Economic Theory
Hopes of a soft landing for the US economy will intensify over the coming months, allowing equities to rally. However, even if an equilibrium of high employment and low inflation is reached, it will be difficult to keep the economy there. Investors should remain tactically bullish on stocks but look to turn defensive in the second half of 2023.
In this <i>Strategy Outlook</i>, we present the major investment themes and views we see playing out next year and beyond.
2023 will be another challenging year for the US equity market, characterized by the Fed’s battle with inflation, slowing economic growth, and earnings contraction. The S&P 500 is likely to reach new lows in the first half of the year falling as much as 20-25%, only to rebound sharply in the second half, once all the bad news is priced in.
In this Special Report, we consider what some common monetary policy rules are recommending for the major central banks and derive conclusions on duration strategy and country allocation for bond investors. We conclude that rate hike expectations in most countries may appear appropriate given the current global backdrop of high inflation and low unemployment, but look elevated on a forward-looking basis versus slowing global growth and peaking global inflation.
屈曲した供給の枠組みは、パンデミックが始まって間もなく米国のインフレがなぜ急激に上昇したのか、そして今後6か月で経済が良性のディスインフレーションを経験する可能性が高い理由を説明するのに役立つ。
As the FOMC explicitly acknowledged this week, monetary policy operates with substantial lags. We see the risks to stocks as tilted to the upside over the next 6 months but are neutral on global equities over a 12-month horizon.
Falling inflation will allow bond yields to decline in the major economies over the next few quarters. As such, we recommend that investors shift their duration stance from underweight to neutral over a 12 month-and-longer horizon and to overweight over a 6-month horizon. Structurally, however, a depletion of the global savings glut could put upward pressure on yields.
The kinked Phillips curve not only explains why inflation surged last year but makes a number of surprising predictions, chief of which is that inflation could fall significantly over the coming months without a major increase in the unemployment rate. In the near term, that is bullish for stocks.
Listen to a short summary of this report Executive Summary On the eve of the pandemic, most developed economies were operating at close to full capacity – the aggregate supply curve, in other words, had become very steep (or inelastic). Not surprisingly, in such an environment, pandemic-related stimulus, rather than boosting output, simply stoked inflation. Looking out, the inverse may turn out to be true: Just as an increase in aggregate demand did more to lift prices than output during the pandemic, a decrease in aggregate demand may allow inflation to fall without much loss in production or employment. Skeptics will argue that such benign disinflations rarely occur, pointing to the 1982 recession. But long-term inflation expectations were close to 10% back then. Today, they are broadly in line with the Fed’s target. Equities will recover from their recent correction as headline inflation continues to fall and the risks of a US recession diminish. Go long EUR/USD on any break below 0.99. Contrary to the prevailing pessimistic view, Europe is heading for a V-shaped recovery. The Aggregate Supply Curve Becomes Very Steep When Spare Capacity Is Exhausted Bottom Line: The US economy is entering a temporary Goldilocks period of falling inflation and stronger growth. The latest correction in stocks will end soon. Investors should overweight global equities over the next six months but look to turn more defensive thereafter. Dear Client, I will be attending BCA’s annual conference in New York City next week. Instead of our regular report, we will be sending you a Special Report written by Mathieu Savary, BCA’s Chief European Strategist, and Robert Robis, BCA’s Chief Fixed Income Strategist, on Monday, September 12. Their report will discuss estimates of global neutral interest rates. We will resume our regular publication schedule on September 16. Best Regards, Peter Berezin, Chief Global Strategist The Hawks Descend On Jackson Hole Chart 1Markets Still Think The Fed Will Start Cutting Rates Next Year Jay Powell’s Jackson Hole address jolted the stock market last week. Citing the historical danger of allowing inflation to remain above target for too long, the Fed chair stressed the need for “maintaining a restrictive policy stance for some time.” Powell’s comments were consistent with the Fed’s dot plot, which expects rates to remain above 3% right through to the end of 2024. However, with the markets pricing in rate cuts starting in mid 2023, his remarks came across as decidedly hawkish (Chart 1). While Fedspeak can clearly influence markets in the near term, our view is that the economy calls the shots over the medium-to-long term. The Fed sees the same data as everyone else. If inflation comes down rapidly over the coming months, the FOMC will ratchet down its hawkish rhetoric, opting instead for a wait-and-see approach. The Slope of Hope Could inflation fall quickly in the absence of a deep recession? The answer depends on a seemingly esoteric concept: the slope of the aggregate supply curve. Economists tend to depict the aggregate supply curve as being convex in nature – fairly flat (or “elastic”) when there is significant spare capacity and becoming increasingly steep (or “inelastic”) as spare capacity is exhausted (Chart 2). The basic idea is that firms do not require substantially higher prices to produce more output when they have a lot of spare capacity, but do require increasingly high prices to produce more output when spare capacity is low. Chart 2The Aggregate Supply Curve Becomes Very Steep When Spare Capacity Is Exhausted When the aggregate supply curve is very elastic, an increase in aggregate demand will mainly lead to higher output rather than higher prices. In contrast, when the aggregate supply curve is inelastic, rising demand will primarily translate into higher prices rather than increased output. In early 2020, most of the developed world found itself on the steep side of the aggregate supply curve. The unemployment rate in the OECD stood at 5.3%, the lowest in 40 years (Chart 3). In the US, the unemployment rate had reached a 50-year low of 3.5%. Thus, not surprisingly, as fiscal and monetary policy turned simulative, inflation moved materially higher. Goods inflation, in particular, accelerated during the pandemic (Chart 4). Perhaps most notably, the exodus of people to the suburbs, combined with the reluctance to use mass transit, led to a surge in both new and used car prices (Chart 5). The upward pressure on auto prices was exacerbated by a shortage of semiconductors, itself a consequence of the spike in the demand for electronic goods. Chart 3The Pandemic Began When The Unemployment Rate In The OECD Was At A Multi-Decade Low Chart 4With Supply Unable To Meet Demand, Goods Prices Surged During The Pandemic The supply curve for labor also became increasingly inelastic over the course of the pandemic. Once the US unemployment rate fell back below 4%, wages began to accelerate sharply. The kink in the Phillips curve had been reached (Chart 6). Chart 5Car Prices Went On Quite A Ride During The Pandemic Chart 6Wage Growth Soared When The Economy Moved Beyond Full Employment Chart 7Job Switchers Usually See Faster Wage Growth Faster labor market churn further turbocharged wage growth. Both the quits rate and the hiring rate rose during the pandemic. Typically, workers who switch jobs experience faster wage growth than those who do not (Chart 7). This wage premium for job switching increased during the pandemic, helping to lift overall wage growth. A Symmetric Relationship? All this raises a critical question: If an increase in aggregate demand along the inelastic side of the aggregate supply curve mainly leads to higher prices rather than increased output and employment, is the inverse also true – that is, would a comparable decrease in aggregate demand simply lead to much lower inflation without much of a loss in output or employment? If so, this would greatly increase the odds of a soft landing. Skeptics would argue that disinflations are rarely painless. They would point to the 1982 recession which, until the housing bubble burst, was the deepest recession in the post-war era. The problem with that comparison is that long-term inflation expectations were extremely high in the early 1980s. Both consumers and professional forecasters expected inflation to average nearly 10% over the remainder of the decade (Chart 8). To bring down long-term inflation expectations, Paul Volcker had to engineer a deep recession. Chart 8Long-Term Inflation Expectations Are Much Better Anchored Now Than In The Early 1980s Chart 9Real Long Terms Bond Yields Are Currently A Fraction Of What They Were Four Decades Ago Jay Powell does not face such a problem. Both survey-based and market-based long-term inflation expectations are well anchored. Whereas real long-term bond yields reached 8% in 1982, the 30-year TIPS yield today is still less than 1% (Chart 9). The Impact of Lower Home Prices Chart 10Supply-Side Constraints Limited Home Building During The Pandemic, Helping To Push Up Home Prices While falling consumer prices would boost real incomes, helping to keep the economy out of recession, a drop in home prices would have the opposite effect on consumer spending. As occurred with other durable goods, a shortage of building materials and qualified workers prevented US homebuilders from constructing as many new homes as they would have liked during the pandemic. The producer price index for construction materials soared by over 50% between May 2020 and May 2022 (Chart 10). As a result, rising demand for homes largely translated into higher home prices rather than increased homebuilding. Real home prices, as measured by the Case-Shiller index, have increased by 25% since February 2020, rising above their housing bubble peak. As we discussed last week, US home prices will almost certainly fall in real terms and probably in nominal terms as well over the coming years. Chart 11Despite Higher Home Prices, Households Have Not Been Using Their Homes As ATMs How much of a toll will falling home prices have on the economy? It took six years for home prices to bottom following the bursting of the housing bubble. It will probably take even longer this time around, given that the homeowner vacancy rate is at a record low and reasonably prudent mortgage lending standards will limit foreclosure sales. Thus, while there will be a negative wealth effect from falling home prices, it probably will not become pronounced until 2024 or so. Moreover, unlike during the housing boom, US households have not been tapping the equity in their homes to finance consumption (Chart 11). This also suggests that the impact of falling home prices on consumption will be far smaller than during the Great Recession. Inelastic Commodity Supply While inelastic supply curves had the redeeming feature of preventing a glut of, say, new autos or homes from emerging, they also limited the output of many commodities that face structural shortages. Compounding this problem is the fact that the demand for many commodities is very inelastic in the short run. When you combine a very steep supply curve with a very steep demand curve, small shifts in either curve can produce wild swings in prices. Nowhere is this problem more evident than in Europe, where a rapid reduction in oil and gas flows has caused energy prices to soar, forcing policymakers to scramble to find new sources of supply. Europe’s Energy Squeeze At this point, it looks like both the UK and the euro area will enter a recession. In continental Europe, the near-term outlook is grimmer in Germany and Italy than it is in France or Spain. The latter two countries are less vulnerable to an energy crunch (Spain imports a lot of LNG while France has access to nuclear energy). Both countries also have fairly resilient service sectors (Spain, in particular, is benefiting from a boom in tourism). The good news is that even in the most troubled European economies, the bottom for growth is probably closer at hand than widely feared. Despite the fact that imports of Russian gas have fallen by more than 60%, Europe has been able to rebuild gas inventories to about 80% of capacity, roughly in line with prior years (Chart 12). It has been able to achieve this feat by aggressively buying gas on the open market, no matter the price. While this has caused gas prices to soar, it sets the stage for a possible retreat in prices in 2023, something that the futures market is already discounting (Chart 13). Chart 12Europe: Squirrelling Away Gas For The Winter Chart 13Natural Gas Prices In Europe Will Come Back Down To Earth Europe is also moving with uncharacteristic haste to secure new sources of energy supply. In less than one year, Europe has become America’s biggest overseas market for LNG. A new gas pipeline linking Spain with the rest of Europe should be operational by next spring. In the meantime, Germany is building two “floating” LNG terminals. Germany has also postponed plans to mothball its nuclear power plants and has approved increased use of coal-fired electricity generators. Chart 14The Euro Is Undervalued France is seeking to boost nuclear capacity. As of August 29, 57% of nuclear generation capacity was offline. Electricité de France expects daily production to rise to around 50 gigawatts (GW) by December from around 27 GW at present. For its part, the Dutch government is likely to raise output from the massive Groningen natural gas field. All this suggests that contrary to the prevailing pessimistic view, Europe is heading for a V-shaped recovery. The euro, which is 30% undervalued against the US dollar on a purchasing power parity basis, will rally (Chart 14). Go long EUR/USD on any break below 0.99. Investment Conclusions Chart 15Falling Inflation Should Boost Real Wages And Buoy Consumer Confidence On the eve of the pandemic, most developed economies were operating at close to full capacity – the aggregate supply curve, in other words, had become very steep (or inelastic). Not surprisingly, in such an environment, pandemic-related stimulus, rather than boosting output, simply stoked inflation. Looking out, the inverse may turn out to be true: Just as an increase in aggregate demand did more to lift prices than output during the pandemic, a decrease in aggregate demand may allow inflation to fall with little loss in production or employment. Will this be the end of the story? Probably not. As inflation falls, US real wage growth, which is currently negative, will turn positive. Consumer confidence will improve, boosting consumer spending in the process (Chart 15). The aggregate demand curve will shift outwards again, triggering a “second wave” of inflation in the back half of 2023. Rather than cutting rates next year, as the market still expects, the Fed will raise rates to 5%. This will set the stage for a recession in 2024. Investors should overweight global equities over the next six months but look to turn more defensive thereafter. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn & Twitter Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
In this <i>Strategy Outlook</i>, we present the major investment themes and views we see playing out for the rest of the year and beyond.