Developed Countries
Cheap capital supported a boom in M&A activity last year. However, M&A activity appears to have peaked, and is now slowing down from high levels. Rising borrowing costs are making it more expensive for corporations to fund acquisitions, which will…
According to BCA Research’s European Investment Strategy service, German yields can rise above 2% without causing a public finance crisis in Italy. How high can yields rise in the Eurozone before Italy experiences meaningful funding stresses? The team…
Executive Summary From Net Borrower To Net Lenders Yields are rising across Europe. Peripheral spreads are unlikely to experience the same violent widening as last decade. Europe now has a buyer of last resort. Italy and Spain have moved from current account deficit to current account surplus nations. However, Italy and Spain are not conducting the kind of structural reforms necessary to cause public debt-to-GDP ratios to fall back below the Maastricht Treaty criteria. Nonetheless, based on our stress tests, Italian and Spanish yields can rise significantly more before debt-servicing costs become a major problem in these nations. Economic activity, not Spanish or Italian public finances, is the true constraint on European yields. Bottom Line: German yields can rise above 2% without causing a public finance crisis in Italy and Spain. To reach this level, however, nominal growth in Europe must remain robust. As a result, any pullback in yields caused by oversold conditions in the bond market will be temporary. Year-to-date, German 10-year yields have risen more than 80bps, while spreads have widened in the periphery. This has supercharged the interest rate moves: Italian BTP yields and Spanish Bono yields are up nearly 120bps and 110bps, respectively. As a result, Italian government bonds now offer a 2.4% yield, a level not experienced durably since the first half of 2019. Meanwhile, Spanish yields are close to 1.7%—their highest levels since 2017. Investors are increasingly concerned by the damage levied by higher yields in Southern Europe. Since 2018, Italian public debt has risen by 32% of GDP to 170% of GDP, and Spanish public debt has risen by 28% of GDP to 138% of GDP. These higher debt burdens beg the following question: How high can European yields rise before a new sovereign debt crisis engulfs the Eurozone? Private sector financial balances and the balance of payments in the periphery are now very different from what they were between 2008 and 2012. As a result, the odds of a similar crisis are much lower than last decade, which should allow German yields to rise further in the coming years. Italy and Spain have moved on from experiencing an EM-style balance of payment crisis with explosive debt market dynamics. They are now stuck in a Japanese scenario of excess private sector savings and low economic growth. “This Time Is Different” These might be the four most dangerous words in finance, but understanding the differences between the present situation and the sovereign debt crisis is essential to assessing the impact of higher yields on Italian and Spanish public finances. Chart 1From Net Borrower To Net Lenders The most important transformation in the Southern European economies is the rise in private sector savings. From 1999 to 2013, Italy’s private sector financial balance averaged 2.2% of GDP. Constant government deficits resulted in a significant national dissaving, forcing the country to borrow from abroad as expressed by a current account deficit that lasted from 2000 to 2013 (Chart 1, top panel). At the present moment, Italy’s current account is in a surplus equal to 3.5% of GDP, as private savings stand at 13% of GDP, up from 5% before COVID-19. The change is even more dramatic in Spain. The Spanish private sector financial balance was in a large deficit from 1999 to 2008, which averaged 5.6% of GDP and reached a nadir of 11.3% of GDP in 2007. As a result, Spain relied on foreign lending between 1980 and 2012, with a current account deficit that averaged 3% of GDP over that period (Chart 1, second panel). The switch from the status of foreign borrower to the status of surplus nation is fundamental. A country where excess private savings are so abundant they can finance large public deficits and still generate current account surpluses will experience more limited pressure on borrowing costs than a country that needs to borrow from abroad. Japan is a perfect example. Elevated public borrowing ends up being a vehicle to absorb private sector excess savings and does not constitute profligacy. Despite higher debt loads, Italy’s public finances seem more sustainable than those of Spain. The International Monetary Fund’s (IMF) October 2021 Fiscal Monitor forecast shows the Italian primary budget balance, both on an absolute basis and on a cyclically-adjusted basis, moving from -6% and -2.9% of GDP, respectively, closer to zero by 2026 (Chart 2). In Spain, primary budget balances, both on an absolute basis and on a cyclically-adjusted basis, are anticipated to improve from -8.9% and -3.4% of GDP, respectively, to -2.5% of GDP by 2026. Despite these deficits, the IMF also expects public debt to decrease by 10% of GDP to 146% in Italy and to remain flat at 120% of GDP in Spain (Chart 3). Importantly, in both cases, the upward pressure on public debt will be limited over the next five years because private savings are already high and unlikely to rise further. Chart 2Public Deficits Will Narrow Further Chart 3Debt Will Stay High, So Will Private Savings The role of the European Central Bank (ECB) as a backstop also contributes to creating a different environment than the one that prevailed prior to the “whatever it takes” era. Before Mario Draghi’s landmark July 2012 speech, there was no explicit buyer of last resort in the European sovereign debt market. Now, there is one, and its presence limits how rapidly private sector buyers might lose confidence in a country’s bond market and how far spreads can widen, even if the central bank buying has its own limit. In fact, Draghi’s forward guidance calmed the markets and caused a 250bps and 280bps collapse in Italian and Spanish 10-year yields before the ECB had even purchased a single BTP or Bono. The role of the ECB as a buyer of last resort remains crucial going forward. Yields in Italy and Spain are still 480bps and 600bps below their 2011-2012 peaks at a time when investors anticipate an end to the PEPP and APP purchases. Importantly, these spreads are narrower, even though the APP and the PEPP have purchased far more German and French sovereign bonds than Italian and Spanish bonds (Chart 4). As long as the ECB continues to emphasize that it maintains its optionality to support Italian and Spanish bond markets, even as its asset purchases end, peripheral spreads will not move back above 300bps, especially since Euroscepticism is not the risk it once was (Chart 5). Chart 4Germany and France, Not Spain and Italy, Dominated PEPP Buying Chart 5Euroscepticism on the Wane Bottom Line: As illustrated by the evolution of their current account balances, peripheral Eurozone economies have moved from deep savings deficits to a state of surplus savings. This makes them less vulnerable to the funding crises that prompted the European sovereign debt crisis. Moreover, the Eurozone now has a buyer of last resort for sovereign bonds: the post-Draghi ECB. Its presence, not its continued buying, creates the necessary insurance to limit buying strikes by the private sector, which also curtails how far Italian or Spanish spreads can widen. Long-Term Problems Abound In the long term, Italy and Spain will only be able to curtail government debt-to-GDP ratios meaningfully if trend growth recovers. This means more reforms are needed to boost productivity and labor participation rates (Chart 6). Chart 6Reforms, Not Austerity, Will Bring Debt Down Below Maastricht Levels Chart 7Competitiveness Problems In The Periphery For now, the picture remains bleak. Spain emerged out of the sovereign debt crisis with strong reform zeal. The Mariano Rajoy government reformed pensions and the labor market, which prompted a significant decline in unit labor costs compared to the Euro Area average. The pace of reforms has slowed, however, and the Pedro Sánchez government has eroded some of its predecessor’s efforts. As a result, since 2018, Spanish unit labor costs have increased once again relative to the rest of the Eurozone (Chart 7). Italy never implemented significant reforms, because it has long been beset by political paralysis. Unit labor costs are not outstripping the rest of the Eurozone, but productivity continues to lag. Economic growth in Italy and Spain will remain tepid in the coming years, which will prevent any meaningful decline in debt. The poor trend in relative competitiveness and productivity of the past few years is unlikely to be undone. Work by the OECD shows that prior to the pandemic, Spain and Italy had shifted away from being among the leading reformers in Europe. Instead, this role now falls to France, Greece, Austria, and Germany (Chart 8), which confirms last week’s analysis that France’s reform effort remains serious, even if it is less ambitious than what transpired over the past five years. As a consequence of slow growth, investment in Spain and Italy will trail behind the rest of the Eurozone. Thus, private sector savings will remain elevated and private nonfinancial sector debt loads are unlikely to increase meaningfully (Chart 9). As a result, the public sector will continue to absorb the private sector’s excess savings, which means that the debt-to-GDP ratio could sustain more upside pressure than what either the IMF or the OECD anticipate. Chart 8Italy And Spain As Reform Laggards Chart 9Private Debt Is Not The Problem These dynamics bear a striking resemblance to what happened in Japan. They also imply that Italy and Spain will remain a drag on European growth for years to come, as long as the fundamental reasons behind the private sector’s elevated savings rate are not addressed. Bottom Line: Italian and Spanish public debt-to-GDP ratios will continue to deteriorate as reform efforts are too tepid to lift durably trend GDP growth. Their private sectors will continue to save more than they invest, which, in turn, will push government debt higher. The Italian and Spanish economies will remain a drag on European growth for the foreseeable future. Stress Test Scenarios How high can yields rise in the Eurozone before Italy and Spain experience meaningful funding stresses? We explore two scenarios: one in which 10-year yields rise by an additional 2%, and a very aggressive scenario in which they rise a whopping 5%, bringing Italian and Spanish borrowing costs in the vicinity of the European debt crisis of 2011-2012. To conduct this experiment, we use a simple approach of regressing debt-service payments as a share of GDP on the level of yields. Modeling debt payments in euros was another alternative, but yield levels are also affected by the evolution of nominal GDP. As a result, using this approach considers both the numerator and the denominator of the debt-service payment modeling. Chart 10Private Debt Is Not The Problem Under the first scenario, Italian 10-year yields would rise to 4.4% from 2.4% today. This is still well below the 7.5% yield recorded in late 2011. In this context, government debt servicing would reach 4.5% of GDP, which is comparable to the average that prevailed prior to the Euro Area crisis (Chart 10). This suggests that Italian yields slightly above 4% are still somewhat manageable, albeit far from ideal. Under the second scenario, 10-year BTP yields would rise to 7.4% from 2.4% today. This is comparable to the level of yields observed at the apex of the European sovereign debt crisis, but it assumes that this yield level would remain in place for a year. As a result of the higher debt load today compared to a decade ago, the resulting debt-servicing costs have reached 5.4% of GDP, which is higher than those between 2012 and 2013 (Chart 10). This scenario is clearly unsustainable and suggests that yields of this magnitude would cripple the Italian government. Moving to Spain, the dynamics are slightly different. Spain’s refinancing schedule is more front-loaded than that of Italy. As a result, using the yields on 10-year Bonos as an independent variable in our regression approach does not explain well the evolution of Spanish debt-servicing costs. Instead, a simple regression model using both 3-year and 10-year yields does a much better job, because it reflects the heavier rollover of Spanish debt. Chart 11Stress Testing Spanish Public Finances In the first scenario, 3-year yields would rise by 1% to 1.7% and 10-year yields would increase from 2% to 3.7%, well below the 7% yields that prevailed in 2012. As a result, the Spanish government’s debt-servicing costs would be expected to rise to 2.8% of GDP, which is well below the levels that prevailed at the apex of the European debt crisis, but still above the level that existed in the first decade following the introduction of the euro (Chart 11). While far from ideal, this level is easily manageable for the Spanish government and is comparable to the Eurozone average prior to 2008. In the second scenario, 3-year yields are assumed to rise 2.5% to 3.2% and 10-year yields to increase an extra 5% to 6.7%, still slightly shy of the 7% yields from 2012. In this scenario, debt servicing costs are expected to jump above 3.5% of GDP (Chart 11) and are unsustainable unless nominal GDP growth remains above 7% and the primary budget balance improves to zero. As a result, an increase in Bono yields toward 7% is far too high for the Spanish government to withstand. We acknowledge that, although it points to an upper bound in yields, the second scenario is highly unlikely for several reasons. First, a 500bps increase in 10-year yields would far exceed the roughly 350bps rise experienced during the sovereign debt crisis of the previous decade. More importantly, many factors have changed since then: Spain and Italy’s shift from borrowing nations to surplus savings nations, the role of the ECB as buyer of last resort, greater support for the euro across all the Eurozone nations, and greater unity among EU countries as exemplified by the NextGenerationEU (NGEU) program. The first scenario would be painful but manageable for both Italy and Spain. It suggests that peripheral yields may rise meaningfully in the coming years, especially if nominal GDP growth remains higher than it was last decade when fiscal austerity was Europe’s mantra. However, fiscal austerity was self-defeating because, the more orthodox countries tried to be, the worse their growth was, making debt arithmetic unmanageable (Chart 12). Chart 12Counterproductive Austerity We can go one step further. Even if Italian and Spanish spreads widen another 100bps from this point on and settle between 200bps and 300bps above German yields, European public finances can withstand German yields rising to 2%. This seems surprising, but we cannot forget the context. German yields cannot reach those levels in a vacuum. If they increase that much, it is because nominal growth is strong, which makes debt arithmetic more manageable in the European periphery. Statistically, the relationship between Spanish debt servicing costs and German yields is negative, while the link between Italian debt servicing costs and German yields is statistically low, underscoring the role of growth. However, if German yields were to rise as Europe’s nominal GDP growth settled back to last decade’s range, then Italian and Spanish debt would implode. This is a far-fetched scenario; even the recent ECB’s pivot reflects stronger nominal activity. This does not mean that German yields will rise above 2% in the next five years, but rather it highlights that economic activity, not the peripheral nations’ public finances, is the true constraint on European yields. Bottom Line: The ECB’s role as a buyer of last resort, the shift to savings surpluses in Italy and Spain, as well as the greater European unity and lower Euroscepticism prevalent across the continent limit how far spreads can rise in the periphery. In this context, Spain and Italy can withstand higher yields than those of the last decade, since these higher borrowing costs reflect stronger nominal economic activity. Ultimately, the true constraint on German yields is not the finances of Southern Europe, but rather the state of economic growth in the Eurozone. Conclusions Related Report European Investment StrategyThe Lasting Bond Bear Market European yields continue to have significant upside, as we expect European growth to remain stronger than it was last decade even if Italy and Spain will continue to lag behind the rest of Europe. As we observed two weeks ago, Europe is no longer burdened by untimely fiscal austerity. Furthermore, the efforts to decrease the energy dependence on Russia and modernize the European economy will continue to support capex and aggregate demand. The upper band on German yields seems to be around 2%, assuming that Italian and Spanish spreads rise 100bps to 150bps over the coming years. Even the banking sector in the periphery can withstand significant upside in bond yields. BTPs and Bonos represent 11% and 6.8% of the Spanish and Italian financial sectors’ balance sheet, respectively (Chart 13). This is much higher than the role of OATs and Bunds in the French and German financial sectors, but Spanish and Italian banks have much lower NPLs and enjoy much more robust Tier-1 capital ratios than they did a decade ago (Chart 14). As a result, the doom-loop that plagued those economies ten years ago is not as pronounced. In fact, bank lending rates in Italy and Spain are now lower than they are in Germany, which contrasts greatly with the previous decade (Chart 14, bottom panel). Chart 13Exposure To The Home Country Chart 14Improved Bank Health In The Periphery Bottom Line: Bonds around the world and in Europe are massively oversold and are due for a countertrend rally. This pullback in yields, however, will be transitory. Higher trend nominal GDP growth around the world and in Europe indicates that yields have much further to rise over the next five years. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations
Executive Summary Fed officials maintained the drumbeat of hawkish commentary last week, reiterating their commitment to use the full might of their tools to bring inflation to heel. Stock and bond markets reacted adversely when dovish Governor Brainard joined the chorus, but no one should have been surprised. The FOMC is unanimous in its resolve to combat inflation before long-run expectations become unmoored. Markets may also have been discomfited by the coming shrinking of the Fed’s balance sheet. Though balance sheet runoff should exert some modest upward pressure on bond yields, we do not expect markets to dwell on it for long. Housing activity is squarely in the crosshairs of tighter monetary policy. Mortgage rates are extremely low relative to history, however, and homes remain quite affordable. We expect the housing market will weather the backup in rates. A plucky band of first-time organizers spurred workers in a New York City Amazon warehouse to vote to form a union. Labor advocates rejoiced, but it is premature to mark the event as a turning point for organized labor. What Goes Up Must Come Down Bottom Line: Last week’s Fed “news” was not particularly newsworthy. The FOMC will prioritize its inflation mandate over its full employment mandate until further notice, but the economy is well suited to withstand higher rates and even the housing market won’t buckle in the face of them. Feature Just when you thought it was safe to go back in the water, Fed speakers roiled rates markets again last week, pushing the 10-year Treasury yield over 2.6% for the first time in three years. Although Fed Governor Brainard was simply lining up behind every other governor and district president who’s been in range of a microphone over the last several weeks, her tough talk on inflation in a Tuesday morning speech jolted the 10-year yield 10 basis points (bps) higher, from 2.45% to 2.55%, and it tacked on another 10 bps overnight, hitting 2.65% as New York-based fixed income traders switched on their terminals Wednesday morning. Stocks tumbled after Brainard’s remarks, as well, with the S&P 500 shedding 1% in back-to-back sessions. Both markets got a respite after the March FOMC meeting minutes contained no further revelations but the 10-year yield marched to 2.70% on Friday. The market action demonstrated that investors remain on edge, despite the S&P 500’s 10% bounce. From our perspective, there was nothing too notable in Brainard’s comments. She may be seen as one of the more reliably dovish members of the FOMC, but Chair Powell has been at pains to stress that the entire committee is “determin[ed],” as the minutes put it, “to take the measures necessary to restore price stability.” With inflation readings persisting well above the FOMC’s target level, one participant after another has hammered home the message in speeches and interviews that the committee is unanimously resolved to wield its tools to bring it to heel. Related Report US Investment StrategyIt All Depends On Whom You Ask Hiking the fed funds rate is the committee’s foremost weapon in the fight against inflation, and it has guided investors to discount a more rapid pace of 2022 increases and a modestly higher end point for this tightening cycle. We think the fixed income market is underestimating the terminal, or peak, rate but expect that it will require hard evidence before it reassesses its conviction that the economy cannot withstand a fed funds rate above 2.5%. It will take time to gather that evidence, as it won’t be available until the funds rate is at least 2%, so we expect that the 10-year yield will soon peak in tandem with inflation, but investors are especially uncertain and volatile financial markets reflect it. The FOMC can also adjust the size of its balance sheet to regulate the stimulus it’s providing to the economy. This tool pales in importance relative to the funds rate and despite Ben Bernanke’s smug remark at BCA’s 2015 conference that “quantitative easing works in practice but not in theory,” definitive evidence of its effects remains elusive. We therefore do not expect that curtailing reinvestment of principal repayments from the Fed’s stockpile of securities holdings will have a meaningful direct effect on the economy. Last week’s guidance that the runoff will be faster than it was in 2018-19 makes sense, given that the Fed’s securities holdings are twice as large (Chart 1), and that flush households and businesses are in markedly better shape than they were in the aftermath of the crisis. Chart 1The Funds Rate Matters More Than The Size Of The Balance Sheet There is no settled consensus on what the Fed’s balance sheet reduction will mean for the economy and markets. The US Investment Strategy view is that asset purchases are mainly a signaling device; they let economic participants and investors know that zero interest rate policy will remain in place until some period after they end. Balance sheet runoff doesn’t provide any similar information about the future; it simply indicates that the FOMC will be pursuing a supplemental stimulus reduction measure alongside its far more influential increases in short rates. Removing a price-insensitive buyer from the marketplace should put modest upward pressure on interest rates because they should have to rise, all else equal, to induce other buyers to step in to replace it. We expect, therefore, that the runoff will tighten financial conditions at the margin and exert a modest drag on economic activity. Some of that marginal tightening must have already occurred, as the Fed has taken pains to telegraph the balance sheet runoff, but it will likely contribute to volatility as markets try to settle on the proper outcome to discount. What About Housing? Interest rates affect the entire economy, but housing is the most rate-sensitive industry. Houses are the ultimate big-ticket items – they are the most expensive purchase most households will make and nearly all of them are financed via mortgages. Demand for single-family housing, away from the post-GFC phenomenon of investment buyers paying cash, is acutely sensitive to interest rates. The tide of available buyers ebbs and flows as monthly mortgage payments rise and fall. The housing market therefore finds itself in the crosshairs of the Fed’s tough talk about inflation and the homebuilder stocks have been demolished so far this year, losing a third of their value to lag every other subindustry group in the S&P 500 except closely related home furnishings (Chart 2). The stock rout contrasts with the upbeat housing market outlook we offered two months ago. Though we acknowledge that housing’s prospects have dimmed somewhat since mid-to-late February, we remain more optimistic than the consensus and are confident that a pronounced slowdown is not in store. Chart 2A Brutal Selloff ... The subsequent 75-bps surge in Freddie Mac’s national 30-year fixed-rate mortgage proxy (Chart 3, middle panel) has made homes less affordable for the median buyer (Chart 3, top panel). The drop in affordability has been modest, however, as it has been cushioned by a narrowing of the gap between median income and median home prices (Chart 3, bottom panel). Despite the last two months’ dip, homes remain quite affordable relative to history. Chart 3... Despite Solid Affordability Since its predecessor index began in 1971, affordability had only ever surpassed the 140 level that has marked the bottom of the post-crisis range for a brief period in the early seventies (Chart 4, top panel). While mortgage rates are clearly moving in the wrong direction, they remain extremely low. One must squint to register their current advance in the context of the series’ entire history (Chart 4, third panel). Despite rising rates, median income gains have kept the mortgage servicing burden steady – and historically light – for several months (Chart 4, second panel). Though we expect that mortgage rates will stop vaulting upward and possibly even retrace some of their advance as inflation peaks, their recent move has been unfriendly to the housing market. Viewed from the perspective of the National Association of Realtors’ affordability index, however, their level remains quite favorable, and we do not worry that great swaths of would-be buyers are going to be shut out of the market. The respondents to the NAHB’s homebuilder sentiment survey agree. While the forward sales component swooned by ten points from January to February (Chart 5, bottom panel), current sales largely kept pace (Chart 5, second panel) and potential buyer traffic rose (Chart 5, third panel). The overall index slipped a bit since January but – stop us if you’ve heard this before – remains very strong relative to history (Chart 5, top panel). Chart 4The American Dream Is Not Out Of Reach Chart 5Homebuilders See Clear Skies Ahead ... Though demand has surely waned, as rising rates sideline some marginal buyers, we expect it will remain robust, especially as the sizzling rental market offers little relief. Supplies of new and existing homes remain constrained. Restrictive zoning laws, sporadically soaring input costs, supply chain issues and difficulty finding skilled workers have hampered new home construction. Inventories of existing homes remain historically depleted (Chart 6, middle panel) and the share of homes that are vacant remains at all-time lows (Chart 6, bottom panel). Chart 6... As Their Product Is In Short Supply Chart 7Real Mortgage Rates Are Not A Problem The bottom line is that the housing picture has worsened somewhat but we still believe conditions are better than the gloomy consensus perception. Construction and sales activity will surprise to the upside over the rest of the year and residential investment will augment economic activity, not detract from it. Although the ITB homebuilder ETF has been a drag on performance since we added it to our cyclical ETF portfolio last month, we will continue to hold it as a pure play on the resilience of domestic demand. It is hard to see demand evaporating in the fashion implied by the homebuilders’ skid when real mortgage rates are at such extreme lows, no matter how they are adjusted for inflation (Chart 7). David Wins A Round Against Goliath Workers at a fulfillment center in Staten Island voted two weeks ago to become the first domestic Amazon employees to form a union. The vote, along with a concurrent re-vote at a Bessemer, Alabama warehouse that union organizers lost, was closely watched by labor relations experts. Amazon is the second-largest private employer in the US, with more than a million employees, and its size and reputedly trying working conditions make it an especially appealing target for unions. Labor advocates were quick to characterize the vote as a watershed moment, but it is far too early to call an inflection point. The outcome of the Amazon vote was front-page news because it was so improbable. Despite a cyclically favorable labor market, wage earners trying to unionize confront a gaping structural resource disparity with multinational companies. The fledgling Amazon Labor Union’s (ALU) victory in Staten Island was startling but it still faces an arduous climb to bring Amazon to the negotiating table and work out a contract agreement. Amazon will be able to introduce delays at every step of the process, eroding ALU’s meager resources while pursuing a strategy of running out the clock on the current labor-friendly administration. One of the key takeaways from our January-February 2020 Special Reports on US labor relations history was that employees are only to achieve gains when the government – courts, legislatures and the executive branch – does not favor employers. The series of reports were meant to alert investors to the possibility that Democratic wins in the 2020 election could send the pendulum swinging back in employees’ favor after 40 years of tilting toward employers, carrying important implications for corporate profit margins and inflation. Chart 8The Tortoise And The Hare The election did mark a change in the White House’s attitude toward labor, installing the self-declared “most pro-union president leading the most pro-union administration in American history.1” Since President Biden took office, the National Labor Relations Board has forcefully asserted itself in its role as the official referee of union elections to the point that Amazon has accused it of taking the unions’ side instead of serving as a neutral arbiter. The president himself would seem to have been taking sides last week when he took the rare step of calling out Amazon by name during remarks to a group of unionized workers. “The choice to join a union belongs to workers alone,” he said. “By the way, Amazon, here we come. Watch.” The White House press secretary quickly walked back the comments, placing them in the context of the president’s established support for unionization and collective bargaining. “What he was not doing is sending a message that he or the U.S. government would be directly involved in any of these efforts or take any direct action.2” Regardless of whether President Biden was attempting to send a message or had ventured off-topic as is his wont, it is unclear how much his administration can do to tilt the scales in workers’ favor. New Deal-era laws endowed workers with the right to organize and employers are not allowed to obstruct their efforts to do so. There are multiple gray areas in union election campaigns, however, and employers regularly deploy a wide range of actions that are not explicitly prohibited to keep unions out of their workplace. Most importantly, this administration may only be in charge until January 2025. It can use the NLRB, OSHA, the Department of Labor and the Department of Justice to try to advance workers’ cause for four years but labor has been on the back foot for four decades. It is likely to lose its legislative majorities in November’s midterms, the federal bench is populated by a majority of judges disposed to see things from employers’ point of view and many state legislatures are markedly anti-union. Without another term, the jury is out on the administration’s ability to effect durable change. The takeaway for investors is that a wage-price spiral has not yet taken hold and our bet is that it won’t. The tight labor market has endowed workers with more leverage than they’ve had in many cycles, but structurally the labor relations landscape bears more characteristics of the Reagan Era (1980-2020) than the New Deal Era (1933-1980). Real average hourly earnings have risen since the pandemic arrived in the US (Chart 8, top panel), but we find it telling that all of the real wage growth occurred in the first year of the pandemic. Across Year 2, nominal wages have failed to keep up with consumer price inflation (Chart 8, bottom panel), despite White House support in the midst of a labor market so tight that it squeaks. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Remarks by President Biden in Honor of Labor Unions | The White House Accessed April 7, 2022. 2 Biden Appears to Show Support for Amazon Workers Who Voted to Unionize - The New York Times (nytimes.com) Accessed April 7, 2022.
Canada’s March labor force survey generated a positive surprise, underscoring the strength of the Canadian economy. The unemployment rate fell by 0.2 percentage points to 5.3% – the lowest in records that go back to 1976. Although the number of jobs added…
In an Insight earlier last week, we noted that comments from Fed Governor Lael Brainard and the release of the minutes from the March FOMC meeting impacted yields at the long-end of the US Treasury curve. Both Brainard’s comments and the minutes were focused…
US bank stocks are down 16.6% since mid-February, underperforming the S&P 500 by 18.5% over this period. Notably, this underperformance occurred as the 10-year Treasury yield increased by 74 bps. This marks a break in the typically positive relationship…
According to BCA Research’s Foreign Exchange Strategy service, most central banks continue to dial up their hawkish rhetoric, led by the Fed. This is putting upward pressure on the dollar. The key data releases the Federal Reserve watches continue to…
Executive Summary The Dollar Has Broken Above Overhead Resistance Most central banks continue to dial up their hawkish rhetoric, led by the Fed. This is putting upward pressure on the dollar (Feature Chart). The big surprise has been resilient inflationary pressures across many economies. In our view, the market has already priced in an aggressive path for interest rates in the US, putting the onus on the Fed to deliver on these expectations. Meanwhile, other central banks that are also facing domestic inflationary pressures will play catch up. Our short USD/JPY position was triggered at 124. While there are no immediate catalysts for yen bulls, the currency is very cheap, and speculators are very short. Look to sell the DXY soon. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short DXY 102 2022-04-07 - SHORT USD/JPY 124 2022-04-05 0.02 Bottom Line: Technically, the dollar has broken above overhead resistance, putting it within striking distance of the March 2020 highs at 103. However, given stretched positioning, our bias is that incremental increases in the DXY will require much more upside surprises in US interest rates. This is not our base case. Feature The dollar performed well in the first quarter of this year. Year-to-date, the DXY index is up 3.9%. Remarkably, this has coincided with strength in many commodity currencies such as the BRL, ZAR, COP, CLP, and AUD, that tend to be high beta plays on a falling dollar (Chart 1). Technically, the dollar has broken above overhead resistance, putting it within striking distance of the March 2020 highs of 103 (Chart 2). However, given stretched positioning, our bias is that incremental increases in the DXY will require much more upside surprises in US interest rates. This is not our base case. Chart 1The Dollar And Commodity Currencies Have Been Strong This Year Chart 2The Dollar Has Broken Above Overhead ##br##Resistance As we have highlighted in past reports, the dollar continues to face a tug of war. If rates rise substantially in the US, and that undermines the US equity market leadership (Chart 3), the dollar could suffer. If US rates rise by less than what the market expects, record high speculative positioning in the dollar will surely reverse. Chart 3Dollar Tailwinds Remain Intact This week’s Month-In Review report goes over our take on the latest G10 data releases, and the implication for currency strategy both in the near term and longer term. US Dollar: The Fed Stays Hawkish Chart 4The Case For More Tightening The dollar DXY index is up 3.9% year-to-date. The key data releases the Federal Reserve watches continue to suggest a hawkish path for interest rates going forward. Inflation remains strong in the US. Headline CPI came in at 7.9% year-on-year in February and is expected to accelerate in next week’s release. Nonfarm payrolls are still robust. The US added 431K jobs in March, nudging the unemployment rate to a cycle low of 3.6%. Wages are inflecting higher, which is pulling up unit labor costs. The Atlanta Fed Wage Growth Tracker currently sits at 6%. These developments continue to underpin market expectations for aggressive interest rate increases. The market now expects the Fed to raise rates to 2.25% by December 2022. Speculators are also very long the dollar. The mispricing in the dollar comes from the fact that markets are expecting the Fed to be more aggressive than other central banks in curtailing monetary accommodation this year (as proxied by two-year yield spreads). However, the reality is that other central banks are also ratcheting up their hawkish rhetoric. As such, we expect policy convergence to be a theme that will play out in 2022, putting downward pressure on the dollar. In conclusion, our 3-month view on the dollar is neutral, based on the risk of further escalation in the Ukrainian crisis and robust inflation prints, but our 9-month assessment will be to sell the dollar on any strength. We are revising our year-end target on the DXY to 95. The Euro: Stagflation Chart 5Euro Area Real Yields Are Too Low The euro continues to weaken, down 4.2% this year, after hitting an intraday low of 1.08 last month. Economic data in the eurozone has been soft, especially on the back of a surge in the number of new Covid-19 cases, rising energy costs driven by the military conflict between Ukraine and Russia, and a weak euro adding to upward pressure on inflation. This is pinning the euro area in a stagflationary quagmire. More specifically: The headline HICP (harmonized index of consumer prices) index for the euro area was 7.5% for March. The hawks in the ECB are very uncomfortable with last week’s HICP release of 9.8% in Spain, 7.3% in Germany, and 7% in Italy. House prices in the euro area are accelerating on the back of very low real rates. This is increasing the unaffordability of homes across the eurozone. One of our favorite measures of economic activity, the Sentix Economic Index, tumbled in April. At -18, this is the lowest since July 2020, a negative surprise vis-à-vis the expected -9.4. Faced with a deteriorating economic backdrop, but strong inflationary pressures, the ECB has chosen a hawkish path to maintain credibility. Asset purchases will be tapered this year, and rate hikes are on the table. Forward markets are now pricing 53 bps of interest rate increases this year. In our view, while the ECB will not deliver the pace of rate hikes anticipated by markets in the near term, pricing of interest rate differentials between the eurozone and the US will narrow, as the ECB plays catch up. We are neutral on the euro over a 3-month horizon but are buyers over 9 months and beyond. Stay long EUR/GBP as a play on policy convergence between the ECB and BoE. Our year-end target for EUR/USD is 1.18. The Japanese Yen: A Contrarian View Chart 6Too Many Yen Bears The Japanese Yen: A Contrarian View The Japanese yen is down 7% year-to-date. This pins it as the worst performing G10 currency this year. The story for Japan (and the yen) has been a very slow emergence from the latest Covid-19 wave. This has kept domestic inflation very subdued, allowing the BoJ to stay dovish, even as the external environment has done better. This has pushed interest rate differentials against the Japanese yen. The latest trigger for the selloff in the yen was the BoJ’s commitment to maintain yield curve control as global interest rates have been surging. This pushed USD/JPY above 125, the highest since 2015. On the back of this move, incoming economic data justified the BoJ’s stance. Headline inflation has picked up (still at 0.9%), but core “core” inflation remains at -1%. At 1.21, the job-to-applicant ratio is well below its pre-pandemic level of around 1.6. Ergo, the labor market is not as tight as a 2.7% unemployment rate suggests. Wage growth is improving, currently at 1.2% for February. That said, is it hard to argue that Japanese workers have bargaining power and can trigger a wage/inflation spiral that will allow the BoJ to pivot. Related Report Foreign Exchange StrategyThe Yen In 2022 Despite these negatives, we are constructive on the yen because the downside is well priced in, while upside surprises are not. Real rates remain higher in Japan than for other G10 countries. Speculators are also very short the yen. As we highlighted last week, the yen is also extremely cheap. We went short USD/JPY at 124. Our view is that interest rate expectations for the US are overdone in the near term. As such a stabilization/retracement in global yields could be a bullish development for yen bulls. Our target is 110 with a stop at 128. British Pound: A Hawkish BoE Chart 7The Case For A Hawkish BoE The pound is down 3.4% year-to-date. The Bank of England has been one of the more aggressive central banks, raising interest rates to 0.75% last month. Inflation continues to soar in the UK - headline CPI was at 6.2% in February while core inflation clocked in at 5.2%. This prompted the governor to send a letter to the Chancellor of the Exchequer, explaining why monetary policy has allowed inflation to deviate from the BoE’s mandate of 2%. According to the BoE’s projections, inflation will rise above 8% this year before peaking. At the same time, taxes are slated to rise in the UK this month. While the labor market continues to heal, the combination will be a hit to consumer sentiment in the near term. The SONIA curve in the UK is pricing 130 bps of price hikes this year. While the BOE must contain inflationary pressures (in accordance with their mandate), the risks of a policy mistake have risen. Tight monetary and fiscal policy in the UK could stomp out any budding economic green shoots. The pound is also very sensitive to global financial conditions, and an equity market correction, especially on the back of heightened tensions in Ukraine, will put pressure on cable. We are short sterling, via a long EUR position. In our view, the EUR/GBP cross is heavily underpricing the risks to the UK economy in the near term. Australian Dollar: A Commodity Story Chart 8The RBA Will Stay Patient The Australian dollar is up 3% year-to-date, making it the best performing G10 currency. The Reserve Bank of Australia kept rates on hold at its April 5th meeting, but it ratcheted up its hawkish tone. The two critical measures that the RBA is focusing on, inflation and wages, have been improving. As a result, the shift in the RBA stance was justified. Since its March meeting, home prices have continued to accelerate, rising 23.7% year-on-year in Q4. Meanwhile, the unemployment rate has fallen to a cycle low of 4% in Q4. This is below many measures of NAIRU. The RBA expects inflationary pressures to remain persistent in 2022, but ultimately fall to 2.75% in 2023. This will still be at the upper bound of their 2%-3% target range. Admittedly, wages are still low by historical standards, but as Governor Philip Lowe has highlighted, the behavior of the Phillip’s Curve at these low levels of unemployment is unpredictable. The external environment is also AUD bullish. The RBA Index of Commodity prices soared by 40.9% year-on-year in March, widening the gap with a rather muted AUD (up 3.4% this year). In our view, the market is concerned about the zero-Covid policy in China (Australia’s biggest export partner), which could dim Australia’s economic outlook in the near term. On the flip side, many speculators are now short the Aussie which is bullish from a contrarian perspective. A healthy trade balance is also putting upward pressure on the currency. We are lifting our limit buy on AUD/USD to 72 cents, after being stopped out for a modest profit earlier this year. New Zealand Dollar: Positive Catalysts, But Overvalued Chart 9Home Price Inflation In New Zealand Is Rolling Over The New Zealand dollar is up 1% year-to-date. The Reserve Bank of New Zealand is among the most hawkish within the G10. The cash rate is at 1%, the highest among major developed economies on the back of economic data which remains robust. Home prices, a metric the RBNZ monitors to calibrate monetary policy, are rising 23.4% year-on-year as of March. While we are modestly positive on the Kiwi, it has become very expensive according to most of our models. The result is that the trade balance continues to print a deficit, with the latest data point in February deteriorating to NZ$ -8.4 billion. Kiwi bonds also offer the highest yield in the G10, meaning the market has already priced a hawkish path of interest rates by the RBNZ. Given the crosscurrents mentioned above, we are neutral the kiwi versus the dollar over both a 3-month and 9-month horizon. Canadian Dollar: The BoC Will Stay Hawkish Chart 10The BoC Will Hike Next Week The CAD is up 0.4% year-to-date. The Bank of Canada is expected to raise interest rates by 50bps to 1% at next week’s meeting. This is not a surprise, since all the measures the BoC looks at to calibrate monetary policy are robust. Both headline and core inflation are well above the midpoint of the 1%-3% target range. The common, trim, and median inflation prints are either at or above the upper bound of the central bank’s target at 2.6%, 4.3%, and 3.5%, respectively. This suggests inflationary pressures in Canada are broad based. Employment in Canada is back above pre-pandemic levels, with the unemployment rate slated to come in at 5.4% with today’s release, close to estimates of NAIRU. House price inflation is raging across many cities in Canada, which argues that monetary policy is too easy and mortgage rates are too low. We have always highlighted that the key driver of the CAD remains the outlook for monetary policy and the path of energy prices. In the near term, oil prices will stay volatile as the situation in Ukraine continues to be very fluid, but the CAD has not priced in the fact that the BoC is leading the interest rate cycle vis-à-vis the US this time around. Speculators are only neutral the CAD, an appropriate stance over the next three months. That said, we are buyers of CAD over a 9-to-12-month horizon, with a target of 0.84. Swiss Franc: A Safe Haven Chart 11The SNB Will Lean Against Franc Strength The Swiss economy continued to fare well in the first quarter. The manufacturing PMI jumped to 64 in March. Retail sales were up 12.8% year-on-year in February. The labor market remains strong with unemployment near pre-pandemic levels. Switzerland’s direct exposure to the war appears relatively limited with little inflationary spillovers. CPI stood at 2.4% year-on-year in March, with about 1% of the increase coming from energy prices. The Swiss economy is still generating a record trade surplus, coming in at CHF 5.7bn in February. Safe-haven inflows into the franc have dampened inflationary dynamics. This leaves room for the SNB to continue easing monetary policy for longer relative to other central banks in the developed world. In terms of monetary policy, the SNB kept interest rates unchanged at -0.75% at its Q1 meeting. The SNB has also described the franc as “highly valued” and said that it is willing to intervene in FX markets as necessary to counter the upward pressure in the currency. Sight deposits have been rising in March. We are neutral CHF on both a 3-month and 9-month horizon but will be buyers of EUR/CHF at current levels. Norwegian Krone: Bullish On A 12-18 Month Horizon Chart 12NOK Has A Policy Tailwind The NOK is flat this year. In March, the Norges Bank raised the policy rate by 25 bps to 0.75%, in line with policymakers’ previous statements. Citing rising import prices and a tight labor market, the committee now expects to increase rates to 2.5% by the end of 2023, up from an assessment of 1.75% in December. Inflation accelerated again in February, with headline and core CPI at 3.7% and 2.1% year-on-year respectively. Despite the removal of all Covid-19 restrictions in mid-February, consumer demand data remained soft with retail sales, household consumption, and loan growth all down in February. Still, the overall economy remains strong, and the Bank expects a rebound in demand going forward. The manufacturing PMI jumped to 59.6 in March after a three-month decline. Industrial production rose 1.6% year-on-year in February, after lackluster performance in January. The trade surplus remains robust. Registered unemployment fell to 2% in March and with rising wage expectations, the case for tighter monetary policy remains intact. The uncertainty over energy-related sanctions can keep oil prices volatile in the near time, as well as the NOK. That said, our commodity team expects oil to average $93/bbl next year, which is higher than what the forward markets are pricing. That will be bullish for the NOK. Swedish Krona: Lower Now, Strong Later Chart 13The SEK Is Not Pricing Rate Hikes By The Riksbank SEK is down 4% year-to-date. The Riksbank remains one of the most dovish central banks in the G10, keeping the repo rate at 0% at its February meeting, with no hikes projected until 2024. Since then, inflation data has come in well above expectations and several board members have spoken out on the need to reevaluate monetary policy. The OIS curve is now pricing about two hikes by the end of the year. CPIF was 4.5% year-on-year in February and the measure excluding energy jumped to 3.4%, up from 2.5% in January. With fears that the conflict in Ukraine will exacerbate this trend, a survey of 12-month inflation expectations stood at a record 10.2% in March. While inflation is surprising to the upside, underlying economic data has been on the weaker side. The Swedish new orders-to-inventory ratio has fallen sharply. Consumer confidence also dipped in March, to the lowest point since the Global Financial Crisis. Sweden remains highly sensitive to eurozone economic conditions. As such, it is also in the direct firing range of any economic turbulence in the euro area, though it will also benefit from growth stabilization later this year, should macroeconomic risks abate. SEK is the second most undervalued currency based on our Purchasing Power Parity models and is likely positioned for a coiled spring rebound when the Riksbank eventually turns more hawkish. We are neutral SEK over a 3-month horizon but are bullish longer term. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary