Market Returns
Highlights Chart 1Second Half Rebound The leveling-off of bullish sentiment toward the dollar and the perception of fading political risk have caused spread product to rally hard since the end of June. Indeed, corporate bonds are almost back into the black versus Treasuries for the year (Chart 1). We caution against buying into either of these trends. We have demonstrated that divergences between the U.S. and the rest of the world usually end with weaker U.S. growth,1 and our geopolitical strategists warn that American tensions with both Iran and China are poised to ramp up after the November midterms.2 Add in persistent monetary tightening and corporate profit growth that is barely keeping pace with debt growth, and it becomes clear that the corporate spread environment is turning more negative. Investors should maintain below-benchmark portfolio duration and only a neutral allocation to spread product versus Treasuries. Evidence of deteriorating profit growth is required before turning more negative on spread product. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 78 basis points in September, bringing year-to-date excess returns up to -16 bps. The index option-adjusted spread tightened 8 bps on the month, and currently sits at 114 bps. Corporate bonds remain expensive with 12-month breakeven spreads for both A and Baa-rated credit tiers below their 25th percentiles since 1989 (Chart 2). Further, with inflation now at the Fed's target, monetary policy will provide less and less support for corporate bond returns going forward. These are the two main reasons we downgraded our cyclical corporate bond exposure to neutral in June.3 Gross leverage for the nonfinancial corporate sector declined in Q2, for the third consecutive quarter (panel 4), though the declines have been quite modest. Dollar strength and accelerating wage growth will weigh on corporate profits in the second half of the year, and with corporate profit growth just barely keeping pace with debt growth (bottom panel), odds are that leverage will start to rise. Midstream and Independent Energy companies remain attractively valued after adjusting for duration and credit rating (Table 3). These two sectors stand to benefit from rising oil prices into next year, as is expected by our commodity strategists.4 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 104 basis points in September, bringing year-to-date excess returns up to +326 bps. The average index option-adjusted spread tightened 22 bps on the month, and currently sits at 316 bps. Our measure of the excess spread available in the High-Yield index after accounting for default losses is currently 209 bps, below the long-run mean of 247 bps (Chart 3). This tells us that if default losses are in line with our expectations during the next 12 months, we should expect high-yield returns of 209 bps in excess of duration-matched Treasuries, assuming also no capital gains/losses from spread tightening/widening. But the default loss expectations embedded in our calculation are also extremely low relative to history (panel 4). Our assumption, derived from the Moody's baseline default rate forecast and our own forecast of the recovery rate, calls for default losses of 1.07% during the next 12 months. Default losses have rarely come in below that level. While most indicators suggest that default losses will remain low for the next 12 months, historical context clearly demonstrates that the risks are to the upside. Meanwhile, with gross corporate leverage likely to rise in the second half of the year,5 and job cut announcements already trending higher (bottom panel), current default loss forecasts appear overly optimistic. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in September, bringing year-to-date excess returns up to -7 bps. The conventional 30-year zero-volatility MBS spread tightened 5 bps on the month, driven by a 4 bps decline in the compensation for prepayment risk (option cost) and a 1 bp tightening in the option-adjusted spread. The excess return Bond Map on page 15 shows that MBS offer a relatively poor risk/reward trade-off, particularly compared to Aaa-rated non-Agency CMBS, High-Yield and Sovereigns. However, our Bond Map does not account for the macro environment, which remains favorable for the sector. Refi activity is tepid, and continued Fed rate hikes will ensure that it stays that way (Chart 4). Meanwhile, lending standards have been slowly easing since 2014 (bottom panel). Despite the steady easing, the Fed's most recent Senior Loan Officer Survey reports that mortgage lending standards remain at the tighter end of the range since 2005. This suggests that further easing is likely going forward. In a recent report we noted that residential investment has decelerated in recent months, with the weakness mostly stemming from multi-family construction.6 Demand for single-family housing remains robust, and we see no potential negative impact on MBS spreads during the next 6-12 months. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 48 basis points in September, bringing year-to-date excess returns up to +38 bps. Sovereign debt outperformed the Treasury benchmark by 151 bps, bringing year-to-date excess returns up to +67 bps. Foreign Agencies outperformed by 70 bps on the month, bringing year-to-date excess returns up to +34 bps. Local Authorities outperformed by 50 bps, bringing year-to-date excess returns up to +91 bps. Supranationals outperformed Treasuries by 4 bps, bringing year-to-date excess returns up to +16 bps. Domestic Agency bonds outperformed by 6 bps, bringing year-to-date excess returns up to +10 bps. After adjusting for differences in credit rating and duration, the average spread available from the USD-denominated Sovereign index is unattractive compared to the U.S. corporate bond space (Chart 5). Dollar strength should also cause Sovereign debt to underperform U.S. corporates in the coming months (panel 3). But the outlook could be worse for the Sovereign index. Mexico, Colombia and the Philippines make up approximately 50% of the index's market cap, and our Emerging Markets Strategy team has found that none of those countries are particularly vulnerable to a slowdown in Chinese aggregate demand.7 Mexico and Columbia are particularly insulated. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 36 basis points in September, bringing year-to-date excess returns up to +153 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 2% in September, and currently sits at 87% (Chart 6). This is about one standard deviation below its post-crisis mean and only slightly above the average of 81% that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. In a recent report we demonstrated that while M/T yield ratios are low, municipal bonds offer attractive yields compared to corporate bonds.8 For example, we observe that a 5-year Aa-rated municipal bond carries a yield of 2.40% versus a yield of 3.42% for a comparable corporate bond index. This implies that an investor with an effective tax rate of 30% should be indifferent between the two bonds. Moving further out the curve, the breakeven tax rate falls to 23% at the 10-year maturity point and is even lower at the 20-year maturity point. The greater attractiveness of long-maturity munis is consistent across credit tiers, and investors should favor long-dated over short-dated municipal debt (bottom panel). Treasury Curve: Favor The 7-Year Bullet Over The 1/20 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve underwent a roughly parallel upward shift in September. While the 10-year Treasury yield rose 19 bps, the 2/10 slope was unchanged at 24 bps and the 5/30 slope flattened 3 bps to reach 25 bps. The yield curve is already quite flat, and our models suggest that a lot more flattening is discounted. For example, our 1/7/20 butterfly spread model shows that 32 bps of 1/20 flattening is priced into the 1/7/20 butterfly spread for the next six months (Chart 7).9 With the U.S. economy growing strongly and the Fed moving at a gradual +25 bps per quarter pace, the curve is likely to flatten by less than is currently discounted on a cyclical (6-12 month) horizon. This argues for positioning in curve steepeners. In a recent report we also made the case for owning steepeners as a hedge against the risk that weak foreign growth infiltrates the U.S. via a stronger dollar.10 We found that the yield pick-up is similar for the different steepener trades we considered, and also that the 7-year yield has the most downside in the event of a pause in the Fed's tightening cycle. This argues for maintaining our position long the 7-year bullet and short the 1/20 barbell, a position that has earned +37 bps since it was initiated in May. TIPS: Overweight Chart 8Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 16 basis points in September, bringing year-to-date excess returns up to +138 bps. The 10-year TIPS breakeven inflation rate rose 6 bps on the month and currently sits at 2.14%. The 5-year/5-year forward TIPS breakeven inflation rate rose 7 bps and currently sits at 2.25%. Both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates remain below the 2.3% to 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed's 2% target. TIPS breakeven rates have held firm in recent months, despite the sharp drop in commodity prices (Chart 8). This suggests that investors' inflation expectations are increasingly being swayed by U.S. core inflation, which is now more or less consistent with the Fed's target (bottom panel). In recent reports we showed that year-over-year core inflation (both CPI and PCE) is likely to flatten-off during the next six months.11 But continued inflation prints near the Fed's target should be sufficient to drive long-dated breakevens higher, into our target range. This will occur as persistent prints near target cause investors' fears of deflation to gradually ebb. ABS: Neutral Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in September, bringing year-to-date excess returns up to +29 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 4 bps on the month and now stands at 33 bps, just below its pre-crisis minimum. The excess return Bond Map on page 15 shows that consumer ABS offer attractive return potential compared to other high-rated spread products - such as Agency CMBS and Domestic Agencies - but also carry a greater risk of losses. The Bond Map also reveals that Aaa-rated credit card ABS offer a more attractive risk/reward trade-off than Aaa-rated auto loan ABS. We continue to recommend favoring the former over the latter. Credit quality trends have been slowly moving against the ABS sector and we think caution is warranted. The consumer credit delinquency rate bottomed in 2015, albeit from a very low level, and it should continue to head higher based on the trend in household interest coverage (Chart 9). Average consumer credit bank lending standards have also been tightening for nine consecutive quarters (bottom panel). Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 41 basis points in September, bringing year-to-date excess returns up to +167 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 6 bps on the month and currently sits at 83 bps (Chart 10). In a recent report we showed that the macro picture for CMBS is decidedly mixed.12 A typical negative environment for CMBS is characterized by tightening bank lending standards for commercial real estate loans and falling demand. At present, both lending standards and demand for nonresidential real estate loans are close to unchanged (bottom two panels). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 13 basis points in September, bringing year-to-date excess returns up to +54 bps. The index option-adjusted spread tightened 1 bp on the month and currently sits at 44 bps. The Bond Maps on page 15 show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this defensive sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of September 28, 2018) Chart 12Total Return Bond Map (As Of September 28, 2018) Table 4Butterfly Strategy Valuation (As Of September 28, 2018) Table 5Discounted Slope Change During Next 6 Months (BPs) Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "A Story Told Through Charts: The U.S. Midterm Election", dated September 19, 2018, available at gps.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 4 Please see Commodity & Energy Strategy Weekly Report, "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl", dated September 20, 2018, available at ces.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "More Than One Reason To Own Steepeners", dated September 25, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "More Than One Reason To Own Steepeners", dated September 25, 2018, available at usbs.bcaresearch.com 7 Please see Emerging Markets Strategy Special Report, "Deciphering Global Trade Linkages", dated September 27, 2018, available at ems.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 9 For further details on our yield curve models please see U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15, 2018, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, "More Than One Reason To Own Steepeners", dated September 25, 2018, available at usbs.bcaresearch.com 11 Please see U.S. Bond Strategy Weekly Report, "No Excuses", dated September 18, 2018, available at usbs.bcaresearch.com 12 Please see U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem", dated July 17, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)
Highlights Q3/2018 Performance Breakdown: The Global Fixed Income Strategy (GFIS) recommended model bond portfolio outperformed its custom benchmark in the third quarter of 2018 by +9bps. This raised the overall 2018 year-to-date performance to +6bps. Winners & Losers: The outperformance came mostly from our defensive duration positioning, which benefitted as global bond yields rose during the quarter, but also from successful country selection (overweight Australia & New Zealand, underweight the U.S., Canada & Italy). Our underweight tilts on EM credit were the largest drag on performance after the sharp EM rally in September. Scenario Analysis: The combination of defensive overall duration positioning and underweight allocations to EM and European credit should allow the model bond portfolio to outperform its custom benchmark index over the next year. Feature This week, we present the performance numbers of the BCA Global Fixed Income Strategy (GFIS) model bond portfolio for the 3rd quarter of 2018. We also update our scenario analysis of the future expected performance of the portfolio based on the risk-factor based return forecasting framework we introduced earlier this year. As a reminder to existing readers (and for new clients), the portfolio is a part of our service that is meant to complement the usual macro analysis of global fixed income markets. The model portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors, by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Broadly speaking, the portfolio did slightly outperform its benchmark index over the past three months, driven mostly by defensive duration positioning during a period of rising developed market bond yields. The portfolio would have done considerably better if not for a September rally in emerging market (EM) credit that flew in the face of our maximum underweight position in EM. We still have strong conviction in those two main themes - higher global bond yields and EM underperformance - and we fully expect our model portfolio to generate larger outperformance over the next year. Q3/2018 Model Portfolio Performance Breakdown: Duration Underweights Pay Off The total return of the GFIS model bond portfolio was +0.12% (hedged into U.S. dollars) in the third quarter of the year, which outperformed the custom benchmark index by +9bps (Chart of the Week).1 The main driver of the outperformance was our structural below-benchmark portfolio duration stance, which benefited as the overall Bloomberg Barclays Global Treasury Index yield rose to 1.54% - the highest level since April 2014. The portfolio's excess return got as high as +19bps on September 4th, before seeing some pullback in recent weeks as our main spread product tilt - underweight EM hard currency sovereign and corporate debt - enjoyed a counter-trend rally in September from the bearish spread widening seen since the start of 2018. Chart of the WeekDefensive Duration Stance = Q3 Outperformance Table 1GFIS Model Bond Portfolio Q3/2018 Overall Return Attribution In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +17bps of outperformance versus our custom benchmark index while the latter lagged the benchmark by -8bps (Table 1). The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. Chart 2GFIS Model Bond Portfolio Q3/2018 Government##BR##Bond Performance Attribution By Country Chart 3GFIS Model Bond Portfolio Q3/2018 Spread##BR##Product Performance Attribution By Sector The main individual sectors of the portfolio that drove the excess returns were the following: Biggest outperformers Underweight Japanese government bonds (JGBs) with maturities beyond 10 years (+7bps) Underweight U.S. Treasuries with maturities beyond 7 years (+6bps) Underweight French government bonds with maturities beyond 7 years (+2bps) Underweight Italian government bonds (+2bps) Overweight JGBs with maturities up to 10 years (+1bp) Biggest underperformers Underweight EM USD-denominated sovereign debt (-3bps) Underweight EM USD-denominated corporate debt (-3bps) Underweight euro area investment grade corporate debt (-2bps) Underweight euro area high-yield corporate debt (-1bp) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio. The returns are hedged into U.S. dollars (we do not take active currency risk in this portfolio) and also adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during the third quarter (red for underweight, blue for overweight, gray for neutral weight). Chart 4Ranking The Winners & Losers From The Model Portfolio In Q3/2018 Spread product sectors dominate the left half of that chart, as credit spreads have tightened across the board since the early September peak. The best performing sector during Q3 in our model portfolio universe was EM hard currency sovereign debt, which has delivered a total return of +2.8% since September 4th (with spreads tightening by 50bps) after losing -0.7% in July and August. Similar performance stories occurred in corporate debt in the U.S. and Europe during the quarter. That credit outperformance comes after the sustained spread widening seen in virtually all global credit markets (excluding U.S. high-yield) since January of this year. The main drivers that prompted that widening - Fed tightening, a stronger U.S. dollar, diminishing asset purchases from the European Central Bank (ECB) and Bank of Japan (BoJ), some cyclical slowing of non-U.S. growth - are still in place. With our geopolitical strategists continuing to highlight the additional risks of U.S.-China and U.S.-Iran tensions intensifying after next month's U.S. Midterm elections, a cautious stance on global spread product - as we have maintained since downgrading our recommended overall credit exposure to neutral in late June - is still warranted.2 Outside of spread product, our model portfolio tilts generally lined up with the sector returns shown in Chart 4. We have overweights on two of the best performing government bond markets (Australia and New Zealand) and underweights on three of the worst performers (U.S., Canada, Italy). Interestingly, despite having overweights on two of the worst performing government bond markets - Japan and the U.K. - the excess return contribution from those countries did not hurt the model bond portfolio return in Q3 (+8bps and 0bps, respectively). This was due to the curve steepening bias embedded within our overweight country tilts (i.e. more duration allocated to shorter-maturity buckets, see the model portfolio details on Page 14), which benefitted as yield curves in those countries bear-steepened. Net-net, we are satisfied with the modest portfolio outperformance seen in Q3, given that the rally in global credit markets went against our more defensive posture on spread product exposure. Bottom Line: The GFIS recommended model bond portfolio outperformed its custom benchmark in the third quarter of 2018 by +9bps. This put the overall 2018 year-to-date performance into positive territory (+6bps). The outperformance came entirely from our defensive duration positioning, which benefitted as global bond yields rose during the quarter, and from successful country selection. Our underweight tilts on EM credit were the largest drag on performance after the sharp EM rally in September. Future Drivers Of Portfolio Returns Looking ahead, the performance of the model bond portfolio will continue to benefit from two primary trends: rising global bond yields and growth divergences that continue to favor the U.S. In terms of the specific weightings in the GFIS model bond portfolio, we still prefer owning U.S. corporate debt versus equivalents in Europe and EM. When we downgraded our recommended allocation to U.S. and investment grade corporates to neutral from overweight back in July, we also cut the portfolio exposure to euro area corporates, as well as to all EM hard currency debt, to underweight. The latter changes were necessary to maintain our desired higher exposure to U.S. corporate debt versus non-U.S. corporates, although it did leave the model portfolio with a small overall underweight stance on global spread product (Chart 5). Importantly, we are maintaining a below-benchmark stance on overall portfolio duration, which is now one full year shorter than our benchmark index duration (Chart 6), even as we have grown more cautious on credit exposure. This is because we still see potential medium-term upward pressure on bond yields coming from tightening monetary policies (Fed rate hikes, ECB tapering of bond purchases) and increasing inflation expectations. The majority of global central bankers are dealing with tight labor markets and slowly rising inflation rates. While global growth has cooled a bit from the rapid pace seen in 2017, it has not been by enough to force policymakers to shift to a more dovish bias. Chart 5Spread Product Allocation:##BR##Neutral U.S., Underweight Non-U.S. Chart 6Maintaining##BR##Below-Benchnmark Duration Our underweights on EM and euro area spread product have left the portfolio in a "negative carry" position where it yields 34bps less than the benchmark index (Chart 7). In a backdrop of stable markets and low volatility, being short carry will be a drag on the model bond portfolio performance as we saw over the past month. Yet we do not see the recent market calm as being sustainable, with all plausible outcomes pointing to more volatile markets, largely driven by U.S.-centric events (more Fed tightening, a stronger dollar, U.S. growth convergence to slower non-U.S. growth, increased trade protectionism, higher oil prices due to U.S.-Iran tensions). We continue to suggest a cautious allocation of investor risk budgets against this backdrop. We have been targeting a tracking error (relative volatility versus the benchmark) for our model bond portfolio in the 40-60bp range, well below our 100bps maximum. Our current allocations give us a tracking error right at the bottom of that range (Chart 8).3 Chart 7The Cost Of Being More Defensive On Credit Chart 8Maintaining A Cautious Allocation Of The Risk Budget Scenario Analysis & Return Forecasts Back in April of this year, we introduced a framework for estimating total returns for all government bond markets and spread product sectors, based on common risk factors.4 For credit, returns are estimated as a function of changes in the U.S. dollar, the Fed funds rate, oil prices and market volatility as proxied by the VIX index (Table 2A). For government bonds, non-U.S. yield changes are estimated using historical betas to changes in U.S. Treasury yields (Table 2B). This framework allows us to conduct scenario analysis based on projected returns for each asset class in the model bond portfolio universe by making assumptions on those individual risk factors. Table 2AFactor Regressions Used To Estimate##BR##Spread Product Yield Changes Table 2BEstimated Government Bond##BR##Yield Betas To U.S. Treasuries With these tools, we than can attempt to forecast returns for each bond sector under different scenarios. We can then use those forecasts to predict the expected return for our model bond portfolio under those same scenarios. In Tables 3A & 3B. we show three differing scenarios, with all the following changes occurring over a one-year horizon. Table 3AScenario Analysis For The GFIS Model Portfolio Table 3BU.S. Treasury Yield Assumptions For The Scenario Analysis Our Base Case: the Fed delivers another 100bps of rate hikes, the U.S. dollar rises +5%, oil prices rise by +10%, the VIX index increases by five points from current levels, and U.S. Treasury yields rise by 40bps across the curve. A Very Hawkish Fed: the Fed delivers 150bps of rate hikes, the U.S. dollar rises by +10%, oil prices rise by +10%, the VIX index increases by ten points from current levels and there is a sharp bear flattening of the U.S. Treasury curve (2yr yield +75bps, 10yr yield +40bps). A Very Dovish Fed: the Fed only hikes rates by 25bps, the U.S. dollar falls by -5%, oil prices fall by -20%, the VIX index increases by fifteen points from current levels and there is a modest bull steepening of the U.S. Treasury curve. In this scenario, the Fed puts the rate hiking cycle on hold in response to a sharp tightening of U.S. financial conditions. Table 3A shows the expected returns for all three scenarios based on our risk-factor framework. The model bond portfolio is expected to outperform the custom benchmark index in all three scenarios we have laid out. This occurs even with the negative carry coming from the credit underweights in EM and Europe, with losses from credit spread widening projected to be larger than the yield give-up from being underweight. The excess returns are modest, however, with only 6bps of outperformance expected in our base case scenario and 13bps expected in the "Very Hawkish Fed" and "Very Dovish Fed" scenarios. This return distribution, with better outcomes occurring in the "tails", is a desirable property to have as it relates to the VIX/volatility forecasts embedded in the scenarios. Both of the non-base case scenarios have a higher VIX (Chart 9), even in the case of the "Very Dovish Fed" outcome where a severe U.S. financial market selloff (coming complete with a higher VIX) would be the necessary trigger for the Fed to reverse course and begin cutting interest rates (Chart 10). Such a backdrop would obviously hurt our below-benchmark duration stance, but would help our underweight EM/Europe spread product recommendations. Chart 9Risk Factors For Scenario Analysis Chart 10UST Yield Moves For Scenario Analysis Of course, our recommendations will not be static at current levels throughout the next twelve months. We increasingly expect that our next major allocation move will be downgrade U.S. spread product exposure and raise U.S. Treasury allocations, especially after the Fed delivers a few more 25bps-per-quarter rate hikes and the U.S. dollar rises further. This will provide a boost to the portfolio's expected returns through renewed spread widening and, potentially, a reduction of our below-benchmark overall duration stance as Treasury yields reach likely cyclical peaks. Bottom Line: The combination of defensive overall duration positioning and underweight allocations to EM and European credit should allow the model bond portfolio to outperform its custom benchmark index over the next year. Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Time To Take Some Chips Off The Table: Downgrade Global Spread Product Exposure To Neutral", dated June 26th 2018, available at gfis.bcaresearch.com. 3 In general, we aim to target a tracking error no greater than 100bps. We think this is reasonable for a portfolio where currency exposure is fully hedged and less than 5% of the portfolio benchmark is in bonds with ratings below investment grade. 4 Please see BCA Global Fixed Income Strategy Weekly Report, "GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start", dated April 10th 2018, available at gfis.bcareseach.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Feature GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of September 30, 2018. The quant model has not made significant allocation changes as shown in Table 1. As shown in Table 2 and Charts 1, 2 and 3, the overall model underperformed its benchmark by 53 bps in September, largely driven by Level 2 model which underperformed its benchmark by 156 bps. Japan was the largest underweight in the model, yet Japan was the best performing country in September, which contributed largely to the model's underperformance. Since going live, the overall model has outperformed its benchmarks by only 7 bps, driven by the Level 2 outperformance of 46 bps offset by the 8 bps of Level 1 underperformance. Even though the model underperformed significantly in both August and September, it's still within the back-tested range based on one-year and four-year changes. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, "Global Equity Allocation: Introducing The Developed Markets Country Allocation Model," dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model Dear Client, As advised last month, we have suspended the GAA Equity Sector Selection Model due to the significant changes in the GICS sector classifications, implemented at the end of September. We will rebuild the model using the newly constituted sectors once full back data is available from MSCI, which we understand will be in December. We thank you for your understanding. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Aditya Kurian, Senior Analyst adityak@bcaresearch.com
Highlights Portfolio Strategy The firming long-term housing demand backdrop, lumber price cost relief, steady new home prices and favorable new home sales expectations, all signal that it is time to buy homebuilders. On the flip side, we do not want to overstay our welcome in the S&P home improvement retail index as a number of leading industry profit indicators have started to wave a yellow flag. Recent Changes Boost the S&P Homebuilding index to overweight today. Trim the S&P Home Improvement Retail index to neutral and lock in gains of 13.3% today. Table 1 Feature Another week, another SPX all-time high. Investors have refocused their attention on the important macro drivers: solid profits, easing fiscal policy, and still-benign monetary policy with the real fed funds rate barely probing 0%. Trade-related rhetoric has taken the back seat as it has now become obvious that the rest of the world will bear the brunt of President Trump's trade escalation. Our EPS growth models are sniffing this out, with the SPX ticking higher, while our global profit model sinking close to nil (Chart 1). Chart 1Ex-U.S. EPS Will Bear The Brunt Of Trade Wars Importantly, we are impressed by how thick-skinned the market has become to negative trade-related news. Putting the looming Chinese tariffs into proper perspective is instructive. Assuming a 25% tariff rate on $250bn worth of Chinese manufactured goods and no relief from the renminbi's steep depreciation since April, results in a "tax" of $63bn. The net new "tax" is actually $53bn as an average 3.8%1 import tariff rate already exists on manufactured goods. The consumer and corporations will bear the brunt of this "tax", so it is worth examining the data on household net worth, consumer incomes, and corporate sales. Federal Reserve data show that household net worth increased by $8.1tn in the past year. BEA data reveal that total wage & salary disbursements increased by $400bn, and BCA's projections call for $600bn increase in SPX sales for 2019 (using IBES data for calendar 2019, Chart 2). In other words, it becomes clear that $53bn in a new tariff "tax" will barely eat into net worth, consumer incomes or corporate revenue flows. In addition, according to the IMF, fiscal easing in 2019 will surpass even this year's fiscal expansion in the U.S. The upshot is that over 1% of GDP in fiscal thrust in 2019 thwarts the specter of tariffs, before the fiscal impulse turns negative starting in 2020 (bottom panel, Chart 2). Meanwhile, following up from last week's report when we posited that the current macro backdrop resembles more the mid-2000s than the late-1990s, we are challenging ourselves and asking what if we are wrong in our assessment. Could we actually be replaying a late-1990s episode instead? Revisiting the late-1990s in more detail is in order, refreshing our memory on the sequence of events that led to the climactic LTCM bailout, and highlighting potential signposts that can be helpful in navigating today's macro and equity market maps. In March 1997 the Fed raised rates and pushed the fed funds rate to 5.5%. In hindsight that was a mistake as the Fed then paused the tightening cycle and watched as the Thai baht began to tumble in late-June 1997, eventually gripping all of the emerging world. True, the U.S. stock market modestly pulled back in October 1997 and the VIX spiked to 38. Then, as equities recovered in Q1/1998 and jumped to fresh all-time highs, suddenly the yield curve inverted in May 1998. Undeterred, the S&P 500 hit another peak in July of 1998 before falling roughly 20% in the subsequent month. Finally, once Russia defaulted and the Fed had to bail out the banks due to the LTCM fiasco, the FOMC, late in the game in September 1998, started to ease monetary policy, and engineered a steepening of the yield curve (Chart 3). Chart 2Trade "Tax" A Drop In The Bucket Chart 3Sequence Of Macro Events Matters The most important signpost from this trip down memory lane is the yield curve. In other words, heed the signal from the bond market: the yield curve inversion correctly predicted a reversal of Fed policy and naturally led the temporary peak in the stock market. Importantly, despite the peak-to-trough near-20% decline in the SPX between July and late-August 1998, if someone had bought the index on Jan 2, 1998 and held through the cathartic LTCM bailout, they remained in the black (bottom panel, Chart 3), and a buy the dip strategy was a winning one. As a last reminder, the SPX jumped another 65% from the August 1998 trough until the March 2000 peak that was preceded, once again, by another yield curve inversion. At the current juncture, were the yield curve to invert we would become overly cautious on the broad equity market as we highlighted in late-June2, and would begin to transition the portfolio away from cyclicals and toward defensives. But, we are not there yet. Thus, we sustain our sanguine broad equity market outlook on a 9-12 month horizon and our SPX target remains 10% higher with EPS doing all the heavy lifting as the multiple moves sideways (for more details, please refer to our April 30th, 2018 Weekly Report titled "Lifting SPX Target"). This week we are taking a deeper dive in housing and housing-related equities and making a subsurface portfolio shift. Look Through The Housing Soft Patch, And... While housing-related data releases have been slightly weaker than anticipated lately, we deem that this softness is transitory as housing market fundamentals rest on solid foundations. On the demand side, first-time home buyers still make only a third of total home sales and the homeownership rate is near generational lows, underscoring that pent up housing demand exists. In fact, the percentage of 18-34 year-olds that live with their parents remains close to 32% a multi-decade high and also represents another source of housing demand that has been dormant because of the Great Recession (Chart 4). Importantly, household formation is still running at a higher clip than housing starts and permits, signaling that the risk of a significant supply/demand imbalance is rising. Historically, this gets resolved via higher prices. Further on the supply side, inventories of existing and new homes for sale remain low and point toward a tight residential housing market (Chart 5). The 98.5% homeowner occupancy rate corroborates the apparent residential real estate market tightness. Chart 4Homeownership Still Well Within Reach Chart 5Positive Housing Demand/Supply Dynamics True, affordability has taken a hit both as a result of rising home price inflation and mortgage rates. But, putting affordability in historical context reveals that homeownership is still well within reach. Were we to exclude that aberration of the post 2007 surge in affordability owing to the collapse in house prices and all-time lows in mortgage rates, affordability is higher than the 1992-2007 range and only lower than the early 1970s. The reason is largely because of still generationally-low interest rates (Chart 5). While a rising interest rate backdrop and sustained house price inflation will continue to dent affordability, as long as job certainty remains intact and wage growth picks up steam as we expect (please see Chart 4 from last week's publication), we doubt that the U.S. housing market will suffer a relapse. ...Boost Homebuilders To Overweight, But... In that light, we recommend augmenting exposure to overweight in the S&P homebuilding index. With the labor market at full employment and unemployment insurance claims on the verge of breaking below the 200K mark, housing starts should regain their footing (Chart 6) and propel homebuilding profits. In addition, the latest Fed Senior Loan Officer survey showed that demand for residential real estate loans ticked higher, while simultaneously bankers remain willing extenders of mortgage credit. The implication is that new home sales will likely reaccelerate in the coming months (third & bottom panels, Chart 7). Chart 6Homebuilders Rest On Solid Foundations Chart 7Lumber Input Cost Relief While galloping lumber prices were previously a key reason for putting the S&P homebuilding index on our high-conviction underweight list, the recent liquidation, down $300/thousand board feet since the mid-May peak, in lumber prices represents a massive input cost relief for homebuilders (second panel, Chart 7). With regard to the relative pricing power front, previous price concessions (new home prices compared with existing home prices) are paying off as new home sales are steadily gaining a larger slice of the overall home sales pie (second & third panels, Chart 8). As input cost relief is slated to kick in during the next few months, especially on the framing lumber front, at a time when new home prices have stabilized, homebuilding sales and profits will likely overwhelm (bottom panel, Chart 8). While the latest NAHB/Wells Fargo National Home Market survey showed some softness on the overall housing market index (HMI), keep in mind that both the HMI and the sales expectations subcomponents of the survey are squarely above the 50 boom/bust line and only slightly below the recent cyclical highs (top and second panels, Chart 9). This healthy housing backdrop is also evident in plentiful construction job openings and expanding national house prices (third & bottom panels, Chart 9). Nevertheless, there are two risks to our upbeat S&P homebuilding view. First, interest rates. At the margin, rising mortgage rates can be a source of deficient housing demand especially for first-time home buyers. However, as mentioned earlier, interest rates are generationally low (middle panel, Chart 10) and the job market remains vibrant which should continue to entice first-time home buyers to make one of the largest purchase decisions of their lifetime. Chart 8Price Hikes Should Stick Chart 9Big Gaps Set To Narrow Chart 10Two Risks: Interest Rates & Wages Second, industry wage inflation. Construction sector wages are climbing rapidly, as much as 150bps faster than overall average hourly earnings (bottom panel, Chart 10). This is another key input cost for homebuilders that could eat into profit margins, especially if new home price inflation does not stick. In sum, a firming long-term housing demand backdrop, lumber price cost relief, steady new home prices and favorable leading indicators of new home sales will more than offset rising interest rates and industry wage inflation. Bottom Line: A playable opportunity has surfaced to ride the S&P homebuilding index higher. Lift exposure to overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM. ...Don't Over Stay Your Welcome In Home Improvement Retailers Nevertheless, we do not want to overstay our welcome on the other residential real estate-levered consumer discretionary subgroup, the S&P home improvement retail (HIR) index. We recommend a downgrade to a benchmark allocation for a relative gain of 13.3% since the July 5, 2016 inception. Such a move does not reflect a worsening overall housing view; as we made clear in our analysis above, we remain housing market bulls. Instead, we are concerned that too much euphoria is already priced in HIR equities. Chart 11 shows that fixed residential investment as a percentage of GDP is up 50% from trough to the recent peak (similar to the advance in existing home sales), whereas relative HIR performance is up 170% in the same time frame. Our worry is that optimistic sell side analysts' relative profit forecasts will be hard to attain, let alone surpass (bottom panel, Chart 11). Three main reasons are behind our softening EPS backdrop for home improvement retailers. First, our HIR model has plunged on the back of the wholesale liquidation in lumber prices and rising interest rates (Chart 12). Lumber deflation in particular will prove a profit headwind as building supply Big Box retailers make a set margin on wood products. Chart 11Too Much Euphoria Chart 12Timberrrr! Second, household appliance and furniture & durable selling prices have tentatively crested, and represent another source of profit headaches for HIR (bottom panel, Chart 13). Finally, select industry operating metrics suggest that the easy profits are behind HIR. Not only is our productivity growth proxy (sales per employee) on the verge of deflating, but also an inventory surge has sunk the HIR sales-to-inventories ratio into the contraction zone (second & third panels, Chart 13). But there are still some pockets of strength in the home improvement retailing industry that prevent us from turning outright bearish on the S&P HIR index. Despite the aforementioned easing in appliance and furniture wholesale prices, our HIR implicit price deflator has spiked on a short-term rate of change basis, likely owing to firm demand for remodeling activity. Indeed, the latest NAHB remodeling survey remains perched near record highs. The implication is that the recent lull in industry sales growth may reverse (middle and bottom panels, Chart 14). Importantly, a large driver of the previous cycle's remodeling activity was the availability of HELOCs and the stratospheric rise in Mortgage Equity Withdrawal (popularized by Fed economist Dr. James Kennedy). Now that home equity has nearly doubled to near 60% from the depths of the GFC, there are rising odds that homeowners may begin to tap their rebuilt equity and embark upon more renovations (top & middle panels, Chart 15). Tack on rising disposable incomes (bottom panel, Chart 15) and a buoyant labor market and the outlook for remodeling activity brightens further. Chart 13Operational Trouble Brewing... Chart 14...But Offsets... Chart 15...Exist Netting it out, is it prudent to lock in gains in the S&P HIR index as profit drivers have downshifted at the margin. Bottom Line: Crystalize gains of 13.3% in the S&P HIR index since inception, and downgrade exposure to neutral. The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Source: The World Bank, https://data.worldbank.org/indicator/TM.TAX.MANF.SM.FN.ZS?locations=US&name_desc=true 2 Please see BCA U.S. Equity Strategy Weekly Report, "Has The Reward/Risk Tradeoff Changed?" dated June 25, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights So What? President Trump is treating the midterm election as a hurdle. Once cleared, he will restart "Maximum Pressure" policy towards China and Iran that will induce market volatility. The outcome of the election, however, has only a marginal investment relevance. Why? A Democrat-held Congress will not have the votes to overturn President Trump's signature economic policies: tax cuts, deregulation, and stimulus. Removal from power requires 67 votes in the Senate, out of the reach for Democrats. President Trump will pursue aggressive foreign and trade policies, regardless of the midterm outcome. As such, the midterm outcome is a non-diagnostic variable. Also... Rising stroke-of-pen risk, combined with President Trump's unorthodox foreign and trade policies, will likely intensify following the midterm election. Therefore, it is difficult to "buy on (midterm-related) dips," despite our call that the election does not matter. Feature Should investors care about the upcoming midterm election? The answer is yes, but marginally. A gridlocked Congress, our most likely outcome, is historically less positive for equities than an electoral outcome that results in a unified executive and legislature (Chart 1). The reality, however, is that economic and monetary variables are overwhelmingly more important for investors than politics.1 Table 1 illustrates the impact of four factors on monthly S&P 500 price returns. The first two columns demonstrate the effect on returns of recessions and tightening monetary policy, respectively, whereas the last two columns measure the effects of gridlock and reduced uncertainty in the 12-months following presidential and midterm elections.2 The table presents the beta of a simple regression based on dummy variables for each of the four components (t-statistics are shown in parentheses). Chart 1A Unified Congress Is A Boon For Stocks Table 1A Divided Government Is Marginally Negative For Stocks As expected, the macro context has a much larger impact on stock returns than politically driven effects. The impact of political gridlock is shown to be negative regardless of the timeframe, but only just. Could 2018 be different? Given the extraordinary level of polarization - captured in Chart 2 by the difference in presidential approval by party identification - this time could, indeed, be different. But, we do not think it will be. As we discussed last week,3 Democrats in Congress would not be able to impact the three crucial pillars of the Trump Reflation Trade: De-regulatory agenda: The executive branch is in charge of the deregulatory agenda, which investors should note kindled corporate animal spirits on day 1 of the Trump presidency (Chart 3). Chart 2Presidential Approval Variance Signals Peak Polarization Chart 3Trump's Mere Election Stoked Animal Spirits Tax cuts: Without 67 votes in the Senate, the Democrats cannot overturn a presidential veto that is certain to be used on any tax-hikes as long as President Trump is in power. They won't even get to the 60 votes necessarily to invoke cloture and thus avoid a Republican filibuster on tax, immigration, or other policy reforms. Fiscal policy: We see no chance of the Democratic Party becoming the party of fiscal discipline ahead of the 2020 election. Voters are not demanding budget discipline, despite the obvious rise in budget deficits (Chart 4), so why would the Democratic Party nail itself to the fiscal conservative cross over the next two years? What of the impeachment risk? There is no empirical evidence that impeachment proceedings have any impact on U.S. equity markets.4 And we would fade any concerns that an impeachment push would cause President Trump to seek relevancy abroad with aggressive foreign and trade policies because we expect him to do so regardless of the midterm outcome! Nonetheless, we do think that investors are in for a mild surprise this November (Chart 5). First, the data suggests that Democrats will have a wave election. In fact, we are raising our probability of a Democratic House victory to 70%, largely in line with current expectations. Second, we are also raising our call on the Senate to a "too-close-to-call." Essentially, we think that the Democratic Party may be able to pick up a Senate seat, which would be an extraordinary outcome given that they are defending 26 seats out of the 35 in contention.5 While such an electoral surprise may not have immediate investment implications in 2018 and 2019, it could have implications beyond 2020. The Senate electoral math significantly changes in 2020, with Republicans currently set to defend 21 seats out of 33 in contention (a number that could grow due to retirements). A Democratic sweep of U.S. institutions in 2020 could significantly alter the long-term earnings outlook in the U.S., especially if America's center-left party swings further to the left by then. Such an outcome would put an end to the two-decade long divergence in profits and wages as share of the total economy (Chart 6). But more on that at a later point. In this report, we focus on the upcoming election itself. Chart 4Voter Fiscal Preferences Are Not Fixed Chart 5Our Senate Call Is Out Of Consensus Chart 6What Is Not Sustainable Will Stop Midterm Election: The Twenty Charts To Watch History is stacked against the Republican Party. Chart 7 shows that the president's party has lost, on average, 24 seats since the 1950 midterm election. Only Clinton in 1998 - at the top of an epic bull market and with an approval rating of 66% (!) - and Bush Jr. in 2002 - following a once-in-a-generation terrorist attack on the U.S. homeland - managed to eke out positive gains. Even in those Goldilocks conditions, Clinton's Democrats only picked up a paltry five seats in the House (none in the Senate), while Bush's GOP gained two Senate and eight House seats. Chart 7Midterm Elections Normally Spell Doom For The President's Party Polls suggest that this time will not be different. Both the congressional generic ballot (Chart 8) and President Trump's popularity - at just 39% - (Chart 9) are signaling a wave election for the Democrats. Chart 8Polling Gives Dems The Advantage Chart 9President Trump Is A Drag On The GOP... But what about the roaring economy? Astonishingly, economic performance has a negative correlation with electoral outcomes in congressional elections (Chart 10)! This data point is so counterintuitive that it must be wrong. At the very least, history suggests that there is no clear relationship between the economy and congressional returns. Chart 10...Whereas The Economy Is Unlikely To Provide A Tailwind The economy only matters when things are going wrong. Current polls, in other words, are already pricing in a solid economic context, with the Democratic lead over the Republicans having narrowed from double-digits since the economy began roaring in January (Chart 11). At this point, however, it is highly unlikely that two more months of solid economic performance will have much of an effect on voter preferences. In fact, the importance of the economy, jobs, and budget deficits to voters has been declining since 2014 (Chart 12). Chart 11The Economy Is Already Baked In The (Polling) Cake Chart 12Voters Care Less About Economic Issues In addition, investors should remember that voter experience of the economic recovery is highly polarized. During Obama's presidency, Republican voter consumer sentiment and expectations were at recession levels. Magically, on November 8, 2016, both Republicans and Democrats changed their sentiment (Chart 13). Independent voters are, unsurprisingly, somewhere in the middle. Chart 13Voters Cannot Agree On Economic Performance Anyway Primary election turnouts are confirming that the economy is not the primary driver of voter enthusiasm. Democrats have seen 8.9 million more voters vote in the 2018 primaries, compared to the 2014 midterm election. Meanwhile, GOP voters - who are presumably more enthused about the economy - have only seen a pickup of 3.8 million new primary voters. The pattern of primary voting is similar to the one in 2010, when the Tea Party revolt energized the Republican base in opposition to President Obama. In 2010, Republicans increased primary turnout in 186 congressional districts compared to the 2006 election. Satisfied with President Obama's win in 2008, Democrats only increased the primary turnout in 35 districts. As a result, the GOP picked up 63 House seats and gained control of the lower chamber of Congress. This time around, the numbers foreshadow a similar wave, but in favor of the left. Democrats have seen their turnout increase in 123 electoral districts, compared to the 2014 election. This includes 20 of the most competitive races this year. Republicans, meanwhile, have seen an increase in enthusiasm in only 19 congressional districts this year. The death knell for Republicans in the House of Representatives, in our view, will be the abnormally large number of retirements (Chart 14). Incumbency has a powerful effect in congressional races. On average, incumbents easily win over 90% of their races for the House (Chart 15). Chart 14Double More GOP Retirements This Year Chart 15Incumbents Normally Carry The Day The average margin of victory for the Republican representatives not running for re-election in the 42 electoral districts in 2016 was 28.3%6 (Table 2). This sounds like too high of a hurdle for Democrats to leap over. However, that is precisely what Democratic candidates have done in the House and Senate special elections in 2017 and 2018. The average GOP lead in those races is down from 29.2% in 2016 to just 8.5% today, a 20.7% swing (Table 3). This math explains why the Cook Political Report, the premier U.S. election forecasting consultancy, sees the number of competitive Republican-held seats more than doubling in 2018 (Chart 16), whereas the number of competitive Democratic-held seats has collapsed. Table 2Republicans Not Seeking Re-Election In 2018 Table 3Non-Incumbent Republicans Lost 20% Advantage In Special Elections Our Senate model is similarly flashing red for the Republican Party. Despite an overwhelming structural advantage in the 2018 cohort - having to only defend nine seats - our model is predicting that the Democrats will hold all their Senate seats and pick up one (in Nevada) (Chart 17). Chart 16Number Of GOP Seats At Risk Has More Than Doubled! Chart 17Our Senate Model Is Generous To The Democrats We modeled the individual Senate races by combining the state and national economic and political variables with the latest available opinion polling.7 We only focused on the races that we believe are currently competitive and we may change the mix as new information becomes available. The results of our "beta" model, expressed as a margin of victory by the Republican candidate (GOP total vote minus Democrat total vote), show that the Democrats have a surprisingly decent chance of picking up the Senate. Highly concerning for President Trump and the GOP is that the Democratic Senate candidates have a healthy lead in three out of the four contested Midwest races (Chart 18), suggesting that Trump's crossover appeal to blue-collar voters is not working when he is not the candidate (or perhaps, even more alarming for the GOP, when Hillary Clinton is not his opponent). The only tight Midwest election is in Indiana, where Democratic incumbent Joe Donnelly's lead is within the margin of error. Another concern for the Republicans is that the Democrats have largely fielded centrist candidates in the House and Senate races. For example, former Tennessee Governor (2003-2011), Phil Bredesen, is a conservative Democrat currently leading in the polls against his Republican opponent. Democratic candidates for election in Republican-held Arizona and Nevada are similarly centrists and thus competitive (Chart 19). Furthermore, in the 42 seats where Republicans are fielding non-incumbents, our research suggests that Democrats only fielded 14 left-wing/progressive candidates.8 Despite the media's focus on left-wing/progressive candidates - such as Alexandria Ocasio-Cortez in the Bronx or Ayanna Pressley in Boston - the vast majority of Democratic candidates in the non-coastal U.S. have been centrists. This means that GOP candidates will have very few "lay-ups" in November. Putting it all together, we would give Democrats a 70% chance of picking up the necessary 23 seats to take over the House. In the Senate, the next two months will determine the outlook for GOP candidates. Investors should fade the message from the current polling - and thus our model - as voters have paid very little attention to local races before Labor Day. However, if the current trajectory in the congressional generic poll and Trump's popularity holds until November, the likelihood of a GOP hold in the Senate will fall. For President Trump, a result where he loses the House and the Senate would be a political disaster. Should investors prepare for the volatility of impeachment in that case? The midterm election is a non-diagnostic variable. The Senate requires 67 votes to convict the president and thus remove him from power. A 50 +1 majority will not help Democrats get to that level any more than a 50 -1 minority would. They will need Republican Senators to join them in the impeachment endeavor. For that to happen, Republican voters will have to lose confidence in President Trump in droves, as they once did in President Nixon. As Chart 20 clearly illustrates, we are nowhere near that point today. Chart 18The Midwest: Is The Trump Magic Gone? Chart 19The Sun-Belt: No Place To Hide For The GOP? Chart 20Trump Is Not Nixon (Yet) Investment Implications: Much Ado About Nothing Putting it all together, this year's midterm election has a good chance of dominating the news flow by producing a shocking electoral surprise. In the immediacy of an outcome that hands the control of the entire Congress to the fired-up Democrats, it would be smart to bet on a brief risk asset pullback. However, the Democrats will not be able to unravel any of President Trump's main economic policies. In fact, investors may be presented with higher odds of an infrastructure plan and even of an immigration deal, if President Trump faces reality and comes to the middle ground on some of his demands (as President Clinton did after his disastrous 1994 midterm election). As for impeachment and the risk of President Trump "seeking relevancy abroad," our high conviction view is that he will continue pursuing unorthodox foreign and trade policies regardless of the midterm outcome. The just-announced 10% tariff on $200 billion of Chinese imports confirms our alarmist view on trade tensions. In fact, President Trump has explicitly threatened an increase of the tariff rate to 25% by the end of the year in order to put more pressure on Beijing. The increase in the tariff rate would be a significant escalation in the trade war, one that we do not expect Chinese policymakers to simply roll over and accept. Meanwhile, the U.S. embargo on Iranian oil exports will officially begin on November 4, just two days before the midterm election date. This is not a coincidence, but a product of White House design. We expect President Trump to turn the screws on Iranian exports in ways that President Obama did not.9 Given the potential impact on domestic gasoline prices, the White House has decided to coincide the pressure on Tehran with the end of the election season. The midterm election, therefore, is important only in terms of timing. Once it is out of the way, President Trump will refocus on his "maximum pressure" tactic, which he believes (and we agree) led to a breakthrough in North Korea policy. Unfortunately for the markets, we do not expect that the maximum pressure tactic will work as smoothly with Iran and China.10 The final risk to markets is the creeping "stroke of pen" risk from potential regulation of technology enterprises. Joseph Simons, the Trump appointed new chair of the Federal Trade Commission, recently said that "the broad antitrust consensus that has existed... for about 25 years is being challenged... the U.S. economy has grown more concentrated and less competitive."11 His comments have dovetailed the threat to FAANG stocks that exists from a shift in U.S. anti-trust enforcement, one that would take the anti-trust practice away from the consumer-friendly approach of the "Chicago School."12 Chart 21FAANG Stocks + Microsoft Have Dramatically Outperformed... Table 4...Generating 50% Of The 2018 S&P 500 Return! This is a big risk for the ongoing bull market as the reason why the S&P 500 has performed well is due to the performance of a few (enormous) technology stocks that have seen both earnings and valuation multiples expand amid one of the longest economic growth phases in history (Chart 21 and Table 4). And yet the one thing that a plurality of Democrats and Republicans seem to agree with is that major tech companies should be regulated (Chart 22). Privacy advocates - who tend to lean left or libertarian - and conservatives, who feel that their commentators are being silenced by Silicon Valley, could form a classic "bootleggers and abolitionists" coalition against the FAANGs post midterm election. In fact, it is the one thing that Trump, and his supporters may (Chart 23), have in common with a potentially left-leaning Congress. Chart 22Majority Of Americans Want Tech Regulated Chart 23Conservatives Distrust Tech Companies How should investors play the midterm election? It is tough to say. We do not think the Democrats' takeover of Congress will be a catalyst for the markets. However, there are a slew of concerning geopolitical developments that will accelerate post-election, some specifically because President Trump will become more aggressive following the electoral hurdle. As such, we would be cautious. While it may serve investors well to "buy on dips" related to the fear of a "Socialist" takeover of Congress, it will be difficult to disassociate such hysteria from genuinely bearish narratives emanating from the Middle East, with trade policy, or stroke of pen risks looming over FAANG stocks. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Ekaterina Shtrevensky, Research Associate ekaterinas@bcaresearch.com 1 Please see BCA U.S. Investment Strategy Weekly Report, "A Party On The QE2," dated November 8, 2010, available at usis.bcaresearch.com. 2 We include the last factor in the regression because it could be that the market responds positively in the post-election period, irrespective of the election outcome, simply because political uncertainty is diminished. 3 Please see BCA Geopolitical Strategy Weekly Report, "Fade The Midterms, Not Iraq Or Brexit," dated September 12, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 5 We are counting Senators Angus King (Maine) and Bernie Sanders (Vermont) as "Democrats" in this tally as they both caucus with the Democratic Party and generally vote very much in line with their left-leaning peers. 6 Excludes Pennsylvania due to redistricting in early 2018, and OK-01, as the candidate ran unopposed. 7 The state variables include the annual percent change in personal income, the annual change in the Philadelphia Fed Coincident index, and incumbency. The national variables include presidential approval ratings, a variable indicating whether the last presidential election was close, and the annual percent change in real GDP, CPI, industrial production, and the DXY. We add to this mix of national and state data the latest opinion polling by state race and the generic congressional ballot. 8 This number is largely our judgement call based on the statements from the Democratic primary winners. However, the fact that there is no unified progressive movement - akin to the 2010 Tea Party revolution - confirms our view. 9 Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "Are You Ready For 'Maximum Pressure?'," dated May 16, 2018, available at gps.bcaresearch.com. 11 Please see Diane Bartz, "Trump's antitrust enforcer considers shifting up a gear," dated September 13, 2018, available at reuters.com. 12 Please see BCA Geopolitical Strategy and U.S. Equity Strategy Special Report, "Is The Stock Rally Long In The FAANG?" dated August 1, 2018, available at gps.bcaresearch.com.