which means a reduction of China's imports of U.S. crops does not mean the U.S. crops will go to waste. While American crops are clearly trading at a disadvantage from the perspective of a Chinese buyer, there are still other foreign markets open to American ag exports. Now that these crops are selling at a discount, they have become much more competitive, incentivizing a shift in trade flows. This has already started - the U.S. has increased exports to consumers such as Egypt and Mexico, and even found soybeans buyers in Argentina and Brazil, both major producers of soybeans (Chart 7)! Chart 6Seasonality Is Partly To Blame Chart 7New Markets Opening Up For American Beans Option 2: China Will Adjust Its Feed Recipe China's decision to remove import tariffs on animal feed ingredients from Asian suppliers also highlights another policy route. To the extent possible, Chinese consumers will attempt to find substitutes for the now-more-costly U.S. imports. This includes supplies from alternative producers, and imports of substitute products. The potential from this option depends on the availability of close substitutes to replace ags exports affected by the Sino - U.S. trade dispute. In the case of soybeans, Chinese bean imports are crushed to produce meal and oil. The former is then used as a primary protein in livestock feed, while the latter is refined to be used in foods. Similarly, the majority of corn is also used as a critical ingredient in animal feed. As such, in face of higher costs, bean crushers will likely turn to meal from other protein substitutes such as rapeseed, peanuts and sunflower seeds. Nevertheless, soybean meal remains the optimal source of protein for livestock. Thus, while China will attempt to reduce its consumption of the tariff-laden U.S. ags, alternatives are not perfect substitutes. Consequently, this option does not completely eliminate the need for soybean imports. Option 3: Eat Into Ag Inventories Chart 8Chinese Stocks Will - Partially -##BR##Cushion The Blow Chinese ag inventories are relatively high and can cushion the blow to supply, at least temporarily (Chart 8). This means we may see a decline in Chinese stocks, on the back of drawdowns to fill in the gap left by lower imports from the U.S. While Beijing's stocks are notoriously large, there are reports that, in some cases, they are of low quality, and are unfit for human and animal consumption. Thus, this policy may appear more feasible on paper than in reality. Without accurate information regarding the size and quality of China's ag inventories, it is impossible to determine the potential of this option. Option 4: Absorb the Price Hike: Continue Importing - Now Pricier - U.S. Ags Chinese buyers likely will attempt to exhaust options 1 - 3 above, before resorting to purchasing now-pricier U.S. grains and beans. Nevertheless, it is inevitable - some U.S. ags will continue to flow to China. The relevant question - admittedly extremely difficult to quantify - is with regards to the magnitude of the impact. This essentially will depend on China's ability to use options 1 - 3, to avoid the now-higher import costs. While in the case of soybeans, U.S. exports have been shunned for now, the true test will come in the fall after the Brazilian harvest is over, and the market is flooded with the American crops. Furthermore, the 25% increase in costs due to the tariffs will, to some extent, be offset by the discount in the price of the American crops. Fundamentals Imply Higher Ag Prices While ag markets have taken several direct hits recently, we believe global fundamentals are not as bearish as current pricing conditions suggest. In the event there is a de-escalation of trade disputes - Scenario 2 above - prices will rebound to levels implied by fundamentals. While soybeans are expected to record a small surplus in the 2018 - 19 crop year, wheat and corn will be in a global deficit (Chart 9). Furthermore, global inventories - measured in stocks-to-use terms - are expected to come down. In the case of corn and soybeans, this will be the second consecutive annual decline (Chart 10). Chart 9Bullish Fundamentals On Back##BR##Of Corn And Wheat Deficits... Chart 10...And Falling##BR##Inventories In the corn market, the inventory drawdown is , to a large extent, driven by Chinese policy which is incentivizing the consumption of stocks by offering lower subsidies to corn farmers vs. soybeans, and through measures to encourage corn use for ethanol. This is expected to bring stocks down to levels last witnessed in the 1960s! On the other hand, U.S. soybean stocks are expected to continue increasing in line with lower demand for American beans by the world's largest soybean consumer (China). As always, weather is the biggest source of near term supply-side uncertainty. Wheat prices are supported by weather concerns in Europe - particularly the Black Sea region - which is damaging crops there. This is especially important given the expectation of a smaller crop there this year. Some Final Notes A couple of distinctions within the ags space reveals some ags are more vulnerable to the ongoing dispute than others. These are the number of sellers and the number of buyers in these markets. For instance, U.S. soybean exports have fewer foreign markets than corn, making them relatively more susceptible to downward price movements as supplies back up and are forced to find alternative markets. This is especially true since China is the single largest consumer of soybeans (Chart 11). Chart 11Global Wheat Market Relatively Insulated From Trade Frictions On the other hand, the global wheat market resembles a perfectly competitive market. This means that there are many buyers and sellers, each with limited ability to influence prices. Given that both the U.S. and China are price takers in this market, wheat prices will be relatively more insulated from trade headwinds. As such, we favor wheat in the current environment. Bottom Line: American farmers will be the losers in the still-evolving Sino - American trade disputes, as barriers are imposed on their exports, rendering them uncompetitive for their most significant foreign consumer. However, this will open markets for other global producers - most notably Brazil, Argentina, and the Black Sea region - making farmers there the winners in this dispute. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Special Report titled "The U.S. And China: Sizing Up The Crisis," dated July 11, 2018, available at gps.bcaresearch.com. 2 Please see "Factbox: USDA's $12 billion farmer relief package," dated July 24, 2018, available at reuters.com. 3 Please see BCA Research's Commodity & Energy Strategy Weekly Reports titled "Ags Could Get Caught In U.S. Tariff Imbroglio," dated March 15, 2018, page 9 from "Oil Price Forecast Steady, But Risks Expand," dated March 22, 2018, and "Ag Price Volatility Will Pick Up," dated May 3, 2018. 4 Our colleagues at BCA's Geopolitical Strategy team expect the trade dispute to intensify, especially before the mid-terms. However, tariffs already have been placed on most ag commodities we follow. This leaves little room for further risk from this direct channel, unless tariff rates are increased. 5 Please see "China does not need U.S. soybeans for state reserves: Sinograin official," dated June 12, 2018, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Highlights President Trump has taken the next step in the trade war by charging some of America's major trading partners with outright currency manipulation. However, we are not headed for Plaza Accord 2.0, because neither the ECB nor the PBOC will re-orient policy until their own economic and inflation dynamics warrant it. Moreover, we doubt the FOMC will be bullied into keeping rates lower than policymakers deem appropriate. With the labor market showing signs of overheating, the Fed will stick with its current game plan and ignore President Trump's tweets. The worsening trade dispute is the key risk that investors face and there are growing signs that uncertainty regarding the future of the world trade order is dampening animal spirits and global capital spending. Risk tolerance should be no more than benchmark. Based on previous late cycle periods, the fact that S&P 500 profit margins are still rising suggests that most risk assets will outperform bonds and other defensive sectors in the near term. Nonetheless, timing is always difficult and we have decided to focus on capital preservation given extended valuations and a raft of risks that could cause a premature end to the bull market. The flattening U.S. yield curve is also worrying. We would not ignore the signal if the curve inverts, although there are reasons to believe that it is not as good a recession signal as it has been in the past. We wish to see corroborating evidence from our other favorite indicators before trimming risk asset exposure to underweight. A peak in the S&P 500 operating margin would be a strong sign that the end of the cycle is drawing close. Even if trade tensions soon die down and global growth holds up, the extended nature of the U.S. economic and profit cycle make asset allocation particularly tricky. Attractive late-cycle assets to hold include structured product, Timberland and Farmland. High-quality bonds will of course outperform in the next recession, but yields are likely to rise in the meantime. We believe that U.S. Agency MBS are unattractively valued, but should remain insulated from negative shocks such as a trade war or higher Treasury yields. We also like Agency CMBS. Oil and related plays are not a reliable late-cycle play, but we are bullish because of the favorable supply-demand outlook. However, this does not carry over to base metals, where we are more cautious. Feature We warned in last month's Overview that investors had not yet seen "peak pessimism" on the global trade front. Right on cue, President Trump raised the stakes again in July by threatening to impose tariffs on virtually all imports of Chinese goods. Congress is pushing the President to be tough on China because American voters have soured on trade. China will not easily back down with the authorities responding in kind to the U.S. President's trade threats. They have also allowed the RMB to depreciate to cushion the trade blow (Chart I-1). It is not clear whether the authorities purposely depressed the RMB or whether they simply failed to lean against market pressures. Either way, it is a dangerous approach because it has clearly raised the U.S. President's ire. Chart I-1RMB Is Much Weaker Across The Board President Trump has taken the next step in the broader trade war by charging some major trading partners with outright currency manipulation. The script appears to be following previous times that the U.S. sought trade adjustment via tariffs and currency re-alignment: the early 1970s and the 1985 Plaza Accord. Adjusting currencies on a sustained basis requires much more than simply "talking down" the dollar. There must be major changes in relative monetary and/or fiscal policies vis-à-vis U.S. trading partners. On the fiscal front, expansionary U.S. policy is working at cross purposes with the desire to have a weaker dollar and a smaller trade gap. We do not foresee the U.S. President having any success in changing the broad thrust of monetary policy either. Europe and Japan enjoyed booming economies in the early 1970s and mid-1980s, and thus had the luxury of placating the U.S. by adjusting monetary policy and thereby appreciating their currencies. Today, it is difficult to see how either Europe or China can afford significant monetary policy tightening that generates major bull markets in their currencies. Neither the ECB nor the People's Bank of China (PBOC) will re-orient policy until their own economic and inflation dynamics warrant it.1 It is also unlikely that the Bank of Japan will raise the 10-year yield target to either strengthen the yen or to help bank profits. This is not Plaza Accord 2.0. Powell Isn't Arthur Burns As for the Fed, we doubt the FOMC will be bullied into keeping rates lower than policymakers deem appropriate. The Fed is more open and independent today than in the 1970s and 1980s. Even if Fed Chair Powell were amenable, any hint that he is being politically manipulated to change course would result in a bond market riot that would rattle investors to their core. More likely, the Fed will stick with its current game plan and ignore President Trump's tweets. Powell could not be any clearer in his July Congressional Testimony: "With a strong job market, inflation close to our objective, and the risks to the outlook roughly balanced, the FOMC believes that-for now-the best way forward is to keep gradually raising the federal funds rate." Investors should not be fooled by the uptick in the U.S. unemployment rate in June. The rise reflected a pop in the labor force participation rate. However, the labor force figures are volatile and there is no upward trend evident in the participation rate. The real story is that the labor market continues to tighten. The number of people outside the labor force who want a job, as a percentage of the total working-age population, is back to pre-recession lows. The Employment Cost Index for private-sector workers shows that wage growth is accelerating. Moreover, the New York Fed's Underlying Inflation Gauge, which leads core CPI inflation by 18 months, has already jumped to almost 3 ½% (Chart I-2). Small businesses are increasingly able to pass on cost increases to consumers (Chart I-3). Chart I-2U.S. Inflation Is Percolating Chart I-3U.S. Pricing Power On The Rise The Minutes from the mid-June FOMC meeting included a lengthy discussion of the growing signs of inflation pressure and labor shortage. Firms are responding to the lack of qualified labor by offering training, automating, and boosting wages. Anecdotal evidence suggests that bottlenecks and other cost pressures are boiling over in the transportation sector. Despite an acute shortage of truck drivers, the average hourly earnings data do not show any acceleration in their wages (Chart I-4, second panel). However, these data do not include bonuses, which have been on the rise. The PPI for truck transportation services was up 7.7% year-over-year in June, while the Cass Freight Index that tracks full-truckload prices rose 15.9% year-over-year. The latter does not even include fuel costs. These pipeline cost pressures have implications not only for the Fed, but for corporate profit margins as well (see below). Chart I-4U.S. Transportation Is Boiling Over The U.S. Yield Curve: A Red Flag? The FOMC expects that the fed funds rate will continue to rise and will temporarily exceed its 2.9% estimate of the neutral rate. If the true neutral rate is higher than the Fed's estimate, then the FOMC could find itself hiking too slowly and the economy could severely overheat. And vice versa if the true neutral rate is below 2.9%. We are keeping a close eye on the yield curve as an indication of policy tightness. If the curve inverts with a few more Fed rate hikes, it would signal that the market believes that policy is turning restrictive. It is possible that the yield curve is not as good a recession signal as it has been in the past. First, there is a lot of uncertainty regarding the neutral fed funds rate in the post-GFC world. The collective market wisdom on this could be wrong. Indeed, BCA's Chief Global Strategist, Peter Berezin, makes the case that the neutral rate is rising faster than most investors believe.2 Structural factors have depressed the neutral rate, including population aging and low productivity growth. However, these structural tailwinds for bond prices are now slowly turning into headwinds. Moreover, as Peter argues, cyclical pressures are acting to lift the neutral rate. Private credit growth is rising faster than nominal GDP growth again. The same is true for housing and equity wealth, at a time when the personal saving rate is falling. All this implies strong desired spending which, in turn, suggests a higher neutral rate of interest. It will be important to watch the housing market; if it remains healthy in the face of rate hikes, it means that the neutral rate is still north of the actual fed funds rate. Chart I-5 presents today's market expectation for the real fed funds rate, based on the forward OIS curve and the forward CPI swaps curve. Technical issues may be distorting forward rates in 2019, but we are more interested in expectations further into the future. The real fed funds rate is expected to hover in the 55-75 basis point range until 2024. It then rises to about 1%, but not until almost the end of the next decade. This appears overly complacent to us, suggesting that the risks are to the upside for market expectations of the terminal, or neutral, short-term interest rate. If the neutral rate is indeed higher than the market is currently discounting, then an inverted curve may be premature in signaling that policy is too tight and that an economic slowdown is on the horizon. Moreover, the term premium on long-term bonds may still be depressed by asset purchases by the Fed and the other major central banks, again suggesting that the curve will more easily invert than in the past. There is much disagreement on this issue, even among FOMC members and among BCA strategists. This publication is sympathetic to the work done by the Fed Staff which suggests that the term premium has been substantially depressed by quantitative easing. Chart I-6 shows the annual change in the size of G4 central bank balance sheets (inverted), along with an estimate of the term premium in the 10-year government bonds of the major countries. The chart is far from conclusive, but it is consistent with the view that QE has depressed term premia worldwide. Moreover, forward guidance and the low level of inflation since the GFC have undoubtedly dampened interest-rate volatility, which theory suggests is a key driver of the term premium. Chart I-5Policy Rate Expectations Chart I-6Depressed Term Premiums ##br##Distort Yield Curves The factors that have depressed the term premium are beginning to reverse, including G4 central bank balance sheets. Still, the premium will trend higher from a low starting point, suggesting that an inverted curve today may not necessarily signal a recession. That said, it would be wrong to completely dismiss a U.S. curve inversion, given its excellent track record. Historically, the 3-month/10-year Treasury slope has worked better than the 2/10 yield slope in terms of calling recessions. An inversion of the 3-month/10-year curve has successfully heralded all seven recessions in the past 50 years with one false positive signal. Nonetheless, the curve tends to be very early, inverting an average of almost 12 months before the recession. And, given the possible distortion to the term premium, we would want to see corroborating evidence before jumping to the conclusion that an inverted curve is sending a correct recession signal. For example, the U.S. and/or global Leading Economic Indicator would need to turn negative. The bottom line is that a curve inversion would not be enough on its own to further trim risk asset exposure to underweight. Nonetheless, we are not dismissing the message from the yield curve either, especially in the context of a trade war that could prematurely end the expansion. Trade War Hitting Economy? Estimates based on macro models suggest that the damage to global GDP growth from higher tariffs would be quite small. Nonetheless, these models do not incorporate the indirect, or second-round, effects of rising tariff walls. Business leaders abhor uncertainty, and will no doubt hold off on major capital expenditure plans until the trade dust settles. The uncertainty can then ripple through the economy to industries that are not directly affected by the trade action. The extensive use of global supply chains reinforces this ripple effect. Labor is not free to move between countries or between industries to facilitate shifts in production that are required by changing tariffs. Capital is more mobile, but it is still expensive to shift machinery. Some of the world's capital stock could become "stranded", raising the cost of the tariffs to the world economy. Finally, important economies-of-scale are lost when firms no longer have access to a single large global market. This month's Special Report, beginning on page 18, sorts out the U.S. equity sector winners and the losers from a trade war with China. Spoiler alert: there are not many winners! The bottom line is that the trade threat for the global economy and risk assets is far from trivial. The negative trade headlines have not had a meaningful economic impact so far, but there are some worrying signs. A number of indicators suggest that global growth continues to slow, including the BCA Global Leading Economic Indicator diffusion index, the Global ZEW sentiment index and the BCA Global Credit Impulse index (Chart I-7). The softness in these indicators predates the latest flaring of trade tensions. Nonetheless, business confidence outside the U.S. has dipped (fourth panel). Growth in capital goods imports for an aggregate of 20 countries continues to decelerate, along with industrial production for capital goods and machinery & electrical equipment in the major advanced economies (production related to energy, consumer products and IT remain strong; Chart I-8). Chart I-7Global Growth Is Still Moderating... Chart I-8...In Part Due To Capital Spending None of these data are flagging a disaster, but they all support the view that uncertainty regarding the future of the world trade order is dampening animal spirits and global capital spending. Even if trade tensions soon die down, the extended nature of the U.S. economic and profit cycle make asset allocation particularly tricky. Late Cycle Investing Some of our economic and policy analysis over the past year has focused on previous late-cycle periods. Specifically, we analyzed the growth, inflation and policy dynamics after the point when the economy reached full employment (i.e. when the unemployment rate fell below the CBO estimate of full employment). This month we look at asset class returns during late cycle periods. We wanted to use as broad a range of asset classes as possible, although data limitations mean that we can only analyze the late-cycle periods at the end of the 1990s and the mid-2000s (Chart I-9). To refine the analysis, we split the late-cycle periods into two parts: before and after S&P 500 profit margins peak. One could use other signposts to split the period, such as a peak in the ISM manufacturing index. However, using the S&P operating profit margin proved to be a more useful break point across the cycles in terms of timing trend changes in risk assets. Table I-1 presents total returns for the following periods: (1) the full late-cycle period - i.e. from the point at which full employment is reached until the following recession; (2) from the point of full employment to the peak in the S&P margin; (3) from the peak in the margin to the recession; and (4) during the subsequent recession. All returns are annualized for comparison purposes, and the data shown are the average of the late 1990s and mid-2000 late-cycle periods. Chart I-9Margin Peak Signals Very Late Cycle Table I-1Late-Cycle Asset Returns We must be careful in interpreting the results because no two cycles are exactly the same, and we only have two cycles in our sample of data. Nonetheless, we make the following observations: Treasury bond returns are positive across the board, which seems odd at first glance. However, in both cases the selloff occurred before the late-cycle period began. Yields then fluctuated in a range, and then began to fall after margins peaked. Global factors also contributed to Greenspan's "conundrum" of stable bond yields in the years before the Great Recession. We do not expect a replay this time around given the low starting point for real yields and the fact that the Fed is encouraging an overshoot of the inflation target. Bonds are unlikely to provide positive returns on a six month horizon. Similar to Treasurys, investment-grade (IG) corporate bond returns were positive across the board for the same reason. However, IG underperformed Treasurys after margins peaked and into the recession. High-yield bonds followed a similar pattern, but suffered negative absolute returns after margins peaked. U.S. stocks began to sniff out the next recession after margins peaked. Small caps outperformed large caps in the recessions, but relative performance was mixed after margins peaked. We are avoiding small caps at the moment based on poor fundamentals and valuations. Growth stocks had a mixed performance versus value stocks before and after margins peaked, but tended to outperform in the recessions. Dividend Aristocrats performed well relative to the overall equity market after margins peaked and into the recessions on average, but the performance was not consistent across the two late cycles. EM stocks performed well before margins peak, and poorly during the recessions. However, the performance is mixed in the period between the margin peak and the recession. We recommend an underweight allocation because of poor macro fundamentals and tightening financial conditions. In theory, Hedge Funds are supposed to be able to perform well in any environment, but returns were a mixed bag after margins peaked. The return performance of Private Equity, Venture Capital and Distressed Debt were similar to the S&P 500, albeit with more volatility. Avoid them after margins peak. Structured Product is one of the few categories that performed well across all periods and cycles. The index we used includes MBS, CMBS and ABS. Farmland and Timberland returns were attractive across all periods and cycles, except for Timberland during one of the recessions. Oil and non-oil commodities tended to perform poorly during recession, but returns were inconsistent in the other phases shown in the table. Gold was also a mixed bag. The historical return analysis underscores that it is dangerous to remain aggressively positioned late in an economic cycle because risk assets can begin to underperform well before evidence accumulates that the economy has fallen into recession. Using the peak in the S&P 500 operating profit margin as a signal to lighten up appears prudent. Based on this approach, investors should generally remain overweight risk assets generally, including stocks, corporate bonds, hedge funds, private equity and real estate, as long as margins are still rising. Investors should scale back in most of these areas as soon as margins peak. For fixed income, investors should be looking to raise exposure but move up in quality after margins peak. Oil and related plays are not a reliable late-cycle play, but we are bullish because of the favorable supply-demand outlook. However, this does not carry over to base metals, where we are more cautious. There are some assets other than government bonds that generated a positive average return late in the cycle and during the recession periods, suggesting that they are good late-cycle assets to hold. However, this is misleading because in some cases they experienced a significant correction either during or slightly before the recession (see the maximum drawdown columns in Table I-1; blank cells indicate that the asset did not experience a correction). These include IG credit, CMBS, ABS, Gold and Dividend Aristocrats. The only assets in our list that provided both a positive return across all the phases in Table I-1 and avoided a correction during the recessions, were mortgage-backed securities, Timberland and Farmland. A Special Report from BCA's Global Asset Allocation service found that Timberland is a superior inflation hedge to Farmland, but the latter is a superior hedge against recessions and equity bear markets.3 We believe that Agency MBS are unattractively valued, but should remain insulated from negative shocks such as a trade war or higher Treasury yields (as long as the Treasury selloff is not extreme). Our fixed income team also likes Agency CMBS.4 When Will U.S. Margins Peak? It is impressive that S&P 500 after-tax operating margins are extremely elevated and still rising. The trend has been aided by tax cuts, but corporate pricing power has improved and wage growth has not yet accelerated enough to damage margins. Chart I-10 presents some indicators to monitor as we await the cyclical peak in profit margins. These are generally not leading indicators, but they do provide some warning when they roll over late in the cycle. The first is the BCA Margin Proxy, which is the ratio of selling prices for the non-financial corporate sector to unit labor costs. Margins have tended to fall historically when the growth rate of this ratio is below zero. The same is true for nominal GDP growth minus aggregate wages. The aggregate wage bill incorporates both changes in wages/hour and in total hours worked. We are also watching a diffusion index of the changes in margins for the industrial components of the S&P 500, as well as BCA's Corporate Pricing Power indicator. The latter takes into consideration price changes at the detailed industry level. Chart I-10U.S. Profit Margin Indicators To Watch None of these indicators are signaling an imminent top in margins, but all appear to have peaked except the Corporate Pricing Power indicator. An equally-weighted average of these four indicators, labelled the U.S. Composite Margin Indicator in Chart I-10, is falling but is still above the zero line. We would not be surprised to see S&P 500 margins peak for the cycle late early in 2019. Conclusions: The S&P 500 has so far been largely immune to shocking trade headlines with the help of a solid start to the U.S. Q2 earning season. Based on previous late cycle periods, the fact that S&P 500 profit margins are still rising suggests that investors should remain fully-exposed to most risk assets. Nonetheless, timing is always difficult and we have decided to focus on capital preservation given extended valuations and a raft of risks that could cause a premature end to the bull market. These risks include a possible hard economic landing in China, crises in one or more EM countries, and an escalation in the trade war among others. Some investors appear to believe that the U.S. can "win" the trade war, but there are no winners when tariff walls are rising. We are not yet ready to go underweight on risk assets, but risk tolerance should be no more than benchmark. This includes equities, corporate bonds, EM assets and other risky sectors. An inversion of the yield curve could trigger a shift to underweight, although this signal would have to be corroborated by our other favorite U.S. and global indicators. Attractive late-cycle assets to hold include structured product, Timberland and Farmland. The first statements by Jay Powell as FOMC Chair underscored that it is too early to hide in Treasurys. Market expectations for real short-term interest rates are overly benign out to the middle of the next decade. Moreover, the Fed is not in a position to be proactive in leaning against the negative impact of rising tariffs because inflation is near target and the labor market is showing signs of overheating. This means that bond yields are headed higher until economic pain is clearly evident. Keep duration short of benchmark. Long-term rate expectations for the Eurozone appear even more complacent than they do for the U.S. The real ECB policy rate is expected to remain in negative territory until 2028 (Chart I-5)! At some point there will be a convergence of real rate expectations with the U.S., which will boost the value of the euro. Nonetheless, we believe that it is too early to position for rate convergence. Core inflation is still well below target and Eurozone economic growth has softened recently, suggesting that the ECB will be in no hurry to lift rates once asset purchases have ended. ECB policymakers will be disinclined to cater to President's Trump's desire for tighter monetary policy in Europe, which means that the U.S. dollar has more upside versus the euro and in broad trade-weighted terms. An escalation in the trade war would augment upward pressure on the greenback. As the dollar's behavior during the Global Financial Crisis illustrates, even major shocks that originate from the U.S. tend to attract capital inflows into the safe-haven Treasury market. Emerging market assets are particularly vulnerable to another upleg in the dollar because of the high level of U.S. dollar-denominated debt. Favor DM to EM equity markets and currencies. Mark McClellan Senior Vice President The Bank Credit Analyst July 26, 2018 Next Report: August 30, 2018 1 For more information on why a replay of the 1985 Plaza Accord is unlikely, please see BCA Geopolitical Strategy Weekly Report "The Dollar May Be Our Currency, But It Is Your Problem," dated July 25, 2018, available on gps.bcaresearch.com 2 Please see BCA Global Investment Strategy Weekly Report "U.S. Housing Will Drive the Global Business Cycle...Again," dated July 6, 2018, available on gis.bcaresearch.com 3 Please see BCA Global Asset Allocation Service Special Report "U.S. Farmland & Timberland: An Investment Primer," dated October 24, 2017, available on gaa.bcaresearch.com 4 Please see BCA's U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem," dated July 17, 2018, available on usbs.bcaresearch.com II. U.S. Equity Sectors: Trade War Winners And Losers In this Special Report, we shed light on the implications of the U.S./Sino trade war for U.S. equity sectors. The threat that trade action poses to the U.S. equity market is greater than in past confrontations. Perhaps most importantly, supply chains are much more extensive, globally and between China and the U.S. Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The USTR claims that it is being strategic in the Chinese goods it is targeting, focusing on companies that will benefit from the "Made In China 2025" initiative. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad import categories. The only major items left for the U.S. to hit are apparel, footwear, toys and cellphones. Beijing is clearly targeting U.S. products based on politics in order to exert as much pressure on the President's party as possible. Based on a list of products that comprise the top-10 most exported goods of Red and Swing States, China will likely lift tariffs in the next rounds on civilian aircraft, computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits. Supply chains within and between industries and firms mean that the impact of tariffs is much broader than the direct impact on exporters and importers. We measure the relative exposure of 24 GICs equity sectors to the trade war based on their proportion of foreign-sourced revenues and the proportion of each industry's total inputs that are affected by U.S. tariffs. The Semiconductors & Semiconductor Equipment sector stands out, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. China may also attempt to disrupt supply chains via non-tariff barriers, placing even more pressure on U.S. firms that have invested heavily in China. Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance are most exposed. U.S. technology companies are particularly vulnerable to an escalating trade war. Virtually all U.S. manufacturing industries will be negatively affected by an ongoing trade war, even defensive sectors such as Consumer Staples. The one exception is defense manufacturers, where we recommend overweight positions. Our analysis highlights that the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, and the S&P Financial Exchanges & Data subsector is one of our favorites. The trade skirmish is transitioning to a full-on trade war. The U.S. has imposed a 25% tariff on $50 billion worth of Chinese goods, and has proposed a 10% levy on an additional $200 billion of imports by August 31. China retaliated with tariffs on $50 billion of imports from the U.S., but Trump has threatened tariffs on another $300 billion if China refuses to back down. That would add up to over $500 billion in Chinese goods and services that could be subject to tariffs, only slightly less than the total amount that China exported to the U.S. last year. BCA's Geopolitical Strategy has emphasized that President Trump is unconstrained on trade policy, giving him leeway to be tougher than the market expects.1 This is especially the case with respect to China. There will be strong pushback from Congress and the U.S. business lobby if the Administration tries to cancel NAFTA. In contrast, Congress is also demanding that the Administration be tough on China because it plays well with voters. Trump is a prisoner of his own tough pre-election campaign rhetoric against China. The U.S. primary economic goal is not to equalize tariffs but to open market access.2 The strategic goal is much larger. The U.S. wants to see China's rate of technological development slow down. Washington will expect robust guarantees to protect intellectual property and proprietary technology before it dials down the pressure on Beijing. The threat that the trade war poses to the U.S. equity market is greater than in past confrontations, such as that between Japan and the U.S. in the late 1980s. First, stocks are more expensive today. Second, interest rates are much lower, limiting how much central banks can react to adverse shocks. Third, and perhaps most importantly, supply chains are much more extensive, globally and between China and the U.S. Nearly every major S&P 500 multinational corporation is in some way exposed to these supply chains. Chart II-1 shows that Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The Global Value Chain Participation rate, constructed by the OECD, is a measure of cross-border value-added linkages.3 In this Special Report, we shed light on the implications of the trade war for U.S. equity sectors. Complex industrial interactions make it difficult to be precise in identifying the winners and losers of a trade war. Nonetheless, we can identify the industries most and least exposed to a further rise in tariff walls or non-tariff barriers to trade. We focus on the U.S./Sino trade dispute in this Special Report, leaving the implications of a potential trade war with Europe and the possible failure of NAFTA negotiations for future research. Chart II-1Measuring Global Supply Chains Trade Channels There are at least five channels through which rising tariffs can affect U.S. industry: The Direct Effect: This can be positive or negative. The impact is positive for those industries that do not export much but are provided relief from stiff import competition via higher import tariffs. The impact is negative for those firms facing higher tariffs on their exports, as well as for those firms facing higher costs for imported inputs to their production process. These firms would be forced to absorb some of the tariff via lower profit margins. Some industries will fall into both positive and negative camps. U.S. washing machines are a good example. Whirlpool's stock price jumped after President Trump announced an import tariff on washing machines, but it subsequently fell back when the Administration imposed an import tariff on steel and aluminum (that are used in the production of washing machines); Indirect Effect: The higher costs for imported goods are passed along the supply chain within an industry and to other industries that are not directly affected by rising tariffs. This will undermine profit margins in these indirectly-affected industries to the extent that they cannot fully pass along the higher input costs; Foreign Direct Investment: Some Chinese exports emanate from U.S. multinationals' subsidiaries in China, or by Chinese or foreign OEM suppliers for U.S. firms. Even though it would undermine China's economy to some extent, the Chinese authorities could make life more difficult for these firms in retaliation for U.S. tariffs on Chinese goods. Macro Effect: A trade war would take a toll on global trade and reduce GDP growth globally. Besides the negative effect of uncertainty on business confidence and, thus, capital spending, rising prices for both consumer and capital goods will reduce the volume of spending in both cases. Moreover, corporate profits have a high beta with respect to economic activity. We would not rule out a U.S. recession in a worst-case scenario. Obviously, a recession or economic slowdown would inflict the most pain on the cyclical parts of the S&P 500 relative to the non-cyclicals, in typical fashion. Currency Effect: To the extent that a trade war pushes up the dollar relative to the other currencies, it would undermine export-oriented industries and benefit those that import. However, while we are bullish the dollar due to diverging monetary policy, the dollar may not benefit much from trade friction given retaliatory tariff increases by other countries. Some of the direct and indirect impact can be mitigated to the extent that importers facing higher prices for Chinese goods shift to similarly-priced foreign producers outside of China. Nonetheless, this adjustment will not be costless as there may be insufficient supply capacity outside of China, leading to upward pressure on prices globally. Targeted Sectors: (I) U.S. Tariffs On Chinese Goods As noted above, the U.S. has already imposed tariffs on $50 billion of Chinese imports and has published a list of another $200 billion of goods that are being considered for a 10% tariff in the second round of the trade war. The first round focused on intermediate and capital goods, while the second round includes consumer final demand categories such as furniture, air conditioners and refrigerators. The latter will show up as higher prices at retailers such as Wal Mart, having a direct and visible impact on U.S. households. Appendix Table II-A1 lists the goods that are on the first and second round lists, grouped according to the U.S. equity sectors in the S&P 500. The U.S. Trade Representative (USTR) claims that the Chinese items are being targeted strategically. It is focusing on companies that will benefit from China's structural policies, such as the "Made In China 2025" initiative that is designed to make the country a world leader in high-tech areas (see below). Table II-1 reveals the relative size of the broad categories of U.S. imports from China, based on trade categories. The top of the table is dominated by Motor Vehicles, Machinery, Telecommunication Equipment, Computers, Apparel & Footwear and other manufactured goods. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad categories in Table II-1. The only major items left for the U.S. to hit are Apparel and Footwear, as well as two subcategories; Toys and Cellphones. These are all consumer demand categories. Table II-1U.S. Imports From China (January-May 2018) (II) Chinese Tariffs On U.S. Goods Total U.S. exports to China were less than $53 billion in the first five months of 2018, limiting the amount of direct retaliation that China can undertake (Table II-2). The list of individual U.S. products that China has targeted so far is long, but we have condensed it into the broad categories shown in Table II-3. The U.S. equity sectors that the new tariffs affect so far include Food, Beverage & Tobacco, Automobiles & Components, Materials and Energy. China has concentrated mainly on final goods in a politically strategic manner, such as Trump-supported rural areas and Harley Davidson bikes whose operations are based in Paul Ryan's home district in Wisconsin. Table II-2U.S. Exports To China (January-May 2018) Table II-3China Tariffs On U.S. Goods What will China target next? Chart II-2 shows exports to China as percent of total state exports, and Chart II-3 presents the value of products already tariffed by China as a percent of state exports. Other than Washington, the four states most targeted by Beijing are conservative: Alaska, Alabama, Louisiana and South Carolina. Chart II-2U.S. Exports To China By State Chart II-3Value Of U.S. Products Tariffed By China (By State) Beijing is clearly targeting products based on politics in order to exert as much pressure on the President's party as possible. To identify the next items to be targeted, we constructed a list of products that comprise the top-10 most exported goods of Red States (solidly conservative) and Swing States (competitive states that can go either to Republican or Democratic politicians). Appendix Tables II-A2 and II-A3 show this list of products, with those that have already been flagged by China for tariffs crossed out. Table II-4 shows the top-10 list of products that are not yet tariffed by China, but are distributed in a large proportion of Red and Swing states. What strikes us immediately is how important aircraft exports are to a large number of Swing and Red States. In total, 27 U.S. states export civilian aircraft, engines and parts to China. This is an obvious target of Beijing's retaliation. In addition, we believe that computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits are next. Table II-4Number Of U.S. States Exporting To China By Category Market Reaction Chart II-4 highlights how U.S. equity sectors performed during seven separate days when the S&P 500 suffered notable losses due to heightened fears of protectionism. Cyclical sectors such as Industrials and Materials fared worse during days of rising protectionist angst. Financials also generally underperformed, largely because such days saw a flattening of the yield curve. Tech, Health Care, Energy and Telecom performed broadly in line with the S&P 500. Consumer Staples outperformed the market, but still declined in absolute terms. Utilities and Real Estate were the only two sectors that saw absolute price gains. The market reaction seems sensible based on the industries caught in the cross-hairs of the trade action so far. At least some of the potential damage is already discounted in equity prices. Nonetheless, it is useful to take a closer look at the underlying factors that should determine the ultimate winners and losers from additional salvos in the trade war. Chart II-4S&P 500: Impact Of Trade-Related Events Determining The Winners And Losers The U.S. sectors that garner the largest proportion of total revenues from outside the U.S. are obviously the most exposed to a trade war. For the 24 level 2 GICS sectors in the S&P 500, Table II-5 presents the proportion of total revenues that is generated from operations outside the U.S. for the top five companies in the sector by market cap. Company reporting makes it difficult in some cases to identify the exact revenue amount coming from outside the U.S., as some companies regard "domestic" earnings as anything generated in North America. Nonetheless, we believe the data in Table II-5 provide a reasonably accurate picture. Table II-5Foreign Revenue Exposure (2017) Semiconductors, Tech Equipment, Materials, Food & Beverage, Software and Capital Goods are at the top of the list in terms of foreign-sourced revenues. Not surprisingly, service industries like Real Estate, Banking, Utilities and Telecommunications Services are at the bottom of the exposure list. U.S. companies are also exposed to U.S. tariffs that lift the price of imported inputs to the production process. This can occur directly when firm A imports a good from abroad, and indirectly, when firm A sells its intermediate good to firm B at a higher price, and then on to firm C. In order to capture the entire process, we used the information contained in the Bureau of Economic Analysis' Input/Output tables. We estimated the proportion of each industry's total inputs that are affected by already-implemented U.S. tariffs and those that are on the list for the next round of tariffs. These estimates, shown in Appendix Table II-A4 at a detailed industrial level, include both the direct and indirect effects of higher import costs. At the top of the list is Motor Vehicles and Parts, where Trump tariffs could affect more than 70% of the cost of all material inputs to the production process. Electrical Equipment, Machinery and other materials industries are also high on the list, together with Furniture, Computers & Electronic Parts and Construction. Unsurprisingly, service industries and Utilities are in the bottom half of the table.4 We then allocated all the industries in Appendix Table II-A4 to the 24 GICs level 2 sectors in the S&P 500, in order to obtain an import exposure ranking in S&P sector space (Table II-6). Table II-6U.S. Import Tariff Exposure Chart II-5 presents a scatter diagram that compares import tariff exposure (horizontal axis) with foreign revenue exposure (vertical axis). The industries clustered in the top-right of the diagram are the most exposed to a trade war. Chart II-5U.S. Industrial Exposure To A Trade War With China The Semiconductors & Semiconductor Equipment sector stands out by this metric, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. Food, Beverage & Tobacco lies between the two extremes. Joint Ventures And FDI Table II-7Stock Of U.S. Direct ##br##Investment In China (2017) As mentioned above, most U.S. production taking place in China involves a joint venture. The Chinese authorities could attempt to disrupt the supply chain of a U.S. company by hindering production at companies that have ties to U.S. firms. Data on U.S. foreign direct investment (FDI) in China will be indicative of the industries that are most exposed to this form of retaliation. The stock of U.S. FDI in China totaled more than $107 billion last year (Table II-7). At the top of the table are Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance. Apple is a good example of a U.S. company that is exposed to non-tariff retaliation, as the iPhone is assembled in China by Foxconn for shipment globally with mostly foreign sourced parts. Our Technology sector strategists argue that U.S. technology companies are particularly vulnerable to an escalating trade war (See Box II-1).5 BOX II-1 The Tech Sector The U.S. has applied tariffs on the raw materials of technology products rather than finished goods so far. At a minimum, this will penalize smaller U.S. tech firms which manufacture in the U.S. and provide an incentive to move production elsewhere. Worst case, the U.S. tariffs might lead to component shortages which could have a disproportionately negative impact, especially on smaller firms. Although it has not been proposed, U.S. tariffs on finished goods would be devastating to large tech companies such as Apple, which outsources its manufacturing to China. China appears determined to have a vibrant high technology sector. The "Made In China 2025" program, for example, combines ambitious goals in supercomputers, robotics, medical devices and smart cars, while setting domestic localization targets that would favor Chinese companies over foreigners. The ZTE sanctions and the potential for enhanced export controls have had a traumatic impact on China's understanding of its relatively weak position with respect to technology. As a result, because most high-tech products are available from non-U.S. sources, Chinese engineers will likely be encouraged to design with non-U.S. components; for example, selecting a Samsung instead of a Qualcomm processor for a smartphone. Similarly, China is a major buyer of semiconductor capital equipment as it follows through with plans to scale up its semiconductor industry. Most such equipment is also available from non-U.S. vendors, and it would be understandable if these suppliers are selected given the risk which would now be associated with selecting a U.S. supplier. The U.S. is targeting Chinese made resistors, capacitors, crystals, batteries, Light Emitting Diodes (LEDs) and semiconductors with a 25% tariff. For the most part these are simple, low cost devices, which are used by the billions in high-tech devices. Nonetheless, China could limit the export of these products to deliver maximum pain, leading to a potential shortage of qualified parts. A component shortage can have a devastating impact on production since the manufacturer may not have the ability to substitute a new part or qualify a new vendor. Since the product typically won't work unless all the right parts are installed, want of a dollar's worth of capacitors may delay shipping a $1,000 product. Thus, the economic and profit impact of a parts shortage in the U.S. could be quite severe. Conclusions: When it comes to absolute winners in case of a trade war, we believe there are three conditions that need to be met: Relatively high domestic input costs. Relatively high domestic consumption/sales; the true beneficiaries of a tariff are those industries who are allowed to either raise prices or displace foreign competitors, with the consumer typically bearing the cost. Relatively low direct exposure to global trade - international trade flows will certainly slow in a trade war. There are very few manufacturing industries that meet all of these criteria. Within manufacturing, one would typically expect the Consumer Staples and Discretionary sectors to be the best performers. However, roughly a third of the weight of Staples is in three stocks (PG, KO and PEP) that are massively dependent on foreign sales. Moreover, a similar weight of Discretionary is in two retailers (AMZN and HD) that are dependent on imports. As such, consumer indexes do not appear a safe harbor in a trade war. Nevertheless, if the trade war morphs into a recession then consumer staples (and other defensive safe-havens) will outperform, although they will still decrease in absolute terms. Transports are an industry that has relatively high domestic labor costs and an output that is consumed virtually entirely within domestic borders. However, their reliance on global trade flows - intermodal shipping is now more than half of all rail traffic - means they almost certainly lose from a prolonged trade dispute. There is one manufacturing industry that could be at least a relative winner and perhaps an absolute winner: defense. Defense manufacturers certainly satisfy the first two criteria above, though they do have reasonably heavy foreign exposure. However, we believe high switching costs and the lack of true global competitors mean that U.S. defense company foreign sales will be resilient. After all, a NATO nation does not simply switch out of F-35 jets for the Russian or Chinese equivalent. Further, if trade friction leads to rising military tension, defense stocks should outperform. Finally, the ongoing global arms race, space race and growing cybersecurity requirements all signal that these stocks are a secular growth story, as BCA has argued in the recent past.6 Still, as highlighted by the data presented above, the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, especially the S&P Financial Exchanges & Data subsector (BLBG: S5FEXD - CME, SPGI, ICE, MCO, MSCI, CBOE, NDAQ). Another appealing - and defensive - sector is Health Care Services. With effectively no foreign exposure and a low beta, these stocks would outperform in the worst-case trade war-induced recession. Mark McClellan Senior Vice President The Bank Credit Analyst Marko Papic Senior Vice President Geopolitical Strategy Chris Bowes Associate Editor U.S. Equity Strategy 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 3 For more information, please see: "Global Value Chains (GVSs): United States." May 2013. OECD website. 4 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. 5 Please see BCA Technology Sector Strategy Special Report "Trade Wars And Technology," dated July 10, 2018, available at tech.bcaresearch.com 6 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. Appendix Table II-1 Allocating U.S. Import Tariffs To U.S. GICS Sectors Appendix Table II-2 Exports By U.S. Red States Appendix Table II-3 Exports By U.S. Swing States Appendix Table II-4 Exposure Of U.S. Industries To U.S. Import Tariffs III. Indicators And Reference Charts Our equity-related indicators flashed caution again in July, despite robust U.S. corporate earnings indicators. Forward earnings estimates continued to surge in July. The net revisions ratio and the earnings surprises index remained well above average, suggesting that forward earnings still have upside potential in the coming months. However, several of our indicators suggest that it is getting late in the bull market. Our Monetary Indicator is approaching very low levels by historical standards. Equities are still close to our threshold of overvaluation, at a time when our Composite Technical Indicator appears poised to break down. An overvalued reading is not bearish on its own, but valuation does provide information on the downside risks when the correction finally occurs. Equity sentiment is close to neutral according to our composite indicator, but the low level of implied volatility suggests that investors are somewhat complacent. Our U.S. Willingness-to-Pay (WTP) indicator has fallen significantly this year, and the Japanese WTP appears to be rolling over. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Flows into the U.S. stock market are waning, and those into the Japanese market are wavering. Flows into European stocks have flattened off. Finally, our Revealed Preference Indicator (RPI) for stocks remained on a ‘sell’ signal in July. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. The U.S. 10-year Treasury is slightly on the inexpensive side and our Composite Technical Indicator suggests that the bond has still not worked off oversold conditions. This suggests that the consolidation period has further to run, although we still expect yields to move higher over the remainder of the year. This month’s Overview section discusses the upside potential for the term premium in the yield curve and for market expectations of the terminal fed funds rate. This year’s dollar rally has taken it to very expensive levels according to our purchasing power parity estimate. The long-term trend in the dollar is down, but we still believe it has some upside while market expectations for the terminal fed funds rate adjust upward. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst
Highlights Our forecast of higher geopolitical risk in 2018 is coming to fruition; President Trump's two key policies, economic populism (fiscal stimulus) and mercantilism (trade tariffs), will counteract each other; Stimulus is leading to trade deficits and a stronger dollar, while a stronger dollar encourages trade deficits. This is a problem for Trump in 2020; The administration will seek coordinated international currency moves, but the U.S. has less influence today than it did at the time of key 1971 and 1985 precedents; Favor DM over EM assets; favor U.S. over DM stocks; and expect Trump to threaten tariffs against currency manipulation. Feature "China, the European Union and others have been manipulating their currencies and interest rates lower, while the U.S. is raising rates while the dollars [sic] gets stronger and stronger with each passing day - taking away our big competitive edge. As usual, not a level playing field... The United States should not be penalized because we are doing so well. Tightening now hurts all that we have done. The U.S. should be allowed to recapture what was lost due to illegal currency manipulation and BAD Trade Deals. Debt coming due & we are raising rates - Really?" - President Donald Trump, tweet, July 20, 2018 "The dollar may be our currency, but it is your problem." - Treasury Secretary John Connally, 1971, speaking to a group of European officials Chart 1A Fiscal Boost Will Accelerate Inflation In April 2017, BCA's Geopolitical Strategy concluded that "Political Risks Are Overstated In 2017," but also "Understated In 2018."1 At the heart of our forecast was the interplay between three factors: "Domestic Policy Is Bullish USD:" We argued in early 2017 that the political "path of least resistance" would lead to "tax cuts in 2017" and that President Trump's economic policies "will involve greater budget deficits than the current budget law augurs." The conclusion was that "even a modest boost to government spending will motivate the Fed to accelerate its tightening cycle at a time when the output gap is nearly closed and unemployment is plumbing decade lows" (Chart 1). "Chinese Growth Scare Is Bullish USD:" We also correctly predicted that "Chinese data is likely to decelerate and induce a growth scare." Even though Chinese data was peachy in early 2017, we pointed out that "Chinese policymakers have gone forward with property market curbs and begun to tighten liquidity marginally in the interbank system." We would go on to produce several in-depth research reports throughout the year that outlined these reform efforts and linked them to President Xi Jinping's reduced political constraints following the nineteenth National Party Congress in October.2 "European Political Risks Are Bullish USD:" Finally, we argued that a combination of political risks - e.g., the 2018 Italian election - and the slowdown in China would reverberate in Europe, forcing "the ECB to be a lot more dovish than the market expects." Our conclusion in April 2017 - quoted verbatim below - was that these three factors would combine to force President Trump to try to talk down the greenback: The combination of Trump's domestic policy agenda and these global macro-economic factors will drive the dollar up. At some point in 2018, we assume that USD strength will begin to irk Donald Trump and his cabinet, particularly as it prevents them from delivering on their promise of shrinking trade deficits. We suspect that President Trump will eventually reach for the "currency manipulation" playbook of the 1970s-80s. On July 20, President Trump put a big red bow on our forecast by doing precisely what we expected: talking down the USD by charging the rest of the world with currency manipulation. Speaking with CNBC, Trump pointed out that "in China, their currency is dropping like a rock and our currency is going up, and I have to tell you it puts us at a disadvantage." President Trump is correct: Beijing is definitely manipulating the currency, as we pointed out last week (Chart 2).3 Chart 2The CNY Is Much Weaker Than The DXY Implies Chart 3U.S. Outperformance Should Be Bullish USD But President Trump wants to have his cake and eat it too. His economic stimulus is inevitably leading to a widening trade deficit. With tax cuts and increased capital spending, U.S. demand is growing faster than demand in the rest of the world. This economic outperformance in the context of stalling global growth is leading to the greenback rally that we forecast (Chart 3). When the U.S. economy outperforms the rest of the world, the Fed tends to be in the lead of tightening policy among G10 economies, spurring a rally in the trade-weighted dollar index (Chart 4).4 A rising currency then reinforces the trade deficit. Chart 42018 Rally Is Not Over There is much uncertainty regarding President Trump's true preferences, but we know two things: he is an economic populist and a mercantilist. He has been clear on both fronts throughout his campaign. The problem for President Trump is that the two policies are working against one another. His stimulus has spurred a USD rally that will likely offset the impact of his tariffs, particularly the more modest 10% variety he has said he will impose on all Chinese imports (Chart 5). Chart 5Trump Threatens Tariffs On All ##br##Chinese Imports (And Then Some) The Trump administration is therefore facing a choice: triple-down on tariffs, potentially causing a market and economic calamity in the process; or, use protectionism as a bargaining chip in a bout of orchestrated and negotiated, global, currency manipulation. As we pointed out last April, President Trump would not be the first to face this choice: 1971 Smithsonian Agreement President Richard Nixon famously closed the gold window on August 15, 1971 in what came to be known as the "Nixon shock."5 Less understood, but also part of the "shock," was a 10% surcharge on all imported goods, the purpose of which was to force U.S. trade partners to appreciate their currencies against the USD. Much like Trump, Nixon had campaigned on a mercantilist platform in 1968, promising southern voters that he would limit imports of Japanese textiles. As president, he staffed his cabinet with trade hawks, including Treasury Secretary John Connally who was in favor of threatening reduced U.S. military presence in Europe and Japan to force Berlin and Tokyo to the negotiating table. Connally also gave us the colorful quote for the title of this report and also famously quipped that "foreigners are out to screw us, our job is to screw them first." The economists in the Nixon cabinet - including Paul Volcker, then the Undersecretary of the Treasury under Connally - opposed the surcharge, fearing retaliation from trade partners, but policymakers like Connally favored brinkmanship. The U.S. ultimately got other currencies to appreciate, mostly the deutschmark and yen, but not by as much as it wanted. Critics in the administration - particularly the powerful National Security Advisor Henry Kissinger - feared that brinkmanship would hurt Trans-Atlantic relations and thus impede Cold War coordination. As such, the U.S. removed the surcharge merely four months later without meeting most of its objectives, including increasing allied defense-spending and reducing trade barriers to U.S. exports. Even the currency effects dissipated within two years. 1985 Plaza Accord The U.S. reached for the mercantilist playbook once again in the early 1980s as the USD rallied on the back of Volcker's dramatic interest rate hikes. The subsequent dollar bull market hurt U.S. exports and widened the current account deficit (Chart 6). U.S. negotiators benefited from the 1971 Nixon surcharge because European and Japanese policymakers knew that the U.S. was serious about tariffs and had no problem with protectionism. The result was coordinated currency manipulation to drive down the dollar and self-imposed export limits by Japan, both of which had an almost instantaneous effect on the Japanese share of American imports (Chart 7). Chart 6Dollar Bull Market And Current Account Balance In 1980s-90s Chart 7The U.S. Got What It Wanted From Plaza Accord The Smithsonian and Plaza examples are important for two reasons. First, they show that Trump's mercantilism is neither novel nor somehow "un-American." It especially is not anti-Republican, with both Nixon and Reagan having used overt protectionism and currency manipulation in recent history. Second, the experience of both negotiations in bringing about a shift in the U.S. trade imbalance will motivate the Trump administration to reach for the same "coordinated currency manipulation" playbook. In fact, Trump's Trade Representative, Robert Lighthizer, is a veteran of the 1985 agreement, having negotiated it for President Ronald Reagan. Should investors get ahead of the Plaza Accord 2.0 by shorting the greenback? The knee-jerk reactions of the market suggest that this is the thinking of the median investor. For instance, the DXY fell by 0.7% on the day of Trump's tweet. We disagree, however, and are sticking with our long DXY position, initiated on January 31, 2018, and up 6.17% since then.6 Why? Because 2018 is neither 1985 nor 1971. President Trump, and America more broadly, is facing several constraints today. As such, we do not expect that he will find eager partners in negotiating a coordinated currency manipulation. Chart 8Globalization Has Reached Its Apex Chart 9Global Protectionism Has Bottomed Economy: Europe and Japan were booming economies in the early 1970s and mid-1980s, and had the luxury of appreciating their currencies at the U.S.'s behest. Today, it is difficult to see how either Europe or China (now in Japan's place) can afford significant monetary policy tightening that would engineer structural bull markets in their currencies. For Europe, the risk is that the peripheral economies may not survive a back-up in yields. For China, if the PBOC engineered a persistently strong CNY/USD, it would tighten financial conditions and hurt the export sector. Apex of Globalization: U.S. policymakers were able to negotiate the 1971 and 1985 currency agreements in part because of the underlying promise of growing trade. Europe and Japan agreed to a tactical retreat to get a strategic victory: ongoing trade liberalization. In 2017-18, however, this promise has been muted. Global trade has peaked as a percent of GDP (Chart 8), average tariffs have bottomed (Chart 9), and the number of preferential trade agreements signed each year has collapsed (Chart 10). Temporary trade barriers have ticked up since 2008 (Chart 11). To be clear, these signs are not necessarily proof that globalization is reversing, but merely that it has reached its apex. Nonetheless, America's trade partners will be far less willing to agree to coordinated currency manipulation in an era where the global trade pie is no longer growing. Chart 10Low-Hanging Fruit Of Globalization Already Picked Chart 11Temporary Trade Barriers Ticking Up Multipolarity: The U.S. is simply not as powerful - relatively speaking - as it was at the height of the Cold War (Chart 12). As such, it is difficult to see how President Trump can successfully bully major economies into self-defeating currency manipulation. The Cold War gave the U.S. far greater leverage, particularly vis-à-vis Europe and Japan. Today, Trump's threats of pulling out of NATO are merely spurring Europeans to integrate further as Russia is no longer the threat it once was. There are no Soviet tank divisions arrayed across the Fulda Gap in Eastern Germany. In fact, Russia is cutting defense spending and further integrating into the European economy with new pipeline infrastructure (which Trump has pointedly criticized). And China is overtly hostile to the U.S. and thus completely unlike Japan, which huddled under the American nuclear umbrella during the U.S.-Japan trade war. Chart 12The U.S. Has Less Weight To Throw Around Is the Trump administration ignoring these major differences? No. There may be a much simpler explanation for President Trump's dollar bearishness: domestic politics. We only see a probability of around 20% that the U.S. trade deficit will shrink during the course of Trump's first term in office. Most likely, the trade deficit will widen as domestic stimulus supercharges the U.S. economy relative to the rest of the world and the greenback rallies. Economic slowdown in China and EM will likely further expand the U.S. trade deficit as these economies cut interest rates and allow their exchange rates to drop. President Trump therefore has a problem. The only way the trade deficit will shrink by 2020 is if the U.S. enters a recession and domestic demand shrinks - but presidents do not survive re-election during recessions. If a recession does not develop, he will have to explain to voters in early 2020 why the trade deficit actually surged, despite all his tough rhetoric, tariffs, and trade negotiations. The charge of currency manipulation could therefore do the trick, blaming the rest of the world for the USD rally that was largely caused by U.S. stimulus. Bottom Line: We do not expect the Fed to respond to President Trump's rhetoric. The current Powell Fed is not the 1970s Burns Fed. As such, we would fade any upcoming weakness in the USD. We expect the dollar bull market to carry on in 2018 and to continue weighing on global risk assets, namely EM equities and currencies. Investors should remain overweight DM assets relative to EM in terms of broad global asset allocation, and overweight U.S. equities in particular relative to other DM equities. The major risk to our bullish USD view is not a compliant Fed but rather a China that "blinks." Beijing has begun some modest stimulus in the face of the economic slowdown produced by the Xi administration's aforementioned efforts to contain systemic financial risk. Over the next month, we will dive deep into Chinese politics to see if the trade conflict will prompt Xi to reverse his attempt to tighten policy and once again embrace a resurgence in credit growth. In the long term, however, we expect that the Trump administration will grow frustrated with the fact that its two main policies - economic populism at home and mercantilism abroad - will offset each other and that the U.S. trade imbalance will continue to grow apace. At that point, President Trump may decide to reach for two levers: staffing the Fed with über doves and/or ratcheting up tariffs to much higher levels. We expect the latter to be the more likely outcome than the former, and either would result in a serious blowback from the rest of the world that would unsettle markets. More importantly, it would be the death knell of globalization, stranding trillions of dollars of capex behind suddenly very relevant national borders. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, and "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, "China Down, India Up," dated March 15, 2017, "China: Looking Beyond The Party Congress," dated July 19, 2017, "China's Nineteenth Party Congress: A Primer," dated September 13, 2017, "China: Party Congress Ends... So What?" dated November 1, 2017, "A Long View Of China," dated December 28, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Whoever Said Anything About Bluffing?" dated July 18, 2018, available at gps.bcaresearch.com. 4 Please see BCA Foreign Exchange Strategy Weekly Report, "The S&P Doesn't Abhor A Strong Dollar," dated July 20, 2018, available at fes.bcaresearch.com. 5 Please see Douglas A. Irwin, "The Nixon shock after forty years: the import surcharge revisited," World Trade Review 12:01 (January 2013), pp. 29-56, available at www.nber.org; and Barry Eichengreen, "Before the Plaza: The Exchange Rate Stabilization Attempts of 1925, 1933, 1936, and 1971," Behl Working Paper Series 11 (2015). 6 Please see BCA Geopolitical Strategy Weekly Report, "America Is Roaring Back! (But Why Is King Dollar Whispering?)," dated January 31, 2018, available at gps.bcaresearch.com.