Economic Growth
Executive Summary Ebbing Stagflation Fear Will Prompt Rerating European inflation will rise further before peaking this summer. Core CPI will reach between 2.8% and 3.2% by year-end before receding. The combination of stabilizing growth and the eventual peak in inflation will cause stagflation fears to recede. European assets have greater upside. Cyclicals, small-caps, and financials will be major beneficiaries of declining stagflation fears. The underperformance of UK small-cap stocks is nearing its end. UK large-cap equities are a tactical sell against Eurozone and Swedish shares. TACTICAL INCEPTION DATE RETURN SINCE INCEPTION (%) COMMENT EQUITIES Buy European & Swedish Equities / Sell UK Large Caps Stocks 03/21/2022 Bottom Line: Stagflation fears are near an apex as commodity inflation recedes. A peak in these fears will allow European asset prices to perform strongly over the coming quarters. Despite a glimmer of hope that Ukraine and Russia may find a diplomatic end to the war, the reality on the ground is that the conflict has intensified. Although the hostilities are worsening and the European Central Bank (ECB) surprised the markets with its hawkish tone, European assets have begun to catch a bid. The crucial question for investors is whether this rebound constitutes a new trend or a counter-trend move? Our view about Europe is optimistic right now. The path is not a direct line upward. The recent optimism about the outcome of the Russia-Ukraine talks is premature; however, we are getting to the point when markets are becoming desensitized to the war and energy prices are losing steam. Moreover, the increasing number of statements by Chinese economic authorities pointing toward greater stimulus and support to alleviate the pain created by China’s stringent zero-COVID policy are another positive omen. Higher Inflation For Some Time European headline inflation is set to exceed 7% this summer and core CPI will increase between 2.8% and 3.2% by the end of 2022. Related Report European Investment StrategySpring Stagflation The main force that will push inflation higher in Europe remains commodity prices. Energy inflation is extremely strong at already 32% per annum (Chart 1). It will increase further because of both the recent jump in Brent prices to EUR122/bbl on March 8 and the upsurge in natural gas prices, which were as high as EUR212/MWh on the same day before settling to EUR106/MWh last Friday. The impact of energy prices will not be limited to headline inflation and will filter through to core CPI (Chart 1, bottom panel). The average monthly percentage change in the Eurozone core CPI inflation stands at 0.25% for the past six months (compared to an average of 0.09% over the past ten years), or the period when energy-prices inflation has been the strongest. Assuming monthly inflation remains at such an elevated level, annual core CPI will hit 3.3% in the Eurozone by the end of 2022 (Chart 2). Chart 2Core CPI to Rise Further Chart 1Energy Inflation: Alive And Well The picture is not entirely bleak. Many forces suggest that these inflationary forces will recede before year-end in Europe. Energy prices are peaking, which is consistent with a diminishing inflationary impulse from that space. We showed two weeks ago that the massive backwardation of oil curves, the heavy bullish sentiment, and the high level of risk-reversals were consistent with a severe but transitory adjustment in the energy market. Oil markets will experience further volatility, as uncertainty around peace/ceasefire negotiations continues to evolve in Ukraine. Nonetheless, the peak in energy prices has most likely been reached. BCA’s energy strategists expect Brent to average $93/bbl in 2022 and in 2023. The potential for a decline in headline CPI after the summer is not limited to energy prices. Dramatic moves in the commodity market, from metals to agricultural resources, have made headlines. Yet, the rate of change of commodity prices is decelerating, hence, the commodity impulse to inflation is slowing sharply. As Chart 3 shows, this is a harbinger of a slowdown in European headline CPI. Related Report European Investment StrategyFallout From Ukraine Looking beyond commodity markets, the recent deceleration in European economic activity also suggests weaker inflation in the latter half of 2022. Germany will likely suffer a recession because it already registered a negative GDP growth in Q4 2021. Q1 2022 growth will be even worse because of the country’s high exposure to both China and fossil fuel prices. More broadly, the recent deceleration in the rate of change of both the manufacturing and services PMIs is consistent with an imminent peak in the second derivative of goods and services CPI (Chart 4). Chart 3Commodity Impulse Is Peaking Chart 4Inflation's Maximum Momentum Is Now Underlying drivers of inflation also remain tame in Europe. European negotiated wages are only expanding at a 1.5% annual rate, which translates into unit labor costs growth of 1% (Chart 5). This contrast with the US, where wages are expanding at a 4.3% annual rate. A peak in inflation, however, does not mean that CPI readings will fall below the ECB’s 2% threshold anytime soon. The European economy continues to face supply shortages that the Ukrainian conflict exacerbates (Chart 6). Moreover, the recent wave of COVID-19 in China increases the risk of disruptions in supply chains, as highlighted by the closure of Foxconn factories in Shenzhen. Finally, inflation has yet to peak; mathematically, it will take a long time before it falls back below levels targeted by Frankfurt. Chart 5The European Labor Market Is Not Inflationary Chart 6Not Blemish-Free Bottom Line: European headline inflation will peak this summer, probably above 7%. Additionally, core CPI is likely to reach between 2.8% and 3.2% in the second half of 2022. As a result of a decline in the commodity impulse, inflation will decelerate afterward, but it will remain above the ECB’s 2% target for most of 2023. Hopes For Growth Two weeks ago, we wrote that Europe was facing a stagflation episode in the coming one to two quarters, but that, ultimately, economic activity will recover well. Recent evidence confirms that assessment. Chart 7A Coming Chinese Tailwind? The tone of Chinese policymakers is becoming more aggressive, in favor of supporting the economy. On March 16, Vice-Premier Liu He highlighted that Beijing was readying to support property and tech shares and that it will do more to stimulate the economy. True, this response was made in part to address the need to close cities affected by the sudden spike of Omicron cases around China. Nonetheless, the global experience with Omicron demonstrates that, as spectacular and violent the surge in cases may be, it is short-lived. Meanwhile, the impact of stimulus filters through the economy over many months. As a result, Europe will experience the impact of China’s Omicron-induced slowdown, while it also suffers from the growth-sapping effects of the Ukrainian conflict; however, it will also enjoy the positive effect on growth of a rising credit impulse over several subsequent quarters (Chart 7). Beyond China, the other themes we have discussed in recent weeks remain valid. First, European fiscal policy will become looser, as governments prepare to fight the slowdown caused by the war, while also increasing infrastructure spending to wean Europe off Russian energy. Moreover, European military spending is well below NATO’s 2% objective. This will not remain the case, as military expenditure may leap from less than EUR100bn per year to nearly EUR400bn per year over the coming decade. Second, European spending on consumer durable goods still lags well behind the trajectory of the US. With the energy drag at its apex today, consumer spending on durable goods will be able to catch up in the latter half of the year, especially with the household savings rate standing at 15% or 2.5 percentage points above its pre-COVID level. Bottom Line: European growth will be very low in the coming quarters. Germany is likely to face a technical recession as Q1 2022 data filters in. Nonetheless, Chinese stimulus, European fiscal support, pent-up demand, and a declining energy drag will allow growth to recover in the latter half of the year. As a result, we agree with the European Commission estimates that European growth will slow markedly this year. Market Implications In the context of a transitory shock to European economic activity and a coming peak in inflation, European stock prices have likely bottomed. Chart 8Depressed Sentiment To Help Beta Sentiment has reached levels normally linked with a durable market floor. The NAAIM Exposure Index has fallen to a point from which global markets often recover. Europe’s high beta nature increases the odds that European equities will greatly benefit in that context (Chart 8). Valuations confirm that sentiment toward European assets has reached a capitulation stage. The annual rate of change of the earnings yields in the earnings yields has hit 73%, which is consistent with a market bottom (Chart 9). More importantly, the change in European forward P/E tracks closely our European Stagflation Sentiment Proxy (ESSP), based on the difference between the Growth and Inflation Expectations’ components of the ZEW survey (Chart 10). For now, our ESSP indicates that stagflation fears in Europe have never been so widespread, but these fears will likely dissipate as energy inflation declines. This process will lift European earnings multiples. Chart 9Bad News Discounted? Chart 10Ebbing Stagflation Fear Will Prompt Rerating Earnings revisions will likely bottom soon as well. The ESSP is currently consistent with a dramatic decline in European net earnings revisions (Chart 10, bottom panel). It will take a few more weeks for lower earnings revisions to be fully reflected. However, they follow market moves and, as such, the 17% decline in the MSCI Europe Index that took place earlier this year already anticipates their fall. Consequently, as stagflation fears recede, earnings revisions will rise in tandem with equity prices. Chart 11Maximum Pressure On Corporate Spreads A decline in stagflation fears is also consistent with a decrease in European credit spreads in the coming months (Chart 11). This observation corroborates the analysis from the Special Report we published jointly with BCA’s Global Fixed-Income Strategy team last week. In terms of sectoral implications, a decline in stagflation fears is often associated with a rebound in the performance of small-cap equities relative to large-cap ones (Chart 12, top panel). This reflects the greater sensitivity of small-cap equities to domestic economic conditions compared to large-cap stocks. Moreover, small-cap equities had been oversold relative to their large-cap counterparts but now, momentum is improving (Chart 12). As a result, it is time to buy these equities. Similarly, financials have suffered greatly from the recent events associated with the Ukrainian conflict. European financial institutions have not only been penalized for their modest exposure to Russia, they have also historically declined when stagflation fears are prevalent (Chart 13). This relationship reflects poor lending activity when the economy weakens, and the risk of a policy-induced recession caused by high inflation. Financials will continue their sharp rebound as stagflation fears dissipate. Chart 13Financials Have Suffered Enough Chart 12Small-Caps Time To Shine The dynamics in inflation alone are very important. As Table 1 highlights, in periods of elevated inflation over the past 20 years, financials underperform the broad market by 11.3% on average. It is also a period of pain for small-cap equities and cyclicals. Logically, exiting the current environment will offer opportunities in European cyclical equities and for financials in particular. Table 1Who Suffers From High Inflation? Chart 14Long Industrials & Materials / Short Energy Finally, a pair trade buying industrials and materials at the expense of energy makes sense today. Materials and industrials suffer relative to energy equities when stagflation rises, especially in periods when these fears reflect rising energy pressures (Chart 14). A reversal in relative earnings revisions in favor of materials and industrials will propel this position higher. Bottom Line: Sentiment toward European assets reached a selling climax in recent weeks. Stagflation fears in Europe have reached an apex, and their reversal will lift both multiples and earnings revisions in the subsequent quarters. Diminishing stagflation fears will also boost the appeal of European corporate credit, contributing to an easing in financial conditions. Small-cap stocks, cyclicals, and financials will reap the greatest benefits from this adjustment. Going long materials and industrials at the expense of energy stocks is an attractive pair trade. Key Risk: A Policy Mistake The view above is not without risks. The number one threat to European growth and assets is a policy mistake from the ECB. On March 10, 2022, the ECB’s policy statement and President Christine Lagarde’s press conference showed that the Governing Council (GC) will decrease asset purchases faster than anticipated. Chart 15Will The ECB Repeat It Past Mistakes? It is important to keep in mind the dynamics of 2011. Back then, the ECB opted to increase interest rates as European headline CPI was drifting toward 2.6% on the back of rising energy prices. According to our ESSP, the April 2011 interest rates hike took place at the greatest level of stagflation fears recorded until the current moment (Chart 15). Lured by rising inflation, the ECB ignored underlying weaknesses in European economic activity, which wreaked havoc on European financial markets and growth. If the ECB were to increase rates as growth remains soft, a similar outcome would take place. For now, the ECB’s communications continue to de-emphasize the need for rate hikes in the near term, which suggests that the GC is cognizant of the risk created by weak growth over the coming months. Waiting until next year, when activity will be stronger and the output gap will be closed, will offer the ECB a better avenue to lift rates durably. This risk warrants close monitoring of the ECB’s communication over the coming months. If headline inflation does not peak by the summer, the ECB is likely to repeat its past error, which will substantially hurt European assets. Our optimism is tempered by this threat. UK Outperformance Long In The Tooth? Last week, the Bank of England (BoE) increased the Bank Rate by 25bps to 0.75%, in a move that was widely expected. Yet, the pound fell 0.7% against the euro and gilt yields fell 6 bps. This market reaction reflected the BoE’s choice to temper its forward guidance. The central bank is now expected to increase interest rates to 2.2% next year, before they decline in 2024. The dovish projection of the BoE shows the MPC’s concerns over the impact of higher energy costs and rising National Insurance contributions on household spending. In the BoE’s opinion, the economy is very inflationary right now, but it will slow, which will mitigate the inflationary impact down the road. We share the BoE’s worries about the UK’s near-term economic outlook. The combination of higher taxes, higher interest rates, and rising energy costs will have an impact on growth. However, the rapid decline in small-cap stocks, which have massively underperformed their large cap-counterparts, already discounts considerable bad news (Chart 16). Additionally, small-cap equities relative to EPS have begun to stabilize, while relative P/E and price-to-book ratios have also corrected their overvaluations. In this context, UK small-cap equities are becoming attractive. Chart 17UK vs Eurozone: A Stagflation Bet Chart 16UK Small-Cap Stocks Have Purged Their Excesses In contrast to small-cap stocks, UK large-cap equities have greatly benefited from the global stagflation scare. The UK large-cap benchmark had the right sector mix for the current environment, overweighting defensive names as well as energy and resources. It is likely that when stagflation fears recede, UK equities will undo their outperformance (Chart 17). Technically, UK equities are massively overbought against Euro Area and Swedish stocks, both of which have been greatly impacted by stagflation fears and their pro-cyclical biases (Chart 18 & 19). An attractive tactical bet will be to sell UK large-cap stocks while buying Eurozone and Swedish equities, as energy inflation declines and as China’s stimulus boosts global industrial activity in the latter half of 2022 Bottom Line: Move to overweight UK small-cap stocks within UK equity portfolios. Go long Euro Area and Swedish equities relative to UK large-cap stocks as a tactical bet. Chart 18UK Overbought Relative To Euro Area... Chart 19… And Sweden Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades
Executive Summary Investors Think The Fed Will Not Be Able To Raise Rates Much Above 2% The neutral rate of interest is 3%-to-4% in the United States. This is substantially higher than the market estimate of around 2%. It is also higher than the central tendency range for the Fed’s terminal interest rate dot, which remained at 2.3%-to-2.5% following this week’s FOMC meeting. If the neutral rate turns out to be higher than expected, this is arguably good news for stocks over the short-to-medium term because it lowers the risk that the Fed will accidentally induce a recession this year by bringing rates into restrictive territory. Over a longer-term horizon of 2-to-5 years, however, a higher neutral rate is bad news for stocks because it means that investors will eventually need to value equities using a higher discount rate. It also means that the Fed could find itself woefully behind the curve in normalizing monetary policy. Bottom Line: Global equities will rise over the next 12 months as the situation in Ukraine stabilizes, commodity prices recede, and inflation temporarily declines. Stocks will peak in the second half of 2023 in advance of a second, and currently unexpected, round of Fed tightening beginning in late-2023 or 2024. Dear Client, Instead of our regular report next week, we will be sending you a Special Report written by Matt Gertken, BCA Research’s Chief Geopolitical Strategist, discussing the geopolitical implications of the war in Ukraine. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. As always, I will hold a webcast discussing the outlook the week after, on Thursday, April 7th. Best regards, Peter Berezin Chief Global Strategist https://www.linkedin.com/in/peter-berezin-1289b87/ https://twitter.com/BerezinPeter A Two-Stage Fed Tightening Cycle The FOMC raised rates by 25 basis points this week, the first of seven rate hikes that the Federal Reserve has telegraphed in its Summary of Economic Projections for the remainder of 2022. We expect the Fed to follow through on its planned rate hikes this year, but then go on pause in early-2023, as inflation temporarily comes down. However, the Fed will resume raising rates in late-2023 or 2024 once inflation begins to reaccelerate and it becomes clear that monetary policy is still too easy. This second round of monetary tightening is currently not anticipated by market participants. If anything, investors think the Fed is more likely to cut rates than raise rates towards the end of next year (Chart 1). The Fed’s own views are not that different from the markets’: The central tendency range for the Fed’s terminal interest rate dot remained at 2.3%-to-2.5% following this week’s FOMC meeting, with the median dot actually ticking lower to 2.4% from 2.5% (Chart 2). Chart 2The Fed Is Still In The Secular Stagnation Camp A Higher Neutral Rate Our higher-than-consensus view of where US rates will eventually end up reflects our conviction that the neutral rate of interest is somewhere between 3% and 4%. One can think of the neutral rate as the interest rate that equates the amount of investment a country wants to undertake at full employment with the amount of savings that it has at its disposal.1 Anything that reduces savings or increases investment would raise the neutral rate (Chart 3). As we discussed last month, a number of factors are likely to lower desired savings in the US over the next few years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and the receipt of generous government transfer payments (Chart 4). Household wealth has soared since the start of the pandemic (Chart 5). Conservatively assuming that households spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by nearly 4% of GDP. Chart 5Net Worth Has Soared Since The Pandemic The household deleveraging cycle has ended (Chart 6). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. Banks are easing lending standards on consumer loans across the board. Baby boomers are retiring. They hold over half of US household wealth, considerably more than younger generations (Chart 7). As baby boomers transition from savers to dissavers, national savings will decline. Chart 6US Household Deleveraging Pressures Have Abated Chart 7Baby Boomers Have Amassed A Lot Of Wealth Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 8). On the investment front: The deceleration in trend GDP growth, which depressed investment spending, has largely run its course.2 According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today. The CBO expects potential growth to edge down only slightly to 1.7% over the next few decades (Chart 9). Chart 8Fiscal Policy: Tighter But Not Tight Chart 9Much Of The Deceleration In Potential Growth Has Already Happened After moving broadly sideways for two decades, core capital goods orders – a leading indicator for capital spending – have broken out to the upside (Chart 10). Capex intention surveys remain upbeat (Chart 11). The average age of the nonresidential capital stock currently stands at 16.3 years, the highest since 1965 (Chart 12). Chart 10Positive Signs For Capex (I) Similar to nonresidential investment, the US has been underinvesting in residential real estate (Chart 13). The average age of the housing stock has risen to a 71-year high of 31 years. The homeowner vacancy rate has plunged to the lowest level on record. The number of newly finished homes for sale is half of what it was prior to the pandemic. Chart 11Positive Signs For Capex (II) Chart 12An Aging Capital Stock Chart 13Housing Is In Short Supply The New ESG: Energy Security and Guns The war in Ukraine will put further pressure on the neutral rate, especially outside of the United States. Chart 14European Capex Should Recover After staging a plodding recovery following the euro debt crisis, European capital spending received a sizable boost from the launch of the NextGenerationEU Recovery Fund (Chart 14). Capital spending will rise further in the years ahead as European governments accelerate efforts to make their economies less reliant on Russian energy. Meanwhile, European governments are trying to ease the burden from rising energy costs. France has introduced a rebate on fuel starting on April 1st. It is part of a EUR 20 billion package aimed at cutting heating and electricity bills. Other countries are considering similar measures. European military spending will also rise. Germany has already announced that it will spend EUR 100 billion more on defense. European governments will also need to boost spending to accommodate potentially several million Ukrainian refugees. A Smaller Chinese Current Account Surplus? Chart 15Will China Be A Source Of Excess Savings? The difference between what a country saves and invests equals its current account balance. Historically, China has been a major exporter of savings, which has helped depress interest rates abroad. While China’s current account surplus has declined as a share of its own GDP, it has remained very large as a share of global ex-China GDP, reflecting China’s growing weight in the global economy (Chart 15). Many analysts assume that China will double down on efforts to boost exports in order to offset the drag from falling property investment. However, there is a major geopolitical snag with that thesis: A country that runs a current account surplus must, by definition, accumulate assets from the rest of the world. As the freezing of Russia’s foreign exchange reserves demonstrates, that is a risky proposition for a country such as China. Rather than increasing its current account surplus, China may seek to bolster its economy by raising domestic demand. This could be achieved by either boosting domestic investment on infrastructure and/or consumption. Notably, the IMF’s latest projections foresee China’s current account surplus falling by more than half between 2021 and 2026 as a share of global ex-China GDP. If this were to happen, the neutral rate in China and elsewhere would rise. The Path to Neutral: The Role of Inflation If one accepts the premise that the neutral rate in the US is higher than widely believed, what will the path to this higher rate look like? The answer hinges critically on the trajectory of inflation. If inflation remains stubbornly high, the Fed will be forced to hike rates by more than expected over the next 12 months. In contrast, if inflation comes down rapidly, then the Fed will be able to raise rates at a more leisurely pace. As late as early February, one could have made a strong case that US inflation was set to fall. The demand for goods was beginning to moderate as spending shifted back towards services. On the supply side, the bottlenecks that had impaired goods production were starting to ease. Chart 16 shows that the number of ships anchored off the coast of Los Angeles and Long Beach has been trending lower while the supplier delivery components of both the ISM manufacturing and nonmanufacturing indices had come off their highs. Since then, the outlook for inflation has become a lot murkier. As we discussed last week, the war in Ukraine is putting upward pressure on commodity prices, ranging from energy, to metals, to agriculture. BCA’s geopolitical team, led by Matt Gertken, expects the war to worsen before a truce of sorts is reached in a month or two. Meanwhile, a new Covid wave is gaining momentum. New daily cases are rising across Europe and have exploded higher in parts of Asia (Chart 17). In China, the number of new cases has reached a two-year high. The government has already locked down parts of the country encompassing 37 million people, including Shenzhen, a major high-tech hub adjoining Hong Kong. Chart 17Covid Cases Are On The Rise Again In Some Countries Most new cases in China and elsewhere stem from the BA.2 subvariant of Omicron, which appears to be at least 50% more contagious than Omicron Classic. Given its extreme contagiousness, China may be forced to rely on massive nationwide lockdowns in order to maintain its zero-Covid strategy. While such lockdowns may provide some relief in the form of lower oil prices, the overall effect will be to worsen supply-chain disruptions. Watch For Signs of a Wage-Price Spiral As the experience of the 1960s demonstrates, the relationship between inflation and unemployment is inherently non-linear: The labor market can tighten for a long time with little impact on prices and wages, only for a wage-price spiral to suddenly develop once unemployment falls below a certain threshold (Chart 18). Chart 18A Wage-Price Spiral Was Ignited By Very Low Unemployment Levels In The 1960s Chart 19Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution For the time being, a wage-price spiral does not appear imminent. While wage growth has picked up, most of the increase in wages has occurred at the bottom end of the income distribution (Chart 19). Chart 20More Low-Wage Employees Should Return To Work Low-wage workers have not returned to the labor force to the same extent as higher-wage workers (Chart 20). However, now that extended unemployment benefits have lapsed and savings deposits are being drawn down, the incentive to resume work will strengthen. An influx of workers back into the labor market will cap wage growth, at least for this year. Long-Term Inflation Expectations Still Contained A sudden increase in long-term inflation expectations can be a precursor to a wage-price spiral because the expectation of higher prices can induce consumers to shop now before prices rise further, while also incentivizing workers to demand higher wages. Reassuringly, long-term inflation expectations have not risen that much. Expected inflation 5-to-10 years out in the University of Michigan survey registered 3.0% in March, down a notch from 3.1% in February (Chart 21). While the widely followed 5-year, 5-year forward TIPS inflation breakeven rate has climbed to 2.32%, it is still at the bottom of the Fed’s comfort zone of 2.3%-to-2.5% (Chart 22).3 Chart 21Long-Term Inflation Expectations Remain Contained (I) Chart 22Long-Term Inflation Expectations Remain Contained (II) Chart 23The Magnitude Of Damage Depends On How Long The Commodity Price Shock Lasts Moreover, the jump in market-based inflation expectations since the start of the war in Ukraine has been fueled by rising oil prices. The forwards are pointing to a fairly pronounced decline in the price of crude and most other commodity prices over the next 12 months (Chart 23). If that happens, inflation expectations will dip anew. Investment Implications The neutral rate of interest is higher in the United States than widely believed. A higher neutral rate is arguably good for stocks over the short-to-medium term because it lowers the risk that the Fed will accidentally induce a recession this year by bringing rates into restrictive territory. Over a longer-term horizon of 2-to-5 years, however, a higher neutral rate is bad news for stocks because it means that investors will eventually need to value stocks using a higher discount rate. It also means that the Fed could find itself woefully behind the curve in normalizing monetary policy. While the war in Ukraine and yet another Covid wave could continue to unsettle markets for the next month or two, global equities will be higher in 12 months than they are now. With inflation in the US likely to temporarily come down in the second half of the year, bond yields probably will not rise much more this year. However, yields will start moving higher in the second half of next year as it becomes clear that policy rates still have further to rise. The bull market in stocks will end at that point. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 These savings can either by generated domestically or imported from abroad via a current account deficit. 2 Theoretically, there is a close relationship between trend growth and the equilibrium investment-to-GDP ratio. For example, if real trend growth is 3% and the capital stock-to-GDP ratio is 200%, a country would need to invest 6% of GDP net of depreciation to maintain the existing capital stock-to-GDP ratio. In contrast, if trend growth were to fall to 2%, the country would only need to invest 4% of GDP. 3 The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Dear Client, Next week, in lieu of our regular weekly report, I will be hosting two webcasts where I will discuss our view on China’s economy and financial markets. In particular, I will share our view on the announced economic growth target and stimulus measures for this year, as well as our takes on the recent developments in China’s onshore and offshore equity markets. The webcasts will be held on Wednesday, March 23 at 9:00 AM HKT (Mandarin) and Wednesday, March 23 at 9:00 AM EDT (English). I look forward to discussing with you during the webcast. We will return to our regular publishing schedule on Wednesday, March 30. Best regards, Jing Sima China Strategist Executive Summary Demand For Housing Remains In The Doldrums Chinese policymakers set an ambitious goal for this year’s economic expansion. While the growth target is above market consensus and a positive surprise, the path will be full of obstacles. Policy restrictions will be the biggest hurdle. While the authorities will continue to ease some industry policies, it is unlikely that all regulations will be rolled back at once. Therefore, it is questionable whether the announced growth-supporting measures will be enough to offset the housing slump and a slow recovery in consumption. We remain cautious on Chinese stocks. In the near term, equities will face headwinds from risk-off sentiment among global investors and a prolonged downturn in domestic demand. Policymakers will eventually allow more aggressive easing in the next 6 to 12 months. We will look for signs of more reflationary efforts and a better price entry point to upgrade Chinese stocks. We are closing our tactical trade of Long MSCI Hong Kong Index/Short MSCI ACW, due to spillover effects from Chinese offshore tech stock selloff on the Hong Kong equity market. ASSET INITIATION DATE RETURN SINCE INCEPTION (%) COMMENT LONG MSCI HONG KONG INDEX / SHORT MSCI ALL COUNTRY WORLD 1/19/2022 -0.08 Closed Bottom Line: Chinese policymakers are aiming for above-expectation economic growth this year. However, we recommend that investors lie low given the substantial challenges that China faces in expanding its economy. Feature Beijing set the 2022 economic growth target during last week’s National People’s Congress (NPC) at “around 5.5%”, which exceeds the market consensus. The topline growth target is encouraging. However, the announced stimulus measures are less than meets the eye. Fiscal support will increase, but not massively. Monetary policy may ease further. However, the easing efforts since July last year have failed to boost sentiment among private-sector corporates and households. Importantly, policy restrictions in the past several years, such as reducing local governments’ shadow bank borrowing and property developers’ leverage, and stringent counter-COVID measures, are having a lasting effect on the economy. As such, China’s domestic demand will likely remain sluggish until more aggressive policy easing is introduced. Meanwhile, Chinese stock prices in absolute terms have been falling due to global equity market selloffs and concerns about China’s domestic economy, although Chinese onshore stocks have fared better than their offshore peers. We expect that China will eventually allow more substantive easing to shore up growth and meet the target. Meanwhile, investors should remain cautious. We recommend that global shareholders with exposure to Chinese onshore stocks maintain a neutral position in their portfolios for now. We continue to look for signs of more reflationary efforts and the right opportunity to upgrade Chinese onshore stocks, especially if prices decline further in the near term. We maintain our underweight stance on Chinese offshore stocks, in both absolute terms and relative to global equities. De-listing from the US stock exchange is a real risk for some of the big-name Chinese tech companies. We will provide more insights on this topic in the coming weeks. In the meantime, we are closing our tactical trade: Long MSCI Hong Kong Index/Short MSCI All Country World with a minor 0.08% loss. While the recent steep falls in the MSCI Hong Kong Index prices may provide some buying opportunities in the next 6 to 12 months, near-term downside risks are substantial due to geopolitical tensions as well as a new round of lockdowns in the mainland. An Ambitious Growth Target … The 5.5% growth goal set for 2022 is the lowest in more than three decades, but it is above the consensus forecast of close to 5% and the IMF’s projection of 4.8% (Chart 1). The target also marks a significant departure from the past couple of years and reinforces our view that the authorities are determined to ensure a stable domestic economy amid rising geopolitical turmoil (Table 1). Chart 1China Set An Above-Expectation Growth Target For 2022 Table 12022 Economic And Policy Targets The stimulus measures unveiled at last week’s NPC imply that Beijing will mainly use fiscal levers to support the economy. Some key takeaways from the published Government Work Report include: Chart 2A Significant Jump In Available SPBs In 2022 A bigger fiscal push. The fiscal budget is set at 2.8% of GDP this year, or 3.37 trillion yuan, and is a modest decrease from the 3.2% deficit in 2021. The quota for local government special purpose bonds (SPBs) remains unchanged at RMB3.65 trillion yuan. However, local governments will be allowed to carry over SPB proceeds from last year, which will add about RMB1.1 trillion yuan to fund this year’s spending. This translates to about RMB4.7 trillion yuan in SPB in 2022, an 80% jump from the actual usage of 2.57 trillion yuan in 2021 (Chart 2). Furthermore, tax and fee cuts will total RMB2.5 trillion yuan, more than double the 2021 amount. Small and medium enterprises will receive value-added tax credits and refunds. Tax cuts will favor the service sectors most affected by the pandemic, along with manufacturing, and science and technology research. The fiscal budget also includes a record-high transfer from the central to local governments. Adding central government fund transfers and off-budgetary fiscal expenditures, we estimate that the augmented fiscal deficit this year will be around 7.8% of GDP, implying a fiscal thrust of more than 2% of GDP. The estimated thrust will be a reversal from the negative impulse of 2.1% of GDP in 2021 (Chart 3). Further easing in monetary policy. The government reiterated that money supply and total social financing (TSF) growth should be consistent with nominal GDP growth. We expect another cut next month in the reserve requirement ratio and/or the policy rate. We also maintain our view that the credit impulse – measured by the 12-month change in adjusted TSF as a percentage of GDP – will climb to 29% of GDP (assuming an 8% nominal GDP for 2022), 2 percentage points higher than the 27% of GDP in 2021 (Chart 4). Chart 3Fiscal Thrust In 2022 Could Reach More Than 2% Of GDP Chart 4China Needs To Create RMB35 Trillion In Credit In 2022 Chart 5"Green Investment" Will Get A Big Boost This Year A more relaxed carbon reduction policy. The government did not announce an annual numeric target related to de-carbonization or energy consumption intensity reduction. Nonetheless, a more relaxed policy setting will allow flexibility, especially in the first half of the year when infrastructure projects will be accelerated. In the second half, however, there is still a risk that de-carbonization efforts will step up to align the country’s carbon and energy intensity reduction with the 14th Five-Year Plan target. Still, the negative impact from de-carbonization seen last year will be much smaller this year, while green energy development will make an increased contribution to this year’s growth (Chart 5). Bottom Line: China set an ambitious economic growth target of 5.5% for the year, relying on fiscal stimulus to shore up topline economic growth. … But A Challenging Path Ahead Achieving growth of “around 5.5%” will not be easy. As noted in previous reports, the regulations put in place in a wide range of industries since 2017 significantly constrain growth in both credit creation and the economy. Furthermore, aggressive regulatory crackdowns on the property sector and internet-related industries last year, coupled with rising domestic COVID cases and a new round of lockdowns, will likely have enduring ramifications on private-sector sentiment and weaken the effectiveness of policy easing. The following risks are notable: Constraints on infrastructure investment. We expect infrastructure investment to pick up from last year’s meager 0.5% growth. Even so, a larger fiscal impulse for 2022 would not necessarily lead to an outsized increase in infrastructure spending by local governments. In 2019, the fiscal deficit widened to 5% of GDP from 3.5% in 2018 and the quota for local government SPBs increased by 60% from a year earlier. However, infrastructure investment only grew by 3.3% in 2019, 1.5 percentage points higher than that in 2018 (Chart 6). The key factor is that the rebound in shadow banking activities, which highly correlate with infrastructure spending by local governments, was subdued in 2019. The stock of shadow banking continues to shrink in February, indicating that local governments remain extremely cautious in expanding their off-balance sheet leverage (Chart 6, bottom panel). Chart 6Shadow Bank Lending Continues To Shrink In February Chart 7Demand For Housing Remains In The Doldrums Demand for housing is still in the doldrums. February’s credit data paints a bleak picture of demand for housing, which is also reflected in recent hard data on home sales (Chart 7). It is questionable whether policymakers will allow a significant re-leverage, i.e. a 2016/17-style widespread easing in the property sector to stimulate demand for housing. So far, the government has stated that the housing policy should be city specific. Some cities have already lowered mortgage rates and down payment thresholds. Pledged supplementary lending, a tool that the government utilized to monetize massively excess inventories in the market in 2015/16, has also ticked up (Chart 8). Nevertheless, we do not expect the authorities to allow a sharp upturn in home prices or leverage by households and/or property developers (Chart 9). The government reiterated its stance at last week’s NPC that “housing is for living in and not for speculation.” Chart 8PSL Injections Ticked Up This Year Chart 9Policymakers Are Trying To Avoid Further Inflating The Housing Price Bubble Chart 10Aggregate Demand For Housing Will Dwindle Along With Shrinking Labor Force Furthermore, demands for housing and property-sector investment in China are set to structurally shift lower due to the country’s slumping birthrate and shrinking working-age population (Chart 10). China’s total population will start to shrink within the next five years and the United Nations estimates that China’s marriageable population will be less than 350 million by 2030 – a drop of nearly 100 million people from 2010. Slowing urbanization rates are also a constraint for housing demand. China’s urban population growth is on a sharp downtrend; only 12 million people moved to cities last year, less than half the number who migrated in 2016. Weak consumption. The NPC reported that the government will provide support in rural areas for the consumption of new-energy vehicles (NEVs) and home appliances. There also was a mention of services for elder care and tax credits for having babies. However, there was no indication of a fiscal transfer to low-income households or a cash payout/consumption voucher to boost the marginal propensity to spend. Chart 11Sharply Rising New Cases In China And Its Zero-COVID Policy Will Constraint Domestic Consumption Ultimately, it will be difficult for Chinese policymakers to bolster consumption without relaxing COVID containment measures (Chart 11). The government has made it clear that relaxing COVID policy will not be possible in the near term, given the ongoing outbreaks in China. Therefore, any improvement in household consumption, which accounts for about 40% of China’s GDP, will remain modest. Bottom Line: China’s economic progress this year will hinge on whether a rebound in infrastructure investment can offset the negative effects from slumping demand for real estate and weak consumption. Investment Implications China will eventually ease policies more aggressively to ensure a stable domestic economic, financial and political environment against highly uncertain global and domestic backdrops. More easing and stimulus could be forthcoming by mid-2022, especially when the mainland's COVID situation is rapidly worsening and front-loaded fiscal supports will start to lose momentum. Meanwhile, Chinese stocks face substantial downside risks derived from the turmoil in global equity markets and a downturn in domestic profit growth. As witnessed in China’s onshore and offshore risk assets in the past two weeks, a slightly more positive signal from the NPC was not enough to offset the jitters from heightened geopolitical tensions and rising domestic COVID cases (Chart 12A and 12B). Chart 12AChinese Onshore Stocks Are Not Immune To Geopolitical Risks... Chart 12B...But Have Fared Better Than Their Offshore Peers We maintain our neutral stance on Chinese onshore stocks in a global portfolio, but do not yet recommend that investors buy in the onshore market in absolute terms. We also continue to recommend overweight Chinese government bonds versus stocks in the onshore market, and an underweight stance on Chinese offshore equities in both absolute and relative terms. Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations
Executive Summary The RMB And Real Interest Rates The RMB has overshot and will likely consolidate gains in the coming months. The said, the yuan remains underpinned by a current account surplus, positive real rates, and a valuation cushion. This will support modest appreciation over the next 12-18 months (Feature Chart). The dollar is likely to enter a period of weakness beyond the Russo-Ukrainian crisis, underpinning a firm RMB. Yield spreads between China and the US will narrow across the bond curve, slowing the pace of any RMB appreciation. In its quest to dominate Asian trade flows, China will also seek a stable yuan which can be an anchor for regional currencies. Low volatility in the Chinese bond and currency market will increasingly make it an attractive hedge for global portfolio managers. This will encourage RMB inflows. The financial sanctions on Russia from the ongoing Ukrainian conflict will accelerate Chinese diversification from US assets. It will also boost the use of RMB in global trade, lifting its share in global FX reserves. Bottom Line: In the near term, USD/CNY is due for a bounce and could retrace to 6.5. It is also the case that a lot of the gains in the Chinese RMB have been frontloaded, suggesting a flattish path ahead. Beyond the near term, we expect the DXY to hit 90 in the next 12-18 months, which will boost the RMB towards 6.0. Feature The RMB has been strong across the board versus most major currencies (Chart 1). Year-to-date, the DXY dollar index is up 2% while the CFETS basket is up 3%. This places the Chinese yuan as one of the best performing major currencies this year. Such a configuration where USD/CNY diverges from the broad dollar trend has been very rare in recent history (Chart 2). More importantly, this has occurred amidst very low volatility. Chart 1A Bull Market In Yuans Chart 2USD/CNY And The Dollar Diverge In this Special Report, we try to understand the driving forces behind a rising RMB, to gauge its likely path going forward. In our view, while the yuan is vulnerable tactically, it is underpinned by strong structural forces that support modest appreciation over the next 12-18 months. The Chinese Economy, Interest Rates, And The RMB An exchange rate is simply a mechanism to equalize rates of returns across countries. For most currencies, the key determinants of this arbitrage window are real interest rate differentials. In China, while nominal interest rates vis-à-vis the US have been collapsing, real interest rate differentials are near a record high. This has been the key driver of a rising RMB (Chart 3). Real interest rates tend to matter because high and rising inflation destroys the purchasing power of any currency. Our bias is that higher real rates in China versus the US will persist and keep the RMB firm. Five key reasons underpin this view: The Chinese economy is expected to accelerate this year relative to the US. The IMF expects 4.8% GDP growth in China, versus 4% in the US. Bloomberg consensus estimates corroborate this view – 5.2% growth is expected for China this year, versus 3.6% for the US. Even the Chinese government’s GDP growth target this year is 5.5%, much higher than street estimates. US interest rates are likely to rise over the medium term, but so will those in China. The Chinese credit impulse has bottomed, and it is usually a good precursor to both stronger economic activity and higher relative government bond yields (Chart 4). Chart 3The RMB And Real Versus Nominal Rates Chart 4Interest Rate Differentials And The Credit Impulse While Chinese productivity growth is slowing, it remains structurally higher compared to that in the US or Europe. Stronger productivity growth suggests the neutral rate of interest in China will remain higher than in Western economies for years to come. This will continue to attract further fixed-income inflows. The RMB is a procyclical currency and tends to benefit when flows into emerging market assets in general, and Chinese stocks in particular, are fervent. While the Chinese authorities have cracked down on the property and information technology/communication service sectors, they have done so without causing widespread capital flight and hurting the RMB (Chart 5). Going forward, odds are that the interest from foreign bargain hunters will rise as these sectors reset from lower and much cheaper levels. It is well known that the Chinese economy has excess capacity, which is inherently deflationary (and positive for real rates). Like Japan, China has excess savings and deficient demand (Chart 6). However, in an inflationary world, this excess capacity can easily be exported, especially to the US, which is on the verge of overheating. A healthy trade balance in China suggests there is little reason for the RMB to depreciate meaningfully. Chart 6Excess Savings In China And Low Inflation Chart 5The RMB And Chinese Equities It is remarkable that despite being the largest commodity importer in the world, terms of trade in China is picking up. Rising terms of trade is usually synonymous with a stronger currency. On the flip side, a stronger currency will also temper inflationary pressures in China (Chart 7). Chart 7The RMB, Terms Of Trade And Inflation The bottom line is that real interest rates will remain relatively high in China, even as the US begins to tighten monetary policy while China eases. The reason is that the US economy is much more inflationary, and Chinese bond yields tend to rise when the PBoC stimulates growth. Market Liberalization And Portfolio Flows With attractive real yields, Chinese bonds have been gaining widespread investor appeal. Their inclusion in the world’s three major bond indices has been a seminal milestone in the process of liberalizing the Chinese fixed-income market. Chinese bonds have also acted as perfect portfolio hedges, moving inversely to US and global equities (Chart 8). The result has been significant portfolio inflows into Chinese bonds. As a reminder, Chinese bonds were initially included in the Bloomberg Barclays Global Aggregate Index (BBGA) in April 2019. Following that, they were added to the JP Morgan Government Bond - Emerging Market Index (GBI-EM) in February 2020. Finally, FTSE Russell announced their inclusion of in the FTSE World Government Bond Index (WGBI) as of October 2021. Since their inclusion, a net US$350 billion has flowed into Chinese bonds. We estimate that about 35% of that has been due to index inclusion. The amount of Chinese onshore bonds held by overseas investors has breached US$600 billion, a record high (Chart 9). Chart 9A Healthy Appetite From Foreign Investors Chart 8RMB Bonds As A Portfolio Hedge In a nutshell, the path of the RMB in the short term will follow relative growth dynamics between China and the rest of the world, but structural factors such the inclusion of RMB bonds in global portfolios will underpin strong inflows into the Chinese fixed-income market. The Dollar, Trade, And Lessons From The Ukrainian Conflict Chart 10China Is Destocking USDs Another factor to consider vis-à-vis the RMB is the dollar’s reserve status, and the overreach that it commands. Quite simply, transactions conducted in US dollars anywhere fall under US law. This means that if a company in any country buys energy from Iran and the transaction is done in US dollars, the Treasury has powers to sanction the parties involved. Russian holdings of US Treasurys peaked during the Georgian war and have since fallen to near 0% of total reserves. Even so, the world has witnessed how vulnerable the Russian economy has been to a cut-off from the Society For Worldwide Interbank Financial Telecommunication (SWIFT) messaging system. China is the largest holder of US Treasurys and what it decides to do with this war chest of savings is of critical importance. At a minimum, a few trends that have been underway in recent years are likely to accelerate. China will continue to destock its holding of Treasurys into gold and other currencies (Chart 10). This will put downward pressure on the dollar and boost the RMB. In fact, ever since China started destocking Treasurys in earnest in 2015, the DXY has been unable to sustainably punch through the 100 level. Trade flows in Asia remain rather buoyant, even as globalization has peaked (Chart 11A and 11B). With most Asian countries having China as a large trading partner, the logical step will be more and more invoicing in RMB. Most global trade hubs in history (such as Hong Kong for example) have always sought a stable currency with low volatility to instill confidence in trade. China is likely to also favor a stable RMB. Chart 11AChina Could Dominate Asian Trade Chart 11BAsian Trade Is Booming As Asian trade continues to expand, the PBoC can step in as the regional central bank and lender of last resort. It is notable that China is already engaging in this role. Since the global financial crisis, the number of bilateral swap lines offered to foreign central banks by the PBoC has ballooned (Chart 12). According to the most recent data (from the PBoC), the Chinese central bank had bilateral local currency swap agreements with central banks or monetary authorities in 40 countries and regions, with a total amount of around 4 trillion yuan. The People’s Bank of China has massive foreign exchange reserves, worth about US$3.2 trillion. This means it can provide swap agreements that will almost cover the totality of EM foreign dollar debt. The Cross-Border Interbank Payment System (CIPS) already allows the transfer and clearing of yuan-denominated payments. In 2021, the system processed US$12.7 trillion, a 75% increase in turnover from the previous year.1 While the system still largely relies on SWIFT messaging for most cross-border transactions, progress towards independence is moving fast. The key point is that as China continues to rise as an economic power and increases the share of RMB trade within its sphere of influence, the yuan will naturally become the de facto Asian currency. This will allow the RMB to continue to gain international appeal (Chart 13). Chart 12The People's Bank Of Asia? Chart 13The RMB And International Appeal Valuation Concerns Most of the discussion above has focused on the cyclical outlook for the Chinese economy and bond yields, as well as the geopolitical ramifications from the Russo-Ukrainian conflict. While the macro environment is by far the most important driver of currencies, valuation and sentiment tend to matter as well. On this note: Our productivity model suggests the RMB is at fair value. Productivity in China remains higher than among its western trading partners, but the gap has been closing. This has flattened the slope of the fair-value model (Chart 14). That said, the US and Europe are generating much higher inflation than China, suggesting there is higher pressure for unit labor costs to rise in these countries. This will improve the competitive profile of the RMB. Our PPP model for the RMB, using an apples-to-apples consumer basket vis-à-vis the US suggests the RMB is undervalued by 11% (Chart 15). Historically, such levels of undervaluation have seen the RMB appreciate by 2% per year over the next 4 years (Chart 16). Chart 14The RMB Is At Fair Value Based On Productivity Trends Chart 15The RMB Is Cheap Based On Relative Prices Chart 16Potential RMB Returns For Foreign Investors Valuation tends to be important because it is usually the trigger for imbalances to manifest themselves. Back in 2015-20162 when Chinese capital outflows (especially illicit flows) were rampant amongst global and Chinese concerns, the RMB also happened to be very overvalued. Today, such a risk is much limited. Concluding Thoughts The RMB and the dollar tend to move in harmony, and so a discussion of one entails talking about the other. We have characterized the dollar this year as caught in a tug of war. Specifically, aggressive rate hikes by the Federal Reserve will boost interest rate differentials in favor of the US but undermine the equity market via a derating in stocks. This will tighten financial conditions, nudging the Fed to pivot. On the other hand, less accommodation by the Fed will significantly unwind the rate-driven rally that has nudged the DXY close to 100. On the other hand, the Chinese credit impulse has bottomed meaning bond investors will benefit from rising bond yields in China. Equity investors will also benefit from a cheaper market, as well as exposure to sectors that are primed to benefit as the global economy reopens. This combination could sustain the pace of foreign capital inflows. In the near term, USD/CNY is due for a bounce and could retrace to 6.5. It is also the case that a lot of the gains in the Chinese RMB have been front loaded, suggesting a flattish path ahead. Beyond the near term, we expect the DXY to hit 90 in the next 12-18 months, which will boost the RMB towards 6.0. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Reuters: https://www.reuters.com/markets/europe/what-is-chinas-onshore-yuan-clearing-settlement-system-cips-2022-02-28/ 2 Please see Chinese Investment Strategy Special Report, titled “Monitoring Chinese Capital Outflows,” dated March 20, 2019, available at cis.bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary
Executive Summary On a tactical (3-month) horizon, the inflationary impulse from soaring energy and food prices combined with the choke on growth from sanctions will weigh on both the global economy and the global stock market. As such, bond yields could nudge higher, the global stock market has yet to reach its crisis bottom, and the US dollar will rally. But on a cyclical (12-month) horizon, the short-term inflationary impulse combined with sanctions will be massively demand-destructive, at which point the cavalry of lower bond yields will charge to the rescue. Therefore: Overweight the 30-year T-bond and the 30-year Chinese bond, both in absolute terms and relative to other 30-year sovereign bonds. Overweight equities. Overweight long-duration US equities versus short-duration non-US equities. Fractal trading watchlist: Brent crude oil, and oil equities versus banks equities. The DAX Has Sold Off ##br##Because It Expects Profits To Plunge… …But The S&P 500 Has Sold Off ##br##Because The Long Bond Has Sold Off Bottom Line: In the Ukraine crisis, the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. If anything, the fixation on inflation and sanctions may increase short-term pain for both the economy and the stock market, before the cavalry of lower bond yields ultimately charges to the rescue. Feature Given the onset of the largest military conflict in Europe since the Second World War, with the potential to escalate to nuclear conflict, you would have thought that the global stock market would have crashed. Yet since Russia’s full-scale invasion of Ukraine on February 24 to the time of writing, the world stock market is down a modest 4 percent, while the US stock market is barely down at all. Is this the stock market’s ‘Wile E Coyote’ moment, in which it pedals hopelessly in thin air before plunging down the chasm? Is this the stock market’s ‘Wile E Coyote’ moment, in which it pedals hopelessly in thin air before plunging down the chasm? Admittedly, since the invasion, European bourses have fallen – for example, Germany’s DAX by 10 percent. And stock markets were already falling before the invasion, meaning that this year the DAX is down 20 percent while the S&P 500 is down 12 percent. But there is a crucial difference. While the DAX year-to-date plunge is due to an expected full-blooded profits recession that the Ukraine crisis will unleash, the S&P 500 year-to-date decline is due to the sell-off in the long-duration bond (Chart I-1 and Chart I-2). This difference in drivers will also explain the fate of these markets as the crisis evolves, just as in the pandemic. Chart I-1The DAX Has Sold Off Because It Expects Profits To Plunge... Chart I-2...But The S&P 500 Has Sold Off Because The Long Bond Has Sold Off During The Pandemic, Central Banks And Governments Saved The Day… We can think of a stock market as a real-time calculator of the profits ‘run-rate.’ In this regard, the real-time stock market is several weeks ahead of analysts, whose profits estimates take time to collect, collate, and record. For example, during the pandemic, the stock market had already discounted a collapse in profits six weeks before analysts’ official estimates (Chart I-3 and Chart I-4). Chart I-3The German Stock Market Is Several Weeks Ahead Of Analysts Chart I-4The US Stock Market Is Several Weeks Ahead ##br##Of Analysts We can also think of a stock market as a bond with a variable rather than a fixed income. Just as with a bond, every stock market has a ‘duration’ which establishes which bond it most behaves like when bond yields change. It turns out that the long-duration US stock market has the same duration as a 30-year bond, while the shorter-duration German stock market has the same duration as a 7-year bond. Pulling this together, and assuming no change to the very long-term structural growth story, we can say that: The US stock market = US profits multiplied by the 30-year bond price (Chart I-5 and Chart I-6). The German stock market = German profits multiplied by the 7-year bond price (Chart I-7 and Chart I-8). Chart I-5US Profits Multiplied By The 30-Year Bond Price... Chart I-6...Equals The US Stock Market Chart I-7German Profits Multiplied By The 7-Year Bond Price... Chart I-8...Equals The German Stock Market When bond yields rise – as happened through December and January – the greater scope for a price decline in the long-duration 30-year bond will hurt the US stock market both absolutely and relatively. But when bond yields decline – as happened at the start of the pandemic – this same high leverage to the 30-year bond price can protect the US stock market. When bond yields decline, the high leverage to the 30-year bond price can protect the US stock market. During the pandemic, the 30-year T-bond price surged by 35 percent, which more than neutralised the decline in US profits. Supported by this surge in the 30-year bond price combined with massive fiscal stimulus that underpinned demand, the pandemic bear market lasted barely a month. What’s more, the US stock market was back at an all-time high just four months later, much quicker than the German stock market. …But This Time The Cavalry May Take Longer To Arrive Unfortunately, this time the rescue act may take longer. One important difference is that during the pandemic, governments quickly unleashed tax cuts and stimulus payments to shore up demand. Whereas now, they are unleashing sanctions on Russia. This will choke Russia, but will also choke demand in the sanctioning economy. Another crucial difference is that as the pandemic took hold in March 2020, the Federal Reserve slashed the Fed funds rate by 1.5 percent. But at its March 2022 meeting, the Fed will almost certainly raise the interest rate (Chart I-9). Chart I-9As The Pandemic Took Hold, The Fed Could Slash Rates. Not Now. As the pandemic was unequivocally a deflationary shock at its outset, it was countered with a massive stimulatory response from both central banks and governments. In contrast, the Ukraine crisis has unleashed a new inflationary shock from soaring energy and food prices. And this on top of the pandemic’s second-round inflationary effects which have already dislocated inflation into uncomfortable territory. Our high conviction view is that this inflationary impulse combined with sanctions will be massively demand-destructive, and thereby ultimately morph into a deflationary shock. Yet the danger is that myopic policymakers and markets are not chess players who think several moves ahead. Instead, by fixating on the immediate inflationary impulse from soaring energy and food prices, they will make the wrong move. In the Ukraine crisis, the big risk is that the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. If anything, the fixation on inflation and sanctions may increase short-term pain for both the economy and the stock market. Compared with the pandemic, both the sell-off and the recovery will take longer to play out. In the Ukraine crisis, the big risk is that the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. One further thought. The Ukraine crisis has ‘cancelled’ Covid from the news and our fears, as if it were just a bad dream. Yet the virus has not disappeared and will continue to replicate and mutate freely. Probably even more so, now that we have dismissed it, and Europe’s largest refugee crisis in decades has given it a happy hunting ground. Hence, do not dismiss another wave of infections later this year. The Investment Conclusions Continuing our chess metaphor, a tactical investment should consider only the next one or two moves, a cyclical investment should be based on the next five moves, while a long-term structural investment (which we will not cover in this report) should visualise the board after twenty moves. All of which leads to several investment conclusions: On a tactical (3-month) horizon, the inflationary impulse from soaring energy and food prices combined with the choke on growth from sanctions will weigh on both the global economy and the global stock market. As such, bond yields could nudge higher, the global stock market has yet to reach its crisis bottom, and the US dollar will rally (Chart I-10). Chart I-10When Stock Markets Sell Off, The Dollar Rallies But on a cyclical (12-month) horizon, the short-term inflationary impulse combined with sanctions will be massively demand-destructive, at which point the cavalry of lower bond yields will charge to the rescue. Therefore: Overweight the 30-year T-bond and the 30-year Chinese bond, both in absolute terms and relative to other 30-year sovereign bonds. Overweight equities. Overweight long-duration US equities versus short-duration non-US equities. How Can Fractal Analysis Help In A Crisis? When prices are being driven by fundamentals, events and catalysts, as they are now, how can fractal analysis help investors? The answer is that it can identify when a small event or catalyst can have a massive effect in reversing a trend. In this regard, the extreme rally in crude oil has reached fragility on both its 65-day and 130-day fractal structures. Meaning that any event or catalyst that reduces fears of a supply constraint will cause an outsized reversal (Chart I-11). Chart I-11The Extreme Rally In Crude Oil Is Fractally Fragile Equally interesting, the huge outperformance of oil equities versus bank equities is reaching the point of fragility on its 260-day fractal structure that has reliably signalled major switching points between the sectors (Chart I-12). Given the fast-moving developments in the crisis, we are not initiating any new trades this week, but stay tuned. Chart I-12The Huge Outperformance Of Oil Equities Versus Banks Equities Is Approaching A Reversal Fractal Trading Watchlist Biotech To Rebound US Healthcare Vs. Software Approaching A Reversal Norway's Outperformance Could End Greece’s Brief Outperformance To End Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Executive Summary Upgrade Global Duration Exposure To Neutral The Russian invasion of Ukraine is a stagflationary shock that comes at a difficult time for developed market central banks that have been laying the groundwork for a tightening cycle. We tactically upgraded our recommended duration exposure in the US to neutral last week, as the market was pricing in too much Fed tightening in 2022. We are doing similar upgrades in non-US government bonds this week for the same reason. We are maintaining our cyclical country allocations, however, as those remain in line with interest rate pricing beyond 2022. We are underweight markets where terminal rate expectations remain too low (the US, UK & Canada) and overweight countries where markets are discounting too many rate hikes in 2023/24 (Germany, Japan, Australia). In light of the instability caused by the Russian invasion of Ukraine, we are reducing weightings in our model bond portfolio to credit sectors highly exposed to the war - European high-yield and emerging market hard currency debt. Bottom Line: The Ukraine war comes at a time when global growth momentum was already starting to roll over and with global inflation momentum set to peak soon. Upgrade duration exposure to neutral from underweight in global bond portfolios. Feature Among the tail risks that investors contemplated in their planning for 2022, World War III was likely not ranked too highly on the list. The horrific images of the Russian invasion of Ukraine – and the sharp response of the West to isolate Russia through unprecedented economic and financial sanctions - have shocked global financial markets that had been focused on relatively mundane concerns like the timing of interest rate hikes. BCA sent a short note to all clients late last week that discussed the investment implications of the invasion for several asset classes. In this report, we consider the bond market ramifications of war in Eastern Europe. Our main conclusion is that the Ukraine situation will produce a brief “stagflationary” shock that will boost global inflation and slow global growth, on the margin. High energy prices will be the main driver of that stagflation, given the uncertainties over the availability of Russian oil and natural gas supplies (Chart 1). Tighter financial conditions - beyond what has already occurred so far this year as global equity and credit markets have sold off (Chart 2) – will also contribute to the moderation of the pace of global growth. Chart 1A Mild Inflationary Shock From The Russian Invasion Chart 2The Ukraine War Is Adding To 2022 Risk-Off Trends The stagflation shock should be relatively short, perhaps 3-6 months. BCA’s Commodity & Energy Strategy service expects OPEC to eventually supply more oil to the global market – a move that was already likely before the Russian invasion – helping to reduce the Russian supply premium in oil prices. Putin will likely have to be satisfied with claiming eastern Ukraine rather than being stuck in a protracted battle with fierce Ukrainian resistance while Russia suffers under crippling sanctions. BCA’s Geopolitical Strategy service does not expect the conflict to spread beyond Ukraine’s borders, as neither Russia nor NATO have an interest in war with each other (despite the nuclear saber-rattling by Russian President Putin in response to Western sanctions). A mild bout of stagflation will only delay, and not derail, the cyclical move towards tighter global monetary policies in response to elevated inflation and tightening labor markets, particularly in the US. This will take some of the upward pressure off global bond yields as central banks will be less hawkish than expected in 2022, but does not change the outlook for higher bond yields in 2023 and 2024. In terms of changes to our fixed income investment recommendations, and the allocations to our Model Bond Portfolio, we come to the following three conclusions. Upgrade Tactical Non-US Duration Exposure To Neutral We recently upgraded our recommended tactical duration exposure in the US to neutral, with the Fed likely to deliver fewer rate hikes this year than what is discounted by markets. The Ukraine situation makes it even more likely that the Fed will underwhelm expectations. A 50bp rate hike at the March FOMC meeting is now off the table, as the equity and credit market selloffs in response to the conflict have tightened US (and global) financial conditions on the margin. However, the war is not enough of a negative shock to US growth to derail the Fed from starting a gradual tightening process this month with a 25bp hike. Our decision to change our US duration stance was largely predicated on a view that US inflation will soon peak and slow significantly over the rest of 2022. However, there is a strong case to increase non-US duration exposure, as well. Our Global Duration Indicator - comprised of leading cyclical growth indicators and which itself leads the year-over-year change in our “Major Countries” GDP-weighted aggregate of 10-year government bond yields by around six months - peaked back in February 2021 (Chart 3). The Global Duration Indicator is now at a “neutral” level consistent with more stable bond yield momentum. Declines in the ZEW economic expectations survey in the US and Europe, and in our global leading economic indicator, are the main culprits behind the fall in the Global Duration Indicator (Chart 4). Chart 3Upgrade Global Duration Exposure To Neutral Chart 4Growth Expectations Have Turned Less Bond Bearish ... For Now While the ZEW series have rebounded in the first two months of 2022, which could set the stage for a move back to higher yields later this year, the Ukraine situation will likely hurt economic expectations (particularly in Europe) in the near-term. We expect our Global Duration Indicator to continue signaling a more neutral backdrop for global bond yields over the next few months. In our Model Bond Portfolio on pages 13-14, we are expressing our view change by increasing the duration for all countries such that the overall duration of the portfolio is in line with the custom benchmark index (7.5 years). Importantly, we view this as only a tactical view change for the next few months, as developed economy interest rate markets are still discounting too few rate hikes – and in some countries like the UK and US, actual rate cuts – in 2023/24 (Chart 5). Chart 5Priced For Short, Shallow Hiking Cycles Maintain Cyclical Government Bond Country Allocations That Favor Lower Inflation Regions Chart 6Oil Is Inflationary Now, Will Be Disinflationary Later While we are neutralizing our global duration stance over a tactical time horizon (0-6 months), we are sticking with our current recommended cyclical (6-18 months) government bond country allocations. These are based on underlying inflation trends and the expected monetary policy response over the next couple of years. As noted earlier, BCA’s commodity strategists expect oil prices to fall from current war-elevated levels in response to increased supply from OPEC. The benchmark Brent oil price is forecasted to reach $88/bbl at the end of this year and $87/bbl and the end of 2023. The result will be a sharp decline in the year-over-year growth rate of oil prices that will help bring down headline inflation in all countries (Chart 6). Lower energy inflation, however, will not be the only factor reducing overall inflation across the developed world. Goods price inflation should also slow from current elevated levels over the next 6-12 months, as consumer spending patterns shift away from goods towards services with fewer pandemic-related restrictions on activity. Less goods spending will help ease some of the severe supply chain disruptions that have fueled the surge in global goods price inflation over the past year. That process has likely already begun – indices of global shipping costs have peaked and supplier delivery times have been shortening according to global manufacturing PMI surveys. The shift from less goods spending towards more services spending will lead to trends in overall inflation being determined more by services prices than goods prices. The central banks in countries that have higher underlying inflation, as evidenced by faster services inflation, will be under more pressure to tighten policy over the next couple of years. Therefore, our current cyclical recommended country allocations (and our Model Bond Portfolio weightings) within developed market government bonds reflect the relative trends in services inflation. We are currently recommending underweights in the US, UK and Canada where services inflation is currently close to 4%, well above the central bank 2% inflation targets (Chart 7). At the same time, we are recommending overweights in core Europe (Germany and France) and Australia, where services inflation is around 2.5%, and Japan where services prices are deflating (Chart 8). Chart 7Higher Underlying Inflation In Our Recommended Underweights Chart 8Lower Underlying Inflation In Our Recommended Overweights Chart 9Faster Wage Growth In Our Recommended Underweights The trends in services inflation are also reflected in wage growth in those same groups of countries – much higher in the US, UK and Canada compared to Australia, the euro area and Japan (Chart 9). We expect these relative trends to continue over the next 12-24 months, with higher underlying inflation pressures forcing the Fed, the Bank of England (BoE) and the Bank of Canada (BoC) to be much more hawkish, on a relative basis, than the European Central Bank (ECB), the Reserve Bank of Australia (RBA) and the Bank of Japan (BoJ). Our current bond allocations not only fit with underlying inflation trends, but also with market-based interest rate expectations. In Table 1, we show the pricing of interest rate expectations over the next few years, taken from Overnight Index Swap (OIS) forwards. We show the OIS projection for 1-month interest rates 12 months from now and 24 months from now. We also include 5-year/5-year forward OIS rates as a measure of market expectations of the terminal rate, a.k.a. the peak central bank policy rate over the next tightening cycle. In the table, we also added neutral policy rate estimates taken from central bank sources.1 Table 1Medium-Term Interest Rate Expectations Still Too Low In The US & UK In the US and UK, the OIS rate projections two years out, as well as the 5-year/5-year forward rate, are below the range of neutral rate estimates. This justifies an underweight stance on both US Treasuries and UK Gilts with both the Fed and BoE now in tightening cycles. In Japan and Australia, the OIS projections are already within the range of neutral rate estimates, but the RBA and, especially, the BoJ are not yet signaling a need to begin normalizing the level of policy rates. This justifies an overweight stance on Australian government bonds and Japanese government bonds. In the euro area, OIS projections are below the range of neutral rate estimates, but the ECB is now signaling that any monetary tightening actions will need to be delayed because of the growth uncertainties stemming from the Ukraine conflict and high energy prices. Thus, an overweight stance on core European government debt is still warranted. In Canada, the OIS projections are within the range of neutral rate estimates, but the BoC has been preparing markets for a series of rate hikes. This makes our underweight stance on Canadian government bonds a more “mixed” call, although we remain confident that Canadian bonds will underperform in a global bond portfolio context versus European and Japanese government bonds. In sum, we see our recommended country allocations as the most efficient way to express our cyclical (medium-term) central bank views, given the strong link between forward interest rate expectations and longer-term bond yields (Chart 10). This is why we are not making changes to our country allocation recommendations alongside our move to tactically upgrade our global duration stance to neutral. Chart 10Too Much Tightening Priced Over The Next Year Chart 11Bond Markets Not Priced For A Relatively More Hawkish Fed Given our high-conviction view that markets are underestimating how high the Fed will need to lift interest rates in the upcoming tightening cycle – likely more than any other major developed economy central bank - positioning for US Treasury market underperformance on a 1-2 year horizon still looks like an attractive bet with forward rates priced for little change in US/non-US bond spreads (Chart 11). A wider US Treasury-German Bund spread remains our highest conviction cross-country spread recommendation. Reduce Spread Product Exposure In Europe & Emerging Markets Chart 12Cut EM & European High-Yield Exposure, But Stay O/W Italian BTPs The geopolitical uncertainty stemming from the Ukraine war and the stagflationary near-term impact of high energy prices are negatives for all risk assets, on the margin. That leads us to tactically reduce the allocation to spread product to neutral versus government debt in our Model Bond Portfolio. We are implementing this by cutting allocations to riskier fixed income sectors that are most impacted by the Russia/Ukraine conflict – European high-yield corporate debt and emerging market (EM) USD-denominated hard currency debt (Chart 12). We had already been cautious on EM debt before the Russian invasion, with an underweight allocation to both USD-denominated sovereigns and corporates, so the latest moves just increase the size of the underweight. European high-yield, on the other hand, had been one of our highest conviction overweight positions – particularly versus US high-yield - entering 2022. However the Ukraine war is likely to have a bigger negative impact on the European economy than the US economy, thus we are cutting our recommended exposure to European high-yield only. The uncertainty of a war on European soil, combined with the spike in energy prices (especially natural gas), is negative for European growth momentum, reducing 2022 euro area real GDP growth by as much as 0.4 percentage points according to ECB estimates. This raises the hurdle for any ECB monetary tightening this year. An early taper of bond buying in the ECB’s Asset Purchase Program, an outcome that ECB officials claim is a required precursor to rate hikes, is now highly unlikely. Fears of reduced ECB bond buying had weighed on the relative performance of Italian government bonds last month, but a more dovish ECB policy stance should lead to lower Italian yields and a narrowing of the BTP-Bund spread (bottom panel). We continue to recommend a cyclical overweight stance on Italian government debt. A Final Thought We need to reiterate that the recommended changes made in this report – increasing global duration exposure to neutral and cutting EM and European high-yield – are over a tactical time horizon, largely in response to the Ukraine conflict. This is more of a “risk management” exercise, rather than a change in our fundamental cyclical views. We still believe global growth will remain above trend in 2022 and likely 2023, which will prevent a complete unwind of last year’s inflation surge, particularly in the US. We expect global bond yields to begin climbing again later this year and into 2023, and we envision an eventual return to a below-benchmark duration stance. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The sources of the neutral rate estimates are listed in the footnotes of Table 1. 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 Chinese Onshore Stocks Are Less Impacted By External Factors We are upgrading Chinese onshore stocks from underweight to neutral relative to global stocks. At the same time, we are closing our tactical trade of long Chinese investable stocks/short global stocks. In the near term, Russia’s armed invasion of Ukraine will spark a further selloff in global risk assets. Volatility in Chinese onshore stock prices will remain high; A-share prices in absolute terms may also drop but should fall by less than their peers in European and emerging markets. On the other hand, Chinese offshore stocks are more vulnerable to geopolitical risks compared with their onshore counterparts. There are tentative signs that home prices may be stabilizing, although demand for housing remains in deep contraction. Chinese policymakers remain vigilant in preventing the property market from overheating and credit creation from overshooting. However, the ongoing Russia/Ukraine incursion has the potential to catalyze a larger stimulus package in China. If the escalating geopolitical crisis threatens the global economy, China’s authorities will likely strengthen policy supports at home to buttress the country’s domestic political, economic and financial conditions. Bottom Line: Chinese onshore stocks will weather the ongoing geopolitical storm better than their offshore and global peers. China’s economy is also less negatively impacted by the Russia/Ukraine hostilities. If the crisis deepens, China’s leadership will likely step up measures to support its economy and ensure stable domestic financial and political dynamics. Feature The conflict between Russia and Ukraine unnerved global financial markets in the past few weeks. Chinese offshore stocks were not insulated from the geopolitical event; the MSCI China Index declined by about 4% in February, in-line with the selloff in global stocks. Chart 1Chinese Onshore Financial Markets Held Up Relatively Well Last Month The current global geopolitical environment, however, has turned us a bit more positive on Chinese onshore stocks in relative terms. In the near term, the onshore market should hold up better than its offshore and European counterparts. China’s closed capital market prevents panic capital outflows and its large current account surplus as well as favorable real interest rate differentials help to maintain strength in the RMB (Chart 1). On a cyclical basis, China’s domestic economic fundamentals will continue to drive prices in the A-share market. China’s aggregate economy is less affected by the Russia/Ukraine conflict than Europe. Energy supplies from Russia to China will likely continue and may even accelerate, mitigating the risks of energy shock-induced inflation spikes. As such, we are upgrading Chinese onshore stocks from underweight to neutral in a global portfolio, both in tactical and cyclical time horizons. We remain cautious about the size of Chinese stimulus for the year and, therefore, are neutral in our cyclical view on Chinese onshore stocks relative to global equities. Despite some nascent signs of reflation and an easing of housing policy in a few Chinese cities, aggregate property demand remains weak and overall policy easing in the sector has been marginal. Nonetheless, the situation surrounding Ukraine and the global sanctions against Russia are highly fluid and may provide some ground for Chinese policymakers to ramp up stimulus at home. If the conflict intensifies and derails the European/global economy, Beijing will be more inclined to adopt measures to ensure the stability of its domestic economy, financial markets and political dynamics. Meanwhile, we are closing our long MSCI China/short MSCI global tactical trade. Chinese offshore stocks are more vulnerable to geopolitical tensions and risk-off sentiment among global investors. The Russia Incursion Has Limited Direct Impact On China’s Economy Chinese stocks were not immune last week to the global financial market’s gyrations triggered by Russia’s invasion of Ukraine. While Russia’s attack on its neighbor will create short-term disruptions on the prices of global commodities and China’s A-shares, the cyclical performance of Chinese onshore stocks is tied to the country’s domestic economic fundamentals. The military conflict between Russia and Ukraine should have a limited knock-on effect on China’s business cycle dynamics for the following reasons: Russia and Ukraine together account for less than 3% of Chinese total exports as of 2021, limiting the negative impact from reduced demand in the region on China’s current account balance. Chart 2Ukraine: China’s Major Source Of Agricultural Commodity Supplies Russia’s incursion of Ukraine may have consequences on China’s food prices. Ukraine is a major agricultural commodity exporter to China, hence a prolonged military conflict may disrupt agricultural supplies and push up imported food prices in China (Chart 2). In this scenario, we expect that Beijing will provide subsidies to ease pressures on domestic food prices due to supply shocks, rather than tighten monetary policy to reduce demand. China is unlikely to experience shocks linked to possible energy disruptions. Russia is a core exporter of energy to China and supplies of crude oil, natural gas and coal have increased in recent years (Chart 3). We do not expect that Russia’s energy supply to China will be disrupted. Indeed, following the 2014 Russia’s invasion of Crimea, Russia’s crude oil exports to China increased by 40% (Chart 3, top panel). We anticipate that oil prices will fall from the current level in the second half of the year, limiting the upshot from higher oil prices on Chinese inflation. So far, the US and EU have announced tough sanctions on Russia’s non-energy sectors, but they have avoided halting Russia’s energy exports. In the unlikely scenario that energy flows from Russia to Europe are disrupted in any meaningful and long-lasting way, either through European sanctions or a Russian embargo, Russia would probably turn to China to absorb its energy exports. Given that Russia cannot easily replace Europe with any other alternative market, particularly natural gas, China would gain an upper hand in price negotiations with the Russians (Chart 4). Thus, a steady supply of cheap natural gas and other forms of energy would be a net positive for China’s economy. Chart 4Russia Cannot Easily Replace Europe With Any Alternative Consumer Other Than China Chart 3Russia's Ties With China On Energy Supplies Will Likely Strengthen Meanwhile, oil’s current price spike may widen the gap in profits between China’s upstream and downstream industrial enterprises (Chart 5). However, the effect from higher oil prices on Chinese downstream manufacturers should be temporary. Our Commodity and Energy Strategists believe that the Russian invasion will prompt increased production from core OPEC producers. These production increases would reduce prices from last week’s $105 per barrel level to $85 per barrel by the second half of 2022 and keep it at that level throughout 2023 (Chart 6). Chart 6Crude Oil Price Risk Premium Will Abate But Not Disappear Chart 5Rising Oil Prices May Temporarily Widen Profit Gaps Between China's Up- And Downstream Industries Bottom Line: Russia’s invasion of Ukraine should have a limited direct impact on China’s domestic economy, inflation and monetary policy. Tentative Signs Of Home Price Stabilization Although the property market is showing some signs of improvement, the aggregate demand for homes remains very sluggish. Recently released housing data in China show some slight progress, as fewer cities reported a month-on-month drop in new home prices in January (Chart 7). The monthly average new home prices among China’s 70 cities were broadly flat last month following four consecutive months of falling prices. Tier 1 and Tier 2 cities had the largest increases in home prices, whereas prices in other regions continued to contract through January, albeit to a lesser degree (Chart 7, bottom panel). The minor improvement in home prices reflects recently implemented measures to help shore up the flagging market. Last month, the PBoC cut the policy rate by 10 bps and reduced the one- and five-year loan prime rates by 10 bps and 5 bps, respectively. Moreover, last week several regional banks lowered the down payments on mortgages for homebuyers. Chart 8...Demand For Housing Remains In Deep Contraction Chart 7Although There Are Some Early Signs Of Stabilization In Home Prices... Nonetheless, the aggregate demand for housing remains weak. China’s 100 largest developers experienced a roughly 40% year-on-year plunge in total sales in January, indicating that recent easing measures failed to revive the downbeat sentiment among homebuyers (Chart 8). Bottom Line: Policymakers will remain vigilant in not inducing another surge in house prices and will continue to target steady home prices. As such, it is too early to upgrade our cyclical view on China’s property market, stimulus and economic recovery. Investment Conclusions We are upgrading Chinese onshore stocks to neutral relative to global equities (both tactically and in the next 6 to 12 months), while closing our tactical trade of long MSCI China/short MSCI global index. Chart 9Chinese Onshore Stock Prices Are Largely Driven By Domestic Rather Than External Factors... Given the limited impact of the Russia/Ukraine conflict on China’s domestic economy and the low correlation to the global equity index, Chinese onshore stock prices may also fall in absolute terms in the coming weeks, but not by as much as their offshore and European counterparts (Chart 9). Furthermore, while we maintain a cautious cyclical outlook for China’s stimulus, the ongoing geopolitical crisis has the potential to provide a catalyst for Chinese policymakers to stimulate the domestic economy more forcefully. If the clash evolves into a real risk to the European economy and global financial markets, odds are high that Chinese policymakers will step up stimulus measures to ensure domestic stability. In this scenario, Chinese onshore stocks will likely outperform global equities. In the past, Chinese authorities refrained from a credit overshoot when the business cycle slowed in an orderly manner, but they stimulated substantially following an exogenous shock. For example, China rolled out massive stimulus packages after the 2008 Global Financial and the 2011/12 European credit crises. Beijing did not directly respond to Russia’s 2014 annexation of Crimea with additional monetary support to China’s domestic economy. However, the Chinese authorities started to aggressively stimulate when a collapse in domestic demand coincided with a global manufacturing recession in 2015. Chart 10...Whereas Chinese Offshore Stocks Are More Vulnerable To Global Risk-Off Sentiment The PBoC’s outsized liquidity injection in the interbank system last Friday is also a sign that Beijing is willing to accelerate policy easing if the geopolitical backdrop meaningfully worsens. Regarding Chinese investable stocks, we maintain our cyclical underweight stance relative to global equities. In the near term, risk-off sentiment among global investors will undermine the performance of Chinese offshore stocks in both absolute and relative terms (Chart 10). Over a longer time horizon (6 to 12 months), growth stocks will likely underperform value stocks when global stocks recover. Thus, the tech-heavy MSCI China Index is less attractive to investors compared with other emerging and developed market equities that are more value-centric. Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations