Economic Growth
Highlights Banks, households, and businesses are still swimming in cash: Asset purchases and zero rates are ending, but banks, households and businesses have more cash than they know what to do with. It will not be easy for the Fed to mop up enough accommodation to slow the economy in a material way this year. The flood of liquidity may be a headwind for interest rates in 2022, … : The biggest banks have positioned themselves to benefit from rising rates and may limit the backup in yields as they deploy their unused capital hoard into it. … and protect equities from suffering meaningful de-rating: All the money has to go somewhere, and equities may be the default winner if bonds and cash are poised to deliver negative real returns. The rosy near-term outlook implied by the biggest banks’ observations suggests that the bull market in risk assets isn’t over yet: Households have ramped up spending but have barely begun to tap into their excess savings and businesses are confident and well-heeled. Above-trend economic growth should bolster corporate earnings, credit performance and financial asset prices, keeping the bull market going through the end of the year. What The Banks See The SIFI banks (BAC, C, JPM and WFC) and USB kicked off fourth quarter earnings across three days bracketing the Martin Luther King long weekend. Their performance wasn’t bad – the SIFIs squarely beat analysts’ consensus estimates and USB came up about 3% short – but investors apparently wanted more from a group that had burst out of the gate to start 2022. Banks were market darlings in the year’s first nine sessions as investors sought out stocks that could outperform in a rising rate environment, and the SIFIs and USB beat the S&P 500 by 12 percentage points (Chart 1). Over the three sessions that they reported earnings, they gave back more than a third of their relative outperformance, though they still have a 7-point year-to-date advantage. Chart 1Rate Play Our focus, however, is not on the banks themselves or their stocks’ relative performance. We’re after what the principal financial intermediaries are seeing from their privileged vantage point into activity across the economy. We examine the banks’ earnings releases and listen to their earnings calls for insight into the broad macro backdrop as revealed by borrower performance, lender willingness, the state of the financial system and the actions and intentions of households and businesses. Considering the banks’ calls from that perspective, several growth-friendly themes emerged. Households remain flush with cash, even at the lower end of the wealth distribution, heralding robust 2022 consumption. Deposits from households and businesses continue to pile up, supporting credit performance and likely pushing out the date when net charge-off rates will rise to more normalized levels. The deposit flows are increasing the banks’ capacity to lend, and they are champing at the bit to deploy their cash into new loans. Investment banking pipelines are full and rampant liquidity should see to it that new debt and equity offerings meet with a warm reception once they come to market, as long as the current bout of market turbulence doesn’t lead to a lasting rollback in animal spirits. All in all, the banks’ observations affirmed our constructive take on the economy through at least the end of the year. Households are already spending in a way that validates our time-release view of fiscal transfers and their incomes have apparently risen enough that they have not yet begun to deplete the savings they built up from Congress’ pandemic largess. Businesses remain flush and are looking to replenish depleted inventories to reduce their vulnerability to supply chain disruptions. M&A activity is still hot and underwriting calendars are full. Yields are poised to rise as the Fed dials down monetary accommodation, but it’s possible the banks’ eagerness to put their idle cash to work will help limit how high they can go. Households Have Been Spending (Chart 2), But They Still Have Loads Of Dry Powder (Chart 3) … [F]or the holiday period of November and December, [debit and credit] spending was up 26% over 2019. … And so far this year that strength continues. [S]pending of all types through January 17 … [was] up over 11% versus the start of ’21, which is well up over ’20 and ’19, and that bodes well for the rest of the year and quarter. (Moynihan, BAC CEO) Chart 2You Can't Keep An Avid Consumer Down Chart 32 Trillion Of Excess Savings ... [C]ombined credit and debit [card] spend was up 27% versus the fourth quarter of 2019, with each quarter in 2021 showing sequential growth compared to 2019. Within that, travel and entertainment spend was up 13% versus 4Q19, though we have seen some softening in recent weeks contemporaneously with the Omicron wave. (Barnum, JPM CFO) Consumer credit card spend also continued to be strong, up 28% from the fourth quarter of 2020 and up 27% from the fourth quarter of 2019. All spending categories were up in the fourth quarter compared to a year ago, with the largest increases in travel, fuel, entertainment and dining. (Scharf, WFC CEO) [W]hile there is some softening [from Omicron] in restaurant, travel and entertainment in recent weeks, overall spending remained strong in the first week of January with credit card up 26% and debit card up 29% versus the same week in 2020. (Scharf, WFC) [W]e are seeing increases in [card] spend volume … across the board, [with] branded card spend volumes up 24% and retail services spend volumes up 16%[.] People are using our cards, which is a good thing. (Mason, C CFO) [C]onsumer[s] [are] in really good shape, … spending … 25% more than they spent pre-COVID, 25% more. And that number drives all the order books for everybody else. (Dimon, JPM CEO) We believe there’s lots of potential spending capacity left as average deposit balances (Chart 4) continue to move up … despite … heavy spending[.] We had [only] one cohort of deposits that dipped [in any] month [in] the last part of the year: … customers who had balances of $2,000 or less pre-pandemic [saw their balances] dip by 1% [in November]. Other than that, every cohort from June [through] December [had their balances] grow every month. And what’s striking is that the balances for people who had less than $2,000 average balances before the pandemic [now have] five times [their pre-pandemic] balances. [C]ustomers who had $10,000 in their accounts before the pandemic are now sitting with two times [that] in their accounts. (Moynihan, BAC) Chart 4... Are Sitting In Checking Accounts, Waiting To Be Spent … Helping Credit Performance (Chart 5) And Keeping A Lid On Card Balances (Chart 6) Chart 6Cash-Rich Consumers Don't Need To Carry Credit Card Balances The asset quality of our customers remains very healthy and net charge-offs this quarter fell to a historical low of … 15 basis points of average loans. … Our credit card loss rate was 1.42%, … less than half of the pre-pandemic rate, [and] it improved in every quarter during the year. (Borthwick, BAC CFO) [O]ur 30, … 60 or 90 days past [due consumer loans] are staying at … low levels. … [C]ustomer [checking account] balances, elevated in some cases five times [above] … pre-pandemic levels … probably account for a lot of the consumer credit quality improvement. We’re anticipating at some point it will go back towards more normal historical levels. We just think it’s going to bump around here for a little while. (Borthwick, BAC) [W]e’re exiting the fourth quarter with a card net charge-off rate of … something like 1.2% -- -- Which you’ll never see again (Barnum and Dimon, JPM) [C]redit card [charge-offs] has been a number that we’ve never seen in our lives. Middle market has been lower than ever. … Mortgages have been lower than ever. They’re all low. Eventually, they’re going to normalize. (Dimon, JPM) In terms of [card] losses, … [we are seeing] very low loss levels. [W]hen I look at the delinquency trend, there’s really nothing to focus on there. [Delinquencies] remain quite low and we don’t see any signs or areas of concern. (Mason, C) Payment rates do remain stubbornly high, [negatively] impacting our loan growth … in [our] cards businesses. (Mason, C) Consumer credit performance remains strong with higher collateral values for homes and autos and consumer cash reserves remain[ing] above pre-pandemic levels. (Santomassimo, WFC CFO) Credit quality remains strong. Over the next few quarters, we expect the net charge-off ratio to remain lower than historical levels, but normalize over time as the effects of the pandemic continue to subside. (Dolan, USB CFO) Business Borrowing May Be Turning A Corner (Chart 7) Chart 7Are Middle-Market Corporate Borrowers Really Back? [Sequential] growth was broad-based across all commercial lending segments. We saw improvement in new loans as well as improvement in utilization from existing clients. … In the all-important small business segment, lending activity is running consistently above pre-pandemic levels. (Moynihan, BAC) We are seeing an uptick in revolver utilization rates, … and it remains sort of skewed to the smaller clients. But we are starting to see an uptick … even in the bigger clients. … [O]ne driver of that is CEOs and management teams have been burned by low inventory levels as a result of the supply chain problems, wanting to run higher inventories and that is maybe driving higher utilization. … At the same time, we’re hearing quite a bit of confidence in the C suites, and all else equal that should be positive for C[ommercial]&I[ndustrial] loan growth. The levels there are modest still in a world where capital markets have been exceptionally receptive to … [bond] issuance … and so people [have been] well-funded [by the] capital markets. (Barnum, JPM) Commercial loan balances started to increase late in the third quarter and have now grown for four consecutive months with growth accelerating in December. … Increases in middle-market banking were driven by growth from our larger clients, a modest uptick in revolver utilization and strong seasonal borrowing. Growth in asset-based lending and leasing was driven by new client wins as well as increased levels from higher prices and some increase in inventory levels. (Santomassimo, WFC) We are encouraged by the loan growth momentum and we have a positive outlook for 2022, given improving client sentiment and business conditions, and continued strength in certain focused commercial portfolios, such as asset-backed securitization lending and supply chain financing. (Cecere, USB CEO) [W]e’re now starting to see a nice shift with respect to the commercial and the C&I portfolios. … At the end of the fourth quarter, we saw nice expansion of utilization rates, … like 60 basis points on average from the third quarter, but in December it was up almost 2.5%. … [P]eople are rebuilding their inventories on the commercial side. I think … they still have some [supply chain] concerns, so I think they’re being cautious about making sure they have inventory to be able to run their business. And I think they’re starting to make business investment ahead of the consumer spend and the economic growth they see in 2022. (Dolan, USB) [The] number one fourth-quarter trend that looks positive going into 2022 is the increase in utilization rates, which we haven’t seen for a number of quarters. (Cecere, USB) Banks Have Tons Of Dry Powder (Chart 8) And Want To Put It To Work (Chart 9) When The Time Is Right Chart 8Water, Water Everywhere And Not A Drop To Drink Chart 9Banks Are Eager To Lend Given continued deposit growth and low rates, our asset sensitivity to rising rates remains significant. (Borthwick, BAC) [W]e still have significant dry powder to put to work with either client demand [loans] or in an increasing rate environment [securities], which we expect. (Mason, C) [W]e have huge firepower to grow, to expand, to make loans, to extend duration. I’ve never seen a bank with [our level of] liquidity: $1.7 trillion in cash and marketable securities and $1 trillion in loans. There’s $500 or 600 billion of those cash and marketable securities that could be deployed in higher-yielding assets or loans when and if the time comes. (Dimon, JPM) [Our] expectation is that when long-term rates rise, which we’re starting to see now, we’re going to be able to take advantage of the rising rate environment. … We [deployed some cash into securities] in the fourth quarter but employed hedging strategies to keep the duration of those purchases relatively short … to maintain as much asset sensitivity going into 2022 as we possibly could. (Dolan, USB) [W]e want maximum flexibility as long-term rates start to rise. (Dolan, USB) Investment Implications Chart 10Comeback Or Head Fake? The biggest banks told a consistent story about the US economy on their earnings calls. Activity is rising, as evidenced by avid consumption that gathered momentum across 2021, a pickup in business and consumer appetite for borrowing that quickened toward the end of the year (Chart 10), and expressions of confidence from businesses that are directing capital to replenishing inventories and buying equipment. Credit performance is tremendously strong with record-low net charge-off rates and low delinquency rates underpinned by bloated business and consumer deposit balances. Abundant cash reserves provide further fuel for consumption and should keep GDP growth well above its trend level. The growth and credit tailwinds suggest that a recession is not lurking around the corner and therefore offer a green light for investors to overweight equities within multi-asset portfolios. As detailed in the last two reports on rate hikes’ impact, we do not view the recent equity turbulence, triggered by a surge in Treasury yields, as the start of an inflection point for financial markets. We are inclined to see the decline as more of a buying opportunity than a herald of a new shift in the business cycle. The Fed has the means to slow the economy if it sets its mind to it but given the amount of cash that is overwhelming banks, businesses, households and investors, draining enough accommodation to do so by the end of 2022 is an awfully tall order. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com
Highlights Data from the UK revealed it is tantalizingly close to declaring COVID-19 an endemic virus, indicating Britain likely will exit the pandemic ahead of other states soon. The UK is a bellwether market regarding its public-health response to the coronavirus. Some 95% of its population is estimated to carry COVID-19 antibodies (Chart of the Week). Other states – e.g., the US, the EU – have followed the UK with a lag, which we expect will continue. While the Fed's reassurance it will be able to hike rates without disrupting labor markets no doubt encourages markets – and boosted commodity prices – we believe the return to economic normalcy that would be ushed in by endemicity will release pent-up consumer demand for goods and services. This will spur commodity demand. If COVID-19 becomes endemic in enough economies globally, it also would fuel inflation, and inflation expectations.1 Given the tight supplies of industrial commodities – chiefly oil, natural gas and base metals – our assessment of upside price risk is higher now than it was at year-end 2021. We remain long broad-based commodity exposure via the COMT ETF, the PICK ETF, and the S&P GSCI index. Feature Fed Chair Powell's confidence that the US central bank will raise rates and keep inflation under control without destabilizing labor markets stole the show earlier this week. The media credited Powell's remarks for the burst of enthusiasm that lifted commodities as an asset class higher. While none would gainsay the Fed's importance to commodity markets, we would point out the approaching endemicity of COVID-19 in the UK – and the likely follow-on from the US and other large commodity-consuming states – is of equal, if not greater, moment. The UK has been out in front on its public-health response to the COVID-19 pandemic and has become a bellwether in the northern hemisphere; the US will follow. This week, the UK's Office for National Statistics (ONS) reported ~ 95% of England's population tested positive for antibodies to COVID-19 via infection or vaccination in the week beginning 29 November 2021. Similar results were reported for Scotland, Wales and Northern Ireland. This is generally observed in all age cohorts tracked by ONS.2 According to David Heymann of the London School of Hygiene and Tropical Medicine, "population immunity seems to be keeping the virus and its variants at bay, not causing serious illness or death in countries where population immunity is high."3 In a briefing hosted by Chatham House this week, Heymann observed, “And probably, in the UK, it’s the closest to any country of being out of the pandemic if it isn’t already out of the pandemic and having the disease as endemic as the other four coronaviruses” currently in circulation, which are responsible for roughly a quarter of common colds.4 Based on UK government data, the ratios of hospitalizations and deaths to COVID-19 cases has been falling precipitously (Chart 2). This is encouraging, given the sharp increase in cases driven by the rapid spread of the omicron mutant, which appears to be rolling over. Medical experts in the UK suggest the data also point to a possible peaking in the omicron surge. This would lighten the load on hospitals, as well as reduce death rates attributed to the coronavirus (Chart 3).5 Return To Normal? Nothing will return commodity markets to economic normalcy faster than endemicity. If this stays on track over the next month or so, it will spur commodity demand sooner rather than later, as pent-up consumer demand for goods and services is discounted by trading markets. If, as the data appear to indicate, the UK's transition from pandemic to endemic COVID-19 is followed by other states like the US and EU a few months later, we would expect a renewed leg up in the post-pandemic commodities rally. This would be apparent in futures contracts, which already are pricing commodity deliveries a month or more hence. Such a turn of events would force us to accelerate our time table for oil-demand recovery, which we expect will come in 2H22. This could restore our $80/bbl forecast for 2022, and lift our 2023 expectation. We also would have to revisit our copper and base metals view, and bring forward the timing of the copper-price rally we expect will lift COMEX refined copper to $4.80/lb and $6.00/bbl in 2022 and 2023, respectively, on average.6 These industrial commodities would see demand increase amid extremely tight supply conditions. Oil markets are tightening on the back of OPEC 2.0's production discipline, and the inability of many member states to fully restore the 400k b/d every month it signed on for beginning in August of last year, owning to production shortfalls outside the core producers of the coalition (Chart 4). Copper, the base-metals bellwether, remains very tight, as seen in balances (Chart 5) and inventories (Chart 6). Chart 4OPEC 2.0s Strategy Works Chart 5Coppers Physical Deficits Will Persist... Chart 6Globally, Exchange Warehouses Tighten China's zero-COVID-19 policy, which has resulted in numerous lock-downs at the local level, has yet to dent oil demand, which, for the time being, is hovering ~ 16mm b/d. We will be updating our oil balances and price forecasts next week, and will have a more extensive analysis of supply-demand balances then. Return Of Speculative Interest Expected With Endemicity Hedge funds have been reducing their exposure to the industrial commodities over the past year, which suggests they either have better alternatives for investing, or did not believe the rallies in commodities over the past year were durable, given the repeated demand shocks visited upon these markets by COVID-19 (Chart 7). We expect that once the pandemic becomes endemic, hedge funds will return to these markets. All the same, given the higher likelihood of price rallies in these markets, we would expect hedge funds to be cited as a cause of higher prices, as typically happens when markets take a sharp leg higher. Regular readers of our research are aware that this generally is not the case – hedge funds follow the news; they don't lead it. This past week we revisited earlier research to see if hedge-fund involvement in commodity markets causes the prices to go up or down to any meaningful degree. And, again, we found no relationship between hedge-fund positioning and the level of commodity prices.7 The presumed influence of hedge funds has been a persistent feature of futures markets in the post-GFC world, following the collapse of commodity prices along with financial markets in 2008. An entire literature has sprung up to explore the influence of these funds on commodity price formation. Below we highlight a few representative articles consistent with our results. Büyüksahin and Harris (2011) show hedge funds and other speculators follow prices – they do not lead them – based on the Granger-causality testing they performed on oil prices and speculative positioning.8 Brunetti et al (2016) argue hedge funds' trading stabilizes markets – i.e., they provide a bid when markets are selling off and an offer when markets are well bid – while swap-dealer trading is uncorrelated with price volatility.9 Knittel and Pindyck (2016) found speculation has reduced volatility in prices since 2004, including during the 2007-08 price run-up.10 Using a straightforward supply-demand-inventory model, they examined cash and storage markets to determine whether speculation had any effect on them or on convenience yields based on cash-vs-futures spreads. They concluded: "We found that although we cannot rule out that speculation had any effect on oil prices, we can indeed rule out speculation as an explanation for the sharp changes in prices beginning in 2004. Unless one believes that the price elasticities of both oil supply and demand are close to zero, the behavior of inventories and futures-spot spreads are simply inconsistent with the view that speculation has been a significant driver of spot prices. If anything, speculation had a slight stabilizing effect on prices." Investment Implications Assuming the UK remains a bellwether for DM economies with reasonably effective vaccine programs, or which have experienced an omicron surge, markets could be close to exiting the COVID-19 pandemic and entering a phase in which the coronavirus is endemic. This would be bullish for demand. And given the extended tightness on the supply side for industrial commodities in particular, it could presage another leg up in prices as economic normalcy returns. We continue to favor broad-based commodity exposure via the COMT ETF, the PICK ETF, and the S&P GSCI index. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish US LNG baseload and peak liquification capacity is expected to rise ~ 13% this year to 11.4 Bcf/d and 13.8 Bcf/d (on a December-to-December basis), based on the EIA's latest estimates. The agency's forecast for LNG exports is up 17.3% to 11.5 Bcf/d this year, and 12.1 Bcf/d in 2023. With these increases in baseload and peak export capacity, the US is set to become the largest exporter of LNG in the world this year, in the EIA's estimation. This will be integral to US foreign policy, particularly in markets where the US competes with Russia for export sales, in our estimation. Within North America, US pipeline gas exports to Mexico and Canada are expected to average just under 9 Bcf/d this year, a 5% increase vs. 2021, and 9.2 Bcf/d in 2023. Base Metals: Bullish In China, seasonally low production, as stainless-steel firms undergo maintenance, and the upcoming Winter Olympics in February are keeping steel production subdued. To compound this supply shortage, tight raw material markets, particularly that of iron ore and nickel are buoying steel prices. Heavy rainfall in southern-eastern Brazil is curtailing iron ore production in the region. After Australia, Brazil is the second largest iron ore exporter to China. Nickel prices hit a 10-year high on Tuesday on the back of falling inventories. An LME outage also precipitated the price rise. Dwindling inventories point to increasing demand for the metal as electric vehicle companies ramp-up production and sales this year, particularly in China, where the government stated it will remove EV subsidies by the end of 2022. According to The China Passenger Car Association, EV sales in the country will double to 6 million this year. Precious Metals: Bullish Based on the December FOMC minutes, the markets are now pricing in a more hawkish tilt from the Fed, and expect an initial rate hike by March. The Fed may also shrink its balance sheet soon after the initial rate hike, in line with its expectation the U.S. economy will recover faster this time around. While higher nominal interest rates and tighter monetary policy will increase the opportunity cost of holding gold (Chart 8), the commodity-driven inflation we expect this year – especially if COVID-19 becomes endemic across major economies – will buoy demand for the yellow metal as an inflation hedge. An endemic virus this year will also boost physical gold demand from China and India. Footnotes 1 Please see More Commodity-Led Inflation On The Way, which we published on 9 December 2021. 2 Please see Coronavirus (COVID-19) latest insights: Antibodies, published by the ONS on December 23, 2021. 3 Please see Covid-19: UK ‘closest of any country in northern hemisphere to exiting pandemic’, published on January 11, 2022 by msn.com. 4 Please see What four coronaviruses from history can tell us about covid-19, published by newscientist.com on April 29, 2020. 5 Please see Omicron may be headed for a rapid drop in US and Britain, published by msn.com on January 11, 2022 published by msn.com. 6 Please see 2022 Key Views: Past As Prelude For Commodities, which we published on December 16, 2021. 7 We ran cointegrating regressions – using DOLS and ARDL models – to check for any equilibrium between prices and hedge fund positioning and found none. We looked at the post-GFC period from 2010 to now, since this is the data the US Commodity Futures Trading Commission (CFTC) provides for hedge funds and tested whether hedge-fund positions (in the form of open interest) explained prices vs. the alternative (i.e., prices explain hedge-fund positioning). We again found prices explain position (and not vice versa) for crude oil, natural gas, copper and gold. 8 Please see Büyüksahin, Bahattin and Jeffrey H. Harris (2011),"Do Speculators Drive Crude Oil Futures Prices?" The Energy Journal, 32:2, pp. 167-202. This paper used unique data sets provided by the CFTC. 9 Please see Brunetti, Celso, Bahattin Büyüksahin, and Jeffrey H. Harris (2016), "Speculators, Prices, and Market Volatility," Journal of Financial and Quantitative Analysis, 51:5, pp. 1545-74. 10 Please see Knittel, Christopher R. and Robert S. Pindyck (2016), "The Simple Economics of Commodity Price Speculation," American Economic Journal: Macroeconomics 8:2, pp. 85–110. Investment Views and Themes Strategic Recommendations Trades Closed In 2021
Highlights Global equities are poised to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Non-US markets are likely to outperform. We examine the four pillars that have historically underpinned stock market performance. Pillar 1: Technically, the outlook for equities is modestly bullish, as investor sentiment is nowhere near as optimistic as it usually gets near market tops. Pillar 2: The outlook for economic growth and corporate earnings is modestly bullish as well. While global growth is slowing, it will remain solidly above trend in 2022. Pillar 3: Monetary and financial conditions are neutral. The Fed and a number of other central banks are set to raise rates and begin unwinding asset purchases this year. However, monetary policy will remain highly accommodative well into 2023. Pillar 4: Valuations are bearish in the US and neutral elsewhere. Investors should avoid tech stocks in 2022, focusing instead on banks and deep cyclicals, which are more attractively priced. The Bedrock For Equities In assessing the outlook for the stock market, our research has focused on four pillars: 1) Sentiment and other technical factors, which are most pertinent for stocks over short-term horizons of about three months; 2) cyclical fluctuations in economic growth and corporate earnings, which tend to dictate the path for stocks over medium-term horizons of about 12 months; 3) monetary and financial conditions, which are also most relevant over medium-term horizons; and finally 4) valuations, which tend to drive stocks over the long run. In this report, we examine all four pillars, concluding that global equities are likely to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Pillar 1: Sentiment And Other Technical Factors (Modestly Bullish) Chart 1US Equities: Breadth Is A Concern Scaling The Wall Of Worry Stocks started the year on a high note, before tumbling on Wednesday following the release of the Fed minutes. Market breadth going into the year was quite poor. Even as the S&P 500 hit a record high on Tuesday, only 57% of NYSE stocks and 38% of NASDAQ stocks were trading above their 200-day moving averages compared to over 90% at the start of 2021 (Chart 1). The US stock market had become increasingly supported by a handful of mega-cap tech stocks, a potentially dangerous situation in an environment where bond yields are rising and stay-at-home restrictions are apt to ease (more on this later). That said, market tops often occur when sentiment reaches euphoric levels. That was not the case going into 2022 and it is certainly not the case after this week's sell-off. The number of bears exceeded the number of bulls in the AAII survey this week and in six of the past seven weeks (Chart 2). The share of financial advisors registering a bullish bias declined by 25 percentage points over the course of 2021 in the Investors Intelligence poll. Option pricing is far from complacent. The VIX stands at 19.6, above its post-GFC median of 16.7. According to the Minneapolis Fed’s market-based probabilities model, the market was discounting a slightly negative 12-month return for the S&P 500 as of end-2021, with a 3.6 percentage-point larger chance of a 20% decline in the index than a 20% increase (Chart 3). Chart 3Option Pricing Is Not Pointing To Elevated Complacency Chart 2Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Equities do best when sentiment is bearish but improving (Chart 4). With bulls in short supply, stocks can continue to climb the proverbial wall of worry. Whither The January Effect? Historically, stocks have fared better between October and April than between May and September (Chart 5). One caveat is that the January effect, which often saw stocks rally at the start of the year, has disappeared. In fact, the S&P 500 has fallen in January by an average annualized rate of 5.2% since 2000 (Table 1). Other less well-known calendar effects – such as the tendency for stocks to underperform on Mondays but outperform on the first trading day of each month – have persisted, however. Table 1Calendar Effects Bottom Line: January trading may be choppy, but stocks should rise over the next few months as more bears join the bullish camp. Last year’s losers are likely to outperform last year’s winners. Pillar 2: Economic Growth And Corporate Earnings (Modestly Bullish) Economic Growth And Earnings: Joined At The Hip The business cycle is the most important driver of stocks over medium-term horizons of about 12 months. The reason is evident in Chart 6: Corporate earnings tend to track key business cycle indicators such as the ISM manufacturing index, industrial production, business sales, and global trade. Chart 6The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons Chart 7PMIs Signaling Above-Trend Growth Global growth peaked in 2021 but should stay solidly above trend in 2022. Both the service and manufacturing PMIs remain in expansionary territory (Chart 7). The forward-looking new orders component of the ISM exceeded 60 for the second straight month in December. The Bloomberg consensus is for real GDP to rise by 3.9% in the G7 in 2022, well above the OECD’s estimate of trend G7 growth of 1.4% (Chart 8). Global earnings are expected to increase by 7.1%, rising 7.5% in the US and 6.7% abroad (Chart 9). Our sense is that both economic growth and earnings will surprise to the upside in 2022. Chart 9Analysts Expect Single-Digit Earnings Growth Plenty Of Pent-Up Demand For Both Consumer And Capital Goods US households are sitting on $2.3 trillion in excess savings (Chart 10). Around half of these savings will be spent over the next few years, helping to drive demand. Households in the other major advanced economies have also buttressed their balance sheets. Chart 10Plenty Of Pent-Up Demand After two decades of subdued corporate investment, capital goods orders have soared. This bodes well for capex in 2022. Inventories remain at rock-bottom levels, which implies that output will need to exceed spending for the foreseeable future (Chart 11). On the residential housing side, both the US homeowner vacancy rate and the inventory of homes for sale are near multi-decade lows. Building permits are 11% above pre-pandemic levels (Chart 12). Chart 11Business Investment Should Be Strong In 2022 Chart 12Residential Construction Will Remain Well Supported Chart 13China's Credit Impulse Has Bottomed Chinese Growth To Rebound, Europe To Benefit From Lower Natural Gas Prices Chinese credit growth decelerated last year. However, the 6-month credit impulse has bottomed, and the 12-month impulse is sure to follow (Chart 13). Chinese coal prices have collapsed following the government’s decision to instruct 170 mines to expand capacity (Chart 14). China generates 63% of its electricity from coal. Lower energy prices and increased stimulus should support Chinese industrial activity in 2022. Like China, Europe will benefit from lower energy costs. Natural gas prices have fallen by nearly 50% from their peak on December 21st. A shrinking energy bill will support the euro (Chart 15). Chart 14Coal Prices Are Renormalizing In China Chart 15A Shrinking Energy Bill Will Support The Euro Omicron Or Omicold? While the Omicron wave has led to an unprecedented spike in new cases across many countries, the economic fallout will be limited. The new variant is more contagious but significantly less lethal than previous ones. In South Africa, it blew through the population without triggering a major increase in mortality (Chart 16). Preliminary data suggest that exposure to Omicron confers at least partial immunity against Delta. The general tendency is for viral strains to become less lethal over time. After all, a virus that kills its host also kills itself. Given that Omicron is crowding out more dangerous strains such as Delta, any future variant is likely to emanate from Omicron; and odds are this new variant will be even milder than Omicron. Meanwhile, new antiviral drugs are starting to hit the market. Pfizer claims that its new drug, Paxlovid, cuts the risk of hospitalization by almost 90% if taken within five days from the onset of symptoms. Bottom Line: While global growth has peaked and the pandemic remains a risk, growth should stay well above trend in the major economies in 2022, fueling further gains in corporate earnings and equity prices. Pillar 3: Monetary And Financial Factors (Neutral) Chart 17The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months Tighter But Not Tight Monetary and financial factors help govern the direction of equity prices both because they influence economic growth and also because they affect the earnings multiple at which stocks trade. There is little doubt that a number of central banks, including the Federal Reserve, are looking to dial back monetary stimulus. However, there is a big difference between tighter monetary policy and tight policy. Even if the FOMC were to raise rates three times in 2022, as the market is currently discounting, the fed funds rate would still be half of what it was on the eve of the pandemic (Chart 17). Likewise, even if the Fed were to allow maturing assets to run off in the middle of this year, as the minutes of the December FOMC meeting suggest is likely, the size of the Fed’s balance sheet will probably not return to pre-pandemic levels until the second half of this decade. A Higher Neutral Rate We have argued in the past that the neutral rate of interest in the US is higher than widely believed. This implies that the overall stance of monetary policy remains exceptionally stimulative. Historically, stocks have shrugged off rising bond yields, as long as yields did not increase to prohibitively high levels (Table 2). Table 2As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Will Recover If the neutral rate ends up being higher than the Fed supposes, the danger is that monetary policy will stay too loose for too long. The question is one of timing. The good news is that inflation should recede in the US in 2022, as supply-chain bottlenecks ease and spending shifts back from goods to services. The bad news is that the respite from inflation will not last. As discussed in Section II of our recently-published 2022 Strategy Outlook, inflation will resume its upward trajectory in mid-2023 on the back of a tightening labor market and a budding price-wage spiral. This second inflationary wave could force the Fed to turn much more aggressive, spelling the end of the equity bull market. Bottom Line: While the Fed is gearing up to raise rates and trim the size of its balance sheet, monetary policy in the US and in other major economies will remain highly accommodative in 2022. US policy could turn more restrictive in 2023 as a second wave of inflation forces a more aggressive response from the Fed. Pillar 4: Valuations (Bearish In The US; Neutral Elsewhere) US Stocks Are Looking Pricey… While valuations are a poor timing tool in the short run, they are an excellent forecaster of stock prices in the long run. Chart 18 shows that the Shiller PE ratio has reliably predicted the 10-year return on equities. Today, the Shiller PE is consistent with total real returns of close to zero over the next decade. Investors’ allocation to stocks has also predicted the direction of equity prices (Chart 19). According to the Federal Reserve, US households held a record high 41% of their financial assets in equities as of the third quarter of 2021. If history is any guide, this would also correspond to near-zero long-term returns on stocks. Chart 19Valuations Matter For Long-Term Returns (II) … But There Is More Value Abroad Valuations outside the US are more reasonable. Whereas US stocks trade at a Shiller PE ratio of 37, non-US stocks trade at 20-times their 10-year average earnings. Other valuation measures such as price-to-book, price-to-sales, and dividend yield tell a similar story (Chart 20). Chart 20AUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) Chart 20BUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) Cyclicals And Banks Overrepresented Abroad Our preferred sector skew for 2022 favors non-US equities. Increased capital spending in developed economies and incremental Chinese stimulus should boost industrial stocks and other deep cyclicals, which are overrepresented outside the US (Table 3). Banks are also heavily weighted in overseas markets; they should also do well in response to faster-than-expected growth and rising bond yields (Chart 21). Table 3Deep Cyclicals And Financials Are Overrepresented Outside The US Chart 21Rising Bond Yields Will Help Bank Shares Bottom Line: Valuations are more appealing outside the US, and with deep cyclicals and banks set to outperform tech over the coming months, overseas markets are the place to be in 2022. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Highlights US economic data remains robust, but economic surprises are rolling over relative to other G10 countries. Meanwhile, the Fed is turning a tad more hawkish, which is positive for the greenback in the short term but could hurt growth over a cyclical horizon. A hawkish Fed and dovish PBoC could set the stage for an economic recovery outside the US. We are not fighting the Fed (dollar bullish in the near term), and most of our trades are at the crosses. These include long EUR/GBP, long AUD/NZD and long CHF/NZD. We also have a speculative long on AUD/USD. We were stopped out of our short USD/JPY trade at break even and will look to reinstate at more attractive levels. Feature The dollar was the best performing G10 currency last year (Chart 1), which begs the question if this outperformance will be sustained in 2022. In this week’s report, we go over a few key data releases in the last month and implications for currency markets. Most recently, PMI releases across the developed world have remained robust but are peaking (Chart 2). The key question is whether the slowdown proves genuine, and if so, whether the US can maintain economic leadership versus the rest of the G10. Chart 2AGlobal PMIs Are Softening, Especially In The US Chart 2BGlobal PMIs Are Softening, Especially In The US The next key question is what central banks do about inflation. It is becoming clearer that rising prices are not a US-centric phenomenon but a global problem (Chart 3). Our bias is that central banks cannot meaningfully diverge on the inflation front. This will create trading opportunities. Chart 3AInflation Is A Global Problem Chart 3BInflation Is A Global Problem Over the next few pages, we look at the latest data releases and implications for currency strategy. US Dollar: Strong Now, Weaker Later? The dollar DXY index fell 0.4% in December and is up 0.5% year to date. A growth rotation from the US to other economies continues, even though US economic data over the last month remains rather robust. The latest release of the ISM manufacturing index remained strong at 58.7 for December, but this has rolled over from 61.1 in the previous month. More importantly, the prices paid index fell from 82.4 to 68.2. This suggests inflationary pressures are coming in, which could assuage tightening pressure on the Federal Reserve. In other data, the trade deficit continues to widen, hitting a record -$97.8bn in November. Durable goods orders for November rose 2.5%, the biggest increase in six months. The consumer confidence index from the Conference Board has also rebounded, rising to 115.8 in December. Home prices are also rising, with an increase of almost 20% year on year in October. This suggests monetary conditions in the US remain very easy, relative to underlying demand. A tighter Fed is what the US needs, but the perfect calibration of monetary policy could prove difficult to achieve. The Fed minutes this week highlighted a preference for a faster pace of policy normalization, in the face of a tightening labor market and persistent inflationary pressures. This put the US dollar in a quandary, relative to other developed market currencies. If the US tightens monetary policy, while China eases, it strengthens the dollar in the near term, but tightens US financial conditions that have been the bedrock of US demand. This will suggest peak US demand in the coming months, and a bottoming in demand for countries that are more sensitive to Chinese monetary conditions. Chart 4AUS Dollar Chart 4BUS Dollar The Euro: All Bets On China? The euro was up 0.4% in December. Year-to-date, the euro is down 0.5%. Inflation continues to rise in the eurozone, which begs the question of how long the ECB can remain on a dovish path and maintain credibility on its inflation mandate. PPI came out at 23.7% year-on-year, the highest in several decades. Core consumer price index (CPI) in the eurozone is at 4.9%, a whisker below US levels. Economic data remain resilient in the euro area, despite surging Covid-19 cases. The ZEW expectations survey rose to 26.8 in December from 25.9. The trade balance remains in a healthy surplus (though rolling over). In a nutshell, economic surprises in the eurozone have been outpacing those in the US over the last month. The ECB continues to maintain a dovish stance, keeping rates on hold and reiterating that inflation should subside in the coming quarters. According to their forecasts, inflation is headed below 2% by the end of 2022. This could prove wrong in a world where inflation is sticky globally and driven by supply-side factors. In the near term, we expect a policy convergence between the ECB and the BoE. As such, we are long EUR/GBP on this basis. Over the longer term, we expect the ECB to lag the Fed, and thus we will fade any persistent strength in the euro. Chart 5AEuro Chart 5BEuro The Japanese Yen: The Most Hated Currency The Japanese yen was down 2% in December. It is also down 0.6% year-to-date. Overall, the yen was the worst performing G10 currency in 2021. Good news out of Japan continues to be underappreciated, while bad news is well discounted. Industrial production rose 5.4% in November, from a contraction the previous month, and the Jinbun Bank manufacturing PMI edged higher in December to 54.3. Retail sales are inflecting higher, and the national CPI has bottomed, easing pressure on the Bank of Japan to remain ultra-accommodative. The bull case for the yen remains intact. First, as we have witnessed recently, it will perform well in a market reset, given it is the most shorted G10 currency. Second, and related, the yen tends to do well with rising volatility, which we should expect in the coming months. Third, Covid-19 infections in Japan remain low, meaning should global cases rollover, Japan could be quicker in jumpstarting an economic recovery. Finally, an equity market rotation from expensive markets like the US towards cheaper and cyclical markets like Japan, will benefit the yen via the portfolio channel. From a valuation standpoint, the yen is the cheapest G10 currency according to our PPP models. We were long the yen and stopped out at break even (114.40). We will look to re-enter this trade at more attractive levels. Chart 6AJapanese Yen Chart 6BJapanese Yen British Pound: Near-Term Volatility The pound was up 1.9% in December. Year-to-date, cable is flat. UK data continues to moderate from high levels, similar to the picture in the US. Covid-19 infections continue to surge, but the December manufacturing PMI remains resilient at 57.9. Retail sales and house prices are also robust, and the latest CPI print for November, at 5.1%, justifies the interest rate hike by the Bank of England last month. The near-term path for the pound will be dictated by portfolio flows, and the ability of the BoE to deliver aggressive rate hikes already priced in the market. With the UK running a basic balance deficit, a dry up in foreign capital could hurt the pound. This will also be the case if the BoE does not deliver as many hikes as is discounted by markets. A rollover in energy costs (electricity prices are collapsing), and potentially, inflation could be catalyst. The post-Brexit environment also remains quite volatile. This short-term hiccup underpins our long EUR/GBP call. Longer term, incoming data continues to strengthen the case for the BoE to tighten policy. At 4.2%, the unemployment rate is at NAIRU. Wages are also inflecting higher. As such, the pound should outperform over the longer-term, as the BoE continues to normalize policy. Chart 7ABritish Pound Chart 7BBritish Pound Australian Dollar: Top Pick For 2022 The Australian dollar was up 2.2% in December. Year-to-date, the Aussie is down 1.4%. Covid-19 continues to ravage Australia, prompting the government to adopt measures such as threatening to deport superstar athletes who refuse to be vaccinated. Combined with the zero-Covid policy in China (Australia’s biggest export partner), the economic outlook remains grim in the near term. In our view, such pessimism opens a window to be cautiously long AUD. First, speculators are very short the currency. Second, low interest rates are reintroducing froth in the property market that the authorities have fought hard to keep a lid on. Home prices in Sydney and Melbourne are rising close to 20% year-on-year. Most inflation gauges are also above the midpoint of the RBA’s target. Our playbook is as follows: China eases policy, allowing Australian exports to remain strong. This will allow the RBA to roll back its dovish rhetoric, relative to other central banks. This will also trigger a terms of trade recovery and interest rate support for the AUD. We are cautiously long AUD at 70 cents, and recommend investors stick with this position. Chart 8AAustralian Dollar Chart 8BAustralia Dollar New Zealand Dollar: Up Versus USD, But Lower On The Crosses The New Zealand dollar was up 0.25% in December, while down 1.1% year to date. The Covid-19 situation is much better in New Zealand, compared to its antipodean neighbor, but recent economic developments still have a stagflationary undertone. Headline CPI and house prices are rising at the fastest pace in decades, but wage growth remains very muted. With the RBNZ that now has house price considerations in its mandate, the risk is that further rate hikes hamper the recovery. Data wise, the trade balance continues to print a deficit as domestic demand in China remains tepid. New Zealand currently has the highest G10 10-year government bond yield, suggesting marginally tighter financial conditions. Meanwhile, portfolio flows into New Zealand have turned negative in recent quarters, especially driven by defensive equity outflows. Overall, the kiwi will benefit from a recovery in China but less so than the AUD, which is much shorted and has a better terms of trade picture. As such we are long AUD/NZD. Chart 9ANew Zealand Dollar Chart 9BNew Zealand Dollar Canadian Dollar: Next Up After AUD? The CAD was up 1.4% in December. Year to date, the loonie is down 0.7%. The key driver of the CAD in 2022 remains the outlook for monetary policy, and the path of energy prices. We are optimistic on both fronts. On monetary policy, CPI inflation remains above the central bank’s target, house prices are rising briskly, and the trade balance continues to improve meaningfully. This provides fertile ground for tighter monetary settings. Employment in Canada is already above pre-pandemic levels and has now settled towards trend growth of around 2%. This suggests a print of 30,000 - 40,000 jobs (27,500 in December), is in line with trend. The unemployment rate continues to drop, hitting 6.0%. Oil prices also remain well bid, as outages in Libya offset planned production increases by OPEC. Should Omicron also fall to the wayside, travel resumption will bring back a meaningful source of demand. Net purchases of Canadian securities continue to inflect higher, as the commodity sector benefits from a terms-of-trade boom. We are buyers of CAD over a 12–18-month horizon. Chart 10ACanadian Dollar Chart 10BCanadian Dollar Swiss Franc: Line Of Defense The Swiss franc was up 0.8% in December and has fallen by 0.9% year to date. The Swiss economy continues to fare well amidst surging Covid-19 infections. Meanwhile, as a defensive currency, the franc has benefitted from the rise in volatility, especially compared to other currencies like the New Zealand dollar over the course of 2021 (we are long CHF/NZD). Economic wise, the unemployment rate has dropped to 2.5%, inflation is rising briskly, and house prices remain very resilient. This is lessening the need for the central bank to maintain ultra-accommodative settings. It is also interesting that the Swiss franc is well shorted by speculators engaging in various carry trades. Our baseline is that the Swiss National Bank is likely to lag the rest of the G10 in lifting rates from -0.75%, currently the lowest benchmark interest rate in the world. That said, this is well baked in the consensus suggesting any risk-off event or pricing of less monetary accommodation in other markets will help the franc. One area of opportunity is being long EUR/CHF, where the market has priced a very dovish ECB, even relative to the SNB. We are long this cross (which could suffer in the short term) but should rise longer term. Chart 11ASwiss Franc Chart 11BSwiss Franc Norwegian Krone: A Beta Play On A Lower Dollar The Norwegian krone was up 2.7% in December and is down 0.9% year to date. Norway was a developed market beacon of how to handle the pandemic until the more contagious Omicron variant started to ravage the economy. The latest data prints suggest core CPI is falling and house price appreciation is rolling over. Headline inflation remains strong, and the latest retail sales release shows 1% growth month on month for November suggesting some resilience amidst the pandemic. The Norges Bank has been the most orthodox in the G10, raising interest rates and promising to continue doing so in the coming quarters. Should Omicron prove transient and oil prices stay resilient, this will be a “carte blanche” for the Norges bank to keep normalizing policy. Norway’s trade balance and terms of trade remain robust. Meanwhile, portfolio investment in some unloved sectors in Norway could provide underlying support for the NOK. We are buyers of the NOK on weakness. Chart 12ANorwegian Krone Chart 12BNorwegian Krone Swedish Krona: A Play On China The SEK was up 0.3% in December and is down 1% year to date. The performance of the Swedish economy continues to strengthen the case for the Riksbank to tighten monetary policy. In recent data, the trade balance remains in a surplus as of November, household lending is rising 6.6% year on year (November), retail sales remain robust, and PPI is inflecting higher. Manufacturing confidence also improved in December, along with improvement in labor market conditions. The Riksbank will remain data dependent, but it has already ended QE. It remains one of the most dovish G10 central banks and is slated to keep its policy rate flat at 0% at least until 2024. This could change if inflationary pressures remain persistent. A bounce in Chinese demand could be the catalyst that triggers this change. We have no open positions now in SEK, but will look to go short USD/SEK and EUR/SEK should more evidence of a Swedish recovery materialize. Chart 13ASwedish Krona Chart 13BSwedish Krona Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Forecast Summary
We have entered a new phase of the cycle, with central banks in most developed markets turning more hawkish (the Bank of England surprisingly hiking in December, and the Fed signaling three rate hikes for 2022). How much does this matter for equities and other risk assets? Our view is that, as long as economic growth continues to be strong (and we think it will), and provided that central banks don’t overdo the tightening (and, with inflation likely to come down this year, we think excess tightening is unlikely), the hawkish turn might temporarily raise volatility and cause the occasional correction, but it does not undermine the case for equities to outperform bonds over the next 12 months. We remain overweight global equities. Economic growth is likely to continue to be well above trend for the next year or two (Chart 1), driven by (1) consumers spending some of the $5 trillion of excess savings they have accumulated in the G10 economies, (2) the unprecedented wealth effect from recent stock and house price rises (Chart 2), and (3) strong capex as companies strive to increase capacity to meet the consumer demand (Chart 3). The upsurge in Covid cases in December (Chart 4) will undoubtedly slow growth temporarily. But the signs are that the now-prevalent Omicron variant is mild, and its rapid spread could help the developed world achieve “herd immunity” thanks to widespread vaccination and natural immunity, though emerging countries – especially China – may continue to struggle. Chart 1Growth Will Continue To Be Above Trend Chart 2Growth Will Be Boosted By The Wealth Effect... Chart 3...And Capex To Increase Production With US growth very strong – the Atlanta Fed Nowcast suggests Q4 QoQ annualized real GDP growth was 7.6% – and core PCE inflation 4.1%, it is hardly surprising that the Fed wants to accelerate the rate at which it withdraws accommodation. The FOMC dots, which see three rate hikes this year and another three in 2023, are unexceptional and close to what the futures market has already been (and still is) pricing in (Chart 5). Chart 4Covid Cases Not Leading to Hospitalizations And Deaths Chart 6Fed Hikes Have Usually Caused Only A Short-Lived Selloff Chart 5The Futures Market Is In Line With The FOMC Dots In the past, the first Fed hike in a cycle has often triggered a mild short-term sell off in stocks (the timing depending on how well the hike was flagged in advance), but the equity market digested the news rapidly, quickly resuming its upward trend as the Fed continued to tighten (Chart 6). The same was true around the tapering and end of asset purchases in 2013-17 (Chart 7). All that depends, though, on whether the Fed is rushed into further rate hikes because inflation surprises even more to the upside. Our view remains that inflation will decline this year. The high inflation prints we are seeing now are mostly the result of exceptional demand for consumer manufactured goods, which the supply side has temporarily been unable to fulfil, causing shortages. This can be seen in the very different pattern of goods and services inflation (Chart 8). As we have argued previously, the supply response is now kicking in for key inputs into manufactured goods, such as semiconductors and shipping and, with demand likely to shift to services this year as the pandemic fades, this should bring inflation down. Chart 7Tapering Didn't Much Affect Stocks Either Chart 8Inflation Probably Will Decline This Year That said, the year-on-year inflation number will continue to look scary for some time, even if month-on-month inflation settles back to its pre-pandemic level of 0.2% (Chart 9). The consensus average forecast of 3.3% core PCE inflation in 2022 is factoring in monthly inflation around this level. The risks to inflation remain to the upside, particularly if wages respond to higher prices (US wage growth is currently 4-6%, significantly lagging behind price inflation – Chart 10), causing companies to raise prices further, triggering a price-wage spiral. Chart 9Year-On-Year Inflation Will Remain High Chart 10Risk Of A Price-Wage Spiral? All this suggests a year of significant volatility and uncertainty. The US stock market has not seen a correction (a drop of more than 10%) in this cycle, and there were no drawdowns last year of more than 5% (Chart 11). This is unusual: There were six 10%-plus corrections in the 2009-2019 bull market. The US equity rally is also looking increasingly narrow, with the run-up to a record-high in December driven by just a few large-cap growth stocks (Chart 12). This – and pricey valuations – makes it vulnerable and, as a hedge to downside risks, we continue to recommend an overweight in cash (rather than government bonds, which offer very asymmetrical returns, with significant downside in the event that inflation proves to be stubborn). Chart 11Where Have All The Corrections Gone? Chart 12Stock Market Has Got Very Narrow The other policy focus remains China. The authorities’ recent cut of the banks’ reserve ratio and more dovish talk does suggest that they are now concerned about how weak growth has become (Chart 13). A slight loosening of monetary policy has probably caused credit growth to bottom (Chart 14). However, our China strategists argue that the easing is likely to be only moderate since policymakers want to continue with structural reforms, such as reducing debt. The next few months may resemble early 2019 when the PBOC engineered a brief injection of liquidity which lasted only a few months. Moreover, the slump in the property market has not run its course (Chart 15), and this will hamper the authorities’ ability to accelerate infrastructure spending, much of which is financed by local governments’ property sales. Even if Chinese credit growth and the property market do pick up a little, the economy – and indeed commodity prices – will not bottom for another 6-9 months (Chart 16). But, when this happens, it would be a signal to turn more risk-on and bullish on cyclical countries and sectors, such as Emerging Markets, Europe, and Value stocks. Chart 13Chinese Data Looks Very Poor Chart 14Is Credit Growth Now Bottoming? Chart 15Slump In China Property Is Not Over Chart 16It Will Take A While For Commodity Prices To Pick Up Equities: While we remain overweight equities, returns this year will be only modest. Returns in 2020 were driven by multiple expansion, and last year by strong margin expansion (Chart 17), as often happens in Years 1 and 2 of a bull market. But this year, while sales growth should remain strong, BCA Research’s US equity strategists’ model points to a small decline in margins, which are at a record high (Chart 18). The PE multiple is likely to fall further too, as it usually does when the Fed is hiking. Even with buybacks and dividends, this amounts to a total return from US equities of only about 8%. Chart 17What Can Drive Returns In 2022? Chart 18Margins Likely To Slip From Record High Chart 19Europe Is More Sensitive To China Slowing... Nonetheless, we continue to prefer the US to other developed markets. Europe is more sensitive to the slowdown in China (Chart 19) and tends to underperform when global growth is slowing and is concentrated in services. Neither is it notably cheap versus the US relative to history (Chart 20). Emerging Markets face multiple headwinds, from the slowdown in China, to rampant inflation that is forcing central banks to hike aggressively (Brazil, for example has raised rates to 9.25% from 2% since April even in the face of weak growth and continuing risks from Covid). Chart 20...And Not Particularly Cheap Chart 22US Treasurys Are Attractive to Europeans And Japanese Chart 21Long Rates Low Given Fed Signaling Fixed Income: Long-term rates are surprisingly low, given the hawkish pivot of the Fed and other central banks (Chart 21). One explanation Fed chair Powell has given is the attractiveness of US Treasurys, after FX hedges, to European and Japanese investors (Chart 22). He is correct about this, but the advantage will wane as the Fed raises rates (while the ECB and BOJ don’t). We continue to forecast the 10-year Treasury yield to rise to 2-2.25% by the time of the first Fed hike. We are underweight duration and expect a moderate steepening of the yield curve. TIPs look richly valued, especially at the short end. We are neutral on US TIPs, where 10-years at least represent a hedge against tail-risk inflation. Inflation-linked bonds in the euro zone are particularly unattractive now (Chart 23). Chart 23Breakevens Already Pricing In A Lot Of Inflation In credit, we continue to see value in riskier high-yield bonds, where US B- and Caa-rated names are trading at breakeven spreads close to historic averages (Chart 24). Our global fixed-income strategists have also recently turned more positive on US dollar-denominated EM debt, which offers a decent spread pickup versus US corporate debt of the same credit rating and maturity (Chart 25). Currencies: Relative monetary policy between the US and Europe and Japan could mean some further upside for the dollar over the next few months (Chart 26). However, the dollar is expensive relative to fair value, long-dollar is an increasingly crowded trade and, in the second half of the year, a rebound in China would boost growth in Europe and Emerging Markets, which would be positive for commodity currencies. Bearing that in mind, we remain neutral on the USD. Chart 25...As Are Some EM Dollar Bonds Chart 26Dollar To Rise On More Hawkish Fed? Chart 28Gold Is Vulnerable To Rising Real Rates Commodities: Metals prices are likely to suffer further in the first half of the year, as China’s growth continues to slow. This would suggest a further decline in the equity Materials sector. Nonetheless, we continue to have a neutral on commodities as an asset class because of the positive long-term story: Demand for metals for use in alternative energy is not being met by increased supply because investor pressure is stymying capex in the mining sector (Chart 27). It makes sense to have long-term exposure to metals such as copper and lithium which are used in electric vehicles. The oil price is mostly determined currently by Saudi supply. Our energy strategists forecast Brent oil to average $78.50 in 2022 and $80 in 2023, roughly the same as the current spot price. We remain neutral on gold: The bullion is not particularly attractively valued currently and will suffer if, as we expect, real long-term rates rise (Chart 28). Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Recommended Asset Allocation
Highlights Global growth will remain above-trend in 2022, although with more divergence between regions than at any time during the pandemic (US strong, Europe steady, China slowing). Global inflation will transition from being driven by supply squeezes towards more sustainable inflation fueled by tightening labor markets - a shift leading to tighter monetary policies that are not adequately discounted in the current low level of bond yields, most notably in the US. Maintain below-benchmark overall global duration exposure. Diverging growth and inflation trends will lead to a varying pace of monetary policy tightening between countries, resulting in greater opportunities to benefit from relative bond market performance and cross-country yield spread moves. Underweight government bonds in countries where central banks are more likely to hike rates in 2022 (the US, the UK, Canada) versus overweights where monetary policy is more likely to remain unchanged (Germany, France, Italy, Australia, Japan). Deeply negative real bond yields reflect an implied path of nominal interest rates that is too low relative to inflation expectations in the majority of developed countries. Real bond yields will adjust higher in countries where rate hikes are more likely, resulting in more stable inflation breakevens compared to 2021. Stay neutral global inflation-linked bonds versus nominal government debt. A tightening global monetary policy backdrop and rising real interest rates will weigh on returns in global credit markets, even as strong nominal economic growth minimizes downgrade and default risks. Like government bonds, global growth and policy divergences will create relative investment opportunities between countries, especially later in 2022 when the Fed begins to hike rates and China begins to ease macro policies. Overweight euro area high-yield and investment grade corporates versus US equivalents. Limit exposure to EM hard-currency debt until there are clear signals of China policy stimulus and upside momentum on the US dollar fades. Feature Dear Client, This report, detailing our global fixed income investment outlook for next year, will be our last for 2021. We wish you a very safe, happy and prosperous 2022. We look forward to continuing our conversation in the new year. Rob Robis, Chief Global Fixed Income Strategist BCA Research’s Outlook 2022 report, “Peak Inflation – Or Just Getting Started?”, outlining the main investment themes for the upcoming year based on the collective wisdom of our strategists, was sent to all clients in late November. In this report, we discuss the broad implications of those themes for the direction of global fixed income markets, along with our main investment recommendations for 2022. A Brief Summary Of The 2022 BCA Outlook The tone of the 2022 Outlook report was quite positive on the prospects for global growth, even with the recent development of the rapid spread of the Omicron COVID-19 variant. It remains to be seen how severe this new variant will be in terms of hospitalizations and deaths compared to previous COVID waves. We assume that any negative economic impacts from Omicron in the developed economies will be contained to the first half of 2022, however, given more widespread vaccination rates (including booster shots) and greater access to anti-viral treatments. The baseline economic scenario in 2022 is one of persistent above-trend growth in the developed world (Chart 1) with a closing of output gaps in the US and euro area. The mix of spending in those economies will shift away from goods towards services, although Omicron may delay that transition until later in 2022. Chart 1Another Year Of Above Trend Growth Expected In 2022 Chart 2Strong Fundamental Support For US Growth Chart 3China In 2022: Deceleration Leading To Policy Easing The US looks particularly well supported to maintain a solid pace of economic activity. The US labor market is very strong. Monetary policy remains accommodative (although that is slowly changing). Financial conditions are still easy, with the lagged impact of elevated equity and housing values providing a robust tailwind to consumer spending that is already well supported by excess savings resulting from the pandemic (Chart 2). China starts the year as a “one-legged” economy supported only by external demand, and policy stimulus later in the year will eventually be needed for the Chinese government to reach its growth targets (Chart 3).That policy shift will have significant implications for the outlook of many financial assets as 2022 evolves, including emerging market (EM) fixed income, industrial commodity prices and the US dollar (as we discuss later in this report). Global inflation will recede from the overheated pace of 2021 as supply chain bottlenecks become less acute. Inflationary pressures in 2022 will come from more “normal” sources like tightening labor markets, rising wage growth and higher housing costs (rents). This constellation of lower unemployment with still-elevated underlying inflation will look most acute in the US, leading the Fed to begin a tightening cycle that is not fully discounted in US Treasury yields. The broad investment conclusions of the BCA 2022 Outlook are more positive for global equity markets relative to bond markets, although with elevated uncertainty stemming from Omicron and future China stimulus. The views are more nuanced for other assets, like the US dollar (stronger to start the year, weaker later) and oil prices (essentially flat from pre-Omicron levels). Our Four Key Views For Global Fixed Income Markets In 2022 The following are the main implications for global fixed income investment strategy based off the conclusions from the 2022 BCA Outlook. Key View #1: Maintain below-benchmark overall global duration exposure. As we have noted in the title of our report, the investment outlook for 2022 is more complicated for investors to navigate than the relatively straightforward story from this time a year ago. Then, the development of COVID-19 vaccines led to optimism on reopening from 2020 lockdowns, but with no threat of the early removal of pandemic monetary and fiscal policy stimulus. The fixed income investment implications at the time were obvious, in the majority of developed countries - expect higher government bond yields, steeper yield curves, wider inflation breakevens and tighter corporate credit spreads. Today, the story is more complicated, but is still one that points to higher global bond yields. Take, for example, global fiscal policy. According to the IMF, the US is expected to see no fiscal drag in 2022 thanks to the Biden Administration’s spending initiatives, while Europe and EM will see significant fiscal drag (Chart 4). However, in the case of Europe, this should not be viewed negatively as it is the result of expiring pandemic era employment and income support programs that are no longer needed after economies emerged from wholesale lockdowns. So less fiscal stimulus is a sign of a healthier European economy that is more likely to put upward pressure on global bond yields, on the margin. The outlook for global consumer spending is also a bit more complicated, but still one that points to higher bond yields. Consumer confidence was declining over the final months of 2021 in the US, Europe, the UK, Canada and most other developed countries. This occurred despite falling unemployment rates and very strong labor demand, which would typically be associated with consumer optimism (Chart 5). High global inflation, which has outstripped wage gains and reduced real purchasing power, is why consumers have become gloomier in the face of healthy job markets. Chart 4Global Fiscal Policy Divergence In 2022 Chart 5Lower Inflation Will Help Boost Consumer Confidence The implication is that the expectation of lower inflation outlined in the 2022 BCA Outlook, which sounds bond-bullish on the surface, could actually prove to be bond-bearish if it makes consumers more confident and willing to spend. On that note, there are already signs that the some of the sources of the global inflation surge of 2021 are fading in potency. Commodity price inflation has rolled over, in line with slowing momentum in manufacturing activity and a firmer US dollar (Chart 6). Measures of global shipping costs, while still elevated, have stopped accelerating. The spread of the Omicron variant may delay a further easing of supply chain disruptions in the short-term, but on a rate of change basis, the upward pressure on global inflation from supply squeezes will diminish in 2022. The inflation story will also be more complicated next year. While there will be less inflation from the prices of commodities and durable goods, there will be more inflation from the elimination of output gaps, tightening labor markets and an overall dearth of global spare capacity. Put another way, expect the gap between global headline and core inflation rates to narrow in most countries, but with domestically generated core inflation rates remaining elevated (Chart 7). Chart 6Some Relief On Supply-Driven Inflation On The Way Chart 7Global Inflation Will Be Lower, But More Sustainable, In 2022 The more complicated investment story for 2022 extends to global bond yields themselves. Longer-maturity government bond yields remain far too low given the mix of very high inflation and very low unemployment in many countries. Chart 8Bond Markets Vulnerable To More Hawkish Repricing Even as major central banks like the Fed are tapering bond purchases and signaling more rate hikes in 2022, and others like the Bank of England (BoE) have actually raised rates, bond yields remain low. The reason for this is that markets are discounting very low terminal rates – the peak level of policy rates to be reached in the next monetary tightening cycle. We proxy this by looking at 5-year overnight index swap (OIS) rates, 5-years forward. A GDP-weighted aggregate of those forward OIS rates for the major developed economies (the US, Germany, the UK, Japan, Canada and Australia) is currently 0.9%. This compares to GDP-weighted 10-year government bond yield of 0.8% (Chart 8). Forward OIS rates and 10-year bond yields are typically closely linked, which suggests upward scope for longer-maturity bond yields as markets begin to discount a higher trajectory for policy rates. We see this as the primary driver of higher bond yields in 2022 – an upward adjustment of interest rate expectations as central banks like the Fed, BoE and Bank of Canada (BoC) promise, and eventually deliver, more rate hikes than markets currently expect. We therefore recommend maintaining a below-benchmark stance on overall interest rate (duration) exposure in global bond portfolios in 2022. Government bond yield curves will eventually see more flattening pressure as central banks tighten, most notably in the US, but not before longer-term yields rise to levels more consistent with the most likely peak levels of central bank policy rates. Key View #2: Underweight government bonds in countries where central banks are more likely to hike rates in 2022 (the US, the UK, Canada) versus overweights where monetary policy is more likely to remain unchanged (Germany, France, Italy, Australia, Japan). The more complicated fixed income investing story for 2022 also extends to country allocation decisions, with more opportunities to take advantage of diverging bond market performance and cross-country spread moves. Current pricing in OIS curves shows a very modest expected path for interest rates in the major developed economies (Chart 9). Some central banks, like the BoE, BoC and the Reserve Bank of New Zealand (RBNZ) are expected to be more aggressive with rate hikes in 2022 compared to the Fed. Yet there are not many rate hikes discounted beyond 2022, even in the US (Table 1). Chart 9Markets Are Pricing Short, Shallow Hiking Cycles Table 1Only Modest Tightening Expected Over The Next Three Years The US OIS curve is currently priced for an expectation that the Fed will struggle to hike the fed funds rate beyond 1.25% by the end of 2024, even with the latest set of FOMC rate forecasts calling for 75bps of rate hikes in 2022 alone. In the case of the UK, markets are pricing in lower rates in 2024 after multiple rate hikes in 2022/23, indicative of an expectation of a policy error of BoE “overtightening” even with the BoE Bank Rate expected to peak just above 1% The relative performance of government bond markets is typically correlated to changes in relative interest rate expectations. That was once again evident in 2021, where the UK, Canada and Australia significantly underperformed the Bloomberg Global Treasury aggregate in the third quarter as markets moved to rapidly price in multiple rate hikes (Chart 10). That volatility of bond market performance was particularly unusual Down Under, as the Reserve Bank of Australia (RBA) did not signal any desire to begin hiking rates in 2022, unlike the BoE and BoC. As rate expectations in those three countries stabilized in the fourth quarter, their government bonds began to outperform. On the other hand, relative government bond performance was more stable in the euro area, Japan and the US for most of 2021 (Chart 11). In the case of the US, rate hike expectations only began to move higher in September after the Fed signaled that tapering of bond purchases was imminent. Even then, markets have moved slowly to discount 2022 rate hikes. Now, the pricing in the US OIS curve is more in line with the median interest rate “dot” from the latest FOMC projections, calling for three rate hikes next year starting in June. Chart 10Rate Hike Expectations Driving Relative Bond Returns Chart 11Stay Underweight US Interest Rate Exposure Looking ahead to next year, we see the widening divergences on growth, inflation and monetary policies between countries leading to the following investible opportunities on country allocation in global bond portfolios. Underweight US Treasuries Chart 12Cyclical Upside Risk To Longer-Dated UST Yields The Fed has already begun to taper its bond buying, which is set to end by March 2022. As shown in Table 1, 79bps of rate hikes are discounted in the US by the end 2022, but only another 41bps are priced over the subsequent two years. Survey-based measures of interest rate expectations are similarly dovish, even with the US unemployment rate now at 4.2% - within the FOMC’s range of full employment (NAIRU) estimates between 3.5-4.5% - and wage inflation accelerating (Chart 12). Markets are underestimating how much the funds rate will have to rise over the next 2-3 years as the Fed belated catches up to a very tight US labor market and inflation persistently above the Fed’s 2% target. Stay below-benchmark on US interest rate risk, through both reduced duration exposure and lower portfolio allocations to Treasuries. Overweight Core Europe While interest rate markets are underestimating how much monetary tightening the Fed will deliver, the opposite is true in Europe. The EUR OIS curve is discounting 39bps of rate hikes to the end of 2024, even with cyclical growth indicators like the manufacturing PMI and ZEW expectations survey well off the 2021 highs (Chart 13). At the same time, there is little evidence to date indicating that the surge in European inflation this year, which has been narrowly concentrated in energy prices and durable goods prices, is feeding through into broader inflation pressures or faster wage growth. We recommend maintaining an overweight allocation to core European government bond markets (Germany, France), particularly versus underweights in US Treasuries. Our expectation of a wider 10-year US Treasury-German bund spread is one of our highest conviction views for 2022, playing on our theme of widening growth, inflation and monetary policy divergences (Chart 14). Chart 13Stay Overweight European Interest Rate Exposure Chart 14Expect More US-Europe Spread Widening In 2022 Overweight European Peripherals Chart 15Stay O/W European Peripheral Exposure To Begin 2022 The ECB will be allowing its Pandemic Emergency Purchase Program, or PEPP, to expire at the end of March 2022. Beyond that, the ECB has announced that the pace of buying in the existing pre-pandemic Asset Purchase Program (APP) will be upsized from €20bn per month to between €30-40bn until at least the third quarter of 2022. This represents a meaningful slowing of the pace of ECB bond purchases, which were nearly €90bn per month under PEPP. Nonetheless, unlike most other developed economy central banks that are ending pandemic-era quantitative easing (QE) programs, the ECB will still be buying bonds on a net basis and expanding its balance sheet in 2022 (Chart 15). The central bank has taken great care in signaling that no rate hikes should be expected in 2022, likely to avoid any unwanted surges in Peripheral European bond yields or the euro. A continuation of asset purchases reinforces that message, leaving us comfortable in maintaining an overweight recommendation on Italian and Spanish government bonds for 2022. Underweight the UK and Canada Chart 16Stay U/W UK & Canadian Interest Rate Exposure A combination of rapidly tightening labor markets and soaring inflation is almost impossible for any inflation-targeting central bank to ignore. That is certainly the case in the UK, where the unemployment rate is 4.2% with two job vacancies available for every unemployed person – a series high for that ratio (Chart 16, top panel). UK headline CPI inflation is at a 10-year high of 5.2% and the BoE expects inflation to peak around 6% in April 2022. Medium-term inflation expectations, both market based and survey based, are also elevated and well above the BoE’s 2% inflation target. The BoE surprised markets a couple of times at the end of 2021, not delivering on an expected hike in November and actually lifting rates in December in the midst of the intense UK Omicron wave. We see the latter decision as indicative of the central bank’s growing concern over high UK inflation becoming embedded in inflation expectation. The BoE will likely have to eventually raise rates to a level higher than the 2023 peak of 1.1% currently discounted in the GBP OIS curve. That justifies an underweight stance on UK interest rate exposure (both duration and country allocation) in 2022. A similar argument applies to Canada. The Canadian unemployment rate now sits at 6.0%, closing in on the February 2020 pre-COVID low of 5.7%. The BoC’s Q3/2021 Business Outlook Survey showed a net 64% of respondents reporting intensifying labor shortages (the highest level in the 20-year history of the survey). Wage growth is accelerating, headline CPI inflation is running at 4.7% and underlying inflation (trimmed mean CPI) is now at 3.4% - the latter two are well above the BoC inflation target range of 1-3%. The CAD OIS curve currently discounts 147bps of rate hikes in 2022, which is aggressively hawkish, but very little is priced beyond that in 2023 (another 19bp hike) and 2024 (a rate cut of 24bps). The BoC estimates that the neutral interest rate in Canada is between 1.75% and 2.75%. Thus, markets do not expect the BoC to lift rates to even the low end of that range over the next three years, despite a very tight labor market and an inflation overshoot. We see this as justifying a continued underweight stance on Canadian interest rate exposure (both duration and country allocation) in 2022, even with markets already discounting significant monetary tightening next year. Overweight Australia and Japan Outside of Europe, we recommend overweights on Australian and Japanese government bonds entering 2022 (Chart 17). The RBA has been quite clear in what needs to happen before it will begin to lift rates. Australian wage growth must climb into the 3-4% range that has coincided with underlying Australian inflation sustainably staying in the RBA’s 2-3% target range. Wage growth and trimmed mean CPI inflation only reached 2.2% and 2.1%, respectively, for the latest available data from Q3/2021. As Australian wage and inflation data is only released on a quarterly basis, the RBA will not be able to assess whether wage dynamics are consistent with reaching its inflation target until the latter half of 2022. The AUD OIS curve is currently discounting 119bps of rate hikes in 2022 and an additional 86bps of hikes in 2023. Those are both far too aggressive for a central bank that is unlikely to begin lifting rates until the end of 2022, at the very earliest. Thus, we recommend an overweight stance on Australian bond exposure in global bond portfolios in 2022. The case for overweighting Japanese government bonds is a simple one. There are none of the inflation or labor market pressures seen in other countries to justify a hawkish turn by the Bank of Japan (bottom panel). Japanese core CPI is shockingly in deflation (-0.7%), bucking the trend seen in other countries and showing no pass-through from rising energy prices of global supply chain disruptions. This makes Japan a good defensive “safe haven” bond market against the backdrop of rising global bond yields that we expect in 2022. Chart 17Stay O/W Australian & Japanese Interest Rate Exposure Chart 18Our Recommended DM Government Bond Country Allocations In summary, our government allocations reflect the growing gap between expected monetary policy changes in 2022. This gives us a bias to favor lower-yielding markets, with Australia being the notable exception (Chart 18). However, in an environment where global bond volatility is expected to increase as multiple central banks exit QE and begin rate hiking cycles, carry/yield considerations play a secondary role in determining optimal country allocations. Key View #3: Stay neutral global inflation-linked bonds versus nominal government debt Another part of the global fixed income universe where the investment story has become more complicated is inflation-linked bonds. Overweighting inflation-linked bonds versus nominal government debt was the right strategy for bond investors as economies reopened from 2020 COVID lockdowns and global growth recovered. Booming commodity prices and supply chain squeezes added to the positive backdrop for linkers in 2021, as realized inflation soared to levels not seen in over a generation in many countries. Yet now, there is much less upside potential for inflation breakevens from current levels. Our Comprehensive Breakeven Indicators (CBI) are one of our preferred tools to assess the attractiveness of inflation-linked bonds versus nominals within the developed markets. For each country, the CBI reflects the distance of 10-year inflation breakevens from three different measures – the fair value from our breakeven spread model, medium-term survey-based inflation expectations and the central bank inflation target. The further breakevens are from these three measures, the less scope there is for additional increases in breakevens. As can be seen in Chart 19, there is limited upside potential for breakevens in almost all countries. Only Canada has a CBI below zero, with the CBIs for the UK, US, Germany and Italy well above zero. With central banks belated starting to respond to high realized inflation with tapering and rate hikes, it is still too soon to move to a full-blown underweight stance on global inflation-linked bond exposure versus nominal government debt. Instead, we recommend no more than a neutral exposure in countries where our CBIs are relatively lower – Canada, Australia, Japan – and underweight allocations where the CBIs are relatively higher – the UK, Germany, Italy and France (Chart 20). One country where we are deviating from our CBI signal is the US. We are keeping the recommended US TIPS exposure at neutral to begin 2022, but we anticipate downgrading TIPS later in 2022 if the Fed begins to lift rates sooner and more aggressively than expected. We do recommend positioning within that neutral overall TIPS allocation by underweighting shorter maturities versus longer-dated TIPS, A more hawkish Fed and some likely deceleration of realized US inflation should result in a steeper TIPS breakeven curve and a flatter TIPS real yield curve. Beyond looking at inflation breakevens, the outlook for real bond yields may be THE most complicated part of the 2022 investment story. Perhaps no single topic generates a greater debate among BCA’s strategists than real bond yields, which remain negative across the developed world (Chart 21). Determining why real yields are negative is critical for making calls across other asset classes beyond just government bonds. Valuations for equities and corporate credit have become more closely correlated with real yields in recent years. Real yield differentials are also an important factor driving currency levels. Chart 20Our Recommended Inflation-Linked Bond Allocations We see negative real yields as a reflection of persistent central bank policy dovishness that looks increasingly unrealistic. Chart 22 should look familiar to regular readers of Global Fixed Income Strategy. We show real central bank policy rates (adjusted for realized inflation) and the market-implied expectations for those real rates derived from the forward curves for OIS rates and CPI swap rates. Chart 21Negative Real Yields: Global Bonds' Biggest Vulnerability In the US, UK and Europe, markets are pricing a future path for nominal short-term interest rates that is consistently lower than the expected path of inflation. If markets believe that central banks will be unwilling (or unable) to ever lift policy rates above inflation, or that neutral medium-term real interest rates are in fact negative in most developed countries, then it should come as no surprise that longer-maturity real bond yields should also be negative. We do not subscribe to the view that neutral real rates are negative across the developed world, especially in the US. Even if we did, however, such a view is already reflected in the future pricing of bond yields and interest rates. As outlined earlier, OIS curves in many countries are underestimating how high nominal policy rates will go in the next 2-3 years. The potential for a “real rate shock”, where central banks tighten policy at a faster pace than markets expect, is a significant risk for global financial markets in the coming years. We see this as more of a risk for markets in 2023, with the Fed likely to become more aggressive on rate hikes and even the ECB likely to begin considering an interest rate adjustment. For 2022, however, we do expect global real yields to stabilize and likely begin to turn less negative as central banks continue to tighten policy. Key View #4: Overweight euro area high-yield and investment grade corporates versus US equivalents. Limit exposure to EM hard-currency debt until there are clear signals of China policy stimulus and upside momentum on the US dollar fades. The outlook for global credit markets in 2022 has also become more complicated, particularly for corporate bonds and EM hard currency debt. On the one hand, the levels of index yields (Chart 23) and spreads (Chart 24) for investment grade and high-yield corporate debt in the US, euro area and UK have clearly bottomed. The Omicron threat to global growth may be playing a role in the recent increases, but the more likely culprit is growing central bank hawkishness and fears of tighter monetary policy. Chart 23Global Corporate Bond Yields Have Reached A Cyclical Bottom Chart 24Global Corporate Bond Spreads Have Reached A Cyclical Bottom On the other hand, the fundamental backdrop for corporate debt is not conducive to major spread widening. As outlined at the start of this report, nominal economic growth in the major developed economies remains solid, which supports the expansion corporate revenues. Combined with still-low borrowing rates, this creates a relatively positive backdrop that limits risks from downgrades and defaults. Chart 25Monetary Policy Backdrop Turning More Negative For Credit Markets Corporate bond performance, both absolute returns and excess returns versus government debt, has worsened on a year-over-year basis for the latter half of 2021 (Chart 25). That has coincided with slowing growth in the balance sheets of the Fed and other major central banks and, more recently, the flattening trend of government bond yield curves as markets have discounted 2022 rate hikes. This suggests that monetary policy tightening expectations are dominating the still relatively positive fundamental backdrop for corporate credit. Looking ahead to 2022, we see a greater need to focus on relative value and cross-country valuation considerations when allocating to developed market corporate debt – particularly when looking the biggest markets in the US and euro area. We see a strong case for favoring euro area corporates over US equivalents, both for investment grade and particularly for high-yield. Our preferred method of corporate bond valuation is looking at 12-month breakevens. Breakevens measure the amount of spread widening that would need to occur over a one year horizon to eliminate the yield advantage of owning corporate bonds over government bonds of similar duration. We calculate this as the ratio of the index spread to the index duration for a particular credit market, like US investment grade. We then take a percentile ranking of those 12-month breakevens to determine the attractiveness of spreads versus its own history. On that basis, the 12-month breakeven for US investment grade corporates looks very unattractive, sitting near the bottom of the historical distribution (Chart 26). This reflects not only tight spreads but also the high durations of investment grade credit. US high-yield corporate spreads are not as stretched, but are also not particularly cheap, with the 12-month breakeven sitting at the 34th percentile of its distribution. In the euro area, the 12-month breakeven for investment grade is not as stretched as in the US, sitting in the 36th percentile (Chart 27). The euro area high-yield 12-month breakeven looks similar to the US, at the 24th percentile of its historical distribution. Chart 26US Corporate Spread Valuations Are Not Compelling Chart 27Euro Area Corporate Spread Valuations Are Also Stretched Our current recommended strategy on US corporate exposure is to be neutral investment grade and overweight high-yield. We see no reason to change that view to begin 2022. However, we do anticipate downgrading US corporate exposure later in the year when the Fed begins to lift interest rates and the US Treasury curve flattens more aggressively. Earlier, we recommended positioning for a wider US Treasury-German bund spread as a way to play for the growing policy divergence between a more hawkish Fed and a still dovish ECB. Another way to do that is to overweight euro area corporate debt versus US equivalents, for both investment grade and especially for high-yield. In terms of potential default losses, the outlook is positive on both sides of the Atlantic. Moody’s is projecting a 2022 default rate of 2.3% in the US and 2.2% in the euro area (Chart 28). The last two times that the default rates were so similar, in 2014/15 and 2017/18, also coincided with a period of euro area high-yield outperforming US high-yield (on a duration-matched and currency-matched performance). We see that pattern repeating in 2022. Chart 28Favor Euro Area High-Yield Over US Equivalents In 2022 When looking within credit tiers, we see the best value in favoring Ba-rated euro area high-yield versus US equivalents when looking at 12-month breakeven percentile rankings (Chart 29). Yet even looking at just yields rather than spread, lower-rated euro area high-yield corporates offer more attractive yields than US equivalents, on a currency-hedged basis (Chart 30). Chart 31Stay Cautious On EM Hard Currency Debt Turning to EM hard currency debt, we recommend a cautious stance entering 2022. EM fundamentals that typically need to in place to produce tighter EM credit spreads are currently not in place. Chinese economic growth is slowing, commodity price momentum is fading and the US dollar is appreciating versus EM currencies (Chart 31). An improvement in non-US economic growth will help turn around all three trends, especially the strengthening US dollar which typically trades off US/non-US growth differentials. The key to any non-US growth acceleration in 2022 will come from China. When Chinese policymakers announce more aggressive stimulus measures in 2022, as we expect, that would represent an opportunity to turn more positive on EM USD-denominated debt. Until that happens, we recommend staying underweight EM hard currency debt, with a slight bias to favor sovereigns over corporates. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index
Dear Clients, Next week, in addition to sending you the China Macro And Market Review, we will be presenting our 2022 outlook on China at our last webcasts of the year “China 2021 Key Views: A Challenging Balancing Act”. The webcasts will be held Wednesday, December 15 at 10:00 am EDT (English) and Thursday, December 16 at 9:00 am HKT (Mandarin). Best regards, Jing Sima China Strategist Highlights China’s policymakers are balancing between staying the course with structural reforms and stabilizing the economy. This carefully calibrated approach means that Beijing will only initiate piecemeal policy easing in the near term. China will ramp up investment in the new economy, which is too small to fully offset the drag on the aggregate economy from weakening old economy sectors. In the next three to six months, the economy will deteriorate further, but Beijing will only press the stimulus accelerator harder if their pressure points are breached. A zero-tolerance policy towards COVID will be maintained for the foreseeable future. Uncertainties surrounding the Omicron variant will reinforce this approach. The common prosperity policy initiative will likely accelerate ahead of the 20th National Congress of the Chinese Communist Party (NCCCP) in the fall of 2022. While the plan will ultimately benefit income and consumption for the majority of Chinese households, the uncertainties surrounding impending tax reforms will curb demand for housing and luxury goods in the short term. We remain underweight Chinese stocks. Prices for onshore stocks will likely fall in the next three to six months when the market starts to price in lower-than-expected economic growth and disappointing stimulus. Selloffs in the first half of 2022 may present an opportunity to turn positive on onshore stocks in absolute terms. We will turn bullish on Chinese stocks relative to global equities only when credit expansion overshoots weakness in the economy, which has a low likelihood. We continue to favor onshore stocks versus offshore within a Chinese equity portfolio. Tensions between the US and China may intensify leading up to the political events next year. Chinese offshore stocks, highly concentrated in internet companies, still face the risks of being caught in both geopolitical crossfires and domestic regulatory pressures. Feature China’s economy slowed significantly in 2H21, with the extent of policy tightening and magnitude of the decline in growth much larger than global investors expected. As we forecasted in our last year’s Key Views report, 2021 marked the beginning of a new era in which policymakers would switch gears from building a "moderately prosperous society" to becoming a "great modern socialist nation”.The pivot means that officials would tolerate slower economic growth, implement tougher financial and industry regulations, and accelerate structural reforms. On the cusp of 2022, we are cautious about the willingness of China’s top leadership to initiate large-scale policy easing. Even though policy tone has shifted to a more pro-growth bias, authorities are still trying to replace old economic drivers with the new economy sectors. Furthermore, they are struggling to maintain a delicate balance between boosting short-term growth and maintaining long-term reforms goals. As a result, their policies are sending mixed signals. As seen in 2018 and 2019, the policymakers’ reluctance to activate a full-scale stimulus does not bode well for global commodity prices. Chinese onshore stocks underperformed their global counterparts during the 2018-19 period. Chinese stocks will face nontrivial headwinds in the coming months and warrant a cautious stance until more stimulus is introduced and the macro picture begins to meaningfully improve. The main themes in our outlook for 2022 are discussed below. Key View #1: Balancing Between The Old And New Economies Despite a recent pro-growth bias in the policy tone, the speed of easing has been incremental and the magnitude piecemeal. Moreover, authorities are telegraphing policy support in new economy sectors (such as high tech and clean energy), while only somewhat loosening restrictions in old economy sectors (mainly property and infrastructure). Chart 1Current Easing Path Is Looking A Lot Like In 2018/19 China’s policy framework has shifted since late 2017 as we noted in previous reports. The top leadership is more determined to stay the course with reforms and tolerate slower growth in the old economy. Our BCA Li Keqiang Leading Indicator highlights policymakers’ carefully calibrated policy actions to avoid a dramatic overshoot of credit growth; these actions are consistent with 2018/19 and starkly contrast with policy frameworks in 2012 and 2015. Monetary conditions have meaningfully eased, but the rebound in money supply and credit growth has lagged and is muted due to heightened regulatory oversight (Chart 1). Investors should keep low expectations about the policymakers’ willingness to boost growth in old economy sectors. The easing of restrictions in property sector – from prompting banks to resume lending to qualified homebuyers and developers, to allowing funding for developers to acquire distressed real estate assets – are steps to alleviate an escalating risk of widespread bankruptcies among real estate developers. However, regulators have not changed the direction of their structural policies. Funding constraints placed on both developers and banks since last August remain intact. Banks still need to meet the “two red lines” that set the upper limit on the portion of their lending to the property sector, while developers must bring their leverage ratios below the “three red lines” by end-2023. Maintaining these binding constraints on developers and banks will continue to weigh on the housing market in the coming years. The recent easing may reduce the intensity of funding constraints, but the banks will be extremely cautious to extend lending to a broad range of developers. Aggressive crackdowns on property market speculation in the past 12 months has fundamentally shifted both developers’ and consumers’ expectations for future home prices. Growth in home sales and new projects dropped to their 2015 lows, while current real estate inventories are comparable to 2015 highs (Chart 2). Therefore, unless regulators are willing to initiate more aggressive policy boosts, such as cutting mortgage rates and/or providing government funds to monetize inventory excesses in the housing market, the current easing measures probably will not revive sentiment in the property market. Thus, odds are that the property market downtrend will extend through 2022 (Chart 3). Chart 2Downward Momentum In Property Market Comparable To 2015 Chart 3Policymakers Will Have To Allow Significant Re-leveraging To Revive The Market Chart 4Key Indicators Show Weak Signs Of Revival In Infrastructure Spending We expect some modest increase in infrastructure spending next year from the meager 0.7% growth in 2021, but we are skeptical that policymakers will allow any substantial rebound. Shadow banking activity and infrastructure project approval, two key indicators we monitor for signs of a meaningful easing in infrastructure spending, show little improvement (Chart 4). Our outlook for infrastructure investment is based on the following: Since 2017 policymakers have assumed a much more hawkish approach toward reducing investment in the capital-intensive and unproductive old economic sectors. Next year’s 20th NCCCP will not fundamentally change this policy setting. The 19th NCCCP in late 2017 deviated from the past; infrastructure investment growth downshifted following the event, whereas significant spending boosts had followed previous NCCCPs (Chart 5). Beijing adhered to its structural downshift in infrastructure spending even during the 2018/19 US-China trade war and after last year’s pandemic-induced economic contraction. Chart 5Infrastructure Investment Shifted To A Lower Gear Following The 19th NCCCP Secondly, government spending since 2017 has tilted towards social welfare over building “bridges to nowhere”, a meaningful change from the past and in keeping with President Xi Jinping’s political priorities (Chart 6). The trend will likely continue next year because local governments need to maintain large social welfare budgets to counter the economic impact of the prolonged domestic battle against COVID. Local government revenues, on the other hand, will be reduced due to slumping land sales. Thirdly, there has been strong policy guidance by the central government to shift investment to the new economy sectors and away from traditional infrastructure projects. The PBoC in early November launched the carbon emission reduction facility (CERF) to offer low interest loans to financial institutions that help firms cut carbon emissions. China’s new economy sectors have experienced rapid growth in recent years, but in the short-term, infrastructure spending in those sectors will not fully offset a reduction in traditional infrastructure (Chart 7). The combined spending in tech infrastructure (including information transmission such as 5G technology and services) and green energy stood at RMB1.6 trillion last year, compared with the RMB19 trillion investment in traditional infrastructure and RMB14 trillion in the real estate sector. Bottom Line: Beijing will continue to push for investment in new economy sectors since the leadership is determined to reduce dependency on unproductive segments of the economy. Even as the economy slows, they will be reluctant to ramp up leverage and channel capital to the old economy sectors. Unfortunately, the small size of the new economy’s sectors versus the old economy will inhibit their ability to stabilize and accelerate economic growth via these policies. Key View #2: The Pressure Points We do not think Beijing will allow the economy to freefall past the “point of no return”. The economy still needs to grow by 4.5-5.0% per annum between 2021 and 2035 to achieve the target of doubling GDP by 2035 (Chart 8A and 8B). Chart 8AThe Structural Downshift In Chinese Growth Will Continue… Chart 8B...But A 5%+/- Rate Of Growth Will Keep China Well On Track Of Doubling Its GDP By 2035 Investors should watch the following pressure points to assess whether China’s leaders will feel the urgency to turn policy to outright reflationary: A collapse in onshore financial market prices. China’s economic fundamentals will weaken further in the next three to six months and the risks to Chinese equity prices are on the downside. However, the odds are still low that the onshore equity, bond and currency markets will plunge as in 2015. Onshore stocks are cheaper than during the height of their 2015 boom-bust cycle, margin trading remains well below its 2015 level and economic fundamentals are stronger (Chart 9). Selloffs by global investors in China’s offshore equity and high-yield bond markets have not triggered much panic in the onshore markets and, therefore, will not drive Beijing to change its macro policy (Chart 10). Chart 9Valuations In Chinese Stocks Are Not As Extreme As In 2015 Chart 10Onshore Markets Have Been Relatively Calm Chart 11China/US Growth Rates In 2022 Will Be Uncomfortably Close, Based On IMF Forecasts Narrowing growth differentials between China and the US. In the IMF’s October World Economic Outlook, economic growth in 2022 for China and the US is projected at 5.6% and 5.2%, respectively. The forecast suggests that next year the growth differential between the two largest economies will be narrowed to less than one percentage point, rarely seen in China’s post-reform history (Chart 11). Notably, the most recent Bloomberg consensus estimate for the 2022 US real GDP growth is much lower at 3.9%, whereas China is expected to grow by 5.3% and in line with the IMF forecast. We do not suggest that Beijing will make its policy decisions based on these growth projections. Rather, we expect that if China’s growth in 1H22 falls behind that in the US, Chinese policymakers will feel an urgency to stimulate the economy and show a better economic scorecard ahead of the all-important 20th NCCCP next fall. Rising unemployment. Current data shows a mixed picture. Unemployment rates have been falling in all age groups (Chart 12). Demand for labor in urban areas, on the other hand, has been shrinking (Chart 13). The employment subindex in China’s service PMIs has also been dropping. Our view is that the resilient export/manufacturing sector has provided strong support to employment this year, while the labor supply in urban areas has been sluggish due to tighter travel restrictions and frequent regional lockdowns. The combination of strong manufacturing demand for labor and a lack of supply has reduced excesses in the labor market and the urgency to stimulate the economy (Chart 13, bottom panels). However, the picture could change if China’s exports start to slow into next year. Chart 12China's Unemployment Rate Is Falling... Chart 13...But Demand For Labor Is Also Falling Bottom Line: In the coming year, investors should watch for three pressure points that may trigger more forceful growth-supporting actions from policymakers: the onshore financial markets, economic growth differentials between the US and China, and labor market dynamics. Key View #3: The Exit Strategy Chart 14Service Sector Activities Have Been Restricted By Domestic Covid Cases And Frequent Lockdowns China will not completely lift its zero-tolerance policy toward COVID in the coming year. We will likely see tightened domestic preventive measures leading to the Beijing Olympics in February and the NCCCP in October. The zero-tolerance policy cannot be sustained in the long run; China’s stringent counter-COVID measures have created a stop-and-go pattern in China’s service sector, which has taken a toll on household consumption (Chart 14). As such, Chinese policymakers will face a trade-off between hefty economic costs from its current counter-COVID measures, and the potential social costs and risks if there is a dramatic increase in domestic COVID cases. China is estimated to have fully vaccinated more than 80% of its citizens and is close to launching its own mRNA vaccine next year to be used as a booster shot. However, the inoculation rate will likely matter less to Beijing’s decision to relax its draconian approach towards COVID given the emergence of the virulent Omicron variant. Recent statement by China's top respiratory experts suggests that China will return to normalcy if fatality rate of COVID-19 drops to around 0.1%, and when R0 (the virus reproduction ratio) sits between 1 and 1.5. A more important factor that could influence Beijing’s decision is the development and effectiveness of anti-viral drug treatments. Pfizer recently announced that its anti-viral oral drug Paxlovid can reduce the hospitalization and death rates by 89% if taken within three days of the onset of symptoms. The drug-maker has announced its intention to produce enough of the medication to treat 50 million people in 2022. China’s Tsinghua University has also developed an antibody combination drug that may reduce hospitalization and mortality by 78% and is expected to be approved by Chinese regulators within this year. Beijing’s decision to abandon its zero-tolerance policy, therefore, will be based on the combined effectiveness of both vaccines and treatments. If clinical trials prove that the new antiviral drugs are effective in treating COVID patients, combined with China’s aggressive rollout of booster shots, then Beijing may incrementally relax its COVID containment measures by late 2022 or early 2023. Bottom Line: China will not loosen its zero-tolerance policy until a combination of vaccines and treatments proves to be effective against COVID. Key View #4: Common Prosperity Will Gather Steam We expect the notion of common prosperity espoused by President Xi Jinping to gain momentum ahead of the 20th NCCCP. Beijing will likely roll out measures to support consumption, particularly for low-income households. At the same time, there is a high possibility that policymakers will introduce taxes on luxury goods and accelerate the legislative process on real estate taxes. Chart 15The Slump In Property Market Will Likely Be An Extended One The property market will remain in a limbo in 2022. In the near term, potential homebuyers will likely maintain their wait-and-see attitude before details of real estate taxes are disclosed. Home sales will remain in contraction despite improved mortgage lending conditions (Chart 15). Consumption taxes are expected to increase, targeting consumer discretionary and/or luxury goods. Chinese consumption of luxury goods benefited from government pro-growth measures last year, flush liquidity in the market and global travel restrictions. Meanwhile, growth in aggregate household income and consumption has been lackluster. President Xi Jinping’s common prosperity policy initiative is intended to narrow the income and wealth gap between the rich and poor. Moreover, empirical studies show that the marginal propensity to consume among lower- and middle-income groups, which account for more than 80% of China’s total population, is significantly higher than that of high-income groups. We expect more support for lower income groups as Beijing looks to stabilize the economy and narrow the wealth gap. Bottom Line: There is a high probability that policymakers will introduce taxes on the consumption of luxury goods and initiate the legislative process on real estate taxes in the next 12 months. Investment Conclusions Chinese stocks in both the onshore and offshore markets have cheapened relative to global equities. However, in absolute terms onshore stocks are not unduly cheap and offshore stocks are cheap for a reason (Chart 16). We remain defensive in our investment strategy for Chinese stocks in the next two quarters, given the headwinds facing the onshore and offshore markets. We do not rule out the possibility that China’s authorities will stimulate more forcefully in the next 12 months. However, for Chinese policymakers to ramp up leverage again, the near-term dynamics in the country’s economic cycle will have to significantly worsen. Chinese stocks will sell off in this scenario, but the selloff will provide investors with a good buying opportunity in the expectation of a more decisive stimulus (Chart 17). Chart 16Chinese Onshore Stocks Are Not Particularly Cheap, While Offshore Stocks Are Cheap For A Reason Chart 17Selloff Risks Are High Before The Economy Stabilizes Chart 18A Deja Vu Of 2018-2019? If the economy slows in an orderly and gradual manner, then there is a slim chance that policymakers will allow an overshoot in stimulus. The Politburo meeting on Monday sent a stronger pro-growth message, the PBoC cut the reserve requirement ratio (RRR) rate by 50bps, and regulators will likely allow a front-loading of local government special-purpose bonds in Q1 next year. However, based on the lessons learned in 2019, regulators can be quick to scale back policy support if they see there is a risk of overshooting in credit expansion (Chart 18). The measured stimulus during the 2018-2019 period did not bode well for Chinese stocks or global commodity prices (Chart 19A and 19B). Meanwhile, we do not think the recent selloff in offshore stocks provided good buying opportunities. In the next 6 to 12 months, any tactical rebound in Chinese investable stocks will present a good selling point. Chart 19AChina's Measured Stimulus In 2018-2019 Did Not Bode Well For Global Commodity Prices Chart 19BChinese Stocks Underperformed In 2018-2019 Investable stocks, highly concentrated in China’s internet companies, are caught in domestic regulatory clampdowns and geopolitical crossfires. We expect tensions between China and the US to intensify in 2022 in light of next fall’s 20th NCCCP in China and mid-term elections in the US. Furthermore, Didi Global’s decision to delist from the New York Stock Exchange last week highlights that both China and the US are unanimous in their efforts (although for different reasons) to remove Chinese firms from US bourses. Risks associated with future delisting of Chinese firms will continue to depress the valuations of Chinese technology stocks. Jing Sima China Strategist jings@bcaresearch.com Market/Sector Recommendations Cyclical Investment Stance
Highlights Omicron vs. The Fed: The new COVID variant has thrown a growth scare into markets, but the bigger concern is the Fed belated playing catch up to high inflation and low unemployment. Fade the Omicron bond rally, and position for higher US Treasury yields over the next year with the Fed threatening to taper faster, and potentially hike sooner, than markets expect. New Zealand: Underlying growth and inflation fundamentals, soaring house prices, and the central bank’s historical reaction function indicate that the Reserve Bank of New Zealand will lift the cash rate to 2% by the end of 2022. However, markets are already priced for this, leaving little room for New Zealand debt to continue underperforming on a relative basis. We are upgrading New Zealand sovereigns to neutral and initiating a long NZ/short US 10-year spread trade. A Year-End Bout Of Uncertainty Chart of the WeekMarkets Have Been Worried About The Fed Since September Over the past two weeks, we have published Special Reports and thus have not had an opportunity to comment on market moves and news. Needless to say, it has been an eventful period! The emergence of the new Omicron variant, and the hawkish shift in the Fed’s guidance on future policy moves, have injected fresh uncertainty and volatility into global financial markets. Since the existence of Omicron was revealed to the world on Nov 26, 30-year US Treasury yields have fallen by as much as -23bps and the S&P 500 index has been down by as much as -4.4%. Yet the evolving Fed stance, with Fed Chair Jerome Powell hinting last week that the end of tapering and start of rate hikes could begin sooner than expected next year, is having a more lasting influence on risk asset performance. Dating back to the September 23 FOMC meeting, when the Fed first signaled an imminent tapering of bond purchases and pulled forward the timing of liftoff into 2022, the 2-year US Treasury yield has gone up from 0.22% to 0.63%. Importantly, there has been little pullback on the pricing at the front-end of the US Treasury curve due to the Omicron shock. That pre-September-FOMC low in the 2-year Treasury yield also marked the peak in riskier fixed income market performance for 2021, with the Bloomberg Global High-Yield and Emerging Market USD-Denominated Sovereign total return indices down -2.0% and -1.8%, respectively, since Sept 23 (Chart of the Week). Other risk assets also appear to be responding more to news about the Fed than Omicron. Equity markets stopped climbing since the Fed announced the first taper of bond purchases at the November 3 FOMC meeting – three weeks before the world knew of Omicron - which also coincided with troughs in the VIX index and corporate credit spreads, not only in the US but in Europe and emerging markets as well (Chart 2). Of course, it is difficult to disentangle which is having a greater impact, the variant or the Fed, when details on both are evolving at the same time. Omicron Investors are understandably right to be nervous about a new COVID variant that can reportedly evade existing vaccines and even infect those who have had COVID previously. The whole idea of “putting COVID in the rearview mirror’ that has helped fuel booming equity and credit markets was predicated on vaccines being both effective and widely available. However, when investors see COVID case numbers start to pick up in the US and Europe, with vaccination rates twice that of South Africa where Omicron was first detected (Chart 3), this raises concern about a return to pre-vaccine economic restrictions and uncertainty. Chart 2A Typical Risk-Off Response To The Emergence Of Omicron Chart 3Omicron Putting A Dent In Vaccine Optimism The “Omicron effect” on fixed income markets has been most evident in the repricing of interest rate expectations. Since the presence of Omicron was revealed on November 26, there has been a reduction in the cumulative amount of tightening discounted to the end of 2024 in the overnight index swap (OIS) curves of the major developed economies (Table 1). The moves were most evident in the US (32bps of hikes priced out), Canada (37bps) and Australia (37bps). Table 1Pricing Out Some Rate Hikes Because Of Omicron Much is still unknown about the dangers of the Omicron variant. The admittedly very early data out of South Africa, however, indicates that there has not been a major surge in hospitalizations related to Omicron cases. A new COVID strain that proves to be more virulent, but that does not strain health care systems, should help allay investor concerns over a major economic hit from Omicron. This presents an opportunity to put on positions that will profit from a rebound in global bond yields led by higher US Treasury yields. The Fed The Omicron threat to date has not been enough to move the Fed off its plans to rein in the monetary accommodation put in place in 2020 to fight the pandemic. If Omicron is to have any impact on the US economy, it will do so at a time when the economy continues to grow well above trend. The November reading on the ISM Manufacturing survey showed strength in the overall index, with a stabilization of the New Orders/Inventory ratio that leads overall growth, and only a very modest reduction in the still-elevated Prices Paid and Supplier Deliveries indices (Chart 4). The Atlanta Fed’s GDPNow model is suggesting that US real GDP growth could come in at a whopping 9.7% in Q4. As further evidence that the US economy is growing at a pace well above trend, just look to labor market data. New US jobless claims are at the lowest level since 1969. The November US Payrolls report showed that the headline unemployment rate fell 0.4 percentage points on the month to 4.2% - within the range of full employment estimates of the FOMC - even with actual job growth falling short of consensus forecasts (Chart 5, top panel). Chart 4Nothing Bond-Bullish In US Manufacturing The improving health of the labor market is being felt more broadly, with big declines seen in unemployment rates for minorities and less-educated Americans (second panel). That point is of critical importance to the Powell Fed that has emphasized reducing racial and educational gaps in US unemployment as part of reaching its goal of “maximum employment”. Chart 5Nothing Bond-Bullish In US Labor Markets Tightening labor markets are also evident in accelerating wage momentum. Excluding the 2020 spike driven by labor force compositional effects related to COVID lockdowns, the year-over-year growth in average hourly earnings reached a 39-year high of 5.9% in November (third panel). The Fed now seems willing to finally confront high US inflation and strong economic growth with some tightening of monetary policy. Chart 6A Near-Term Break From Supply-Fueled Inflation? Powell caused some investor agita last week when he indicated that the taper could end before mid-2022, the previous FOMC guidance, which would open the door for rate hikes. We see Powell’s comments as less about signaling an intensifying hawkishness and more about giving the Fed optionality on when to start lifting rates next year in the event the US economy continues to overheat. The Fed strongly believes that tapering must end before rate hikes can begin, so a more accelerated taper allows for an earlier liftoff date, if necessary. To that end, the supply fueled surge in inflation this year, which has lingered for far longer than the Fed anticipated, may be showing some signs of easing. Several indices of global shipping container prices are off the highs, while there is a reduced backlog of container ships off key US ports like Los Angeles. Overall commodity price momentum has peaked, in line with slower, but still strong, global industrial activity (Chart 6). An easing of supply-driven price pressures would be welcome by the FOMC. It would allow time to evaluate both the Omicron threat and evolving US labor market dynamics, instead of being forced to fight a rearguard action against accelerating inflation. However, a shift away from goods/commodity inflation to more domestically driven inflation would not lessen the need for the Fed to begin lifting rates next year – in fact, it could even strengthen the case for the Fed to hike rates faster, and by more, than currently discounted in markets. Importantly, forward looking indicators are still pointing to solid US growth next year (Chart 7): The Conference Board’s leading economic indicator continues to grow at a pace signaling above-trend growth US financial conditions remain highly accommodative even with the recent market turbulence The New York Fed’s yield curve based recession probability model is indicating that the spread between the 10-year US Treasury yield and the 3-month US Treasury bill rate, currently 138bps, is consistent with only a 9% chance of a US recession over the next year (bottom panel) We continue to recommend a below-benchmark duration stance within US fixed income portfolios, with a yield target on the 10-year benchmark US Treasury yield of 2-2.25% to be reached by the end of 2022. We also continue to recommend positioning in Treasury curve steepening trades. This is admittedly a counter-intuitive suggestion given that the Fed is moving towards a rate hiking cycle, but we see too much flattening priced into the Treasury forward curve over the next year (Chart 8). Chart 7A Positive Message From US Leading Growth Indicators Chart 8Our Favorite Bearish US Rates Trades For global bond investors, our favorite trade that will benefit from higher US bond yields next year is to position for a wider 10-year US Treasury-German Bund spread (bottom panel). We expect the ECB to avoid any rate increases until at least mid-2023, well after the Fed has begun to tighten. Forward curves in the US and Germany currently discount a relatively stable Treasury-Bund spread in 2022, thus there is no negative carry incurred by positioning for a wider spread. Bottom Line: Omicron has thrown a growth scare into markets, but the bigger concern is that the Fed is belated starting to play catch up to high inflation and low unemployment. Fade the Omicron bond rally, and position for higher US Treasury yields over the next year. New Zealand: How Much Further Can The Bond Selloff Go? Chart 9NZ Sovereign Underperformance Has Been Driven By RBNZ Hawkishness Over the past year, New Zealand bonds have sold off much faster than developed market peers (Chart 9). Markets correctly recognized the Reserve Bank Of New Zealand (RBNZ) as a central bank that would move more aggressively to tamp down on inflation and manage the financial stability and political risks arising from soaring house prices. The RBNZ has already delivered back-to-back hikes at its October and November meetings, after its plans to hike at the August meeting were thrown off by the Delta variant. Markets are now pricing in a further 172bps of tightening over the coming year, having largely faded any downside growth risk from the Omicron variant. Expectations of continued tightening have been buoyed by the response of New Zealand policymakers, who are largely looking past the Omicron variant. Restrictions have already begun to ease, with the country having entered its “Traffic Light” COVID-19 Protection Framework. The new variant is also unlikely to affect the RBNZ’s tightening path, with Chief Economist Yuong Ha stating that, given the lifting of restrictions, the RBNZ would have raised rates even if Omicron had become known before its November 24 meeting. Given the bond-bearish backdrop, New Zealand government bonds have underperformed substantially this year. On a relative hedged and duration-matched basis, New Zealand sovereigns have underperformed by -6.6% year-to-date with -4.0 percentage points of that underperformance coming after July 21 when we formally moved to an underweight stance on New Zealand debt within global government bond portfolios (Chart 9, bottom panel). However, with monetary policy entering a new phase, led by an increasingly hawkish Fed, we believe it is appropriate to re-assess our New Zealand call and judge whether this underperformance can continue into 2022. The growth picture is broadly supportive of the RBNZ’s stated policy path. Real GDP as of Q2 was above its pre-Covid trend and 2.6% over the RBNZ’s own estimate of potential GDP, supported by an easing of travel restrictions and strong consumer spending (Chart 10). On a forward-looking basis, however, the risk is now that the economy is running too hot, jeopardizing future growth. Consumer and business sentiment has been worsening as inflation expectations soar, with consumers fearing a hit to purchasing power and businesses concerned about the impact of rising input costs on profit margins. Household and business inflation fears also have a strong basis in the realized inflation data, which has soared to a 10-year high of 4.9% (Chart 11). More troublingly, underlying inflation measures such as the trimmed mean and core (excluding food and energy) are now at series highs of 4.8% and 4%, respectively, indicating that higher inflation could prove to be sticky. The RBNZ now sees headline inflation peaking at 5.7% in Q1/2022 before settling to 2% by the end of its forecast horizon in 2024. Chart 10The NZ Economy Is Overheating Chart 11The RBNZ Will Welcome A Slight Growth Slowdown The RBNZ clearly attributes higher inflation to an economy running above longer-term capacity rather than short-term supply factors. The Bank’s measure of the output gap is now at the most positive level since 2007, and survey measures of capacity utilization remain elevated. In contrast to the Fed, which is still nominally focused on maximum employment, the RBNZ actually believes that employment is above its maximum sustainable level, and sees a rising unemployment rate as necessary to ease capacity constraints. Given that the RBNZ is clearly comfortable with, and will likely welcome, a gradual rise in unemployment, it will take much more than a slight growth shock to deter the RBNZ from its tightening path. Chart 12Higher Rates Necessary To Stabilize The NZ Housing Market The newest, and most politically potent, part of the RBNZ’s remit—house prices – has further supported a bias to tighten monetary policy. However, while still dramatically elevated, house price growth looks to have peaked (Chart 12). The central bank’s hawkish shift earlier in the year has made a clear impact, with house price growth peaking shortly after mortgage rates started picking up in April of this year. Overall household mortgage credit has also begun to decelerate, indicating that the passthrough from monetary policy to credit demand and housing via the mortgage rate is working as intended. However, there is likely further to go. The last time house price growth was somewhat stable around 6.6% in the 2012-2019 period, benchmark 5-year mortgage rates averaged 6.1%. Assuming the spread between the 5-year mortgage and policy rates remains around 4%, history indicates that we would need to see the policy rate rise to at least 2% to cool down the housing market. That 2% level is also the RBNZ’s mean estimate of a “neutral” cash rate—a level at which policy would be neither accommodative nor restrictive (Chart 13). Current market pricing is quite consistent with the RBNZ’s own projected path of rates as of the November meeting—both of which are set to exceed the neutral rate by the end of 2022. Historical experience from the pre-crisis period indicates that this is not uncommon, and that a bout of restrictive policy might be needed to cool down an overheating economy. Indeed, if the RBNZ’s historical reaction to inflation is any guide, it seems likely that policymakers will want to push rates above inflation. The top two panels of Chart 14 show how anomalous deeply negative real policy rates are in New Zealand. Even if we make the case that developed market real rates are in a structural downtrend, as realized real rates have peaked out at successively lower levels with each tightening cycle, the current gap between the cash rate and core inflation seems obviously unsustainable and requires a tightening of policy. Chart 14NZ Real Rates Are Too Low Chart 15Go Long The 10-Year NZ Government Bond/US Treasury Spread Another way to think about where policy rates are in relation to a “neutral” level is to look at the yield curve (Chart 14, bottom panel). Typically, the yield curve inverts when markets judge that monetary policy is too restrictive and that short rates are too high relative to a long-run average. However, the New Zealand government bond curve has historically remained inverted for extended periods of time, troughing at around -100bps. This again indicates that the RBNZ is comfortable raising rates above neutral and keeping policy restrictive when needed. Putting together the four factors we have looked at—growth, inflation, asset prices, and the RBNZ’s reaction function—it looks likely that the RBNZ will continue along the tightening path it has set out and chances of any dovish surprise seem slim. At the same time, markets are priced to perfection in terms of the pace and amount of tightening discounted. For New Zealand sovereigns to continue underperforming, however, we will need to see markets price in, on the margin, even more tightening from the RBNZ relative to its peers. With the Fed and other central banks having become more focused on responding to US inflation dynamics, bond-bearish upside shocks to market rate expectations will increasingly come from outside New Zealand. At the same time, in the event of a negative global growth shock, perhaps relating to COVID-19, there is relatively more room for hikes to be priced out in New Zealand. Given our view that bond and rates markets have appropriately priced in the extent of the RBNZ’s likely tightening cycle, we are upgrading New Zealand sovereign debt to neutral, taking profits on our current underweight stance. While we do not include New Zealand debt in our model bond portfolio, we are expressing our view via a new tactical cross-country spread trade: long New Zealand 10-Year government bonds vs. US 10-Year Treasuries (Chart 15). Forwards are currently pricing in a flat spread between the two countries, meaning that any future spread tightening will put our trade in the black. Given that there is more space for markets to price in increased hawkishness from the Fed, we believe that spread compression is likely. We are implementing this trade by going long New Zealand cash bonds and shorting 10-year US Treasury futures. Details can be found on Page 18. Bottom Line: Underlying growth and inflation fundamentals, soaring house prices, and the central bank’s historical reaction function indicate that the Reserve Bank of New Zealand will lift the cash rate to 2% by the end of 2022. However, markets are already priced for this, leaving little room for New Zealand debt to continue underperforming on a relative basis. We are upgrading New Zealand sovereigns to neutral and initiating a long NZ/short US 10-year spread trade. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com GFIS Model Bond Portfolio Recommended Positioning Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Duration Regional Allocation Spread Product Tactical Overlay Trades