Economic Growth
BCA Research’s China Investment Strategy service continues to recommend a neutral stance in Chinese equities within a global portfolio. China’s economic data moved up slightly in May from an extremely depressed level in April. A normalization of the supply…
Executive Summary Russia Squeezes EU Natural Gas Major geopolitical shocks tend to coincide with bear markets, so the market is getting closer to pricing this year’s bad news. But investors are not out of the woods yet. Russia is cutting off Europe’s natural gas supply ahead of this winter in retaliation to Europe’s oil embargo. Europe is sliding toward recession. China is reverting to autocratic rule and suffering a cyclical and structural downshift in growth rates. Only after Xi Jinping consolidates power will the ruling party focus exclusively on economic stabilization. The US can afford to take risks with Russia, opening up the possibility of a direct confrontation between the two giants before the US midterm election. A new strategic equilibrium is not yet at hand. Tactical Recommendation Inception Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 18.3% Bottom Line: Maintain a defensive posture in the third quarter but look for opportunities to buy oversold assets with long-term macro and policy tailwinds. Feature 2022 is a year of geopolitics and supply shocks. Global investors should remain defensive at least until the Chinese national party congress and US midterm election have passed. More fundamentally, an equilibrium must be established between Russia and NATO and between the US and Iran. Until then supply shocks will destroy demand. Checking Up On Our Three Key Views For 2022 Our three key views for the year are broadly on track: 1. China’s Reversion To Autocracy: For ten years now, the fall in Chinese potential economic growth has coincided with a rise in neo-Maoist autocracy and foreign policy assertiveness, leading to capital flight, international tensions, and depressed animal spirits (Chart 1). Related Report Geopolitical StrategyWill China Let 100 Flowers Bloom? Only Briefly. Rising incomes provided legitimacy for the Communist Party over the past four decades. Less rapidly rising incomes – and extreme disparities in standards of living – undermine the party and force it to find other sources of public support. Fighting pollution and expanding the social safety net are positives for political stability and potentially for economic productivity. But converting the political system from single-party rule to single-person rule is negative for productivity. Mercantilist trade policy and nationalist security policy are also negative. China’s political crackdown, struggle with Covid-19, waning exports, and deflating property market have led to an abrupt slowdown this year. The government is responding by easing monetary, fiscal, and regulatory policy, though so far with limited effect (Chart 2). Economic policy will not be decisive in the third quarter unless a crash forces the administration to stimulate aggressively. Chart 1China's Slowdown Leads To Maoism, Nationalism Chart 2Chinese Policy Easing: Limited Effect So Far Chart 3Nascent Rally In Chinese Shares Will Be Dashed Once General Secretary Xi Jinping secures another five-to-ten years in power at the twentieth national party congress this fall, he will be able to “let 100 flowers bloom,” i.e. ease policy further and focus exclusively on securing the economic recovery in 2023. But policy uncertainty will remain high until then. The party may have to crack down anew to ensure Xi’s power consolidation goes according to plan. China is highly vulnerable to social unrest for both structural and cyclical reasons. The US would jump to slap sanctions on China for human rights abuses. Hence the nascent recovery in Chinese domestic and offshore equities can easily be interrupted until the political reshuffle is over (Chart 3). If China’s economy stabilizes and a recession is avoided, investors will pile into the rally, but over the long run they will still be vulnerable to stranded capital due to Chinese autocracy and US-China cold war. If the Politburo and Politburo Standing Committee are stacked with members of Xi’s faction, as one should expect, then the reduction in policy uncertainty will only be temporary. Autocracy will lead to unpredictable and draconian policy measures – and it cannot solve the problem of a shrinking and overly indebted population. If the Communist Party changes course and stacks the Politburo with Xi’s factional rivals, to prevent China from going down the Maoist, Stalinist, and Putinist route, then global financial markets will cheer. But that outcome is unlikely. Hawkish foreign policy means that China will continue to increase its military threats against Taiwan, while not yet invading outright. Beijing has tightened its grip over Tibet, Xinjiang, and Hong Kong since 2008; Taiwan and the South China Sea are the only critical buffer areas that remain to be subjugated. Taiwan’s midterm elections, US midterms, and China’s party congress will keep uncertainty elevated. Taiwan has underperformed global and emerging market equities as the semiconductor boom and shortage has declined (Chart 4). Hong Kong is vulnerable to another outbreak of social unrest and government repression. Quality of life has deteriorated for the native population. Democracy activists are disaffected and prone to radicalization. Singapore will continue to benefit at Hong Kong’s expense (Chart 5). Chart 4Taiwan Equity Relative Performance Peaked Chart 5Hong Kong Faces More Troubles Chart 6Japan Undercuts China China and Japan are likely to engage in clashes in the East China Sea. Beijing’s military modernization, nuclear weapons expansion, and technological development pose a threat to Japanese security. The gradual encirclement of Taiwan jeopardizes Japan’s vital sea lines of communication. Prime Minister Fumio Kishida is well positioned to lead the Liberal Democratic Party into the upper house election on July 10 – he does not need to trigger a diplomatic showdown but he would not suffer from it. Meanwhile China is hungry for foreign distractions and unhappy that Japan is reviving its military and depreciating its currency (Chart 6). A Sino-Japanese crisis cannot be ruled out, especially if the Biden administration looks as if it will lose its nerve in containing China. Financial markets would react negatively, depending on the magnitude of the crisis. North Korea is going back to testing ballistic missiles and likely nuclear weapons. It is expanding its doctrine for the use of such weapons. It could take advantage of China’s and America’s domestic politics to stage aggressive provocations. South Korea, which has a hawkish new president who lacks parliamentary support, is strengthening its deterrence with the United States. These efforts could provoke a negative response from the North. Financial markets will only temporarily react to North Korean provocations unless they are serious enough to elicit military threats from Japan or the United States. China would be happy to offer negotiations to distract the Biden administration from Xi’s power grab. South Korean equities will benefit on a relative basis as China adds more stimulus. 2. America’s Policy Insularity: President Biden’s net approval rating, at -15%, is now worse than President Trump’s in 2018, when the Republicans suffered a beating in midterm elections (Chart 7). Biden is now fighting inflation to try to salvage the elections for his party. That means US foreign policy will be domestically focused and erratic in the third quarter. Aside from “letting” the Federal Reserve hike rates, Biden’s executive options are limited. Pausing the federal gasoline tax requires congressional approval, and yet if he unilaterally orders tax collectors to stand down, the result will be a $10 billion tax cut – a drop in the bucket. Biden is considering waiving some of former President Trump’s tariffs on China, which he can do on his own. But doing so will hurt his standing in Rust Belt swing states without reducing inflation enough to get a payoff at the voting booth – after all, import prices are growing slower from China than elsewhere (Chart 8). He would also give Xi Jinping a last-minute victory over America that would silence Xi’s critics and cement his dictatorship at the critical hour. Chart 7Democrats Face Shellacking In Midterm Elections Chart 8Paring Trump Tariffs Won't Reduce Inflation Much Chart 9Only OPEC Can Help Biden - And Help May Come Late Biden is offering to lift sanctions on Iran, which would free up 1.3 million barrels of oil per day. But Iran is not being forced to freeze its nuclear program by weak oil prices or Russian and Chinese pressure – quite the opposite. If Biden eases sanctions anyway, prices at the pump may not fall enough to win votes. Hence Biden is traveling to Saudi Arabia to make amends with Crown Prince Mohammed bin Salman. OPEC’s interest lies in producing enough oil to prevent a global recession, not in flooding the market on Biden’s whims to rescue the Democratic Party. Saudi and Emirati production may come but it may not come early in the third quarter. Lifting sanctions on Venezuela is a joke and Libya recently collapsed again (Chart 9). Even in dealing with Russia the Biden administration will exhibit an insular perspective. The US is not immediately threatened, like Europe, so it can afford to take risks, such as selling Ukraine advanced and long-range weapons and providing intelligence used to sink Russian ships. If Russia reacts negatively, a direct US-Russia confrontation will generate a rally around the flag that would help the Democrats, as it did under President John F. Kennedy in 1962 – one of the rare years in which the ruling party minimized its midterm election losses (Chart 10). The Cuban Missile Crisis counted more with voters than the earlier stock market slide. 3. Petro-States’ Geopolitical Leverage: Oil-producing states have immense geopolitical leverage this year thanks to the commodity cycle. Russia will not be forced to conclude its assault on Ukraine until global energy prices collapse, as occurred in 2014. In fact Russia’s leverage over Europe will be greatly reduced in the coming years since Europe is diversifying away from Russian energy exports. Hence Moscow is cutting natural gas flows to Europe today while it still can (Chart 11). Chart 10Biden Can Afford To Take Risks With Russia Chart 11Russia Squeezes EU's Natural Gas Chart 12EU/China Slowdown Will Weigh On World Russia’s objective is to inflict a recession and cause changes in either policy or government in Europe. This will make it easier to conclude a favorable ceasefire in Ukraine. More importantly it will increase the odds that the EU’s 27 members, having suffered the cost of their coal and oil embargo, will fail to agree to a natural gas embargo by 2027 as they intend. Italy, for example, faces an election by June 2023, which could come earlier. The national unity coalition was formed to distribute the EU’s pandemic recovery funds. Now those funds are drying up, the economy is sliding toward recession, and the coalition is cracking. The most popular party is an anti-establishment right-wing party, the Brothers of Italy, which is waiting in the wings and can ally with the populist League, which has some sympathies with Russia. A recession could very easily produce a change in government and a more pragmatic approach to Moscow. The Italian economy is getting squeezed by energy prices and rising interest rates at the same time and cannot withstand the combination very long. A European recession or near-recession will cause further downgrades to global growth, especially when considering the knock-on effects in China, where the slowdown is more pronounced than is likely reported. The US economy is more robust but it will have to be very robust indeed to withstand a recession in Europe and growth recession in China (Chart 12). Russia does not have to retaliate against Finland and Sweden joining NATO until Turkey clears the path for them to join, which may not be until just before the Turkish general election due in June 2023. But imposing a recession on Europe is already retaliation – maybe a government change will produce a new veto against NATO enlargement. Russian retaliation against Lithuania for blocking 50% of its shipments to the Kaliningrad exclave is also forthcoming – unless Lithuania effectively stops enforcing the EU’s sanctions on Russian resources. Russia cannot wage a full-scale attack on the Baltic states without triggering direct hostilities with NATO since they are members of NATO. But it can retaliate in other ways. In a negative scenario Moscow could stage a small “accidental” attack against Lithuania to test NATO. But that would force Biden to uphold his pledge to defend “every inch” of NATO territory. Biden would probably do so by staging a proportionate military response or coordinating with an ally to do it. The target would be the Russian origin of attack or comparable assets in the Baltic Sea, the Black Sea, Ukraine, Belarus, or elsewhere. The result would be a dangerous escalation. Russia could also opt for cyber-attacks or economic warfare – such as squeezing Europe’s natural gas supply further. Ultimately Russia can afford to take greater risks than the US over Kaliningrad, other territories, and its periphery more broadly. That is the difference between Kennedy and Biden – the confrontation is not over Cuba. Russia is also likely to take a page out of Josef Stalin’s playbook and open a new front – not so much in Nicaragua as in the Middle East and North Africa. The US betrayal of the 2015 nuclear deal with Iran opens the opportunity for Russia to strengthen cooperation with Iran, stir up the Iranians’ courage, sell them weapons, and generate a security crisis in the Middle East. The US military would be distracted keeping peace in the Persian Gulf while the Europeans would lose their long-term energy alternative to Russia – and energy prices would rise. The Iranians – who also have leverage during a time of high oil prices – are not inclined to freeze their nuclear program. That would be to trade their long-term regime survival for economic benefits that the next American president can revoke unilaterally. Bottom Line: Xi Jinping is converting China back into an autocracy, the Biden administration lacks options and is willing to have a showdown with Russia, and the Putin administration is trying to inflict a European recession and political upheaval. Stay defensive. Checking Up On Our Strategic Themes For The 2020s As for our long-term themes, the following points are relevant after what we have learned in the second quarter: 1. Great Power Rivalry: The war in Ukraine has reminded investors of the primacy of national security. In an anarchic international system, if a single great nation pursues power to the neglect of its neighbors’ interests, then its neighbors need to pursue power to defend themselves. Before long every nation is out for itself. At least until a new equilibrium is established. For example, Russia’s decision to neutralize Ukraine by force is driving Germany to abandon its formerly liberal policy of energy cooperation in order to reduce Russia’s energy revenues and avoid feeding its military ambitions. Russia in turn is reducing natural gas exports to weaken Europe’s economy this winter. Germany will re-arm, Finland and Sweden will eventually join NATO, and Russia will underscore its red line against NATO bases or forces in Finland and Sweden. If this red line is violated then a larger war could ensue. Chart 13China Will Shift To Russian Energy Until Russia and NATO come to a new understanding, neither Europe nor Russia can be secure. Meanwhile China cannot reject Russia’s turn to the east. China believes it may need to use force to prevent Taiwan independence at some point, so it must prepare for the US and its allies to treat it the same way that they have treated Russia. It must secure energy supply from Russia, Central Asia, and the Middle East via land routes that the US navy cannot blockade (Chart 13). Beijing must also diversify away from the US dollar, lest the Treasury Department freeze its foreign exchange reserves like it did Russia’s. Global investors will see diversification as a sign of China’s exit from the international order and preparation for conflict, which is negative for its economic future. However, the Russo-Chinese alliance presents a historic threat to the US’s security, coming close to the geopolitical nightmare of a unified Eurasia. The US is bound to oppose this development, whether coherently or not, and whether alone or in concert with its allies. After all, the US cannot offer credible security guarantees to negotiate a détente with China or Iran because its domestic divisions are so extreme that its foreign policy can change overnight. Other powers cannot be sure that the US will not suffer a radical domestic policy change or revolution that leads to belligerent foreign policy. Insecurity will drive the US and China apart rather than bringing them together. For example, Russia’s difficulties in Ukraine will encourage Chinese strategists to go back to the drawing board to adjust their plans for military contingencies in Taiwan. But the American lesson from Ukraine is to increase deterrence in Taiwan. That will provoke China and encourage the belief that China cannot wait forever to resolve the Taiwan problem. Until there is a strategic understanding between Russia and NATO, and the US and China, the world will remain in a painful and dangerous transitional phase – a multipolar disequilibrium. Chart 14Hypo-Globalization: Globalizing Less Than Potential 2. Hypo-Globalization: If national security rises to the fore, then economics becomes a tool of state power. Mercantilism becomes the basis of globalization rather than free market liberalism. Hypo-globalization is the result. The term is fitting because the trade intensity of global growth is not yet in a total free fall (i.e. de-globalization) but merely dropping off from its peaks during the phase of “hyper-globalization” in the 1990s and early 2000s (Chart 14). Hypo-globalization is probably a structural rather than cyclical phenomenon. The EU cannot re-engage with Russia and ease sanctions without rehabilitating Russia’s economy and hence its military capacity – which could enable Russia to attack Europe again. The US and China can try to re-engage but they will fail. Russo-Chinese alliance ensures that the US would be enriching not one but both of its greatest strategic rivals if it reopened its doors to Chinese technology acquisition and intellectual property theft. Iran will see its security in alliance with Russia and China. China has an incentive to develop Iran’s economy so as not to depend solely on Russia and Central Asia. Russia has an incentive to develop Iran’s military capacity so as to deprive Europe of an energy alternative. Both Russia and China wish to deprive the US of strategic hegemony in the Middle East. By contrast the US and EU cannot offer ironclad security guarantees to Iran because of its nuclear ambitions and America’s occasional belligerence. Thus the world can see expanding Russian and Chinese economic integration with Eurasia, and expanding American and European integration with various regions, but it cannot see further European integration with Russia or American integration with China. And ultimately Europe and China will be forced to sever links (Chart 15). Globalization will not cease – it is a multi-millennial trend – but it will slow down. It will be subordinated to national security and mercantilist economic theory. 3. Populism/Nationalism: In theory, domestic instability can cause introversion or extroversion. But in practice we are seeing extroversion, which is dangerous for global stability (Chart 16). Chart 15Global Economic Disintegration Chart 16Internal Sources Of Nationalism Russia’s invasion of Ukraine derived from domestic Russian instability – and instability across the former Soviet space, including Belarus, which the Kremlin feared could suffer a color revolution after the rigged election and mass protests of 2020-21. The reason the northern European countries are rapidly revising their national defense and foreign policies to counter Russia is because they perceive that the threat to their security is driven by factors within the former Soviet sphere that they cannot easily remove. These factors will get worse as a result of the Ukraine war. Russian aggression still poses the risk of spilling out of Ukraine’s borders. China’s Maoist nostalgia and return to autocratic government is also about nationalism. The end of the rapid growth phase of industrialization is giving way to the Asian scourge: debt-deflation. The Communist Party is trying to orchestrate a great leap forward into the next phase of development. But in case that leap fails like the last one, Beijing is promoting “the great rejuvenation of the Chinese nation” and blaming the rest of the world for excluding and containing China. Taiwan, unfortunately, is the last relic of China’s past humiliation at the hands of western imperialists. China will also seek to control the strategic approach to Taiwan, i.e. the South China Sea. China’s claim that the Taiwan Strait is sovereign sea, not international waters, will force the American navy to assert freedom of passage. American efforts to upgrade Taiwan relations and increase deterrence will be perceived as neo-imperialism. The United States, for its part, could also see nationalism convert into international aggression. The US is veering on the brink of a miniature civil war as nationalist forces in the interior of the country struggle with the political establishment in the coastal states. Polarization has abated since 2020, as stagflation has discredited the Democrats. But it is now likely to rebound, making congressional gridlock all but inevitable. A Republican-controlled House will find a reason to impeach President Biden in 2023-24, in hopes of undermining his party and reclaiming the presidency. Another hotly contested election is possible, or worse, a full-blown constitutional crisis. American institutions proved impervious to the attempt of former President Trump and his followers to disrupt the certification of the Electoral College vote. However, security forces will be much more aggressive against rebellions of whatever stripe in future, which could lead to episodes in which social unrest is aggravated by police repression. If the GOP retakes the White House – especially if it is a second-term Trump presidency with a vendetta against political enemies and nothing to lose – then the US will return to aggressive foreign policy, whether directed at China or Iran or both. In short, polarization has contaminated foreign policy such that the most powerful country in the world cannot lead with a steady hand. Over the long run polarization will decline in the face of common foreign enemies but for now the trend vitiates global stability. Chart 17Germany And Japan Rearming It goes without saying that nationalism is also an active force in Iran, where 83-year-old Supreme Leader Ayatollah Khamenei is attempting to ensure the survival of his regime in the face of youthful social unrest and an unclear succession process. If Khamenei takes advantage of the commodity cycle, and American and Israeli disarray, he can make a mad dash for the bomb and try to achieve regime security. But if he does so then nationalism will betray him, since Israel and/or the US are willing to conduct air strikes to uphold the red line against nuclear weaponization. If any more proof of global nationalism is needed, look no further than Germany and Japan, the principal aggressors of World War II. Their pacifist foreign policies have served as the linchpins of the post-war international order. Now they are both pursuing rearmament and a more proactive foreign policy (Chart 17). Nationalism may be very nascent in Germany but it has clearly made a comeback in Japan, which exacerbates China’s fears of containment. The rise of nationalism in India is widely known and reinforces the trend. Bottom Line: Great power rivalry is intensifying because of Russia’s conflict with the West and China’s inability to reject Russia. Hypo-globalization is the result since EU-Russia and US-China economic integration cannot easily be mended in the context of great power struggle. Domestic instability in Russia, China, and the US is leading to nationalism and aggressive foreign policy, as leaders find themselves unwilling or unable to stabilize domestic politics through productive economic pursuits. Investment Takeaways BCA has shifted its House View to a neutral asset allocation stance on equities relative to bonds (Chart 18). Chart 18BCA House View: Neutral Stocks Versus Bonds Geopolitical Strategy remains defensively positioned, favoring defensive markets and sectors, albeit with some exceptions that reflect our long-term views. Tactically stay long US 10-year Treasuries, large caps versus small caps, and defensives versus cyclicals. Stay long Mexico and short the UAE (Chart 19). Strategically stay long gold, US equities relative to global, and aerospace/defense sectors (Chart 20). Among currencies favor the USD, EUR, JPY, and GBP. Chart 19Stay Defensive In Q3 2022 Chart 20Stick To Long-Term Geopolitical Trades Chart 21Favor Semiconductors But Not Taiwan Chart 22Indian Tech Will Rebound Amid China's Geopolitical Risks Chart 23Overweight ASEAN Go long US semiconductors and semi equipment versus Taiwan broad market (Chart 21). While we correctly called the peak in Taiwanese stocks relative to global and EM equities, our long Korea / short Taiwan trade was the wrong way to articulate this view and remains deeply in the red. Similarly our attempt to double down on Indian tech versus Chinese tech was ill-timed. China eased tech regulations sooner than we expected. However, the long-term profile of the trade is still attractive and Chinese tech will still suffer from excessive government and foreign interference (Chart 22). Go long Singapore over Hong Kong, as Asian financial leadership continues to rotate (see Chart 5 above). Stay long ASEAN among emerging markets. We will also put Malaysia on upgrade watch, given recent Malaysian equity outperformance on the back of Chinese stimulus and growing western interest in alternatives to China (Chart 23). Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix
Executive Summary The Fed has sought to convince one and all of its commitment to overcome high inflation and asset markets have taken heed, tightening financial conditions at a breakneck pace. As we write, the S&P 500 is down 23% year to date, the Bloomberg Barclays Treasury index is down 10%, its sister Corporate and High Yield indexes are down 15% and 12%, respectively, and the dollar had risen by 10% at its peak last week. According to Goldman Sachs’ Financial Conditions Index, the combination has amounted to a 3-percentage-point drag on GDP. Financial markets’ reaction function vis-a-vis monetary policy actions in this tightening cycle has been markedly different than in the previous three tightening cycles. Where tighter financial conditions had previously followed tighter monetary policy with a lengthy lag, they moved ahead of the Fed this time. If the recession is further away than moves in the bond, equity and foreign exchange markets imply, or if inflation eases across the rest of the year in line with our expectations, risk assets are poised to rebound. All Together Now Bottom Line: The FOMC appears to be on course to induce a recession in its quest to bring inflation to heel. The outlook for financial markets depends on when the recession arrives and how bad it will be, however, and we see scope for positive surprises on both counts. Feature 2022 has not been a good year for financial markets and the action over the last week and a half has made it decidedly worse. In six sessions through Thursday, the S&P 500 nosedived 11%, swooning into bear market territory and unwinding nineteen months of advances. The benchmark 10-year Treasury note’s yield needed just three sessions to back up 45 basis points, from 3.05% to 3.5%. The upheaval has not been unique to the US – inflation and decelerating growth are global phenomena and central banks around the world are scrambling to tighten monetary conditions to rein in rising consumer prices while markets agonize about the effect on growth – but the Fed has been at the center of the storm and last week’s FOMC meeting inspired more swings. This week’s report highlights the most important takeaways from the latest FOMC meeting and how financial markets and Fed policy may interact going forward. There are several factors that are at least slightly different this time. Those differences may keep volatility elevated but they do not condemn stocks and bonds to continued declines. Financial markets have made huge pre-emptive moves that may be subject to reversals as inflation data improve and/or growth holds up better than expected. Prioritizing Price Stability Times have changed. Until inflation began to stir last year, the Fed had been able to prioritize the full employment element of its dual mandate for the entire post-crisis period. Chair Powell made it abundantly clear that price stability is the FOMC’s top priority now, opening his post-meeting remarks with the “overarching message” that it has the means and the will to bring inflation back down to its target level. Living up to this commitment will not be as much fun as trying to prod the economy back to full employment, and it looks as if it will ultimately result in a recession. Following 150 basis points (bps) of hikes so far this year, the target range for the fed funds rate now stands at 1.5-1.75%, and the revised Summary of Economic Projections (SEP) indicated that the median FOMC participant expects another 175 bps of hikes across the year’s remaining four meetings, bringing the funds rate to 3.25-3.5% by year end, at the low end of the money markets’ expectations range (Chart 1). Chart 1Markets And The Fed Are On The Same Page During the press conference, Powell repeatedly cited the committee’s concern over rising inflation expectations, calling out the increase in 5-year inflation expectations in the University of Michigan’s preliminary June survey as “quite eye-catching.” The series rose from 30 basis points, to 3.3%, after spending the last four months at 3% and the previous ten in a tight 2.9-3.1% range. The reading was the highest since 2008, when the average national gasoline price first rose above $4 per gallon (Chart 2). Chart 2An "Eye-Catching" Move ... Threading The Needle FOMC participants’ median projections for real growth, unemployment and inflation at the end of 2022, 2023 and 2024 were benign to pollyannaish, signaling their confidence that the committee will be able to thread the needle, wrestling inflation back to target while maintaining trend growth and capping the unemployment rate at 4.1%. That would meet anyone’s definition of a soft landing, but soft landings have been notoriously elusive. It is fiendishly difficult to fine-tune a complex multi-faceted economy with central bankers’ blunt tools. Empirically, every unemployment rate increase of at least one-third of a percentage point has led to a recession (Chart 3), so even the modest one-half point rise envisioned in the SEP could bring some challenges. A closer examination of past unemployment rate increases suggests a potential way around the dour history, but it depends on reversing the decline in labor force participation that is not yet fully understood. The labor force participation rate – the share of the 16-and-over population that is either working or actively looking for a job – remains more than a percentage point below its pre-pandemic level (Chart 4). If it recovered its early 2020 share, the labor force would expand by 2.8 million people. Chart 3... That Could Put Upward Pressure On The Unemployment Rate Chart 4The Mystery Of The Missing Workers If the participation rate were restored to its pre-pandemic level, the fortified labor force would allow for payroll expansion despite the unemployment rate increases envisioned in the latest SEP, as per the population growth and household-to-establishment-survey conversion rate estimates embedded in Table 1. It is reasonable to think that the expansion could continue, or the ensuing recession would be mild, despite a rising unemployment rate if payrolls manage to keep growing. An increasing unemployment rate/increasing payrolls scenario is plausible, but we cannot deem it probable when we do not know what has impeded the participation rate’s recovery. The committee is unlikely to be of one mind on the participation rate question, but it may hold the key to reconciling the sunny projections with the observed difficulty of achieving a soft landing. Table 1A Path To A Soft Landing We’ll Take The Over We agree with Chair Powell and the FOMC’s assessment that solid consumer balance sheets and robust job gains have the economy on a sound footing, despite slowing growth. We do not see familiar underlying vulnerabilities that herald a reversal like an overreliance on debt, broad supply overhangs or an investment boom that has gone on too long. Inflation is the signal problem in the US and the rest of the world, and we continue to expect that it will recede in the second half as supply constraints in pandemic-squeezed segments ease and the pre-emptive backup in yields holds back some marginal demand for big-ticket items that require financing. No one knows the equilibrium fed funds rate in real time, but Powell indicated the committee thinks it’s around 3.5%, placing the year end 2022 median funds rate dot just shy of equilibrium and the median 2023 dot in modestly restrictive territory. A recession is the likely outcome of the rate hike campaign, but if the target rate doesn’t exceed the equilibrium rate until early next year, it may not begin until the middle of 2023 or early in 2024. Given that the consensus view now appears to be that a recession will begin this year if it hasn’t done so already, and financial markets have gone a long way toward pricing in its effects, we don’t see much upside to joining the bearish chorus now. We’ll take the over on the recession-by-year-end proposition. The Big Difference This Time When asked how high the funds rate has to go to arrest inflation, Powell offered the following description of how rate hikes work. “I … look at it this way: We move the policy rate that affects financial conditions, and that affects the economy. We have [more] rigorous ways to think about it, but ultimately it comes down to, ‘do we think financial conditions are in a place where they’re having the desired effect on the economy?’ And that desired effect is we’d like to see demand moderating.” Related Report US Investment StrategyInflation And Investing Two questions later, he approvingly noted how much bang the committee had already gotten for its buck to this point in the tightening campaign. “[T]his year has been a demonstration of how well [guidance] can work. With us having … done very little in the way of raising interest rates, financial conditions have tightened quite significantly through the expectations channel, as we’ve made clear what our plans are. I think that’s been … very healthy[.]” We stay away from making value judgments about policy, though we can see that a central banker would be in favor of anything that shortens the lag between policy actions and their economic effect. It is immediately obvious, however, that the current rate hike campaign’s real-time impact on financial conditions contrasts sharply with the last three decades’ campaigns (Chart 5). Every one-point change in the Goldman Sachs Financial Conditions Index (FCI) is calibrated to correspond to a one-percentage-point change in real GDP. The FOMC hiked by 175 bps ahead of the 2001 recession and the FCI eventually rose four points, peaking in October 2002, 29 months after the FOMC pushed fed funds to its terminal rate and 21 after it began cutting rates. After the 2004-6 “conundrum” campaign, when financial conditions eased despite 17 consecutive quarter-point rate hikes, the FCI tightened by five points, reaching its peak almost three years after the last hike and 18 months after the first cut. Chart 5Seize The Day Chart 6Decoupling Some of the response is a simple reflection of the about-face in the inflation backdrop. As our Chief Emerging Markets Strategist Arthur Budaghyan predicted in February 2021, Treasury yields and stock prices have flipped from several decades of positive correlation (rising stock prices offset falling bond valuations and vice versa) in a disinflationary environment to negative correlation in an inflationary environment. Now that Treasury bond, corporate bond and stock prices have been falling together, and the safe-haven dollar has risen amidst the general flight from risk, all of the FCI’s subcomponents have been reinforcing one another, making the index jumpier. More volatile financial conditions raise the probability of overshoots. To wit, has the FCI moved too far, too soon? The volcanic upward move in the 10-year Treasury yield has severed its reliable empirical link with the gold-to-commodity ratio (Chart 6, top panel) and the relative performance of cyclical and defensive equity sectors (Chart 6, bottom panel). They suggest a retracement could be in store. Projected policy rate differentials between the Fed and other currency majors’ central banks are narrowing as monetary policy makers rush to combat inflation. Gloom about growth is widespread. Any positive global growth surprise, from China regarding COVID or stimulus, from the Ukrainian theater, or from supply chain relief, could reel in the extended dollar. Investors should not lose sight of the potential that the coming recession could be mild. A 25% selloff in the S&P 500 may be nearly enough to address that outcome. As of Thursday’s close, the index’s forward four-quarter multiple was down to 15.5 from just under 22 at the start of the year – stocks were expensive, but the nearly 30% de-rating haircut has been severe. The 15.5 multiple assumes the next four quarters’ earnings grow almost 10% year-over-year, which looks ambitious. 5% growth would yield a 16.2 multiple, while no growth would price stocks at 17 times. Those multiples are not cheap, but a lot of froth has come out of the equity market. Against the gloom that has taken over financial markets, we think the next twelve months can be rewarding for investors in risk assets. We are alert to the principal ways our constructive view could be proven wrong and will change our view if it is invalidated by the evidence, but we remain overweight equities in a multi-asset portfolio over the cyclical three-to-twelve-month timeframe. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com
Executive Summary Structural Tailwinds For The Franc Volatility in FX markets is likely to remain elevated, as witnessed by the reaction of a full circle of central bank meetings this week.Policy convergence remains a good bet for interest rate curves and currency pairs. The SNB surprised markets by raising interest rates by 50 bps, to -0.25%, the first hike since 2007.Higher volatility will continue to buoy the Swiss franc in the short run.Structural appreciation in the franc is also likely over the coming decades (Feature Chart). Swiss stocks often perform well during economic downturns, but they are not particularly cheap, and are vulnerable to higher interest rates. Investors should only overweight Swiss stocks if they expect more significant downside to global stocks.Valuation favors the franc versus the dollar. However, EUR/CHF and GBP/CHF are closer to fair value. CHF/JPY is expensive; hence, the yen is a better hedge for downside economic surprises. Go short CHF/JPY as a trade.BCA’s Foreign Exchange Strategy was short CHF/SEK at 10.2 with stop loss at 10.5. That stop was hit overnight, triggering a loss of -3.3%. Stand aside for now.Bottom Line: Favor the franc over the short term against other pro-cyclical currencies, with a view to downgrade CHF when it becomes evident that economic growth is bottoming. Any further bout of Swiss equity outperformance, prompted by global risk aversion, offers an attractive selling opportunity versus Eurozone stocks.Feature Chart 1The SNB Has Capitulated To Rising Inflation Volatility in FX markets is likely to remain elevated. This week, the Fed delivered its first 75 bps interest rate hike since 1994. It also increased its expected year-end level for the Fed Funds rate to 3.4% from 1.9%, and to 3.8% from 3.4% at the end of 2023. The FX market had been warming up to a hawkish surprise, but the dollar surged on the news, hitting a fresh two-decade high of 105.5, before later reversing gains.Meanwhile, the European Central Bank (ECB) held an emergency meeting on Wednesday, to try to mitigate the rise in Italian yields, which hit as high as 4.2% on Tuesday, or 243 bps over German 10-year yields. The subsequent statement released by the Governing Council offered no concrete details. Yes, the reinvestments of the proceeds from maturing debt in the Pandemic Emergency Purchase Program (PEPP) will flow mostly to peripheral markets, but investors want clarity on the nature of the long-awaited policy plan to tackle fragmentation risk in the Euro Area. As a result, peripheral bond markets will remain fragile until a bold program comes to fruition.To cement currency volatility this week, SNB Governor Thomas Jordan surprised markets by raising interest rates by 50 bps in Switzerland, to -0.25%, the first hike since the Global Financial Crisis (Chart 1). The negative interest rate threshold for sight deposits was also lowered, a move encouraging banks to pack reserves at the SNB. The Bank of England also raised interest rates in line with market expectations. The move initially disappointed GBP bulls, but sterling is holding above our 1.20 floor.An environment of monetary policy uncertainty, rising recession risks in response to high inflation, and the potential for central bank policy mistakes bodes well for safe-haven assets. In Europe, the market with the strongest defensive profile is Switzerland. In this report, we address whether investors should bet on continued appreciation of the franc and an outperformance of Swiss stocks, especially now that the SNB has turned hawkish.Switzerland Versus The WorldGlobal economic growth is slowing and a small/open economy like Switzerland’s has not been spared. The KOF economic barometer, a key leading indicator for Swiss GDP growth, has collapsed over the past twelve months from 144 to 97 as global industrial activity decelerated (Chart 2). Despite softening growth, global inflation refuses to decline, forcing central banks worldwide to lean into the slowdown. This threatens to cut the post-pandemic business cycle expansion short. Chart 2The SNB Is Tightening Into A Slowing Economy Surprisingly, the Swiss economy is generally performing better than the rest of Europe. Historically, Swiss economic performance is procyclical due to the large share of exports within its GDP. Hence, a slowdown in global manufacturing often creates a large threat to Swiss growth. Going forward, can the Swiss economy diverge from that of the rest of the world (Chart 3)? Such a divergence is not probable, but a few factors will protect the Swiss economy:Switzerland still has one of the lowest policy rates in the G10, even after today’s 50bps interest rate increase. This has tremendously helped ease monetary conditions. Our monetary gauge is at its most accommodative level in over two decades (Chart 4). Chart 3The Swiss Economy Is Procyclical Chart 4Swiss Monetary Conditions Are Still Accommodative Swiss inflation remains the lowest in the G10 outside Japan. In Switzerland, the main driver of price increases has been goods, while services inflation remains subdued. Consequently, the SNB has been tolerating an appreciating franc to temper imported inflation (Chart 5), while keeping domestic borrowing costs at very accommodative levels. In its updated forecasts, the SNB now expects a -0.25% interest rate to allow Swiss inflation to moderate to 1.9% in 2023 and 1.6% in 2024. Chart 5Swiss Inflation Is Surprising To The Upside Part of the reason Switzerland has low inflation has been the tremendous productivity gains, especially relative to its trading partners (Chart 6). Swiss income-per-capita is elevated, but wage growth has lagged output gains, which limits the risk of a wage-inflation spiral. It is notable that part-time employment continues to dominate job gains, implying that the need for precautionary savings will remain high in Switzerland. Chart 6A Productivity Profile For Switzerland Higher productivity growth and the elevated national savings leave their footprint on the trade data. The Swiss trade balance is hitting fresh highs, unlike Europe or Japan (Chart 7). This could potentially create a problem for the Swiss economy as it puts upward pressure on the CHF at a time when global manufacturing output is slowing. However, Switzerland specializes in high value-added exports with an elevated degree of complexity, that stand early in global supply chains. These type of goods are likely to remain in high demand in a global environment marked by supply-chain bottlenecks and high-capacity utilization. Chart 7Structural Tailwinds For The Franc Finally, Switzerland does not import energy to fulfill its electricity production. Hydropower accounts for roughly 61.4% of electricity generation, followed by nuclear power at 28.5%. This has partially insulated Switzerland from the energy shock hurting economic activity and trade balances in the EU. For example, German electricity generation is 28.8% coal and 14.7% natural gas.Bottom Line: The Swiss economy is reopening and is relatively insulated from the Russia-Ukraine conflict. This limits to some degree how closely Switzerland will track the global and European economic slowdown. It creates a departure from the traditional pro-cyclicality of the Swiss economy.The SNB, The SARON Curve, And The Swiss FrancIf the Swiss economy surprises to the upside, the case for the SNB to tolerate a rising franc becomes even stronger. The pace of foreign exchange reserve accumulation is already decelerating (Chart 8). Governor Thomas Jordan has been very clear: as global prices rise, the fair value of the franc is also rising, which implies a willingness to tolerate currency strength. In a purchasing power parity framework, higher external inflation makes Swiss goods relatively cheaper. This allows foreigners to bid up the currency.Even with today’s updated pricing, the SNB is still expected to remain among the most dovish central banks in the G10 (Chart 9). If inflationary pressures prove sticky, the SNB will step up its hawkish rhetoric. If inflationary fears subside, then global rates will fall as well, which has usually been a boon for the franc. More specifically, this would be negative for the EUR/CHF cross (Chart 10). Chart 8Less Intervention By The SNB Chart 9The SARON Curve Has Adjusted Higher Chart 10EUR/CHF And Bund Yields Can Continue To Diverge The Swiss economy can tolerate an appreciating CHF, but can it withstand higher interest rates? We believe so. Switzerland is a net creditor nation, but its domestic non-financial debt is also extremely elevated. Thus, the Swiss economy is vulnerable to higher rates, especially the housing market (Chart 11). Nonetheless, internal adjustments will soften the blow and increase affordability. Of note, property speculation in Switzerland has decreased in response to macroprudential measures. Growth in rental housing prices, which usually constitute the bulk of investment homes, has collapsed, but the price of owner-occupied homes has proven more robust (Chart 12). A cap on the percentage of secondary homes in any Canton as well as tighter lending standards have also helped. In a renewed update to its Financial Stability Report, Fritz Zurbrügg, Vice Chairman of the Governing Board, suggests that Swiss banks are well capitalized, especially given the recent reactivation of the countercyclical capital buffer. Chart 11Higher Rates Are A Risk For Swiss Real Estate Chart 12Some Adjustment Already In Investment Home Prices In the very near term, demographics might also be a tailwind. The pandemic limited immigration to Switzerland, but the working-age population is rebounding anew (Chart 13), which will create a cushion under housing and support domestic demand. Chart 13A Small Demographic Tailwind For Home Prices Stronger aggregate demand in an inflationary world will justify the need for less monetary accommodation. In a nutshell, the SNB is likely to continue walking the path of “least regrets” like most central banks, by tightening monetary policy to meet its 2% inflation mandate, but pausing if economic conditions warrant.The currency has historically been used as a key tool for calibrating financial conditions. From a fundamental perspective, our PPP models suggest the franc is quite cheap versus the dollar but at fair value versus the euro and sterling. This is echoed by Governor Jordan, who no longer views the franc as expensive. Our models adjusts the consumption basket in Switzerland for an apples-to-apples comparison across both the UK and the eurozone (Chart 14). Chart 14AA CHF Is At Fair Value Versus The EUR And GBP Chart 14BA CHF Is At Fair Value Versus The EUR And GBP Finally, hedging costs for shorting the franc against the dollar have risen substantially (Chart 15). As such, any short bets on the franc are likely being placed naked. If the Fed ends up tempering its pace of rate hikes next year in response to weaker US activity, short-covering activity is likely to accentuate any pre-existing strength in the CHF. Chart 15Hedging Costs For USD/CHF Carry Trades Have Risen Hedging Costs Are Prohibitive Bottom Line: The franc is undervalued against the dollar, and a good hedge against a rise in volatility versus other procyclical currencies. This places the franc in a good “heads I win, tails I don’t loose too much” bet. Swiss interest rates are also likely to climb higher. However, because the franc will do the bulk of the monetary tightening, the SNB is likely to lag the expectations now embedded in the SARON curve.What About Swiss Equities?Despite the cyclical nature of the Swiss economy, Swiss equities are extremely defensive. Swiss stocks have little to do with the domestic economy and are mostly a collection of large multinationals, dominated by the healthcare and consumer staples sectors, which together account for roughly 60% of the Swiss MSCI benchmark.This defensive attribute has created its own problem for Swiss equities. Relative to the Eurozone, the Swiss market has moved massively ahead of profitability, and it is now more expensive than at the apex of the European debt crisis in 2012 (Chart 16). Moreover, the jump in German yields is becoming increasingly problematic for Swiss stocks that historically perform poorly when global interest rates are rising (Chart 17). Chart 16Swiss Stocks Are Expensive Chart 17A Lost Tailwind In the near term, Swiss equities will only be able to defy the gravitational pull created by demanding valuations and higher yields if global risk aversion remains elevated. However, once global stocks find a floor and Italian spreads begin to narrow, Swiss stocks are likely to underperform massively (Chart 18). It could take a few more weeks before the BTP/Bund spreads narrow as the recent ECB announcement was rather tepid. However, the ECB holding an emergency meeting and issuing a formal statement addressing the problem facing peripheral bond markets suggests that a formal program designed to manage fragmentation risk will emerge before the end of the summer.Beyond their defensive attributes, Swiss stocks also correlate to the Quality Factor. The robust performance of this factor since the turn of the millennium, in Europe and globally, has allowed the Swiss market to greatly outperform Eurozone equities (Chart 19). However, the Quality Factor has begun to underperform, which indicates that the Swiss market is losing another of its underpinnings. Chart 18Near-term, Follow Risk Aversion Chart 19Swiss Stocks Are About Quality These observations imply that over the next 12 to 18 months, Swiss equities will underperform their Euro Area counterparts. Materials and consumer staples stand out as the two sectors with the most extended valuations relative to their Euro Area competitors, especially since their relative performances have become dissociated from relative profits (Chart 20). They should carry maximum underweights relative to their European counterparts. The healthcare sector is Switzerland’s largest market weight. It is not as expensive relative to the Eurozone as the materials and consumer staples sectors, but it carries enough of a premium that investors should still underweight this sector relative to its eurozone competitor (Chart 21). Chart 20Dangerous Setup For Swiss Materials and Staples Chart 21The Swiss Heavyweight Is Becoming Pricey Bottom Line: The defensive nature of the Swiss market has allowed for a large outperformance over European equities. However, the Swiss market is now very expensive on a relative basis, and it is vulnerable to higher interest rates. While global risk aversion can still buoy the Swiss market in the near term, conditions are falling into place for Swiss stocks to underperform their Eurozone counterpart over a 12-to-18 month window. Materials and consumer staples are the sectors mostly likely to experience a large underperformance relative to their Euro Area competitors, followed by the healthcare sector. Investment ConclusionsVolatility in FX markets is likely to remain elevated, as witnessed by the reaction of a full circle of central bank meetings this week.Policy convergence remains a good bet for interest rate curves and currency pairs. The SNB surprised markets by raising interest rates by 50 bps, to -0.25%, the first hike since 2007 (Chart 1).Higher volatility will continue to buoy the Swiss franc in the short run.Structural appreciation in the franc is also likely over the coming decades.Swiss stocks often perform well during economic downturns, but they are not particularly cheap, and vulnerable to higher interest rates. Investors should only overweight Swiss stocks if they expect more significant downside to global stocks.Valuation favors the franc versus the dollar. However, EUR/CHF and GBP/CHF are closer to fair value. CHF/JPY is expensive; hence the yen is a better hedge for downside economic surprises. Go short CHF/JPY as a trade.BCA’s Foreign Exchange Strategy was short CHF/SEK at 10.2 with stop loss at 10.5. That stop was hit overnight, triggering a loss of -3.3%. Stand aside for now. Chester NtoniforForeign Exchange Strategistchestern@bcaresearch.comMathieu Savary Chief European StrategistMathieu@bcaresearch.com
Executive Summary Was FAANGM A Bubble? US inflation has become broad-based, and the labor market is very tight. Wages are a lagging variable, and they will be rising rapidly in the coming months, even as the economy slows. Although US growth will be slowing and global trade will be contracting, the Fed will remain hawkish over the coming months. This is an unprecedented environment and is negative for global and EM risk assets. The US trade-weighted dollar will continue to appreciate as long as the Fed sounds and acts in a hawkish manner and global trade contracts. Consistent with a US dollar overshoot, EM financial markets will undershoot. Even though EM equity and local bond valuations have become attractive, their fundamentals are still negative. A buying opportunity in EM will occur when the Fed makes a dovish pivot and China stimulates more aggressively. We reckon that these conditions will fall into place sometime in H2 this year. Bottom Line: For now, we recommend that investors stay defensive in absolute terms and underweight EM within global equity and credit portfolios. The dollar has more upside in the near term but a major buying opportunity in EM local currency bonds is approaching. Feature Last week, after a two and a half year hiatus, I travelled to Europe to visit clients. I also took the opportunity catch up with Ms. Mea, a global portfolio manager and a long-standing client. Prior to the pandemic, we met regularly to discuss global macro and financial markets. She was happy to resume our in-person meetings, and we met in Amsterdam over dinner last Friday. This report provides the key points of our conversation for the benefit of all clients. Ms. Mea: I am very happy that we are again able to meet in person. Video meetings are good, but in-person meetings are better. One’s body language often gives away their level of confidence regarding investment recommendations. Answer: Agreed. My meetings with clients this week have reminded me of the value of in-person meetings. Chart 1Our Calls On Various EM Asset Classes Ms. Mea: Before our meeting I reviewed the evolution of your investment views since the pandemic erupted. Let me try to summarize them, and correct me if I miss something. Even though you upgraded your medium-term view on Chinese growth in May 2020 due to the stimulus, you remained skeptical of the rally in global risk assets. In Q2 2020, you upgraded your stance on EM bonds and in July 2020 you lifted the recommended allocation to EM equities and currencies from underweight to neutral (Chart 1). In the summer and fall of 2020, you were still wary of a deflationary relapse in developed economies. However, since January 2021, your outlook for the US shifted drastically to overheating and inflation. Since then, you have been very vocal about inflation risks in the US. At the same time, you have been warning about a major slowdown in Chinese growth. Regarding financial markets, in March 2021, you downgraded EM stocks and bonds to underweight and recommended shorting select EM currencies versus the US dollar (Chart 1). I should say that your call on US inflation and China’s slowdown have played out very well over the past 18 months. Let’s zero in on US inflation. It was just last year that many investors and analysts claimed that inflation is good for stocks because it helps their top line growth. Why then have global markets panicked? Chart 2Record Wealth Destruction In US Stocks And Bonds Answer: Not many people have a deep understanding of inflation and its impact on financial markets because most investors lack experience in navigating financial markets during an inflation era. In fact, the US equity and bond market selloffs of the past 12 months have wiped out about $12 trillion and $3.5 trillion off their respective market value. This adds up to a combined $15.5 trillion or about 60% of US GDP and already exceeds the wipeouts during the March 2020 crash and all other bear markets (Chart 2). The way we think about macro and markets must change in an inflation regime. In our seminal February 25, 2021 Special Report titled A Paradigm Shift In The Stock-Bond Relationship, we made the case that the US economy and its financial markets were about to enter a new paradigm of higher inflation. We argued that US core CPI would spike well above 2% and US share prices and US government bond yields would become negatively correlated. A similar paradigm shift occurred in 1966 (Chart 3). In short, we argued that the era of low US inflation was over, and as a result, equities and bonds would selloff simultaneously. This will remain the roadmap for investors as long as core inflation is high. Chart 3A Paradigm Shift: US Stock Prices And Bond Yields Correlation Over Decades Ms. Mea: Do you think the Fed is behind the curve? Answer: Yes, the Fed has fallen behind the curve, and, as we have repeatedly argued over the past 12 months, the US inflation genie is out of the bottle. There is a lot of confusion in the global investment community about how we should think about inflation, and about how and when the various measures of inflation matter. As consumers, we care about headline inflation because it affects our purchasing power. So, changes in all goods and service prices, including energy and food, matter to consumers. However, this does not mean that central banks should target and set policy based on headline inflation. Rather, central banks should target genuine broad-based inflation in the economy before it becomes entrenched. Ms. Mea: Can you explain why in certain cases a surge in energy, food and other prices leads to entrenched inflation but in other cases it does not? Answer: Let me give you an example. When consumers experience rapidly rising food and energy prices, they will likely demand faster wage growth from their employers. If businesses are enjoying strong demand for their goods/services and facing a tight labor market, they might have little choice but to agree to pay raises to sustain their business. Companies will then attempt to protect their profit margins by hiking their selling prices. Households may accept higher prices given their incomes are rising. This dynamic could cause inflation to become broad-based and entrenched. In this case, central banks should lift rates to slow the economy materially and cool off the labor market to end the wage-price spiral. If employees fail to negotiate hefty pay raises, odds are that inflation will not become broad-based. The more households spend on energy and food, the less income they will have to spend on other items, causing their discretionary spending to contract. In this case, there is no rush for central banks to tighten policy. If monetary authorities tighten materially, the economy will experience a full-fledged recession. In short, wage dynamics will determine whether inflation becomes broad-based. Labor market conditions will ultimately dictate this outcome. Ms. Mea: But why are wages more important than the price of fuel or food in determining whether inflation becomes broad-based? Answer: To be technically correct, unit labor costs, not wages, are key to inflation dynamics. Unit labor cost = (wage per hour) / (productivity). Productivity is output per hour. Given that labor is the largest cost component of US businesses, unit labor costs will swell and profit margins will shrink when salaries rise faster than productivity. CEOs and business owners always do their best to protect the their profit margins. Thus, accelerating unit labor costs will lead them to raise their selling prices. In the wake of wage gains, consumers might accept higher goods and service prices. If they do and go on to demand even higher wages, the economy will enter a wage-price spiral. This is why wage costs, more specifically unit labor costs, are the most important variable to monitor. If high energy and food prices lead employees to demand faster wage growth from their employers, and if they are granted wage increases above and beyond their productivity advances, inflation will become more broad-based and genuine. If consumers push back against higher prices, i.e., reduce their spending, corporate profits will plunge, and companies will freeze investment and lay off employees. Wages will slow and inflation will wane. Ms. Mea: Are all economies currently experiencing a wage-price spiral? Answer: The US and some other countries have been experiencing a wage-price spiral over the past 12 months. In other countries, including many developing economies, a wage-price spiral is currently absent. In the US, labor demand exceeds supply by the widest margin since 1950 (Chart 4). The upshot is that wages will continue to rise in response to persistently high inflation (Chart 5). Chart 4US Labor Demand Is Exceeding Labor Supply By The Widest Margin Since 1950 Chart 5US Wage Growth Is Already Very High Wages in the US are currently rising at a rate of 6-6.5% or so. US productivity growth is around 1.5%. As a result, unit labor costs are rising at a 4.5-5% annual rate, the fastest rate for corporate America in the past 40 years (Chart 6). As Chart 6 demonstrates, unit labor costs have been instrumental in defining core CPI fluctuations over the past 70 years in the US. Chart 6US Unit Labor Costs Are Rising At The Fastest Rate Since 1982 Chart 7US Core Of Core Inflation Is High And Not Falling In short, both surging unit labor costs and the acceleration of super core CPI measures like trimmed-mean CPI and median CPI suggest that US inflation has become broad-based and a wage-inflation spiral has taken hold in the US (Chart 7). Critically, wages are a lagging variable and are not reset all at once for all employees. American employees will continue to demand substantial wage hikes both to offset the last 12 months of lost purchasing power and to protect their purchasing power for the next 12 months. Hence, we will be witnessing faster wage growth in the coming months even as the economy slows. For many continental European economies and for several EM economies, wage growth is still weak. Chart 8 illustrates that nominal wage growth in India, Indonesia, China and Mexico are very subdued. Sluggish wage gains in emerging economies are consistent with the profile of their domestic demand. Domestic demand in these large developing economies remains extremely weak. In many cases, the level of domestic demand in real terms is still below its pre-pandemic level (Chart 9). Chart 8EM Wages Are Very Tame Chart 9EM Domestic Demand Is Depressed In China, deflation, rather than inflation, is the main economic threat. Headline and core inflation are within a 1-2% range (Chart 10), domestic demand is very weak, and the unemployment rate has risen in the past 12 months. Chart 10China's Inflation Is Subdued Ms. Mea: Do you expect the US economy to contract? Answer: US growth will decelerate substantially, and certain segments of the economy could shrink for a couple of quarters. My expectation is that US corporate profits will contract materially. Slowing top line growth, narrowing profit margins, shrinking global trade and a strong dollar are all major headwinds for the S&P 500 EPS. EM EPS are also heading towards a major contraction. This is why I view EM fundamentals as negative even though EM valuations have become attractive. Ms. Mea: You have recently written that global trade volumes are about to contract. What is your rationale and is there any evidence that this is already happening? Answer: US and EU demand for consumer goods ex-autos has been booming over the past two years. Households have overspent on goods ex-autos (Chart 11). Given that their disposable income is contracting in real terms and a preference to spend on services, households will markedly curtail their purchases of consumer goods in the coming months. This will hurt global manufacturing in general, and emerging Asia in particular. Some forward-looking indicators are already signaling a contraction in global trade: US retail inventories (in real terms) have swelled (Chart 12, top panel). US retailers will dramatically reduce their orders. Chart 11Global Trade Volumes Will Shrink In H2 2022 Chart 12US Import Volumes Are Set To Contract Besides, US railroad carload is already shrinking, signaling reduced goods shipments (Chart 12, bottom panel). Taiwanese shipments to China lead global trade and they point to an impending slump (Chart 13, top panel). Also, the Taiwanese manufacturing shipments-to-inventory ratio has dropped below 1 (Chart 13, bottom panel). Finally, industrial metal prices are breaking down despite easing lockdowns in China and continued sanctions on Russia (Chart 14). This is a sign of downshifting global manufacturing. Chart 13A Red Flag For Global Trade Chart 14Industrial Metal Prices Are Breaking Down Ms. Mea: Won’t a global trade contraction push down goods prices and help US inflation? Answer: Correct, it will bring down US goods inflation but not services inflation. Importantly, as we discussed above, US inflation has already spilled into wages and has become broad-based. Plus, it is hovering well above the Fed’s target. Hence, the Fed cannot dial down its hawkishness now, even if goods price inflation drops significantly. In brief, even though US growth will be slowing and global trade will be contracting over the coming months, the Fed is likely to remain hawkish. This is an unprecedented environment and is negative for global and EM risk assets. Ms. Mea: What are the financial market implications of entrenched inflation in the US and the lack of genuine inflationary pressures in many emerging economies? Answer: As long as the Fed sounds and acts in a hawkish manner and/or global trade contracts, the US trade-weighted dollar will continue to appreciate. The greenback is a countercyclical currency and rallies when global trade slumps. On the whole, the USD will likely overshoot in the near run. Consistent with a US dollar overshoot, EM financial markets will undershoot. Even though investor sentiment on EM equities and USD bonds is very low (Chart 15), a final capitulation selloff is still likely. In short, EM valuation and positioning are positive for future potential returns yet their fundamentals (business cycle, profits, return on capital, etc.) are still negative. A buying opportunity in EM will emerge when the Fed makes a dovish pivot, China stimulates more aggressively, and EM equity and bond valuations improve further. We reckon that these conditions will fall into place sometime in H2 this year. If the Fed turns dovish early without taming US inflation, it will fall behind the inflation curve and the US dollar will begin its bear market. Investors will respond by embracing EM financial assets. EM local currency bonds in particular offer value (Chart 16). Prudent macro policies and the lack of wage pressures entail a good medium-to-long term opportunity in EM local currency bonds. Chart 15Investor Sentiment On EM Stocks And USD Bonds Is Low Chart 16US TIPS Yields Should Roll Over For EM Local Bond Yields To Decline As EM currencies put in a bottom, local yields will come down. This will help their equity markets. Ms. Mea: Speaking of a capitulation selloff, how far can it go? Both for EM stocks as well as the S&P 500? Chart 17S&P500: Where Is Technical Support Line? Answer: As long as US bond yields and oil prices do not start falling on a consistent basis, the S&P 500 will remain under selling pressure. Technicals can help us gauge the likely magnitude of the move. The S&P 500 has dropped to a major technical support, but it will likely be broken. The next support is around 3100-3200 (Chart 17). The EM equity index is sitting on a technical support now (Chart 18). The next support level is 15-17% below the current one. Chart 18EM Stocks in USD Terms Could Drop Another 15% Critically, US equity investors should also consider whether the US equity bull market that has been in place since 2009 is over. If it is, then the S&P 500 bear market could last long, and prices could drop significantly. Chart 19Was FAANGM A Bubble? A few observations that investors should keep in mind: First, over the past 12 years, FAANGM stocks have followed the profile of the Nasdaq 100 (Chart 19). In short, FAANGM stocks have risen as much as the Nasdaq 100 index did in the 1990s. Second, when retail investors rush into an asset class, it often signals the final phase of the bull market. Once the bull market ends, the ensuing bear market is vicious. The behavior of tech/internet stocks and the broader S&P 500 fits this profile extremely well. For several years after the Lehman crash, individual investors were hesitant to buy US stocks. However, the resilience of US equities led to a buy the dip mentality in 2019-20. Retail investors joined the equity party en masse in early 2020. The post retail frenzy hangover is usually very painful and prolonged. Based on this roadmap, it seems that the 2020-21 retail-driven rally was the final upleg in the S&P 500 bull market. By extension, we have entered a bear market that could be vicious and extended. All the excesses of the 10-year FAANGM and S&P500 bull markets will need to be worked out before a new bull market emerges. Finally, a high inflation regime raises the bar for the Fed to rescue the stock market. This also entails lower equity multiples than we have in the S&P500 now. Ms. Mea: What do you make of EM’s recent outperformance versus DM stocks? When will you upgrade EM versus DM? Answer: Indeed, EM stocks have recently outperformed DM stocks. We might be witnessing a major transition in global equity market leadership. We have held for some time that an equity leadership change from the US to the rest of the world and from TMT stocks to other segments of the global equity market would likely take place during or following a major market selloff. The ongoing equity bear market seems to be exactly that catalyst. Chart 20For EM Equities To Outperform, USD Needs To Weaken If the S&P 500 bull market is over, the global equity leadership will also change away from US and TMT stocks to other stock markets and sectors. That said, to upgrade EM stocks, we need to change our view on the USD because EM relative equity performance versus DM closely tracks the inverted trade-weighted US dollar (Chart 20). In the near term, we believe the greenback has more upside potential. In particular, Asian currencies and equity markets cannot outperform when the Fed is hawkish and global trade is contracting. Latin American currencies have benefited since early this year from the spike in commodity prices. However, worries about a US recession, a strong dollar and a lack of strong recovery in the Chinese economy will push industrial metal prices lower. As shown in Chart 14 above, industrial metal prices are breaking down. This is a bad omen for Latin American markets. On the whole, we will likely be upgrading EM versus DM later this year. For now, we recommend that investors stay defensive and underweight EM within global equity and credit portfolios. We also continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN, PHP and IDR; as well as HUF vs. CZK, and KRW vs. JPY. A major buying opportunity in local currency bonds is approaching. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com
Executive Summary Economic growth is now a casualty, and not a driver, of monetary policy choices. Inflation is dictating where central banks are taking interest rates. Our baseline view remains that core US inflation will cool by enough on its own without the need for the Fed to deliver a policy-induced recession. However, the odds of the latter have increased after the upside surprise in the May US CPI report. The ECB has been dragged into the same morass as other major central banks – tightening policy because of soaring inflation, despite broad-based signs of sluggish economic growth. We still see the pricing of cumulative rate hikes in the euro area as being too aggressive, even after last week’s clear announcement from the ECB that a string of future rate hikes was coming. With the ECB also announcing an end to its QE program, but offering no details on a replacement, markets have been given the green light to push Italian yields/spreads higher (and the euro lower) until there is an ECB response to market fragmentation in European sovereign debt. Bottom Line: The Fed is still more likely than the ECB to follow through on rate hikes discounted in US and European interest rate curves - position for renewed widening of the Treasury-Bund spread. Italian bond yields will remain under upward pressure until the contours of an ECB plan to stabilize Peripheral Spreads alongside rate hikes are revealed – tactically position for a wider BTP-Bund spread. Central Bankers Cannot Worry About Growth … Or Your Investment Portfolio The US consumer price index (CPI) report for May was yet another bond-bearish shock in a year full of them. With US headline US inflation hitting an 41-year high of 8.6%, the Treasury market adjusted bond yields upward to reflect both higher inflation expectations and even more aggressive Fed tightening. Coming only a day after the June European Central Bank (ECB) meeting that provided guidance that a series of rate hikes would begin in July, that could include a 50bp hike at the September meeting, financial markets worldwide moved to price in the risk that policy-induced recessions were the only way to bring down soaring global inflation. The result: global bond yields soared to new highs for the year, while risk assets of all shapes and sizes were hammered. We have our doubts that today’s class of policymakers – especially the Fed - has the stomach to repeat the actions of former Fed Chair Paul Volcker, who famously pushed US interest rates above the double-digit inflation rates of the late 1970s to engineer a deep recession to crush inflation. The starting point of the current tightening cycle is even further behind the curve than during the Volcker era, in terms of “realized” real interest rates, with the 10-year US Treasury yield now over five percentage points below headline US CPI inflation (Chart 1). Related Report Global Fixed Income StrategyAssessing The Risks To Our Main Views Central bankers are now faced with the no-win scenario of pushing nominal policy rates higher to chase soaring inflation in a bid to maintain inflation fighting credibility, regardless of the spillover effects on financial market stability or economic growth expectations. More worryingly, the rate hikes needed to establish that credibility are not only becoming more frequent but larger. 50bps has become the “standard” size for developed market rate hikes. The Fed may have upped the ante with the 75bp hike at yesterday's FOMC meeting. Such is the reality of a funds rate still only at 1.75% but with US inflation pushing toward 9%. The timing of the latest hawkish shifts from the Fed, ECB and others is surprising, looking purely from a growth perspective. The OECD leading economic indicators for the US, euro area and China are slowing, alongside depressed consumer confidence and deteriorating business sentiment (Chart 2). Similar readings are evident in comparable measures in other major economies, both in developed and emerging economies. This would normally be the type of backdrop that would entice central banks to consider easing monetary policy - IF inflation was subdued, which is clearly not the case today. Chart 1Does Powell Need To Channel His Inner Volcker? In fact, high inflation is the reason why economic sentiment has worsened. Chart 2Worrying Signs For Global Growth Consumers see income growth that is lagging inflation, especially for everyday items like gasoline and food. Businesses are seeing input costs rising, especially for labor in an environment of tight job markets. Inflation has become broad-based, across goods, services and wages. This is true for countries that are more advanced in their monetary tightening cycles - the US, Canada and the UK - where inflation rates are remarkably similar (Chart 3). But it is also now true in countries with lower (but still accelerating) inflation rates and where central banks have been slower to tighten monetary conditions, like the euro area and Australia (Chart 4). Chart 3Inflation Turning More 'Domestic' (Services / Wages) Here Chart 4Still No Major Services/Wage Inflation Overshoots Here For the Fed, assessing the underlying momentum of US inflation, and setting monetary policy accordingly, has become a bit trickier. While headline inflation continues to accelerate in response to rising energy and food prices, core inflation ticked lower in both April and May and now sits at 6.1%, down from 6.5% in March. Longer-term survey-based measures of inflation expectations have been moving steadily higher, with the University of Michigan 5-10 year consumer inflation expectations survey now up to a 14-year high of 3.3% (Chart 5). Yet longer-term market-based inflation expectations have been more stable, with the 10-year TIPS breakeven now at 2.66%, down from the late April peak of 3.02%. There are also some mixed signals visible within the US inflation data. Core goods CPI inflation clocked in at 8.5% in May, down from the recent peak of 12.4% in February 2022, while core services CPI inflation accelerated to a 14-year high of 5.2% in May (Chart 6). A similar divergence can be seen when looking at the Atlanta Fed’s measures of “sticky” and “flexible” price inflation. Core flexible CPI inflation – measuring prices that adjust more rapidly – has fallen from a peak of 19% to 12.3% in May. At the same time, core sticky CPI inflation for prices that are slower to adjust sped up to an 31-year high of 5% in May. Chart 5Some Mixed Inflation Messages For The Fed Chart 6US Inflation Will Eventually Be Lower, But 'Stickier' Chart 7Stick With UST-Bund Spread Widening Trades In terms of the Fed’s next policy moves, the acceleration of core services (and sticky) inflation means underlying inflation momentum remains strong enough to make it difficult for the Fed to tighten by less than markets are discounting over the next year. Yet the deceleration of core goods (and flexible) inflation, if it continues, can lead to an eventual peak in overall US inflation. This would ease pressure on the Fed to tighten policy more aggressively than markets are expecting to slam the brakes on US economic growth. For nervous markets worried about Fed-induced recession risks, the clear peak in US inflation that we had been expecting has likely been pushed out further into the latter half of 2022. Thus, a significant fall in US Treasury yields that would provide relief to stressed risk assets is unlikely in the near term. Our preferred way to play that upward pressure on US Treasury yields is through an underweight stance on US Treasuries in global bond portfolios, rather than a below-benchmark duration stance. That is particularly true versus German Bunds - the 10-year UST-Bund yield spread is now well below the fair value level from our fundamental valuation model (Chart 7). Bottom Line: It is not clear that the Fed needs to “pull a Volcker” and generate a policy-induced recession to cool off US inflation. However, the Fed is far more likely to hike rates in line with market expectations than the ECB over the next 6-12 months. Stay underweight US Treasuries versus core Europe in global bond portfolios. The ECB Takes The Patient Off Life Support The ECB is finally coming to grips with surging European inflation. At last week’s policy meeting, the ECB Governing Council voted to end new bond buying via the Asset Purchase Program, while also signaling that a 25bp rate hike was on the way in July, with more hikes to follow – perhaps as much as 50bps in September if inflation remains elevated. Chart 8Markets Pricing In A Highly Aggressive ECB The central bank provided a new set of quarterly economic projections that, unsurprisingly, included significant upward revisions to the inflation forecasts. The 2022 headline HICP inflation forecast was bumped from 5.1% to 6.8%, the 2023 forecast from 2.1% to 3.5% and the 2024 forecast was nudged higher from 1.9% to 2.1%. The projections for core HICP inflation were also increased to 3.3% for 2022, 2.8% for 2023 and 2.3% for 2024. The central bank now expects euro area inflation to stay above its 2% inflation target throughout its forecast period – even with a 20% decline in oil prices, and 36% fall in natural gas prices, built into the projection between 2022 and 2024. A move towards tighter monetary policy has been heralded by our ECB Monitor, which remains elevated largely due to its inflation component (Chart 8). By contrast, the growth component of the Monitor has rolled over and is now at levels consistent with unchanged monetary policy. Yet in the current environment of very elevated inflation, concerns about the economy are taking a back seat to maintaining the ECB’s inflation-fighting credibility. In the relatively young history of the ECB, dating back to the inception of the euro in 1998, there have only been three true hiking cycles that involved multiple interest rate increases: 2000, 2006-08 and 2011. In each case, both growth and inflation were accelerating in a broad-based way across the majority of euro area countries. Today, inflation is surging, with the headline HICP inflation rate hitting 8.1% in May, while core inflation (ex energy and food) is a more subdued but still high 4.4%. Economic growth is decelerating, however, with leading economic indicators now slowing in a majority of euro area countries (Chart 9). Chart 9Coming Up: An Unusual ECB Tightening Cycle That Ignores Growth The ECB’s updated economic growth forecasts were downgraded for this year and next, with real GDP growth now expected to reach 2.8% in 2022 and 2.1% in both 2023 and 2024. Cutting growth forecasts for the current year was inevitable given the uncertainties stemming from the Ukraine war and soaring European energy prices. However, the projected growth rates do seem optimistic in the face of deeply depressed readings on economic sentiment from reliable measures like the ZEW index or the European Commission consumer confidence index, both of which have fallen sharply to levels last seen during the 2020 pandemic shock (Chart 10). Demand for European exports is also sluggish, particularly exports to China which are now flat in year-over-year terms. A similar pattern can be seen in the ECB’s inflation forecasts, which seem too optimistic in projecting lower wage growth and core inflation through 2024, even with the euro area unemployment rate forecasted to stay below 7% - under the OECD’s full employment estimate of 7.7% over the same period (Chart 11). Chart 10Overly Optimistic ECB Growth Forecasts Chart 11Overly Optimistic ECB Inflation Forecasts? The ECB is facing the same communications problem as other central banks at the moment. There is a fear of forecasting a major growth slowdown that would scare financial markets, even though that is a necessary condition to help bring down elevated inflation. At the same time, projections of a big decline in inflation that would limit the need for economy-crushing monetary tightening are not credible in the current environment of historically elevated headline inflation with very low unemployment rates. Interest rate markets understand the bind that the ECB finds itself in, and have moved to price in a very rapid jump in policy rates over the next 1-2 years. The 1-month OIS rate, 2-years forward is now at 2.5%, a high level compared to estimates of the neutral ECB policy rate, which lies between 1-1.5%. Core European bond yields have moved up alongside those rising rate expectations, with the 10-year German bund yield now at 1.64%, a far cry from the -0.18% yield at the start of 2022. Additional German yield increases will prove to be more difficult in the months ahead. There has already been a major upward adjustment in the inflation expectations component of yields, with the 10-year euro CPI swap rate now up to 2.6% compared to 2% at the start of this year (Chart 12). Importantly, those inflation expectations have stabilized of late, even in the face of high oil prices. Meanwhile, real bond yields, while still negative, have also moved up substantially and are now back to levels that prevailed before the ECB introduced negative policy rates in 2014 (bottom panel). With so much bond-bearish news now priced into core European bond yields, additional yield increases from here would require a more fundamental driver – an upward repricing of terminal interest rate expectations. On that note, the German yield curve is signaling that the terminal rate in the euro area is not much above 1.75%, as that is where bond yield forwards have converged to for both long and short maturity bonds (Chart 13). Chart 12How Much Higher Can Bund Yields Realistically Go? Chart 13Markets Signaling A 1.75% Terminal Rate Given our view that the neutral rate in Europe is, at best, no more than 1.5%, ECB rate hikes much beyond that level would likely invert a Bund curve that is priced for only a 1.75% terminal rate. An inverted Bund curve would also raise the odds that Europe enters a policy-induced recession – turning a bond bearish outcome into a bond bullish one. Even with the relatively aggressive policy expectations priced into European bond yields, it is still too soon to raise European duration exposure with inflation still accelerating. We prefer maintaining a neutral duration stance until there is a clear peak in realized European inflation – an outcome that would also favor a shift into Bund curve steepeners as the markets price out rate hikes and, potentially, begin to discount future rate cuts. Does The ECB Even Have A Plan For Italian Debt? The ECB seems to have a clear near-term plan on the timing, and even the potential size, of rate hikes. There is far less clarity on how it will deal with stabilizing sovereign bond yields post-APP in the countries that benefitted from ECB asset purchases, most notably Italy. By offering no details on a replacement to APP buying of riskier European debt at last week’s policy meeting, markets were given the green light to test the ECB’s resolve by pushing Italian bond yields higher (and the euro lower). Volatility in both markets will continue until there is a credible ECB response to so-called “market fragmentation” in European sovereign debt (i.e. higher yields and wider spreads versus Bunds in the Periphery). With the benchmark 10-year Italian BTP yield pushing above 4%, the ECB tried to calm markets yesterday by announcing an emergency meeting of the Governing Council to discuss “anti-fragmentation” policy options. The announcement triggered a relief rally in BTP prices, likely fueled by short covering. But the ECB statement was again light on concrete details, only noting that: a) reinvestments from maturing bonds from the now-completed Pandemic Emergency Purchase Program (PEPP) could be used “flexibly” to support stressed parts of the European bond market b) the timeline for ECB researchers to prepare proposals for a “new anti-fragmentation instrument” would be accelerated. We expect the ECB to eventually produce a credible bond buying plan to support Peripheral European bond markets – but only after an “iterative” trial-and-error process where trial balloon proposals are floated and skeptical financial markets respond. Chart 14Stay Cautious On Italian Government Bonds There is almost certainly some serious horse trading going on within the ECB Governing Council, with inflation hawks demanding more rate hikes in exchange for their support of new plans to deal with market fragmentation. Details such as the size of any new program, the conditions under which it would be activated, and country purchase limits (if any) will need to be ironed out. Internal ECB debates will prolong that trial-and-error process with financial markets, keeping yield/spread/FX volatility elevated in the short-term. On a strategic (6-18 month) time horizon, we see a neutral allocation to Italy in global bond portfolios as appropriate, given the tradeoff between increasingly attractive yields and the uncertain timing of effective ECB market stabilization proposals. On a more tactical horizon (0-6 months), we expect Italian yields and spreads versus Germany to remain under upward pressure until a viable anti-fragmentation program is announced (Chart 14). To play for that move, we are introducing a new position in our Tactical Overlay Trade portfolio, selling 10-year Italy futures and buying 10-year German Bund futures. The details of the new trade, including the specific futures contracts and weightings for the two legs of the trade to make it duration-neutral, can be found in the Tactical Trade table on page 18. As we monitor and discuss this trade in future reports, we will refer to the well-followed 10-year Italy-Germany spread (currently 225bps) to determine targets and stop levels of this bond futures spread trade. We are setting a stop-out on this trade if the 10-year Italy-Germany spread has a one-day close below 200bps, while targeting a potential widening to 275-300bps (the 2018 peak in that spread). Bottom Line: The ECB’s lack of conviction on designing a plan to support Peripheral bond markets during the upcoming period of interest rate hikes will keep upward pressure on Peripheral yields/spreads over the next few months. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com GFIS Model Bond Portfolio Recommended Positioning Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Tactical Overlay Trades
Executive Summary The recent pullback was all about a multiples contraction while strong earnings growth helped absorb the blow. With the multiple contraction phase complete, the S&P 500 performance is now all about earnings. Consensus still expects earnings to grow at 10% over the next 12 months, despite negative corporate guidance and a whole constellation of factors that present challenges to corporate profitability. We need to see downgrades or earnings will disappoint. Our brand-new model predicts that earnings growth will trend towards zero over the next three months. Earnings growth is a tug of war between rising input costs and corporate pricing power. There is a high likelihood of an earnings recession, even if an economic recession is unlikely over the next 12 months. Because growth is slowing not only in the US but also abroad. If an earnings recession does materialize, equities may have another leg down, perhaps another 5-8%. Earnings Growth Is A Tug Of War Between Rising Costs And Pricing Power Bottom Line: We forecast that earnings growth will undershoot consensus expectations and an earnings recession is likely. Since the multiples contraction phase of the bear market is likely over, equities performance will be dictated by earnings growth. In the short run, we expect equities to be range-bound, with rallies and pullbacks alternating. In case of an earnings recession, equities may fall another 5-8%. Feature Related Report US Equity StrategyMarginally Worse Ever since the Fed started hiking interest rates back in March, investors started worrying about the recession. The BCA house view is that a recession is unlikely over the next 12 months. However, to us, of even greater concern is the likelihood of an earnings disappointment or even an outright earnings recession. We believe that earnings growth will slow dramatically. We wrote back in October 2021 report, “Marginally Worse”, that margins will contract at the beginning of the year – indeed, this prediction materialized during the Q1-2022 earnings season (Chart 1). Shrinking profit margins are likely to translate into flat to negative real earnings growth over the next 12 months. However, economic and earnings growth expectations remain elevated. As our readers may recall from the “Have We Hit Rock Bottom?” and “Fat and Flat” reports, we believe that for the markets to begin to heal, growth expectations need to come down and a negative outlook needs to get priced in. Chart 1Margins Are Contracting In this week’s report, we take a close look at the S&P 500 earnings growth expectations and provide our own estimate based on a simple regression model. We will also discuss implications for the US equity market. Sneak Preview: We estimate that earnings growth will trend towards zero over the next three to six months, consistent with current trends in US economic growth, inflation, corporate pricing power, monetary conditions, and the strength of the USD. Sell-off Driven By Multiples Contraction, Not Earnings Growth This year’s sell-off has been triggered by fears of an aggressive Fed, tighter monetary policy, and rising rates. However, decomposition of the total return demonstrates that the pullback was all about multiples contraction, while strong earnings growth helped absorb the blow (Chart 2). A pertinent question is what happens to the market when earnings growth softens? One may wonder whether the bad news has already been priced in, as multiples tend to front-run growth. A case in point is strong market performance in 2020 on the back of multiples expansion in anticipation of a post-pandemic rebound in earnings growth (Chart 3). Chart 2Sell-off Was Driven By A Multiples Contraction Chart 3Multiples Lead Earnings With multiples down from 23x to 17x over the past two years, and the S&P 500 down by 19% from its January 2022 peak, arguably much of the upcoming earnings growth slowdown/contraction is priced in. Much but not all. The next chapter of the bear market will be driven by earnings growth. Earnings Growth Headwinds As we have pointed out on multiple occasions, it is confounding that, despite negative corporate guidance and a whole constellation of factors that present challenges to corporate profitability, earnings estimates for 2022 have been revised up (Chart 4) and stand at about 10% (Chart 5). However, at long last, upgrades are starting to moderate (Chart 6). We need to see downgrades. Chart 42022 Earnings Estimates Are Still Trending Up Chart 5Earnings Are Expected To Grow At 10% Chart 6Analysts Are No Longer Upgrading Chart 7Slowing Global Growth Has An Adverse Effect On The US Earnings Growth Since the beginning of 2022, there have been quite a few developments that will weigh on earnings growth: Slowing growth in the US and globally means sales growth is decelerating. This week, the World Bank downgraded global GDP growth from 4.1% to 2.9%. Global manufacturing PMI is also trending towards 50 (Chart 7). Consumer demand is weakening: Negative real wage growth saps consumers’ confidence and cuts into their purchasing power. Moreover, demand for goods is returning to the pre-pandemic trend, and retail sales, especially in real terms, are flagging (Chart 8). Demand for services remains strong, but the S&P 500 index is dominated by goods producers. Corporate pricing power is still strong but is showing signs of waning as many US consumers, distraught by the negative wage growth, are strapped for cash (Chart 9). Chart 8Retail Sales Are Contracting In Real Terms Chart 9Corporate Pricing Power Is Waning Prices of raw materials have soared and supply disruptions are exacerbated by lockdowns in China and the war in Ukraine. Companies’ COGS (Cost of Goods Sold) bills are skyrocketing. Nominal wage growth is 6% and is on the rise, affecting companies’ bottom lines. The dollar is strong: it has gained 15% since January 2021. This makes US goods more expensive and reduces companies’ earnings via the currency translation effect. These are the reasons why it is increasingly hard for companies to preserve margins and grow earnings – a commentary that we have heard repeatedly during earnings calls. According to Refinitiv, for Q2-2022, there have been 73 negative EPS preannouncements issued by S&P 500 corporations, compared to 42 positive EPS preannouncements (N/P=73/42=1.7). A year ago, in Q2-2021, the N/P ratio was 0.8, with more companies offering positive guidance. All of this points to weakening profitability. Refinitiv also estimates the earnings growth rate for the S&P 500 for Q2-2022 at 5.3%. If the energy sector is excluded, the growth rate declines to -1.9%. We believe growth will come to a halt or contract into the end of the year. We expect slower top-line growth and shrinking profit margins to translate into flat to negative real earnings growth over the next 12 months. Earnings Recessions Often Happen When The Economy Is Still Growing One may wonder if an earnings recession is even possible without an economic recession. In fact, that happened quite a lot in the past. Out of 27 earnings recessions since 1927, 11 did not coincide with economic recessions (Chart 10). Chart 10Earnings Recessions And Economic Recession Often Don't Coincide The S&P 500 does not mirror the US economy, with the former dominated by larger companies, many of which are multinationals and more exposed to global demand and the USD than the broad economy. Also, services and consumer spending constitute roughly 70% of the US economy, while the index overrepresents manufacturing, technology, and goods-producing companies. With the S&P 500 being global in nature, quite a few earnings recessions were triggered by events abroad: The 2016 earnings recession was caused by the devaluation of the Chinese yuan; in 2012, one was triggered by a post-GFC double-dip recession in Europe; and the 1998 one was triggered by an Asian financial crisis. It is also often the case that a profit recession is a harbinger of economic recession. Both the 2000 dot-com crash and GFC economic recessions were preceded by earnings recessions, one starting in December 2000, and the other in August 2007. The 2019 earnings recession was brief and came hand in hand with widespread fears of the end of the business cycle. Hence, we believe that a confluence of factors both at home and abroad, as discussed above, makes an earning recession a high probability event. There is a high likelihood of an earnings recession, even if an economic recession is unlikely over the next 12 months, because of slowing growth not only in the US but also abroad. Modeling Earnings Growth Since we are distrustful of the consensus of 10% expected eps growth, we have built our own simple earnings growth forecast model to gauge what earnings growth rate we may expect over the next quarter. The model has five factors, each of which has fundamental relevance to earnings growth (Table 1): Table 1EPS Growth Forecast Model ISM PMI is a gauge of US economic growth and a proxy for top-line growth. PPI stands for the change in input costs. Pricing Power is a BCA proprietary indicator and captures companies’ ability to pass costs onto their customers. HY Spreads indicate costs of borrowing and also the state of the economy (spreads tend to shoot up in a slowing economy). USD represents the ability of US multinationals to sell goods abroad. Roughly 35% of S&P 500 sales are outside the US. Each factor is calculated on a year-on-year percentage change basis, with a three-month lag to allow the effects of macroeconomic developments to get priced in. Adjusted R2 is 65%, which is a strong fit. All factors are statistically significant at the 1% level. The model forecasts that earnings growth will come down from 6% MoM as of April 2021 to 1.3% as of August 2022 (Chart 11). While this does not map directly to the “next 12 months” of eps growth, it does indicate that earnings growth is trending towards zero in nominal terms and will be outright negative in real terms. Further, while we are unable to predict earnings growth more than three months ahead, we do expect that it will reach zero and then shift into contraction territory into the balance of the year. Chart 11Model Predicts That Earnings Growth Will Be Flat Looking closer at the key drivers of growth (Chart 12), we observe that there is a tug of war between pricing power and rising costs (PPI), with earnings growth falling as pricing power starts to give away ground. The other factors that have an adverse effect on earnings growth are slowing growth (ISM PMI), an appreciating dollar, and rising borrowing costs (HY spreads). Chart 12Earnings Growth Is A Tug Of War Between Rising Costs And Pricing Power The model indicates that earnings growth is trending towards zero over the next three months. Price Target What does all of this mean for US equities? If the multiple contraction phase is complete, the S&P 500 performance is now all about earnings. If we expect earnings to grow only 0-3% in nominal terms, with the forward earnings multiple unchanged at roughly 18x, then the S&P 500 is likely to come down another couple of percentage points. If earnings contract 5%, the index may be down as much as 8%. If multiples contract another point to 17x and earnings contract by 5%, the market may be down as much as 15% (Table 2). Table 2The S&P 500 Target Scenario Analysis For now, we are sticking with our “fat and flat” thesis expecting the S&P 500 performance to continue to trend down as rallies and pullbacks alternate. Earnings growth slowdown/shallow contraction is likely to result in another leg down of roughly 5-8%. Investment Implications Street forward earnings growth expectations are too high at 10% and need to be downgraded. There are multiple reasons why earnings growth will be underwhelming, ranging from slowing growth abroad to weaker demand for goods and rising wages at home. We anticipate that earnings growth will be flat to negative into the balance of the year. The multiple contraction phase of the bear market is over, and now equities performance will be dictated by earnings growth. If an earnings recession does materialize, equities may have another leg down, perhaps another 5-8%. Bottom Line We forecast that earnings growth will undershoot consensus expectations and that an earnings recession is likely. Since the multiple contraction phase of the bear market is likely over, equity performance will be dictated by earnings growth. In the short run, we expect equities to trend down, with rallies and pullbacks alternating. In the case of an earnings recession, equities may fall another 5-8%. Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com Recommended Allocation Recommended Allocation: Addendum
Executive Summary Hiring is slowing and layoffs have begun to rise, but today's robust net increases in non-farm payrolls are inconsistent with an approaching recession. The demise of the American consumer has been greatly exaggerated. Households have lots of savings to spend and the capacity to borrow against them if they choose. The extensive forward guidance that the Fed has been at pains to provide to markets may have fueled a sharp preemptive tightening in financial conditions that might prove premature if it reduces the Fed's need to cool the economy itself. None of the three components of our simple recession indicator (the slope of the yield curve, the year-over-year change in the Leading Economic Index and our assessment of monetary policy settings) is sounding the alarm, or even flashing yellow. No Recession Warning In This Series Bottom Line: Although gloom is increasingly pervasive among investors, we remain constructive on risk assets and the economy over the next twelve months, and reiterate our recommendation to overweight equities in a balanced portfolio. Feature Per the mosaic theory of security analysis, analysts, portfolio managers and independent investors piece together fragments of publicly available information to form a thesis about a company’s prospects. After appraising the company’s securities based on that thesis, the analyst/PM/investor determines whether they’re overvalued, undervalued or fairly valued and takes the appropriate action in his/her portfolio. All market participants are in a race to be among the first to see the outline of the complete picture as the opportunities to exploit mispricings are inversely related to the available share of relevant data. Security fair values become more apparent as more bits of colored glass begin to circulate and alpha-seeking investors have to move on to the next mostly incomplete puzzle to find an edge. Related Report US Investment StrategyAll The Way To Ticker Symbols The same framework applies to macroeconomic analysis. It’s especially apt now, given the lack of a close precedent for the monetary and fiscal support policy makers lavished on the economy to protect it from COVID-19’s potential ravages and the way that data flows have refused to conform to a well-defined trend supported by a stable narrative theme. Macro data and news from individual companies are stuck in a one-step-forward, one-step-back pattern as embodied by stagnant stock indexes. The S&P 500 paced the same 100-point path between 4,075 and 4,175 for two full weeks before tumbling through the bottom of the range last Thursday and losing contact with it on Friday after the May CPI report showed that inflation remains stubbornly high (Chart 1). Chart 1Stocks See The Glass As Half-Empty The details of the May CPI report weren’t as bad as the headlines, though we were surprised and disappointed by its failure to confirm our view that inflation is peaking. From the full range of puzzle pieces we already have, however, we continue to think the picture for risk assets and the economy one year from now will be encouraging. We spent last week speaking and mingling at a conference and meeting with clients one-on-one last week, confirming that our sanguine view is decidedly in the minority as investors have become increasingly resigned to the idea that inflation cannot be brought down to a tolerable level without squeezing the economy. We think there is a middle way, at least over the next twelve months, as we highlight below by reviewing some of the largest and most important factors. Employment If a recession were imminent, we would expect to see hiring begin to sputter. Year-over-year payrolls growth has slowed, but it remains more than a standard deviation above the mean (Chart 2, top panel), at its highest level in 38 years. Annualized month-over-month growth is strong as well, if not as much of an outlier as year-over-year growth (Chart 2, bottom panel). Going forward, payrolls growth is poised to remain strong (Chart 3, top panel), as small businesses’ hiring intentions are very high (Chart 3, second panel), temporary employment is still elevated (Chart 3, third panel) and initial unemployment claims, while rising, are extremely low (Chart 3, bottom panel). Chart 2Payrolls Are Growing At A Nice Clip ... Chart 3... And Will Continue To Do So Consumption Chart 4Solid Footing We have stressed that households’ massive pandemic savings have provided them with ample ability to consume. They have worked down the debt they took on ahead of the financial crisis, restoring the household debt-to-GDP ratio to its 2002 level (Chart 4, second panel), which is much more lightly borne today than it was then, thanks to interest rates that remain extremely low despite their recent backup (Chart 4, bottom panel). It is an open question, subject to occasionally fierce debate within BCA, if households have the willingness to consume the mountain of savings they have amassed since COVID-19 reached the US. Our answer has been an unequivocal yes, and we have been working under the purposely conservative assumption that households will spend just half of their $2 trillion-plus stash. So far, the data are on our side: consumers have not lost their appetite for dining out, returning to restaurants at their pre-pandemic pace once the Omicron coast was clear (Chart 5, top panel). Travelers are returning to the skies, as well, undeterred by soaring airfares (Chart 5, bottom panel). Although passenger levels have not made it all the way back to their 2019 levels, nearly 60% more passengers have passed through TSA checkpoints so far this year than they did at this point in 2021, and credit card usage indicates that reduced business travel is responsible for the shortfall, as individuals have eagerly sought to cure their cabin fever (Chart 6). Chart 5Back To Restaurants, Bars ... Chart 6... And The Friendly Skies Private Investment/Credit Spreads Although consumption accounts for two-thirds of overall US output, or three-and-a-half times more than investment, the latter is slightly more likely to bring about a contraction in GDP because it is considerably more volatile.1 Nonresidential investment accounts for the lion’s share of private investment and BCA’s capex model projects that it will remain robust over the next two quarters (Chart 7). Residential investment will have to grapple with the housing slowdown imposed by the sudden and significant increase in mortgage rates, but we agree with our Bank Credit Analyst colleagues’ assessment that housing is unlikely to tank the economy.2 Homes remain undersupplied after several years of insufficient construction and the spread between the baseline 30-year fixed mortgage rate and the 10-year Treasury yield has become so stretched that it appears that the mortgage rate may have already reached its 2022 peak (Chart 8). Chart 7Capex Prospects Are Good ... Wider corporate bond spreads and intimations that banks are becoming less eager to lend could signal a further tightening of financial conditions. There have been three major spread-widening episodes in the high yield era (Chart 9, top panel) and none began until three preconditions had been met. Chart 8... And Mortgage Borrowers Are Due For A Break The Fed had to have completed its rate hiking cycle (Chart 9, second panel), our proprietary Corporate Health Monitor (CHM) had to have crossed into deterioration (Chart 9, third panel) and the Fed’s quarterly Senior Loan Officer survey had to indicate that a majority of banks was imposing tighter credit standards on business borrowers (Chart 9, bottom panel). None of those conditions is in place yet, though banks' lending appetites may be shrinking and the first quarter was not great for corporate health. Chart 9Perhaps Forward Guidance Was TMI Broad Recession Probability Pulling back to 30,000 feet, none of the key recession prerequisites we constantly monitor is yet signaling any distress. The 3-month bill/10-year note segment of the Treasury yield curve remains solidly upward sloping (Chart 10). The Leading Economic Index (LEI) is nowhere close to contracting on a year-over-year basis (Chart 11), and the target fed funds rate is far below our estimate of the equilibrium fed funds rate (Chart 12). Each series has issued its own false signal – an above-equilibrium fed funds rate has been a necessary, but hardly sufficient, recession condition – but they have a perfect track record when considered together. Chart 10When The Yield Curve Inverts, ... Chart 11... Year-Over-Year LEI Contracts ... Chart 12... And Monetary Policy Settings Are Restrictive, A Recession Soon Follows Investment Implications The May CPI report only strengthened the conviction of those holding bearish views and will at least temporarily fuel a barrage of gloomy headlines that might sway the uncommitted. It has reduced the marginal probability that the Fed will be able to thread the needle and meet its price stability mandate without taking direct aim at its full employment goals. We still expect that the Fed will be able to maintain its balancing act for another twelve months because we think inflation will begin to come down on its own once the fevers in new and used auto prices and airfares finally break. The more remote that prospect seems to investors, the more stock prices will fall and bond yields will rise if the bullish view, or something slightly less bearish than discounted, comes to pass. The University of Michigan’s consumer sentiment survey made an all-time low in the preliminary June data released Friday morning. We are less concerned about the headline number – Open Table reservations and busy TSA security lines suggest investors are better served by focusing on what consumers do than how they feel, and the Michigan gloom is contradicted by the Conference Board survey's modest optimism – than we are about the upward turn in consumers’ long-run inflation expectations. Respondents to the Michigan survey increased their median estimate for inflation in five to ten years to 3.3% from 3% over the previous four months (the estimate had been between 2.9 and 3.1% for ten months beginning last August). If workers’, businesses’, investors’ and consumers’ long-run inflation expectations become unmoored, an inflation mindset in which high prices beget still higher prices could threaten to take hold, forcing the Fed to channel its inner Paul Volcker, shattering our temporary thread-the-needle thesis. For now, the term structure of inflation expectations remains sharply inverted. That’s to say that TIPS breakevens, CPI swaps and survey respondents continue to expect that intermediate- and long-term inflation will slow considerably from its currently elevated levels. If they begin to lose faith that very high inflation readings are a temporary phenomenon, we will have to revisit our glass-half-full perspective. We are not irresolute, but like Lord Keynes, when the data change, we change our minds. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 The probability that investment could decline enough in any given quarter to zero out 2% growth in consumption and government spending is 23%, based on its historical distribution. The probability that consumption could wipe out 2% growth in investment and government spending is 17.6%. Government spending, which is one-fourth the size of consumption and considerably more stable than comparably sized investment, has just a 2.3% probability of negating trend growth in the other components. (All calculations disregard net exports.) 2 "Is The US Housing Market Signaling An Imminent Recession?" Bank Credit Analyst Special Report, June 2022.