Geopolitics
Highlights The pace of globalization is slowing, reflecting the culmination of a decades-long process of integrating China and other emerging economies into the international trading system. Most commentators overstate the benefits of globalization, while glossing over the increasingly large distributional effects. A modest retreat from globalization would not irrevocably harm global growth, but a full-fledged trade war certainly would. Investors are underestimating the likelihood of disruptive trade measures from a Trump administration. Tactically underweight global equities. U.S. large cap tech stocks will suffer the most from a turn towards trade protectionism and from the curtailment of H-1B visa issuance under Trump's immigration plan. EM stocks could also come under pressure. Treasurys are oversold, but the structural trend for bond yields remains to the upside. The trade-weighted dollar could rally another 5% from current levels. And Take Your Damn Trump Hat With You If there is one sure way to get thrown out of a Davos party, it is by telling the assembled guests that globalization is not all that it is cracked up to be. After all, don't all cultured people know that globalization has made the world vastly richer? Well, maybe it has, but the evidence is not nearly as clear-cut as most people might imagine. Twenty years ago, the consensus among economists and policymakers was that international capital mobility should be strongly encouraged. Poor countries had a myriad of profitable investment opportunities, but lacked the savings to finance them, so the argument went. The solution, they were told, was to borrow from wealthier countries, which had a surfeit of savings. In the early 1990s, everything seemed to be going to plan. Emerging markets were running large current account deficits, using the proceeds from capital inflows to finance all sorts of investment projects. And then the Peso Crisis struck. And then the Asian Crisis. And just as quickly as the money came in, it came straight out. The result was mass defaults and depressed economies. Since then, most emerging economies have been trying to maintain current account surpluses - exactly the opposite of what theory would predict. Not to worry, the experts reassured us. What happened in emerging markets could not happen to developed economies with their strong institutions and sophisticated methods for allocating capital. The global financial crisis and later, the European sovereign debt crisis, put these claims to shame. Faced with this reality, the IMF published an official report in 2012 acknowledging that "rapid capital inflow surges or disruptive outflows can create policy challenges." It concluded that "there is ... no presumption that full liberalization is an appropriate goal for all countries at all times."1 This was a stunning about-face for an institution that, among other things, had sharply criticized Malaysia for imposing capital controls in 1998. Diminishing Returns To Globalization In contrast to capital account liberalization, the case for free trade in goods and services stands on sturdier ground. That said, proponents of free trade tend to overstate the benefits. As Paul Krugman has noted, the widely-used Eaton-Kortum model suggests that only about 5% of the increase in global GDP since 1990 can be attributed to higher trade flows.2 Moreover, it appears that the benefits to middle class workers in advanced economies from globalization have fallen over time. This is partly because trade liberalization, like most aspects of economic life, is subject to diminishing returns. Chart 1 shows that each succeeding round of trade liberalization has resulted in ever-smaller declines in average tariff rates. With tariffs on most tradeable goods now close to zero in the U.S. and most other advanced economies, there is less scope to liberalize trade further. As a result, proposed trade deals such as the Trans-Pacific Partnership (TPP) have focused on harmonizing business regulations and expanding patent and copyright protections. To call these deals "free trade agreements" is a stretch. Chart 1Tariffs Have Little Room To Decline Further Granted, many "invisible" barriers continue to stymie trade. John Helliwell has documented that a typical firm in Toronto generates roughly ten times as much sales from customers in Vancouver as it does from a similarly-sized, equidistant city in the U.S. such as Seattle.3 As it turns out, differences in legal systems and labor market institutions across countries, as well as differing social networks, can be as important an obstacle to trade flows as tariffs and quotas. But think about what this implies: If globalization were the key to economic development, then Canada, as a small economy situated next to a much larger neighbour, could prosper by dismantling these massive invisible trade barriers. However, we know that this proposition cannot be true: Canada is already a very rich economy, so any further trade liberalization would only boost incomes at the margin. What's Behind The Trade Slowdown? The analysis above helps put the much-discussed slowdown in global trade into context (Chart 2). As the IMF concluded in its most recent World Economic Outlook, while much of the deceleration in trade growth is attributable to cyclical factors, structural considerations also loom large.4 In particular, the boost to global trade over the past few decades stemming from the collapse of communism, the progressive elimination of most trade barriers, and the decision by most developing economies to abandon import-substitution policies appears to have run its course (Chart 3). In addition, the regional disaggregation of the global supply chain is slowing. These days, motor vehicle parts are shipped across national borders many times over before the final product rolls off the assembly line. The manufacturing process can only be broken down so much before diminishing returns set in. Chart 2Global Trade ##br##Growth Is Slowing Chart 3The Low-Hanging Fruits Of ##br##Globalization Have Been Picked Productivity gains in the global shipping industry are also moderating. As Marc Levinson argued in his book "The Box," the widespread adoption of containerization in the 1970s completely revolutionized the logistics and transportation industry. As a consequence, the days when thousands of longshoremen toiled in the great ports of Baltimore and Long Beach are long gone. Nowadays, huge cranes move containers off ships and place them into waiting trucks or trains. To the extent that there are still technological advances on the horizon - think self-driving trucks - these are likely to reduce intranational transport costs more than international costs. This could result in even slower trade growth by encouraging onshoring. Trade And Income Distribution Chart 4China's Rise Came Partly At ##br##The Expense Of U.S. Rust Belt Workers As every first-year economics student learns, David Ricardo's Theory of Comparative Advantage predicts that real wages will rise when countries specialize in the production of goods that they can manufacture relatively well. Students who stick around (and manage to stay awake) for second-year economics might learn about the Heckscher-Ohlin model. This model qualifies Ricardo's findings. Yes, free trade raises average real wages, but there can be large distributional effects. In particular, low-skilled workers could actually suffer a decline in real wages when rich countries increase trade with poorer countries. As trade ties between advanced and developing countries have grown, these distributional issues have become more important. David Autor has documented that increasing Chinese imports have had a sizable negative effect on manufacturing employment in the U.S. (Chart 4).5 It is thus not surprising that voters in Rust Belt states were especially receptive to Donald Trump's protectionist rhetoric. A Tale Of Two Globalizations: China Versus Mexico Most economists agree that trade liberalization has disproportionately benefited developing economies. Nevertheless, there too the benefits are often overstated. China, of course, is frequently cited as an example of a country that has prospered by integrating itself into the global economy. But what about Mexico? It also made a massive push to liberalize trade starting in the mid-1980s, which culminated in NAFTA in 1994. As a consequence, the ratio of Mexican exports-to-GDP rose from 13% in 1994 to 35% at present. Yet, as Chart 5 shows, GDP-per-hour worked has actually declined relative to the U.S. over this period. One key reason why China benefited more from globalization than Mexico is that China had a much better educated workforce. This allowed it to quickly absorb technological know-how from the rest of the world, setting the stage for the spectacular growth of its own domestic industries. Sadly, when it comes to human capital, China is more the exception than the rule across developing economies (Chart 6). Chart 5Trade Liberalization Has Not ##br##Improved Mexico's Relative Productivity Chart 6Educational Achievement ##br##In Emerging Economies: China Stands Out Noble... And Not So Noble Lies To be clear, the discussion above should not be interpreted as arguing that globalization is bad for growth. Trade openness does matter for economic development. However, other things, such as the level of human capital and the quality of domestic economic institutions, matter even more. How can one reconcile this view with the near-apocalyptic terms in which many commentators discuss the anti-globalization sentiment sweeping across many developed economies? Let me suggest two explanations: one noble, one less so. The noble explanation goes beyond economics. Proponents of trade liberalization often argue that the 1930 Smoot-Hawley Tariff Act was a leading cause of the Great Depression. On purely economic grounds, this argument makes little sense. Exports accounted for less than 6% of U.S. GDP in 1929. While trade volumes did fall rapidly between 1929 and 1932, this was mainly the result of the economic slump, rather than the cause of it. In fact, trade volumes actually fell more in the immediate aftermath of the 2008 financial crisis (Chart 7). Yet, from a political perspective, the importance of Smoot-Hawley is hard to deny. At a time when Nazi Germany was on the rise, the U.S. and its allies were squabbling over trade issues. As such, the main problem with Smooth-Hawley was not that it pushed the U.S. into a Depression, but that it sabotaged diplomatic coordination at a time when it was most needed. One suspects that something similar underlies much of the angst over Trump's trade policies. The Global Trade Alert, currently the most comprehensive database for all types of trade-related measures imposed since the global financial crisis, shows an increase in protectionist measures over the last few years (Chart 8). The risk is that this trend will accelerate after Donald Trump is sworn in as President. Chart 7Global Trade Fell More ##br##During The Great Recession Chart 8Protectionist Measures ##br##Are On The Rise Considering that globalization ran into diminishing returns some time ago, a modest unwinding of globalization would probably not have the calamitous impact that many fear. However, just like a plane that fails to fly sufficiently fast will fall to the ground, a "modest unwind" may prove difficult to achieve in practice. Globalization, in other words, may be approaching stall speed. And given the large number of issues that require global cooperation - terrorism, migration, climate change - that is a risk which requires attention. Money Talks If that were all to the story, it would be easy to forgive those who overstate the economic benefits from globalization in order to preserve the political ones. One suspects, however, that there may also be a self-serving motive at work. The integration of millions of workers from China and other developing economies into the global labor market has put downward pressure on wages, boosting profit margins in the process. Not surprisingly, CEOs, hedge fund managers, and other titans of industry have benefited greatly from this development. Chart 9 shows that most of the increase in income equality since 1980 has occurred not at the 99th percentile, but at the 99.99th percentile and higher. It would be naïve to think that the colossal gains that some have enjoyed from globalization would not color what they say on the subject. Chart 9The (Really) Rich Got Richer Investment Conclusions U.S. equities have been in rally mode since the election. Many aspects of Trump's agenda are good for stocks - corporate tax cuts, deregulation, and fiscal stimulus, just to name a few. These factors make us somewhat constructive on equities over a long-term horizon. Chart 10Tech Stocks Are Heavily ##br##Exposed To Globalism Nevertheless, it cannot be denied that Trump's anti-globalization rhetoric represents a direct threat to corporate earnings. While some of Trump's protectionist proposals will undoubtedly be watered down, investors are underestimating the likelihood of disruptive trade measures. Unlike on most issues where he has flip-flopped repeatedly, Trump has consistently espoused a mercantilist view on trade since the 1980s. He is also the sort of person that strives to reward his supporters while disparaging those who slight him. Rust Belt voters awarded Trump the presidency. Their loyalty will not be forgotten. This means the stock market's honeymoon with Donald Trump may not last much longer. We remain tactically cautious global equities and are expressing that view by shorting the NASDAQ 100 futures. Globally-exposed large cap tech stocks will suffer the most from a turn towards trade protectionism and from the curtailment of H1-B visa issuance under Trump's immigration plan (Chart 10). Emerging market equities are also likely to feel the heat from rising protectionist sentiment in developed economies. A stronger dollar will only add to EM woes by putting downward pressure on commodity prices and making it more expensive for EM borrowers to service dollar-denominated loans. As we discussed in "A Trump Victory Would Be Bullish For The Dollar" and "Three Controversial Calls: Trump Will Win, And The Dollar Will Rally," the three key elements of Trump's policy agenda - fiscal stimulus, tighter immigration controls, and higher tariffs - are all inflationary, and hence are likely to prompt the Fed to raise rates more than it otherwise would.6 Higher U.S. rates, in turn, will keep the greenback well bid. We expect the real trade-weighted dollar to strengthen another 5% from current levels. The flipside of a stronger dollar is increasing monetary policy divergence between the U.S. and the rest of the world. U.S. bond yields have risen significantly since the election. Tactically, we would not be adding to short duration positions at current levels. Structurally, however, the 35-year bond bull market is over. As we discussed in our latest Strategy Outlook,7 weak potential GDP growth is eroding excess capacity around the world, which is bad news for bonds. Population aging could also shift from being bullish to bearish for bonds, as more people retire and begin to draw down their savings. Meanwhile, central banks are looking for ever more creative ways to boost inflation, while the populist wave is forcing governments to abandon austerity measures. Lastly, and most relevant to this week's discussion, globalization - an inherently deflationary force - is in retreat. This, too, suggests that the longer-term risks to inflation are to the upside. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see "The Liberalization And Management Of Capital Flows: An Institutional View," IMF Executive Summary, November 14, 2012. 2 Paul Krugman, "The Gains From Hyperglobalization (Wonkish)," The New York Times, October 1, 2013. 3 John F. Helliwell and Lawrence L. Schembri, "Borders, Common Currencies, Trade And Welfare: What Can We Learn From The Evidence?" Bank of Canada Review, Spring 2005. 4 Please see "Global Trade: What's behind the Slowdown?" in "Subdued Demand: Symptoms and Remedies," IMF World Economic Outlook (October 2016). 5 David Autor, David Dorn, and Gordon Hanson, "The China Syndrome: Local Labor Market Effects Of Import Competition In The United States," The American Economic Review, Vol. 103, No. 6, (2013): pp. 2121-2168. 6 Please see Global Investment Strategy Weekly Report, "A Trump Victory Would Be Bullish For The Dollar," dated June 3, 2016, and Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com 7 Please see Global Investment Strategy, "Strategy Outlook Fourth Quarter 2016: Supply Constraints Resurface," dated October 7, 2016, available at gis.bcaresearch.com Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Recent market moves have been emotionally driven and speculative in nature. The risk is now that tighter monetary conditions risk crimping growth in the near term. Since 2014, whenever the 10-year Treasury yield has reached 2.5%, equity prices have corrected. This remains an important marker for when investors should begin to worry that the level of yields are moving into restrictive territory. Fiscal stimulus will be a positive development and could dominate the investment landscape for some time. But investors should not view it as a panacea for growth headwinds. Feature Investors continue to digest the ramifications of the new configuration in Washington. In this week's report, we answer the most frequently asked queries that we have received from clients. As always, please do not hesitate to contact us with yours. 1. How Has Your Forecast For Markets Changed Since November 9? We had been cautious on risk assets, we had been dollar bulls, and we had been advocating slightly underweight/neutral bond duration positions prior to the elections, as highlighted in the November 7 Weekly Report. Our cautious stance on equities, particularly large-cap stocks, has not changed. Our main worry has been that corporations continue to lack pricing power and top-line growth will struggle to grow meaningfully in 2017. In other words, profit margins are a headwind - as they often are at this point of the cycle (Chart 1). But contrary to past recoveries, persistent low growth means that top-line growth will not provide the same offset to a margin squeeze driven by rising labor costs (Chart 2). Chart 1Equity Market On Fire Chart 2Profit Margin Squeeze Intact For Now Our expectations have been for earnings growth to be in the mid-single digits in 2017, with risks to the downside depending on the degree of dollar strength. True, although the above profit outlook is rather uninspiring, it does not justify an underweight allocation to equities. Monetary policy is still accommodative and a recession is unlikely. However, as the Fed drains the punchbowl, volatility will increase as the onus of equity price appreciation falls heavily on profit drivers. Leading up to the election, we made the case that any adverse reaction to a Trump win would be very short and was not the main event for financial markets on a 6-12 month time horizon. Since November 9, there has been a strong, emotional reaction to the Trump win. Our first read of potential policy outcomes is that the "new America" will be far less business-friendly than equity prices are currently suggesting. The headwinds to multinationals from trade reform and immigration constraints may well offset any positive developments from deregulation in the financial and energy sectors. Most importantly, fiscal spending is positive to the extent that new projects and spending will boost top-line growth. But as we discuss below, the violent Treasury sell-off risks crimping growth before any fiscal spending kicks in. Moreover, so far gauges of policy uncertainty have stayed subdued, but that may change quickly, given the number of unknowns ahead and potential negative reactions from other countries to the new U.S. government. Taken together, we see no reason to upgrade our view on equities. For bonds, we had been expecting that the Fed would raise rates in December, because the economic and inflation data have been sufficiently strong relative to policymakers' thresholds to proceed with a rate hike. The bond market had not been fully discounting this outcome; our view was that the 10-year Treasury could move to 2% or slightly higher, due to the re-pricing of the Fed. Our models suggested that fair value on the 10-year Treasury was around 2% and so once bond yields got that level, a trading range would be established. Treasuries were overvalued for most of this year, and a symmetric shift to undervaluation could now occur. However, we have doubts that we have entered a new bond bear market. Market expectations for U.S. interest rates are rapidly converging to the Fed's forecasts. The rise in yields should pause once the gap has closed. Finally, we have been cyclical dollar bulls for some time. Our principle reason is due to the favorable gap in interest rate differentials between the U.S. and most other major currencies. We see no reason to change our dollar bullish stance. 2. Is Fiscal Spending Really The New Panacea? Our view can be summarized as: Curb Your Enthusiasm. Fiscal stimulus is a positive development. Since the early days of the Great Recession, monetary policymakers have been working alone. Monetary policy has become ineffective at boosting growth, and currency depreciation only shifts growth between countries, it does not create more. Fiscal spending is an opportunity to increase the "GDP pie." But as we wrote two weeks ago, the type of fiscal spending matters, a lot. Income tax cuts on high income earners as well as corporate tax cuts tend to have a low multiplier effect (well below 1), while direct spending by government, e.g. infrastructure outlays, tends to have a much higher multiplier (above 1). Equally important is the interest rate regime that coincides with fiscal stimulus. When an economy is near full employment and there is a risk that above trend growth will create inflation, central banks tend to react, and thus dull the force of the initial stimulus. That is the current economic scenario. The bottom line is that fiscal spending will give a fillip to GDP growth for a few quarters in late in 2017 and perhaps in 2018, but investors should be careful in assuming that fiscal spending will meaningfully change the long-term U.S. growth trajectory as it is not a solution for structural headwinds, such as an aging population. Chart 3Can The Economy Handle Higher Yields? 3. What Can We Monitor To Understand The Direction Of Policy With Trump As President? Cabinet appointments will be a key area of interest for financial markets. These personnel will ultimately help shape Donald Trump's policy path. There will likely be many rumors about potential appointments, but we believe it is best to ignore near-term noise and focus on Trump's announcements in December and the Senate's official appointments in January. 4. How High Can Bond Yields Get Before The Sell-off Becomes Economically Damaging? The economic backdrop has improved over the past two years and is much closer to full employment. Thus, underlying economic growth is better positioned to withstand a rise in yields. For example, better job prospects and security will allow prospective homeowners to better absorb higher mortgage rates. Still, investors should note that some equity sectors have already responded to the tightening. Chart 3 shows that home improvement stocks are underperforming significantly. What has changed is the greater role of the currency in overall monetary condition tightening. Indeed, the tightening in monetary conditions over the past twelve months has been principally due to the dollar rise. Our U.S. fixed income team's model of fair value for government bonds is based on global PMIs as a proxy for growth, policy uncertainty, and sentiment toward the U.S. dollar. The current reading suggests that 10-year Treasuries are fairly valued when at around 2.25%. Note that fair value has been moving higher in recent weeks on the back of better global economic news. Since 2014, i.e. the start of the dollar rally, whenever the 10-year Treasury yield has reached 2.5%, equity prices have corrected (Chart 4). We think this remains an important marker for when investors should begin to worry that the level of yields are moving into restrictive territory. Chart 4How Long Can Equities Shrug Off Rising Bond Yields? 5. Deregulation And Other Pro-Business Reforms Will Surely Spur Improved Business Confidence And Investor Animal Spirits? We are unsure. History has shown that periods of deregulation (the 1980s and 1990s especially) were conducive to high equity market returns and strong business growth, so this is indeed a positive factor. But there is a lot that can go wrong. Allan Lichtman, a political historian who has correctly predicted all of the past eight Presidential elections, is now predicting that Trump will be impeached within the next four years, due to previous improper business dealings. If that were to occur, we would expect market sentiment to be negative, closely akin to the Worldcom and Enron accounting scandals, which shook faith in the role of the public company CEO. One important gauge will be the global uncertainty index (Chart 5). Uncertainty leads to an increase in risk aversion, and can spur a flight into the safety of government bonds. So far, readings are benign, but should be monitored closely. Chart 5Beware A Rise In Uncertainty 6. What Are The Prospects For Fed Rate Hikes? We don't expect a major shift in the message from the Fed (i.e. the Fed dot plots) until monetary policymakers have better visibility on what the fiscal landscape will look like (Chart 6). Chart 6Fed Will Wait And See Janet Yellen's testimony last week indicates that a December rate hike is almost a certainty. However, there was no hint that the Fed is preparing for a more aggressive tightening cycle thereafter. Her assessment of the economy was balanced, noting that growth improved to 3% in Q3 from 1% in H1, but downplayed the full extent of the rebound due to a rise inventories and a surge in soybean exports. She described consumer spending to be posting "moderate gains," business investment as "relatively soft," manufacturing to be "restrained" and housing construction as "subdued." There was nothing to suggest that the Fed is revising its growth and inflation forecasts following last week's election. Yellen expects growth to continue at a "moderate pace" and inflation to return to 2% in the "next couple of years." Larger budget deficits would likely prompt the Fed to raise rates more aggressively, but for now, their bias is still to manage asymmetric downside risks. 7. Where Would You Deploy New Funds Today? Into cash. Recent market moves have been emotionally driven and speculative in nature. If the new American government succeeds in implementing a pro-business strategy of lower corporate taxes, increased infrastructure spending, a lighter regulatory burden for the financial services industry, while simultaneously avoiding any negative shocks from trade reform, foreign policy blunders, and general decline in economic and policy uncertainty, then perhaps the current risk-on market moves make some sense. However, that is a massive list, especially for a new President without political experience. In other words, markets have overshot and policy is likely to under-deliver. The risk is now that tighter monetary conditions risk crimping growth in the near term. 8. You Like Small Caps, But Are Cautious On High Yield Corporate Credit. These Two Markets Tend To Perform Similarly. Can You Comment? Historically, the absolute performance of small caps and high-yield corporate bond spreads have been tightly negatively correlated. This is because owning both investments tend to be considered a risk-on strategy. But over the past several years, this relationship has weakened and particularly, the correlation between high-yield corporate bond spreads and relative performance of small/large caps has loosened (Chart 7). This is in part because small cap sector weightings are now more closely aligned with large cap weightings. In other words, the S&P 600 index is no longer overly exposed to cyclical relative to the larger cap weightings. Chart 7Small Caps Are A Winner We expect small caps to outperform S&P 500 companies because they tend to have a domestic focus and will be more insulated from a rise in the dollar. As well, small caps, by virtue of being more geared to domestic growth, will benefit from ongoing better U.S. growth rates than global markets. Relative profit margins proxies favor small caps as well. 9. Is There A Structural Bear Market In Voter Turnout In The U.S.? A certain number of headlines have quoted a drastically lower turnout numbers for the 2016 election than in 2012. This has been reinforced by a theory of a structural downturn in voter participation. Both statements are incorrect. Early estimates for this year's election show that approximately 58.1 percent of eligible voters cast ballots, down from 58.6 percent in 2012.1 Note that these are just estimates. It is plausible that any decline in voter turnout in 2016 is due to the extreme unpopularity of both candidates (Chart 8). It is unlikely that this experience will be repeated in future elections. As for the longer-term picture, as Chart 9 shows that voter turnout had been, in fact, rising steadily since 2000. Chart 8Clinton And Trump Are Making (The Wrong Kind Of) History Chart 9Americans Like Voting, Just Not These Candidates 10. What Are Your Expectations For Upcoming Elections In Europe? A narrative has emerged in the financial industry since Donald Trump's victory and the U.K.'s decision to leave the EU: there is a structural shift towards anti-establishment movements. But we feel this is overstated. France is a case in point as Marine Le Pen, leader of the Euroskeptic National Front (FN), is reportedly enjoying a tailwind. To be sure, she can win the 2017 Presidential election, but her probability of winning has been inappropriately inflated following the U.S. election and, according to our Geopolitical experts, is approximately only 10%.2 Because Marine Le Pen is going to face off against an "establishment" candidate, she offers the alternative to the status quo that the French are seeking. But she is trailing her likely second round opponent, Alain Juppé, by around 40% in the polls. Le Pen is sticking to her negative views on the EU and euro membership. That is a formidable obstacle, since 70% of the French support the euro. The bottom line is that we do not believe that the U.S. election has had a meaningful influence on European voters. Developed nations across the globe are struggling with the same structural issues such as low growth and income inequality. It should not be surprising that common reactions and responses are occurring in various countries. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please See "United States Elections Project," available at http://www.electproject.org/2016g. 2 Please see Geopolitical Strategy Special Report, "Will Marine Le Pen Win?," dated November 16, 2016, available at gps.bcaresearch.com.
Highlights The 50bps spike in the JPM global government bond yield since August constitutes one of the most aggressive tightenings since the Great Recession. Higher bond yields weaken credit growth, and weaker credit growth almost always depresses subsequent GDP growth. Maintain at most a neutral weighting to equities. Lean against the aggressive sell-offs in Healthcare, Consumer Goods, Telecoms and government bonds. Lean against the aggressive rally in Financials. Feature November 9 is an important date in the annals of history. November 9, 1989 was the day that the Berlin Wall came down. Chart of the WeekGlobalization Has Been Good For Profits, Bad For Wages Through 1961-89, the Berlin Wall divided a city. More significantly, it symbolized a divided world. So when the wall came down on November 9, 1989, it marked a new era of globalization. Goods, services, capital and people started to move around the world much more freely, resulting in greater efficiencies and lower costs. In developed economies, profits surged. Using the United States as an example, in the 27 years since the Berlin Wall came down, stock market real earnings per share have gone up 200% (Chart I-2). Chart I-2The Backdrop For Populism But globalization has exacted a heavy price: the pressure on wages means that in the 27 years since the Berlin Wall came down, U.S. median household real income has gone up just 10%. By comparison, in the 28 years that the Berlin Wall stood, the median household real income went up 60% (Chart of the Week). November 9 is also the date that Donald Trump won the presidency of the United States. So exactly 27 years after one symbolic wall fell, is another one about to go up? Will Mr. Trump's promised wall with Mexico symbolize a new era of anti-globalization, and a reversal of the economic and financial trends since the Berlin Wall came down? Flaws In The Trump Plan Economists are almost unanimous that protectionism, trade barriers and tariffs - in other words, "building walls" - depresses long-term global growth. It is conceivable that protectionism could help some parts of the U.S. economy, though other parts might lose out as trading partners retaliated. It is inconceivable that protectionism would be good for the world economy as a whole. Chart I-3One Of The Most Aggressive Tightenings ##br##Since The Great Recession But what about Trump's noise about fiscal stimulus, and specifically infrastructure spending - why would anybody not get excited about that? The two word answer is: crowding out. If a dollar that is borrowed and spent by the government (or even forecast to be borrowed and spent by the government) pushes up the bond yield (Chart I-3), it makes it more expensive for the private sector to borrow and spend. If, as a result, the private sector scales back its borrowing by a dollar, the dollar of government spending would have no impact on GDP. This is because the dollar of government spending has crowded out a dollar of private sector spending. The fiscal multiplier would be zero. But doesn't the euro area debt crisis provide compelling evidence of the power of fiscal thrust and a very high fiscal multiplier? No, not exactly. The fiscal multiplier was high through the debt crisis because euro area austerity - a fiscal tightening - very unusually coincided with sharply rising bond yields - which killed private sector borrowing. In other words, fiscal tightening and private sector tightening were reinforcing each other. Through 2009-12, when the euro area debt crisis escalated, the relationship between fiscal tightening and growth in GDP per capita in 13 sampled economies had a near-perfect explanatory power (r-squared of 0.9); and its slope of 1.5 indicated an extremely high average fiscal multiplier (Chart I-4). But through 2012-15, after Mario Draghi "did whatever it takes" the unusual combination of fiscal tightening and higher bond yields no longer existed, and both the explanatory power of the relationship and fiscal multiplier collapsed (Chart I-5). Chart I-4A Very Strong Connection Between Fiscal Policy And Growth Through 2009-12... Chart I-5...But No Connection Between Fiscal Policy And Growth Through 2012-15 The lesson is that the efficacy of fiscal stimulus and infrastructure spending crucially depends on its impact on the bond yield - and thereby on private sector borrowing. Now note that the 6-month increase in the U.S. (and global) 10-year bond yield constitutes one of the sharpest tightenings since the Great Recession. Higher borrowing costs depress credit growth as captured in the 6-month credit impulse (Chart I-6). A weaker 6-month credit impulse then almost always depresses subsequent 6-month GDP growth (Chart I-7). Chart I-6Higher Borrowing Costs Depress##br## Credit Growth... Chart I-7...And Weaker Credit Growth Depresses ##br##Subsequent GDP Growth So yes, fiscal stimulus and infrastructure spending could be effective as long as the bond yield is anchored, as it is in Japan. But if the bond yield goes up sharply, the consequent drag from the private sector will partly or entirely negate any putative boost from the government. Explaining Market Shocks And Electoral Shocks In his seminal book Thinking, Fast And Slow psychologist and Nobel Laureate Daniel Kahneman1 proposed that the human brain has evolved two separate and independent systems for decision making: a fast, rapid-response, associative way of thinking which he calls "System 1" and a slow, analytical, measured way of thinking which he calls "System 2". The two ways of thinking, fast and slow, have evolved to protect us from two types of threat to our survival: immediate, and long-term. Thousands of years ago, the immediate threat to survival might have been a sudden noise in the bushes suggesting that a predator was stalking. Today, for a bond investor, the immediate threat might be a sudden noise about aggressive U.S. fiscal stimulus, suggesting that the end of deflationary pressures is nigh. Faced with this immediate but uncertain threat, using the slow and measured thinking of System 2 could be fatal. So we obey the fast-thinking, associative, emotional System 1 and run for cover - or sell bonds. Thousands of years ago, a long-term threat might have been a war of attrition against an enemy tribe. Today, for the bond investor, the long-term threat might be the end of the debt super cycle, suggesting that deflationary pressures will persist. Faced with this long war of attrition, an over-reliance on the impulsive decisions of System 1 could also be fatal. We must use the measured analysis and strategies of slow-thinking System 2. Kahneman's System 1 and 2 is also an excellent framework to help explain how the simple messages of the Brexiteers and Donald Trump led to stunning success at the ballot box. Faced with job destruction and stagnant real wages, many people intuitively believe that less globalization, less competition and less immigration must mean more jobs and a better standard of living. Associative and emotional System 1 immediately identifies with simple messages such as "take back control" or "build a wall". The success of the Brexiteers and Donald Trump was to acknowledge the deep malaise that many people are feeling and offer simple and intuitive cures. To be absolutely clear, this is neither an endorsement nor a criticism of the Brexiteers or Donald Trump, but simply an explanation of why their message hit home. Still, as we have argued, the more analytical and measured System 2 will find that the simple and intuitive cures that the Brexiteers and Donald Trump offer are not the panaceas that they might first seem. The Immediate Investment Decision Short-term traders generally use the rapid-response, associative, emotional System 1 for their decision making. Long-term investors generally use the slow, analytical, measured System 2. But after a shock, disoriented long-term investors may also switch from System 2 to System 1 and just follow the herd. Eventually though, System 2 switches back on, and the excessive herding and trend-following reverses. At the moment, several sector trends are at or near such a point of reversal according to our excessive groupthink indicator (Chart I-8, Chart I-9, Chart I-10, Chart I-11, Chart I-12). Chart I-8Healthcare Reversals After Excessive Trend-Following Chart I-9Consumer Goods Reversals After Excessive Trend-Following Chart I-10Telecoms Reversals After Excessive Trend-Following Chart I-11Financials Reversals After Excessive Trend-Following Chart I-12Government Bond Reversals After Excessive Trend-Following Specifically, on a 3-month trading view, we would lean against the aggressive sell-offs in Healthcare, Consumer Goods, Telecoms and government bonds; and we would lean against the aggressive rally in Financials. More generally, what does the Trump victory mean for European equities? In today's highly-connected financial markets, mainstream investments in Europe overwhelmingly depend on global developments, and not on parochial issues. The dominant components of the Eurostoxx600, FTSE100, DAX30, CAC40, AEX, SMI, and other major indices, are multinationals with a truly global footprint. So the answer rests on two subsidiary questions: What does the Trump victory mean for global monetary conditions? What does the Trump victory mean for global growth? As already mentioned, global monetary conditions have tightened significantly in recent months, and in accelerated fashion after the Trump victory. The 50bps tightening in the JPM global government bond yield since August constitutes one of the sharpest 3-month spikes since the Great Recession. But as in previous cases, the spike may be self-limiting given its squeeze on credit sensitive sectors and emerging markets. Since August, the dividend yield on equities is little changed - meaning that equities have become more expensive relative to bonds. But this is hard to justify as short-term growth prospects have, if anything, worsened. To repeat the powerful messages from Chart 6 and Chart 7, higher bond yields weaken credit growth; and weaker credit growth almost always depresses subsequent GDP growth. Putting all this together, asset allocators should maintain at most a neutral weighting to equities. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Daniel Kahneman won the Nobel Prize in economics in 2002 for his work on decision making. Fractal Trading Model* There are no new trades this week. After the big recent moves in markets, four open positions were closed at their trading-rule limits, two at profit targets, two at stop-losses. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart 1-13 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights EM risk assets will continue to plunge as U.S. bond yields and the U.S. dollar have more upside. Asset allocators should maintain an underweight allocation to EM within global equity and credit portfolios. Upgrade Russian stocks from neutral to overweight within an EM equity portfolio. Reinstate the long Russia ruble / short Malaysian ringgit trade. Feature The rout in emerging markets (EM) risk assets will persist, regardless of the direction of the U.S. equity market. While president-elect Donald Trump's potential fiscal stimulus will boost U.S. growth, it will not be sufficient to offset the negative impact on EM from rising U.S. Treasury yields and a stronger U.S. dollar. On a broader scale, risks of protectionist measures from the incoming U.S. administration are non-trivial, which will make investors even more jittery on EM. Notably, from a historical perspective, firm U.S. growth has not been a panacea for EM, particularly when the latter's domestic fundamentals were poor and commodities prices were falling. For example, EM in general and emerging Asia in particular collapsed in 1997- '98 when U.S. real GDP growth was averaging 4.5%, and European real GDP growth was 3.5%. In particular, U.S. import volumes were booming at double-digit rates, but this was insufficient to circumvent the crisis in Asia (Chart I-1). Importantly, U.S. bond yields were falling during the 1997-'98 period. Chart I-1Strong U.S. Growth Is No Panacea For EM Stocks It is hard to expect similar U.S. growth nowadays, even with Trump's potential fiscal impetus. Meanwhile, any fiscal boost in Europe so far remains a forecast. Besides, back in the 1990s, the U.S. and Europe were dominant sources of global demand - and China was not at all an economic power. Since the late 1990s, the significance of China and the rest of EM has grown enormously, while the importance of the U.S. and Europe with respect to global demand in general and EM in particular has fallen. In short, the outlook for stronger growth in the U.S. is not a reason to turn bullish on EM because the latter's fundamentals are poor. The U.S. dollar rally will persist. The greenback is close to being fairly valued, or only slightly expensive (Chart I-2). Typically, major cycles run until a market becomes considerably expensive or very cheap. It is not often that markets bottom or peak at their fair value. Odds are that the U.S. dollar will become more expensive before this bull market is over. In effect, the U.S. dollar rally is reflective of America sucking in capital. This will leave EM current account deficit countries exposed. As the currencies of these countries plummet and their local bond yields rise, their share prices will plunge and credit spreads will widen. Importantly, Trump's trade protectionist rhetoric could accelerate the depreciation in the Chinese RMB. If and when America imposes import tariffs on China, the latter will compensate via further yuan depreciation. In fact, Chinese residents will "assist" the People's Bank of China in devaluing the currency by converting their RMBs into U.S. dollars. As the RMB weakens further, probably at a faster speed, other Asian currencies will plummet (Chart I-3). In fact, odds are high that EM financial markets will once again become sensitive to the RMB. Chart I-2The U.S. Dollar Is Not Expensive Chart I-3RMB And Emerging Asian Currencies Apart from shorting the RMB versus the U.S. dollar, on October 19 we recommended shorting the KRW against the THB because the Korean won was one of most vulnerable EM currencies to continued RMB depreciation and renewed JPY weakness. We reiterate this trade today. Consistent with U.S. dollar appreciation, commodities prices will drop. One unsustainable post-U.S. presidential election move has been the rally in industrial metals in general, and copper in particular. Traders have bid up copper prices as the metal had lagged the rally in risk assets since February (Chart I-4). Nevertheless, expectations that U.S. infrastructure spending will considerably boost world demand for industrial metals are misplaced. The U.S. accounts for a very small portion of global industrial metals demand, including copper. Chart I-5 demonstrates that U.S. demand for copper is seven times smaller than that of China. On average, China accounts for about 50% of global demand for industrial metals, while the U.S. accounts for slightly less than 10%. Chart I-4The Rally In Copper ##br##Prices Is Unsustainable Chart I-5Industrial Metals ##br##Consumption: U.S. Versus China Hence, any reasonable rise in U.S. demand will not be sufficient to offset a single-digit percentage drop in China's intake of industrial metals, which we expect to occur in 2017. Finally, the Chilean mining firm Codelco - the largest copper producer in the world - in recent weeks has cut its premiums on copper shipped to Asia and Europe.1 This is a move to reduce prices - and a sign that demand is weak relative to supply. This leads us to believe that a rally driven by financial investors at a time of inferior demand-supply balance will prove short-lived. Investors should consider shorting copper on any further price strength. The selloff in U.S. and global bonds will likely persist well into December, which in turn will unravel the turmoil in bond proxies and high-multiples stocks (Chart I-6). In our July 13 Weekly Report,2 we argued that U.S. bond yields had bottomed and a selloff would prove painful as lower yields increases their duration. As a result, even a small rise in yields would lead to considerable bond price declines. Since then, while G7 bond yields initially grinded higher, they have surged over the past week. U.S. 10-year and 30-year bond yields have risen by 40 and 36 basis points, respectively since November 1. This translates into a 3.5% and 7.5% price decline for 10-year and 30-year bonds, accordingly. A similar scenario has also played out with EM bonds - both U.S. dollar and local-currency denominated. Accumulating considerable losses will force further bond liquidation. Our feeling is that many bond proxies and markets that benefited from lower yields will be seriously damaged in the coming weeks. Consistently, EM carry trades are at risk of further unraveling. Interestingly, Chart I-7 demonstrates that many high-yielding EM local bond markets are at a critical technical juncture. Odds are that their yields are heading considerably higher after troughing at their long-term moving averages. Chart I-6U.S. Bond Yields ##br##And Bond Proxies Chart I-7AEM Local-Currency Bonds Are ##br##At Critical Technical Resistance Levels Chart I-7BEM Local-Currency Bonds Are##br## At Critical Technical Resistance Levels Bottom Line: EM risk assets will continue to plunge. Stay put and remain defensive. Asset allocators should maintain an underweight allocation to EM within both global equity and credit portfolios. Currency traders who are not already short should consider shorting a basket of the following EM currencies: BRL, CLP, ZAR, TRY, IDR and MYR. In addition, we recommend maintaining our short RMB versus USD trade, as well as our short KRW / long THB position. Today, we are also reinstating the long RUB / short MYR trade (see section on Russia below). For more details on other currency, fixed-income, credit and equity positions, please refer to our Open Position Tables on pages 12-13. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com 1 Please see: Codelco cuts 2017 China copper premium by 27% to $72/t.- sources (2016, November 14). Retrieved from https://www.metalbulletin.com/Article/3601613/Latest-news/Codelco-cuts-2017-China-copper-premium-by-27-to-72-sources.html 2 Please refer to the Emerging Markets Strategy Weekly Report, titled "Risks To Our Negative EM View," dated July 13, 2016; a link is available on page 14. Russia: Overweight Equities; Reinstate Long RUB / Short MYR Trade Chart II-1Overweight Russian Stocks ##br##Versus The EM Equity Benchmark Russia stands out as one of the few EM countries that will likely benefit from Trump's presidency. As such, we recommend dedicated EM investors overweight Russia within both EM equity and credit portfolios. The energy and financial equity sectors together account for 75% of the Russian MSCI equity index, and we think they will continue to outperform their EM peers for the following reasons: With the ruble serving as a shock absorber, Russia's oil and gas sector has been able to weather the volatility in energy prices. If it wasn't for the ruble's massive devaluation in 2014-15, Russian energy companies would have struggled to stay solvent. While we expect oil prices to drop toward $35 per barrell, Russian energy stocks will still perform better than their EM counterparts. Furthermore, going forward, oil prices will outpace industrial metals prices. This should help Russian stocks, credit, and the currency outperform their EM peers (Chart II-1). As we argued above (please refer to page 3), the latest rally in industrial metals prices - based on expectations of U.S. infrastructure spending - does not make sense to us. In fact, the U.S. is a much more important consumer of oil than industrial metals in total world aggregate demand. Hence, strong U.S. growth and weaker Chinese growth (our baseline assumption) should be associated with oil prices outperforming base metals prices. Russia is much more advanced in its deleveraging cycle than most other EM economies. This will help banks and consumer stocks outperform their EM peers. In March 2016 we highlighted our preference for Russia's banking system relative to Malaysia's, and initiated a relative equity trade: long Russian stocks / short Malaysian stocks. This trade has already returned 30% and we believe it still has further to go. Today, we extend this positive view on Russia's banking system vis-à-vis Malaysia, to one versus the entire EM bank universe. In contrast to other emerging markets, Russian banks have been recognizing NPLs and have increased their provisions significantly (Chart II-2). Russia has now been in recession for two years and its banks have increased their NPL provisions and their credit growth has already slowed down significantly. This stands in stark contrast to other emerging markets, where banks are failing to realize NPLs and increase provisions adequately, despite substantially slower economic growth and elevated debt levels. In fact, Russia's domestic credit impulse is already starting to head into positive territory (Chart II-3), while the same indicator for the overall EM aggregate will be negative over the next 12 months or so. Russia's financial market outperformance will be aided by orthodox macro policies. This stands in contrast to unorthodox measures in many other developing countries. In terms of monetary policy, the Central Bank of Russia has refrained from injecting excess liquidity into the system or intervening in the foreign exchange market. Moreover, the central bank has been canceling the licenses of smaller banks. This is bullish for listed banks, as their market share will increase (Chart II-4). Chart II-2Russian Banks Have Recognized ##br##NPLs And Raised Provisions Chart II-3Russia's Credit Impulse ##br##Is Turning Positive Chart iI-4Russia: Banking Sector Consolidation ##br##Is Bullish For Listed Banks With respect to fiscal policy, although the government has exceeded its planned budget deficit of 3% of GDP for 2016, we believe this is not an issue given that Russia's total government debt is very low at only 16.5% of GDP. Lastly, our bias is that the recent victory of President-elect Trump will be marginally positive for the Russian economy relative to other EM. While the U.S. is not a major importer of Russian exports, investors will begin to price in sanction relief. European sanctions are particularly important for Russia and a substantive improvement in U.S.-Russia relations could lead some relatively pro-Russia European governments (Italy, Hungary, Greece, etc.) to demand that EU sanctions be either rolled back fully or significantly modified. Therefore, since Russia does not export as many goods to the U.S. compared to other emerging markets and sanctions may be easing soon, the nation is much more insulated from potential U.S. protectionist measures than many other EM countries. Investment Recommendations The Russian economy is further along its necessary adjustment path compared to the rest of the EM world, and there is less downside at the moment. Furthermore, Russian monetary and fiscal policymakers have undertaken orthodox policy measures in the face of an economic crisis - which cannot be said of many other EM countries. As such, we recommend dedicated EM investors upgrade Russia from neutral to overweight within an EM equity portfolio. We reiterate an overweight stance on Russian sovereign and corporate credit and recommend holding the following trades: Short Russian CDS / long South African CDS Long Russian and Chilean corporate credit / Short Chinese offshore corporate credit. We also recommend currency traders reinstate the long RUB / short MYR trade (Chart II-5). The two currencies are sensitive to energy prices, but the Russian economy is likely to recover soon, while the Malaysian economy has much more downside ahead. Excessive liquidity injections in Malaysia relative to somewhat tighter monetary conditions in Russia will lead to ringgit depreciation versus the ruble (Chart II-6). Lastly, the ruble offers a higher carry than the ringgit. Consistent with the currency trade, we are maintaining our long Russian / short Malaysian equity trade. Chart II-5Reinstate Long RUB / ##br##Short MYR Trade Chart II-6Malaysia And Russia: ##br##Non-Orthodox Versus Orthodox Stephan Gabillard, Research Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations