Policy
Executive Summary China Needs To Create RMB35 Trillion In Credit In 2022 The pace of credit creation in January increased sharply over December. However, the jump was less than meets the eye compared with previous easing cycles and adjusted for seasonality. Our calculation suggests that a minimum of approximately RMB35 trillion of new credit, or a credit impulse that accounts for 29% of this year's nominal GDP, will be needed to stabilize the economy. January’s credit expansion falls short of the RMB35 trillion mark on a six-month annualized rate of change basis. Our model will provide a framework for investors to gauge whether the month-over-month credit expansion data is on track to meet our estimate of the required stimulus. Despite an improvement in January's credit growth from December, it is premature to update Chinese stocks (on- and off-shore) to overweight relative to global equities. Bottom Line: Approximately RMB35 trillion in newly increased credit this year will probably be needed to revive China’s domestic demand. Any stimulus short of this goal would mean that investors should not increase their cyclical asset allocation of Chinese stocks in a global portfolio. Feature January’s credit data for China exceeded the market consensus. The aggregate total social financing (TSF) more than doubled in the first month of 2022 from December last year. However, on a year-over-year basis, the increase in January’s TSF was smaller than in previous easing cycles, such as in 2013, 2016 and 2019. Furthermore, underlying data in the TSF reflects a prolonged weak demand for bank loans from both the corporate and household sectors. While January’s uptick in credit expansion makes us slightly more optimistic about China’s policy support, economic recovery and equity performance in the next 6 to 12 months, we are not yet ready to upgrade our view. An estimated RMB35 trillion in newly increased credit this year will likely be necessary to revive flagging domestic demand. In the absence of seasonally adjusted TSF data in China, our framework will help investors determine whether incoming stimulus is on course to meet this objective. Interpreting January’s Credit Numbers Chart 1A Sharp Increase In Credit Creation In January January’s credit creation beat the market consensus to reach RMB6.17 trillion, pushed up by a seasonal boost and a frontloading of government bond issuance (Chart 1). However, the composition of the TSF data reflects an extended weakness in business and consumer credit demand. On the plus side, net government bond financing, including local government special purpose bonds, rose to RMB603 billion last month, more than twice the amount from January 2021 (Chart 1, bottom panel). Corporate bond issuance also picked up, reflecting cheaper market rates and more accommodative liquidity conditions (Chart 2). Furthermore, shadow credit (including trust loans, entrust loans and bank acceptance bills) also ticked up in January compared with a year ago. The increase in informal lending sends a tentative signal that policymakers may be willing to ease the regulatory pressure on shadow bank activities (Chart 3). Chart 2Corporate Financing Through Bond Issuance Also Increased Chart 3Shadow Banking Activity Ticked Up For The First Time In A Year Meanwhile, several factors suggest that the surge in January’s credit expansion may be less than what it appears to be at first glance. First, credit growth is always abnormally strong in January. Banks typically increase lending at the beginning of a year, seeking to expand their assets rapidly before administrative credit quotas kick in. In recent years loans made during the first month of a year accounted for about 17% - 20% of total bank credit generated for an entire year. Secondly, the credit flow in January, although higher than in January 2021, was weaker than in the first month of previous easing cycles. Credit impulse – measured by the 12-month change in TSF as a percentage of nominal GDP – only inched up by 0.6 percentage points of GDP in January this year from December, much weaker than that during the first month in previous easing cycles (Chart 4). TSF increased by RMB980 billion from January 2021, lower than the RMB1.5 trillion year-on-year jump in 2019 and the RMB1.4 trillion boost in 2016 (Chart 4, bottom panel). Chart 4The Magnitude Of Increase In January’s Credit Impulse Less Than Meets The Eye Chart 5Corporate Demand For Bank Credit Remains Soft Furthermore, China’s households and private businesses have significantly lagged in their responses to recent policy easing measures and their demand for credit remained soft in January (Chart 5). Bank credit in both short and longer terms to households were lower than a year earlier due to downbeat consumer sentiment (Chart 6A and 6B). Chart 6AConsumption Was Unseasonably Weak During Chinese New Year Chart 6BHouseholds' Propensity To Consume Continues Trending Down How Much Stimulus Is Necessary? Our calculation suggests that China will probably need to create approximately RMB35 trillion in new credit, or 29% of GDP in credit impulse, over the course of this year to avoid a contraction in corporate earnings. In our previous reports, we argued that the state of the economy today is in a slightly better shape than the deep deflationary period in 2014/15, but the magnitude of the property market contraction is comparable to that seven years ago. Chart 7 illustrates our approach, which uses a model of Chinese investable earnings growth. The model is designed to predict the likelihood of a serious contraction in investable earnings in the coming 12 months. It includes variables on credit, manufacturing new orders and forward earnings momentum. The chart shows that the flow of TSF as a share of GDP needs to reach a minimum of 28.5% in order that the probability of a major earnings contraction falls below 50%. The size of the credit impulse necessary is 2 percentage points higher than that achieved last year, but still lower than the scope of the stimulus rolled out in 2016. Assuming an 8% growth rate in nominal GDP in 2022, the credit flow that should to be originated this year would be about RMB35 trillion, as illustrated in Chart 8. The chart also shows that this amount would exceed a previous high in credit flow reached in late-2020. Chart 7China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession Chart 8China Needs To Create RMB35 Trillion In Credit In 2022 Based on a 3-month annualized rate of change, January’s credit growth appears that it will achieve the RMB35 trillion mark. However, the jump in TSF largely reflects a one-month leap in frontloaded local government bond issuance and it is not certain if private credit will accelerate in the months ahead. For now, we contend the stimulus have been insufficiently provided during the past six months (Chart 8, bottom panel). Chance Of A Stimulus Overshoot? We will closely monitor whether the month-to-month pace of credit growth is consistent with the scope of the reflationary policy response required to revive China’s domestic demand. Despite a sharp improvement in January’s headline credit number, we view the policy signal from January’s credit data as neutral. China’s unique cyclical patterns and the lack of official seasonally adjusted data make monthly credit figures difficult to interpret. Charts 9 and 10 represent an approach that we previously introduced to help gauge whether the pace of credit creation is on track to meet the stimulus called for to stabilize the economy. Chart 9Jan Credit Growth Looked To Be Stronger Than A “Half-Strength” Credit Cycle… Chart 10…But It Is Too Early To Conclude It Is In Line With What Is Needed The charts show an average cumulative amount of TSF as the year advances, along with a ±0.5 standard deviation, based on data from 2010 to 2021. The thick black line in both charts shows the progress in new credit creation this year, assuming an 8% annual nominal GDP growth rate. Chart 9 shows the cumulative progress in credit, assuming a 27% new credit-to-GDP ratio for the year, whereas Chart 10 assumes 30%. The 27% ratio scenario shown in Chart 9, which is slightly higher than the magnitude of stimulus in 2019, would correspond to a very measured credit expansion. If the thick black line continues to trend within this range, it would suggest that policymakers are reluctant to allow credit growth to surge. Consequently, global investors should continue an underweight stance on Chinese stocks. In contrast, Chart 10 represents a 30% rate of TSF as a share of this year’s GDP; this would be the adequate stimulus needed for a recovery in domestic demand. A cumulative amount of TSF that trends within or above this range would provide more confidence that a credit overshoot similar to 2015/16 and 2020 would occur. Investment Conclusions It is premature to upgrade Chinese stocks to an overweight cyclical stance (i.e. over 6-12 months) within a global portfolio. For now, we recommend investors stay only tactically overweight in Chinese investable equities versus the global benchmark, given their cheap relative valuations. Meanwhile, the increase in January’s TSF, while registering an improvement relative to previous months, does not signal that the pace of credit growth will be strong enough to overcome the negative ramifications of the ongoing deceleration in housing market activity. Therefore, in view of policymakers’ steadfast desire to avoid another major credit overshoot, our cyclical recommendation to underweight Chinese stocks remains unchanged. Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations
Feature This week, we present the third edition of the BCA Research Global Fixed Income Strategy (GFIS) Global Credit Conditions Chartbook – a review of central bank surveys of bank lending standards and loan demand. The data from lending surveys during the last quarter of 2021 were mixed, with business credit standards easing in the US, Japan, Canada, and New Zealand while remaining mostly unchanged in the euro area and UK (Chart 1). Supply chain disruptions have had a two-pronged effect on borrowing. While they have hurt business confidence and prospects, they have also created loan demand as firms look to replenish depleted inventory stocks. The overall picture is one of solid economic fundamentals that are nonetheless perturbed by inflation concerns and lingering uncertainty regarding Covid-19 infections. Chart 1Credit Standards Eased In Most Developed Markets In Q4/2021 An Overview Of Global Credit Conditions Surveys Chart 2Credit Standards And Spreads Are Correlated After every quarter, major central banks compile surveys to assess prevailing credit conditions. The purpose is to obtain from banks an assessment of how their lending standards and demand for loans, for both firms and consumers, changed over the previous quarter. Most surveys also ask questions about the key factors driving these changes and expectations for the next quarter.1 For fixed income investors, these surveys are valuable for a few reasons. Firstly, data on consumer lending is a window into consumer health while business loan demand sheds light on the investment picture. These help derive a view on the path of future economic growth and interest rates and thus, the appropriate duration stance of a bond portfolio. Also, credit standards can tell us about the pass-through from fiscal and monetary policy measures to realized financial conditions (i.e. corporate borrowing rates). Most importantly, credit standards exhibit a direct correlation with corporate bond spreads (Chart 2). As they have access to detailed, non-public information on a large number of borrowers, loan officers are uniquely positioned to evaluate corporate health. When banks are tightening standards, they see an issue with the credit quality of either current or future loans, which impacts borrowing costs in the corporate bond market. Tightening standards indicate a worsening borrowing backdrop and weaker growth, which then pushes up corporate spreads. Vice-versa, easing standards imply a favorable backdrop and plentiful liquidity—both bullish signs for spread product. US In the US, a net percentage of domestic respondents to the Fed’s Senior Loan Officer Survey, reported easing standards for commercial and industrial (C&I) loans to firms of all sizes over Q4/2021 (Chart 3). This marks the fourth consecutive quarter of easing standards. However, banks did report a slower pace of easing, which correlates with tighter financial conditions on the margin (top panel). While we are still in a period of easy financial conditions in absolute terms, this could soon start to change as hot inflation prints and booming economic data cause the Fed to turn increasingly hawkish. Despite this, banks expect to ease standards further over 2022, indicating confidence that underlying economic fundamentals and corporate health will be able to weather monetary tightening. US banks also reported stronger C&I loan demand from all firms in Q4, marking three consecutive quarters of improvement (middle panel). The picture was optimistic, with banks attributing increased loan demand to inventory financing, mergers & acquisitions, and fixed investment. Meanwhile, only 4.2% and 12.5% of banks saw a decrease in internal funds and increasing precautionary demand, respectively, as somewhat important. Inventories accounted for all but 2% of the 6.9% annualized GDP growth in Q4. With inventory stocks still depressed in absolute terms, we expect inventory restocking will continue to buoy demand over 2022. Chart 3US Credit Conditions Chart 4US Loan Demand Outlook For 2022 On the consumer side, banks reported easier standards across the board, with standards easing for credit card, auto, and other consumer loans (bottom panel). However, the pace of easing, which has historically been good at calling turning points in consumer confidence (on a rate-of-change basis), appears to have peaked. Consumer sentiment has already been battered by rampant inflation and falling real wage expectations; tighter credit standards down the road could prove to be a further headwind. As part of the one-off special questions in this edition of the survey, respondents were asked about the reasoning behind their outlook for loan demand over 2022 (Chart 4). Of those that expected higher demand, 70% cited higher spending and investment demand from borrowers as their income prospects improved. Meanwhile, only 33% thought that precautionary demand for liquidity would be a factor. Lenders thought that both, a worsening or an improvement in supply chain disruptions, could contribute to increased demand. 53% expected that continued disruption would create greater inventory financing needs. Meanwhile, 55% expected that easing supply chain troubles would boost demand as product availability concerns faded. Of those that expected weaker loan demand, interest rates were by-and-large the biggest factor, with an overwhelming 96% believing that rising rates would quell loan demand. This was followed by concerns that supply chain disruptions would keep prices high and product availability scarce (70%). On the whole, the responses capture a US economy that is at a tipping point, with market participants watching to see how it weathers an aggressive rate hiking cycle from the Fed. While underlying economic variables such as growth and employment remain strong, it still remains to be seen how much of a tightening in financial conditions the markets can bear. Euro Area In the euro area, banks on net reported a very slight tightening of standards to enterprises for the second consecutive quarter in Q4/2021 (Chart 5). Effectively, standards were unchanged as 96 of the 100 respondents to the survey reported no change from Q3. Slightly lower risk tolerance from banks contributed to tightening while lower risk perceptions related to the general economic outlook and the value of collateral had an easing effect. As in the US, standards in the euro area do show a correlation to overall financial conditions. Those have already tightened noticeably since the February 3rd meeting of the European Central Bank (ECB) Governing Council where President Lagarde set a more hawkish tone. While banks do expect a slight easing of standards over Q1/2022, that is unlikely given high inflation and geopolitical uncertainties which will negatively impact risk perceptions. Chart 5Euro Area Credit Conditions Chart 6Credit Demand In Major Euro Area Economies Loan demand growth from enterprises was remarkably strong in Q4, with 18% of firms reporting increased demand for loans (middle panel). The main driver was increased demand for inventories, followed closely by fixed investment and merger & acquisition needs. Loan demand leads realized growth in inventories, which has been already been picking up. In Q1, banks expect continued growth in loan demand, albeit at a slower pace. On the consumer side, however, loan demand only increased slightly, with the pace of growth slowing from the previous quarter (bottom panel). This was in line with consumer confidence taking a hit from rising inflation and the Omicron variant in the fourth quarter. The generally low level of interest rates had a small positive impact, while durable goods spending had a slight negative impact on consumer credit demand. Lenders expect moderate growth in consumer credit demand in Q1. Moving to the four major euro area economies, demand for loans to enterprises picked up in Germany, France, and Italy, while remaining unchanged in Spain (Chart 6). Fixed investment needs made a positive contribution across the board. This is corroborated by data on total lending, which is still growing on a year-on-year basis, even though the pace of growth is slowing in all the major euro area economies except Spain. UK In the UK, overall corporate credit standards eased slightly in Q4/2021, marking the fourth straight quarter of easing (Chart 7). However, there was dispersion along firm size. Large private non-financials accounted for all the easing and standards for small and medium firms actually tightened slightly. Going forward, lenders expect a further easing in standards in Q1, about on par with the easing seen in Q4. Chart 7UK Credit Conditions Chart 8UK Lenders Expect A Robust Growth To Ease Credit Availability On the demand side, lenders reported slightly weaker corporate demand for lending in Q4. Again, the results were uneven across firm size – loan demand from large firms strengthened moderately, while demand from small and medium firms weakened. On average, lenders expect a slight pickup in corporate demand over Q1. Moving to the UK consumer, demand for unsecured lending continued to rise at a brisk pace, hovering around the highest levels since Q4/2014 (bottom panel). Going forward, lenders expect a continued increase in demand, but at a much slower pace. The strong developments in loan growth are seemingly at odds with the GfK consumer confidence index which has declined a total of 12 points since its July peak. Although the Bank of England does not survey respondents on the factors driving household unsecured lending demand, the divergence between confidence and loan demand suggests that precautionary demand for liquidity is playing a role. This lines up with the GfK survey, where expectations for the general economic situation over the next year are in freefall with consumers bracing for high inflation and further Bank Rate increases. Pivoting back to the drivers of corporate lending, the leading factor behind increased credit availability was an improvement in the overall economic outlook, followed by market share objectives (Chart 8). In contrast to the UK consumer, lenders are bullish on the economic outlook and believe it will continue to drive further easing over Q1/2022. On the demand side, investment in commercial real estate, which has seen steady improvement since Q3/2020, was the leading factor. This was followed by merger & acquisition and inventory financing needs. Capital investment needs, meanwhile, were a drag on demand. Moving forward, real estate investment and inventory restocking needs are expected to drive demand. Japan In Japan, credit standards to firms and households continued to ease in Q4/2021 (Chart 9). However, more than 90% of respondents in each case reported that standards were basically unchanged, and there were no reported instances of tightening among the sample of 50 lenders. Those that did report easier standards cited aggressive competition from other banks and strengthened efforts to grow the business. The vast majority of lenders expect standards to remain unchanged over Q1, but there is a slight easing expected on a net percentage basis. Chart 9Japan Credit Conditions Business loan demand on the whole was unchanged in Q4 although small and medium firms did increase demand slightly (middle panel). In contrast to other regions, business loan demand tends to behave counter-cyclically in Japan, with businesses borrowing more on a precautionary basis when they are pessimistic and vice-versa. Those dynamics were at play in Q4, with lenders attributing increased demand to a fall in firms’ internally generated funds. Banks expect a slight net pickup in demand next quarter, in line with business confidence which has fallen from its September peak on the back of concerns about Covid-19 infections, supply chain disruptions, and rising input prices. On the consumer side, loan demand was basically unchanged, with a very small net percentage of banks reporting weaker demand (bottom panel). The key reason for decreased demand was a decrease in household consumption, which is in line with retail sales, where the pace of growth has been falling. Even though core inflation in Japan is low, consumers are still exposed to rising energy prices, which might cause them to tighten other parts of their budgets. Canada Chart 10Canada Credit Conditions In Canada, business lending standards continued to ease at a slightly slower pace in Q4/2021 (Chart 10). This marks the fourth consecutive quarter of easing conditions, coming amid booming economic activity, high capacity utilization, and buoyant sentiment. Both, price and non-price lending conditions eased at roughly the same pace. On the consumer side, non-mortgage lending conditions continued to ease, but at a slower pace (middle panel). 1-year ahead consumer spending growth expectations, sourced from the Bank of Canada’s (BoC) Survey Of Consumer Expectations, and non-mortgage lending conditions typically display an inverse correlation, with expected spending growth increasing when standards are getting easier on the margin and vice-versa. The divergence in Q4 is explained in part by excess savings accumulated during the pandemic that have yet to be spent down, and in part by expected price increases over the coming year. In either case, it demonstrates that nominal spending has room to grow even in an environment where consumer credit availability is worsening. We also saw mortgage standards ease at a slightly slower pace in Q4, with both price and non-price lending conditions easing (bottom panel). While the BoC has made a hawkish pivot, underlying conditions are still easy – the conventional 5-year mortgage rate is still flat at 4.79%, the same level as Q3/2020. However, house price growth has peaked, and rate hikes this year will help prices moderate further. New Zealand Chart 11New Zealand Credit Conditions In New Zealand, business credit standards eased in the six month period ended September 2021 (Chart 11). However, the real impact of the Reserve Bank of New Zealand’s (RBNZ) tightening is being felt in the housing market, where actual standards entered tightening territory. More importantly, a net 23.1% of respondents expect mortgage credit availability to erode by the end of March; if realized, this figure would be a series high. Banks reporting less credit availability cited regulatory changes and risk perceptions. On the mortgage loan demand side, banks continued to see increased demand even after the record spike in March 2021 (middle panel). Going forward, demand is expected to moderate and fall from current levels. These dynamics have already made their mark on house prices which have already peaked, indicating that the RBNZ’s push is working as intended. Business loan demand does not appear to have been much affected by higher rates, with demand picking up slightly and expected to increase going forward (bottom panel). However, confidence has been falling since September 2021, with businesses feeling the twin bite of supply chain disruptions and labor shortages. Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Appendix: Where To Find The Bank Lending Surveys A number of central banks publish regular surveys of bank lending conditions in their domestic economies. The surveys, and the details on how they are conducted, can be found on the websites of the central banks: US Federal Reserve: https://www.federalreserve.gov/data/sloos.htm European Central Bank: https://www.ecb.europa.eu/stats/ecb_surveys/bank_lending_survey/ Bank of England: https://www.bankofengland.co.uk/credit-conditions-survey/2021/2021-q4 Bank of Japan: https://www.boj.or.jp/en/statistics/dl/loan/loos/index.htm/ Bank of Canada: https://www.bankofcanada.ca/publications/slos/ Reserve Bank of New Zealand: https://www.rbnz.govt.nz/statistics/c60-credit-conditions-survey Footnotes 1 The weblinks to each individual survey for the US, euro area, UK, Japan, Canada and New Zealand can be found in the Appendix on page 12. GFIS Model Bond Portfolio Recommended Positioning Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Duration Regional Allocation Spread Product Tactical Overlay Trades
Highlights A feedback loop has emerged in European markets. Tightening financial conditions will preempt the European Central Bank from hiking rates as much as the money market is pricing in. The widening in peripheral and credit spreads is overdone. Investors already long should maintain their positions. Investors without exposure will soon find an attractive entry point. Despite these near-term gyrations, the ECB is still on track to hike interest rates once in Q4 2022 and lift them aggressively in 2023. Feature Last week’s hawkish pivot by the European Central Bank (ECB) continues to affect markets. We take the words of the ECB at their face value; we anticipate the Governing Council (GC) to begin lifting interest rates at the end of 2022 and to continue to do so steadily over 2023 and 2024. However, as the shock filters through financial asset prices, we become more confident that the ECB will not lift rates five times in 2022 as the Euro Short Term Rate (ESTR) curve currently anticipates. Chart 1Growing Tensions In The Periphery... First, the behavior of Italian and Greek bond markets constitutes a major support to our view. Italian and Greek 10-year spreads have widened by respectively 46 and 65 basis points over the past six trading days (Chart 1). This tension highlights that investors still view these economies as continental trouble spots. Meanwhile, the ECB’s communication continues to highlight the need for flexibility to maintain order in the sovereign debt market. The GC does not want inadvertently to engineer a severe tightening in financial conditions in the already fragile periphery. In this context, it is highly unlikely that the ECB will rush to terminate the Asset Purchase Program (APP), an end on which rate hikes depend. Second, the corporate bond market is also going through a significant period of ruction. Both investment grade and high-yield bond yields have risen rapidly in recent days, and they are now retesting their late-2018 levels (Chart 2, top two panels). Spreads too are widening meaningfully, even though they remain further away from their 2018 highs (Chart 2, bottom two panels) The ECB is unwilling to let a liquidity shock morph into a solvency problem for European firms. For now, the behavior of the European credit market remains consistent with a liquidity shock. Funding markets are experiencing a violent adjustment, which is bleeding into the overall level of spreads. However, investors are not differentiating based on credit risk. Chart 3 shows that CCC credit (the lowest rated HY bonds) is not selling off relative to the overall high-yield index, which we would anticipate if investors were worried about underlying default risk. Chart 3No Distinction On Credit Risk Chart 2...And In European Corporates If the liquidity shock were to deepen further and last long enough, the resilience of the corporate sector would fritter away. However, the GC has tried to resist a deflationary shock for more than ten years now, and a solvency problem would undo all the progress made toward escaping the European liquidity trap, especially because wages have yet to recover. Third, members of the ECB’s GC are already trying to talk down the market. President Christine Lagarde displayed a more dovish tone when she spoke in front of the EU Parliament on February 7, 2022. ECB Chief Economist Philippe Lane remains steadfast that wages are not yet a problem. The Governor of the Bank of France, François Villeroy de Galhau still sees an imminent peak in CPI, and Olli Rehn, Governor of the Bank of Finland, recently lectured about the need for a gradual normalization of policy. Even hawks like the Bundesbank’s Joachim Nagel or the DNB’s Klaas Knot have gestured toward higher rates, but only toward the end of the year. In this context, we expect credit spreads to begin to narrow again; however, it will likely first require an easing in funding pressures. This is unlikely to happen until US yields form an interim peak. However, as Chart 4 highlights, the Treasury market is becoming extremely oversold. Moreover, a JP Morgan survey shows that its clients are massively short duration. The risk of a pullback in Treasury yields is growing, even if rising inflation and fears of a tighter Fed prevail for now. If US yields were to decline Bunds would likely follow the Treasury market because the ECB is becoming louder that it does not want to tighten financial conditions abruptly. Hence, a pullback in global risk-free yields will be the key to a period of calm in credit spreads, since valuations have improved materially, with the breakeven spreads on investment grade and high-yield bonds moving back to their 43rd and 44th percentiles, respectively (Chart 5). A stabilization in global yields and European spreads should also percolate to the peripheral sovereign bond market and limit the upside to Italian and Greek spreads. Chart 4Oversold Treasurys Chart 5Restoring Value In Corporates Bottom Line: The tightening in financial conditions taking place in Europe indicates that money market curves are pricing in the path for European policy rates too aggressively. The ECB has changed since 2011. It will not let peripheral borrowing costs threaten the recovery in Southern European economies, nor will it allow a liquidity shock in the corporate bond market to become a solvency issue that will damage growth prospects. European peripheral and corporate spreads will narrow once global risk-free rates peak. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com
Executive Summary The Pandemic-Led Surge In E-Commerce Spending Is Reverting Back To Trend Rising interest rates and a cooling in pandemic-related tech spending will cap the upside for technology shares over the remainder of 2022. Looking further out, US big tech companies are likely to suffer from heightened competition in increasingly saturated markets. Concerns about big tech’s excessive market power, cavalier attitudes towards personal data, proclivity for censoring non-establishment opinions, and the deleterious impact of social media on teenage mental health are all fueling a public backlash. Investors should expect increased regulation and antitrust enforcement of big tech companies in the years ahead. Bottom Line: The hegemony of today’s US-based big tech companies is coming to an end. While we do not expect tech stocks to decline in absolute terms in 2022, they will lag the S&P 500. Given tech’s heavy representation in the US, investors should underweight the US in a global equity portfolio. Sinking Ark Tech stocks have had a tough ride since the start of the year. So far in 2022, the NASDAQ Composite has fallen 9.3% compared to 5.5% for the S&P 500. The ARK Innovation ETF, Cathie Wood’s collection of “disruptor” companies, has dropped -22%, and is now down -53% from its peak last year (Chart 1). We expect tech shares to lag the market during the remainder of 2022. The pandemic was a boon for many tech companies. Generous stimulus payments and stay-at-home policies led to a surge in e-commerce spending (Chart 2). As economies continue to reopen, many tech companies could face an air pocket in demand for their goods and services. Chart 1Tech Stocks: Rough Start to 2022 Chart 2The Pandemic-Led Surge In E-Commerce Spending Is Reverting Back To Trend Despite some softening of late, retail sales remain well above their pre-pandemic trendline (Chart 3). If Amazon’s still-rosy projections are any guide, a further slowdown in goods spending is something that the analyst community is not fully discounting (Chart 4). Chart 3US Retail Spending Is Above Trend Chart 4Amazon Sales Estimates May Be Too Optimistic Rate Hikes Will Disproportionately Hit Tech Chart 5Long Rates Anticipate The Movements In Short Rates US rate expectations continued to move up this week, egged on by St. Louis Fed President James Bullard’s statement earlier today declaring that he favors raising interest rates by a full percentage point by the start of July. The market is now pricing in six rate hikes by the end of the year. Historically, bond yields have increased starting about four months before the first rate hike and over the period in which the Fed is raising rates (Chart 5). While we do not think the Fed will need to deliver more tightening this year than what is already discounted, we do think that investors will eventually be forced to revise up their expectations of the neutral rate to between 3%-and-4%. As Chart 6 shows, the market expects the Fed to stop raising rates when they reach 2%, which we regard as unrealistic. Chart 6The Market Thinks The Fed Will Not Be Able To Lift Rates Above 2% An increase in the market’s estimate of the neutral rate will push up bond yields. Unlike banks, tech tends to underperform in a rising yield environment (Chart 7). Priced For Perfection? Higher bond yields and a reversion-to-trend in tech spending would be less of a problem for technology shares if valuations were cheap. They are not, however. The Nasdaq Composite still trades at 29-times forward earnings compared to 20-times forward earnings for the broader S&P 500 (Chart 8). Chart 8Tech Shares Are No Bargain Chart 7Rising Bond Yields Will Help Bank Stocks But Hurt Tech Shares Tech investors would argue that such a hefty valuation premium is warranted given the tech sector’s superior growth prospects. Underlying this argument is the assumption that just because tech spending will grow more quickly than the rest of the economy, this will necessarily translate into above-average earnings growth and outsized returns for publicly-listed tech companies. But is that really the case? Over short horizons of a few years, there is a decent correlation between relative industry growth and relative equity returns (Chart 9). However, that relationship evaporates over very long-term horizons (Chart 10). In fact, since 1970, the best-performing equity sector has been tobacco, hardly a paragon of technological innovation (Chart 11). Chart 9Stocks In Industries That Experience A Burst Of Output Growth Do Tend To Outperform Other Stocks … Chart 10… But Over The Long Haul, Companies In Fast- Growing Industries Do Not Outperform Their Peers Chart 11Tobacco Industry Returns Have Smoked All Others What Goes Around Comes Around Table 1History Shows Leaders Can Become Laggards Tech stock enthusiasts tend to forget that the disruptors themselves can be disrupted. History is littered with tech companies that failed to keep up with a changing world: RCA, Kodak, Polaroid, Atari, Commodore, Novell, Digital, Sinclair, Wang, Iomega, Corel, Netscape, AltaVista, AOL, Myspace, Compaq, Sun, Lucent, 3Com, Nokia, Palm, and RIM were all major players in their respective industries, only to fade into oblivion. Table 1 shows that all but one of the ten biggest tech names in the S&P 500 IT index in 2000 underperformed the broader market by a substantial degree over the subsequent ten years. Today, the incentive for startups to emerge has never been stronger. Venture capital funds are flush with cash. Tech profit margins are near record highs, making challenging the incumbents an increasingly enticing goal. About one-third of the outperformance of US tech stocks since 1996 can be explained by rising relative profit margins, with faster sales growth and relative P/E multiple expansion explaining 45% and 23% of the remainder, respectively (Chart 12). Chart 12Decomposing Tech Outperformance Meta’s Malaise Chart 13Unlike Economists, Facebook Just Ain't Cool No More Which of today’s tech titans could join the “has been club”? As we flagged in August, Meta is certainly a possibility. In its disastrous quarterly earnings report, the company revealed that globally, the number of Facebook users is shrinking for the first time ever. While this came as a surprise to many investors, the writing has been on the wall for a long time. According to Piper Sandler’s survey of teen preferences conducted late last year, only 27% of teenagers used Facebook, down from 94% in 2012 (Chart 13). Meta has been fortunate in that many Facebook users have migrated to Instagram, a social media platform it acquired in 2012. Unfortunately, the latest data suggests that even Instagram usage is starting to slow as more young people flock to TikTok. Google Also Vulnerable Unlike Meta, Alphabet crushed earnings estimates. However, the similarities between the two companies may be greater than most investors are willing to admit. Like Facebook, Google’s profits almost entirely come from ad spending. According to eMarketer, Google garnered 44% of digital ad spending in 2021 while Facebook took in 23%. Digital advertising accounted for 63% of all ad spending in 2021, up from 58% in 2020 and 51% in 2019. While there may be scope for digital ads to take further market share, eventually, growth in digital ad spending will converge with overall consumption growth, which in the US is likely to average no more than 2% in real terms over time. Monopoly Power Another important similarity between Meta and Alphabet is that both companies are increasingly coming under scrutiny from politicians and regulators. The antitrust case brought against Alphabet by 14 US states contains a litany of allegations of unfair practices. After an initial failed attempt, the Federal Trade Commission’s antitrust suit against Meta is also moving forward. Privacy Matters In addition, the way big tech companies handle private data is raising some hackles. In its annual report filed earlier this month, Meta warned that it would need to shut down Facebook and Instagram in Europe unless regulators drew up new privacy regulations. This came on top of Meta’s disclosure that it will lose $10 billion this year after Apple introduced pop-ups on the iPhone’s operating system asking users if they wanted to be tracked by apps. Turn Off That Phone! Another looming worry revolves around the corrosive impact of excessive social media usage on mental health. Academic studies have shown that adolescents who use Facebook and Instagram frequently feel greater anxiety and unease than those who do not. The share of students reporting high levels of loneliness more than doubled in both the US and abroad over the past decade, a trend that predates the pandemic (Chart 14). In 2020, the last year for which comprehensive data is available, one-quarter of US girls between the ages of 12 and 17 reported experiencing a major depressive episode, up from 12% in 2011 (Chart 15). Chart 15The Rise In Depression Rates Coincided With Increased Social Media Usage Chart 14Alone In The Crowd Backlash Public contempt for tech companies is fueling a political backlash. According to a Gallup poll conducted last year, only 34% of Americans held a favorable view of tech companies such as Amazon, Facebook, and Google, down from 46% in 2019; 45% had an unfavorable opinion, up from 33% in 2019 (Chart 16). Chart 16Americans Do Not Hold Tech Companies In High Regard The shift in public sentiment over the past two years has been entirely driven by Independent and Republican voters, many of whom feel that tech companies are unfairly censoring their opinions (Table 2). The same poll revealed that the majority of Americans – including the majority of Republicans – now favor increased regulation of tech companies. Table 2American Views On Big Tech Investment Conclusions Chart 17Value Stocks Are Cheap Considering that global growth is likely to remain above-trend this year, we do not expect tech stocks to decline in absolute terms. A flattish, though volatile, trajectory is the most plausible outcome. In relative terms, however, tech stocks will underperform. Despite having outperformed tech-heavy growth stocks by 14% since last November, value stocks remain exceptionally cheap by historic standards (Chart 17). Tech stocks are overrepresented in the US. Thus, if tech continues to underperform, it stands to reason that non-US equities will outperform their US peers over the coming years. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Executive Summary A Floor In Biden’s Approval? Biden’s approval rating is forming a bottom. Democrats will pivot away from Covid-19 to boost the economy and consumer sentiment. While Democrats face a dismal midterm election, Republican infighting could conceivably cost the GOP control of the Senate. Policy uncertainty will rise as the election approaches. Republican infighting is unlikely to affect the outcome in the House of Representatives, although Republicans could lose three-to-nine seats that they might otherwise hold if the party establishment fails to coordinate effectively with former President Trump as we expect. Our tactical trades hinge on Biden’s near-term external risks: the risk of an energy shock that weighs on Treasury yields and pushes up the dollar. Defensives like health care should benefit. Our cyclical recommendations continue to favor cyclical equities such as small cap energy stocks. Bottom Line: Investors should be tactically prepared for geopolitical risks to push up the dollar and push down Treasury yields in the short run, contrary to the cyclical BCA House View. Feature Has Biden’s Approval Hit The Floor? Probably. President Biden’s net approval rating is still under water at -9%, only slightly better than President Trump’s at this stage in the approach to the 2018 midterm elections. Biden’s handling of the economy receives a lower approval rating, which is dangerous for his party because the economy is likely to be the most important issue in the midterm election, given that the Covid-19 pandemic is waning. If Biden follows the path of his predecessors then his approval rating will trend upward as the midterm approaches. That will not prevent a Republican victory in the House but it could affect the Senate and the size of the Republican majority (Chart of the Week). The latest jobs report saw 467, 000 new jobs created. The labor participation rate grew from 81.9% to 82%, while women’s participation rose from 56.5% to 56.8%. The unemployment rate ticked up from 3.9% to 4%, with the broader U6 measure rising from 7.2% to 7.9%, but the reason was that more workers joined the workforce, which is a good thing for the economy (Chart 1). The Omicron variant of the Covid-19 virus is having little impact so the labor market is continuing to heal, a positive for the Biden administration, which is otherwise struggling. Chart 1A Solid Jobs Report American sentiment about the economy will hinge on inflation. If inflation abates along with the virus then the Democratic Party will be able to pare some losses in the midterms. At the moment the polarization of economic sentiment – divergence based on partisan affiliation – is declining, but for reasons that will give the administration a headache. Democratic sentiment is falling while Republican sentiment is improving (Chart 2). If inflation stays high, Republican sentiment will tick back down and the public will be increasingly united in a negative view of the president’s economic management. If inflation peaks and rolls over, Democratic sentiment will recover as the election approaches and Republican sentiment will at least not get much worse. Chart 2Economic Sentiment Polarization In Decline For this reason Biden and the Democrats are rapidly pivoting away from Covid-19 and social restrictions and trying to create the “return to normalcy” that failed last year. While they were in the opposition they had an interest in hyping the virus but now they are the incumbents and it is important to show that the pandemic is in the rear-view mirror. With 64% of Americans now vaccinated, and 40% having received booster shots, government social restrictions are likely to become less stringent (Chart 3). The latest data from the service sector will motivate this policy pivot away from the virus. The manufacturing sector improved again last month but the non-manufacturing sector was less upbeat in January. Services activity declined by a whopping 12% in January. It is still above its November 2020 level, when Biden got elected, but only by around 2.2%. The non-manufacturing employment index declined by 4.3% and only stands 0.8% above its November 2020 level. The ratio of new orders to inventories declined by 0.6% in January (Chart 4). Chart 3Democrats To Pivot Away From Covid-19These statistics suggest that the non-manufacturing sector slowed down sharply in January, probably due to omicron and post-Christmas belt tightening. But employers did not let go of a lot of workers, as seen by the discrepancies between business activity and employment. The mostly positive jobs report reinforces this point. The weakness is seen as temporary and employers expect higher demand in coming months. Now that consumer durable spending is running out of steam (at least, excluding cars), consumers are likely to switch to consuming services, as long as services are open for them to consume. There is little reason to think restrictions will stay tight, given the political points cited above. Even in Europe the Covid “hawks” are loosening controls. Chart 4Democrats Want To Boost Service Sector All that being said, the Biden administration has limited ability to control inflation that emanates from foreign supply shocks (e.g. Asia, Russia, Iran). Also voter perceptions of inflation will lag, even if inflation starts to abate. Crime and immigration will also weigh on the administration this fall. And the political clockwork favoring the opposition in midterm elections is remorseless. Bottom Line: Biden and the Democrats are likely to shift policy focus away from emphasis on the pandemic, which weighs on the service sector and employment, and instead pursue other policy options in preparation for the midterm election. The outlook is not positive but if Biden’s approval rating bottoms then Democrats’ chances of performing better in the midterm elections will rise and policy uncertainty will also rise. Will GOP Infighting Affect The Midterms? Maybe In The Senate Former President Trump clashed with former Vice President Mike Pence and others in the Republican Party over whether Pence had the right “to change the Presidential Election results” in 2020 by refusing to validate electoral college votes from states in which electoral fraud was alleged. Pence called the idea “un-American” and reiterated his position that the vice president has no “unilateral authority” to discard a state’s electoral votes while certifying the electoral count.1 Trump lashed out because moderate Republicans are flirting with Democrats over how to pass a bipartisan revision to the Electoral Count Act of 1887, which left a number of ambiguities in the US electoral process, including about the vice president’s role in election certification. It is conceivable that the law will be revised in time for the 2024 election but odds are against a quick solution: the original law took 10 years to pass. Throughout the 2022-24 election cycle, Trump will continue to clash with his party, which raises the single greatest risk to Republicans: that they will be too divided to capitalize fully on the Democrats’ weaknesses. We do not expect Trump to coordinate effectively with Republicans. His interest in revolutionizing the political establishment and winning a second term in 2024 diverges from the interest of the traditional Republicans, who want to preserve the political establishment with themselves on top, and want a fresh face to contend for eight years in the White House in 2024. However, Trump controls a plurality of the party’s grassroots voters (about 54%2 according to opinion polls) so that the Republican Party cannot afford to spurn him. If Trump were willing to cooperate with party leaders, then he would have cooperated when it mattered most: ahead of the Georgia special elections on January 5, 2020. If he had recognized the constitutional supremacy of the electoral college vote, he might have saved Republican control of the Senate. He did not, so the burden of proof falls on those who say that Trump can coordinate effectively with the Republican Party at critical junctures. Most likely the party will continue to play both sides, keeping Trump in the party but seeking a post-Trump future. Trump will continue to pursue the Republican nomination in 2024 and the party will have to acquiesce to him as long as he retains the support of a majority of the party’s grassroots. Trump’s conflict with the party will flare up in the primary elections this spring because Trump will endorse his own favorite candidates regardless of whether the Republican establishment agrees and views them as the most likely to win. Any success of Trump-backed populists in the primaries may become a liability for Republicans in the general election if the seat is competitive and the Democrats put up a moderate candidate. This point is primarily relevant in the Senate: Five Senate Republicans are stepping down, leaving an open competition in Alabama, Missouri, North Carolina, Ohio, and Pennsylvania (Table 1). The last three of these (NC, OH, PA) are competitive seats, especially if the Republican candidate is weak and Biden’s approval revives by the time of the vote. Trump has only made an endorsement in North Carolina, where his candidate is far from assured to win. Given that control of the Senate could hang on a single seat, it is at least possible that Trump’s split with the GOP could affect the Senate balance of power in 2023-24. Table 1Senate Incumbents Not Seeking Re-Election, 2022 Trump will also have an impact on the House of Representatives but he is less likely to affect the outcome of the midterm there, given that Republicans are likely to win 40 seats when they only need five to take control. There are a lot more Democrats retiring from the House than Republicans in this cycle, a positive indication for Republicans (Chart 5). In total there are 48 competitive seats (13 Republican-leaning, 22 Democrat-leaning, and 13 toss-up).3 Of these 48 competitive seats, 12 seats are “open” (no incumbent), divided evenly among Republicans and Democrats. In most of these competitive seats, but especially in Democrat-leaning seats and toss-up seats, a Trump-backed Republican will have a harder time winning than a traditional Republican. All ten Republicans who voted to impeach President Trump after the January 6 rebellion are vulnerable to Trump challengers (Table 2). Three are already retiring. Given that Wyoming Representative Liz Cheney won her seat by a 44% margin, and yet is polling poorly relative to her Trump-backed challenger, it is fair to say that all seven of the remaining Republican impeachers are vulnerable to a Trumpist challenge. Of these, the general election could be competitive in five seats, i.e. those held by John Katko (R, NY-24), David Valadao (R, CA-21), Peter Meijer (R, MI-3), Fred Upton (R, MI-6), and Jaime Herrera Beutler (R, WA-3). However, given that the national tide does not favor the Democrats, five seats is the maximum that Democrats could poach from this group of lawmakers due to Republican infighting (three is a more likely number). Chart 5House Members Not Seeking Re-Election, 2022 Table 2House Republicans Who Voted To Impeach President Trump More broadly there are 21 moderate Republicans in the House whose seats could be vulnerable to intra-party struggle (Table 3): So far President Trump has only endorsed candidates in seats which Republicans are highly likely to win anyway: namely Beth Van Duyne (R, TX-24), Mario Diaz-Balart (R, FL-25), and Carlos Gimenez (R, FL-26). But as the primary heats up, Trump’s endorsements could cause more tension with the Republican Party machinery. The following six moderate Republicans’ seats could be at risk: Maria Elvira Salazar (R, FL-27), Rodney Davis (R, IL-13), Jeff Van Drew (R, NJ-2), Andrew Garbarino (R, NY-2), Mike Turner (R, OH-10), and Brian Fitzpatrick (R, PA-1). Of these, Fitzpatrick and Garbarino do not face any challengers yet, and only Davis faces a Trump-backed challenger. So six is the maximum Democrats could steal while one-to-three vulnerable seats is more likely. Table 3Republican Moderates Vulnerable To Populist Challengers Summing up, the Republican Party could fail to retain three-to-nine Republican seats that they might otherwise win in this cycle. Previously we put the number at five-to-nine seats. These numbers do not include any Democratic-leaning seats that Republicans could fail to poach if they choose a populist candidate who is not competitive in a “purple” state or district. In conclusion, Republican infighting will not prevent Republicans from retaking the House of Representatives this fall. Cyclical factors in favor of Republicans will overwhelm their internal differences. But infighting could leave them with a smaller majority than consensus expects. In 2024 Republican internal divisions will become much more important than in 2022. A competitive Republican primary election for president will reduce Republican odds in the general election. If President Trump fails to win the nomination, he could defect and form his party. If he wins the nomination, Liz Cheney or another traditional Republican could defect and run as a third party, acting as a spoiler. Given the tight margins of victory in presidential elections, even a splinter group could steal enough votes to determine the outcome. The midterms will shed light on the depth of GOP divisions but in general these divisions reinforce our view that while Democrats will perform poorly in the midterms, they are still favored to retain the White House in 2024. Bottom Line: While the odds are stacked against Democrats in the midterms, Republican infighting could affect several Senate seats and will subtract anywhere from three-to-nine seats from expected seat gains in the House. While control of the House will not be affected, it is conceivable that control of the Senate could hang in the balance. Policy uncertainty will rise if Republican infighting makes Senate races more competitive later this year. Housekeeping To conclude we offer a few remarks on our outstanding investment recommendations: Cyclically Long Energy Small Caps: US energy production is rising in keeping with global oil and commodity prices. West Texas Intermediate crude sells for $89 per barrel on the spot market, inventories are drawing, OPEC 2.0 is intact, and there are plenty of supply risks on the horizon. American natural gas exports are picking up but not enough to meet demand if conflict in Ukraine causes a European shortage, while US oil exports are falling (Chart 6). Chart 6US Energy Production Picking Up Evidence from initial unemployment claims in O&G-dependent states like North Dakota and Wyoming suggests that shale producers need more time to ramp up production (Chart 7), as highlighted by our Commodity Strategist Bob Ryan. Small cap energy stocks have not benefited much from the sharp spike in energy prices this year. We see this as an opportunity, given that US small caps are insulated from geopolitical troubles and will become key players if shortages occur (Chart 8). The risk comes if the supply response overwhelms the supply disruptions, as occurred in 2014 – but oil companies were in a much better position to surge production at that time. The 2015 nuclear deal with Iran also appeared more durable at that time than it will this year if it is rejoined, and there is no guarantee it will be rejoined. Cyclically Long Infrastructure Stocks: Infrastructure stocks peaked along with the equity market and in the wake of the Biden administration’s $550 billion Infrastructure Investment and Jobs Act, which is now being implemented. Indicators of infrastructure construction peaked in late 2020 and early 2021 and are slipping of late. But as long as the economy does not relapse into recession they should stabilize, especially as the virus wanes and global demand recovers (Chart 9). Cyclically Long Cyber-Security Stocks: Global threats, proxied by the Canadian dollar’s exchange rate with the Russian ruble, suggest that cyber security stocks will rebound after getting caught up in the current tech selloff (Chart 10). Tech stocks are also likely to bounce if inflation expectations peak as the Federal Reserve kicks into action. Chart 7It Takes Time To Boost Shale Output Chart 8US Small Caps Yet To Benefit From Oil Price Chart 9Buy The Dip In Infrastructure Stocks Chart 10Cyber Stocks A 'Buy' In Tech Selloff Investment Takeaways Chart 11A Floor In Biden’s Approval? US financial markets do not care about the midterm elections in the near term but that will change as policy uncertainty will rise over the course of the year. A bottom in Biden’s approval rating (Chart 11) and Republican primary election infighting both suggest that the Democratic Party’s odds in the midterms will improve going forward, raising policy uncertainty, especially over the Senate. Midterm uncertainty typically works in favor of the US dollar, Treasuries, defensive equity sectors, and growth stocks. As such it poses a risk to current market trends. The recent selloff in Big Tech confirms what we have argued since we launched the US Political Strategy: the tech sector faces a slow boil from inflation and rising interest, which are more immediate threats than government regulation. Having said that, we favor growth versus value on a tactical basis as we expect the dollar to rise and Treasury yields to fall on the back of geopolitical risks in the near term (Chart 12). Chart 12A Tactical Bounce For Tech Stocks? Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.kuri@bcaresearch.com Footnotes 1 See Vice President Michael R. Pence’s letter, dated January 6, 2021, available at “Read Pence’s full letter saying he can’t claim ‘unilateral authority’ to reject electoral votes,” PBS, pbs.org. See also Mychael Schnell, “Trump says he wanted Pence to overturn election, eyes effort to reform law,” January 31, 2022, and Brett Samuels, “Pence breaks with Trump: ‘I had no right to overturn the election,’” February 4, 2022, thehill.com. 2 Please see “Over half of Americans believe the country's economy is headed in the wrong direction,” Ipsos, December 29, 2021, Ipsos.com 3 See Cook Political Report, “2022 House Race Ratings,” February 8, 2022, cookpolitical.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 The End Of The Negative Bond Yield Era Recent price action in developed market government bond markets confirms a backdrop that has been in place for the past several years - movements in US Treasuries define the trend in global yields, but Europe sets the effective floor. Higher core European bond yields are also pushing up non-European yields, in the context of the current global monetary policy tightening cycle. The hawkish market pricing for the ECB this year has gone a bit too far, as the start of European rate hikes this year is more likely in Q4 than in the summer – and only after ECB asset purchases begin to formally wind down. In the UK, the Bank of England appears to be trying to front load policy tightening, both rate hikes and balance sheet runoff, in response to overshooting UK inflation. A shorter, sharper policy tightening cycle means that the UK Gilt curve will continue to bear-flatten. Bottom Line: Within the “Big 3” developed market central banks, the Fed and Bank of England are more likely to deliver discounted rate hikes than the ECB over the next 6-12 months. Remain underweight US Treasuries and UK Gilts versus German Bunds in global bond portfolios. Feature Chart 1A Global Repricing Of Interest Rate Expectations Persistent elevated inflation readings are forcing policymakers to move up the timetable of expected cyclical interest rate increases, but without signaling any change to longer-term interest rate expectations. The result has been an upward move in bond yields led by a repricing of shorter-term yields, leading to bearish yield curve flattening pressure across the developed markets (Chart 1). As the global bond bear market has intensified and broadened across countries and fixed income sectors, the amount of bonds worldwide with negative yields has been slashed by $9 trillion since December (Chart 2). Some notable examples: the 10-year German Bund yield is now up to +0.26%, the 30-year US real TIPS yield is now at +0.04% and even the 5-year Japanese government bond yield climbed to +0.02% for the first time since 2016. Last week, bond markets had to digest both a 25bp Bank of England (BoE) rate hike - that was almost a 50bp move - and a huge upside surprise in the January US employment report. However, it was the more hawkish-than-expected messaging from the European Central Bank (ECB) that really rattled fixed income markets. At the February monetary policy meeting, ECB President Christine Lagarde opened the door to potential ECB rate hikes this year, a notable change from the previous forward guidance that rates would stay unchanged in 2022. This not only triggered a major decline in European government bond prices, but also notable jumps in bond volatility for both longer-term and, especially, shorter-term yields. Implied volatilities for swaptions on 2-year European swap rates now sit at the highest levels since the depths of the European Debt Crisis in 2011 (Chart 3). Chart 2The End Of The Negative Bond Yield Era Chart 3The Front-Ends Of Yield Curves Awaken Overnight index swap (OIS) curves are now discounting multiple rate hikes from the Fed (+127bps), BoE (+125bps) and ECB (+46bps) this year. Tighter monetary policy is the inevitable consequence of the current combination of steady above-trend growth, tight labor markets and very high inflation in those countries. This mix will continue to put upward pressure on global bond yields through a blend of steady inflation expectations and higher real yields as pandemic era monetary stimulus is removed – a process that is already underway in the US and Europe (Chart 4). Our Central Bank Monitors – designed to measure the cyclical pressure to change monetary policy – are all indicating the need for tightening in the US, UK and euro area. However, the risk is that tightening perceived to be too aggressive or too rapid will be received poorly by financial markets that have grown accustomed to easy money policies during the pandemic. Given the current starting point of high equity valuations and relatively tight corporate credit spreads in the US, financial conditions are no impediment to additional Fed rate hikes in 2022 (Chart 5). The same cannot be said in the UK, where the steady appreciation of the trade-weighted pound is tightening financial conditions, on the margin. In the euro area, financial conditions remain relatively stimulative, as the euro is undervalued on a trade-weighted basis. Chart 4A Recipe For Even Higher Bond Yields Given high realized inflation, financial stability concerns are playing a secondary role in the policy deliberations of central banks facing an inflation-fighting credibility crisis. In the absence of a big fall in inflation, it will take much larger selloffs in equity and corporate credit markets than what has occurred so far in 2022 before policymakers would step back from interest rate increases over the next year. Chart 5Financial Conditions Are No Impediment To Rate Hikes The ECB Will Lag The Fed On Rate Hikes Chart 6Faster Growth & Slower Inflation Expected In 2022 One of our highest conviction bond market views to begin 2022 called for US Treasuries to underperform German Bunds. Our view was based on the likelihood that the Fed would lift the fed funds rate multiple times this year and the ECB was likely to hold off on rate hikes until the first half of 2023 at the earliest. Last week’s shift in the ECB’s tone does not change that relative call. The Fed is still under far greater pressure to hike rates than the ECB, even if there is now a greater chance that the ECB could begin to tighten by the end of 2022. From an economic growth perspective, both central banks have good reasons to consider withdrawing monetary accommodation. The economic expectations in both the US and euro area have started to recover, according to the ZEW survey of financial market professionals, with a bigger bounce seen in the latter since the trough of last October (Chart 6). The fading Omicron wave is likely playing a large role in lifting economic expectations, as the variant has proven to be less lethal than previous waves of the virus. The ZEW survey also asks respondents about their views on future inflation and interest rate changes. The ZEW Inflation Expectations index has fallen back to pre-pandemic lows in both the US and euro area, indicating that a majority expect lower inflation in the US and Europe over the next year. Both the Fed and ECB also expect inflation to fall from current elevated levels this year. However, there is still a much stronger case for tightening in the US given the tight labor market that is pushing up wages. Last week’s January US payrolls data was a shocker, with employment rising +476,000 on the month when some forecasters were calling for an outright contraction in jobs due to the impact of the Omicron variant. Wage growth accelerated smartly, with average hourly earnings up 0.7% on the month and 5.7% on a year-over-year basis (Chart 7). This continues the trend of wage acceleration seen in other data series like the Employment Cost Index, confirming that the US labor market is tight enough to elicit a strong policy response from the Fed. In the euro area, the recent economic data has been a bit more mixed. The Markit manufacturing PMI rose to a five-month high of 59.0 in January, beating expectations. However, the services PMI fell to a nine-month low of 51.2 as renewed COVID lockdowns weighed on consumer confidence and spending (Chart 8). With Omicron numbers now slowing, some recovery in consumer spending is likely over the next few months as euro area governments reduce restrictions. However, the manufacturing recovery will struggle to gain significant upside momentum without stronger demand for European exports – an outcome that is not currently heralded by an upturn in reliable indicators like the global leading economic indicator or the China credit impulse (Chart 9). Chart 7Persistent US Labor Market Strength Chart 8A Mixed Picture On European Growth Even within the euro area inflation data, there are mixed trends that make it less clear that a major tightening cycle is necessary. Headline euro area HICP inflation hit a 37-year high of 5.1% in January, which was heavily influenced by a 28.6% rise in the energy component of the index (Chart 10). Goods price inflation reached 6.8%, its highest level since 1991, fueled by global supply chain disruptions and greater consumer demand for goods versus services during the pandemic. For the latter, services inflation reached a much more subdued 2.4% in January, in line with core HICP inflation of 2.3%. We expect goods price inflation to slow substantially, on a global basis and not just in Europe, as supply chain disruptions ease over the course of 2022 and consumers shift spending back towards services from durable goods as economies reopen post-Omicron. Chart 9A Gloomy Picture For European Exports Chart 10European Inflation Surge Focused On Energy & Goods Surging oil and natural gas prices will keep the energy component elevated over the next few months, particularly if geopolitical tensions over Ukraine result in Russia withholding natural gas supplies to Europe. Yet it is not clear how much of this will pass through to core inflation, which actually decelerated in January from the 2.6% pace seen in December 2021 despite surging energy prices. What does a typical ECB liftoff look like? Should the ECB focus more on the headline or core inflation numbers when deciding if rate hikes are necessary later this year? The answer may lie more in the breadth across countries, rather than depth across sectors, of euro area inflation pressures. In the relatively short history of the ECB, dating back to the inception of the euro in 1998, there have been only three monetary tightening episodes that involved interest rate increases: 1999-00, 2006-08 and 2011. In Chart 11, we show the percentage share of individual euro area countries that have accelerating growth momentum (measured as a leading economic indicator above the level of a year earlier), and with headline/core inflation above the ECB’s 2% target. In all three of those past ECB tightening episodes, essentially all euro area countries had to see strong growth or inflation at or above the ECB target before the ECB would hike rates. Chart 11The Growth & Inflation Conditions For An ECB Rate Hike Are In Place Chart 12Watch European Wages To Determine The ECB's Next Move(s) A similar story can be told looking at the state of the euro area labor market. The 1999-00 and 2006-08 tightening cycles occurred when nearly all euro area countries had an unemployment rate below the OECD’s estimate of the full employment NAIRU (Chart 12). Only in 2011, which was widely regarded as a major policy error, did the ECB hike rates without widespread labor market strength across the euro area. Right now, the breadth of the growth and inflation data across the euro area would indicate that the ECB will soon begin to tighten policy, if history is any guide. The one missing piece of the puzzle is faster wage growth. Euro area wage growth is severely lagging compared to other developed economies. For the last known data point in Q3/2021, wages were only growing at a 1.5% year-over-year rate. Wage growth has very likely accelerated since then, with the overall euro area unemployment rate now down to an all-time low of 7.0%, well below the OECD NAIRU estimate of 7.7%. The ECB will need to see confirmation of that faster wage growth in the data, however, before embarking on a path of rate hikes. Since last week’s ECB meeting, numerous ECB officials – including President Lagarde - have stated that asset purchases must stop before rate hikes can begin. While the ECB’s pandemic emergency bond buying program is set to end next month, the existing Asset Purchase Program is set to continue with no expiry date. If the ECB officials are to be taken at their word, it is very difficult to imagine a scenario where asset purchases would be fully wound down (i.e. net purchases of zero, with buying only to replace maturing bonds held by the ECB) before the July liftoff date now priced into the Euro OIS curve. Such a rapid removal of the ECB bid would be very disruptive to the riskier parts of European fixed income markets, like Italian and Greek sovereign debt, that have benefited from heavy ECB buying under the pandemic bond buying program. European bond strategy implications While an ECB rate hike in 2022 is now a more probable scenario, it is not yet a done deal. The European growth picture remains mixed, and inflation readings outside of supply-constrained energy and durable goods – including wages - are far less threatening than headline inflation. At the moment, underlying inflation pressures are far more intense in the US. Durable goods inflation in the US reached 16.8% on a year-over-year basis last month, but climbed to “only” 3.8% in Europe (Chart 13). The Cleveland Fed’s trimmed mean CPI index accelerated to 4.8% in January, compared to 3.0% for the euro area trimmed mean CPI inflation gauge constructed by our colleagues at BCA Research European Investment Strategy. Chart 13Stay Positioned For A Wider UST-Bund Spread The Fed has a lot more work ahead of it in terms of tightening monetary policy to rein in inflation pressures (and inflation expectations) than the ECB. This will lead to a faster pace of rate hikes in the US than in Europe and renewed widening of the US Treasury-German Bund yield spread. Financial conditions in Europe will also play a role in limiting when, and how much, the ECB can eventually tighten monetary policy. Yields and spreads on the riskier parts of the European fixed income markets like Italian government bonds have already widened substantially in response to the more hawkish guidance from the ECB (Chart 14). The euro has also stabilized after the steady depreciation seen since the May 2021 peak. Markets are obviously pricing in an end to ECB asset purchases – the precursor to rate hikes – which would force the private sector to absorb a greater share of Italian bond issuance than has been the case over the past few years. It will likely take higher yields to entice those buyers compared to the price-insensitive ECB that has been buying Italian debt as a monetary policy tool. The speed of the adjustment in Italian bond yields has no doubt alerted the ECB Governing Council to the financial stability risks of moving too fast on tightening monetary conditions. We must acknowledge that most the recent trends in the Treasury-Bund spread (narrower) and Italian bond yields/spreads (higher) go against our current strategic recommendations to overweight European fixed income. Markets have moved to price in a far more aggressive move from the ECB than we had envisioned for 2022. However, as highlighted above, it is not clear that the ECB needs to dial back monetary accommodation as rapidly as markets now expect. Thus, we are sticking with our strategic recommendations to overweight euro area government bonds, both in the core and periphery, in global bond portfolios. At the same time, we continue to recommend a below-benchmark duration stance within dedicated European portfolios, even with the 10-year German Bund yield having already reached our end-2022 yield target of 0.25% (Chart 15). European bond yields will remain under upward pressure until euro area inflation finally peaks and the ECB will be under less pressure to tighten. Chart 14ECB Facing An "Italy-vs-Inflation" Tradeoff Chart 15Too Much, Too Soon Priced Into Bund Yields Bottom Line: Markets are overestimating how quickly the ECB can begin to tighten European monetary policy. An initial rate hike can occur in Q4 of this year, at the earliest, which is later than the current mid-summer liftoff date discounted in interest rate forwards. Ride out the current European rates volatility and stay overweight European government debt versus the US. UK Update: The BoE Wants To Tighten Fast At last week's policy meeting, the BoE Monetary Policy Committee (MPC) voted 5-4 to raise Bank Rate by 25bps to 0.5%. That close vote is less dovish than it appears, though, as the four “dissenting” MPC members wanted to raise rates by 50bps instead! This was a hawkish surprise that resulted in bearish flattening of the UK Gilt yield curve. Chart 16UK Gilts: Volatile, But Underperforming We have maintained a below-benchmark strategic recommendation on Gilts since August of last year. The relative performance of Gilts versus the Bloomberg Global Treasury benchmark index has seen tremendous volatility since then, particular after the BoE delayed the expected initial rate hike last November (Chart 16) Gilts began to underperform again after the BoE hiked in December and have continued to be one of the worst performing G10 bond markets, validating our bearish call. After last week’s BoE hike, we still see value in betting on additional Gilt underperformance, as markets may still be underestimating how high the BoE will have to raise rates in the current tightening cycle. In the new set of economic projections from the BoE’s Monetary Policy Report published last week, the central bank raised its expectation for the April peak in UK inflation to 7.25% (Chart 17). This compares to the latest inflation rate of 5.4%. Higher energy and goods prices account for three-quarters of that expected inflation increase, according to the BoE. UK inflation is projected to fall rapidly from that April peak, in response to an expected deceleration of energy and goods prices and slower UK economic growth. However, the Monetary Policy Report also highlighted that domestic UK cost pressures are intensifying in response to a very tight UK labor market. The BoE’s Agents’ survey of UK businesses reported that UK firms continue to have difficulty filling job openings, while also having success in passing on rising labor costs into selling prices. Thus, the UK labor market is now the critical variable to watch to determine how many more rate hikes the BoE will need to deliver in the current cycle. On that note, the BoE expects UK wage growth to accelerate to just under 5% over the next year, which is well above the central bank’s estimate of “underlying” pre-pandemic wage growth around 3.5%. Inflation expectations in the UK remain elevated. The YouGov/Citigroup survey shows that UK consumers expect inflation to be 4.8% on year from now and 3.8% 5-10 years ahead (Chart 18, top panel). Market-based inflation expectations have been more volatile of late but CPI swaps are pricing in inflation of 5.0% in two years and 4.2% in ten years.1 Thus, by any measure – realized inflation, expected inflation or wage growth – UK inflation is too high, which justifies tighter monetary policy. The UK OIS curve now discounts a peak in Bank Rate of 1.85% in April 2023, but this is immediately followed by rate cuts that take Bank Rate to 1.5% by the end of 2024. That path over the next year is a bit more hawkish than the results from the BoE’s new Market Participants Survey of bond investors, which showed an expected peak in Bank Rate of 1.5% sometime in the latter half of 2023. In both cases, Bank Rate is expected to settle below the BoE’s 2% inflation target, or below current inflation expectations. Suggesting an implied belief that the BoE will not be able to raise real interest rates into positive territory. In terms of forward guidance, several BoE officials have noted that they expect that only a few more hikes will be needed to help bring UK inflation back down to the 2% target. Yet the OIS curve is pricing in a “policy error” scenario where the BoE pushes up rates too rapidly and is then forced to cut rates soon afterward. We see both the BoE guidance and the OIS pricing as far too cautious on the eventual peak in Bank Rate, which leads us to maintain our underweight recommendation on UK Gilt exposure, both in terms of duration and country allocation in global bond portfolios. Chart 17BoE Sees A Short, Sharp Shock From Inflation & Rates We have also been recommending a Gilt curve steepening trade in our Tactical Overlay portfolio on page 20 since last October. This trade went long a 10-year Gilt bullet versus a barbell combination of a 7-year and 30-year Gilt. Chart 18Stay Underweight UK Gilts Our view at the time of trade inception was that a Gilt steepener would benefit from a scenario where the market would be forced to reassess how high rates would go in the next BoE tightening cycle. However, the BoE now appears to be “front loading” the tightening cycle by moving rates sooner and more aggressively, as evidenced by the near 50bp rate hike last week, while also moving to an accelerated runoff of bonds accumulated during quantitative easing operations. The Gilt yield curve has flattened considerably in response to increasing BoE hawkishness, with the yield spread between the 10-year and 2-yield Gilt now down to a mere +17bps. While we still see the potential for the longer-end of the Gilt curve to rise in response to an eventual repricing of terminal rate expectations that appear too low, the BoE’s acceleration of its hiking timetable will make it difficult for the curve to bearishly steepen in the near term. Thus, we are closing out our tactical Gilt curve steepener at a small gain of +23bps. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 UK CPI swaps, and inflation breakevens on index-linked Gilts, reference the UK Retail Price Index (RPI) which typically runs higher than the UK Consumer Price Index (CPI). This imparts an upward bias to UK inflation expectations when compared to CPI swaps and breakevens in other countries. Currently, RPI inflation is running at 7.5% compared to CPI inflation of 5.4%. GFIS Model Bond Portfolio Recommended Positioning Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Cyclical Recommendations (6-18 Months) Tactical Overlay Trades
Executive Summary Chinese Onshore Stock Prices And Earnings Are Set To Deteriorate Macro fundamentals indicate that for the time being there is no basis to overweight Chinese onshore stocks (in both absolute terms and relative to global stocks) given the outlook for profit growth contraction in 1H22. We are reluctant to shift our stance on Chinese domestic stocks to overweight in the next 6 to 12 months due to the following non-trivial risks: a subdued recovery in China’s economic activity, a deceleration in fiscal impulse in 2H22, a re-focus on reducing carbon emissions, as well as higher US bond yields and tighter global liquidity conditions. Despite a sharp drop in January, valuations in Chinese onshore stocks are still neutral in absolute terms, and only slightly cheaper than global stocks. As such, Chinese onshore stocks offer little valuation buffer in the wake of any negative surprises. Bottom Line: We maintain our underweight stance on Chinese onshore stocks (in both absolute terms and relative to global equities) due to non-trivial risks in the coming year. Feature China’s stock markets was very weak in the first month of 2022. The domestic equity market tumbled by 8% in January, while the offshore market dropped by 3%. We discussed our view on Chinese investable stocks in last week’s report and recommended that investors go long on investable value stocks versus growth stocks. This week’s report focuses on the onshore market. While we expect the economy to stabilize by mid-year on the back of increased policy support, we are reluctant to move to a cyclical overweight in the next 6 to 12 months, in both absolute terms and relative to their global peers. Near-term challenges in economic fundamentals will continue to weigh on Chinese domestic stocks. Over a cyclical time frame, the main risks to a bullish view on Chinese stocks are fourfold: a potentially subdued economic recovery; a sharp deceleration in fiscal impulse in the second half of the year; a re-acceleration in de-carbonization efforts; as well as higher bonds yields in the US and tighter global financial conditions. Chinese onshore stocks are not as deeply discounted as their offshore peers and, therefore, are less able to counter any negative surprises. Macroeconomics Matter Chart 1Weak Economic Fundamentals Undermine Stock Performance China’s economic fundamentals still drive corporate earnings and the country’s domestic stock performance, despite an escalation in monetary policy easing (Chart 1). Current macro fundamentals do not provide a legitimate support for investors to overweight Chinese stocks. The domestic stock market’s rocky start to 2022 underscores extremely fragile sentiment and heightened anxiety among investors. Credit growth bottomed in October last year but has not shown any signs of a strong rebound. Corporate demand for credit remains in the doldrums while turmoil in the housing market has disincentivized households from taking mortgages (Chart 2). The real economy, which in previous business cycles lagged credit growth by about six to nine months, has not responded to policy easing measures. Housing market indicators in January deteriorated further (Chart 3). Moreover, the nation’s counter-COVID measures have disrupted a recovery in the service sector and private consumption. Chart 2Demand For Loans Remains Weak Chart 3Housing Sales Weakened Further In January Chart 4Chinese Onshore Stock EPS Is Set To Deteriorate The financial market is forward looking and macro policies have become more market friendly. However, Chart 4 suggests that China's onshore corporate profits are set to deteriorate in the coming six months or so, and investors will likely react negatively to any further weakness in China’s measures of economic activity. Bottom Line: At the moment, China’s domestic economic fundamentals do not support an overweight stance in Chinese stocks. Mindful Of Cyclical Risks Chinese authorities have prioritized stimulating growth through countercyclical measures in 2022. However, we are reluctant to move to a cyclical overweight stance because we see four significant risks to turning bullish towards Chinese stocks (in both absolute and relative terms) in the next 6 to 12 months. These scenarios not only threaten the performance of Chinese stocks relative to global equities but could also prevent Chinese stocks’ absolute performance from trending higher. A subdued recovery in China’s economic activity. When policymakers wait too long to decisively stimulate the economy, business and consumer sentiment as well as the economy can remain downbeat for a prolonged period. For example, in the 2014/15 business cycle, monetary policy started to ease in early 2015, but policymakers hesitated to back down from supply-side reforms. As a result, the economy did not bottom until Q1 2016. Business activity and the financial markets reached their lows only after the authorities opened the “flood irrigation” to the economy by massively stimulating the housing sector (Chart 5). Arguably China’s economy is in a better shape now than in 2014/15 and the ongoing economic slowdown is not the result of a four-year downtrend in industrial activity as was the case prior to 2015’s economic slump (Chart 6). The drop in the A-share market in January was nothing compared with the turmoil in the financial markets seven years ago. Chart 5Economic Activity Picked Up In Q1 2016 Following A Massive Stimulus Chart 6China's Economy In General Is In A Better Shape Now Than In 2014/15... On the other hand, the housing market, which is estimated to account for about 29% of China’s economy, is currently decelerating at the same pace as in 2014/15. Growth in home sales and new projects dropped to their 2015 lows, while real estate inventories are comparable to the 2015 highs (Chart 7). Furthermore, property developers and consumers are even more indebted than during the 2014/15 cycle (Chart 8). Chart 7...But Downward Momentum In Property Market Comparable To 2015 Chart 8Chinese Real Estate Developers And Households Are More Leveraged Now Than In 2015 Chart 9Policymakers Will Have To Allow Significant Re-leveraging To Revive The Housing Market As noted in a previous report, unless regulators are willing to initiate more aggressive policy boosts as in 2015/16, the ongoing easing measures will not be sufficient to revive sentiment in the property market. Thus, the property market downtrend will likely extend through 2022 (Chart 9). The IMF recently revised its 2022 growth projection for China from 5.6% to 4.8%. It attributed the sharp downgrade to China’s protracted financial stress in the housing sector and pandemic-induced disruptions related to a zero-tolerance COVID-19 policy. A sub-5% economic expansion in 2022, although still an improvement from the 4.5% average annual rate in 2H21, is subdued and below China’s potential growth. Such a weak economic recovery will weigh on investor sentiment towards Chinese stocks in the coming year. A deceleration in fiscal impulse in 2H22. The impulse in fiscal stimulus - without any intervention - will fall sharply in the second half of the year. The Ministry Of Finance has approved a quota of RMB1.46 trillion in local government special purpose bonds (SPBs), which accounts for more than one-third of the yearly SPB quota, to be issued in Q1 this year. Chart 10Large Amount Of Local Government Debts Due In 2H22 However, the frontloading of SPBs also means that the fiscal impulse will slow significantly in 2H22. Our geopolitical strategists have noted that a total of RMB2.7 trillion worth of local government bonds (LGB) will reach maturity this year, with RMB2.2 trillion coming due after June 2022 (Chart 10). The number of maturing LGBs in 2H22 will be only slightly smaller than those in all of 2021; in 2021 42% of LGBs issued were re-financing bonds to pay off existing local government debts, undermining real fiscal support for the economy. Furthermore, authorities have not loosened their grip on implicit local government debts (Chart 11). These so-called shadow banking debts through local government financing vehicles (LGFVs) are an important source of funding for investments in infrastructure projects. If the central government does not reverse its efforts to curb hidden debts while explicit fiscal stimulus also wanes, then we will likely see a sharp deceleration in fiscal support in 2H22. Lastly, we think Chinese policymakers are still serious about preventing “flood irrigation” type of stimulus, and will not opt for it unless the economic slowdown is much sharper. In Q1 2019 stock prices jumped sharply, boosted by an above-expectation pace of local government SPB issuance and credit expansion. However, following the public spat between Premier Li Keqiang and the PBoC over whether the January 2019 credit spike represented “flood irrigation-style” stimulus, policymakers quickly scaled back credit expansion in Q2 and onshore stock prices ended the year 5% lower than in Q1 (Chart 12). Chart 11Authorities Have Kept Tight Grip On Shadow Banking Activity Chart 12Policymakers Scaled Back Stimulus And Took The Wind Out Of Onshore Stocks In 2019 Carbon emission reduction targets are still viable. In the current 14th Five-Year Plan (2021-2025), the cumulative targets reduction in energy consumption intensity is 13.5%.1 Last year’s energy crisis slowed the de-carbonization process and energy consumption intensity fell by 2.7% in 2021, missing the official annual target of 3%. To meet the de-carbonization target by 2025, energy consumption intensity will have to be lowered by at least 2.7% per year in the next four years. If energy- and carbon-intensive infrastructure activity picks up sharply in 1H22, then policymakers will have to renew their vigilance to constrain carbon-intensive activities later this year. The de-carbonization target has become a key parameter for assessing the performance of local governments, and meeting de-carbonization targets is particularly important given the rotation of local officials will be completed in late 2022. Furthermore, the initiative to reduce energy intensity reflects China’s commitment to move to a green economy. Given the important political events in both China and the US in the fall of 2022, meeting the annual de-carbonization target will be an important projection of China’s international image and will likely play a role in US-China negotiations. Chart 13Prior To The Pandemic, Chinese Stocks Had Little Correlation With US Treasury Yields Higher bond yields in the US and tighter global liquidity conditions. Historically, Chinese onshore stocks have exhibited a loose cyclical correlation with US government bond yields (Chart 13). Nonetheless, if US bond yields rise more than global investors expect and to a level that is economically restrictive, then capital expenditures and household consumption in the US will weaken. This, in turn, will weigh down global trade and Chinese exports of manufactured goods. Against the backdrop of escalating US bond yields, Chinese onshore stocks may passively outperform their US counterparts because China’s A-share market is heavily weighted in value stocks. However, A-share prices in absolute terms will not be immune to heightened volatility in the global financial markets. The risk-off sentiment across global bourses will discourage portfolio flows into emerging economies including China. On a monthly basis, foreign portfolio net inflows account for less than 1% of the onshore equity market trading volume, but in recent years foreign portfolio inflows have increasingly influenced China’s onshore market sentiment and prices (Chart 14). China’s domestic household savings will not provide much support to stock prices this year. Chinese households have increasingly invested in the domestic equity market in the past few years, given that the authorities have been vigilant in containing price inflation in the property market.2 While we think Chinese consumers will continue rotating investment from property to financial market, household savings growth has fallen sharply since mid-2021, which means there have been less available funds to invest in the stock market (Chart 15). Chart 15Chinese Households' Quickly Diminishing Dry Powder Chart 14Foreign Investors Have Become More Influential In The Chinese Onshore Market Bottom Line: For the time being, the significant risks described above make us reluctant to turn bullish on Chinese stocks in both absolute and relative terms. Investment Conclusions There are few upsides related to Chinese onshore stocks in the next 6 to 12 months. However, there are two risks to our underweight stance on Chinese onshore stocks: First, we cannot rule out the possibility that Chinese policymakers will go “all in” for economic stability and allow a significant credit overshoot. In this scenario, a strong pickup in credit growth will produce a rebound in profit growth and support share prices in absolute terms and relative to global equities. Secondly, recent gyrations in global financial markets, coupled with China’s sluggish domestic economy, have triggered shakeouts in the onshore equity markets. The pullback in stock prices has helped to shed some excesses in Chinese stock valuations. Chart 16In Very Optimistic Scenario Chinese Stocks Would Have Some Upside Potential Vs. Global If the stimulus in the next 6 to 12 months returns Chinese corporate profit growth to their 2021 peaks, then Chinese stock prices (in absolute terms) will also approach or go back to their early-2021 highs. Chart 16 highlights that reverting to these levels would imply a return of about 10-15% for domestic stocks in both absolute and relative price terms. We think China’s potential to command a higher multiple than global stocks is capped, barring a major structural improvement in earnings growth. However, Chart 16 (bottom panel) shows that Chinese onshore stocks at their height early last year were still cheaper than their global counterparts. Therefore, in a scenario where Beijing does “whatever it takes” to stimulate its economy, we will have no strong reasons to argue against a return of domestic forward multiples and a strong earnings growth back to levels seen in early-2021. Jing Sima China Strategist jings@bcaresearch.com Footnotes 1 Energy consumption intensity refers to energy consumption per unit of GDP. 2 There was a sharp jump in demand in 2020 for investment products from households; mutual funds in China raised money at a record pace, bringing in over 2 trillion yuan ($308 billion), which is more than the total amount in the previous four years. Strategic Themes Cyclical Recommendations Tactical Recommendations
Executive Summary The European Central Bank (ECB) has engaged in a decisive pivot toward higher policy rates. Markets are pricing in a first interest-rate hike in July and three more increases thereafter in 2022. This is too much for one year. Limited domestic inflationary pressures, weakness in long-term inflation expectations, economic slack, and vulnerability in the periphery will limit the ECB to one hike in December. Nonetheless, the ECB will increase interest rates more than the market anticipates beyond 2022. The UK is setting up for a dangerous latter half of 2022. Too Much Now, Not Enough Later Bottom Line: Bet on a steepening of the euro short-term rate (€STR) curve. Current pricing for 2022 is too aggressive; however, it is too timid beyond the yearend. European financials will be the prime beneficiary of this tilt. Feature On Thursday, February 3, ECB President Christine Lagarde announced a decidedly hawkish pivot at the ECB press conference. The Frankfurt-based institution, worried by higher-than-anticipated inflation, no longer excludes rate hikes for 2022. In a context in which the BoE is resolutely hiking rates and the Fed is ready to initiate a sustained tightening campaign, investors are pricing in a 10bp ECB rate hike as early as July 2022. They also foresee three additional increases by the end of the year. We agree that the ECB will start lifting the deposit rate this year; however, we expect the tightening to begin in December. Nonetheless, we expect the ECB to lift policy rates more aggressively than the €STR prices in subsequent years. European Inflation Is Different Chart 1Surprise! The knee-jerk reaction of investors to price in a sudden, sustained campaign of ECB rate hikes this year similar to that of the Fed is natural in light of elevated Eurozone inflation and inflation surprises (Chart 1). However, we continue to view European inflation as distinct from US inflation. European inflation remains dominated by dynamics in the energy market. While headline inflation increased from 5% to 5.1% in January, the core Consumer Price Index (CPI) declined modestly to 2.3% from 2.6%. Crucially, the variance of headline CPI is still almost fully explained by the variance of its energy component (Chart 2, top panel). However, it is concerning that there is also evident pass-through from energy prices to core CPI taking place today (Chart 2, bottom panel). Naturally, natural gas prices play a particularly important role in this energy-driven inflation spike (Chart 3). Chart 2Energy Still Drives Inflation Chart 3Natural Gas Remains Key Imported inflation is another key driver of European inflation. Chart 4 highlights that there is a robust relationship between the level of headline Harmonized Index of Consumer Prices (HICP) across EU nations and their import prices. This confirms that a large proportion of the European inflationary outburst has taken root outside of the continent’s borders. Chart 4Imported Inflation? Despite this energy-driven, imported inflation, domestic pressures are still much more muted than those in the US. VAT increases played an important role in pushing core CPI higher. Without this contribution, CPI excluding food and energy would be 50 bps lower (Chart 5). Meanwhile, rent inflation remains a modest 1.1%, which is significantly lower than that in the US (Chart 6, top panel), whereas used car CPI is not nearly as extreme as across the Atlantic (Chart 6, bottom panel). Chart 5Elevated Contribution From Taxes Chart 6Comparatively Muted Domestic Inflation Drivers Wage dynamics too are not yet as concerning in the Eurozone as they are in the US. Negotiated wages remain near a record low of 1.4%, and unit labor costs at 0.9% are still inconsistent with strong underlying inflationary pressures (Chart 7, top and second panel). The labor market is tightening and the Euro Area unemployment rate fell to a new low at 7%. However, the total hours worked have not yet reached their pre-pandemic levels (Chart 7, third panel), which suggests that it could take a few more months before the dislocation caused by the pandemic has been fully absorbed and wages become a risk. That being said, it is only a matter of time, as job vacancies are skyrocketing (Chart 7, bottom panel). Chart 8Plentiful Slack Chart 7The Labor Market Will Heat Up... Later The European output gap also limits a repetition of the wage-price spiral taking hold in the US. The OECD’s Weekly Tracker of GDP, a proxy for the overall Eurozone comprised of Germany, France, Italy, and Spain, reveals that, as of mid-January, aggregate output was still 4.9% below its pre-pandemic trend (Chart 8, top panel). Looking at the actual GDP of European countries individually, only France stands above its pre-pandemic trend, whereas Germany, Italy, and Spain still linger well below the average economic path that prevailed from 2012 to 2019 (Chart 8, bottom panels). Chart 9The Inflationary Role Of Bottlenecks Bottlenecks have also played an important role in relation to higher inflation. Goods inflation is much more elevated than services inflation (Chart 9, top panel), and industrial companies rank the ability to procure equipment and materials as their most important production constraint (Chart 9, second panel). However, production bottlenecks are dissipating. A recent Ifo survey highlights that the proportion of retailers with procurement issues declined from 82% in December 2021 to 57% in January 2022. Moreover, the supplier deliveries indexes of the PMIs are improving across the world. In fact, our simple Supply Disruption Index has begun to rollover, which points toward an imminent end to the wave of inflation surprises (Chart 9, bottom panel). European inflation expectations bear the imprint of those more modest domestic inflationary pressures, which explains the comparatively more limited wage-price spiral on the continent. The inflation expectations of Eurozone households are rising, but they are still within the norm of the past 20 years. In the US, they are breaking out. Moreover, our Index of Common Inflation Expectations, designed to mimic the New York Fed’s measure, remains well contained and is tentatively rolling over (Chart 10). Collectively, these forces explain the radically different inflation profiles of the Euro Area and the US. On the western shore of the Atlantic, the two-year annualized rate of change of the core CPI has completely shattered its highs of the past 20 years, indicating that more than simple base-effects are contributing to inflation (Chart 11, top panel). Meanwhile, the two-year annualized rate of change of the European core CPI is higher than the past deflationary eight years, but it is still low compared to the rates that prevailed prior to the European sovereign debt crisis (Chart 11, bottom panel). Chart 10Inflation Expectations: Unlike The US Chart 11Realized Inflation: Unlike The US Chart 12The Coming CPI Peak? Going forward, there remains a high likelihood that Eurozone inflation will soon peak. The impact of the German VAT increases will soon dissipate from the data, energy inflation will diminish as the annual rate of change of oil and natural gas prices peaks, and the growth in monetary aggregates has normalized sharply. Most importantly, in the absence of significant domestic inflationary pressures, the sharp decline in the ZEW Inflation Expectations components point toward a deceleration in headline HICP (Chart 12). Nonetheless, we cannot be too sanguine. The European output gap is likely to close this year and wages pressures will emerge before the end of 2022. As a result, inflation will not fall below 2% anytime soon. Moreover, as we wrote last week, any long-lasting crisis in Ukraine will prevent energy inflation from declining, and thus, there remains significant upside risk to our inflation view in the coming months. Bottom Line: European inflation remains dominated by energy prices and imported price pressures. For now, domestic inflation dynamics are still mild, which explains why Europe’s inflation profile is much shallower than that of the US. Moreover, the near-term picture suggests that the imported inflation will peak, giving a respite to the HICP. Nonetheless, toward the yearend, domestic inflationary forces will pick up as wages gain traction. ECB Pricing: Too Much And Too Little ECB President Christine Lagarde delivered a message that was loud and clear: The ECB is abandoning its ultra-dovish stance. Despite this policy pivot, investors are pricing in too many hikes this year, whereas we only expect one rate increase toward yearend. True, if energy prices spike anew, risks to this forecast will be skewed to the upside. Nonetheless, we are inclined to fade the number of rate hikes priced in for 2022 and bet for more hikes in 2023 and 2024 (Chart 13). Chart 13Too Much Now, Not Enough Later Why does our base case only include one rate hike in December? First, we are considering the entirety of the inflation picture. As we argued above, inflationary dynamics in Europe are much tamer than those in the US, especially in terms of domestic inflation, which the ECB can influence. Moreover, the ECB is still reeling from its infamous 2011 policy mistake, which accentuated underlying deflationary pressures and caused the ECB to undershoot its mandate for eight years in a row (Chart 14). Inflation expectations also offer some leeway to the ECB. Predictions by professional forecasters continue to track below two percent for the medium term. Importantly, market-based inflation expectations remain consistent with a temporary inflation shock, and do not meet yet the ECB’s criteria of being above the 2% target durably. 10-year CPI swaps hover around 2%, driven by the jump in 2-year CPI swaps to 2.7%. Long-dated expectations approximated by the 5-year/5-year forward CPI swap remain below 2% and the inflation curve is its most inverted on record (Chart 15). Chart 15Inflation Swaps Don't Fit The ECB's Criteria Chart 14The Legacy Of The 2011 Mistake In the end, President Lagarde did mention in the press conference that inflation is finally moving toward its target after years of undershoot. In the context described above, it is likely that the ECB will continue to tolerate some higher inflation in the near term if it represses the deflationary mentality that had engulfed the Eurozone last decade and caused a progressive Japanification of the region. This is a small price to pay to exit at last the lower bound of interest rates on a durable basis. Second comes the sequencing of policy. President Lagarde reiterated the importance of the order of events. First, the ECB will have to bring asset purchases to a net zero before lifting rates. It has yet to curtail purchases. The March meeting will be of paramount importance, since it will feature the tapering schedule of the central bank. We continue to see a progressive pace of declining assets purchases that will likely end in September 2022. Moreover, the ECB will want to see how the European economy and markets will absorb the TLTRO cliff this June, when EUR1.3 trillion of facility expire. Chart 16The Italian Constraint Third, the ECB remains hamstrung by financial dynamics in the periphery. On Thursday, as Bund yields rose 10 basis points, BTP yields rose 21 basis points, bringing the Italian-German spread to 150bps, its highest level since September 2020 (Chart 16). Simply put, the periphery remains fragile because Italy and Spain sport some of the most negative output gaps in the region. Waiting for a stronger position out of those countries would let the ECB increase rates further down the road, allowing for a cleaner exit from negative policy rates in Europe. While these factors continue to favor a cautious posture by the ECB in 2022 and, therefore, support our base view of only one 10bps hike in December to be flagged when net purchases end in September, they will evolve and allow for many more hikes in 2023 and 2024. We expect the following developments to unfold: The output gaps across the region will close this year, which will put the economy in a position of strength and generate stronger domestic inflationary pressures down the road. Salaries will begin to accelerate meaningfully by the summer. This force will accentuate domestic inflationary pressures in late 2022 and 2023, and will contribute to higher household inflation expectations. The periphery will grow increasingly stronger as the Next Generation EU (NGEU) disbursements accelerate in 2022 and 2023. These disbursements are primarily geared toward infrastructure/capex spending (Chart 17) and will therefore sport elevated fiscal multipliers. The resulting strength will provide more resilience to the periphery and limit the tightening of financial conditions caused by higher interest rates. Chart 17The NGEU Will Matter… A Lot Chart 18Terminal Rates Are Too Low In the longer term, we also believe that markets still understate the ability of the ECB to lift rates. The market-derived terminal rate proxy for Europe is in the vicinity of the levels recorded in the wake of the European sovereign debt crisis last decade (Chart 18). Fiscal policy is more generous, however, and thus domestic demand is stronger. As a corollary, the accelerator model implies that capex will be more robust than it was last decade. Finally, the European Union is not as politically divided as it once was, which creates a stronger block. Together, these developments suggest that the r-star or the neutral rate of interest in the Euro Area is higher than last decade. Bottom Line: The €STR curve is pricing in the potential path of the ECB this year too aggressively. The ECB is likely to start raising rates in December, not in July. Domestic inflation and inflation expectations remain too modest, while the periphery remains fragile. Moreover, the ECB will stick to the previously decided sequence that calls for an end to net asset purchases ahead of hikes. Beyond 2022, we expect the ECB to increase rates more than what is priced into the €STR curve. Investment Implications The first implication of our view is that the European yield curve is likely to steepen further in the coming year. This is true in absolute terms but also relative to the US. We remain long European steepeners relative to US ones. Second, we continue to favor European financials. European banks are a direct equity play on higher yields and on a steeper yield curve (Chart 19). Moreover, European financials have upside relative to their US competitors. They are cheap, and they will benefit from the relative steepening in the European yield curve (Chart 20). Additionally, European monetary conditions will remain easier this year than US ones, whereas European growth will continue to catch up to the US. Chart 20Roll Over XLF Chart 19Banks Will Shine More Chart 21A Bit More Stress Third, the equity market correction might have a little more to run. In the near term, equities had become very oversold. This week’s bounce makes sense after the S&P 500’s RSI plunged below 30. However, hedge funds are not shorting the market as violently as they did in 2018, yet all the major global central banks (apart from the BoJ) are abandoning their pandemic-driven policy. As a result of the prospect of a global decline in liquidity, a retest of the 2018-lows in net exposure is likely as we approach the March Fed meeting, especially as credit spreads are still too low to cause a meaningful change in tone by the Fed (Chart 21). Thus, European stocks could experience another wave of selling in the coming weeks, especially when the risks surrounding Ukraine have yet to clear. Keep some protections in place. Finally, the euro has surged this week. With looming Ukrainian risk, the potential for a repricing downward of the near-term European policy rates and the risk of a last sell-off in equities, the euro could give up some of its recent gains and remain in a churning pattern, in place since December 2021. The uncertainty is therefore elevated for near-term traders. However, considering last week’s ECB pivot and the likelihood of an upward revision of the €STR curve for 2024 rates, long-term investors should use a pull back in the euro in the coming weeks to gain exposure to long EUR/USD. What About The BoE? Last week, the Bank of England increased rates by 25bps to 0.5%, which was a widely expected move. The BoE is naturally ahead of the ECB because inflation swaps stand at 4.3% and are even higher than those in the US. The BoE is forced to be more aggressive because inflation expectations are becoming unmoored, which raises the risk of a wage-price spiral north of the Channel. This is a legacy of years of higher inflation and of the labor-supply problems created by Brexit. Additionally, the UK is exiting Omicron lockdowns faster than the Euro Area, which accentuates its near-term economic strength. The UK is not, however, out of the woods. A perfect storm is brewing for the remainder of the year. Interest rates are set to rise sharply, energy price caps will disappear in two months, and the budget is anticipating a significant tightening in the coming quarters after taxes rise in April. This will hurt economic activity in the latter half of the year and will cause tensions in the domestic market. The tax hikes are not guaranteed and a reversal is still possible. PM Boris Johnson is currently embroiled in the so-called “Partygate” scandal and Rishi Sunak, Chancellor of the Exchequer, is seen as the most likely candidate within the Conservative Party to replace Johnson if he were to be pushed out of power by the 1922 Committee. As a colleague observed, it remains to be seen whether Sunak’s political ambitions will scuttle his fiscal rectitude. Nonetheless, the threats to UK small-cap stocks are increasing, warranting a cautious stance if the tax increases are not revoked in the coming weeks. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades