BCA Indicators/Model
Highlights At just under 3-in-10 odds, the probability Brent crude oil prices will exceed $80/bbl by year-end is now more than double what it was at the beginning of the year, following President Trump's announcement he would withdraw the U.S. from the 2015 Joint Comprehensive Plan of Action (JCPOA), and re-impose all economic sanctions against Iran (Chart of the Week). Chart of the WeekProbability Brent Exceeds $90/bbl Is Understated By Markets We believe these odds are too low. Indeed, we think the odds of Brent prices ending above $90/bbl this year are higher than the 1-in-8 chance being priced in the markets presently, even though this is up from just under 4% at the beginning of the year. We also expect sharper down moves going forward, as news flows become noisier. Speculators have loaded the boat on the long side, and they will be exquisitely sensitive to any unexpected softening in fundamentals - e.g., a supply increase or the whiff of lower demand - given their positioning (Chart 2). Chart 2Specs Have Loaded the Boat##BR##Getting Long Brent and WTI Exposure Our research indicates that spec positioning in the underlying futures can, under some circumstances, dominate the evolution of oil options' implied volatility, the markets' key gauge of risk and the essential component of option pricing. As new risk factors arising from Trump's decision emerge, we expect option implied volatility to increase, as the frequency of spec re-positioning increases. Energy: Overweight. We are getting long Feb/19 $80/bbl Brent calls expiring in Dec/18 vs. short Feb/19 $85/bbl calls, given our assessment that the odds of ending the year above $90/bbl are higher than the market's expectation. We also recommend getting long Aug/19 $75 Brent calls vs. short Aug/19 $80/bbl calls. We already are long Dec/18 $65/bbl Brent calls vs. short $70/bbl calls expiring at the end of Oct/18, which are up 74.2% since they were recommended in Feb/18. Rising vol favors long options positions. The new positions will put on at tonight's close. Base Metals: Neutral. Refined copper imports in China grew 47% y/y in March. For the first four months of 2018 they are up 15% y/y. Imports of copper ores and concentrates were up 9.7% y/y in the January - April period. Precious Metals: Neutral. We remain strategically long gold and tactically long spot silver. A stronger USD continues to weigh on both. Ags/Softs: Underweight. The USDA's weekly Crop Progress report indicates farmers in the U.S. are catching up in their spring planting, converging toward averages for this time of year. Nevertheless, the condition of winter wheat remains a concern. Feature The wild swings in crude oil prices following President Trump's decision not to waive nuclear-related sanctions against Iran - down ~ 2% after Trump's announcement Tuesday, then up more than 2.5% the following morning - resolved one of the more important "known unknowns" ahead of schedule - to wit, would the U.S. re-impose nuclear-related sanctions against Iran, or continue to waive them.1 Ahead of Trump's announcement this week, speculators clearly were building long positions in Brent and WTI, as seen in Chart 2. Among other things, stout fundamentals, which we have been highlighting, and a possible tightening of supply on the back of the re-imposition of U.S. sanctions were obvious catalysts for building the bullish positions. We find specs do not Granger-cause oil prices, and typically these traders are reacting to fundamental news.2 This is consistent with other research into this topic.3 In other words, we find specs essentially follow the fundamentals, they don't lead them, and, as a result, the level of oil prices largely is explained by supply, demand and inventories. Based on the Granger-causality tests and our fundamental modeling, we believe oil markets are, to a very large extent, efficient in the sense that prices reflect most publicly available information.4 This is not to say, however, that the role of speculation can be dismissed as trivial to price formation. Spec Positioning Matters For Implied Volatility In Oil Our most recent research, building on earlier work on speculation in oil markets, finds that the concentration of speculators on the long side or the short side of the market actually does play a significant role in how volatility evolves (Chart 3, bottom panel).5 Other factors are important to the evolution of volatility, as well - i.e., U.S. financial conditions, particularly the stress in the system as measured by the St. Louis Fed's Financial Stress Index; EM equity volatility; and y/y percent changes in WTI oil prices themselves (Chart 3). But spec positioning clearly dominates: In periods of rising or elevated volatility, it explains most of the change in WTI option implied volatilities (Chart 4). This can push volatility higher when it occurs. However, on the downside, this does not hold - Working's T Index is not material to the evolution of implied volatility when uncertainty about future oil prices is low or decreasing. Chart 3Key Variables##BR##Explaining Volatility Chart 4Spec Positioning Dominates##BR##Evolution of WTI Implied Volatility Working's T Index and implied volatility are independent of price direction - they are directionless, therefore they cannot be used to forecast prices.6 These variables tend to increase when the quality of information available to the market deteriorates - i.e., when it becomes more difficult to form expectations about future oil prices. This is, we believe, an attractive time for informed speculators to enter the market and use their information to make profits. We find two-way Granger-causality between WTI implied volatility and Working's T, when the annual change in excess speculation is one-standard deviation above or below its mean. This means the more specs are concentrated on one side of the market in the underlying futures - long or short - the more influence their positioning has on volatility, and that the higher volatility is the more specs are drawn to the market. Given that specs' beliefs are different, this means there is a rising number of long or short spec contracts relative not only to specs on the other side of the market, but also to long and short hedgers. Why Speculation Is Important Prices do not suddenly manifest themselves in markets fully aligned with fundamentals. They are made efficient by hedgers off-loading risk based on their marginal costs, and speculators uncovering information that is material to the level at which prices clear markets. The goal of speculation is to buy low and sell high. Hedging and speculation are both done in the presence of noise, or pseudo-information that has no real connection with where markets clear.7 Information is to noise as substance is to a void. Noise can look like information, as Black (1986) notes, and people can trade on it, but they will lose money and eventually go out of business. Information, on the other hand, is costly, as Grossman and Stiglitz (1980) point out. To incentivize someone (a speculator) to gather it and feed it into prices via the market clearing - i.e., buying and selling based on information - they have to be able to make a profit. Speculators supply the liquidity necessary for trading - and, most importantly, hedging - to occur. Successful speculators make profits. Therefore, the information on which they trade is more often germane to the market-clearing process than not. To be successful they have to be willing to buy when prices are low, expecting them to go higher, and to sell when prices are high, expecting them to go lower. As Paul Samuelson wryly observed, "Is there any other kind of price than 'speculative' price? Uncertainty pervades real life and future prices are never knowable with precision. An investor is a speculator who has been successful; a speculator is merely an investor who last lost his money."8 Known Unknowns Will Keep Vol Elevated Chart 5BCA's Oil Price Forecast Unchanged,##BR##Following Trump's Iran Announcement In the wake of Trump's announcement, the fundamental and geopolitical landscape has been re-cast, creating additional "known unknowns", particularly re how the U.S. will implement the renewed sanctions and the timing of these moves. Among the new known unknowns, which can only be resolved with the passage of time, are: The precise timing and extent of the re-imposed sanctions on the part of the U.S., which will evolve over the next 90 to 180 days. Demand-side implications of higher prices, particularly in EM economies where policymakers used the low prices following OPEC's 2014 - 16 market-share war to eliminate fuel subsidies, which prevented high prices from being experienced by their citizens. The supply-side implications of higher prices on U.S. shale production - does production and investment, including pipeline take-away capacity, take another leg higher? The Kingdom of Saudi Arabia's (KSA) ability to raise output, given the Kingdom said it would be raising output in the event Iranian volumes are lost to export markets. The fate of the Saudi Aramco IPO, and how the re-imposition of sanctions by the U.S. on Iran affects the royal family's decision on whether to float 5% of the company publicly. Will production in distressed states in- and outside of OPEC be negatively affected by increasing geopolitical risk?9 Among the "known unknowns," Iran's next moves rank high, as do responses to such moves by the U.S. and its allies. The U.S. and its Gulf allies clearly view Iran as a threat and, with the re-imposition of sanctions against Iran, are confronting it. Iran has a similar view vis-à -vis the U.S. and its Gulf allies. Left to be determined: Does Iran increase its level of direct action against KSA, upping the ante, so to speak, in its ongoing proxy wars with the Kingdom? Is Gulf production threatened? Are U.S. - European relations threatened by Trump's action? Thus far, European leaders have indicated they remain committed to the sanctions deal Trump walked away from. What would it take for OPEC 2.0 to restore actual production cuts we estimate at 1.1 to 1.2mm b/d to the market? What would it take to trigger a release of the U.S. Strategic Petroleum Reserve (SPR), estimated at just under 664-million-barrel, which could be released to the market at a rate of 500k to 1mm b/d? These known unknowns are not causing us to change our price forecast for this year - $74/bbl for Brent and $70/bbl for WTI, based on our fundamental modeling (Chart 5). However, we do think price risk is to the upside in both markets, given the elevated geopolitical tensions in the market. We continue to expect more frequent prices excursions to and through $80/bbl for the balance of the year, particularly for Brent. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 We lay out some of these "known unknowns" in BCA Research's Commodity & Energy Strategy Weekly Report "Tighter Balances Make Oil Price Excursions To $80/bbl Likely," published April 19, 2018. In addition to the Iran issues, which have been resolved, Venezuela looms large. Oil production declined by 900k b/d between December 2015 and March 2018, with half of that occurring in the past six months. We are carrying Venezuela's current production at ~ 1.5mm b/d, although other estimates have it lower. With the country moving closer to collapsing as a functioning state, the risk to its oil output and exports is high. 2 Granger-causality refers to an econometric test developed by Clive Granger, the 2003 Nobel laureate in economics. It determines whether past values of one variable can be said to predict, or cause, the present value of another variable. 3 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Specs Back Up The Truck For Oil," published April 26, 2018, available at ces.bcaresearch.com. See also the International Energy Agency's "Oil: Medium-Term Market Report 2012;" and "The Role of Speculation in Oil Markets: What Have We Learned So Far?" by Bassam Fattouh, Lutz Kilian and Lavan Mahadeva, published by The Oxford Institute For Energy Studies. Also, see "Speculation, Fundamentals, and The Price of Crude Oil," by Kenneth B. Medlock III, published by the James A. Baker III Institute for Public Policy at Rice University, August 2013. 4 This is the semi-strong form of market efficiency. For a discussion of how markets impound information in prices, please see Eugene Fama's Noble lecture, "Two Pillars of Asset Pricing," which was reprinted in the June 2014 issue of The American Economic Review (p. 1467). 5 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Specs Back Up The Truck For Oil," published April 26, 2018, in which we introduce Holbrook Working's "T Index," a measure of speculative concentration in futures and options markets. It is available at ces.bcaresearch.com. Briefly, Working's T Index shows how much speculative positioning exceeds the net demand for hedging from commercial participants in the market. Excessive speculation - spec positioning in excess of hedging demand by commercial interests - could be read into index values above 1.0. However, the U.S. CFTC notes values of Working's T at or below 1.15 do not provide sufficient liquidity to support hedging, even though "there is an excess of speculation, technically speaking." Formally, Working's T Index looks like this: 6 Please see Irwin, S. H. and D. R. Sanders (2010), "The Impact of Index and Swap Funds on Commodity Futures Markets: Preliminary Results", OECD Food, Agriculture and Fisheries Working Papers, No. 27. 7 Please see Black, Fischer (1986), "Noise," in the Journal of Finance, 41:3; and Grossman, Sanford J., and Stiglitz, Joseph E. (1980), "On the Impossibility of Informationally Efficient Markets," in the June issue of the American Economic Review. 8 Please see Samuelson, Paul A. (1973), "Mathematics Of Speculative Price," in the January 1973 SIAM Review, 15:1. 9 Please see "Geopolitical Certainty: OPEC Production Risks Are Playing To Shale Producers' Advantage," published by BCA's Energy Sector Strategy on May 9, 2018, which discusses these production risks in depth. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of April 30, 2018. There are no significant changes in the model's allocation this month, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD, %) As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 20 bps in April, largely driven by the Level 2 model which outperformed by 44 bps while the Level 1 model outperformed only by 2 bps. Since going live, the overall model outperformed the MSCI World by 156 bps, due to the 493 bps of outperformance from the Level 2 model which allocates funds among 11 non-U.S. countries. The Level 1 model (which allocates funds between U.S. and the non-U.S.) is on par with the MSCI world benchmark.Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Text below For more details on the models, please see Special Report, "Global Equity Allocation: Introducing The Developed Markets Country Allocation Model," dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of April 30, 2018. For the third consecutive month, the model maintains a defensive positioning generating an alpha of 60 bps for the month of April. Following the end of trade threats (for now), the growth component of the model has stabilized. But, overall the model maintains the same weights from last month with an aggregate tilt of 1.3% towards defensive sectors. Energy remains the only cyclical sector with an overweight on the back of favorable valuations and improving momentum. Among defensive sectors, utilities maintains a large overweight of 5% on the back of better momentum. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," dated July 27, 2016, available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Aditya Kurian, Senior Analyst adityak@bcaresearch.com
Highlights Corporate Bonds & The Yield Curve: Corporate bond excess returns fall sharply once the yield curve flattens to below 50 basis points, though they typically remain positive until the yield curve inverts. Interestingly, excess returns for equities relative to Treasuries exhibit the opposite pattern. Corporate Bonds & Leverage: The outlook for top-line corporate revenue growth is strong, but employee compensation costs will also rise this year. We are doubtful that corporate profit growth will keep pace with debt growth for the remainder of year, meaning that leverage is likely to rise. Rising leverage will be a signal to reduce exposure to corporate bonds. Bond Map: We perform a back-test to assess the effectiveness of the Bond Map framework for sector allocation that was introduced in last week's report. Feature It's been a while, but last week's bond market performance was reminiscent of an old fashioned risk-on phase. The 10-year Treasury yield reached its highest level since early 2014, causing a temporary halt in the yield curve's flattening trend. Spread product also responded to investor optimism, and returns from the investment grade corporate bond index now lag the duration-equivalent Treasury index by only 52 basis points year-to-date, up from a mid-March trough of -94 bps (Chart 1). High-Yield index returns also rebounded, and that index is now outpacing Treasuries by +150 bps so far this year. Chart 1Corporate Credit: Annual Excess Returns But for corporate bond investors, now is not the time for complacency. Out of the criteria we use to signal turns in the credit cycle, we are progressively checking more and more off our list.1 Spreads are already tight relative to history and corporate debt levels are already high. That much has been true for some time. Next up, we await a more restrictive monetary policy and a more severe slow-down in corporate profit growth to below the pace of corporate debt growth. Both of those conditions also need to be met before corporate defaults start to occur and spreads start to widen materially. In this week's report we consider each of those two conditions in turn, noting the triggers that will need to be hit for us to downgrade our current overweight allocation to corporate bonds. Condition 1: Restrictive Monetary Policy Chart 2Monetary Policy Not Yet Restrictive On the monetary policy front, we expect that monetary conditions will turn restrictive in the not-to-distant future (Chart 2). For the time being, long-maturity TIPS breakeven inflation rates are still below levels that are consistent with the Fed achieving its 2% inflation target. The 10-year TIPS breakeven inflation rate is currently 2.17% and the 5-year/5-year forward TIPS breakeven inflation rate is 2.24%. But once both of those rates reach a range between 2.3% and 2.5%, they will be consistent with well-anchored inflation expectations and the Fed will have one less reason to stay cautious. We will start paring exposure to corporate bonds once both the 10-year TIPS breakeven inflation rate and the 5-year/5-year forward TIPS breakeven inflation rate cross above the 2.3% threshold. The re-anchoring of inflation expectations will also impart further upside to nominal Treasury yields, and we therefore maintain our below-benchmark duration stance and continue to follow the road-map laid out in our February report detailing the two-stage Treasury bear market.2 Another traditional signal of restrictive monetary policy is a flat or inverted yield curve (Chart 2, panel 2). Intuitively, a very flat yield curve tells us that the market expects very few (if any) Fed rate hikes in the future. An inverted yield curve tells us that the market actually anticipates rate cuts. While the yield curve is not yet close to inverting, it is approaching levels that are consistent with much lower (and often negative) excess returns for both investment grade and high-yield corporate bonds, as is discussed below. A third indicator of the stance of monetary policy is simply the spread between the real federal funds rate and an estimate of its equilibrium level - the level consistent with neither an accommodative nor a restrictive policy stance (Chart 2, bottom panel). While the fact that the real fed funds rate is currently quite close to the popular Laubach-Williams estimate of its equilibrium level certainly reinforces our view that policy is almost restrictive, the large degree of uncertainty inherent in this sort of estimate leads us to prefer the market signals from the slope of the yield curve and TIPS breakeven inflation rates when forming an investment strategy. The Yield Curve And Corporate Bond Returns To assess the importance of the yield curve as a predictor of turns in the credit cycle, we split each cycle going back to the mid-1970s into regimes based on the yield curve slope. We then calculate excess returns during each phase for both investment grade and high-yield corporate bonds, as well as the stock-to-bond total return ratio. We use the 3/10 yield curve slope instead of the more often quoted 2/10 slope because it allows for the inclusion of more historical data. This decision did not materially impact the results of our analysis. Chart 3 shows how we divided each cycle into three phases: Chart 3Corporate Bond Performance And The Yield Curve Phase 1 runs from the end of the previous NBER-defined recession until the slope crosses below 50 bps. Phase 2 runs from the time that the slope crosses below 50 bps until it crosses below zero. Phase 3 runs from the time that the yield curve first inverts to the start of the next recession. Notice that we do not include recessionary periods in our analysis, usually the periods with the worst excess corporate bond returns. The results of our analysis are shown in Table 1, and the first obvious result is that corporate bond excess returns are much higher in Phase 1 than in Phase 2, although Phase 2 returns are usually still positive.3 Negative excess returns occur more often than not in Phase 3, after the yield curve has inverted. Table 1Risk Asset Performance In Different Yield Curve Regimes The biggest exception to the above observations is that Phase 2 High-Yield returns actually exceeded Phase 1 High-Yield returns in the 2001-07 cycle. In our view, this exception results from the fact that corporate profit growth was well above corporate debt growth in 2005, and did not really decline until 2007, shortly after the yield curve inverted. In contrast, Phase 2 returns were exceptionally weak in the prolonged period between 1994 and 2000. In this instance, corporate profit growth actually fell below corporate debt growth in 1998, well before the yield curve inverted in 2000. This reinforces that both the stance of monetary policy and the trend in corporate leverage matter for corporate bond returns. The latter is discussed in the next section of this report. Another interesting result shown in Table 1 is that the pattern of stock market excess returns over Treasuries is the mirror image of the pattern in corporate bond excess returns. The stock market tends to perform better in Phase 2 than in Phase 1, and often even performs well in Phase 3 after the yield curve has inverted. This means that multi-asset investors should consider paring exposure to corporate bonds relative to Treasuries before they think of reducing exposure to the stock market. Bottom Line: Restrictive monetary policy is one condition that must be met before we reduce exposure to corporate bonds in our recommended portfolio. The first indication of this will likely be the re-anchoring of long-maturity TIPS breakeven inflation rates in a range between 2.3% and 2.5%. We will start paring exposure to corporate bonds when that occurs. The slope of the yield curve is already at levels that are consistent with very low excess returns. Though we demonstrate that an inverted yield curve is historically linked to even lower returns. Conviction that the yield curve is about to invert will be another trigger to further reduce corporate bond exposure in the future. Condition 2: Rising Leverage The second condition that will cause us to take even more credit risk off the table is when gross leverage for the nonfinancial corporate sector - calculated as total debt over pre-tax profits - enters an uptrend. Chart 4 shows that periods of spread widening almost always coincide with rising gross leverage, or put differently, periods when the rate of debt growth exceeds the rate of profit growth. Profit growth has kept pace with debt growth during the past few quarters, causing leverage to flatten-off and allowing corporate spreads to narrow. Going forward, the outlook for top-line corporate revenue growth (a.k.a. net value added) remains favorable, owing to an ISM index that is well above the 50 boom/bust line and still climbing (Chart 5). But on the expense side of the ledger, employee compensation - the largest expense for the corporate sector - is also poised to increase in the months ahead. Unit labor costs jumped sharply in the fourth quarter of 2017 (Chart 5, panel 2), and with the unemployment rate at 4.1% and the economy still adding jobs at a robust pace - nonfarm payrolls have increased by an average of +211k during the past six months - a further acceleration in employee compensation is likely this year. Chart 4Corporate Leverage Has Flattened Off Chart 5Wage Growth Will Hamper Profits The key question then becomes whether corporations will be able to offset rising compensation costs by lifting prices. This remains uncertain, but early indications are not favorable. Our Profit Margin Proxy - the growth in the corporate sector's implicit selling price deflator relative to the growth in unit labor costs - does an excellent job tracking pre-tax profits (Chart 5, bottom panel). At the moment, this indicator signals that profit growth will moderate in the coming quarters. Bottom Line: The outlook for top-line corporate revenue growth is strong, but employee compensation costs will also rise this year. We are doubtful that corporate profit growth will keep pace with debt growth for the remainder of year. A decline in the rate of profit growth to below the rate of corporate debt growth will be another signal to reduce exposure to corporate bonds. The Bond Map Back-Test Last week we introduced the BCA Bond Map, a graphical depiction of the current risk/reward trade-off on offer from the different sectors of the U.S. bond market.4 To summarize, in our excess return Bond Map we plot the number of days of average spread tightening required for each sector to earn 100 bps of excess return on the vertical axis, and the number of days of average spread widening required for each sector to lose 100 bps versus Treasuries on the horizontal axis (Chart 6). The diagram is then split into four quadrants based on the location of the Bloomberg Barclays Aggregate index, which we have modified to also include junk bonds. The upper-left quadrant, which we label "Best Bets", contains those sectors that offer less risk and greater excess return potential than the benchmark. The upper-right quadrant, which we label "Exciting", contains those sectors that offer higher risk than the benchmark but also higher potential returns. The bottom-left ("Boring") quadrant contains those sectors with low risk of losses but also low probability of gains, and the bottom-right ("Avoid") quadrant contains those sectors with higher risk than the benchmark and lower expected returns. As can be seen in Chart 6, the current excess return Bond Map shows that Local Authorities, Foreign Agencies and investment grade corporate bonds offer the best combination of risk and expected return. No sectors currently plot in the "Avoid" quadrant. Chart 6Excess Return Bond Map (As Of April 20, 2018) This week, we publish the results of a back-test of the real time performance of our Bond Map. To do this we produced the Bond Map at the beginning of each calendar year starting in 2006 and then calculated average excess returns for each quadrant. For example, if three sectors were in the "Best Bets" quadrant at the beginning of the year, we calculated 12-month excess returns for each sector and then averaged them together to get an excess return for "Best Bets" sectors that year.5 Table 2 shows the average and standard deviation of calendar year excess returns for each quadrant, using a sample that spans from 2006-2017. As would be expected, the "Exciting" quadrant displays the highest average excess return, but also the highest standard deviation. Conversely, the "Boring" quadrant delivers the lowest average return and the lowest risk. The performance of the "Best Bets" quadrant is somewhere in between, delivering a greater average return than the "Boring" quadrant with less risk than the "Exciting" quadrant. Although the Sharpe Ratio for the "Best Bets" quadrant turns out to be worse than the Sharpe ratio for both the "Exciting" and "Boring" quadrants. This provides some support for the investment strategy of favoring either the "Exciting" or "Boring" quadrants depending on your assessment of the macro environment. The "Avoid" quadrant actually delivered negative excess returns on average, with elevated risk. Table 2Excess Return Bond Map Track Record (2006-2017) For comparison we also show the average and standard deviation of excess returns for the Bloomberg Barclays Aggregate index, augmented with High-Yield. The benchmark delivered excess returns only slightly greater than the "Boring" quadrant, with significantly more risk. The total return version of the Bond Map is shown in Chart 7. This is identical to the excess return Bond Map, except it shows the number of days of average increase/decrease in yields for each sector to lose/earn 5% total return. We perform the identical back-test as with the excess return map, and display the results in Table 3. Chart 7Total Return Bond Map (As Of April 20, 2018) Table 3Total Return Bond Map Track Record (2006-2017) Here we see the interesting result that the average total returns are higher in the "Best Bets" quadrant than in the "Exciting" quadrant, but strangely the "Best Bets" quadrant also delivered greater volatility. The "Boring" quadrant delivered the best Sharpe Ratio, while the "Avoid" sector delivered both lower average returns and greater volatility than the "Boring" quadrant. For comparison, the average total returns for the Aggregate index (plus High-Yield) were lower than the total returns from any of the four quadrants, but also with less volatility. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 We define the "turn" in the credit cycle as when corporate defaults start to occur and corporate spreads enter a sustained widening phase. 2 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 3 For the Phase 1 period in Cycle 2 we use an interval of June 1983 to July 1988 because High-Yield excess returns are only available starting in June 1983. In reality, the Phase 1 period should have started when the prior recession ended in December 1982. Using the correct interval (starting in December 1982) investment grade corporate bond excess returns are +131 bps and the stock-to-bond ratio returns are +5.19%, both annualized. 4 Please see U.S. Bond Strategy Weekly Report, "Back To Basics", dated April 17, 2018, available at usbs.bcaresearch.com 5 We started our back-test sample in 2006 even though our sector data goes back to 2000. Because our bond map relies on historical estimates of spread/yield volatility, we wanted a sample of at least five years of data before starting the test. With each passing year more back-data is incorporated into our spread/yield volatility estimates, which should improve the Bond Map's accuracy over time. Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Global corporate bond markets have seen both ups and downs so far in 2018. Credit spreads in the developed markets and emerging markets, both for investment grade (IG) and lower quality credit tiers, tightened in January. This was followed by a sharp widening of spreads in the two months after the "VIX spike" in early February. Spreads have begun narrowing again in April, but remain above levels that began the year in all major countries with one notable exception - U.S. high-yield. Feature The volatility in corporate credit is a reflection of the growing list of investor worries, coming at a time when yields and spreads still remain near historically low levels in almost all markets. Topping that list is the fear that low unemployment and rising inflation rates will force the major central banks to maintain a more hawkish (or, at least, less dovish) policy bias in the medium term, even with the global economy losing some upside momentum so far this year after a robust 2017. Add in other concerns over U.S. trade policy (i.e. tariffs), U.S. fiscal policy (i.e. wider deficits, more U.S. Treasury issuance) and even signs of potential stresses in global funding markets (i.e. wider LIBOR-OIS spreads), and it is no surprise that more uncertain investors have become less comfortable with the risks stemming from credit exposure. This can be seen in the volatility of mutual fund and ETF flows into riskier bond categories like U.S. high-yield (HY), which saw a whopping -$19.8bn in outflows in Q1/2018, but has already seen +$3.8bn in inflows in April - possibly in response to the surprisingly strong results seen in Q1 U.S. corporate earnings reports.1 Against this backdrop of more uncertainty in credit markets, we are presenting our latest update of the BCA Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) that are designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 16. In this CHM Chartbook, we introduce new country coverage to our CHM universe, adding a bottom-up measure for Japan and both top-down and bottom-up CHMs for Canada. After these new additions, we now have CHMs covering 92% of the Barclays Bloomberg Global Corporate Bond Index universe, based on country market capitalization weightings. The broad conclusion from the latest readings on our CHMs is that global credit quality has enjoyed a cyclical improvement in response to the coordinated growth seen in 2017, but with important geographical differences (Chart 1): Chart 1Global Corporates: Now Supported##BR##By Growth, Not Central Banks Credit quality in the U.S. has improved on the back of the solid performance of U.S. profits over the past year, but high leverage and low interest coverage suggest corporates are highly vulnerable to any slowing in economic growth Underlying credit quality in euro area corporates remains supported by low interest rates and the easy money policies of the European Central Bank (ECB), but the CHMs are trending in the wrong direction due to poor profitability metrics - most notably, a very depressed return on capital - and rising leverage among core European issuers U.K. corporate health continues to benefit from a very robust short-term liquidity position, although sluggish profitability and weak interest coverage suggest potential medium-term problems beneath the surface Japanese corporates are in good shape, enjoying strong interest coverage and low leverage, although absolute levels of profitability remain much lower than the other countries in our CHM universe Canadian corporate health has enjoyed some modest cyclical improvement, but low absolute levels on profitability and interest coverage, combined with high leverage, point to underlying risks. Looking ahead, the tailwinds that have supported corporate health and the performance of global corporate debt in the past couple of years - a coordinated cyclical upturn driving solid earnings growth, with low inflation allowing monetary policies to stay accommodative - are becoming headwinds. Inflation expectations are moving higher in most countries, fueled by low unemployment rates and rising oil prices. This is most evident in the U.S., where the additional boost to growth from fiscal stimulus will keep the Fed on its rate hiking path over the next year. A mild inflation upturn is also visible in the euro area and Japan, where the ECB and Bank of Japan (BoJ) are already contributing to a less favorable liquidity backdrop for corporates by reducing the pace of their asset purchases. That trend is projected to continue over the next year, to the detriment of credit market returns that have been boosted by those unusual monetary policies (see the bottom panel of Chart 1). At some point within the 6-12 months, more hawkish central banks will act to slow global economic growth, triggering a more fundamental underperformance of corporates versus government bonds. For now, the backdrop remains supportive, but the clock is ticking as the end of this credit cycle draws closer. U.S. Corporate Health Monitors: A Cyclical Improvement, But Underlying Problems Persist Our top-down CHM for the U.S. has been flashing "deteriorating health" for fourteen consecutive quarters dating back to the middle of 2014 (Chart 2). Yet there has been a modest cyclical improvement seen in many of the individual CHM ratios over the past couple of years - most importantly, return on capital and profit margins - helping push the top-down level to close to the zero line. It is important to note that, due to delays in the reporting of the data used in the top-down U.S. CHM, the latest reading is only from the 4th quarter of 2017.2 A move into "improving health" territory in the 1st quarter of 2018 would require additional increases in cyclical profitability measures. This will be difficult to achieve with U.S. economic growth cooling off a bit in the first three months of 2018 (although the enactment of the Trump corporate tax cuts will likely help support the after-tax measure of margins used in the top-down CHM as 2018 progresses). From a longer-term perspective, the fact that the top-down CHM return on capital metric is well off the post-crisis peak is a disturbing development, given that non-financial corporate profit margins have been stable over the same period. This suggests a more fundamental problem with weak U.S. productivity growth and lower internal rates of return on marginal investments for companies, which is a longer-term concern for U.S. corporate health when the economic growth backdrop becomes less friendly. The bottom-up versions of the U.S. CHMs for IG corporates (Chart 3) and HY companies (Chart 4) have also both improved, with the HY indicator sitting right at the zero line. This confirms that the signal from our top-down CHM is being reflected in both higher-rated and lower quality companies. Yet the longer-term problems of high leverage and low returns on capital are not going away. In particular, HY interest and debt coverage remains near multi-decade lows. Chart 2Top-Down U.S. CHM:##BR##A Cyclical Pause Of A Structural Deterioration Chart 3Bottom-Up U.S. Investment Grade CHM:##BR##A Bit Better, But Still Deteriorating What is rather worrying is the fact that IG interest coverage has fallen in recent years, despite high profit margins and historically low corporate borrowing rates. This indicates that the stock of debt has now expanded to a point where the interest expense required to service that debt is eating up a greater share of corporate earnings, even at a time when profit growth is still quite strong. This will raise downgrade risk if corporate borrowing rates were to increase significantly or the U.S. experiences a major economic downturn. Interest costs would rise while earnings deteriorate, which would push interest coverage to historic lows, as was discussed in a recent report from our flagship Bank Credit Analyst service.3 For now, we are still recommending playing the growth phase of the business cycle by staying overweight U.S. corporate debt within global fixed income portfolios (Chart 5). The time to scale back positions will come after U.S. inflation expectations rise to levels consistent with the Fed's inflation target (i.e. when both the 5-year/5-year forward U.S. TIPS breakeven and the outright 10-year TIPS breakevens reach 2.4-2.5%). This will give the Fed confidence to follow through on its rate hike projections, pushing the funds rate to restrictive levels. In turn, that will dampen future corporate profit expectations and raise risk premiums on U.S. corporate bonds. With those breakevens now sitting at the highest point in four years (2.19%), that tipping point for credit markets is drawing nearer. Chart 4Bottom-Up U.S. High-Yield CHM:##BR##A Strong Cyclical Improvement Chart 5The Beginning Of The End Of##BR##The U.S. Credit Cycle Euro Corporate Health Monitors: Getting Better Thanks To The Economy & The ECB Our top-down Euro Area CHM remains in "improving health" territory, as it has for the entire period since the 2008 crisis. The trend in the indicator has been steadily worsening since 2015, however, and the top-down CHM now sits just below the zero line (Chart 6). The steady deterioration of the top-down CHM is due to declines in profit margins, return on capital and debt coverage. This is offsetting the high and rising levels of short-term liquidity and interest coverage, which are being supported by the easy money policies of the ECB (negative short-term interest rates, liquidity programs designed to prompt low-cost bank lending, and asset purchase programs that include buying of corporate bonds). Compared to the top-down CHMs we have constructed for other countries, there is an even longer lag on data availability from euro area government statisticians. Our top-down euro area CHM is only available to the 3rd quarter of 2017 and, therefore, does not reflect the strong performance of the euro area economy at the end of last year. Our bottom-up versions of the euro area CHMs for IG (Chart 7) and HY (Chart 8), which are based on individual earnings data that is more timely, both show that corporate health continued to improve at the end of 2017. Return on capital for euro area IG issuers (both domestic issuers and foreign issuers in the European bond market) is between 8-10%, similar to the level in the bottom-up U.S. IG CHM but higher than the equivalent measures in our U.K., Japan and Canada CHMs. Both interest coverage and liquidity ratios for euro area IG are also close to U.S. IG levels. The euro area HY CHM is also showing improvement though declining leverage, although these results should be interpreted with caution as the sample size is relatively small. Chart 6Top-Down Euro Area CHM:##BR##Health Improving At A Diminishing Rate Chart 7Bottom-Up Euro Area##BR##Investment Grade CHMs: Steady Improvement Within the Euro Area, our bottom-up CHMs show that the gap has closed between issuers from the core countries versus those in the periphery, but all still remain in the "improving health" zone. (Chart 9). Return on capital, interest coverage and debt coverage are higher in the core, while liquidity is better in the periphery despite more highly levered balance sheets. Chart 8Bottom-Up Euro Area High-Yield CHMs:##BR##Steady Improvement As Leverage Declines Chart 9Bottom-Up Euro Area IG CHMs:##BR##Core Vs. Periphery While all of our euro area CHMs are indicating healthier balance sheets, that fact is already discounted in the low yields and tight spreads for both IG and HY issuers (Chart 10). Euro area corporates are also benefitting from the supportive bid of the ECB, which buys credit as part of its asset purchase program. We expect the ECB to fully taper its government bond purchases by the end of 2018, while continuing to reinvest the proceeds of maturing debt in 2019 and beyond. It is less clear what the ECB will do with its corporate bond buying program, and there has been some speculation that the ECB could leave its corporate program untouched while tapering the government purchases. That would be a scenario that could be keep euro area credit spreads tight, although the momentum in the euro area economy will likely be the more important driver of credit valuations. If the soft patch in growth seen in the first few months of 2018 continues in the coming months, euro area credit spreads would likely widen, although by less than if the ECB was not buying corporates. We have preferred to own U.S. corporates over Euro Area equivalents for much of the past year. The gap between our top-down CHMs for the U.S. and Europe has proven to be an excellent directional indicator for the relative performance of U.S. credit vs. Europe (Chart 11). That CHM gap continues to favor U.S. credit, although that has not yet flowed through into any meaningful outperformance of U.S. IG and HY corporates. Chart 10European Credit:##BR##Spreads & Yields Have Bottomed Out Chart 11Relative Top-Down CHMs##BR##Still Favor The U.S. Over Europe U.K. Corporate Health Monitor: Still No Major Causes For Concern The top-down U.K. CHM remains firmly in the "improving health" zone, led by cyclical improvements in profit margins and interest coverage, combined with very strong short-term liquidity (Chart 12). Return on capital remains near 20-year lows around 6%, however, mirroring levels seen in this ratio in the CHMs for other countries. Profit margins remain at 20%, near the middle of the historical range. U.K. credit has benefitted from highly stimulative monetary policy settings by the Bank of England (BoE) - especially after the 2016 Brexit shock when the central bank not only lowered policy rates, but announced bond buying programs for both Gilts and U.K. corporates. The BoE has begun to take back some of that monetary easing by raising rates 50bps since last November. However, we remain skeptical that the central bank will be able to deliver much additional tightening over the rest of 2018 given sluggish growth, falling realized inflation and lingering Brexit uncertainties weighing on business confidence. An environment of mushy domestic growth and a stand-pat central bank would typically be good for risk assets like corporate credit. Yet both yields and spreads have been drifting higher in recent months, mirroring the trends seen in other global corporate bond markets (Chart 13). It is difficult to paint a scenario of renewed outperformance of U.K. credit versus Gilts without a fresh catalyst like accelerating growth or monetary easing. Yet the combination of accommodative monetary policy with a solid credit backdrop leads us to maintain a neutral recommendation on U.K. corporate debt. Chart 12U.K. Top-Down CHM:##BR##Steady Improvement Chart 13U.K. Credit: Yields & Spreads##BR##Are Drifting Higher Japan Corporate Health Monitor: A Small, But Very Healthy, Market We introduced our Japan CHM in a recent Weekly Report.4 We only have a bottom-up version of the indicator at the moment, as there is not the same consistency of top-down data sources as are available in other countries. Furthermore, the Japanese corporate bond market is small, as companies have historically chosen to borrow money (when needed) through bank loans and not bond issuance. This means that we have a much more limited amount of data available with which to build a Japan CHM, which covers only 43 companies and only goes back to 2006. The Japan CHM has been in "improving health" territory for the past decade, driven by very healthy liquidity levels and rising return on capital and interest coverage (Chart 14). While the trend in the latter two ratios differs from what is shown in all CHMs for other countries, it is noteworthy that Japan's return on capital has risen to a "high" level (6%) that is similar to the current historically low levels in the U.S. and Europe. The comparison is even less flattering when looking at profit margins, which have been steadily improving over the past five years but are only around 6% - less than half the levels seen in the bottom-up IG CHMs for the U.S. and Europe. Turning to the corporate spread, it has slightly widened in 2018, but by a far smaller amount than seen in other corporate bond markets (Chart 15). We have shown that Japanese corporate spreads are highly correlated to the level of the yen. The direct effect is obvious, as a stronger yen will hurt the competitiveness and profitability of the exporter-heavy Japanese non-financial corporate sector. Yet a strong yen is also a reflection of the market's belief in the next move by the BoJ with regards to Japanese monetary policy. On the front, we continue to expect the BoJ to maintain a very dovish policy stance, with no change in the central bank's interest rate targets (both for short-term interest rates and the 10yr JGB yield). The bigger issue will be if the current softness in the Japanese economic data turns into a broader trend, which would damage corporate profits and likely result in some widening of Japanese credit spreads.  Chart 14Japan Bottom-Up CHM:##BR##Very Healthy Chart 15Japanese Corporates##BR##Will Continue To Outperform JGBs Canada Corporate Health Monitor: In Good Shape On A Cyclical Basis In this CHM Chartbook, we are introducing new CHMs for Canada. Like Japan, this is another relatively small market. Canadian corporates represent a slightly larger share of the Bloomberg Barclays Global Investment Grade Corporate Bond Index (5%) than Japan (3%). The average credit rating of the Canadian corporate bond index is A2/A3, which is higher quality than that of the U.S. IG index with but with similar credit spreads over their respective government bonds. However, due to the lack of liquidity and market accessibility, Canadian corporates are considered a niche market that has not gained much attention from global investors. We created both a top-down and bottom-up version of the Canada CHM. For the bottom-up CHM, we gathered data on 85 companies from both the Bloomberg Canadian dollar-denominated IG and HY indices. We combined IG and HY bonds into one set of data given the small sample sizes of each category, which also allows us to compare it to the top-down Canadian CHM that does not distinguish by credit quality. Both Canadian CHMs are firmly in the "improving health" territory (Chart 16). Unsurprisingly, these CHMs have shown a reasonably strong correlation to oil prices, which are a key driver of the Canadian economy through the energy sector. This can be seen in the deterioration in the CHMs after global oil prices collapsed in 2014/15, and the subsequent improvement as oil prices have recovered over the past couple of years. Going through the individual CHM components, leverage has been steadily rising and currently sits around 100%. While Canada's problems with high household debt levels are well known, the Bank for International Settlements (BIS) noted in its March 2018 Quarterly Review that high Canadian corporate leverage could also pose a future problem for the Canadian economy.5 Among the other CHM ratios, return on capital and profit margin have fallen for nearly a decade, although there has been some moderate improvement of late thanks to higher oil prices. Debt coverage and interest coverage are also showing some very moderate recovery due to low interest rates - a trend also observed in other countries where central banks have maintained easy monetary policy. Canadian corporate bond valuations are not cheap at the moment, with the index spread around decade-lows of 100bps (Chart 17). BCA's commodity strategists expect global oil prices to continue climbing over the next year, which should support Canadian corporate valuations versus government bonds given past correlations. We also expect the Bank of Canada to continue to slowly raise interest rates over the next year, as well, mimicking moves we also anticipate from the U.S. Federal Reserve. Given the cyclical signs of improving corporate health from our Canadian CHMs, and our bearish views on Canadian government bonds, we are upgrading our recommended allocation on Canadian corporates to overweight while downgrading governments. This is strictly a carry trade, however, as we do not anticipate spreads narrowing much from current levels. Chart 16Canada CHMs:##BR##Cyclical Improvements, Structural Problems Chart 17Canadian Corporates:##BR##No Cyclical Case For Spread Widening Yet Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Top-down CHMs are now available for the U.S., euro area, the U.K. and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.6 The financial data of a broad set of individual U.S. and euro area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Table 1Definitions Of Ratios##BR##That Go Into The CHMs Appendix Chart 1We Now Have CHM Coverage For 92% Of##BR##The Developed Market Corporate Bond Universe 1 http://lipperalpha.financial.thomsonreuters.com/2018/04/high-yield-bond-funds-attract-investor-attention/ 2 The majority of data used in the top-down U.S. CHM comes from the Federal Reserve's quarterly Financial Accounts Of The United States Z1 release (formerly known as the Flow of Funds), which is typically published in the third month following the end of a quarter. Thus, those data inputs for Q1/2018 will not be available until June. 3 Please see Section II of the March 2018 edition of The Bank Credit Analyst, available at bca.bcaresearch.com. 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Sticking With The Plan", dated March 13th 2018, available at gfis.bcaresearch.com. 5 https://www.bis.org/publ/qtrpdf/r_qt1803.htm 6 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors 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 Our indicators suggest that investors should be especially cautious in the next month or two. April's Beige Book supports our view that higher inflation will lead to at least three more Fed rate hikes this year. However, the nation's trade policy is a concern for businesses. BCA's Bankers' Beige Book is booming. The Q1 earnings reporting season is off to a strong start, with both EPS and revenue growth exceeding consensus expectations at the start of April. Feature U.S. equity prices may struggle in the next few months. BCA's base case is that global growth will stabilize at an above-trend pace. Fiscal policy is a tailwind and global monetary policy remains easy, although several central banks are removing some of the accommodation. Moreover, the Fed sees only moderate risks to financial stability at home and abroad, its latest Beige Book is upbeat amid concerns over trade and labor shortages, and the Q1 earnings season is off to a strong start. BCA's Bankers' Beige Book for Q1 is booming. Nonetheless, BCA's Global Investment Strategy's MacroQuant model1 suggests that equities will struggle in the short-term. In our Bank Credit Analyst publication, the Equity Scorecard (Chart 1) and its Bear Market Checklist (Table 1) are both flashing red.2 The U.S.-China trade spat will linger for several more months and trade protectionism remains a risk. BCA's Geopolitical Strategy service notes that the stock market will likely seesaw during the summer as confusion grows amidst the upcoming geopolitical event risk (Table 2).3 Markets could also dip on Iran-U.S. tensions, an escalation of the conflict in Syria and a Russia-West confrontation. Indeed, sanctions on Russia are already pushing some base metal prices higher. Moreover, oil prices are more susceptible to supply disruptions given the tightness of global oil markets (Chart 2). BCA views any spike in oil prices as a tax on U.S. consumers. Chart 1Equity Scorecard: Flashing Red Table 1Exit Checklist Table 2Protectionism: Upcoming Dates To Watch Chart 2Oil Markets Are Tight Bottom Line: The 12-month cyclical outlook is still reasonably positive for risk assets such as stocks. Nonetheless, the near-term is fraught with risk. Our indicators suggest that investors should be especially cautious in the next month or two. Focus On Financial Stability Chart 3FOMC Is Closely Monitoring##BR##Financial Stability BCA views financial stability as a third mandate4 for the Fed, along with low and stable inflation, and full employment. Financial stability was not discussed at the FOMC's March 20-21 meeting, despite the spike in financial market volatility in early February. At the prior meeting in January, Fed staff continued to characterize financial vulnerabilities of the U.S. financial system as moderate on balance, but they declined to provide an assessment of foreign financial stability (Chart 3). However, in November 2017, Fed staff highlighted specific vulnerabilities in various foreign economies, including weak banks, heavy indebtedness in the corporate and/or household sector, rising property prices, overhangs of sovereign debt and significant susceptibility to various political developments. The Fed does not provide a financial stability grade at every meeting. Fed staff described financial conditions as moderate in September and December 2013, and then again in April 2014. The next assessment was only in January 2016 but since then, it has upped its discussions. Fed staff provided an assessment of financial stability in 8 of its 16 subsequent meetings. FOMC participants debated the issue at all but 1 of its 8 meetings in 2017, and in 13 of the 16 since April 2016. Fed Chair Jay Powell has followed his predecessor's lead in highlighting financial stability. Former Chair Janet Yellen elevated the topic during her tenure, leading discussions or staff briefings in 26 of the 32 meetings she presided over. The February 2018 edition of the Fed's semiannual Monetary Policy Report (MPR),5 which was the first one in Powell's tenure, has a full section devoted to financial stability. The report characterized the vulnerabilities of the financial system as moderate. Every MPR since July 2013 has provided an update on financial stability. Powell addressed financial stability in a June 2017 speech when he was a Fed governor and also reviewed the concern at his Senate confirmation hearing in November 2017. Moreover, in March's post-FOMC news conference, Powell answered a question about market bubbles by detailing the FOMC's approach to financial stability, and reiterated that financial vulnerabilities were "moderate." The San Francisco Fed noted that a more restrictive monetary policy could pose risks to financial stability.6 A surprise tightening can pressure U.S. bank balance sheets via higher market leverage. Moreover, a higher fed funds rate often leads to an expansion of assets held by money market funds (MMFs) (Chart 4). It concluded that during the 2007-2009 crisis, funding problems for MMFs spread across to the financial system and infected the real economy. In October 2016, the SEC introduced reforms aimed at targeting instability in the MMF sector. Still, the FOMC will closely watch MMF flows as the tightening cycle continues. Chart 4Money Market Funds And The Fed Funds Rate Bottom Line: BCA expects the Fed to remain vigilant about financial stability, but this means that rates will increase only gradually despite below-target inflation. The central bank must find the optimal pace to encourage employment and stable prices while guarding against financial excesses developing if policy stays too loose for too long. Beige Book Highlights The Beige Book released last week ahead of the FOMC's May 1-2 meeting suggested that uncertainty surrounding U.S. trade policy was an important headwind in March and early April. The Fed's business and banking contacts mentioned either tariffs or trade policy 44 times in the Beige Book; there were only 3 mentions in the March edition. Moreover, uncertainty came up nine times in April (Chart 5, panel 5) and eight were related to trade policy. There were just two mentions of the word in the March Beige Book. BCA's view is that trade-related uncertainty will persist through at least mid-year.7 Chart 5Latest Beige Book Supports##BR##The Fed's View On Rates, Inflation and Economy BCA's quantitative approach8 to the Beige Book's qualitative data continues to point to underlying strength in the U.S. economy, a tighter labor market and higher inflation. Moreover, references to a stronger dollar have disappeared from the Beige Book. Chart 5, panel 1 shows that at 55% in April, BCA's Beige Book Monitor dipped to its lowest level since November 2017 when doubts over the tax bill weighed on business sentiment. The number of "weak" words in the Beige Book remained near four-year lows; the number of strong words returned to last summer's hurricane levels. The tax bill was noted five times in the latest Beige Book, down from 15 in March and 12 in January. The legislation was cast in a positive light in five of six mentions. Based on minimal references to a robust dollar in the past seven Beige Books, the greenback should not be an issue for corporate profits in Q1 2018. The handful of references sharply contrasts with 2015 and early 2016 when there were surges in Beige Book comments (Chart 5, panel 4). The last time that seven consecutive Beige Books had so few remarks about a strong dollar was in late 2014. BCA's stance is that the dollar will move modestly higher in 2018. The disagreement on inflation between the Beige Book and the Bureau of Labor Statistics widened in April's Beige Book (Chart 5, panel 3). The number of inflation words in the Beige Book rose to a nine-month peak in April, nearly matching the cycle high hit in July 2017. Core PCE also increased in early 2018. However, in the past year, inflation measured by the PCE deflator and CPI failed to match the escalation in inflation references. In the past, increased remarks about inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. April's Beige Book continued to highlight labor shortages, especially among skilled workers in key areas of the economy. Several contacts noted trouble finding moderately skilled workers in the manufacturing sector. Additionally, a lack of truck drivers, IT and software employees, and construction workers were often cited. Table 3 shows industries with labor shortages. In the year ended March 2018, the gain in average hourly earnings in most of the industries was faster than average. Moreover, in nearly all these categories, labor market conditions are currently the tightest since before the onset of the 2007-2009 recession. More details can be found in a recent Fed study on labor shortages in the manufacturing sector.9 BCA's Beige Book Commercial Real Estate (CRE) Monitor10 remains in a downtrend (Chart 6). The Fed has highlighted valuation concerns in CRE and BCA's Global Investment Strategy service recently stated that the sector is increasingly vulnerable.11 Table 3Labor "Shortages" Identified##BR##In The Beige Book Chart 6Beige Book Commercial##BR##Real Estate Monitor Bottom Line: April's Beige Book supports our view that higher inflation will lead to at least three more Fed rate hikes by the end of the year. Labor shortages may be spreading from highly skilled to moderately skilled workers. The nation's tax policy still gets high marks from the business community, but ongoing concerns over trade policy will restrain growth. Bankers' Beige Book Booming Chart 7Bankers' Beige Book BCA's Big 5 Bank Lending Beige Book12 for Q1 2018 highlights several positive trends in the financial sector. All five banks were uniformly upbeat about loan growth, although there was some unease about commercial real estate loans. Chart 7 shows key banking-related variables cited in the Bank Lending Beige Book. Appendix Table 1 shows the Big 5 Bank Lending Beige Book for Q1 2018. Several bank executives noted that Q1 was a seasonally weak time for loan growth. Comments on the credit quality of the banks' loan and credit card portfolios were equally positive. Bank managements highlighted how higher rates have improved their net interest margins in Q1 and noted that further Fed rate hikes would benefit operations. Moreover, our panel of bank CFOs and CEOs cited the positive impact of the 2017 Tax Cut and Jobs Act on their businesses via better loan growth, stronger capital market activity and more capital spending. Several noted that their corporate clients are also experiencing benefits from the tax bill. Bottom Line: The banking system is humming. Lenders are ready to extend credit to businesses and consumers to boost the economy despite higher rates. The tax bill continues to be a positive for banks and their corporate clients. BCA's U.S. Equity strategists recommend an overweight position in the S&P 500's financial sector, with a high conviction overweight on banks.13 Strong Start The Q1 reporting season is off to a strong start, with both EPS and revenue growth exceeding consensus expectations at the start of April. We previewed the S&P 500's Q1 2018 earnings earlier this month.14 Just under 15% of companies have reported results thus far, with 77% beating consensus EPS projections, which is well above the long-term average of 69%. Furthermore, 75% posted Q4 revenues over expectations, exceeding the long-term average of 56%. The surprise factor for Q1 stands at 5% for EPS and 2% for sales. Both readings are right at the average surprise recorded in the past five years. The surprise figures are even more impressive given that analysts bumped up their Q1 assessments in 10 of 11 sectors between the start of 2018 and the beginning of the Q1 reporting season. Analysts' estimates typically move lower as a quarter unfolds, which has the effect of lowering the bar for results. Table 4S&P 500: Q1 2018 Results* We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning in mid-2018. Nonetheless, initial results imply that Q1 will be another quarter of margin expansion. Average earnings growth (Q1 2018 versus Q1 2017) is stout at 19% with revenue growth at 8%. However, on a four-quarter basis, U.S. margins fell slightly in the fourth quarter. Still, they remain at a high level on the back of decent corporate pricing power. Strength in earnings and revenues is broadly based (Table 4). Earnings per share rose in Q1 2018 versus Q1 2017 in all 11 sectors. EPS results are particularly robust in energy (71%), financials (29%), materials (27%) and technology (24%). The energy, materials and technology sectors likewise all experienced substantial sales gains (14%, 12% and 14% respectively). Excluding energy, S&P 500 profits in Q1 2018 versus Q1 2017 are still vigorous at 18%. Our U.S. Equity Strategy service introduced profit models for the S&P 500's sectors in January.15 Optimistic managements have raised the bar significantly for 2018 results in the past few months (Chart 8). On October 1, 2017, before the GOP introduced the tax bill, the bottom-up estimate for the S&P 500's 2018 EPS growth stood at 11%. As of April 19, 2018, the estimate is 20%. Moreover, the upward revisions are widespread. Calendar year 2018 EPS growth rate estimates in 10 of 11 sectors are higher today than at the start of October 2017. Chart 8The Bar Is High For 2018 EPS; Focus Should Shift To 2019 Soon While the ebullience is due to the tax bill, solid global growth, a steeper yield curve and higher energy prices are also responsible. The tax bill lowered the corporate tax rate for 2018 and the repatriation holiday provides firms with excess cash. As noted in the previous section, U.S. trade policy is a concern in several industries. Table 5 reports the Q4 2017 profit and sales performance of globally - and domestically - oriented firms (Q1 data will be available later this quarter). At year-end, domestic firms' earnings and revenue surprise outpaced that of global industries. However, global firms saw more robust sales and EPS growth than companies with sales mainly from domestic sources. Analysts expect EPS growth to slow considerably in 2019 from the anticipated 2018 clip, which matches BCA's view (Chart 9). However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in early 2020. Table 52017 Q4 Earnings##BR##Breakdown Chart 9Strong S&P 500 EPS Growth Ahead,##BR##Will Start To Slow Soon Bottom Line: EPS growth is expected to peak at over 20% later this year (4-quarter moving total basis using S&P 500 data). Growth is expected to decelerate thereafter since we have factored in a modest margin squeeze as U.S. wage growth picks up (Chart 9). The incorporation of the fiscal stimulus lifted the U.S. EPS growth profile relative to our previous forecast. Nonetheless, BCA believes that the earnings backdrop will remain a tailwind for the equity market. The Tax Cut and Job Act raised expectations for 2018 in most sectors and so far, corporate managements have exceeded the lofty projections. However, it may be more difficult to maintain in the second half of 2018. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Global Investment Strategy Weekly Report "Is China Headed For A Minsky Moment?," dated April 13, 2018. Available at gis.bcaresearch.com. 2 Please see BCA Research's Bank Credit Analyst Monthly Report, dated February, 2018. Available at bca.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report "Expect Volatility... Of Volatility," dated April 11, 2018. Available at gps.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017. Available at usis.bcaresearch.com. 5 https://www.federalreserve.gov/monetarypolicy/2018-02-mpr-summary.htm 6 https://www.frbsf.org/economic-research/publications/economic-letter/2018/february/monetary-policy-cycles-and-financial-stability/ 7 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," April 4, 2018. Available at gps.bcaresearch.com. 8 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Great Debate Continues," April 17, 2017. Available at usis.bcaresearch.com. 9 https://www.federalreserve.gov/econres/notes/feds-notes/evaluating-labor-shortages-in-manufacturing-20180309.htm 10 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Summer Stress Out", dated July 3, 2017. Available at usis.bcaresearch.com. 11 Please see BCA Research's Global Investment Strategy Weekly Report, "Three Tantalizing Trades - Four Months On", dated January 19, 2018. Available at gis.bcaresearch.com. 12 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Commitments," January 20, 2014. Available at usis.bcaresearch.com. 13 Please see BCA Research's U.S. Equity Strategy Weekly Report, "High Conviction Calls," dated November 27, 2017. Available at uses.bcaresearch.com. 14 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Policy Peril," dated April 9, 2018. Available at usis.bcaresearch.com. 15 Please see BCA Research's U.S. Equity Strategy Special Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models," January 16, 2018. Available at uses.bcaresearch.com. Appendix: Bankers Beige Book
Highlights Portfolio Strategy Expensive valuations leave no room to maneuver in the S&P real estate index that has to contend with a higher interest rate backdrop and deteriorating cash flow growth fundamentals. Trim to underweight. In contrast, capital markets stocks are firing on all cylinders and the return of animal spirits, the capex upcycle, booming M&A activity and a brighter operating backdrop auger well for this highly cyclical financials sub-index. Stay overweight. Recent Changes S&P Real Estate - Downgrade to underweight today. Table 1 Feature Equities rebounded in the past two weeks, as earnings took center stage and they delivered beyond expectations. Impressively, the blended Q1 EPS growth rate is running at 20% (versus 18.5% expected on April 1) with roughly 18% of the S&P 500 constituents reporting profit numbers. This earnings validation served as a catalyst for the SPX to briefly reclaim the key 50-day moving average and, most importantly, the Advance/Decline (A/D) line hit fresh all-time highs. Historically, the A/D line and the S&P 500 move hand-in-hand and there is a high chance that the SPX will follow suit in the coming quarters (top panel, Chart 1). Our upbeat cyclical 9-12 month equity market view remains intact, as the odds of a recession are close to nil. Despite fears of a generalized global trade war, global trade volumes have been resilient vaulting to multi-year highs on a short-term rate of change basis (middle panel, Chart 2). While a global growth soft patch cannot be ruled out, as long as manufacturing PMIs can stay above the 50 boom/bust line, synchronized global growth will remain the dominant macro theme. Chart 1New Highs Ahead? Chart 2What Slowdown? The IMF concurred in its April, 2018 World Economic Outlook: "The global economic upswing that began around mid-2016 has become broader and stronger. This new World Economic Outlook report projects that advanced economies as a group will continue to expand above their potential growth rates this year and next before decelerating, while growth in emerging market and developing economies will rise before leveling off." 1 The bond market is also not sending a distress signal as very sensitive junk bond spreads have nosedived of late (shown inverted, bottom panel, Chart 1). Under such a backdrop, EPS will continue to shine and underpin stocks (Chart 2). Nevertheless, steeply decelerating money supply growth is slightly disconcerting. This is not only a U.S. only phenomenon, but G7 money supply growth is also losing momentum. Chinese and overall emerging markets money growth numbers are also stuck in a rut (Chart 3). While this could be the precursor to a global growth slowdown, we would expect commodity prices to be the first to sniff it out (Chart 4). Clearly this is not the case as commodities spiked last week. Moreover, keep in mind that money growth tends to peak before recessions and what we are currently observing is likely a typical late cycle phenomenon. We will continue to closely monitor money growth around the globe, as this steep deceleration represents a risk to our sanguine equity market view. This week we are updating our corporate pricing power indicators. Chart 5 shows that our corporate sector pricing power proxy and our diffusion index are holding on to recent gains. On the labor front, the business sector's overall wage inflation and associated diffusion index from the latest BLS employment report ticked lower (fourth panel, Chart 5). Chart 3Money Growth Yellow Flag... Chart 4... But Commodities Are Resilient Chart 5No Margin Trouble Yet However, the spread between job switchers and stayers (courtesy of the Atlanta Fed Wage Growth Tracker) suggests that wage inflation should pick up steam in the coming months. While rising pay would eat into profit margins and thus dent profits ceteris paribus, this would be problematic only if businesses failed to lift selling prices in the coming months. We assign low odds to this outcome as domestic (and global) final demand is firm, suggesting that companies will manage to pass on rising input prices either down the supply channel, to the government and/or the consumer. Table 2Industry Group Pricing Power Table 2 summarizes the sectorial results. We calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Chart 6Cyclicals Have The Upper Hand Over 83% of the industries we cover are lifting selling prices, and 45% are doing so at a faster clip than overall inflation. This is a slight improvement compared with our late-January report The number of outright deflating sectors dropped by three to 10 since our last update. Encouragingly, only 7 industries are experiencing a downtrend in selling price inflation, on par with our most recent report. Impressively, deep cyclicals/commodity-related industries continue to dominate the top ranks, occupying the top 7 slots (top panel, Chart 6). Improving global trade dynamics and sustained softness in the greenback are behind the commodity complex's ability to increase prices. In contrast, tech, telecom, autos and airlines populate the bottom ranks of Table 2. In sum, firming corporate sector pricing power will continue to boost sales growth for the rest of the year. Tack on operating leverage kicking into higher gear at this stage of the cycle, especially for the high fixed cost deep cyclical businesses, and still modest wage inflation, and profit margins and EPS growth will remain upbeat. This week we downgrade a niche interest rate-sensitive sector and update our view on a very cyclical financials sub-sector. DowngREITing There are good odds that laggard REITs will suffer the same fate as telecom services and utilities stocks and plumb relative all-time lows, breaching the early 2000s nadir (Chart 7). A higher interest rate backdrop, a key BCA theme for 2018, along with deteriorating profit fundamentals compel us to downgrade the niche S&P real estate sector to an underweight stance. Real estate stocks are behaving like fixed income proxied equities, given that, by construction, REITs are high dividend yielding. Thus, a tightening monetary backdrop serves as a noose around their necks (top panel, Chart 8). Not only is the Fed slated to raise interest rates two or three more times this year, but FOMC median projections also assume an additional two to three hikes in 2019. At the margin, competing higher yielding risk free assets will eat into demand for REITs. On the operating front, a number of indicators we track are sending an outright bearish signal for the commercial real estate (CRE) sector. The occupancy rate has crested just shy of 90% or 160bps below the previous cycle's peak. Rising vacancies are emblematic of decreasing rents and thus CRE related cash flows (middle panel, Chart 8). Chart 7New Lows Looming Chart 8Rental Deflation Alert Importantly, CRE prices continue to defy gravity and are steeply deviating from our petered out occupancy rate composite (bottom panel, Chart 8). This supply/demand imbalance typically resolves itself via deflating prices. Industry overbuilding explains this disequilibrium, as ZIRP and loose credit standards encouraged a construction boom. Overall non-residential construction is probing all-time highs and multi-family housing starts are expanding close to 400K/annum, a level that has coincided with previous peaks in the CRE market (third & fourth panels, Chart 9). This industry oversupply should weigh heavily on rents especially given the slackening demand backdrop, according to the message from our REITs Demand Indicator (RDI). The softening RDI reading also bodes ill for CRE price inflation (bottom panel, Chart 10). The latest Fed Senior Loan Officer Survey (FSLOS) corroborates that demand for CRE loans is in a steady decline and bankers are not willing extenders of CRE credit, exerting a downward pull on CRE prices (middle panel, Chart 10). Chart 9Rents Are Under Attack Chart 10CRE Prices Skating On Thin Ice Historically, demand for CRE loans as per the FSLOS has been an excellent leading indicator of actual CRE loan growth, and the current message is grim (second panel, Chart 11). It would be unprecedented for another upleg to take root in the CRE market with the absence of credit growth to fuel such an overshoot phase. Worrisomely, there is no valuation cushion to absorb the plethora of possible CRE mishaps. Cap rates have troughed for the cycle and a rising interest rate backdrop warns that a de-rating in expensive valuations is looming (third panel, Chart 11). While CRE credit quality shows no signs of deterioration, at this stage of the cycle and given weak industry profit fundamentals we would caution against extrapolating such good times far into the future (bottom panel, Chart 11). Adding it all up, our S&P real estate profit growth model does an excellent job encapsulating all of these forces, and it is currently sending an unambiguous sell signal (Chart 12). Chart 11Happy Days Are Over Chart 12Model Says Sell Bottom Line: Downgrade the niche S&P real estate index to a below benchmark allocation. Capital Markets: Stay The Bull Course We upgraded capital markets stocks to an above benchmark allocation mid-May last year. Our thesis, recovering overall market top and bottom line growth would prolong the overshoot phase in equities at a time when monetary conditions would stay sufficiently loose, has panned out and this hyper sensitive early-cyclical index has added alpha to our portfolio raising the question: is it time to book profits or are there more gains in store? The short answer is that it is too soon to crystalize gains. This financials sub-index thrives when animal spirits are rising, CEOs embrace an expansionary mindset, and investor risk appetites are healthy. The opposite is also true. We first started exploring the underappreciated global capex upcycle theme in mid-October2 and by late-November it became one of our two core themes for 2018 (rising interest rate backdrop is the other).3 The second panel of Chart 13 shows that capex intentions move in tandem with relative EPS and are pointing toward a profit reacceleration in the coming months. Bankers are also willing extenders of credit, a necessary fuel for the capex upcycle phase, and demand for loans is upbeat as per our commercial loans & leases model. Historically, such a macro backdrop has been a sweet spot for capital markets stocks (Chart 13). Not only business, but investor confidence is also sky high. Junk bond spreads have once again plumbed multi-year lows and even investment grade bond spreads are tight (high-yield spread shown inverted, Chart 1). Corporate bond issuance remains resilient. The Equity Risk Premium has also narrowed by 200bps since the end of the manufacturing recession (shown inverted, top panel, Chart 14), reducing the cost of equity capital. This is fertile ground both for IPOs and secondary stock offerings. Chart 13Solid Foundation Chart 14Enticing Operating Backdrop Meanwhile, the return of volatility has caused revenue generating equity trading desks to breathe a huge sigh of relief, as we had posited in early March,4 and this earnings season made abundantly clear. Trading volumes have soared and margin debt continues to climb both in absolute terms and relative to GDP (Chart 14). If volatility stays elevated as the year progresses, as we expect, then more gains are likely for investment bank trading desks. The upshot is that the capital markets' EPS upswing is in the early innings. Another key earnings driver, M&A activity, is booming around the globe. Still sloshing global liquidity with near generationally low interest rates is fueling an M&A spree. In the U.S. alone, M&A has hit a fresh cycle high and is running near $3.1Tn/annum. Even relative to output, M&A has returned to the previous cycle's peak (bottom panel, Chart 14), and is music to the ears of investment bankers. The implication is that a capital markets ROE expansion phase looms (bottom panel, Chart 15). On the operating front, capital markets employment is hyper-cyclical. Investment banks are quick to slash labor costs during a downturn and equally swift to expand headcount in anticipation of good times. Currently, industry payrolls are rising steadily and outpacing overall non-farm payroll growth, and represent a positive backdrop (Chart 16). Chart 15M&A Fever Is Positive... Chart 16...And So Is Rising Headcount Sell-side analysts have taken notice and EPS pessimism has violently swung into extreme optimism in the past 18 months. Granted, President Trump's election and tax reform euphoria are part of the slingshot recovery in EPS expectations. However, firming industry-specific EPS growth prospects are also driving analysts' upward revisions (bottom panel, Chart 16). Bottom Line: We recommend an above benchmark allocation in the still compellingly valued S&P investment banks & brokers index. The ticker symbols for the stocks in this index are: BLBG: S5INBK - ETFC, GS, MS, RJF, SCHW. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 http://www.imf.org/en/Publications/WEO/Issues/2018/03/20/world-economic-outlook-april-2018 2 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Special Report, "Top 10 Reasons We still Like Banks," dated March 5, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Stay neutral small over large caps (downgrade alert)
Highlights U.S. Treasury Curve: The U.S. Treasury curve has flattened to new cyclical lows as the market has moved to fully price in the Fed's interest rate forecasts. Inflation expectations must rise further for those forecasts to be fully realized, however. Expect renewed U.S. curve steepening through higher inflation expectations and longer-term Treasury yields in the next 3-6 months. UST-Bund Spread Update: Stay in our recommended 10yr UST-Bund spread widening trade. as Treasury yield increases will not be matched in Bunds given slowing euro area economic momentum and a more balanced tone from the ECB. Global IG Corporate Sector Allocation: Our investment grade (IG) sector allocations, taken from our relative value models, have added positive performance since our last update in August. Feature The unpredictable, and at times unruly, behavior of financial markets over the first few months of 2018 has been exhausting for investors. A calm January was followed by the early February volatility spike and, more recently, huge intraday swings based on the ebb and flow of news on U.S. trade and foreign policy. Yet when looking at the year-to-date returns for various asset classes, the numbers do not seem unusually alarming given the amount of surrounding noise. Chart of the WeekA Long Road Back From The VIX Spike The S&P 500 index is only down -0.7%, while both equities in both the euro area and emerging markets (EM) equities are up +1.8% and +1.1%, respectively (using MSCI data in U.S. dollar terms). Credit markets are also delivering rather boring performance so far in 2018, from U.S. high-yield (+1.2% excess return over government debt) to euro area investment grade and EM hard currency corporates (both with an -0.1% excess return in U.S. dollar terms). Admittedly, these numbers look far less flattering considering the robust rally in risk assets in January. Yet the year-to-date returns simply do not line up with our impression of how investors' feel about how this year has gone so far. The perception is much gloomier than the actual outcome. Right now, markets are looking for guidance and direction and finding little of both. A big problem is that global bond yields, most notably in the U.S., have not fallen much from the highs for the year - even with global growth clearly losing some steam in the first quarter of 2018. The reason? Global inflation is in a mild cyclical upswing, a product of persistently tight labor markets and rising oil prices (Chart of the Week). The "leadership" in government bond markets has shifted away from accelerating global growth and an upward repricing of future central bank tightening, to rising inflation and unchanged monetary policy expectations. The notion of central bankers not being friendly to the markets remains our key theme for this year. We continue to expect that policymakers will not respond to the latest softer patch of economic data and will focus more on the reacceleration of inflation. This is especially true with risk assets stabilizing and volatility measures like the U.S. VIX index continuing to drift lower and, more importantly, the "volatility of volatility" (as measured by the VVIX index) now back to the levels that prevailed before the early February volatility spike (bottom panel). Although as BCA's strategists discussed at our View Meeting yesterday, volatility can quickly return with a vengeance given softer global growth momentum, and with the geopolitical calendar heating up next month (the U.S. government must make its final decision on the China trade tariffs and investment restrictions).1 This led the group to downgrade our recommended global equity exposure and upgrade our global bond exposure on a tactical (0-3 months) basis, although our more medium-term cyclical allocations (6-12 months) were unchanged (overweight stocks versus bonds). From the point of view of global bond markets, we may now be in period of mild "stagflation" with softening growth and rising inflation. We remain of the view that the former is temporary and the latter is not. This backdrop will keep global bond yields under upward pressure for at least the next few months, with better expected performance of corporate debt over governments - albeit with the potential for higher volatility given more elevated geopolitical risks. What Next For The U.S. Treasury Curve? The Treasury curve flattened to a new cyclical low last week, with the spread between 2-year and 10-year bonds now sitting at 45bps. On the surface, this flattening seems consistent with a Fed that is maintaining a "cautiously hawkish" message and that its rate hike plans for 2018 are unchanged despite more volatile financial markets. Chart 2This UST Curve Flattening Is Different What makes this current episode different from other bouts of Treasury curve flattening over the past five years, however, is the starting point for the absolute of bond yields. According to our two-factor valuation model for the 10-year Treasury yield, yields are now just a touch above fair value, which is currently 2.78%. That yield valuation was at least +25bps before the previous flattening episodes between 2014 and 2017 (Chart 2). That distinction is critical in differentiating a bull flattener from a bear flattener. Simply put, longer-dated Treasuries are not yet cheap enough to suggest that investors should extend duration risk to benefit from any additional curve flattening from here. In fact, we see a greater risk that Treasury curve re-steepens a bit from here, as there is more room for longer-term inflation expectations to move higher than there is for the front-end of the curve to reprice an even more hawkish Fed. The recent softening of cyclical global economic data has been occurring while realized inflation rates have been slowly rising from depressed levels (Chart 3). Yet in the U.S., the slowing of growth seen in the first quarter of the year remains very modest compared to that seen in Europe or Japan, while core inflation rates (for both the CPI index and the PCE deflator) have accelerated back to 2%. The Atlanta Fed's GDPNow forecasting model is calling for Q1/2018 growth of 1.9%, while the New York Fed's Nowcast model is predicting Q1 growth of 2.8%. While both forecasts are a deceleration from the 3% rates seen in the previous three quarters in 2017, neither is below U.S. potential GDP growth, which the U.S. Congressional Budget Office now estimates to be 1.9%. Even in China, where the economy had been slowing as policymakers have aimed to tighten monetary policy and slow credit growth, cyclical indicators such as the Li Keqiang index (the preferred indicator of our China strategists) have shown a bit of a rebound of late. Right now, underlying U.S. growth and inflation momentum are still pointing towards the Fed delivering on its current projection of an additional 50bps of rate hikes in 2018, taking the funds rate to 2.25%, with even a chance of an additional hike if inflation continues to accelerate. This is essentially fully priced with a 2-year Treasury yield just under 2.4%, however, and the real funds rate is now at neutral according to measures like the Fed's r-star. Therefore, additional flattening pressures from the front end of the curve are unlikely unless the Fed is willing to signal a faster pace of rate hikes than currently laid out in its economic projections (the "dots"). At the same time, the 10-year TIPS inflation breakeven remains 25-35bps below the 2.4-2.5% range that would be consistent with the market expecting U.S. inflation to sustainably return to the Fed's 2% inflation target on the headline PCE deflator. Hence, a steeper Treasury curve is far more likely than a flatter Treasury curve from current levels. Where could this view go wrong? Perhaps the Trump administration's trade skirmishes with China could broaden into a full-on trade war that could cause deeper damage to U.S. equities, dampen growth expectations and drive longer-term yields lower. Coming at a time when there is a significant short position in the U.S. Treasury market, this could look similar to the prolonged bull-flattening seen in 2015-16. During that episode, duration exposure flipped from a big net short to very net long according to measures like the J.P. Morgan Duration Survey (Chart 4, top panel), while the market priced out all expected Fed rate hikes (2nd panel). However, that also occurred alongside a 50bp decline in inflation expectations (3rd panel) and a big deceleration of U.S. growth (bottom panel), both related to a weakening global economy and collapsing oil prices. It is uncertain if the current U.S.-China trade skirmish would have an equivalent impact on both the U.S. economy and the Treasury curve, especially given a starting point of stronger global growth a far more positive demand/supply balance in world oil markets. Chart 3A Whiff Of Stagflation? Chart 42018 Is Not 2015/16 In sum, we are sticking to our view that the Treasury curve is more likely to bear-steepen through higher longer-term yields than flatten bearishly through more discounted Fed hikes or flatten bullishly through much weaker growth and inflation. We continue to recommend a below-benchmark duration stance in the U.S., within an underweight allocation in a currency-hedged global government bond portfolio. We are also are sticking with our tactical trade of staying short the 10-year U.S. Treasury versus the 10-year German Bund, even with the spread now looking a bit too wide on our fundamentals-based valuation model (Chart 5). The unrelenting string of disappointing economic data in the euro area has already resulted in a far more cautious tone from European Central Bank (ECB) officials regarding the potential for quick rate hikes after the expected end of the asset purchase program at the end of this year. The gap between the U.S. and euro area data surprise indices has proven to be a good directional indicator for the Treasury-Bund spread (Chart 6, bottom panel). Given our views on the potential for renewed bear-steepening in the Treasury curve, which is unlikely to be matched in the German curve in the next 3-6 months, we see no reason to take profits yet on our spread trade. Chart 5UST-Bund Spread Now A Bit Too Wide... Chart 6...But Too Soon For Spread Tightening Bottom Line: The U.S. Treasury curve has flattened to new cyclical lows as the market has moved to fully price in the Fed's interest rate forecasts. Inflation expectations must rise further for those forecasts to be fully realized, however. Expect renewed U.S. curve steepening through higher inflation and longer-term Treasury yields in the next 3-6 months. Stay in our recommended 10-year Treasury-Bund spread widening trade, as Treasury yield increases will not be matched in Bunds given slowing euro area economic momentum and a more balanced tone from the ECB. A Brief (And Belated) Performance Update For Our Corporate Bond Sector Allocations It has been some time (August 2017) since we last published a performance update for our investment grade (IG) corporate sector allocations for the U.S., euro area and U.K. As a reminder, those allocations come from our relative value model, which is designed to measure the valuation of each individual sector compared to the overall Barclays Bloomberg corporate bond index for each region. The methodology takes each sector's individual option-adjusted spread (OAS) and regresses it in a panel regression with all the other sectors in each region, as a function of the sector's duration, convexity (duration squared) and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and the fair value OAS is our valuation metric from the model for each region. The latest output from the models can be found in the tables and charts in the Appendix starting on Page 14. We also show the duration-times-spread (DTS) for each sector in those tables, using that as our primary way to measure the volatility of each sector. The scatterplot charts in the Appendix show the tradeoff between the valuation residual from our model and each sector's DTS. Chart 7Performance Of Our IG Sector Allocations We then apply individual sector weights based on the model output and our desired level of overall spread risk that we wish to take in our recommended credit portfolio. At our last update in August 2017, we made a decision to keep the overall (weighted) DTS of our sector tilts roughly equal to the overall IG corporate DTS for each region. With credit spreads looking tight at the time, credit spread curves flat relative to history, and with the Fed in the midst of a tightening cycle, we did not see a case for taking aggressive spread risk (i.e. having a high aggregate DTS) in the portfolio. The performance of our latest sector recommendations since our last update in August 2017, and in the first quarter of 2018, are shown in Chart 7. We show both the total return and excess return of each sector versus duration-matched government bonds. Since that last review, our U.K. sector allocations have performed the best, delivering an additional 12bps of total return and 10bps of excess return versus the U.K. IG corporate index. Our euro area corporate allocations have added 2bps of total return and 3bps of excess return, while our U.S. allocations have modestly underperformed both on total return (-1bp) and excess return. We also show the performance numbers for just the first quarter of 2018 in Chart 7, and we will present the return numbers on this quarterly basis in the future as part of our regular model bond portfolio performance reviews. The sector allocations offered a modest underperformance in Q1 2018, with -5bps of total return and -8bps of excess return coming mostly from euro area and U.K. allocations. The U.S. allocations actually outperformed by +3bps on a total return basis in Q1. The return numbers for our U.S. sector allocations can be found in Table 1. Since our last update in August, the best performing sectors (in excess return terms) for our U.S. portfolio allocation were the overweights to all Energy sub-sectors (+35bps combined), Cable & Satellite (+4bps) and Banks (+4bps). Of those names, only the Independent Energy sub-sector delivered a positive excess return (+3bps) in Q1 2018. Table 1U.S. Investment Grade Performance The return numbers for our euro area sector allocations can be found in Table 2. Since our last update in August, the best performing sectors (in excess return terms) for our euro area portfolio allocation were the overweights to Financials (+35bps, coming mainly from Banks, Senior Debt and Insurance) and Integrated Energy (+13bps). Those overweights also delivered small positive excess returns (+3bps and +1bps, respectively) in Q1 2018. The return numbers for our U.K. sector allocations can be found in Table 3. Since our last update, the best performing sector (in excess return terms) was the overweight to Financials (+6bps, coming mostly from Banks). Looking ahead, credit spread curves remain very flat by historical standards (Chart 8), which suggests there is not enough spread compensation for extending credit risk to lower quality tiers. Thus, we are sticking with keeping our target DTS for our combined sector allocations equal to that of the overall IG index for each region. We will update our sector allocations in an upcoming Weekly Report. Table 2Euro Area Investment Grade Performance Table 3U.K. Investment Grade Performance Chart 8Credit Quality Curves Remain Very Flat Bottom Line: Our investment grade (IG) sector allocations, taken from our relative value models, have added positive performance since our last update in August. We continue to recommend a cautious approach to sector allocation, targeting index levels of spread risk (in aggregate) in the U.S. euro area and U.K. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Expect Volatility ... Of Volatility", dated April 11, 2018, available at gps.bcaresearch.com. Appendix Appendix Chart 1U.S. Corporate Sector Valuation And Recommended Allocation* Appendix Chart 1U.S. Corporate Sector Risk Vs. Reward* Appendix Table 2Euro Area Corporate Sector Valuation And Recommended Allocation* Appendix Chart 2Euro Area Corporate Sector Risk Vs. Reward* Appendix Table 3U.K. Corporate Sector Valuation And Recommended Allocation* Appendix Chart 3U.K. Corporate Sector Risk Vs. Reward* Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns