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BCA Research’s US Investment Strategy service reviewed the performance of S&P 500 operating earnings, earnings multiples and returns in five inflation regimes to see how equities have responded to inflation over the last 75 years. In the extreme…
Executive Summary Tighter Financial Conditions May Affect Growth Inflation Outlook: Inflation is becoming entrenched, spreading beyond a few pandemic-related items to “sticky price” categories. A wage-price spiral and unmoored inflation expectations translate into upside risk to the 2.5% consensus core PCE forecast. Consumer Spending: Americans are being forced to allocate a larger proportion of income towards food and gas, shifting consumption away from discretionary spending. As such, consumer spending alone may not be able to keep the economy afloat. On a 50bps hike: The rate hike increments are less important than the message the Fed is sending out to the market: Talking up 50 bp rate rises, the Fed is signaling that is it laser-focused on inflation, which is reassuring. Tightening and the economy: Aggressive monetary tightening will lead to slower economic growth, but this is not yet reflected in consensus economic growth forecasts. Recession Coming? Economic growth is slowing but off high levels, and recession is not imminent. Our recession indicator does not flash danger. However, we are watching out for a growth disappointment. Bottom Line: In a commentary to our bi-monthly sector chart pack report, we provide answers to the most frequently asked questions on the state of the US economy. Feature Performance Markets never cease to surprise. In March, US equities staged an unexpected rally despite the backdrop of a hawkish Fed, raging inflation, surging energy prices, and a war in the heart of Europe. The reversal was broad-based, not leaving a single sector in the red (Chart I-1). The S&P 500 has regained 9% since the market bottom on March 8, 2022 and is only 5.5% off its all-time high. The NASDAQ has rebounded 13%. Is this rally sustainable? In a report a couple of weeks ago, we aimed to answer this question. We recommended patience, although many ingredients, such as attractive valuations and oversold technical conditions, were already in place. Our reasons for patience were that: Economic growth expectations are still elevated and bottom-up earnings growth forecasts need to come down, to reflect slowing growth, a tighter monetary regime, and higher commodities and energy prices. Our view is unchanged. This week was a busy one: A media interview with The Deep Dive, and two virtual conferences in Australia, one run by Insider Network and the other by Equity Forum. In today’s cover report for our sector chartpack, we answer questions we received from the media and conference audience, that we believe will be of interest to clients. Chart I-1Powerful Rebound Questions And Answers The Consumer Price Index (CPI) increased by 7.9% and the PCE price index, the Fed’s preferred measure of inflation, came in at 6.4% in February – readings not seen since 1982. What is your outlook on inflation? Inflation will come down, assisted by the arithmetic of the base effect. However, it is unlikely to revert to levels that the Fed and the US consumer will consider acceptable. Moreover, inflation could surprise further to the upside. The concern is that inflation is becoming entrenched. It has spread beyond a few pandemic-related items to goods for which prices are usually sticky (Chart I-2). There are also clear signs that price increases are feeding through to wage increases. Real wage growth remains negative at -2%, while demand for labor is robust – there are 1.7 open jobs per job seeker, and companies are raising wages to retain talent (Chart I-3). Subsequently, they will raise prices to pass on cost increases to customers. These are fertile conditions for a wage-price spiral, with inflation becoming even more entrenched. Chart I-2Even Sticky Prices Are Now Rising Chart I-3Rising Wages Are In Lockstep With Rising Prices Further, inflation expectations have become unmoored: According to a University of Michigan survey, consumers expect prices to rise by 5.5% over the next year, and by more than 3% a year over five to 10 years (Chart I-4). Concerningly, the upward adjustment in inflation expectations is relentless. The war in Ukraine exacerbates many causes of inflation: Its indirect effects are shortages of raw materials, energy, and shipping disruptions (Chart I-5). Chart I-4Inflation Expectations Are Unmoored Chart I-5Supply Chains Remain Disrupted Consensus forecasts for US core PCE inflation see it coming down to 2.5% by next year. The risk is that it could exceed that. Bottom Line: Inflation will come down but may not normalize any time soon. What is the effect of food and energy inflation on consumer spending? Negative real wage growth bites into consumer purchasing power, sapping confidence (Chart I-6). It does not help that food and energy prices are up by 8% and 14% respectively year over year (Chart I-7). However, the rising price of necessities has the most pronounced effect on low earners: Food accounts for more than a quarter of the after-tax income of the lowest quintile of earners, falling to just over five percent of income for top earners (Chart I-8). As many Americans are forced to allocate a larger proportion of income towards food and gas, they have to shift consumption away from discretionary spending. Thus, a high price for gasoline does not necessarily suppress demand for gasoline but rather reduces demand for, say, fast-food meals. Chart I-6High Inflation Saps Consumer Confidence Chart I-7Food And Energy Prices Have Surged This change in a spending basket explains a slowdown in consumer spending: PCE increased only 0.2% month-on-month in February, which is underwhelming compared to the 0.7% expected. It also explains rising credit-card balances (Chart I-9). Chart 8Rising Cost Of Food Cuts Into Discretionary Spending... Chart I-9Many Consumers Are Struggling At the same time, we know that US consumers have $2.3 trillion in excess savings – which are clearly not uniformly distributed across income groups. This nice stash of cash provides a solid consumer spending cushion for the US economy, but it may not be up to the challenge of keeping the economy afloat single-handedly. Bottom Line: For now, the US consumer is in good shape but there are cracks in the foundation as lower-income Americans are clearly struggling with rising food and gas prices. Fed Chair Jerome Powell noted last week that the Fed could raise rates from the traditional 25 basis points per meeting to 50 basis points if necessary. Do you think 50 basis points will have much of an impact on inflation or on the real economy? The Fed has gotten way behind the curve. In retrospect, it should have raised rates last summer – and it now understands its error. Its first hike this cycle came only when the economy had already over-heated (Chart I-10). At long last, the Fed, despite its dual objective, is laser-focused on inflation. As with most central banks, signaling is presumably more important than action – remember the famous Mario Draghi’s “whatever it takes.” Talking up 50 bp rate rises, the Fed is signaling that “the inflation cop is back in town.” And while it will be hard for the Fed to put the inflation genie back in the bottle, it is reassuring that it will at least try. As for a potential 50-basis-point rate rise, for now it does not present an immediate threat to the real economy: Real rates remain negative and monetary conditions are fairly loose, while the neutral rate (that elusive r-star) is still quite a ways off from where the rates are now (Chart I-11). Bottom Line: The rate hike increments are less important than the message the Fed is sending out to the market. Chart I-10The Fed Is Behind The Curve Chart I-11The Market Expects The Fed To Move Aggressively To Combat Inflation What will be the effect of monetary tightening on economic growth? Related Report US Equity StrategyHave US Equities Hit Rock Bottom? While early on, rate hikes can be shrugged off by a strong economy, over time, tighter financial conditions necessary to combat inflation, augur badly for growth. While financial conditions are still loose, they have already tightened on the back of higher long-term rates, widening credit spreads, and a strengthening dollar. The Goldman Sachs Financial Conditions Index points to the ISM Manufacturing Index falling below 50 later this year (Chart I-12). However, as we have pointed out in our “Have We Hit Rock Bottom Yet?” report, GDP growth forecasts do not reflect tighter monetary conditions and higher commodity prices (Chart I-13). The Atlanta Fed Nowcast points to only 0.9% annualized growth in Q1, yet consensus expectations have barely budged. Bottom Line: Aggressive monetary tightening will lead to slower economic growth. Chart I-12Tighter Financial Conditions May Affect Growth Chart I-13The GDP Forecasts Have Not Been Revised Down To Reflect New Challenges Investors are increasingly worried that the US is heading for a recession. What are your views? As my colleague, US Investment Strategist Doug Peta has put it: “Fed Chair Powell is attempting to steer the US economy between the Scylla of a recession and the Charybdis of entrenched high inflation.” Indeed, the Fed has a narrow margin of error for achieving a “soft landing.” The war in Ukraine makes the Fed’s objective even more challenging. Alan Blinder, a former Fed economist and current Princeton University professor who has a forthcoming book on monetary and fiscal policy history over the past 60 years, says the Fed has just once in the last 11 tightening periods nailed a “perfect soft landing” – in the early 1990s. But twice more, in the mid-1960s and early 1980s, the central bank raised interest rates without sparking an official recession—and such “soft-ish” landings, he said in a recent presentation, are not all that rare.1 This is a track record we find disturbing. However, we share Powell’s view that “the probability of a recession within the next year is not particularly elevated… all signs are that this is a strong economy and, indeed, one that will be able to flourish… in the face of less accommodative monetary policy.” We concur. A recession is unlikely in the next 12 months or so. The US economy is in the midst of a classic slowdown stage of the business cycle: Growth is still strong albeit slowing, inflation is elevated, liquidity is (still) abundant, capacity utilization is high, and the unemployment rate is low (Table 1). The American consumer is unhappy but has not tightened purse strings much yet. Importantly, growth is slowing off high levels so this stage can take a long time (Chart I-14). Table I-1Stages Of The Business Cycle Doug Peta’s simple recession indicator, built from components that have reliably provided an advance warning, reinforces this conclusion. The 3-month/10-year segment of the yield curve is not yet close to inverting (Chart I-15). Chart I-14The Business Cycle Indicator Signals Slowdown Chart I-1510-Year Treasury Yield Less 3-Months Treasury Bills Segment Is Not Inverted The year-over-year change in the Conference Board’s Leading Economic Index is way above the zero line that has signaled past recessions (Chart I-16). The ISM Manufacturing PMI is well above 50. The Fed funds rate is nowhere near its equilibrium/neutral level, which we judge to be north of 3%, and it is highly unlikely to get there by the end of the year (Chart I-17). Chart I-16The LEI YoY% Is Way Above Zero Chart I-17The Fed Funds Rate Is Far From Neutral Excluding the pandemic, recessions over the last 50-plus years have occurred only when all three components sound the alarm; not one is flashing red now and not one is likely to do so during 2022. Bottom Line: We are watching out not for a recession, but for a growth disappointment. Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com S&P 500 Chart II-1Macroeconomic Backdrop Chart II-2Profitability Chart II-3Valuations And Technicals Chart II-4Uses Of Cash Communication Services Chart II-5Macroeconomic Backdrop Chart II-6Profitability Chart II-7Valuations And Technicals Chart II-8Uses Of Cash Consumer Discretionary Chart II-9Macroeconomic Backdrop Chart II-10Profitability Chart II-11Valuations And Technicals Chart II-12Uses Of Cash Consumer Staples Chart II-13Macroeconomic Backdrop Chart II-14Profitability Chart II-15Valuations And Technicals Chart II-16Uses Of Cash Energy Chart II-17Macroeconomic Backdrop Chart II-18Profitability Chart II-19Valuations And Technicals Chart II-20Uses Of Cash Financials Chart II-21Macroeconomic Backdrop Chart II-22Profitability Chart II-23Valuations And Technicals Chart II-24Uses Of Cash Health Care Chart II-25Sector vs Industry Groups Chart II-26Profitability Chart II-27Valuations And Technicals Chart II-28Uses Of Cash Industrials Chart II-29Macroeconomic Backdrop Chart II-30Profitability Chart II-31Valuations And Technicals Chart II-32Uses Of Cash Information Technology Chart II-33Macroeconomic Backdrop Chart II-34Profitability Chart II-35Valuations And Technicals Chart II-36Uses Of Cash Materials Chart II-37Macroeconomic Backdrop Chart II-38Profitability Chart II-39Valuations And Technicals Chart II-40Uses Of Cash Real Estate Chart II-41Macroeconomic Backdrop Chart II-42Profitability Chart II-43Valuations And Technicals Chart II-44Uses Of Cash Utilities Chart II-45Macroeconomic Backdrop Chart II-46Profitability Chart II-47Valuations And Technicals Chart II-48Uses Of Cash Table II-1Performance Table II-2Valuations And Forward Earnings Growth Footnotes 1 "Recession Risks Are Rising. Can the Fed Stick a Soft Landing?" Barron's (barrons.com) Recommended Allocation Recommended Allocation: Addendum
Executive Summary US inflation is running at its highest level in over four decades. Although we expect it will soon peak, it appears certain to remain above the Fed’s 2% target level for an extended period. The war in Ukraine and COVID’s assault on China could give rise to a new round of supply disruptions that keep inflation at very high levels even after the initial wave of bottlenecks is cleared. Long-term price stability may best position an economy to achieve its potential, but real S&P 500 earnings have grown twice as fast when CPI inflation is above its mean than they have when it is below its mean. Historically, inflation has only begun to squeeze nominal earnings growth at two-standard-deviation extremes. Meaningful equity de-rating has been a feature when inflation exceeds its mean, however, and investors will have to be alert for any signs that TINA might be losing its grip on financial markets. We do not think that low-to-no-yield Treasuries or cash yet offer an appealing alternative, but animal spirits are always subject to change. Bumping Up Against Tactical Limits Bottom Line: The question of how to navigate an inflationary environment is likely to be with investors across 2022 and beyond. We continue to recommend overweighting equities over our cyclical 6-12-month timeframe, but risks are heightened and we will change course if conditions dictate. Feature With consumer prices rising at a clip not seen in over 40 years, inflation is a hot-button topic for anyone with even a passing interest in the US economy. The relentless series of upside inflation surprises have investors preoccupied with finding havens. To help get a handle on where to invest against varying inflation backdrops, we divided inflation into five regimes since the consumer price index (CPI) was launched in 1947: extreme inflation (an annualized quarter-over-quarter rate more than two standard deviations above its mean), high inflation (more than one but less than or equal to two standard deviations above the mean), moderate inflation (up to one standard deviation above the mean), moderately low inflation (one standard deviation below the mean up to the mean) and deflation (two standard deviations below the mean up to one standard deviation below the mean). Related Report US Investment StrategyThe Last Line Of Inflation Defense (Is Holding Fast) We reviewed the performance of S&P 500 operating earnings, earnings multiples and returns in each CPI regime to see how equities have responded to inflation over the last 75 years. We then reviewed the available total return data for Treasuries, investment-grade corporate bonds and high-yield corporate bonds and analyzed them alongside equity total returns. The empirical record enhances our confidence in earnings growth, but the S&P 500 currently trades at nearly 20 times forward four-quarter earnings, and it is especially vulnerable to de-rating, given that contracting valuations have been the driver of underperformance when inflation exceeds its mean. We find it hard to contemplate overweighting fixed income over the next year when nominal yields are so far below the rate of inflation. It may require a modest leap of faith to believe that equity multiples can maintain their cruising altitude, but the odds are very long that a 10-year Treasury note yielding 2.4% will protect its owner’s purchasing power when prices might rise by 3.5% to 4.5% over the next year. The positive real returns that Treasuries have delivered in high-inflation environments since 1984 were achieved over a lengthy stretch in which inflation compensation at the date of purchase repeatedly topped actual inflation to maturity. Today it appears as if ex-ante inflation compensation is likely to prove woefully inadequate and we are skeptical that bonds can live up to their historical return patterns. 75 Years Of Inflation Data Chart 1 shows 299 quarters of annualized inflation data in standard deviation increments since the CPI was constructed in 1947. The shape of the distribution bears out the notion that prices are sticky to the downside; the population mean is well above the median as the high-inflation right tail is longer and fatter than the deflationary left tail. Across the CPI’s entire history, inflation has averaged 3.52% on an annualized quarter-over-quarter basis with a standard deviation (“sigma”) of 3.55%. Based on those parameters, we define extremely high inflation as CPI increases above 10.62% (17 instances), high inflation as 7.08% to 10.62% (22 instances), moderately high inflation as 3.53% to 7.07% (82 instances), moderately low inflation as -0.02% to 3.52% (155 instances), disinflation as -3.57% to -0.03% (21 instances) and deflation as less than -3.57% (2 instances). Chart 1The Complete Annualized CPI Distribution Inflation And Equities We examined movements in operating earnings, trailing multiples and closing prices for the S&P 500 in each of the six inflation regimes, though we discarded the outlier deflation bucket for insufficient data. In the extreme (greater-than-two-sigma) inflation scenario, S&P 500 earnings initially surged amidst the early postwar period’s pent-up demand explosion before going backwards in the Korean War inflation, the sharp 1973-75 recession and the Volcker double dip (Chart 2, dark solid line). An expanding P/E multiple (dashed line) helped to mitigate the blow from shrinking earnings, but equity investors endured sharp real declines (bottom panel, light solid line). Chart 2Extreme Inflation Squashes Earnings The one-to-two-sigma high-inflation scenario is a mirror image of the extreme inflation scenario. Nominal earnings growth surged (Chart 3, top panel) and managed to hold up well in real terms (Chart 3, bottom panel), but the index’s multiple de-rated at a vicious 15.5% annualized rate, sticking investors with double-digit real losses. 70% of this regime played out from 1973 to 1982 and it also spanned some of 1990-91 and great recessions. The last two data points occurred in 2021, when flat multiples allowed equities to benefit from robust earnings growth, but previously melting multiples illustrate the peril for equities if monetary tightening induces a hard landing. Chart 3High Inflation: Surging Nominal Earnings, Fierce De-Rating The zero-to-one-sigma moderate-inflation scenario has fostered such robust earnings growth that even a steady de-rating headwind cannot hold back equity returns (Chart 4). Despite spanning the entire 1973-74 recession and the early stages of the global financial crisis, the moderate-inflation regime has been solidly conducive to growth. Chart 4Moderate Inflation Is Great For Growth Just over half of the quarters have met our minus-one-to-zero-sigma moderately low inflation standard. They have featured subpar nominal earnings growth, but a benign inflation backdrop has helped them close the gap with mean real growth and a re-rating tailwind has pushed real annualized S&P 500 price returns above 7% (Chart 5). Most of the post-crisis period has unfolded against a moderately low inflation backdrop, which has been good for equity investors even as concerns about tepid growth lingered. Chart 5Moderately Low Inflation Is The Enduring Equity Sweet Spot The minus-two-to-minus-one-sigma deflationary backdrop in which the price level contracts has featured even weaker aggregate growth, but a 10% annualized re-rating boost has allowed equities to deliver double-digit returns (Chart 6). One would expect growth to wither when the price level is deflating but ex-1Q20, when the pandemic halted activity in its tracks, growth in this phase has topped growth in every other phase. That counterintuitive result illustrates that inflation is a lagging indicator that exerts a heavy influence on monetary policy, which impacts the economy with a lag, while markets are forward looking. The ends of the inflation distribution are likely to mark inflection points where momentum reverses. Chart 6Once Prices Deflate, The Danger Has Already Passed Our survey of equity performance across inflation regimes has shown that inflation is much better for earnings growth than disinflation/deflation until it reaches extreme levels. Nominal earnings have grown three times as fast and real earnings have grown twice as fast when inflation is above its 3.52% mean than when it’s below it (Table 1). The fundamental tailwind that comes with perky inflation is almost entirely offset by multiple contraction, however, just as the growth drag from low inflation is offset by multiple expansion. We don’t think investors should be unduly worried that inflation will squash growth this year, but they do need to be alert to anything that might presage de-rating. Table 1Inflation And Earnings, Multiples, And Returns Inflation And Bonds To fill out the asset allocation picture, we also reviewed the performance of the Bloomberg US Treasury, US Corporate and US High Yield Total Return Indices. Table 2 tracks annual nominal and real total returns for all three indices, along with the S&P 500, since the second half of 1983, when the high-yield index was launched. The distribution of CPI changes from 1983 forward is more concentrated about the mean than the entire population distribution beginning in 1947 and nearly 80% of observations fall within one standard deviation of the mean, so the tail distributions have comparatively few observations. Table 2Inflation, Treasuries And Spread Product Nonetheless, the extant tail observations suggest that high yield’s positive carry failed to generate positive excess returns over Treasuries in high-inflation environments while spread widening and increased defaults caused them to lag Treasuries amidst extreme deflation. Investment grade also lagged Treasuries in the tails, albeit by a smaller margin than high yield. High yield comfortably outperformed within the core minus-one-to-plus-one-sigma range, when equities also shined. The bottom line is that Treasuries have provided welcome ballast to multi-asset portfolios in both high-inflation and deflationary episodes over the last 40 years. They were even bigger winners from late 1972, when the Treasury and corporate indexes began, through late 1983, sporting annualized real returns that beat those of high-grade corporates and the S&P 500 by five and eight percentage points, respectively, when inflation exceeded its mean. We question the applicability of the empirical record in the current environment, however, as ex-ante inflation compensation routinely outstripped ex-post inflation over the four-plus decades that it was compiled. Even as the 10-year yield has recently flirted with 2.5%, we expect that the inflation compensation embedded in long-duration bonds will prove inadequate to preserve bondholders’ purchasing power over the bonds’ remaining life. Portfolio Construction The findings from our inflation review do not spur us to make any changes to the ETF portfolio. We continue to believe that the near-term foundations of the US economy are strong and will support above-trend growth over our six- to twelve-month investment timeframe. US growth is at risk from the war in Ukraine and the ongoing COVID-19 revival and aggressive Fed tightening could stifle the effects of past fiscal and monetary stimulus measures that have not yet been felt. We are actively monitoring global geopolitical and public health developments, along with the Fed, though we think it will be difficult for Chair Powell and company to surprise hawkishly over the rest of this year. We believe the moves we made four weeks ago, when we temporarily closed out our equity overweight, reduced our cyclicals-over-defensives positioning, dialed back our value and small-cap overweights, initiated direct exposure to the metals and mining space via the XME ETF and trimmed our Treasury underweight, will protect the portfolio adequately against ongoing inflationary surges and sporadic growth headwinds. The direct homebuilder exposure we took on via the ITB ETF at that time has weighed on performance, but we are sticking with it as we believe the widespread pessimism about the industry’s prospects has gotten way overdone. The labor market remains robust, as the March employment report and the February JOLTS release reiterated last week, less pecunious households are flush with excess pandemic savings and the wealthy are reveling in an unprecedented surge in household net worth. The global situation merits tactical caution, and it looks as if the S&P 500 has hit the top of its near-term range (Chart 7, top panel) while the VIX may have reached a near-term bottom (Chart 7, bottom panel), but our sanguine cyclical view remains intact. Chart 7Equities May Have Reached Another Short-Term Turning Point ETF Portfolio Review - March The cyclical ETF portfolio returned 1.26% in March (Appendix Table), outperforming its benchmark by a modest 8 basis points (“bps”). Our bond underweight was auspicious as yields rose across all maturities last month. Overweighting the riskier segments of the fixed-income market – junk bonds and preferred stocks via the VRP ETF – generated 14 bps of relative performance. However, our equity positioning chipped away at those gains. We underweighted Utilities, March’s top performing sector, and overweighted value, which lagged. Our large Energy overweight mitigated those drags, leaving us with positive net alpha. Since inception two months ago, the portfolio’s value-added stands at 18 bps. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Jennifer Lacombe Associate Editor JenniferL@bcaresearch.com Cyclical ETF Portfolio
Executive Summary Equities Are Still Attractive Versus Bonds Macroeconomic Outlook: Global growth will reaccelerate in the second half of this year provided a ceasefire in Ukraine is reached. Inflation will temporarily come down as the dislocations caused by the war and the pandemic subside, before moving up again in late 2023. Equities: Maintain a modest overweight in stocks over a 12-month horizon, favoring non-US equities, small caps, and value stocks. Look to turn more defensive in the second half of 2023 in advance of another wave of inflation. Fixed income: The neutral rate of interest in the US is around 3.5%-to-4%, which is substantially higher than the consensus view. Bond yields will move sideways this year but will rise over the long haul. Overweight Germany, France, Japan, and Australia while underweighting the US and the UK in a global bond portfolio. Credit: Corporate debt will outperform high-quality government bonds over the next 12 months. Favor HY over IG and Europe over the US. Spreads will widen again in late 2023. Currencies: As a countercyclical currency, the US dollar will weaken later this year, with EUR/USD rising to 1.18. We are upgrading our view on the yen from bearish to neutral due to improved valuations. The CNY will strengthen as the Chinese authorities take steps to boost domestic demand. Commodities: Oil prices will dip in the second half of 2022 as the geopolitical premium in crude declines and more OPEC supply comes to market. However, oil and other commodity prices will start moving higher by mid-2023. Bottom Line: The cyclical bull market in stocks that began in 2009 is running long in the tooth, but the combination of faster global growth later this year and a temporary lull in inflation should pave the way for one final hurrah for equities. Dear Client, Instead of our regular report this week, we are sending you our Quarterly Strategy Outlook, where we explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. Next week, please join me for a webcast on Monday, April 11 at 9:00 AM EDT (2:00 PM BST, 3:00 PM CEST, 9:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist P.S. You can now follow me on LinkedIn and Twitter. I. Overview We continue to recommend overweighting global equities over a 12-month horizon. However, we see downside risks to stocks both in the near term (next 3 months) and long term (2-to-5 years). In the near term, stocks will weaken anew if Russia’s stated intentions to scale back operations in Ukraine turn out to be a ruse. There is also a risk that China will need to temporarily shutter large parts of its economy to combat the spread of the highly contagious BA.2 Omicron variant. While stocks could suffer a period of indigestion in response to monetary tightening by the Fed and a number of other central banks, we doubt that rates will rise enough over the next 12 months to undermine the global economy. This reflects our view that the neutral rate of interest in the US and most other countries is higher than widely believed. If the neutral rate ends up being between 3.5% and 4% in the US, as we expect, the odds are low that the Fed will induce a recession by raising rates to 2.75%, as the latest dot plot implies (Chart 1). Chart 1The Market Sees The Fed Raising Rates To Around 3% And Then Backing Off The downside of a higher neutral rate is that eventually, investors will need to value stocks using a higher real discount rate. How fast markets mark up their estimate of neutral depends on the trajectory of inflation. We were warning about inflation before it was cool to warn about inflation (see, for example, our January 2021 report, Stagflation in a Few Months?; or our February 2021 report, 1970s-Style Inflation: Yes, It Could Happen Again). Our view has been that inflation will follow a “two steps up, one step down” pattern. We are currently near the top of those two steps: US inflation will temporarily decline in the second half of this year, as goods inflation drops but service inflation is slow to rise. The decline in inflation will provide some breathing room for the Fed, allowing it to raise rates by no more than what markets are already discounting over the next 12 months. Unfortunately, the respite in inflation will not last long. By the end of 2023, inflation will start to pick up again, forcing the Fed to resume hiking rates in 2024. This second round of Fed tightening is not priced by the markets, and so when it happens, it could be quite disruptive for stocks and other risk assets. Investors should overweight equities on a 12-month horizon but look to turn more defensive in the second half of 2023. II. The Global Economy War and Pestilence Are Near-Term Risks BCA’s geopolitical team, led by Matt Gertken, was ringing the alarm bell about Ukraine well before Russia’s invasion. Recent indications from Russia that it will scale back operations in Ukraine could pave the way for a ceasefire; or they could turn out to be a ruse, giving Russia time to restock supply lines and fortify its army in advance of a new summertime campaign against Kyiv. It is too early to tell, but either way, our geopolitical team expects more fighting in the near term. The West is not keen to give Putin an easy off-ramp, and even if it were, it is doubtful he would take it. The only way that Putin can salvage his legacy among his fan base in Russia is to decisively win the war in order to ensure Ukraine’s military neutrality. For his part, Zelensky cannot simply agree to Russia’s pre-war demands that Ukraine demilitarize and swear off joining NATO unless Russian forces first withdraw. To give in to such demands without any concrete security guarantees would raise the question of why Ukraine fought the war to begin with. The Impact of the Ukraine War on the Global Economy The direct effect of the war on the global economy is likely to be small. Together, Russia and Ukraine account for 3.5% of global GDP in PPP terms and 1.9% in dollar terms. Exports to Russia and Ukraine amount to only 0.2% of G7 GDP (Chart 2). Most corporations have little direct exposure to Russia, although there are a few notable exceptions (Chart 3). Chart 2Little Direct Trade Exposure To Russia And Ukraine In contrast to the direct effects, the indirect effects have the potential to be sizable. Russia is the world’s second largest oil producer, accounting for 12% of annual global output (Chart 4). It is the world’s top exporter of natural gas. About half of European natural gas imports come from Russia. Russia is also a significant producer of nickel, copper, aluminum, steel, and palladium. Chart 3Only A Handful Of Firms Have Significant Sales Exposure To Russia Chart 4Russia is The World's Second Largest Oil Producer Russia and Ukraine are major agricultural producers. Together, they account for a quarter of global wheat exports, with much of it going to the Middle East and North Africa (Chart 5). They are also significant producers of potatoes, corn, sugar beets, and seed oils. In addition, Russia produces two-thirds of all ammonium nitrate, the main source of nitrogen-based fertilizers. Largely as a result of higher commodity prices and other supply disruptions, the OECD estimates that the war could shave about 1% off of global growth this year, with Europe taking the brunt of the hit (Chart 6). At present, the futures curves for most commodities are highly backwardated (Chart 7). While one cannot look to the futures as unbiased predictors of where spot prices are heading, it is fair to say that commodity markets are discounting some easing in prices over the next two years. If that does not occur, global growth could weaken more than the OECD expects. Chart 5Developing Economies Buy The Bulk Of Russian And Ukrainian Wheat Chart 6The War In Ukraine Could Shave One Percentage Point Off Of Global Growth Chart 7Futures Curves For Most Commodities Are Backwardated Another Covid Wave Two years after “two weeks to flatten the curve,” the world continues to underappreciate the power of exponential growth. Suppose that it takes five days for someone with Covid to infect someone else. If everyone with Covid infects an average of six people, the cumulative number of Covid cases would rise from 1,000 to 10 million in around four weeks. Suppose you could cut the number of new infections in half to three per person. In that case, it would take about six weeks for 10 million people to be infected. In other words, mitigation measures that cut the infection rate by half would only extend how long it takes for 10 million people to be infected by two weeks. That’s not a lot. The point is that any infection rate above one will generate an explosive rise in cases. In the pre-Omicron days, keeping the infection rate below one was difficult, but not impossible for countries with the means and motivation to do so. As the virus has become more contagious, however, keeping it at bay has grown more difficult. The latest strain of Omicron, BA.2, appears to be 40% more contagious than the original Omicron strain, which itself was about 4-times more contagious than Delta. BA.2 is quickly spreading around the world. The number of cases has spiked across much of Europe, parts of Asia, and has begun to rise in North America (Chart 8). In China, the authorities have locked down Shanghai, home to 25 million people. Chart 8Covid Cases Are On The Rise Again The success that China has had in suppressing the virus has left its population with little natural immunity; and given the questionable efficacy of its vaccines, with little artificial immunity as well. Moreover, as is the case in Hong Kong, a large share of mainland China’s elderly population remains completely unvaccinated. Chart 9New Covid Drugs Are Set To Hit The Market This presents the Chinese authorities with a difficult dilemma: Impose severe lockdowns over much of the population, or let the virus run rampant. As the logic of exponential change described above suggests, there is not much of a middle ground. Our guess is that the Chinese government will choose the former option. China has already signed a deal to commercialize Pfizer’s Paxlovid. The drug is highly effective at preventing hospitalization if taken within five days from the onset of symptoms. Fortunately, Paxlovid production is starting to ramp up (Chart 9). China will probably wait until it has sufficient supply of the drug before relaxing its zero-Covid policy. While beneficial to growth later this year, this strategy could have a negative near-term impact on activity, as the authorities continue to play whack-a-mole with Covid. Chart 10Inflation Is Running High, Especially In The US Central Banks in a Bind Standard economic theory says that central banks should adjust interest rates in response to permanent shocks, while ignoring transitory ones. This is especially true if the shock in question emanates from the supply side of the economy. After all, higher rates cool aggregate demand; they do not raise aggregate supply. The lone exception to this rule is when a supply shock threatens to dislodge long-term inflation expectations. If long-term inflation expectations become unanchored, what began as a transitory shock could morph into a semi-permanent one. The problem for central banks is that the dislocations caused by the Ukraine war are coming at a time when inflation is already running high. Headline CPI inflation reached 7.9% in the US in February, while core CPI inflation clocked in at 6.4%. Trimmed-mean inflation has increased in most economies (Chart 10). Fortunately, while short-term inflation expectations have moved up, long-term expectations have been more stable. Expected US inflation 5-to-10 years out in the University of Michigan survey stood at 3.0% in March, down a notch from 3.1% in January, and broadly in line with the average reading between 2010 and 2015 (Chart 11). Survey-based measures of long-term inflation expectations are even more subdued in the euro area and Japan (Chart 12). Market-based inflation expectations have risen, although this partly reflects higher oil prices. Even then, the widely-watched 5-year, 5-year forward TIPS inflation breakeven rate remains near the bottom of the Fed’s comfort range of 2.3%-to-2.5% (Chart 13).1 Chart 11Long-Term Inflation Expectations Remain Contained In The US... Chart 12... And In The Euro Area And Japan Chart 13The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone Goods versus Services Inflation Most of the increase in consumer prices has been concentrated in goods rather than services (Chart 14). This is rather unusual in that goods prices usually fall over time; but in the context of the pandemic, it is entirely understandable. Chart 14Goods Prices Have Been A Major Driver Of Overall Inflation The pandemic caused spending to shift from services to goods (Chart 15). This occurred at the same time as the supply of goods was being adversely affected by various pandemic-disruptions, most notably the semiconductor shortage that is still curtailing automobile production. Chart 15AGoods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Chart 15BGoods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Looking out, the composition of consumer spending will shift back towards services. Supply chain bottlenecks should also abate, especially if the situation in Ukraine stabilizes. It is worth noting that the number of ships on anchor off the coast of Los Angeles and Long Beach has already fallen by half (Chart 16). The supplier delivery components of both the manufacturing and nonmanufacturing ISM indices have also come off their highs (Chart 17). Even used car prices appear to have finally peaked (Chart 18). Chart 16Shipping Delays Are Abating Chart 17Delivery Times Are Slowly Coming Down Chart 18Used Car Prices May Have Finally Peaked On the Lookout for a Wage-Price Spiral Could rising services inflation offset any decline in goods inflation this year? It is possible, but for that to happen, wage growth would have to accelerate further. For now, much of the acceleration in US wage growth has occurred at the bottom end of the income distribution (Chart 19). It is easy to see why. Chart 20 shows that low-paid workers have not returned to the labor market to the same degree as higher-paid workers. However, now that extended unemployment benefits have lapsed and savings deposits are being drawn down, the incentive to resume work will strengthen. Chart 19Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Chart 20More Low-Wage Employees Should Return To Work Chart 21More Workers Will Return To Their Jobs Once The Pandemic Ends The end of the pandemic should allow more workers to remain at their jobs. In January, during the height of the Omicron wave, 8.75 million US workers (5% of the total workforce) were absent from work due to the virus (Chart 21). How High Will Interest Rates Eventually Rise? If goods inflation comes down swiftly later this year, and services inflation is slow to rise, then overall inflation will decline. This should allow the Fed to pause tightening in early 2023. Whether the Fed will remain on hold beyond then depends on where the neutral rate of interest resides. Chart 22The Yield Curve Inverted in Mid-2019 But Growth Accelerated The neutral rate, or equilibrium rate as it is sometimes called, is the interest rate consistent with full employment and stable inflation. If the Fed pauses hiking before interest rates have reached neutral, the economy will eventually overheat, forcing the Fed to resume hiking. In contrast, if the Fed inadvertently raises rates above neutral, unemployment will start rising, requiring the Fed to cut rates. Markets are clearly worried about the latter scenario. The 2/10 yield curve inverted earlier this week. With the term premium much lower than in the past, an inversion in the yield curve is not the powerful harbinger of recession that it once was. After all, the 2/10 curve inverted in August 2019 and the economy actually strengthened over the subsequent six months before the pandemic came along (Chart 22). Nevertheless, an inverted yield curve is consistent with markets expectations that the Fed will raise rates above neutral. That is always a dangerous undertaking. Raising rates above neutral would likely push up the unemployment rate. There has never been a case in the post-war era where the 3-month moving average of the unemployment rate has risen by more than 30 basis points without a recession occurring (Chart 23). Chart 23When Unemployment Starts Rising, It Usually Keeps Rising As discussed in the Feature Section below, the neutral rate of interest is probably between 3.5% and 4% in the US. This is good news in the short term because it lowers the odds that the Fed will raise rates above neutral during the next 12 months. It is bad news in the long run because it means that the Fed will find itself even more behind the curve than it is now, making a recession almost inevitable. The Feature Section builds on our report from two weeks ago. Readers familiar with that report should feel free to skip ahead to the next section. III. Feature: A Higher Neutral Rate Conceptually, the neutral rate is the interest rate that equates the amount of investment a country wants to undertake at full employment with the amount of savings that it has at its disposal.2 Anything that reduces savings or increases investment would raise the neutral rate (Chart 24). Chart 24The Savings-Investment Balance Determines The Neutral Rate Of Interest A number of factors are likely to lower desired savings in the US over the next few years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and the receipt of generous government transfer payments (Chart 25). Household wealth has soared since the start of the pandemic (Chart 26). Conservatively assuming that households spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by 4% of GDP. Chart 25Plenty Of Pent-Up Demand Chart 26Net Worth Has Soared Since The Pandemic The household deleveraging cycle has ended (Chart 27). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. For the first time since the housing boom, mortgage equity withdrawals are rising. Banks are easing lending standards on consumer loans across the board. Chart 27US Household Deleveraging Pressures Have Abated Chart 28Baby Boomers Have Amassed A Lot Of Wealth Baby boomers are retiring. They hold over half of US household wealth, considerably more than younger generations (Chart 28). As baby boomers transition from being savers to dissavers, national savings will decline. Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 29).Chart 29Fiscal Policy: Tighter But Not Tight On the investment front: The deceleration in trend GDP growth, which depressed investment spending, has largely run its course.3 According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today. The CBO expects potential growth to edge down only slightly to 1.7% over the next few decades (Chart 30). After moving broadly sideways for two decades, core capital goods orders – a leading indicator for capital spending – have broken out to the upside (Chart 31). Capex intention surveys remain upbeat (Chart 32). The average age of the nonresidential capital stock currently stands at 16.3 years, the highest since 1965 (Chart 33). Chart 30Much Of The Deceleration In Potential Growth Has Already Happened Chart 31Positive Signs For Capex (I) Chart 32Positive Signs For Capex (II) Chart 33An Aging Capital Stock Similar to nonresidential investment, the US has been underinvesting in residential real estate (Chart 34). The average age of the housing stock has risen to a 71-year high of 31 years. The homeowner vacancy rate has plunged to the lowest level on record. The number of newly finished homes for sale is half of what it was prior to the pandemic. Chart 34US Housing Is In Short Supply The New ESG: Energy Security and Guns The war in Ukraine will put further upward pressure on the neutral rate, especially outside of the United States. After staging a plodding recovery following the euro debt crisis, European capital spending received a sizable boost from the launch of the NextGenerationEU Recovery Fund (Chart 35). As Mathieu Savary points out in his latest must-read report on Europe, capital spending will rise further in the years ahead as European governments accelerate efforts to make their economies less reliant on Russian energy. Germany has already announced plans to construct three new LNG terminals. The push to build out Europe’s energy infrastructure is coming at a time when businesses are looking to ramp up capital spending. As in the US, Europe’s capital stock has aged rapidly over the past decade (Chart 36). Chart 35European Capex Should Recover Chart 36European Machines Need More Than Just An Oil Change Chart 37The War In Ukraine Calls For More Spending Across Europe Meanwhile, European governments are trying to ease the burden from rising energy costs. For example, France has introduced a rebate on fuel. It is part of a EUR 20 billion package aimed at cutting heating and electricity bills. European military spending will rise. Military spending currently amounts to 1.5% of GDP, well below NATO’s threshold of 2% (Chart 37). Germany has announced that it will spend EUR 100 billion more on defense. European governments will also need to boost spending to accommodate Ukrainian refugees. The UN estimates that four million refugees have left Ukraine, with the vast majority settling in the EU. A Smaller Chinese Current Account Surplus? The difference between what a country saves and invests equals its current account balance. Historically, China has been a major exporter of savings, which has helped depress interest rates abroad. While China’s current account surplus has declined as a share of its own GDP, it has remained very large as a share of global ex-China GDP, reflecting China’s growing weight in the global economy (Chart 38). Many analysts assume that China will double down on efforts to boost exports in order to offset the drag from falling property investment. However, there is a major geopolitical snag with that thesis: A country that runs a current account surplus must, by definition, accumulate assets from the rest of the world. As the freezing of Russia’s foreign exchange reserves demonstrates, that is a risky proposition for a country such as China. Rather than increasing its current account surplus, China may seek to bolster its economy by raising domestic demand. This could be achieved by either boosting domestic infrastructure spending or raising household consumption. Notably, China’s credit impulse appears to have bottomed and is set to increase in the second half of the year. This is good news not just for Chinese growth but growth abroad (Chart 39). Chart 38Will China Be A Source Of Excess Savings? Chart 39China's Credit Impulse Appears To Have Bottomed The IMF’s latest projections foresee China’s current account surplus falling by more than half between 2021 and 2026 as a share of global ex-China GDP. If this were to happen, the neutral rate in China and elsewhere would rise. IV. Financial Markets A. Portfolio Strategy Chart 40The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles As noted in the overview, if the neutral rate turns out to be higher than currently perceived, the Fed is unlikely to induce a recession by raising rates over the next 12 months. That is good news for equities. A look back at the past four Fed tightening cycles shows that stocks often wobble when the Fed starts hiking rates, but then usually rise as long as rates do not move into restrictive territory (Chart 40). Unfortunately, a higher neutral rate also means that investors will eventually need to value stocks using a higher discount rate. It also means that any decline in inflation this year will not last. The US economy will probably start to overheat again in the second half of 2023. This will set the stage for a second, and more painful, tightening cycle in 2024. Admittedly, there is a lot of uncertainty over our “two steps up, one step down” forecast for inflation. It is certainly possible that the “one step down” phase does not last long and that the resurgence in inflation we are expecting in the second half of next year occurs earlier. It is also possible that investors will react negatively to rising rates, even if the economy is ultimately able to withstand them. As such, only a modest overweight to equities is justified over the next 12 months, with risks tilted to the downside in the near term. More conservative asset allocators should consider moving to a neutral stance on equities already, as my colleague Garry Evans advised clients to do in his latest Global Asset Allocation Quarterly Portfolio Outlook. B. Fixed Income Stay Underweight Duration Over a 2-to-5 Year Horizon Our recommendation to maintain below-benchmark duration in fixed-income portfolios panned out since the publication of our Annual Outlook in December, with the US 10-year Treasury yield rising from 1.43% to 2.38%. We continue to expect bond yields in the US to rise over the long haul. Conceptually, the yield on a government bond equals the expected path of policy rates over the duration of the bond plus a term premium. The term premium is the difference between the return investors can expect from buying a long-term bond that pays a fixed interest rate, and the return from rolling over a short-term bill. The term premium has been negative in recent years. Investors have been willing to sacrifice return to own long-term bonds because bond prices usually rise when the odds of a recession go up. The fact that monthly stock returns and changes in bond yields have been positively correlated since 2001 underscores the benefits that investors have received from owning long-term bonds as a hedge against unfavorable economic news (Chart 41). However, now that inflation has emerged as an increasingly important macroeconomic risk, the correlation between stock returns and changes in bond yields could turn negative again. Unlike weak economic growth, which is bad for only stocks, high inflation is bad for both bonds and stocks. Chart 41Correlation Between Stock Returns And Bond Yields Could Turn Negative If bond yields start to rise whenever stock prices fall, the incentive to own long-term bonds will decline. This will cause the term premium to increase. Assuming the term premium rises to about 0.5%, and a neutral rate of 3.5%-to-4%, the long-term fair value for the 10-year US Treasury yield is 4%-to-4.5%. This is well above the 5-year/5-year forward yield of 2.20%. Move from Underweight to Neutral Duration Over a 12-Month Horizon Below benchmark duration positions usually do well when the Fed hikes rates by more than expected over the subsequent 12 months (Chart 42). Chart 42The Golden Rule Of Bond Investing Given our view that US inflation will temporarily decline later this year, the Fed will probably not need to raise rates over the next 12 months by more than the 249 basis points that markets are already discounting. Thus, while a below-benchmark duration position is advisable over a 2-to-5-year time frame, it could struggle over a horizon of less than 12 months. Our end-2022 target range for the US 10-year Treasury yield is 2.25%-to-2.5%. Chart 43Bond Sentiment And Positioning Are Bearish Supporting our decision to move to a neutral benchmark duration stance over a 12-month horizon is that investor positioning and sentiment are both bond bearish (Chart 43). From a contrarian point of view, this is supportive of bonds. Global Bond Allocation BCA’s global fixed-income strategists recommend overweighting German, French, Australian, and Japanese government bonds, while underweighting those of the US and the UK. They are neutral on Italy and Spain given that the ECB is set to slow the pace of bond buying. The neutral rate of interest has risen in the euro area, partly on the back of more expansionary fiscal policy across the region. In absolute terms, however, the neutral rate in the euro area is still quite low, and possibly negative. Unlike in the US, where inflation has risen to uncomfortably high levels, much of Europe would benefit from higher inflation expectations, as this would depress real rates across the region, giving growth a boost. This implies that the ECB is unlikely to raise rates much over the next two years. As with the euro area, Japan would benefit from lower real rates. The Bank of Japan’s yield curve control policy has been put to the test in recent weeks. To its credit, the BoJ has stuck to its guns, buying bonds in unlimited quantities to prevent yields from rising. We expect the BoJ to stay the course. Unlike in the euro area and Japan, inflation expectations are quite elevated in the UK and wage growth is rising quickly there. This justifies an underweight stance on UK gilts. Although job vacancies in Australia have climbed to record levels, wage growth is still not strong enough from the RBA’s point of view to justify rapid rate hikes. As a result, BCA’s global fixed-income strategists remain overweight Australian bonds. Finally, our fixed-income strategists are underweight Canadian bonds but are contemplating upgrading them given that markets have already priced in 238 basis points in tightening over the next 12 months. Unlike in the US, high levels of consumer debt will also limit the Bank of Canada’s ability to raise rates. Modest Upside in High-Yield Corporate Bonds Credit spreads have narrowed in recent days but remain above where they were prior to Russia’s invasion of Ukraine. Since the start of the year, US investment-grade bonds have underperformed duration-matched Treasurys by 154 basis points, while high-yield bonds have underperformed by 96 basis points (Chart 44). The outperformance of high-yield relative to investment-grade debt can be explained by the fact that the former has more exposure to the energy sector, which has benefited from rising oil prices. Looking out, falling inflation and a rebound in global growth later this year should provide a modestly supportive backdrop for corporate credit. High-yield spreads are still pricing in a default rate of 3.8% over the next 12 months (Chart 45). This is well above the trailing 12-month default rate of 1.3%. Our fixed-income strategists continue to prefer US high-yield over US investment-grade. Chart 44Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Chart 45Spread-Implied Default Rate Is Too High European credit is attractively priced and should benefit from any stabilization in the situation in Ukraine. Our fixed-income strategists prefer both European high-yield and investment-grade bonds over their US counterparts. As with equities, the bull market in corporate credit will end in late 2023 as the Fed is forced to resume raising rates in 2024 in the face of an overheated economy. C. Currencies Chart 46Widening Interest Rate Differentials Have Supported The Dollar The US Dollar Will Weaken Starting in the Second Half of 2022 Since bottoming last May, the US dollar has been trending higher. While the dollar could strengthen further in the near term if the war in Ukraine escalates, the fundamental backdrop supporting the greenback is starting to fray. If US inflation comes down later this year, the Fed is unlikely to raise rates by more than what markets are already discounting over the next 12 months. Thus, widening rate differentials will no longer support the dollar (Chart 46). The dollar is a countercyclical currency: It usually weakens when global growth is strengthening and strengthens when global growth is weakening (Chart 47). The dollar tends to be particularly vulnerable when growth expectations are rising more outside the US than in the US (Chart 48). Chart 47The Dollar Is A Countercyclical Currency Chart 48Better Growth Prospects Abroad Will Weigh On The US Dollar Global growth should rebound in the second half of the year once the pandemic finally ends and the situation in Ukraine stabilizes. Growth is especially likely to recover in Europe. This will support the euro, a dovish ECB notwithstanding. Chester Ntonifor, BCA’s Foreign Exchange Strategist, expects EUR/USD to end the year at 1.18. The Dollar is Overvalued The dollar’s ascent has left it overvalued by more than 20% on a Purchasing Power Parity (PPP) basis (Chart 49). The PPP exchange rate equalizes the price of a representative basket of goods and services between the US and other economies. PPP deviations from fair value have done a reasonably good job of predicting dollar movements over the long run (Chart 50). Chart 49USD Remains Overvalued Chart 50Valuations Matter For FX Long-Term Returns Reflecting the dollar’s overvaluation, the US trade deficit has widened sharply (Chart 51). Excluding energy exports, the US trade deficit as a share of GDP is now the largest on record. Equity inflows have helped finance America’s burgeoning current account deficit (Chart 52). However, these inflows have ebbed significantly as foreign investors have lost their infatuation with US tech stocks. Chart 51The US Trade Deficit Has Widened Chart 52Net Inflows Into US Equities Have Dried Up Dollar positioning remains stretched on the long side (Chart 53). That is not necessarily an obstacle in the short run, given that the dollar tends to be a momentum currency, but it does suggest that the greenback could weaken over a 12-month horizon as more dollar bulls jump ship. The Yen: Cheaper but Few Catalysts for a Bounce The trade-weighted yen has depreciated by 6.4% since the start of the year. The yen is 31% undervalued relative to the dollar on a PPP basis (Chart 54). In a nod to these improved valuations, we are upgrading our 12-month and long-term view on the yen from bearish to neutral. Chart 53Still A Lot of Dollar Bulls Chart 54The Yen Has Gotten Cheaper While the yen is unlikely to weaken much from current levels, it is unlikely to strengthen. As noted above, the Bank of Japan has no incentive to abandon its yield curve control strategy. Yes, the recent rapid decline in the yen is a shock to the economy, but it is a “good” shock in the sense that it could finally jolt inflation expectations towards the BoJ’s target of 2%. If inflation expectations rise, real rates would fall, which would be bearish for the currency. Favor the RMB and other EM Currencies The Chinese RMB has been resilient so far this year, rising slightly against the dollar, even as the greenback has rallied against most other currencies. Real rates are much higher in China than in the US, and this has supported the RMB (Chart 55). Chart 55Higher Real Rates In China Have Supported The RMB Chart 56The RMB Is Undervalued Based On PPP Despite the RMB’s strength, it is still undervalued by 10.5% relative to its PPP exchange rate (Chart 56). While productivity growth has slowed in China, it remains higher than in most other countries. The real exchange rates of countries that benefit from fast productivity growth typically appreciates over time. China holds about half of its foreign exchange reserves in US dollars, a number that has not changed much since 2012 (Chart 57). We expect China to diversify away from dollars over the coming years. Moreover, as discussed earlier in the report, the incentive for China to run large current account surpluses may fade, which will result in slower reserve accumulation. Both factors could curb the demand for dollars in international markets. Chart 57Half Of Chinese FX Reserves Are Held In USD Assets A resilient RMB will provide a tailwind for other EM currencies. Many EM central banks began to raise rates well before their developed market counterparts. In Brazil, for example, the policy rate has risen to 11.75% from 2% last April. With inflation in EMs likely to come down later this year as pandemic and war-related dislocations subside, real policy rates will rise, giving EM currencies a boost. D. Commodities Longer-Term Bullish Thesis on Commodities Remains Intact BCA’s commodity team, led by Bob Ryan, expects crude prices to fall in the second half of the year, before moving higher again in 2023. Their forecast is for Brent to dip to $88/bbl by end-2022, which is below the current futures price of $97/bbl. Chart 58Dearth Of Oil Capex Will Put A Floor Under Oil Prices The risk to their end-2022 forecast is tilted to the upside. The relationship between the Saudis and the US has become increasingly strained. This could hamper efforts to bring more oil to market. Hopes that Iranian crude will reach global markets could also be dashed if, as BCA’s geopolitical strategists expect, the US-Iran nuclear deal falls through. A cut-off of Russian oil could also cause prices to rise. While Urals crude is being sold at a heavy discount of $30/bbl to Brent (compared to a discount of around $2/bbl prior to the invasion), it is still leaving the country. In fact, Russian oil production actually rose in March over February. An escalation of the war would make it more difficult for Russia to divert enough oil to China, India, and other countries in order to evade Western sanctions. Looking beyond this year, Bob and his team see upside to oil prices. They expect Brent to finish 2023 at $96/bbl, above the futures price of $89/bbl. Years of underinvestment in crude oil production have led to tight supply conditions (Chart 58). Proven global oil reserves increased by only 6% between 2010 and 2020, having risen by 26% over the preceding decade. Stay Positive on Metals As with oil, there has been little investment in mining capacity in recent years. While a weaker property market in China will weigh on metals prices, this will be partly offset by increased infrastructure spending. The shift towards green energy will also boost metals prices. The typical electric vehicle requires about four times as much copper as a typical gasoline-powered vehicle. Huge amounts of copper will also be necessary to expand electrical grids. Favor Gold Over Cryptos After breaking above $2,000/oz, the price of gold has retreated to $1,926/oz. In the near term, gold prices will be swayed by geopolitical developments. Longer term, real rates will dictate the direction of gold prices. Chart 59 shows that there is a very strong correlation between the price of gold and TIPS yields. If we are correct that the neutral rate of interest is 3.5%-to-4% in the US, real bond yields will eventually need to rise from current levels. Gold prices are quite expensive by historic standards, which represents a long-term risk (Chart 60). Chart 59Strong Correlation Between Real Rates And Gold Chart 60Gold Is Quite Pricey From A Historical Perspective That said, we expect the bulk of the increase in real bond yields to occur only after mid-2023. As mentioned earlier, the Fed will probably not have to deliver more tightening that what markets are already discounting over the next 12 months. Thus, gold prices are unlikely to fall much in the near term. In any case, we continue to regard gold as a safer play than cryptocurrencies. As we discussed in Who Pays for Cryptos?, the long-term outlook for cryptocurrencies remains daunting. Many of the most hyped blockchain applications, from DeFi to NFTs, will turn out to be duds. Concerns that cryptocurrencies are harming the environment, contributing to crime, and enriching a small group of early investors at the expense of everyone else will lead to increased regulatory scrutiny. Our long-term target for Bitcoin is $5,000. E. Equities Equities Are Still Attractively Priced Relative to Bonds Corporate earnings are highly correlated with the state of the business cycle (Chart 61). A recovery in global growth later this year will bolster revenue, while easing supply-chain pressures should help contain costs in the face of rising wages. It is worth noting that despite all the shocks to the global economy, EPS estimates in the US and abroad have actually risen this year (Chart 62). Chart 61The Business Cycle Drives Earnings Chart 62Global EPS Estimates Have Held Up Reasonably Well Chart 63Equities Are Still Attractive Versus Bonds As Doug Peta, BCA’s Chief US Strategist has pointed out, the bar for positive earnings surprises for Q1 is quite low: According to Refinitiv/IBES, S&P 500 earnings are expected to fall by 4.5% in Q1 over Q4 levels. Global equities currently trade at 18-times forward earnings. Relative to real bond yields, stocks continue to look reasonably cheap (Chart 63). Even in the US, where valuations are more stretched, the earnings yield on stocks exceeds the real bond yield by 570 basis points. At the peak of the market in 2000, the gap between earnings yields and real bond yields was close to zero. Favor Non-US Markets, Small Caps, and Value Valuations are especially attractive outside the US. Non-US equities trade at 13.7-times forward earnings. Emerging markets trade at a forward P/E of only 12.1. Correspondingly, the gap between earnings yields and real bond yields is about 200 basis points higher outside the US. In general, non-US markets fare best in a setting of accelerating growth and a weakening dollar – precisely the sort of environment we expect to prevail in the second half of the year (Chart 64). US small caps also perform best when growth is strengthening and the dollar is weakening (Chart 65). In contrast to the period between 2003 and 2020, small caps now trade at a discount to their large cap brethren. The S&P 600 currently trades at 14.4-times forward earnings compared to 19.7-times for the S&P 500, despite the fact that small cap earnings are projected to grow more quickly both over the next 12-months and over the long haul (Chart 66). Chart 64A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks Chart 65US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening Globally, growth stocks have outperformed value stocks by 60% since 2017. However, only one-tenth of that outperformance has come from faster earnings growth (Chart 67). This has left value trading nearly two standard deviations cheap relative to growth. Chart 66Small Caps Look Attractive Relative To Large Caps Chart 67Value Remains Cheap Chart 68Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Tech stocks are overrepresented in growth indices, while banks are overrepresented in value indices. US banks have held up relatively well since the start of the year but have not gained as much as one would have expected based on the significant increase in bond yields (Chart 68). With the deleveraging cycle in the US coming to an end, US banks sport both attractive valuations and the potential for better-than-expected earnings growth. European banks should also recover as the situation in Ukraine stabilizes. They trade at only 7.9-times forward earnings and 0.6-times book. On the flipside, structurally higher bond yields will weigh on tech shares. Moreover, as we discussed in our recent report entitled The Disruptor Delusion, a cooling in pandemic-related tech spending, increasing market saturation, and concerns about Big Tech’s excessive power will all hurt tech returns. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. 2 These savings can either by generated domestically or imported from abroad via a current account deficit. 3 Theoretically, there is a close relationship between trend growth and the equilibrium investment-to-GDP ratio. For example, if real trend growth is 3% and the capital stock-to-GDP ratio is 200%, a country would need to invest 6% of GDP net of depreciation to maintain the existing capital stock-to-GDP ratio. In contrast, if trend growth were to fall to 2%, the country would only need to invest 4% of GDP. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
The US employment report reveals that the labor market recovery is progressing well. Nonfarm payrolls increased by a robust 431 thousand in March. Although this is slightly below expectations of a 490 thousand increase, January and February payrolls were…
Eurozone CPI inflation surged from 5.9% y/y in February to a record high of 7.5% y/y in March and beat expectations of a 6.7% y/y increase. Soaring headline inflation came on the back of a massive 44.7% increase in energy prices. The core CPI index which…
Executive Summary The Dollar And The Yield Curve The dollar has tended to decline 3-to-6 months after the Fed starts hiking interest rates. This has been true since the mid-1990s. Beyond that timeframe, the path of the dollar has depended on what other central banks are doing, and/or which stage of the business cycle we are in. The flattening yield curve in the US is coinciding with a strong dollar (Feature chart), but the historical evidence is that this relationship is very fickle. While the dollar tends to rise during recessions, the average business cycle over the last 40 years has also lasted 90 months, making a recession in the next year possible, but not probable. The dollar has usually followed a long boom/bust cycle of 10 years. If the Fed stays behind the inflation curve, we could be entering a period of weakness akin to the pre-Volcker years in the 70s. The greenback has also tended to be seasonally strong in H1 and weaker in H2. The yen has generally been the best-performing currency shortly after a Fed rate hike. Go short USD/JPY if it touches 124. RECOMMENDATION INCEPTION LEVEL inception date RETURN Short USD/JPY 124 2022-04-01 - Bottom Line: Our bias remains that the DXY index does not have much upside above 100. Our 12-month target remains 90. Feature Chart I-1Dollar Action Before Curve Inversions Is Mixed Rudi Dornbusch was one of the pioneers behind the theory that currency markets tend to overreact. His observation was as simple as it was brilliant. Currency markets are fluid, while prices tend to be sticky. Therefore, a monetary response to an inflation overshoot will initially cause a knee-jerk reaction in the currency before it settles back towards equilibrium. While we have oversimplified Dornbusch’s overshooting model, it is hard to ignore the fact that today’s currency and bond markets could potentially be overreacting. The 10-year/2-year US Treasury spread briefly turned negative this week, as the short end catapulted higher. Historically, that has been a precursor to an impending recession. This is important because the dollar has usually done well during recessions, even though its performance ahead of doomsday has been mixed over a 40-year period (Chart I-1). Given this backdrop, this report attempts to answer a few questions. How has the dollar performed over prior Federal Reserve tightening cycles? What drives the relationship between the dollar and the yield curve? Are the Fed rate hikes currently priced in the short end of the curve credible? Which currencies have historically excelled or suffered once the Fed begins to tighten policy? And finally, what is the roadmap investors should use to gauge the path of the dollar going forward? The Dollar And The Yield Curve Chart I-2A Rising Dollar Has Tracked A Flattening Curve The relationship between the dollar and the yield curve has been tight over the last three years. A flattening curve throughout most of 2018 signaled US policy was getting too restrictive relative to underlying economic conditions. The dollar was also rising (Chart I-2). The Federal Reserve eventually responded by cutting rates, which allowed the curve to steepen again, eventually putting a top in the greenback. Our Chief US Bond Strategist, Ryan Swift, has characterized this cycle as the dollar/bond feedback loop (Chart I-3). Chart I-3The Dollar/Bond Feedback Loop In retrospect, this feedback loop works through two channels. First, almost 90% of global transactions are conducted in US dollars, which means the cost of doing business (paying for imports, reconciling accounts payables, servicing debt, and so on) rises for foreigners as the dollar appreciates. This puts a break on economic activity abroad. Second, as a counter-cyclical currency, the dollar tends to attract capital when growth in the rest of the world is slowing, reinforcing this loop. Eventually, a strong dollar and rising domestic bond yields put a break on US economic activity, which causes the Fed to back off. Investors with a high-conviction view that we are close to a recession should be buying the dollar on weakness. In our view, many central banks are becoming too hawkish at the exact moment global growth is set to slow. That said, not unlike the Dornbusch analogy at the start of this text, currency markets have overreacted. Specifically: Over the last 40 years, the average business cycle has lasted 90 months. An inverted yield curve does not corroborate this fact, considering the recession in 2020. It is well known that there are previous episodes of the yield curve inverting, without an impending recession. This time around, rate hike expectations have been heavily priced at the front end of the curve, while being underpriced at the long end. The inference is that the market thinks the Fed is about to make a policy mistake. With policy rates in the US still at 25-50 bps, those near-term rate expectations will turn out to be wrong if US economic growth does indeed slow, forcing the Fed to pivot. The term premium in the US (and globally) is very low, and could rise as quantitative easing is wound down, and yield-curve control is relaxed in bond markets such as Japan. That could help lift longer-term bond yields. Global yield curves have tended to move in unison, with the UK curve historically being the first to invert ahead of a recession. That has not yet happened. Elsewhere, Japanese, and German yield curves are steep (Chart I-4). Chart I-4Global Yield Curves Tend To Move In Unison Historically, the relationship between the yield curve and the dollar has not been consistent (Chart I-5). In the early 80s, the dollar initially rose with a steepening yield curve. In retrospect, rising real rates at the long end of the Treasury curve drove the initial dollar rally. The backdrop was Federal Reserve Chairman Paul Volcker’s resolve to crack down on inflation. Thereafter, rising trade imbalances on the back of a strong dollar eventually led to the Plaza Accord in 1985, which weakened the dollar despite a curve that remained steep. In the 1990s, the dollar rose along with a flattening curve and a productivity boom in the US. In both the latter half of the 2000s and 2010s, the curve flattened, but the performances of the dollar in each case were opposites - weakness in the 2000s, but strength over the last decade. Chart I-5No Consistent Relationship Between The Dollar And The Yield Curve The bottom line is that the dollar tends to do well during recessions, which historically has happened after the yield curve inverts. Prior to that, the performance of the dollar is mixed. Dollar Performance Over Prior Tightening Cycles Chart I-6The Dollar Falls After The First Fed Rate Hike The dollar has tended to decline 3-to-6 months after the Fed starts hiking interest rates. This has been true since the mid-1990s (Chart I-6). The average decline after six months has been 5.3%. This will pin the DXY at around 95 or so by late summer. As the Appendix shows, while this relationship has been consistent for the dollar, it has been inconclusive for the hiking cycles of other central banks. The exceptions are the CAD, GBP, and SEK which tend to rally three months after their respective central banks raise rates. The AUD initially stalls but performs well one year after the Reserve Bank of Australia lifts interest rates. There is a rationale as to why the dollar performs well ahead of interest rate increases by the Fed, and falters shortly after. Historically, the Fed has usually been the first to start the process of hiking interest rates globally. It has also been the central bank that has lifted rates by the most (Chart I-7). This history of credibility has nudged forward markets to grow accustomed to anticipating the Federal Reserve to be ahead of the curve. As of now, US policy rates stand at 0.25% but the two-year yield is at 2.4%. This divergence could be viewed as vote of credibility akin to during the Volcker years (Chart I-8). Chart I-7The Fed Has Usually Led The Hiking Cycle Chart I-8The 2-Year/3-Month Treasury Spread Is Very Wide Beyond a 3-to-6-month timeframe, the path of the dollar has depended on what other central banks are doing (Table I-1). The BoE, BoC, Norges Bank, and RBNZ all raised rates before the Fed. The Riksbank and RBA ended QE ahead of the Fed. The BoJ’s balance sheet has been flat-to-shrinking since 2021. The US dollar has tended to do well when US interest rates are in the top decile amongst the G10 countries (Chart I-9). While that was true before the Covid-19 crisis, it is no longer the case today. This suggests the onus is on the Fed to meet market expectations and keep the dollar strong. Table I-1The Performance Of Currencies Is Mixed When Their Resident Central Bank Hikes Rates Chart I-9The Fed Is Lagging Other G10 Central Banks Interestingly, the yen has generally done very well around Fed rate hikes (Chart I-10), followed by commodity currencies (Table I-2). It also happens to be incredibly cheap today (Chart I-11). Our bias is that should inflation pick up faster in Japan, the yen will rally ahead of any anticipated changes to monetary policy. Chart I-10G10 Currencies Around The First Fed ##br##Rate Hike Table 2Most Currencies Appreciate Shortly After The First Fed Rate Hike Chart I-11The Yen Is Very Cheap Are Fed Rate Hikes Sustainable? There is a case to be made that the Federal Reserve could indeed hike interest rates faster than other economies. The 3-month rate-of-change in the dollar has closely followed the mini-growth oscillations between the US and other G10 economies (Chart I-12). US growth is now relatively strong (as measured by relative PMIs or relative economic surprise indices). Barring a global recession, the Fed has more scope to raise interest rates. Related Report Foreign Exchange StrategyThe Yen In 2022 On the flip side, financial conditions in the US are tightening quickly as mortgage rates rise, and the dollar soars. This is happening at a time when growth is weak in China and the PBoC is on an easing path. Chinese long bond yields (a proxy for Chinese growth) tend to rise when the PBoC stimulates growth. (Chart I-13). When the number of Covid-19 cases in China rolls over, there will be a case for growth to firmly bottom. Chart I-12Economic Growth Is Relatively Strong In The US Chart I-13The Chinese Economy Is Soft This is important since most Asian economies are very dependent on China to close their output gaps and reach escape velocity in economic growth. Take the example of Japan. Tourist arrivals (mainly from Asia) generally represent 25% of the overall Japanese population but today, that number remains near zero. As a result, consumption outlays in Japan are well below the pre-pandemic trend (Chart I-14). As growth recovers, the Japanese economy should be one of the best candidates for generating non-inflationary growth. This is a bullish backdrop for the currency. Chart I-14Japanese Consumption Is Well Below Trend Finally, real interest rates in the US remain very low. Empirically, currencies react more to the path of relative real rates (Chart I-15). Chart I-15US Real Rates Are Very Low Seasonality: Friend Or Foe? Coincidentally, the dollar also usually weakens in the second half of the year (Chart I-16). This dovetails with our bias that the dollar also underperforms after the first Fed interest rate hike. This has been especially true over the last decade (Chart I-17). Chart I-16The Dollar Is Seasonally Weak In H2 Chart I-17The Dollar Is Seasonally Weak In H2 The dollar has already priced in that the Fed will lead the interest rate hiking cycle. However, as we have been highlighting in recent reports, rising inflation is a global problem and not one that is exclusive to the US. The hawks in the ECB are very uncomfortable with this week’s HICP (harmonized index of consumer prices) release of 9.8% in Spain, 7.3% in Germany, and 7% in Italy. As a comparison, headline inflation in the US is 7.9%. A weak euro will only fan the inflationary flame in the eurozone. The Japanese economy could be next in unleashing inflationary surprises, especially on the back of a very cheap yen (Chart I-11). This will raise the probability that the Bank of Japan eases yield curve control. In short, the potential for upside surprises in interest rates is highest outside the US. Concluding Thoughts The academic evidence suggests that short-term interest rates matter more for currencies, especially when policy is close to the zero bound. The BIS report on the topic concludes that short maturity bonds have had the strongest FX impact.1 Moreover, near the effective lower bound, the foreign-exchange impact is greater as the adjustment burden falls onto the exchange rate. As FX becomes the axle of adjustment at lower interest rates, a strong dollar and weaker euro and yen are likely to grease the wheels of an economic rebound in these latter economies. For now, economic momentum in the US is stronger, which indicates that the Fed will initially deliver the bulk of rate hikes priced in the OIS curve this year. Beyond then, if growth picks up faster outside the US, especially in the euro area and Japan, then the USD could enter a consolidation phase. Finally, the yen has tended to be the best-performing currency after a Fed rate hike. Go short USD/JPY if it touches 124. Appendix: Currency Performance Around Interest Rate Hikes United States United States Euro Area Japan United Kingdom Canada Australia New Zealand Switzerland Norway Sweden Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Ferrari, Massimo, Kearns, Jonathan and Schrimpf, Andreas, “Monetary policy’s rising FX impact in the era of ultra-low rates,” Bank of International Settlements, April 2017. Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary
US personal spending fell below expectations in February. The rate of growth of nominal personal spending slowed sharply from 2.7% m/m to 0.2% m/m, below the anticipated 0.5% m/m. In real terms, personal spending declined by 0.4% m/m following January’s 2.1%…
Executive Summary Europe Is Russia's Key Gas Customer Full-on rationing of natural gas by Germany took a step closer to reality, as the standoff with Russia over its insistence on being paid in roubles for gas plays out. News that Germany initiated its first step toward rationing spiked European and UK natgas prices by more than 12% on Wednesday. Higher prices for coal, oil and renewable energy will follow, as these energy sources compete at the margin with natgas in Europe. Inflation and inflation expectations will move higher if Germany ultimately rations scarce natgas supplies. We are watching to see who blinks first – Germany or Russia. The risk of aluminum-smelter shut-downs in Europe once again is elevated. Other metals-refining operations also are at risk of shutdown if rationing is invoked. Trade difficulties arising from Russia's invasion of Ukraine and related sanctions will lead to further bottlenecks on base-metal exports from Russia, as Rusal warned this week. This will further confound the energy transition. Western governments will be forced to accelerate investments and subsidies in carbon-capture technology as fossil-fuel usage and prospects revive. Bottom Line: Fast-changing EU natural gas supply-demand dynamics are impacting competing energy and base metals markets. This is throwing up confusion around the global renewable-energy transition and extending its timetable. Fossil fuels fortunes are being revived, as a result. We remain long commodity index exposure and the equities of oil-and-gas producers and base-metals miners. Feature Events in the EU natural gas markets are changing rapidly in the wake of fast-changing developments in the Russia-Ukraine war. In the wake of these changes, economic prospects for Europe and Russia are rapidly evolving – both potentially negatively over the short run. Full-on rationing of natural gas by Germany took a step closer to reality, as its standoff with Russia over payment for gas in roubles plays out. News Germany is preparing its citizens for rationing spiked European and UK natgas prices by more than 12% Wednesday. It's not clear whether Russia or Germany are bluffing on this score. Russia's oil and gas exports last year accounted for close to 40% of the government's budget. According to Russia's central bank, crude and product revenue last year amounted to just under $180 billion, while pipeline and LNG shipments of natgas generated close to $62 billion last year. Europe is Russia's biggest natgas market, accounting for ~ 40% of its exports. However, as the relative shares of revenues indicate, natgas exports are less important to Russia than crude and liquids exports. Losing this revenue stream for a year would amount to losing ~ $25 billion of revenue, all else equal. In the event, however, the net loss might be lower, since this would put a bid under the natgas market ex-Europe, which would offset part or most of the lost natgas sales to Europe. If Russia is able to re-market those lost volumes, it could offset the loss of European sales. Knock-On Effects The immediate knock-on effect of this news turns out to be higher prices for oil, UK and European natgas. This is not unexpected, as gasoil competes at the margin with natgas in space heating markets, while competition across regions also can be expected to increase. Once again, the risk of aluminum-smelter shut-downs in Europe is elevated if rationing is imposed by Germany. Other metals-refining operations also are at risk of shutdown if rationing is invoked. Lastly, fertilizer production in Europe would be materially impacted, given some 70% of fertilizer costs are accounted for by natgas. In addition to these endogenous EU effects, trade difficulties arising from Russia's invasion of Ukraine and related sanctions will lead to further bottlenecks on base-metal exports from Russia, as Rusal warned this week.1 This will further confound the energy transition as the world's third-largest aluminum smelter faces sanctions – official and self-imposed – and the loss of inputs from Western suppliers, along with reduced access to capital and funding from the West. If, over time, Russia's base metals industries are degraded by the lack of access to capital and technology as oil and gas will be, the global renewable-energy transition will be slowed considerably. We already expect Russia's oil and gas production to fall over time due to the economic isolation created by Russia's invasion of Ukraine, rendering it a diminished member of OPEC 2.0. Russia accounts for ~ 10% of global crude oil supplies, and is the second largest producer of crude oil in the coalition. A long-term degradation of its production profile will exacerbate the persistent imbalance between demand relative to supply globally, which continues to force oil inventories lower (Chart 1). On the metals side, Russia accounts for 6%, 5% and 4% of global primary aluminum, refined nickel and copper production. Persistent supply deficits have left inventories in these markets – particularly nickel and copper – tight and getting tighter (Chart 2).2 Chart 1Oil Inventories Remain Tight... Chart 2… As Do Metals Inventories Europe's Radical Pivot In a little over a month's time, the EU has been forced to abandon once-immutable post-Cold War beliefs shared by the electorate and politicians of all stripes. Ever-deepening commercial ties with Russia did not ensure EU energy security, nor did they obviate what arguably is any state's primary responsibility: Protecting and defending its citizens. Because of its failed engagement policy with Russia over the post-Cold War interval, the EU is forced to scramble to restore its energy production and expand its sources of energy imports. In addition, it is repeatedly asserting its intent to "double down" of the speed of its renewable-energy transition. And, last but certainly not least, it is forced to rapidly rearm itself in industrial commodity markets that are in the midst of prolonged physical deficits and inventory drawdowns.3 The Russian invasion of Ukraine spurred the EU to action on both the energy and defense fronts. It is rushing head-long into eliminating its dependence on Russia for fuel, particularly natural gas, and will pursue re-arming its member states forthwith (Chart 3). Chart 3Weaning EU Off Russian Gas Will Prove Difficult On the energy front, the EU adopted a two-prong approach to cleave itself from Russian natgas: 1) Diversify its sources of natural gas, which largely will be in the form of liquified natural gas (LNG), and 2) doubling down on renewable energy generation. EU officials are aiming to replace two-thirds of their Russian gas imports by the end of this year, which is an ambitious target. Over the next two years or so, EU officials hope to fully wean themselves from Russian natgas via a combination of infrastructure buildouts and a renewed push to increase domestic production, which was being throttled back by earlier attempts to secure increased Russian supplies, and a strong focus on renewables. EU's US LNG Deal The EU signed a deal with the US to receive an additional 15 Bcm of natural gas in 2022, and 50 Bcm annually by 2030, which is equal to ~ 30% of the EU’s 2020 Russian gas imports. How exactly this will be done is unknown. In 2021, the EU imported 155 bcm of natgas from Russia, or more than 3x the amount being discussed with the US; 14 bcm of that was LNG.4 Just exactly what meeting of the minds was achieved between the EU and US government is totally unclear at this point. The US is not an LNG supplier, nor can it order private companies to renege on existing contacts. The US government likely will use its good offices to attempt to persuade Asian buyers to allow their contracted volumes to be diverted to European buyers, but that would, in all likelihood, mean they would switch to another fuel (e.g., coal) as an alternative if they take that deal. This would, we believe, require some sort of financial incentive to induce such behavior. US liquefaction capacity is also running at near full capacity (Chart 4). While there are projects in the pipeline, in the medium-term (2 – 5 years) the lack of export capacity will act as a constraint to the amount of LNG that can be shipped to the EU. Chart 4Europe Critical To Russia's Gas Industry For Russia, its shipments of gas to OECD-Europe represent more than 70% of its exports (Chart 5). Arguably, Europe is just as important to Russia as Russia is to Europe. With the EU set on a course to sever ties completely, Russia will be forced to invest in pipeline capacity to take more of its gas to China via the Power of Siberia 2 pipeline. In the short-term, US LNG exports to the EU will face headwinds since much of Central and Eastern Europe rely on piped gas from Russia. As a result, many countries within Europe are not equipped with sufficient regasification facilities and are running at near peak utilization rates (Chart 6). Germany does not have any such capacity. Chart 5Not Much Room For US LNG Exports To Grow… Chart 6…Or For Additional European LNG Imports LNG import facilities that have additional intake capacity in the Iberian Peninsula and Eastern Europe do not have sufficient pipeline capacity to move gas inland. This will require additional infrastructure investment as well. To deal with this lack of infrastructure, Germany, Italy and the Netherlands are moving quickly to procure Floating Storage and Regasification (FSRUs) to convert LNG back to its gaseous state. While not the five-year proposition a dedicated LNG train requires to bring on line, setting up FSRUs still could be a years-long process.5 How quickly these assets can be mobilized, and the volumes they can deliver remain to be seen. Investment Implications Fast-changing EU natural gas supply-demand dynamics are impacting competing energy and base metals markets. This is throwing up confusion around the global renewable-energy transition and extending its timetable. Fossil fuels fortunes are being revived, as a result. At this point it is impossible to handicap the odds of a cut-off of Russian natgas to Europe, or its duration if it does occur. Either way, competitive suppliers to Russia – particularly US shale-gas producers selling into the LNG market and the vessels that transport it – will benefit regardless of the course taken by Germany and Russia on rationing. We remain long commodity index via the S&P GSCI and COMT ETF, and the equities of oil-and-gas producers and base-metals miners via the PICK, XME and XOP ETFs. Commodity Round-Up Energy: Bullish Oil prices were whipsawed by new reports suggesting Russia would substantially reduce its military operations in Kyiv ahead of ceasefire talks with Ukraine, only to have that speculation dashed by US officials indicating nothing had changed in the status quo to warrant such a view. Markets restored the risk premium that fell out of prices on the unwarranted speculation, with Brent prices once again above $110/bbl this week. At present, the fundamental oil picture remains tight. In the run-up to a decision from OPEC 2.0's March meeting today, we continued to expect KSA, the UAE and Kuwait to increase production by up to 1.6mm b/d this year, and another 600k b/d next year. To date, OPEC 2.0 has fallen short by ~ 1.2mm b/d since it started returning production taken off line during the pandemic. In return for higher output, we continue to expect the US to deepen its commitment to defending the Gulf Co-operation Council (GCC) states making up core-OPEC 2.0. If we do not see an increase in core-OPEC 2.0 production, we will have to re-assess our fundamental outlook on KSA's, the UAE's and Kuwait's ability to increase production. We also will have to determine whether – even if the supply is available to return to the market – these states have embraced a revenue-maximization strategy, given the fiscal breakeven price for these states now averages ~ $64/bbl. It also is possible that heavily discounted Russian crude oil – trading more than $30/bbl below Brent (vs. the standard $2.50/bbl Urals normally commands) – convinces core-OPEC 2.0 states that oil prices are not so high for large EM buyers like India and China as to create demand destruction. We believe the latter view likely is prevailing at present. We continue to expect Brent to average $93/bbl this year and next (Chart 7). Base Metals: Bullish BHP Group Ltd. will invest more than $10 billion to expand metals production over the next 50 years in Chile. The metals giant aims to stay ESG compliant, provided there is a supportive investment environment provided by the Chilean government. Resource-rich Latin American countries such as Chile and Peru have elected left-leaning governments intent on redistributing mining profits and ensuring companies comply with the ESG framework. As Chile considers raising mining royalties and redrafts its constitution, mining investment in the country has stalled. Political uncertainty in these countries has coincided with low global copper inventories (Chart 8) and high demand. Chart 7 Chart 8 Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Footnotes 1 Please see Aluminum Giant Rusal Flags Stark Risks Triggered by War in Ukraine published by Bloomberg on March 30, 2022. 2 Please see our Special Report entitled Commodities' Watershed Moment, published on March 10, 2022. It is available at ces.bcaresearch.com. 3 Please see footnote 2. 4 Please see How Deep Is Europe's Dependence on Russian Oil? published by the Columbia Climate School on March 14, 2022. 5 Please see Europe battles to secure specialised ships to boost LNG imports published by ft.com 28 March 2022. Germany appears to be most advanced in its procurement of FSRU capacity, and is close to concluding a deal that would allow it to regasify 27 bcm annually. Investment Views and Themes Strategic Recommendations Trades Closed in 2021