Policy
Yesterday’s ECB monetary policy meeting offered no surprises for investors. All policy interest rates were left unchanged, as were the sizes of the ECB’s asset purchase programs. In the press conference following the meeting, ECB President Christine Lagarde…
Highlights Higher copper prices will follow in the wake of China's surge in steel demand, which lifted Shanghai steel futures to an all-time high just under 5,200 RMB/MT earlier this month, as building and infrastructure projects are completed this year (Chart of the Week). Copper will register physical deficits this year and next, which will pull inventories even lower and will push demand for copper scrap up in China and globally. High and rising copper prices could prompt government officials to release some of China's massive state holdings of copper – believed to total some 2mm MT – if the current round of market jawboning fails to restrain demand and price increases. Strong steel margins and another round of environmental restraints on mills are boosting demand for high-grade iron ore (65% Fe), which hit a record high of just under $223/MT earlier this week. Benchmark iron ore prices (62% Fe) traded at 10-year highs this week, just a touch below $190/MT. We are lifting our copper price forecast for December 2021 to $5.00/lb from $4.50/lb. In addition, we are getting long 2022 CME/COMEX copper vs short 2023 CME/COMEX copper at tonight's close, expecting steeper backwardation. Feature Government-mandated reductions of up to 30% in steel mill operations for the rest of the year in China's Tangshan steel hub to reduce pollution will tighten an already-tight market responding to a construction and infrastructure boom (Chart 2). This boom triggered a surge in steel prices, and, perforce, in iron ore prices (Chart 3). As it has in the past, this sets the stage for the next leg of copper's bull run. Chart of the WeekSurging Steel Presages Stronger Copper Prices In our modeling, we have found a strong relationship between steel prices, particularly for reinforcing bar (rebar), and copper prices, as can be seen in the Chart of the Week. Steel goes into building and infrastructure projects at the front end (in the concrete that is reinforced by steel and in rolled coil products), and then copper goes into the completed project (in the form of wires or pipes). Chart 2Copper Bull Market Will Continue In addition to the building and construction boom, continued gains in manufacturing will provide a tailwind for copper prices, which will be augmented by the global recovery in activity 2H21. Chart 4 shows the relationship between nominal GDP levels and copper prices. What's important here is economic growth in Asia (including China) and ex-Asia is, unsurprisingly, cointegrated with copper prices – i.e., economic growth and industrial commodities share a long-term equilibrium, which explains their co-movement. Chart 3Steel Boom Lifts Iron Ore Prices Media reports tend to focus on the effects of Chinese government spending as a share of GDP – e.g., total social financing relative to GDP – to the exclusion of the economic, particularly when trying to explain commodity price movements. To the extent the Chinese government is successful in further expanding the private sector – on the goods and services sides – organic economic growth will become even more important in explaining Chinese commodity demand. Chart 4Global Economic Grwoth Will Boost Copper Prices In our copper modeling, we find copper prices to be cointegrated with nominal Chinese GDP, EM Asian GDP and EM ex-Asian GDP, along with steel and iron ore prices, which, from a pure economics point of view, is what would be expected. On the other hand, there is no cointegration – i.e., no economic co-movement or a shared trend – between these industrial commodity prices and total social financing as a percent of nominal China GDP. These models allow us to avoid spurious relationships, which offer no help in explaining or forecasting these copper prices. Chart 5Iron Ore, Copper Demand Will Lift With The "Green Energy" Buildout Chart 6Renewables Dominate Incremental New Generation Longer term, as we have written in past research reports, the transition to a low-carbon energy mix favoring distributed renewable electricity generation, more resilient grids and electric vehicles (EVs) will be a major source of demand growth for bulks like iron ore and steel, and base metals, particularly copper (Chart 5).1 Already, renewable generation represents the highest-growth segment of incremental power generation being added to the global grid (Chart 6). Copper Supply Growth Requires Higher Prices Copper supply will have a difficult time accommodating demand in the short term (to end-2022) when, for the most part, the buildout in renewables and EVs will only be getting started. This means that over the medium (to end-2025) and the long terms (2050) significant new supply will have to be developed to meet demand. In the short term, the supply side of refined copper – particularly the semi-refined form of the metal smelters purify into a useable input for manufactured products (condensates) – is running extremely low, as can be seen in the longer-term collapse of Treatment Charges and Refining Charges (TC/RC) at Chinese smelters (Chart 7). At ~ $22/MT last week, these charges were the lowest since the benchmark TC/RC index tracking these charges in China was launched in 2013, according to reuters.com.2 Chart 7Copper TCRCs Fall As Supplies Fall, Pushing Prices Higher The copper supply story also can be seen in Chart 8, which converts annual supply and demand into balances, which will be mediated by the storage market. The International Copper Study Group (ICSG) estimates mine output again registered flat year-on-year growth last year, while refined copper supplies were up a scant 1.5% y/y. Chart 8Physical Deficits Will Draw Copper Stocks... Consumption was up 2.2%, according to the ICSG's estimates, which expects a physical deficit this year of 456k MT, after adjusting for Chinese bonded warehouse stocks. This will mark the fourth year in a row the copper market has been in a physical deficit, which, since 2017, has averaged 414k MT. The net result of this means inventories will once again be relied on to fill in supply gaps, and global stockpiles, which are down ~25% y/y, and will continue to fall (Chart 9). With mining capex weak and copper ore quality falling, higher prices will be required to incentivize significant new investment in production (Chart 10). However, the lead time on these projects is five years in the best of circumstances, which means miners have to get projects sanctioned with final investment decisions made in the near future (Chart 11). Chart 9...Which After Four Years Of Physical Deficits Are Low Chart 10Higher Copper Prices Required To Reverse Weak Capex, Falling Ore Quality Chart 11Falling Lead Times To Bring New Mines Online, But Time Is Short Investment Implications Our focus on copper is driven by the simple fact that it spans all renewable technologies and will be critical for EVs as well, particularly if there is widespread adoption of this technology (Chart 12). We continue to expect copper supply challenges across the short-, medium- and long-term investment horizons. To cover the short term, we recommended going long December 2021 copper on 10 September 2020, and this position is up 39.2%. To cover the longer term, we are long the S&P Global GSCI commodity index and the iShares GSCI Commodity Dynamic Roll Strategy ETF (COMT), recommended 7 December 2017 and 12 March 2021 , respectively, which are down 2.3% and 0.8%. Chart 12Widespread EV Uptake Will Create All New Copper Demand At tonight's close, we will cover the medium-term opportunity of the copper supply-demand story developed above by getting long the 2022 CME/COMEX copper futures strip and short 2023 CME/COMEX copper futures strip, given our expectation the continued tightening of the market will force inventories to draw, leading to a steeper backwardation in the copper forward curve. The principal risks to our short-, medium- and long-term positions above are a global failure to contain the COVID-19 pandemic, which, we believe is a short-term risk. Second among the risks to these positions is a large release of strategic copper concentrate reserves held by China's State Reserve Bureau (aka, the State Bureau of Minerial Reserves). In the case of the latter risk, the actual holdings of the Bureau are unknown, but are believed to be in the neighborhood of 2mm MT.3 Bottom Line: We remain bullish industrial commodities, particularly copper. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Commodities Round-Up Energy: Bullish Texas is expected to add 10 GW of utility-scale solar power by the end of 2022, according to the US EIA. Texas entered the solar market in a big way in 2020, installing 2.5 GW of capacity. The EIA expects The Great State to add ~ 5GW per year in the next two years, which would take total solar capacity to just under 15 GW. Roughly 30% of this new capacity is expected to be built in the Permian Basin, home to the most prolific oil field in the US. By comparison, the leading producer of solar power in the US, California, will add 3.2 GW of new solar capacity, according to the EIA (Chart 13). To end-2022, roughly one-third of total new solar generation in the will be added in Texas, which already is the leading wind-powered generator in the country. Wind availability is highest during the nighttime hours, while solar is most abundant during the mid-day period. Precious Metals: Bullish Palladium prices, trading ~ $2,876/oz on Wednesday, surpassed their previous record of $2,875.50/oz set in February 2020 and are closing in on $3,000/oz, as supply expectations continue to be lowered by Russian metals producer Nornickel, the largest palladium producer in the world (Chart 14). Earlier this week, the company updated earlier guidance and now expects mine output to be down as much as 20% this year in its copper, nickel and palladium operations, due to flooding in its mines. Palladium is used as a catalyst in gasoline-powered automobiles, sales of which are expected to rebound as the world emerges from COVID-19-induced demand destruction and a computer-chip shortage that has limited new automobile supply. In addition, production of platinum-group metals (PGMs) is being hampered by unreliable power supply in South Africa, which has forced the national utility suppling most of the state's power (> 90%) to revert to load-shedding schemes to conserve power. We remain long palladium, after recommending a long position in the metal 23 April 2020; the position is up 35.6%. Chart 13 Chart 14 Footnotes 1 Please see, e.g., Renewables, China's FYP Underpin Metals Demand, which we published 26 November 2020. It is available at ces.bcaresearch.com. 2 Please see RPT-COLUMN-Copper smelter terms at rock bottom as mine squeeze hits: Andy Home published by reuters.com 14 April 2021. The report notes direct transactions between miners and smelters were reported as low as $10/MT, in a sign of just how tight the physical supply side of the copper market is at present. 3 Please see Column: Supercycle or China cycle? Funds wait for Dr Copper's call, published by reuters.com 20 April 2021. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades
Highlights Chart of the WeekThe Bond Bear Mantle Being Passed To Canada? US Treasuries: The steady climb of US bond yields has left longer-maturity Treasuries in an oversold position. However, underlying growth and inflation momentum remains bond bearish and the Fed is likely to begin preparing the market later this year for a tapering of asset purchases in 2022. Maintain a medium-term defensive posture towards US Treasuries (below-benchmark duration and an underweight country allocation). Canada: The Canadian economy is gaining significant positive momentum, with an increased pace of vaccinations boosting optimism despite a third wave of COVID-19. We now see a growing risk of the Bank of Canada shifting to a less dovish policy stance sometime in the next few months, led by a tapering of its bond buying – perhaps even before the Fed does the same (Chart of the Week). Downgrade Canadian government bonds to underweight in global fixed income portfolios. US Treasuries: The Pause That Refreshes Chart 2UST Yield Uptrend Has Paused After leading the global government bond market selloff over the past several months, US Treasury yields have calmed down of late. The 10-year Treasury yield is down 14bps from the most recent peak of 1.74% reached March 31, while the 30-year Treasury yield is down 16bps from the peak of 2.45% reached on March 18. These moves have been concentrated in the real yield component, with inflation breakevens stable, as the 10yr and 30yr TIPS yields are down -15bps and -20bps, respectively, since the dates of those peaks in nominal yields (Chart 2). The drift lower in US yields has occurred in the face of an explosive surge in US economic data. Retail sales rose +9.8% in March compared to February and a staggering +27.7% on a year-over-year basis. The Fed’s regional manufacturing surveys showed very robust results for April, with the New York Empire State index hitting the highest level since October 2017 and the Philadelphia Fed headline index surging to a level last seen in 1973. This follows the very strong payrolls and ISM data for March that came out in early April. Yet the US economic data is not unanimously positive. The latest readings from the University of Michigan consumer confidence and NFIB small business optimism surveys both remained well below pre-pandemic peaks (Chart 3). Annual core CPI inflation only inched up 0.2 percentage points in March to 1.6%, a tepid move compared to the base effect driven surge that took year-over-year headline CPI inflation from 1.7% in February to 2.6%. Chart 3Some Mixed Messages From Recent US Data Chart 4Fewer Positive US Data Surprises The overall flow of US economic data has been disappointing versus elevated expectations, as evidenced by the almost uninterrupted decline in the Citigroup US data surprise index since peaking in July of 2020 (Chart 4). This indicator reliably correlated to the momentum of US Treasury yields prior to the COVID-19 outbreak and now, given the bullish growth combination of vaccine optimism and fiscal stimulus, the bond market’s focus is returning to how US data evolves versus expectations - and what that means for the Fed’s future moves on monetary policy. The most senior leadership at the Fed continues to send a consistent message on policy, with no rate hikes expected before 2024 and no hints at when the tapering of quantitative easing (QE) could begin. Yet some Fed officials have started to be a bit more vocal about their comfort level with the current accommodative policy stance and the associated risks to financial stability and inflation. Last week, Dallas Fed President Robert Kaplan noted that he would like to see the Fed begin to withdraw its support for the economy “at the earliest opportunity”. St. Louis Fed President James Bullard was even more specific, noting that once the share of vaccinated Americans reaches “herd immunity” levels of 75-80%, it will be time for the Fed to debate tapering QE. At the moment, however, there is no need for the Fed to move preemptively. Our Fed Monitor - comprised of economic, inflation and financial market data that would signal pressure for the Fed to ease or tighten policy – is at a neutral level (Chart 5). Our 12-month Fed discounter, which measures the change in interest rates over the next year that is priced into the US overnight index swap (OIS) curve, is at 7bps, consistent with a stand-pat Fed. The latest read this month from the New York Fed’s Survey of Primary Dealers (and Survey of Market Participants) showed no change in the median longer-run expectation for the fed funds rate of 2.25% that has prevailed over the past year (middle panel) – despite a sharp recovery in US growth expectations. Chart 5UST Valuations A Bit Stretched The market pricing of the Fed’s next move is still relatively benign, with liftoff not expected until February 2023. This suggests that a pause in the trend of rising Treasury yields was essentially the market getting a bit ahead of itself in pricing in higher longer-term yields. This can be seen by looking at various valuation measures. For example, the 5-year/5-year forward Treasury yield now sits at 2.4%, which is at the high end of the range of longer-run fed funds rate expectations from the Primary Dealer survey. Also, various measures of the term premium on 10-year Treasury yields have returned to the above-zero levels last seen during the Fed’s 2016-2018 rate hiking cycle – even with the Fed not signaling any need to tighten policy in response to rising inflation expectations. Despite these signs of stretched near-term UST valuation, there is still no sign of major global bond investors being comfortable with increasing exposure to Treasuries. For example, despite yields on 10-year Treasuries (hedged into euros and yen) looking historically attractive compared to the near-zero yields on JGBs and sub-zero yields on German Bunds, the US Treasury’s capital flow data shows that foreign investors remain net sellers of Treasuries (Chart 6). It is possible that those foreign buyers need more evidence of a sustained decrease in US bond volatility before moving money into US Treasuries, where duration losses from higher US yields could wipe out the yield pickup from moving into US bonds. While valuations are a bit stretched for Treasuries, technicals appear very oversold. Both the deviation of the 10-year Treasury yield from its 200-day moving average, and the 6-month rate of change of the Bloomberg Barclays US Treasury total return index, are at levels seen only four previous times since 2010 (Chart 7). The JP Morgan client duration positioning surveys and the Market Vane Treasury sentiment index are also approaching post-2010 bearish extremes. It should be noted that both of those measures reached even more bearish extremes during the latter half of the Fed’s 2026-2018 tightening cycle, so there is potential for Treasury sentiment to become even more bearish once the Fed starts to tighten monetary policy – a scenario looking increasingly likely over the next 6-12 months. Chart 6No Foreign Bid For USTs (Yet) Chart 7USTs Are Technically Oversold We continue to expect a robust US economy and rising inflation to force the Fed to begin preparing the market in the latter half of 2021 for QE tapering in 2022, with the first rate hike of the next tightening cycle coming in late 2022. As that outcome appears largely consistent with current market pricing, amid oversold technicals, it is likely that Treasury yields will continue to move sideways over at least the next few weeks. Yet there is little to suggest that yields have peaked and are about to enter a new downtrend, given the accelerating pace of US vaccinations that is boosting optimism on an eventual end to the US leg of the pandemic. Stay defensive on US Treasury exposure, as the cyclical rise in yields is not over yet. Bottom Line: The steady climb of US bond yields has left longer-maturity Treasuries in an oversold position. However, underlying growth and inflation momentum remain bond bearish and the Fed is likely to begin preparing the market later this year for tapering of asset purchases in 2022. Maintain a medium-term defensive posture towards US Treasuries (below-benchmark duration and an underweight country allocation). Canada: Downgrade To Underweight In a Special Report published back in February along with our colleagues at BCA Foreign Exchange Strategy, we outlined the case for placing Canadian government debt on “downgrade watch” in global fixed income portfolios.1 We expected Canadian bond yields to continue rising along with the rise in global bond yields and, hence, we maintained our below-benchmark recommended duration exposure within Canada. Chart 8Canada: A High Beta Bond Market Once Again However, we concluded that it was too soon to shift to a full-blown underweight stance on Canadian government bonds with COVID-19 cases still raging through the country, the vaccination program off to a very slow start, and the Bank of Canada (BoC)’s QE program preventing Canadian bonds from returning to their usual “high-beta” status within developed economy bond markets. It now appears that we were too cautious on that front. Canadian government bonds have been one of the worst performing markets year-to-date within the Bloomberg Barclays Global Government bond index, delivering a local currency return of –4.1% - worse than the -3.5% return earned on US Treasuries so far in 2021.2 It is clear that the Canadian government bonds are once again a market more sensitive to global interest rate moves (Chart 8). In that February Special Report, we laid out three factors that could prompt the BoC to move to a less dovish, and more bond bearish, monetary policy stance faster than we expected. Much of that list has already started to come to fruition. 1) Good News On The Vaccine Rollout Sadly, Canada is suffering a third wave of COVID-19 cases that has resulted in the nation’s most populous province, Ontario, implementing the harshest lockdown yet seen during the pandemic. Yet the pace of vaccinations has also been rising with the share of Canadians receiving at least one jab is now 21% (Chart 9) - higher than that of the overall European Union (EU). Canada is now administering more daily vaccinations than both the UK and EU. The quickening pace of vaccinations is already providing a major lift to Canadian economic confidence. The Bloomberg Nanos consumer confidence index is at an all-time high (Chart 10), while the BoC’s Business Outlook Survey for the spring of 2021 was incredibly solid. Two-thirds of firms in that survey expect sales to exceed pre-pandemic levels, even with the latest upturn in COVID-19 cases. Chart 9Canadian Vaccine Rollout Improving Chart 10Booming Optimism The BoC’s Q1/2021 Consumer Survey showed similar levels of optimism. 74% of Canadians surveyed aged 25-54 are planning to engage in levels of social and economic activities equal to, or greater than, those seen prior to the pandemic once the majority is vaccinated (Chart 11). A net majority (18%) of those surveyed plan to spend more on the types of “high-touch” service spending unavailable during the pandemic, like travel, movies and dining in restaurants, once a majority is vaccinated (Chart 12). Chart 11Canadians Are Ready To Have Fun Once Again All of the Canadian survey data is sending a clear message: a faster vaccine rollout will leader to much faster spending by consumers and businesses. 2) Signs Of Financial Stability Risks Highly-indebted Canadians' love affair with real estate has always concerned the BoC. While a combination of cutting policy interest rates to zero and ramping up QE helped stabilize Canadian financial markets during the 2020 pandemic shock, it has also set off a new surge of housing speculation. According to the Bloomberg Nanos consumer survey, 67% of Canadians now expect house prices to appreciate. The demand for homes has given a lift to the Canadian economy through a surge in new housing starts (residential investment is 8% of Canadian real GDP), while pushing national house price inflation back above 10% (Chart 13). Chart 12A Surge In "High-Touch" Spending Awaits Canadian Herd Immunity As already indebted Canadian households pile on more debt to partake in another national home-buying party, the BoC must now concern itself with the potential financial stability risks from a too-rapid rise in housing values. Chart 13Yet Another Canadian Housing Boom In a recent speech, BoC Deputy Governor Toni Gravelle noted that the BoC had to introduce QE in 2020 to help fight COVID-related dysfunction across a variety of Canadian financial markets, including government bonds where liquidity dried up.3 Gravelle also noted that the BoC would begin to dial back QE once it was clear that financial markets no longer needed the support from QE. With Canadian equities booming and Canadian corporate bond spreads near the lowest levels of the past decade (Chart 14), it seems clear that the BoC can begin dialing back its government bond purchase program if it is no longer necessary and likely fueling another housing bubble. 3) Additional Large Fiscal Stimulus The governing Canadian Liberal government of Prime Minister Justin Trudeau delivered a massive amount of fiscal stimulus to the pandemic-stricken Canadian economy in 2020. In the 2021/22 federal budget announced yesterday, another huge burst of spending was introduced, equal to C$101bn or 4.2% of Canadian GDP over the next three years. The spending was described as another COVID relief package, but included many long-term programs like national child care, raising the minimum wage and boosting green investments. According to the projections from the latest IMF World Fiscal Monitor, the “fiscal thrust” for Canada – the change in the cyclically-adjusted primary budget balance as a share of GDP - was projected to turn from a stimulus of +9% in 2020 to a drag of -2% in 2021 (Chart 15). The spending announced in the latest budget will effectively eliminate that drag for the next three years. This will provide a major lift to an economy already likely to see booming post-pandemic growth. Chart 14BoC QE No Longer Necessary Chart 15No Fiscal Drag Now Expected In 2021 Chart 16Canadian Real Yields Are Too Low Given the combination of expanding vaccinations, surging confidence, a renewed housing boom and soaring financial markets, it will be difficult for the BoC to maintain its current policy settings for much longer. This is a central bank that engaged in QE reluctantly last year and numerous BoC officials have stated – even in the worst days of the global pandemic - that they would begin to remove accommodation once it was no longer needed. Interest rate markets have already moved to price in a full-blown BoC tightening cycle. The Canadian OIS curve now discounts “liftoff” (a full 25bp rate hike) in October 2022, with 163bps of rate hikes priced in to the end of 2024 (Chart 16). The projected path of rates is below the BoC’s inflation forecasts to 2023. Thus, the implied Canadian real policy rate is expected to remain negative over the next two years – even though the BoC estimates that the neutral policy rate range is 1.75% to 2.75%, or -0.25% to +0.75% in real terms after subtracting the midpoint of the BoC’s 1-3% inflation target band. In other words, Canadian interest rate markets are vulnerable to any BoC shift in a less dovish direction, as seems increasingly likely sometime in the next few months. Our BoC Monitor is rapidly moving out of the “easier policy required” zone (Chart 17), and the rapid improvement in the Canadian employment situation suggests the BoC will be under more pressure to begin signaling a path towards withdrawing policy accommodation. This will start with an announced tapering of QE purchases, perhaps even ahead of any signals from the Fed that it is doing the same (Chart 18). This justifies a more cautious stance on Canadian fixed income exposure. Chart 17Downgrade Canadian Government Bonds To Underweight Chart 18Could The BoC Start Tapering Before The Fed? While a BoC tapering announcement before the Fed would likely put upward pressure on the Canadian dollar versus the US dollar, that would be something the BoC could live with if the economy was rapidly gaining strength – especially as our currency strategists believe the “loonie” to be undervalued. Thus, we are formally downgrading our strategic recommended allocation to Canadian government bonds to underweight (2 out of 5, see table on page 16). We are also maintaining our recommended below-benchmark duration exposure within dedicated Canadian bond portfolios. We are also cutting the allocation to Canada to underweight in our model bond portfolio and placing the proceeds in both, the US and core Europe (see pages 14-15). Bottom Line: The Canadian economy is gaining significant positive momentum, with an increased pace of vaccinations boosting optimism despite a third wave of COVID-19. We now see a growing risk that the Bank of Canada shifts to a less dovish policy stance sometime in the next few months, led by a tapering of its bond buying. Downgrade Canadian government bonds to underweight in global fixed income portfolios. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Foreign Exchange Strategy/Global Fixed Income Strategy Special Report, "Will The Canadian Recovery Lead Or Lag The Global Cycle?", dated February 12, 2021, available at fes.bcaresearch.com and gfis.bcaresearch.com. 2 That Canadian return is virtually the same after hedging into US dollars, hence that local currency return can be compared to the US dollar denominated Treasury market return. 3https://www.bankofcanada.ca/2021/03/market-stress-relief-role-bank-canadas-balance-sheet Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights If fully implemented, President Biden’s Made in America Tax Plan would reduce S&P 500 earnings by about 8%. We expect some of the proposed tax measures to be watered down, resulting in a 5% decline in earnings. Investors are likely to shrug off the near-term impact of higher taxes, given strong economic growth and continued support from accommodative monetary policy. Looking further out, however, we see four reasons why US tax rates are likely to keep rising, eventually reaching levels that hurt stock prices: First, the effective US corporate tax rate is still very low; second, the failure of President Trump’s tax cuts to boost investment spending will make it easier eventually to fully reverse them; third, rising bond yields will make it more expedient to fund spending with higher taxes rather than increased borrowing; and fourth, and most importantly, the political winds are shifting in favor of higher taxes on corporations and the wealthy. The Democrats have been moving leftward on economic matters for some time. For their part, conservative Republicans are starting to ask themselves why they should support tax cuts for a growing list of “woke” companies that seemingly hate them. The US corporate sector is at risk of being left without a party to defend its interests. Thus, while the near-term outlook for stocks is still bright, the long-term outlook is growing increasingly dim. The Biden Tax Plan On March 31st, President Biden unveiled the American Jobs Plan. The plan proposes $2.25 trillion in new federal spending, spread out over eight years, on public infrastructure and other areas. As outlined in the Made In America Tax Plan, the Biden Administration will seek to raise $2 trillion in tax revenue over the next 15 years in order to fund the new spending package. The three most important provisions in the tax plan are: Raising the domestic corporate income tax rate from 21% to 28%. This would bring the tax rate halfway back to where it was prior to the Trump tax cuts (35%). Taking into account the global distribution of corporate profits and other factors, such a tax hike would reduce S&P 500 earnings by about 4%. Increasing the minimum tax on the foreign profits of US companies. The Biden administration proposes doubling the minimum tax rate on Global Intangible Low-Taxed Income (GILTI) from 10.5% to 21%. It also plans to eliminate the Foreign-Derived Intangible Income deduction (FDII). These two measures would reduce S&P 500 earnings by about another 3.5%. A 15% minimum tax on “book income” (i.e., the earnings that companies report to shareholders). The tax applies to corporations with annual profits in excess of $2 billion. The Treasury department estimates that 45 companies will be liable for this tax. It would cut S&P 500 earnings by a further 0.5%. Taken together, these provisions would reduce S&P 500 earnings by about 8%. In practice, we think the impact will be closer to 5%. The Biden plan includes a variety of tax credits, focusing on areas such as clean energy and R&D, which should offset some of the tax increases. The ultimate corporate tax rate is also likely to fall short of 28%. West Virginia Senator Joe Manchin, the critical swing voter, has already said he would prefer to cap it at 25%. What Has Been Priced In? Chart 1Companies That Stand To Lose The Most From Higher Taxes Have Fared Well Our reading of the data suggests that very little of the impact from higher taxes has been baked into either analyst earnings estimates or market expectations. Chart 1 displays the performance of Goldman‘s “Formerly High Tax” and “Formerly Low Tax” equity baskets. The formerly high-taxed companies gained the most from Trump’s tax cuts and presumably would lose the most if the tax cuts were rolled back. Yet, they have outperformed their low-taxed peers since the Georgia runoff election, which handed the Senate to the Democrats. Likewise, earnings estimates have not reacted to the prospect of higher taxes. This is not surprising. Chart 2 shows that analysts did not adjust their earnings estimates until shortly after President Trump signed the Tax Cuts and Jobs Act into law on December 22, 2017. Similar to what happened back then, analysts appear to be waiting for the details of the ultimate tax package before changing their estimates. Chart 2Analysts Have Not Adjusted Their Earnings Estimates To Reflect The Likelihood Of Higher Taxes For Now, Business Cycle Dynamics Are More Important Than Taxes While the failure of the investment community to price in higher taxes represents a headwind to stocks, we would characterize it as a modest headwind. IBES estimates still point to earnings growth of 15% for S&P 500 companies in 2022. It would take an unrealistically large tax hit to keep corporate profits from rising next year. The IMF’s latest economic projections, released a few weeks ago, foresee US real GDP growing by 3.5% in 2022, one full percentage point faster than the Fund expected in January (Table 1). Given the strong correlation between equity returns and economic growth, the equity bull market will likely survive a tax increase (Chart 3). Table 1Growth Remains Robust Chart 3Stocks Usually Outperform Bonds When Economic Growth Is Strong Of course, some stocks could still feel the pinch from higher taxes. The tech sector is especially vulnerable, given that it currently enjoys one of the lowest effective tax rates in the S&P 500 (Chart 4). Tech companies have also been very adept at shifting income from intangible assets such as patents to offshore tax havens, which is likely to put them in the crosshairs of the soon-to-be bulked up IRS.1 We currently favor value over growth stocks. The likelihood that higher taxes will have a disproportionately negative effect on growth sectors such as tech only reinforces this view. Chart 4Tech Is Vulnerable To Higher Taxes Higher Taxes: Start Of A Long-Term Trend? While we are not too worried about the near-term impact of higher taxes on equity prices, we are more concerned about the longer-term consequences. As we discuss below, not only is Biden likely to raise personal income and capital gains taxes to fund future spending initiatives such as the forthcoming American Families Plan, but the pressure to keep raising business taxes will persist well beyond his administration. There are four reasons for this: Reason #1: The effective US corporate tax rate is still very low Chart 5Corporate Tax Revenues Are Low In April 2018, four months after the Tax Cuts and Jobs Act came into effect, the Congressional Budget Office projected that US corporations would pay $276 billion in corporate taxes in 2019. In the end, they paid only $230 billion.2 US corporate income tax receipts stood at only 1% of GDP in 2018-19, half of what they were in 2013-17 (Chart 5). During Ronald Reagan’s second term in office, US corporations faced an effective tax rate of around 30%. Today, it is less than 15% (Chart 6). As a share of GDP, the US government collects less corporate tax revenue than almost all other OECD economies (Chart 7). Chart 6The Economy-Wide Effective Corporate Tax Rate Has Been Shrinking For More Than Three Decades Chart 7US Corporate Taxation Is Not High Chart 8Trump Was Unlucky To Be Singled Out By The IRS Moreover, the US government often does not even bother to even collect the money that is owed to it. Audits of corporations with more than $20 billion in assets are down 50% since 2011. Audits of individuals with annual income above $1 million are down 80% (Chart 8). In his testimony to the US Senate this week Chuck Rettig, IRS Commissioner, estimated that tax evasion costs the government $1 trillion per year. Reason #2: The failure of Trump’s tax cuts to boost investment spending will make it easier to eventually fully reverse them If the Trump tax cuts had raised investment spending, it would be easier to overlook the negative effect that they had on the budget deficit. The evidence, however, suggests that lower corporate taxes did very little to spur capex. Chart 9 shows that capital spending barely increased as a share of GDP in the two years following the passage of the Tax Cuts and Jobs Act. According to the International Monetary Fund, only one-fifth of the tax cuts were used to finance capital investment and R&D spending.3 Along the same lines, Hanlon, Hoopes, and Slemrod found that fewer than a quarter of S&P 500 companies discussed plans to increase capex in response to lower taxes during their conference calls.4 Chart 9Trump's Tax Cuts Did Little To Spur Investment Chart 10Business Equipment And IP Do Not Last Long Why did corporate investment fail to rise much? One answer is that a tax on profits is not the same thing as a tax on capital investment. As Appendix 1 explains, lower corporate taxes are unlikely to have much of an effect on debt-financed capital spending when interest costs are tax deductible. Unlike long-lived assets such as homes, most of the corporate capital stock is fairly short-lived (Chart 10). The demand for business equipment and software depends more on the outlook for aggregate demand than on the cost of capital. Finally, as we explained in a report entitled Inequality Led To QE, Not The Other Way Around, the majority of corporate profits these days can be attributed to monopolistic power of one form or another. Standard economic theory suggests that taxing monopoly rents will not reduce output or investment. Reason #3: Rising bond yields will make it more expedient to fund spending with higher taxes rather than increased borrowing With interest rates still at exceptionally low levels, there is no immediate need to raise taxes to finance increased government spending. This is especially true for infrastructure spending, which can reasonably be expected to boost economic growth (and hence tax receipts) over the long haul. Chart 11US Interest Payments Will Skyrocket Under The Status Quo If interest rates were to rise, however, governments would likely find it advantageous to increase taxes rather than face spiralling debt-servicing costs. Public debt levels are very high in the US and in most other economies, so any increase in interest rates would siphon funds from social programs towards bondholders. This would not be popular with voters. The Congressional Budget Office estimates that federal government interest payments will swell rapidly over the coming decades if measures are not taken to rein in budget deficits (Chart 11). As we discuss next, these measures are likely to take the form of higher taxes rather than spending cuts. Reason #4: The political winds are shifting in favor of higher taxes on corporations and the wealthy Democrats have been moving leftward for some time. In 2001, 50% of Democrats said that “government should do more to solve our country’s problems.” Today, that number is 83% (Chart 12). Chart 12Democrats Want More Government Chart 13Big Ticket Social And Health Care Spending To Keep Rising While Republicans continue to show a preference for small government, this may not last. Medicare and Social Security consume over 40% of all federal non-interest spending. Outlays on both programs (Medicare in particular) are set to grow rapidly over the coming years (Chart 13). To the extent that the political preferences of older Americans lean Republican, this could make the GOP more inclined to support higher taxes in order to sustain benefits to the elderly. The fact that corporations and the rich increasingly favor socially liberal policies is leading conservative Republicans to ask why they should continue to support tax cuts for people and companies that seemingly hate them. Whereas Joe Biden won the richest US counties by 20 percentage points last November, Trump saw his support rise in the poorest counties (Chart 14). Reflecting this trend, the share of Republicans who expressed “hardly any confidence in Corporate America” rose from 19% in February 2018 to 30% in March 2021 (Chart 15). Chart 14Democrats Have Made Serious Inroads Among The Better-Off Chart 15Republicans Growing More Skeptical Of Corporate CEOs More than twice as many Republicans now favor raising corporate taxes as lowering them (Chart 16). Nationally, 73% of Americans are dissatisfied with the influence that corporations have over the nation, a 25-point jump from 2001 (Chart 17). Chart 16More Americans Want To Soak The Rich Chart 17Souring Attitudes Toward Big Corporations Given the shift in public opinion, it is not too surprising that the Republican response to Biden‘s tax plan was decidedly “low energy”. After a perfunctory condemnation of the plan, Republican leaders quickly pivoted to attacking “woke” corporations. Addressing the corporate reaction to Georgia’s new election law, Senate Republican Leader Mitch McConnell declared “We are witnessing a coordinated campaign by powerful and wealthy people to mislead and bully the American people.” He went on to say, “From election law to environmentalism to radical social agendas to the Second Amendment, parts of the private sector keep dabbling in behaving like a woke parallel government. Corporations will invite serious consequences if they become a vehicle for far-left mobs to hijack our country from outside the constitutional order.” If current trends continue, as we suspect they will, the US corporate sector will be left without a party to defend its interests. Thus, while the near-term outlook for stocks is still bright, the long-term outlook is growing increasingly dim. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Appendix 1: When Do Higher Taxes On Corporate Profits Reduce Investment? Suppose a company is considering whether to purchase a piece of machinery for $1000. Let us assume that the company faces an external rate of return, r, of 8%. That is to say, it can borrow and lend at 8%. The accompanying table illustrates how the firm’s profits will vary depending on its internal rate of return (the return on investment that the machine will generate). Let us start with the case where the company finances the purchase of the machine by issuing new debt. For now, assume that the internal rate of return is 10% and that the machine can be used indefinitely (i.e., it never depreciates). In this case, the machine will generate $100 in operating income per year. After subtracting the $80 in interest expense, the company will be left with $20 in pre-tax income (Example A). Suppose the company faces an income tax of 20% and interest is fully tax deductible. Then, the company will pay a tax of $20*0.2=$4, leaving it with $16 in after-tax profits (Example B). Notice that while the tax reduced the company’s after-tax profit, it did not extinguish the incentive to purchase the machine in the first place. After all, while $20 is better than $16, $16 is still better than zero. Thus, in this simple example, we see that when the purchase of capital equipment is financed through debt and interest payments are fully tax deductible, the imposition of a profit tax will not affect the ultimate decision of whether to invest or not. Things change when interest is not tax deductible. In this case, the internal rate of return must rise to r/(1-t) to make the company indifferent between buying the machine or not. In the example above, this means the internal rate of return must increase to 8%/(1-0.2)=10%. Then, the company will make an operating profit of $100, pay $20 in tax on that profit, and after paying $80 in interest, end up breaking even (Example C). The calculus in deciding whether to invest in new capital equipment is similar for equity financing as it is for debt financing when interest payments are not tax deductible. The best way to think about equity financing is to ask how much the market price of the machine will be after the company purchases it. If there is no tax and the internal rate of return is 10%, the market price will be $100/0.08=$1250 (Example D). Since the company can buy the machine for $1000, it makes sense to buy it. If the owner of the machine has to pay a profit tax of 20% on the stream of income that it generates, its market value will only be $80/0.08=$1000 (Example E). At this point, the company is indifferent about whether to purchase the machine or not. How do things change when we abandon the assumption that the machine lasts forever? The main difference is that the decision of whether to buy the machine becomes less sensitive to changes in the cost of capital. For example, suppose the machine only lasts one year. To make it worthwhile for the company to purchase that machine, the revenue that it generates in that one year must rise dramatically (Example F). This makes the decision to purchase the machine much less dependent on the interest rate and more dependent on business cycle considerations, especially the outlook for aggregate demand. Appendix Table 1 Footnotes 1 Jed Graham, “Biden's Tax Plan: What It Means For Amazon, Google, Facebook, Apple, Microsoft,” Investor’s Business Daily (April 8, 2021). 2 “The Accuracy of CBO’s Baseline Estimates for Fiscal Year 2019,” Congressional Budget Office (December 2019). 3 Emanuel Kopp, Daniel Leigh, Susanna Mursula, and Suchanan Tambunlertchai, “U.S. Investment Since the Tax Cuts and Jobs Act of 2017,” IMF Working Paper (May 31, 2019). 4 Michelle Hanlon, Jeffrey L. Hoopes, and Joel Slemrod, “Tax Reform Made Me Do It!” NBER Working Paper 25283 (November 2018). Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Highlights Stronger global growth in the wake of continued and expected fiscal and monetary stimulus, and progress against COVID-19 are boosting oil demand assumptions by the major data suppliers for this year. We lifted our 2021 global demand estimate by 640k b/d to 98.25mm b/d, and assume OPEC 2.0 will make the necessary adjustments to keep Brent prices closer to $60/bbl than not, so as not to disrupt a fragile recovery. We are maintaining our 2022 and 2023 Brent forecasts at $65/bbl and $75/bbl. Commodity markets are ignoring the rising odds of armed conflict involving the US, Russia and China and their clients and allies. Russia has massed troops on Ukraine’s border and warned the US not to interfere. China has massed warships off the coast of the Philippines, and continues its incursions in Taiwan’s air-defense zone, keeping US forces on alert. Intentional or accidental engagement would spike oil prices. Two-way price risk abounds. In addition to the risk of armed hostilities, faster distribution of vaccines would accelerate recovery and boost prices above our forecasts. Downside risk of a resurgence in COVID-19-induced lockdowns remains, as rising death and hospitalization rates in Brazil, India and Europe attest (Chart of the Week). Feature Oil-demand estimates – ours included – are reviving in the wake of measurable progress in combating the COVID-19 pandemic in major economies, and an abundance of fiscal and monetary stimulus, particularly out of the US.1 On the back of higher IMF GDP projections, we lifted our 2021 global demand estimate by 640k b/d to 98.25mm b/d in this month’s balances. In our modeling, we assume OPEC 2.0 will make the necessary adjustments to keep Brent prices closer to $60/bbl than not, so as not to disrupt a fragile recovery. In an unusual turn of events, the early stages of the recovery in oil demand will be led by DM markets, which we proxy using OECD oil consumption (Chart 2). Thereafter, EM economies, re-take the growth lead next year and into 2023. Chart of the WeekCOVID-19 Deaths, Hospitalizations Threaten Global Recovery Chart 2DM Demand Surges This Year Absorbing OPEC 2.0 Spare Capacity We continue to model OPEC 2.0, the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, as the dominant producer in the market. The growth we are expecting this year will absorb a significant share of OPEC 2.0’s spare capacity, most of which – ~ 6mm b/d of the ~ 8mm b/d – is to be found in KSA (Chart 3). The core producers’ spare capacity allows them to meet recovering demand faster than the US shale producers can mobilize rigs and crews and get new supply into gathering lines and on to main lines. We model the US shale producers as a price-taking cohort, who will produce whatever the market allows them to produce. After falling to 9.22mm b/d in 2020, we expect US production to recover to 9.56mm b/d this year, 10.65mm b/d in 2022, and 11.18mm in 2023 (Chart 4). Lower 48 production growth in the US will be led by the shales, which will account for ~ 80% of total US output each year. Chart 3Core OPEC 2.0 Spare Capacity Will Respond First To Higher Demand Chart 4Shale Is The Marginal Barrel In The Price Taking Cohort OPEC 2.0’s dominant position on the supply side allows it to capture economic rents before non-coalition producers, which will remain a disincentive to them until the spare capacity is exhausted. Thereafter, the price-taking cohort likely will fund much of its E+P activities out of retained earnings, given their limited ability to attract capital. Equity investors will continue to demand dividends that can be maintained and grown, or return of capital via share buybacks. This will restrain production growth to those firms that are profitable. We expect the OPEC 2.0 coalition’s production discipline will keep supply levels just below demand so that inventories continue to fall, just as they have done during the COVID-19 pandemic, despite the demand destruction it caused (Chart 5). These modeling assumptions lead us to continue to expect supply and demand will continue to move toward balance into 2023 (Table 1). Chart 5Supply-Demand Balances in 2021 Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) We continue to expect this balancing to induce persistent physical deficits, which will keep inventories falling into 2023 (Chart 6). As inventories are drawn, OPEC 2.0’s dominant-producer position will allow it to will keep the Brent and WTI forward curves backwardated (Chart 7).2 We are maintaining our 2022 and 2023 Brent forecasts at $65/bbl and $75/bbl (Chart 8). Chart 6OPEC 2.0 Policy Continues To Keep Supply Below Demand... Chart 7OECD Inventories Fall to 2023 Chart 8Brent Forecasts Rise As Global Economy Recovers Two-Way Price Risk Abounds Risks to our views abound on the upside and the downside. To the upside, the example of the UK and the US in mobilizing its distribution of vaccines is instructive. Both states got off to a rough start, particularly the US, which did not seem to have a strategy in place as recently as January. After the US kicked its procurement and distribution into high gear its vaccination rates soared and now appear to be on track to deliver a “normal” Fourth of July holiday in the US. The UK has begun its reopening this week. Both states are expected to achieve herd immunity in 3Q21.3 The EU, which mishandled its procurement and distribution likely benefits from lessons learned in the UK and US and achieves herd immunity in 4Q21, according to McKinsey’s research. Any acceleration in this timetable likely would lead to stronger growth and higher oil prices. The next big task for the global community will be making vaccines available to EM economies, particularly those in which the pandemic is accelerating and providing the ideal setting for mutations and the spread of variants that could become difficult to contain. The risk of a resurgence in large-scale COVID-19-induced lockdowns remains, as rising death and hospitalization rates in Brazil, India and Europe attest. Cry Havoc The other big upside risk we see is armed conflict involving the US, Russia, China and their clients and allies. Commodity markets are ignoring these risks at present. Even though they do not rise to the level of war, the odds of kinetic engagement – planes being shot down or ships engaging in battle in the South China Sea – are rising on a daily basis. This is not unexpected, as our colleagues in BCA Research’s Geopolitical Strategy pointed out recently.4 Indeed, our GPS service, led by Matt Gertken, warned the Biden administration would be tested in this manner by Russia and China from the get-go. Russia has massed troops on Ukraine’s border and warned the US not to interfere. China has massed warships off the coast of the Philippines, and continues its incursions in Taiwan’s air-defense zone, keeping US forces on alert. Political dialogue between the US and Russia and the US and China is increasingly vitriolic, with no sign of any leavening in the near future. Intentional or accidental engagement could let slip the dogs of war and spike oil prices briefly. Finally, OPEC 2.0 is going to have to accommodate the “official” return of Iran as a bona fide oil exporter, if, as we expect, it is able to reinstate its nuclear deal – i.e., the Joint Comprehensive Plan of Action (JCPOA) – with Western states, which was abrogated by then-President Donald Trump in 2018. This may prove difficult, given our view that the oil-price collapse of 2014-16 was the result of the Saudis engineering a market-share war to tank prices, in an effort to deny Iran $100+ per-barrel prices that had prevailed between end-2010 and mid-2014. OPEC 2.0, particularly KSA, has not publicly involved itself in the US-Iran negotiations. However, it is worthwhile recalling that following the disastrous market-share war launched in 2014, KSA and the rest of OPEC 2.0 did accommodate Iran’s return to markets post-JCPOA. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish Brent and WTI prices rallied sharply following the release of the EIA’s Weekly Petroleum Status Report showing a 9.1mm-barrel decline in US crude and product stocks for the week ended 9 April 2021. This was led by a huge draw in commercial crude and distillate inventories (5.9mm barrels and 2.1mm barrels, respectively). These draws came on the back of generally bullish global demand upgrades by the major data services (EIA, IEA and OPEC) over the past week. These assessments were supported by EIA data showing refined-product demand – i.e., “product supplied” – jumped 1.1mm b/d for the week ended 9 April. With vaccine distributions picking up steam, despite setbacks on the Johnson & Johnson jab, the storage draws and improved demand appear to have catalyze the move higher. Continued weakness in the USD also provided a tailwind, as did falling real interest rates in the US. Base Metals: Bullish Nickel prices fell earlier this week, as China’s official Xinhua news agency reported that Chinese Premier, Li Keqiang stressed the need to strengthen raw materials’ market regulation, amidst rising commodities prices, which been pressuring corporate financial performance (Chart 9). This statement came after China’s top economic advisor, Liu He also called for authorities to track commodities prices last week. Nickel prices fell by around $500/ ton earlier this week on this news, and were trading at $16,114.5/MT on the London Metals exchange as of Tuesday’s close. Other base metals were not affected by this news. Precious Metals: Bullish The US dollar and 10-year treasury yields fell after March US inflation data was released earlier this week. US consumer prices rose by the most in nearly nine years. The demand for an inflation hedge, coupled with the falling US dollar and treasury yields, which reduce the opportunity cost of purchasing gold, caused gold prices to rise (Chart 10). This uncertainty, coupled with the increasing inflationary pressures due to the US fiscal stimulus will increase demand for gold. Spot COMEX gold prices were trading at $1,746.20/oz as of Tuesday’s close. Ags/Softs: Neutral The USDA reported ending stocks of corn in the US stood at 1.35 billion bushels, well below market estimates of 1.39 billion and the 1.50 billion-bushel estimate by the Department last month, according to agriculture.com’s tally. Global corn stocks ended at 283.9mm MT vs a market estimate of 284.5mm MT and a Department estimate of 287.6mm MT. Chart 9Base Metals Are Being Bullish Chart 10Gold Prices To Rise Footnotes 1 Please see US-Russia Pipeline Standoff Could Push LNG Prices Higher, which we published on 8 April 2021 re the IMF’s latest forecast for global growth. Briefly, the Fund raised its growth expectations for this year and next to 6% and 4.4%, respectively, nearly a full percentage-point increase versus its January forecast update for 2021 2 A backwardated forward curve – prompt prices trading in excess of deferred prices – is the market’s way of signaling tightness. It means refiners of crude oil value crude availability right now over availability a year from now. This is exactly the same dynamic that drives an investor to pay $1 today for a dollar bill delivered tomorrow than for that same dollar bill delivered a year from now (that might only fetch 98 cents today, e.g.). 3 Please see When will the COVID-19 pandemic end?, published 26 March 2021 by McKinsey & Co. 4 Please see The Arsenal Of Democracy, a prescient analysis published 2 April 2021 by BCA’s Geopolitical Strategy. The report notes the Biden administration “still faces early stress-tests on China/Taiwan, Russia, Iran, and even North Korea. Game theory helps explain why financial markets cannot ignore the 60% chance of a crisis in the Taiwan Strait. A full-fledged war is still low-probability, but Taiwan remains the world’s preeminent geopolitical risk.” Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades
Highlights Biden will host a global summit for Earth Day on April 22-23, giving public attention to his climate change policy push. Investors should count on Biden’s green infrastructure package becoming the bulk of his climate push, given uncertainty over the 2022 midterm elections. However, over the long run, American public opinion is shifting in favor of renewables and the US will seek to maintain its technological edge via participating in the green tech race. Go long our “Biden Fiscal Advantage Basket” versus the Nasdaq 100. Feature The Biden administration’s $2.3 trillion American Jobs Plan is often referred to as a “green infrastructure” package and in this report we take a look at what makes it green – and what are the investment implications. Biden will virtually host a global climate summit on April 22-23, Earth Day, which the Chinese President Xi Jinping is expected to attend, thus providing momentum to the green investment theme. The stock market anticipated Biden’s electoral victory last year and renewable energy stocks rallied exorbitantly, with ultra-easy monetary and fiscal policy as a fundamental support. The market’s reaction to Biden’s official outline of his plan last month suggests that investors are energized about Biden’s infrastructure package but already suffering from some green fatigue (Chart 1). However, this bill’s passage will initiate the US’s official entrance into the global green energy race and from that point of view renewable plays should recover. Once the American Jobs Plan passes, likely sometime this fall, Biden’s climate agenda will be virtually finished, from an investment perspective. Investors have little visibility beyond 2022 as the president’s party rarely hangs onto the House of Representatives in his first midterm election. However, over the long run, American public opinion is shifting in favor of renewable energy. And Biden also has regulatory tools to push the Democratic Party’s climate agenda from 2022-24 regardless. Chart 1Biden's AJP Already Priced Chart 2Biden’s First Budget: Boom In Non-Defense Discretionary Spending Biden’s first presidential budget, released on April 13, also highlights the US’s attempt to boost climate policy (the Environmental Protection Agency’s funding would go up by 21%). More broadly it highlights the US’s ongoing sea change in fiscal policy. Discretionary spending turned around under President Trump’s populism and will continue under Biden’s populism. The difference lies in social spending versus defense. Biden proposes a 15.2% increase in non-defense discretionary spending, with education, commerce, health, and environment while the departments of defense and justice see much smaller increases (Chart 2). But we doubt that even defense spending will be curtailed given the US’s global strategic challenges. The president’s budget proposals are drops in the bucket compared to the trillions in his economic stimulus packages. Biden’s American Family Plan will be outlined in detail later this month but it only has a 50/50 chance of passing by the 2022 midterm election. This leaves us with the American Jobs Plan as the real macro policy factor to watch. And in the case of green energy, in particular, the Democrats may not have another opportunity to pass major legislation for many years. The US’s Strategic Basis For Green Energy The American Jobs Plan is billed as a $2.3 trillion green infrastructure package but in reality the package should be broken into traditional infrastructure ($784 billion for roads and bridges), social welfare ($647 billion for elderly care, education, etc), green initiatives ($370 billion for electrical grid and retrofits, etc), tech initiatives ($280 billion for broadband, semiconductors, research and development), and small business support, in order of dollar value (Chart 3). The implication is that climate policy is important but not the top priority. Still, $370 billion is the biggest green package the US has ever launched. It consists of $150 billion for “hard” green infrastructure, such as new electricity grid and $220 billion for “soft” green infrastructure, such as tax credits for buying EVs (Chart 4). Chart 3Biden’s AJP: Green Initiatives Total $370 Billion Chart 4Biden’s AJP: Green Initiatives Mostly Rebates/Incentive The US has moved slowly on green energy policy – relative to Europe or China – because it does not face the same strategic necessity. China faces domestic social unrest if it does not reduce pollution, it faces American strategic containment if it does not reduce its dependency on the Middle East (35% of total oil consumption), and it faces the middle-income trap if it does not increase innovation and productivity. Europe is similarly dependent on a geopolitical enemy for its energy supply – Russia provides 35% of its oil consumption and 38% of its natural gas – and it must also increase productivity. Europe and China are net energy importers who have a great strategic interest in making energy supply a matter of manufacturing prowess rather than divine natural resource endowment (Chart 5). The US is late to the green energy game in part because it does not share the same degree of strategic necessity. Like the EU, the US took care of its most pressing pollution problems decades ago. But unlike the EU, the US is a net energy exporter thanks to the fracking revolution. However, the US is not truly energy independent – an Iranian closure of the Strait of Hormuz would cause global oil prices to spike and trigger a recession. And the US also has a powerful strategic interest in maintaining its global leadership and its edge in technology, innovation, and productivity (Chart 6). The US cannot afford to miss out on the green tech race even if starting from a more secure natural resource base. Chart 5US Green Focus Less Motivated By Energy Security Than China, EU US public opinion is also following European opinion regarding climate change and environmental protection. True, voters are more urgently concerned about the economy, jobs, and health care over the environment – as we showed in our Special Report on health care earlier this year. But the administration has decided not to rehash the health care battles of the Obama administration – having seen Republicans fail to repeal Obamacare – and instead to open up a new policy domain with climate change. Even if the environment is low priority for most voters, they do not oppose green projects in principle – in fact, they favor renewable energy over fossil fuels when it comes to the US’s energy future (Chart 7). And voters strongly favor infrastructure, which means they are more susceptible to green energy projects when presented as part of a broader infrastructure buildout – as opposed to a transformative “Green New Deal” designed to revolutionize every aspect of US life. Chart 6US Green Focus Motivated By Global Innovation/Tech Race Chart 7US Public Supports Renewable Energy The US shift to green energy is well underway, with renewables ready to surpass coal in the national energy mix (Chart 8). The natural gas boom of the past decade has worked wonders in reducing coal dependency and hence overall carbon emissions (Chart 9). Chart 8Shift To Renewables Well Underway Chart 9US Carbon Emissions To Fall Further Bottom Line: The US does not have the same energy security problems as China and the EU, which is one reason the US trails these competitors in green energy production and policy. But the US has a powerful interest in maintaining its technological edge and productivity growth. So policymakers will continue to push the green agenda even as the public follows Europe in becoming more favorable toward it over the long run. US Climate Policy Will Advance In Fits And Starts The fact that the US lacks the same strategic urgency as Europe and China suggests that the green energy push in the US will progress in fits and starts rather than in a straight line. Popular opinion cited above is supportive enough to allow a political party to push a green agenda if it has control of both the White House and Congress. The Biden administration has moderate-to-strong political capital based on our Political Capital Index (Appendix). But this could change with the next election, which would introduce a ruffle in the current narrative in which Biden saves planet earth. One factor that helps Biden is that his presidency is entirely about economic stimulus and recovery, which enables him to minimize the regulatory and punitive side of his party’s energy agenda. While the American Jobs Plan includes corporate tax hikes, his climate policy in itself is all about spending rather than taxation. There is no carbon pricing scheme anywhere to be seen. And Biden’s Transportation Secretary, Pete Buttigieg (“Mayor Pete,” a center-left politician from Indiana), immediately reversed his recent suggestion that the government levy a gasoline tax or vehicle mileage tax. Biden cannot get any revolutionary green measures passed through the Senate, given that moderate Democrats like Senators Joe Manchin of West Virginia and John Tester of Montana hail from coal-heavy states. The Democrats must also pay heed to the swing states for future elections. Biden only narrowly won his home state of Pennsylvania, after pledging to phase out oil and natural gas in the last presidential debate. True, Biden’s American Jobs Plan will remove subsidies for the oil and gas sector – but these subsidies are not very large. Notably, subsidies for renewables already overwhelm those for traditional infrastructure, even under the Trump administration (Chart 10). Chart 10Subsidy Reform Will Promote Renewables Chart 11Green Policy At Risk In 2022 Midterm These points underscore the fact that US climate policy is uncertain over the medium term, when the pandemic fades and the Democrats attempt more ambitious climate proposals. The Republican Party supports the traditional energy sector and is skeptical about climate change. The GOP could easily make a net gain of five seats in the 2022 midterm elections and take back control of the House of Representatives. They would not be able to repeal Biden’s laws or regulations, given his veto and likely Democratic majority in the Senate, but they would be able to pare back green funding. Republicans are not uniform on the issue of climate but more than half of Trump supporters in 2020 considered climate change unimportant. Young party members, moderates, and women were more split on the issue, with 60% of moderate Republicans viewing climate change as somewhat or very important (Chart 11). The takeaway is that Republicans would obstruct but not repeal future climate policy. Climate policy would be limited to Biden’s regulations until at least 2024. Hence investors can expect US climate policy to plow forward in the short run but to encounter resistance in the medium run. This is also likely to be the case as various other crises will emerge and soak up government attention and resources (most likely geopolitical conflicts). Chart 12Green Policy More Likely Over Long Term Over the long run climate policy will have more reliable support. Younger Republicans support federal environmental policy more than their elders, are increasingly favorable toward government regulation to that end, and prefer renewables to fossil fuels (Chart 12). The millennials and younger generations will make up more than half of the electorate by around 2028. Even then the government’s focus on climate will wax and wane given the other pressing matters of the day. Investment Takeaways A tsunami of money has been created, a lot of it is finding its way into the stock market, and a lot of it is finding its way into green and sustainable energy companies – companies that now have a privileged position in terms of both government support and conspicuous consumption. Combine this with a tidal wave of institutional funds pouring into anything and everything labeled ESG (environmental, social, and governance) – and the stigma attached to climate skepticism and denialism – and investors should fully expect irrational exuberance and stock bubbles. Consider the US’s premier EV maker, Tesla. The vertical run-up in Tesla stock has occurred alongside the run-up in US money supply. Tesla’s price trend conforms with the profile of a range of stock market bubbles of the past (Chart 13), as shown by our US Equity Strategy. Chart 13ALow Rates And Vast Money Growth... Chart 13B...Will Fuel Green Bubble That being said, renewables stocks surged throughout 2020 on the back of stimulus and Biden’s likely election – and have since fallen back. They have underperformed cyclical and defensive sectors alike this year to date (Chart 14). As highlighted above, the Democrats’ climate ambitions could yet be pared back in the Senate. However, given the argument in this report, there is sufficient political capital for the climate provisions of the American Jobs Plan to pass. Renewable plays should recover, at least on a tactical, “buy the rumor, sell the news” basis. To play Biden’s American Jobs Plan, our US Equity Strategist Anastasios Avgeriou constructed a “Biden Fiscal Advantage Basket” comprising eight ETFs and one stock, all equal weighted (Chart 15, top panel). Instead of buying specific stocks, Anastasios opted for ETFs so as to diversify away company-specific risk. Chart 14Renewables Corrected But Will Recover Chart 15Introducing The Biden Fiscal Advantage Basket The goal was to filter for ETFs that hold mostly US companies and that offered the highest possible liquidity. From a portfolio construction perspective, he aimed to match the different spending segments of Biden’s White House proposal with an ETF. The ticker symbols included in the basket are: PAVE, PHO, QCLN, TAN, WOOD, SOXX, HAIL, GRID and SU. We choose SU as there is no pure play Canadian oil sands ETF trading in USD. Granted there is some replication of stocks included in these ETFs. In certain ETFs there is also a sizable international stock exposure, including EM and Chinese stocks. One final caveat is that these ETFs have a high concentration of technology stocks. Our sense is that this basket should outperform the S&P500 on a cyclical and structural basis albeit not tactically (Chart 15, middle panel). However, given the high-tech exposure, our preferred way to express this trade is via a long/short pair trade versus the QQQ high-tech ETF, which tracks the largest 100 companies on the Nasdaq stock exchange (Chart 15, bottom panel). Table 1 shows a number of related ETFs that did not make the cut but that readers may find intriguing and that deserve further research. Later this month we will publish a joint special report with our US Equity Strategy service, updating our views on Biden’s proposals and elaborating on this equity basket. Table 1Infrastructure and Renewables Related ETFs More broadly, US equities are still enjoying a positive cyclical backdrop, whereas the passage of the American Jobs Plan later this year has a 50% chance of marking peak stimulus (the American Families Plan may not pass). Tactically, however, we are more cautious. There are also several pronounced foreign policy stress tests facing the Biden administration imminently, including serious Russia/Ukraine, Israel/Iran, and China/Taiwan saber-rattling that we fully expect to engender volatility and safe-haven flows. At least one FOMC member, Saint Louis Fed President Jim Bullard, is now openly thinking about thinking about the Fed’s tapering asset purchases – that is, once the US vaccination rate reaches 75%. Our US Investment Strategy recently showed that this rate of vaccination could be reached as early as September. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Appendix Table A1Political Risk Matrix Table A2Political Capital Index Table A3APolitical Capital: White House And Congress Table A3BPolitical Capital: Household And Business Sentiment Table A3CPolitical Capital: The Economy And Markets Table A4Biden’s Cabinet Position Appointments
Highlights Global Inflation: The case for maintaining a strategic overall allocation to inflation-linked bonds (ILBs) versus nominal government debt in dedicated global fixed income portfolios remains intact. Global growth expectations are accelerating as vaccinations increase, spare capacity is increasingly being absorbed across the developed world and central banks (led by the Federal Reserve) continue to show no inclination to tighten policy anytime soon. Inflation-Linked Bond Allocations: ILB valuations, however, are no longer uniformly cheap across all countries. Real yields are now moving in a less coordinated fashion as markets try to sort out the timing and pace of eventual future central bank tightening. We recommend shifting inflation-linked bond exposure from Canada to Germany, as both markets have similar valuations but the Bank of Canada is likely to turn less dovish well ahead of the ECB. Feature Chart of the WeekMarkets Remain Unconcerned About An Inflation Overshoot The global reflation trade over the past year has been highly rewarding to investors. Equity and credit markets worldwide have delivered outstanding returns on the back of highly stimulative monetary and fiscal policies implemented to deal with the negative economic effects of COVID-19. The global INflation trade has also paid off for investors in inflation-linked bonds (ILBs), which have outperformed nominal government debt across the developed economies dating back to last spring. The rising trend for global inflation breakevens remains intact, but is approaching some potential resistance points. A GDP-weighted average of 10-year breakeven inflation rates among the major developed economies is just shy of the 2% level that has represented a firm ceiling over the past decade (Chart of the Week). At the same time, the Bloomberg consensus forecast for headline CPI inflation for that same group of countries calls for an increase to only 1.8% by year-end before slowing to 1.7% in 2022. The latest forecasts from the IMF are similar, calling for headline inflation in the advanced economies to reach 1.6% in 2021 and 1.7% in 2022. If those modest forecasts for realized inflation come to fruition, then there is likely not much more upside in inflation breakevens, in aggregate. Country selection within the ILB universe will become more important over the next 6-12 months, as divergences in growth, realized inflation and central bank reactions will lead to a more heterogeneous path for global inflation breakevens. Underlying Inflation Backdrop Still Supports Rising Breakevens On a total return basis, ILBs enjoyed an extended run of success prior to this year. The cumulative total return of the asset class (in local currency terms) between 2012 and 2020 was a whopping 61% in the UK, 25% in Canada, 22% in the US and 21% in the euro area (aggregating the individual countries in the region with inflation-linked bonds). However, the absolute performance of ILBs has been more disperse on a country-by-country basis so far in 2021. ILBs are down year-to-date in Canada (-6.2%), the UK (-5.0%) and the US (-1.4%). On the other hand, euro area ILBs have delivered a positive total return of +0.5% so far in 2021. Real bond yields have climbed off the lows in the US, UK and, most notably, Canada where the overall index yield on the Bloomberg Barclays inflation-linked bond index is now in positive territory for the first time since before the pandemic started (Chart 2). At the same time, real bond yields have been drifting lower in the euro area. These real yield moves are related to shifting perceptions of central bank responses to the global growth upturn. For example, pricing in overnight index swap (OIS) curves have pulled forward the timing and pace of future interest rate increases in the US and Canada – i.e. real policy rates will become less negative - while there has been comparatively little change in euro zone rate expectations. While the absolute returns for ILBs have become less correlated, the relative trade between nominal and inflation-linked government bonds in all countries remains intact. 10-year breakeven inflation rates have been steadily climbing in the US and UK, while depressed Japanese breakevens have crept modestly higher (Chart 3). Even Europe, where inflation has remained subdued for years, has seen a significant shift higher in inflation breakevens. (Chart 4). The turn in breakevens has occurred alongside a major change in investor perceptions of future inflation, with surveys like the ZEW showing an overwhelming majority of financial professionals expecting higher inflation in the US, Europe and the UK. Chart 2A Fading Bull Market In Inflation-Linked Bonds Chart 3A Solid Recovery In Inflation Expectations Chart 4European Inflation Expectations Starting To Normalize Inflation forecasts have shifted in response to faster global growth expectations on the back of vaccine optimism and aggressive US fiscal stimulus. Yet inflation forecasts remain modest compared to the huge growth figures expected for 2021 and 2022. In its latest World Economic Outlook published last week, the IMF upgraded its global real GDP forecast to 6.0% for 2021 and 4.4% for 2022. This represented an increase of 0.5 and 0.4 percentage points, respectively, from the last set of forecasts published back in January. While growth upgrades occurred across all major developed and emerging economies, the biggest upgrades came in the US and Canada, for both 2021 and 2022. As a result, the IMF projects the output gap in both countries to turn positive over 2022 and 2023, and be nearly closed in core Europe, Australia and Japan (Chart 5). The IMF is not projecting a major inflation surge on the back of those upbeat growth forecasts, though. While headline inflation in the US is expected to climb to 2.3% in 2021 and 2.4% in 2022, the same measure in Canada is only projected to rise to 1.7% and 2.0% over the same two years. European inflation is expected to remain subdued, reaching only 1.4% this year and drifting back to 1.2% in 2022 despite real GDP growth averaging 4.1% over the two-year period. The IMF attributes the benign inflation outcomes, even in the face of booming growth rates and the rapid elimination of output gaps, to the structural disinflationary backdrop for so-called “non-cyclical” inflation (Chart 6). The IMF defines this as the components of inflation indices that are less sensitive to changes in aggregate demand. The IMF estimates show that the contribution from non-cyclical components to overall inflation in the advanced economies had fallen to essentially zero at the end of 2020. Chart 5A Big Expected Narrowing Of Output Gaps Chart 6Non-Cyclical Components Still Weighing On Global Inflation There is considerable upside risk for the more cyclical components of inflation that could result in inflation overshooting the IMF projections (Chart 7). Chart 7Cyclical Backdrop Is Inflationary For example, in the US, the Prices Paid component of the ISM Manufacturing index remains elevated at post-2008 highs, while the year-over-year change in the Producer Price Index soared to 6% in March. Across the Atlantic, the European Commission business and consumer surveys have shown a big surge in the net balance of respondents expecting higher inflation in manufacturing and retail trade. Previous weakness in the US dollar and surging commodity prices are playing a major role in this rapid pick-up in price pressures seen in many countries. Given the current backdrop of strong global growth expectations, with actual activity accelerating as vaccinations increase and more parts of the global economy reopen, inflation pressures are unlikely to fade in the near term. With realized inflation rates set to spike due to base effect comparisons to the pandemic-fueled collapse one year ago, the upward pressure on global ILB inflation breakevens will persist in the coming months – especially with breakevens still below levels that would prompt central banks to turn less dovish sooner than expected. Bottom Line: The case for maintaining a strategic overall allocation to inflation-linked bonds (ILBs) versus nominal government debt in dedicated global fixed income portfolios remains intact. Global growth expectations are accelerating as vaccinations increase, spare capacity is increasingly being absorbed across the developed world and central banks (led by the Federal Reserve) continue to show no inclination to tighten policy anytime soon. Assessing Value In Developed Market Inflation-Linked Bonds Chart 8USD Outlook Now More Mixed Although the current backdrop remains conducive to a continuation of the rising trend in global ILB breakevens, there are factors that could begin to slow the upward momentum. The future path of the US dollar is now a bit less certain (Chart 8). While the DXY index is still down 7.4% compared to a year ago, it is up 2.4% so far in 2021. Shorter-term real interest rate differentials between the US and the other major developed markets remain dollar-bearish. At the same time, longer-term real yield differentials have risen in favor of the US (middle panel). Furthermore, US growth is outperforming other developed economies, typically a dollar-bullish factor (bottom panel). Given the usual negative correlation between the US dollar and commodity prices, a loss of downside dollar momentum could also slow the pace of commodity price appreciation. This represents a risk to additional global ILB outperformance versus government bonds. Our GDP-weighted aggregate of 10-year ILB breakevens for the major developed economies is currently just under 2% - levels more consistent with oil prices over $80/bbl than the current price closer to $60/bbl (Chart 9). Chart 9Breakevens Consistent With Much Higher Oil Prices Given some of these uncertainties over the strength of any future inflationary push from a weaker US dollar and rising commodity prices, a broad overweight allocation to ILBs across the entire developed market universe may no longer generate the same strong returns versus nominal government bonds seen over the past year. With the “easy money” already having been made in the global breakeven widening trade, country allocation within the ILB universe has now become a more important dimension for bond investors to consider. To assess the relative attractiveness of individual ILB markets, we turn to a few valuation tools. Our regression-based valuation models for 10-year ILB breakevens in the US, UK, France, Italy, Germany, Japan, Canada and Australia are all presented in the Appendix on pages 14-17. The two inputs into the model are the annual rate of change of the Brent oil price in local currency terms (as a measure of shorter-term inflation pressure) and a five-year moving average of realized headline CPI inflation (as a longer-term trend that provides a structural “anchor” for breakevens based off actual inflation outcomes). We first presented these models in April 2020, but we have now made a change in response to some of the unprecedented developments witnessed over the past year.1 Despite the strong visual correlation between the level of oil prices and inflation breakevens in most countries, we chose to use the annual growth of oil prices, rather than the level, in our breakeven models. This is because we found it more logical to compare a rate of change concept like inflation (and breakevens) to the rate of change of oil. However, the oil input into our breakeven models could produce nonsensical results during periods of extreme oil volatility that did not generate equivalent swings in breakeven inflation rates. A good example of that occurred in 2016, when the annual rate of change of the Brent oil price briefly surged toward 100%, yet 10-year US TIPS breakevens did not rise above 2% (Chart 10). An even bigger swing in oil prices has occurred over the past year, with oil prices up over +200% compared to the collapse in prices that occurred one year ago. Putting such an extreme move into our US model would have pushed the “fair value” level of the 10-year TIPS breakeven to 4% - an implausible outcome given that the 10-year breakeven has never risen to even as high as 3% in the entire 24-year history of the TIPS market. Chart 10Pass-Through Of Extreme Oil Moves Has Limits To deal with this problem, we have truncated the rate of change of oil prices in all our breakeven models at levels consistent with past peaks of breakevens. Going back to the US example, we have “capped” the rate of change of the Brent oil price at +40%, as past periods when oil price momentum was greater than 40% did not translate into any additional increase in TIPS breakevens. We then re-estimated the model using this truncated oil price series to generate fair value breakeven levels. Chart 11A Mixed Impact Of USD Moves On Non-US Breakevens We did this for all eight of our individual country breakeven models and in all cases, truncating extreme oil moves improved the accuracy of the model. Interestingly, we did not truncate the downside momentum of oil prices, as there was no obvious “cut-off” point where periods of collapsing oil prices did not generate equivalent declines in breakevens. Oil prices remain the most critical short-term variable to determine ILB breakeven valuation. While it is intuitive to think that currency movements should also have a meaningful impact on inflation (both realized and expected), the effect is not consistent across countries. For example, euro area breakevens appear to be positively correlated to the euro, while Japanese breakevens rarely rise without yen weakness (Chart 11). One other factor to consider when evaluating the value of breakevens is the possible existence of an inflation risk premium component during periods of higher uncertainty over future inflation. Such uncertainty could result in increased demand for ILBs from investors driving up the price of ILBs (thus lowering the real yield) relative to nominal yielding bonds, leading to wider breakevens that do not necessarily reflect a true rise in expected inflation. A simple way to measure such an inflation risk premium is to compare market-based breakevens to survey-based measures of inflation forecasts taken from sources like the Philadelphia Fed's Survey of Professional Forecasters and the Bank of Canada’s Survey Of Consumer Expectations. The assumption here is that the survey-based measures represent a more accurate (or, at least, less biased) depiction of underlying inflation expectations in an economy. We present these simple measures of inflation risk premia, comparing 10-year breakevens to survey-based measures of inflation expectations, in Chart 12 and Chart 13. Breakevens had been trading well below survey-based measures of inflation expectations after the negative pandemic growth shock in 2020 in all countries shown. After the steady climb in global breakevens seen over the past year, those gaps have largely disappeared, with breakevens now trading slightly above survey based inflation expectations in the US, UK and Australia. Chart 12No Major Inflation Risk Premia In These Markets Chart 13Canadian & Australian Breakevens In Line With Inflation Surveys Chart 14Assessing The Value Of Breakevens In Chart 14, we show the valuation residuals from our 10-year ILB breakeven models, along with two other measures of potential breakeven valuation: a) the distance between current breakeven levels and their most recent pre-pandemic peaks; and b) the difference between breakevens and the survey-based measures of inflation expectations. The model results show that breakevens are furthest below fair value in France, Japan and Germany, and the most above fair value in the UK and Australia. The message of undervaluation from our models is confirmed in the other two metrics for France, Japan, Germany, Canada and Italy. The overvaluation message for Australia is consistent across all three valuation metrics, while the signals are mixed for US and UK breakevens. In Japan, while the combined signals of all three valuation metrics indicate that breakevens are far too low, the very robust positive correlation between Japanese breakevens and the USD/JPY exchange rate implies that a bet on wider breakevens requires a much weaker yen. In Canada, while the 10-year breakeven does appear cheap, the real yield has also climbed faster than any of the other countries over the past several months as markets have rapidly repriced a more hawkish path for the Bank of Canada. Recent comments from Bank of Canada officials have leaned a bit hawkish, hinting at a possible taper of its bond-buying program, as the central bank appears unhappy with the renewed boom in Canadian housing values. An early tightening of monetary conditions would likely cap any additional upside in Canadian inflation breakevens. In Europe, the undervaluation of breakevens is more compelling. The ECB is likely to maintain its dovish policy settings into at least 2023, even if growth recovers later this year as increased vaccinations lead to the end of lockdowns. As shown earlier, European breakevens can continue to rise even if the euro is also appreciating versus the US dollar, especially if growth is recovering and oil prices are rising. Euro area breakevens are likely to continue drifting higher over at least the rest of 2021. Currently in our model bond portfolio, we have allocations to ILBs out of nominal government bonds in the US, France, Canada and Italy, with no allocations in Germany, Japan, Australia or the UK. After assessing our valuation measures, we are comfortable with the ILB exposure in France and Italy and lack of positions in the UK and Australia. We still see the upside case for US breakevens, with the economy reopening rapidly fueled further by fiscal policy, and the Fed likely to maintain its current highly dovish forward guidance until much later in 2021. We are reluctant to add exposure to Japanese ILBs, despite attractive valuations, as we are not convinced that USD/JPY has enough upside potential to help realize that undervaluation of Japanese breakevens. Thus, as a new change to our model portfolio this week that reflects our assessment of ILB breakeven valuations and risks, we are closing out the exposure to Canadian ILBs and adding a new position in German ILBs of equivalent size (see the model bond portfolio tables on pages 18-19). Bottom Line: ILB valuations are no longer uniformly cheap across all countries. Real yields are now moving in a less coordinated fashion as markets try to sort out the timing and pace of eventual future central bank tightening. We recommend shifting inflation-linked bond exposure from Canada to Germany, as both markets have similar valuations but the Bank of Canada is likely to turn less dovish well ahead of the ECB. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Report, "Global Inflation Expectations Are Now Too Low", dated April 28, 2020, available at gfis.bcaresearch.com. Appendix Chart A1Our US 10-Year Inflation Breakeven Model Chart A2Our UK 10-Year Inflation Breakeven Model Chart A3Our France 10-Year Inflation Breakeven Model Chart A4Our Italy 10-Year Inflation Breakeven Model Chart A5Our Japan 10-Year Inflation Breakeven Model Chart A6Our Germany 10-Year Inflation Breakeven Model Chart A7Our Canada 10-Year Inflation Breakeven Model Chart A8Our Australia 10-Year Inflation Breakeven Model Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Duration: Treasury yields look fairly valued on several different valuation metrics and the yield curve discounts a much quicker pace of rate hikes than is currently signaled by the Fed’s “dot plot”. However, the economic data continue to beat expectations by a wide margin. This suggests that bond yields could overshoot their fair value in the near term. Maintain below-benchmark portfolio duration. Employment: The US employment boom is just getting started. Total employment is still 8.4 million below pre-pandemic levels, but 37% of missing jobs are from the Leisure & Hospitality sector where demand is about to surge. Fed: The US economy will reach the Fed’s definition of “maximum employment” in 2022. This will cause the Fed to lift rates before the end of 2022, an event that will be preceded by an announcement of asset purchase tapering either late this year or early next year. Feature Chart 1Price Pressures Building The past two weeks brought us a couple of interesting developments directly related to the Treasury market. First, long-dated Treasury yields declined somewhat, presumably because many investors concluded that the yield curve is already priced for the full extent of future Fed rate hikes. Second, we received further evidence – from March’s +916k employment report, the 12% year-over-year increase in producer prices and continued elevated readings from PMI Prices Paid indexes – that economic activity is recovering more quickly than even the most optimistic forecasters anticipated (Chart 1). These two opposing forces highlight a tension in the current outlook for US Treasury yields. Yields now look fairly valued on several different valuation metrics, a fact that justifies keeping bond portfolio duration close to benchmark. However, cyclical economic indicators are surging, a fact that suggests yields will keep rising in the near-term, causing them to overshoot fair value for a time. This week’s report looks at this tension between valuation indicators and cyclical economic indicators through the lens of our Checklist To Increase Portfolio Duration. While we think there are convincing arguments in favor of both “At Benchmark” and “Below Benchmark” portfolio duration stances on a 6-12 month investment horizon, we are deciding to stick with our recommended “Below Benchmark” stance for now, until the economic data are more in line with market expectations. Checking In With Our Checklist Back in February, following the big jump in bond yields, we unveiled a Checklist of several criteria that would cause us to increase our recommended portfolio duration stance from “Below Benchmark” to “At Benchmark”.1 As is shown in Table 1, the Checklist contains seven items that can be grouped into two categories: Valuation Indicators that compare the level of Treasury yields to some estimate of fair value Cyclical Indicators that look at whether trends in the economic data are consistent with rising or falling bond yields Table 1Checklist For Increasing Duration Valuation Indicators Chart 2Valuation Indicators As mentioned above, valuation indicators show that Treasury yields are roughly consistent with fair value, suggesting that a neutral duration stance is appropriate. First, consider the 5-year/5-year forward Treasury yield relative to survey estimates of the long-run neutral fed funds rate (Chart 2). Last week, survey estimates from the New York Fed’s Survey of Market Participants and Survey of Primary Dealers were updated to March, and while there was some upward movement in the estimated long-run neutral rate ranges, the median estimates in both surveys were unchanged from January. The result is that the 5-year/5-year forward Treasury yield remains near the top-end of its survey-derived fair value band (Chart 2, top 2 panels). Second, the same two surveys also ask respondents to forecast what the average fed funds rate will be over the next 10 years. We can derive an estimate of the 10-year term premium by subtracting those forecasts from the 10-year spot Treasury yield (Chart 2, bottom 2 panels). In this case, respondents did raise their average fed funds rate forecasts and our term premium estimates were revised down as a result. While both term premium estimates are now below their 2018 peaks, they remain elevated compared to recent historical averages. Third, we turn to the front-end of the yield curve to look at what sort of Fed rate hike path is priced into the market (Chart 3). We see that the market is currently priced for Fed liftoff in December 2022 and for a total of four 25 basis point rate hikes by the end of 2023. Only a handful of FOMC participants forecasted a similar path at the March Fed meeting. Chart 3Market Priced For December 2022 Liftoff We discussed the wide divergence between market expectations and the Fed’s “dot plot” in a recent report.2 Essentially, the divergence boils down to the Fed focusing more on actual economic outcomes while the market takes its cues from economic forecasts. We think there’s good reason for optimism about the economy, and therefore expect that the Fed will revise its interest rate forecasts higher in the coming months as the “hard” economic data improve. However, we should point out that respondents to the New York Fed’s Survey of Primary Dealers and Survey of Market Participants also have much more benign interest rate forecasts than the market, and respondents to those surveys do not share the Fed’s bias toward actual economic outcomes. Table 2 shows that the average respondent to the Survey of Market Participants only sees a 35% chance that the Fed will lift rates before the end of 2022 and the Survey of Primary Dealers displays a similar result. Table 2Odds Of A Fed Rate Hike By End Of Year The wide gap between rate hike expectations embedded in the yield curve and forecasts from both the FOMC and the New York Fed’s surveys suggests that Treasury yields are at least fairly valued, and perhaps too high. However, the most important question is whether the market’s rate hike expectations look lofty compared to our own forecast. As is explained in the below section (titled “The Employment Boom Is Just Getting Started”), we think that the jobs market will be strong enough for the Fed to lift rates before the end of 2022 and that the market’s anticipated rate hike path looks reasonable. However, even this view is only consistent with a neutral stance toward portfolio duration. Chart 4Higher Inflation Is Priced In For our final valuation indicator we focus specifically on the outlook for inflation compared to what is already priced into the forward CPI swap curve (Chart 4). The forward CPI swap curve is priced for headline CPI inflation to rise to 2.7% by May 2022 before falling back down only slightly. In reality, year-over-year headline CPI will probably spike to even higher levels during the next two months but will then recede more quickly. We think it’s reasonable to expect headline CPI inflation to be between 2.4% and 2.5% in 2022, a range consistent with the Fed’s 2% PCE target, but the forward CPI swap curve reveals that this outcome is already priced. All in all, the message from the valuation indicators in our Checklist is that a robust economic recovery is already reflected in market prices. Thus, even with our optimistic economic outlook, Treasury yields look fairly valued, consistent with an “At Benchmark” portfolio duration stance. Cyclical Indicators While valuation indicators perform well over longer time horizons, they are notoriously bad at pinpointing market turning points. It’s for this reason that we augment our Checklist with cyclical economic indicators, specifically high-frequency cyclical economic indicators that correlate tightly with bond yields. First, we look at the ratio between the CRB Raw Industrials commodity price index and gold (Chart 5). The CRB index is a good proxy for global economic growth and gold is inversely correlated with the stance of Federal Reserve policy – gold falls when policy is perceived to be getting more restrictive and rises when policy is perceived to be easing. This ratio has shown little evidence of rolling over and further gains are likely as the economy emerges from the pandemic. We also look at other high-frequency global growth indicators like the relative performance between cyclical and defensive equities and the performance of Emerging Market currencies (Chart 5, panels 2 & 3). The trend of cyclical equity sector outperformance continues while EM currencies have shown some tentative signs of weakness. The US dollar is one particularly important indicator for bond yields. As US yields rise relative to yields in the rest of the world it makes the US bond market a more attractive destination for foreign investors. When US yields are attractive enough, these foreign inflows can stop them from rising. One good indication that US yields are sufficiently high to attract a large amount of foreign interest is when investor sentiment toward the dollar turns bullish. For now, the survey of dollar sentiment we track shows that investors are still bearish on the US dollar (Chart 5, bottom panel). Bearish dollar sentiment supports further increases in bond yields. Chart 5Cyclical Indicators Chart 6Data Surprises Still Positive Finally, we track the US Economic Surprise Index as an excellent summary indicator of the US data flow relative to market expectations. The index also correlates tightly with changes in bond yields (Chart 6). Though the index has fallen significantly from the absurd highs seen late last year, it is still elevated compared to typical historical levels. In general, bond yields tend to rise when the economic data are beating expectations, as indicated by a positive Surprise Index. All in all, we see that the cyclical indicators in our Checklist are sending a very different signal than the valuation indicators. This suggests a high probability that yields could overshoot fair value in the near term. Bottom Line: Treasury yields look fairly valued on several different valuation metrics and the yield curve discounts a much quicker pace of rate hikes than is currently signaled by the Fed’s “dot plot”. However, the economic data continue to beat expectations by a wide margin. This suggests that bond yields could overshoot their fair value in the near term. Maintain below-benchmark portfolio duration. The Employment Boom Is Just Getting Started Chart 7Defining "Maximum Employment" The Fed has conditioned the first rate hike of the cycle on both (i) 12-month PCE inflation being at or above 2% and (ii) the labor market being at “maximum employment”. As we’ve previously written, we see strong odds that the inflation trigger will be met in time for a 2022 rate hike.3 This week, we assess the likelihood that “maximum employment” will be reached in time for the Fed to lift rates next year. Fed communications have made it clear that the FOMC’s definition of “maximum employment” is equivalent to an environment where the unemployment rate is between 3.5% and 4.5% - the range of FOMC participants’ NAIRU estimates – and the labor force participation rate has made a more-or-less complete recovery to pre-pandemic levels (Chart 7). Following March’s blockbuster employment report, we update our calculations of the average monthly nonfarm payroll growth that must occur to hit “maximum employment” by different future dates (Tables 3A-3C). Table 3AAverage Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% By The Given Date Table 3BAverage Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4% By The Given Date Table 3CAverage Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 3.5% By The Given Date For example, to reach the Fed’s definition of “maximum employment” by December 2022, nonfarm payroll growth must average between +410k and +487k per month between now and then. To reach “maximum employment” by the end of this year, payroll growth must average between +701k and +833k over the remaining nine months of 2021. It’s probably unrealistic to expect a return to “maximum employment” by the end of this year, but we do expect at least a couple more monthly payroll reports that are even stronger than last month’s +916k. Our optimism stems from the industry breakdown of the current jobs shortfall. Table 4 shows the change in overall nonfarm payrolls between February 2020 and March 2021. In total, we see that the US economy is missing 8.4 million jobs compared to pre-pandemic. We also see that 3.1 million (or 37%) of those jobs come from the Leisure & Hospitality sector. That sector is predominantly made up of restaurants and bars, two services where demand is about to ramp up significantly as COVID vaccination spreads across the US. A few months in a row of 1 million or more jobs added is highly likely in the near future. Table 4Employment By Industry Bottom Line: We see the boom in employment as just getting started and we expect that the US economy will reach the Fed’s definition of “maximum employment” in 2022. This will cause the Fed to lift rates before the end of 2022, an event that will be preceded by an announcement of asset purchase tapering either late this year or early next year. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.bcaresearch.com/webcasts/detail/387 2 Please see US Bond Strategy Weekly Report, “The Fed Looks Backward While Markets Look Forward”, dated March 23, 2021, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Limit Rate Risk, Load Up On Credit”, dated March 16, 2021, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification