Geopolitics
Executive Summary Equities Are Still Attractive Versus Bonds Macroeconomic Outlook: Global growth will reaccelerate in the second half of this year provided a ceasefire in Ukraine is reached. Inflation will temporarily come down as the dislocations caused by the war and the pandemic subside, before moving up again in late 2023. Equities: Maintain a modest overweight in stocks over a 12-month horizon, favoring non-US equities, small caps, and value stocks. Look to turn more defensive in the second half of 2023 in advance of another wave of inflation. Fixed income: The neutral rate of interest in the US is around 3.5%-to-4%, which is substantially higher than the consensus view. Bond yields will move sideways this year but will rise over the long haul. Overweight Germany, France, Japan, and Australia while underweighting the US and the UK in a global bond portfolio. Credit: Corporate debt will outperform high-quality government bonds over the next 12 months. Favor HY over IG and Europe over the US. Spreads will widen again in late 2023. Currencies: As a countercyclical currency, the US dollar will weaken later this year, with EUR/USD rising to 1.18. We are upgrading our view on the yen from bearish to neutral due to improved valuations. The CNY will strengthen as the Chinese authorities take steps to boost domestic demand. Commodities: Oil prices will dip in the second half of 2022 as the geopolitical premium in crude declines and more OPEC supply comes to market. However, oil and other commodity prices will start moving higher by mid-2023. Bottom Line: The cyclical bull market in stocks that began in 2009 is running long in the tooth, but the combination of faster global growth later this year and a temporary lull in inflation should pave the way for one final hurrah for equities. Dear Client, Instead of our regular report this week, we are sending you our Quarterly Strategy Outlook, where we explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. Next week, please join me for a webcast on Monday, April 11 at 9:00 AM EDT (2:00 PM BST, 3:00 PM CEST, 9:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist P.S. You can now follow me on LinkedIn and Twitter. I. Overview We continue to recommend overweighting global equities over a 12-month horizon. However, we see downside risks to stocks both in the near term (next 3 months) and long term (2-to-5 years). In the near term, stocks will weaken anew if Russia’s stated intentions to scale back operations in Ukraine turn out to be a ruse. There is also a risk that China will need to temporarily shutter large parts of its economy to combat the spread of the highly contagious BA.2 Omicron variant. While stocks could suffer a period of indigestion in response to monetary tightening by the Fed and a number of other central banks, we doubt that rates will rise enough over the next 12 months to undermine the global economy. This reflects our view that the neutral rate of interest in the US and most other countries is higher than widely believed. If the neutral rate ends up being between 3.5% and 4% in the US, as we expect, the odds are low that the Fed will induce a recession by raising rates to 2.75%, as the latest dot plot implies (Chart 1). Chart 1The Market Sees The Fed Raising Rates To Around 3% And Then Backing Off The downside of a higher neutral rate is that eventually, investors will need to value stocks using a higher real discount rate. How fast markets mark up their estimate of neutral depends on the trajectory of inflation. We were warning about inflation before it was cool to warn about inflation (see, for example, our January 2021 report, Stagflation in a Few Months?; or our February 2021 report, 1970s-Style Inflation: Yes, It Could Happen Again). Our view has been that inflation will follow a “two steps up, one step down” pattern. We are currently near the top of those two steps: US inflation will temporarily decline in the second half of this year, as goods inflation drops but service inflation is slow to rise. The decline in inflation will provide some breathing room for the Fed, allowing it to raise rates by no more than what markets are already discounting over the next 12 months. Unfortunately, the respite in inflation will not last long. By the end of 2023, inflation will start to pick up again, forcing the Fed to resume hiking rates in 2024. This second round of Fed tightening is not priced by the markets, and so when it happens, it could be quite disruptive for stocks and other risk assets. Investors should overweight equities on a 12-month horizon but look to turn more defensive in the second half of 2023. II. The Global Economy War and Pestilence Are Near-Term Risks BCA’s geopolitical team, led by Matt Gertken, was ringing the alarm bell about Ukraine well before Russia’s invasion. Recent indications from Russia that it will scale back operations in Ukraine could pave the way for a ceasefire; or they could turn out to be a ruse, giving Russia time to restock supply lines and fortify its army in advance of a new summertime campaign against Kyiv. It is too early to tell, but either way, our geopolitical team expects more fighting in the near term. The West is not keen to give Putin an easy off-ramp, and even if it were, it is doubtful he would take it. The only way that Putin can salvage his legacy among his fan base in Russia is to decisively win the war in order to ensure Ukraine’s military neutrality. For his part, Zelensky cannot simply agree to Russia’s pre-war demands that Ukraine demilitarize and swear off joining NATO unless Russian forces first withdraw. To give in to such demands without any concrete security guarantees would raise the question of why Ukraine fought the war to begin with. The Impact of the Ukraine War on the Global Economy The direct effect of the war on the global economy is likely to be small. Together, Russia and Ukraine account for 3.5% of global GDP in PPP terms and 1.9% in dollar terms. Exports to Russia and Ukraine amount to only 0.2% of G7 GDP (Chart 2). Most corporations have little direct exposure to Russia, although there are a few notable exceptions (Chart 3). Chart 2Little Direct Trade Exposure To Russia And Ukraine In contrast to the direct effects, the indirect effects have the potential to be sizable. Russia is the world’s second largest oil producer, accounting for 12% of annual global output (Chart 4). It is the world’s top exporter of natural gas. About half of European natural gas imports come from Russia. Russia is also a significant producer of nickel, copper, aluminum, steel, and palladium. Chart 3Only A Handful Of Firms Have Significant Sales Exposure To Russia Chart 4Russia is The World's Second Largest Oil Producer Russia and Ukraine are major agricultural producers. Together, they account for a quarter of global wheat exports, with much of it going to the Middle East and North Africa (Chart 5). They are also significant producers of potatoes, corn, sugar beets, and seed oils. In addition, Russia produces two-thirds of all ammonium nitrate, the main source of nitrogen-based fertilizers. Largely as a result of higher commodity prices and other supply disruptions, the OECD estimates that the war could shave about 1% off of global growth this year, with Europe taking the brunt of the hit (Chart 6). At present, the futures curves for most commodities are highly backwardated (Chart 7). While one cannot look to the futures as unbiased predictors of where spot prices are heading, it is fair to say that commodity markets are discounting some easing in prices over the next two years. If that does not occur, global growth could weaken more than the OECD expects. Chart 5Developing Economies Buy The Bulk Of Russian And Ukrainian Wheat Chart 6The War In Ukraine Could Shave One Percentage Point Off Of Global Growth Chart 7Futures Curves For Most Commodities Are Backwardated Another Covid Wave Two years after “two weeks to flatten the curve,” the world continues to underappreciate the power of exponential growth. Suppose that it takes five days for someone with Covid to infect someone else. If everyone with Covid infects an average of six people, the cumulative number of Covid cases would rise from 1,000 to 10 million in around four weeks. Suppose you could cut the number of new infections in half to three per person. In that case, it would take about six weeks for 10 million people to be infected. In other words, mitigation measures that cut the infection rate by half would only extend how long it takes for 10 million people to be infected by two weeks. That’s not a lot. The point is that any infection rate above one will generate an explosive rise in cases. In the pre-Omicron days, keeping the infection rate below one was difficult, but not impossible for countries with the means and motivation to do so. As the virus has become more contagious, however, keeping it at bay has grown more difficult. The latest strain of Omicron, BA.2, appears to be 40% more contagious than the original Omicron strain, which itself was about 4-times more contagious than Delta. BA.2 is quickly spreading around the world. The number of cases has spiked across much of Europe, parts of Asia, and has begun to rise in North America (Chart 8). In China, the authorities have locked down Shanghai, home to 25 million people. Chart 8Covid Cases Are On The Rise Again The success that China has had in suppressing the virus has left its population with little natural immunity; and given the questionable efficacy of its vaccines, with little artificial immunity as well. Moreover, as is the case in Hong Kong, a large share of mainland China’s elderly population remains completely unvaccinated. Chart 9New Covid Drugs Are Set To Hit The Market This presents the Chinese authorities with a difficult dilemma: Impose severe lockdowns over much of the population, or let the virus run rampant. As the logic of exponential change described above suggests, there is not much of a middle ground. Our guess is that the Chinese government will choose the former option. China has already signed a deal to commercialize Pfizer’s Paxlovid. The drug is highly effective at preventing hospitalization if taken within five days from the onset of symptoms. Fortunately, Paxlovid production is starting to ramp up (Chart 9). China will probably wait until it has sufficient supply of the drug before relaxing its zero-Covid policy. While beneficial to growth later this year, this strategy could have a negative near-term impact on activity, as the authorities continue to play whack-a-mole with Covid. Chart 10Inflation Is Running High, Especially In The US Central Banks in a Bind Standard economic theory says that central banks should adjust interest rates in response to permanent shocks, while ignoring transitory ones. This is especially true if the shock in question emanates from the supply side of the economy. After all, higher rates cool aggregate demand; they do not raise aggregate supply. The lone exception to this rule is when a supply shock threatens to dislodge long-term inflation expectations. If long-term inflation expectations become unanchored, what began as a transitory shock could morph into a semi-permanent one. The problem for central banks is that the dislocations caused by the Ukraine war are coming at a time when inflation is already running high. Headline CPI inflation reached 7.9% in the US in February, while core CPI inflation clocked in at 6.4%. Trimmed-mean inflation has increased in most economies (Chart 10). Fortunately, while short-term inflation expectations have moved up, long-term expectations have been more stable. Expected US inflation 5-to-10 years out in the University of Michigan survey stood at 3.0% in March, down a notch from 3.1% in January, and broadly in line with the average reading between 2010 and 2015 (Chart 11). Survey-based measures of long-term inflation expectations are even more subdued in the euro area and Japan (Chart 12). Market-based inflation expectations have risen, although this partly reflects higher oil prices. Even then, the widely-watched 5-year, 5-year forward TIPS inflation breakeven rate remains near the bottom of the Fed’s comfort range of 2.3%-to-2.5% (Chart 13).1 Chart 11Long-Term Inflation Expectations Remain Contained In The US... Chart 12... And In The Euro Area And Japan Chart 13The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone Goods versus Services Inflation Most of the increase in consumer prices has been concentrated in goods rather than services (Chart 14). This is rather unusual in that goods prices usually fall over time; but in the context of the pandemic, it is entirely understandable. Chart 14Goods Prices Have Been A Major Driver Of Overall Inflation The pandemic caused spending to shift from services to goods (Chart 15). This occurred at the same time as the supply of goods was being adversely affected by various pandemic-disruptions, most notably the semiconductor shortage that is still curtailing automobile production. Chart 15AGoods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Chart 15BGoods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Looking out, the composition of consumer spending will shift back towards services. Supply chain bottlenecks should also abate, especially if the situation in Ukraine stabilizes. It is worth noting that the number of ships on anchor off the coast of Los Angeles and Long Beach has already fallen by half (Chart 16). The supplier delivery components of both the manufacturing and nonmanufacturing ISM indices have also come off their highs (Chart 17). Even used car prices appear to have finally peaked (Chart 18). Chart 16Shipping Delays Are Abating Chart 17Delivery Times Are Slowly Coming Down Chart 18Used Car Prices May Have Finally Peaked On the Lookout for a Wage-Price Spiral Could rising services inflation offset any decline in goods inflation this year? It is possible, but for that to happen, wage growth would have to accelerate further. For now, much of the acceleration in US wage growth has occurred at the bottom end of the income distribution (Chart 19). It is easy to see why. Chart 20 shows that low-paid workers have not returned to the labor market to the same degree as higher-paid workers. However, now that extended unemployment benefits have lapsed and savings deposits are being drawn down, the incentive to resume work will strengthen. Chart 19Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Chart 20More Low-Wage Employees Should Return To Work Chart 21More Workers Will Return To Their Jobs Once The Pandemic Ends The end of the pandemic should allow more workers to remain at their jobs. In January, during the height of the Omicron wave, 8.75 million US workers (5% of the total workforce) were absent from work due to the virus (Chart 21). How High Will Interest Rates Eventually Rise? If goods inflation comes down swiftly later this year, and services inflation is slow to rise, then overall inflation will decline. This should allow the Fed to pause tightening in early 2023. Whether the Fed will remain on hold beyond then depends on where the neutral rate of interest resides. Chart 22The Yield Curve Inverted in Mid-2019 But Growth Accelerated The neutral rate, or equilibrium rate as it is sometimes called, is the interest rate consistent with full employment and stable inflation. If the Fed pauses hiking before interest rates have reached neutral, the economy will eventually overheat, forcing the Fed to resume hiking. In contrast, if the Fed inadvertently raises rates above neutral, unemployment will start rising, requiring the Fed to cut rates. Markets are clearly worried about the latter scenario. The 2/10 yield curve inverted earlier this week. With the term premium much lower than in the past, an inversion in the yield curve is not the powerful harbinger of recession that it once was. After all, the 2/10 curve inverted in August 2019 and the economy actually strengthened over the subsequent six months before the pandemic came along (Chart 22). Nevertheless, an inverted yield curve is consistent with markets expectations that the Fed will raise rates above neutral. That is always a dangerous undertaking. Raising rates above neutral would likely push up the unemployment rate. There has never been a case in the post-war era where the 3-month moving average of the unemployment rate has risen by more than 30 basis points without a recession occurring (Chart 23). Chart 23When Unemployment Starts Rising, It Usually Keeps Rising As discussed in the Feature Section below, the neutral rate of interest is probably between 3.5% and 4% in the US. This is good news in the short term because it lowers the odds that the Fed will raise rates above neutral during the next 12 months. It is bad news in the long run because it means that the Fed will find itself even more behind the curve than it is now, making a recession almost inevitable. The Feature Section builds on our report from two weeks ago. Readers familiar with that report should feel free to skip ahead to the next section. III. Feature: A Higher Neutral Rate Conceptually, the neutral rate is the interest rate that equates the amount of investment a country wants to undertake at full employment with the amount of savings that it has at its disposal.2 Anything that reduces savings or increases investment would raise the neutral rate (Chart 24). Chart 24The Savings-Investment Balance Determines The Neutral Rate Of Interest A number of factors are likely to lower desired savings in the US over the next few years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and the receipt of generous government transfer payments (Chart 25). Household wealth has soared since the start of the pandemic (Chart 26). Conservatively assuming that households spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by 4% of GDP. Chart 25Plenty Of Pent-Up Demand Chart 26Net Worth Has Soared Since The Pandemic The household deleveraging cycle has ended (Chart 27). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. For the first time since the housing boom, mortgage equity withdrawals are rising. Banks are easing lending standards on consumer loans across the board. Chart 27US Household Deleveraging Pressures Have Abated Chart 28Baby Boomers Have Amassed A Lot Of Wealth Baby boomers are retiring. They hold over half of US household wealth, considerably more than younger generations (Chart 28). As baby boomers transition from being savers to dissavers, national savings will decline. Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 29).Chart 29Fiscal Policy: Tighter But Not Tight On the investment front: The deceleration in trend GDP growth, which depressed investment spending, has largely run its course.3 According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today. The CBO expects potential growth to edge down only slightly to 1.7% over the next few decades (Chart 30). After moving broadly sideways for two decades, core capital goods orders – a leading indicator for capital spending – have broken out to the upside (Chart 31). Capex intention surveys remain upbeat (Chart 32). The average age of the nonresidential capital stock currently stands at 16.3 years, the highest since 1965 (Chart 33). Chart 30Much Of The Deceleration In Potential Growth Has Already Happened Chart 31Positive Signs For Capex (I) Chart 32Positive Signs For Capex (II) Chart 33An Aging Capital Stock Similar to nonresidential investment, the US has been underinvesting in residential real estate (Chart 34). The average age of the housing stock has risen to a 71-year high of 31 years. The homeowner vacancy rate has plunged to the lowest level on record. The number of newly finished homes for sale is half of what it was prior to the pandemic. Chart 34US Housing Is In Short Supply The New ESG: Energy Security and Guns The war in Ukraine will put further upward pressure on the neutral rate, especially outside of the United States. After staging a plodding recovery following the euro debt crisis, European capital spending received a sizable boost from the launch of the NextGenerationEU Recovery Fund (Chart 35). As Mathieu Savary points out in his latest must-read report on Europe, capital spending will rise further in the years ahead as European governments accelerate efforts to make their economies less reliant on Russian energy. Germany has already announced plans to construct three new LNG terminals. The push to build out Europe’s energy infrastructure is coming at a time when businesses are looking to ramp up capital spending. As in the US, Europe’s capital stock has aged rapidly over the past decade (Chart 36). Chart 35European Capex Should Recover Chart 36European Machines Need More Than Just An Oil Change Chart 37The War In Ukraine Calls For More Spending Across Europe Meanwhile, European governments are trying to ease the burden from rising energy costs. For example, France has introduced a rebate on fuel. It is part of a EUR 20 billion package aimed at cutting heating and electricity bills. European military spending will rise. Military spending currently amounts to 1.5% of GDP, well below NATO’s threshold of 2% (Chart 37). Germany has announced that it will spend EUR 100 billion more on defense. European governments will also need to boost spending to accommodate Ukrainian refugees. The UN estimates that four million refugees have left Ukraine, with the vast majority settling in the EU. A Smaller Chinese Current Account Surplus? The difference between what a country saves and invests equals its current account balance. Historically, China has been a major exporter of savings, which has helped depress interest rates abroad. While China’s current account surplus has declined as a share of its own GDP, it has remained very large as a share of global ex-China GDP, reflecting China’s growing weight in the global economy (Chart 38). Many analysts assume that China will double down on efforts to boost exports in order to offset the drag from falling property investment. However, there is a major geopolitical snag with that thesis: A country that runs a current account surplus must, by definition, accumulate assets from the rest of the world. As the freezing of Russia’s foreign exchange reserves demonstrates, that is a risky proposition for a country such as China. Rather than increasing its current account surplus, China may seek to bolster its economy by raising domestic demand. This could be achieved by either boosting domestic infrastructure spending or raising household consumption. Notably, China’s credit impulse appears to have bottomed and is set to increase in the second half of the year. This is good news not just for Chinese growth but growth abroad (Chart 39). Chart 38Will China Be A Source Of Excess Savings? Chart 39China's Credit Impulse Appears To Have Bottomed The IMF’s latest projections foresee China’s current account surplus falling by more than half between 2021 and 2026 as a share of global ex-China GDP. If this were to happen, the neutral rate in China and elsewhere would rise. IV. Financial Markets A. Portfolio Strategy Chart 40The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles As noted in the overview, if the neutral rate turns out to be higher than currently perceived, the Fed is unlikely to induce a recession by raising rates over the next 12 months. That is good news for equities. A look back at the past four Fed tightening cycles shows that stocks often wobble when the Fed starts hiking rates, but then usually rise as long as rates do not move into restrictive territory (Chart 40). Unfortunately, a higher neutral rate also means that investors will eventually need to value stocks using a higher discount rate. It also means that any decline in inflation this year will not last. The US economy will probably start to overheat again in the second half of 2023. This will set the stage for a second, and more painful, tightening cycle in 2024. Admittedly, there is a lot of uncertainty over our “two steps up, one step down” forecast for inflation. It is certainly possible that the “one step down” phase does not last long and that the resurgence in inflation we are expecting in the second half of next year occurs earlier. It is also possible that investors will react negatively to rising rates, even if the economy is ultimately able to withstand them. As such, only a modest overweight to equities is justified over the next 12 months, with risks tilted to the downside in the near term. More conservative asset allocators should consider moving to a neutral stance on equities already, as my colleague Garry Evans advised clients to do in his latest Global Asset Allocation Quarterly Portfolio Outlook. B. Fixed Income Stay Underweight Duration Over a 2-to-5 Year Horizon Our recommendation to maintain below-benchmark duration in fixed-income portfolios panned out since the publication of our Annual Outlook in December, with the US 10-year Treasury yield rising from 1.43% to 2.38%. We continue to expect bond yields in the US to rise over the long haul. Conceptually, the yield on a government bond equals the expected path of policy rates over the duration of the bond plus a term premium. The term premium is the difference between the return investors can expect from buying a long-term bond that pays a fixed interest rate, and the return from rolling over a short-term bill. The term premium has been negative in recent years. Investors have been willing to sacrifice return to own long-term bonds because bond prices usually rise when the odds of a recession go up. The fact that monthly stock returns and changes in bond yields have been positively correlated since 2001 underscores the benefits that investors have received from owning long-term bonds as a hedge against unfavorable economic news (Chart 41). However, now that inflation has emerged as an increasingly important macroeconomic risk, the correlation between stock returns and changes in bond yields could turn negative again. Unlike weak economic growth, which is bad for only stocks, high inflation is bad for both bonds and stocks. Chart 41Correlation Between Stock Returns And Bond Yields Could Turn Negative If bond yields start to rise whenever stock prices fall, the incentive to own long-term bonds will decline. This will cause the term premium to increase. Assuming the term premium rises to about 0.5%, and a neutral rate of 3.5%-to-4%, the long-term fair value for the 10-year US Treasury yield is 4%-to-4.5%. This is well above the 5-year/5-year forward yield of 2.20%. Move from Underweight to Neutral Duration Over a 12-Month Horizon Below benchmark duration positions usually do well when the Fed hikes rates by more than expected over the subsequent 12 months (Chart 42). Chart 42The Golden Rule Of Bond Investing Given our view that US inflation will temporarily decline later this year, the Fed will probably not need to raise rates over the next 12 months by more than the 249 basis points that markets are already discounting. Thus, while a below-benchmark duration position is advisable over a 2-to-5-year time frame, it could struggle over a horizon of less than 12 months. Our end-2022 target range for the US 10-year Treasury yield is 2.25%-to-2.5%. Chart 43Bond Sentiment And Positioning Are Bearish Supporting our decision to move to a neutral benchmark duration stance over a 12-month horizon is that investor positioning and sentiment are both bond bearish (Chart 43). From a contrarian point of view, this is supportive of bonds. Global Bond Allocation BCA’s global fixed-income strategists recommend overweighting German, French, Australian, and Japanese government bonds, while underweighting those of the US and the UK. They are neutral on Italy and Spain given that the ECB is set to slow the pace of bond buying. The neutral rate of interest has risen in the euro area, partly on the back of more expansionary fiscal policy across the region. In absolute terms, however, the neutral rate in the euro area is still quite low, and possibly negative. Unlike in the US, where inflation has risen to uncomfortably high levels, much of Europe would benefit from higher inflation expectations, as this would depress real rates across the region, giving growth a boost. This implies that the ECB is unlikely to raise rates much over the next two years. As with the euro area, Japan would benefit from lower real rates. The Bank of Japan’s yield curve control policy has been put to the test in recent weeks. To its credit, the BoJ has stuck to its guns, buying bonds in unlimited quantities to prevent yields from rising. We expect the BoJ to stay the course. Unlike in the euro area and Japan, inflation expectations are quite elevated in the UK and wage growth is rising quickly there. This justifies an underweight stance on UK gilts. Although job vacancies in Australia have climbed to record levels, wage growth is still not strong enough from the RBA’s point of view to justify rapid rate hikes. As a result, BCA’s global fixed-income strategists remain overweight Australian bonds. Finally, our fixed-income strategists are underweight Canadian bonds but are contemplating upgrading them given that markets have already priced in 238 basis points in tightening over the next 12 months. Unlike in the US, high levels of consumer debt will also limit the Bank of Canada’s ability to raise rates. Modest Upside in High-Yield Corporate Bonds Credit spreads have narrowed in recent days but remain above where they were prior to Russia’s invasion of Ukraine. Since the start of the year, US investment-grade bonds have underperformed duration-matched Treasurys by 154 basis points, while high-yield bonds have underperformed by 96 basis points (Chart 44). The outperformance of high-yield relative to investment-grade debt can be explained by the fact that the former has more exposure to the energy sector, which has benefited from rising oil prices. Looking out, falling inflation and a rebound in global growth later this year should provide a modestly supportive backdrop for corporate credit. High-yield spreads are still pricing in a default rate of 3.8% over the next 12 months (Chart 45). This is well above the trailing 12-month default rate of 1.3%. Our fixed-income strategists continue to prefer US high-yield over US investment-grade. Chart 44Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Chart 45Spread-Implied Default Rate Is Too High European credit is attractively priced and should benefit from any stabilization in the situation in Ukraine. Our fixed-income strategists prefer both European high-yield and investment-grade bonds over their US counterparts. As with equities, the bull market in corporate credit will end in late 2023 as the Fed is forced to resume raising rates in 2024 in the face of an overheated economy. C. Currencies Chart 46Widening Interest Rate Differentials Have Supported The Dollar The US Dollar Will Weaken Starting in the Second Half of 2022 Since bottoming last May, the US dollar has been trending higher. While the dollar could strengthen further in the near term if the war in Ukraine escalates, the fundamental backdrop supporting the greenback is starting to fray. If US inflation comes down later this year, the Fed is unlikely to raise rates by more than what markets are already discounting over the next 12 months. Thus, widening rate differentials will no longer support the dollar (Chart 46). The dollar is a countercyclical currency: It usually weakens when global growth is strengthening and strengthens when global growth is weakening (Chart 47). The dollar tends to be particularly vulnerable when growth expectations are rising more outside the US than in the US (Chart 48). Chart 47The Dollar Is A Countercyclical Currency Chart 48Better Growth Prospects Abroad Will Weigh On The US Dollar Global growth should rebound in the second half of the year once the pandemic finally ends and the situation in Ukraine stabilizes. Growth is especially likely to recover in Europe. This will support the euro, a dovish ECB notwithstanding. Chester Ntonifor, BCA’s Foreign Exchange Strategist, expects EUR/USD to end the year at 1.18. The Dollar is Overvalued The dollar’s ascent has left it overvalued by more than 20% on a Purchasing Power Parity (PPP) basis (Chart 49). The PPP exchange rate equalizes the price of a representative basket of goods and services between the US and other economies. PPP deviations from fair value have done a reasonably good job of predicting dollar movements over the long run (Chart 50). Chart 49USD Remains Overvalued Chart 50Valuations Matter For FX Long-Term Returns Reflecting the dollar’s overvaluation, the US trade deficit has widened sharply (Chart 51). Excluding energy exports, the US trade deficit as a share of GDP is now the largest on record. Equity inflows have helped finance America’s burgeoning current account deficit (Chart 52). However, these inflows have ebbed significantly as foreign investors have lost their infatuation with US tech stocks. Chart 51The US Trade Deficit Has Widened Chart 52Net Inflows Into US Equities Have Dried Up Dollar positioning remains stretched on the long side (Chart 53). That is not necessarily an obstacle in the short run, given that the dollar tends to be a momentum currency, but it does suggest that the greenback could weaken over a 12-month horizon as more dollar bulls jump ship. The Yen: Cheaper but Few Catalysts for a Bounce The trade-weighted yen has depreciated by 6.4% since the start of the year. The yen is 31% undervalued relative to the dollar on a PPP basis (Chart 54). In a nod to these improved valuations, we are upgrading our 12-month and long-term view on the yen from bearish to neutral. Chart 53Still A Lot of Dollar Bulls Chart 54The Yen Has Gotten Cheaper While the yen is unlikely to weaken much from current levels, it is unlikely to strengthen. As noted above, the Bank of Japan has no incentive to abandon its yield curve control strategy. Yes, the recent rapid decline in the yen is a shock to the economy, but it is a “good” shock in the sense that it could finally jolt inflation expectations towards the BoJ’s target of 2%. If inflation expectations rise, real rates would fall, which would be bearish for the currency. Favor the RMB and other EM Currencies The Chinese RMB has been resilient so far this year, rising slightly against the dollar, even as the greenback has rallied against most other currencies. Real rates are much higher in China than in the US, and this has supported the RMB (Chart 55). Chart 55Higher Real Rates In China Have Supported The RMB Chart 56The RMB Is Undervalued Based On PPP Despite the RMB’s strength, it is still undervalued by 10.5% relative to its PPP exchange rate (Chart 56). While productivity growth has slowed in China, it remains higher than in most other countries. The real exchange rates of countries that benefit from fast productivity growth typically appreciates over time. China holds about half of its foreign exchange reserves in US dollars, a number that has not changed much since 2012 (Chart 57). We expect China to diversify away from dollars over the coming years. Moreover, as discussed earlier in the report, the incentive for China to run large current account surpluses may fade, which will result in slower reserve accumulation. Both factors could curb the demand for dollars in international markets. Chart 57Half Of Chinese FX Reserves Are Held In USD Assets A resilient RMB will provide a tailwind for other EM currencies. Many EM central banks began to raise rates well before their developed market counterparts. In Brazil, for example, the policy rate has risen to 11.75% from 2% last April. With inflation in EMs likely to come down later this year as pandemic and war-related dislocations subside, real policy rates will rise, giving EM currencies a boost. D. Commodities Longer-Term Bullish Thesis on Commodities Remains Intact BCA’s commodity team, led by Bob Ryan, expects crude prices to fall in the second half of the year, before moving higher again in 2023. Their forecast is for Brent to dip to $88/bbl by end-2022, which is below the current futures price of $97/bbl. Chart 58Dearth Of Oil Capex Will Put A Floor Under Oil Prices The risk to their end-2022 forecast is tilted to the upside. The relationship between the Saudis and the US has become increasingly strained. This could hamper efforts to bring more oil to market. Hopes that Iranian crude will reach global markets could also be dashed if, as BCA’s geopolitical strategists expect, the US-Iran nuclear deal falls through. A cut-off of Russian oil could also cause prices to rise. While Urals crude is being sold at a heavy discount of $30/bbl to Brent (compared to a discount of around $2/bbl prior to the invasion), it is still leaving the country. In fact, Russian oil production actually rose in March over February. An escalation of the war would make it more difficult for Russia to divert enough oil to China, India, and other countries in order to evade Western sanctions. Looking beyond this year, Bob and his team see upside to oil prices. They expect Brent to finish 2023 at $96/bbl, above the futures price of $89/bbl. Years of underinvestment in crude oil production have led to tight supply conditions (Chart 58). Proven global oil reserves increased by only 6% between 2010 and 2020, having risen by 26% over the preceding decade. Stay Positive on Metals As with oil, there has been little investment in mining capacity in recent years. While a weaker property market in China will weigh on metals prices, this will be partly offset by increased infrastructure spending. The shift towards green energy will also boost metals prices. The typical electric vehicle requires about four times as much copper as a typical gasoline-powered vehicle. Huge amounts of copper will also be necessary to expand electrical grids. Favor Gold Over Cryptos After breaking above $2,000/oz, the price of gold has retreated to $1,926/oz. In the near term, gold prices will be swayed by geopolitical developments. Longer term, real rates will dictate the direction of gold prices. Chart 59 shows that there is a very strong correlation between the price of gold and TIPS yields. If we are correct that the neutral rate of interest is 3.5%-to-4% in the US, real bond yields will eventually need to rise from current levels. Gold prices are quite expensive by historic standards, which represents a long-term risk (Chart 60). Chart 59Strong Correlation Between Real Rates And Gold Chart 60Gold Is Quite Pricey From A Historical Perspective That said, we expect the bulk of the increase in real bond yields to occur only after mid-2023. As mentioned earlier, the Fed will probably not have to deliver more tightening that what markets are already discounting over the next 12 months. Thus, gold prices are unlikely to fall much in the near term. In any case, we continue to regard gold as a safer play than cryptocurrencies. As we discussed in Who Pays for Cryptos?, the long-term outlook for cryptocurrencies remains daunting. Many of the most hyped blockchain applications, from DeFi to NFTs, will turn out to be duds. Concerns that cryptocurrencies are harming the environment, contributing to crime, and enriching a small group of early investors at the expense of everyone else will lead to increased regulatory scrutiny. Our long-term target for Bitcoin is $5,000. E. Equities Equities Are Still Attractively Priced Relative to Bonds Corporate earnings are highly correlated with the state of the business cycle (Chart 61). A recovery in global growth later this year will bolster revenue, while easing supply-chain pressures should help contain costs in the face of rising wages. It is worth noting that despite all the shocks to the global economy, EPS estimates in the US and abroad have actually risen this year (Chart 62). Chart 61The Business Cycle Drives Earnings Chart 62Global EPS Estimates Have Held Up Reasonably Well Chart 63Equities Are Still Attractive Versus Bonds As Doug Peta, BCA’s Chief US Strategist has pointed out, the bar for positive earnings surprises for Q1 is quite low: According to Refinitiv/IBES, S&P 500 earnings are expected to fall by 4.5% in Q1 over Q4 levels. Global equities currently trade at 18-times forward earnings. Relative to real bond yields, stocks continue to look reasonably cheap (Chart 63). Even in the US, where valuations are more stretched, the earnings yield on stocks exceeds the real bond yield by 570 basis points. At the peak of the market in 2000, the gap between earnings yields and real bond yields was close to zero. Favor Non-US Markets, Small Caps, and Value Valuations are especially attractive outside the US. Non-US equities trade at 13.7-times forward earnings. Emerging markets trade at a forward P/E of only 12.1. Correspondingly, the gap between earnings yields and real bond yields is about 200 basis points higher outside the US. In general, non-US markets fare best in a setting of accelerating growth and a weakening dollar – precisely the sort of environment we expect to prevail in the second half of the year (Chart 64). US small caps also perform best when growth is strengthening and the dollar is weakening (Chart 65). In contrast to the period between 2003 and 2020, small caps now trade at a discount to their large cap brethren. The S&P 600 currently trades at 14.4-times forward earnings compared to 19.7-times for the S&P 500, despite the fact that small cap earnings are projected to grow more quickly both over the next 12-months and over the long haul (Chart 66). Chart 64A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks Chart 65US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening Globally, growth stocks have outperformed value stocks by 60% since 2017. However, only one-tenth of that outperformance has come from faster earnings growth (Chart 67). This has left value trading nearly two standard deviations cheap relative to growth. Chart 66Small Caps Look Attractive Relative To Large Caps Chart 67Value Remains Cheap Chart 68Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Tech stocks are overrepresented in growth indices, while banks are overrepresented in value indices. US banks have held up relatively well since the start of the year but have not gained as much as one would have expected based on the significant increase in bond yields (Chart 68). With the deleveraging cycle in the US coming to an end, US banks sport both attractive valuations and the potential for better-than-expected earnings growth. European banks should also recover as the situation in Ukraine stabilizes. They trade at only 7.9-times forward earnings and 0.6-times book. On the flipside, structurally higher bond yields will weigh on tech shares. Moreover, as we discussed in our recent report entitled The Disruptor Delusion, a cooling in pandemic-related tech spending, increasing market saturation, and concerns about Big Tech’s excessive power will all hurt tech returns. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. 2 These savings can either by generated domestically or imported from abroad via a current account deficit. 3 Theoretically, there is a close relationship between trend growth and the equilibrium investment-to-GDP ratio. For example, if real trend growth is 3% and the capital stock-to-GDP ratio is 200%, a country would need to invest 6% of GDP net of depreciation to maintain the existing capital stock-to-GDP ratio. In contrast, if trend growth were to fall to 2%, the country would only need to invest 4% of GDP. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Executive Summary Energy and National Security Will Drive the Market Our 2022 key views are broadly on track. Biden’s shift from domestic to foreign policy is dominating the other views. However, Democrats still have a 65% chance of passing a reconciliation bill that will raise taxes to pay for green energy and prescription drug caps. Then gridlock will set in. The US is developing a new national consensus. Generational change is promoting the shift to proactive fiscal policy to address the country’s social unrest and rising foreign policy challenges. Polarization is still at peak levels in the short term but will fall over the coming decade as the US pursues “nation building” at home while confronting geopolitical rivals. The return of Big Government is being priced into the bond market today. But it will be Limited Big Government, as the sharp spike in inflation today will provoke a backlash. Recommendation Inception Level Inception Date Return Long Aerospace And Defense Vs. Broad Market (Cyclical) 30-Mar-22 Long Oil And Gas Transportation And Storage Vs. Broad Market (Cyclical) 30-Mar-22 Long Refinitive Renewable Energy Vs. Broad Market (Tactical) 30-Mar-22 Bottom Line: Investors dedicated to the US market should stay tactically defensive. Cyclically favor the new US policy consensus on national defense, infrastructure, cyber security, and energy security. Feature The title of our annual outlook was “Gridlock Begins Before The Midterms.” We argued that Biden would still have some room for legislative maneuver in the first half of 2022 but that checks and balances would grow as the year went on. Checks will grow due to (1) the looming midterm elections; (2) Biden’s falling political capital and need to rely on executive action; (3) rising foreign policy challenges. Of these, foreign policy has proven decisive, with Russia invading Ukraine and the US and Europe imposing economic sanctions. The resulting energy shock is adding to inflation, weighing on consumer confidence, stock market multiples, and investor sentiment (Chart 1). Having said that, we also argued that congressional Democrats still had enough political capital to pass a watered-down fiscal 2022 budget reconciliation bill before the scene of action shifted to the White House. The second quarter is the last chance for this prediction to come true – and we are sticking with our 65% odds. The reconciliation bill will be even more watered down than we expected. But the point is that fiscal policy – especially tax hikes – can still move markets in the second quarter, even though inflation, the Fed, and the war will have a bigger influence. Chart 1US Seeks National Security And Energy Security Related Report US Political Strategy2022 Key Views: Gridlock Begins Before The Midterms The war in Europe is clearly the most important political, geopolitical, and policy dynamic for investors this year. It is prompting some important congressional action that speaks to Biden’s room for maneuver in the first half of the year. In so doing it reinforces our long-term themes of “Peak Polarization” and “Limited Big Government.” As Americans face rising foreign policy challenges, a new bipartisanship is emerging, particularly on industrial and trade policy. Checking Up On Our Three Key Views For 2022 Here are our three key trends for 2022 with comments about their development over the past three months: 1. From Single-Party Rule To Gridlock: We argued that the Biden administration would pass a watered-down reconciliation bill on a party-line vote by June at latest. Then Congress would grind to a halt for election campaigning, to be followed by Republicans taking one or both chambers of Congress, restoring gridlock and making it hard to pass major legislation from the second half of 2022 through 2024. This view is still generally on track. The basis for believing that a bill will still pass is that the Democrats are in trouble in the midterms and badly need a legislative victory. Public opinion polls suggest they face a beating reminiscent of President Trump and the Republicans in 2018 (Chart 2). Democrats trail Republicans in enthusiasm. Only about 45% of Democrats and 42% of Biden voters are enthusiastic to vote, while 50% of Republicans and 54% of Trump voters are enthusiastic. Men, who lean Republican, are more enthusiastic than women, by 51% to 38%, according to the pollster Morning Consult.1 With the economy and foreign policy rising as the most important issues of the election, Democrats have lost their key issues of health care and the pandemic. Notably Democrats have also lost ground on traditional strengths like education. However, the Ukraine war has put a new emphasis on energy security which Democrats are harnessing to repackage their climate agenda. Hence Democrats will make a last-ditch effort to pass a reconciliation bill before the summer campaigning gets under way. The “Build Back Better” plan was always going to be watered down but now it will be extensively revised. The bill will now have to be closer to neutral in its impact on the deficit so as not to feed inflation. Public opinion polls back in January, when the bill was primarily a social welfare bill, showed 61% of political independents in favor, not to mention 85% of Democrats. A majority of independents supported the bill even when asked about each provision separately and when the tax hikes were made plain.2 By halting progress on the left-wing version of the bill that the House of Representatives passed late last year, West Virginia Senator Joe Manchin saved his party from passing a highly stimulative fiscal bill in the middle of the biggest outbreak of inflation since the 1980s, when the output gap was virtually closed (Chart 3). Chart 2Democrats Not Faring Much Better Than Trump Republicans In 2018 Chart 3Output Gap Closed, No More Stimulus Needed Now Manchin will face a “Build Back Slimmer” bill that will be harder to oppose when Congress comes back from Easter.3 Our research over the past year suggests that Manchin is likely to vote for a bill that meets his main demands. The bill will be crafted for his approval. Manchin supports corporate tax hikes, funding for green energy transition (as long as it is not punitive toward certain sources or technologies), and a cap on prescription drug costs.4 Tax hikes, such as a minimum 15% corporate tax rate on book earnings, will be included, albeit diluted from the original proposals. Most investors have forgotten about the risk of tax hikes altogether so stock investors may not be happy that the US is hiking taxes amid inflation. Earnings estimates for the year are not reflecting any negative news, whether energy shock, or weak consumer confidence, or new taxes (Chart 4). If the bill fails to pass, equity investors may well cheer, since they are worried about inflation rather than deflation and the bill will not truly be deficit-neutral. Chart 4Inflation, War, Potentially Tax Hikes Will Weigh On Earnings Estimates Given Democrats’ thin majorities in both houses (222 versus 210 seats in the House and 50 versus 50 seats in the Senate), a single defection in the Senate can derail the bill, so we cannot have high conviction that it will pass. We are sticking with our 65% subjective odds. Passage of a reconciliation bill will slightly help Democrats’ fortunes ahead of the midterm but Republicans are still highly likely to win at least the House of Representatives. So the transition to gridlock will still occur. Only very rarely do ruling parties gain seats in the midterms. Biden’s loss of support among women voters is a tell-tale sign that trouble looms, as was the case for the Obama administration at this stage in its first term (Chart 5). The implication for financial markets is that the budget reconciliation bill will bring a negative surprise in the form of tax hikes that will weigh on bullish or pro-cyclical sentiment in the second quarter, at least marginally. Chart 5Women Like Biden Less Than Obama, Who Suffered Midterm Losses Chart 6Biden's Energy Shock 2. From Legislative To Executive Power: Similarly we anticipated a transition from legislative action to executive action over the course of 2022. After the budget reconciliation bill is decided, the president will have to rely on executive action to achieve any policy goals. We expected this trend to derive from Biden’s regulatory aims as well as from the need to respond to rising geopolitical challenges, especially the energy shock (Chart 6). This shock is the single biggest reason for the market consensus that Democrats will lose Congress this year. The chief equity sector winner was the energy industry, as we expected. Now Biden needs to encourage rather than discourage supply. Until Biden decides whether to lift sanctions on Iran, volatility will prevail in energy markets. But Biden will condone domestic energy production, with a view to alleviating shortages prior to 2024. He will abandon his left wing and adopt the Obama administration’s permissiveness toward domestic energy, which will help oil and natural gas rig counts to rise (Chart 7). Renewable energy policy will gain traction as it will now clearly be seen in the context of national security and energy security. It also combines trade policy with national security in the form of exports to allies. The US now has a free pass to help Europe diversify away from Russian energy. Not that the US can replace Russia but merely that it can make a dent in both oil and liquefied natural gas (Chart 8). Subsidies for green energy are still likely but not a carbon tax or punitive measures toward the fossil fuel industry. Chart 7Biden Revives Obama Truce With O&G Chart 8US Helps Europe Diversify Away From Russia 3. From Domestic To Foreign Policy: We fully expected Biden to be forced to pay attention to foreign affairs in 2022, despite his desire to focus on the voter ahead of midterms. We argued that he would maintain a defensive or reactive foreign policy since he would not want to create higher inflation ahead of the midterms and yet oil producers like Russia or Iran would go on offensive due to energy shortage. While Biden has imposed harsh sanctions on Russia, we still define his foreign policy as defensive rather than offensive. First, Biden is reacting to a Russian attack and will not sabotage a ceasefire. Second, Biden is carving out exceptions to US sanctions rather than disciplining or coercing allies into adopting US policy. The administration’s chief foreign policy aim is to refurbish US alliances. Hence the US condones the EU’s continued energy imports from Russia, thus ensuring that Russian energy makes it into the global market, unless the Russians cut natural gas exports (Chart 9). Nevertheless a risk to our view is that Biden will start to adopt a more offensive foreign policy, especially if Democrats are floundering ahead of the midterms. He could turn more aggressive about sanction enforcement if Russia starts bombarding Kyiv again. Or he could slap broad sanctions on China for helping Russia bypass sanctions. To be clear, we fully expect secondary sanctions on China, based on US record of doing so, but we expect them to be targeted rather than broad (Table 1). Chart 9Russian Energy Still Reaches Global Market Table 1US Will Slap China With Sanctions Over Russia – Sooner Or Later Foreign policy will define US politics and policy in 2022. What matters for markets is whether the energy supply shock gets worse as a result of Biden’s handling of Russia and Iran. A worse energy shock will amplify stock market volatility. On one hand, if Biden suffers a humiliating foreign policy defeat, it will reinforce the negative trends for Democrats in the 2022-24 cycle. Since Republicans, especially former President Trump, would be expected to pursue an offensive rather than defensive foreign and trade policy (e.g. toward Iran’s nuclear program and China’s economy), global economic policy uncertainty would rise and investor risk appetite would fall in this situation (Chart 10). On the other hand, investors will be surprised if Biden achieves a remarkable domestic or foreign policy success that boosts Democrats’ odds in 2022. An early ceasefire in Ukraine combined with a reconciliation bill would give Biden and Democrats a boost. Global policy uncertainty might rise anyway but it would not be super-charged and it would be flat-to-down relative to US policy uncertainty. Democrats could conceivably retain control of the Senate in the latter case. Our quantitative election model says Democrats have a 49% chance of retaining the Senate (Chart 11). This means the election is too close to call, though subjectively we would agree with the model and bet on the Republicans since they only need to gain one seat on a net basis. The model shows Georgia and Arizona flipping back to the Republican side. If the economy and opinion polling improve between now and November, the swing states will see higher probabilities of Democrats staying in power but the model is trending against Democrats and shows their odds of victory falling in every state. Chart 10US Political Outlook Affects Relative Policy Uncertainty Chart 11Senate Race Too Close To Call, But Quant Model Now Tips Republicans Anything that pares Democrats’ expected losses in Congress will cause US economic policy uncertainty to rise since it goes against the consensus view. Moreover if Republicans only win the House, they will be obstructionist and disruptive in 2023-24, whereas if they win all of Congress they will have to produce bills and try to compromise with Biden. Thus a Republican House but Democratic Senate would imply an increase in policy uncertainty. By contrast, anything that hurts the Democrats will reinforce current expectations and imply that tax hikes might fail, or that they will freeze after the reconciliation bill, which would be marginally positive for US equity investors in an inflationary context. Bottom Line: Democrats still have a 65% subjective chance of passing a reconciliation bill that raises taxes. Investors should favor defensives over cyclicals. Checking Up On Our Strategic Themes For The 2020s Our central long-term thesis is that generational change, social instability, and foreign policy threats are generating a new national consensus in the United States, particularly on economic policy. Hence US political polarization is peaking in the short run and will decline over the long run. The new consensus rests on proactive fiscal policy and a larger government role in the economy to reduce social unrest and improve national security. Table 2 shows our three strategic US political themes. The past year’s inflation surge and the Ukraine war will affect these themes, so we make the following points: Table 2US Political Strategy Structural Themes 1. Millennials/Gen Z Rising: Labor market participation is recovering rapidly from the pandemic. However, workers older than 55 years are not rejoining rapidly, implying that retirees are staying retired and not yet chasing rising wages. Prime age women, however, are rejoining the work force, in a sign that as kids get back to school mothers can return to work (Chart 12). The implication is that the labor shortage will continue for the foreseeable future due to the generational transition but not due to any shift toward traditional values or lifestyles among young women. 2. Peak Polarization: Polarization has fallen after the 2020 election, as expected, but will likely stay at or near peak levels over the 2022-24 election cycle (Chart 13). Chart 12Generational Shift Evident In Labor Participation Chart 13Polarization Near Peak Levels But Will Fall Over Long Run For example, Biden’s reconciliation bill will feed polarization in 2022, since it can only pass on a party-line vote. But its tax and spending programs will have majority support, will redirect funds from corporations that pay low effective tax rates toward corporations that provide renewable energy solutions. Domestic manufacturing will benefit. Another example: Another Biden-Trump showdown in 2024 will fuel polarization but 2024 or 2028 and subsequent elections will see fresh faces with updated policy platforms. The merging of trade protectionism and renewable energy exemplifies the new policy evolution. Again, with polarization at historic levels, domestic terrorism of whatever stripe is a pronounced risk in 2022 and the coming years. But any significant political violence will ultimately drive a new national consensus in favor of federalism. 3. Limited Big Government: The story of the 2000s and 2010s was the revival of Big Government, first in the George W. Bush national security state, then in the Barack Obama liberal spending tradition, then in the big spending Republican tradition with Trump, and finally in the liberal tradition again with Biden. The combination of popular discontent at home and great power struggle abroad means that the US is unlikely to slash either social programs or defense spending. As for tax hikes, aggressive tax hikes are impractical. Biden may pass some tax hikes but the budget deficit will continue to expand over the long run (Chart 14). At the same time, the shift to Big Government is occurring with an American context. The geography, constitution, and political system militate against centralization. The return of inflation means that fiscal conservatism will also make a comeback, starting with Republicans in the House in 2023, who will oppose new spending as a standard opposition tactic. So while Big Government has returned, and bond investors are pricing this sea change by pushing up Treasury yields, nevertheless the market will also need to price the fact that the growth of government still faces structural limits. Chart 14Reconciliation Bill Will Have Miniscule Impact On Budget Outlook These structural themes face crosswinds in 2022. The Millennials and younger generations will not carry the day in the midterm election – the Baby Boomers and Greatest Generation will. Peak polarization will bring negative surprises for investors over the 2022-24 election cycle and potentially even in 2024-28 if Trump is reelected. A Democratic reconciliation bill will expand government programs in 2022, while Republicans will revert to big spending ways if they gain full control of government again in 2025. Nevertheless the evidence suggests that generational change, peak polarization, and limited big government will prevail over time. The younger generations favor more proactive fiscal policy. Fiscal policy will address social unrest and geopolitical threats. But big government will drive inflation, which will in turn force voters to impose limits on government over the long run. Bottom Line: The US will opt to inflate away its debt over the long run – but it will also need growth and some structural reform once the ills of inflation become fully absorbed by voters. The huge bout of inflation in 2022 is only the beginning of this political process, though it will also accelerate the process. Investment Takeaways Stocks tend to be flattish ahead of midterm elections. This includes elections when a united government becomes gridlocked as is likely in 2022-23. Equities tend to perform better after election uncertainty passes. The transition from single-party government to gridlock also tends to imply higher yields until after the election is over, at which point yields decline (Chart 15). Single-party governments can manipulate fiscal policy to try to stay in power. Chart 15Stocks Tend To Be Flat, Bond Yields High, Until After Midterm Elections Defensives are outperforming cyclicals on slowing growth, rising interest rates, rising labor costs and energy prices, and rising uncertainty. Our worst call for Q1 was our tactical long growth over value stocks. We made this trade knowing it went against our strategic approach, which has favored value over growth since we launched the US Political Strategy in January 2021. Our reasoning was that a geopolitical crisis would cause a temporary spike in energy prices but a longer drop in bond yields. In fact bond yields rose anyway. We still think tech is increasingly attractive, especially after the corporate minimum tax passes. The brief inversion of the 2-year/10-year yield curve suggests the US economy is flirting with recession. Other parts of the curve are not yet confirming this signal and there can be a long lead time between inversion and recession. However, there is not yet a ceasefire in Ukraine and certainly not a durable ceasefire. The US and Iran do not yet have a deal to avoid a major increase in geopolitical tensions. The risk of a bigger energy shock from Russia or Iran or both is significant and could shorten the cycle. We recommend going strategically long S&P 500 oil and gas transportation and storage relative to the broad market. We also recommend taking advantage of the lull in fighting in Ukraine to join our Geopolitical Strategy in going strategically long US defense stocks relative to the broad market. Tactically we recommend going long renewable energy since the Democrats’ pending reconciliation bill will benefit from broader public recognition of the need for the energy security of both the US and its allies (Chart 16). Chart 16Go Long Defense, Energy Storage, And Renewables Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Footnotes 1 See “National Tracking Poll,” Morning Consult and Politico, #2202029, February 5-6, 2022, assets.morningconsult.com. 2 Admittedly this poll is by a left-leaning organization but polling throughout 2021 supports the general conclusion that a majority of political independents support the key proposals. See Anika Dandekar and Ethan Winter, “Majority of Voters Still Want the Build Back Better Act Passed,” Data for Progress, January 4, 2022, dataforprogress.org. 3 See Nick Sobczyk and Nico Portuondo, “Democrats eye ‘Build Back Slimmer’ on reconciliation,” E&E News, March 24, 2022, eenews.net. 4 See Eugene Daniels, “The Left Gears Up to Take on Manchin Again,” Politico, March 29, 2022, politico.com. See also “Regan, McCarthy, Wyden talk revival of BBB,” The Fence Post, March 25, 2022, thefencepost.com. Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets
Executive Summary Expansion In European Defense European yields have significant upside on a structural basis. European government spending will remain generous, which will boost domestic demand; meanwhile, lower global excess savings will lift the neutral rate of interest and structurally higher inflation will boost term premia. A short-term pullback in yields is nonetheless likely; however, it will not short-circuit the trend toward higher yields on a long-term basis. CYCLICAL INCEPTION DATE RETURN SINCE INCEPTION (%) COMMENT EQUITIES Favor European Aerospace & Defense Over European Benchmark 3/28/2022 Favor European Aerospace & Defense Over Other Industrials 3/28/2022 Bottom Line: Investors should maintain a below-benchmark duration in their European fixed-income portfolios. Higher yields driven by robust domestic demand and strong capex also boost the appeal of industrial, materials, and financials sectors. Aerospace and defense stocks are particularly appealing. The economic impact of the war in Ukraine continues to drive the day-to-day fluctuations of the market; however, investors cannot ignore the long-term trends in the economy and markets. The direction of bond yields over the coming years is paramount among those questions. Does the recent rise in yields only reflect the current inflationary shock caused by both supply-chain impairments and commodity inflation—that is, is it finite? Or does that rise mirror structural forces and therefore have much further to run? We lean toward yields having more upside over the coming years, propelled higher by structural forces. As a result, we continue to recommend investors structurally overweight sectors that benefit from a rising yield environment, such as financials and industrials, while also favoring value over growth stocks. The defense sector is particularly attractive. Three Structural Forces Behind Higher Yields The current supply-chain disruptions and inflation crises have played a critical role in lifting European yields. However, a broader set of factors underpins our bearish bond view—namely, the lack of fiscal discipline accentuated by the consequences of the Ukrainian war, the likely move higher in the neutral rate of interest generated by lower savings, and the long-term uptrend in inflation. Profligate Governments Chart 1 Larger government deficits will contribute to higher European yields. Europe is not as fiscally conservative as it was before the COVID-19 crisis. Establishment politicians must fend off pressures caused by voters attracted to populist parties willing to spend more. Consequently, IMF estimates published prior to the Ukrainian war already tabulated that, for the next five years, Europe’s average structurally-adjusted budget deficit would be 2.4% of GDP wider than it was last decade (Chart 1). Chart 2Expanding Military Spending The Ukrainian crisis is also prompting a fiscal response that will last many years. Europe does not want to stand still in the face of the Russian threat. Today, Western Europe’s military spending amounts to 1.5% of GDP, or €170 billion. This is below NATO’s threshold of 2% of GDP. Rebuilding military capacity will take large investments. Thus, European nations are likely to move toward that target and even go beyond. Conservatively, if we assume that military spending hits 2% of GDP by the end of the decade, it will rise above €300 billion (Chart 2). Weaning Europe off Russian energy will also prevent a significant fiscal retrenchment. This effort will take two dimensions. The first initiative will be to build infrastructures to receive more LNG from the rest of the world to limit Russian intake. Constructing regasification and storage facilities as well as re-directing pipeline networks be costly and require additional CAPEX over the coming years. The second initiative will be to double-up on green initiatives to decrease the need for fossil fuel. The NGEU funds are already tackling this strategic goal. Nonetheless, the more than €100 billion reserved for renewable energy and energy preservation initiatives was only designed to kick-start hitting the EU’s CO2 emission target for 2050. Accelerating this process not only helps cutting the dependence on Russian energy, but it is also popular with voters. The path of least resistance is to invest in that sphere and to increase such investment beyond the current sums from the NGEU program. The last fiscal push is likely to be more temporary. The UN estimates that four million refugees have left Ukraine, with the vast majority settling in the EU. Accommodating that many individuals will be costly and will add to government spending across the region. Even if mostly transitory, this spending will have an important impact on activity. Larger fiscal deficits push yields higher for two reasons. Greater sovereign issuance that does not reflect a negative shock to the private sector will need to offer higher rates of returns to attract investors. Moreover, greater government spending will boost aggregate demand, which increases money demand. As a result, the price of money will be higher than otherwise, which means that interest rates will rise—as will yields. Decreasing Global Excess Savings Decreasing global excess savings will put upward pressure on the global neutral rate of interest, a phenomenon Peter Berezin recently discussed in BCA’s Global Investment Strategy service. This process will be visible in Europe as well. The US will play an important role in the process of lifting global neutral rates because the dollar remains the foundation of the global financial system. Compared to last decade, the main drag on US savings is that household deleveraging is over. As households decreased their debt load following the global financial crisis, a large absorber of global savings vanished, putting downward pressure on the price of those savings. Today, US households enjoy strong net worth equal to 620% of GDP and have resumed accumulating debt (Chart 3). Consequently, the downward trend in US total private nonfinancial debt loads has ended. The US capex cycle is likely to experience a boost as well. As Peter highlighted, the US capital stock is ageing (Chart 4). Moreover, the past five years have witnessed three events that underscore the fragility of global supply-chains: a disruptive Sino-US trade war, a pandemic, and now a military conflict. This realization is causing firms to move from a “just-in-time” approach to managing supply-chains to a “just-in-case” one. The process of building redundancies and localized supply chains will add to capex for many years, pushing up ex-ante investments relative to savings, and thus, interest rates. Chart 3US Households Are Done Deleveraging Chart 4An Ageing US Capital Stock China’s current account surplus is also likely to decline. For the past two decades, China has been one of the largest providers of savings to the global economy. This is a result of an annual current account surplus that first averaged $150 billion per year from 2000 to 2010 and then $180 billion from 2010 to 2020, and now stands at $316 billion. Looking ahead, China wants to use fiscal policy more aggressively to support demand, which often boosts imports without increasing exports. Also, more domestically-oriented supply chains around the world will limit the growth of Chinese exports. This combination will compress Chinese excess savings, which will place upward pressure on the global neutral rate of interest. Europe is not immune to declining savings. Over the past ten years, the Euro Area current account surplus has averaged €253 billion. Germany’s current account surplus stood at 7.4% of GDP before the pandemic. Those excess savings depressed global rates in general and European ones especially (Chart 5). As in the US, Europe’s capital stock is ageing and needs some upgrade (Chart 6). Moreover, greater government spending boosts aggregate demand. Because investment is a form of derived demand, stronger overall spending promotes capex to a greater extent. Thus, Europe’s public infrastructure push will lift private capex and curtail regional excess savings beyond the original drag from wider fiscal deficits. Additionally, the European population is getting older and will have to tap into their excess savings as they retire. This process will further diminish Europe’s current account surplus, that is, its excess savings. Chart 5Excess Savings Cap Relative Yields Chart 6An Ageing European Capital Stock Too Structurally Higher Inflation BCA believes that the current inflation surge is temporary and mostly reflects a mismatch between demand and supply. However, we also anticipate that, once this inflation climax dissipates, inflation will settle at a level higher than that prior to COVID-19 and will trend higher for the remainder of this decade. Labor markets will tighten going forward because policy rates remain well below neutral interest rates. Output gaps will close because of robust government spending and capex. This will keep wage growth elevated in the US and reanimate moribund salary gains in the Eurozone (Chart 7). This process, especially when combined with less efficient global supply chains and lower excess savings (which may also be thought of as deficient demand), will maintain inflation at a higher level than in the past two decades. Higher inflation will lift yields for two main reasons. First, investors will require both greater long-term inflation compensation and higher policy rates than in the past. Second, higher inflation often generates greater economic volatility and policy uncertainty, which means that today’s minimal term premia will increase over time (Chart 8). Together, these forces will create a lasting upward drift in yields. Chart 7European Wages Will Eventually Revive Chart 8Term Premia Won't Stay This Low Bottom Line: European yields will sport a structural uptrend for the remainder of the decade. Three forces support this assertion. First, European government spending will remain generous, supported by infrastructure and military spending. Second, global excess savings will recede as US consumer deleveraging ends, global capex rises, and the Chinese current account surplus narrows. Europe will mimic this process in response to an ageing population, greater government spending, and capex. Finally, inflation is on a structural uptrend, which will warrant higher term premia across the world. Not A Riskless View There are two main risks to this view, one in the near-term and one more structural. The near-term risk is the most pertinent for investors right now. Global yields may have embarked on a structural upward path, but a temporary pullback is becoming likely. As Chart 9 highlights, the expected twelve-month change in the US policy rate is at the upper limit of its range of the past three decades. Historically, when the discounter attains such a lofty level, a retrenchment in Treasury yields ensues, since investors have already discounted a significant degree of tightening. The same is true in Europe, where the ECB discounter is also consistent with a temporary pullback in German 10-year yields (Chart 10). Chart 9Discounters Point To A Treasury Rally... Chart 10... And A Bund Rally Chart 11A Mixed Message Investor positioning confirms the increasing tactical odds of a yield correction. The BCA Composite Technical Indicator for bonds is massively oversold, which often anticipates a bond rally (Chart 11). This echoes the signals from the JP Morgan surveys that highlight the very low portfolio duration of the bank’s clients. However, the BCA Bond Valuation Index suggests that bonds remain expensive. Together, these divergent messages point toward a temporary bond rally, not a permanent one. The longer-term risk is regularly highlighted by Dhaval Joshi in BCA’s Counterpoint service. Dhaval often shows that the stock of global real estate assets has hit $300 trillion or 330% of global GDP. Real estate is a highly levered asset class and global cap rates have collapsed with global bond yields. With little valuation cushion, real estate prices could become very vulnerable to higher yields. Nevertheless, real estate is also a real asset that produces an inflation hedge. Moreover, rental income follows global household income, and stronger aggregate demand will likely lift median household income especially in an environment in which globalization has reached its apex and populism remains a constant threat. Bottom Line: Global investor positioning has become stretched; therefore, a near-term pullback in yield is very likely, especially as central bank expectations have become aggressive. Nonetheless, a bond rally is unlikely to be durable in an environment in which bonds are expensive and in which growth and inflation will remain more robust than they were last decade. A greater long-term risk stems from expensive global real estate markets. However, real estate is sensitive to global economic activity and inflation, which should allow this asset class ultimately to weather higher yields. Investment Conclusions An environment in which yields rise will inflict additional damage on global bond portfolios. This is especially true in inflation-adjusted terms, since real yields stand at a paltry -0.76% in the US and -2.5% in Germany. Hence, we continue to recommend investors maintain a structural below-benchmark duration bias in their portfolios. Nonetheless, investors with enough flexibility in their investment mandate should take advantage of the expected near-term pullback in yields. Those without this flexibility should use the pullback as an opportunity to shorten their portfolio duration. Higher yields will also prevent strong multiple expansion from taking place; hence, the broad stock market will also offer paltry long-term real returns. Another implication of rising yields, especially if they reflect stronger growth and rising neutral interest rates, is to underweight growth stocks relative to value stocks (Chart 12). Growth stocks are expensive and very vulnerable to the pull on discount rates that follows rising risk-free rates. Meanwhile, stronger economic activity driven by infrastructure spending and capex will help the bottom line of industrial and material firms. Financials will also benefit. Higher yields help this sector and robust capex also boosts loan growth, which will generate a significant tailwind for banking revenues. Hence, rising yields will boost the attractiveness of banks, especially after they have become significantly cheaper because of the Ukrainian war (Chart 13). Chart 12Favor Value Over Growth Chart 13Bank Remain Attractive Related Report European Investment StrategyFallout From Ukraine Finally, four weeks ago, we highlighted that defense stocks were particularly appealing in today’s context. The re-armament of Europe in response to secular tensions with Russia is an obvious tailwind for this sector. However, it is not the only one. A long-term theme of BCA’s Geopolitical Strategy service is the expanding multipolarity of the world. The end of an era dominated by a single hegemon (the US) causes a rise in geopolitical instability and tensions. The resulting increase in conflict will invite a pickup in global military spending. Chart 14Defense Will Outshine The Rest European defense and aerospace stocks are expensive, with a forward P/E ratio approaching the top-end of their range relative to the broad market and other industrials. However, their relative earnings are also depressed following the collapse in airplane sales caused by the pandemic. Our bet on the sector is that its earnings will outperform the broad market as well as other industrials because of the global trend toward military buildup. As relative earnings recover their pandemic-induced swoon, so will relative equity prices (Chart 14). Bottom Line: Higher yields warrant a structural below-benchmark duration in European fixed-income portfolios, even if a near-term yield pullback is likely. As a corollary, value stocks will outperform growth stocks while industrials, materials, and financials will also beat a broad market whose long-term real returns will be poor. Within the industrial complex, aerospace and defense equities are particularly appealing because a global military buildup will boost their earnings prospects durably. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades
According to BCA Research’s Geopolitical Strategy service, investors should favor bourses that are least exposed to the secular US geopolitical conflict with Russia and China. The US cannot defeat China in a war, so it will continue to penalize China’s…
Executive Summary Biden’s Low Approval On Foreign Policy The energy shock stemming from President Biden’s foreign policy challenges could get worse, especially if US-Iran talks fail. The energy and inflation shocks condemn the Democrats to a dismal midterm election showing, even if Biden handles the Ukraine crisis reasonably well and his approval rating stabilizes. Biden’s foreign policy is still somewhat defensive, focusing on refurbishing US alliances, and as such should not force the EU to boycott Russian energy outright. Biden’s foreign policy doctrine will likely be set in stone with his imminent decision on whether to rejoin the 2015 nuclear deal with Iran. We doubt it will happen but if it does the market impact will be fleeting due to lack of implementation. Biden’s foreign policy toward China will likely grow more aggressive over time. Recommendation (Cyclical) Inception Level Initiation Date Return Long ISE Cyber-Security Index 647.53 Dec 8, 2021 -4.6% Bottom Line: President Biden foreign policy challenges are creating persistent downside risks for equity markets. Feature External risk is one of our key views for US politics in 2022. This risk includes but is not limited to the war in Ukraine. The Biden administration’s urgent foreign policy challenges are creating persistent downside risks for the global economy and financial markets in the short run – embodied in rising energy costs (Chart 1). Related Report US Political Strategy2022 Key Views: Gridlock Begins Before The Midterms Chart 1Oil Prices And Prices At The Pump Ukraine Can Still Hurt US Stocks The Ukraine war is not on the verge of resolution – more bad news is likely to hit US equity markets. The Russian military is bombarding the port city of Mauripol, which will fall in the coming days or weeks (Map 1). Given that Mauripol is refusing to surrender, it is highly unlikely that the central government in Kiev will surrender anytime soon. Map 1Russian Invasion Of Ukraine 2022 The military situation is approaching stalemate and yet ceasefire talks are not promising. The Ukrainians do not accept Russian control of Donbas and Crimea and will need to hold a referendum on the terms of any peace agreement. Lack of progress will drive the Russians to escalate the conflict, whether by means of bombardment, troop reinforcements, or bringing the Belarussian military into the fight. The United States and its allies are increasing defense support for Ukraine while warning that Russia could use chemical, biological, or even tactical nuclear weapons. In our sister Geopolitical Strategy service we argue that the war to get worse before it gets better, with Russia determined to replace the government in Kiev. US investors should expect continued equity market volatility. US and global growth expectations are yet to be fully downgraded as a result of the global energy shortage – the Fed now expects GDP growth of 2.8% while the Atlanta Fed shows GDP clocking in at 1.3%, well below consensus expectations (Chart 2). Corporate earnings will suffer downgrades as a result of higher energy costs. The Federal Reserve just started hiking interest rates and it is not discouraged by foreign affairs. Real rates will rise. Chairman Jerome Powell sounded a hawkish tone by saying that he is willing to hike by 50 basis points at a time if required. The threat of a wage-price spiral is real. The 2-year/10-year Treasury slope is on the verge of inverting. The Fed’s new interest rate projections suggest that the interest rate will rise above the neutral rate in 2023-24. Chart 2Growth Will Take A Hit Ukraine’s Impact On The Midterm Elections A negative foreign policy and macroeconomic background will compound the Democratic Party’s woes in the midterm elections. Biden’s approval rating is languishing at Donald Trump levels, yet without Trump’s high marks on the economy (Chart 3). Biden will not be able to turn the economy around because even if inflation starts to abate, voters will react to the one-year and two-year increase in inflation rather than any month-on-month improvement. Republicans have pulled ahead of Democrats in generic congressional ballot opinion polling (Chart 4). Even if Biden’s ratings stabilize ahead of the midterms (even if he handles Ukraine well), Democrats face a shellacking. The market is rightly priced for Republicans to take over all of Congress, though the GOP’s odds of taking the Senate are lower than consensus holds (Chart 5). A Republican victory is not negative for US corporate earnings but uncertainty over the general direction of US policy will continue to weigh on the equity market this year. Chart 3Biden’s Approval Ratings Chart 4Republicans Take The Lead Biden’s foreign policy can and will get a lot more aggressive if the Democratic Party views its election odds as so dismal that foreign tensions come to be seen as a source of badly needed popular support. That is not yet the case but developments with Russia and Iran could force the administration to adopt a more offensive foreign policy, which would be negative for financial markets. Hence investors will have to worry about rising policy uncertainty over the 2022-24 political cycle. Chart 5Midterm Election Odds Biden’s Policy Toward Russia And Europe It is too soon to say precisely what is the “Biden Doctrine” of foreign policy. The withdrawal from Afghanistan and the war in Ukraine were thrust upon Biden. What will define his foreign policy is how he handles Russia, Iran, and China going forward. By the end of the year, Biden will have forged his foreign policy doctrine, for better or worse. Biden began with a defensive foreign policy. His administration’s primary intention is to refurbish US alliances in Europe and Asia to counter Russia and China. Consider: In 2021, Biden condoned Germany’s deepening economic and energy integration with Russia (i.e. the Nord Stream II pipeline). Russia’s invasion forced Germany to change its mind and join the US and other democracies in imposing harsh sanctions on Russia. Even so, the US is calibrating its actions to what the European allies can stomach. Biden is attempting to negotiate new trade deals with allies, by contrast with President Trump’s tendency to slap tariffs on allies as well as rivals.1 Biden is likely to try to revive the Transatlantic Trade and Investment Partnership (TTIP) with Europe, he is scheduled to restart talks with the UK about a post-Brexit trade deal, and he will probably attempt to rejoin the Trans-Pacific Partnership (CPTPP) in future. Now that Russia has invaded Ukraine, Biden’s foreign policy is becoming more aggressive, albeit still within certain limitations: The US is not willing to send troops to defend Ukraine or impose a no-fly zone, which would trigger direct conflict with Russia. But the US is continuing to provide Ukraine with lethal weapons, which helped precipitate the war. Congress recently voted to increase Ukraine aid by $13.6 billion, including $6.5 billion in defense support, including drones, Stinger anti-aircraft missiles, and Javelin anti-tank missiles. These are supposed to start arriving in Ukraine in a few days. The US is reportedly looking into providing Ukraine with Soviet-era SA-8 air defense, though not the S-300s missile defense.2 The US is bulking up its military presence across Europe to deter Russia from broadening its attacks beyond Ukraine. Biden has declared a red line in that he will defend “every inch” of NATO territory. This means that a single Russian attack that spills over into Poland or another NATO country will precipitate a new and bigger crisis (and financial market selloff). The risk going forward is that American policy could grow increasingly aggressive to the point that tensions with Russia escalate. Unlike Russia and Europe, the US does not have vital national interests at stake in Ukraine. American national security is not directly threatened by the war there. Hence the US can afford to take actions that its European allies would prefer not to take. As long as Biden prioritizes solidarity with the Europeans, geopolitical risks may be manageable for the markets. But if Biden attempts to lead an even bolder charge against Russia (or China), then risks will become unmanageable. So far Biden is allowing Europe to impose sanctions at its own pace and intensity. The Europeans must tread more carefully than the US, lest sanctions cause a broad energy cutoff that plunges their economy into recession along with Russia’s. This would destabilize the whole Eurasian continent and increase the chances of strategic miscalculation and a broader military conflict. Europe has opted for a medium-term strategy of energy diversification while avoiding the US’s outright boycott of Russian energy. The EU depends on Russia for 26% of its oil and 16% of its natural gas imports (Chart 6). The dependency is higher for certain countries. Germany, Italy, Hungary, and others oppose an outright boycott – and a single EU member can veto any new sanctions. Theoretically the Europeans could ban oil while still accepting natural gas. Natural gas trade routes are fixed due to physical pipelines, whereas oil is more easily rerouted, leaving Russia with alternatives if Europe stops importing oil. But Russia exports 63% of its oil to developed markets and 65% of its natural gas, with the bulk of that going to the European Union at 48% and 15% respectively (Chart 7). Russia’s economy would suffer from an oil ban and it would assume that a natural gas ban would soon follow, which could unhinge expectations that war tensions can be contained. Chart 6EU Mulls Boycott Of Russian Oil Chart 7Russian Regime Depends On O&G Given the damaged state of the Russian economy and high costs of war, Moscow will probably keep accepting energy revenues as long as Europe is buying. But if it believes Europe will cut off the flow, then it has an incentive to act first. This is a risk, not our base case. Still, as Russia targets the capital Kiev with intense shelling and civilian casualties increase, US pressure for an expansion of sanctions will increase. This is the risk that investors need to monitor. If the US brings the EU around to adopting sanctions on Russian energy then equity markets will plunge anew. And since Europe is diversifying over time anyway, Russia will have to escalate the war now to try to achieve its aims before its source of funds dries up. Biden’s Policy Toward China Biden’s foreign policy also started out defensively with regard to China. Biden intended to stabilize relations, i.e. engage in some areas like climate policy and avoid expanding President Trump’s trade war. Both the Democratic Party and the Communist Party face important political events in 2022 and their inclination is to prevent global instability from interfering. But the Ukraine war has made this goal harder. As with Europe the immediate question is whether Biden will try to force China to cooperate on Russia sanctions. But in China’s case Biden is more likely to use punitive measures – at least eventually. After a two-hour bilateral phone call on March 18, Biden “described the implications and consequences if China provides material support to Russia as it conducts brutal attacks against Ukrainian cities and civilians.”3 Biden’s threat of sanctions is a negative for Chinese exporters and banks (Chart 8). Chinese stock markets were already suffering from China’s historic confluence of internal and external political and economic risks. The Ukraine war has increased the fear of western investors that investing in China will result in stranded capital when strategic tensions rise explode, as with Russia. Chart 8Biden Threatens China With Sanctions Economically, China is much more dependent on the West than Russia. While Germany and Russia take a comparable share of Chinese exports, at 3.4%and 2.0% respectively, the EU takes up more than three times as many Chinese exports as the Commonwealth of Independent States, at 15.4% versus 3.2% (Chart 9A Chart 9B). China was never eager to commit to an exclusive economic relationship with Russia at the expense of its western markets. Strategically, however, China cannot afford to reject Russia. Chart 9AEU Wary Of Targeting China Chart 9BEU Wary Of Targeting China Russia has now severed ties with the West and has no choice but to offer favorable deals to China on the whole range of relations. China’s greatest strategic threat is US sea power; Russia offers a strategically vital overland source of natural resources. Russia also offers intelligence and security assistance in critical regions like Central Asia and the Middle East that China needs to access. Like Russia, China fears US containment policy and views US defense relations with its immediate neighbors as a fundamental national security threat. President Biden reassured China that US policy toward the Taiwan Strait has not changed but also said that the US opposes any unilateral attempt to change the status quo. The implication is that China will segregate its EU and Russia networks of trade and finance to minimize the impact of any US secondary sanctions. China will offer Russia some assistance while making diplomatic gestures to maintain economic relations with Europe. The Europeans will lobby the Americans not to expand sanctions on China. The Biden administration will be reluctant to increase sanctions on China immediately, since it wants to maintain global stability in general, control the pace of rising global tensions, and maintain maneuverability for immediate problems with Russia and Iran. Biden’s priority is to rebuild US alliances and Europe will be averse to expanding the sanction regime to China. Therefore any sanctions on China will come only slowly and with ample warning to global investors. But sanctions are possible over the course of the year. If the Biden administration concludes that it has utterly lost domestic support, that the midterm elections are a foregone conclusion, then it can afford to get tougher in the international arena in hopes that it can improve its standing with voters. Biden’s Policy Toward Iran While Afghanistan and Ukraine were thrust upon Biden, the major foreign policy challenge in which he retains the initiative is whether to rejoin the 2015 nuclear deal with Iran. Thus it may be policy toward Iran and the Middle East that defines the Biden doctrine. The Ukraine war has not stopped the Biden administration from seeking to rejoin the 2015 Joint Comprehensive Plan of Action, which was a strategic US-Iran détente that sought to freeze Iran’s nuclear program in exchange for its economic development. The original nuclear deal occurred with Russia’s blessing after the US and EU overlooked Russia’s invasion of Crimea. Now negotiations toward rejoining that deal are reaching the critical hour. The US has supposedly offered Russia guarantees to retain Russian support. The reason for Biden to rejoin the 2015 deal is to open Iran’s oil and natural gas reserves to the global and European economy and thus mitigate the global energy shock ahead of the midterm elections. Iran could return one million barrels per day to global markets. There is also a strategic logic for normalizing relations with Iran: to maintain a balance of power in the Middle East, reduce US military commitment there, provide Europe with greater security, and free up resources to counter Russia and China. Whether the deal will fulfill these ends is debatable but the Biden administration apparently believes it will. Biden is capable of rejoining the deal because the critical concessions do not require congressional approval. Through executive action alone, Biden could meet Iran’s demands: sanctions relief, delisting the Iranian Revolutionary Guard Corps as a terrorist organization, and ensuring that Russo-Iranian trade (especially nuclear cooperation) is not exempted from the new Russia sanctions. There will be domestic political blowback for each of these concessions but not as much as there will be if gasoline prices continue to rise due to greater global instability stemming from the Middle East. The Iranians are also capable of rejoining the deal. Supreme Leader Ali Khamenei, in his Persian New Year speech, gave a green light for President Ebrahim Raisi’s administration to pursue policies that would remove US sanctions. Khamanei implied that Iran should let the West lift sanctions while continuing to fortify its economy to future US sanctions.4 While the US and Iran are clearly capable of a stop-gap deal, it will not be a durable agreement – and hence any benefits for global energy supply will be called into question. The reason is that the underlying strategic logic is suffering: Biden will appear incoherent if he alienates Saudi Arabia and the UAE while appealing to them to increase oil production – and they are more capable than Iran on this front (Chart 10). Biden will appear incoherent if he agrees to secure Russo-Iranian trade at the same time as he seeks to cut Russia off from all other trade. Biden may not achieve a reduction in regional tensions through an Iran deal, since Israel insists that it is not bound to the nuclear deal. If Iran does not comply with the nuclear freeze, Israel will ramp up military threats. The Iranians cannot trust American guarantees that the next president, in 2025, will not tear up the nuclear deal and re-impose sanctions on Iran. The Iranians need Russian and Chinese assistance so they cannot afford to embark on a special new relationship with the West. Ultimately the Iranians are highly likely to pursue deliverable nuclear weapons for the sake of regime survival, as our Geopolitical Strategy has argued. Chart 10US-Iran Deal Will Not Be Durable Thus Biden may choose a deal with Iran but we would not bet on it. Moreover any stop-gap deal will be undermined in practice, so that the investment repercussions will be ephemeral. If Biden fails to clinch his Iran deal as expected, then the world faces an even larger energy shock due to rising tensions in the Middle East. Investment Takeaways The Biden administration’s foreign policy challenges will compound its macroeconomic challenges and weigh on the Democratic Party in the midterm elections. The war in Ukraine will hurt Biden and the Democrats primarily because of the energy shock. The energy shock will get worse if Biden fails to agree to a stop-gap deal with Iran. But we expect either the US or Iran to back out for strategic reasons. With Republicans likely to reclaim Congress this fall, US political polarization will remain at historically high levels over the course of the 2022-24 election cycle. However, Russia’s belligerence underscores our view that rising geopolitical threats will cause the US to unify and reduce polarization over the long run. The war reinforces our US Political Strategy themes of “Peak Polarization” and “Limited Big Government,” as a new bipartisan consensus is forming around the view that the federal government should take a larger role in the economy to address national challenges both at home and abroad. One of our cyclical investment ideas stemming from these themes is to buy cyber-security stocks. President Biden warned US government and corporations on March 21 that Russia could stage cyber attacks against the United States and that private businesses must be prepared. Cyber stocks have suffered amid the general rout in tech stocks but they are starting to recover. Year to date, they are outperforming the S&P 500, and the tech sector, and look to be starting to outperform defensive sectors (Chart 11). Chart 11Biden Warns Of Cyber Attacks Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Footnotes 1 See Yuka Hayashi, “U.S., U.K. Strike Trade Deal to End Tariffs on British Steel and American Whiskey”, Wall Street Journal, March 22, wsj.com 2 See Nancy Youssef and Michael Gordon, “U.S. Sending Soviet Air Defense Systems It Secretly Acquired to Ukraine”, Wall Street Journal, March 21, wsj.com. 3 White House, “Readout of President Joseph R. Biden Jr. Call with President Xi Jinping of the People’s Republic of China,” March 18, 2022, whitehouse.gov. 4 Ayatollah Ali Khamenei implied at his Persian New Year speech that a deal with the Americans could go forward. He emphasized the need to improve the economy and implied that some of the economic burdens will go away starting this year. He pointed to a way forward with US sanctions intact, while also saying that he did not discourage attempts to remove sanctions. “We should not tie the economy to sanctions... It is possible to make economic advances despite U.S. sanctions. It is possible to expand foreign trade, as we did, enter regional agreements and have achievements in oil and other areas … I never say to not go after sanctions relief, but I am asking you to govern the country in a way in which sanctions do not hurt us.” See “Iran's Khamenei Says Economy Should Not Be Tied to U.S. Sanctions,” Reuters, March 21, 2022, usnews.com. Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets
Executive Summary Investors Think The Fed Will Not Be Able To Raise Rates Much Above 2% The neutral rate of interest is 3%-to-4% in the United States. This is substantially higher than the market estimate of around 2%. It is also higher than the central tendency range for the Fed’s terminal interest rate dot, which remained at 2.3%-to-2.5% following this week’s FOMC meeting. If the neutral rate turns out to be higher than expected, this is arguably good news for stocks over the short-to-medium term because it lowers the risk that the Fed will accidentally induce a recession this year by bringing rates into restrictive territory. Over a longer-term horizon of 2-to-5 years, however, a higher neutral rate is bad news for stocks because it means that investors will eventually need to value equities using a higher discount rate. It also means that the Fed could find itself woefully behind the curve in normalizing monetary policy. Bottom Line: Global equities will rise over the next 12 months as the situation in Ukraine stabilizes, commodity prices recede, and inflation temporarily declines. Stocks will peak in the second half of 2023 in advance of a second, and currently unexpected, round of Fed tightening beginning in late-2023 or 2024. Dear Client, Instead of our regular report next week, we will be sending you a Special Report written by Matt Gertken, BCA Research’s Chief Geopolitical Strategist, discussing the geopolitical implications of the war in Ukraine. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. As always, I will hold a webcast discussing the outlook the week after, on Thursday, April 7th. Best regards, Peter Berezin Chief Global Strategist https://www.linkedin.com/in/peter-berezin-1289b87/ https://twitter.com/BerezinPeter A Two-Stage Fed Tightening Cycle The FOMC raised rates by 25 basis points this week, the first of seven rate hikes that the Federal Reserve has telegraphed in its Summary of Economic Projections for the remainder of 2022. We expect the Fed to follow through on its planned rate hikes this year, but then go on pause in early-2023, as inflation temporarily comes down. However, the Fed will resume raising rates in late-2023 or 2024 once inflation begins to reaccelerate and it becomes clear that monetary policy is still too easy. This second round of monetary tightening is currently not anticipated by market participants. If anything, investors think the Fed is more likely to cut rates than raise rates towards the end of next year (Chart 1). The Fed’s own views are not that different from the markets’: The central tendency range for the Fed’s terminal interest rate dot remained at 2.3%-to-2.5% following this week’s FOMC meeting, with the median dot actually ticking lower to 2.4% from 2.5% (Chart 2). Chart 2The Fed Is Still In The Secular Stagnation Camp A Higher Neutral Rate Our higher-than-consensus view of where US rates will eventually end up reflects our conviction that the neutral rate of interest is somewhere between 3% and 4%. One can think of the neutral rate as the interest rate that equates the amount of investment a country wants to undertake at full employment with the amount of savings that it has at its disposal.1 Anything that reduces savings or increases investment would raise the neutral rate (Chart 3). As we discussed last month, a number of factors are likely to lower desired savings in the US over the next few years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and the receipt of generous government transfer payments (Chart 4). Household wealth has soared since the start of the pandemic (Chart 5). Conservatively assuming that households spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by nearly 4% of GDP. Chart 5Net Worth Has Soared Since The Pandemic The household deleveraging cycle has ended (Chart 6). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. Banks are easing lending standards on consumer loans across the board. Baby boomers are retiring. They hold over half of US household wealth, considerably more than younger generations (Chart 7). As baby boomers transition from savers to dissavers, national savings will decline. Chart 6US Household Deleveraging Pressures Have Abated Chart 7Baby Boomers Have Amassed A Lot Of Wealth Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 8). On the investment front: The deceleration in trend GDP growth, which depressed investment spending, has largely run its course.2 According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today. The CBO expects potential growth to edge down only slightly to 1.7% over the next few decades (Chart 9). Chart 8Fiscal Policy: Tighter But Not Tight Chart 9Much Of The Deceleration In Potential Growth Has Already Happened After moving broadly sideways for two decades, core capital goods orders – a leading indicator for capital spending – have broken out to the upside (Chart 10). Capex intention surveys remain upbeat (Chart 11). The average age of the nonresidential capital stock currently stands at 16.3 years, the highest since 1965 (Chart 12). Chart 10Positive Signs For Capex (I) Similar to nonresidential investment, the US has been underinvesting in residential real estate (Chart 13). The average age of the housing stock has risen to a 71-year high of 31 years. The homeowner vacancy rate has plunged to the lowest level on record. The number of newly finished homes for sale is half of what it was prior to the pandemic. Chart 11Positive Signs For Capex (II) Chart 12An Aging Capital Stock Chart 13Housing Is In Short Supply The New ESG: Energy Security and Guns The war in Ukraine will put further pressure on the neutral rate, especially outside of the United States. Chart 14European Capex Should Recover After staging a plodding recovery following the euro debt crisis, European capital spending received a sizable boost from the launch of the NextGenerationEU Recovery Fund (Chart 14). Capital spending will rise further in the years ahead as European governments accelerate efforts to make their economies less reliant on Russian energy. Meanwhile, European governments are trying to ease the burden from rising energy costs. France has introduced a rebate on fuel starting on April 1st. It is part of a EUR 20 billion package aimed at cutting heating and electricity bills. Other countries are considering similar measures. European military spending will also rise. Germany has already announced that it will spend EUR 100 billion more on defense. European governments will also need to boost spending to accommodate potentially several million Ukrainian refugees. A Smaller Chinese Current Account Surplus? Chart 15Will China Be A Source Of Excess Savings? The difference between what a country saves and invests equals its current account balance. Historically, China has been a major exporter of savings, which has helped depress interest rates abroad. While China’s current account surplus has declined as a share of its own GDP, it has remained very large as a share of global ex-China GDP, reflecting China’s growing weight in the global economy (Chart 15). Many analysts assume that China will double down on efforts to boost exports in order to offset the drag from falling property investment. However, there is a major geopolitical snag with that thesis: A country that runs a current account surplus must, by definition, accumulate assets from the rest of the world. As the freezing of Russia’s foreign exchange reserves demonstrates, that is a risky proposition for a country such as China. Rather than increasing its current account surplus, China may seek to bolster its economy by raising domestic demand. This could be achieved by either boosting domestic investment on infrastructure and/or consumption. Notably, the IMF’s latest projections foresee China’s current account surplus falling by more than half between 2021 and 2026 as a share of global ex-China GDP. If this were to happen, the neutral rate in China and elsewhere would rise. The Path to Neutral: The Role of Inflation If one accepts the premise that the neutral rate in the US is higher than widely believed, what will the path to this higher rate look like? The answer hinges critically on the trajectory of inflation. If inflation remains stubbornly high, the Fed will be forced to hike rates by more than expected over the next 12 months. In contrast, if inflation comes down rapidly, then the Fed will be able to raise rates at a more leisurely pace. As late as early February, one could have made a strong case that US inflation was set to fall. The demand for goods was beginning to moderate as spending shifted back towards services. On the supply side, the bottlenecks that had impaired goods production were starting to ease. Chart 16 shows that the number of ships anchored off the coast of Los Angeles and Long Beach has been trending lower while the supplier delivery components of both the ISM manufacturing and nonmanufacturing indices had come off their highs. Since then, the outlook for inflation has become a lot murkier. As we discussed last week, the war in Ukraine is putting upward pressure on commodity prices, ranging from energy, to metals, to agriculture. BCA’s geopolitical team, led by Matt Gertken, expects the war to worsen before a truce of sorts is reached in a month or two. Meanwhile, a new Covid wave is gaining momentum. New daily cases are rising across Europe and have exploded higher in parts of Asia (Chart 17). In China, the number of new cases has reached a two-year high. The government has already locked down parts of the country encompassing 37 million people, including Shenzhen, a major high-tech hub adjoining Hong Kong. Chart 17Covid Cases Are On The Rise Again In Some Countries Most new cases in China and elsewhere stem from the BA.2 subvariant of Omicron, which appears to be at least 50% more contagious than Omicron Classic. Given its extreme contagiousness, China may be forced to rely on massive nationwide lockdowns in order to maintain its zero-Covid strategy. While such lockdowns may provide some relief in the form of lower oil prices, the overall effect will be to worsen supply-chain disruptions. Watch For Signs of a Wage-Price Spiral As the experience of the 1960s demonstrates, the relationship between inflation and unemployment is inherently non-linear: The labor market can tighten for a long time with little impact on prices and wages, only for a wage-price spiral to suddenly develop once unemployment falls below a certain threshold (Chart 18). Chart 18A Wage-Price Spiral Was Ignited By Very Low Unemployment Levels In The 1960s Chart 19Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution For the time being, a wage-price spiral does not appear imminent. While wage growth has picked up, most of the increase in wages has occurred at the bottom end of the income distribution (Chart 19). Chart 20More Low-Wage Employees Should Return To Work Low-wage workers have not returned to the labor force to the same extent as higher-wage workers (Chart 20). However, now that extended unemployment benefits have lapsed and savings deposits are being drawn down, the incentive to resume work will strengthen. An influx of workers back into the labor market will cap wage growth, at least for this year. Long-Term Inflation Expectations Still Contained A sudden increase in long-term inflation expectations can be a precursor to a wage-price spiral because the expectation of higher prices can induce consumers to shop now before prices rise further, while also incentivizing workers to demand higher wages. Reassuringly, long-term inflation expectations have not risen that much. Expected inflation 5-to-10 years out in the University of Michigan survey registered 3.0% in March, down a notch from 3.1% in February (Chart 21). While the widely followed 5-year, 5-year forward TIPS inflation breakeven rate has climbed to 2.32%, it is still at the bottom of the Fed’s comfort zone of 2.3%-to-2.5% (Chart 22).3 Chart 21Long-Term Inflation Expectations Remain Contained (I) Chart 22Long-Term Inflation Expectations Remain Contained (II) Chart 23The Magnitude Of Damage Depends On How Long The Commodity Price Shock Lasts Moreover, the jump in market-based inflation expectations since the start of the war in Ukraine has been fueled by rising oil prices. The forwards are pointing to a fairly pronounced decline in the price of crude and most other commodity prices over the next 12 months (Chart 23). If that happens, inflation expectations will dip anew. Investment Implications The neutral rate of interest is higher in the United States than widely believed. A higher neutral rate is arguably good for stocks over the short-to-medium term because it lowers the risk that the Fed will accidentally induce a recession this year by bringing rates into restrictive territory. Over a longer-term horizon of 2-to-5 years, however, a higher neutral rate is bad news for stocks because it means that investors will eventually need to value stocks using a higher discount rate. It also means that the Fed could find itself woefully behind the curve in normalizing monetary policy. While the war in Ukraine and yet another Covid wave could continue to unsettle markets for the next month or two, global equities will be higher in 12 months than they are now. With inflation in the US likely to temporarily come down in the second half of the year, bond yields probably will not rise much more this year. However, yields will start moving higher in the second half of next year as it becomes clear that policy rates still have further to rise. The bull market in stocks will end at that point. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 These savings can either by generated domestically or imported from abroad via a current account deficit. 2 Theoretically, there is a close relationship between trend growth and the equilibrium investment-to-GDP ratio. For example, if real trend growth is 3% and the capital stock-to-GDP ratio is 200%, a country would need to invest 6% of GDP net of depreciation to maintain the existing capital stock-to-GDP ratio. In contrast, if trend growth were to fall to 2%, the country would only need to invest 4% of GDP. 3 The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Executive Summary Global Oil Price Pushes Up Inflation Expectations The US cut off of Russian energy exports has limited immediate impact because EU trade with Russia continues. Russia is unlikely to embargo the EU as it needs revenues to wage war. However, the EU will diversify away from Russia over time, which means that Russia will intensify its efforts to replace the government in Ukraine. The Biden administration began with an adversarial posture toward the energy sector, both US producers and Gulf Arab petro-states. Now it is adjusting its stance as prices surge. The OPEC states do not favor Biden but have an interest in calibrating production to avoid global recession and prolong their profit windfall. Even if the US restores the 2015 nuclear deal with Iran, which we doubt, investors should fade the oil price implications and stay focused on OPEC. Recommendation (Tactical) Inception Level Inception Date Return Long DXY (Dollar Index) 96.19 Feb 23, 2022 2.9% Bottom Line: Stagflation is the likeliest economic outcome of today’s global supply constraints. Feature Biden’s Oil Policy: Implications Will the Ukraine crisis lead to a US recession? The probability of a recession is 7.7% today, according to the bond market, but the oil price shock suggests that the probability will only increase from here. Stagflation, at least, is now highly likely. Short-term interest rates are rising faster than long-term rates, causing the 2-year/10-year Treasury slope to slide toward inversion, though it is not there yet. That would be a telltale sign of a looming recession (Chart 1). The 3-mo/10-year Treasury yield slope is nowhere near inverting and has a better record of predicting recessions than the 2-year/10-year. The Federal Reserve’s interest rate hikes are expected to cause the 10-year yield to rise and the yield curve to steepen. But exogenous shocks may push short rates even higher. When the oil price doubles, a recession often ensues. Out of the past seven recessions, five of them witnessed an oil spike beforehand. True, not every spike causes a recession. But the causality is clear. Today’s spike is large enough to be recessionary (Chart 2). The critical question is where will the price settle? If it settles above $90-$100 per barrel then it will erode global demand. Chart 1An End-Of-Cycle Crisis? Chart 2Oil Price Often Doubles Before Recessions Most likely the price will settle at around $85 per barrel by the end of 2022, and average $85 in 2023, according to our Commodity & Energy Strategy. High prices will discourage consumption and incentivize new production, leading to a price drop and new equilibrium. The OPEC cartel will increase production because they want to prolong the business cycle. Non-OPEC producers like US shale oil companies will also increase production. It is not likely that the US will significantly lift sanctions on Iran and Venezuela, though that would free up 1.3 million barrels per day and 700,000 barrels per day respectively. More on this below. Even so, this year’s energy spike will feed into a larger bout of inflation that is eroding real incomes. Headline consumer price inflation is running at 7.9% as of February, the highest in four decades. Core inflation is running at 6.4%. The Ukraine war did not prevent the European Central Bank from delivering a hawkish surprise in its fight against inflation on March 10, so it is even less likely to prevent the Fed from delivering a hawkish surprise on March 16. The Fed has a history of hiking rates even during geopolitical crises (as during the Arab oil embargo of 1973), which implies that the war in Ukraine will not prevent the Fed from hiking rates four times or more this year. There is a close relationship between the global oil price and the financial market’s long-term inflation expectations (Chart 3). When the costs of production and transportation go up, investors start to expect higher prices. Expectations are already rising because of the global pandemic, stimulus, supply constraints, wage pressure, and tardy policy normalization. Gasoline prices at the pump will shape consumer expectations (Chart 4). Chart 3Global Oil Price Pushes Up Inflation Expectations Chart 4Geopolitics Compound Inflation Yet high commodity prices are not coinciding with strong global growth and a weak dollar, as one might suspect. Global growth is falling and the dollar is strengthening. The energy shock from Russia will rattle importing countries like Europe, China, and India and thus enhance the dollar’s rise (Chart 5). Investor sentiment will suffer as the war in Ukraine reinforces the secular rise in geopolitical risk. Global policy uncertainty is also rising sharply, which will reinforce the dollar, weighing on global economic activity. Chart 5Dollar Strengthens on Weak Global Growth Bottom Line: A stagflationary dynamic is taking shape. Moreover the risk of recession is underrated by the bond market’s measure of recession probability. Investors should maintain tactically bearish trades and cut losses on cyclically bullish trades that suffer from higher rates and persistent inflation. US Boycotts Russia And Begs OPEC The Biden administration’s decision to ban Russian oil exports – and to encourage private sector boycotts of the Russian energy trade – raises the potential for the Russian conflict to escalate beyond Ukraine’s borders. While a total boycott of Russian oil exports is unlikely, it would be one of the larger oil shocks in modern history (Chart 6). Unlike the Iranian attack on the Saudi oil refinery in 2019, the Russian shock would come amid an existing energy shortage. Chart 6Worst Case Oil Risk in Historical Context There are two critical questions about US policy at this stage: Will the US foist its energy boycott on Europe, triggering a Russian retaliation? This could plunge Europe into recession and further upset the global economy. Will the US convince the OPEC cartel to increase oil production? A production boost would reduce prices and help to rebalance the economy, salvaging the business cycle. The next two sections discuss these options. US Boycotts Russia The first question is how Russia will respond to the US boycott and whether the Biden administration will try to force Europe to adopt the boycott. The US is comfortable boycotting Russian energy because oil and gas imports only account for 0.6% of GDP and those from Russia only 0.04%. Europe cannot make the same decision. While O&G imports are only 2.21% of GDP, and Russian O&G imports at 0.4%, these numbers will spike to near 2008 levels as a result of the price shock (Charts 7A & 7B). Major European countries, notably Germany, have already rejected the US boycott, and any EU direct sanctions require unanimity. The EU is instead outlining a plan to diversify away from Russia more gradually. This is a medium-term threat to Russia and hence a major concern for global stability but it is not an instant cutoff, which would cause an immediate recession in Europe. Chart 7AThe US Is Energy Independent... Chart 7B...The EU Is Not The EU’s plan would theoretically reduce its dependency on Russian energy by 66% by the end of the year. But that is easier said than done. Also, Europe cannot simply swap the US for Russia. American exports to the rest of the world could be redirected to Europe, but the switch requires an overhaul of supply chains. A total switch of US exports to Europe is impracticable in the short run and would leave other US allies dependent on Russian exports (Charts 8A & 8B). Chart 8AUS Will Not Replace Russian Energy Anytime Soon Chart 8BUS Will Not Replace Russian Energy Anytime Soon US shale producers are only starting to increase production. With WTI crude oil at $100, and Henry Hub natural gas spot price at $4.6 per million BTU, American production will speed up. But US companies are more focused on profitability and returns to shareholders than they were at the beginning of the shale boom, which has restrained oil production (Charts 9A & (9B). Chart 9AUS Production And Exports Increase After Pandemic Lull Chart 9BUS Production And Exports Increase After Pandemic Lull The Biden administration has not yet fully adopted the tactics necessary: promoting the domestic fossil fuel industry and coordinating it for purposes of national strategy. American oil executives complain that while the Biden administration courts foreign energy producers and contemplates arbitrarily lifting sanctions on Iran and Venezuela, it has not approached domestic producers about facilitating production.1 Meanwhile there is a risk that Russia will retaliate against western sanctions by cutting off natural gas to the EU, for instance via the Nord Stream I pipeline. This is a risk, rather than a base case, because Moscow would prefer to sell energy as long as Europe is buying – and even increase the amount it produces at today’s high prices. Russian energy exports to the EU account for 5% of Russian GDP and thus provide an important lifeline at a time when the country is suffering heavily under banking, technology, and trade sanctions (Chart 10). Russian natural resource exports on average provide 43% of government revenue, which is essential for Moscow to carry on its war effort (Chart 11). Chart 10Russia Will Not Punish EU For US Boycott Chart 11Russia Needs EU Energy Imports And yet Russians are now slapping an embargo on agricultural exports, constricting global food supply and pushing up food prices. The implication is that a reduction in energy exports to the EU is not out of the question, especially an incremental reduction aimed at increasing Russian diplomatic pressure on Europe. If the Russians cut off Europe, it will fall into a severe recession and the energy shock will risk a global recession. While US direct trade exposure to Europe is limited, at about 3.8% of GDP (Chart 12A), nevertheless the US would suffer from price pressures. The US is already seeing import prices rise toward 2008 levels (Chart 12B). Chart 12AUS Exposure To The EU Is Limited... Chart 12B...But Its Import Prices Will Rise Bottom Line: The US is boycotting Russian oil but not forcing the EU to join the boycott. Europe is pursuing gradual diversification but Russia is unlikely to cut off Europe’s supply. However, this dynamic is showing signs of faltering, which means investors are justified in taking further risk off the table. US Begs OPEC The Biden administration started off on the wrong foot with the Gulf Arab states by criticizing them for autocratic government and human rights abuses, threatening to withhold arms sales, and trying to restore the 2015 nuclear deal and détente with Iran. Now, with a global energy shock unfolding, Biden is going back to Saudi Arabia and the UAE and imploring them to increase oil production and ease the supply pressure. The Arab states are reportedly giving him the cold shoulder, ignoring his phone calls while answering Russian President Vladimir Putin’s calls.2 These states never have an interest in producing oil at any US president’s beck and call. The US and Iran have also reached a critical stage in nuclear negotiations. So it is only fitting that the Arab states play hard to get. While the UAE ambassador to the US suggested that his country supporting increasing production on March 9, the country’s energy minister said the opposite. However, the core OPEC states are even less likely to do Russia’s bidding. Moscow propped up the Syrian regime, arms and subsidizes Iran, and aspires to gain ever greater control over Middle East exports to Europe. The Gulf states also know that the Russians will produce as much energy as they can since they need the revenues to sustain their war (Chart 13). Chart 13Core OPEC Countries Have An Interest In Increasing Oil Supply The Gulf states rely on the US military for national security, they fear that US-Iran détente will lead to US abandonment and Iranian regional ascendancy, and they seek to sustain their centrality to the global oil market. They want to prolong their export revenues in the context of a growing global economy for the sake of their own delicate internal stability and reforms. They do not aim to incentivize non-OPEC oil production and renewable energy transition with excessive prices, or to trigger a global recession (Chart 14). Hence the Saudi and UAE strategy will be to lower the oil price closer to their fiscal breakeven rate of $82.3 and $62.8 (oil price consistent with a balanced budget) and prolong the business cycle (Chart 15). Chart 14Core OPEC Does Not Want To Threaten Their Fiscal Future Chart 15Current Oil Price Comfortably Supports Fiscal Spending In OPEC The critical factor in the negotiation with the Biden administration will be Iran, their chief rival. Biden is trying to rejoin the 2015 nuclear deal, which would require removing sanctions in exchange for Iran’s halting its nuclear progress. A deal would bring 1.3 million barrels per day online, at least for the next two years or so. It could also prompt the Saudis or others to increase production to prevent Iran from stealing market share, as occurred in 2014 (Chart 16). Any deal would reduce the risk of military conflict in the short term and as such would remove some risk premium from oil prices. If Biden agrees to walk away from the Iran deal, then perhaps the Saudis and UAE will oblige him with a larger and quicker production boost. They know the Democratic Party is doomed in this year’s midterm elections anyway. Sanctions are not preventing the Iranians from exporting oil today and there is very little chance that they will truly abandon their quest for nuclear weapons (Chart 17). Chart 16Production Ramped Up Ahead Of The Iran Deal In 2015 Chart 17Production May Ramp Up Again As Iran Managed To Evade Sanction Either way the core OPEC members need to adjust the oil supply to maintain market share and prolong the business cycle. Taking it all together, investors should expect oil prices to remain volatile and for oil supply risks to remain elevated, meaning that oil prices will likely resume their rise after the expected OPEC intervention. Biden is also tinkering with the idea of easing sanctions on Venezuela. This would take a long time and require regime change to come to fruition. Venezuela produces about 700,000 barrels per day at present, down from about 2 million bpd in 2017.Given the lack of capital, investment, and engineering expertise, the Venezuelans probably cannot increase production beyond 1 million bpd over the next year or so. Of that, maybe 600,000 barrels could be sent to export markets, according to our Commodity & Energy Strategist Bob Ryan. The US cannot remove all sanctions from Venezuela as it does not recognize the legitimacy of President Nicolas Maduro’s regime. The Department of Justice indicted Maduro in 2020. Accommodating Maduro will create even more bad blood between the Democrats and the Cuban-American voters in electorally critical Florida. US companies will be reluctant to get involved in oil production in Venezuela on such a flimsy basis, as they will fear future sanctions if Republicans win in 2024. So investment in Venezuela, and hence oil production, will remain limited even if Biden waives some sanctions. Bottom Line: Biden’s attempts to ease sanctions on Iran and Venezuela are unlikely to have a lasting impact on oil prices. But it is possible that he will convince the OPEC states to increase production, as their own interests support such a move. Investment Takeaways Comparing Russia’s 2022 invasion of Ukraine to the original invasion in 2014, the major trends are parallel: stocks are falling relative to bonds, cyclical sectors are underperforming defensives, and small caps are outperforming large caps (Chart 18A). Chart 18AMarket Response 2022 Versus 2014 Chart 18BMarket Response 2022 Versus 2014 If Russia imposes an energy embargo or OPEC refuses to increase production, then there will be an even larger global energy shock and a European recession that will weigh on global growth. The dollar will stay well bid in the near term. Value stocks are far outpacing growth stocks in the 2022 crisis, in keeping with high inflation and rising bond yields (Chart 18B). While we favor value over growth on a structural basis, we took the opposite stance as a tactical trade at the beginning of this year in expectation of falling bond yields, which has backfired. We are closing this trade for a loss of 7.7%. Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Footnotes 1 See Shannon Pettypiece, “White House, oil industry spar anew over drilling as gas prices surge”, NBC News, March 12, nbcnews.com. 2 See Holman Jenkins, “The Putin Endgame,” The Wall Street Journal, March 1, 2022, wsj.com Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets