Economic Growth
Highlights The U.K. economy has been holding up fairly well, despite the overhang of political uncertainty. However, even before the actual withdrawal of the U.K. from the E.U. has occurred, Brexit has left a lasting mark on the U.K. economy through elevated uncertainty, severe weakness in business investment spending, and anemic productivity. The net result is an economy with lower trend growth, a structurally weaker exchange rate, and relatively high domestic inflation. Brexit will be delayed beyond October 31. No-deal Brexit is an overstated risk unless an early election strengthens Boris Johnson’s hand. That is unlikely. The investment outlook for the British pound and U.K. gilts is highly binary: a “smooth” Brexit is bullish for the pound and bearish for gilts, while no-deal Brexit would push both the pound and gilt yields even lower. Feature Ever since the United Kingdom voted in 2016 to exit the European Union, the outlook for the economy and financial assets has been tied to the binary outcome of whether or not an exit would be orderly. This has been a tremendous source of uncertainty, putting the Bank of England (BoE) in one of the most inconvenient positions ever faced by a central bank. In this week’s report, we look to address a few high-level questions. First, has the slowdown in the U.K. economy been run of the mill, given the global manufacturing recession? Or has it been unduly protracted given heightened political uncertainty? If the latter, what are the prospects of a rebound should anything other than a “no-deal” Brexit prevail? Finally, has there been irreparable damage already done to the economy because of delayed investment, with longer-term ramifications irrespective of the relationship outcome with the E.U.? An Employment Boom The U.K. is currently experiencing the best jobs recovery since the Second World War. 4.2 million new jobs have been created over the past decade, nudging the employment-to-population ratio to the highest level in almost 50 years. What is remarkable is that this recovery looks even more impressive than that of the U.S., where labor market conditions have been very robust. For example, in the U.S., the employment rate stands at 60.9%, just a nudge below the U.K. but still nearly four percentage points below its pre-crisis peak (Chart 1). Compared to the eurozone, the outperformance of the U.K. labor market has been very evident. Despite this recovery, the pickup in wages has been the most tepid since the Boer War. The quality of jobs has also been stellar – full-time job creation has outpaced part-time and female participation rates are soaring. The jobs bonanza has also been broad across regions and industries. Yes, the manufacturing sector has seen some measure of volatility, but aside from the East Midland region, unemployment rates continue to converge downward across the United Kingdom (Chart 2) Chart 1An Employment Boom Chart 2Recovery Is Broad-Based Despite this recovery, the pickup in wages has been the most tepid since the Boer War. In a July speech, the BoE’s chief economist, Andy Haldane, rightly noted that the lost decade of pay has been an equal-opportunity disaster across the major U.K. regions. From the 1950s until the Great Recession, real pay in the U.K. grew by about 2% per annum. Since the Great Recession, real pay has stagnated at a rate of -0.4% per year (Chart 3).1 Chart 3Wages Stagnated Until Recently There have been a few reasons for this. First, there has been strong growth in self-employment, zero-hours contracts and agency work. So even though the share of full-time work has been rising during the post-crisis period, it remains well below its pre-crisis highs. This has increased the fluidity of the labor market, lowering the cost of doing business in the process. Compensation of self-employed or zero-hours contract workers lies significantly below their permanent counterparts. The silver lining is that this phenomenon is not specific to the U.K., but is happening worldwide, especially in Europe where structural reform has disentangled rigidities in the labor market. The key question going forward is whether the nascent rise in wages will continue. Over a cyclical horizon, our contention is that should positive employment trends continue, the U.K. could begin to experience significantly stronger wage pressures. There are four fundamental reasons for this: Job offers continue to outpace the number of seekers. Depending on the measure used, there are 20%-40% more jobs than there are applicants (Chart 4). This impasse cannot easily be resolved by a higher employment rate (it is at a secular high) or lower unemployment. The BoE estimates NAIRU in the U.K. is at 4.4%, which means that the unemployment rate is firmly below its structural level. Business surveys continue to suggest that a shortage of skilled labor is among the top problems firms are facing. The Phillips curve in the U.K. has flattened in the last few years, but wage growth has started to inflect higher of late. Like many other countries, the Phillips curve in the U.K. is kinked, whereby the convexity of wage growth increases as the unemployment gap closes. The velocity of circulation in the jobs market, also known as the job-to-job flow, has picked up. This has historically been positive for wage growth (Chart 5). This is also mirrored by the quits rate, which has been accelerating since 2012. Chart 4Wage Pressures Should Mount Chart 5Velocity Of U.K. Employment Rising At the moment, the transmission mechanism from a tight labor market to higher wages is being impeded by political uncertainty, which will continue to cast a near-term shadow on longer-term hiring plans. For example, for all the talk of the U.K. being a financial center, attrition in banking and insurance employment remains entrenched (Chart 6). The U.K. continues to attract a significant amount of financial business, especially in the foreign exchange market, but there was a clear hit to volumes in 2016, the year the Brexit referendum was held (Chart 7). Meanwhile, for the manufacturing sector, it will take a while to rekindle animal spirits and re-attract foreign direct investment. Chart 6Attrition In Manufacturing And Finance Employment Chart 7The U.K. Is An Important Financial Center That said, the U.K. economy remains mostly driven by services, meaning wages will still face some measure of upward pressure. Service sector wage growth has been robust and unless the manufacturing recession grows deeper and starts to infect other sectors of the U.K. economy, the path of least resistance for wages remains up. Bottom Line: The U.K. economy has been holding up fairly well, despite the overhang of political uncertainty. Virtuous Circle Of Spending While the U.K. income pie could grow, a lack of confidence is nonetheless constraining spending. Chart 8 shows that U.K. consumer confidence has negatively diverged from trends in both the U.S. and the euro area. There have been a few offsetting factors at play suggesting that once the clouds of Brexit uncertainty lift, spending could re-accelerate higher. The transmission mechanism from a tight labor market to higher wages is being impeded by political uncertainty, which will continue to cast a near-term shadow. A big driver for retail sales in the U.K. is tourist arrivals and the weaker pound is likely to keep attracting an influx of visitors (Chart 9). Chart 8Confidence Will Be Key For ##br##Any Recovery Chart 9The Cheap Pound Will Encourage ##br##Foreign Shoppers The U.K. commands many of the world’s leading brands that will benefit from a cheap currency. The household deleveraging process is well advanced, and the tentative recovery in borrowing and mortgage applications is helping to cushion the fall in U.K. house prices. This is underpinned by the fact that mortgage-borrowing costs in the U.K. have collapsed along with yields (Chart 10). That said, any rise is borrowing will be mitigated by the fact that household debt-to-GDP in the U.K. remains higher than in many other developed economies. Chart 10Low Rates Should Help Housing Chart 11Cost-Push Inflation Inflation expectations are blasting upward, partly in response to the weaker currency. What is remarkable is that the pound has plummeted by a lot more than is warranted on a fundamental PPP basis. This will bring about imported inflation (Chart 11). Bottom Line: The big risk to the U.K. economy is that it enters into stagflation. A BoE survey pins the loss to output in the event of a no-deal Brexit at around 3% of GDP, but these are estimates since the bulk of the economic adjustment might occur through the exchange rate. The range of estimates for the economic impact of a no-deal (Table 1), perhaps not coincidentally, mirrors the range of Britain’s recessions in the 20th century (Chart 12). This puts the BoE in a particularly uncomfortable “wait and see” mode. For example, if a hard exit leads to a fall in the pound and a rise in inflation expectations, it is not clear the BoE’s Monetary Policy Committee would cut rates if it were to meet its inflation mandate. Table 1Wide Range Of Estimates For Impact ##br##Of No-Deal Brexit Chart 12Past British Recessions Offer Guidelines ##br##For No-Deal Impact Brexit Uncertainty Has Already Caused Lasting Damage To U.K. Growth A major drag on U.K. economic growth over the past three years has been the collapse in business confidence and associated contraction in capital spending (Chart 13). Since the 2016 Brexit vote, business investment has been substantially weaker than at similar points in previous U.K. business cycles – by a cumulative 26%, according to the BoE (Chart 14). While some of the softness seen in 2019 can also be attributable to slowing global economic growth and uncertainty related to the U.S.-China trade war, U.K. capital spending has been far weaker than that of other advanced economies (Chart 15). Since the 2016 Brexit vote, business investment has been substantially weaker than at similar points in previous U.K. business cycles – by a cumulative 26%. This is a critical point to consider when judging the long-run damage that has already been inflicted on the U.K. economy just from the uncertainty of Brexit. The best way to evaluate this damage is through the lens of capital spending, the growth of which is highly correlated to changes in productivity and potential economic growth (Chart 16). Chart 13Gloomy U.K. Businesses Have Stopped Investing Chart 14Massive Underperformance Of U.K. Capex Compared To History ... Chart 15...And Compared To ##br##Global Peers Chart 16A Lasting Hit To The U.K. Economy From Brexit Uncertainty An important research paper published by the BoE last month – co-authored by two current members of the BoE Monetary Policy Committee, Ben Broadbent and Silvana Tenreyro – discusses the linkages between Brexit uncertainty, capital spending and U.K. productivity.2 The authors concluded that the economic effects of the Brexit referendum result can be categorized as a response to an anticipated, persistent decline in productivity growth for the tradeable sectors of the U.K. economy. In that framework, the following chain of events would occur after the “news” of weaker expected productivity (i.e. the Brexit referendum result) is announced: Chart 17A Misallocation of Resources An immediate and permanent fall in the relative price of non-tradeable output relative to tradeable output, i.e. the real exchange rate. Resources shift to the tradeable sector to take advantage of the higher relative price, leading to an increase in output and a rise in exports. Productivity growth in the tradeable sector then falls, as heralded by the “news” of the Brexit vote, leading to a shift in economic resources back towards the higher productivity non-tradeable sectors. U.K. interest rates fall relative to the world, as financial markets discount the expected relatively slower path of U.K. productivity. Aggregate business investment growth slows, but overall employment growth remains resilient. This is exactly how the U.K. economy has evolved since the 2016 Brexit vote: The BoE’s trade-weighted index for the pound has fallen in both nominal and real terms. The export share of U.K. real GDP rose from 27% to 30%, while the investment share of real GDP declined from 10% to 9% (Chart 17, top panel). Annual employment growth in U.K. services (non-tradeable) fell from 2.1% to zero by the end of 2018, but has since begun to recover; manufacturing (tradeable) employment growth initially increased from 0.5% to 2.7% within a year of the Brexit vote, before slowing back to 0% in 2018, and is also starting to move higher (Chart 17, third panel). Productivity growth has declined from 1.9% to nil, even as wage growth has accelerated due to the steady pace of labor demand at a time of low unemployment (Chart 17, bottom panel). On a sectoral level, the worst growth rates of realized productivity growth are occurring in tradeable industries like metal products and financial services, while the highest productivity growth is seen in non-tradeable industries like professional services and retail (Chart 18).3 Chart 18Latest U.K. Productivity Growth Rates, By Industry Summing it all up, according to the analytic framework of the BoE research paper, the Brexit referendum result essentially created a signal, manifested by the plunge in the British pound, for the misallocation of U.K. resources away from higher-productivity non-tradeable industries to lower productivity tradeable sectors. If true, we would also expect to see the following: Chart 19Inflationary Consequences of Brexit Uncertainty Much higher inflation rates in more domestically-focused measures like services and wages. Faster growth in unit labor cost as a result of the gap between accelerating wages and stagnant productivity. Structurally higher inflation expectations. Lower real interest rates in the U.K. than in other advanced economies. Prolonged weakness in the exchange rate. Again, all of this has come to fruition in the U.K. (Chart 19): Services CPI inflation is now at 2.2%, compared to only 1.7% for overall CPI inflation. Unit labor costs growth has accelerated from below zero before the Brexit referendum to a 2%-3% range since the end of 2016. The real 10-year gilt yield (deflated by the 10-year CPI swap rate) is now -3.1%, compared to a 0% real yield on 10-year U.S. Treasurys. The trade-weighted British pound remains close to its post-Brexit referendum lows. It is clear that the Brexit uncertainty has resulted in a structurally weaker, and more inflationary, U.K. economy – an outcome that may not be quickly reversed in the event a no-deal Brexit is avoided. This has important implications for the future monetary policy decisions of the BoE and the investment outlook for the pound and U.K. gilts. Bottom Line: Even before the actual withdrawal of the U.K. from the E.U. has occurred, Brexit has left a lasting mark on the U.K. economy through elevated uncertainty, severe weakness in business investment spending and anemic productivity. The net result is an economy with lower trend growth, a structurally weak exchange rate, and relatively high domestic inflation. Political Uncertainty Prevails Chart 20Public Opposes No-Deal Brexit Even after considering the cyclical and structural state of the U.K. economy, as we have done in this report, the near-term outlook is still entirely dependent on the Brexit outcome. The state of Brexit is more uncertain than ever due to the Supreme Court case against the government’s suspension of Parliament and Prime Minister Boris Johnson’s refusal to obey an order by Parliament to seek an extension to the October 31 exit deadline. What is not in doubt is that parliament opposes a disorderly, no-deal Brexit. And the best polling suggests that public opinion opposes a no-deal Brexit as well (Chart 20). Members soundly rejected Prime Minister Boris Johnson’s negotiation strategy in September – they prohibited both a no-deal Brexit and voted against holding an early election on two separate occasions (Chart 21). Johnson lost his coalition majority and yet cannot go to new elections, leaving him hamstrung until Parliament returns. What is likely regardless of the outcome is a substantial increase in fiscal spending, The United Kingdom is not a seventeenth-century Stuart monarchy – Parliament is the supreme political body in the constitution and its decrees cannot be permanently ignored or disobeyed. Whenever Parliament reconvenes, likely October 14, it will have the ability to ensure that the Brexit deadline is extended. The E.U. is likely to grant an extension because it is in the E.U.’s interest to delay or cancel Brexit and demonstrate to all members that leaving the bloc is neither desirable nor practical. The result will then be an election. Chart 21Boris Johnson’s Negotiation Strategy Failed Chart 22A Hung Parliament Is The Likely Outcome Election polls show the Conservative Party breaking out, the Liberal Democrats overtaking Labour, and the Brexit Party maintaining an edge (Chart 22). Translating these polls to parliamentary seats is not straightforward because the first-past-the-post electoral system means that a smaller party can steal crucial votes from the most popular party leaving the second- or third-most popular party to win the seat. The key point is that the Brexit Party is a single-issue party and the Tories under Johnson are now monopolizing that same issue. If this dynamic persists, the Lib Dems pose a greater threat of splitting Labour’s votes than the Brexit Party does of splitting Conservative votes. The result is that it is still possible for the Conservatives to gain a majority, even though it seems unlikely given that they need 325-plus seats and have fallen to 288 seats after purging unruly members and losing leadership in Scotland. A hung Parliament is a more likely outcome. A hung Parliament will prolong the indecision and uncertainty – but will also be likely to remain united against a no-deal Brexit. An opposition coalition government will prevent a no-deal Brexit. Even a single-party Tory majority is not a disastrous outcome, as it would increase Johnson’s leverage with the E.U. and increase the likelihood that the E.U. would offer some concessions to get a withdrawal agreement passed, resulting in a Brexit deal and an orderly exit (Specifically, a Northern Irish limitation to the backstop, or a sunset clause or withdrawal mechanism for the same). Such a deal is in Johnson’s best interests so that he does not preside over a recession from the moment he returns to office. All of these outcomes point toward either an exit deal or a new chapter in which parliament seeks a new referendum. Chart 23Expect An Increase In Fiscal Spending The worst outcome for the markets would be a weak Tory coalition majority that cannot agree on Ireland or pass an exit deal, as this could lead to paralysis, as it did with Theresa May, at a time when the prime minister is committed to delivering an exit come hell or high water. This is the scenario in which no-deal once again becomes a genuine risk. Subjectively we have estimated that the risk of no-deal is around 30%, but this is currently falling, not rising, as a result of parliament’s strong majorities against that outcome in September – and only an election can change that. It is fruitless trying to predict the U.K.’s future political landscape without knowing the conclusion of the Brexit saga. What is likely regardless of the outcome is a substantial increase in fiscal spending, reversing the “austerity” of the aftermath of the Great Recession. This trend is already apparent from Johnson’s current attempt to present a generous social spending package at the Tory party conference this fall – which would, if vindicated by a new election, represent a turnaround in Conservative fiscal policy (Chart 23). More fiscal spending will be needed to counteract the negative impact of a disorderly Brexit, or to placate the middle class once it becomes clear that leaving the E.U. is not a panacea for the UK’s problems, or to fulfill the agenda of an opposition government when it comes to power. In the event that a no-deal Brexit occurs, the U.K. will not only face a tumultuous economic aftermath, but the constitutional struggles among the three kingdoms will reignite due to the negative impact in Northern Ireland and the likely revival of Scottish independence efforts. Bottom Line: The U.K. is not a dictatorship and the prime minister cannot refuse to obey Parliament’s will. Parliament has voted clearly to delay a no-deal Brexit and will continue to do so. A disorderly exit remains a risk because an eventual election could return the Tories to power. But in this case, the E.U. will be more likely to offer a concession that enables Parliament to pass a withdrawal bill. The odds of no deal are no higher than 30%. The structural takeaway, regardless of the outcome, is that fiscal spending will rise. Investment Conclusions The episodes surrounding the collapse of the pound in 1992 carry important lessons for today.4 Crucially, most of the adjustment in the pound happened quickly, but a key difference from today is that an exit from the European Exchange Rate Mechanism was unanticipated, unlike Brexit. Foreign exchange markets are extremely fluid and adjust to expectations quite quickly. Peak to trough, cable has already fallen by circa 30% suggesting the bulk of the downward adjustment is done. Chart 24A Binary Brexit Outcome for Gilts The British currency is free floating, meaning there are less “hidden sins” compared to the fixed exchange rate period. That said, the fair value of the pound has structurally weakened. Our bias is that if there is a hard Brexit, the pound could easily drop to the 1.10-1.15 zone. Part of this move will be an undershoot. In the case of a soft Brexit (or no Brexit), the pound should converge toward the mid-point of its historical real effective exchange rate range, which would pin it 15%-20% higher, or at around 1.50. From a risk-reward perspective, this looks attractive. For U.K. gilts, the direction of yields is also dependent on the Brexit outcome, as there is essentially no change in policy rates discounted in the U.K. Overnight Index Swap (OIS) curve (Chart 24). A “smooth” Brexit would allow the BoE to return its focus to fighting elevated U.K. inflation expectations. That would likely result in both higher gilt yields and a flattening of the gilt yield curve, as the market prices in future BoE rate hikes, and lower longer-term inflation expectations. A rising cable will also temper inflation expectations. Neither gilts nor U.K. inflation-linked bonds would perform well in this scenario.. A “no deal” Brexit, on the other hand, would prompt the BoE to cut interest rates in order to offset the potential hit to business and consumer confidence. This could occur even if inflation expectations remain high or rise further on pound weakness. That would mean lower gilt yields and a steepening of the gilt curve. Going overweight gilts but also long inflation-linked bonds would be the best way to position for this outcome. The scenarios for fiscal easing outlined earlier would also influence the shape of the gilt curve, resulting in some degree of bearish steepening as the gilt curve prices in both larger deficits and higher future inflation, all else equal. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Matt Gertken, Geopolitical Strategist mattg@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 Andrew G Haldane, “Climbing the Jobs Ladder,” Bank of England, July 23, 2019 2 Bank of England External MPC Unit Discussion Paper No. 51, “The Brexit vote, productivity growth and macroeconomic adjustments in the United Kingdom”, August 2019 3 London’s role as a major global financial center makes the U.K. financial services industry a “tradeable” sector, in that a significant share of its output is “traded” to non-U.K. users. 4 Mathias Zurlinden, “The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM,” Economic Research, Vol. 75, No. 5 (September/October 1993). Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Dear Client, Owing to BCA’s 40th Annual Investment Conference in New York City next week, we will not be publishing a report on Friday, September 27. We will return to our regular publishing schedule on Friday, October 4, when we will be sending out our quarterly Strategy Outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights The spike in oil prices underscores the vulnerability of key Saudi oil facilities. The fact that OPEC spare capacity is on the low side is an added source of concern. Fortunately, if oil prices do rise again, the impact on the global economy will be mitigated by the following: 1) the amount of oil necessary to produce one unit of real GDP is much lower than in the past; 2) oil prices are currently nowhere near restrictive levels; 3) higher oil prices will boost investment in the energy sector; and 4) unlike in the past, central banks will not need to hike rates to quell oil-induced inflationary pressures. The Federal Reserve is likely to cut rates once more in October and then keep rates on hold through 2020. The Fed will also begin expanding the size of its balance sheet to alleviate tensions in funding markets. Investors should remain overweight equities relative to bonds and start tilting exposure towards EM assets and cyclical stocks later this year. Feature All Aboard The Crude Oil Roller Coaster Chart 1A Price For The Books After gapping up by nearly 20% to $72/barrel on Monday morning – the biggest one-day spike in history – Brent oil prices have retreated to the $64-$65 range, representing a markup of around 7% over last Friday’s close (Chart 1). The near-term direction of oil prices will be governed by how quickly the Saudis are able to restore lost output. Brent fell by over $3/barrel on Tuesday following news reports quoting key Saudi sources saying that state-run Saudi Aramco would be able to bring production back to normal in the next two-to-three weeks. Bob Ryan, BCA’s chief commodity strategist, is skeptical of this reassurance. He notes that the drone attacks destroyed highly sophisticated “one-of-a-kind” equipment that had been specially built for the Abqaiq facility. Beyond the near-term impact, the longer-term question is whether Sunday’s pre-dawn strike is the start of a new violent trend. The fact that much of Saudi Arabia’s oil infrastructure is densely concentrated in the eastern part of the country makes it vulnerable to further attacks. The proliferation of drone technologies is also a source of concern since such devices can be used to wreak significant havoc at minimal cost. Chart 2Limited Availability Of Spare Capacity To Offset Outages Chart 3Key Strategic Petroleum Reserves Iran’s apparent involvement in the attack further complicates matters. As Matt Gertken, BCA’s chief geopolitical strategist, has argued, the drone strike may have been orchestrated by hardliners in Iran who regard President Rouhani’s efforts to restart negotiations with the United States as evidence of appeasement (some of these hardliners are also profiting from the sanctions by smuggling crude out of the country). President Trump’s decision to sack John Bolton over Bolton’s opposition to making any deal with the Iranians may have created a sense of urgency among the hardliners. In this respect, attacking Iran would probably give the hardliners what they want. All this has occurred at a time when OPEC spare capacity – the difference between what the cartel is capable of producing and what it is actually producing – is below its historic average (Chart 2). Crude oil reserves have also been trending lower within the OECD. Saudi Arabia’s own reserves have fallen by over 40% since peaking in 2015 (Chart 3). Oil And The Economy: How Big A Risk? While a major spike in oil prices is not our base case, it cannot be ruled out completely. If the price of crude were to increase significantly, how much damage would this do to the global economy? History is certainly not encouraging: Every single U.S. recession since 1970 has been preceded by a large jump in oil prices (Chart 4). Chart 4Oil Spikes And Recessions Chart 5The Global Economy Is Less Oil Intensive The fact that we are dealing with a potential supply disruption only makes things worse. It is one thing if oil prices are rising in response to stronger global growth; it is quite another if prices rise at a time, such as the present, when global growth is under pressure. Despite these concerns, there are four reasons to be optimistic that higher oil prices will not precipitate a major global economic downturn. First, the global economy is less reliant on oil than in the past. Chart 5 shows that the amount of oil necessary to produce one unit of real GDP has fallen by half since 1990. Second, oil prices are still quite low by historic standards. Even after this week’s jump, Brent is still 24% below where it was last October (Chart 6). In real terms, both Brent and WTI are more than 60% below their 2008 highs. Chart 6Oil Prices Are Well Off Their 2008 Peak Third, if oil prices do stay elevated, this will encourage investment in the oil patch, which will eventually bring prices back down. It is worth remembering that rising oil prices reduce aggregate demand in part by shifting wealth from oil consumers, who tend to spend most of their disposable income, to oil producers, who are often inclined to save the windfall from higher oil prices in such entities as sovereign wealth funds. However, if higher oil prices cause producers to expand production, the positive “investment effect” could offset much of the negative “consumption effect” on aggregate demand. Ironically, this means that a transfer of production from easily accessible oil deposits, such as those in Saudi Arabia, to less accessible shale or deep-sea deposits has the effect of increasing overall energy-sector capital spending, even if it does entail a loss of average efficiency. Fourth, higher oil prices today are unlikely to dislodge long-term inflation expectations. This represents a critical difference between the 1970s, 80s, and early 90s when central banks often felt the need to hike rates in the face of rising oil prices (Chart 7). These days, central banks are more likely to see oil price increases – especially those due to supply-side disruptions – as negative income shocks. Such shocks warrant looser, rather than tighter, monetary policy. Chart 7Core Inflation No Longer Driven By Oil Prices FOMC Cuts Rates As Expected This brings us to this week’s Fed meeting. As widely expected, the Fed cut rates by 25 basis points. It also lowered the projected policy rate path. Compared to the Summary of Economic Projections released in June – which suggested no rate change in 2019, one rate cut in 2020, and one rate hike in 2021 – the median dots in the September Summary of Economic Projections released this week show two cuts in 2019, no rate change in 2020, one rate hike in 2021, and one rate hike in 2022. Seven out of 17 participants penciled in a projected third cut for 2019. Judging from the tone of his post-meeting press conference, Jay Powell, dressed in his trademark bipartisan purple tie, was likely among those advocating for further easing. While it is far from a done deal, an additional rate cut in October appears more likely than not. In total, we expect 75 basis points in cuts, equivalent to the amount of easing orchestrated during both the 1995/96 and 1998 mid-cycle slowdowns (Chart 8). The Fed appears to be using these two episodes as a template for its current thinking. Chart 8Will The Fed Follow The 1990s Template Of 75 Bps Of Mid-Cycle Easing? The Fed is also likely to start expanding the size of its balance sheet starting in November. The spike in funding rates this week, while not at all related to the sort of counterparty risk that prevailed during the financial crisis, still underscored the fact that bank reserves are becoming increasingly scarce. To the extent that the Fed creates bank reserves when it purchases assets, this would help alleviate funding pressures. We are assuming that rate cuts beyond 75 basis points in total are possible. However, this would require a significant deceleration in U.S. growth, which looks unlikely. Real personal consumption spending is on track to increase by 3.1% in Q3, according to the Atlanta Fed’s GDPNow (Chart 9). While business capex spending continues to be weighed down by the manufacturing recession, rays of light are emerging. Industrial production rose by 0.6% in August, well above the consensus forecast of 0.2%. Despite an ongoing drag from the auto sector, manufacturing output rose by a solid 0.5%. Chart 9Inventories And Net Exports Have Subtracted From Growth Chart 10Easier Financial Conditions Will Boost Global Growth Globally, the growth picture remains shaky. Looking out, the sharp easing in financial conditions should boost activity (Chart 10). The nascent de-escalation in trade tensions, if sustained, should also help. As such, we continue to expect global growth to stabilize in the coming months and accelerate into year-end. Investment Conclusions Oil prices are likely to rise over the next 12 months. Geopolitical tensions could contribute to any upward pressure on the price of crude, but most of the increase in prices will probably be driven by stronger global growth. If global growth does pick up, the dollar will probably weaken (Chart 11). A weaker dollar will further boost oil prices, along with other commodity prices (Chart 12). Chart 11The Dollar Is A Countercyclical Currency Chart 12A Weaker Dollar Bodes Well For Commodities Stronger global growth, rising commodity prices, and a weaker dollar will hurt safe-haven government bonds but boost stocks. EM and cyclical equity sectors should gain disproportionately. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Strategy & Market Trends MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades
ECB President Mario Draghi managed to achieve his last “whatever it may take” moment. Interest rates on the ECB Deposit Facility have been cut to -0.5% from -0.4%, which is slightly less than traders anticipated. However, the ECB’s Asset Purchase Program has…
Highlights The fundamental backdrop continues to be mixed, but last week’s key data releases were encouraging on balance: While the U.S. manufacturing ISM survey entered contraction territory, and European manufacturing PMIs remained moribund, the services surveys were quite strong, and services contribute much more to developed economies’ total output. The U.S. economy should be able to grow at trend for the next six to twelve months: Consumption is underpinned by a robust labor market, federal government spending will not flag ahead of the 2020 elections, and state and local revenues are well supported. Investment is unlikely to sabotage the other two pillars of the U.S. economy. The view that inflation is deader than New York Mayor de Blasio’s presidential ambitions is widespread and entrenched: Participating on a panel at an inflation-themed conference last week, we were struck by the conviction that inflation is going nowhere over the next few years. The risk-reward of taking the other side of that debate may be quite attractive. Feature Another week, another mixed set of data releases. Last Tuesday, the bears’ most cherished fantasies seemed to be within reach as the ISM Manufacturing Index slid below the boom-bust line in a print that fell well short of consensus expectations. The S&P 500, which had probed around August’s 2,945 resistance level in the final pre-Labor Day session, quickly shed more than a percentage point in response. The U.S. data confirmed the message from the previous day’s European manufacturing PMIs: global manufacturing remains in a deep funk, and a turnaround is not yet at hand. It’s hard to get a recession without tight monetary policy, and it’s hard to get a bear market without a recession, ... Wednesday’s European services PMI releases gave the bulls a lift. Though manufacturing activity truly stinks (Chart 1), it shows no signs of contaminating the services sector, which is still expanding at a solid clip (Chart 2). The U.S. ISM Non-Manufacturing Index surged in August, beating consensus expectations by the same two-point margin by which manufacturing fell short. U.S. equities were already trading higher on the back of an imminent resumption of U.S.-China negotiations when the series was released Thursday morning, and the combination helped the S&P 500 decisively break through the level that had held it in check for a month (Chart 3). Chart 1Global Manufacturing ##br##Is Ailing ... Chart 2... But The Service Sector Is Expected To Expand Chart 3Breakout Taking a step back from the consistently mixed data, recessions don’t occur when monetary conditions are easy. Equity bear markets rarely occur outside of recessions, so our default position is to remain at least equal weight equities in a balanced portfolio. We estimate that the equilibrium fed funds rate is somewhere in the neighborhood of 3 to 3.25%, so the monetary backdrop remains comfortably accommodative with fed funds at 2.25% and seemingly heading to 2% or lower in the coming months. Our estimate of equilibrium is no more than an estimate, however, so we are reprising our analysis of where consumption, investment and government spending are headed over the next six to twelve months. We remain constructive on the basis of that analysis. The GDP Equation GDP is the sum of consumption, investment, government spending and net exports. Rendered as an equation, GDP = C + I + G + (X-M). Net exports are not terribly meaningful for the comparatively closed U.S. economy, and we take a small fixed trade deficit as a given, so we reduce the equation to GDP = C + I + G. Ex-trade, consumption accounts for two-thirds of output, and fixed investment and government spending for one-sixth each. At four times each of the other components’ weight, consumption is the dominant driver of U.S. activity. Investment is considerably more variable, however, making it more likely to wipe out trend growth from the other drivers (Chart 4). As we showed the first time we performed the (C+I+G) analysis, investment would only have to fall to 0.83 standard deviations below its long-run mean to zero out 2% growth in consumption and government spending.1 Chart 4Investment Is The Wild Card In a normal distribution, events 0.83 or more standard deviations below the mean are expected to occur randomly about 20% of the time. It would take a -1.31-sigma consumption event (probability ≈ 10%) to zero out 2% growth in the rest of the economy. An expansion-killing decline in government spending would be a -1.86-sigma event (probability ≈ 3%). Investment is most likely to be the swing factor tilting the economy in the direction of a recession. Consumption Both retail sales and personal consumption expenditures have accelerated since early April (Chart 5). A robust labor market should continue to support consumption spending, as our payroll model projects a pickup in hiring (Chart 6, top panel), thanks to more ambitious NFIB hiring plans (Chart 6, second panel) and falling initial unemployment claims (Chart 6, bottom panel). Job openings are at their highest level in the 19-year history of the series, indicating that demand for new employees is high, and an elevated quits rate indicates that employers are paying up to poach workers from each other to satisfy that demand. We reiterate that more Americans will be working at the end of 2019 than at the end of 2018, and that all of them will be getting paid more, on average. A robust labor market will give household incomes a boost, and solid balance sheets will give them leave to spend it. Households don’t have to spend income gains, however. If they choose instead to save them, or divert them to paying down debt, consumption won’t get much of a near-term boost. The state of household balance sheets is also a driver of consumption’s direction, and they’ve improved at the margin since our last review. The savings rate moved sharply higher in the interim (Chart 7, top panel) and household debt as a share of GDP ticked lower (Chart 7, second panel), while the burden of servicing existing debt remains light (Chart 7, bottom panel). Chart 5Consumption Is Healthy Chart 6Hiring Is Poised To ##br##Tick Higher, ... Chart 7... And Households Are In A Position To Spend Bottom Line: Consumption remains well supported and will likely continue to be over a six- to twelve-month horizon. Investment Despite hopes that the reduction in corporate income tax rates and immediate expensing of qualified investments would promote capital expenditures, growth in nonresidential fixed investment has been uninspiring. Looking ahead, surveys of corporate investment intentions are decent coincident indicators of capex, and their monthly releases provide some leading insights into quarterly GDP investment. Capital spending plans in the NFIB small business survey have bounced since early April (Chart 8, top panel), but capex plans in the regional Fed surveys have weakened (Chart 8, bottom panel). Although both surveys have turned down, they remain at fairly elevated levels, suggesting that an investment plunge capable of negating trend growth in consumption and government spending is unlikely. Chart 8Neither Here Nor There Residential investment is less than a quarter of nonresidential investment and therefore typically only has a marginal impact on investment. It remains in a slump, with momentum in starts and permits sputtering (Chart 9, top panel); existing home sales running in place (Chart 9, middle panel); and inventories of homes for sale up since April, albeit still at low levels relative to history (Chart 9, bottom panel). Despite a sharp decline in mortgage rates since the end of last year, housing activity has failed to revive. Conversations with various market participants lead us to believe that zoning restrictions, sparse quantities of affordable land, difficulty in assembling construction crews, and a general idling of smaller developers in the wake of the crisis have all contributed to insufficient supplies of the entry-level and first-move-up homes for which there is ample demand. Chart 9Housing Is Weaker Than It Should Be, But It Doesn't Mean The Economy Is In Trouble Bottom Line: Neither nonresidential nor residential investment appears vulnerable enough to spark a decline in investment that could cause the economy to stall out. Government Spending All systems are go from a fiscal perspective. The federal spending taps will surely be open in a hotly contested presidential election year. State income and sales tax revenues have improved since our last review in April (Chart 10, top two panels), and should be well supported by a strong labor market. Solid home price appreciation will nudge the appraisals underpinning property taxes higher (Chart 10, third panel), supporting municipal tax receipts. Government spending will continue to hold up its end. Chart 10State And Local Revenues Will Hold Up Is Inflation Dead? Chart 11Another Upleg Is Coming We participated in a panel discussion last week at an inflation-linked products conference. The panel included Fed researchers and a veteran inflation-products trader turned investment manager. After a wide-ranging discussion that touched on U.S. economic prospects, the message from the yield curve, the impact of trade tensions and the continuing relevance of the Phillips Curve, each panelist was asked if inflation has already peaked for the cycle. The response was a resounding unanimous yes until we got our turn. The other panelists were not laypeople, traders, bottom-up analysts, or anyone else with only a passing interest in macroeconomics. They were experts, and we were struck by the conviction with which they dismissed the possibility that inflation could yet break out in the current cycle. Judging by the shrinking scale of the annual conference (this year’s edition was half the size of the previous two years’), the idea that inflation is dead for the foreseeable future has found a wide following. We do not think that inflation, and bond yields, will go anywhere in the immediate future, but it is far from assured that they will remain moribund for the rest of the expansion (Chart 11). Taking the other side looks attractive to us, given the preponderance of inflation-is-dead opinions. It is not terribly surprising that wide output gaps opened following an especially job-destructive downturn. With economic capacity considerably ahead of aggregate demand across the major economies, inflation had little chance of taking hold at an economy-wide level. The picture is changing, however, with the IMF estimating that the U.S. output gap closed in 2017 and in the advanced economies as a whole sometime last year (Chart 12). Goods inflation is primarily a global phenomenon, and with the IMF estimating that output gaps persist in Australia, Canada, Japan and the U.K., international slack can still mitigate domestic price pressures, though new tariff barriers would bind inflation more closely to domestic conditions. Services inflation, which is much more domestically driven, could begin to perk up now that unemployment is below NAIRU in the Eurozone as well as the U.S. (Chart 13). Finally, while central banks are hardly omnipotent, Milton Friedman’s always-and-everywhere admonition leaves little doubt that the monetary authorities can boost inflation expectations if they really want to. Chart 12Demand Has Caught Up To Capacity Chart 13Mind The Gap Investment Implications The investing backdrop is hardly ideal. Spreads are tight, stocks aren’t cheap, the two largest standalone economies are trying to inflect pain on each other, the U.K. can’t agree on how to get divorced from the EU, and the fate of the longest U.S. expansion on record is in doubt. The risks are well known, however, and save-haven assets have gotten pretty crowded. While the danger that shaky confidence could become self-fulfilling is real, our base case is that the expansion will trundle along, allowing stocks to rise as the worst-case scenarios fail to come to pass. It is at least possible that rumors of inflation’s demise have been greatly exaggerated. We continue to recommend that investors remain at least equal weight equities in balanced portfolios and at least equal weight spread product within bond allocations. We enthusiastically endorse our bond colleagues’ overweight TIPS recommendation. When nearly everyone agrees that a particular outcome cannot happen, it is often worth carving out some space in a portfolio in the event it actually does. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see Table 1 of the April 8, 2019 U.S. Investment Strategy Weekly Report, “If We Were Wrong,” available at usis.bcaresearch.com
Highlights Global bond yields have closely tracked the trajectory of global growth. While the global economy remains fragile, some positive signs are emerging: Our global leading economic indicator has moved off its lows; global financial conditions have eased significantly; U.S. household spending remains resilient; and China is set to further increase stimulus. Neither a severe escalation of the trade war nor a hard Brexit is likely. A simple comparison between current dividend yields and bond yields implies that global equities would need to fall by an outsized amount over the next decade for bonds to outperform stocks. As global growth stabilizes and then begins to recover over the coming months, bond yields will rebound from depressed levels. Investors should overweight stocks versus bonds for now, and look to upgrade EM and European equities later this year. Feature Global Growth Driving Bond Yields Chart 1Global Bond Yields: How Low Will They Go? Global bond yields rose sharply yesterday on word that U.S. and Chinese trade negotiators will meet in October. The announcement by China’s State Council of additional stimulus measures and better-than-expected data on the health of the U.S. service sector also drove the bond sell-off. The jump in yields follows a period of almost unrelenting declines. After hitting a high of 3.25% last October, the U.S. 10-year yield fell to 1.43% this Tuesday, just shy of its all-time low of 1.34% reached on July 5, 2016. The 30-year Treasury yield broke below 2% for the first time in history on August 15, falling to as low as 1.91% this week. It now stands at 2.07%. In Japan and across much of Europe, bond yields remain firmly in negative territory (Chart 1). The large movements in bond yields can be attributed to both the state of the global economy as well as to changes in how central banks are reacting to economic uncertainty. Just as stronger global growth pushed yields higher between mid-2016 and early-2018, the deceleration in growth since then has pulled yields lower. Chart 2 shows that there has been a close correlation between changes in the U.S. 10-year yield and the ISM manufacturing index. The release on Tuesday of a weaker-than-expected ISM manufacturing print for August was enough to push the 10-year yield down by seven basis points within a matter of minutes. Chart 2The Deceleration In Growth Has Pulled Yields Down The forward-looking new orders component of the ISM manufacturing index sunk to a seven-year low. The export orders component fell to the lowest level since 2009. Export volumes track ISM export orders quite closely (Chart 3). Not surprisingly, the ISM press release noted that trade remains “the most significant issue” for U.S. manufacturers. Chart 3Export Volumes Track The ISM Export Component The only redeeming feature in the report was that the customers’ inventories index dropped a notch from 45.7 in July to 44.9 in August. A reading below 50 for this subindex indicates that manufacturers believe that their customers are holding too few inventories, which is positive for future production. Global Manufacturing PMI Not Looking Much Brighter The Markit global manufacturing PMI remained below 50 for the fourth month in a row in August. While the global PMI did edge up slightly from July’s reading, this was largely due to a modest rebound in the Chinese PMI, which rose from 49.9 to 50.4. The improvement in the China Markit-Caixin PMI stands in contrast to the further deterioration observed in the “official” National Bureau of Statistics PMI. The former is more heavily geared towards private-sector exporting companies, and hence may have been influenced by the front-loading of exports ahead of the planned tariff increase on Chinese exports to the United States. Some Positive Signs Chart 4Global LEI Has Moved Off Its Lows In light of the disappointing manufacturing data, it is too early to call a bottom in the global industrial cycle. Nevertheless, there are some hopeful signs. Our Global Leading Economic Indicator (LEI) has moved off its lows (Chart 4). It usually leads the PMIs by a few months. Sterling will probably be the best performing currency in the G7 over the next five years. Despite ongoing weakness in the manufacturing sector, household spending has held up in most economies. In the U.S., the nonmanufacturing ISM index jumped to 56.4 in August from 53.7 in July. Real personal consumption is still on track to grow by 2.8% in Q3 according to the Atlanta Fed (Chart 5). The euro area services PMIs have also been resilient (Chart 6). In Germany, where the manufacturing PMI stood at 43.5 in August, the services PMI rose to 54.8. Chart 5Inventories And Net Exports Have Subtracted From U.S. Growth In Q2 And Q3 Chart 6AThe Service Sector Has Softened Much Less Than Manufacturing (I) Chart 6BThe Service Sector Has Softened Much Less Than Manufacturing (II) Global financial conditions have eased significantly, mainly thanks to the steep decline in bond yields. The current level of financial conditions implies that global growth could rebound swiftly (Chart 7). The Chinese government is also likely to step up fiscal/credit stimulus over the coming months in an effort to shore up growth. In a boldly worded statement released on Wednesday, the Chinese State Council promised to further increase bond issuance to finance infrastructure projects, while cutting interest rates and reserve requirements. A stronger Chinese economy should benefit global growth (Chart 8). Chart 7Easier Financial Conditions Will Benefit Global Growth Chart 8Stronger Chinese Growth Should Benefit The Global Economy The Trade War: Moving Towards A Détente? The announcement that the U.S. and China will resume trade negotiations on October 5th is a step in the right direction. As we noted last week, both parties have an incentive to de-escalate the trade conflict. President Trump wants to prop up the stock market and the economy in order to improve his re-election prospects. China also wants to bolster growth.1 Chart 9Would China Really Be Better Off Negotiating With A Democrat As President? As difficult as it has been for China to deal with Donald Trump, trying to secure a trade deal with him after he has been re-elected would be even more challenging. This would be especially the case if Trump thought that the Chinese had tried to sabotage his re-election bid. Even if Trump were to lose the election, it is not clear that China would end up with someone more palatable to deal with on trade matters. Does the Chinese government really want to negotiate over labor standards and human rights with President Warren, who betting markets now think has a better chance of becoming the Democratic nominee than Joe Biden (Chart 9)? While Republicans in Congress would be able to restrain a Democratic president on domestic issues, the president would still enjoy free rein over trade policy. Brexit Uncertainty Adding To Investor Angst Two weeks before the Brexit vote on June 23, 2016, I wrote that “Just like my gut told me last August that Trump would do much better at the polls than almost anyone thought possible, I increasingly feel that come June 24th, the EU may find itself with one less member.”2 Chart 10Brexit Opposition Has Been Growing Soon after the shocking verdict, we argued that a hard Brexit would prove to be politically infeasible, meaning that the U.K. would either end up holding another referendum or be forced to negotiate some sort of customs union with the EU. Our view that a hard Brexit will not happen has not changed. Chart 10 shows that opposition to Brexit has only grown since that fateful day. Boris Johnson does not have enough votes in Westminster to force a hard Brexit. Another election would not change this outcome, given that it would almost certainly produce a hung parliament. In any case, it is not clear that Johnson actually wants a hard Brexit. The Times of London recently reported that the government’s own contingency plans for a hard Brexit, weirdly code-named “Operation Yellowhammer,” predicted a crippling logjam at British ports leading to shortages of fuel, food and medicine.3 Boris Johnson is all hat and no cattle. He will be forced to make a deal with the EU. Buy the pound on any dips. Sterling will probably be the best performing currency in the G7 over the next five years. Central Banks: Cut First, Ask Questions Later Chart 11Inflation Expectations Are Low Across The Globe Despite a few glimmers of good news, central banks are in no mood to take any chances. St. Louis Fed President James Bullard said it bluntly last week: “Our job is to get the yield curve uninverted.”4 If history is any guide, global growth will stabilize and begin to recover over the coming months. Inflation expectations are below target in most economies (Chart 11). Central banks know full well that if the current slowdown morphs into a full-blown recession, they will be out of monetary ammunition very quickly. In such a setting, it does not make sense to hold your punches. Much better to generate as much inflation as possible, and as soon as possible, so that real rates can be brought deeper into negative territory if economic circumstances later warrant it. What If The Medicine Works? The risk of easing monetary policy too much is that economies will eventually overheat, producing more inflation than is desirable. It is easy to forget that the aggregate unemployment rate in the G7 is now below its 2007 lows (Chart 12). True, inflation has yet to take off, but this may simply be because inflation is a lagging indicator (Chart 13). Chart 12Unemployment Rates Keep Trending Lower Chart 13Inflation Is A Lagging Indicator For all the talk about how the Phillips curve is dead, the empirical evidence suggests it is very much alive and well (Chart 14). Ironically, this means that lower interest rates today could set the stage for much higher rates in the future if hyperstimulative monetary policies ultimately generate a bout of inflation. Chart 14The Phillips Curve Is Alive And Well Chart 15The Dollar Is A Countercyclical Currency Investment Conclusions Like most economic forecasters, central banks tend to extrapolate recent trends too far into the future. Global growth has been weakening since early 2018 so it seems reasonable to assume that this trend will persist into next year. However, as we have documented, global industrial cycles tend to last about three years – 18 months of rising growth followed by 18 months of falling growth.5 If history is any guide, global growth will stabilize and begin to recover over the coming months. Should that occur, we will enter an environment where the lagged effects of easier monetary policy are hitting the economy just when the manufacturing cycle is taking a turn for the better. Stocks are likely to fare well in such a setting, while long-term bond yields will move higher. As a countercyclical currency, the dollar will also start to weaken anew (Chart 15). Granted, an intensification of the trade war or some other major adverse shock would upset this rosy forecast. Nevertheless, current market pricing offers a fairly large cushion against downside risks. Thanks to the drop in bond yields, the equity risk premium is quite high globally (Chart 16). Even if one were to assume that nominal dividend payments remain unchanged for the next ten years, the S&P 500 would still need to fall by more than 20% in real terms over the next decade for bonds to outperform stocks (Chart 17). Euro area stocks would need to drop by more than 42%. U.K. stocks would need to plummet by at least 60%! Chart 16AEquity Risk Premia Remain Quite High (I) Chart 16BEquity Risk Premia Remain Quite High (II) Chart 17AStocks Need To Fall By A Considerable Amount For Bonds To Outperform Over A 10-Year Horizon (I) Chart 17BStocks Need To Fall By A Considerable Amount For Bonds To Outperform Over A 10-Year Horizon (II) Investors should remain overweight stocks versus bonds over the next 12 months. We intend to upgrade EM and European equities once we see a bit more evidence that global growth has troughed. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1Please see Global Investment Strategy Weekly Report, “A Psychological Recession?” dated August 30, 2019. 2Please see Global Investment Strategy Weekly Report, “Worry About Brexit, Not Payrolls,” dated June 10, 2016. 3Rosamund Urwin and Caroline Wheeler, “Operation Chaos: Whitehall’s Secret No-Deal Brexit Preparations Leaked,” The Times, August 18, 2019. 4“Fed’s Bullard Sees ‘Robust Debate’ Over Half-Point Cut,” Bloomberg, August 23, 2019. 5Please see Global Investment Strategy Weekly Report, “Three Cycles,” dated July 26, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades
Highlights The lingering global manufacturing recession and the substantial drop in U.S. bond yields have been behind the decoupling between both EM stocks and the S&P 500, and cyclical and defensive equities. Neither the most recent economic data, nor the relative performance of global cyclicals, China-related plays and high-beta markets herald a broad-based and lasting risk-on phase in global markets. On the contrary, economic and market signposts continue to indicate either further bifurcation in global markets or a risk-off period. We review some of our long-standing themes and associated recommendations. Feature Global financial markets have become bifurcated. On one hand, numerous segments of global financial markets leveraged to global growth, including EM stocks, have already sold off (Chart I-1). On the other hand, share prices of growth companies, defensive stocks and global credit markets have remained resilient. Chart I-2 shows that a similar divergence has taken place within EM asset classes: EM share prices have plummeted while EM corporate credit excess returns have not dropped much. Chart I-1Bifurcated Equity Markets Chart I-2Bifurcated Markets In EM How to explain this market bifurcation? Financial markets sensitive to global trade and manufacturing cycles have been mirroring worsening conditions in global trade and manufacturing. Some of the affected segments include: Global cyclical equity sectors. Emerging Asia manufacturing-related currencies (KRW, TWD and SGD) versus the U.S. dollar (Chart I-3). EM and DM commodity currencies (Chart I-4). Chart I-3Total Return (Including Carry): KRW, TWD And SGD Vs. USD Chart I-4EM And DM Commodity Currencies Industrial and energy commodities prices. U.S. high-beta stocks as well as U.S. small caps (Chart I-5). Chart I-5U.S. High-Beta Stocks DM bond yields. Crucially, the current global trade and manufacturing downturns have taken place despite robust U.S. consumer spending. In fact, our theme for the past several years has been that a global business cycle downturn would occur despite ongoing strength in American household spending. The rationale has been that China and the rest of EM combined are large enough on their own to bring down global trade and manufacturing, irrespective of strength in U.S. consumer spending. At the current juncture, one wonders whether such a market bifurcation is justified. It is not irrational. The basis for decoupling between cyclical and defensive equities has been U.S. bond yields. The substantial downshift in U.S. interest rate expectations has led to a re-rating of non-cyclicals and growth company stocks. Corporate bonds have also done well, given the background of a falling risk-free rate. Will the current market bifurcation continue? Or will these segments in global financial markets recouple and in which direction? What To Watch China rather than the U.S. has been the epicenter of this slowdown, as we have argued repeatedly in the past. Hence, a major rally in global cyclical equities and EM risk assets all hinge on a recovery in the Chinese business cycle. The basis for decoupling between cyclical and defensive equities has been U.S. bond yields. The substantial downshift in U.S. interest rate expectations has led to a re-rating of non-cyclicals and growth company stocks. Even though Caixin’s PMI for China was slightly up in August, many other economic indicators remain downbeat: The latest hard economic data out of Asia suggest that global trade/manufacturing continues to contract. Korea’s total exports in August contracted by 12.5% from a year ago, and its shipments to China plunged by 20% (Chart I-6). The import sub-component of China’s manufacturing PMI is not showing signs of amelioration (Chart I-7). The mainland’s import recovery is very critical to a revival in global trade and manufacturing. Chart I-6Korean Exports: No Recovery Chart I-7Chinese Imports To Remain Weak Chart I-8German Manufacturing Confidence German manufacturing IFO business expectations and current conditions both suggest that it is still early to bet on a global trade recovery (Chart I-8). Newly released August data points reveal that U.S., Taiwanese, and Swedish manufacturing new export orders continue to tumble. To gauge whether bifurcated markets will recouple and whether it will occur to the downside or the upside, investors should watch the relative performance of China-exposed markets, global cyclicals and high-beta plays – the ones that have already sold off substantially. The notion is as follows: These markets’ relative performance will likely bottom before their absolute performance recovers. If so, their relative performance will likely foretell the outlook for their absolute performance. Concerning share prices of growth companies, defensive equity sectors and credit markets, these segments are at risk because of expensive valuations and crowded investor positioning. In other words, they could sell off even if a global recession is avoided. Concerning share prices of growth companies, defensive equity sectors and credit markets, these segments are at risk because of expensive valuations and crowded investor positioning. To assess the outlook for global cyclicals and China-related plays, we are monitoring the following financial market indicators: The Risk-On/Safe-Haven currency ratio is the average of high-beta commodity currencies such as the CAD, AUD, NZD, BRL, CLP and ZAR total return (including carry) indices relative to the average of JPY and CHF total returns (including carry). This ratio is dollar-agnostic. This ratio is making a new cyclical low (Chart I-9). Hence, it presently warrants a negative view on global growth, China’s industrial sector and commodities. Global cyclical equity sectors seem to be on the edge of breaking down versus defensives (Chart I-10). This ratio does not signal ameliorating global growth conditions. Chart I-9The Risk-On/Safe-Haven Currency Ratio Chart I-10Global Cyclicals Versus Defensives Chart I-11U.S. High-Beta Stocks Versus S&P 500 Finally, U.S. high-beta stocks continue to underperform the S&P 500 (Chart I-11). This is consistent with overall U.S. growth deceleration. Bottom Line: Neither the most recent economic data, nor the relative performance of global cyclicals, China-related plays and high-beta markets herald a broad-based and lasting risk-on phase in global markets. On the contrary, economic and market signposts continue to foreshadow either further bifurcation in global markets or a risk-off period. Continue trading EM stocks and currencies on the short side, and underweighting EM risk assets versus DM. Our Investment Themes And Positions Some of our open positions often run for years because they reflect our long-standing themes. Our core theme has for some time been that a global trade/manufacturing recession will be generated by a growth relapse in China. To capitalize on this theme, we have been recommending a short EM stocks / long 30-year U.S. Treasurys strategy since April 2017. This recommendation has produced a 25% gain since its initiation (Chart I-12). Continue betting on lower local interest rates in emerging economies where the central bank can cut rates despite currency depreciation. To implement this theme, we have been recommending receiving swap rates in Korea and Chile for the past several years. Our reluctance to recommend an outright buy on local bonds stems from our bearish view on both currencies – the Korean won and Chilean peso. In fact, we have been shorting both the KRW and the CLP against the U.S. dollar. Chart I-13 shows that swap rates in Korea and Chile have dropped substantially since our recommendations to receive rates in these countries. More rate cuts are forthcoming in these economies, and we are maintaining these positions. Chart I-12EM Stocks Have Massively Underperformed U.S. Bonds Chart I-13Continue Receiving Rates In Korea And Chile We have been bearish on EM banks in general and Chinese banks in particular. We have expressed these themes in a number of ways: Short EM and Chinese / long U.S. bank stocks. Short EM banks / long EM consumer staples (Chart I-14). Within Chinese banks, we have been short Chinese medium and small banks / long large ones. All these strategies remain valid. In credit markets, we have been favoring U.S. corporate credit versus EM sovereign and corporate credit. Ability to service debt is better among U.S. debtors than EM/Chinese borrowers. We have been playing this theme in the following ways: Underweight EM sovereign and corporate credit / overweight U.S. investment-grade corporates (Chart I-15). Chart I-14Short EM Banks / Long EM Consumer Staples Chart I-15Underweight EM Credit / Overweight U.S. Investment-Grade Corporates Underweight Asian high-yield corporate credit / overweight emerging Asian investment-grade corporates. As a bet on a deteriorating political and business climate in Hong Kong, in our Special Report on Hong Kong SAR from June 27, we reiterated the following positions: Short Hong Kong property stocks / long Singapore equities. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Mexico: Crying Out For Policy Easing The Mexican economy is heading into a full-blown recession. Most segments of the economy are in contraction, and leading indicators point to further downside. Both manufacturing and non-manufacturing PMIs are well below 50 (Chart II-1). Monetary policy remains too restrictive: Nominal and real interest rates are both very high and plunging narrow money (M1) growth is signaling further downside in economic activity (Chart II-2). Chart II-1The Economy Is Deteriorating Chart II-2Narrow Money Points To Negative Growth An inverted yield curve signifies that the central bank is behind the curve and foreshadows growth contraction (Chart II-3). Fiscal policy has tightened as the government has remained committed to achieving a primary fiscal surplus of 1% of GDP in 2019 (Chart II-4, top panel). Consequently, nominal government expenditures have been curbed (Chart II-4, bottom panel). The government’s fiscal stimulus has not been large and has been implemented too late. Chart II-3A Message From The Inverted Yield Curve Chart II-4Fiscal Policy Has Tightened A Lot Finally, business confidence is extremely low due to uncertainty over President Andrés Manuel López Obrador’s (AMLO) policies towards the private sector. The president is attempting to revive business confidence, but it will take time. Chart II-5Mexico Versus EM: Domestic Bonds And Sovereign Credit Our major theme for Mexico has been that both monetary and fiscal policies are very tight. Consequently, we have been recommending overweight positions in Mexican domestic bonds and sovereign credit relative to their respective EM benchmarks. (Chart II-5). Recessions are bad for share prices, but in tandem with prudent macro policies, they can be positive for fixed-income markets. Meanwhile, we have been favoring the Mexican peso relative to other EM currencies due to the fact that AMLO is not as negative for the country as was initially perceived by markets. With inflation falling and the Federal Reserve cutting rates, Banxico will ease further. Yet, it will likely cut rates slower than warranted by the economy. The longer the central bank takes to ease, the lower domestic bond yields will drop. Concerning sovereign credit, investors should remain overweight Mexico within an EM credit portfolio. Mexico’s fiscal position is healthier, and macroeconomic policies will be more prudent relative to what the market is currently pricing. We continue to believe concerns about Pemex’s financing and its impact on government debt are overblown, as we discussed in detail in our previous Special Report. In July, the government released an action plan for Pemex financing. We view this plan as marginally positive. To supplement this plan, the government can use the $14.5 billion federal budget stabilization fund to fill in financing shortfalls in the coming years. Importantly, the starting point of Mexican public debt is quite low, which will allow the government to finance Pemex in the years to come by borrowing more from markets. Recessions are bad for share prices, but in tandem with prudent macro policies, they can be positive for fixed-income markets. Lastly, our overweight recommendation in Mexican stocks has not played out. However, we are maintaining it for the following reasons: Chart II-6 illustrates that when Mexican domestic bond yields decline relative to EM ones (shown inverted on Chart II-6), Mexican share prices usually outperform their EM counterparts in common currency terms. Consistent with our view that Mexican local currency bonds will outperform their EM peers, we expect Mexican stocks to outpace the EM equity benchmark. The Mexican bourse’s relative performance against EM often swings with the relative performance of EM consumer staples versus the EM equity benchmark. This is due to the large share of consumer staples stocks in Mexico (34.5%) compared to that in the EM benchmark (7%). Consumer staples stocks are beginning to outpace the EM equity index, raising the odds of Mexican equity outperformance versus its EM peers (Chart II-7). Chart II-6Local Bond Yields And Relative Stocks: Mexico Versus EM Chart II-7Consumer Staples Have A Large Weight In Mexican Bourse We do not expect a major rally in this nation’s stock market given the negative growth outlook. Our bet is that Mexican share prices - having already deflated considerably - will drop less in dollar terms than the overall EM equity index. Bottom Line: We continue to recommend an overweight stance on Mexican sovereign credit, domestic bonds and equities relative to their respective EM benchmarks. The main risk to the Mexican peso stems from persisting selloff in EM currencies. Traders’ net long positions in the MXN are elevated posing non-trivial risk (Chart II-8). We have been long MXN versus ZAR but are taking profit today. This trade has generated a 9.7% gain since March 29, 2018. A plunging oil-gold ratio warrants a caution on this cross rate in the near term (Chart II-9). Chart II-8Investors Are Long MXN Chart II-9Take Profits On Long MXN / Short ZAR Trade Juan Egaña, Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
As the summer holidays become a memory, central banks globally are mobilizing to fight mounting recession risks. More than 30 at last count are busily easing financial conditions to boost growth (Chart of the Week). Going into 4Q19, this monetary stimulus – coupled with fiscal stimulus globally – should allow growth ex-U.S. to revive, which will weaken the USD. This will be bullish for commodity demand in general, oil in particular. Fundamentally, the supply side of the oil market is in good shape. Production discipline by OPEC 2.0 will be maintained, while members of the coalition iterate on the level of output required to keep the rate of growth on the supply side below that of consumption.1 Capital discipline is being forced on U.S. shale-oil operators by markets. This will restrain their output growth rates to levels markets can absorb without inducing unintended inventory accumulation. A ceasefire in the Sino-U.S. trade war also could brighten short-term demand prospects and revive global trade volumes. This would indicate a recovery in manufacturing, given the heavy weight of manufactured goods in trade flows, and also in the the low-sulfur marine fuel markets. Going into 4Q19 and 1Q20, these supply-demand fundamentals will tighten markets, and force crude oil and refined product inventories lower. This will push Brent crude oil prices to our forecast levels of $66 and $75/bbl on average this year and next, with WTI trading $6.50 and $4/bbl under that. In addition, it would further backwardate crude oil forward curves. Chart of the WeekFinancial Conditions Continue Easing Among the risks to this view: Too-weak monetary/fiscal stimulus, leading to a failure to revive demand and stave off recession; a breakdown in OPEC 2.0’s production discipline; an expansion of the Sino-U.S. trade war; a disorderly Brexit; and, critically, a stubbornly strong USD, which raises the risk of direct intervention in FX markets by the U.S. central bank. Highlights Energy: Overweight. Saudi Aramco’s board of directors apparently has ruled out a listing of its IPO in New York, owing to legal risk in the U.S., according to Reuters news service.2 Riyadh and London reportedly are favored by board members. The Kingdom’s Crown Prince Mohammed bin Salman reportedly has the final say. Base Metals: Neutral. The nickel rally likely corrects over the short term, after a vertical shot that lifted the metal ~56.2% between early June and this week. This was partly fueled by speculation over commentary from an Indonesian official in July reinforcing the country’s stated goal of banning raw ore exports by 2022. Indonesia is the largest nickel ore producer in the world.3 Precious Metals: Neutral. Our tactical long platinum position is up 3.9% since it was recommended last week. We continue to expect platinum will draft in gold’s wake, benefiting from safe-haven demand for precious metals generally. Fundamentally, the risk of power outages in South Africa, which produces ~67% of the world’s platinum, remains high this month, putting platinum-group metal production at risk there. Technically, the metal held long-term support at $785/oz this year – a level that goes back to the Global Financial Crisis lows – and has since rallied ~ 18%. Ags/Softs: Underweight. Chinese tariffs on U.S. soybean imports went up 5% to a total of 30% September 1, coinciding with the imposition of additional tariffs on $300 billion of Chinese imports. Feature USD strength remains a headwind to stronger EM growth, which is keeping oil demand growth in check (Chart 2).4 Indeed, in local-currency terms, oil prices remain closer to their 2014 highs, when Brent and WTI were trading above $100/bbl (Chart 3). The persistently strong USD is one reason we lowered our oil-demand forecast four times this year, which puts it at 1.2mm b/d for 2019. Chart 2USD Strength Hinders Oil Demand Growth Chart 3USD Strength Keeps Local-Currency Costs High The slowdown in global oil demand began in 2H18 and picked up speed in 1H19. We believe this largely was the result of a global tightening in financial conditions – apparent in the Chart of the Week – led by the Fed, which, with near-singular determination, raised its policy rate four times last year. Fed policy kept USD-denominated assets well bid, but, equally importantly, it raised the costs of commodities and all goods and services invoiced in USD globally in local-currency terms. This reduced aggregate demand ex-U.S. as households’ and firms’ discretionary incomes fell.5 Commodity demand also was derailed by the extended de-leveraging campaign by Chinese policymakers, which ran from 2017-18 and succeeded in its goal of bringing down the country’s debt-to-GDP ratio and the growth rate of leverage. Central Banks Scramble To Revive Growth The Treasury may be forced to up the ante and directly intervene in FX markets to weaken the dollar. To reverse the tightening of monetary conditions worldwide, central banks this year started moving to more accommodative monetary-policy settings, which we expect will continue to support looser financial conditions around the globe. In addition, fiscal stimulus either is being deployed or readied in key EM economies like China and India, which, together, account for 36% of the 53.5mm b/d of EM oil consumption we estimate for 2019. These policy responses should revive GDP growth – particularly in EM economies – and, all else equal, oil demand in the process going into 4Q19. The performance of our leading indicators support this expectation (Chart 4). That said, with so many systematically important central banks weakening their currencies, the USD could remain strong in relative terms.6 If the dollar remains a safe-haven asset in uncertain markets, while serving as the world’s reserve/invoicing/funding currency, weakening the USD during a period of high financial stress could be difficult. In that case, the Treasury may be forced to up the ante and directly intervene in FX markets to weaken the dollar. Chart 4Global LEIs Bottomed And Are Moving Up Managing Financial Conditions In A Trade War We do not expect the Sino-U.S. trade war to be resolved. National security, foreign policy and technology positions that have been advanced by both sides appear impossible to walk back (e.g., protecting 5G networks from spying, and safeguarding intellectual property). This suggests the Sino-U.S. relationship is in the early stages of a Cold War, which could go hot in the short run.7 Still, a short-term agreement or ceasefire this year or next is still possible. The basis for such a shift would be President Trump staging a retreat to try to clinch a deal and improve the economy prior to his re-election campaign. China might accept a temporary reprieve. This would allow both sides to retreat to re-group for the almost-certain renewed trade tension that will mark the Sino-U.S. relationship going forward. Over the short run, a ceasefire could brighten demand prospects and revive global trade volumes. This would be supportive of crude oil and refined-products markets, particularly the low-sulfur marine fuel market, which, on January 1, will be bound by IMO 2020 standards.8 In the medium to longer-run, however, neither the U.S. nor China will cede ground if it strengthens the hand of the other, particularly regarding national security and technology, which will continue to be the key concern for all national security issues. This complicates fiscal and monetary policy for both sides going forward, along with trade relationships for each. We do not believe either side has these issues sorted, and likely will need time and space to develop policies for the medium- and longer-term. It also means each side’s respective allies will have to make hard choices in deciding whose camp they will migrate toward. These considerations cloud the outlook for the medium- to long-term oil markets. We will be exploring them in greater depth in forthcoming Commodity & Energy Strategy reports. Investment Implications We remain broadly long in our exposure to oil markets, expecting the fundamentals outlined above to tighten supply, strengthen demand and draw down inventories. Given this view, we remain long WTI flat price, and long 4Q19 Brent futures vs. short 4Q20 Brent futures, expecting a steeper backwardation. We also remain long the S&P GSCI commodity index, given its relatively heavy exposure to energy markets. Bottom Line: Supply-demand fundamentals, coupled with a favorable fiscal and monetary backdrop, indicate oil prices will move higher from current levels toward our forecasts of $75/bbl and $71/bbl next year for Brent and WTI, respectively. This view is not without risk – chiefly around the Sino-U.S. trade war, and the risk that an expansion of tensions would stunt global demand for oil significantly. We continue to follow this closely. Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Footnotes 1 OPEC 2.0 is the name we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. It was formed in 2016 to manage production and reduce oil inventory levels globally. For a complete summary of our supply-demand expectations for this year and next, please see the August 22, 2019 Commodity & Energy Strategy Weekly Report, "USD Strength Slows Oil Demand Growth; 2020 Brent Forecast Remains At $75/bbl". 2 Please see Exclusive: Saudi Aramco board sees too many risks for New York IPO - sources, published by reuters.com August 30, 2019. 3 Please see Nickel price forecast revised up as speculative rally boosts tight market — report, published by mining.com August 29, 2019. 4 We have shown in previous research EM income growth accounts for most of the growth in oil demand globally. This year, for example, we expect EM demand growth to account for 87% of 2019’s 1.2mm b/d growth in oil consumption. Next year, EM is expected to account for 79% of the 1.5mm b/d of growth we expect. For this reason, oil prices – and base metals prices – are a good barometer of the of EM income growth. 5 Maurice Obstfeld noted at the Fed’s June 2019 Conference on Monetary Policy Strategy, Tools, and Communication Practices (A Fed Listens Event) that the USD is not only the world’s reserve currency, it also is the dominant invoicing and funding currency. “… the dollar’s invoice-currency role affects the international price mechanism by influencing how U.S. monetary policy will move real exchange rates, inflation, and export competitiveness throughout the world. … (The) dollar’s funding currency role mediates the transmission of U.S. monetary policy to global financing conditions. “Through both mechanisms, U.S. monetary policy has an outsized impact on global economic activity – consistent with the evidence on unconventional policy spillovers. … The Federal Reserve, more than other central banks, should therefore consider spillbacks from the global economy as a relevant transmission mechanism for its policies.” Prof. Obstfeld’s paper can be downloaded at the Fed website, Global Dimensions of U.S. Monetary Policy. 6 In the August 26, 2019, issue of BCA Research’s U.S. Investment Strategy, our colleague Doug Peta, chief U.S. investment strategist, notes, “No central bank wants a stronger currency while confronting a demand deficiency aggravated by trade tensions and a global manufacturing slowdown. The New York Times Business section put the prevailing policy winds into living color in a nearly full-page, four-column graphic spotlighting the 32 central banks that have cut their policy rate so far this year.” For further discussion, please see Market Messages, published August 26, 2019, by BCA Research’s U.S. Investment Strategy. It is available at usis.bcaresearch.com. 7 Our geopolitical strategists make the odds of a trade agreement 40%, perhaps a bit higher. Please see Big Trouble In Greater China, published August 23, 2019, by BCA Research’s Geopolitical Strategy, for an excellent discussion of the fraught Sino-U.S. relationship. It is available at gps.bcaresearch.com. 8 We expect global shipping-fuels market to tighten as UN-mandated fuel standards kick in next year. This will keep ship fuels, specifically Gasoil and ULSFO, and other distillate prices – e.g., diesel and jet fuel – elevated relative to other refined products like gasoline. This will boost demand for lighter, sweeter crudes – particularly Brent and similar grades – that allow refiners to raise distillate yields, as they scramble to meet higher demand for low-sulfur ship-fuel next year. For more information on IMO 2020, please see IMO 2020: The Greening Of The Ship-Fuel Market, published by BCA Research’s Commodity & Energy Strategy February 28, 2019. It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades