Trump And U.S. Treasury Yields

Given recent improvements in global growth and breakouts in global bourses post-Brexit, the low bond yields represent a conundrum. Could Trump really be an answer to the puzzle?

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The 10-year nominal rate is inversely correlated with the probability of Donald Trump winning the U.S. election. So why buy Treasurys as a hedge against a Trump presidency? Generally speaking, Trump is a reason to own safe-haven assets for two reasons:

Trade: Trump could start a trade war with China in 2017. The consequences of a mercantilist America would be profound, potenitally throwing the world economy into a 1930s-like “beggar-thy-neighbor” spiral at a time when global trade is already weak.

Geopolitics: Trump is right when he says that the world is a mess because America is weak. The rest of the world has become a lot more powerful in the last two decades of relative peace and prosperity. The end result is global multipolarity, where numerous countries can pursue their interests independent of one another. We know from political science theory, formal modeling, empirical analysis, as well as the last five years of conflagrations that such a distribution of power is the most likely to create the sort of “messy world” that Trump claims he will “fix”.

Our U.S. bond strategists are not too surprised by the above relationship. They have pointed out that economic factors alone cannot explain the most recent downleg in bond yields. Rising “policy uncertainty”, which includes U.S. politics, has also been depressing bond yields.

Is China Transitioning Into A Free Market Economy?

The financial community still tends to assume that China will eventually become a Western-style developed market economy. Our geopolitical strategists do not think this is realistic.

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There is no doubt that the service sector continues to improve at the expense of the long-dominant manufacturing and resource sectors. However, it is very unlikely that China will abandon investment-led growth anytime soon. Chinese people are admirable savers, which necessitates a high level of investment. Exporters are unable, and consumers unready, to pick up the slack in GDP growth if investment is cut. Poverty and regional disparities remain challenges that only large-scale investment can address. Further, the investment model may be inescapable until China’s leaders embrace political decentralization and rule of law, and accept the socio-political realities of “consumer sovereignty.”

As for state involvement, the government currently supports SOEs as the backbone of key sectors and prevents liquidation even of non-strategic and failing quasi-state companies. As long as this continues, truly private business will operate at a disadvantage.

As for foreign access, China is getting more, not less, protectionist as it moves up the production value chain and develops a consumer economy. There is no reason to think the Xi administration will reverse course on this front.

Bottom Line: Weak but stable growth, financial instability, and simmering but not boiling social discontent do not encourage aggressive reform initiatives.

Are Chinese Equities Breaking Higher?

Chinese H shares have broken above their 200-day moving average, a key technical level. Can the up-trend continue?

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Fiscal measures have boosted Chinese business activity and corporate sector top-line growth. According to our China Investment Strategy service, the bigger factor behind improving profits is monetary easing that has lifted corporate profitability and margins.

Our Monetary Conditions Index (MCI) for China has eased considerably since the beginning of the year, due to a combination of falling interest rates and the depreciation in the trade-weighted renminbi. Given the Chinese corporate sector’s lofty debt levels and its high exposure to overseas markets, monetary conditions fundamentally matter for performance, particularly manufacturers of tradable goods. Therefore it is not at all surprising that the easing MCI in recent months has begun to boost corporate profits and lift overall business conditions.

Looking forward, we expect the Chinese authorities will remain accommodative, which means the MCI should continue to ease. Despite recent easing, the MCI remains tighter than historical norms, which calls for more monetary stimulus. At minimum, it is highly unlikely that the People’s Bank of China will allow for another round of dramatic tightening in monetary conditions. The risk of a growth relapse and significant negative earnings surprises due to monetary tightening is very low.

Bottom Line: An accommodative policy stance and improving growth conditions are positive for Chinese equities.

Slowing U.S. Trend GDP Growth

While last week’s U.S. Q2 GDP report disappointed on the downside, it was part of a longer period of sub-par growth. This reflects a significant deterioration in the potential growth rate of the U.S. economy.

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The sum of labor force and productivity growth is a simple way to estimate the trend GDP growth rate of an economy. The chart above shows the 5-year moving averages of labor force and productivity growth in the U.S. The data are smoothed to remove cyclical fluctuations in both series and to get a better sense of the long-term trends. The chart is quite sobering. Taken at face value, it suggests that U.S. trend growth has slowed to a multi-decade low of around 1%.

Although this exercise tells more about the past performance of the economy, it is hard to be optimistic that trend growth will suddenly re-accelerate. Demographics will dictate the growth in the labor force. In a report published late last year, the Bureau of Labor Statistics estimates that the U.S. work force will grow at an average annual rate of 0.5% for the next decade. Productivity trends are much more difficult to forecast. However, weak business investment and a potential peak in education attainment argue for continued slow productivity growth.

Weaker trend GDP growth will imply slower growth in corporate profits and also a lower equilibrium real interest rate for the economy. Please see the next Insight for a discussion of the real interest rate.

Is A Blow-Off In Global Equities On The Horizon?

Our Global equity strategists look at three factors that could feed a blow-off phase in stocks.

First, the character of the equity market advance may shift and a rotation out of defensives and into cyclicals could transpire. Since the previous market peak, defensive stocks have handily outperformed due to the drubbing in global bond yields. As the global bond bull market goes on hiatus at least for a while – a view that BCA’s Global Investment Strategy service has posited – defensive sectors may feel the heat.

Second, investors’ perceptions of improving global growth may be enough to move the needle in the still extremely oversold and under-owned cyclical sectors.

Third, there appears to be ample sidelined cash to flow back into stocks if a bear capitulation occurs and investors throw in the towel in order to participate in an advance. Tack on the recent flurry of global M&A activity encouraged by ultra-low bond yields and equity prices can vault higher.

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Bottom Line: Further equity strength should be characterized as a high-risk, liquidity-driven overshoot phase in global stocks. While both the magnitude and longevity of such a phase are difficult to gauge, our best guess is that weak earnings, a hawkish Fed and geopolitical risks could spoil the party.

For additional details please visit gss.bcaresearch.com