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Executive Summary More Regional Divergences Within Our Global LEI The BCA global leading economic indicator (LEI) is still in a downtrend, but its diffusion index – which tends to lead the overall global LEI at major cyclical turning points – has crept higher since bottoming in January. The diffusion index is rising in part because of very marginal increases in the LEIs of a few countries, but there have been more decisive increases in the LEIs of two major countries outside the developed world – China and Brazil. There is not yet enough evidence pointing to a true bottoming of the BCA global LEI anytime soon, but an improvement in the LEI diffusion index above 50 (i.e. a majority of countries with a rising LEI) would be a more convincing signal that global growth momentum is set to rebound. Bottom Line: Given the uncertain message on growth from our global LEI, and with inflation rates still too high for central banks to pivot dovishly, we recommend staying close to neutral on overall global fixed income duration and modestly defensive on overall spread product exposure. Feature Investors can be forgiven for being a bit confused by some conflicting messages in recent global economic data. For example, US real GDP contracted in both the first and second quarter of this year – a so-called “technical recession” – and consumer confidence is at multi-decade lows, yet the US unemployment rate fell to 3.5%, the lowest level since 1969, in July. A similar story is playing out across the Atlantic, where a historic surge in energy prices was supposed to have already tipped the euro area into recession, yet real GDP expanded in both Q1 and Q2 at an above-trend pace and unemployment continues to decline. At times like the present, when market narratives do not always line up with hard data, we always believe it important to look within our vast suite of indicators to help clear the fog. One of our most trusted growth indicators, the BCA Global Leading Economic Indicator (LEI), is still falling and, thus, signaling a continued deceleration of global growth over at least the next 6-9 months. However, there are some signs of more optimistic news embedded within our global LEI stemming from outside the developed economies, which could be a potential early sign of a bottoming in global growth momentum. In this report, we dig deeper into the guts of our global LEI to assess the odds of an imminent turning point in the LEI and, eventually, global growth. This has important implications for global bond yields, which are likely to remain rangebound until there is greater clarity on global growth momentum (and inflation downside momentum). What Leads The Leading Indicator? The BCA global LEI is a composite index that combines the LEIs of 23 individual countries using GDP weights. The underlying list of countries differs from that of the widely followed OECD LEI, which is comprised of data from 33 countries but with a heavy weighting on developed market economies. The overall OECD LEI excludes important exporting countries such as Taiwan and Singapore, which are highly sensitive to changes in global growth. Most importantly, the OECD LEI omits the world’s largest economy, China. For our global LEI, we prefer to use a smaller set of countries but one that includes China and a bigger weighting on emerging market (EM) economies. For most of the nations in our global LEI, we do use the country-level LEIs produced by the OECD.1 That also includes several large and important non-OECD EM countries for which the OECD calculates LEIs - a list that includes China, Brazil, India, Russia, Indonesia and South Africa. For a few selected countries, however, we use the following data: US, Korea, Taiwan and Singapore: LEIs produced by national government data sources or, in the case of the US, the Conference Board. Argentina, Malaysia and Thailand: LEIs are produced in-house at BCA, a necessary step given the lack of domestically-produced LEIs in those countries at the time our global LEI was first constructed. We find that our global LEI leads global real GDP growth by around six months, and leads global industrial production growth by around twelve months (Chart 1). Chart 1A Gloomy Message From Our Global LEI The latest reading on the global LEI from July is pointing to a further deceleration of global GDP into a “growth recession” where GDP is expanding slower than the pace of potential global GDP growth (less than 2%). The global LEI is also pointing to an outright contraction of global industrial production, a path also signaled by the JPMorgan global manufacturing PMI index which hit a two-year low of 51.1 – closing in on the 50 level that signifies expanding industrial activity – in July. Chart 2A Ray Of Hope On Global Growth? The momentum of our global LEI is largely influenced by its breadth. Specifically, we have found that when a growing share of countries within the global LEI have individual LEIs that are rising, the overall LEI will eventually follow suit. Thus, the diffusion index of our global LEI, which measures the percentage share of countries with rising individual LEIs, is itself a fairly good leading indicator of the global LEI at major cyclical turning points. We may be approaching such a turning point, as our global LEI diffusion index has increased from a low of 9 back in January of this year to the level of 30 in July (Chart 2). In past business cycles, the diffusion index has tended to lead the global LEI by around 6-9 months, which suggests that a bottom in the actual global LEI could occur sometime in the next few months – although that outcome is conditional on the magnitude of the rise in the diffusion index. In the top half of Table 1, we list previous episodes since 1980 where the global PMI diffusion index followed a similar path to that seen in 2022 – bottoming out below 10 and then rising to at least 30. We identified nine such episodes. In the table, we also show the subsequent change in the level of the global LEI after the increase in the diffusion index. Table 1Global LEI Diffusion Index Greater Than 50 Typically Signals LEI Uptrend The historical experience shows that an increase in the diffusion index to 30 was only enough to trigger a decisive rebound in the global LEI over a 6-12 month horizon in the 2000-01 and 2008 episodes. In several episodes, the global LEI actually contracted despite the pickup in the diffusion index. Related Report Global Fixed Income StrategyDovish Central Bank Pivots Will Come Later Than You Think In the bottom half of Table 1, we run the same analysis but define the episodes as when the diffusion index rose from a low below 10 to at least 50. Unsurprisingly, periods when at least half of the countries have a rising LEI tend to result more frequently in the overall global LEI entering an uptrend within one year – although the two most recent episodes in 2010 and 2018-19 were notable exceptions. Bottom Line: After looking at past experience, the latest pickup in the global LEI diffusion index has not been by enough to confidently forecast a rebound in the LEI – and, eventually, faster global growth. No Broad-Based Improvement In Our Global LEI When grouping the countries within our global LEI by geographical region, it is clear that there is still no sign of improvement in North America or Europe, but some signs of bottoming in Asia and Latin America (Chart 3). Typically, the regional LEIs tend to be very positively correlated during major cyclical moves in the overall LEI, with no one region being particularly better than the others at consistently leading the global business cycle. Chart 3More Regional Divergences Within Our Global LEI Table 2Country Weightings In Our Global LEI Of course, the global LEI is a GDP-weighted index that is dominated by the US and China (Table 2). When looking at individual country LEIs, the recent improvement in the LEI diffusion index looks less impressive. Some countries, like the UK and Korea, have only seen a tiny fractional uptick in the most recent LEI reading – moves small enough to qualify as statistical noise, even though the tiniest of positive moves still register as an “increase” when calculating the diffusion index. When looking at all the individual country LEIs within our global LEI, only two countries stand out as having meaningful increases over the past few months – China and Brazil (Chart 4). In the case of China, the idea that there could be signs of improving growth runs counter to the broad swath of recent data that highlight slowing momentum of Chinese consumer spending, business investment and residential construction. However, the production-focused components of the OECD’s China LEI, which we use in our global LEI, have shown some improvement of late (Chart 5). For example, motor vehicle production grew at a 32% year-over-year rate in July according to the OECD’s data, while total construction activity (based on OECD aggregates of production by industry) rose 9% year-over-year. Chart 4LEI Improvement In China & Brazil, Sluggish Elsewhere Chart 5Improvement In Some Components Of The OECD's China LEI The OECD’s LEI methodology is designed to include the minimum number of data series to optimize the fit of the LEI to the growth rate of each country’s industrial production index, which does lead to some peculiar series being included in the LEIs. However, there are signs of a potential rebound in Chinese economic growth evident in indicators preferred by our emerging market strategists, like the change in overall credit and fiscal spending as a share of GDP, a.k.a. the credit and fiscal impulse (Chart 6). The latter has shown a modest improvement that is hinting at faster Chinese growth in 2023, similar to the OECD’s China LEI. Turning to Brazil, the improvement in the OECD’s LEI there is focused on more survey-based data, like confidence among manufacturers and expectations on the demand for services. However, some hard data that the OECD includes in its Brazil LEI, namely net exports to Europe, have also shown clear improvement (Chart 7). Chart 6China Credit/Fiscal Impulse Signaling A Growth Rebound Bottom Line: The modest improvement in our global LEI diffusion index is even less than meets the eye, as only China and Brazil have seen LEI increases that are meaningfully greater than zero. Chart 7Improvement In Many Components Of The OECD's Brazil LEI Investing Around The Global LEI Chart 8Global Financial Conditions Not Signaling An LEI Rebound Investors spend a sizeable chunk of their time focused on the future growth outlook to make investment decisions. This would, presumably, give leading economic indicators a useful role in any investment process. However, when looking at the relationship between our global LEI and the returns on risk assets like equities and corporate credit, the correlation is highly coincident (Chart 8). In other words, risk assets are themselves leading indicators of future economic growth – so much so that equity indices are often included as a component of the leading indicators of individual countries. On that front, the recent rebound in global equity markets, and the pullback in global credit spreads from the mid-June peak, could be signaling a more stable growth outlook that would be reflected in a bottoming of our global LEI. However, the monetary policy cycle matters, as evidenced by the correlation between the shape of government bond yield curves and our global LEI (bottom panel). That relationship is less strong than that of the LEI and equity/credit returns, but there are very few examples where yield curves are flat, or even inverted as is now the case in the US, and leading indicators are rising. Chart 9Stay Neutral On Overall Duration Exposure In the current environment where more central banks are worrying more about overshooting inflation than slowing growth, a turnaround in our global LEI will be difficult to achieve until inflation is much closer to central bank target levels, allowing policymakers to loosen policy and steepen yield curves. We do not expect such a scenario to unfold over at least the next 12-18 months, given broad-based entrenched inflation pressures in global services and labor markets. While leading indicators may not be of much value in forecasting risk assets, we do find value in using them to forecast moves in government bond yields. Regular readers of BCA Research Global Fixed Income Strategy will be familiar with our Global Duration Indicator, comprised of growth-focused measures that have historically had a leading relationship to the momentum (annual change) in developed market bond yields (Chart 9). The Duration Indicator contains both the global LEI and its diffusion index, as well as the ZEW expectations indices for the US and Europe. Three of those four indicators remain at depressed levels suggesting waning bond yield momentum. Overshooting global inflation has weakened the correlation between bond yield momentum and our Duration Indicator over the past year. However, with global commodity and goods inflation now clearly decelerating, we expect bond momentum to begin tracking growth dynamics more closely again. This leads us to expect bond yields to remain trapped in ranges over at least the balance of 2022, defined most prominently by the 10-year US Treasury yield trading between 2.5% and 3%. Bottom Line: Given the uncertain message on growth from our global LEI, and with inflation rates still too high for central banks to pivot dovishly, we recommend staying close to neutral on overall global fixed income duration and modestly defensive on overall spread product exposure. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Details on how the OECD calculates the individual country leading economic indicators can be found here: http://www.oecd.org/sdd/leading-indicators/compositeleadingindicatorsclifrequentlyaskedquestionsfaqs.htm\ 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* Cyclical Recommendations (6-18 Months)
Executive Summary Then And Now Investors are fixated on inflation; for now, the peak in US CPI is a positive for global stocks. However, this tailwind could easily transform into fear if inflation becomes deflation. The risk of deflation is greater than investors currently appreciate. In the early 1920s, the policy-driven inflation of World War One quickly morphed into a violent deflationary shock, which prompted a severe bear market. Even in the absence of the gold standard, many contemporary factors parallel those that were apparent before 1921. As a result, if commodity prices do not stabilize by year-end, investors will start to worry about deflation. This fear could prompt another sell-off in stocks, which would be particularly painful in Europe. Buy protection against deflation while it is cheap by selling EUR/JPY. Continue to favor defensive over cyclical equities. Bottom Line: The deflation risk for 2023 is greater than the investment community currently appreciates. While it remains a tail risk, it is an underpriced one. As a result, investors should use the current rebound in stocks to buy protection against deflation. Last week, the NASDAQ entered a new bull market following a decline in US inflation. European stocks have rallied too, albeit considerably less so, only rising 12.5% since their July 5th low. We have participated in this rally, having taken a more constructive view on European equities and other risk assets since our return from a trip visiting clients in Europe. Related Report European Investment StrategyQuestions From The Road The decline in US inflation is likely to remain a tailwind for global equities in the near future. The pandemic-related factors that spiked inflation in the past quarters are ebbing, and commodity inflation is decreasing. However, BCA’s US bond strategists expect this window to be short-lived. Labor market tightness and strong rents suggest that core CPI will stabilize around 4%. Nonetheless, as long as this window is open, stocks should remain bid. Investors expecting the demise of this current rebound continue to pin their view on stubborn inflation. While sticky inflation is an undeniable risk, it is a threat well understood by the market. However, another danger lurks, which is much less appreciated by investors: deflation. Investors currently underestimate its odds, when deflation could prove even more damaging to the market than sticky inflation. Remembering 1921 Chart 1The 1921 Bear Market The most famous period of deflation in US economic history is the Great Depression. This is not, however, an appropriate parallel. The 1921 recession, at which time deflation hit a historical low of 16% per annum, is the more direct potential equivalent to today. It was accompanied by a 47% crash in the market that brought the Shiller P/E to five (Chart 1, top panel). At the end of WWI, the stock market experienced a rapid rally, with the Dow Jones jumping 58% from its low in March 1918 to its peak in November 1919. In that time frame, inflation was robust, with headline CPI averaging 16% between 1917 and 1920. Inflation was high because of a combination of factors: The war had forced a substantial loosening of fiscal policy with the Federal debt rising from 2.7% of GDP in 1916, before the entry of the US in the conflict, to 32.9% in 1921. The money supply experienced an unprecedented surge. At the beginning of the war, the US was a neutral party and European powers purchased large quantities of US goods. The resulting trade surplus pushed the US stock of gold from $1.5bn in 1914 to $2.6bn in 1920. Meanwhile, to help finance the government’s wartime expenditures, the newly created Federal Reserve expanded its banknote issuance and its claims on the banking system, which meant that Fed money rose from 21% of high-power money in April 1917 to 59% by November 1918. As a result of these two concurrent trends, the money supply doubled between 1916 and June 1920. The Fed was slow to remove the accommodation. The New York discount rate, which had fallen from 6% to 4% as war broke out in Europe, was only increased to 4.75% in the Spring of 1918 and stayed there until January 1920. The global economy was facing potent supply constraints. Large swaths of the European capital stock had been destroyed by the war, at the same time as the US economy had been redesigned to supply military goods, not consumer goods. As a result, inflation remained perky in 1919 and 1920, despite the end of the conflict. The fiscal and monetary supports suddenly ended in 1920, and the economy entered a vicious contraction that caused industrial production to plunge by 36% in 1921 and deflation to hit 16% (Chart 1, second and third panel). The fiscal easing suddenly shifted toward fiscal rectitude under the administration of Warren Harding, which greatly hurt domestic demand in 1921. Additionally, the inflow of gold from the war period morphed into outflow, as European powers enjoyed trade surpluses after their currencies fell 60% to 30% against the dollar between 1919 and the start of 1921. Moreover, the Fed increased the discount rate to 6% in 1920 and cut back the ratio of Fed money to gold, which caused M2 to swing from a 20% growth annual growth rate in Q1 1920 to a 7% contraction in Q3 1921. Simultaneously, corporate borrowing rates soared (Chart 1, fourth and fifth panel) The shock of stagflation and the associated deep output contraction caused the Dow Jones to collapse by 47% from late 1919 to August 1921. The market only stabilized once deflationary pressures ebbed, after the Fed had cut back the discount rate to 6% and around the same time when commodity prices began to firm up. By the end of the bear market, the reconstituted S&P 500 was trading at a cyclically-adjusted P/E of 5.2, and profits had fallen 81% from their 1916 peak. Bottom Line: The 1921 bear market was one of the most violent of the twentieth century. It was caused by an economic contraction and deep deflation that engulfed the US economy after the monetary and fiscal support of WWI had been removed. It only ended once deflationary forces began to ebb, after commodity prices found a floor. What Are The Parallels? At first glance, the parallels between 1921 and today seem negligible. Yes, inflation was raging in 1920, but deflation was a direct consequence of the gold standard that forced a rapid contraction in high-powered money, especially as gold fled the US in 1921. Chart 2Inflationary Fiscal And Monetary Policy The similarities, however, are remarkable too. As a result of the COVID-19 pandemic, the economy was subjected to similar conditions as that of the US around WWI. The US economy witnessed a massive explosion of fiscal stimulus that pushed the Federal deficit from 5% in 2019, to 10% and 6% of GDP in 2020 and 2021, respectively. Moreover, the Federal Reserve generated extremely accommodative monetary conditions during and after the pandemic, when its balance sheet more than doubled and M2 grew by 41% (Chart 2). Additionally, the global economy has witnessed extraordinary supply-side disruptions that have added to inflationary pressures created by the extreme push to aggregate demand from fiscal and monetary policy.1 Chart 3The Money Supply Is Contracting However, as in 1921, these forces are moving in the opposite direction. The fiscal thrust in the US was deeply negative in 2021 and 2022, when fiscal policy subtracted 4% and 2% from GDP growth, respectively. Moreover, the Fed’s policy tightening campaign is exceptionally aggressive. The Fed has increased rates by 2.25% in five months, and, based on the OIS curve, will push up interest rates by an additional 1.3% by the year-end (Chart 3). As a result, the recent contraction in M2 has further to run, even if the US economy is not constrained by its golden tethers (Chart 3, bottom panel). Between 1920 and 1921, investors had trouble judging how far the Fed would tolerate money contraction, which is again the case. Chart 4The Dollar Is Deflationary While the gold standard has been dissolved, the recent wave of dollar strength creates deflationary forces that are similar to the bullion anchor in the 1920s. In the US, the strength in the dollar is limiting imported inflation. US import prices have rolled over, a trend likely to continue. Once converted in USD, Chinese PPI is almost contracting today, which is no small matter when China is the marginal supplier of goods for the world (Chart 4). A strong dollar is deflationary for the global economy, not just that of the US. A rising greenback hurts commodity prices and also tightens global liquidity conditions. Already, the dollar-based liquidity is contracting and EM FX reserves – which are a form of high-powered money similar to gold flows in the 1920s – are tanking, even after adjusting for the confiscation of Russian reserves in the wake of the Ukrainian conflict (Chart 4, bottom panel). To defend their currencies as the dollar rallies, EM central banks are forced to tighten policy, which hurts their domestic economies. This phenomenon is also visible in advanced economies. The weak euro has played a role inching the ECB toward aggressive rate hikes, while the Riksbank and the Swiss National Bank are both lifting interest rates to fight the inflationary impact of their currencies falling against the greenback. Global supply constraints are also defusing. The price of shipping commodities and goods around the world is declining meaningfully (Chart 5). Meanwhile, deliveries by suppliers are accelerating globally, which is contributing to a very rapid easing of our indicator of US Supply Constraints (Chart 5, bottom panel). Beyond these parallels with the early 1920s, demand is already weakening globally. Hampered by the current rise in living costs, households have begun to reduce the volume of goods they purchase, while companies have maintained robust production schedules. As a result, inventories are swelling around the world (Chart 6). Historically, the best cure for elevated inventories is lower prices. Chart 5Easing Supply Constraints Chart 6Inventories And Weak Demand Are Deflationary Bottom Line: There is no guarantee that deflation will become the prevailing force in the global economy. However, the risk is there—and this threat is woefully underappreciated by the investment community. At this current juncture, investors are welcoming lower commodity prices as they take the edge off ebullient inflation. However, if commodity prices do not stabilize by year-end, then investors will begin to worry about deflation. As the 1921 experience showed, deflation is very painful for stocks because it is so negative for profits. While the absence of the gold standard means that the deep deflation of 1921 is extremely unlikely, a period of deflation would nonetheless have a very negative impact on stocks, since they trade at 29 times cyclically-adjusted earnings, not 6.2 times, as was the case in November 1919. What Does This Mean For European Assets? A bout of global deflation would be especially painful for European equities. European equities are more cyclical than their US counterparts, which means that they often underperform when global growth is weak and global export prices of manufactured goods are falling (Chart 7). In other words, a deflationary shock in the US would be felt more acutely in the European market than in that of the US. Additionally, the euro would likely weaken further. Already, the European money impulse (the change in M1 flows) is contracting, which augurs poorly for European economic activity (Chart 8). The addition of a deflationary shock to the weak domestic backdrop would prompt further outflows from Europe, which would hurt the euro even more. Chart 7European Stocks Hate Deflationary Busts Chart 8European Activity Is Weak Chart 9A Value Trap? Finally, with respect to the European cyclicals-to-defensive ratio, our Combined Mechanical Valuation Indicator suggests that European cyclicals have purged their overvaluation relative to their defensive counterparts (Chart 9). However, in previous deflationary outbreaks such as those in 1921 or the 1930s, cyclicals deeply underperformed defensive equities, no matter how cheap they became. This time around, we would expect the same outcome from cyclicals. Moreover, even if investors do not price in a deflationary risk early next year, European cyclicals remain hampered by the deceleration in the Chinese economy and the energy rationing that will hit Europe this winter. As a result, we continue to fade any rebound in the European cyclicals-to-defensives ratio. Bottom Line: Even if a deflationary shock is a risk that is more likely to emanate from the US, European markets will not be immune. The European economy is already weak, and the cyclicality of European equities creates greater vulnerability to deflation. Thus, while deflation in 2023 is a tail risk, investors should use the current rebound in global risk assets to buy protection cheaply. Selling EUR/JPY and favoring defensive European markets continue to make sense in light of this risk. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Footnotes 1Another similarity is that the Spanish Flu was decimating the population from late WWI to 1921. Tactical Recommendations Cyclical Recommendations Structural Recommendations
Listen to a short summary of this report. Executive Summary Significant Savings Provide A Moat Around Consumers Three mega moats will protect the US economy over the next 12 months: 1) A high number of job openings; 2) Significant pent-up demand; and 3) Strong Fed credibility, which has kept bond yields from rising more than they otherwise would have in response to higher inflation. Ironically, a recession will only occur when investors start believing that a recession will not occur. Without more economic optimism, real yields will not rise into restrictive territory. The double-dip 1980/82 recessions, the 1990-91 recession, the 2001 recession, and the 2007-09 Great Recession were all preceded by an almost identical 21-to-23-month period of a flat unemployment rate. The unemployment rate has been fairly stable since March when it hit 3.6%. Given the three moats, we suspect that it will move sideways well into next year. At that point, the trajectory of inflation will determine the path for the unemployment rate and the broader economy. Inflation will fall significantly over the coming months thanks to lower food and energy prices and easing supply-chain pressures. However, falling inflation could sow the seeds of its own demise. As prices at the pump and the grocery store decline, real wage growth will turn positive. This will bolster consumer confidence, leading to more spending, and ultimately, a reacceleration in core inflation. Bottom Line: Stocks will rise over the next six months as recession risks abate, but then decline over the subsequent six months as it becomes clear that the Fed has no intention of cutting rates in 2023 and may even need to raise them further. On balance, we recommend a neutral exposure to global equities over a 12-month horizon. Don’t Bet on a US Recession Just Yet Many investors continue to expect the US economy to slip into recession this year. The OIS curve is discounting over 100 basis points in rate cuts starting in 2023, something that would probably only happen in a recessionary environment (Chart 1). In contrast to the consensus view, we think that the US will avoid a recession. This is good news for stocks in the near term because it means that earnings estimates, which have already fallen meaningfully this year, are unlikely to be cut any further (Chart 2). It is bad news for stocks down the road because it means that rather than cutting rates in 2023, the Fed could very well have to raise them. Chart 1Investors Expect Fed Tightening To Give Way To An Easing Cycle In 2023 These two conflicting considerations lead us to expect stocks to rise over the next six months but then to fall over the subsequent six months. As such, we recommend an above-benchmark exposure to global equities over a short-term tactical horizon but a neutral exposure over a 12-month horizon. Three mega moats will protect the US economy over the next 12 months: 1) A high number of job openings; 2) Significant pent-up demand; and 3) Strong Fed credibility, which has kept bond yields from rising more than they otherwise would have in response to higher inflation. Let’s explore each in turn. Moat #1: A High Number of Job Openings While job openings have fallen over the past few months, they are still very high by historic standards (Chart 3). In June, there were 1.8 job openings for every unemployed worker, up from 1.2 in February 2020. At the peak of the dotcom bubble, there were 1.1 job openings per unemployed worker. A high job openings rate means that many workers who lose their jobs will have little difficulty finding new ones. This should keep the unemployment rate from rising significantly as labor demand cools on the back of higher interest rates. Some investors have argued that the ease with which companies can advertise for workers these days has artificially boosted reported job openings. We are skeptical of this claim. For one thing, it does not explain why the number of job openings has risen dramatically over the past two years since, presumably, the cost of job advertising has not changed that much. Moreover, the Bureau of Labor Statistics bases its estimates of job openings not on a tabulation of online job postings but on a formal survey of firms. For a job opening to be counted, a firm must have a specific position that it is seeking to fill within the next 30 days. This rules out general job postings for positions that may not exist. We are also skeptical of claims that increased layoffs could significantly push up “frictional” unemployment, a form of unemployment stemming from the time it takes workers to move from one job to another. There is a great deal of churn in the US labor market (Chart 4). In a typical month, net flows in and out of employment represent less than 10% of gross flows. In June, for example, US firms hired 6.4 million workers. On the flipside “separations” totaled 5.9 million in June, 71% of which represented workers quitting their jobs. Chart 3A High Level Of Job Openings Creates A Moat Around The Labor Market Chart 4Labor Market Churn Tends To Increase As Unemployment Falls In fact, total separations (and hence frictional unemployment) tend to rise when the labor market strengthens since that is when workers feel the most emboldened to quit. The reason that the unemployment rate increases during recessions is not because laid-off workers need time to find a new job but because there are simply not enough new jobs available. Fortunately, that is not much of a problem today. Moat #2: Significant Pent-Up Demand US households have accumulated $2.2 trillion (9% of GDP) of excess savings since the start of the pandemic, most of which reside in highly liquid bank deposits (Chart 5). Admittedly, most of these savings are skewed towards middle- and upper-income households who tend to spend less out of every dollar of income than the poor (Chart 6). Nevertheless, even the top 10% of income earners spend about 80% of their income (Chart 7). This suggests that most of these excess savings will be deployed, supporting consumption in the process. Chart 5Significant Savings Provide A Moat Around Consumers Chart 6Unlike The Poor, Middle-To-Upper Income Households Still Hold Much Of Their Pandemic Savings Some commentators have argued that high inventories will restrain production, even if consumer spending remains buoyant. We doubt that will happen. While retail inventories have risen of late, the retail inventory-to-sales ratio is still near all-time lows (Chart 8). Moreover, real retail sales have returned to their pre-pandemic trend (Chart 9A). Overall goods spending is still above trend, but has retraced two-thirds of its pandemic surge with little ill-effect on the labor market (Chart 9B). Chart 7Even The Wealthy Spend Most Of Their Income Chart 8Retail Inventory-To-Sales Ratios Have Rebounded, But Remain Low Chart 9ASpending On Goods Has Been Normalizing (I) Chart 9BSpending On Goods Has Been Normalizing (II) The latest capex intention surveys point to a deceleration in business investment (Chart 10). Nevertheless, we doubt that capex will decline by very much. Following the dotcom boom, core capital goods orders moved sideways for two decades (Chart 11). The average age of the nonresidential capital stock rose by over two years during this period (Chart 12). Excluding investment in intellectual property, business capex as a share of GDP is barely higher now than it was during the Great Recession. Not only is there a dire need to replenish the existing capital stock, but there is an urgent need to invest in new energy infrastructure and increased domestic manufacturing capacity. Chart 10Capex Intentions Have Dipped Chart 11Capex Has Been Moribund For The Past Two Decades (I) With regards to residential investment, the homeowner vacancy rate has fallen to a record low. The average age of US homes stands at 31 years, the highest since 1948. Chart 13 shows that housing activity has weakened somewhat less than one would have expected based on the significant increase in mortgage rates in the first six months of 2022. Given the recent stabilization in mortgage rates, the chart suggests that housing activity should rebound by the end of the year. Chart 12Capex Has Been Moribund For The Past Two Decades (II) Chart 13Housing Activity Should Rebound On The Back Of Low Vacancy Rates, An Aging Housing Stock, And Stabilizing Mortgage Rates Moat #3: Strong Fed Credibility Even though headline inflation is running at over 8% and most measures of core inflation are in the vicinity of 5%-to-6%, the 10-year bond yield still stands at 2.87%. Two things help explain why bond yields have failed to keep up with inflation. First, investors regard the Fed’s commitment to bringing down inflation as highly credible. The TIPS market is pricing in a rapid decline in inflation over the next two years (Chart 14). The widely-followed 5-year, 5-year forward TIPS inflation breakeven rate is still near the bottom end of the Fed’s comfort zone. Chart 14AWell-Anchored Long-Term Inflation Expectations Have Kept Bond Yields From Rising More Than They Would Have Otherwise Chart 14BWell-Anchored Long-Term Inflation Expectations Have Kept Bond Yields From Rising More Than They Would Have Otherwise Households tend to agree with the market’s assessment. While households expect inflation to average over 5% over the next 12 months, they expect it to fall to 2.9% over the long term. As Chart 15 illustrates, expected inflation 5-to-10 years out in the University of Michigan survey is in line with where it was between the mid-1990s and 2015. This is a major difference from the early 1980s, when households expected inflation to remain near 10%. Back then, Paul Volcker had to engineer a deep recession in order to bring long-term inflation expectations back down to acceptable levels. Such pain is unlikely to be necessary today. Chart 15Households Expect Inflation To Come Back Down Chart 16Markets Think That The Real Neutral Rate Is Low The second factor that is suppressing bond yields is the market’s perception that the real neutral rate of interest is quite low. The 5-year, 5-year TIPS yield – a good proxy for the market’s estimate of the real neutral rate – currently stands at 0.40%, well below its pre-GFC average of 2.5% (Chart 16). Ironically, a recession will only occur when investors start believing that a recession will not occur. Without more economic optimism, real yields will not rise into restrictive territory. When Will the Moats Dry Up? The US unemployment rate is a mean-reverting series. When unemployment is very low, it is more likely to rise than to fall. And when the unemployment rate starts rising, it keeps rising. In the post-war era, the US has never avoided a recession when the unemployment rate has risen by more than one-third of a percentage point over a three-month period (Chart 17). Chart 17When Unemployment Starts Rising, It Usually Keeps Rising With the unemployment rate falling to a 53-year low of 3.5% in July, it is safe to say that we are in the late stages of the business-cycle expansion. When will the unemployment rate move decisively higher? While it is impossible to say with certainty, history does offer some clues. Remarkably, the double-dip 1980/82 recessions, the 1990-91 recession, the 2001 recession, and the 2007-09 Great Recession were all preceded by an almost identical 21-to-23-month period of a flat unemployment rate (Chart 18 and Table 1). Coincidentally, the Covid-19 recession was also preceded by 22 months of a stable unemployment rate. To the extent that the economy was not showing much strain going into the pandemic, it is reasonable to assume that the unemployment rate would have continued to move sideways for most of 2020 had the virus never emerged. Chart 18The Bottoming Phase Of The Unemployment Rate Has Only Begun Inflation is the Key The unemployment rate has been fairly stable since March when it hit 3.6%. Given the three moats discussed in this report, we suspect that it will move sideways well into next year. At that point, the trajectory of inflation will determine the path of the unemployment rate and the broader economy. As this week’s better-than-expected July CPI report foreshadows, inflation will fall significantly over the coming months, thanks to lower food and energy prices and easing supply-chain pressures. The GSCI Agricultural Index has dropped 24% from its highs and is now below where it was before Russia’s invasion of Ukraine (Chart 19). Retail gasoline prices have fallen 19% since June, with the futures market pointing to a substantial further decline over the next 12 months. In general, there is an extremely strong correlation between the change in gasoline prices and headline inflation (Chart 20). Supplier delivery times have also dropped sharply (Chart 21). Chart 19Agricultural Prices Have Started Falling Chart 20Headline Inflation Tends To Track Gasoline Prices Falling inflation could sow the seeds of its own demise, however. As prices at the pump and the grocery store decline, real wage growth will turn positive. That will bolster consumer confidence, leading to more spending (Chart 22). Core inflation, which is likely to decrease only modestly over the coming months, will start to accelerate in 2023, prompting the Fed to turn hawkish again. Stocks will falter at that point. Chart 21Supplier Delivery Times Have Declined Chart 22Falling Inflation Will Boost Real Wages And Consumer Confidence Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn and Twitter Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Executive Summary Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation Inflation is not about oil, food or used car prices. Looking at prices of individual components of a consumer basket is akin to missing the forest for the trees. Despite the latest drop in US headline inflation, various core CPI measures continue trending up and registered considerable month-on-month rises in July. Wages and, more specifically, unit labor costs are the true measure of genuine and persistent inflation. US wage growth is very elevated, and the pace of unit labor cost gains has surged to a 40-year high. The conditions for sustainable and persistent disinflation in the US are not yet present. US inflation will prove to be much stickier and more entrenched than many market participants presently believe. The recovery in China will be U- rather than V-shaped, with risks tilted to the downside. The mainland’s property market breakdown is structural, not cyclical. Excesses are very large, and problems are snowballing, rendering the enacted policy stimulus insufficient. Bottom Line: US core inflation lingering above 4% and easing financial conditions will compel the Fed to continue hiking rates. This will cap global risk asset prices and put a floor under the US dollar. We continue to recommend an underweight allocation to EM in global equity and credit portfolios. Consistently, we are also reluctant to chase EM currencies higher. Feature The bullish macro narrative circulating in the investment community is that conditions for a cyclical rally in global risk assets have fallen into place. Specifically: US inflation will drop sharply as US growth has crested and commodity prices have plunged; The Fed is nearing the end of a tightening cycle; China has stimulated sufficiently, and its economy is about to recover, which will boost economic conditions among its trading partners in general and EM in particular. These assumptions along with the fact that the S&P 500 index has found support at a 3-year moving average – a proven line of defense – suggest that US share prices have likely bottomed (Chart 1). Are we witnessing déjà vu of the 2011, 2016, 2018 and 2020 market bottoms? Chart 1Déjà Vu? Is 2022 Like The 2011, 2016 And 2018 Bottoms In The S&P 500? We have reservations about all of the above fundamental conjectures. We elaborate on these reservations in this report. On the whole, we contend that the current environment is different, and the roadmaps of all post-2009 equity market bottoms are not necessarily currently applicable. BCA’s Emerging Markets Strategy team believes that (1) US consumer price inflation is much more entrenched and will prove stickier than is commonly believed; and (2) the Chinese property market’s breakdown is structural, not cyclical; hence, the recovery will not gain traction easily. Is This The End Of The US Inflation Problem? Not Quite This week’s US inflation data confirmed that headline CPI inflation has probably peaked: prices in several categories plunged. However, inflation is not about oil, food or used car prices. Chart 2 reveals that historically there have been several episodes whereby core inflation remains elevated despite plunging oil prices. Chart 2US Core Inflation Does Not Always Follow Oil Prices Looking at price dynamics among the individual components of the CPI basket is akin to missing the forest for the trees. Inflation is a very inert and persistent phenomenon. Underlying inflation does not change its direction often and/or quickly. That is why we believe that it is premature to celebrate the end of the US inflation problem. A few observations on this matter: Despite the drop in US headline inflation, various core CPI measures − like trimmed-mean CPI, median CPI and core sticky CPI − all continue trending up and registered substantial month-on-month rises in July (Chart 3). The range of core inflation based on these annual and month-month annualized rates is between 4-7%. In brief, the rate of genuine/sticky inflation is well above the Fed’s 2% target. Given its unconditional commitment to bringing inflation down to 2%, the Fed will continue hiking interest rates ceteris paribus. Chart 3US Core CPI Measures Are Still Very High Chart 4US Wages Growth Has Been Surging We continue to emphasize that wages and, more specifically, unit labor costs are the true measures of persistent and genuine inflation. We have written at length about why wages and unit labor costs are more important to inflation than oil or food prices. US wage growth is very elevated and is accelerating (Chart 4). Unit labor costs, calculated as hourly wages divided by productivity, have also been surging to a 40-year high (Chart 5, top panel). Chart 5Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation The reason for this very strong wage growth and swelling unit labor costs is the very tight labor market. The bottom panel of Chart 5 demonstrates that labor demand is still outpacing labor supply by a wide margin. Hence, wage inflation will not subside until the unemployment rate rises meaningfully. Bottom Line: Conditions for sustainable and persistent disinflation in the US are not yet present. Inflation will prove to be much stickier and more entrenched than many market participants presently believe. Core inflation lingering above 4% and easing financial conditions will compel the Fed to continue hiking rates. This will cap risk asset prices and put a floor under the US dollar. China: Is This Time Different? If one believes that China’s current business cycle is similar to all previous ones seen since 2009, odds are that a buying opportunity in China-related financial markets is at hand. Chart 6 illustrates that the credit and fiscal spending impulse leads the business cycle by about nine months. Given that this impulse bottomed late last year, a trough in the Chinese business cycle is due. Chart 6Is A Recovery In China's Business Cycle Imminent? It is always risky to suggest that this time is different. Nevertheless, at the risk of being wrong, we contend that a combination of (1) property markets woes, (2) an impending export contraction, and (3) the dynamic zero-COVID policy will reduce the multiplier effect of current stimulus measures. Hence, a meaningful recovery in economic activity will likely fail to materialize in the coming months. The challenges facing the mainland property market are now well known. Yet, excesses are very large, and problems are snowballing, making policy stimulus insufficient. In particular: Authorities are contemplating bailout funds for property developers in the range of RMB 300-400 billion to enable them to complete housing that has been pre-sold. This is not sufficient financing for overall property construction. Table 1How Large Are Property Developers Bailout Funds? Table 1 illustrates that these amounts are equal to just 3-4% of annual fixed-asset investment in real estate excluding land purchases, 1.5-2% of total financing of developers, and 3-4% of the advance payments that property developers received for pre-sold housing in 2021. Property developers will not be receiving any cash upon the completion and delivery of presold housing units because they were paid in advance. Hence, without liquidating their other assets, homebuilders cannot repay the bailout financing. Consequently, only state financing can work here because, from the viewpoint of providers of this financing, this scheme de-facto means throwing good money after bad. The property industry in China is extremely fragmented. This makes bailouts difficult to organize and execute. There are officially about 100,000 property developers in China. The overwhelming majority of them are not state-owned companies. Plus, the two largest property developers, Evergrande (before defaulting) and Country Garden, had only 3.8% and 3.3% of market share respectively in 2020. The failure of homebuilders to complete and deliver pre-sold housing units could unleash a death spiral for them. In recent years, 90% of housing units have been pre-sold, i.e., buyers made advance payments/prepayments, often taking out mortgages (Chart 7, top panel). Witnessing the inability of developers to deliver on presold units, a rising number of people may decide to wait to buy. The largest source of developers’ financing – advance payments for pre-sold housing units – might very well dry up. This source has accounted for 50% of real estate developers’ total financing in recent years (Chart 7, bottom panel). In brief, a vicious cycle is possible. The lack of financing for homebuilders bodes ill for construction activity (Chart 8). Chart 7China: Housing Presales And Pre-Payments Are Critical To Developers Chart 8Lack Of Homebuilder Financing = Shrinking Construction Activity Chart 9Chinese Property Developers Are Extremely Leveraged Besides, property developers are very leveraged with an assets-to-equity ratio close to nine (Chart 9). They have grown accustomed to borrowing heavily to accumulate real estate assets. They have been starting but not completing construction (Chart 10, top panel). We have been referring to this phenomenon as the biggest carry trade in the world. The bottom panel of Chart 10 shows two different measures of residential floor space inventories held by property developers. One measure subtracts completed floor space from started floor space, and another one deducts sold floor space from started floor space. On both measures, residential inventories are enormous. In theory, they could raise funds by selling their real estate assets. However, if they all try to sell simultaneously, there will not be enough buyers, and asset prices will plunge, which could lead to a full-blown debt deflation spiral. The last time the real estate market was similarly distressed in 2014-15, the central bank launched the Pledged Supplementary Lending (PSL) facility. This was effectively a QE program to monetize housing. This was the reason why housing recovered strongly in 2016-2017. There is currently no such program up for discussion. On the whole, odds are that the current property market breakdown is structural, not cyclical. Financial markets – the prices of stocks and USD bonds of property developers – convey a similar message and continue to plunge (Chart 11). Chart 10Excessive Property Inventories Chart 11No Green Light From Property Stocks And Corporate Bond Prices Chart 12There Has Been No Recovery In China Without A Revival in Real Estate Without an improvement in the housing market, a meaningful business cycle recovery is unlikely in China. Chart 12 illustrates that all recoveries in the Chinese broader economy since 2009 occurred alongside a revival in property sales. The importance of the property market goes beyond its size. Rising property prices lift household and business confidence, boosting aggregate spending and investment. The sluggish housing market and falling house prices will impair consumer and business confidence. This, along with uncertainty related to the dynamic zero-COVID policy, will dent consumer spending and private investments. Finally, the upcoming contraction in Chinese exports will dampen national income growth. Taken together, the multiplier effect of stimulus in the upcoming months will be lower than it has been in previous periods of stimulus. There are two areas that will see meaningful improvement in the coming months: infrastructure spending and autos. BCA’s China Investment Strategy service discussed the outlook for auto sales in a recent report. Chart 13Green Shoots In China's Infrastructure Investment On the infrastructure front, there has been mixed evidence of an improvement in activity. The top and middle panels of Chart 13 demonstrate that Komatsu machinery’s operational hours and the number of approved infrastructure projects might be bottoming. However, the installation of high-power electricity lines has fallen to a 15-year low (Chart 13, bottom panel). As we elaborated in last month’s report, the new financing/stimulus for infrastructure development will not result in new investments. Rather, it will by and large offset the drop in local government (LG) revenues from land sales this year. In short, there is little new stimulus for infrastructure beyond what was approved in the budget plan earlier this year. Bottom Line: The recovery in China will be U- rather than V-shaped, with risks tilted to the downside. Investment Recommendations Our bias is that the rebound in global risk assets could last for a few more weeks. The basis is that investor positioning in risk assets was very light when this rebound began. Plus, falling oil prices could reinforce the idea among investors that US inflation is no longer a problem. Looking beyond the next several weeks, the outlook for global and EM risk assets is dismal. Markets will realize that the Fed cannot halt its tightening with core inflation well above 4-5%. Hawkish Fed policy and contracting global trade will boost the US dollar and weigh on cyclical assets. We continue to recommend an underweight allocation to EM in global equity and credit portfolios. Consistently, we are also reluctant to chase EM currencies higher. EM local bonds offer value, as we have argued over the past couple of months, but for now we prefer to focus on yield curve flattening trades. We continue betting on yield curve flattening/inversion in Mexico and Colombia and are long Brazilian 10-year domestic bonds while hedging the currency risk. In addition, we recommend investors continue receiving 10-year swap rates in China and Malaysia. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)
Executive Summary Realized Real Interest Rates Must Rise Policymakers must continue engineering higher real interest rates, and tighter financial conditions, to help cool off growth and bring down overshooting inflation. This will inevitably lead to inverted yield curves across most of the developed world, following the recent trend of US Treasuries. US growth expectations remain overly pessimistic, which opens up the potential for more near-term bond-bearish upside data surprises like the July employment and ISM Services reports. The Bank of England – under increasing political pressure for its relatively timid response to the massive UK inflation overshoot – is now forecasting a long policy-induced recession as the only way to tame UK inflation expected to reach 13% by year-end. Expect UK Gilts to be a relative outperformer within developed bond markets over the next 12-18 months. Bottom Line: Stay overweight UK Gilts versus US Treasuries in global bond portfolios, but increase exposure to yield curve flattening in both countries. The Fed and Bank of England are both on course to push monetary policy into restrictive, growth-damaging territory. Don’t Get TOO Comfortable Taking Risk In a bit of a summer surprise, global financial markets have been staging a mild recovery from the stagflationary doom that prevailed during the first half of 2022. In the US, the S&P 500 index is up 14% from the year-to-date intraday low reached on June 16, with the VIX index back down to low-20s zone last seen in April (Chart 1). High-yield corporate bond spreads in the US and euro area are down 97bps and 36bps, respectively, since that mid-June trough in US equities. Even emerging market equities and credit – the most unloved of asset classes in 2022 – have stabilized. Related Report Global Fixed Income StrategyIt’s Time To Flip The Script - Upgrade UK Gilts Some of this risk rally is surely short-covering, but there are some valid reasons to be less pessimistic on growth-sensitive risk assets. In the US, where the back-to-back contractions in GDP in the first two quarters of the year have stoked recession fears, the latest data releases have seen upside surprises suggesting an expanding, not contracting, economy (Chart 2). The July ISM non-manufacturing (services) index rose +1.4 points in July to 56.7, a broad-based move that included increases in Production, New Orders and New Export Orders. Core durable goods orders rose +0.5% in June for the second straight month. The biggest surprise was the July Payrolls report, which showed a whopping +528,000 increase in employment – over twice the expected gain of +250,000 – with a downtick in the unemployment rate to 3.5%. Chart 1Stepping Back From The Recessionary Abyss Chart 2The US Recession Talk May Have Been Premature Chart 3Goods Inflation Pressures Easing There was also some good news on the inflation front in the latest US data. The Prices Paid components of both the ISM manufacturing and non-manufacturing indices showed big declines, 18.5pts and 7.8pts respectively, in July, continuing the downtrends that began in the latter half of 2021 (Chart 3). This is not just a US story. The Prices Paid components of the S&P Global manufacturing PMIs in the euro area, the UK, Japan and China have also been falling. Lower global commodity prices, particularly for oil, are playing a large role in the pullback in reported business input costs. The Supplier Deliveries components of both ISM reports also fell on the month, continuing a trend seen throughout 2022 as global supply chain pressures have eased. Combined with the drop in the Prices Paid data, global PMIs are sending a strong message - inflationary pressures on the traded goods side of the global economy are finally easing. Slower goods inflation, however, does not provide an all-clear for risk assets on a cyclical basis. Non-goods price pressures are showing little sign of peaking across most of the developed world. Labor markets remain tight, and both wage inflation and services inflation rates continue to accelerate in the major economies of the US, UK and euro area at a pace well above central bank inflation targets (Chart 4). Until these domestic sources of inflation show signs of peaking, central banks will continue to push up policy rates to slow growth, generate higher unemployment and, eventually, bring domestically driven inflation back down to central bank targets. Expect the so-called Misery Index, summing headline inflation and the unemployment rate, to remain elevated across the major developed economies until negative real interest rates begin to rise through a combination of more nominal rate hikes and, eventually, slower inflation (Chart 5). Chart 4Domestic Inflation Pressures Accelerating Chart 5Realized Real Interest Rates Must RiseAs we discussed in last week’s report, bond markets were getting way ahead of themselves in pricing in aggressive rate cuts in 2023, especially in the US. This was setting up for a potential move higher in yields on any positive data news. Within the “Big 3” developed economies, US Treasuries look most vulnerable to a rebound in bond yield momentum, judging by what looks like a true bottom in the mean-reverting Citigroup US Data Surprise Index (Chart 6). The flow of data surprises is more mixed in the euro area and UK and is not yet at the stretched extremes that would signal a sustainable increase in bond yields. Taken at face value, this fits with our current recommendation to underweight the US, and overweight core Europe and the UK, within global government bond portfolios. With central banks now on track to push policy rates into restrictive territory, there is the potential for additional flattening of already very flat yield curves across the Big 3. Forward rates are not priced for additional curve flattening in those markets, looking at both the 2-year/10-year and 5-year/30-year government bond curves (Chart 7). This makes positioning for more curve flattening in the US, UK and euro area a positive carry trade by leaning against the pricing of forward rates. Chart 6Greater Potential For Bond-Bearish Data Surprises In The US Chart 7Increase Exposure To Curve Flattening In The 'Big 3' We are adjusting the positioning within the BCA Research Global Fixed Income Strategy Model Bond Portfolio this week to benefit from the trend towards additional curve flattening in the US, the UK and core Europe (Germany and France). With the 2-year/10-year curve already inverted by -45bps in the US, we see better value by adding flattening exposure between the 5-year and 30-year points – a curve segment that is not yet in inversion. In the UK and euro area, we see a case for positioning for flattening across the entire yield curve. Bottom Line: Stay overweight both UK Gilts and core European government bonds versus US Treasuries in global bond portfolios, but increase exposure to yield curve flattening in all countries. The Fed and Bank of England are both clearly on course to push monetary policy into restrictive, growth-damaging territory, and the ECB may be forced to do the same. Painful Honesty From The Bank Of England The Bank of England (BoE) delivered its largest rate hike since 1995 last week, raising Bank Rate by 50bps to 1.75%. Planned sales of UK Gilts accumulated by the BoE during the quantitative easing phase of pandemic stimulus, at a pace of £10bn per quarter starting in September, were also announced. While those moves were largely expected by markets, the BoE’s new set of economic forecasts contained quite a shocker – an expectation of recession starting in Q4 of this year, running through the end of 2023 (Chart 8). The UK unemployment rate is expected to rise substantially from the current 3.8% to 6.3% by Q3/2025. Chart 8Brutal Honesty In The Latest BoE Forecasts Chart 9Energy Prices Driving BoE Inflation Forecasts We are hard pressed to remember the last time a major central bank announced a forecast of a prolonged economic downturn as part of its baseline scenario to bring inflation to its target. Such is the predicament that the BoE finds itself in, with headline UK inflation expected to soar to 13% by the end of 2022 – a mere 11 percentage points above the central bank’s inflation target. The BoE has been forced to sharply ratchet up that expected peak in UK inflation at both the May and August policy meetings this year. This is largely due to the massive increase in UK energy prices with the Energy component of the UK CPI index up over 50% in year-over-year terms. According to analysis published in the BoE August 2022 Monetary Policy Report, the direct impact of higher energy prices was projected to account for roughly half of that expected 13% peak in UK inflation this year (Chart 9). At the same time, falling energy prices embedded into futures curves are expected to full unwind that effect in 2023. The BoE’s recession call is also conditioned on a market-implied path for interest rates, with a 2023 peak in Bank Rate of just over 3% priced into the UK OIS curve. Looking beyond the energy price surge, there are signs that the BoE will not have to tighten as aggressively as interest rate markets are currently expecting. Our BoE Monitor, constructed using growth, inflation and financial market variables that would typically pressure the central bank to tighten or loosen monetary policy, has clearly peaked (Chart 10). All three components of the Monitor have rolled over, although inflation pressures remain the strongest contributor to the elevated absolute level of the Monitor. From a growth perspective, there are many reasons to expect the UK economy to enter a recession without much more prodding from BoE rate hikes (Chart 11): Chart 10Our BoE Monitor Sees Easing Cyclical Pressure To Raise Rates Chart 11A Broad-Based Slowing Of UK Growth Both the S&P Global manufacturing and services PMIs are on target to soon fall below the 50 level that indicates positive growth (top panel) Consumer confidence has collapsed as surging inflation has overwhelmed household income growth, leading to a contraction in retail sales volume growth (middle panel) The BoE’s Agents’ Survey of individual businesses shows a sharp deterioration in business investment spending plans (bottom panel). Yet even with growth clearly slowing already, the sheer magnitude of the inflation overshoot is forcing markets to discount a fairly aggressive path for UK interest rates over the next year. This is not only evident in the OIS curve, but also in the BoE’s own Market Participants Survey (MPS) of UK investors. According to the just released August MPS, the median expectation is for Bank Rate to peak at 2.5% next year (Chart 12). This is a sizeable increase from the previous expected peak of 1.75% from the last MPS in May, but is still below the discounted peak in rates from the OIS curve of 3.1%. The bigger news is that the, according to the August MPS, the median survey participant now believes that the neutral range for Bank Rate is now 2-2.5%, up from the 1.5-2.0% range in the May MPS. Therefore, the August MPS forecasted peak Bank Rate of 2.5% is only at the high end of neutral and not restrictive. Yet both the OIS curve and the August MPS expect the BoE to immediately pivot from rate hikes to rate cuts in the second half of 2023. Chart 12UK Interest Rate Markets Have Adjusted Neutral Rate Expectations Chart 13The BoE Is Facing Severe Public Scrutiny The notion that the BoE would pivot so quickly next year, when their own forecasts still call for UK inflation to be over 9% in the third quarter of 2023, seem somewhat optimistic. Especially with the BoE under tremendous public and political pressure because of runaway UK inflation. The leading candidate to become the next UK Prime Minister, Foreign Secretary Liz Truss, has already gone on record stating that she would look to change the BoE’s remit as Prime Minister to focus solely on keeping inflation low. Meanwhile, the latest BoE Inflation Attitudes Survey shows more respondents are now dissatisfied with the BoE than satisfied (Chart 13). 1-year-ahead inflation expectations from that same survey are now at 4.6%, while 5-year/5-year forward breakevens from UK index-linked Gilts are still at 3.8%. With inflation expectations still so elevated, and with the BoE’s own forecasts calling for headline UK inflation to not fall back to the 2% BoE target until Q3/2024, it is unlikely that the BoE will revert to rate cuts as quickly as markets expect – especially given the accelerating wage dynamics in the UK labor market. According to the BoE’s measure of “underlying” wage growth, which adjusts headline wage inflation data for pandemic effects from furloughs and shifting labor composition, wages are growing at a 4.2% year-over-year rate (Chart 14). The BoE’s own modeling work indicates that 2.9 percentage points of that wage growth is due to the level of short-term inflation expectations, with only 0.9 percentage points coming from productivity growth. Thus, the BoE cannot let its foot off the monetary brake until short-term inflation expectations fall substantially from current elevated levels – especially with employment indicators still pointing to a very tight supply-constrained, post-COVID UK labor market. Chart 14A Wage-Price Spiral In The UK? Given that interplay of rising headline inflation, elevated inflation expectations and tight labor markets, the BoE will likely be forced to begin unwinding the current rate hiking cycle later than markets expect. This will eventually lead to an inversion of the UK Gilt yield curve as the BoE pushes policy rates to restrictive territory and the UK economy falls into recession faster than other countries (like the US). Chart 15Stay Overweight UK Gilts, With A Curve Flattening Bias We still believe that the Fed is more likely than the BoE to fully follow through on market-discounted rate hikes over the next year, which was a major reason why we upgraded our cyclical recommendation on UK Gilts to overweight back in May. However, with the BoE now under more pressure to wring high inflation out of the UK economy by keeping policy tighter for longer, we also see value in positioning for that eventual inversion of the UK Gilt curve (Chart 15). We see the sequencing as being inversion first, and relative Gilt outperformance later, although we do not expect the relative performance of Gilts to worsen with the UK economy set to enter recession before other major economies. Importantly, the forward rates in the Gilt curve are still priced for a somewhat steeper yield curve, making curve flattening trades along the entire curve attractive as positive carry trades that pay you to wait for the eventual policy driven inversion. The 2-year/10-year and 2-year/30-year flatteners look particularly attractive from that carry-focused perspective. Bottom Line: The BoE– under increasing political pressure for its relatively timid response to the massive UK inflation overshoot – is now forecasting a long policy-induced recession as the only way to tame UK inflation expected to reach 13% by year-end. Expect UK Gilts to be a relative outperformer within developed bond markets over the next 12-18 months, and enter positive carry Gilt curve flatteners now to benefit from the inevitable inversion of the curve. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com GFIS Model Bond Portfolio Recommended Positioning Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months)
Executive Summary High profile economists Larry Summers and Olivier Blanchard have recently cast doubt on the Federal Reserve’s claim that a soft landing is possible for the US economy. We explore the arguments from both sides of the debate and conclude that the economic data will likely support the Fed’s soft landing thesis during the next six months. However, the unemployment rate will rise more significantly as we move deeper into 2023 and the Fed continues to run a restrictive monetary policy. This report also provides an update on our recommended portfolio duration and high-yield positioning, and suggests a tweak to our recommended positioning across the Treasury curve. Specifically, we advise clients to enter a duration-matched position long the 5/30 barbell and short the 10-year bullet. The Beveridge Curve Bottom Line: Investors should keep portfolio duration close to benchmark and maintain a neutral (3 out of 5) allocation to high-yield bonds. Investors should also exit positions long the 2-year bullet versus a duration-matched cash/5 barbell and enter a position long a 5/30 barbell versus the 10-year bullet. Feature This week’s report digs into a recent macro debate between two high profile economists – Larry Summers and Olivier Blanchard – and the Federal Reserve about whether a “soft landing” is possible for the US economy. We summarize the debate below and offer our own thoughts on its implications for investment strategy. But first, we provide a quick update on our recent thinking about US bond portfolio construction, including a change to our recommended yield curve positioning. Positioning Update Portfolio Duration In recent reports we have written that we would reduce our recommended portfolio duration stance from “at benchmark” to “below benchmark” if the 10-year Treasury yield falls to 2.5% or if core inflation converges to our 4%-5% estimate of its underlying trend (Chart 1).1 The 10-year yield came close to hitting our 2.5% trigger last week but then quickly reversed course. It moved even higher after Friday’s extremely strong employment report, and it now sits at 2.78%. We are sticking with our plan. Despite July’s blockbuster job gains, trends in both initial and continuing jobless claims suggest that the unemployment rate is more likely to rise than fall during the next few months (Chart 2). Supply chain indicators also point toward falling inflation (Chart 2, bottom panel). Against this backdrop, it wouldn’t be too surprising to see bond yields experience another downleg. Chart 1Stay Neutral For Now Chart 2Unemployment Has Bottomed High-Yield Turning to credit, we continue to recommend an underweight allocation to spread product (including investment grade corporate bonds) versus Treasuries, but with a slightly higher allocation (neutral) to high-yield. We think that high-yield spreads can tighten in the near-term as recession fears are allayed and inflation rolls over. However, the medium-to-long run macro environment is negative for spread product and we will be quick to reduce junk exposure if spreads reach their 2017-19 average (Chart 3) or if core inflation converges with our 4%-5% estimate of trend. Chart 3Tracking The Junk Rally Treasury Curve Chart 4Buy A 5/30 Flattener Finally, this week we tweak our recommended yield curve positioning by closing our prior recommendation: long 2-year bullet versus duration-matched cash/5 barbell, and by initiating a new trade: long 5/30 barbell versus a duration-matched 10-year bullet. We only initiated that 2 over cash/5 trade a couple weeks ago on the view that 2/5 Treasury curve inversions don’t tend to last very long.2 However, it has since become clear that our timing was premature. In fact, we probably shouldn’t anticipate a significant 2/5 steepening until the Fed’s tightening cycle is near its end, which we do not believe to be the case. Instead, we recommend that investors shift into a duration-matched position that is overweight a 5/30 barbell versus the 10-year bullet. This trade offers a positive yield differential of 16 bps (Chart 4) and will profit from a flattening of the 5-year/30-year Treasury slope. The 5/30 slope has steepened in recent weeks, but further steepening is only likely to occur near the end of a Fed tightening cycle. Given that we see significant further tightening ahead, it’s much more likely that the 5/30 slope will fall to zero or even turn negative (Chart 4, top panel). The Battle Of The Beveridge Curves Our battle begins with a speech from Fed Governor Christopher Waller that was given back in May.3 In that speech, Waller made the case for why the large number of job vacancies gave him “reason to hope that policy tightening in current circumstances can tame inflation without causing a sharp increase in unemployment.” Waller’s argument was based on the historical relationship between the job vacancy rate and the unemployment rate, a relationship known as the Beveridge Curve (Chart 5). In essence, Waller’s argument for a “soft landing” boils down to the observation that the Beveridge Curve shown in Chart 5 has shifted up since the pandemic. That is, since March 2020 we have consistently seen more job vacancies for any given unemployment rate. His contention is that, as economic activity slows, rather than moving to the right along the Beveridge Curve, the curve will shift down toward its pre-pandemic level. In other words, the job vacancy rate will decline significantly without a large uptick in the unemployment rate. Chart 5The Beveridge Curve Objection! In a paper published this month, Olivier Blanchard, Alex Domash and Larry Summers (BDS) take issue with Waller’s claims from two different angles, a theoretical one and an empirical one.4 First, from a theoretical perspective, BDS describe three factors that lead to either movements along the Beveridge Curve or shifts in the curve itself. 1) Economic Activity. Stronger economic activity leads to more job vacancies and a lower unemployment rate. In other words, a shift to the left along the Beveridge Curve, illustrated as the journey from point A to point B in Chart 6. Chart 6An Illustrated Beveridge Curve 2) Matching Efficiency. If available jobs are a worse match for the skills of the unemployed labor force, then it will lead to a higher job vacancy rate for any given unemployment rate. In other words, a shift up in the Beveridge Curve from point B to point C in Chart 6. 3) Reallocation Intensity. If people switch jobs more frequently, then there will also tend to be more vacancies for any given level of unemployment. Again, this would shift the Beveridge Curve up from point B to point C in Chart 6. Using a model and data from the JOLTS survey, BDS attempt to decompose how much of these three factors have contributed to the current positioning of the Beveridge Curve. The authors estimate that economic activity has increased significantly since the end of 2019, but also that the labor market’s matching efficiency has declined, and that reallocation intensity has increased (Chart 7). Chart 7An Illustrated Beveridge Curve While monetary tightening can weaken economic activity, it cannot change the labor market’s matching efficiency or its reallocation intensity. Therefore, the authors argue, unless matching efficiency and reallocation intensity naturally revert to their pre-COVID levels, weaker economic activity will manifest as a movement to the right along the post-2020 Beveridge Curve, leading to a higher unemployment rate. This, in our view, is the crux of the “soft landing” debate. Are the recent changes in labor market matching efficiency and reallocation intensity temporary or permanent? Next, we move to BDS’ empirical arguments. The authors construct a time series of the job vacancy rate going back to the 1950s and then examine changes in both the job vacancy rate and the unemployment rate following cyclical peaks in the vacancy rate. Their results show that a falling job vacancy rate almost always coincides with a rising unemployment rate (Table 1). In other words, if history is any guide, it is very unlikely that the Fed will be able to push the job vacancy rate down without seeing an increase in unemployment. Table 1Average Change In The Unemployment Rate And The Vacancy Rate After A Peak In The Vacancy Rate That said, the authors’ results also reveal a dynamic known as the Beveridge Loop. Notice in Table 1 that a drop in the vacancy rate leads to a much smaller increase in the unemployment rate during the first six months following the vacancy rate peak than it does during the first 12 months or first 24 months. In other words, there is some empirical validity to Fed Governor Waller’s argument that the early impact of Fed tightening will be felt primarily through a falling job vacancy rate. The 2018/19 Example We can illustrate the Beveridge Loop with a recent example, one that interestingly was not included in BDS’ empirical analysis. The job vacancy rate peaked in November 2018 and then trended lower until the pandemic struck in early 2020. Interestingly, this 2018-19 drop in the job vacancy rate occurred alongside a modest decline in the unemployment rate. Chart 8 shows what the Beveridge Curve looked like during this period. Notice that, rather than moving back to its January 2018 point in a straight line, the Beveridge Curve formed a loop after peaking in November 2018. Chart 8The 2018/19 Beveridge Loop What allowed the labor market to achieve this “soft landing” in 2018/19? The most likely answer is that labor force participation rose significantly during this period (Chart 9). The influx of workers into the labor force allowed the unemployment rate to keep falling even as continuing unemployment claims bottomed out. Chart 9The 2018/19 Soft Landing The BCA Verdict Our view is that the incoming economic data will appear to validate the Fed’s “soft landing” view during the next six months, but that the unemployment rate will start to rise more significantly as we move deeper into 2023. As we have stated in prior reports, a significant increase in the unemployment rate will eventually be required to tame inflation, but that increase likely won’t occur as soon as many market participants expect.5 In essence, we anticipate a large Beveridge Loop. A loop that, in fact, appears to already be forming (Chart 5). We have shown that the empirical evidence supports the idea that a Beveridge Loop will occur during the early stages of a slowdown. Further, theory and empirical evidence demonstrate that the Beveridge Curve is convex. This suggests that the Beveridge Loop could be particularly large in this cycle given that the vacancy rate is starting from such a high level. Perhaps the bigger question, though, is whether the Beveridge Curve will re-converge with its pre-pandemic level during the next 6-12 months. On this question we side more with Blanchard, Domas and Summers. While we think that matching efficiency can continue to improve along its current trend (Chart 7, panel 2), the widespread adoption of work-from-home suggests that the labor market has probably experienced a permanent increase in reallocation intensity. On matching efficiency, the best evidence for continued improvement comes from a breakdown of employment by industry (Table 2). Notice that the three sectors (other than government) that have experienced the greatest job losses since the pandemic – Health Care, Leisure & Hospitality and Other Services – also have three of the highest job openings rates. This suggests that there shouldn’t be a permanent friction between matching those missing workers to available jobs. Table 2Employment By Industry Finally, working from our 2018/19 example, we can assess the likelihood that an increase in labor force participation will cushion the upside in the unemployment rate. Here, we see some potential for the prime age participation rate to rise back to its pre-COVID level, but the re-entry of recently retired workers over the age of 55 is more in doubt. Overall, it’s highly unlikely that the overall participation rate will re-gain its pre-pandemic level (Chart 10). Chart 10Labor Force Participation The bottom line is that the next six months will likely look more like a soft landing than a hard one. The job vacancy rate will fall quickly and the unemployment rate will stay relatively low, causing the Beveridge Curve to form a large loop. However, the Beveridge Curve will not revert to its pre-COVID level any time soon. As we move deeper into 2023, the Beveridge Curve will stop looping and the unemployment rate will rise significantly. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Recession Now Or Recession Later?”, dated July 26, 2022. 2 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Low Conviction US Bond Market”, dated July 12, 2022. 3https://www.federalreserve.gov/newsevents/speech/files/waller20220530a.pdf 4https://www.piie.com/publications/policy-briefs/bad-news-fed-beveridge-space#:~:text=The%20Federal%20Reserve%20seeks%20to,together%20and%20remain%20unlikely%20now. 5 Please see US Bond Strategy Weekly Report, “Three Conjectures About The US Economy”, dated July 19, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns
The Bank of England hiked interest rates by 50bps on Thursday, lifting the bank rate to 1.75% with the majority (8-1) of the MPC voting in favor of the outsized increase. Revisions to the forecast indicate that the central bank is facing a challenging task.…