Europe
Highlights We remain bullish on the dollar, but no longer think that being long the greenback is the "slam-dunk" trade that it was earlier this year. A reacceleration in growth outside the U.S. and an overly dovish Fed represent the biggest risks to our constructive dollar view. China is likely to stimulate its economy, but concerns about high debt levels and malinvestment will limit the scale of any fiscal/credit stimulus. Letting the RMB slide may prove to be the preferable option. Worries about debt sustainability in Italy and EM contagion to European banks will constrain credit growth in the euro area, thus keeping the ECB in a highly dovish mode. For the time being, we favor developed market stocks over their EM peers. At the sector level, we would overweight defensives relative to deep cyclicals. U.S. stocks will outperform European stocks in dollar terms, although the performance is likely to be much more balanced in local-currency terms. The longer-term path for Treasury yields is to the upside. Nevertheless, a stronger dollar, coupled with safe-haven flows into the Treasury market, could temporarily push the 10-year yield down to 2.5% over the next few months. Feature The Dollar At A Crossroads After surging by 10% between February 1st and August 15th, the broad trade-weighted dollar has fallen by 0.9% over the past two weeks. Despite the latest setback, the greenback is still 23.2% above its 2014 lows and only 2.8% below its December 28, 2016 high (Chart 1). BCA continues to maintain a bullish view on the dollar. However, given recent market action, it is useful to stress-test our thesis in order to explore what could go wrong with it. As we discuss below, a key risk to the dollar is that global growth reaccelerates, with the U.S. once again going from leader to laggard in the global growth horserace. Global Growth And The Dollar The dollar tends to strengthen when global growth is deteriorating. Since the U.S. is a "low-beta" economy dominated by services rather than manufacturing and primary industries, an environment in which the global economy is slowing is usually one where the U.S. is outperforming the rest of the world. Chart 2 shows that there is a strong correlation between the value of the trade-weighted dollar and the difference between The Conference Board's U.S. Leading Economic Indicator (LEI) and the non-U.S. LEI. The gap between the U.S. and the non-U.S. LEI is still quite large. However, it has started to shrink recently, reflecting both a dip in the U.S. LEI as well as a small improvement in the non-U.S. LEI. The implication is that the U.S. economy is outshining the rest of the world, but the magnitude of outperformance has begun to narrow. Looking forward, the fate of the dollar will hinge on whether growth in the rest of the world can catch up with the United States. By definition, this can happen either if U.S. growth falls or non-U.S. growth rises. We examine each possibility in turn. Chart 1Despite Recent Pullback, ##br##The Dollar Is Still Close To Its 2016 High Chart 2The U.S. Economy Is Still Outperforming The Rest Of The World, But The Gap Is Starting To Narrow U.S. Growth: As Good As It Gets? The second quarter was probably the high watermark for U.S. growth for the rest of this cycle. Real GDP expanded by 4.2%, more than double most estimates of trend growth. The deceleration in payroll growth in July, a string of weak housing data releases, and the drop in the national ISM surveys alongside declines in a number of regional surveys such as the Philly Fed PMI, all point to a somewhat softer third quarter GDP growth reading. How worried should dollar bulls be? We see three reasons to downplay the negative impact on the dollar from the recent string of softer economic data. While the U.S. economy has slowed, it is still quite strong. The Bloomberg consensus forecast suggests that real GDP will increase by 3% in Q3. The Atlanta Fed's GDPNow model predicts 4.1% growth, while the New York Fed's Nowcast anticipates a more modest growth rate of 2%. The underlying drivers of aggregate demand remain supportive. U.S. financial conditions have loosened recently, thanks mainly to narrower credit spreads and higher equity prices (Chart 3). The effects of fiscal stimulus have also yet to make their way fully through the economy, especially with respect to government spending. The consumer is in great shape. The unemployment rate is near a 20-year low and the savings rate stands at a comfortable 6.7%, well above the level that the current ratio of household net worth-to-disposable income would predict (Chart 4). The housing vacancy rate is close to all-time lows, which limits the downside risk both to home prices and construction activity (Chart 5). Chart 3U.S. Financial Conditions Have Eased Recently Chart 4The Savings Rate Has Room To Fall Some of the apparent slowdown in U.S. growth appears to be due to intensifying supply-side constraints rather than faltering demand (Chart 6). This is important because slower growth resulting from weaker demand should, in principle, cause the Fed to moderate the pace of rate hikes, whereas slower growth resulting from an overheated economy should prompt the Fed to accelerate the pace of rate hikes. The latter is much better for the dollar than the former. Chart 5Low Housing Inventories Will ##br##Support Home Prices And Construction Chart 6U.S. Economy Is Hitting Supply-Side ##br##Constraints The Fed's Fate Is In The Stars What is true in principle, however, does not always match what happens in practice. In his Jackson Hole address, Jay Powell invoked a Draghi-esque phrase when saying that the FOMC would "do whatever it takes" to keep inflation expectations from becoming unmoored.1 Nevertheless, he also said that "there does not seem to be an elevated risk of overheating" at the moment. This is a curious statement considering the abundant evidence that U.S. firms are struggling to find qualified workers. To his credit, Powell stressed the inherent difficulty of "navigating by the stars," that is, of setting monetary policy based on highly imprecise estimates of the natural rate of unemployment, u*, and the neutral real rate of interest, r*. What he did not say is that the Fed's current estimates of these "stars" stand at record lows, which introduces a dovish bias into monetary policy should these estimates prove to be too low. Our baseline view is that the Federal Reserve will raise rates more than the market is currently discounting. We also doubt the Fed will succumb to President Trump's pressure to keep rates low or to accommodate any effort by the Treasury to intervene in the foreign exchange market with the aim of driving down the value of the dollar. That said, the risk to this view is that the Fed reacts too slowly to rising inflation. This could cause real rates to drift lower, with adverse consequences for the dollar. The China Policy Wildcard The discussion above suggests that the dollar would suffer either if U.S. growth slows significantly or if the Fed falls too far behind the curve in normalizing monetary policy. An additional risk to the dollar is that growth outside the U.S. picks up. This would suck capital away from the U.S. and into the rest of the world, with adverse consequences for the greenback. At present, the biggest question mark around the global growth outlook concerns China. The Chinese economy has struggled of late, with trade tensions adding to the misery (Chart 7). The stock market is down in the dumps. On-shore corporate yields for low-quality borrowers continue to rise. Industrial production, retail sales, and fixed asset investment all disappointed in July, following a further drop in the PMIs. The economic surprise index remains in negative territory. Only the housing market is showing renewed vigour, with both starts and sales rebounding (Chart 8). Chart 7China: Some Signs Of A Struggling Economy... Chart 8...With Housing Being The Main Exception The central bank has responded by easing liquidity. Interbank rates fell from a peak of 5.9% in late 2017 to 2.9% today. The authorities have also instructed local governments to expedite their spending plans, while ordering state-owned banks to expand lending to the export sector and for infrastructure-related projects. Fiscal/credit stimulus of the sort the authorities engaged in both 2009 and 2015 carries significant risks, however. Debt levels have reached stratospheric levels and concerns about excess capacity and malinvestment abound. We suspect these facts will cause policymakers to be more guarded than they would otherwise be. What's Next For The RMB? Letting the RMB weaken offers an alternative way to stimulate the economy - and one, crucially, that does not require piling on evermore debt. In contrast to more roads and bridges, a cheaper Chinese currency would not be welcome news for the rest of the world. A weaker RMB makes it more difficult for other economies to compete against China. A weaker currency also increases the costs to Chinese firms of importing raw materials, thus putting downward pressure on commodity prices. Despite efforts by emerging markets to diversify their economies, EM earnings remain highly correlated with industrial metals prices (Chart 9). Despite the presence of capital controls, the USD/CNY exchange rate has broadly tracked the one-year swap differential between the U.S. and China over the past few years (Chart 10). The differential has dropped from close to 300 basis points at the beginning of this year to less than 100 basis points today. Given that prospect of further Fed rate hikes, the only way the Chinese authorities will be able to keep the interest rate differential from falling even more is by tightening monetary policy themselves. This could slow credit growth and thus weaken the economy. The failure to raise rates, however, would probably cause the RMB to fall further. Both outcomes would be problematic for the rest of the world. Chart 9EM Earnings Are Correlated ##br##With Industrial Metal Prices Chart 10USD/CNY Tracks China-U.S. ##br##Interest Rate Differentials Our bet is that the authorities will ultimately choose to keep domestic monetary conditions fairly easy - leading to a weaker RMB - but will use administrative controls to prevent credit growth from accelerating too rapidly. That said, we would not rule out the possibility that the authorities succeed in stimulating the economy in a way that precludes further currency weakness. If this stimulus coincides with a thawing in trade tensions, it could lead to a burst in optimism about China specifically, and global growth in general. Such an outcome would hurt the dollar. The Euro Area: Keeping The Recovery On Track After putting in a strong performance in 2017, the economy in the euro area has struggled to maintain momentum this year. Growth is still above trend, but the overall tone of the data has been lackluster at best, with the risks to growth increasingly tilted to the downside. Weaker growth in China and other emerging markets certainly has not helped. However, much of the problem lies closer to home. The election of a populist government in Italy renewed concerns about debt sustainability in the euro area's third largest economy. The 10-year yield reached a four-year high of 3.2% this week. It is now 150 basis points above its April 2018 lows (Chart 11). The resulting tightening in Italian financial conditions will continue to weigh on growth in the months ahead. Bank credit remains the lifeblood of the euro area economy. Chart 12 shows that the 12-month credit impulse - defined as the change in credit growth from one 12-month period to the next - tends to move closely with GDP growth. Euro area credit began to moderate this year even before the Italian imbroglio and worries about the exposure of European banks to vulnerable emerging markets came on the scene. It will be difficult for euro area GDP growth to accelerate unless credit growth revives. In the absence of faster credit growth, the ECB will have little choice but to remain firmly in dovish mode. Chart 11Italian Populism Meets The Bond Market Chart 12Euro Area Credit Growth Has Flatlined The best-case scenario for the common currency is that EM stresses subside, and the Italian government reaches a friendly agreement with the European Commission over next year's budget. The thawing in Brexit negotiations would also help. We are skeptical that any of these three things will happen, but if one or a number of them did occur, this would benefit the euro at the expense of the dollar. Investment Conclusions We are not as bullish on the dollar as we were earlier this year. Sentiment towards the greenback has clearly improved (Chart 13). The narrative about a "synchronized global growth recovery" that was all the rage last year has also given way to a more sober appreciation of the problems facing emerging markets. In short, markets have moved a long way towards our view of the world. Still, we are not ready to abandon our strong dollar view. Chinese stimulus or not, the structural challenges facing emerging markets - high debt levels, poor productivity growth - will not go away. The same goes for Europe and its litany of political and economic travails. Even if the dollar did manage to weaken again, this would constitute an unwelcome easing in U.S. financial conditions at a time when the Fed wants to tighten financial conditions in order to keep the economy from overheating. From this perspective, a weaker dollar just means that the Fed would need to hike rates even more than it otherwise would. Since more rate hikes will buttress the dollar, the extent to which the dollar can weaken is self-limiting. In short, interest rate differentials between the U.S. and its trading partners should continue to favor the greenback. Assuming the dollar does strengthen from here, emerging markets will be the main casualties. While EM assets have cheapened considerably, Chart 14 shows that neither EM equities, credit, nor currencies are at levels that have marked past bottoms. Global investors should continue to favor developed market stocks over their EM peers. At the equity sector level, investors should overweight defensives over deep cyclicals. Regionally, this posture implies that U.S. stocks will outperform European stocks in dollar terms, although the performance is likely to be much more balanced in local-currency terms. Chart 13Investors Have Turned More Bullish On The Dollar Chart 14EM Assets Are Not Very Cheap As we recently discussed in a two-part Special Report,2 the longer-term path for Treasury yields is to the upside. Nevertheless, a broad-based appreciation in the value of the dollar, coupled with safe-haven flows into the Treasury market, could temporarily push the 10-year yield down to 2.5% over the next few months. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Jerome H. Powell, "Monetary Policy in a Changing Economy," Speech at "Changing Market Structure and Implications for Monetary Policy," a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 24, 2018. 2 Please see Global Investment Strategy Special Reports, "1970s-Style Inflation: Could It Happen Again? (Part 1)," dated August 10, 2018; "1970s-Style Inflation: Could It Happen Again? (Part 2)," dated August 24, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The global 6-month credit impulse is likely to turn up in the fourth quarter. This warrants profit-taking in some pro-defensive equity sector, regional, and country allocation... ...for example, in the 35 percent outperformance of European healthcare versus banks in just seven months. But do not become aggressively pro-cyclical until the 10-year yield on the Italian BTP (now at 3.2) moves closer to 3... ...and the sum of the 10-year yields on the U.S. T-bond, German bund and JGB (now at 3.4) also moves closer to 3. Chart Of The WeekThe Cycle Is About To Turn Feature One of the most common questions we get is, when will the cycle turn? And our response is always, which cycle? The cycle that most people focus on is the so-called business cycle, which describes multi-year economic expansions punctuated by recessions. However, the business cycle - to the extent that it is a cycle - is very irregular. Its upswings and downswings vary greatly in length (Chart I-2). This irregularity is one reason why economists are useless at calling the turns. Nevertheless, investors still obsess with calling the business cycle because they think this is the only cycle that drives the financial markets. Chart I-2The Business Cycle Is Very Irregular We disagree. Nature bestows us with a multitude of cycles with different periodicities: the daily tides, the monthly phases of the moon, the annual seasons, and the multi-year climate cycles. So it would be unnatural, and somewhat arrogant, to assume the economy and financial markets possess only one cycle. In fact, just as in nature, the economy and financial markets experience a multitude of cycles with different periodicities. There Is Not One Cycle In The Economy, There Are Many If you plotted yearly changes in temperature, you would get a flat line and you would think there were no seasons! The point being that you cannot see a yearly cycle if you look at yearly changes. To see the cyclicality of the seasons, you must plot 6-month changes in temperature. Likewise, you cannot see the shorter-term cycles in the economy and financial markets using analysis, such as yearly changes, designed to see longer-term cycles. Once you grasp this basic maths, the mini-cycles in the economy and financial markets will stare you in the face (Chart I-3), and a whole new world of investment opportunities will open up. Chart I-3The Mini-Cycle Is Very Regular As we advised on January 4: "Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging eight months. As the current mini-upswing started in May 2017 we can infer that it is likely to end at some point in early 2018. So one surprise could be that global growth will lose steam in the first half of 2018 rather than in the second half, contrary to what the consensus is expecting... Pare back exposure to cyclicals and redeploy to defensives" The advice proved to be very prescient. The global economy did enter a mini-downswing sourced in the emerging markets (Charts I-4 - I-6). Chart I-4The U.S. Mini-Downswing Was Muted... Chart I-5...The Euro Area Mini-Downswing Was Also Muted... Chart I-6...But The China Mini-Downswing Was Severe Nevertheless, the global nature of financial markets meant that the German 10-year bund yield declined by 40 bps, while European healthcare equities outperformed banks by a mouth-watering 35 percent, and materials by 15 percent (Chart I-7 and Chart I-8). Some of these performances are as large as can be gained in a full business cycle begging the question: Why obsess with the impossible-to-predict business cycle when there are equally rich pickings in the easier-to-predict mini-cycle? Chart I-7Banks Vs. Healthcare Tracks The Mini-Cycle Chart I-8Materials Vs. Healthcare Tracks The Mini-Cycle Furthermore, if you get the equity sector calls right, you will get the equity regional and country calls right too. As cyclicals have underperformed, the less cyclically-exposed S&P500 has been the star performer of the major regional indexes. And cyclical-heavy stock markets like Italy's MIB have strongly underperformed defensive-heavy stock markets like Denmark's OMX (Chart I-9). Chart I-9Italy Vs. Denmark = Banks Vs. Healthcare It follows that the evolution of the global economic mini-cycle is pivotal in every investment decision (Box 1). BOX 1 The Theory Of Economic And Market Mini-Cycles The academic foundation of the global economic mini-cycles is a model called the Cobweb Theorem.1 When bond yields rise, interest rate sensitive sectors in the economy feel a headwind, but with a lag. Similarly, when bond yields decline, interest rate sensitive sectors feel a tailwind, but again with a lag. The lag occurs because credit demand leads credit supply by several months. As credit demand leads credit supply, the turning point in the price of credit (the bond yield) always leads the quantity of credit supplied (the credit impulse). The result is a perpetual mini-cycle oscillation in both economic variables. And because the quantity of credit supplied is a marginal driver of economic activity, this also creates mini-cycles in economic activity. These mini-cycles are remarkably regular with half-cycle lengths averaging around eight months and the regularity creates predictability. Moreover, as most investors are unaware of this predictability, the next turning point is not discounted in financial market prices - providing a compelling investment opportunity for those who do recognise the existence and predictability of these cycles. The Mini-Cycle Will Soon Turn Up The global 6-month credit impulse entered its current mini-downswing in January. Given that mini-downswings tend to last around eight months, we should expect the global economy to exit its mini-downswing in September, the escape valve being the recent decline in bond yields (Chart Of The Week). The caveat is that bond yields were slow to react to the mini-downswing and the decline in 10-year yields, averaging around 40 bps from the peak, has been pretty shallow. It follows that the next mini-upswing could be delayed to October/November, and be somewhat muted. Nevertheless, the surprise could be that global growth will stabilise in the fourth quarter of 2018, contrary to what the consensus is expecting. And this would suggest taking some of the most mouth-watering profits in pro-defensive equity sector, regional, and country allocation - for example, in the 35 percent outperformance of European healthcare versus banks (Chart I-10). Chart I-10Banks Have Severely Underperformed Healthcare Would we go a step further and become pro-cyclical? Not yet. One reason is that there is a limit to how far bond yields can rise before destabilising the very rich valuations of all risk-assets. This is captured in our 'rule of 4' which says that when the sum of the 10-year yields on the U.S. T-bond, German bund, and Japanese government bond (JGB) exceeds 4 - which broadly equates to the global 10-year yield exceeding 2 percent - it is time to go underweight equities. With the sum now equal to 3.4, yields can rise by only 25-30 bps before hurting risk-assets. Another reason for circumspection is that the investment landscape is still scattered with a large number of landmines, one of which has its own rule of 4. The Other 'Rule Of 4': The Italian 10-Year Bond Yield When Italian bond prices decline, it erodes the value of Italian banks' €350 billion portfolio of BTPs and weakens the banks' balance sheets. Investors start to get nervous about a bank's solvency when equity capital no longer covers net non-performing loans (NPLs). On this basis, the largest Italian banks now have €160 billion of equity capital against €130 billion of net NPLs, implying excess capital of €30 billion (Chart I-11). It follows that the markets would start to worry about Italian banks' mark-to-market solvency if their bond valuations sustained a drop of around a tenth from the recent peak. We estimate this equates to the 10-year BTP yield breaching and remaining above 4 percent (Chart I-12).2 Chart I-11Italian Banks' Equity Capital Exceeds Net NPLs By 30 Bn Euro Chart I-12Italian Banks' Solvency Would Be In Question If The 10-Year Yield Breached 4% Today the 10-year BTP yield stands just shy of 3.2 percent, but it is about to enter a testing period. The Italian government must agree its 2019 budget by September and present a draft to the European Commission by mid-October. The budget must tread a fine line. Cutting the structural deficit to appease the Commission would diminish the credibility of the populist government. It would also be terrible economics, making it harder for Italy to escape its decade-long stagnation.3 On the other hand, locking horns with Brussels and aggressively increasing the structural deficit might panic the bond market. The optimal outcome would be to leave the structural deficit broadly where it is now. To sum up, the global 6-month credit impulse is likely to turn up in the fourth quarter, warranting some profit-taking in pro-defensive positions. But we do not advise aggressive pro-cyclical sector, regional, and country allocation until the 10-year yield on the Italian BTP (now at 3.2) - and the sum of the 10-year yields on the U.S. T-bond, German bund and JGB (now at 3.4) - both move closer to 3. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11 2018 and available at eis.bcaresearch.com. 2 Assuming that the average maturity of Italian banks' BTPs is around 5 years. 3 Please see the European Investment Strategy Special Report 'Monetarists Vs Keynesians: The 21st Century Battle' July 12 2018 available at eis.bcaresearch.com. Fractal trading Model* In support of the preceding fundamental analysis, the outperformance of healthcare versus banks is technically extended. Its 130-day fractal dimension is at the lower bound which has reliably signalled previous trend exhaustions. On this basis we would position for a 10% reversal with a symmetrical stop-loss. In other trades, long PLN/USD reached the end of its 65-day holding period comfortably in profit, and is now closed. This leaves six open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-13 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Lesson 1: Inflation is a non-linear phenomenon. Lesson 2: Beware government interference in monetary policy. Lesson 3: An emerging markets shock is deflationary for developed markets. Lesson 4: The 'Rule of 4' for equities and bonds. Feature We took a much needed holiday last week, hoping that financial markets would enter a midsummer slumber. Our hopes were dashed. The timing of the Turkish lira crisis reminded us of the old adage: time, tide - and financial markets - wait for no man. But on reflection, our summer holiday gave us the time for some, well... reflection: a precious quality in a world that is rapidly neglecting the value of reasoned analysis. The addiction to minute-by-minute commentary and knee-jerk reaction - epitomised by the Twitterati - means that we are 'thinking fast', when we should be 'thinking slow'. So here, after some reflection, are four long-term lessons from the Turkish lira crisis. Lesson 1: Inflation Is A Non-Linear Phenomenon. Turkey's recent experience clearly demonstrates that inflation is non-linear - meaning that inflation doesn't move in a gradual or controlled fashion. Non-linear phenomena experience sudden and explosive phase-shifts (Chart I-2). In Turkey's case, a major cause of its currency crisis was that inflation recently phase-shifted out of a well-established channel to its current 16 percent rate (Chart of the Week). Chart of the WeekTurkish Inflation Experienced A Non-Linearity Chart I-2Inflation Can Experience A Phase-Shift People struggle with the concept of non-linearity because the vast majority of our day to day experiences are linear, meaning the output is proportionate to the input. The speed of our car depends linearly on the pressure on the accelerator pedal; the temperature in our home depends linearly on the thermostat setting; the volume of music in our headphones depends linearly on the volume setting; and so on. Likewise, the vast majority of economic models - including the infamous DSGE inflation models used by central banks - assume linear relationships.1 But some phenomena are non-linear. An example you might relate to is trying to get a small amount of tomato ketchup out of crusted-over squeezy bottle. It is impossible. You squeeze and no ketchup comes out; you squeeze harder and still nothing comes out; and then suddenly you get the explosive phase-shift: the entire bottle empties on your plate! Inflation also experiences violent phase-shifts. The main reason is that people cannot perceive small changes in inflation, making inflation expectations very sticky, which is to say non-linear. The Turkish people might not perceive inflation rising from 8 percent to 10 percent, but they would certainly perceive it rising to 16 percent. Hence, as policymakers squeeze the ketchup bottle, nothing happens at first. But at a tipping point, the self-reinforcement of inflation expectations becomes explosive. Whereupon, the whole bottle comes out. The broad money supply, M, gaps up because it becomes rational for banks to lend as much as possible. And its velocity, V, also gaps up because it becomes rational to spend the money - both newly created and pre-existing balances - as quickly as possible (Chart I-3-Chart I-6). So the product MV, which equals nominal GDP, experiences an even sharper non-linearity. Chart I-3The Velocity Of Money... Chart I-4...Is A Non-Linear Phenomenon Chart I-5The Money Multiplier... Chart I-6...Is A Non-Linear Phenomenon This begs the question: when should we worry about a sudden phase-shift in developed market inflation rates? The answer comes from Lesson 2. Lesson 2: Beware Government Interference In Monetary Policy. An economy's broad money supply, M, is dominated by loans. So to expand the broad money supply, somebody has to borrow money. This means that the danger of an inflation phase-shift rises sharply if the government can borrow and spend money at will, with the central bank creating it.2 Over the past few centuries, the British government - by periodically leaving the gold standard - did exactly this to pay for the Napoleonic Wars, the Crimean War and the First World War (Chart I-7). Chart I-7The British Government Created Inflation To Pay For Wars Which answers the question of when to worry. The government has to get into cahoots with the central bank. In other words, the central bank loses its independence and fiscal policy has the scope to become ultra-loose. This describes the situation in Turkey, where President Erdogan has forced the central bank to suppress interest rates, while putting his son-in-law in charge of the Turkish treasury. Could something similar happen in developed economies? President Trump's fiscal stimulus combined with his recent attempt to influence Federal Reserve policy (to more dovish) is a small step in this direction. Nevertheless, the major developed market central banks are on a hawkish path. They are squeezing less on the ketchup bottle. Therefore, the real risk of a phase-shift in developed market inflation will arise not before the next global downturn, but after it - when desperate policymakers might resort to desperate measures. In the near term, we expect developed market inflation to remain contained, and one supporting reason comes from Lesson 3. Lesson 3: An Emerging Markets Shock Is Deflationary For Developed Markets. The slowdown and recent shock in emerging markets has caused the dollar and yen to surge. Even the euro - on a broad trade-weighted basis - has held up very well through the Turkish lira crisis and is up 2 percent in 2018 (Chart I-8). Chart I-8An EM Shock Boosts DM Currencies... Meanwhile, since May, industrial metal prices have plunged 20 percent (Chart I-9) and even the crude oil price is down by 10 percent. Chart I-9...And Depresses Industrial Commodity Prices An emerging market shock also threatens the developed market banking system by impairing its foreign loans. Thereby, it risks stifling domestic credit creation. The combination of stronger currencies, lower commodity prices, and potentially weaker bank credit creation is a disinflationary headwind for developed markets in the near term. Lesson 4: The 'Rule of 4' For Equities And Bonds. If developed market inflation remains contained in the near term, it should also keep a lid on bond yields. This is significant because our non-consensus call is that the main threat to developed market risk-assets comes not from trade wars and/or a global economic slowdown; it comes from rich valuations which will become dangerously unstable if bond yields march much higher. The bond yield that matters is the global long bond yield. Effectively, this is the weighted average of its three main components: the 10-year yields on the U.S. T-bond, the German bund and the Japanese government bond (JGB). But for a useful rule of thumb, just sum the three yields. A sum above 4 - which broadly equates to the global 10-year yield rising above 2 percent - means it is time to go underweight equities. A sum between 3.5 and 4 means a neutral stance to equities. A sum well below 3.5 means an overweight stance to equities - because it would justify even richer valuations. Investment Recommendations Asset allocation: Our 'rule of 4' sum now stands at 3.3, indicating a close to neutral stance to equities. For bonds, we have since May recommended an overweight position in a portfolio of high-quality government 30-year bonds. The recommendation is performing well, and it is appropriate to stick with it for the time being. Sector allocation: Stay overweight the classical defensives versus the classical cyclicals: materials, industrials and banks. This recommendation has fared spectacularly well. Healthcare has outperformed banks by 20 percent since February, so the pressing question is: when to take profits? We anticipate at some point in the fourth quarter. Within the cyclical sectors, prefer banks over oil and gas. Regional and country equity allocation: the geographical allocation of equities follows directly from the sector allocation. Our preferred ranking of sectors necessarily means that our preferred ranking of major equity markets is: S&P500 first, Eurostoxx50 and Nikkei225 second (tied), FTSE100 third. Again, this recommendation has performed extremely well. Currency allocation: Since February, our main currency recommendations have been short EUR/JPY, long EUR/USD, and long EUR/CNY. In effect the recommendations reduce to: long JPY/USD and long EUR/CNY, and this combination has proved to be an excellent 'all-weather' position (Chart I-10). Stick with it for the time being. Chart I-10Long JPY/USD And EUR/CNY Has Been##br## A Good 'All-Weather Combination' Finally, our long-standing short Turkish lira versus South African rand position has returned a mouth-watering 73 percent in four years.3 It is time to close the short Turkish lira position and bank the profits. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Dynamic Stochastic General Equilibrium models. 2 For example, by giving all public sector workers a 50% pay rise! 3 After the cost of carry, based on interest rate differentials. Fractal Trading Model* Market reaction to the Turkish lira crisis caused our two most recent trades to hit their stop-losses, but it has also created new opportunities. The aggressive sell-off in industrial commodities appears technically extended. So this week's recommended trade is an intra-cyclical equity sector pair-trade: long global basic resources, short global chemicals. The profit target is 3.5% with a symmetric stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Dear Client, We had intended to send you the second part of our two-part special report on long-term inflation risks this week, but given the sharp moves in the dollar and emerging market assets, we decided to write this bulletin instead. Barring any further major market turbulence, we will send you the sequel to the inflation report next week. Best regards, Peter Berezin, Chief Global Strategist Highlights The dollar rally and EM selloff have further to go. The U.S. economy is firing on all cylinders, while the rest of the world is sputtering. Turkey is not an isolated case. Emerging markets as a whole have feasted on debt over the past decade, and now will be held to account. We remain neutral on global equities, while underweighting EM relative to DM and overweighting defensives relative to deep cyclicals. Brewing EM stresses could cause the 10-year Treasury yield to temporarily fall to 2.5%, leading to a further flattening of the yield curve. However, the long-term path for yields is up. Feature King Dollar Reigns Supreme Our expectation going into this year was that the dollar would strengthen, triggering turmoil in emerging markets. This thesis has panned out, raising the question of whether it is time to declare victory and move on. We don't think so. While market positioning has clearly shifted closer towards our own views, we still think that the stronger dollar/weaker EM story has further to run. To understand why, it is useful to review the reasoning behind our thesis. Our bullish dollar view was based on a simple observation, which is that the U.S. had finally reached a point where aggregate demand was starting to outstrip supply. This implied that the dollar would need to strengthen in order to shift demand away from the United States. It is amazing how many commentators still think that the U.S. can divert spending towards imported goods without any change in the value of the dollar. Americans do not care what the CBO's or IMF's estimate of the domestic output gap is when they are deciding whether to buy U.S. or foreign-made goods. They care about relative quality-adjusted prices. Since the U.S. is a fairly closed economy - imports are only 15% of GDP - we reckoned that the dollar would need to strengthen considerably in order to displace a significant amount of domestic production with foreign-made goods. This is exactly what happened. Still More Upside For U.S. Rates Currency values tend to track interest rate differentials (Chart 1). As such, our prediction of a stronger dollar entailed the expectation that investors would increasingly price in a more hawkish path for the fed funds rate. This has indeed occurred. Since the start of the year, the expected fed funds rate has risen by 34 basis points for end-2018 and by 65 basis points for end-2019 (Chart 2). Chart 1Historically, The Dollar Has Moved In Line With Interest Rate Differentials Chart 2Rate Expectations Have Increased, ##br##But There Is Still A Long Way To Go Our sense is that U.S. interest rate expectations can rise further. Faster wage growth will boost consumption. The household savings rate can also fall from its current elevated level, which will give consumer spending an additional boost (Chart 3). Business investment should remain firm. Chart 4 shows that capex intentions are strong, while bank lending standards for commercial and industrial loans, which tend to lead loan growth, continue to ease. Fiscal stimulus will also goose the economy. Chart 3Consumption Could Accelerate As The Savings Rate Drops Chart 4U.S. Capex Investment Going Strong Could interest rate expectations move up more in the rest of the world than in the U.S., causing the dollar to tumble? It is possible, but unlikely. In contrast to most other central banks, the Fed wants to tighten financial conditions in order to keep the economy from overheating. A weaker dollar would entail an easing of financial conditions, and hence would require an even more hawkish response from the Fed. Currency Intervention Is Unlikely To Succeed Some have speculated that the Trump administration will intervene in the foreign exchange market in order to drive down the value of the dollar. We doubt this will happen, but even if such interventions were to take place, they would not be successful. Presumably, currency interventions would take the form of purchases of foreign exchange, financed through the issuance of Treasurys. The purchase of foreign currency would release U.S. dollars into the financial system, but the sale of Treasury securities would suck out those dollars from the financial system. The net result would be no change in the volume of U.S. dollars in circulation - what economists call a "sterilized" intervention. Both economic theory and years of history show that sterilized interventions do not have lasting effects on currency values. The Fed could, of course, provide funding for the Treasury's purchases of foreign exchange, leading to an increase in the monetary base. This would be tantamount to an unsterilized intervention. However, such a deliberate attempt to weaken the dollar by expanding the money supply would fly in the face of the Fed's efforts to cool growth by tightening financial conditions. We highly doubt the Fed's current leadership would go along with this. Emerging Markets In The Crosshairs This brings us to emerging markets. EM equities almost always fall when U.S. financial conditions are tightening (Chart 5). One can believe that emerging market stocks will go up; one can also believe, as we do, that the Fed will do its job and tighten financial conditions. But one cannot believe that both of these things will happen at the same time. Some pundits think that the plunge in the Turkish lira is not emblematic of the problems facing emerging markets. We are skeptical of this sanguine conclusion. Chart 6 shows that as a share of both GDP and exports, EM dollar-denominated debt is now as high as it was in the late 1990s. Turkey may be the worst of the lot, but it is hardly an isolated case. Chart 5Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Chart 6EM Dollar Debt Is High Chart 7 presents a vulnerability heat map for a number of key emerging markets.1 We consider fourteen variables (expressed as a share of GDP, unless otherwise noted): 1) Current account balance; 2) Net international investment position; 3) External debt; 4) Change in external debt during the past five years; 5) External debt-servicing obligations coming due over the next 12 months as a share of exports; 6) External funding requirements over the next 12 months as a share of foreign exchange reserves; 7) Private sector savings-investment balance; 8) Private-sector debt; 9) Change in private-sector debt over the past five years; 10) Government budget balance; 11) Government debt; 12) Change in government debt over the past five years; 13) Share of domestic debt held by overseas investors; and 14) Inflation. Our analysis suggests that Turkey, Argentina, Colombia, Brazil, Mexico, Chile, South Africa, and Indonesia are all vulnerable to balance of payments stresses. Chart 7Vulnerability Heat Map For Key EM Markets Of course, asset markets in some of these economies have already moved quite a bit over the past few months, so it is useful to benchmark their stock markets and currencies to the underlying macro risks they face. For stock markets, we do this by comparing the heat map score with a composite valuation measure that incorporates price-to-book, price-to-sales, price-to-forward earnings, price-to-cash flow, and the dividend yield. Our analysis suggests that stocks in Russia and Korea are rather cheap, while equities in Indonesia, Mexico, South Africa, and Argentina are still quite expensive (Chart 8, top panel). Chart 8Some EM Stock Markets And Currencies Have Not Fully Priced In Macro Risks For currencies, we compare the heat map score with the level of the real effective exchange rate relative to its ten-year average. The Mexican peso, Brazilian real, Chilean peso, Indonesian rupiah, and South African rand still look pricey on this basis (Chart 8, bottom panel). In contrast, the Turkish lira and the Argentine peso are starting to look fairly cheap, although they could still get quite a bit cheaper before finding a floor. The China Wildcard The last time emerging markets seemed at risk of melting down was in 2015. Fortunately for them, China came to the rescue, delivering a massive double dose of fiscal and credit easing. Things may not be so straightforward this time around. China does not want to let its economy falter, but high debt levels and an overvalued housing market have made the usual policy prescriptions less appealing. As such, we would not necessarily conclude that the recent decline in the Chinese three-month interbank rate is a signal that the authorities want to see much faster credit growth (Chart 9). They may simply want to see a weaker currency. This is an important distinction because while faster credit growth would boost demand for EM exports, a weaker yuan would hurt other emerging markets by giving China a leg up in competitiveness. A weaker yuan would also make it more expensive for Chinese companies to import natural resources, thus putting downward pressure on commodity prices. It is too soon to know what policy mix the Chinese authorities will choose to pursue. Investors should pay close attention to the monthly data on the growth rates of social financing and local government bond issuance. So far, the combined credit and fiscal impulse has continued to weaken, suggesting that the authorities are in no hurry to open the stimulus floodgate (Chart 10). Chart 9Is China Trying To Stimulate Credit ##br##Growth Or Weaken The Yuan? Chart 10China Has Been Slow To Open The Credit And Fiscal Spigots Worries About The Euro Area Slower EM growth is likely to take a bigger toll on the euro area than the United States. Exports to emerging markets account for only 3.6% of GDP for the U.S., compared to 9.7% of GDP for the euro area. Euro area banks also have more exposure to emerging markets than U.S. banks. Notably, Spanish banks have sizeable exposure to Turkey and other vulnerable emerging markets (Chart 11). Meanwhile, worries about Italy have resurfaced. The 10-year Italian bond yield has moved back above 3%, not far from its May highs. The gap in fiscal policy between what Italy's new populist government has promised voters and what the European Commission is willing to accept remains a mile wide. Italian banks have become increasingly wary of financing their spendthrift government. With the ECB stepping back from asset purchases, two critical buyers of Italian debt are moving to the sidelines. The credit impulse in the euro area turned negative even before concerns about emerging markets and Italian politics came to the fore. As Chart 12 shows, the credit impulse has reliably tracked euro area growth. Right now, there is little reason to think that European banks will open the credit spigots, suggesting that euro area growth will be lackluster. Chart 11Who Has More Exposure To EM? Chart 12Euro Area Credit Impulse Suggests Growth Will Remain Lackluster Investment Conclusions If last year was the year of global growth resynchronization, this year is turning into one of desynchronization. The U.S. economy is outperforming the rest of the world, and the dollar is benefiting in the process. As we go to press, the broad trade-weighted dollar is up 6.1% year-to-date and stands only 2.2% below its December 28, 2016 high (Chart 13). From a long-term perspective, the greenback has become expensive, so we are inclined to close our strategic long DXY trade for a potential carry-adjusted profit of 15.7% if it reaches our target of 98 (as of the time of writing, the DXY is at 96.5). However, even if we were to close this trade, our tactical bias would be to remain long the dollar until clearer evidence emerges that the brewing EM crisis is about to abate. We moved from overweight to neutral on global equities on June 19. The MSCI All-Country World index has fluctuated a lot since then, but is currently up only 0.7% in dollar terms. Developed markets have gained 1.4%, while emerging markets have lost 3.8% (Chart 14). We have yet to reach a capitulation point for EM equities. The number of shares in the iShares MSCI Turkey ETF has almost doubled since August 3rd, as a stampede of bottom fishers have plowed into the fund (Chart 15). Equity investors should maintain our recommendation to underweight emerging markets relative to DM and to favor defensive sectors over deep cyclicals. We expect euro area stocks to perform in line with their U.S. peers in local-currency terms, but to underperform in dollar terms over the remainder of the year. Chart 13The Dollar Is Back Near Its Highs Chart 14Stock Market Performance: Roller Coaster Ride Chart 15Foreign Investors And Turkish Stocks: ##br##Trying To Catch A Falling Knife In the fixed-income realm, the long-term trend in global bond yields remains to the upside, but near-term EM stresses could cause the 10-year Treasury yield to temporarily fall back towards 2.5%. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 We collaborated with our colleague Mathieu Savary and his team at BCA’s Foreign Exchange Strategy to build this heat map. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights It has not been a lot of fun being a corporate bond investor in 2018. Global credit markets have struggled to deliver positive returns, amid a news flow that has been overwhelming at times. Geopolitical uncertainty, shifting monetary policy biases, greater inflation pressures, intensifying trade tensions, a rising U.S. dollar, slowing Chinese growth - all have combined to form a backdrop where investors should require wider risk premiums to own risky assets like corporate debt. Yet are wider spreads justified relative to the underlying financial health of companies? Feature Chart 1Global Corporates: Fading Support From##BR##Growth & Monetary Policy Against this backdrop of more uncertainty in credit markets, we are presenting our latest update of the BCA Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) that are designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 16. The broad conclusion from the latest readings on our CHMs is that global credit quality has been enjoying a cyclical improvement across countries, regions and credit tiers. The U.S. has delivered the biggest improvement in corporate health, compared to the recent past and to bearish investor perceptions as well. Much of that can be attributed to the impact of the Trump corporate tax cuts, though. At the same time, there have even been significant improvements in profitability metrics in regions that have lagged during the current global economic expansion, like Peripheral Europe. We recently downgraded our overall global spread product allocation to neutral.1 This reflected the increased concerns of the BCA Strategists that valuations on global risk assets looked rich compared to growing geopolitical risks (U.S.-China trade tensions, U.S.-Iran military tensions). Yet it also was related to the ongoing development of our biggest investment theme for 2018 - the eventual likely collision between tightening global monetary policy and rich valuations on global risk assets. Looking ahead, the tailwinds that have been supportive for corporate health and the performance of global corporate debt in the past couple of years - a coordinated cyclical upturn driving solid earnings growth, with low inflation allowing monetary policies to stay accommodative - are becoming headwinds (Chart 1). The overall OECD leading economic indicator, which is well correlated to the annual excess returns of global high-yield debt, has peaked. Central banks are either delivering rate hikes, talking about rate hikes, or cutting back on the pace of balance sheet expansion. All of these factors will weigh on corporate bond returns over the next 6-12 months. U.S. Corporate Health Monitors: Improving Thanks To Resilient Growth & Tax Cuts Chart 2Top-Down U.S. CHM:##BR##Boosted By Cyclically Strong Profits Our top-down CHM for the U.S. has been in the "deteriorating health" region for fifteen consecutive quarters dating back to the middle of 2014 (Chart 2). That streak appears set to end soon, as the indicator has been falling since peaking in 2016 and now sits just above the zero line. The resilience of the U.S. economy, combined with the positive impact on U.S. profitability from the Trump corporate cuts, has put U.S. companies in a cyclically healthier position, even with relatively high leverage. It is important to note that the top-down CHM uses after-tax earnings measures in several of the ratios the go into the indicator: return on capital, profit margin and debt coverage. All three of those ratios saw significant upticks in the first quarter of 2018, which is the latest available data for the top-down CHM. The Trump tax cuts did take effect at the start of the year, but given the robust results seen in reported second quarter profits reported so far, a bigger impact will likely be visible once we are able to update the CHM for the most recently completed quarter. The ability for U.S. companies to continue expanding margins will be tested in the next 6-12 months. The tight U.S. labor market is pushing up wage growth, which will pressure margins and prompt some firms to try and raise prices to compensate. Firming U.S. inflation is already keeping the Fed on a 25bps-per-quarter pace of rate hikes, and perhaps more if U.S. inflation continues to accelerate without any slowing of U.S. economic growth. If the Fed starts actively targeting a slower pace of U.S. growth to cool off inflation, credit markets will take notice and U.S. corporate debt will underperform. From a fundamental perspective, the top-down U.S. CHM suggests that the U.S. credit cycle is being extended by the stubborn endurance of the U.S. business cycle. There are no imminent domestic pressures on U.S. corporate finances that should require wider credit spreads to compensate for rising default risk. The bottom-up versions of the U.S. CHMs for investment grade (IG) corporates (Chart 3) and high-yield (HY) companies (Chart 4) have also both improved, with the HY indicator now crossing over the zero line into "improving health" territory. This confirms that the signal from our top-down CHM is being reflected in both higher-rated and lower quality companies. Yet the longer-term issues of high leverage and low interest/debt coverage are not going away, suggesting that potential problems are being stored up for the next U.S. economic downturn. What also remains worrying is the fact that IG interest coverage has fallen in recent years, despite high profit margins and historically low corporate borrowing rates. This indicates that the stock of U.S. corporate debt is now so large that the interest expense required to service that debt is eating up a greater share of corporate earnings, even at a time when profit growth is still quite strong. This will raise downgrade risk if corporate borrowing rates were to rise significantly or if U.S. earnings growth slows sharply. We moved our recommended stance on U.S. IG and HY to neutral at the end of June as part of our downgrade of overall global spread product exposure. We may consider a move back to overweight (versus U.S. Treasuries) on any meaningful spread widening given our optimistic view on U.S. economic growth and the positive measure on credit risk signaled by our CHMs. Yet it may be difficult to get such an opportunity. The U.S. is reaching a more challenging point in the monetary policy cycle with the Fed likely to shift to a restrictive stance within the next 6-12 months. At the same time, there are risks to the U.S. economy stemming from the widening U.S.-China trade conflict, a stronger U.S. dollar and, potentially, the growing turmoil in emerging markets. Yet the state of U.S. corporate health has improved substantially, leaving companies less immediately vulnerable to any of those shocks. Given this balance of risks, a neutral stance on U.S. corporates remains appropriate (Chart 5). Chart 3Bottom-Up U.S. Investment Grade CHM:##BR##Stable, But Watch Profit Margins Chart 4Bottom-Up U.S. High-Yield CHM:##BR##Cyclical Improvement Chart 5U.S. Corporates:##BR##Stay Neutral IG & HY Euro Corporate Health Monitors: Strong Economy, Big Improvements Our top-down euro area CHM remains in "improving health" territory, as has been the case for the past decade (Chart 6). The indicator had been worsening towards the zero line during 2016-17, but rebounded in the first quarter of 2018 thanks to a pickup in profit margins and debt coverage. Those positive developments are even more impressive since they occurred during a quarter when there was some cooling from the robust pace of economic growth seen in 2017. Chart 6Top-Down Euro Area CHM: Modestly Improving Interest coverage and liquidity remain in structural uptrends, supported by the super-easy monetary policies of the European Central Bank (ECB) that have lowered corporate borrowing costs (negative short-term interest rates, liquidity programs designed to prompt low-cost bank lending, and asset purchase programs that include buying of corporate bonds). Our bottom-up versions of the CHMs for euro area IG (Chart 7) and HY (Chart 8), which are based on individual company earnings data, both confirm the positive message from the top-down CHM. For IG, a noticeable gap has opened up between domestic and foreign issuers in the euro area corporate bond market. Return on capital, operating margins, interest coverage and debt coverage all ticked higher in the first quarter of this year, while leverage slightly declined. Those developments were not repeated among the foreign issuers in our sample. Within the Euro Area, our bottom-up CHMs show that the gap has closed between IG issuers from the core countries versus the periphery, but both remain in the "improving health" zone. (Chart 9). Somewhat surprisingly, the only ratios where there is a material difference are leverage (150% and falling in the periphery, 100% and stable in the core countries) and interest coverage (rising sharply toward 5x in the periphery, stable just above 6x in the core). Despite the improvement in the CHMs, credit spreads for euro area IG and HY have both widened over the course of 2018, while excess returns have been negative year-to-date (Chart 10). Looking ahead, we see the biggest threat for euro area corporate bond performance to come from a shift in ECB policy. We expect the ECB to follow through on its commitment to fully taper net new government bond purchases by the end of 2018, while continuing to reinvest the proceeds of maturing debt in 2019 and beyond. It is less clear what the ECB will do with its corporate bond buying program, and there has been some speculation that the ECB could leave its corporate program untouched while tapering the government purchases. We doubt that the ECB would want to make such a distinction that would artificially suppress corporate borrowing costs relative to government yields. The ECB is more likely to end both programs concurrently at the end of the year, which will remove a major prop under the euro area corporate bond market. This is a main reason why we are currently recommending an underweight stance on euro area corporates versus U.S. corporates. Chart 7Bottom-Up Euro Area Investment Grade CHMs: Domestic Issuers Looking Better Chart 8Bottom-Up Euro Area High-Yield CHMs: Falling Leverage, Mediocre Profitability Chart 9Bottom-Up Euro Area IG CHMs: Periphery Improving vs Core Yet the bigger reason why we prefer corporates from the U.S. over the euro area is that the relative improvement in corporate health has been bigger in the U.S. The gap between our top-down CHMs for the U.S. and Europe has proven to be an excellent directional indicator for the relative performance of U.S. credit vs Europe (Chart 11). That CHM gap continues to favor U.S. credit, which has been outperforming over the past several months (on a common currency basis compared to euro area debt hedged in USD). Chart 10Euro Area Corporates:##BR##Stay Underweight IG & HY Chart 11Relative Top-Down CHMs:##BR##Continue To Favor U.S. over Europe U.K. Corporate Health Monitor: Deteriorating Amid Rising Domestic Risks The U.K. CHM saw a significant deterioration in the first quarter of 2018, thanks largely to slowing U.K. growth that has impacted all the profit-focused ratios (Chart 12). The CHM is still in the "improving health" zone, but just barely. Seeing the return on capital, profit margin, interest coverage and debt coverage ratios all roll over at historically low levels is a worrying sign for future U.K. credit quality. This is especially true given the extremely stimulative monetary policy run by the Bank of England (BoE) since the 2008 Global Financial Crisis. The only ratio in the U.K. CHM that has seen steady improvement over the past decade is short-term liquidity (bottom panel), which has been boosted by steady increases in working capital. The performance of U.K. credit has benefited from the BoE's additional monetary policy measures taken after the shock Brexit vote in 2016. This involved both interest rate cuts and asset purchases, which included buying of U.K. corporate bonds. The BoE has shifted its policy bias from easing to tightening over the past year, even with sluggish U.K. economic growth and still-unresolved uncertainty about the future U.K. trading relationship with the European Union. This has raised the risks that the BoE could commit a policy error through additional interest rate hikes over the next 6-12 months, especially if policymakers focus more on targeting higher real policy rates as we discussed in a recent Weekly Report.2 U.K. corporates have been a laggard among global credit markets throughout 2018 and especially so in the month of July during a generally positive month for global corporate debt (Chart 13). We see the underperformance continuing in the coming months, as wider spreads will be required given the uncertainties surrounding Brexit, economic growth and BoE monetary policy. Stay underweight U.K. corporate debt within an overall neutral allocation to global spread product. Chart 12U.K. Top-Down CHM: Cyclical Deterioration Chart 13U.K. Corporates: Stay Underweight Japan Corporate Health Monitor: No Problems Here We added Japan to our suite of global CHMs earlier this year.3 Although the Japanese corporate bond market is small (the Bloomberg Barclays Japan Corporates index only has a market capitalization of $116bn), the asset class does provide opportunities for investors to pick up a bit of yield versus zero-yielding Japanese government bonds (JGBs) Japanese corporate health has been excellent for the past decade, with the CHM steadily holding in "improving health" territory (Chart 14). The trends in the Japan CHM ratios since 2008 are quite different than those seen in the CHMs for other countries. Leverage has been steadily falling, return on capital has been steadily rising (and has now converged to the 6% level seen in other countries' CHMs), and the interest coverage multiple of 9.6x is by far the largest in our CHM universe. Default risk is non-existent in Japan. Only pre-tax operating margins for our bottom-up Japan CHM have lagged those in other countries, languishing at 6% for the past three years. Yet Japanese corporate profits are at all-time highs, a logical outcome when companies can borrow at less than 50bps and earn a return on capital of 6%. That wide gap should allow Japanese companies to continue to earn steady, strong profits even with wage inflation finally showing life in Japan alongside a 2.3% unemployment rate. Japanese corporate bond spreads have widened a bit in 2018, but remain far more stable compared to corporates in other developed markets (Chart 15). The lack of spread volatility has allowed Japanese corporates to steadily outperform JGBs since 2011, even as all Japanese bond yields have collapsed. That trend is likely to continue, as the Bank of Japan (BoJ) is still a long way from being able to credibly pull off any upward adjustment of the current 0% BoJ yield target on 10-year JGBs. Chart 14Japan Bottom-Up CHM: Still Healthy,##BR##But Has Cyclical Improvement Peaked? Chart 15Japan Corporates:##BR##Stay Overweight vs JGBs Importantly, the BoJ recently introduced new forward guidance that states there will be no interest rate hikes until at least 2020. This will positively affect Japanese corporate health by keeping borrowing costs extremely low and preventing any unwanted strength in the yen that could damage Japanese competitiveness. There is a risk that increasing global trade tensions could impact the export-heavy Japanese economy and damage corporate profit growth and corporate bond performance. We do not yet see that as a major risk that could derail the Japanese economy and we continue to recommend an overweight stance on Japanese corporate debt vs JGBs. Canada Corporate Health Monitor: Faster Growth Hiding Structural Warts We introduced both top-down and bottom-up CHMs for Canada in our previous CHM Chartbook in April. As was the case then, both CHMs are in "improving health" territory (Chart 16). These CHMs are typically correlated to the price of oil, as befits Canada's status as a major energy exporter. Yet the strong CHMs also reflect the solid pace of overall Canadian economic growth. Looking at the individual components of the Canada CHMs, the leverage ratios for both measures have been steadily rising and currently sit above 100%. The return on capital has been in a structural downtrend, as is the case for most countries in our CHM universe (excluding Japan), but has ticked up alongside faster economic growth over the past couple of years. There was a noticeable drop in the margin ratio for the bottom-up CHM, coming entirely from the HY firms within our sample group of companies. Interest coverage and debt coverage ratios remain depressed, even with some improvement in corporate profits. This is partially due to rising interest rates as the Bank of Canada (BoC) has been tightening monetary policy - a trend that we expect to continue over the next 6-12 months. Canadian corporate bond spreads have widened slightly since the start of 2018, but remain tight relative to a longer-term history (Chart 17). Excess returns over Canadian government bonds have flattened out after enjoying a very solid period of outperformance in 2016-17. Looking ahead, there are balanced risks to the outlook for Canadian corporate debt. Chart 16Canada CHMs: Cyclically Improving,##BR##But Longer-Term Problems Are Building Chart 17Canadian Corporates:##BR##Stay Neutral Vs Canadian Government Debt We continue to expect the BoC to hike rates because of solid growth and faster inflation in Canada. Yet we do not see the BoC moving rapidly to a restrictive monetary stance that would damage growth expectations and trigger some credit spread widening. At the same time, we also see risks stemming from Canada-U.S. trade disagreements that could hurt Canadian growth and cause investors to demand cheaper valuations for Canadian corporate bonds. Adding it all up, a neutral stance on Canadian corporates versus government debt remains appropriate, largely as a carry trade. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Top-down CHMs are now available for the U.S., euro area, the U.K. and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.4 The financial data of a broad set of individual U.S. and euro area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. Table 1Definitions Of Ratios That Go Into The CHMs With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Appendix Chart 1We Now Have CHM Coverage For 92% Of The Developed Market Corporate Bond Universe 1 Please see BCA Global Fixed Income Weekly Report, "Time To Take Some Chips Off The Table; Downgrade Global Corporate Bond Exposure To Neutral", dated June 26 2018, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "An R-Star Is Born", dated August 7th 2018, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Sticking With The Plan", dated March 13th 2018, available at gfis.bcaresearch.com. 4 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Without a true banking union it is impossible to have a true monetary union. The result is a fragmented monetary policy. A fragmented monetary policy with an inflexibly rigid fiscal policy is a recipe for economic and political polarization. Until the banking union is complete, policymakers must permit a more fragmented fiscal policy as a crucial economic counterbalance. Expect a multi-year narrowing in core euro area long bond yield spreads versus their counterparts in the U.K. and U.S. Extremely loose monetary policy is inappropriate for Germany and France and ineffective for Italy. If Italy's banking system does recover to full functionality, the best long-term investment play will be Italy's real estate market. The equity play is Covivio. Feature The European Monetary Union is a contradiction because European monetary policy is not united; it is fragmented. Granted, the euro area has one policy interest rate, and one currency. But monetary policy works principally through accelerations and decelerations in the broad money supply, whose main component is bank credit. It follows that when the banking system is fragmented, a genuine monetary union is elusive. Italy Is 'Yin', The Rest Of Europe Is 'Yang' Economist Richard Koo distinguishes two distinct phases of an economy, a 'yin' phase and a 'yang' phase, with the key difference being the financial health of the private sector including the all-important banking system. In a yang economy, the private sector and the banks are solvent and functional. In such an economy, the smaller and less intrusive the government, the better. Fiscal policy is ineffective because it crowds out private investment. But monetary policy is highly effective because a forward-looking private sector generates a demand for bank credit which will accelerate or decelerate according to the policy interest rate. In a yin economy, the opposite is true. The private sector and/or the banks are insolvent and dysfunctional. In such an economy, monetary policy is ineffective. No amount of depressing interest rates, central bank liquidity injections, or bond buying is able to stimulate bank lending. This is because impaired balance sheets prevent the private sector from borrowing and/or the banks from lending. But in a yin economy, fiscal policy is highly effective. Because the private sector is single-mindedly paying down debt, the government can borrow and spend these private sector debt repayments and excess savings with no danger of crowding out. Indeed in a yin economy, if the government consistently applies an appropriately sized fiscal stimulus, the economy can continue to grow at a healthy pace. Chart I-1-Chart I-6 should make it crystal clear that while Germany and France have a yang economy, Italy has a yin economy. Chart I-1Italy Has A 'Yin' Economy: ##br##Monetary Policy Is Not Effective... Chart I-2...But Fiscal Policy##br## Is Effective Chart I-3France Has A 'Yang' Economy: ##br##Monetary Policy Is Effective... Chart I-4...But Fiscal Policy##br## Is Not Effective Chart I-5Germany Has A 'Yang' Economy:##br## Monetary Policy Is Effective... Chart I-6...But Fiscal Policy ##br##Is Not Effective A Monetary Union Needs A Banking Union In Germany and France, bank credit has surged in response to the ECB's ultra-accommodative monetary policy. But in Italy, bank credit growth is almost non-existent. Through the past ten years, no amount of depressing interest rates, central bank liquidity injections, or bond buying has been able to stimulate Italy's money supply (Chart I-7 and Chart I-8). Chart I-7Italian Banks Are ##br##Not Lending... Chart I-8...Because The Italian Banking System Has##br## Been Left Undercapitalised For A Decade Furthermore, when the ECB bought Italian government bonds from investors, where did Italian investors deposit the hundreds of billions of euros they received? Not in the local Italian banks, but in German banks, which they deemed to be much safer. Italian banks are not lending, and their depositors are still very wary, because the Italian banking system has been left undercapitalized for a decade. The irony is that the ECB's bond-buying was supposed to help Italy the most, but has probably helped it the least (Chart I-9). Chart I-9The ECB's Bond-Buying Has Exacerbated##br## The Target2 Imbalances Europe's full-fledged banking union is still years away. Europe has established a single supervisor for its 130 largest banks. It has also set up a single resolution fund (SRF) to wind down failing banks in an orderly fashion. Unfortunately, the SRF's coffers will not be full for another six years.1 Until then, the SRF will not be credible to the financial markets without a backstop. A candidate to provide such a backstop would be the European Stability Mechanism (ESM), but this is work in progress. Europe also lacks a common deposit insurance scheme. Knowing that the buck stops with the national government makes depositors wary, as has been the case recently in Italy. The large international banks are keen to implement a pan-European deposit insurance scheme. But this requires a clean-up of bank balance sheets in certain countries, notably Italy. Otherwise, the prudent banks will balk at the prospect of paying for the past mistakes of their less prudent competitors. Again, this is work in progress which may take several years to complete. A Fragmented Monetary Policy Requires A Fragmented Fiscal Policy If the entire euro area economy enters a yin phase, the constituent governments are allowed to use fiscal policy to support growth. For example, when the whole euro area went into a yin phase during the debt crisis, the European Commission relaxed the normal 3% cap on government deficits, and this fiscal stimulus helped the most troubled countries to weather the storm. But what if one country enters a yin phase, while the others are still in a yang phase? For example, a 'no-deal' Brexit would hit Ireland much harder than other euro area economies. The EU budget can help to an extent but, at just 1% of Europe's GDP compared to almost 20% in the U.S., the budget is small. This might still be sufficient to help Ireland, but it is insufficient for a large economy like Italy. The ESM can also help, but the assistance arrives too late - when the troubled country has already lost market access, and thereby is in, or close to, a recession. The unfortunate truth is that without a true banking union it is impossible to have a true monetary union. The result is a fragmented monetary policy, as is the case right now. A fragmented monetary policy with an inflexibly rigid fiscal policy is a recipe for economic polarization and thereby, political polarization. Therefore, until the banking union is complete, policymakers must permit a more fragmented fiscal policy as a crucial economic counterbalance. Because ultimately, a less economically polarized euro area will be a more successful and united euro area. An important test to this thesis has now arrived, as the new government in Italy prepares next year's budget. The government must agree its fiscal plan by September and present a draft to the European Commission by mid-October. Italy was projected to reduce its structural deficit by about 0.8 percent. But given that Italy will have one of the world's lowest structural deficits in the coming years, this reduction seems unnecessarily drastic (Table I-1). Because an increase in the deficit might unnerve the markets, the optimal outcome would be to leave the structural deficit close to its current level. Table 1Italy Will Have One Of The World's Lowest Structural Deficits We end with two brief thoughts for investors. The evidence clearly shows that the ECB's extremely loose monetary policy is wholly inappropriate for the euro area's mostly yang economy and largely ineffective for Italy's yin economy. On this premise, expect a multi-year narrowing in core euro area long bond yield spreads versus their counterparts in the U.K. and U.S. Finally, if Italy's banking system does gradually recover to full health and functionality, the best long-term investment play will be Italy's real estate market, in which prices have been bid down to depressed levels due to a lack of a lack of bank financing. On this premise, the long-term equity play is Covivio. Please note that I am taking a brief summer break, so the next weekly report will come out on August 23. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 The SRF will be gradually built up during 2016-2023 and shall reach the target level of at least 1% of the amount of covered deposits of all credit institutions within the Banking Union by December 31 2023. Fractal Trading Model* We have seven open positions, so we are not adding any new trades this week. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations
Highlights Real Rate "Targeting": Global central bankers are increasingly following the Fed's lead by paying more attention to the appropriate level of real interest rates that will keep inflation stable given low unemployment (r-star). This raises a new potentially bearish element for global bond markets through higher real yields. U.K.: The Bank of England hiked rates last week, despite sluggish growth, slowing inflation and elevated Brexit uncertainties. Additional rate hikes will be difficult to deliver, however, without a change in trend for those factors. Stay overweight Gilts in global hedged bond portfolios. Japan: The conditions for a shift higher in the Bank of Japan's bond yield targets - a weaker yen, core inflation at 1.5% and much higher U.S. bond yields - are still not yet in place. Stay overweight JGBs. Feature Chart Of The WeekA 'New, New Normal' Of Higher Real Rates? Three major central banks met last week and, surprisingly, the most important message did not come from the Federal Reserve. The Bank of England (BoE) and Bank of Japan (BoJ) both delivered policy decisions that appeared more hawkish on the surface, even though the underlying message was far more mixed. The BoE hiked rates by 25bps, while the BoJ tweaked its yield curve control policy by raising the allowable ceiling for the 10-year Japanese Government Bond (JGB) to 0.2%. Yet both central banks signaled - through published research, commentary and outright forward guidance - that the timing of the next policy move is uncertain. This contrasts with the Fed, who continues to signal a slow-but-steady path of U.S. rate hikes over at least the next year. The BoE and BoJ are dealing with the same issues that all the major developed market central banks are facing now - how to reconcile low unemployment and an apparent dearth of spare economic capacity with only modest upward inflation momentum and real interest rates that appear too low (Chart of the Week). Against that backdrop, the communication of central banker strategies to the public, and to the financial markets, is critical to their success, defined by keeping inflation stable around target levels. The Fed has been a leader in introducing nuance into the execution, and communication, of post-crisis policymaking. First, by focusing more on underutilized capacity in the U.S. labor market to justify keeping the funds rate low despite the headline unemployment rate falling below its estimate of "full" employment. Later, by focusing attention on real interest rates and the possibility that the neutral level of that rate (a.k.a. "r-star") can vary cyclically from levels that would previously have been considered consistent with full employment and stable inflation. In both cases, the Fed has provided a framework that allows some wiggle room as it continues to normalize away from crisis-era policy settings. Passionate advocates of the concept like current New York Fed President John Williams have led the Fed's growing focus on r-star. Yet in its latest Inflation Report published last week, the BoE dedicated five full pages to the topic of estimating r-star in the U.K.1 Other central banks have discussed their own estimates of r-star over the past year, as well.2 This is an important point for global bond markets. If other central banks begin to follow the lead of the Fed and elevate the importance of "real rate targeting" into their inflation targeting frameworks, then real bond yields could have significant upside with policy rates still not above realized inflation in the major developed economies. This will especially be true if factors that have kept r-star cyclically depressed in many countries in the post-crisis era - weak productivity growth, fiscal consolidation, excess capacity in labor markets, household deleveraging, among others - continue to slowly dissipate. At the moment, the most important themes for global financial markets relate to the ongoing Fed tightening cycle, the potential for policy stimulus in China in response to slowing domestic growth, and the slowing growth of central bank balance sheets (Chart 2). All three are bond bearish. We could add a fourth item to that list - U.S. protectionism, which can lead to slowing global through diminished trade activity. While there is evidence from many countries that a more uncertain outlook for global trade has negatively affected business confidence, there is also some tentative evidence that the deceleration in global trade activity may be in the process of stabilizing (Chart 3). Yet even if the U.S. - China trade tensions worsen and industrial activity slows further, tariffs and trade barriers represent a supply shock that could result in higher global inflation and prevent a meaningful decline in bond yields. Summing it all up for our government bond investment strategy, we continue to recommend: a below-benchmark overall portfolio duration stance country allocation (Chart 4) with underweight exposure to countries where central banks can credibly raise interest rates (U.S., Canada) and overweight exposure where rate hikes will be more difficult to deliver (U.K., Japan, Australia) Bottom Line: Global central bankers are increasingly following the Fed's lead by paying more attention to the appropriate level of real interest rates that will keep inflation stable given low unemployment (r-star). This raises a new potentially bearish element for global bond markets through higher real yields. Chart 2The Biggest Market Risks Are Bond Bearish Chart 3Tentative Signs Of Global Trade Stabilization? Chart 4Underweight Countries That Can Credibly ##br##Raise Rates (And Vice Versa) Stay Overweight U.K. Gilts, Even After The BoE Rate Hike The BoE delivered a 25bp rate hike last week, bringing its Bank Rate to 0.75%. The growth and inflation forecasts for the next three years were essentially unchanged, however. The hike was described by BoE Governor Mark Carney as a sign of growing confidence by the Monetary Policy Committee (MPC) in its forecast. Thus, another step towards normalizing the Bank Rate from accommodative levels was appropriate. In the press conference following the MPC meeting, Carney noted that the recent pickup in U.K. wage growth was an important development. Carney said that with the economy at full employment,3 the BoE's job is to "manage demand" to control inflation while nominal wage growth expands. Real wage growth has crept back into positive territory in recent months (Chart 5). Numerous indicators were presented in the August 2018 Inflation Report to suggest that U.K. labor markets are growing increasingly tight - including faster wage growth for those switching jobs than those staying in jobs (bottom panel) and survey data showing greater pay increases in sectors facing recruitment and retention difficulties. The BoE did downplay the recent cooling of realized U.K. inflation, which has been more a product of the stability of the pound than an easing of domestic inflation pressures. While this is true, market-based measures of inflation expectation like CPI swaps have also been following the path of the pound, rather than typical forces like oil prices, since the collapse in the pound after the 2016 Brexit vote (Chart 6). On the margin, however, the more stable pound means that U.K. inflation will be more influenced by domestic factors, like tight labor markets and wage pressures. Chart 5Mixed Signals From The U.K. Labor Market Chart 6U.K. Inflation Following The Pound, Not The Labor Market As discussed earlier, the BoE did devote a significant section of the latest Inflation Report to the topic of the neutral real rate or r-star. The BoE noted that there was a longer-term and shorter-term r-star, and that the latter had to be deeply negative in recent years given the shocks from the 2008 Financial Crisis and recession to the 2016 Brexit vote to the fiscal austerity of recent Conservative governments. As the impacts of those shocks fades, the shorter-term r-star increases, requiring faster BoE rate hikes. Or as it was described in the Inflation Report: "The expected rise in r* over coming years, combined with the absorption of spare capacity over the forecast period, means that - even as inflation is projected to fall back toward 2% - the Bank Rate is likely to need to rise gradually to keep inflation at the target. But the persistence of the fall in the trend real rate means that any rises in the Bank Rate are expected to be limited, and interest rates are likely to need to remain low by historical standards for some time to come." That sounds like the BoE wanting to have its cake and eat it too, talking up rate hikes while making the case for rates to stay low for longer. The longer-run r-star estimates shown in the Inflation Report (between 0.5% and 1.5%) when added to the 2% BoE inflation target, suggests that the neutral nominal Bank Rate is between 2.5% and 3.5%. That does imply that there is a lot of scope for additional BoE rate hikes without even reaching a level that could be considered "'neutral' from a longer-term perspective" (Chart 7). It will be difficult for the BoE to deliver on any additional rate hikes, however, while both the economy and inflation are decelerating. The current pricing in the U.K. Overnight Index Swap (OIS) curve shows that there are only 42bps of hikes discounted by the end of 2020. That represents a very low hurdle to overcome, even if the U.K. economy remains sluggish and the Brexit outcome turns ugly. From a strategy perspective, we think that Gilt yields can rise above the current shallow path of the forward curve over the next 6-12 months, suggesting that a below-benchmark duration stance in the U.K. is appropriate. Yet with U.K. growth slowing and leading indicators suggesting more of that is to come, and with still no resolution to the Brexit negotiations with the March 29, 2019 "Brexit Day" looming in the distance, Gilt yields are likely to stay relatively subdued versus global peers. We continue to recommend an overweight stance on Gilts in hedged global bond portfolios (Chart 8). Chart 7U.K. Real Rates Are WAY Below Longer-Run R-Star Chart 8Stay Overweight U.K. Gilts Bottom Line: The Bank of England hiked rates last week, despite sluggish growth, slowing inflation and elevated Brexit uncertainties. Additional rate hikes will be difficult to deliver, however, without a change in trend for those factors. Stay overweight Gilts in global hedged bond portfolios. Bank of Japan: Zero Pressure On The 0% Target Global bond yields got a bit of a jolt recently from the most unlikely of sources - Japan, the place where bond volatility goes to die. Amid media speculation that the Bank of Japan (BoJ) was considering an upward adjustment to its JGB yield target, the 10-year JGB took several runs at breaching the BoJ's implied pain threshold of 0.10%, resulting in the BoJ intervening with offers of "unlimited" purchases to quell the selloff. Yet at the monetary policy meeting last week, the BoJ only delivered modest changes: The allowable range for the 10-year JGB yield was widened to -0.20% to +0.20% New forward guidance was introduced indicating no rate hikes until at least 2020 A shift in the BoJ's equity ETF purchases to favor ETF's that target a broader index We were not surprised by the outcome, given that there was absolutely no reason why the BoJ should have even considered a change in policy settings. Back in February, we outlined the three things that we believed must ALL occur before the BoJ could plausibly raise its yield target for the 10-year Japanese government bond (JGB).4 Five months later, none of those conditions has been met (Chart 9): 1) The USD/JPY exchange rate must at least get back to the 115-120 range. USD/JPY has struggled to reach even the bottom end of our target range, only getting to an intraday high of 113.17 on July 19th. The starting point for the yen must be weaker than that before the BoJ can deliver any sort of more hawkish policy that would likely send the yen roaring higher. 2) Japanese core CPI inflation and nominal wage inflation must both rise sustainably above 1.5%. The extremely tight Japanese labor market (Chart 10) has finally begun to put upward pressure on wage growth, which now sits at 2.2% on a year-over-year basis. There has been no follow through into core inflation, however, which only got as high at 0.5% in March before sliding back to 0.2% in June. Chart 9None Of Our Conditions For A BoJ Hike Have Been Met Chart 10How Does This Job Market Not Produce Inflation? 3) The 10-year JGB yield must reach an overvalued extreme versus U.S. Treasuries. We judge this by looking at the residual from a fundamental model of the 10-year JGB yield published by the BoJ. The model includes both the 10-year U.S. Treasury yield as the proxy for global yields, and the share of outstanding JGBs owned by the central bank to measure the impact of BoJ buying (Table 1). That model suggests that current JGB yields are only at fair value, and that U.S. Treasury yields have to rise by a lot more (to at least 3.5%) to make the current level of JGB yields look "expensive", thus justifying a higher BoJ yield target (USD/JPY would likely be in the 115-120 range if that happened, as well). Yet despite all these factors arguing against any change in the BoJ's policy settings, the topic was seriously discussed at last week's policy meeting, according to Reuters.5 The renewed weakness of Japanese inflation scuttled any chance that a serious policy change could be delivered. The decision to widen the allowable yield range for the 10-year JGB yield not associated with any signaled change to the 0% yield target. Investors got the hint, and yields have calmed down after the late July turbulence. The BoJ is increasingly backed into a corner with its hyper-easy monetary policy. There is no spare capacity in the economy, with the unemployment rate at a 25-year low of 2.4% and the BoJ estimating that the output gap is closed. Our own Japan Central Bank Monitor is no longer in negative territory, indicating that the next policy move should be a tightening (Chart 11). The BoJ has indeed been "tightening", but only by reducing the pace of its bond buying. BoJ purchases now only matches the pace of new JGB - a far cry from when the BoJ was buying more than all new JGBs issued between 2013 and 2017 (bottom two panels). Table 1JGB Yield Model Chart 11BoJ Has Been Quantitatively Tightening There is a reported disagreement within the BoJ over the impact of the negative interest rate and yield curve control policies on Japanese bank profitability and lending capacity. Yet any sort of rate hike, at either end of the yield curve, would result in a sharp increase in the yen. To have that happen now would harm Japanese exporters' competitiveness at the worst possible time. Economic growth is decelerating in two of Japan's major trading partners, China and South Korea. At the same time, U.S. protectionism risks trade wars that would slow global trade at a time when Japanese export growth, and business confidence, may already be peaking (Chart 12). We continue to recommend an overweight position in Japanese government debt within hedged global government bond portfolios. Admittedly, the idea of overweighting a market where nearly half of all bonds still have a negative yield does not sound like a path to riches. Yet the BoJ stands out as the one major central bank that has virtually no chance at credibly talking about, much less delivering, any sort of monetary tightening with core inflation close to 0%. If non-Japanese yields continue to rise over the next 6-12 months, as we expect, then JGBs will once again be a relative outperformer in a global bond bear market (Chart 13). Chart 12Japan Is Vulnerable To A Global Trade War Chart 13Stay Overweight JGBs In Hedged Global Bond Portfolios Bottom Line: The conditions for a shift higher in the Bank of Japan's bond yield targets - a weaker yen, core inflation at 1.5% and much higher U.S. bond yields - are still not yet in place. Stay overweight JGBs. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The r-star discussion can be found on pages 39-43 of the August 2018 BoE Inflation Report, which can be found here https://www.bankofengland.co.uk/-/media/boe/files/inflation-report/2018/august/inflation-report-august-2018.pdf 2 For example, the BoJ's estimates of Japan's r-star can be found here, https://www.boj.or.jp/en/research/wps_rev/wps_2018/data/wp18e06.pdf, while the Bank of Canada's estimates for Canadian r-star can be found here https://www.bankofcanada.ca/wp-content/uploads/2017/11/boc-review-autumn2017-dorich.pdf 3 The BoE estimates full employment to be around the current unemployment rate of 4.25%, which is well below the OECD's estimate of 5.5% shown in the top panel of Chart 5. 4 Please see BCA Global Fixed Income Strategy Special Report "What Would It Take For The Bank Of Japan To Raise Its Yield Target?" dated February 13, 2018, available at gfis.bcaresearch.com 5 https://www.reuters.com/article/us-japan-economy-boj-policy-insight/bojs-architect-of-shock-and-awe-plots-retreat-from-stimulus-idUSKBN1KR0TA Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns