Japan
Highlights U.S. Treasuries: The surprisingly positive response from financial markets to last week's Fed rate hike should force the Fed to quickly shift back to a hawkish bias. Maintain an underweight exposure to U.S. Treasuries, and an overall below-benchmark portfolio duration stance. Bearish Fed Trade: As a new tactical trade, go short the January 2018 fed funds futures contract to benefit from the Fed ramping up the hawkish language again. Japan: Japanese inflation remains too low for the Bank of Japan to move away from its 0% target on JGB yields anytime soon, even with signs of better Japanese growth and rising pressure on global bond yields. Upgrade low-beta Japan to above-benchmark in global hedged bond portfolios, while downgrading core Europe (Germany, France, the Netherlands) to neutral. Feature Chart of the WeekAre Central Banks OK With This? The major central banks all had a chance to send a more hawkish message to the markets in the past couple of weeks, and every one took a pass. Even the Fed, who actually hiked rates, signaled that U.S. monetary policy would not be tightened more aggressively than previously planned, which financial markets took very bullishly. With the global economy finally enjoying a synchronized upturn after several years of sluggishness, policymakers are showing no interest in hitting the brakes too hard, too soon and risking a sudden downturn in growth The current backdrop of improving economic momentum, with central banks remaining accommodative, is sustaining the strong performance of growth-sensitive assets like equities and corporate debt over government bonds. This should continue over the next 6-12 months. Inflation rates, both realized and expected, continue to rise across the developed economies alongside faster economic growth, putting upward pressure on government bond yields (Chart of the Week). Central bank dovishness is looking increasingly non-credible as long as this dynamic persists, but policymakers will likely be slow to respond without a more rapid rise in inflation. Bond yields will continue to climb higher against this backdrop, first from continued increases in inflation expectations and, later, from a shift to less restrictive monetary settings. We continue to recommend a below-benchmark duration stance, while underweighting government bonds versus corporate debt, particularly in the U.S. This week, we are making a significant portfolio shift to get even more defensive within our government bond allocation, upgrading low-beta Japan to above-benchmark while downgrading core Europe (Germany, France & the Netherlands) to neutral. The Fed Declares Victory Over "Low-flation" The market response to last week's Fed tightening was consistent with the idea of a "dovish hike", with U.S. equity and bond markets rallying while the U.S. dollar sold off and overall U.S. financial conditions actually easing. There was heightened nervousness heading into the meeting that the Fed could signal a faster or steeper trajectory for interest rates. That turned out to be a false alarm, as not much was changed from the Fed's prior guidance to markets. The range for the funds rate was raised to 0.75-1.00%, as expected, but there was virtually no change to any of the median FOMC member projections for GDP growth, inflation or interest rates out to 2019. Another 50bps of increases are expected this year, with 75bps in both 2018 and 2019 (Chart 2). This would bring the funds rate to 3% in 2019, which is the median FOMC member's assessment of where the terminal rate lies. The pricing from the U.S. Overnight Index Swap (OIS) curve shows that market expectations for the funds rate are in line with the Fed's projections for this year, but lower for the next two years. Our proxy measure for the market's assessment of the terminal rate - the 5-year OIS rate, 5-years forward - sits at 2.25%, 75bps below the Fed's number. Our bias is closer to the market on this point, as we do not see a need for the funds rate, in real terms, to end this tightening cycle much above 0% against a backdrop of still very high U.S. debt levels and low U.S. productivity growth. A 0% real funds rate would be the result of the Fed successfully getting U.S. inflation expectations back to its 2% target level, with a nominal funds rate of 2%. That inflation goal has not yet been reached, however, as inflation expectations are still below levels consistent with the Fed's inflation target (Chart 3, bottom panel). Chart 2FOMC & Market Disagree Beyond This Year Chart 3Few Signs Of An Overheating U.S. Economy The FOMC has made it clear that they believe the U.S. economy is running very close to full employment. Yet the recent modest deceleration in the various measures of wage inflation (middle panel) suggests that there could still be some excess slack in the U.S. labor market - even with the recent Payrolls reports showing job growth of over 200k per month. If that pace is sustained for several months, however, the unemployment rate will likely fall further and wage pressures will intensify. In the near-term, the Fed will continue to focus on financial markets to get a sense of whether current policy settings are too restrictive or too accommodative. One recent development on this front is that the correlation between the U.S. dollar (USD) and risk assets has flipped, with a stronger USD now positively correlated to global equities and credit (Chart 4). This shift was already starting to happen before the election of Donald Trump and his pro-growth agenda last November, likely because the global economy was improving as evidenced by the accelerating trend in our global purchasing managers' index (PMI, bottom panel). We have written extensively about the Fed being stuck in a "policy loop" in the past couple of years, where a shift to a more hawkish bias would sharply drive up the USD and cause a risk-off move in global financial markets. This unwanted tightening of financial conditions would cause the Fed to back off from its hawkishness, causing the USD to soften and markets to rally. We have argued that the way to break out of this loop would likely be a rise in non-U.S. economic growth that would allow the Fed to continue slowly normalizing U.S. monetary policy without disrupting global markets. We seem to be in that period now. One implication of this is that the longer risk assets can withstand rising U.S. interest rates and a stronger USD, the more the fed funds rate and U.S. Treasury yields must rise in response to U.S. economic strength. For this reason, we continue to recommend a below-benchmark duration stance on U.S. Treasuries on a 6-12 month horizon. We also maintain our bias towards a bear-steepening of the Treasury curve through our butterfly trade, long the 5-year bullet versus a duration-matched 2-year/10-year barbell. The curve will remain positively correlated to inflation expectations until those reach the Fed's target level, after which any additional Fed rate hikes will likely flatten the yield curve in a more typical pattern during the latter stages of a tightening cycle. It is possible, though, that because markets shrugged off the latest rate increase, the Fed could return to sending hawkish signals in the near term. To play for this possibility, our colleagues at BCA U.S. Bond Strategy recommend that investors add a tactical trade: going short the January 2018 fed funds futures contract (Chart 5). We are today adding this trade to our list of Tactical Overlay Trades (see page 12). Chart 4The Strong USD Is Not A Problem Chart 5Go Short January 2018 Fed Funds Futures We calculate that this trade will return 11bps in a scenario where the Fed lifts rates twice more before the end of the year and 37bps in a scenario where the funds rate is raised a more aggressive-than-expected three times. However, we do not expect to hold this trade until the end of the year. Rather, we expect the Fed will nudge rate expectations higher in the next month or two in response to the latest easing of financial conditions, and that these gains will be realized over a much shorter horizon. We also add a caveat that, in the present environment, it is safer to implement any "hawkish Fed trades" in either fed funds futures or the OIS market. The Eurodollar market does not provide the same potential for gains because the LIBOR / OIS spread is currently elevated and could tighten to offset the profits from rising rate expectations. Bottom Line: The surprisingly positive response from financial markets to last week's Fed rate hike could force the Fed to quickly shift back to a hawkish bias. Maintain below-benchmark exposure to U.S. Treasuries. As a new tactical trade, go short the January 2018 fed funds futures contract to benefit from the Fed ramping up the hawkish language again. Japan: A Weaker Yen Is Still The Only Way Out The Bank of Japan (BoJ) stayed on hold last week, as expected. There had been some increased speculation of late that the BoJ could start to signal a potential increase in its 0% target for the 10-year Japanese Government Bond (JGB) yield, given the rising trend in global yields and signs of better growth in Japan. At the press conference following the BoJ meeting, however, Governor Kuroda shot down that notion, saying that the current accommodative policy stance must be maintained given how far Japanese inflation is below the central bank's 2% target. It remains far too soon for the central bank to signal any shift to a less accommodative stance, as both the pace of economic growth and inflation are not only modest but lagging the current global upturn. In Chart 6, we show some Japanese growth variables relative to an aggregate of the same data for the major developed economies.1 What is clear from the chart is that Japan is benefitting from faster global growth on the industrial side, with the manufacturing PMI above 50. However, the domestic demand story is not as positive, with consumer confidence and real retail sales growth languishing. The lack of real income growth remains the biggest drag on Japanese consumers, as we show in another set of international comparisons in Chart 7. Japan's unemployment rate, currently at 3%, is below the OECD's estimate of the full employment level (consistent with stable domestic inflation pressures). This is in contrast to the other major economies, which are either at, or close to, full employment. Yet Japanese wages continue to struggle, both in nominal terms (a year-over-over growth rate of 1%) and real terms (a year-over-year growth rate of 0.4%). The current annual spring round of Japanese wage negotiations is showing that downward pressure remains powerful, with many manufacturing companies offering pay raises only half as large as those of last year.2 Chart 6Japan Is Lagging The Global Upturn Chart 7Still No Wage Growth In Japan Japan is still struggling to generate positive rates of inflation, even as price growth is accelerating in the other major economies (Chart 8). This is keeping Japanese inflation expectations, which the BoJ believes are mostly a function of the recent performance of actual inflation, subdued. As always, the only reliable source of Japanese inflation seems to be yen weakness. We continue to see this as the only way out of the low-inflation trap for Japan - keeping Japanese interest rates depressed versus the rest of the world, thus weakening the yen through increasingly unattractive interest rate differentials. The BoJ's 0% yield curve targeting framework has been successful in keeping rate differentials wide enough to soften up the yen, especially against the USD (Chart 9). Given our expectations of additional Fed rate hikes, and higher U.S. Treasury yields, over the rest of the year, the yen will likely depreciate further as long as the BoJ sticks with its current interest rate targets. A similar argument holds for the yen versus the Euro, given the increasing likelihood that the European Central Bank (ECB) will be forced to signal a less accommodative monetary policy stance later this year. Against this backdrop, JGBs are likely to outperform the major global government bond markets over the rest of 2017. We upgraded our recommended stance on JGBs from underweight to neutral last October after the BoJ introduced its yield curve targeting framework. In Chart 10, we show the relative performance of JGBs versus some other bond benchmarks, on a duration-matched and common-currency (hedged into USD) basis. We broke up the returns into two periods, from our October 11, 2016 Japan upgrade to January 31 of this year when we upgraded our U.S. corporate bond exposure and cut our overall portfolio duration stance to below-benchmark. The chart shows that JGBs were a good defensive hedge during the latter part of 2016 when global yields were rising, led by U.S. Treasuries. The more recent period, however, shows a much more negligible relative performance, both against other government bonds and corporate debt, during a period where global bond yields have generally traded sideways. Chart 8Japan Inflation Still A No-Show Chart 9A Weaker Yen Is Still Necessary Chart 10Relative Performance Of JGBs Given our views that U.S. Treasury yields will continue to move higher in the next 6-9 months, and that the performance of core European government bonds will suffer over the same period as the ECB signals a slower pace of asset purchases for next year, a return to the late 2016 relative performance of JGBs is very likely. Thus, we are upgrading Japan to an above-benchmark stance in our model portfolio this week, while downgrading core Europe (Germany, France, the Netherlands) to neutral. This is purely a move to get even more defensive in our overall country exposures, by allocating into JGBs which are low-beta to both U.S. Treasuries (where we are already below-benchmark) and core European government debt. Bottom Line: Japanese inflation remains too low for the Bank of Japan to move away from its 0% target on JGB yields anytime soon, even with signs of better Japanese growth and rising pressure on global bond yields. Upgrade Japan to above-benchmark in global hedged bond portfolios, while downgrading core Europe (Germany, France, the Netherlands) to neutral. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The U.S., Euro Area, U.K., Canada & Australia 2 https://www.ft.com/content/0895c4ee-eb3b-11e5-888e-2eadd5fbc4a4 The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights In this week's report, we update the "Three Controversial Calls"1 we made at BCA's New York Investment Conference held on September 26-27th, 2016. Call #1: "Trump Wins, And The Dollar Rallies." We still see 5% more upside for the greenback. Call #2: "Japan Overcomes Deflation." Inflation expectations have moved higher over the past five months, while the yen has weakened. This trend will persist. Call #3: "Global Banks Finally Outperform." Bank shares have beaten their global benchmark by 14% since we made this prediction. European financials have finally turned the corner. Feature Call #1: "Trump Wins, And The Dollar Rallies" Chart 1From Unrealistic To Even More Unrealistic We never bought into the notion that a Trump victory would cause investors to flee the dollar. On the contrary, we argued that most of Trump's policies were bond bearish/dollar bullish. In particular, we reasoned that Trump's attempts to browbeat companies into moving production back home would help reduce the U.S. trade deficit, boosting aggregate demand in the process. Efforts to curb illegal immigration would also push up the wages of low-skilled workers. Meanwhile, fiscal stimulus would fire up the labor market at a time when it was already approaching full employment. Fiscal Deficit On Upward Path With nearly four months having passed since the election, what have we learned? First, and foremost, a big increase in the budget deficit still looks likely. As Trump's address to the joint session of Congress on Tuesday night underscored, the president has plenty of specific areas in mind where he would like to increase spending (more money for defense, infrastructure, etc.) and a long list of taxes he would like to cut (corporate and personal income taxes, estate taxes, a new childcare tax credit,2 etc.). We do not take seriously Trump's pledge to pay for increased military spending by cutting annual nondefense discretionary spending by $54 billion relative to the existing CBO baseline. Chart 1 shows that under current budgetary rules, nondefense discretionary spending is set to decline from 3.3% of GDP in 2016 - already close to a historic low - to only 2.7% of GDP in 2026. Cutting that portion of the budget above and beyond what has already been legislated is unrealistic. There simply aren't enough programs like the National Endowment for the Arts that Republicans can take to the woodshed without facing a severe political backlash (Chart 2). As long as big ticket entitlement programs such as Social Security and Medicare remain unscathed - which Treasury Secretary Steven Mnuchin confirmed would be the case earlier this week - overall government spending will rise, not fall. Chart 2Nondefense Discretionary Spending: Where The Money Goes Trump And Trade The one category where Trump would be more than happy to see taxes go up is on imports. The constraint here is political. A unilateral move to legislate large-scale import duties would be in gross violation of WTO rules and could spark a global trade war. Many of Trump's Republican colleagues, as well as a fair number of Democrats, also favor free trade and would resist such an effort. One solution that Trump vaguely alluded to in his speech is to raise duties on imports within the context of a broader tax reform bill. A border adjustment tax, for example, would bring in $1.2 trillion in revenues over ten years.3 As we argued in a Special Report earlier this year, the introduction of a BAT would be highly dollar bullish.4 Pulling Back The Welcome Mat? On immigration, Trump has sent mixed messages. On the one hand, he continues to insist that he will build "the wall" and has maintained his hardline stance on refugee policy. On the other hand, he has backed off his campaign promise to reverse Obama's executive order protecting the so-called "dreamers." This order allows immigrants who came to the U.S. illegally as children to remain in the country indefinitely, provided they do not commit a serious criminal offence. During his speech, Trump signaled a willingness to shift the U.S. immigration system towards one based on merit, similar to what countries such as Canada and Australia already have. This is an excellent idea, but it raises the question of what will happen to the 11 million illegal aliens currently residing in the country, the vast majority of whom are poorly educated. It is important to remember that U.S. immigration laws are already very strict. Trump has given the U.S. Immigration and Customs Enforcement agency (ICE) greater leeway in enforcing these laws, while also pledging to hire 5,000 more border agents and 10,000 additional ICE officers. As such, a "status quo immigration policy" under Trump could prove to be much more restrictive than the one under Obama even if no new legislation is passed. A key implication is that labor shortages in areas such as construction and hospitality services may intensify. Solid U.S. Growth Outlook Favors A Stronger Dollar Meanwhile, the U.S. growth picture remains reasonably bright (Chart 3). This may not be obvious from current Q1 tracking estimates, which are pointing to real GDP growth of below 2%. However, the weak Q1 numbers are mainly due to an unexpectedly large jump in imports and a sharp decline in inventory accumulation. According to the Atlanta Fed's model, taken together these two factors have shaved a full percentage point off growth. Real private final demand is still rising at nearly 3% (Chart 4). If U.S. growth stays solid as we expect, the Fed will raise rates three or four times this year, starting in March. This is slightly more than the market is currently pricing in, which should be enough to ensure that the trade-weighted dollar strengthens by another 5% or so over the remainder of the year (Chart 5). We see the greatest upside for the dollar versus EM currencies, and as we discuss next, against the yen. Chart 3U.S. Economic Data Are Upbeat Chart 4Trade And Inventories Detract From ##br##A Bright Q1 Growth Picture Chart 5Real Rate Differentials Are ##br##Driving UpThe Dollar Call #2: "Japan Overcomes Deflation" Many of the forces that have exacerbated deflation in Japan, such as corporate deleveraging and falling property prices, have run their course (Chart 6). The population continues to age, but the impact that this is having on inflation may have reached an inflection point. For most of the past 25 years, slow population growth depressed aggregate demand by reducing the incentive for companies to build out new capacity. This generated a surfeit of savings relative to investment, helping to fuel deflation. Now, however, as an ever-rising share of the population enters retirement, the overabundance of savings is disappearing. The household saving rate currently stands at 2.8% - down from 14% in the early 1990s - while the ratio of job openings-to-applicants has soared to a 25-year high (Chart 7). Chart 6Japan: Easing Deflationary Forces Chart 7Japan: Low Household Saving Rate ##br##And A Tightening Labor Market Chart 8Investors Still Not Entirely ##br##Convinced Japan Is Eradicating Deflation Government policy is finally doing its part to slay the deflationary dragon. The Abe government shot itself in the foot by tightening fiscal policy by 3% of GDP between 2013 and 2015. It won't make the same mistake again. The Bank of Japan's efforts to pin the 10-year yield to zero also seem to be bearing fruit. As bond yields in other economies have trended higher, this has made Japanese bonds less attractive. That, in turn, has pushed down the yen, ushering in a virtuous circle where a falling yen props up economic activity, leading to higher inflation expectations, lower real yields, and an even weaker yen. Stay Short The Yen Consistent with this narrative, market-based inflation expectations have risen over the past five months. But with inflation swaps still pricing in inflation of only 0.6% over the next 20 years, there is plenty of scope for real rates to fall further (Chart 8). This implies that investors should maintain a structurally short position in the yen. A weaker yen will help boost Japanese stocks, at least in local-currency terms. As a relative play, investors should consider overweighting Japanese exporters versus domestically-exposed sectors. Multinational manufacturers stand to gain the most, as they will benefit from increased overseas sales, while the highly automated, capital-intensive nature of their operations will limit the burden of rising real wages. Call #3: "Global Banks Finally Outperform" Global bank shares have risen by 25% since we made this call, outperforming the MSCI All Country World Index by 14% (Chart 9). The thesis that we outlined five months ago still remains intact (Charts 10 and 11): Chart 9Global Bank Shares Have Bounced Chart 10Factors Supporting Bank Stocks Chart 11Global Banks Are Still Fairly Cheap Improving business and consumer confidence should continue to support credit demand. Stronger economic growth will reduce nonperforming loans. Capital ratios have improved significantly, reducing the risk of further equity dilution. Yield curves have steepened since last summer, which should flatter net interest margins. Despite the run-up in share prices over the past five months, valuations remain attractive. Looking across regions, European banks stand out as being particularly attractive over a cyclical horizon of about 12 months. BCA's European Corporate Health Monitor continues to improve, foreshadowing further progress in mending loan books (Chart 12). The ECB's lending survey indicates that a majority of banks are seeing stronger loan demand (Chart 13). This suggests that credit growth is not about to stall anytime soon. Meanwhile, euro area banks are trading at a miserly 0.8-times book value, which gives valuations plenty of upside. Chart 12Euro Area: Improving Corporate Health Chart 13Euro Area: Banks See Rising Loan Demand Political Risks Chart 14This Will Not Get Le Pen Into The Elysee Palace The risk is that European political developments sabotage this thesis. Our view here is "near-term sanguine, long-term cautious." We continue to think that populism is in a long-term secular bull market. However, unlike in the case of Brexit or Trump, populist leaders in continental Europe will have to wait until the next economic downturn (probably in two or three years) before they seize power. To that extent, the prevailing - though admittedly rather myopic - consensus view is correct: Marine Le Pen will not become president this year. Keep in mind that the National Front underperformed during regional elections in December 2015, just weeks after the terrorist attacks in Paris. Despite a recent uptick in the polls, support for Le Pen is actually lower now than it was back then (Chart 14). As long as the French economy continues to show signs of tentative improvement, the establishment parties will succeed in keeping Le Pen out of power. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. 2 Despite the populist sounding nature of this proposal, the Tax Policy Center estimates that 70% of the childcare credits will go to households earning $100,000 and up. See Lily L. Batchelder, Elaine Maag, Chye-Ching Huang, and Emily Horton, "Who Benefits from President Trump's Child Care Proposals?" Tax Policy Center (February 27, 2017) for details. 3 James R. Nunns, Leonard E. Burman, Jeffrey Rohaly, Joseph Rosenberg, and Benjamin R. Page, "An Analysis of the House GOP Tax Plan," Tax Policy Center (September 16, 2016). 4 Please see Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
How Long Is The Sweet Spot? Table 1Recommended Allocation The sweet spot on a baseball bat, scientists find,1 is the small area about two inches (5 cm) long, some six inches from the tip. The sweet spot for global risk assets may not be much bigger. The 22% rise in global equities since February last year has been driven by a "goldilocks" combination of recovering economic activity, quiescent inflation, and still-accommodative monetary policy. But, after such a strong rally, markets must walk a fine line - no slowdown in growth and no surprising tightening of monetary conditions - for prices to rise further. Our analysis suggests that they can, but the risk of a correction is rising. A lot of the better news of the past year has already been priced in. The price-to-sales ratio for U.S. stocks is close to an all-time high, and even the plain-vanilla 12-month forward PE ratio has reached 17.5x, the highest since 2002 (Chart 1). Volatility has fallen to a low level, with the VIX not rising above 12 over the past month, and the S&P500 index going 98 days without a one-day decline of 1% or more, the longest such period since 1995 (Chart 2). To a degree, this is justified by the recent strong pick-up in global growth. Sentiment indicators have accelerated since the election of President Trump, and even hard data is now showing the first signs of recovery (Chart 3) with, for example, U.S. retail sales rising 5.6% year-on-year in January, and core durable goods orders starting to follow the rise in companies' capex intentions (Chart 4). Similar positive economic surprises are visible in Europe, Japan, China and elsewhere. The problem is that further upside surprises are likely to be limited. Regional Fed NowCast surveys for Q1 real GDP growth are already at 2.5-3.1%. Consensus forecasts for S&P500 earnings growth in 2017 look about right at 10.5% but, with a stronger dollar and rising wages, are unlikely to be beaten. Chart 1Historically High Valuations Chart 2Time For A Pull-Back? Chart 3Hard Data Starting To Recover Too Chart 4Orders To Follow Capex Intentions Headline inflation has picked up (to 2.5% in the U.S. and 1.9% in the Eurozone), mainly because of higher oil prices, but core inflation remains sufficiently under control that central banks don't need to slam on the brakes. The rise in unit labor costs in the U.S. suggests that core PCE inflation will gradually move up to 2% during the year (Chart 5). The latest FOMC minutes revealed that members want a further rate hike "fairly soon", and BCA expects the Fed to raise three times this year (to which the futures market ascribes only a 36% probability). But Fed policy remains very accommodative (Chart 6), the European Central Bank is unlikely to end its asset purchases soon on account of political and banking system concerns, and the Bank of Japan remains committed to its 0% yield target for 10-year government bonds until inflation is well above 2%. Absent a powerful fiscal stimulus in the U.S. or a move by the "hard money" advocates in the Trump administration to change the Fed's modus operandi, we think its unlikely that a tightening of monetary policy will drag down asset prices. Chart 5Labor Costs Putting Pressure On Prices Chart 6Fed Policy Still Accomodative Risks certainly abound. The Trump administration could start a trade war with China. Its proposals for corporate and personal tax cuts could disappoint both in terms of their details and the timing of Congress's passing them. European politics remain a concern, with the probability of Marine Le Pen becoming French President increasing recently (though it remains small). But risk markets tend to rise on a wall of worry. Investor sentiment is not particularly bullish at the moment, with the bull/bear ratio among individual investors barely above 1 (Chart 7) and flows into equity funds in recent months not reversing the outflows of last year (Chart 8). Chart 7Retail Investors Not So Bullish Chart 8Equity Flows Are Still Tepid After a year of a strong cyclical risk-on rally, progress from now on will get tougher. A short-term change of direction is quite possible (and has already happened in some assets, with the yen moving back to 112 and the 10-year Treasury yield to 2.3%). But we expect economic growth to remain robust this year - with U.S. real GDP growth likely to come in close to 3% on the back of surprises in capex - which will push the 10-year Treasury yield above 3% by year-end. In this environment, we continue to favor equities over bonds, and maintain our pro-risk tilt in equity sectors, credit and alternative assets. Equities: U.S. equities have outperformed Eurozone ones by 5% year-to-date, mainly because of worries about Europe's political risk and the fragility of its banking sector. Though we think the political risks are overstated (except perhaps in Italy), we continue to prefer the U.S. in common currency terms because of our expectations of further dollar appreciation and because the lower volatility of the U.S. helps reduce the beta of our recommended portfolio. Emerging markets have outperformed global equities by 3% YTD, mainly on the back of stronger commodities prices. But we remain underweight EM because of the risks from a stronger dollar and rising global rates, concerns about protectionism and debt refinancing, and because of the likelihood that China's rebound will run out of steam over the next 12 months (Chart 9). Fixed Income: Rates have pulled back recently: long-term institutional investors have begun to find attraction in the long end of the U.S. Treasury yield curve at 2-3%, though speculative investors remain short (Chart 10). With the Fed likely to raise rates three times this year, inflation expectations to pick up further, and nominal GDP growth in the U.S. to reach 4.5-5%, we expect the U.S. 10-year yield to rise above 3%. We therefore remain underweight duration and prefer inflation-linked over nominal bonds. In the improving economic environment, we continue to like credit, but find valuations more attractive for investment-grade bonds than for high-yield. Currencies: Dollar appreciation has been on hold since January but we think the long-term trend remains in place because of the probable direction of relative interest rates. Neither Japan nor the Eurozone is likely to move towards monetary tightening over the next 12 months. Even if the Trump administration were to want a weaker dollar, a few tweets would not be enough to offset monetary fundamentals. And, while it is true that sentiment towards the dollar is already bullish, this has historically not precluded further appreciation, for example in the late 1990s (Chart 11). Chart 9EM Equities Correlated With China PMIs Chart 10Divergent Views On U.S. Bonds Chart 11Optimism Need Not Stop USD's Rise Commodities: The oil price remains close to its equilibrium level at around $55 a barrel, with the OPEC agreement largely holding but being offset by a production increase from the U.S. shale drillers, whose rig count has doubled since last May. We are neutral on industrial commodities: Chinese demand resulting from last year's reflationary policy is likely to be offset by the stronger dollar. Gold remains a useful portfolio hedge in a world of elevated geopolitical worries and inflation tail-risk, but is also negatively correlated with the U.S. dollar. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see, for example, "The Sweetspot of a Hollow Baseball or Softball Bat", by Daniel A. Russell, Pennsylvania State University, available at www.acs.psu.edu/drussell/bats/sweetspot.html Recommended Asset Allocation Model Portfolio (USD Terms)
Highlights Despite our tactical bullish stance, the cyclical outlook remains firmly negative for the yen, with a 12-month target for USD/JPY above 120. The BoJ is currently committed to an inflation overshoot, with this solid commitment, a strong economy will be able to lift inflation expectations, depress real interest rates, and hurt the yen. The key improvements pointing to higher inflation expectations are: Already positive inflation expectation dynamics, the closing of the output gap, the removal of the fiscal drag, the tightness in the labor market, and the end of the private-sector deleveraging. The tactical environment suggests that nimble traders with short investment horizons should stay short USD/JPY for now. Longer-term investors may want to add to short bets on the yen on further weaknesses. Feature We have espoused a cyclically bearish stance on the yen since September when the BoJ began targeting the price of money instead of the quantity of money, aiming for stable JGB yields around 0%.1 More recently, we have been buyers of the yen on a tactical basis. Here, we are reviewing whether this tactical call should morph into a cyclical bullish stance on the yen or whether the primary trend for the yen still points lower. Ultimately, we expect USD/JPY to punch through 120 on a 12 month basis. The Liquidity Trap Our framework to analyze the yen rests on one key assumption: Japan remains mired in liquidity trap dynamics. As we have pointed out before, the key symptom of this disease is evident in the Land of the Rising Sun: Loan demand has become irresponsive to changes in private sector borrowing costs (Chart I-1). In this environment, we can experience strange dynamics. As we argued in details a few months ago, when both in a liquidity trap and at the lower bound of interest rates, the demand for money is infinite, and interest rates are independent of the level of output in the economy.2 In other words, a decrease in exports, government spending, or investment, hurts demand without affecting nominal interest rates (Chart I-2, middle panel). However, in the long run, decreases in aggregate demand exert downward pressure on prices, and thus, lower inflation expectations today (Chart I-2, bottom panel). The opposite is true for a positive demand shock. Chart I-1The Symptom Of Disease Chart I-2The Thing That Should Not Be In this topsy-turvy world, a negative shock to growth, by decreasing inflation expectations, pushes up real interest rates, and thus the exchange rate. Meanwhile, a positive shock increases inflation expectations, pulling down real rates and the exchange rate as well. This is fundamental as USD/JPY continues to trade closely in line with real rate differentials between the U.S. and Japan (Chart I-3). Chart I-3USD/JPY: No Money Illusion Here This is even truer now that the Bank of Japan is both trying to keep 10-year JGB yields near 0%, and has promised to keep a very accommodative monetary policy in place until inflation has overshoot the price stability target of an average inflation rate of 2% over the whole business cycle. In other words, the BoJ's inflation target is near symmetrical and monetary policy will only harden once previous inflation undershoots below 2% have been compensated by an extended period of inflation overshoot. Also, we expect the BoJ to stay committed to this policy. Not only does Abenomics remain popular in Japan, but we expect Kuroda to be re-appointed to lead the BoJ. Moreover, the last two members of the policy committee not appointed by Abe will see their terms end in 2017. After this year, the BoJ committee will fully represents Abe's wishes. Under this framework, the key to expect the yen to fall is therefore not valuation, nor the current account outlook - two factors pointing to a higher yen - but whether or not the economy and inflation expectations can improve durably on a cyclical basis. In the next section, we explore the key positive economic developments underpinning our negative JPY stance. Bottom Line: As the BoJ is strongly committed to maintaining an extremely dovish stance until inflation overshoots by a wide-enough margin to compensate for previous undershoots, key economic improvements in Japan should lead to higher inflation expectations, falling Japanese real interest rates, and a much weaker yen. The Five Samurais We see five reasons to remain bearish the JPY: Inflation expectation dynamics, the closing output gap, the disappearance of the fiscal drag, the labor market tightness, and the end of the Japanese private sector's deleveraging. Factor 1: Inflation Expectations Are Already Unhinged Even before the BoJ aggressively targeted 0% JGB yields, Japanese inflation expectations were on an improving path. During the 2012 summer, markets began correctly anticipating the December electoral victory of Shinzo Abe, apprehending that his BoJ was about to massively ramp up quantitative easing. Japanese 5-year/5-year forward CPI swaps soon decoupled from the rest of the world and the U.S. (Chart I-4). Chart I-4The BoJ Policy Has Already Borne Fruit Chart I-5The Mechanics Of Price-Level Targeting So strong has the perceived commitment of the BoJ to higher inflation been that Japanese inflation expectations never tanked the way U.S. ones did after 2014. These dynamics contributed to keep Japanese real rates depressed relative to U.S. ones. Moreover a virtuous circle was created where lower real rates supercharged the USD/JPY's rally, lifting it by more than 60% from 77 in September 2012 to 125 in June 2015, and this further supported Japanese inflation expectations. In the summer of 2015, as EM and commodity prices began imploding on the growing expectation of a Chinese economic hard landing, Japanese inflation expectations did relapse, strengthening the yen rally. But again, unlike in the U.S., Japanese CPI swaps never fell to new lows, pointing to some improving dynamics for the domestic component of Japanese inflation expectation formations. Going forward, we expect Japanese inflation expectations to move further up. The price level targeting mechanism put in place by the BoJ last fall reinforces inflationary dynamics (Chart I-5). Any anticipated tightening in monetary policy in response to economic improvements has been pushed further away in the future, in a world where inflation may be higher locally and globally. Additionally, if global and local inflation rises, because nominal interest rates are pegged at low levels, the increase in inflation expectations puts additional downward pressure on real rates, further stimulating the domestic economy, further weakening the yen, and further boosting inflation expectations. The circuits for positive feedback loops are being laid in place. Factor 2: The Output Gap Based on the OECD's estimates, the Japanese output gap has now moved into positive territory for the first time since 2007-2008, the last episode where Japan experienced anything close to inflation (Chart I-6). Prior to then, the last time the Japanese output gap was as positive as it will be in 2017 was in 1993, among the last years when Japanese core inflation was still above 1%. While this reflects the global phenomenon of low productivity growth, the low level of supply expansion in Japan has been augmented by the 2% decline in the labor force since 1998. This means that the capacity constraints in the Japanese economy are easy to reach even if average real GDP growth has only been 0.8% since 2010. The cyclical improvements in the business cycle only point toward an increasingly positive output gap and rising inflationary pressures. To begin with, business confidence and PMIs are all very robust (Chart I-7). Chart I-6No More Slack In Japan Chart I-7Japanese Businessmen Feel Good The strength of the U.S. ISM index suggests that Japanese exports have more upside (Chart I-8) as well. Not only does a stronger Japanese trade balance contributes to a larger positive output gap, but also, strong export growth has often been the key precursor to higher capex in Japan (Chart I-8, bottom panel). Finally, the credit dynamics remain supportive. Bank loan growth has not slowed much, despite the large tightening in Japanese monetary conditions in 2016. With conditions now easing in the country, we expect the credit impulse, which has bottomed around the zero line, to re-accelerate going forward, supporting excess demand above potential GDP growth (Chart I-9). Together, all these factors suggest that the improvement in the Japanese shipments-to-inventory ratio witnessed since March 2016 will continue to lift Japanese inflation expectations higher (Chart I-10). Chart I-8Strong Japanese Exports ##br##Will Filter To Capex Chart I-9The Japanese Credit ##br##Impulse Will Rebound Chart I-10Upward Momentum In ##br##Japanese Inflation Expectations Factor 3: Fiscal Policy Another key factor that has hampered the Japanese economy since 2013 has been the large fiscal belt-tightening experience by the country. In the wake of the 2011 Tohoku earthquake, the government primary deficit blew up to 7.7% of potential GDP in 2011. It will hit 3.5% for 2017, but the IMF does not forecast much more narrowing of the government budget gap (Chart I-11). This signifies that the great brake that slowed the Japanese economy and prevented a rise in inflation is being lifted. In fact, we expect the Japanese government deficit to increase again. First, Abe's upper house electoral victory last summer was built on a campaign of larger government spending. Second, with an approval rating of 56% four years into his premiership, Abe remains a highly popular prime minister for a country plagued by 15 changes of government since 1990. This is a vote of confidence by the Japanese public toward his "Abenomics" program. Finally, military spending is likely to increase. As recently as 2005, Japan's and China's defense budgets were the same; today, China outspends Japan by four times (Chart I-12). In an increasingly unstable Asia-Pacific region, where China, Russia, and North Korea are all conducting more independent foreign policy agendas, Japan will be forced to fend for itself with more military spending, underscoring the relatively hawkish agenda of the Abe administration on this front. This will require more spending by Tokyo in this arena. Chart I-11Vanishing Japanese##br## Fiscal Drag Chart I-12The Geopolitical Imperative To Increase ##br##Japanese Government Spending Factor 4: The tightening Labor Market The Japanese labor market has now become very tight and key supply-side adjustments are behind us. The job-openings-to-applicants ratio stands at July 1991 levels, the last time when Japan was able to generate any durable wage growth. Additionally, the level of participation of women in the labor force is very elevated. The employment-to-population ratio for prime-age females stands at 74%, well above the 71.4% level of the U.S. today, and just as high as the U.S. in 2000, when that ratio was at its highest (Chart I-13). Additionally, despite a shrinking labor force and population, the total number of employed individuals stands at 65 million, the highest level since 1999 (Chart I-14). Hiring growth is also experiencing its most vigorous upswing in 20 years. Unsurprisingly, nominal wages have been growing since 2013, the longest upswing since 2004 to 2006, and wages are now at their highest level since 2009 (Chart I-14, middle panel). Chart I-13The Japanese Labor Market Is Very Tight (I) Chart I-14The Japanese Labor Market Is Very Tight (II) With the economy remaining robust, the output gap being closed, and the fiscal drag disappearing, this tightening in the labor-market should lead to additional wage gains in Japan. As the labor market slack dissipates further, we expect Japanese employment growth to slow and wages to accelerate their upward path. It is true that the Japanese labor market duality still constitutes a structural damper on Japanese wages, but for now, the very important positive cyclical factors noted above should overpower this long-term negative. Only with additional reform of the labor market will this duality dissipate structurally. Factor 5: End Of The Private Sector Deleveraging The last factor that has turned the corner in Japan is the evolution of the private sector's deleveraging. Non-financial private debt fell from 220% of GDP in 1994 to 160% of GDP today, after having stabilized since 2009 (Chart I-15). At these levels, the Japanese non-financial private debt to GDP is in line with the worldwide average of 157%, much below China's 210%, as well as below the levels recorded in Canada, Australia, New Zealand or Sweden. This development is key for many reasons. First, since 2011, Japanese households have in fact re-levered, with their debt load rising by 6.5% since their trough. This means that Japanese households are generating demand in excess of their earnings, and are therefore a source of inflation in the country. Second, the end of deleveraging has coincided with an end to the decline in Japanese land prices that has put downward pressure on all prices since 1991 (Chart I-16). Finally, the rising debt load of the Japanese government is no longer just a compensating mechanism for the deficiency in demand created by the private sector's sector deleveraging. In fact, like for households, government dissaving is now purely adding to the aggregate demand of Japan, and at the margin, is inflationary. Unsurprisingly, since 2012, periods of accelerating growth in the Japanese broad money supply have now been associated with periods of weakness in the yen (Chart I-17). This highlights the fact that money creation is now generating some increase in inflation expectations as the private sector is not furiously building its savings anymore and as the Kuroda BoJ is not leaning against inflationary developments. Chart I-15Private Sector Deleveraging Is Over Chart I-16Land Prices Are Not A Source Of Deflation Anymore Chart I-17Money Matters Putting It All Together In our view, in an environment where Japan is beginning to generate domestic inflationary pressures of its own, where the output gap is now positive, where the government is not putting a brake on growth anymore, where the labor market is at its tightest in decades, and where private sector deleveraging is not an handicap anymore, any improvement in global growth is likely to result in further increases in Japanese inflation expectations. Our sister service, Global Investment Strategy is long Japanese CPI swaps, a trade we agree with. In the context of FX, with the BoJ firmly on an easing path, rising Japanese inflation expectations will only depress Japanese real rates, exactly as the Fed becomes more aggressive. As a result, on a 12-18 months basis, the downside for the yen is very large. What About Trump? Chart I-8Japan FDI Profile President Trump wants to see a lower dollar to achieve his goal of creating manufacturing jobs in the U.S. Much ink has been spilled on the potential emergence of a Plaza 2.0 accord. We disagree. The U.S. has very little leverage to boost the value of the yen. The Bank of Japan's policy is designed to generate domestic inflationary pressures, the yen is only a casualty of this policy. In fact, with inflation expectations having been so low for so long, no country in the world can better justify having a very loose monetary policy setting than Japan. Also, the 97% surge in the yen that followed the Plaza accord of 1985 caused Japanese interest rates to stay too low relative to the state of the economy. As a result, a massive debt bubble ensued that lifted the economy further, but then prompted the bust which Japan still pays for. Today, the Japanese are unlikely to want to repeat the same mistake. While we do think that deleveraging has ended in Japan, a country with a falling population is unlikely to begin a new private-sector debt supercycle either. Finally, China continues to be an economy that saves too much. This means that China can either allocate these savings domestically through the debt market or export them internationally through its current account surplus. We expect Chinese authorities, who are already very worried by the high debt load in China to choose the second option for the next two years. As a result, BCA foresees further declines in the RMB over the next 12 to 18 months. In this environment, the Japanese would find it very difficult to remain competitive in the Chinese market if their currency rises as the RMB weakens.3 That being said, Trump will want some concessions out of the Japanese. Already, the February 10 meeting between the U.S. president and PM Abe is giving us a glimpse of things to come. Japanese non-tariff barriers on U.S. products are likely to decrease, potentially in the agricultural and automotive field especially. Additionally, Japan still runs a large current account surplus and therefore, a large capital account deficit. We expect Japanese FDIs in the U.S. to only grow going forward. The main beneficiary is likely to be the automotive sector as it would be the key mechanism for Japanese firms to avoid paying large tariffs / punitive taxes and still access the vital U.S. market (Chart I-18). Moreover, this fits well within Trump's agenda as it creates manufacturing jobs in the U.S. Call it a win-win situation if you will. Not Time To Close Short USD/JPY Yet Despite this very negative cyclical view on the yen, we remain committed to our tactical short USD/JPY position: For one, positioning on the yen remains too extreme (Chart I-19). Second, as argued by our European Investment Strategy service, we may be on the cusp of a mini down cycle in the credit impulse, suggesting a temporary deceleration in the G10.4 The recent collapse in quarterly credit growth in the U.S. points exactly in this direction (Chart I-20). Because U.S. 10-year bond yields are so tightly linked to global economic surprises, negative surprises could put temporary downward pressure on Treasury yields (Chart I-21). A move lower in yields would be very supportive of the yen, even if only for a few months. Chart I-19Speculators Are Still Too ##br##Short JPY Tactically Chart I-20Falling Short-Term Credit##br## Impulse In The U.S. Chart I-21Falling Surprises Can##br## Temporarily Help Bond Prices Third, the dollar correction is not over. Sentiment and positioning on the dollar represent tactical hurdles that need to be overcome before the greenback can resume its ascent. Also French OAT / German bunds spreads are at distressed levels, having only been higher at the height of the euro crisis in 2012, and not far off the levels experienced during the ERM crisis of the early 1990s (Chart I-22). This suggests that the risk of a Le Pen presidency is now well known. We agree that the impact of such an event would be enormous, but the 34.5% odds currently assigned to it on Oddschecker are too great, especially now that Bayrou - a centrist politician - is not entering the race and putting his support behind Macron. Finally, the dollar has followed a textbook wave pattern since October. A continuation of this pattern suggests that the DXY has downside toward 97-98 (Chart I-23). Chart I-22OAT / Bund Spreads Price In A Lot Of Negatives Chart I-23A Textbook Wave Pattern In The Dollar The ultimate factor in favor of the continuation of the yen correction is the higher degree of complacency that has settled globally. Our Global Complacency indicator, based on the G10 stock-to-bond ratio, commodity prices, and the VIX is at an extremely elevated level warning of a potential risk-off event globally. Any rollover in this very mean-reverting indicator would prompt a further weakness in USD/JPY as well as AUD/JPY, especially if the BoJ doesn't increase stimulus in the meantime (Chart I-24). Chart I-24AUnless The BoJ Eases Further, Too Much ##br##Complacency Equals Tactically Long JPY Chart I-24BUnless The BoJ Eases Further, Too Much ##br##Complacency Equals Tactically Long JPY Bottom Line: Tactical investors should continue shorting USD/JPY for the moment. More cyclical players can begin deploying capital to short the yen as the cyclical outlook for this currency remains dire, but better opportunity to sell this currency are likely to emerge over the coming months. A dollar-cost averaging strategy seems wise at this point. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see the Foreign Exchange Strategy Weekly Report, "How do You Say "Whatever It Takes" In Japanese?", dated September 23, 2016, available at fes.bcaresearch.com 2 Please see the Foreign Exchange Strategy Weekly Report, "Down The Rabbit Hole", dated April 15, 2016, available at fes.bcaresearch.com 3 For a more detailed discussion on the RMB, please see the Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?", dated February 24, 2017, available at gis.bcaresearch.com 4 For a more detailed discussion of the mini-cycle, please see the European Investment Strategy Weekly Report, "Slowdown: How And When?", dated February 2, 2017, available at eis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The U.S. economy is giving a green light to the Fed to hike. Headline CPI is at 2.5% annually, and core CPI is at 2.3%; Retail sales beat expectations at 0.4% MoM; The core CPI measure is evidence that the U.S. economy is fundamentally strong and dynamic. Real GDP now stands 11% above its pre-recession peak, and it is approaching the Congressional Budget Office's estimate of potential output. The unemployment and output gap are also close to their long-term levels. With the economy closing in on its potential, it is only natural that FOMC participants "expressed the view that it might be appropriate to raise the federal funds rate again fairly soon" in the Minutes. Although a risk of disappointment from Trump's fiscal proposal is possible, the economy's momentum will continue. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The euro area remains robust, with this week's data showing a strong outperformance: German, French and overall euro area PMI increased and beat expectations across all measures, with the exception of France which only outperformed on the Composite measure; Euro area producer prices strengthened to a 2.4% annual pace; After seeing some downside from worries about a Le Pen victory, markets have calmed François Bayrou, a centrist, announced an alliance with presidential candidate Emmanual Macron, adding a resistance to the euro's downside. Substantial volatility can still be expected, however, as a Le Pen victory is not completely out of the realm of possibility, which means that the euro can see some weakness in the near term. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 GBP: Dismal Expectations - January 13, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Positive signs continue to emerge in Japanese data: Industrial production yearly growth came in at 3.2% Nikkei Manufacturing PMI came in at 53.5, outperforming expectations Japan's Leading Economic Index came at 104.8, the highest level since 2015 These economic developments are good news for the BoJ, as it shows them that their price level targeting and yield curve control measures seem to be working. However the objective of these measures is not to achieve these marginal improvements in the economy. The objective is to catapult Japan out of the liquidity trap it is in, which means that these measures will likely stay in place for a while. Therefore, on a cyclical basis we remain short the yen, as we expect USD/JPY to reach 120 on a 12 to 18 month horizon. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 Update On A Tumultuous Year - January 6, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data has painted a mixed picture for the U.K. Industrial and manufacturing production yearly growth came in at 4.3% and 4% respectively. Both measures blew past expectations. Also, in spite of the dramatic fall in the pound, Inflation seems to be relatively contained, as both core and headline numbers came in below expectation at 1.8% and 1.6% respectively. However not everything is good news. Yearly growth for retail sales and retail sales ex fuel underperformed expectations coming at 1.5% and 2.6%, respectively. Additionally, wage growth has been limited, as average weekly earnings yearly growth came below expectations at 2.6%. We continue to be bullish on the pound, particularly against the euro as any additional political risks caused by Brexit are now well known by participants, making the pound very cheap, especially if one takes into account real rate differentials. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD has been the top performing currency against the USD out of the G10, having appreciated 7.11% since the beginning of the year. This rally is increasingly tenuous. Full-time employment has struggled to pick up, while part-time employment increased by 4%. This will hamper wage growth and consumption going forward. This is important as consumption is already 58% of the economy. Meanwhile, net exports have made a negative contribution to GDP growth for almost two years. In fact, Australian exports to China subtracted 1% of GDP growth last year, due to a decline in commodity prices. Going forward, a limited upside in commodity prices and an end to the Chinese easing cycle can exacerbate this decline. On a technical basis, AUD/USD has sustained momentum since the beginning of the year, with the RSI displaying overbought levels since mid-January. The cross is also approaching a key resistance level, pointing to growing risks ahead. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data for New Zealand has not been particularly positive and have weighed on the kiwi: Retail sales underperformed, growing by 0.8% QoQ against expectations of 1.1%. Business NZ PMI fell to 51.6 from last month's 54.5. Nevertheless, a closer look at the data paints a much brighter picture: the decline in NZ PMI seems to have been primarily due to bad weather conditions, which means that the strong fundamentals of the kiwi economy should show up in the data once seasonal factors start to dissipate. Therefore, we are bullish on the NZD versus the AUD, as the structural backdrop for these countries could not be further apart, yet the market is now pricing less than a 10 basis points difference from here until the end of the year. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian employment numbers came out seemingly strong, with a net change in employment of 48,300 and a decrease in the unemployment rate to 6.8%. However, these numbers mask numerous underlying inconsistencies. The decrease in unemployment was the result of a robust part-time employment growth of 5.6%, not the 0.3% growth in full-time employment. Wage growth remains subdued, with average hourly earnings of permanent workers currently increasing at a 1% annual pace, compared to 3.3% a year ago. Furthermore, hours worked have declined by 0.8%, exacerbating the weakness of full-time employment's contribution to activity. Retail sales underperformed expectations, contracting at a 0.5% monthly pace; the measure excluding Autos also contracted at a 0.3% pace. Increasing household debt and festering labor market complications are likely to weigh on consumer confidence. An uncertain outlook on trade developments is an additional handicap to future CAD strength. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 During the last couple of weeks, fear of a Eurosceptick government in Europe's second biggest economy, has lowered EUR/CHF below the implied floor that the SNB has had for the last couple of years. Indeed, last week, as La Pen surged on French presidential polls, this crossed reached 1.063, its lowest level since August 2015. This is bad news for Switzerland, as economic data continues to indicate that the country has not been able to shake off the shackles of deflation: Headline inflation outperformed expectations as it finally exited deflationary territory, coming in at 0%. Industrial production contracted by 3.3% on a year on year basis Given this deflationary backdrop, the SNB will continue to try to limit the downside for this cross. However, on the months leading to the French elections, the floor will continue to get tested. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Inflation seems to be abating in Norway as core and headline inflation numbers fell sharply from last month reading, coming in at 2.1% and 2.8% respectively. This is the result of various factors: First, the inflation caused by the collapse of the krone is starting to fade away. From 2014 to 2016, the krone collapsed along with oil prices. This selloff in the krone passed through inflation to the Norwegian economy via rising imported goods, with a lag. Today, roughly one year after the NOK bottomed, the effects of the currency on inflation is starting to dissipate. Furthermore, labor market dynamics in Norway are anything but inflationary as wage growth is contracting by 4% and although unemployment is low, the Norges Bank has pointed out that is in largely caused by a fall in the participation rate. Thus, given that high inflation is receding, the Norges Bank will keep its easing bias for the time being. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The February 2017 Monetary Policy Statement illustrated a clear dovish stance. Governors and economists at the Riksbank are paranoid about risks emanating from a strong currency and political developments. Tensions from a recently strong SEK have created worries about a potential slowdown in inflation. The Bank has therefore reiterated the possibility of an intervention if the Krona's appreciation is too rapid, making it a very real possibility. A questionable political outlook from the U.S. and the euro area has further hampered the Riksbank's optimism. The euro area is a particular risk since it represents a large source of Sweden's growth, and any damage to the monetary union will have a catastrophic effect on Sweden. Because of these reasons, the Riksbank explicitly stated that it is "still prepared to make monetary policy more expansionary if the upward trend in inflation were to be threatened and confidence in the inflation target weakened." Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
The Tactical Asset Allocation model can provide investment recommendations which diverge from those outlined in our regular weekly publications. The model has a much shorter investment horizon - namely, one month - and thus attempts to capture very tactical opportunities. Meanwhile, our regular recommendations have a longer expected life, anywhere from 3-months to a year (or longer). This difference explains why the recommendations between the two publications can deviate from each other from time to time. Highlights In February, the model underperformed global equities and the S&P 500 in USD and local-currency terms. For March, the model slightly increased its allocation to stocks and cut its weighting in bonds (Chart 1). Within the equity portfolio, the allocation to Europe was increased. The model boosted its weightings to French and Australian bonds at the expense of Canadian and Swedish paper. The risk index for stocks, as well as the one for bonds, deteriorated in February. Feature Performance In February, the recommended balanced portfolio gained 2.1% in local-currency terms, and 0.2% in U.S. dollar terms (Chart 2). This compares with a gain of 3% for the global equity benchmark and a 3.3% gain for the S&P 500. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we provide suggestions on currency risk exposure from time to time. The high allocation to bonds continued to hold back the model's performance. Chart 1Model Weights Chart 2Portfolio Total Returns Weights The model increased its allocation to stocks from 53% to 57%, and cut its bond weighting from 47% to 43% (Table 1). Table 1Model Weights (As Of February 23, 2017) The model increased its equity allocation to Dutch and Swedish equities by 4 points each, Germany and New Zealand by 2 points each, and France and Emerging Asia by 1 point each. Weightings were cut in Italy by 4 points, Latin America by 3 points, Spain by 2 points, and Switzerland by 1 point. In the fixed-income space, the allocation to Australia was boosted by 8 points, France by 6 points, and Germany by 4 points. The model cut its exposure to Swedish bonds by 9 points, Canadian bonds by 6 points, U.S. and U.K. bonds by 3 points each, and Kiwi bonds by 1 point. Currency Allocation Local currency-based indicators drive the construction of our model. As such, the performance of the model's portfolio should be compared with the local-currency global equity benchmark. The decision to hedge currency exposure should be made at the client's discretion, though from time to time, we do provide our recommendations. The most recent bout of dollar depreciation was halted in February. Our Dollar Capitulation Index is below neutral levels. However, it is not extended, meaning that it does not preclude renewed dollar weakness in the near term. That said, assuming no major negative economic surprises, a relatively more hawkish Fed versus its peers should provide support for the dollar (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation Capital Market Indicators The risk index for commodities was little changed in February. The model continues to avoid this asset class (Chart 4). The risk index for global equities rose to its highest level since early 2010, mostly on the back of deteriorating value. Despite this, the model slightly increased its allocation to equities (Chart 5). Chart 4Commodity Index And Risk Chart 5Global Stock Market And Risk The rally in U.S. stocks - driven by optimism about the economic outlook - pushed the value component of the risk index into expensive territory. The model kept a small allocation in U.S. equities. A change in the perception about the ability of the new U.S. administration to boost growth remains a risk for this market (Chart 6). The risk index for euro area equities continues to deteriorate. However, it remains lower than its U.S. counterpart. The continued flow of solid economic data and a weaker currency should bode well for euro area stocks, although political uncertainty is a potential headwind (Chart 7). Chart 6U.S. Stock Market And Risk Chart 7Euro Area Stock Market And Risk All three components of the risk index for Dutch equities are close to neutral levels. As a result, despite the recent deterioration in the overall risk index, it remains one of the lowest among the markets the model covers (Chart 8). The risk index for Swedish stocks worsened. However, the model increased its allocation to this bourse. Swedish equities would be a beneficiary of the continued risk-on environment (Chart 9). Chart 8Netherlands Stock Market And Risk Chart 9Swedish Stock Market And Risk The momentum indicator for global bonds is less stretched in February. Meanwhile, despite its latest decline, the cyclical indicator continues to signal that the positive global economic backdrop is firmly bond-bearish. Taken all together, the risk index for bonds deteriorated in February, although it still remains in the low-risk zone (Chart 10). U.S. Treasury yields moved sideways in February as investors await more guidance from the Fed on the timing of the next hike. A bond-negative cyclical indicator coupled with the unwinding of oversold conditions - as per the momentum measure - led to a deterioration in the risk index for U.S. Treasurys. The latter is almost back to neutral levels. The model trimmed the allocation to this asset class (Chart 11). Chart 10Global Bond Yields And Risk Chart 11U.S. Bond Yields And Risk The momentum indicator remains the main driver of the risk index for Canadian bonds. As a result, the less extreme momentum reading translated into an increase in the risk index for this asset class. (Chart 12). The risk index for Australian bonds moved lower in February, reflecting improvements in all three of its components. The model included the relatively high-yielding Aussie bonds in the portfolio. (Chart 13). Chart 12Canadian Bond Yields And Risk Chart 13Australian Bond Yields And Risk The cyclical indicator for euro area bonds is near expensive levels, and the momentum indicator shows heavily oversold conditions. These two measures are offsetting the cyclical one that is sending a bond-bearish message. While the overall risk index for euro area bonds is in the low-risk zone, the country allocation is concentrated in French paper (Chart 14). The risk level for French bonds is seen as low thanks to oversold momentum. French presidential elections are probably the most important political event in Europe this year. Whether the models' heavy allocation to this asset pans out hinges to a certain extent on the reduction of investor anxiety about this political risk (Chart 15). Chart 14Euro Area Bond Yields And Risk Chart 15French Bond Yields And Risk The 13-week momentum measure for the dollar broke below the zero line, and is currently sitting on its upward-sloping trendline, drawn from the 2010 lows, that has been broken only once before. Meanwhile, the 40-week rate of change measure is still suggesting that the dollar bull market has more legs on a cyclical horizon. Monetary divergences should lend support to the dollar over the cyclical horizon, although the new administration's attempts to talk down the dollar as well as heightened policy uncertainty could translate into more volatility (Chart 16). The weakening trend in the yen hit a snag two months ago, as the 13-week momentum measure reached the lows that previously foreshadowed a consolidation phase after sharp depreciations. This short-term rate-of-change measure has bounced smartly this year reaching a critical level. Meanwhile, the 40-week rate-of-change measure is not warning of a major change in the underlying trend which remains dictated by BoJ's dovish bias (Chart 17). EUR/USD has been gravitating towards 1.05 over the course of February. The short-term rate-of-change measure seems to be holding at the neutral level, while the 40-week rate-of-change measure is in negative territory, but hardly stretched. Political uncertainty has the potential to drive the euro in near term, but the longer-term outlook is mostly a function of the monetary policy divergence between the ECB and the Fed (Chart 18). Chart 16U.S. Trade-Weighted Dollar* Chart 17Yen Chart 18Euro Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com
Highlights The USD bull case is now well known by the market, but this is not strong enough a hurdle to end the dollar's run. The behavior of positioning, the U.S. basic balance of payments, interest rate expectations, and relative central bank balance sheets suggest we are entering the overshoot phase of the rally. Volatility will increase and differentiation on the dollar's pairs is becoming more important. Reflation plays are especially in danger, and the euro could be handicapped by political risk. The yen remains the preferred mean to play the ongoing dollar correction. Feature The dollar bull market has been echoing the path traced in the 1990s (Chart I-1). The key question for investors now is whether the dollar can continue to follow this road map or is the bull market over. The dollar bullish arguments are now well known by market participants, increasing the risk that purchases of the dollar might exhaust themselves. We review the indicators that worry us most and conclude that the dollar bull market could run further. However, as the dollar is now moving into overshoot territory, we expect that the volatility of the rally will only grow. Also, divergences in the dollar on its pairs are becoming more likely. We remain short USD/JPY, and explore the risks to the euro's near-term outlook. Signs Of An Overshoot? Sentiment The first factor that worries us about the future of the USD bull market is the near universality of the positive disposition of investors toward the dollar. However, two observations are in order. First, both sentiment and net speculative positions are not nearly as stretched as they were at the top of the Clinton USD bull market (Chart I-2). Second, it took six years of elevated bullishness and long positioning to prompt the end of the bull market in 2002. Either way, the dollar can continue to climb despite this handicap. Chart I-1Will History Repeat Itself? Chart I-2In The 1990s, The Consensus Was Right This reflects the fact that currency markets can often fall victim to something called the "band-wagon" effect, where a strong trend attracts more funds and perpetuates itself. Chart I-3America Is Great Again, ##br##At Least According To Investors We think this is caused by two factors. Valuation signals in the currency market have a poor track record at making money on a less than 2-year basis. This means that such signals need to be extremely strong before investors act on them. The dollar being 10% overvalued does not fit this description, instead a 20% to 25% overvaluation would hit that mark. Also, a strong upward move in a currency attracts funds to that economy. This creates liquidity in that nation's banking sector, alleviating some of the economic pain created by a rising currency or the tighter monetary policy that often caused the currency in question to rise in the first place. Today, the U.S. economy fits this bill, as private investors are rapaciously grabbing U.S. assets (Chart I-3). The Basic Balance Of Payments We have been struggling with how to interpret a strong basic balance of payment position. On the one hand, an elevated basic balance suggests that there is buying out there supporting a nation's currency. On the other hand, a strong basic balance position, especially if not caused by a current account surplus, suggests that market participants have already implemented their purchases of that nation's currency's and assets. These investors thus need further positive shocks to buy even more of that currency in order to lift its exchange rate ever higher. Today, the basic balance of payments in the U.S. is at a record high of 3.8% of GDP, begging the question of how it can climb higher from here (Chart I-4). However, as the same chart reveals, each of the previous dollar bull markets ended a few years after the U.S. basic balance of payments had peaked. Thus, we currently continue to expect the dollar to strengthen even if the U.S. basic balance position were to deteriorate. Additionally, the euro area basic balance is very depressed today at -3.4% of GDP, despite a current account surplus of 3% of GDP. However, in 1999, the region's basic balance bottomed at -5.6% of GDP, and it took until 2002 before the euro could durably rally, at which point the euro area basic balance had move back near 0% of GDP. Therefore, we would need to see a marked improvement in the euro area's basic balance in order to buy and hold the euro on a 12-to-18 months basis. Interest Rate Expectations Investors have rarely been as convinced as they are today that the Fed will increase interest rates over the coming months. This implies that the room for disappointment is large. However, as Chart I-5 illustrates, this is still not a reason to begin betting on an end to the dollar cyclical bull market. An overshoot in the dollar is marked by a fall in expectations of interest rate hikes as the strong dollar hurts the economy, preventing the Fed from hiking as much as anticipated. Moreover, except in 1994, a decreasing prevalence of rising rate expectations has lead dollar bear markets by more than a year. This suggests that there is room for the dollar to strengthen even if markets downgrade their U.S. rates expectations. Chart I-4The Basic Balance##br## Is A Small Hurdle Chart I-5In An Over Shoot, The Dollar Can Rally ##br##Even If Investors Doubt The Fed Even when looked comparatively, the broad consensus of investors regarding the continuation of monetary divergences between the Fed and the ECB is not yet a hurdle for the dollar to continue beating the euro on a 12-18 months basis. Not only is EUR/USD currently trading in line with relative expectations, previous euro rallies have been preceded by a big upgrade of the expected path of policy in Europe relative to the U.S. We currently expect the ECB to go out of its way to telegraph that even if asset purchases get curtailed in the second half of 2017, this will in no way foretell an imminent increase in European rates. Meanwhile, the Fed is in a firm position to increase rates as U.S. slack has dissipated (Chart I-6). Moreover, the proposed fiscal stimulus of the Trump administration should create inflationary pressures in this environment, solidifying the Fed's resolve to hike rates further. Chart I-6The Fed Pass Toward Higher Rates In Being Cleared Balance Sheet Positions One indicator concerns us more than the others at this point in time. As we wrote two weeks ago, one factor that has propelled the dollar higher has been its relative scarcity. The limited supply of dollar in the offshore markets - courtesy of the meltdown in the prime money-market funds industry and the heavier regulatory burden on banks - has caused cross-currency basis swap spreads to widen, pushing the greenback higher.1 Chart I-7Balance Sheet Dynamics And##br## The Scarcity Of Dollars Currently, the cross-currency basis swap spreads are hovering near record lows. However, as Chart I-7 illustrates, the surplus of euros created by the ECB's balance-sheet expansion as the Fed stopped its own purchases had a role to play in this phenomenon. While we expect the ECB to stand pat on the interest rate front for the foreseeable future, a further tapering of asset purchases in the second half of 2017 and beyond is very likely. This could limit the widening in cross-currency basis swap spreads that has been so helpful to the dollar, especially if the Fed elects not to curtail the size of its balance sheet. Net Net Many indicators suggest that the potential for dollar buying may be on the verge of exhausting itself. However, when looked closer, while these factors are a cause for concern, they still do not preclude an overshoot in the dollar. In fact, if anything, they suggest that the dollar is only now beginning its overshoot phase, a leg of the bull market that historically begins to inflict deeper pain on the U.S. economy as the dollar gets ever more dissociated from its fundamentals. So What? While the above indicators do not yet point to an end of the bull market, they in no way suggest that the dollar cannot suffer episodic corrections. We believe we are in the midst of such an event. Can the correction last further? Yes. To begin with, while the heavy net long positioning in the dollar does not represent much of a cyclical hurdle to beat, it does still constitute an important tactical risk. Our models corroborate this view. DXY is only currently fairly valued based on our intermediate-term timing model. Historically, tactical corrections fully play out once this model is in cheap territory (Chart I-8). Moreover, our capitulation index paints a similar story. This indicator has corrected some of its overbought excesses but remains above levels suggestive of an oversold environment. To the contrary, the fact that this index is still below its 13-week moving average points to additional selling pressures on the USD (Chart I-9). Chart I-8The Dollar Tactical Correction Is Not Over Chart I-9Confirming The Dollar Tactical Downside However, other factors suggest that the dollar could strengthen on certain pairs. The outlook seems especially grim for the reflation plays like the commodity currencies. Our reflation gauge, based on the prices of lumber, industrial metals, and platinum, has moved upward exactly as the U.S. dollar has rallied, a short-lived phenomenon that happened in 2001, 2002, and 2009. In all these cases, the Fed was easing policy and U.S. rates were softening relative to the rest of the world (Chart I-10). We doubt this phenomenon can continue much longer, especially as the Fed is currently tightening policy and U.S. rates are rising relative to the rest of the world. Moreover, Chinese fiscal stimulus was crucial in supporting this divergence in both 2009 and 2016. However, Chinese government spending went from growing at a 25% annual rate in November 2015, to a near 0% rate now. Moreover, the PBoC has already increased rates twice on its medium-term facilities and has also stopped injecting liquidity in the interbank market despite recent upward pressures on the SHIBOR. This tightening could prove problematic for natural resources like coking coal, iron ore, or copper, commodities highly levered to the Chinese real estate market and of which China recently accumulated large inventories (Chart I-11). Chart I-10An Unusual Move Chart I-11Elevated Chinese Metal Inventories Additionally, on the back of the longest expansion in the global credit impulse in a decade, G10 economic surprises have become very perky. However, it will be difficult to beat expectations going forward. Not only have investors ratcheted up their global growth expectations, the recent increase in global interest rates limits the capacity of the credit impulse to grow further. In fact, the recent tightening in U.S. banks credit standards for consumer loans, the fall in the quit rates in the U.S. labor market, and the underperformance of junk bonds relative to Treasurys since late January only re-inforce this message. Sagging global growth, even if temporary, is always a problem for commodities and commodity currencies. The euro faces its own risk: France. Last week, along with our colleagues from BCA's Geopolitical Strategy service, we wrote that the chance of a Le Pen electoral victory is still extremely low and we would buy the euro on any sell-off caused by a rising euro-area breakup risk premium.2 Yet, we are not oblivious to the risk that before the second round of the election is over on May 7th, investors can continue to place bets that Marine will win and that France will exit the euro area. The recent widening of the OAT/Bund spread reflects these exact dynamics as François Fillon's hardship and Macron's love life have taken center stage. So real has been the perception of this risk that spreads on Italian and Spanish bonds have followed suit (Chart I-12). While we are inclined to lean against this move, it is a risk that investors may want to bet on or hedge against. At the current juncture, the euro is fully pricing in these developments, and no mispricing is evident. However, as our model based on real rates differentials, commodity prices, and intra-European spreads shows, if France spreads were to widen further, EUR/USD could suffer (Chart I-13). In fact, if French spreads retest their 2011 levels, the euro could fall toward parity. Chart I-12Le Pen Is Causing A Repricing ##br##Of The Euro Area's Breakup Chance Chart I-13The Euro Will Suffer If French ##br##Bonds Underperform Further Investors wanting to speculate on the French election but wanting to avoid taking on some USD exposure can do so by shorting EUR/SEK, a very profitable strategy when the euro crisis was raging (Chart I-14) or could short EUR/GBP, as interest rates expectations have begun to move against the common currency and in favor of the pound (Chart I-15). While EUR/CHF tends to weaken during times of euro-duress, it is currently trading close to the unofficial SNB floor and we worry that growing intervention by the Swiss central bank will limit any downside on this pair. The currency that is likely to benefit the most against the dollar remains the yen. Not only are investors still very short the yen, but based on our intermediate-term timing model, the yen remains very attractive (Chart I-16). Moreover, the recent large improvement In the Japanese inventory-to-shipment ratio only highlights that the Japanese economy has gathered momentum, decreasing the likelihood of an enlargement of the current set of ultra-stimulative measures from the BoJ. Chart I-14Short EUR/SEK: A Hedge Against Le Pen Chart I-15Downside Risk For EUR/GBP Chart I-16Yen: Biggest Winner If USD Corrects Additionally, any risk-off event caused by a correction of the reflation trade would benefit the yen. Falling commodity prices will hurt Japanese inflation expectations and lift real rate differentials in favor of the yen. A correction in the reflation trade would also put downward pressure on global bond yields, which means that due to the low yield-beta of JGBs, Japanese nominal interest rates spread would further contribute to a narrowing of real interest rate differentials in favor of the JPY. Finally, if investors begin to bet even more aggressively on a breakup of the euro area fueled by the perceived prospects of a Le Pen electoral victory, the vicious wave of risk aversion unleashed around the globe by such an event would likely support the yen beyond our expectations. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please refer to the Foreign Exchange Strategy Weekly Report, "Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism", dated January 27, 207, available at fes.bcaresearch.com 2 Please refer to the Foreign Exchange/ Geopolitical Strategy Special Report, "The French Revolution", dated February 3, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 As we highlighted in previous reports, DXY's losses extended no further than the 99-100 support range, and the index has rebounded since then. A key external driver of the USD is EUR, whose roll-over has coincided with the DXY's rebound. In the coming months, EUR/USD could display downside risk as markets price in election jitters. This could be bullish for the greenback. The budget plan is in discussion. Due in around a month, the tentative plan comprises tax cuts and defense spending mostly. While this is still speculative, this plan may be bullish for the dollar. Until then, it is likely that the DXY will follow in its seasonal trend and be largely unchanged with little upside this month. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 U.S. Border Adjustment Tax: A Potential Monster Issue For 2017 - January 20, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Two main factors are weighing on the euro this week. Firstly, Draghi continues to retain his dovish stance. He stated that there is still "significant degree of labour market slack", which is limiting wage growth, a key contributor to underlying inflation. Secondly, and more substantial, are politically-induced anxieties in the run up to the European elections. In particular, French elections have increased risk premia, forcing the 10-year OAT-Bund spread to reach early-2014 highs. Greek 2-year yields have also spiked above 10%. Volatility is likely to be elevated in the lead up to the French election and possibly through Italian elections. The longer-term outlook will remain dictated by the development of the ECB's monetary policy stance. Report Links: The French Revolution - February 3, 2017 GBP: Dismal Expectations - January 13, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Then yen continues to rally, with USD/JPY already down by almost 5% this year. Uncertainty surrounding the European elections should help continue this trend, given that the yen should benefit from safe haven flows. Nevertheless, the outlook for the yen remains bearish on a cyclical basis, as the measures that the BoJ has taken, such as anchoring 10-year rates near 0, and switching to de facto price level targeting will eventually lower Japanese real rates vis-à-vis the rest of the world. The BoJ has taken these measures to kick start an economy plagued by deflation. Early returns from this policy are mixed: Machinery Orders grew by 6.7% YoY, outperforming expectations. However both housing starts growth and Nikkei Manufacturing PMI fell below expectations, coming at 3.9% and 52.7 respectively. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 On Wednesday, the U.K. House of Commons finally gave their approval to a bill authorizing the government to start exits talks with the European Union. The House of Lords will be the next hurdle that Brexit hopefuls will have to overcome. Although cable suffered from some volatility following the decision it has remained relatively unaffected. We continue to think that the pound has further upside, particularly against the euro, as the negative consequences of Brexit on the British economy are already well priced into cable. Furthermore, increasing uncertainty regarding the French elections should also be bearish for EUR/GBP. If the fear of a Le Pen presidency starts to increase, Brexit will become an afterthought as exiting the European Union takes on a completely different meaning if the integrity of the EU starts being put into question. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The RBA held rates at 1.5% this week on the basis of upbeat business and consumer confidence, and above-trend growth in advanced economies. This decision helped the AUD, as investors repriced dovish bets and interpreted a change in stance. While above-trend growth is possible, Chinese demand is particularly important for Australia. Last week, the PBoC silently tightened their 7-, 14-, and 28-day reverse repo rates by 10 bps each to help alleviate looming risks in the real estate market and general financial stability. This may signal an end to an easing cycle, which may limit demand growth going forward. Australia has its own financial worries. Household debt is at its highest ever, at 186% of disposable income, which would be catastrophic if rates are raised. Lowe also highlighted concerns about a strong AUD and its impact on Australia's economic transition. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The RBNZ decided to keep interest rates unchanged at 1.75% in their monetary policy meeting this Wednesday. Additionally, as expected, Governor Graeme Wheeler stated that the RBNZ had shifted from having a dovish bias to a having neutral one. Nevertheless, the kiwi has depreciated sharply since the announcement, not only because Governor Wheeler highlighted that the currency "remains higher than is sustainable for balanced growth" but also because the RBNZ showed a cautious approach by stating that "premature tightening of policy could undermine growth and forestall the anticipated gradual increase in inflation". However, we believe that the RBNZ will turn more hawkish, as inflationary forces in the economy will eventually put upward pressure on rates. This will lift the NZD, particularly against the AUD. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Uncertainty has come up as a key issue in the Bank of Canada's headlights, as Poloz remains nervous about the future of U.S.-Canada relations. CAD has recently displayed some strength despite this uncertainty. It has appreciated against USD, AUD and NZD. This is likely due to a brightening perception of the Canadian economy with the Ivey PMI recording a reading above 50 for January, at 52.3, above the previous 49.3. Additionally, housing starts beat expectations, dampening housing market concerns. Exports have been strong, which has also fed into this appreciation. A rapidly appreciating currency would exacerbate trade concerns further and adversely affect the Canadian economy. Therefore, it is likely that the BoC remains tilted to the dovish side, which will generate downside for the CAD through rate differentials. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has reached its lowest level since August 2015. At around 1.065, this cross is hovering in the lower range of the implied floor set by the SNB. Increased uncertainty caused by the upcoming European elections cycle will continue to test this floor, as the increased odds of an Eurosceptic government in France will not only decrease the value of the euro but will also put upward pressure on the franc, given its safe haven status. Nevertheless, the SNB will do everything in its power to weaken its currency as the Swiss economy continues to be plagued by deflationary forces: After showing glimpses of a recovery last month Real retail sales contracted by 3.5% YoY, falling well short of expectations. The SVMI Purchasing Manager's Index also came below expectations coming in at 54.6. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has rebounded after reaching 8.20, its lowest level since Trump got elected. Interestingly, the NOK has not been as correlated with oil prices since the start of 2017 as it has been in the past. This is a trend worth monitoring. The inflation picture remains complex, although core and headline inflation have deaccelerated slightly as of late, inflation expectations are at their highest level of the last 9 years. Additionally house prices are growing at nearly 20%, a pace not seen since before the 2008 crisis. The Norges Bank is now facing a tough dilemma between risking an inflation overshoot if they keep their dovish bias or raising rates in an economy where growth for employment, real retail sales and nominal GDP is still in negative territory. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The SEK continues to duplicate the dollar's movements, rolling over slightly from the 7% appreciation it saw over a month and a half. A more accurate measure of the SEK's value, EUR/SEK, paints a similar picture. These movements have been more or less in line with the Riksbank's desired developments, as it indicates a deceleration in the pace of recent appreciation. However, we believe that the rebound in EUR/SEK is not likely to run further. Political turbulence is being priced into the euro. After sustaining near oversold levels, the rebound could be nothing more than momentum exiting from oversold territories. Nevertheless, it is likely that EUR/SEK will correct in the coming months due to European elections. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Dear client, This week, we are sending you an abbreviated version of our weekly bulletin as we are also publishing a piece written by our colleague Peter Berezin, Senior Vice President for our Global Investment Strategy service. This report, titled “U.S. Border Adjustment Tax: A Potential Monster Issue For 2017”, deals in great details with the Republican tax plans. In this report, Peter analyses the economic and financial market implications of the plan and concludes it is likely to be an additional support to the dollar bull market if it gets implemented in full, but not one without repercussions. I trust you will find this report very interesting and relevant. Best regards, Mathieu Savary Feature After continuing to sell off, the dollar regained some composure toward the end of the week. Not only did an elevated CPI print for December contribute to this rally, but so did Fed Chair Janet Yellen's comment that the U.S. economy was getting closer to the FOMC objectives and that the Fed was now closer to being capable of raising rates multiple times a year between now and 2019. Chart 1Froth Had Dissipated##br## From Treasury Yields Additionally, we had been expecting a correction in the dollar as we worried that U.S. bond yields would retrace some of their ascent. The pullback materialized and U.S. bond yields traded in line with our fair value estimate earlier this week (Chart 1). This meant that much of the froth in the dollar had dissipated. Based on these developments, is it time to buy the dollar again? On a cyclical basis, the dollar will make new highs in 12-18 months. However, short-term considerations remain complex. There are two President Trump out there: "Good Trump" and "Bad Trump". Good Trump is a president that talks about deregulation and tax cuts as well as various stimulus measures. This is the president that turbo charged the dollar after the election on hopes of a stronger U.S. economy. Bad Trump is the campaign Trump, the populist president that wants to revive protectionism and that promotes acrimonious international relations between the U.S. and the rest of the world, China in particular. The markets had expected Good Trump to be the first Trump to emerge, yet, the new president seems to have elected to present his Bad Trump profile first. In a way, this makes sense. Trump is focusing on the more economically painful parts of his program, campaign promises wanted by his electorate. This way, Good Trump can swoosh in and save the day by helping the economy closer to the mid-term election in late 2018, in the aim of solidifying the Republican control of Congress. With the 10-year yield back above fair value, the VIX near 12, and EM equities near their pre-November high, the market is not pricing in any flare up of tensions with China, nor any deflationary shock that could emanate from such tensions (Chart 2). Investors were hoping that the talks of stimulus and deregulation would come first, instead they are getting a president that bullies corporations and build up tensions in Asia. The deflationary nature of the tension comes from the reality that while the Chinese economy has improved, China remains handicapped by a large debt load and a low demand for credit. It is ill equipped to handle foreign shocks. Moreover, the easing in Chinese monetary conditions will soon lose steam. Chinese monetary conditions eased because Chinese real rates fell from nearly 12% to -2% on the back of a powerful rebound in the Chinese producer prices (PPI) (Chart 3). This improvement in PPI was itself a byproduct of a rebound in commodity inflation. However, this rebound is soon behind us. Commodity prices troughed in Q1 2016, and have recently slowed their pace of ascent. This means that in the coming months, Chinese PPI will rollover as well and Chinese real borrowing costs will rise again (Chart 4). Chart 2All Must ##br##Go Well Chart 3Can Chinese Monetary ##br##Conditions Improve Further? Chart 4The Commodity Rebound Was A Key Factor##br## Behind The Chinese PPI Rebound This could prove problematic for China where loan demand remains very tepid, pointing to a potential down leg in Chinese industrial activity (Chart 5). This also raises the specter of renewed devaluation pressures on the Chinese yuan, as this would create another valve to alleviate deflationary pressures in the Chinese economy (Chart 6). Further RMB weakness would be welcomed neither by Trump, nor by the markets. Chart 5Chinese Loan Demand ##br##Remains Moribund Chart 6The RMB Is Another Relief Value For##br## Chinese Deflationary Pressures Taking all these factors into account, we remain warry of betting on a strong dollar against the euro and the yen in the coming weeks, at least not until bonds become cheap on our fair value gauge, reflecting these Chinese deflationary risks and a higher geopolitical risk premium. Chart 7EUR/GBP Is Misaligned##br## With Fundamentals Also, this means that we could see a dichotomy emerge between the narrow dollar (DXY) and the broad dollar. While lower bond yields are supportive of the euro and the yen, they do very little for EM and commodity currencies. In fact, EM and commodity currencies are highly leveraged to the Chinese economy and will be vulnerable to any flare up of tensions between China and the U.S., especially after currencies like the AUD and the CAD had already rallied 5% and 4% respectively since the last week of 2016. Thus, we would recommend investors favor risk-off currencies like the euro, the Swiss franc, and the yen at the expense of the AUD, NZD, CAD, and NOK. For the GBP, last week, we published an optimistic take on the British economy. We are looking to short EUR/GBP as rate differentials are still widely bearish of that cross (Chart 7). However, we warned that in anticipation of the actual triggering of article 50 of the Lisbon treaty, the GBP could come under duress. A risk-off event would only strengthen this case. Thus, we remain confident in our preferred strategy to short EUR/GBP once it hits 0.93. Bottom Line: The dollar correction is advanced but is now likely to become more differentiated. Tensions created by a protectionist and bellicose Trump are likely to push bonds into expensive territory. While the attending bond rally could support the euro, the Swiss franc, and the yen against the dollar, these same tensions are likely to support the dollar against EM and commodity currencies. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Will inflation return in Europe & Japan? Can Trumponomics successfully boost U.S. economic growth? Will global market volatility remain this low? Can China avert a crisis and still be the engine of global growth? Feature With a New Year now upon us, fixed income investors are trying to determine what the next move is for global bond yields after the rapid rise at the end of 2016. While much has been made of the impact of the 2016 U.S. election result on the global bond rout, many other important factors will drive fixed income markets this year (Chart of the Week). In our first Weekly Report of the New Year, we present our list of the most important questions for global bond markets in 2017. Chart 1The Big Questions For 2017 Chart 2Taper Tantrum 2.0? Will Inflation Return In Europe & Japan? Extremely low inflation in the Euro Area and Japan over the past few years has forced both the European Central Bank (ECB) and Bank of Japan (BoJ) to pursue exceptionally accommodative monetary policies like negative interest rates and large scale quantitative easing (QE) programs - the latter acting to depress bond term premia among the major developed markets. Much of this decline in headline inflation in both regions was due to the 2014/15 collapse in oil prices and the previous strength in both the euro and yen (Chart 2), but core inflation and wage growth have also been subdued. If headline inflation were to move higher in either Europe or Japan, it could call into question the central banks' commitment to continue hyper-easy monetary stimulus programs. This could raise the threat of another "taper tantrum" in developed bond markets later in 2017. The recovery in global energy prices in 2016, combined with significant currency depreciations related to ECB/BoJ QE, have boosted the annual growth in the local currency price of oil to 72% in the Euro Area and 63% in Japan. Already, headline inflation measures have begun to move higher in response and, judging by past relationships, a move up to 2% headline inflation in both regions by year-end is possible. In Chart 3 & Chart 4, we present simulations for headline inflation in both the Euro Area and Japan assuming the only changes come from movements in oil prices, the euro and the yen. We show two scenarios where the Brent oil price rises to $65/bbl (the high end of the range expected by our commodity strategists in 2017) and $75/bbl (an extreme scenario). In both simulations, the euro and yen continue to weaken versus the U.S. dollar until mid-2017 before recovering to near current levels by year-end. Chart 3Euro Area Inflation Simulation Chart 4Japan Inflation Simulation Our simulations show that headline inflation in both the Euro Area and Japan could rise to at least the 2% level, and perhaps even higher, if oil prices continue to climb and both the yen and Euro weaken towards 125 and parity versus the U.S. dollar, respectively. Given our views on the likely path of interest rates in the U.S. - higher, as the Fed continues hiking rates - the U.S. dollar is likely to strengthen more in 2017. The oil price moves incorporated in our simulations are somewhat more bullish than our base case expectation, but not extraordinarily so. If there are any upside surprises to global growth this year, oil prices could show surprising strength given the production cutbacks occurring in many of the major oil exporting nations. Higher inflation would be welcome by both the ECB and BoJ, especially if it were accompanied by a rise in inflation expectations. Both central banks have acknowledged the role played by low realized inflation in recent years in depressing expected inflation, but the latter could move up surprisingly fast if the markets believe that either central bank will be slow to respond to the rise in realized inflation. That seems like more of a risk in Japan, where the BoJ is aiming for an overshoot of its 2% inflation target and is promising to keep the Japanese government bond (JGB) curve at current levels until that point is reached. The ECB would be much more likely to make the decision to begin tapering their bond purchases if Euro Area inflation approaches 2%. We see this as the biggest potential threat to global bond markets in 2017 - even more than the expected Fed rate hikes, which are already largely priced into the U.S. yield curve. The ECB was able to successfully kick the tapering can down the road last month by choosing to extend its QE program to the end of 2017, but a decision to defer tapering again will be much harder to make if Euro Area inflation is closer to 2%. If the ECB were to announce a taper later in 2017, this would be very damaging for the long ends of yield curves in the developed markets as bond term premia would begin to normalize - perhaps very rapidly. There is more room for adjustment for term premia in core Euro Area government bonds relative to U.S. Treasuries. An ECB taper announcement, or even just expectations of it, would mark the peak in the spread between U.S. Treasuries and German Bunds which is now at the highest levels in a quarter century. Given the busy upcoming election calendar in the Euro Area, the ECB will not want to even mention the word "taper" until later in the year. Until then, owning inflation protection in Europe, and Japan as well, is the best way to position for upside surprises in inflation in those regions. Bottom Line: Rising inflation in the Euro Area and Japan in 2017 will prompt a rethink of the hyper-easy monetary policies of both the ECB and BoJ, but only the former is likely to consider a taper of its bond purchase program this year. That decision would push global bond yields higher via wider term premia and cause Euro Area government bond markets to underperform U.S. Treasuries, but not until later in the year. Can Trumponomics Successfully Boost U.S. Economic Growth? After a long and divisive U.S. election campaign, the curtain is about to officially be raised on the Trump era on January 20. In anticipation of a more pro-growth agenda from the new president, investors have already bid up the valuations of assets sensitive to U.S. economic growth, like equities and corporate bonds, while also driving up both U.S. Treasury yields and the U.S. dollar. Chart 5Time To Spruce Up U.S. Infrastructure Markets are now discounting a fairly rosy scenario for a solid "Trump bump" to U.S. economic growth in 2017. This is to be expected, given that the president-elect won the White House on a platform full of promises to, among other things, boost government infrastructure spending, cut corporate taxes, tear down excess regulations on U.S. companies and adopt a more protectionist U.S. trade policy. In terms of a direct impact to U.S. GDP growth, there are three obvious places where the economic plan of Candidate Trump could turn into stronger growth this year for President Trump: government fixed investment, net exports and private capital expenditure. Trump's infrastructure plans have received much of the attention from those bullish on U.S. growth in 2017; unsurprising given the proposed size of the proposals ($550 billion). This stimulus would appear to be a source of low-hanging fruit to boost U.S. economic growth, as years of underinvestment has left America with an aging government infrastructure in need of an upgrade (Chart 5). Yet the boost to growth from government investment spending has historically not been large, adding between 0.25% and 0.5%, at most, over the past 40 years (bottom panel). Trump's proposed figure of $550 billion would fit right in with that experience, as it would represent 0.3% of the current $18.6 trillion U.S. economy. That assumes that all the proposed infrastructure spending occurs in a single year. Given the usual long lead times for big government infrastructure projects, and the discussions between the White House and the U.S. Congress over the scope and funding of any major government spending initiative, it is highly unlikely that the direct effect of more infrastructure spending will provide much of a boost to U.S. growth in 2017. That impact is more likely to be seen in 2018. A boost to growth from trade is also possible given Trump's fiery protectionist election rhetoric and his decision to nominate China hawks for major cabinet positions. It is unclear if Trump is willing to risk entering a trade war with China (or even Mexico) by raising import tariffs soon after taking office. It is even more uncertain if this will provide much of an immediate lift to U.S. net exports, if tariffs merely raise the cost of imports without any material substitution to domestically produced goods and services. Even if it did, trade has rarely contributed positively to real U.S. GDP growth outside of recessions since 1960. That leaves private fixed investment as the biggest potential source of new growth in the U.S. in 2017. Trump is proposing a cut in the U.S. corporate tax rate from 35% to 15%, while the Republican plan already set out by House Speaker Paul Ryan is calling for a cut to 25%. Both sides also are in favor of a lower "repatriation tax" on corporate profits held abroad, at a rate of 10-15%. So with all parts of the U.S. government in agreement, a move to cut corporate taxes appears to be a near certainty. In the past, efforts to initiate comprehensive tax reform have been not been done quickly in Washington. Our colleagues at BCA Geopolitical Strategy, however, believe that a deal between the White House and Congress could happen in the first half of 2017. The details of the other major policy initiatives that Trump wants done early in his first term - repealing and replacing Obamacare, and the infrastructure spending program - will be much harder to iron out than a tax cut on which both Trump and the Republican Congress agree. Doing the tax reform first will be the easier choice for a new president.1 Cutting corporate taxes seems like a move that should help boost U.S. private investment spending, as it would raise the after-tax return on capital. However, investment spending has already been underperforming relative to after-tax cash flows since the 2008 Financial Crisis, and the effective tax rate paid by the U.S. corporate sector is already much lower than the 35% marginal tax rate (Chart 6). Something else besides tax levels has been weighing on U.S. corporate sentiment with regards to capital spending intentions. It may be that the burden of excess government regulations, which has soared during the years of the Obama administration (bottom panel), has dampened animal spirits in the U.S. corporate sector. On that front, Trump's proposals to slash regulations - none bigger than repealing Obamacare - could help boost business confidence and fuel an upturn in capital spending. Chart 6A Regulatory Burden, Not A Tax Burden Chart 7Making Corporate America Happy Again Some rebound in capex was likely to occur, Trump or no Trump, given the recent improvement in U.S. corporate profits (Chart 7, top panel). This is especially true in the Energy sector which generated the biggest drag on U.S. corporate investment spending after the collapse in oil prices in 2014/15. Since the election, however, there has been a noticeable improvement in confidence within the "C-suite" for American companies. The Duke University/CFO Magazine measure of optimism on the U.S. economy hit the highest level in over a decade (middle panel), while the Conference Board index of CEO optimism soared to the highest level in three years, at the end of 2016. Executive confidence at those levels would be consistent with a pace of capital spending that could add up to 1 full percentage point to U.S. real GDP growth, based on past relationships - (bottom panel). For both of these surveys, executives cited a more positive outlook on future growth after the U.S. election as a major reason for the increase in optimism. In sum, the biggest potential lift to U.S. economic growth in 2017 from Trumponomics will come from business investment and not government spending or exports, and likely by enough to boost overall U.S. GDP growth to an above-trend pace that will prompt the Fed to deliver at least 2-3 rate hikes by year-end. Bottom Line: A major boost to U.S. economic growth from government investment spending and net exports is unlikely in 2017. A pickup in corporate investment, however, seems far more likely given the boost to longer-term business confidence seen after the U.S. elections, coming at a time of improving global economic growth. Will Market Volatility Stay This Low? Given all the uncertainties over the latter half of 2016, from Brexit to Trump to Italy, it is surprising how low market volatility has been. Measures of implied volatility like the VIX index for U.S. equities have remained incredibly subdued, while even the uptick in MOVE index has been relatively modest considering the year-end carnage in the Treasury market (Chart 8). The fact that global risk assets can remain so relatively well-behaved, even after a surprising U.S election result and a Fed rate hike that has boosted the U.S. dollar, is a sign that the "Fed Policy Loop" - where a more hawkish U.S. monetary stance causes an unwanted surge in the U.S. dollar and a selloff in equity and credit markets - has been broken. As we discussed in our 2017 Outlook report, the Fed Policy Loop framework would not apply in an environment where non-U.S. economic growth was improving, as is the currently the case.2 This may be the most obvious explanation for why market volatilities are low, with developed market equities hitting cyclical highs and corporate credit spreads staying at cyclical lows. In other words, volatility is low because growth is accelerating and global central banks (most notably, the Fed) are not slamming on the brakes. Chart 8The Death Of The Fed Policy Loop? Chart 9U.S. Dollar Strength Will Persist In 2017 The strength of the U.S. dollar has been a function of the widening real interest rate differential between the U.S. and the rest of the world (Chart 9), which is likely to continue this year as the Fed delivers a few more rate hikes while U.S. inflation grinds slowly higher. We do not expect the Fed to be forced to shift to a more aggressive pace of tightening than currently implied by the FOMC forecasts. On the margin, this will help keep market volatility at subdued levels. A predictable Fed slowly tightening into an improving economy is not overly problematic for financial markets. That logic would be turned upside down if non-U.S. growth were to begin to slow sharply (not our base case) or if there were some non-U.S. source of uncertainty that could make markets jittery. Last year, political surprises ended up being the biggest shock for financial markets. Given the busy upcoming election schedule in Europe (Table 1), there is concern that a similar story could play out in 2017. Table 1Europe In 2017 Will Be A Headline Risk The shock of Brexit and Trump have investors asking "where will the next populist uprising be?" France seems like the most obvious possibility, with the well-known right-wing (and anti-EU) populist Marine Le Pen running in this year's presidential election. French government debt has already priced in some modestly higher risk premium in recent months (Chart 10). Even in the bastion of stability, Germany, the rise of anti-immigration parties has some forecasting a difficult re-election campaign for Chancellor Angela Merkel later in the year. Our geopolitical strategists have long argued that there is not enough support for populist, anti-EU, anti-immigration parties in either Germany, France or the Netherlands (who also have an election this year) to win an election.3 The recent polling data strongly supports that view, with Le Pen's popularity on the decline for the past three years and with Merkel's popularity holding steady over the past year (Chart 11) - even as horrific terror incidents committed by "foreigners" have occurred on both French and German soil. Chart 10Not Worried About European Populism... Chart 11...For Good Reasons BCA's Chief Geopolitical Strategist, Marko Papic, believes that Italy remains the greatest political risk in Europe in 2017, with elections possible as early as the spring. With the Senate reforms defeated in the December referendum, the country needs to re-write its already complicated electoral laws. This will likely take time, pushing the potential election date to late spring or early summer. If an early election is not called, a new vote must be held by the expiry of the government's mandate in May 2018. Chart 12Italy Is The Biggest Political Risk In Europ Chart 13A Managed Renminbi Depreciation Given the lower support for the euro in Italy than the rest of the Euro Area (Chart 12), and given the strong showing in the polls for the anti-establishment, anti-EU Five Star Movement led by Beppe Grillo, an early Italian election could be the biggest potential political shock for markets in 2017. This likely will not be enough to cause a major flare-up of global market volatility, but it does suggest that investors should remain underweight Italian government debt. Bottom Line: Improving global growth will continue to support low market volatility during 2017, even with the Fed remaining in a tightening cycle. European political risk should not be a Brexit/Trump-type source of concern for investors outside of Italy. Can China Avert A Crisis And Still Be The Engine Of Global Growth? This is a question that we may be asking every year for the next decade, given China's high debt levels and decelerating potential economic growth. Periodic episodes of uncertainty over Chinese currency policy are always a threat to trigger capital outflows, as has occurred over the past year and half (Chart 13). The Chinese authorities have chosen to allow currency depreciation versus the U.S. dollar to help manage the pace of that outflow, particularly during the past year when interest rate differentials have moved in a more dollar-positive direction. With over US$3 trillion in foreign exchange reserves at the government's disposal, the odds remain low that a true economic crisis can unfold in China. Additional renminbi weakness versus the U.S. dollar is likely in 2017, but the recent actions to sharply raise offshore renminbi interest rates is an indication that Chinese authorities will not tolerate a rapidly weakening currency. The incoming Trump administration is obviously an unforecastable wild card here, and China could respond to a new trade war with the U.S. by allowing a more rapid pace of currency weakness versus the dollar. Having said that - if China-U.S. relations don't boil over, then the underlying story for China will be one of improving economic growth in 2017. The underlying growth indicators in our "China Checklist" unveiled late last year (Table 2) continue to improve (Chart 14), and we continue to see China as being a positive contributor to the global economic cycle in 2017 (Donald Trump and his band of China hawks notwithstanding). This is important, as the global upturn seen in 2016 began in China early in the year. This fed through into many other countries either directly via exports to China or indirectly through an improvement in the pricing power for commodity exporters that benefitted from faster Chinese demand. Table 2The GFIS China Checklist Chart 14Chinese Growth Still Improving Bottom Line: China will likely remain a positive driver of the global economic upturn in 2017, with the biggest risk coming from increased tensions with the incoming Trump administration, not accelerating domestic capital outflows. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency", dated November 20th 2016, available at gps.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy Special Report, "How To Think About Global Bond Investing In 2017", dated December 20th 2016, available at gfis.bcarsearch.com 3 Please see BCA Geopolitical Strategy Strategic Outlook 2017, "5 Themes For 2017", dated December 2016, available at gps.bcaresearch.com Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns