Dissecting Global Capex

The outlook for global and U.S. fixed capital formation is grim, according to Global Alpha Sector Strategy’s respective capex indicators (see chart).

In the U.S. (where we have the most detailed data breakdown) non-residential gross private investment comprises 40% of non-consumption GDP. Given the volatility of capex, this is a significant component of non-PCE GDP. Worrisomely, capex has been subtracting from GDP growth with the contribution swinging by over 100bps since the 2011 peak.

In contrast, non-residential fixed capital formation in the euro area (comprises 15% of GDP) is expanding at a healthy clip and positively contributing to GDP growth. The composition of capex is also different compared with the U.S. Outlays on machinery, equipment and weapons are the largest driver of overall capex (>40%) and sport the highest growth rate. Non-residential construction is on the recovery path and while IP is expanding, it has recently lost momentum.

Japan’s non-residential capex is contracting, and drifting lower as a percentage of GDP, dragged down by commercial structures and machinery & equipment spending, and to a lesser extent software. Outlays on transport equipment have been reaccelerating and are the sole capex sector showing signs of life.

From a global equity sector positioning perspective, this analysis is in sync with our recent breakdown of global industrials coverage in the three major regions: we continue to prefer Eurozone and Japanese industrials to their U.S. counterparts, within the context of an overall neutral global industrials weighting.

For additional details, please access the report “Meltdown or Melt-up?” at gss.bcaresearch.com.

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Stick With U.S. Yield Curve Flatteners

Any Fed rate hike pressures will be felt most strongly at shorter maturities, causing the yield curve to flatten further.

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If the U.S. dollar were to strengthen on the back of rising Fed hike expectations, it would lead to an additional tightening of U.S. monetary conditions. This would provide more flattening pressure on the yield curve, as has been the case over the past few years. But with the Fed now aiming for a much flatter path for rates in 2017, a big surge in the U.S. dollar that would depress the long-end of the Treasury curve is less probable. Our call for a flatter yield curve is in the context of a rising trend in U.S. Treasury yields (i.e. a bear-flattener), albeit a more modest one compared to the run-up to the first rate hike at the end of 2015.

Bottom Line: The 2/10-year Treasury curve will continue to flatten as the probability of a December Fed rate hike increases.

Will The Fed Be Trapped Like The BOJ?

The Fed wants to avoid, at all costs, entering the next recession with limited ammunition. Japan has been unable to sustainably lift rates since the turn of the century. Every time the BOJ has attempted to tighten monetary policy, the economy has endured recession. The highest it managed to lift rates was to 0.5% leading up to the Great Recession. The zero lower bound has served as a magnet, severely handicapping Japanese conventional monetary policy.

This is clearly a predicament the Fed wants to avoid, but the similarities with Japan are ee¬rie. The chart highlights that the Fed is closely following in the BOJ’s footsteps. Similarly, the lower bound of the 70% confidence interval of the Fed’s June median fed funds rate pro¬jection, as highlighted by Janet Yellen in her Jackson Hole speech, is flirting with the zero line. While we are not arguing that the U.S. is Japan, the odds are that the Fed will not have raised the Fed funds rate by enough in order to regain policy latitude for the next recession.

Our sense is that the Fed will likely wait until the economic dust settles before raising rates, as the risk/reward tradeoff favors a temporary 3-month deferral of the next rate hike.

For additional details, please access the report “Meltdown or Melt-up?” at gss.bcaresearch.com.

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Are Low Rates Jeopardizing Financial Stability?

Excessive financial deregulation, rather than low interest rates, may be the primary cause of financial crises.

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Our Global Investment Strategy service argues that low interest rates may not have been the main contributing factor to past financial crises. For example, housing bubbles in the Nordic countries in the late 1980s occurred against a backdrop of high interest rates, while persistently low interest rates in the U.S. in the 1950s and 1960s failed to generate asset bubbles or out-of-control credit booms.

Rather, rapid financial deregulation may have been the reason behind prior crises. Encouragingly, the thrust of recent legislation in the U.S. and many other developed economies has transformed banks into the equivalent of well-regulated utilities. This implies lower rates of return on equity and assets for investors, but also diminished risk of massive losses.

As discussed in the next Insight, low interest rates are not generating the same sort of distortions in the real economy as they did during prior stock market booms.

What’s Next For Risk Assets?

A critical concern for investors remains the extent to which asset price appreciation depends on easier financial conditions, in the absence of convincing evidence that the fundamental corporate profit backdrop is to reaccelerate. A benign interpretation of the recent divergence between bond yields and equity prices is the narrative that central bank commitments to ultra-loose monetary settings have depressed bond yields and stimulated global growth, but that the pickup in growth will be non-inflationary, constituting high octane fuel for stocks because it is benign for bonds. A less comfortable explanation is the dynamic that global QE spawns: the so called ‘TINA’ effect that propels private sector capital out of one exceptionally overpriced asset ( high quality, negative yielding government bonds), into another, (high yielding stocks and income proxy assets), keeping returns positive in a negative rate, slow growth world, at the expensive of assuming more risk. Commodity prices offer no comfort that a synchronized recovery in global growth is at hand, which has important implications for Fed policy and the US dollar. Precious metals are still outperforming industrials, suggesting that the plunge in interest rates globally, not stronger end demand for inputs to the manufacturing complex, has boosted commodity prices since February.

1st

In this zero rate world, marginal shifts in relative monetary policy impart deflation to the US via a stronger dollar, a macro variable that features prominently in the FOMC’s peripheral vision. The 20% appreciation in the value of the US dollar since mid-2014 has indeed keyed off of relative shifts in policy as proxied by 2 year swap rate differentials. But the Fed has only managed one quarter point rate increase so far in this cycle while maintaining a bloated balance sheet, so interest rate differentials shifted in favor of the dollar almost exclusively due to other global central banks easing policy. In the absence of Europe, Japan, or China’s economic momentum demonstrating enough strength to justify a moderation in the level of monetary accommodation deployed to support those economies, any increase in the expected path of US rates will prompt a resumption of the dollar’s appreciation, even as markets fixate on how shallow this tightening cycle is likely to be relative to history.

2nd

The reason that asset and currency markets question the Fed’s need and doubt its ability to increase interest rates is that estimates of the equilibrium real rate of interest, the rate allowing an economy to operate at full employment, have dropped so precipitously, implying that current policy isn’t actually that loose. We have been arguing that the real terminal rate is close to zero.

3rd

Even if the end point of the tightening cycle will be lower than it has been, investors shouldn’t extrapolate lower for longer to mean zero forever. The Fed is closer to achieving its mandate of full employment and 2% core inflation, than markets discount. While inflation remains below target, it has clearly bottomed for this cycle. The recent acceleration in domestically-geared core service price inflation is a function of faster wage growth, emblematic of receding labor market slack.

4th

The primary lubricant for EM growth and asset prices in recent months has been easier financial conditions, courtesy of the Fed. Any marginal tightening in financial conditions is a recipe for turbulence in EM assets. More broadly, there isn’t much disagreement about monetary policy’s diminishing marginal ability to sustain asset price appreciation from current valuation levels. Global EPS growth appears to be bottoming and our models point to a break into positive territory by the middle of next year, but with very little cushion for any negative shocks.

5th

We acknowledge investors’ need to generate income; missing out on an incremental melt up in risky assets when ownership of low or negative yielding safe haven assets all but guarantees a real loss of purchasing power makes that bugaboo particularly acute. Central bank asset purchases have exhausted their compression of government bond term premia but continue to push high grade corporate spreads tighter. While we reluctantly accept that the search for yield requires identifying the least expensive asset to satisfy that mandate, we have a high conviction that the combination of continued economic expansion, attractive valuation, and a shift away from fiscal austerity support a strategic allocation to US TIPS, and inflation protection in other markets as well, for that matter. A rate hike in the near term will not alter the Fed’s long term cautious approach to policy normalization so TIPS breakeven yields are destined to rebound from today’s depressed levels.

6th

To find out more, click here to listen to BCA Chief Strategist Caroline Miller’s September 8th Webcast.