Policy
As structural credit booms have ended, economies have one by one entered the state of price stability. First it was Japan; then it was Switzerland; more recently it has been the euro area and the United States. It follows that the 5-year annualized inflation…
Highlights Portfolio Strategy Intensifying recession fears, rising risks of ineffectual monetary policy, and escalating trade policy uncertainty that is shattering corporate America’s capex plans, warn that sizable drawdown risks persist in the broad U.S. equity market in the upcoming 3-12 months. The transition from a virtuous to a vicious EPS-to capex cycle, souring global growth, the firming U.S. dollar that is weighing on cyclical/defensive pricing power and exports, and deteriorating relative balance sheet (b/s) and relative operating metrics compel us to put the cyclicals/defensives portfolio bent on downgrade alert. Recent Changes The cyclicals/defensives portfolio bent is now on our downgrade watch list. Table 1 Feature The SPX moved laterally last week, and remains below the critical 50-day moving average. Recession worries intensified on the back of the first sustained 10/2 yield curve slope inversion. Coupled with the trade war re-escalation, they remain the dominant macro themes. Worrisomely, BCA’s Equity Selloff Indicator captures these dynamics and continues to emit a distress signal (Chart 1). Equities have been relatively resilient in the face of these headwinds. Investors are hoping not only for a U.S./China trade deal, but also that the Fed’s cutting cycle will save the day. Chart 1Mind The Gap What caught our attention from all the speeches at the recent Jackson Hole Symposium was RBA Governor Philip Lowe’s speech, especially the section titled “Elevated Expectations That Monetary Policy Can Deliver Economic Prosperity”.1 Lowe highlighted that “When easing monetary policy, all central banks know that part of the transmission mechanism is a depreciation of the exchange rate. But if all central banks ease similarly at around the same time, there is no exchange rate channel: we trade with one another, not with Mars. There are, of course other transmission mechanisms, but once we cancel out the exchange rate channel, the overall effect for any one economy is reduced. If firms don't want to invest because of elevated uncertainty, we can't be confident that changes in monetary conditions will have the normal effect (stress ours).” The perception that the Fed is going to be the savior of the economy is a big risk, and when reality hits that President Trump’s tariffs are a shock to global final demand and presage profit contraction, volatility will skyrocket (please refer to Chart 3 from the August 19 Weekly Report). Importantly, the virtuous capex upcycle that has been in motion since the Trump inauguration when CEOs voted with their feet and started investing, has ground to a halt according to national accounts (Chart 2). U.S. non-residential fixed investment subtracted from GDP growth last quarter, and we doubt the Fed’s fresh interest rate cutting cycle will arrest the fall. Leading indicators of capital outlays point to additional pain in coming quarters (Chart 2). As a reminder, generationally low interest rates and a real fed funds rate near zero hardly restrict expansion plans. Chart 2Free Falling The shift from a virtuous to a vicious capex cycle is a theme that will start gaining traction as the year draws to a close. While pundits are dismissing the recent steep fall in capex as a one off, our indicators suggest otherwise. The middle panel of Chart 3 clearly depicts this emerging dynamic. Profit growth peaked in 2018 on the back of the massive fiscal easing package and capex is following suit, albeit with a slight lag. There are high odds that a looming profit contraction will further shatter frail animal spirits, sabotage the capex upcycle and tilt into a down cycle. Tack on the ongoing trade uncertainty, and CEOs are certain to, at least, postpone deploying longer-term oriented capital. Worryingly, this transition from a virtuous to a vicious capex cycle is not limited to a few cyclical sectors as we would have expected on the back of the re-escalating Sino-American trade tussle. In fact, basic resources’ and non-capital goods producers’ capital outlays are decelerating, warning that corporate America is in the early stages of retrenchment (bottom panel, Chart 3). Chart 3EPS-To-Capex Down Cycle Chart 4Capex… Charts 4, 5 & 6 break down sectorial capex growth using financial statement reported data from Refinitiv. Seven out of eleven sectors are steeply decelerating from near 20%/annum growth to half that; given that these sectors comprise more than 72% of the total capex pie, they will continue to weigh on overall stock market reported investment. Chart 5…Per… Chart 6…Sector Similarly, the news on the cyclicals versus defensives capex profile is grim. Trade uncertainty and the global growth soft patch has dealt a blow to deep cyclical expansion plans and leading indicators signal that the cyclicals/defensives capex will flirt with the contraction zone in the coming quarters (Chart 7). In sum, intensifying recession fears, rising risks of ineffectual monetary policy, and escalating trade policy uncertainty that is shattering corporate America’s capex plans, warn that sizable drawdown risks persist in the broad U.S. equity market in the upcoming 3-12 months. As a reminder, this is U.S. Equity Strategy’s view, which contrasts BCA’s sanguine equity market house view. Chart 7Relative Capex Blues This week we update our cyclicals versus defensives bias (we are currently neutral) and are compelled to put this portfolio bent on our downgrade watch list. Put The Cyclical/Defensive Tilt On Downgrade Alert Roughly two years ago, when nobody was talking about the brewing capex upcycle, we penned a report titled “Underappreciated Capex” and posited that: “It would be unprecedented if the current business cycle ended without a visible capex upcycle. Since the 1980s recession, all four recessions were preceded by stock market reported capex soaring to roughly a 20% annual growth rate. At the current juncture, capex is merely on the cusp of entering expansion territory and, if history at least rhymes, a significant capex upcycle is looming.” Fast forward to today and as historical empirical evidence had suggested, capex growth peaked near the 20%/annum mark (Chart 3 above). If our assessment is accurate that capex has now likely hit a wall and the virtuous EPS-to-capex cycle reverses to a vicious down cycle as EPS are now contracting, then deep cyclical high-operating leverage sectors are in for a rough ride. This will especially be true if the global recession warnings also morph into an actual recession on the back of the re-escalating Sino-American trade war. More specifically, our capex indicators are firing warning shots. Capex intentions according to a plethora of regional Fed surveys are sinking steadily, which bodes ill for cyclicals versus defensives (Chart 8). One key driver of the capex cycle is China and the emerging markets (EM). News on both fronts is grim. Our real-time indicator that gauges China’s reflation efforts (monetary and fiscal) turning into actual economic activity is Chinese excavator sales that remain in the doldrums (top panel, Chart 9). Chart 8Drop In Capex Will Weigh On Relative Profits Chart 9Elusive Global Growth Granted, global growth remains elusive as we highlighted last week and while softening Chinese economic activity is weighing on global growth, European and Japanese GDP growth is also decelerating with a number of economies already in the contraction zone (bottom panel, Chart 9). Melting global bond yields reflect these growth fears and warn that the relative share price ratio has more downside (middle panel, Chart 9). Export growth is an important indicator that closely tracks the ebbs and flows of global trade. When the trade-weighted U.S. dollar appreciates it dampens trade, the opposite is also true. Currently the Fed’s trade-weighted greenback based on goods has vaulted to cyclical highs, warning that the path of least resistance is lower for trade, thus a net negative for relative export and profit prospects (Chart 10). Similarly, EM capital outflows exacerbate the ongoing global growth blues and put additional strain on EM economies as depreciating currencies sap consumer purchasing power (top panel, Chart 10). The implication is that EM final demand is in retreat. The rising U.S. dollar not only deals a blow to basic resource exports via making them less competitive and leading to market share losses, but it also undermines cyclical sectors' pricing power. The top panel of Chart 11 shows that deflating commodity prices are exerting downward pull on relative share prices. The ISM manufacturing survey’s prices paid subcomponent corroborates this deflationary backdrop. Keep in mind that operating leverage cuts both ways, and now that the pendulum is swinging the opposite way revenue contraction in these high fixed costs industries will fall straight off the bottom line (Chart 11). Chart 10Rising Dollar Dollar Dampens Trade And… Chart 11…Saps Pricing Power Our macro-based cyclicals/defensives EPS growth models do an excellent job in capturing all these moving parts and signal that defensives have the upper hand in the coming quarters (bottom panel, Chart 8). Turning to operating metrics, the inventory buildup in the past few quarters coupled with a softness in overall business sales underscore that relative share prices will continue to trend lower (top panel, Chart 12). On the balance sheet front, relative net debt-to-EBITDA has troughed and widening junk spreads and the inverted yield curve warn that a further relative b/s degrading looms (second & third panels, Chart 12). If our thesis pans out in the coming months, then cash flow growth will come under pressure as the vicious capex cycle flexes its muscles foreshadowing a rise in bankruptcy filings. Already, the news on the profit margin front is disconcerting. Historically, the ISM manufacturing index and relative operating profit margins have been joined at the hip and the recent flirting of the former with the boom/bust line points toward an ominous relative margin squeeze (bottom panel, Chart 12). Chart 12Poor Financial & Operating Backdrop… Chart 13…But Excellent Valuations And Technicals Finally, soft versus hard data surprise oscillations have an excellent track record in forecasting relative share price movements. The current message is to expect additional weakness in relative share prices (second panel, Chart 13). While most of the indicators we track signal that the time is ripe to downgrade this portfolio bent to an underweight stance, bombed out relative valuations, and oversold technicals keep us at bay, at least for the time being (third & bottom panels, Chart 13). However, we are compelled to put the cyclicals/defensives ratio on downgrade alert to reflect the transition from a virtuous to a vicious EPS-to-capex cycle, souring global growth, the firming U.S. dollar that is weighing on cyclical/defensive pricing power and exports, and deteriorating b/s and operating metrics. The way we will execute this downgrade will be via a downgrade of the S&P tech sector (for additional details on the S&P tech sector's downgrade mechanics please refer to last Friday’s U.S. Equity Strategy Insight Report). Bottom Line: Stay on the sidelines in the S&P cyclicals/S&P defensives ratio, but put it on downgrade alert. Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1 https://www.rba.gov.au/speeches/2019/sp-gov-2019-08-25.html Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps
Highlights Our cyclical view is unchanged, … : Despite the evident risks from escalating trade tensions, soft global economic data, and widespread recession concerns, we expect the expansion and the bull markets in spread product and equities will remain intact. … as fiscal largesse has provided the U.S. economy with ample cushion: Per the IMF’s estimates, the fiscal stimulus package centered on the Tax Cuts and Jobs Act of 2017 amounted to about 70 basis points (“bps”) of fiscal thrust in 2018 and another 40 bps in 2019. But how is Congress’ unprecedented experiment shaping up beyond 2019?: The first-order impact of the tax cuts on government revenues is straightforward. The ultimate net effect turns on how lower taxes alter the course of corporate investment and work force participation. The CBO’s latest projections have the federal deficit widening by an additional $1 trillion over the next decade: Supply-side benefits from the 2017 Act have underwhelmed so far, and the fate of the federal budget depends on lawmakers’ restraint. We are long-run bearish on Treasuries and the dollar. Feature The fundamental backdrop remains mixed in the United States and the rest of the world. Global trade has slowed, and the world is experiencing a sharp manufacturing slowdown. The consensus of BCA researchers expects that manufacturing will soon find a footing, and the global economy will revive, helped along by easier monetary policy. A fiscal pick-me-up is long overdue, and would be especially welcome, but we are not holding our breath, especially when Japan finally seems prepared to impose its repeatedly-postponed VAT increase. Opinion within BCA is notably split, and the glass-half-full and glass-half-empty camps remain far apart. The mixed tone of the macro data offers something for bulls and bears, and contributed to the sharp single-day moves that characterized August’s equity action. Although the S&P 500 moved at least 1% in half of its sessions, however, it was down less than 2% for the month through Thursday. After slipping from its 3,000 perch amidst a 5% decline across August’s first three sessions on renewed trade hostilities, it traded in a narrow range between 2,825 and 2,945 the rest of the way (Chart 1). Chart 1Big Daily Swings, But A Tight Monthly Range The Fed is caught in a loop of responding to inorganic shocks. It tightened policy in 2018 while nervously looking over its shoulder at a sizable injection of procyclical fiscal stimulus that wound up exerting less overheating pressure than it had feared. Now it finds itself uncomfortably drawn into the vortex of the trade war, cutting rates to keep the expansion from being snuffed out prematurely by self-inflicted wounds. Various Fed officials seem to be chafing under the burden of serving as a bulwark against the drag from the tariff fights. As Chair Powell admonished in his Jackson Hole address, “[M]onetary policy … cannot provide a settled rulebook for international trade.” Like it or not, the Fed is stuck cleaning up other policymakers’ messes. Jackson Hole would normally have brought down the curtain on any meaningful market news until after Labor Day. But Bill Dudley, the head of the New York Fed from 2009 to 2018, had other ideas. He argued in a Bloomberg opinion column that the Fed should refuse to abet foolhardy trade policy with rate cuts that offset its ill effects. He went on to posit that it is within the Fed’s remit to set policy with an eye toward influencing the outcome of the 2020 presidential election. Dudley’s grenade enlivened a slow news day and had the effect of unifying the economics community in condemnation of his polemic. The Fed swiftly distanced itself from the comments, reiterating that its “decisions are guided solely by its congressional mandate,” and that “political considerations play absolutely no role.” It is hard to know what Dr. Dudley intended to accomplish, but he ensured that we will be at BCA’s 40th Annual Investment Conference bright and early on Friday, September 27th when he kicks off its second day. Initial Estimates Soon after the 2017 Tax Cuts and Jobs Act was passed, the Congressional Budget Office (“CBO”) assessed how its provisions would affect the U.S. economy. Although calculating the components involves myriad complex estimates, the budget equation is quite simple: Budget Surplus/(Deficit) = Revenues – Outlays. Cutting taxes clearly reduces revenues, and the reductions in individual tax rates, partially offset by limits on deductions, were estimated to cost the federal government roughly $300 billion over the next decade. The 10-year tab for lower corporate rates, and immediate expensing of business investments through 2022, was estimated to run about $1 trillion. Relief from some spending constraints brought the total estimated cost to $1.7 trillion. A trillion here, and a trillion there, and pretty soon you’re talking real money. Though the Act was sure to worsen the deficit, it contained provisions meant to encourage investment and labor supply. Corporate tax cuts and the full immediate expensing of investments in software and eligible equipment were expected to permanently increase the nation’s capital stock, thereby boosting the trend pace of productivity growth. A reduced individual income tax burden was expected to encourage more people to enter the workforce and incumbents to work longer hours. Ultimately, the CBO projected that the Act would boost the level of real potential GDP by 0.7%, on average, through 2029. Six Quarters On It follows that people might work more if they are able to keep more of what they earn, but the data since individual income tax rates were reduced at the beginning of 2018 are inconclusive. The labor force participation rate has been treading water for several years (Chart 2, solid line), as it battles against the drag from baby boomer aging (Chart 2, dashed line). Prime-age labor force participation has risen very slowly off of its 2015 bottom, and has spent 2019 unwinding its gains from late last year (Chart 3). Average weekly hours worked remain locked in the narrow range that has prevailed since 2012 (Chart 4). Though it is difficult to isolate the drivers of participation gains, the part rate’s erratic 2018-9 course suggests that the Act has not yet had a discernible work force impact. Chart 2The Baby Boomers Have Become A Demographic Headwind Chart 3Labor Supply ##br##Gains ... Chart 4... Have Yet To Materialize Residential investment, which lost some tax subsidies via the Act’s limits on mortgage interest and state and local tax deductions, has declined in every quarter since it was passed, and we back it out of fixed investment to assess the Act’s impact on corporate investment. As with labor supply, the record so far is mixed. Fixed investment (ex-residential investment) built on its 4Q17 acceleration over the first three quarters of 2018 only to slide in the three subsequent quarters (Chart 5). Publicly traded corporations have proven more eager to share their cash windfall with shareholders than they have been to invest it. Chart 5Investment Stimulus? What Investment Stimulus? Looking Ahead – Activity Effects We accept that lower individual income tax rates make work more attractive. People respond to incentives, and more after-tax pay, all else equal, should encourage some discouraged workers to rejoin the labor market and push some of the currently employed to want to work more. The changes are modest, though, with take-home pay increasing $324, or 2%, for someone earning $20,000, and $1,299, or 3%, for someone earning $50,000 (Table 1). We see the Act as having no more than a modest marginal effect on labor supply, though it should help boost consumption until households begin to factor in seemingly inevitable future tax hikes. Table 1Take-Home Pay Is Up, But Not By Much If the 2017 Act really is going to boost the potential trend rate of growth, it will have to do so by pushing the rate of productivity growth higher.1 Workers are able to produce more in a given block of time when they’re endowed with more and better tools, and new tools require investment. If fixed investment doesn’t accelerate, there’s no reason to expect that productivity will (Chart 6). The capex outlook from the NFIB survey and the various Fed regional manufacturing surveys is iffy, and BCA has previously noted how an aging population and a shift to more capital-light businesses may restrain investment. Chart 6Investment Drives Productivity It will not be an easy matter to boost productivity by boosting capex, though some of businesses’ after-tax cash will likely find its way to investment. To help the process along, Congress incorporated a familiar provision: accelerated depreciation. Accelerated depreciation’s empirical record as an investment catalyst is hardly clear (Box), and we don’t find its theoretical basis terribly compelling. We think the Act’s trend growth impacts are more likely to disappoint the CBO’s expectations than exceed them. Investment confronts demographic headwinds, too. Pushing trend growth higher will not be easy. Box - An Anodyne Prescription A celebrated provision of the Act allows for the immediate expensing of qualified investments until 2022. Accelerated depreciation programs, which allow for more rapid expensing of investments in property, equipment and other depreciable assets in an attempt to stimulate investment, are a stock measure in lawmakers’ stimulus toolkit, but their effectiveness is hardly assured. For one thing, they’re not new, and businesses may have built up an immunity to them, as they have been a continuous feature of the tax code since 1981. The immediate expensing allowed under the 2017 Act is a form of bonus depreciation, which was initially introduced in the wake of the September 11th attacks. It has remained in place for all but one subsequent year, and though investment peaked during the other stretch that provided for immediate write-offs (September 2010 - December 2011), we are skeptical that it will materially increase the size of the capital stock going forward. Accelerated depreciation schemes encourage investment via the time value of money. They do not increase the depreciation benefit provided by a particular investment, they simply speed up its recognition. Savvy businesses may adjust the timing of their investments to take advantage of temporary bonus periods, but they will not necessarily invest more.2 With rock-bottom interest rates squeezing the time value of money, it’s possible that bonus depreciation’s impact may be especially muted this time. Looking Ahead – The Budget Deficit The CBO’s updated projections through 2029, released two weeks ago, call for the budget shortfall to widen by $800 billion more than previously estimated in January. Despite a downward revision of over $1 trillion in projected interest expense, additional spending has weakened the deficit outlook. It appears that elected officials simply can’t help themselves. In a climate in which neither Congress nor voters evince any desire to rein in the deficit, it seems foolishly naïve to assume that future sessions of Congress will abide by built-in expenditure limits like sunset provisions and spending caps. Although the CBO projects that federal revenues will rise across its 10-year forecasting horizon, they will not do so fast enough to keep up with outlays swollen by interest payments on the growing pile of Treasuries (Chart 7). The CBO sees debt as a share of GDP rising to 95% by 2029, within reach of the all-time high recorded after World War II (Chart 8). Financial markets don’t care now, and we don’t think they will any time in the near future, but the CBO’s baseline projections, which assume future Congresses abide by their stated commitments, probably represent an optimistic scenario. We are more inclined to expect the alternative scenarios, in which sunset provisions are ignored, and pre-set spending caps are set aside, to come to pass. Chart 7A Widening Budget Gap ... Chart 8... Leads To An Increased Debt Burden Investment Implications Chart 9The Dollar's Long-Run Direction Is Down Treasury yields are currently within sight of their July 2016 Brexit-inspired lows, and may well revisit them. Negative yields are a common feature well out the maturity curve in core Europe and Japan. A sustained move higher is not in the cards in the near term, and though we do expect yields to rise as the global economy gains some traction later this year, we do not foresee a disruptive move higher even over the next couple of years. The very long-term outlook for Treasuries is lousy, however, and the dollar also faces secular pressures (Chart 9). The U.S. is not likely to turn into Japan, but the next decade’s returns will likely pale beside those earned since 1982. We are congenitally optimistic about humanity, and Americans seem to have a particular knack for pulling rabbits out of hats. We do not see the U.S. turning into Argentina, Greece or even Japan. The debt burden will weigh on potential growth down the road, however, as debt service will limit Congress’ ability to deploy countercyclical adjustments and longer-term investments, and debt issuance will eventually crimp private entities’ access to capital. All of these factors will limit potential economic growth and contribute to softening returns on equity and credit. We continue to foresee tepid returns over the next ten years relative to the returns investors have grown accustomed to over the last four decades, and we would much rather borrow at current rates for the next 20 or 30 years than lend at them. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Economic growth is the sum of growth in productivity and growth in the size of the labor force. Since the Act does not bear on immigration or birthrates, productivity represents its best shot at moving the growth needle. 2 Congressional Research Service Report RL31852, The Section 179 and Section 168(k) Expensing Allowances: Current Law and Economic Effects, by Gary Guenther, May 1, 2018.
Highlights While a self-fulfilling crisis of confidence that plunges the global economy into recession cannot be excluded, it is far from our base case. Provided the trade war does not spiral out of control, it is highly likely that global equities will outperform bonds over the next 12 months. The auto sector has been the main driver of the global manufacturing slowdown. As automobile output begins to recover later this year, so too will global manufacturing. Go long auto stocks. As a countercyclical currency, the U.S. dollar will weaken once global growth picks up. We expect to upgrade EM and European equities later this year along with cyclical equity sectors such as industrials, energy, and materials. Financials should also benefit from steeper yield curves. We still like gold as a long-term investment. However, the combination of higher bond yields and diminished trade tensions could cause bullion to sell off in the near term. As such, we are closing our tactical long gold trade for a gain of 20.5%. Feature “The Democrats are trying to 'will' the Economy to be bad for purposes of the 2020 Election. Very Selfish!” – @realDonaldTrump, 19 August 2019 8:26 am “The Fake News Media is doing everything they can to crash the economy because they think that will be bad for me and my re-election” – @realDonaldTrump, 15 August 2019 9:52 am Bad Juju Chart 1Spike In Google Searches For The Word Recession President Trump’s remarks, made just a few days after the U.S. yield curve inverted, were no doubt meant to deflect attention away from the trade war, while providing cover for any economic weakness that might occur on his watch. But does the larger point still stand? Google searches for the word “recession” have spiked recently, even though underlying U.S. growth has remained robust (Chart 1). Could rising angst induce an actual recession? Theoretically, the answer is yes. A sudden drop in confidence can generate a self-fulfilling cycle where rising pessimism leads to less private-sector spending, higher unemployment, lower corporate profits, weaker stock prices, and ultimately, even deeper pessimism. Two things make such a vicious cycle more probable in the current environment. First, the value of risk assets is quite high in relation to GDP in many economies (Chart 2). This means that any pullback in equity prices or jump in credit spreads will have an outsized impact on financial conditions. Chart 2The Total Market Value Of Risk Assets Is Elevated Chart 3Not Much Scope To Cut Rates Second, policymakers are currently more constrained in their ability to react to adverse shocks, such as an intensification of the trade war, than in the past. Interest rates in Europe and Japan are already at zero or in negative territory (Chart 3). Even in the U.S., the zero-lower bound constraint – though squishier than once believed – remains a formidable obstacle. Chart 4 shows that the Federal Reserve has cut rates by over five percentage points, on average, during past recessions. It would be impossible to cut rates by that much this time around if the U.S. economy were to experience a major downturn. Chart 4The Fed Is Worried About The Zero Bound Fiscal stimulus could help buttress growth. However, both political and economic considerations are likely to limit the policy response. While China is stimulating its economy, concerns about excessively high debt levels have caused the authorities to adopt a reactive, tentative approach. Japan is set to raise the consumption tax on October 1st. Although a variety of offsetting measures will mitigate the impact on the Japanese economy, the net effect will still be a tightening of fiscal policy. Germany has mused over launching its own Green New Deal, but so far there has been a lot more talk than action. President Trump floated the idea of cutting payroll taxes, only to abandon it once it became clear that the Democrats were unwilling to go along. On The Positive Side Despite these clear risks, we are inclined to maintain our fairly sanguine 12-to-18 month global macro view. There are a number of reasons for this: First, the weakness in global manufacturing over the past 18 months has not infected the much larger service sector (Chart 5). Even in Germany, with its large manufacturing base, the service sector PMI remains above 50, and is actually higher than it was late last year. This suggests that the latest global slowdown is more akin to the 2015-16 episode than the 2007-08 or 2000-01 downturns. Chart 5AThe Service Sector Has Softened Much Less Than Manufacturing (I) Chart 5BThe Service Sector Has Softened Much Less Than Manufacturing (II) Second, manufacturing activity should benefit from a turn in the inventory cycle over the remainder of the year. A slower pace of inventory accumulation shaved 90 basis points off of U.S. growth in the second quarter and is set to knock another 40 basis points from growth in the third quarter, according to the Atlanta Fed GDPNow model. Excluding inventories, U.S. GDP growth would have been 3% in Q2 and is tracking at 2.7% in Q3 – a fairly healthy pace given the weak global backdrop (Chart 6). Chart 6The U.S. Economy Is Still Holding Up Well Outside the U.S., inventories are making a negative contribution to growth (Chart 7). In addition to the official data, this can be seen in the commentary accompanying the Markit manufacturing surveys, which suggest that many firms are liquidating inventories (Box 1). Falling inventory levels imply that sales are outstripping production, a state of affairs that cannot persist indefinitely. Third, and related to the point above, the automobile sector has been the key driver of the global manufacturing slowdown. This is in contrast to 2015-16, when the main culprit was declining energy capex. According to Wards, global vehicle production is down about 10% from year-ago levels, by far the biggest drop since the Great Recession (Chart 8). The drop in automobile production helps explain why the German economy has taken it on the chin recently. Chart 7Inventories Are Making A Negative Contribution To Growth Chart 8Auto Sector: The Culprit Behind The Manufacturing Slowdown Importantly, motor vehicle production growth has fallen more than sales growth, implying that inventory levels are coming down. Despite secular shifts in automobile ownership preferences, there is still plenty of upside to automobile usage. Per capita automobile ownership in China is only one-fifth of what it is in the United States, and one-fourth of what it is in Japan (Chart 9). This suggests that the recent drop in Chinese auto sales will be reversed. As automobile output begins to recover later this year, so too will global manufacturing. Investors should consider going long automobile makers. Chart 10 shows that the All-Country World MSCI automobiles index is trading near its lows on both a forward P/E and price-to-book basis, and sports a juicy dividend yield of nearly 4%.1 Chart 9The Automobile Ownership Rate Is Still Quite Low In China Chart 10Auto Stocks Are A Compelling Buy Fourth, our research has shown that globally, the neutral rate of interest is generally higher than widely believed. This means that monetary policy is currently stimulative, and will become even more accommodative as the Fed and a number of other central banks continue to cut rates. Remember that unemployment rates have been trending lower since the Great Recession and have continued falling even during the latest slowdown, implying that GDP growth has remained above trend (Chart 11). As diminished labor market slack causes inflation to rebound from today’s depressed levels, real policy rates will decline, leading to more spending through the economy. Chart 11Unemployment Rates Keep Trending Lower The Trade War Remains The Biggest Risk The points discussed above will not matter much if the trade war spirals out of control. It is impossible to know what will happen for sure, but we can deduce the likely course of action based on the incentives that both sides face. President Trump has shown a clear tendency in recent weeks to try to de-escalate trade tensions whenever the stock market drops. This is not surprising: Despite his efforts to deflect blame for any selloff on others, he knows full well that many voters will blame him for losses in their 401(k) accounts and for slower domestic growth and rising unemployment. What about the Chinese? An increasing number of pundits have warmed up to the idea that China is more than willing to let the global economy crash if this means that Trump won’t be re-elected. If this is China’s true intention, the Chinese will resist making any deal, and could even try to escalate tensions as the U.S. election approaches. It is an intriguing thesis. However, it is not particularly plausible. U.S. goods exports to China account for 0.5% of U.S. GDP, while Chinese exports to the U.S. account for 3.4% of Chinese GDP. Total manufacturing value-added represents 29% of Chinese GDP, compared to 11% for the United States. There is no way that China could torpedo the U.S. economy without greatly hurting itself first. Any effort by China to undermine Trump’s re-election prospects would invite extreme retaliatory actions, including the invocation of the War Powers Act, which would make it onerous for U.S. companies to continue operating in China. Even if Trump loses the election, he could still wreak a lot of havoc on China during the time he has left in office. Moreover, as Matt Gertken, BCA’s Chief Geopolitical Strategist, has stressed, if Trump were to feel that he could not run for re-election on a strong economy, he would try to position himself as a “War President,” hoping that Americans rally around the flag. That would be a dangerous outcome for China. Chart 12Would China Really Be Better Off Negotiating With A Democrat As President? In any case, it is not clear whether China would be better off with a Democrat as president. The popular betting site PredictIt currently gives Elizabeth Warren a 34% chance of winning, followed by Joe Biden with 26%, and Bernie Sanders with 15% (Chart 12). This means that two far-left candidates with protectionist leanings, who would stress environmental protection and human rights in their negotiations with China, have nearly twice as much support as the former Vice President. All this suggests that China has an incentive to de-escalate the trade war. Given that Trump also has an incentive to put the trade war on hiatus, some sort of détente between the U.S. and China, as well as between the U.S. and other players such as the EU, is more likely than not. Investment Conclusions Provided the trade war does not spiral out of control, it is very likely that global equities will outperform bonds over the next 12 months. Since it might take a few more months for the data on global growth to improve, equities will remain in a choppy range in the near term, before moving higher later this year. As we discussed last week, the equity risk premium is quite high in the U.S., and even higher abroad, where valuations are generally cheaper and interest rates are lower (Chart 13).2 Chart 13AEquity Risk Premia Remain Quite High (I) Chart 13BEquity Risk Premia Remain Quite High (II) The U.S. dollar is a countercyclical currency (Chart 14). If global growth picks up later this year, the greenback should begin to weaken. European and emerging market stocks have typically outperformed the global benchmark in an environment of rising global growth and a weakening dollar (Chart 15). We expect to upgrade EM and European equities – along with more cyclical sectors of the stock market such as industrials, materials, and energy – later this year. Chart 14The U.S. Dollar Is A Countercyclical Currency Chart 15EM And Euro Area Equities Usually Outperform When Global Growth Improves Thanks to the dovish shift by central banks around the world, government bond yields are unlikely to return to their 2018 highs anytime soon. Nevertheless, stronger economic growth should lift long-term yields at the margin, causing yield curves to steepen (Chart 16). Steeper yield curves will benefit beleaguered bank stocks. Chart 16Stronger Economic Growth Should Lift Long-Term Bond Yields, Causing Yield Curves To Steepen Finally, a word on gold: We still like gold as a long-term investment. However, the combination of higher bond yields and diminished trade tensions could cause bullion to sell off in the near term. As such, we are closing our tactical long gold trade for a gain of 20.5%. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Box 1 Evidence of Inventory Liquidation In The Manufacturing Sector Footnotes 1 The top ten constituents of the MSCI ACWI Automobiles Index are Toyota (22.6%), General Motors (7.8%), Daimler (7.3%), Honda Motor (6.2%), Ford Motor (5.7%), Tesla (4.8%), Volkswagen (4.8%), BMW (3.8%), Ferrari (3.0%), Hyundai Motor (2.4%). 2 Please see Global Investment Strategy Special Report, “TINA To The Rescue?” dated August 23, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades
Highlights Four ghosts of 2016 are knocking at the door: Brexit, Trump, Brazil, Italy. President Trump and U.S. trade policy are keeping uncertainty high. Upgrade the odds of a no-deal Brexit to about 33%. Expect limited stimulus from Italy and Germany – for now. Brazil’s pension reform is entering its final stretch – buy the rumor, sell the news. Feature Four major political events of 2016 are returning to affect the global investment landscape this fall – though only two of these ghosts are truly frightening. In order of market relevance: Trump: The election of Donald J. Trump as U.S. president, November 8, 2016 Brexit: The U.K. referendum to leave the European Union, June 23, 2016 Italy: The Italian constitutional referendum, December 4, 2016 Brazil: The removal of Brazilian President Dilma Rousseff, August 31, 2016 Italy and Brazil are producing market-positive political results in the short run. Brexit and Trump pose substantial and immediate risks to the global bull market. A pivot by Trump is the headline risk to our view that no trade agreement will be concluded by November 2020, as we outlined in a Special Report last week. At the moment tensions are still escalating. President Trump has ordered an increase in tariffs (Chart 1) and threatened to invoke the International Economic Emergency Powers Act of 1977, which would give him the ability to halt transactions, freeze funds, and appropriate assets. China is retaliating proportionately and virtually incapable of softening its tone prior to its National Day celebration on October 1. The next round of negotiations, slated for Washington in September, could be a flop like the talks in July, or it could be canceled. Investors should stay defensive. The equity market will have to fall to force Trump to stage a tactical retreat. Meanwhile China could intervene violently in Hong Kong SAR. That possibility, the nationalist military parade on October 1, and U.S. actions toward the South China Sea and Taiwan, show that sabers are rattling, causing additional market jitters. Chart 1Trump's Latest Tariff Salvo U.S.-China tensions underpin our tactical safe-haven trade recommendations. But we are not shifting to a cyclically bearish stance until we get clarity on Trump’s and Xi’s handling of their immediate predicament. Brexit is the other acute short-term risk. This was true even before Prime Minister Boris Johnson opted to prorogue parliament from September 10 to October 14, shortening the time that parliament has to either pass a law forbidding a no-deal exit or bring down Johnson’s government in a vote of no confidence. We are upgrading the odds of “no deal” to no higher than 33%, using a conservative decision-making process (Diagram 1). No-deal is not our base case because parliament, the public, and even Johnson himself want to avoid a recession, which is the likely outcome, even granting that the Bank of England will not stand idly by. We are upgrading the odds of “no deal” Brexit to about 33%. Diagram 1Brexit Decision Tree (Revised August 29, 2019) From a bird’s eye point of view, the pound is very attractive (Chart 2). But in the near-term the twists and turns of Britain’s political struggle imply that we will see wild volatility. Our foreign exchange strategists expect that a no-deal Brexit would cause GBP/USD to collapse to 1 after October 31. Assuming our one-in-three odds of such an outcome, the probability-weighted average of cable is about 1.2. Hence investors should not short sterling from here, unless they strongly believe we are underrating the odds of no-deal exit. In the worst-case scenario, a no-deal Brexit will cause an economic shock at a time when Europe is on the brink of recession – Italy and Germany are virtually there. This means there is a substantial risk of additional deflationary pressure piling onto German bunds and sustaining the global bond rally. This pressure will be sharply reduced if Johnson loses an early no confidence vote, but that is a 50/50 call so we would not call time on this rally yet. Stay cautious. Chart 2Pound Can Only Go So Low Italy: Stimulus … Without A Bruising Brussels Battle Italy has avoided a new election by producing an unusual tie-up between the establishment Democratic Party and the anti-establishment Five Star Movement (M5S). The coalition still needs to clear some internal hurdles and an online vote by Five Star members, but an agreement is to be presented to President Sergio Mattarella as we go to press. This is the most market-friendly outcome that could have been expected, as is clear through the sharp drop in Italian government bond yields (Chart 3). Our GeoRisk indicator for Italy is also collapsing. Chart 3Markets Cheer New Italian Coalition This development marks the climax of a story line that we outlined in 2016, when Prime Minister Matteo Renzi lost a constitutional referendum that aimed to strengthen Italian governments to enable deeper structural reforms (he subsequently resigned). At that time we argued that Italy would emerge as a market-relevant political risk due to rampant anti-establishment sentiment, but that this risk would subside when Italy’s populists were shown to be pragmatic at heart, i.e. unwilling to push their conflicts with Brussels to a point that truly reignited European break-up risk. This view is now vindicated – and not only for the short-term. The new coalition comes at the nick of time, with Europe teetering on recession and the risk of a no-deal Brexit rising. The new government will have to deliver the 2020 budget to the European Commission by October 15. The budget will aim to provide fiscal support, including a delay of the legislatively mandated hike in the Value Added Tax from 22% to 24.2%, already rolled over from 2019. The Five Star Movement will demand as a price for its participation in the coalition that social spending go up; the Democratic Party will have learned a lesson while out of power and will be more fiscally permissive and strike a tougher tone with Brussels. The Italian budget talks will be a non-issue: the coalition will cooperate with Brussels. The episode demonstrates that the Italian risk to financial markets is overrated. This point goes beyond the fact that the Democrats and Five Star were able to cooperate. Italy’s leading populist parties have already shown that they are pragmatic and will play the game with Brussels to avoid a financial breakdown. In May 2018, the newly formed populist coalition proposed a gigantic “wish list” budget that would have increased the budget deficit to roughly 7.3% of GDP in 2019. They also appointed a euroskeptic economy minister who almost prevented government formation. The ensuing conflict with Brussels triggered considerable turmoil (Chart 4). Ultimately, however, the populists did precisely what we expected: they bowed to the severe financial constraint on Italy’s banking system. They agreed to a 2019 and 2020 deficit of 2.04% and 2.1%, respectively (Chart 5). Chart 4Italian Populists Prove Pragmatic Chart 5Even Salvini Compromised On Budget Clash At present, the market is relieved that an election was avoided that might have seen Salvini and the League form a government with a much smaller right-wing party (Fratelli D’Italia) (Chart 6) – but the truth is that Salvini had already capitulated to the EU, both on budget matters and the euro currency. He was hardly likely to push for a budget more aggressive than that of the initial proposal in 2018. The clash with Brussels would have been a flash in the pan; the result would have been greater fiscal thrust, which would have been market-positive in the current environment. Chart 6Election Would Have Meant More Stimulus ... And More Political Risk M5S will also push for more spending and has also moderated their stance on the euro. A coalition with the Democrats will not work if the purpose is to push a euroskeptic agenda. There will be a focus on counter-cyclical fiscal policy, pragmatic reforms that the two can agree on, and fighting corruption. The budget talks will be a non-issue: the Democratic Party is an establishment party and the coalition will cooperate with Brussels. Furthermore, the context has changed since 2018 in a way that will reduce budget frictions. There is a need for countercyclical fiscal policy in light of the global slowdown, so the European Commission will have to be more flexible on the budget. This is particularly true if Germany itself loosens its belt on a cyclical basis. The risk to the above is that the coalition shaping up between the Democrats and Five Star is an alliance of convenience that will break down over time. Five Star will remain hard-line on immigration, which is driving anti-establishment sentiment. Italian elections are a frequent affair. Salvini and the League will be waiting in the wings, especially if Brussels proves too tight-fisted or if the Democrats do not toughen their stance on immigration. But as outlined above, Salvini’s own evolution on the euro, on northern Italy, and on the budget and financial stability shows that the economy will have to get a lot worse before Italian euroskepticism presents a renewed systemic risk. Bottom Line: The tentative coalition taking shape in Italy will produce a modest increase in fiscal thrust with minimal frictions with Brussels. As such it is the most market-friendly outcome that could have occurred from Salvini’s push to seize power. Beneath this episode of government change is the political arrangement taking shape in Italy, and across Europe, which calls for a commitment to the European project and currency. The price of this commitment is a tougher line on immigration from European leaders. Germany: Fiscal Loosening, But Not For The States (Yet) Our GeoRisk indicator for Germany is pointing to an increase in risk in recent weeks. Germany is threatened by a potential technical recession and while fiscal stimulus is in preparation, there will not be a fiscal game-changer until Merkel steps down in 2021 – barring a total collapse in the economy that forces her hand in the meantime. The outlook is not improving (Chart 7, top panel). The economy shrank by 0.1% in Q2 2019, exports are falling, and passenger car production is at the lowest level ever recorded (Chart 7, bottom panels). Chart 7German Economy Gets Pummeled Chart 8Germany: Expect Orthodox Stimulus For Now Finance Minister Olaf Scholz has announced that Germany could increase government spending by $55 billion within the context of European and German budget constraints. Split proportionally between 2019 and 2020, this additional spending would not put Germany in violation of the “black zero” rule – a commitment to a balanced budget that limits the federal structural deficit to 0.35% of GDP – even without any additional revenue (Chart 8). There will not be a fiscal game-changer in Germany until Merkel steps down – barring a crisis. The German Chancellery reports that it does not see the need for stimulus in the short term – as long as trade tensions do not escalate and there is no hard Brexit. At present, however, trade tensions are escalating and the odds of a no-deal Brexit are increasing. Moreover China’s economy and stimulus efforts continue to disappoint. In this context Germany’s ruling coalition is putting together a climate change package that would entail additional spending (while stealing some thunder from the increasingly popular Green Party). Given the European Commission’s forecast of Germany’s 2020 budget surplus, 0.8% of GDP, the government could ultimately go further than Scholz’s ~$50bn. This is because the black zero rule provides for exceptions in case of recession (or natural disasters or other crises out of governmental control) with a majority vote in the Bundestag. Hence we are not so much concerned about the magnitude of the stimulus as its timing. First, Merkel and her coalition typically move slower than the market would like in the face of financial and economic challenges. Second, according to the black zero rule, which is transcribed in the German constitution (the Basic Law), the Länder cannot run budget deficits from 2020. Amending the constitution to delay this deadline requires a two-thirds majority in the Bundestag and the Bundesrat – a much taller order than the simple majority needed to boost federal deficits. The governing coalition currently holds 56% of the seats in the Bundestag. If the Greens were brought on board, which they would be inclined to do, this number falls just short of two-thirds at 65.6%. In order to obtain a two-thirds majority in the Bundesrat, the Social Democrats, Christian Democrats, and the Greens would need the support of another party, either the Left or the Free Democrats. This could be done but it would require political will, which is only likely to be sufficient if the German and global economy get worse from here. Meanwhile financial markets will have to settle for the gradual implementation of a stimulus package on the order of 1% of GDP – the one the government is planning. Bottom Line: While Germany will likely roll out a stimulus package by Q4, if third quarter GDP data confirm that the country is in a technical recession, Merkel’s hesitation and budget limits mean that this stimulus will likely be moderate. A marginal upside surprise is possible but it will not represent a true “game changer” on fiscal policy in Germany. The game changer is more likely after Merkel steps down in 2021. The Green Party is surging in Germany and could possibly lead the next government. Even if it doesn’t, its success and Europe-wide developments are pushing German leaders to become more accommodative. Brazil: Reform Or Bust Political turmoil in Brazil over the past five years has ultimately resulted in a right-wing populist government under President Jair Bolsonaro. Bolsonaro is pursuing a pension reform that is universally acknowledged as necessary to straighten out Brazil’s fiscal books, but that the previous government tried and failed to pass. On this front the news is market-positive: having cleared the lower Chamber of Deputies, the pension reforms are now likely to pass the senate. This will lift investor confidence and give Bolsonaro an initial success that he may then be able to translate into additional economic reforms. The Brazilian economy and financial markets are moving in opposite directions. The currency and equities staged a mid-year rally despite negative data releases – shrinking retail sales and industrial production amid high unemployment (Chart 9). More recently these assets relapsed despite tentative signs of improvement on the economic front (Chart 10). All the while, chaos and controversies surrounding Bolsonaro’s government have weighed on his approval rating, ending the honeymoon period after election (Chart 11). Chart 9Brazil: Signs Of Improvement Chart 10Brazil: Markets Sold Despite Pension Progress Chart 11Bolsonaro’s Honeymoon Is Long Gone The mid-year equity re-rating was driven by an improvement in sentiment on the back of the government’s pension reform. The relapse occurred despite the passage of the pension reform bill in the lower house, indicating that global economic pessimism has dominated. The bill’s next step goes to the senate where it faces two rounds of voting before enactment (Diagram 2). It should clear this hurdle by a large margin, though we expect delays. Diagram 2Brazil: Pension Reform Timeline In the second round vote in the lower house on August 6 – which had a smaller margin of victory than the first round – deputies voted largely in line with party alliances (Charts 12A & 12B). Assuming legislators in the senate behave in the same way, the reform should gain the support of 64 of the 81 senators – easily surpassing the 49 votes needed. Even in a more pessimistic scenario where all opposition parties and all independent parties vote against the bill – along with two defecting senators from government-allied parties – the reform would pass by 56-25. Chart 12APension Bill Sailed Through Lower House ... Chart 12B... And Should Pass Senate In Time This favorable outlook is also supported by popular opinion, which indicates that the majority of those polled agree that pension reforms are necessary (Chart 13). This leaves two questions: How soon will the bill clear the senate? According to senate party leaders’ proposed timetable, the bill will undergo its first upper house vote on September 18 with the second round slated for October 2. This is ambitious. The strategy of Senator Tasso Jereissati – who has been appointed senate pension reform rapporteur – is to approve the text in its current form and create a parallel proposed amendment to the constitution (PEC) which will bring together the amendments that senators make to the original text. Dozens of amendments have been filed with the Commission on Constitution and Justice. These will prolong the enactment of the final bill and dilute its impact. We doubt the senate will let Jereissati have his way entirely and hence expect delays and dilution. Chart 13Brazil: Public Now Favors Pension Reform Chart 14Brazil: Pension Reform Not Enough How much savings will the bill generate? Will the reforms be sufficient to improve public debt dynamics in Brazil? The Independent Fiscal Institute of the senate estimates that the reform will generate BRL 744 billion of savings. This is significantly less than the BRL 1.2 trillion initially proposed, and lower than the BRL 860 billion that Economy Minister Paulo Guedes has indicated as the minimum fiscal savings required. Our Emerging Markets strategists argue that the bill falls short of what is needed. While the plan will reduce the fiscal deficit and slow debt accumulation, it will be insufficient to generate primary surpluses over the coming years (Chart 14).1 Moreover, estimated savings in the final bill will likely be further revised down as the bill undergoes more amendments in the senate. What comes after pension reform? The market has focused almost exclusively on this issue to the neglect of Bolsonaro’s wider economic reform agenda. The agenda includes privatization, trade liberalization, tax reforms, and deregulation. Here we are more skeptical. First, Bolsonaro will have spent a lot of political capital on pensions. Second, while the economy and unemployment are always important, they are not the foremost concern for Brazilians (Chart 15). Chart 15Bolsonaro Will Lose Political Capital After Pension Bill Third, the economic agenda is often at odds with Bolsonaro’s social, foreign, and environmental policies: The new Mercosur-European Union trade agreement and ongoing trade negotiations between Mercosur and Canada are positive developments. However the G7 summit in France highlighted that the deal with the EU is at risk due to dissatisfaction with Bolsonaro’s response to the Amazon fires. France and Ireland have threatened to withhold support of the ratification. With world leaders concerned about the political risks of trade liberalization, and with Trump having issued a license to foreign leaders for trade weaponization, an escalation of tensions between the Europeans and Bolsonaro could lead to punitive measures even beyond the delay to the Mercosur-EU deal. Brazil’s China problem: Bolsonaro has been cozying up to President Donald Trump while striking a more aggressive tone with China. This is a risky strategy as it may undermine Brazil’s economic interests. The country’s exports are much more leveraged to China than to the U.S. and have been benefitting on the back of the trade war as China substitutes away from the U.S. (Chart 16). The president’s planned trip to China in October reveals an attempt to mend ties after having accused China of dominating key Brazilian sectors during his election campaign. But it is not clear yet that Bolsonaro will stage a retreat. And if President Trump backtracks on his trade war in order to clinch a deal, Bolsonaro may have lost some goodwill with China without receiving the benefit of China’s substitution effects. Hence Bolsonaro will have to soften his approach to China to make progress on the trade aspect of the reform agenda. Chart 16Brazil: Time To Mend Ties With China Bottom Line: We expect the passage of a diluted pension reform bill that will slow the growth of public debt to some extent. However global headwinds are persisting. And any success on pensions should not be extrapolated to other items on the economic reform agenda. Bolsonaro’s trade liberalization faces difficulties on the surface. Other domestic reforms are even more difficult to achieve in the wake of painful pension cuts. Reforms that enjoy public support and do not require a complicated legislative process are the most likely to be implemented, but even then, legislation and implementation are likely to be long-in-coming in Brazil’s highly fractured congress. As a result we share the view with our Emerging Markets Strategy that the pension reform is a “buy the rumor, sell the news” phenomenon. Housekeeping We are booking gains on our long BCA global defense basket for a 17% gain since inception in October 2018. The underlying thesis for this trade remains strong and we will reinstitute it at an appropriate time, though likely on a relative basis to minimize headwinds to cyclical sectors. We are also finally throwing in the towel on our long rare earth / strategic metals equity trade. The logic behind the trade is intact but it was very poorly timed and the basket has depreciated 24% since inception. Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Footnotes 1 Please see BCA Research’s Emerging Markets Strategy Weekly Report “On Chinese Banks And Brazil,” dated July 18, 2019, available at ems.bcaresearch.com. France: GeoRisk Indicator U.K.: GeoRisk Indicator Germany: GeoRisk Indicator Italy: GeoRisk Indicator Spain: GeoRisk Indicator Russia: GeoRisk Indicator Korea: GeoRisk Indicator Taiwan: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil: GeoRisk Indicator What's On The Geopolitical Radar? Geopolitical Calendar
There will be no U.S. Bond Strategy report next week. Our regular publication schedule will resume on September 10th, with our Portfolio Allocation Summary for September. Highlights Fed: Absent inflationary pressures or excessive financial asset valuations, the Fed must maintain an accommodative policy stance. This means cutting rates if the market demands it. Expect another 25 basis point rate cut in September. Duration: Stronger economic data will eventually lead long-dated bond yields higher, un-inverting the yield curve and allowing the Fed to stop its mini easing cycle. Investors should keep portfolio duration close to benchmark, but stand ready to reduce duration at the first signs of stronger global economic data. Yield Curve & Recessions: An inverted yield curve signals that the market views monetary policy as restrictive. Restrictive policy should be viewed as a necessary pre-condition for recession, but not one that helps much with timing the next downturn. Feature Chart 1Markets Want More Easing And The Fed Should Accommodate Bond investors had their hands full last week, as comments from Fed officials produced an unusually wide range of views. The hawks were most vocal early in the week as Boston Fed President Eric Rosengren, Kansas City Fed President Esther George and Philadelphia Fed President Patrick Harker all made the case for leaving rates at current levels, even as the market continues to price-in another 25 basis point rate cut in September, followed by an additional 50 basis points of cuts between October and February (Chart 1). Fed Chairman Jerome Powell, however, did not try to shift market expectations one way or the other during his Jackson Hole speech on Friday. This suggests that he is probably comfortable with current bond market pricing. In our opinion, we will see another 25 basis point rate cut in September and the Fed is justified in doing so. The Fed Can’t Fight The Markets, And It Shouldn’t Chart 2Keep Financial Conditions Supportive In the current environment, monetary policy exerts its greatest influence on the economy via its impact on broad financial conditions. Easier financial conditions lead to stronger growth and higher inflation in the future (Chart 2), and the Fed must ensure that financial conditions remain accommodative during the current global slowdown. This means that the Fed’s most important job is to ensure that investors perceive Fed policy as supportive for equities and corporate credit. In other words, unless Chairman Powell wants to slow the economy, he must bow down to the markets and deliver enough monetary easing to keep broad financial conditions accommodative. The minutes from the July FOMC meeting, released last week, suggest that the Fed understands this dynamic and will act as appropriate. In their discussion of financial market developments, participants observed that financial conditions remained supportive of economic growth, with borrowing rates low and stock prices near all-time highs. Participants observed that current financial conditions appeared to be premised importantly on expectations that the Federal Reserve would ease policy to help offset the drag on economic growth stemming from the weaker global outlook and uncertainties associated with international trade as well as to provide some insurance to address various downside risks. Chart 3No Sign Of Rising Inflation Expectations... Simply, if the market expects another rate cut in September, the Fed would be wise to deliver. Otherwise, broad financial conditions could tighten sharply, making it more difficult for economic growth to recover. It is not always the case that the Fed should act to ensure that financial conditions remain accommodative. If inflation expectations were breaking out to the upside, or financial asset valuations were stretched, then the case could be made for the Fed to fight back against the market’s easing expectations.1 However, neither of those conditions are in place today. The cost of inflation compensation priced into long-maturity TIPS has collapsed, and it is well below the 2.3% - 2.5% range that would be consistent with well-anchored inflation expectations near the Fed’s target (Chart 3). Survey measures of long-dated inflation expectations have been more stable, but are not threatening to move significantly higher (Chart 3, bottom panel). Equally, financial asset valuations are nowhere near “bubbly” (Chart 4). The risk premium priced into corporate bonds after accounting for expected default losses is above levels seen early last year, while the S&P 500’s 12-month forward Price/Earnings ratio is below its early-2018 peak. If inflation expectations were breaking out to the upside, or financial asset valuations were stretched, then the case could be made for the Fed to fight back against the market’s easing expectations. Further, the 2-year/10-year Treasury slope recently inverted and the broad trade-weighted dollar continues to appreciate (Chart 5). Both of these factors suggest that the market views Fed policy as insufficiently accommodative. St. Louis Fed President James Bullard bluntly summed up the situation in an interview last week, saying that it is “our job to get the yield curve to be un-inverted”. Chart 4...Or Excessive Financial ##br##Asset Valuation Chart 5The Case For More Accommodative Monetary Policy We agree with this sentiment. Absent inflationary pressures or excessive financial asset valuations, the Fed must maintain an accommodative policy stance. This means cutting rates if the market demands it, in an effort to un-invert the yield curve. The Economy Must Lead Chart 6Still Waiting For A Rebound In Global Growth But the Fed can’t un-invert the yield curve all on its own. The Fed can pull down the short-end of the curve, but it needs to economy to cooperate if it wants to boost long-end yields. In fact, if the global economic data improve, then the market will no longer require Fed rate cuts to keep financial conditions accommodative. If the economic data improve a lot, then the market might even be able to live with rate hikes and still maintain supportive broad financial conditions. We haven’t yet seen much evidence of improvement in the global economic data, but we remain confident that a rebound will take hold before the end of the year.2 Flash PMI data for August were released last week and showed a drop in the U.S. figure to below the 50 boom/bust line (Chart 6). The Flash data showed small gains in the Eurozone and Japan, though both of those PMIs also remain below 50. In contrast with the weaker PMI data, Leading Economic Indicators (LEI) are showing some signs of strength. Although both the U.S. and Global (excluding U.S.) LEIs remain at below-average levels relative to their trailing 12-month trends (Chart 7), the Global (ex. U.S.) index bottomed several months ago and the U.S. index ticked higher last month. Troughs in the LEIs tend to precede troughs in both the Global PMIs and bond yields. Chart 7Leading Economic Indicators Suggest The Rebound Might Be Soon Bottom Line: The Fed must keep financial conditions accommodative, and this means satisfying the bond market’s expectations for further rate cuts. Eventually, stronger economic data will lead long-dated bond yields higher, un-inverting the yield curve and allowing the Fed to stop its mini easing cycle. Investors should keep portfolio duration close to benchmark, but stand ready to reduce duration at the first signs of stronger global economic data. The Inverted Yield Curve And Recession Risk We have received a lot of client questions on the topic of using the yield curve to forecast recessions. In this week’s report we explain our views about how the inverted yield curve should be interpreted. In short, we think an inverted yield curve should be viewed as a necessary pre-condition for recession, but not one that helps much with timing the next downturn. The Flash PMI data showed small gains in the Eurozone and Japan, though both of those PMIs also remain below 50. We start by recognizing that many variables have strong track records at forecasting recession, and those variables can be grouped into two broad categories: Financial market indicators (including the yield curve, stock market, oil price, etc…) Economic indicators (including initial jobless claims, unemployment rate, housing starts, etc…) In general, financial market indicators give more advance warning of recession but they are also prone to sending false signals. Economic indicators, on the other hand, are less prone to false signals, but often provide little (if any) advance notice. With this in mind, we turn to Chart 8. The top panel of which shows the New York Fed’s popular Recession Probability Indicator, an indicator derived purely from the 3-month/10-year Treasury slope. We also calculate the same model using the 2-year/10-year slope, but the results are not materially different. Chart 8Recession Probability Indicators The top panel of Chart 8 shows the strengths and weaknesses of using financial market data to forecast a recession. The New York Fed’s model started to rise about 3 years prior to the last recession and 5 years prior to the 2001 recession. The model also fluctuated up and down several times in the late 1990s, suggesting that recession risk was lower in 1998 than in 1996 even though the recession was actually 2 years closer. In general, the model clearly illustrates that the yield curve flattens as the economic recovery ages, but also that the yield curve can provide a recession signal far in advance of the actual recession. The model’s signal can also reverse if the yield curve re-steepens. The bottom panel of Chart 8 shows the New York Fed’s yield curve-based Recession Probability Indicator alongside our own recession indicator, one that is based on several different variables (including the yield curve). Our model is designed to give less lead time than a pure yield curve model, but also fewer false signals. Once again, the late-1990s are instructive. The yield curve-only model was sending a recession signal of varying magnitudes for 5 years before our multi-factor model shot higher in 2001. What can we conclude from looking at these different recession models? Essentially, we should view an inverted yield curve as a signal that the market views monetary policy as restrictive. Restrictive monetary policy is a necessary pre-condition for recession, but it does not help us much with timing. Policy could remain restrictive for several years before the recession takes hold, or policy could move from restrictive to accommodative and the yield curve’s recession signal could vanish. Incorporating The Term Premium, Is This Time Different? Some publications at BCA have made the case that the yield curve’s recession signal is distorted in this cycle because of the deeply negative term premium. While this could be true in theory, in practice, we think it would be unwise to dismiss what the yield curve is telling us about the current stance of monetary policy. Chart 9Uncertainty Around The Term Premium Bond yields consist of two components, short rate expectations and a term premium. The yield curve’s power as a recession indicator comes from the rate expectations component. Assuming a constant term premium, an inverted yield curve means that the bond market expects the overnight rate to fall in the future. This is more likely to happen in a recession. However, if the term premium were deeply negative at the long-end of the yield curve, then an inverted yield curve might simply reflect the negative term premium and not an expectation that the fed funds rate will decline. In theory, this could be the case if, for example, the equity hedging value of Treasury bonds is perceived to be much higher now than in the past. In that case, investors might be willing to pay to take duration risk in order to gain the perceived diversification benefits. That is a plausible story. The problem is that we cannot verify it in the data because bond term premia cannot be accurately estimated. For example, one popular term premium estimate, the New York Fed’s Adrian, Crump and Moench (ACM) estimate, placed the 10-year zero coupon term premium at -84 bps on July 22. On that same date, the spot 10-year Treasury yield was 2.06%. This implies that the market’s 10-year average fed funds rate expectation was (206 bps – (-84 bps)) = 2.9%. In other words, the ACM estimate tells us that on July 22 the market expected the fed funds rate to average 2.9% over the next 10 years. This seems highly implausible, given that the New York Fed’s Survey of Market Participants, taken that same day, shows that the median market participant expected the fed funds rate to average 2% over the next 10 years (Chart 9). According to that median survey response, the 10-year term premium was +6 bps on July 22, not -84 bps! The point is not that survey measures of term premia are preferable to more sophisticated models of the ACM variety. We simply wish to point out that term premia estimates are highly uncertain, and the actual term premium on any given day is impossible to pin down. Once we recognize this fact, then we should at least be skeptical of claims that a negative term premium is distorting the recession signal from the yield curve. Given the uncertainty surrounding term premium estimates, we are inclined to simply take the yield curve’s signal at face value. Bottom Line: The proper interpretation of an inverted yield curve is that it is a signal that the market views monetary policy as restrictive. Restrictive monetary policy is a necessary pre-condition for recession, but it does not help us much with timing. It is conceivable that a deeply negative term premium is currently distorting the yield curve’s signal about the stance of monetary policy. But given the uncertainty surrounding term premium estimates, we are inclined to simply take the yield curve’s signal at face value. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 We have made the case that inflation expectations and financial conditions are the two most important factors to monitor when tracking Fed policy. For further details please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 2 We elaborated on the reasons to expect a rebound in global growth in the U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, “Where’s The Positive Carry In Bond Markets?” dated August 20, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Sovereign bond yields have cratered over the last few months, … : Over the last three months, 10-year yields in the U.S., France, Germany, Switzerland and Australia have fallen by 71, 64, 53, 54, and 67 basis points, respectively. … and the Treasury curve has experienced a significant bull flattening, … : Month-to-date total returns for the Barclays Bloomberg Long, Intermediate and 1-3-Year Treasury Indexes are 9.2%, 1.6% and 1.1%, respectively. … indicating that the bond market thinks more rate cuts are in store: The textbook interpretation of an inverted curve is that monetary policy is too tight and needs to be loosened, but technical factors have amplified the flattening pressure. Is the bond market reacting to weakening growth prospects, or uber-dovish central banks?: The answer has implications well beyond the fixed-income universe. It could mean the difference between an economic slowdown and a market melt-up. Feature BCA researchers convened last week for our monthly View Meeting, much of which was given over to the global decline in sovereign bond yields. Does their plunge owe more to weakening growth prospects or central banks’ synchronized dovish pivot? There have surely been elements of both; after all, central banks wouldn’t be so dovish if they weren’t concerned about the growth outlook. It is clear to our fixed-income strategists that the yield move has overshot the data, however, and they mainly attribute the overshoot to monetary policy. 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.1 The pell-mell rush to cut rates is emblematic of a global scramble for competitiveness. No central bank wants its economy to be caught without a buffer while other economies are busily reinforcing theirs. The Message From The Bond Market Trade tensions are a legitimate threat to global economic growth already challenged by a downswing in the global manufacturing cycle. A recession is a possibility, but it is hardly a foregone conclusion. We agree with our fixed-income colleagues that the yield selloff has overrun the economic fundamentals. Last week’s preliminary European manufacturing PMIs suggested that manufacturing may finally be stabilizing, and there is still no evidence that the manufacturing downturn has infected the services sector (Chart 1). A recession is hardly a foregone conclusion. 10-year Treasury yields have been falling sharply since their 3.25% peak in early November, and the current leg down is the third in a series of sharp declines (Chart 2, top panel). Global sovereign yields have followed the same pattern (Chart 2, bottom panel), but the latest plunge is as much a reflection of ubiquitous easing biases as it is of new concerns about economic weakness. That may sound like a minor point, of interest only to macro specialists, but it has import for all investors. If the yield decline isn’t signaling new softness, then easier financial conditions will be free to act as a tailwind for risk assets. Chart 1Services Are Holding Up ... Chart 2A Brief Inversion ... But Yields Are Freefalling Neither investment-grade (Chart 3, top panel) nor high-yield corporate bond spreads evince any particular concern about the economy (Chart 3, bottom panel). Although they’ve ticked up, they remain near the bottom of their post-crisis range, and are nowhere near the levels they reached in 2011-12, during the federal budget showdown/U.S. downgrade and the flare-up of the Eurozone crisis, or in 2015-16, during the last manufacturing recession. With banks still easing lending standards for corporate and industrial borrowers (Chart 4), spreads won’t undergo a systematic widening. Borrowers do not default as long as there is a lender willing to roll over their maturing obligations, so tighter credit standards are a precondition for spread-widening cycles. Chart 3No Sign Of Stress Among Corporate Borrowers ... Chart 4... And Banks Aren't Applying Any Pressure The Message From The Housing Market Chart 5Lower Rates Have Yet To Impact Housing ... We have been disappointed by residential investment’s muted response to the significant year-to-date decline in mortgage rates (Chart 5, bottom panel). The trajectory of starts and permits (Chart 5, top panel) hasn’t changed, new and existing home sales haven’t perked up (Chart 5, second panel), and mortgage purchase applications (Chart 5, third panel) appear not to have heard the news that rates are much lower. We thought that the swift fall in mortgage rates would promote more residential investment than it has to date. There is a difference, however, between disappointing growth and a full-on contraction. With affordability remaining high relative to history (Chart 6), and apartment rents exceeding monthly mortgage payments in several locales (Chart 7), housing demand should remain well supported. There are no excesses in the housing market in terms of inventory or oncoming supply that would make housing a source of economic or financial instability. Inventory relative to the number of households is bumping around its all-time lows (Chart 8), and cumulative household formations have easily outstripped housing starts since the crisis broke (Chart 9). Structural factors like a lack of supply geared to first-time and first-move-up buyers, and the ravenous appetite of pools of capital purchasing single-family homes for rent, are squeezing out some would-be buyers, but housing is not about to induce a recession. There are plenty of things for investors to be concerned about, but the housing market isn’t one of them. Chart 6... Though They Have Placed Homeownership In Easier Reach Chart 8... Inventories Are At Record Lows, ... The View From Broad And Wall We concede that stocks are not behaving as if all is well. Big daily swings are not a feature of healthy markets, and eight of this month’s sixteen sessions have registered moves of at least 1%. The second quarter’s 3% year-over-year earnings growth is three percentage points better than the consensus expected when earnings season kicked off, however, and despite the single-day moves, the S&P 500 has spent all but the first day of the month in a well-defined range between 2,825 and 2,945 (Chart 10). The market may be jumpy from one day to the next, but investors have not been concerned enough to engage in sustained selling. The equity market’s verdict on housing is more optimistic than ours. Inspired by earnings reports, the S&P 1500 Homebuilders Index have broken out to a new 52-week high (Chart 11). Retailers were the stars of last week’s earnings releases, with Lowe’s, Nordstrom and Target posting double-digit percentage gains after reporting numbers that failed to live up to investors’ worst fears. Equities are validating the view that the U.S. consumer is alive and kicking. Chart 11Homebuilder Stocks Have Broken Out The GDP Outlook Chart 12Capex Intentions: Elevated But Slipping If consumers are well positioned, the U.S. economy should be, too. Consumption accounts for two-thirds of the U.S. economy, with investment and government spending equally dividing the other third. Federal expenditures amount to about 40% of government spending, and between this year’s fiscal thrust and next year’s hotly contested presidential election, D.C. can be counted upon to do its part for the economy. At the state and local level, healthy household income should support state sales and income tax receipts, while still-rising home prices will provide the property taxes to keep municipal coffers full. That leaves fixed asset investment as the economy’s Achilles heel. We are confident, as noted above, that residential investment will not decline enough to pose a problem for the economy, but corporate investment is in the crosshairs of the uncertainty surrounding the multiple trade squabbles. The NFIB survey and the regional Fed surveys indicate that capital expenditure plans are rolling over, even if they remain at a fairly high level (Chart 12). Our base case remains that investment will not fall enough to offset robust consumption and trend-level government spending, but a marked worsening in trade tensions could erode business confidence enough to drag the economy below stall speed. Busted Thesis In our mutual-fund days, we followed one rule without exception. If our thesis for owning a stock was disproved, we got rid of the stock without a backward glance. We no longer manage money, but our clients do, and we try to set a good example, especially in the inevitable instances when things go wrong. We are closing out our agency mREIT recommendation on the ground that we got the rates call underpinning it very wrong. Things went wrong with our agency mortgage REIT recommendation right from the get-go. In retrospect, we should have waited until the FOMC meeting dust settled before putting on a curve-dependent position. We are closing it out now, though, because we recommended the group in anticipation of a steeper yield curve. Given that we think it will take some time for investors to become convinced that a recession is not imminent, and given that mechanical factors may push yields even lower, we do not expect sustained curve steepening for several months. Although we only held it for four weeks, the recommendation left a mark. Through Thursday’s close, our defined subset of agency mREITs lost 11%, while the S&P 500 is down 3.1% and the Barclays High Yield Index is flat. We’re taking our medicine and moving on, but we will take another look at the group when the curve eventually does begin to steepen. Investment Implications Even if recession fears are overblown, as we and a majority of our colleagues believe, it will likely take some time for investors to overcome their concerns. That leads us to believe that equities may be unable to make new highs in the near term, and that Treasury yields have more downside risk than upside risk in the next few months, as rising convexity2 compels investors following asset-liability management strategies to seek out long-maturity bonds. The yield point may sound complex and esoteric, but our Global Fixed Income Strategy team increasingly believes it’s a key to understanding the negative-yield phenomenon and is researching the issue for an upcoming Special Report. Monetary accommodation is not a silver bullet. If the economy has already flipped from expansion to contraction, modest rate cuts parceled out at a deliberate pace will be insufficient to turn things around, and equities and spread product will suffer. If the expansion remains intact, however, rate cuts will help shore up the economy at the margin and quite possibly fuel a new phase of the bull markets in risk assets. Our money is on the latter, and we expect that this bull cycle has one more burst in it that will allow it to sprint to the finish line like the majority of its predecessors. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Smialek, Jeanna and Russell, Karl, “Rates Are Falling Again. That May Be Dangerous.” New York Times, August 17, 2019, p. B1. 2 Duration measures a bond’s sensitivity to changes in interest rates. Convexity measures duration’s sensitivity to changes in interest rates, which increases as rates fall. Investors like life insurers and pension funds, who match the duration of their investment portfolios with the duration of their liabilities, are forced to increase the duration of their bond holdings at an increasing rate as interest rates fall.