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.


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.


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.


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.


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.


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.


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

Where Is The U.S. Neutral Interest Rate Heading?

Some of the forces depressing the equilibrium real interest rate (r*) will abate.


Some factors are likely to shift from being deflationary to being inflationary. For example, weaker productivity growth in the U.S. has dragged down investment spending, reducing aggregate demand and inflation in the process. However, meagre productivity gains have also allowed the U.S. economy to reach full employment despite disappointing GDP growth. Going forward, the economy is likely to bump up against supply-side constraints if growth remains above-trend, putting upward pressure on inflation and interest rates.

Likewise, slower labor force growth has been deflationary thus far because it has reduced the incentive for firms to expand capacity, thus leading to less investment. An aging population has also increased the share of the labor force in their peak savings years – ages 30 to 50. This has raised aggregate savings relative to ex-ante investment intentions, leading to lower interest rates. However, as older workers begin to retire, overall household savings will eventually begin to decline, putting upward pressure on interest rates.

The next Insight looks at forces pulling down the neutral rate.

The Credit Impulse In Emerging Markets

The credit impulse in emerging markets (EM) will be negative over the next 12 months if credit growth converges to nominal GDP growth. This will dampen EM growth and corporate profits.


Credit excesses throughout EM have, for the most part, not been worked out: credit growth in the majority of EM countries remains above nominal GDP growth. According to our EM strategists, a period of indigestion is inevitable after years of booming corporate and household credit. Hence, credit growth is set to slow to at least the pace of nominal GDP growth.

It only takes credit growth to decelerate (i.e. it does not require a credit contraction) for economic growth to suffer and corporate profits to deteriorate. GDP and corporate profits are flow variables, while credit is a stock variable. What influences GDP and profit growth (the first derivative of flow variables) is the change in the credit growth rate (the second derivative of a stock variable). Specifically, it is the second derivative of outstanding credit – which we refer to as the credit impulse – that influences GDP and profit growth.

The chart above demonstrates that if credit growth in EM converges to nominal GDP growth in the next 12 months (for China the next 24 months), the credit impulse will be negative. This will ensure a slowdown in GDP growth and a further contraction in corporate profits across emerging markets.

Staying Power Of The U.S. Equity Rally

U.S. equities have soared higher, and are increasingly expensive: the underlying reward/risk tradeoff remains poor. That said, several of our indicators suggest that the high-risk rally is not over.


There are several reasons why the equity prices could continue to rally for a time:

For one, the Fed is sensitive to dollar strength. Officials have acknowledged that monetary ease in the rest of the world will impact U.S. interest rate decisions because a strong dollar would tighten U.S. monetary conditions. This increases the likelihood that European and Japanese monetary ease will benefit both U.S. equities and bonds.

Second, deflation tail risks in remission: Continued compression of emerging market sovereign and U.S. corporate bond spreads suggest easing abroad is keeping the tail risks that plagued equities in late 2015/early 2016 in remission.

Third, the Fed has room to “wait and see”: Subdued inflation pressures across the board are letting both Fed hawks and doves mark down their terminal rate, or resting spot for the Federal funds rate.

Finally, early-warning indicators not flashing warning signs: Investment bank share prices are rising, both in absolute terms and relative to the S&P 500. Market breadth is improving, judging from the ratio of the equal-weighted Value Line Index to the market cap-weighted S&P 500. Junk bond yields continue to decline in absolute terms and vis-à-vis Treasury yields. In previous cycles, junk bonds have tended to lead equity prices.

The next Insight looks at some potential catalysts for an equity selloff.

Implications Of Declining Returns On Capital In EM

Our EM strategists maintain their bearish view on EM risk assets based on poor credit and economic fundamentals. Persistent foreign capital flows are the biggest threat to their view.


Capital should flow to areas where the return on capital is (RoC) is high and rising. EM RoC has plunged in recent years and has not yet recovered. Importantly, the drop in RoC has not only been due to commodity prices.

The decline in RoC can be attributed to both cyclical and structural factors. The cyclical ones include: a slowdown in top line growth, strong wage/employee compensation growth, poor cost discipline (swelling costs during the boom years), as well as companies raising excessive capital and allocating capital inefficiently (the projects of the past several years have produced low/negative returns on investment). Meanwhile, structural factors include slower productivity growth and a general lack of structural regulatory reforms.

Overall, we do not detect many changes in EM cyclical and structural dynamics, except insofar as the rally in commodities prices over the past six months justifies a turnaround in commodities-producing EM economies. Please see the next Insight.