Europe
Feature The BCA Corporate Health Monitor (CHM) - designed to assess the financial well-being of companies - is one of our most reliable indicators that is also extremely popular with our clients. That is no surprise, as the CHMs have a solid track record in signaling broad turning points in company credit quality. This makes them useful in determining asset allocation recommendations on Investment Grade (IG) and High-Yield (HY) corporate bonds. Chart 1U.S. Corporates Outperforming, ##br##Despite Worsening Credit Quality In this Weekly Report, we present the "top-down" CHMs based on corporate data from national income (i.e. "GDP") accounts for the U.S., Euro Area and the U.K. We also show the "bottom-up" CHMs constructed using the actual reported financial data of individual companies in the U.S., Euro Area and Emerging Markets (EM). The CHMs are shown in a chartbook format that allows for quick visual analysis and comparisons. Going forward, we will publish this CHM Chartbook on a quarterly basis as a regular part of Global Fixed Income Strategy. The broad conclusion from looking at the CHMs is that corporate credit quality has been steadily improving in Europe, the U.K. and in the EM universe over the past couple of years, in sharp contrast to the worsening financial health of highly-levered U.S. companies. Bond investors seem to be ignoring the relative message sent by our CHMs, however, as U.S. corporate debt has outperformed other developed credit markets since the beginning of 2016 (Chart 1). An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is an indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios similar to those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the metrics used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Top-down CHMs are now available for the U.S., Euro Area and U.K. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.1 The financial data of a broad set of individual U.S. and Euro Area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. An EM version of the bottom-up CHM was introduced by the BCA Emerging Markets Strategy team last September, which extends the CHM analysis to EM hard-currency corporate debt.2 Table 1Definitions Of Ratios That Go Into The CHMs U.S. Corporate Health Monitors: Still Deteriorating Chart 2Top-Down U.S. CHM: Still Deteriorating Our top-down CHM for the U.S. has been flashing a deteriorating state of corporate health since mid-2014 (Chart 2). That trend had been showing signs of stabilization last year, but the Q1/2017 data worsened on the back of lower profit margins and returns on capital. The latter now sits just above 5% - a level last seen during the 2009 recession. Corporate leverage, as measured in our top-down CHM using the value of debt versus equity, does not look to be a problem. The story is quite different when using alternative measures like net debt/EBITDA, however, with U.S. leverage exceeding the highs from the Telecom bubble of the early 2000s. While booming equity values certainly flatter the leverage ratio in our top-down CHM, a strong stock market should, to some degree, reflect a better backdrop for growth in corporate profits and creditworthiness. Even against this positive backdrop, however, other credit indicators are flashing some warning signs that leave our top-down CHM in the "deteriorating health" zone. Interest coverage and debt coverage ratios, while still above the lows seen during past recessions, are steadily falling. This does raise concerns for U.S. corporate health if U.S. bond yields begin to climb again, as we expect. However, given the historically low interest rate backdrop for corporate debt, a bigger threat to interest coverage ratios and overall credit quality would come from an economic slump that damages company profits. That is not going to be a problem for the rest of this year, but weaker growth is a more likely outcome in 2018 as the Fed continues its monetary tightening cycle. Our bottom-up CHMs for U.S. IG (Chart 3) and U.S. HY (Chart 4) have shown a bit of improvement in recent quarters relative to the signal from our top-down CHM. This is likely related to the growing gap between corporate profits as reported in the U.S. national accounts data, which are slowing, compared to the reported earnings of publicly traded companies, which are accelerating. Also, leverage in the bottom-up CHMs uses the book value of equity, which is more readily reported by individual companies, and is thus much higher than the measure used in our top-down CHM. Return on capital is at multi-decade lows for both IG and HY corporates, although profit margins look to be in much better shape for IG names relative to HY issuers. HY margins have enjoyed a cyclical improvement, however, largely due to better earnings from HY energy companies (Chart 4, panel 4). Interest coverage and debt coverage are depressed, with HY issuers in much worse shape than IG. Chart 3Bottom-Up U.S. Investment Grade CHM: ##br##Deteriorating Chart 4Bottom-Up U.S. High-Yield CHM: ##br##Some Cyclical Improvement The cumulative message from our top-down and bottom-up U.S. CHMs is that U.S. corporate health has enjoyed some cyclical improvement over the past few quarters, but the state of balance sheets is slowly-but-steadily worsening. High corporate leverage will become a major problem during the next U.S. recession, but is not a major factor weighing on credit spreads at the moment (Chart 5). We are maintaining our overweight stance on U.S. IG and higher-rated U.S. HY, both of which should continue to outperform Treasuries over the next few months, but a repeat performance is far less likely next year. Chart 5No Signs Of Concern##br## In U.S. Corporate Credit Spreads Chart 6Top-Down Euro Area CHM:##br## Improving Euro Area Corporate Health Monitors: Solid Improvement Our top-down Euro Area CHM has been showing steady improvement since 2013, driven by strong profit margins and rising interest and debt coverage ratios (Chart 6). The ultra-stimulative monetary policies of the European Central Bank (ECB) have likely played a large role in helping lower corporate borrowing costs and boosting the interest coverage ratio. The average coupon on bonds in the Bloomberg Barclays Euro-Aggregate Investment Grade corporate index is now down to a mere 2.3% - a far cry from the 5% level that prevailed during the peak of the 2011 Euro Debt crisis or the 3.5% level just before the ECB began its asset purchase program in 2015. Return on capital has fallen over the past decade and now sits at 8%, although profit margins remain quite strong on our top-down CHM measure. Short-term liquidity is at a record high, suggesting no imminent problems for European corporate borrowers. Our bottom-up CHMs for Euro Area IG (Chart 7) and HY (Chart 8) are telling a broadly similar story to the top-down CHM. The bottom-up CHMs have steadily improved in the past couple of years, most notably for domestic issuers of Euro-denominated debt.3 Some improvement in the bottom-up aggregates for operating margins and interest coverage ratios is providing a boost to European credit quality. Chart 7Bottom-Up Euro Area Investment Grade CHMs Chart 8Bottom-Up Euro Area High-Yield CHMs The bottom-up measure of leverage for domestic IG issuers has been steadily declining since the 2009 recession, a sign that European companies have been much more cautious in managing their balance sheet risk than their U.S. counterparts. The same cannot be said for Euro Area domestic HY issuers, where all the individual ratios are at weak absolute levels. When splitting our bottom-up Euro Area IG company list into issuers from core Europe versus countries on the Periphery (Chart 9), the "regional" European CHMs tell broadly similar stories of improving credit quality. The fact that even Peripheral issuers are seeing rising interest coverage and liquidity ratios, despite much higher levels of leverage than in the core, is an indication of how the ECB's low interest rate policies and asset purchase programs (which include buying corporate debt) have helped support the European corporate sector. Net-net, our Euro Area CHMs are sending a signal that there are no immediate stresses on corporate balance sheets or profitability. This is already reflected in the current low level of corporate bond yields and spreads, though (Chart 10). A bigger threat to Euro Area corporates comes from monetary policy. The ECB is under increasing pressure to consider announcing a tapering of its asset purchases - likely to include slower buying of corporates - starting in 2018. There is a risk of a negative market reaction that could undermine future Euro Area corporate bond performance. Because of this, we continue to prefer U.S. corporate debt over Euro Area equivalents, despite the large gap between the U.S. and European top-down CHMs (Chart 11). Chart 9Bottom-Up Euro Area IG CHMs: ##br##Core Vs. Periphery Chart 10Euro Area Corporate Bonds ##br## Have Had A Great Run Chart 11Relative CHMs Starting ##br##To Turn Less Favorable For U.S. Credit U.K. Corporate Health Monitor: Solid Balance Sheet Fundamentals The top-down U.K. CHM has steadily improved over the past couple of years, led by rising profit margins, higher interest coverage and very robust liquidity (Chart 12). Return on capital is low relative to its history, which is consistent with the trends seen in the U.S. and Euro Area and likely reflects the global low productivity backdrop. Fundamental analysis of U.K. corporates may not be of much use at the moment given the extremely accommodative monetary policy environment provided by the Bank of England (BoE). Low interest rates, combined with BoE asset purchases (which include a small amount of corporate debt) and a steep fall in the Pound in the aftermath of the Brexit-driven political uncertainty, are all helping keep the U.K. economy afloat. The BoE is now having to deal with a currency-driven climb in U.K. inflation, with three members of the BoE policy committee even calling for a rate hike at the latest policy meeting. The political backdrop after last year's Brexit vote and this month's closer-than-expected U.K. election result remains too volatile for the BoE to seriously consider any imminent tightening of monetary policy. While it can be debated how much the Brexit uncertainty is truly weighing on the U.K. economy, the BoE is unlikely to take any risks on triggering a growth slowdown by becoming too hawkish, too soon - even with the relatively high level of currency-driven inflation. A combination of a strong CHM and a dovish BoE will allow U.K. corporate debt, both IG and HY, to continue to outperform Gilts. We continue to recommend an overweight allocation to U.K. corporates even though, as in the other countries shown in this report, valuations are not cheap (Chart 13). We have not yet constructed bottom-up versions of the CHM for U.K. corporates to allow us to make any additional comments on the relative merits of U.K. IG and HY debt. This is something we intend to look into for future reports. Chart 12U.K. Corporate Balance Sheets ##br##Are In Good Shape... Chart 13...Which Is Already Reflected In ##br##Tight Credit Spreads Emerging Market Corporate Health Monitor: Cyclically Strong, Structurally Weak The CHM for EM corporates built by our Emerging Markets Strategy team is purely a bottom-up measure. The financial data from 220 EM companies in over 30 countries is used to construct the EM CHM. Only firms that issue U.S. dollar-denominated bonds are included, with banks and other financials also omitted in a similar fashion to the CHMs for the developed economies. A shorter list of financial ratios is used in the EM CHM than the developed CHMs, including: Profit margins Free cash flow to total debt: Liquidity Leverage Unlike the developed CHMs, the ratios are not equally weighted in the construction of the EM CHM. Profit margins and cash flow/debt combined represent 75% of the EM CHM. The weightings are designed to optimize the performance of the EM CHM versus the actual spread movements in the J.P. Morgan CEMBI benchmark index for EM corporate debt. Chart 14EM Corporate Health: Cyclically Solid... The EM CHM is currently pointing to very strong fundamental underpinnings for EM corporates with the indicator at the most credit-positive level in a decade (Chart 14). That recent strength is a modest cyclical improvement after a multi-year deterioration in all the individual EM CHM components (Chart 15). The uptick in global commodity prices in 2016 played a major role in the improvement in the growth-sensitive components (top two panels). However, the biggest structural headwind for EM corporates is the unrelenting rise in balance sheet leverage (bottom panel) - a problem that could come to the forefront if the recent slump in commodity prices persists or developed market interest rates begin to rise more sharply as central banks become marginally less accommodative. For now, we continue to recommend only a neutral allocation to EM hard currency debt, as the positive message sent by the EM CHM appears fully priced into the current low level of EM yields and spreads (Chart 16). Chart 15...But Structurally More Challenged Chart 16EM Corporate Debt Is Not Cheap Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Special Report, "EM Corporate Health Is Flashing Red" dated September 14 2016, available at ems.bcaresearch.com. 3 Given the large share of non-European issuers in the Euro-denominated corporate debt market, we have split our sample set of companies in our bottom-up Euro Area CHMs into "domestic" and "foreign" issuer groups. This allows a more precise analysis of the corporate health of European-domiciled companies. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index
Dear client, This week, we are sending you an abbreviated Weekly Report as we co-authored a Special Report on Wednesday with our sister Geopolitical Strategy service. In our Special Report, available on our website, we argue that Italy's flirtation with leaving the euro area is rooted in its positive experience with devaluations in the 1990s. However, we note that this time is different and devaluing the euro through exit will not be a panacea, as financial market linkages would cause a deep domestic recession that could be brought forward by the mere reality of a referendum on the topic. As such, we think that Italy is unlikely to leave the Euro Area, but that it will remain a drag on the Eurozone - one that will force the European Central Bank to stay a bit more dovish than warranted by conditions in the broader Euro Area. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Feature Chart I-1The Dollar At A Critical Spot Since the end of last week, the dollar has staged a small rebound. This rebound was of the utmost importance as it materialized at an important level. Had DXY punched below the 96 level, the dollar could have sold off toward 93 in a matter of weeks. However, if the dollar can remain above 96, the greenback is likely to have formed a trough for the remainder of 2017 as it will rest above an important congestion zone that has been in place since early 2015 (Chart I-1). What are the odds of the greenback moving back to 93? We think that right now the balance of probability is in favor of a continued rebound. A call on DXY is first and foremost a call on the euro, as EUR/USD represents 60% of this index. We'll thus focus on the dynamics in this pair. Currently, nominal short rate differentials remain in the dollar's favor. As Chart I-2 illustrates, interbank rate spreads between the Euro Area and the U.S. are broadly supportive of the USD. Additionally, in both the late 1990s and in 2005-06, this spread had been much more negative than at present. BCA still expects the spread to grow more negative as the Federal Reserve continues on its intended policy path, while we also believe it will take a few more years before the ECB can begin lifting rates.1 Real rate differentials paint a similar picture. The euro's strength in the second quarter has emerged in spite of a move in real rate spreads in favor of the USD. As Chart I-3 shows, this divergence has mostly reflected dynamics at the short end of the yield curve, but over the past month and a half the real interest rate difference at the 10-year maturity has also diverged from the EUR/USD's path. Chart I-2EUR/USD Short Rate Differentials ##br##Can Grow Deeper Chart I-3EUR/USD Has Dissociated##br## From A Key Driver Technically, the dollar is beginning to look attractive against the euro as well. Our positioning indicator - based on sentiment, net speculative positions, and the euro's advanced/decline line - shows that investors are already positioned the most euro bullish since 2012 (Chart I-4). Our intermediate-term technical indicator is also at highly overbought levels, highlighting the euro's limited upside potential. Most importantly though, these moves have happened as the Euro Area economic surprise index massively beat the U.S. one (Chart I-4, bottom panel). This means that Europe's economic outperformance has been driving the euro's strength, unlike in 2015 when the surge in the European surprise index relative to the U.S. was reflective of the euro's 2014 collapse. This paints a picture where much good European news has been priced into EUR/USD during the recent rally. At current levels, the mean-reverting nature of the relative surprise index suggests that European surprises are unlikely to continue to beat U.S. ones by such a margin going forward. This means that the already overbought euro is likely to lose a key support. Finally, as we highlighted two weeks ago, global analysts have already ratcheted up their year-end estimates for EUR/USD (Chart I-5). Not only are their forecasts at levels that have in recent years been indicative of a peak, but the speed and magnitude of their adjustments has also been exceptional. This corroborates that the positive momentum in the Eurozone vis-à-vis the U.S. has already been internalized by market participants. If anything, this favorable relative economic momentum must only grow going forward for the euro to rally further. However, European LEIs have already rolled over relative to the U.S. as the latter looks set to exit its soft patch in the coming months (Chart I-6). Chart I-4Good News Already ##br##In The Euro Chart I-5Investors Have Already##br## Bought The Euro Chart I-6The Economic Tailwinds For The ##br##Euro Are Beginning To Fade Bottom Line: DXY has rebounded at a crucial level. If it can stay above 96, this would suggest that its correction is over. We are willing to make this bet as the euro - the key component of the DXY - has dissociated from rate differentials on strong optimism toward the economic outlook for Europe - at the exact time that investors have become more incredulous of the Fed's intentions. Due to these dynamics, EUR/USD is now massively overbought and at risk of a further pullback. Cutting Loose Short USD/JPY Last week, we closed our short USD/JPY position at a 4.2% gain. We did so because we see an increasingly less-supportive environment for the yen. To begin with, the U.S. Treasury notes' fair-value model used by our U.S. Bond Strategy service highlights that U.S. bond yields are currently quite expensive, and could be set to rise anew (Chart I-7). Because JGBs possess a very low beta relative to U.S. yields, an environment where global rates rise tends to be associated with rate differentials moving in favor of USD/JPY, often prompting a rally in the latter. Also, the Bank of Japan is keenly aware that it will be very difficult to achieve its 2% inflation target. The yen's recent strength has exerted a significant tightening in Japanese financial conditions that will drag down inflation (Chart I-8). Hence, the BoJ will continue to be among the most dovish central banks in the world. Additionally, while Japanese industrial production has been strong, it looks set to soften in the coming months, which will give further reason to the BoJ to talk down the yen: Japanese industrial production is very much a function of financial conditions. We are entering a window where the recent tightening in Japanese financial conditions should begin to bite industrial production. The growth rate of the Japanese shipments-to-inventories ratio has rolled over, historically a precursor of a slowdown in industrial production (Chart I-9). Chart I-7T-Notes Are Expensive Chart I-8Japanese FCI Points To Lower Inflation Chart I-9Japanese IP Will Turn Finally, the annual growth rate of Japan's industrial production is heavily influenced by China's economic dynamics, as EM represents 43% of Japanese exports. Two months ago, the Keqiang index - a barometer of strength for the Chinese economy based on credit growth, railway freight volumes, and electricity production - hit its highest level since June 2010, levels only recorded in early 2007, early 2005, and early 2004. Even though we do not anticipate it to crater, we do expect its recent rollover to deepen further in response to the recent wave of policy tightening in China. This should result in some weakness for Japan's industrial production. In practice there is little additional actions the BoJ can implement to ease policy further. However, because investors are currently so negative on the prospects for further Fed rate increases, with only 40 basis points priced in over the next 24 months, a re-assurance by the BoJ that easy policy is here to stay could put upward pressure on USD/JPY. While we remain worried about EM assets, we think that shorting the AUD or the NZD against the yen represents better portfolio protection than shorting USD/JPY. Bottom Line: USD/JPY has a generous amount of upside from here. Investors are too pessimistic regarding the Fed's ability to increase rates over the next 24 months. Meanwhile, the recent tightening in Japanese financial conditions is a headache for the BoJ, as it points to weaker inflation and a slowdown in industrial production. Hence, we expect the BoJ will try to talk down the yen over the coming months. EUR/NOK At An Interesting Spot Chart I-10If Brent Doesn't Fall Below,##br## EUR/NOK Is A Short The price action in EUR/NOK caught our eye this week. EUR/NOK is at a critical level and has rallied as investor optimism toward the Euro Area economy continues to grow. Meanwhile, oil prices have collapsed to US$45/bbl. Since Norway is an economy heavily geared to oil-price gyrations, this bifurcation created an ideal combination to generate a EUR/NOK rally. However, by discounting these developments, EUR/NOK has now entered massively overbought territory. Additionally, as Chart I-10 illustrates, the cross has only traded at higher levels at the depth of the financial crisis in the first quarter of 2009 and the early days of 2016. In both instances, Brent was trading below US$40/bbl. A selling opportunity could soon emerge. Our Commodity And Energy Strategy service continues to expect a deepening of the adjustment in global oil inventories as the OPEC 2.0 deal remains in vigor and compliance stays in place.2 This means a move below US$40/bbl for Brent is very unlikely, and the upside in EUR/NOK is extremely limited. While in the coming weeks a move in Brent to between US$44/bbl and US$42/bbl could happen, we think this limited downside points to an attractive risk-reward ratio to shorting this cross. We are currently long CAD/NOK and short EUR/CAD, with the latter having greater potential downside than EUR/NOK. However, due to Canada's deep integration with the U.S. economy, the EUR/CAD trade is often affected by dynamics in the U.S. dollar. Shorting EUR/NOK is thus a cleaner play on oil and removes much of the risk associated with the greenback's fluctuations. Finally, yesterday, the Norges Bank policy release displayed less dovish tone than anticipated by the market. This kind of surprise would create an additional support to being short EUR/NOK. Bottom Line: EUR/NOK looks set to weaken. Over the past 10 years, it has only traded above current levels when Brent prices were below US$40/bbl. Based on our commodity team's analysis, such a move is very unlikely. Thus, any short-term weakness in oil prices should be used to sell EUR/NOK. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled, "Central Banks Are Sticking To Their Guns", dated June 6, 2017, available at fes.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report titled "Time For "Whatever It Takes" In Oil?", dated June 2, 2017, available at ces.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights The divergence between global bond yields and equity prices is not as puzzling as it may first appear. Thus far, lower inflation has dampened the need for central banks to tighten monetary policy. This has caused bond yields to fall, lifting stocks in the process. Looking out, the combination of faster growth and dwindling spare capacity will cause inflation to rise. This is particularly the case for the U.S., where the economy has already reached full employment. The "blow-off" phase for the U.S. economy is likely to last until mid-2018. The dollar and Treasury yields will move higher over this period. The euro and the yen will suffer the most against a resurgent greenback, the pound less so. China's economy will remain resilient, helping to boost commodity prices. This will support the Canadian and Aussie dollars. Stronger global growth will provide a tailwind to emerging markets. However, at this point, most of the good news is already reflected in EM asset valuations. Feature Stocks And Bonds: A Curious Divergence Chart 1Global Growth: Increasing Optimism One could be forgiven for thinking that equity and bond investors are living on different planets. Global bond yields have been trending lower thus far this year, while stocks have been setting new highs. Are bonds signaling an imminent slowdown which equity investors are willfully ignoring? Not necessarily. Almost all of the decline in bond yields has been due to falling inflation expectations. Real yields have remained reasonably steady, suggesting that growth worries are not foremost on investors' minds. The fact that consensus global growth estimates for 2017 and 2018 have continued to grind higher is consistent with this observation (Chart 1). A quiescent inflation picture has given investors more confidence that the Fed will not need to raise rates aggressively. This has pushed down bond yields, weakened the dollar, and fueled the rally in stock prices. The decline in headline inflation, in turn, has been largely driven by lower commodity prices. In the U.S., several one-off factors - including Verizon's decision to move to unlimited data plans, a temporary lull in health care inflation, and a drop in airline fares - have helped keep core inflation in check. The U.S. Economy: It Gets Better Before It Gets Worse Looking out, global growth is likely to remain firm. This should ultimately translate into higher inflation, particularly in the U.S., where the economy has already achieved full employment. Granted, as we discussed last week,1 the U.S. business cycle expansion is getting long in the tooth. However, history suggests that the transition between boom and bust is often accompanied by a revelry of sorts where things get better before they get worse. Call it a "blow-off" phase for the business cycle. The example of the late 1990s - the last time the U.S. unemployment rate fell below NAIRU for an extended period of time - comes to mind. Chart 2 shows that final domestic demand accelerated to 8.3% in nominal terms in Q1 of 2000. Personal consumption growth surged, reaching 8.4% in nominal terms and 5.7% in real terms. Obviously, there are many differences between now and then. However, there is at least one critical similarity: The unemployment rate stood at 4.3% in January 1999. This is exactly where it stands today. And if it keeps falling at its current pace, the unemployment rate will dip below its 2000 low of 3.8% by next summer. As was the case in the past, an overheated labor market will lead to faster wage growth. In the U.S., underlying wage growth has accelerated from 1.2% in 2010 to 2.4% at present (Chart 3). Chart 2The Late 1990s: An End-Of-Cycle Blow-Off Chart 3Stronger Labor Market Is Leading To Faster Wage Growth Granted, this is still well below the levels seen in 2000 and 2007. However, productivity growth has crumbled over the past decade while long-term inflation expectations have dipped. Real unit labor costs - a measure of compensation which adjusts for shifts in productivity growth and inflation - are rising at a faster rate than in 2007 and close to the pace recorded in 2000 (Chart 4). In fact, real wage growth in the U.S. has eclipsed business productivity growth for three straight years (Chart 5). As a result, labor's share of national income is now increasing. Chart 4Real Unit Labor Cost Growth: Back To Its 2000 Peak Chart 5Real Wages Now Increasing Faster Than Productivity What happens to aggregate demand when the share of income going to workers rises? The answer is that at least initially, demand goes up. Companies typically spend less of every marginal dollar of income than workers. This is especially the case in today's environment where the distribution of corporate profits has become increasingly tilted towards a few winner-take-all firms which, for the most part, are already flush with cash (Chart 6). Thus, a shift of income towards workers tends to boost overall spending. In addition, an overheated labor market typically generates the biggest gains for workers at the bottom of the income distribution. Wages for U.S. workers without a college degree have been rising more quickly than those with a university education for the past few years (Chart 7). Such workers often live paycheck-to-paycheck and, hence, have a high marginal propensity to consume. Chart 6A Winner-Take-All Economy Chart 7Tighter Labor Market Boosting Wages Of Less Educated Workers Let's Get This Party Started The discussion above suggests that U.S. aggregate demand could accelerate over the next few quarters. There is some evidence that this is already happening (Chart 8). Despite a moderation in auto purchases, real PCE growth is still tracking at 3.2% in the second quarter according to the Atlanta Fed's GDPNow model. And with the personal saving rate still stuck at an elevated 5.3%, there is scope for consumer spending to grow at a faster rate than disposable income. Chart 9 shows that the current saving rate is well above the level one would expect based on the ratio of household net worth-to-disposable income. Chart 8Solid Near-Term Outlook For U.S. Consumers Financial conditions have eased over the past six months thanks to lower Treasury yields, narrower credit spreads, a weaker dollar, and higher equity prices (Chart 10). Historically, an easing in financial conditions has foreshadowed faster growth (Chart 11). This could make the coming blow-off phase even more explosive than in past business cycles. Some commentators have noted that while financial conditions have eased, bank lending has slowed significantly. If true, this would imply that easier financial conditions are not boosting credit growth in the way one might expect. The problem with this argument is that it takes a far too limited view of the U.S. financial system. Although bank lending to companies has indeed slowed, bond issuance has soared. In fact, total nonfinancial corporate debt rose by $212 billion in the first quarter according to the Fed's Financial Accounts database, the largest increase in history (Chart 12). Chart 10Financial Conditions Have Been Easing... Chart 11...Which Will Support Growth Chart 12Nonfinancial Corporate Debt Surged In Q1 All Good Things Must Come To An End Unfortunately, the burst of demand that often occurs in the late stages of business cycle expansions contains the seeds of its own demise. Initially, when consumer spending accelerates, firms tend to react by expanding capacity. This translates into higher investment spending. However, as labor's share of income keeps rising, an increasing number of firms start incurring outright losses. This causes them to dismiss workers and cut back on investment spending. Such a souring in corporate animal spirits is not an immediate risk for the U.S. economy. Hiring intentions remain solid and businesses are still signaling that they expect to increase capital spending over the coming months (Chart 13). Profit margins are also quite high by historic standards, which gives firms greater room for maneuver. This will change over time, however. Margins are already falling in the national accounts data (Chart 14). History suggests that S&P 500 margins will follow suit. This raises the risk that capex and hiring will start to slow late next year, potentially sowing the seeds for a recession in 2019. We remain overweight global equities on a cyclical 12-month horizon, but will be looking to significantly pare back exposure next summer. Chart 13Corporate America Feeling Great Again Chart 14Economy-Wide Margins Have Slipped The Dollar Bull Market Is Not Over Yet Chart 15Historically, A Rising Labor Share Has Pushed Up The Dollar Until U.S. growth does decelerate, the path of least resistance for bond yields and the dollar will be to the upside. Chart 15 shows the strikingly close correlation between labor's share of income and the value of the trade-weighted dollar. As noted above, the initial effect of accelerating wage growth is to put more money into workers' pockets. This results in higher aggregate demand and, against a backdrop of low spare capacity, rising inflation. Historically, such an outcome has prompted the Fed to expedite the pace of rate hikes, leading to a stronger dollar. This time is unlikely to be any different. The market is currently pricing in only 21 basis points in Fed rate hikes over the next 12 months. This seems far too low to us. Other things equal, a stronger dollar implies a weaker euro and yen. Improved export competitiveness will lead to better growth prospects and higher inflation expectations in the euro area and Japan. Unless the ECB and the BoJ respond by tightening monetary policy, short-term real rates will fall. This, in turn, could put further downward pressure on the euro and the yen. The ECB And The BoJ Will Not Follow The Fed's Lead Many commentators have argued that better growth prospects will cause the ECB and the BoJ to follow in the Fed's footsteps and take away the punch bowl. We doubt it. Labor market slack is still considerably higher in the euro area than was the case in 2008. Outside of Germany, the level of unemployment and underemployment in the euro area is about seven points higher than it was before the Great Recession (Chart 16). If anything, the market has priced in too much tightening from the ECB. Our months-to-hike measure has plummeted from a high of 65 months in July 2016 to 28 months at present (Chart 17). Investors now expect real rates in the U.S. to be only 23 basis points higher than in the euro area in five years' time. This is well below the 76 basis-point gap in the equilibrium rate between the two regions that Holston, Laubach, and Williams estimate (Chart 18). Chart 16Euro Area: Labor Market Slack Is Still High Outside Of Germany Chart 17ECB: Markets Are Pricing In Too Much Tightening Chart 18The Neutral Rate Is Lowest In The Euro Area As for Japan, while it is true that the unemployment rate has fallen to 2.8% - a 22-year low - this understates the true amount of slack in the economy. Output-per-hour in Japan remains 35% below U.S. levels. A key reason for this is that many Japanese companies continue to pad their payrolls with excess labor. This is particularly true in the service sector, which remains largely insulated from foreign competition. In any case, with both actual inflation and inflation expectations in Japan nowhere close to the BoJ's target, this is hardly the time to be worried about an overheated economy. And even if the Japanese authorities were inclined to slow growth, it would be fiscal policy rather than monetary policy that they would tighten first. After all, they have been keen to raise the sales tax for several years now. The Pound Will Rebound Against The Euro, But Weaken Further Against The Dollar Chart 19Pound: Unloved And Underappreciated While we continue to maintain a strong conviction view that the euro and yen will weaken against the dollar, we are more circumspect about other currencies. Bank of England Governor Mark Carney played down speculation this week that the BoE would raise rates later this year, noting in his annual speech at London's Mansion House that "now is not yet the time to begin that adjustment." U.K. growth has been the weakest in the G7 so far in 2017, partly because of growing angst over the forthcoming Brexit negotiations. Nevertheless, U.K. inflation remains elevated and fiscal policy is likely to be eased in the November budget, as Chancellor Hammond confirmed in a BBC interview on Sunday. Sterling is already quite cheap based on our metrics (Chart 19). Our best bet is that the pound will weaken against the dollar over the next 12 months but strengthen against the euro and the yen. We are currently long GBP/JPY. The trade has gained 7.2% since we initiated it in August 2016. CAD Has Upside We went long CAD/EUR in May. Despite the downdraft in oil prices, the trade has managed to gain 2.6% thus far. We are optimistic on the Canadian dollar over the coming months. Our energy strategists remain convinced that crude prices are heading higher. They expect global production to increase by only 0.7 MMB/d in 2017, compared to 1.5 MMB/d growth in consumption. Consequently, oil inventories should fall over the remainder of this year. If history is any guide, this will lead to a rebound in oil prices (Chart 20). The Bank of Canada has also turned more hawkish. Senior Deputy Governor Carolyn Wilkins suggested last week that interest rates are likely to rise later this year. The market is now pricing in a 84% chance of a rate hike in 2017, up from only 18% earlier this month. The Canadian economy continues to perform well (Chart 21). Retail sales are growing briskly, the unemployment rate is close to its lowest level in 40 years, and goods exports are recovering thanks to a weak loonie and stronger growth south of the border. While the bubbly housing market remains a source of concern, this is as much a reason to raise interest rates - to prevent further overheating - as to cut them. Chart 20Falling Oil Inventories Should Lead To Higher Crude Prices Chart 21Canadian Economy: Chugging Along China Will Drive The Aussie Dollar And EM Assets After a very strong start to the year, Chinese growth has slipped a notch. Housing starts slowed in May, as did gains in property prices. M2 growth decelerated to 9.6% from a year earlier, the first time broad money growth has fallen into the single-digit range since the government began publishing such statistics in 1986. Still, the economy is far from falling off a cliff, as evidenced by the fact that the IMF upgraded its full-year 2017 GDP growth forecast from 6.6% to 6.7% last week. Real-time measures of industrial activity such as railway freight traffic, excavator sales, and electricity production remain upbeat. Export growth is accelerating thanks to a weaker currency and stronger global growth. The PBoC's trade-weighted RMB basket has fallen by over 8% since it was introduced in December 2015. Retail sales continue to expand at a healthy clip. The percentage of households that intend to buy a new home has also surged to record-high levels. This should limit the fallout from the government's efforts to cool the housing market. The rebound in exports and industrial output is helping to lift producer prices. Higher selling prices, in turn, are fueling a rebound in industrial company profits (Chart 22). A better profit picture should support business capital spending in the coming months. The government also remains cognizant of the risks of tightening policy too aggressively, especially with the National Party Congress slated for this autumn. The PBoC injected 250 billion yuan into the financial system last Friday. This was the single biggest one-day intervention since January, when demand for cash was running high in the lead up to the Chinese New Year celebrations. Fiscal policy has also been eased (Chart 23). So far, the "regulatory windstorm" of measures designed to clamp down on financial speculation has largely bypassed the real economy. Medium and long-term lending to nonfinancial corporations - a key driver of private-sector capital spending - has actually accelerated over the past eight months (Chart 24). Chart 22China: Higher Selling Prices Fuelling A Rebound In Profits Chart 23Fiscal Spending Is On The Mend Chart 24China: Credit To The Real Economy Is Accelerating The key takeaway for investors is that Chinese growth is likely to slow over the next few quarters, but not by much. Considering that fund managers surveyed by BofA Merrill Lynch in June cited fears of a hard landing in China as the biggest tail risk facing financial markets for the second month in a row, the bar for positive surprises out of China is comfortably low. If China can clear this bar, as we expect it will, it will be good news for the Aussie dollar and other commodity plays. Strong Chinese growth should provide a tailwind for EM assets. However, EM stocks and currencies have already had a major run, which limits further upside. The fact that serial-defaulter Argentina could issue a 100-year bond this week in an offering that was three times oversubscribed is a testament to that. The fundamental problems plaguing many emerging markets - high debt levels, poor governance, and lackluster productivity growth - remain largely unaddressed. Until they are, the long-term outlook for EM assets will continue to be challenging. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights For the time being, our cyclical stance is to underweight the globally-sensitive Energy, Materials and Banks sectors versus Healthcare - in both the equity and credit asset-class. Combined with our expectation of a weakening pound/euro, this necessarily means the following European equity market allocation: Overweight: France, Ireland, U.K., Switzerland and Denmark. Neutral: Germany, Netherlands and Sweden. Underweight: Italy, Spain, and Norway. We anticipate shifting to a more cyclical sector (and country) allocation by the late summer, especially on dips. Feature It is worth reminding readers that picking mainstream equity markets1 is overwhelmingly about the industry sectors and dominant stocks that you are buying, wittingly or unwittingly. Picking equity markets is seldom about the prospects of the underlying domestic economies or head-to-head valuations.2 Chart of the WeekGlobal Energy Has Just Tracked The Global 6-Month Credit Impulse (Down) The usual top-down approach to picking stock markets ignores two dominant features of these markets. First, they have huge variations in their sector exposures. Second, large industry sector groups like Energy, Banks, Healthcare and Technology tend to move en masse under the influence of global or regional rather than domestic drivers. The combination of these two features means that for most stock markets, the sector (and dominant company) impact swamps the effect that comes from the domestic economy. Right now, by far the most important consideration for country pickers is the relative outlook for the globally-sensitive Energy and Banks sectors versus the more defensive Healthcare. As an example, consider the choice between Spain and Switzerland. Spain's IBEX is at the mercy of its huge weighting to Banks, dominated by Santander and BBVA; while Switzerland's SMI is at the mercy of its similarly dominant weighting in the Healthcare sector, via Novartis and Roche. Box I-1 - Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks (Chart 2). France (CAC) is underweight Banks and Basic Materials (Chart 3). Italy (MIB) is overweight Banks (Chart 4). Spain (IBEX) is overweight Banks (Chart 5). Netherlands (AEX) is overweight Technology, underweight Banks (Chart 6). Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy (Chart 7). And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound (Chart 8). Switzerland (SMI) is overweight Healthcare, underweight Energy (Chart 9). Sweden (OMX) is overweight Industrials (Chart 10). Denmark (OMX20) is overweight Healthcare and Industrials (Chart 11). Norway (OBX) is overweight Energy (Chart 12). The U.S. (S&P500) is overweight Technology, underweight Banks (Chart 13). It follows that if Banks underperform Healthcare, it is highly likely that Spain's IBEX will underperform Switzerland's SMI, irrespective of the performances of the Spanish and Swiss domestic economies. For long-term investors, the large skews in sector exposure also mean that a head-to-head comparison of country valuations can be very misleading. At first glance, Spain, trading on a forward price to earnings (PE) multiple of 15.5, appears 15% cheaper than Switzerland, trading on a multiple of over 18. But this head-to-head difference just reflects the impact of forward PEs of Banks at 11 and Healthcare at 18. The Bank sector's lower multiple does not necessarily make it better value than Healthcare. Unlike two developed economies - whose long-term growth prospects tend to be broadly similar - two industry sectors could end up experiencing very different structural growth outcomes. Which would justify very different multiples. Despite its low multiple, a structural underweight to Banks might nonetheless be a good strategy if the sector's structural growth outlook is poor. In such a case, the low multiple is potentially a value trap. Picking Stock Markets The Right Way To reiterate, the decision to overweight or underweight a mainstream equity index should not be based on your view of the country's underlying economy - unless, of course, the country is the potential source of a major tail-risk event. Instead, the decision should be based on your over-arching sector view, combined with the country's skews to specific dominant stocks and sectors (Box I-1). Chart I-2, Chart I-3, Chart I-4, Chart I-5, Chart I-6, Chart I-7, Chart I-8, Chart I-9, Chart I-10, Chart I-11, Chart I-12 and Chart I-13 should leave readers in absolutely no doubt. A market's dominant sector skew is by far the most important determinant of its relative performance. Chart I-2Germany (DAX) Is Overweight Chemicals,##br## Underweight Banks Chart I-3France (CAC) Is Underweight Banks##br## And Basic Materials Chart I-4Italy (MIB) Is Overweight Banks Chart I-5Spain (IBEX) Is Overweight Banks Chart I-6Netherlands (AEX) Is Overweight Technology,##br## Underweight Banks Chart I-7Ireland (ISEQ) Is Overweight Airlines (Ryanair) ##br##Which Is, In Effect, Underweight Energy Chart I-8The U.K. (FTSE100) Is Effectively ##br##Underweight The Pound Chart I-9Switzerland (SMI) Is Overweight Healthcare, ##br##Underweight Energy Chart I-10Sweden (OMX) Is ##br##Overweight Industrials Chart I-11Denmark (OMX20) Is Overweight ##br##Healthcare And Industrials Chart I-12Norway (OBX) Is ##br##Overweight Energy Chart I-13The U.S. (S&P500) Is Overweight Technology, ##br##Underweight Banks Which brings us to the key consideration for country allocation right now: how to allocate to the sectors that feature most often in the skews: Energy and Banks versus Healthcare. For Energy relative performance, note the very strong recent connection with the global 6-month credit impulse. The downswing in the impulse - heralding a very clear growth pause - lines up with the setback in energy and resource prices and the underperformance of these globally-sensitive equity sectors (Chart of the Week and Chart I-14). Meanwhile, in the most recent mini-cycle, Banks' relative performance is tracking the bond yield almost tick for tick (Chart I-15). There are two reasons. For banks, lower bond yields presage both slimmer net interest margins and weaker economic growth. Chart I-14Commodity Price Inflation Is Just Tracking ##br##The Global 6-Month Credit Impulse Chart I-15Financials Are Just Tracking ##br##The Bond Yield So for both Energy and Banks relative performance the overriding question is: when will this mini-downswing end? To answer this question, we note that we are 4-5 months into the global mini-downswing, whose average duration tends to be around 8-9 months. On this basis, now is a little too early to switch to an aggressively pro-cyclical sector allocation. But we would look for potential opportunities by the late summer, especially on sharp dips. Hence, for the time being our cyclical stance is to underweight the globally-sensitive Energy (and Materials) and Banks versus Healthcare. Combined with our expectation of a weakening pound/euro, this necessarily means the following European country allocation: Overweight: France,3 Ireland, U.K., Switzerland and Denmark. Neutral: Germany, Netherlands, and Sweden. Underweight: Italy, Spain, Netherlands and Norway. Clearly, if you have a different cyclical and over-arching sector view, you will arrive at a different country allocation. That's fine. The important point is that the stock and sector skew approach is the right way to pick between mainstream equity indexes. Financials Drive The European Credit Market Finally, an over-arching sector view is also highly relevant for the European corporate credit market. In the euro area, the credit market is heavily skewed towards bank and other financial sector bonds, which account for almost half of euro area corporate bonds by value. By comparison, the U.S. credit market is not so skewed to one dominant sector. Hence, the outlook for the European credit asset-class hinges on the prospects for one sector: Financials (Chart 16). With the European high yield credit spread already close to a 20-year low, we would again wait for a better opportunity before adding aggressively to the European credit asset-class. Chart I-16Mirror Image: European High Yield Credit Spread And Bank Equity Prices Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In the developed world. 2 Please also see the three European Investment Strategy Special Reports 'Picking 5 European Countries The Right Way' November 13, 2014, 'Picking Countries The Right Way: Part 2' March 26, 2015 and 'Picking Countries The Right Way: Part 3' November 12, 2015. 3 But expect a small near-term countertrend underperformance in the CAC40. See page 11. Fractal Trading Model* There are no new trades this week. Last week's trade, long nickel / short palladium has made an encouraging countertrend move at the classic limit of a trend. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-17 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights The Federal Reserve stuck to its guns, which lifted the U.S. dollar despite a disastrous CPI report. We agree with the Fed's assessment and expect U.S. inflation to pick up, clearing the way for higher interest rates and a stronger dollar. With three dissenters voting in favor of higher rates, the Bank of England meeting delivered a hawkish surprise. However, the inflation surge will continue to weigh on consumer spending, limiting the capacity of the BoE to increase rates. Stay short cable, but use any rally in EUR/GBP above 0.88 to short this cross. The Canadian economy is strong, and the CAD should perform well on its crosses. However, USD/CAD downside is limited. Go short EUR/SEK. Feature This week was replete with central bank meetings, most crucially the Federal Reserve and the Bank of England, which provided much-needed color on the near-term future direction of global monetary policy. While the BoE does face a serious rise in inflation, it is still focused on the risks to U.K. growth. In contrast, the Fed mostly ignored the disastrous inflation report released the morning before its policy announcement and kept its focus on the underlying strength in the U.S. economy. We believe both institutions are pursuing the appropriate strategy for their respective economies. The Fed: Straight Ahead Fed Chair Janet Yellen and her gang increased the fed funds rate by 25 basis points to 1-1.25% and pre-announced the parameters around the reduction in the Fed's balance sheet size. On the balance sheet front, the Fed removed any doubt that it will begin reducing its asset holdings this year. Additionally, the Fed provided its new set of forecasts for growth, inflation, unemployment, and interest rates. While it increased its growth forecast for 2017 to 2.2% from 2.1%, it curtailed its core PCE deflator forecast for 2017 by 0.3 percentage points to 1.6%. However, in line with its conviction that the soft patch in inflation is temporary, it kept its 2018 and 2019 core PCE forecasts at 2%. The Fed did also acknowledge that the equilibrium unemployment rate was lower than it believed in March, decreasing its long-term estimate by 0.1% to 4.6%. However, despite recognizing that NAIRU has fallen, the Fed still thinks the labor market is tight. It proceeded to curtail its unemployment rate forecasts by 0.2% in 2017 to 4.3%, and by 0.3% in 2018 and 2019 to 4.2%. Congruent with these forecasts, the Fed did not adjust its intended path for interest rates. It still expects to hike rates once more in 2017, and three more times in both 2018 and 2019. As a result of these policy changes and the intentions associated with the new set of forecasts, the dollar recouped its CPI report-induced decline, and gold suffered. Most interestingly, the market seems to believe that the Fed is entering the realm of policy mistakes as the 2-10-year yield curve flattened considerably, and inflation expectations plunged to their lowest levels since November 4, 2016 (Chart I-1). But is the Fed really making a mistake? We do not think so. Simply put, we agree with the Fed that underlying economic momentum in the U.S. is real, and that both wage growth and inflation will turn the corner this summer. To begin with, our composite capacity utilization gauge, based on both industrial capacity and labor market utilization, is now fully into "no slack" territory. Historically, this has given the Fed the green light to increase interest rates. There is no mystery behind this relationship: when this indicator is above the zero line, inflation pressures emerge and wage growth accelerates (Chart I-2). This time is unlikely to prove different. Chart I-1A Policy ##br##Mistake? Chart I-2Conditions In Place For Higher##br## Inflation And Rates Supporting this assessment, many indicators show that the recent slowdown in wage growth will prove a temporary phenomenon. First, the spread between the Conference Board's "jobs plentiful" and "jobs hard to get" series still points to accelerating average hourly earnings (Chart I-3). Second, the labor market is likely to remain healthy. True, the fastest pace of job creation is behind us, a key symptom that labor market slack is vanishing, but some of our favorite employment indicators - such as Janet Yellen's labor market condition index and the NFIB job openings and hiring plans subcomponents - have picked up again (Chart I-4). In an environment of little slack, this might not translate into impressive nonfarm payroll numbers, but most likely faster wage growth. Chart I-3Wages Will Pick Up Chart I-4Yes, The Labor Market Is Healthy Third, capex intentions are still perky. Historically, capex intentions have tightly correlated with wages, and even the recent softness in wages was forecast by these intentions. This is simply because capex tends to require labor. When corporate investment materializes as worries about the durability of final demand hits cyclical lows, this is generally an environment that requires bidding up the price of labor - i.e. wages. This is precisely the current economic backdrop (Chart I-5). While the slowdown in bank credit to enterprises has caused many commentators to worry about the outlook for capex, we do not share these concerns. For one, although businesses may not have been tapping bank loans in Q1, they have been aggressively borrowing in the bond market (Chart I-6, top panel). Moreover, credit standards are now easing anew, and small firms are reporting little difficulty in accessing credit (Chart I-6, bottom panel). Chart I-5Good Outlook For Growth And Wages Chart I-6I Need Credit; No Problem! With respect to consumption, weren't retail sales on the soft side as well? Here again, we need to step back. Real retail sales continue to grow at a healthy 4.2% annual pace; meanwhile, the so-called control group - which affects GDP computations - was flat in May, but the April number was revised to 0.6% month-on-month, suggesting real consumption will be robust in Q2. In fact, federal income tax withholdings, a good proxy for household income growth, is also accelerating, further supporting consumption (Chart I-7). Overall, we agree with the Fed that the economy is on its way to escaping from its recent soft patch and that wage growth will accelerate. Ryan Swift, who writes our sister U.S. Bond Strategy service, has also recently argued that the U.S. Philips curve remains alive and well, and that wages and inflation will thus pick up again.1 Our own work does highlight the potential for not just wage growth but core CPI to also perk up. U.S. real business sales have been very strong of late, which historically has been a good leading indicator of core inflation (Chart I-8, top panel). Labor market dynamics tell a similar story. Our unemployment diffusion index is also a good leader of core CPI, and after a soft patch is now pointing to firming underlying inflation (Chart I-8, bottom panel). Chart I-7Real Consumption Will Trudge Along Chart I-8Inflation Soft Patch Will End Therefore, we expect the recent negative inflation surprise in the U.S. to reverse. Moreover, inflation surprises in the U.S. are also likely to beat those of the euro area. To a very large extent, Europe's positive inflation surprise, especially relative to the U.S., reflected the 2014 collapse in the euro. The recent stability in the euro since March 2015 further reinforces that the boost to European relative monetary conditions is dissipating, and that European inflation surprise will not outpace the U.S. going forward (Chart I-9). Chart I-9U.S. Inflation Surprises ##br##Will Pick Up Versus Europe's Chart I-10Diverging Policy ##br##Expectations This is very important, as these relative inflation surprise dynamics have been the key factor underpinning divergent expectations behind ECB policy and the Fed's path. While investors have increasingly brought forward the ECB's first hike, they have aggressively curtailed the number of hikes expected in the U.S. over the next two years (Chart I-10). If, as we expect, relative inflation surprises do once again move in favor of the U.S., this gap will disappear, supporting the dollar in the process. Bottom Line: The Fed is right to stay the course. The economy continues to display momentum, and the inflation soft patch should soon dissipate. Moreover, U.S. economic surprises are bottoming. As such, we expect market expectations for inflation and interest rates to move back toward the Fed's forecast, lifting the U.S. dollar in the process. BoE Dissenters Grab The Headlines, But... The poor BoE is in an infinitely more tenuous situation than the Fed. Core inflation continues to pick up, but economic uncertainty is also on the rise. This dichotomy is most pronounced when it comes to wages. At 2.6%, core inflation is now outpacing wage growth, thus real income levels are contracting (Chart I-11). This is problematic because at 65% of GDP, the U.K. is an economy fundamentally driven by consumer spending. As Chart I-12 illustrates, when inflation picks up and puts downward pressure on real wages, consumption sags. Therein lies the BoE's conundrum. Chart I-11U.K.: Inflation Everywhere, But Not In Wages Chart I-12The BOE's Dilemma Despite the three dissenters who voted in favor of a hike this week, we expect the BoE to continue to favor not lifting rates, leaving its accommodation in place.2 Household inflation expectations remain well moored, but a further relapse in growth could prompt a widening of the output gap and produce entrenched deflationary expectations down the line - something BoE Governor Mark Carney and his colleagues want to avoid at all costs. Chart I-13U.K. FDI At Risk Some investors have been wondering out loud about the likelihood of a "soft Brexit" coming back on the agenda, arguing that it would support the pound. Remaining in the common market is, after all, an unmitigated positive for the U.K. But to be part of the common market, the U.K. also has to adopt the sacrosanct freedom of movement of people. We remain unconvinced that the British will budge on this point. Brexit was first and foremost a rejection of neo-liberal ideals that have been perceived as detrimental to the British middle class. And no point has been and continues to be more contentious than immigration. With the EU absolutely unwilling to dilute freedom of movement, access to the common market for the U.K. remains a distant dream. Moreover, with the British median voter switching to the left, a topic discussed in last Friday's Geopolitical Strategy Service Special Report on the election, British politics are likely to become less business friendly.3 Compounding this issue, U.K. industrial production is flat on an annual basis, bucking the global improvement seen last year and implying that the falling pound has not boosted competitiveness in the U.K. manufacturing sector. Together these forces suggest that the recent upsurge in FDI inflows into the U.K. could reverse in coming quarters (Chart I-13), a big problem for a country with a current account deficit of more than 4% of GDP and deeply negative real rates. Ultimately, the pound is cheap, trading at a one-sigma discount to its fair value. This means the market is well aware of the negatives that are weighing on sterling. Thus, the risks to GBP are well balanced. As a result, we expect GBP/USD to finish the year toward 1.2 because of our expectation of USD strength. EUR/GBP has limited upside, and rises above 0.88 should be used to build short positions. Bottom Line: The BoE decision was in line with expectations, but the market was nonetheless surprised by the fact that three MPC members dissented and voted for a rate hike. Sure, British inflation is on the rise, but this is hurting household real incomes, and thus consumption. These dynamics limit the upside risk to policy rates. We think that GBP could weaken against the USD; we would use moves above 0.88 to short EUR/GBP. The Bank Of Canada Volte Face Despite a 5% fall in oil prices this week, the CAD has appreciated 1.2% against the USD. Behind this impressive move has been Monday's speech by Senior Deputy Governor Carolyn Wilkins, in which she hinted that the Bank of Canada's next move will be a hike, coming sooner than investors have been anticipating. The BoC assessed that the negative impact of the fall in oil prices in 2014-'15 has passed, and that domestic strength in the Canadian economy has become self-sustaining. With the output gap expected to close in Q2 2018, the logical path for policy is tighter. Do the indicators warrant such a view? Yes: Canadian employment is quite strong, growing at a 1.8% annual pace. Unemployment too has fallen substantially. Capacity utilization is elevated in the manufacturing sector, thanks to a decade of low corporate investment. If our assessment of the U.S. capex cycle is correct, Canadian goods exports should pick up, adding to capacity and inflationary pressures in the country (Chart I-14). Our Canadian economic diffusion index - based on retail trade, manufacturing sales, building permits, and employment data in the 10 provinces - has sharply accelerated, pointing to a continued rise in GDP growth. Canadian LEIs and PMIs are all strong. Canadian house prices continue to forge ahead, growing at a 14% annual rate, which will additionally support Canadian consumption. This picture highlights that the BoC does have room to adjust its forward guidance, especially if the Fed stays on its desired path. Today, not only are investors the most short CAD since early 2007, but the loonie is cheap relative to real rate differentials (Chart I-15). As a result of these distortions, CAD could respond very positively to continued reaffirmation by the BoC that policy may become tighter. Chart I-14O Canada Chart I-15CAD At A Discount To Rates Practically, due to our broad bullish outlook on the USD, we find the most interesting way to play CAD strength is through its various crosses. Thus, we remain short EUR/CAD, short AUD/CAD, and long CAD/NOK. Bottom Line: The Canadian economy has escaped its funk. True, the long-term risks associated with the housing bubble will ultimately come home to roost. However, in the short term, the BoC is finding room to lift its forward guidance. As a result, CAD is likely to move higher on non-USD crosses. EUR/SEK Is A Short EUR/SEK should weaken in the coming quarters. To begin with, EUR/SEK is trading at a 7% premium against its PPP fair value. Additionally, the real trade-weighted SEK stands at a one-sigma discount to its long-term fundamental fair value, which further highlights the SEK's upside potential versus the euro, the main trading counterparty of Sweden (Chart I-16). Valuations are not enough to motivate a position. Economics need to join the ball. Today, the Swedish output gap is positive while that of Europe remains negative. Unsurprisingly, Swedish core inflation has overtaken that of the euro area (Chart I-17). Moreover, while we have argued at length why euro area core inflation is likely to disappoint going forward,4 pressure on Swedish resources is such that Swedish core inflation is likely to display additional upside (Chart I-18). Chart I-16SEK Is Cheap Chart I-17Swedish Core Inflation Is Outpacing Europe's Chart I-18Swedish Core Inflation Will Rise Further This means there will be attractive relative policy dynamics between the Riksbank and the ECB in the coming months. If the ECB has to tighten policy, the Riksbank has an even better case to be hawkish. If, however, the global economic environment prevents the ECB from tightening and forces it toward an easing bias, these global deflationary pressures should prove more muted in Sweden. Thus, we expect that Swedish policy will tighten relative to the ECB's, despite the economic and inflation environment. Chart I-19CPI Expectations Differential Will Push ##br##Policy Toward A Lower EUR/SEK Additionally, inflation expectations are pointing toward a lower EUR/SEK. The recent Swedish Prospera inflation survey showed that economic agents are expecting a pickup in inflation. As a result, market-based inflation expectations in Sweden have outperformed those in Germany, pointing to a lower EUR/SEK (Chart I-19). Essentially, this reflects potential changes in the relative direction of policy between the two currencies. The big risk to this view is that Stefan Ingves, the Riksbank governor, continues to be one of the most dovish policy makers in the world. However, his term ends on January 1, 2018, and unless he is renewed for another six years, his words and desires will increasingly lose their ability to affect markets. Bottom Line: The Swedish economy is increasingly moving closer to an inflationary environment. This cannot yet be said about the euro area. With inflation expectations sharply moving up in Sweden versus the euro zone, investors should begin betting against EUR/SEK. Housekeeping We are closing our short USD/JPY trade this week at a 4.2% profit. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report titled, "Low Inflation And Rising Debt", dated June 3, 2017, available at usbs.bcaresearch.com 2 Moreover, one of the dissenters was Kristin Forbes, who was attending her last meeting as a member of the MPC. 3 Please see Geopolitical Strategy Special Report titled, "U.K. Election: The Median Voter Has Spoken", dated June 9, 2017, available at gps.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report titled, "ECB: All About China?", dated April 7, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Chairwoman Janet Yellen has halted the dollar selloff for now, with the DXY finally seeing some upside. Following the press conference, the greenback sits 1.2% above the lows seen prior to the Fed policy meeting. We share the view of the Fed and the expect markets to converge over time toward the Fed's forecasts. Additionally, Yellen confirmed that there is still one more hike on the table this year. We believe the market continues to underprice these factors, concentrating too much on what amounts to a temporary soft patch. As we have said in the past, these factors will continue to widen rate differentials between the U.S. and its G10 counterparts. Report Links: Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 Exploring Risks To Our DXY View - May 26, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 EUR/USD dropped on the news of a weak trade balance figure of EUR 19.6 bn, below the expected EUR 27.2 bn. Generally, EUR/USD has remained reasonably static as euro weakness was muted by equal dollar weakness, but recent Fed hawkishness has broken this trend. Draghi's hawkishness is tepid at best and the Fed hiking rates this Wednesday, as well as Yellen reiterating that another hike will be seen later this year will continue to help U.S. policy anticipations relative to Europe. As a result, rate differentials are likely to widen, and the euro to soften. The little appreciation in the euro earlier this week, was a result the following positives: German ZEW Survey's Current Situation went up to 88, beating expectations of 85; Euro Area ZEW Survey's Current Situation also went up to 37.7 from 35.1. Report Links: Look Ahead, Not Back - June 9, 2017 Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been negative: Domestic corporate goods prices grew by 2.1% YoY, against expectations of 2.2%. Machinery orders yearly growth came in at 2.7%, underperforming expectations by a wide margin. Industrial production yearly growth stayed flat at 5.7%. Ultimately, economic activity in Japan will largely depend on the currency. With the yen appreciating for most of 2017, it will be difficult for the Japanese economy to improve sustainably. At this point, we are closing our USD/JPY trade, as the correction in the U.S. dollar has run its course. Meanwhile, we remain bearish on NZD/JPY, as the rising dollar and the tightening in Chinese monetary conditions will deliver a formidable one-two punch to risk assets, and thus weigh on this cross. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Industrial Production contracted by 0.8% on a YoY basis, underperforming expectations. Manufacturing production yearly growth stayed flat, also underperforming. Meanwhile, both core and headline inflation came in above expectations, at 2.6% and 2.9% respectively. Yesterday the BoE came in more hawkish than expected, as Ian McCafferty and Michael Saunders joined Kristin Forbes voting and dissented in favor offor a hike. Meanwhile, in their monetary policy summary the BoE stated that inflation will stay above target for an "extended period". Following the report, EUR/GBP plunged by about 0.8%. We are now not positive on the pound, as core inflation is now outpacing wage growth, a development that should weigh on demand due to the decline in real income. This development could cause GBP/USD and EUR/GBP to reach 1.2 and 0.92 respectively to reach 1.2 by year end, but any move in EUR/GBP above 0.88 should be used to short this cross. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Data out of Australia was mixed this week: National Australia Bank's Business Confidence declined to 7 from 13; Westpac Consumer Confidence fell to -1.8% from -1.1%; However, the unemployment rate dropped to 5.5%, with full-time employment growing by 52,100, and part-time employment shrinking by 10,100. Most of the movement in the AUD was dominated by the employment data, seeing a broad-based increase versus other G10 currencies. While oil prices kept the CAD and NOK at bay, Chinese industrial production and retail sales increased at a 6.5% and 10.7% annual rate, respectively. Iron ore and copper, commodities important to Australia, however, saw little action, but coal saw a slight upside. The above dynamics resulted in the AUD outperforming other currencies versus the USD, and EUR/AUD weakened massively. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: Electronic card retail sales grew by 5.2% year-on-year, increasing from 4.2% the month before. However, the current account deficit came in at 3.1% of GDP against expectations of 2.7%. Meanwhile, yearly GDP growth came in at 2.5%, underperforming expectations. The kiwi rallied this week as expectations of a dovish fed weighed on the dollar, although most of these gains vanished following the FOMC press conference. We continue to be positive on the NZD relative to the AUD, given that the kiwi economy is in much better footing than the Australian one. However, upside for NZD/USD is limited, as this cross has reached highly overbought levels. Furthermore, the tightening in Chinese monetary conditions will become a headwind for a sustainable rally in the NZD. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The downside in oil continues as EIA crude oil stocks decreased by 1.661 million barrels, less than the expected 2.739 million. AUD/CAD and NZD/CAD rallied on the news, while CAD/NOK levelled off. In the commodity space, we remain most positive on the Canadian economy. While oil prices are a hurdle, business and consumer confidence, as well as PMIs remain robust, and the BoC expects the output gap to close in Q2 2018. Our Commodity and Energy Strategy team continues to believe that OPEC cuts and increased oil demand will eventually curtail inventories. We therefore expect our short AUD/CAD trade to prove profitable as markets begin to digest these developments. While the CAD looks good on its crosses, the resumption of the dollar bull market will limit the USD/CAD's downside. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Yesterday, in their monetary policy statement, the SNB reasserted its dovish bias, pledging to keep its extremely accommodative monetary policy in the years to come. Their inflation outlook changed little, upgrading the near term slightly while downgrading the longer term outlook. It is important to consider that when the SNB states that they expect that inflation will reach only 1.5% by the first quarter of 2020, they do so assuming the LIBOR rate stays at -0.75%. Meanwhile, they also signaled that they will stay active intervening in the currency market, with SNB president Thomas Jordan reiterating that the Franc “remains significantly overvalued”. We had previously stated that the implied floor put under EUR/CHF by the SNB could be removed by the end of this year. However, this scenario now seems unlikely, given the strong commitment by the SNB to remain accommodative. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Following a sell-off for most of the beginning of the week, USD/NOK has rebounded sharply, following the FOMC interest rate decision. Furthermore, the disappointing draw in oil inventories also contributed to the surge in USD/NOK. We continue to be bearish on the NOK, given that inflation is still receding in Norway. Recent data supports this, with core inflation and producer prices falling from anewApril. Furthermore, any surge in the U.S. dollar will provide a tailwind to USD/NOK given that this cross is highly sensitive to the dollar. Another cross where we are positioned towe use to take advantage of gain from Norway's economic weakness difficulties is CAD/NOK. The Canadian economy is on ain much stronger footing than the Norwegian one, and the rally in the dollar has historically been a tailwind for this cross. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Sweden's economy is developing as expected, with headline inflation reading at the expected level of 1.7%, with a 0.1% monthly increase. Although inflation decreased from the previous 1.9% reading, the Riksbank's Resource Utilization Indicator - historically, a reliable indicator for core inflation - continues to point up, indicating that core inflation will accelerate further. We are putting on a short EUR/SEK trade on the basis of long-term valuations being in the favor of the krona. With a closed output gap, Sweden's economy is more advanced in its business cycle than the euro area', which points to a further bifurcation in inflation rates between the two. These factors will also warrant a quicker removal of policy support from the Riksbank than the ECB. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights The U.K. and EU may get a technical divorce, but the underlying economic and financial relationship may not end up changing dramatically - which is good news for the pound in the long term. Our 6-12 month preference for currencies is euro first, pound second, dollar third. The euro area economy will perform at least in line with the U.S. economy through 2017, so the T-bond/German bund yield spread will continue to compress. Long euro area retailers, short U.S. retailers has catch-up potential. The focussed stock pair-trade would be long Hornbach (Germany), short Home Depot (U.S.) Feature Brexit Will Become A Fake Divorce Theresa May's stinging reversal at the ballot box last Thursday has left some people wondering: will Brexit actually happen? The answer is very likely yes, but this is no longer the right question to ask. Jeremy Corbyn's resurgent Labour Party, the Scottish National Party, the Liberal Democrats and pro-European Conservatives now form a parliamentary majority which proposes that a non-EU U.K. negotiates tariff-free access to the single market and customs union.1 In such an arrangement, the U.K. and EU would be technically divorced. But economically and financially, the relationship would not be so different to being married. In effect, Brexit would become a fake divorce. Unfortunately, there is a flipside. The U.K. would be unable to reclaim swathes of sovereignty over its borders and its law. This is because the tariff-free movement of goods, services and capital is, in theory, indivisible from the free movement of people. Furthermore, EU law would transcend national law in the regulation and policing of the single market's so-called 'four freedoms'. Admittedly, the four freedoms are an unachieved - and arguably unachievable - ideal. But they are an aspiration which EU policymakers do not want Brexit to threaten. Angela Merkel recently put it in very strong terms: "Cherry-picking (from the four freedoms) would have disastrous consequences for the other 27 member countries... Tariff-free access to the single market can only be possible on the conditions of respecting the four basic freedoms. Otherwise one has to talk about limits to access" Hence, Brexit reduces to a trade-off between the extent of tariff-free access to the European single market that the U.K. wants to keep, and the extent of national sovereignty it is willing to concede (Chart of the Week). Economically and financially, it is largely irrelevant whether the U.K. gets tariff-free access to the single market via a bespoke free-trade arrangement or via membership of an off-the-shelf structure like EFTA or the EEA.2 The much bigger question is: in order to keep most of its tariff-free access to the single market, will the U.K. now downgrade its plans to "take back full control" of its borders and law? Following last Thursday's stunning election result - and its impact on parliamentary composition (Chart I-2 and Chart I-3) - the answer seems to be yes. The U.K. and EU may get a technical divorce, but the underlying economic and financial relationship might not end up changing dramatically. Euro First, Pound Second, Dollar Third Avoiding a dramatic change in the U.K./EU economic and financial relationship reduces the risk of a major disruption to the U.K. economy and the need for further emergency easing from the Bank of England. Thereby, it is good news for the pound in the long term. That said, our 6-12 month preference for currencies is euro first, pound second, dollar third. The crucial point is that currencies and bond market relative performance depends front and centre on the evolution of relative interest rate expectations. In turn, the evolution of relative interest rate expectations must ultimately follow relative economic performance, as evidenced in hard data such as GDP growth, inflation and job creation. Over a period of a few months, central banks can look through hard data on the basis that the data is noisy or "transient". But over periods of 6 months and longer, the noisy and transient excuse wears thin. Central banks' strong commitment to data-dependency means that their actions and/or words must follow the hard data. No ifs, buts or maybes. Hence, relative interest rate expectations ultimately follow relative economic performance (Chart I-4 and Chart I-5). We are unashamedly republishing these two charts from last week because they prove the point so powerfully. Based on the latest PMIs which capture current economic sentiment, and on 6-month credit impulses which lead activity, euro area hard data will continue to perform at least in line with those in the U.S. (Chart I-6). In which case, relative interest rate expectations will continue to converge, the T-bond/German bund yield spread will continue to compress, and euro/dollar will ultimately drift higher. Chart I-4Relative Interest Rate Expectations Must Follow ##br##Relative Economic Performance Chart I-5Relative Bond Yields Must Follow Relative##br## Economic Performance Chart I-6Only A Modest Decline In The Euro Area ##br##6-Month Credit Impulse The Eurostoxx50 Is Not A Play On The Euro Area Economy. So What Is? Does it follow that the Eurostoxx50 equity index will outperform? Not necessarily. Unlike for currencies, interest rates and bond yields, the connection between relative economic performance and relative equity market performance is weak, or even non-existent. Note that the Eurostoxx50 has underperformed the S&P500 this year even though the euro area economy has outperformed. Chart I-7The Global Growth Pause ##br##Has Hurt Cyclicals The reason is that the over-arching driver of an equity market's relative performance is its skew to dominant international sectors and international stocks. The Eurostoxx50 has a higher exposure to the global growth cycle via its dominant weighting in Financials and Resources; conversely the S&P500 has a higher exposure to the less globally-sensitive Technology and Healthcare sectors. The defining sector skew has penalised the Eurostoxx50 versus the S&P500 because globally-sensitive cyclicals have strongly underperformed in a very clear global growth pause. Furthermore, the ever-reliable global 6-month credit impulse strongly suggests that the global growth pause will persist through the summer (Chart I-7). This begs the question: is there a way for equity investors to play the resilient performance of the euro area economy? The answer is yes. But before explaining how, a quick note of caution. An aggregate small cap equity index is not a good way to play a domestic economy. This is because the dominant characteristic of small cap stocks - in aggregate - is their very high beta. Hence, rather than a strong play on the domestic economy, investors are effectively buying highly leveraged exposure to market direction. Great when markets are rising, but painful when they are falling, irrespective of how the domestic economy is faring. Instead, a good equity play on relative economic performance is the relative performance of retailers (Chart I-8). Drilling down further, the relative performance of home improvement retailers is an even purer play (Chart I-9) - given that household spending on home improvement is closely tied to the domestic economic cycle. Chart I-8Retailers Are A Good Play On Relative ##br##Economic Performance Chart I-9Euro Area Home Improvement Retailers ##br##Can Now Ourperform Those In The U.S. On the expectation that the euro area economy will perform at least in line with the U.S. economy,3 the equity market play would be long euro area retailers, short U.S. retailers. In particular, long euro area home improvement retailers, short U.S. home improvement retailers has a lot of catch-up potential. And the focussed stock pair-trade would be long Hornbach (Germany), short Home Depot (U.S.) Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In simple terms, the single market defines the zone of tariff-free trade for European countries with each other. Whereas the customs union defines the zone of a single set of rules and tariffs for European countries to trade with the rest of the world. Membership of the customs union allows goods and services that enter from the rest of the world to then move around Europe unhindered. 2 The European Free Trade Association (EFTA) is a free trade area consisting of Iceland, Liechtenstein, Norway and Switzerland. Iceland, Liechtenstein, and Norway participate in the EU single market through their membership of the European Economic Area (EEA). Whereas Switzerland participates through a set of bilateral agreements with the EU. 3 Based on growth in real GDP per head. Fractal Trading Model* Long nickel / short tin hit its 6.5% profit target and is now closed. This week's trade is to switch to long nickel / short palladium with a 10% profit target. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart I-1Indicators To Watch - Bond Yields Chart I-2Indicators To Watch - Bond Yields Chart I-3Indicators To Watch - Bond Yields Chart I-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations