Trump Cards: What Hand Have Investors Been Dealt?

Markets have rushed to conclude that the Trump administration will unshackle developed world economies from the secular growth stagnation that has depressed equilibrium interest rates and bond yields since the financial crisis. But expansionary fiscal and protectionist trade policies won’t impact growth in a vacuum; their knock on effect on inflation, and thus monetary policy and bond yields, will dictate the ultimate pass through to final aggregate demand in the economy. How will the FOMC shape monetary policy in an environment where visibility on current economic momentum is constructive, but uncertainty around the sequencing and ultimate economic impact of Trump’s policy mix clouds the forecast horizon? The balance of risks in the Treasury market has shifted. Prior to the election, Treasury investors under-estimated the potential for any pro-growth impulse from fiscal policy over the coming year, but the recent reset in yields acknowledges the possibility that instead of continually revising its rate forecast lower for longer, Trump’s policies may force the Fed to transition to move rates higher, sooner.

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A tight labor market is reviving aggregate wage growth. Even the least skilled workers are getting a raise as the pool of unemployed, low-skilled workers has largely evaporated. The unemployment rate for those aged 25 and over without a high school diploma has halved from nearly 16% in 2010 to just under 8% now, such that this group is experiencing the strongest rise in real median weekly earnings now. To be sure, however, this cohort still has a long way to go to make up for lost earning power, having experienced a cumulative -22% decline in real median wages since 1980, the largest loss of all the labor force constituencies if grouped by educational attainment. No wonder this group voted for Trump’s promise to Make America Great Again. A quote embodying the definition of populism is particularly apt in this context: “I equate the person who vibrantly describes my rage with the person who has the solution to my rage.”

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The effectiveness of any fiscal expansion program depends critically on how fully the growth transmission mechanism or fiscal multiplier works. These multipliers can vary widely. The Congressional budget office estimates that large income tax cuts for high income earners or corporate tax relief won’t do much for growth and thus the uneducated factory worker, whereas direct spending by government on outlays such as infrastructure, tends to have a much higher multiplier. Fiscal stimulus can be cumulatively triply stimulative for growth when the economy is operating below potential, versus when it’s operating at potential, because slack usually precludes the need for monetary offset. In an environment where the economy already has momentum, the net fiscal multiplier may be limited, if monetary policymakers respond to the increase in demand from government stimulus by hiking rates more aggressively than they would otherwise.

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Emerging Asian economies have benefited the most from 35 years of globalization. Exports have driven a rise in living standards, as measured by per capita gdp growth. We expect Asian currencies to suffer disproportionately from this new round of dollar strength, as Trump’s trade retribution hits these countries the hardest. Compared to the drubbing Latam currencies have endured since the peak in resource prices in 2011, the KRW, TWD, and SGD are only trading 13%, 9%, and 15% below their post 2010 highs. An appreciating dollar can hurt emerging markets in three ways. First, a stronger dollar can weigh on commodity prices. Second, it can punish emerging market borrowers with significant dollar liabilities. Third, Fed rate hikes are liable to reduce global dollar liquidity, making it difficult for a number of emerging economies to attract enough foreign capital to finance their current account deficits.

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The US yield curve has been under relentless flattening pressure over the last 6 years as markets have doubted the durability of the US business expansion amid numerous negative shocks. The yield curve will be a barometer for how much growth candidate Trump delivers as President Trump. The more stimulus is financed by debt, the more Treasuries will be issued and interest will owed, the higher inflation will climb, and the steeper the curve will get. Right now the Fed telegraphs a rate hike in December of this year, and two more hikes in 2017. The Fed will likely want to avoid a rerun of last December’s market riot by offering too much hawkish guidance about next year without visibility on what form Trump’s economic policies are likely to take.

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To find out more, click here to listen to BCA Chief Strategist Caroline Miller’s November 17th Webcast.

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.

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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.

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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.

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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.

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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.

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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.

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

Will Brexit Put The Bond Bull Out To Pasture?

Almost three weeks on from Britain’s vote to leave the EU, markets have treated this political event as a negative local growth shock but a positive global interest rate shock. The upshot has been a surge in risk assets presumed less vulnerable to the growth drag, but benefiting from the ubiquitous plunge in bond yields. A spike in economic uncertainty, derived from the political uncertainty that the Brexit vote unleashed, drove government bond yields to new lows, as investors sought the safe harbor of high quality government bonds as a hedge against weaker global growth. The critical question is whether or not political uncertainty will actually translate into economic deterioration.

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European bank share performance dictates the pace of bank lending. Undercapitalization and weak credit demand are particularly acute in Italy where 360 bln euros’ worth, or 18% of bank assets, are deemed to be non-performing. If Spain’s ultimate write-down of 40 cents on the euro in the aftermath of its housing bust is any guide, Italian bank’s tangible common equity coverage of gross non-performing loans needs to be 40% to weather a similar storm. New pan-European directives on bank loss resolution require shareholders and junior creditors to absorb some losses before any public recapitalization. Italian households now hold 200bln euros’ worth of bank bonds eligible to be ‘bailed in’, accounting for about 5% of households’ financial assets. For Prime Minister Matteo Renzi, local loss-absorbing bank stakeholders are also voters who, in October, will undertake a referendum on Renzi’s leadership. Failure to secure a mandate for constitutional reform will open the door for the Eurosceptic anti-establishment Five Star Movement to revive existential risks around the viability of the common currency.

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With the world focused on European political risk, China’s currency is quietly drifting lower; so far this year it is down 3% vs the dollar and 7% in trade weighted terms. The RMB is a more important anchor for emerging Asian currencies than the yen, since China exports much more, globally, than Japan. A weaker RMB will allow Chinese producers to cut their export prices in US dollar terms forcing other Asian exporting nations to follow or lose market share. China still represents a source of deflationary pressure that undermines profitability of tradable goods producers globally.

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A slowdown in China, the world’s growth locomotive, has brought the deficiency of aggregate demand in developed economies less greased by credit growth in the post-debt Supercycle era into sharper focus. The growing gap between rich and poor was a key driver of the populist backlash that voted for Brexit. Rising income inequality is also one of the key factors propelling populist, protectionist sentiment in America. This trend has occurred across developed countries, depicted in the GINI coefficient, a measure of income inequality. This trend has led to a decline in real median income which has depressed U.S. aggregate demand by a cumulative 3% of GDP since the late 1970’s. The implication is that enacting policies that reduce income inequality will help combat secular stagnation. Ironically, while the immediate impact of the Brexit vote was a flight to safety pushing global bond yields to new lows, the longer-term outcome is liable to be higher yields. The political and economic uncertainty that Brexit risk inflames has increased the urgency for more proactive efforts to boost stagnating lower and middle class real incomes.

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U.S. Treasury yields are taking their current cues from policy uncertainty and the gravitational pull of negative yielding comparable quality sovereign paper. The Fed and markets will turn their attention back to the US domestic economic scene while they await evidence of the actual economic impact of Brexit risk on European growth. The plunge in Treasury yields belies ongoing progress toward full employment and the pickup in wage growth. We expect that while the pace of job growth has slowed, as is typical of a mature business cycle expansion, job gains in excess of 85-90k per month will be enough to tighten labor markets ultimately pushing inflation up to the Fed’s mandated 2% level. But markets discount almost no chance of the Fed hiking at all this year. This outlook has kept aggregate US financial conditions benign. The Fed is unlikely to ignore the fact that the current pulse of economic growth in the U.S. is pretty constructive.

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Investors have been sourcing income from high quality dividend paying stocks, and capital gains from bonds; this is unlikely to continue. In the near term, we are not inclined to chase the post-Brexit rally because we still see a long bumpy runway of political and economic uncertainty over the coming months. We will upgrade our cyclical outlook for equities relative to bonds on an equity correction of at least 5%, in conjunction with evidence that the global earnings outlook is improving and the policy loosening that we expect comes into clearer view. The US is the most expensive of the developed markets viewed through any valuation lens. The erosion of US profit margins from higher labor costs, balance sheet constraints, and dollar strength coupled with the Fed’s underlying tightening bias favors cheaper markets such as the euro area, Japan, and even China where margins have scope to recover, and policy is likely to be more supportive.

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While the path of least resistance for nominal yields is higher, the global output gap will take years to close; the path to higher nominal yields has to be lower yields for a long time. Thus, the best way to profit from more reflationary policies over the next two years is not by betting on higher nominal yields, but by buying inflation protection.

To find out more, click here to listen to BCA Chief Strategist Caroline Miller’s July 13th Webcast.

Is The Global Reflation Trade Out of Steam?

The confluence of a more dovish Fed since mid-February and evidence that China’s policy stimulus is stabilizing growth there has been instrumental in lifting risk assets over the last quarters. Two macro dynamics are critical to the outlook for the longevity of the reflation trade: 1) Chinese policymakers’ ability to ween the economy off its dependence on credit without torpedoing growth there and in the rest of the emerging world; and 2) the Fed’s reaction function to how global growth and easier financial conditions impact the US outlook.

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China’s reflationary impulse faces the stiff structural headwind of a massive buildup of private sector debt, now over 200% of GDP, towering over even the elevated leverage in advanced economies. China now needs four units of credit to generate a single unit of GDP. Firms are generating less free cash flow: accounts payable relative to sales for Shanghai-listed industrial, material, and property development firms are surging, and non-financial firms’ receivables are also rising even as credit growth booms. Firms are using new borrowing to pay bills rather than invest in new projects.

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But Chinese households save 41% of disposable income, much more than other major economies. Savings leads to more capital investment in the absence of intermediation through the household sector. Understanding the macro implications of a persistently high savings rate informs the odds of the Chinese government being able to reduce the economy’s dependence on credit-intensive investment while sustaining growth. A country’s current account balance is simply the difference between savings and investment. To the extent that a country like China over saves, those savings must be intermediated through domestic investment or exported to the rest of the world via a large current account surplus. China’s credit growth began to accelerate in 2009, precisely when the current account surplus started to narrow. When savings stopped finding an outlet abroad, it started to be transformed into investment via the domestic financial system; savers funneled money into bank deposits which got lent out to willing borrowers.

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Fortunately, as long as a country has ample domestic savings and borrows primarily in its own currency, debt can increase without hitting the proverbial ‘debt wall’ as fast as many expect. In China’s case, non-performing bank debt is also largely self-contained as it consists of loans made by state-owned banks to state-owned enterprises and local governments, which will cushion the eventual cleanup process. But China doesn’t need to face an imminent systemic financial crisis to be a source of deflationary pressure for the global economy in general and the rest of the emerging world in particular. China’s difficulty in shifting the economy away from its high reliance on investment means it will sustain excess capacity in a number of industries, particularly in the manufacturing sector which continues to deflate. This is good news for bonds, but bad news for global industrial corporate pricing power, as it depresses China’s demand for imported capital goods, largely procured from other emerging market nations whose growth will slow as a consequence.

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From the Fed’s perspective, however, China’s efforts to stabilize its economy have quelled fears of a sharp global growth slowdown that ravaged markets earlier in the year. Minutes from the Fed’s April meeting revealed a renewed hawkish tone which prompted markets to discount higher odds of at least one more rate hike this year. From the history of the last 20 years, the unemployment rate doesn’t need to drop much further for wage growth to accelerate, leading to a pickup in core inflation.

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Risky assets have been trading in a wide range since late 2014 as proxied by the total return of the stock to bond ratio. We have seen three episodes of the ratio hitting the top of its range, leveling off, and then selling off abruptly. In each case, the catalyst for the sell-off in risk assets has been markets discounting an overly restrictive Fed, with the 10 year yield topping out corresponding to the tipping point for the stock to bond ratio. Bond yields and rate expectations remain benign for now, but will grind higher in the next few months as markets continue to digest the Fed’s commitment to resuming the tightening cycle. The other warning sign for risk assets is the renewed weakening in the Chinese renminbi. Sharp setbacks in US equities last summer and earlier this year started with a depreciating Chinese currency. The recent stall in China’s growth reacceleration despite aggressive stimulus challenges the longevity of the mini reflation cycle we’ve seen in the last three months.

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To find out more, click here to listen to BCA Chief Strategist Caroline Miller’s May 26th Webcast.

Monetary Policy Endgames: Musings, Misgivings, and Markets

Markets’ dependence on central bank largesse has also revealed the limits of unconventional ultra-accommodative policy. The end of the debt Supercycle poses secular headwinds for growth because the level of debt suppresses central banks’ ability to rekindle a credit cycle. Contrary to fears of QE creating uncontrollable inflation, it turns out that high debt levels are deflationary, and deleveraging is difficult to effect when income is growing so slowly. Monetary policy has lost potency in terms of its ability to stimulate growth by rekindling demand for credit. This is because the credit creation process, the primary channel through which monetary policy typically impacts the economy, is impaired.

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Easier monetary policy has generated asset price reflation, however, which has spawned a wealth effect that has supported spending, in the absence of income growth. Equities have risen mostly thanks to multiple expansion, courtesy of the portfolio balance effect forcing holders of low yielding safe assets into higher risk securities. This asset allocation shift powered shares from 2012 through 2014, while earnings were growing, but since earnings have stopped growing, multiples and share prices have been moving sideways. The portfolio balance effect reflated financial assets when valuations were cheap, but seems to have run out of steam now that they’re not.

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While the effects of quantitative and credit easing on asset prices are a positive sum game, easing financial conditions ubiquitously, the third transmission mechanism for monetary easing, currency depreciation, is a zero sum. Real interest rate differentials drive currency values. In the last two years, outside the US, every G10 central bank but the UK has eased policy; the divergence of this trend with the Fed’s tightening bias has driven the dollar higher, even as expectations for the future path of US short rates have declined. This highlights the fact that no central bank operates in a vacuum, particularly in a growth-starved world.

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Japan’s strategy to engineer an incremental easing in financial conditions via negative rates has backfired. Bank shares have sold off, prompting markets to pare expectations of central banks’ ability to cut rates any further for fear of short-circuiting banks’ ability to function.

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Japanese government debt and household net worth have grown at roughly the same pace over the past two decades, so the deterioration in public finances has coincided with an equal and opposite improvement in household balance sheets. Public sector spending has filled the short fall in aggregate demand created by the drawn out private sector deleveraging cycle. The country has one of the lowest tax revenue to GDP ratios in the developed world and a vast store of taxable household wealth, 250% of GDP, upon which taxes could be levied retroactively via estate taxation. This means that what are now regarded as radical policies – debt monetization, or helicopter money – the practice of permanently increasing the money base through overt central bank financing of the fiscal deficit – can work in Japan. The country can issue debt in its own currency and has scope to tighten fiscal policy when inflation targets are reached without worrying that the unemployment rate will soar.

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It is the exercise price of that proverbial ‘policy put’ option for markets, not its existence that is open to debate. The strike price for such a put is likely a long way down from current asset price levels. This suggests that the path to political endorsement for such stimulus is more economic and financial market pain.

Just because the practical limits of NIRP have been exposed does not mean that monetary policy divergence has peaked. US money markets priced only 59 basis points of rate hikes over the next 24 months, coming into the April Fed meeting, but short rates are not expected to rise until 2019 in the UK and 2021 in Europe and Japan. The need for low to negative rates outside the US ensures that any tightening in US policy will cause the dollar to appreciate, such that the normalization of monetary US policy will occur more through currency adjustment than interest rate hikes.

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