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Executive Summary Expansion In European Defense European yields have significant upside on a structural basis. European government spending will remain generous, which will boost domestic demand; meanwhile, lower global excess savings will lift the neutral rate of interest and structurally higher inflation will boost term premia. A short-term pullback in yields is nonetheless likely; however, it will not short-circuit the trend toward higher yields on a long-term basis. CYCLICAL INCEPTION DATE RETURN SINCE INCEPTION (%) COMMENT EQUITIES Favor European Aerospace & Defense Over European Benchmark 3/28/2022 Favor European Aerospace & Defense Over Other Industrials 3/28/2022 Bottom Line: Investors should maintain a below-benchmark duration in their European fixed-income portfolios. Higher yields driven by robust domestic demand and strong capex also boost the appeal of industrial, materials, and financials sectors. Aerospace and defense stocks are particularly appealing. The economic impact of the war in Ukraine continues to drive the day-to-day fluctuations of the market; however, investors cannot ignore the long-term trends in the economy and markets. The direction of bond yields over the coming years is paramount among those questions. Does the recent rise in yields only reflect the current inflationary shock caused by both supply-chain impairments and commodity inflation—that is, is it finite? Or does that rise mirror structural forces and therefore have much further to run? We lean toward yields having more upside over the coming years, propelled higher by structural forces. As a result, we continue to recommend investors structurally overweight sectors that benefit from a rising yield environment, such as financials and industrials, while also favoring value over growth stocks. The defense sector is particularly attractive. Three Structural Forces Behind Higher Yields The current supply-chain disruptions and inflation crises have played a critical role in lifting European yields. However, a broader set of factors underpins our bearish bond view—namely, the lack of fiscal discipline accentuated by the consequences of the Ukrainian war, the likely move higher in the neutral rate of interest generated by lower savings, and the long-term uptrend in inflation. Profligate Governments Chart 1 Larger government deficits will contribute to higher European yields. Europe is not as fiscally conservative as it was before the COVID-19 crisis. Establishment politicians must fend off pressures caused by voters attracted to populist parties willing to spend more. Consequently, IMF estimates published prior to the Ukrainian war already tabulated that, for the next five years, Europe’s average structurally-adjusted budget deficit would be 2.4% of GDP wider than it was last decade (Chart 1). Chart 2Expanding Military Spending The Ukrainian crisis is also prompting a fiscal response that will last many years. Europe does not want to stand still in the face of the Russian threat. Today, Western Europe’s military spending amounts to 1.5% of GDP, or €170 billion. This is below NATO’s threshold of 2% of GDP. Rebuilding military capacity will take large investments. Thus, European nations are likely to move toward that target and even go beyond. Conservatively, if we assume that military spending hits 2% of GDP by the end of the decade, it will rise above €300 billion (Chart 2). Weaning Europe off Russian energy will also prevent a significant fiscal retrenchment. This effort will take two dimensions. The first initiative will be to build infrastructures to receive more LNG from the rest of the world to limit Russian intake. Constructing regasification and storage facilities as well as re-directing pipeline networks be costly and require additional CAPEX over the coming years. The second initiative will be to double-up on green initiatives to decrease the need for fossil fuel. The NGEU funds are already tackling this strategic goal. Nonetheless, the more than €100 billion reserved for renewable energy and energy preservation initiatives was only designed to kick-start hitting the EU’s CO2 emission target for 2050. Accelerating this process not only helps cutting the dependence on Russian energy, but it is also popular with voters. The path of least resistance is to invest in that sphere and to increase such investment beyond the current sums from the NGEU program. The last fiscal push is likely to be more temporary. The UN estimates that four million refugees have left Ukraine, with the vast majority settling in the EU. Accommodating that many individuals will be costly and will add to government spending across the region. Even if mostly transitory, this spending will have an important impact on activity. Larger fiscal deficits push yields higher for two reasons. Greater sovereign issuance that does not reflect a negative shock to the private sector will need to offer higher rates of returns to attract investors. Moreover, greater government spending will boost aggregate demand, which increases money demand. As a result, the price of money will be higher than otherwise, which means that interest rates will rise—as will yields. Decreasing Global Excess Savings Decreasing global excess savings will put upward pressure on the global neutral rate of interest, a phenomenon Peter Berezin recently discussed in BCA’s Global Investment Strategy service. This process will be visible in Europe as well. The US will play an important role in the process of lifting global neutral rates because the dollar remains the foundation of the global financial system. Compared to last decade, the main drag on US savings is that household deleveraging is over. As households decreased their debt load following the global financial crisis, a large absorber of global savings vanished, putting downward pressure on the price of those savings. Today, US households enjoy strong net worth equal to 620% of GDP and have resumed accumulating debt (Chart 3). Consequently, the downward trend in US total private nonfinancial debt loads has ended. The US capex cycle is likely to experience a boost as well. As Peter highlighted, the US capital stock is ageing (Chart 4). Moreover, the past five years have witnessed three events that underscore the fragility of global supply-chains: a disruptive Sino-US trade war, a pandemic, and now a military conflict. This realization is causing firms to move from a “just-in-time” approach to managing supply-chains to a “just-in-case” one. The process of building redundancies and localized supply chains will add to capex for many years, pushing up ex-ante investments relative to savings, and thus, interest rates. Chart 3US Households Are Done Deleveraging Chart 4An Ageing US Capital Stock China’s current account surplus is also likely to decline. For the past two decades, China has been one of the largest providers of savings to the global economy. This is a result of an annual current account surplus that first averaged $150 billion per year from 2000 to 2010 and then $180 billion from 2010 to 2020, and now stands at $316 billion. Looking ahead, China wants to use fiscal policy more aggressively to support demand, which often boosts imports without increasing exports. Also, more domestically-oriented supply chains around the world will limit the growth of Chinese exports. This combination will compress Chinese excess savings, which will place upward pressure on the global neutral rate of interest. Europe is not immune to declining savings. Over the past ten years, the Euro Area current account surplus has averaged €253 billion. Germany’s current account surplus stood at 7.4% of GDP before the pandemic. Those excess savings depressed global rates in general and European ones especially (Chart 5). As in the US, Europe’s capital stock is ageing and needs some upgrade (Chart 6). Moreover, greater government spending boosts aggregate demand. Because investment is a form of derived demand, stronger overall spending promotes capex to a greater extent. Thus, Europe’s public infrastructure push will lift private capex and curtail regional excess savings beyond the original drag from wider fiscal deficits. Additionally, the European population is getting older and will have to tap into their excess savings as they retire. This process will further diminish Europe’s current account surplus, that is, its excess savings. Chart 5Excess Savings Cap Relative Yields Chart 6An Ageing European Capital Stock Too Structurally Higher Inflation BCA believes that the current inflation surge is temporary and mostly reflects a mismatch between demand and supply. However, we also anticipate that, once this inflation climax dissipates, inflation will settle at a level higher than that prior to COVID-19 and will trend higher for the remainder of this decade. Labor markets will tighten going forward because policy rates remain well below neutral interest rates. Output gaps will close because of robust government spending and capex. This will keep wage growth elevated in the US and reanimate moribund salary gains in the Eurozone (Chart 7). This process, especially when combined with less efficient global supply chains and lower excess savings (which may also be thought of as deficient demand), will maintain inflation at a higher level than in the past two decades. Higher inflation will lift yields for two main reasons. First, investors will require both greater long-term inflation compensation and higher policy rates than in the past. Second, higher inflation often generates greater economic volatility and policy uncertainty, which means that today’s minimal term premia will increase over time (Chart 8). Together, these forces will create a lasting upward drift in yields. Chart 7European Wages Will Eventually Revive Chart 8Term Premia Won't Stay This Low Bottom Line: European yields will sport a structural uptrend for the remainder of the decade. Three forces support this assertion. First, European government spending will remain generous, supported by infrastructure and military spending. Second, global excess savings will recede as US consumer deleveraging ends, global capex rises, and the Chinese current account surplus narrows. Europe will mimic this process in response to an ageing population, greater government spending, and capex. Finally, inflation is on a structural uptrend, which will warrant higher term premia across the world. Not A Riskless View There are two main risks to this view, one in the near-term and one more structural. The near-term risk is the most pertinent for investors right now. Global yields may have embarked on a structural upward path, but a temporary pullback is becoming likely. As Chart 9 highlights, the expected twelve-month change in the US policy rate is at the upper limit of its range of the past three decades. Historically, when the discounter attains such a lofty level, a retrenchment in Treasury yields ensues, since investors have already discounted a significant degree of tightening. The same is true in Europe, where the ECB discounter is also consistent with a temporary pullback in German 10-year yields (Chart 10). Chart 9Discounters Point To A Treasury Rally... Chart 10... And A Bund Rally Chart 11A Mixed Message Investor positioning confirms the increasing tactical odds of a yield correction. The BCA Composite Technical Indicator for bonds is massively oversold, which often anticipates a bond rally (Chart 11). This echoes the signals from the JP Morgan surveys that highlight the very low portfolio duration of the bank’s clients. However, the BCA Bond Valuation Index suggests that bonds remain expensive. Together, these divergent messages point toward a temporary bond rally, not a permanent one. The longer-term risk is regularly highlighted by Dhaval Joshi in BCA’s Counterpoint service. Dhaval often shows that the stock of global real estate assets has hit $300 trillion or 330% of global GDP. Real estate is a highly levered asset class and global cap rates have collapsed with global bond yields. With little valuation cushion, real estate prices could become very vulnerable to higher yields. Nevertheless, real estate is also a real asset that produces an inflation hedge. Moreover, rental income follows global household income, and stronger aggregate demand will likely lift median household income especially in an environment in which globalization has reached its apex and populism remains a constant threat. Bottom Line: Global investor positioning has become stretched; therefore, a near-term pullback in yield is very likely, especially as central bank expectations have become aggressive. Nonetheless, a bond rally is unlikely to be durable in an environment in which bonds are expensive and in which growth and inflation will remain more robust than they were last decade. A greater long-term risk stems from expensive global real estate markets. However, real estate is sensitive to global economic activity and inflation, which should allow this asset class ultimately to weather higher yields. Investment Conclusions An environment in which yields rise will inflict additional damage on global bond portfolios. This is especially true in inflation-adjusted terms, since real yields stand at a paltry -0.76% in the US and -2.5% in Germany. Hence, we continue to recommend investors maintain a structural below-benchmark duration bias in their portfolios. Nonetheless, investors with enough flexibility in their investment mandate should take advantage of the expected near-term pullback in yields. Those without this flexibility should use the pullback as an opportunity to shorten their portfolio duration. Higher yields will also prevent strong multiple expansion from taking place; hence, the broad stock market will also offer paltry long-term real returns. Another implication of rising yields, especially if they reflect stronger growth and rising neutral interest rates, is to underweight growth stocks relative to value stocks (Chart 12). Growth stocks are expensive and very vulnerable to the pull on discount rates that follows rising risk-free rates. Meanwhile, stronger economic activity driven by infrastructure spending and capex will help the bottom line of industrial and material firms. Financials will also benefit. Higher yields help this sector and robust capex also boosts loan growth, which will generate a significant tailwind for banking revenues. Hence, rising yields will boost the attractiveness of banks, especially after they have become significantly cheaper because of the Ukrainian war (Chart 13). Chart 12Favor Value Over Growth Chart 13Bank Remain Attractive Related Report European Investment StrategyFallout From Ukraine Finally, four weeks ago, we highlighted that defense stocks were particularly appealing in today’s context. The re-armament of Europe in response to secular tensions with Russia is an obvious tailwind for this sector. However, it is not the only one. A long-term theme of BCA’s Geopolitical Strategy service is the expanding multipolarity of the world. The end of an era dominated by a single hegemon (the US) causes a rise in geopolitical instability and tensions. The resulting increase in conflict will invite a pickup in global military spending. Chart 14Defense Will Outshine The Rest European defense and aerospace stocks are expensive, with a forward P/E ratio approaching the top-end of their range relative to the broad market and other industrials. However, their relative earnings are also depressed following the collapse in airplane sales caused by the pandemic. Our bet on the sector is that its earnings will outperform the broad market as well as other industrials because of the global trend toward military buildup. As relative earnings recover their pandemic-induced swoon, so will relative equity prices (Chart 14). Bottom Line: Higher yields warrant a structural below-benchmark duration in European fixed-income portfolios, even if a near-term yield pullback is likely. As a corollary, value stocks will outperform growth stocks while industrials, materials, and financials will also beat a broad market whose long-term real returns will be poor. Within the industrial complex, aerospace and defense equities are particularly appealing because a global military buildup will boost their earnings prospects durably. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades
Executive Summary Biden’s Low Approval On Foreign Policy The energy shock stemming from President Biden’s foreign policy challenges could get worse, especially if US-Iran talks fail. The energy and inflation shocks condemn the Democrats to a dismal midterm election showing, even if Biden handles the Ukraine crisis reasonably well and his approval rating stabilizes. Biden’s foreign policy is still somewhat defensive, focusing on refurbishing US alliances, and as such should not force the EU to boycott Russian energy outright. Biden’s foreign policy doctrine will likely be set in stone with his imminent decision on whether to rejoin the 2015 nuclear deal with Iran. We doubt it will happen but if it does the market impact will be fleeting due to lack of implementation. Biden’s foreign policy toward China will likely grow more aggressive over time. Recommendation (Cyclical) Inception Level Initiation Date Return Long ISE Cyber-Security Index 647.53 Dec 8, 2021 -4.6% Bottom Line: President Biden foreign policy challenges are creating persistent downside risks for equity markets. Feature External risk is one of our key views for US politics in 2022. This risk includes but is not limited to the war in Ukraine. The Biden administration’s urgent foreign policy challenges are creating persistent downside risks for the global economy and financial markets in the short run – embodied in rising energy costs (Chart 1). Related Report US Political Strategy2022 Key Views: Gridlock Begins Before The Midterms Chart 1Oil Prices And Prices At The Pump Ukraine Can Still Hurt US Stocks The Ukraine war is not on the verge of resolution – more bad news is likely to hit US equity markets. The Russian military is bombarding the port city of Mauripol, which will fall in the coming days or weeks (Map 1). Given that Mauripol is refusing to surrender, it is highly unlikely that the central government in Kiev will surrender anytime soon. Map 1Russian Invasion Of Ukraine 2022 The military situation is approaching stalemate and yet ceasefire talks are not promising. The Ukrainians do not accept Russian control of Donbas and Crimea and will need to hold a referendum on the terms of any peace agreement. Lack of progress will drive the Russians to escalate the conflict, whether by means of bombardment, troop reinforcements, or bringing the Belarussian military into the fight. The United States and its allies are increasing defense support for Ukraine while warning that Russia could use chemical, biological, or even tactical nuclear weapons. In our sister Geopolitical Strategy service we argue that the war to get worse before it gets better, with Russia determined to replace the government in Kiev. US investors should expect continued equity market volatility. US and global growth expectations are yet to be fully downgraded as a result of the global energy shortage – the Fed now expects GDP growth of 2.8% while the Atlanta Fed shows GDP clocking in at 1.3%, well below consensus expectations (Chart 2). Corporate earnings will suffer downgrades as a result of higher energy costs. The Federal Reserve just started hiking interest rates and it is not discouraged by foreign affairs. Real rates will rise. Chairman Jerome Powell sounded a hawkish tone by saying that he is willing to hike by 50 basis points at a time if required. The threat of a wage-price spiral is real. The 2-year/10-year Treasury slope is on the verge of inverting. The Fed’s new interest rate projections suggest that the interest rate will rise above the neutral rate in 2023-24. Chart 2Growth Will Take A Hit Ukraine’s Impact On The Midterm Elections A negative foreign policy and macroeconomic background will compound the Democratic Party’s woes in the midterm elections. Biden’s approval rating is languishing at Donald Trump levels, yet without Trump’s high marks on the economy (Chart 3). Biden will not be able to turn the economy around because even if inflation starts to abate, voters will react to the one-year and two-year increase in inflation rather than any month-on-month improvement. Republicans have pulled ahead of Democrats in generic congressional ballot opinion polling (Chart 4). Even if Biden’s ratings stabilize ahead of the midterms (even if he handles Ukraine well), Democrats face a shellacking. The market is rightly priced for Republicans to take over all of Congress, though the GOP’s odds of taking the Senate are lower than consensus holds (Chart 5). A Republican victory is not negative for US corporate earnings but uncertainty over the general direction of US policy will continue to weigh on the equity market this year. Chart 3Biden’s Approval Ratings Chart 4Republicans Take The Lead Biden’s foreign policy can and will get a lot more aggressive if the Democratic Party views its election odds as so dismal that foreign tensions come to be seen as a source of badly needed popular support. That is not yet the case but developments with Russia and Iran could force the administration to adopt a more offensive foreign policy, which would be negative for financial markets. Hence investors will have to worry about rising policy uncertainty over the 2022-24 political cycle. Chart 5Midterm Election Odds Biden’s Policy Toward Russia And Europe It is too soon to say precisely what is the “Biden Doctrine” of foreign policy. The withdrawal from Afghanistan and the war in Ukraine were thrust upon Biden. What will define his foreign policy is how he handles Russia, Iran, and China going forward. By the end of the year, Biden will have forged his foreign policy doctrine, for better or worse. Biden began with a defensive foreign policy. His administration’s primary intention is to refurbish US alliances in Europe and Asia to counter Russia and China. Consider: In 2021, Biden condoned Germany’s deepening economic and energy integration with Russia (i.e. the Nord Stream II pipeline). Russia’s invasion forced Germany to change its mind and join the US and other democracies in imposing harsh sanctions on Russia. Even so, the US is calibrating its actions to what the European allies can stomach. Biden is attempting to negotiate new trade deals with allies, by contrast with President Trump’s tendency to slap tariffs on allies as well as rivals.1 Biden is likely to try to revive the Transatlantic Trade and Investment Partnership (TTIP) with Europe, he is scheduled to restart talks with the UK about a post-Brexit trade deal, and he will probably attempt to rejoin the Trans-Pacific Partnership (CPTPP) in future. Now that Russia has invaded Ukraine, Biden’s foreign policy is becoming more aggressive, albeit still within certain limitations: The US is not willing to send troops to defend Ukraine or impose a no-fly zone, which would trigger direct conflict with Russia. But the US is continuing to provide Ukraine with lethal weapons, which helped precipitate the war. Congress recently voted to increase Ukraine aid by $13.6 billion, including $6.5 billion in defense support, including drones, Stinger anti-aircraft missiles, and Javelin anti-tank missiles. These are supposed to start arriving in Ukraine in a few days. The US is reportedly looking into providing Ukraine with Soviet-era SA-8 air defense, though not the S-300s missile defense.2 The US is bulking up its military presence across Europe to deter Russia from broadening its attacks beyond Ukraine. Biden has declared a red line in that he will defend “every inch” of NATO territory. This means that a single Russian attack that spills over into Poland or another NATO country will precipitate a new and bigger crisis (and financial market selloff). The risk going forward is that American policy could grow increasingly aggressive to the point that tensions with Russia escalate. Unlike Russia and Europe, the US does not have vital national interests at stake in Ukraine. American national security is not directly threatened by the war there. Hence the US can afford to take actions that its European allies would prefer not to take. As long as Biden prioritizes solidarity with the Europeans, geopolitical risks may be manageable for the markets. But if Biden attempts to lead an even bolder charge against Russia (or China), then risks will become unmanageable. So far Biden is allowing Europe to impose sanctions at its own pace and intensity. The Europeans must tread more carefully than the US, lest sanctions cause a broad energy cutoff that plunges their economy into recession along with Russia’s. This would destabilize the whole Eurasian continent and increase the chances of strategic miscalculation and a broader military conflict. Europe has opted for a medium-term strategy of energy diversification while avoiding the US’s outright boycott of Russian energy. The EU depends on Russia for 26% of its oil and 16% of its natural gas imports (Chart 6). The dependency is higher for certain countries. Germany, Italy, Hungary, and others oppose an outright boycott – and a single EU member can veto any new sanctions. Theoretically the Europeans could ban oil while still accepting natural gas. Natural gas trade routes are fixed due to physical pipelines, whereas oil is more easily rerouted, leaving Russia with alternatives if Europe stops importing oil. But Russia exports 63% of its oil to developed markets and 65% of its natural gas, with the bulk of that going to the European Union at 48% and 15% respectively (Chart 7). Russia’s economy would suffer from an oil ban and it would assume that a natural gas ban would soon follow, which could unhinge expectations that war tensions can be contained. Chart 6EU Mulls Boycott Of Russian Oil Chart 7Russian Regime Depends On O&G Given the damaged state of the Russian economy and high costs of war, Moscow will probably keep accepting energy revenues as long as Europe is buying. But if it believes Europe will cut off the flow, then it has an incentive to act first. This is a risk, not our base case. Still, as Russia targets the capital Kiev with intense shelling and civilian casualties increase, US pressure for an expansion of sanctions will increase. This is the risk that investors need to monitor. If the US brings the EU around to adopting sanctions on Russian energy then equity markets will plunge anew. And since Europe is diversifying over time anyway, Russia will have to escalate the war now to try to achieve its aims before its source of funds dries up. Biden’s Policy Toward China Biden’s foreign policy also started out defensively with regard to China. Biden intended to stabilize relations, i.e. engage in some areas like climate policy and avoid expanding President Trump’s trade war. Both the Democratic Party and the Communist Party face important political events in 2022 and their inclination is to prevent global instability from interfering. But the Ukraine war has made this goal harder. As with Europe the immediate question is whether Biden will try to force China to cooperate on Russia sanctions. But in China’s case Biden is more likely to use punitive measures – at least eventually. After a two-hour bilateral phone call on March 18, Biden “described the implications and consequences if China provides material support to Russia as it conducts brutal attacks against Ukrainian cities and civilians.”3 Biden’s threat of sanctions is a negative for Chinese exporters and banks (Chart 8). Chinese stock markets were already suffering from China’s historic confluence of internal and external political and economic risks. The Ukraine war has increased the fear of western investors that investing in China will result in stranded capital when strategic tensions rise explode, as with Russia. Chart 8Biden Threatens China With Sanctions Economically, China is much more dependent on the West than Russia. While Germany and Russia take a comparable share of Chinese exports, at 3.4%and 2.0% respectively, the EU takes up more than three times as many Chinese exports as the Commonwealth of Independent States, at 15.4% versus 3.2% (Chart 9A Chart 9B). China was never eager to commit to an exclusive economic relationship with Russia at the expense of its western markets. Strategically, however, China cannot afford to reject Russia. Chart 9AEU Wary Of Targeting China Chart 9BEU Wary Of Targeting China Russia has now severed ties with the West and has no choice but to offer favorable deals to China on the whole range of relations. China’s greatest strategic threat is US sea power; Russia offers a strategically vital overland source of natural resources. Russia also offers intelligence and security assistance in critical regions like Central Asia and the Middle East that China needs to access. Like Russia, China fears US containment policy and views US defense relations with its immediate neighbors as a fundamental national security threat. President Biden reassured China that US policy toward the Taiwan Strait has not changed but also said that the US opposes any unilateral attempt to change the status quo. The implication is that China will segregate its EU and Russia networks of trade and finance to minimize the impact of any US secondary sanctions. China will offer Russia some assistance while making diplomatic gestures to maintain economic relations with Europe. The Europeans will lobby the Americans not to expand sanctions on China. The Biden administration will be reluctant to increase sanctions on China immediately, since it wants to maintain global stability in general, control the pace of rising global tensions, and maintain maneuverability for immediate problems with Russia and Iran. Biden’s priority is to rebuild US alliances and Europe will be averse to expanding the sanction regime to China. Therefore any sanctions on China will come only slowly and with ample warning to global investors. But sanctions are possible over the course of the year. If the Biden administration concludes that it has utterly lost domestic support, that the midterm elections are a foregone conclusion, then it can afford to get tougher in the international arena in hopes that it can improve its standing with voters. Biden’s Policy Toward Iran While Afghanistan and Ukraine were thrust upon Biden, the major foreign policy challenge in which he retains the initiative is whether to rejoin the 2015 nuclear deal with Iran. Thus it may be policy toward Iran and the Middle East that defines the Biden doctrine. The Ukraine war has not stopped the Biden administration from seeking to rejoin the 2015 Joint Comprehensive Plan of Action, which was a strategic US-Iran détente that sought to freeze Iran’s nuclear program in exchange for its economic development. The original nuclear deal occurred with Russia’s blessing after the US and EU overlooked Russia’s invasion of Crimea. Now negotiations toward rejoining that deal are reaching the critical hour. The US has supposedly offered Russia guarantees to retain Russian support. The reason for Biden to rejoin the 2015 deal is to open Iran’s oil and natural gas reserves to the global and European economy and thus mitigate the global energy shock ahead of the midterm elections. Iran could return one million barrels per day to global markets. There is also a strategic logic for normalizing relations with Iran: to maintain a balance of power in the Middle East, reduce US military commitment there, provide Europe with greater security, and free up resources to counter Russia and China. Whether the deal will fulfill these ends is debatable but the Biden administration apparently believes it will. Biden is capable of rejoining the deal because the critical concessions do not require congressional approval. Through executive action alone, Biden could meet Iran’s demands: sanctions relief, delisting the Iranian Revolutionary Guard Corps as a terrorist organization, and ensuring that Russo-Iranian trade (especially nuclear cooperation) is not exempted from the new Russia sanctions. There will be domestic political blowback for each of these concessions but not as much as there will be if gasoline prices continue to rise due to greater global instability stemming from the Middle East. The Iranians are also capable of rejoining the deal. Supreme Leader Ali Khamenei, in his Persian New Year speech, gave a green light for President Ebrahim Raisi’s administration to pursue policies that would remove US sanctions. Khamanei implied that Iran should let the West lift sanctions while continuing to fortify its economy to future US sanctions.4 While the US and Iran are clearly capable of a stop-gap deal, it will not be a durable agreement – and hence any benefits for global energy supply will be called into question. The reason is that the underlying strategic logic is suffering: Biden will appear incoherent if he alienates Saudi Arabia and the UAE while appealing to them to increase oil production – and they are more capable than Iran on this front (Chart 10). Biden will appear incoherent if he agrees to secure Russo-Iranian trade at the same time as he seeks to cut Russia off from all other trade. Biden may not achieve a reduction in regional tensions through an Iran deal, since Israel insists that it is not bound to the nuclear deal. If Iran does not comply with the nuclear freeze, Israel will ramp up military threats. The Iranians cannot trust American guarantees that the next president, in 2025, will not tear up the nuclear deal and re-impose sanctions on Iran. The Iranians need Russian and Chinese assistance so they cannot afford to embark on a special new relationship with the West. Ultimately the Iranians are highly likely to pursue deliverable nuclear weapons for the sake of regime survival, as our Geopolitical Strategy has argued. Chart 10US-Iran Deal Will Not Be Durable Thus Biden may choose a deal with Iran but we would not bet on it. Moreover any stop-gap deal will be undermined in practice, so that the investment repercussions will be ephemeral. If Biden fails to clinch his Iran deal as expected, then the world faces an even larger energy shock due to rising tensions in the Middle East. Investment Takeaways The Biden administration’s foreign policy challenges will compound its macroeconomic challenges and weigh on the Democratic Party in the midterm elections. The war in Ukraine will hurt Biden and the Democrats primarily because of the energy shock. The energy shock will get worse if Biden fails to agree to a stop-gap deal with Iran. But we expect either the US or Iran to back out for strategic reasons. With Republicans likely to reclaim Congress this fall, US political polarization will remain at historically high levels over the course of the 2022-24 election cycle. However, Russia’s belligerence underscores our view that rising geopolitical threats will cause the US to unify and reduce polarization over the long run. The war reinforces our US Political Strategy themes of “Peak Polarization” and “Limited Big Government,” as a new bipartisan consensus is forming around the view that the federal government should take a larger role in the economy to address national challenges both at home and abroad. One of our cyclical investment ideas stemming from these themes is to buy cyber-security stocks. President Biden warned US government and corporations on March 21 that Russia could stage cyber attacks against the United States and that private businesses must be prepared. Cyber stocks have suffered amid the general rout in tech stocks but they are starting to recover. Year to date, they are outperforming the S&P 500, and the tech sector, and look to be starting to outperform defensive sectors (Chart 11). Chart 11Biden Warns Of Cyber Attacks Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Footnotes 1 See Yuka Hayashi, “U.S., U.K. Strike Trade Deal to End Tariffs on British Steel and American Whiskey”, Wall Street Journal, March 22, wsj.com 2 See Nancy Youssef and Michael Gordon, “U.S. Sending Soviet Air Defense Systems It Secretly Acquired to Ukraine”, Wall Street Journal, March 21, wsj.com. 3 White House, “Readout of President Joseph R. Biden Jr. Call with President Xi Jinping of the People’s Republic of China,” March 18, 2022, whitehouse.gov. 4 Ayatollah Ali Khamenei implied at his Persian New Year speech that a deal with the Americans could go forward. He emphasized the need to improve the economy and implied that some of the economic burdens will go away starting this year. He pointed to a way forward with US sanctions intact, while also saying that he did not discourage attempts to remove sanctions. “We should not tie the economy to sanctions... It is possible to make economic advances despite U.S. sanctions. It is possible to expand foreign trade, as we did, enter regional agreements and have achievements in oil and other areas … I never say to not go after sanctions relief, but I am asking you to govern the country in a way in which sanctions do not hurt us.” See “Iran's Khamenei Says Economy Should Not Be Tied to U.S. Sanctions,” Reuters, March 21, 2022, usnews.com. Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets
Executive Summary Tracking Inflation In 2022 Our base case view is that inflation will moderate in the coming months, allowing the Fed to deliver a steady pace of tightening (25 bps per meeting). A 50 bps rate hike is possible at some point this year, but only if long-maturity inflation expectations become un-anchored or core PCE inflation prints consistently above 0.30%-0.35% per month. Historical evidence suggests that Treasury securities perform best when the yield curve is very steep or very flat. All else equal, an inversion of the 2-year/10-year Treasury slope would make us more bullish on bonds. High-yield corporates have performed better than investment grade corporates during the recent sell-off. Investors should continue to favor high-yield corporates over investment grade. Bottom Line: Investors should maintain “at benchmark” portfolio duration and buy Treasury curve steepeners. We also maintain an overweight allocation to high-yield corporate bonds and a neutral allocation to investment grade corporates. We Have Liftoff The Fed followed through on its earlier promise and lifted the funds rate by 25 basis points last week. FOMC participants also sharply revised up their expectations for the future pace of tightening, though this revision mostly just made the Fed’s forecast more consistent with what was already priced in the yield curve. Market rate hike expectations, as inferred from the overnight index swap curve, shifted up only slightly after the Fed’s announcement (Chart 1). Chart 1Rate Expectations As of Monday morning, the bond market is priced for 208 bps of tightening during the next 12 months and 174 bps between now and the end of the year. This is close to the median FOMC forecast which calls for 150 bps of further tightening this year followed by an additional 92 bps in 2023. Last week’s report highlighted the tricky situation faced by the Fed.1 On the one hand, the Fed must tighten quickly enough to keep long-dated inflation expectations anchored. On the other hand, the Fed wants to avoid tightening so quickly that it causes a recession. For investors, we think it makes sense to assume that the Fed will try to split the difference by lifting rates at a pace of 25 bps per meeting for at least the next 12 months. However, there are significant risks to both the upside and downside of this projection. The Odds Of A 50 bps Hike The upside risk is that inflation is sufficiently sticky that the Fed will feel the need to deliver a 50 bps rate hike at some point this year. Last week’s Fed interest rate projections show that 7 out of 16 FOMC participants think that at least one 50 bps rate hike will be necessary. Meanwhile, market prices are consistent with one 50 basis point rate hike and five 25 basis point rate hikes at this year’s six remaining FOMC meetings. We think the Fed will only deliver a 50 bps rate hike if inflation looks to be tracking above the committee’s 2022 forecast or if long-maturity inflation expectations become un-anchored to the upside. Related Report Global Investment StrategyIs A Higher Neutral Rate Good Or Bad For Stocks? On the inflation front, the FOMC’s central tendency forecast calls for core PCE inflation of between 3.9% and 4.4% in 2022, with a median of 4.1%. To match this forecast, core PCE will have to average a monthly growth rate of between 0.30% and 0.35% in each of this year’s eleven remaining months (Chart 2).2 Every monthly inflation print above that range increases the odds of a 50 bps Fed move, every print below that range brings the odds down. As for long-maturity inflation expectations, the Fed likely views them as “well anchored” for the time being. The 10-year TIPS breakeven inflation rate has broken meaningfully above the Fed’s target range but the 5-year/5-year forward TIPS breakeven inflation rate remains consistent with the Fed’s goals (Chart 3). The University of Michigan’s survey measure of 5-10 year household inflation expectations has risen sharply, but it has not yet broken meaningfully above recent historical levels (Chart 3, bottom panel). Chart 2Tracking Inflation In 2022 Chart 3Inflation Expectations Our sense is that inflation is very close to peaking and that lower inflation in the back half of the year will apply downward pressure to inflation expectations and prevent the Fed from delivering a 50 bps hike at any single FOMC meeting. However, we will be closely tracking the evolution of Charts 2 and 3 to see if this situation changes. The Odds Of Skipping A Meeting Chart 4Financial Conditions The downside risk to the Fed’s expected rate hike path results from the fact that financial conditions have already responded aggressively to the Fed’s actions and communications. While it’s certainly true that financial conditions remain extremely accommodative in level terms (Chart 4), we must also acknowledge that, historically, the sort of rapid tightening of financial conditions that we have already seen is almost always followed by a significant slowdown in economic activity (Chart 4, panel 2). On top of all that, the yield curve is now completely flat beyond the 5-year maturity point and the 2-year/10-year Treasury slope is a mere 22 bps away from inversion (Chart 4, bottom panel). The Fed’s new interest rate projections show the median expected interest rate moving above estimates of the long-run neutral rate in 2023 and 2024. This sort of rate hike path is consistent with a mild inversion of the yield curve, and the Fed will likely downplay the yield curve’s recession signal during the next few months. That said, a deepening inversion of the yield curve will only increase market worries about an over-tightening of monetary policy. This could lead to a sell-off in risk assets that would accelerate the tightening of financial conditions and lead to expectations of even slower economic growth. The next section of this report explores what an inverted 2-year/10-year yield curve has historically meant for Treasury returns. Investment Implications Our base case view is that inflation will moderate in the coming months, allowing the Fed to deliver a steady pace of tightening (25 bps per meeting). We also see economic growth slowing but remaining solid enough to prevent a significant sell-off in risk assets and a deep inversion of the yield curve. We also acknowledge, however, that the risks to this view (in both directions) are unusually high. Given all that, our recommended investment strategy is to keep portfolio duration close to benchmark. The market is already well priced for a steady 25 bps per meeting pace of tightening and bond yields will merely keep pace with forwards if that pace is delivered. We also see yield curve steepeners profiting during the next 6-12 months as the yield curve’s flattening trend takes a pause now that market expectations have fully adjusted to the likely path of Fed rate increases. We remain neutral TIPS versus nominal Treasuries at the long-end of the curve, but underweight TIPS versus nominal Treasuries at the front-end. Short-maturity TIPS will underperform as inflation moderates in H2 2022. The Yield Curve And Treasury Returns The historical relationship between the slope of the yield curve and Treasury returns is very interesting. To examine it, we first looked at historical data on excess Treasury index returns versus cash since 1989 (Table 1). Table 112-Month Treasury Excess Returns* Given Different Starting Points For 2-Year / 10-Year Treasury Slope Specifically, we show 12-month excess Treasury returns given different starting points for the 2-year/10-year Treasury slope. For example, when the 2-year/10-year Treasury slope has been between 0 bps and 25 bps, the Bloomberg Barclays Treasury Index has historically outperformed a position in cash by an average of 2.75% during the next 12 months. A 90% confidence interval places expected returns between 1.75% and 3.73%, and excess Treasury returns were positive in 73% of historical observations. The first big conclusion that jumps out from Table 1 is that Treasuries perform best when the yield curve is either very steep or very flat. The worst periods for Treasury returns have tended to occur when the slope is between 25 bps and 100 bps. It’s easy to understand why a very steep yield curve would lead to strong Treasury returns. A steep curve means that Treasuries offer a large yield advantage versus cash, or put differently, an extremely rapid pace of rate hikes would be necessary for cash returns to overcome the carry advantage in bonds. It’s more difficult to understand why Treasury returns have been strong after instances of curve inversion. The most likely reason is that market participants have tended to overestimate the odds of the Fed achieving a “soft landing” and have underestimated the odds of an upcoming recession and rate cuts. The data used in Table 1 are limited in that observations only begin in 1989. As such, the table misses the Paul Volcker period of the early 1980s when Treasuries continued to sell off well after the curve inverted. Chart 5 extends the historical period back to the mid-1970s and uses shading to indicate periods of 2-year/10-year yield curve inversion. Chart 5Yields Tend To Peak Shortly After Curve Inversion Chart 5 reveals a pretty clear pattern. With the exception of the late-1970s/early-1980s episode, the 10-year Treasury yield tends to peak right around the time of 2-year/10-year yield curve inversion, or shortly after in the case of 1989. What can we take away from this analysis? First, the evidence suggests that we should have a bias toward taking more duration risk in our portfolio if and when the yield curve inverts. A more deeply inverted yield curve should also be viewed as a stronger bond-bullish signal than a modestly inverted yield curve. Second, we must acknowledge the major risk to this strategy. Specifically, the risk that inflation will be so high that the Fed will continue to tighten aggressively even after the yield curve inverts, as Paul Volcker did in the early-1980s. Our sense is that the odds of a repeat “Volcker moment” are low. Inflation will naturally fall as the pandemic’s impact wanes and the Fed won’t be forced to deliver another hawkish shock to market expectations. Therefore, we maintain our “at benchmark” recommendation for portfolio duration for now, but we may turn more bullish on bonds if the yield curve inverts. The Poor Performance Of Investment Grade Bonds Chart 6IG Has Lagged HY One notable aspect of recent bond market moves has been that the performance of investment grade corporate bonds has significantly lagged the performance of high-yield corporate bonds during the recent period of spread widening (Chart 6). This is highly unusual. Typically, we expect bonds with more credit risk to behave like “higher beta” securities. That is, we expect lower-rated bonds to perform better in bull markets and worse in bear markets.3 The typical relationships held earlier in the cycle. Chart 7A shows that high-yield corporate bonds delivered stronger excess returns than investment grade corporate bonds from the March 2020 peak in spreads through the end of that year. Chart 7B shows that high-yield continued to outperform investment grade throughout the bull market for spreads in 2021. Chart 7ACorporate Bond Excess Returns* Versus DTS: March 2020 To December 2020 Chart 7BCorporate Bond Excess Returns* Versus DTS: January 2021 To September 2021 Chart 7CCorporate Bond Excess Returns* Versus DTS: September 2021 To Present Based on that relationship, we would expect high-yield to perform worse than investment grade since spreads troughed in September 2021, but that has not been the case (Chart 7C). How do we explain the relatively weak performance of investment grade corporates relative to high-yield? One possible explanation is that the industry composition of the investment grade and high-yield bond universes is different. High-yield has a large concentration in the Energy sector while investment grade is more geared toward Financials. Given the recent surge in oil prices, it’s possible that the strong performance of Energy credits is driving the return divergence between investment grade and high-yield. Chart 8 shows the performance of each individual industry group within both investment grade and high-yield since the September 2021 trough in spreads. It shows that Energy bond returns have indeed been stronger than for other sectors. In fact, high-yield Energy excess returns have been positive! Chart 8Corporate Bond Excess Returns* Versus DTS: September 2021 To Present However, Chart 8 mainly reveals that industry composition only explains part of the divergence between investment grade and high-yield returns. Notice that every single high-yield industry group has outperformed its investment grade counterpart since September 2021. This suggests that there is a more fundamental reason for the divergence between investment grade and high-yield performance. Chart 9Following The 2018 Roadmap Our own sense is that the corporate bond market is following the roadmap from early 2018 (Chart 9). At that time, Fed tightening pushed the Treasury slope below 50 bps and investment grade corporates started to perform poorly, presumably because the removal of monetary accommodation justified somewhat wider corporate bond spreads. However, high-yield performed well in early 2018 as there was no material increase in corporate default risk, even though the Fed was tightening. A similar market narrative could easily be applied to today. Back in 2018, the market narrative shifted late in the year when investors suddenly decided that Fed tightening had gone too far. High-Yield sold off sharply and caught up with investment grade. The Fed was then forced to end its tightening cycle and corporate bonds rallied in early 2019. We see this 2018 roadmap as a significant risk, but not destiny. While there’s a chance that the market will soon decide that the Fed has over-tightened, leading to a sharp sell-off in high-yield. There’s also a chance that gradual Fed rate hikes will continue for much longer than the market anticipates without meaningfully slowing the economy. In that case, high-yield returns would remain solid for some time and the recent spread widening in investment grade would probably abate. For the time being, we find ourselves more inclined toward the latter scenario. Bottom Line: Investors should maintain an overweight allocation to high-yield and a neutral allocation to investment grade corporate bonds within a US bond portfolio. We may soon get a chance to upgrade our corporate bond allocation if inflationary pressures abate and the war in Ukraine shows signs of de-escalation. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “A Soft Landing Is Still Possible”, dated March 15, 2022. 2 PCE data is so far only updated to January 2022. 3 In this report we use Duration-Times-Spread (DTS) as a simple measure of a bond index’s credit risk. A higher DTS means that a bond has greater credit risk and vice-versa. Treasury Index Returns Spread Product Returns Recommended Portfolio Specification Other Recommendations
Executive Summary Fed Chair Powell is attempting to steer the US economy between the Scylla of a recession and the Charybdis of entrenched high inflation. In the benign soft-landing outcome, the economy will continue to grow well above trend while inflation abates as spending transitions from goods to services, supply chains are untangled and base effects offer arithmetic relief. Entrenched high inflation would yield the most bearish outcome as it would leave the Fed with no choice but to squash the economy to stuff the inflation genie back into the bottle. We expect that rate hikes will eventually short-circuit the expansion and the equity bull market, but not for at least another year. Disruptions from the Ukraine conflict and China’s COVID surge place the most bullish case out of reach but the bearish end of the continuum is overly defeatist. The biggest threats to our constructive view are worsening Russia-Ukraine shortages, a conflict with Russia beyond Ukraine, new COVID obstacles and a consumer retreat. The Rates Market Thinks The Fed's Overly Ambitious Bottom Line: We continue to recommend overweighting equities and credit over our cyclical 6-12-month timeframe, but risks are heightened and we will change course if conditions dictate. Feature As telegraphed, the Fed began its rate hiking campaign at last week’s FOMC meeting. It lifted its target range for the fed funds rate 25 basis points (bps) from 0 – 0.25% to 0.25 – 0.5%. In addition to making the nearly unanimously expected 25-bps hike, it indicated that the median FOMC participant expects the funds rate to rise by 25 bps at each of the year’s six remaining meetings and by 87.5 bps in 2023, though Chair Powell stressed the projections are merely a baseline expectation subject to change as economic conditions evolve. Both projections slightly exceeded market expectations going into the meeting. After it ended, the fed funds rate implied by the December 2022 futures contract rose 15 bps to align with the median FOMC voter and the rate implied by the December 2023 fed funds contract rose 18 bps, though it remains about a quarter-point hike shy of the median FOMC projection (Chart 1). Chart 1It Looks Like The Fed Can Only Surprise Hawkishly Chart 2The Dots Turn More Hawkish Widening the lens to consider the entire distribution of projected rate hikes (the Fed’s dots), and considering the mean value instead of the median, the dots get slightly more ambitious, revealing that disappointingly high inflation readings would prod the committee to ramp up the pace of its 2022 hikes. Seven of the sixteen FOMC participants expect at least 200 bps of hikes in 2022, with the mean funds rate projection nudging up to 2.05% (Chart 2, top panel). The rates market has the funds rate topping out between 2½ and 2⅝%, about one 25-bps hike below the average participant’s 2.81% and 2.75% year-end 2023 (Chart 2, middle panel) and 2024 (Chart 2, bottom panel) projections. With five FOMC voters expecting a terminal rate of 3% or above, there is scope for an upside surprise if inflation comes in hotter or lasts longer than anticipated. The other changes in the Summary of Economic Projections related to the committee’s GDP and inflation outlook. Participants marked down their median real 2022 GDP growth projection to 2.8% from 4% while increasing their headline and core PCE price index projections about one-and-a-half percentage points to 4.3% and 4.1%, respectively. 2023 and 2024 real GDP growth forecasts were unchanged while inflation expectations were bumped a little higher. The FOMC’s outlook has dimmed slightly, though it is still calling for a soft landing with the economy growing at an above-trend rate and supporting full employment while inflation eases to near its target level. You Can’t Get There From Here Any central bank’s long-run projections will show the economy moving toward its desired target conditions. One probably wouldn’t toil as a central banker if s/he didn’t think the bank’s tools would work and couldn’t say it out loud (even when voting anonymously) if s/he doubted that they might. An investor should therefore never place too much stock in the FOMC’s projections for key economic indicators two and three years out. “[A]ppropriate[ly] firming … monetary policy” is easier said than done, even in the best of times. Related Report US Investment StrategyThe Last Line Of Inflation Defense (Is Holding Fast) The combination of monetary and fiscal largesse almost certainly staved off a COVID recession, at the cost of fostering some asset-market excesses while quite possibly overstimulating aggregate demand over the intermediate term. The Fed is now left to confront the aftermath with blunt policy tools that work with long and variable lags. It is always a tall order to steer an economy smoothly through the ups and downs of the business cycle; sticking the landing after the pandemic’s emergency monetary and fiscal routines involves a much higher degree of difficulty. Chair Powell put on a brave face in his post-meeting press conference, but he and his colleagues are embarking on this rate hiking cycle under less-than-ideal conditions. “In hindsight, yes, it would have been appropriate to move [to hike rates] earlier. … No one wants to have to put really restrictive monetary policy on in order to get inflation back down. So, frankly, [we] need … [to] … get rates back up to more neutral levels as quickly as we practicably can and then mov[e] beyond [neutral], if [it] turns out to be appropriate.” Bottom Line: Having to move as quickly as is practicable implies that the committee and financial markets might be in for some white-knuckle moments in the months ahead. Soft landings are more common in theory than in practice and it will be especially hard to pull one off now. A Recession Is Not Likely … A narrow margin for error does not mean the Fed is walking a tightrope over two negative extremes, however, and we believe the risks of a growth shortfall are modest. We share Powell’s view that “the probability of a recession within the next year is not particularly elevated.” Aggregate demand is strong and will be supported by households’ and businesses’ fortified balance sheets while the labor market has strength to burn. We think the chair had it just right when he said, “all signs are that this is a strong economy and, indeed, one that will be able to flourish … in the face of less accommodative monetary policy.” Our simple recession indicator, built from components that have reliably provided advance warning, reinforces Powell’s conclusion. The 3-month/10-year segment of the yield curve is not yet close to inverting1 (Chart 3). The year-over-year change in the Conference Board’s Leading Economic Index is way above the zero line that has signaled past recessions (Chart 4). The fed funds rate is nowhere near its equilibrium/neutral level, which we judge to be north of 3%, and it is highly unlikely to get there by the end of the year (Chart 5). Ex-the pandemic, recessions over the last 50-plus years have only occurred when all three components sound the alarm; not one is flashing red now and not one is likely to do so during 2022. Chart 3Recessions Occur When The Yield Curve Inverts, ... Chart 4... The Year-Over-Year Change In The LEI Turns Negative ... Chart 5... And The Target Fed Funds Rate Is Above Its Equilibrium Level … But Inflation Is A Pressing Concern The Fed is right to take action to try to stem inflation, which has found especially fertile soil. Extraordinary monetary and fiscal stimulus have given demand a persistent tailwind; social distancing funneled spending to goods while rolling global COVID surges slowed production and hampered transport, crimping supply; and domestic COVID infections limited labor force participation, tightening the labor market and exerting upward pressure on wages. Just when COVID was finally relaxing its grip, Russia invaded Ukraine, taking major sources of crude oil, natural gas, wheat, corn and several base metals offline while creating new cargo and shipping bottlenecks. The Omicron variant’s emergence in China could bring new supply disruptions. The upshot is that the Ukraine invasion and COVID’s Asian revival could keep inflation elevated, obscuring mitigating factors like a consumption shift from goods to services (Chart 6), diminishing shipping backlogs (Chart 7), increasing labor force participation and more forgiving year-over-year comparisons (base effects). Upside inflation surprises could open the door to a faster pace of rate hikes than markets have already discounted, especially if stubbornly high inflation begins to push up longer-run inflation expectations. Despite their recent rise, long-run expectations remain well anchored for now (Chart 8), while households’ sizable savings cushion better positions them to withstand higher prices. Chart 6A Transitory Inflation Catalyst Chart 7Shipping Bottlenecks Had Been Easing Chart 8Long-Run Inflation Expectations Are Still Manageable Financial Market Impacts Equities took heart from Powell’s talk of the Fed’s commitment to prevent high inflation from becoming entrenched, but his comments were not uniformly reassuring. He specifically called out the red-hot labor market, a key pillar of the favorable growth outlook, as a source of concern. “[I]f you take a look … at today’s labor market, what you have is 1.7-plus job openings for every unemployed person (Chart 9). So that’s a very, very tight labor market, tight to an unhealthy level, I would say.” The Phillips Curve trade-off between growth and inflation still applies after all, but after a dozen years when policymakers and investors were able to ignore it, equity multiples, credit spreads and Treasury yields may no longer account for it. They seem to still be discounting a have-your-cake-and-eat-it-too environment in which growth, even when it’s above trend, is continuously goosed by accommodative policy. Chart 9Too Tight For The Fed Chair There’s also the issue that the Fed’s tools are not suited to fine-tuning economic outcomes. One does not have to be a card-carrying Austrian to harbor some skepticism about central bankers' ability to make targeted tweaks. “[I]n principle, … the idea is we’re trying to better align demand and supply[.] [I]n the labor market, … if you were just moving down the number of job openings so that they were more like one to one, you would have less upward pressure on wages. You would have a lot less of a labor shortage. … And basically across the economy, we’d like to slow demand so that it’s better aligned with supply. … Of course, the plan is to restore price stability while also sustaining a strong labor market. That is our intention, and we believe we can do that. But we have to restore price stability.” It’s a happy circumstance when attaining a goal doesn’t involve a sacrifice, but no pain, no gain is adulthood’s default condition. To paraphrase Powell’s press conference guidance, price stability with full employment would be really nice, but if push comes to shove, price stability has to take precedence. The tight monetary policy needed to restore lost price stability would constitute a major headwind for risk assets and the economy. It would spell the end of the equity and credit bull markets while ushering in the next recession. It is our view that the perception that price stability sacrifices are inevitable is still far away enough that risk assets have roughly nine to twelve good months ahead of them, although we hold it with less conviction than we did before Russia attacked Ukraine and Omicron reached China. Both events have the potential to hasten the end of monetary accommodation and drive investors to reconsider their terminal (peak) fed funds rate expectations. We do not expect that investors will revisit their terminal rate expectations until they can glean some empirical evidence of how the economy behaves when the funds rate exceeds 2.25%. If it takes the FOMC at least a year to get to that level, we expect that any major repricing of longer-term Treasury yields is over a year away. The bottom line is that we remain constructive on financial markets and the US economy over our six-to-twelve-month cyclical timeframe, but the clock is ticking and European fighting and Asian COVID infections are threats to our view. We believe that the decline in equity prices and the widening of high-yield credit spreads adequately compensate investors for the increased potential pitfalls, but we remain vigilant and are maintaining our tactically cautious ETF portfolio positioning until some of the clouds lift. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 We use the 3-month/10-year segment instead of the more common 2-year/10-year because the 3-month bill is a cleaner proxy for short rates than the 2-year note, which embeds estimates of the Fed’s future actions. 2s/10s also fail to measure up empirically, inverting even earlier than the habitually premature 3-month/10-year.
Executive Summary Investors Think The Fed Will Not Be Able To Raise Rates Much Above 2% The neutral rate of interest is 3%-to-4% in the United States. This is substantially higher than the market estimate of around 2%. It is also higher than the central tendency range for the Fed’s terminal interest rate dot, which remained at 2.3%-to-2.5% following this week’s FOMC meeting. If the neutral rate turns out to be higher than expected, this is arguably good news for stocks over the short-to-medium term because it lowers the risk that the Fed will accidentally induce a recession this year by bringing rates into restrictive territory. Over a longer-term horizon of 2-to-5 years, however, a higher neutral rate is bad news for stocks because it means that investors will eventually need to value equities using a higher discount rate. It also means that the Fed could find itself woefully behind the curve in normalizing monetary policy. Bottom Line: Global equities will rise over the next 12 months as the situation in Ukraine stabilizes, commodity prices recede, and inflation temporarily declines. Stocks will peak in the second half of 2023 in advance of a second, and currently unexpected, round of Fed tightening beginning in late-2023 or 2024. Dear Client, Instead of our regular report next week, we will be sending you a Special Report written by Matt Gertken, BCA Research’s Chief Geopolitical Strategist, discussing the geopolitical implications of the war in Ukraine. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. As always, I will hold a webcast discussing the outlook the week after, on Thursday, April 7th. Best regards, Peter Berezin Chief Global Strategist https://www.linkedin.com/in/peter-berezin-1289b87/ https://twitter.com/BerezinPeter A Two-Stage Fed Tightening Cycle The FOMC raised rates by 25 basis points this week, the first of seven rate hikes that the Federal Reserve has telegraphed in its Summary of Economic Projections for the remainder of 2022. We expect the Fed to follow through on its planned rate hikes this year, but then go on pause in early-2023, as inflation temporarily comes down. However, the Fed will resume raising rates in late-2023 or 2024 once inflation begins to reaccelerate and it becomes clear that monetary policy is still too easy. This second round of monetary tightening is currently not anticipated by market participants. If anything, investors think the Fed is more likely to cut rates than raise rates towards the end of next year (Chart 1). The Fed’s own views are not that different from the markets’: The central tendency range for the Fed’s terminal interest rate dot remained at 2.3%-to-2.5% following this week’s FOMC meeting, with the median dot actually ticking lower to 2.4% from 2.5% (Chart 2). Chart 2The Fed Is Still In The Secular Stagnation Camp A Higher Neutral Rate Our higher-than-consensus view of where US rates will eventually end up reflects our conviction that the neutral rate of interest is somewhere between 3% and 4%. One can think of the neutral rate as the interest rate that equates the amount of investment a country wants to undertake at full employment with the amount of savings that it has at its disposal.1 Anything that reduces savings or increases investment would raise the neutral rate (Chart 3). As we discussed last month, a number of factors are likely to lower desired savings in the US over the next few years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and the receipt of generous government transfer payments (Chart 4). Household wealth has soared since the start of the pandemic (Chart 5). Conservatively assuming that households spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by nearly 4% of GDP. Chart 5Net Worth Has Soared Since The Pandemic The household deleveraging cycle has ended (Chart 6). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. Banks are easing lending standards on consumer loans across the board. Baby boomers are retiring. They hold over half of US household wealth, considerably more than younger generations (Chart 7). As baby boomers transition from savers to dissavers, national savings will decline. Chart 6US Household Deleveraging Pressures Have Abated Chart 7Baby Boomers Have Amassed A Lot Of Wealth Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 8). On the investment front: The deceleration in trend GDP growth, which depressed investment spending, has largely run its course.2 According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today. The CBO expects potential growth to edge down only slightly to 1.7% over the next few decades (Chart 9). Chart 8Fiscal Policy: Tighter But Not Tight Chart 9Much Of The Deceleration In Potential Growth Has Already Happened After moving broadly sideways for two decades, core capital goods orders – a leading indicator for capital spending – have broken out to the upside (Chart 10). Capex intention surveys remain upbeat (Chart 11). The average age of the nonresidential capital stock currently stands at 16.3 years, the highest since 1965 (Chart 12). Chart 10Positive Signs For Capex (I) Similar to nonresidential investment, the US has been underinvesting in residential real estate (Chart 13). The average age of the housing stock has risen to a 71-year high of 31 years. The homeowner vacancy rate has plunged to the lowest level on record. The number of newly finished homes for sale is half of what it was prior to the pandemic. Chart 11Positive Signs For Capex (II) Chart 12An Aging Capital Stock Chart 13Housing Is In Short Supply The New ESG: Energy Security and Guns The war in Ukraine will put further pressure on the neutral rate, especially outside of the United States. Chart 14European Capex Should Recover After staging a plodding recovery following the euro debt crisis, European capital spending received a sizable boost from the launch of the NextGenerationEU Recovery Fund (Chart 14). Capital spending will rise further in the years ahead as European governments accelerate efforts to make their economies less reliant on Russian energy. Meanwhile, European governments are trying to ease the burden from rising energy costs. France has introduced a rebate on fuel starting on April 1st. It is part of a EUR 20 billion package aimed at cutting heating and electricity bills. Other countries are considering similar measures. European military spending will also rise. Germany has already announced that it will spend EUR 100 billion more on defense. European governments will also need to boost spending to accommodate potentially several million Ukrainian refugees. A Smaller Chinese Current Account Surplus? Chart 15Will China Be A Source Of Excess Savings? The difference between what a country saves and invests equals its current account balance. Historically, China has been a major exporter of savings, which has helped depress interest rates abroad. While China’s current account surplus has declined as a share of its own GDP, it has remained very large as a share of global ex-China GDP, reflecting China’s growing weight in the global economy (Chart 15). Many analysts assume that China will double down on efforts to boost exports in order to offset the drag from falling property investment. However, there is a major geopolitical snag with that thesis: A country that runs a current account surplus must, by definition, accumulate assets from the rest of the world. As the freezing of Russia’s foreign exchange reserves demonstrates, that is a risky proposition for a country such as China. Rather than increasing its current account surplus, China may seek to bolster its economy by raising domestic demand. This could be achieved by either boosting domestic investment on infrastructure and/or consumption. Notably, the IMF’s latest projections foresee China’s current account surplus falling by more than half between 2021 and 2026 as a share of global ex-China GDP. If this were to happen, the neutral rate in China and elsewhere would rise. The Path to Neutral: The Role of Inflation If one accepts the premise that the neutral rate in the US is higher than widely believed, what will the path to this higher rate look like? The answer hinges critically on the trajectory of inflation. If inflation remains stubbornly high, the Fed will be forced to hike rates by more than expected over the next 12 months. In contrast, if inflation comes down rapidly, then the Fed will be able to raise rates at a more leisurely pace. As late as early February, one could have made a strong case that US inflation was set to fall. The demand for goods was beginning to moderate as spending shifted back towards services. On the supply side, the bottlenecks that had impaired goods production were starting to ease. Chart 16 shows that the number of ships anchored off the coast of Los Angeles and Long Beach has been trending lower while the supplier delivery components of both the ISM manufacturing and nonmanufacturing indices had come off their highs. Since then, the outlook for inflation has become a lot murkier. As we discussed last week, the war in Ukraine is putting upward pressure on commodity prices, ranging from energy, to metals, to agriculture. BCA’s geopolitical team, led by Matt Gertken, expects the war to worsen before a truce of sorts is reached in a month or two. Meanwhile, a new Covid wave is gaining momentum. New daily cases are rising across Europe and have exploded higher in parts of Asia (Chart 17). In China, the number of new cases has reached a two-year high. The government has already locked down parts of the country encompassing 37 million people, including Shenzhen, a major high-tech hub adjoining Hong Kong. Chart 17Covid Cases Are On The Rise Again In Some Countries Most new cases in China and elsewhere stem from the BA.2 subvariant of Omicron, which appears to be at least 50% more contagious than Omicron Classic. Given its extreme contagiousness, China may be forced to rely on massive nationwide lockdowns in order to maintain its zero-Covid strategy. While such lockdowns may provide some relief in the form of lower oil prices, the overall effect will be to worsen supply-chain disruptions. Watch For Signs of a Wage-Price Spiral As the experience of the 1960s demonstrates, the relationship between inflation and unemployment is inherently non-linear: The labor market can tighten for a long time with little impact on prices and wages, only for a wage-price spiral to suddenly develop once unemployment falls below a certain threshold (Chart 18). Chart 18A Wage-Price Spiral Was Ignited By Very Low Unemployment Levels In The 1960s Chart 19Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution For the time being, a wage-price spiral does not appear imminent. While wage growth has picked up, most of the increase in wages has occurred at the bottom end of the income distribution (Chart 19). Chart 20More Low-Wage Employees Should Return To Work Low-wage workers have not returned to the labor force to the same extent as higher-wage workers (Chart 20). However, now that extended unemployment benefits have lapsed and savings deposits are being drawn down, the incentive to resume work will strengthen. An influx of workers back into the labor market will cap wage growth, at least for this year. Long-Term Inflation Expectations Still Contained A sudden increase in long-term inflation expectations can be a precursor to a wage-price spiral because the expectation of higher prices can induce consumers to shop now before prices rise further, while also incentivizing workers to demand higher wages. Reassuringly, long-term inflation expectations have not risen that much. Expected inflation 5-to-10 years out in the University of Michigan survey registered 3.0% in March, down a notch from 3.1% in February (Chart 21). While the widely followed 5-year, 5-year forward TIPS inflation breakeven rate has climbed to 2.32%, it is still at the bottom of the Fed’s comfort zone of 2.3%-to-2.5% (Chart 22).3 Chart 21Long-Term Inflation Expectations Remain Contained (I) Chart 22Long-Term Inflation Expectations Remain Contained (II) Chart 23The Magnitude Of Damage Depends On How Long The Commodity Price Shock Lasts Moreover, the jump in market-based inflation expectations since the start of the war in Ukraine has been fueled by rising oil prices. The forwards are pointing to a fairly pronounced decline in the price of crude and most other commodity prices over the next 12 months (Chart 23). If that happens, inflation expectations will dip anew. Investment Implications The neutral rate of interest is higher in the United States than widely believed. A higher neutral rate is arguably good for stocks over the short-to-medium term because it lowers the risk that the Fed will accidentally induce a recession this year by bringing rates into restrictive territory. Over a longer-term horizon of 2-to-5 years, however, a higher neutral rate is bad news for stocks because it means that investors will eventually need to value stocks using a higher discount rate. It also means that the Fed could find itself woefully behind the curve in normalizing monetary policy. While the war in Ukraine and yet another Covid wave could continue to unsettle markets for the next month or two, global equities will be higher in 12 months than they are now. With inflation in the US likely to temporarily come down in the second half of the year, bond yields probably will not rise much more this year. However, yields will start moving higher in the second half of next year as it becomes clear that policy rates still have further to rise. The bull market in stocks will end at that point. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 These savings can either by generated domestically or imported from abroad via a current account deficit. 2 Theoretically, there is a close relationship between trend growth and the equilibrium investment-to-GDP ratio. For example, if real trend growth is 3% and the capital stock-to-GDP ratio is 200%, a country would need to invest 6% of GDP net of depreciation to maintain the existing capital stock-to-GDP ratio. In contrast, if trend growth were to fall to 2%, the country would only need to invest 4% of GDP. 3 The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Executive Summary The Market Has Priced An Aggressive Path For US Rate Hikes The Federal Reserve has joined other G10 central banks in increasing interest rates this week. However, this has been well priced by both the dollar and short rates in the US (Feature Chart). The key call for currencies therefore is whether the Fed delivers more or less hikes than is currently priced by markets over the course of the next few months. More aggressive rate hikes will boost US bond yields, and send the dollar higher. But it will also undermine US equity multiples, given the tight correlation between the price-to-earnings ratio in the US and the real bond yield. More importantly, US equity market leadership has been an important driver of portfolio inflows into the dollar. Should the Fed deliver less hikes than the aggressive path currently priced by markets, currency investors will also be caught offside. This conundrum puts the DXY at risk. The caveat is that if the US economy is genuinely stronger than the rest of the world, and more insulated from the Russo-Ukrainian conflict, this will warrant higher real US interest rates. We went short NOK/SEK last week given our bias that oil prices had overshot. Tighten stops to protect profits. Bottom Line: Being long the dollar is a consensus trade. While in the near term, this could prove to be the right call, the dollar is also expensive and overbought, which is bearish from a contrarian perspective. Feature The 25 basis point interest rate hike by the Federal Reserve this week has probably been one of the most telegraphed macro events. Interest rate expectations in the US have risen sharply compared to last year (Chart 1). More importantly, as Chart 2 shows, two-year bond yields (a proxy for short rates) have climbed in the US relative to pretty much every other G10 country. Correspondingly, rising interest rate expectations in the US have led to substantial speculative flows into the US dollar. Chart 2The Market Expects The Fed To Hike Faster Than Other Central Banks This Year Chart 1The Market Has Priced An Aggressive Path For US Rate Hikes On the flipside, the outperformance of the US equity market is being threatened by rising interest rates. If rates rise substantially, that could derate US equity multiples, as portfolio inflows are curtailed. US profits also tend to underperform when rates rise. However, if US rates rise by less than what the market expects, net long speculative positioning in the dollar will surely reverse. Non-US Markets Benefit More When Bond Yields Rise Profits tend to drive the equity market over the short run, with valuation starting to matter over longer horizons. When it comes to the US, it is also true that profits tend to underperform the rest of the world as bond yields rise. Why it matters for the dollar is because a better profit picture in the US helps drive portfolio flows into US equities, buffeting the exchange rate (Chart 3). Related Report Global Investment StrategyA Two-Stage Fed Tightening Cycle Chart 4 shows that US profits lag the rest of the world when bond yields are in an uptrend. This is because of the composition of the US equity market. Specifically, the US equity market is underweight financials, energy, materials, and industrials, while overweight information technology, health care, and communication services. Rising inflation benefits commodity-linked sectors, the income statements of which are directly juiced by rising prices. Similarly, banks tend to do better as interest rates rise because net interest margins improve. In a nutshell, rising rates and inflation tend to be better for the profits of value stocks and cyclicals, sectors that are underrepresented in the US. Chart 3The Dollar And US Equities Chart 4Bond Yields And US Profits There is also a valuation angle to higher rates. Because the US market is more overweight sectors with cash flows that backwardated, higher rates will undermine the valuation premium currently commanded by these sectors. This is true both in absolute terms and relative to other markets (Chart 5A and 5B). Chart 5AThe S&P 500 P/E Ratio And Real ##br##Yields Chart 5BThe Valuation Premium In The US Is Inversely Correlated To Bond Yields The key point is that the US equity market is at risk relatively from higher global yields that could undermine relative profit growth and its valuation premium. The US trade deficit currently runs at $90 billion. In 2021, at least 45% of that was financed via foreign equity purchases. A reversal in these flows could undermine the dollar. The Dollar And Relative Interest Rates While portfolio flows into US equities have been reversing, bond inflows have improved (Chart 6). Over the long term, bond flows tend to be the key driver of the US dollar. As Chart 2 shows, most market participants expect the Fed to be among the most hawkish central banks in 2022 and beyond. In fact, December Eurodollar contracts are pricing the Fed to hike interest rates by 218 bps more than the ECB, and 235 bps more than the Bank of Japan (allowing for a small risk premium in this pricing) (Chart 7). Chart 7Investors Are Very Bullish On US Rate Expectations Chart 6Investors Have Been Aggressively Purchasing US Treasurys There are two key risks to a hawkish Fed view, relative to other central banks: First, the Fed is already behind the curve relative to its G10 counterparts. The BoE, RBNZ, BoC, and the Norges Bank have already increased rates. Even the rhetoric at the ECB is shifiting. Relative bond yields do not reflect this reality. Second, and related, rising inflation is a global phenomenon and not specific to the US. Almost every central bank is acknowledging that inflation is a key risk to their mandate, compared to the transitory narrative last year. Chart 8 plots headline inflation across G10 countries. On this basis, it becomes difficult to justify why two-year yields in the UK, for example, are much lower, compared to the US. Chart 8Rising Inflation Is Not A US-Centric Problem If inflation does indeed prove to be sticky, other central banks will have to keep hiking interest rates along with the Fed. If inflation subsides, the Fed might not be as aggressive in tightening policy as the market expects. On a relative basis, this suggests there is a mispricing of how the market views Fed action, relative to other central banks. The key risk to this view is that the US economy can actually withstand much higher rates compared to the rest of the world. While this could be the case, higher rates in Norway and New Zealand are not yet hurting domestic conditions. In fact, it can be argued that weakness in their currencies has unwound a lot of the tightening in financial conditions from higher interest rates. A commodity boom also suggests that these currencies will benefit from rising terms of trade. Conclusion Bond markets have priced higher relative rates in the US, but the Fed could actually lag market expectations, especially relative to commodity-linked currencies (Chart 9). Chart 9Commodity Currencies Have Been Tracking Rate Expectations With A Lag Specifically, higher rates than the market expects in the US will undermine US equity market leadership, reversing substantial portfolio inflows in recent years. This is already occurring at the margin. On the other hand, fewer rate hikes will severely unwind speculative inflows into the US dollar. Housekeeping We went short NOK/SEK on the expectation that oil prices had overshot, especially relative to forward markets (Chart 10). We are tightening the stop loss on this trade to 1.09. Finally, the Bank of England met this week and its transcript reinforced our stance that the BoE will be cornered as it attempts to raise rates amidst a slowing economy. Stay long EUR/GBP. Chart 10Stay Short NOK/SEK But Tighten Stops Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary
Executive Summary For the Fed, maintaining its credibility with a long sequence of rate hikes that does not crash the economy, real estate market, and stock market is akin to the ‘Hail Mary’ move of (American) football. The likelihood that the Fed completes the straight sequence of eight rate hikes which the market is now pricing seems very low. Hence, today we are opening a new trade. Go long the September 2023 Eurodollar futures contract. Additionally, stay underweight Treasury Inflation Protected Securities (TIPS) versus T-bonds. And on a 12-month horizon, underweight the commodity complex, whose elevated prices are highly vulnerable to a near-certain upcoming demand destruction. Fractal trading watchlist: US interest rate futures, 3-year T-bond, Canada versus Japan, AUD/KRW, and EUR/CHF. Spending On Goods Looks Like An Earthquake On A Seismograph Bottom Line: The likelihood that the Fed completes the straight sequence of eight rate hikes which the market is now pricing seems very low. Feature Amid the uncertainties of the Ukraine crisis, there is one certainty. The latest surge in energy and grain prices is a classic supply shock. Prices have spiked because vital supplies of Russian and Ukrainian energy and grains have been cut. This matters for central banks, because to the extent that they can bring down inflation, they can do so by depressing demand. They can do nothing to boost supply. In fact, depressing demand during a supply shock is a sure way to start a recession. But what about the inflation that came before the Ukraine crisis, wasn’t that due to excess demand? No, that inflation came not from a demand shock, but from a displacement of demand shock – as consumers displaced their firepower from services to goods on a massive scale. This matters because central banks are also ill placed to fix such a misallocation of demand. Chart I-1 looks like a seismograph after a huge earthquake, and in a sense that is exactly what it is. The chart shows the growth in spending on durable goods, which has just suffered an earthquake unlike any in history. Zooming in, we can see the clear causality between the surges in spending on durables and the surges in core inflation. The important corollary being that when the binge on durables ends – as it surely must – or worse, when durable spending goes into recession, inflation will plummet (Chart I-2). Chart I-1Spending On Goods Looks Like An Earthquake On A Seismograph Chart I-2The Goods Binges Caused The Core Inflation Spikes But, argue the detractors, what about the uncomfortably high price inflation in services? What about the uncomfortably high inflation expectations? Most worrying, what about the recent surge in wage inflation? Let’s address these questions. Underlying US Inflation Is Running At Around 3 Percent In the US, the dominant component of services inflation is housing rent, which comprises 40 percent of the core consumer price index. Housing rent combines actual rent for those that rent their home, with the near-identically behaving owners’ equivalent rent (OER) for those that own their home. Given the state of the jobs market, there is nothing unusual in the current level of rent inflation. Housing rent inflation closely tracks the tightness of the jobs market, because you need a job to pay the rent. With the unemployment rate today at the same low as it was in 2006, rent inflation is at the same high as it was in 2006: 4.3 percent. In other words, given the state of the jobs market, there is nothing unusual in the current level of rent inflation (Chart I-3). Chart I-3Given The Jobs Market, Rent Inflation Is Where It Should Be Given its dominance in core inflation, rent inflation running at 4.3 percent would usually be associated with core inflation running at around 3 percent – modestly above the Fed’s target, rather than the current 6.5 percent (Chart I-4). Confirming that it is the outsized displacement of spending into goods, and its associated inflation, that is giving the Fed and other central banks a massive headache. Yet, to repeat, monetary policy is ill placed to fix such a misallocation of demand. Chart I-4Given Rent Inflation, Core Inflation Should Be 3 Percent Still, what about the surging expectations for inflation? Many people believe that these are an independent and forward-looking assessment of how inflation will evolve. Yet nothing could be further from the truth. The bond market’s expected inflation is just the result of an algorithm that uses historic inflation. And at that, an extremely short period of historic inflation, just six months.1 The upshot is that when the backward-looking six month inflation rate is low, like it was in the depths of the global financial crisis in late 2008 or the pandemic recession in early 2020, the market assumes that the forward-looking ten year inflation rate will be low. And when the backward-looking six-month inflation rate is high, like early-2008 or now, the bond market assumes that the forward-looking ten year inflation rate will be high. In other words: Inflation expectations are nothing more than a reflection of the last six months’ inflation rate (Chart I-5). Chart I-5Inflation Expectations Are Just A Reflection Of The Last Six Months' Inflation Rate Turning to wage inflation, with US average hourly earnings inflation running close to 6 percent, it would appear to be game, set, and match to ‘Team Inflation.’ Except that this is a flawed argument. To the extent that wages contribute to inflation, it must come from the inflation in unit labour costs, meaning the ratio of hourly compensation to labour productivity. After all, if you get paid 6 percent more but produce 6 percent more, then it is not inflationary (Chart I-6). Chart I-6If You Get Paid 6 Percent More But Produce 6 Percent More, Then It Is Not Inflationary In this regard, US unit labour costs increased by 3.5 percent through 2021, and slowed to just a 0.9 percent (annualised) increase in the fourth quarter.2 Still, 3.5 percent, and slowing, is modestly above the Fed’s inflation target, and could justify a slight nudging up of the Fed funds rate. But it could not justify the straight sequence of eight rate hikes which the market is now pricing. The Fed Is Praying For A ‘Hail Mary’ Fortunately, the bond market understands all of this. How else could you say 7 percent inflation and 2 percent long bond yield in the same breath?! This is crucial, because it is the long bond yield that drives rate-sensitive parts of the economy, such as housing and construction. And it is the long bond yield that sets the level of all asset prices, including real estate and stocks. Although the Fed cannot admit it, the central bank also understands all of this and hopes that the bond market continues to ‘get it.’ Meaning that it hopes that the long end of the interest rate curve does not lift too far and crash the economy, real estate market, and stock market. So why is the Fed hiking the policy interest rate? The answer is that there will be a time in the future when it does need to lift the entire interest rate curve, and for that it will need its credibility intact. Not hiking now could potentially shred the credibility that is the lifeblood of any central bank. Still, to maintain its credibility without crashing the economy the Fed will have to make the ‘Hail Mary’ move of (American) football. For our non-American readers, the Hail Mary is a high-risk desperate move with little hope of completion. Go long the September 2023 Eurodollar futures contract. To sum up, the likelihood that the Fed completes the straight sequence of eight rate hikes which the market is now pricing seems very low. Hence, today we are opening a new trade. Go long the September 2023 Eurodollar futures contract (Chart I-7). Chart I-7The Likelihood That The Fed Completes A Straight Sequence Of Eight Rate Hikes Seems Low Additionally, stay underweight Treasury Inflation Protected Securities (TIPS) versus T-bonds (Chart I-8). Chart I-8Underweight TIPS Versus T-Bonds And on a 12-month horizon, underweight the commodity complex, whose elevated prices are highly vulnerable to a near-certain upcoming demand destruction. Fractal Trading Watchlist Confirming the fundamental analysis in the preceding sections, the strong trend in both the 18 month out US interest rate future and the equivalent 3 year T-bond has reached the point of fragility that has identified previous turning-points in 2018 and 2021 (Chart I-9 and Chart I-10). This week we are also adding to our watchlist the commodity plays Canada versus Japan and AUD/KRW, whose outperformances are vulnerable to reversal. From next week you will be able to see the full watchlist of investments that are vulnerable to reversal on our website. Stay tuned. Finally, the underperformance of EUR/CHF has reached the point of fragility on its 260-day fractal structure that has identified the previous major turning-points in 2018 and 2020 (Chart I-11). Accordingly, this week’s recommended trade is long EUR/CHF, setting a profit target and symmetrical stop-loss at 3.6 percent. Chart I-9The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart I-10The Strong Trend In The 3 Year T-Bond Is Fragile Chart I-11Go Long EUR/CHF Canada Versus Japan Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The expected 10-year inflation rate = (deviation of 6-month annualized inflation from 1.6)*0.2 + 1.6. 2 Source: Bureau of Labor Statistics 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 - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - 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
Global equity markets enjoyed a healthy rebound on Wednesday. Asian equities led the move higher as pledges from Beijing to support the economy and capital markets improved sentiment among investors. Hong Kong’s Hang Seng index rallied 9.08% and the CSI 300…