Economy

Executive Summary Fed policy and the US stock market are on a collision course. US core inflation will not fall below 3.5% unless the economy slows considerably below its potential for a few quarters. As long as US share prices do not fall considerably, i.e., financial conditions do not tighten substantially, the Fed has no reason to halt its tightening and revert its hawkish posture. Odds are that US profit margins and equity multiples will compress, leading to lower share prices in the coming months. In China, monetary and fiscal stimulus have so far been insufficient to produce an economic recovery given the headwinds from the property sector and the rolling lockdowns. A broad-based EM rally will occur only when a commodity bull market is demand driven. The recent spike in commodity prices has been due to supply curtailment. Unit Labor Costs Are The Key To Core Inflation Bottom Line: Maintain an underweight position in EM equities and credit in global equity and credit portfolios, respectively. EM local currency bonds are becoming attractive. We are waiting to buy EM local bonds later this year using the potential weakness in their currencies.     After a two-year hiatus, I traveled to the US last week for in-person meetings with clients. This report summarizes the key questions and points of discussion that emerged during these exchanges. Question: What are the key risks to EM markets at the moment? Answer: First, Fed policy and the US stock market are on a collision course. This is in fact a threat to global risk assets – not just US ones. Second, rolling lockdowns in China and the property market slump will delay the recovery of the mainland economy. Third, after the latest rebound in risk assets, geopolitical risks are underestimated. Before the situation in Ukraine stabilizes, President Putin will likely escalate the conflict to obtain a better negotiating position. The combination of these three risks warrants a cautious stance on EM assets. Chart 1The 1960s: US Inflation Outbreak And Negative Stock Price-To-Bond Yield Correlation Question: Let’s start with the Fed. Why do you think US share prices and the Fed are on a collision course? Historically, there were episodes during which the S&P 500 rallied even though the Fed was hiking rates. Why is this time different? Answer: Extremely elevated US core inflation, rising inflation expectations as well as very expensive equity valuations make this current episode different from those periods in the 1990s, 2000s and even 2010s when US equities advanced amid Fed tightening.  In fact, share prices and bond yields were negatively correlated for 30 years between 1966 and 1997. The current episode is reminiscent of the late 1960s when core inflation spiked, and equity prices became negatively correlated with Treasury yields (Chart 1). As to the interaction between the Fed and financial markets, our reasoning is as follows: As long as US share prices do not fall and US credit spreads do not widen considerably, i.e., financial conditions do not tighten substantially, then the Fed has no reason to halt its tightening and revert its hawkish posture. The basis is that US core inflation is well above target, and inflation expectations are ratcheting up and could become entrenched. Question: Do you expect US inflation to moderate and in turn allow the Fed to go on hold? Answer: Investors and policymakers should differentiate between the annual inflation rate (a statistical measure) and a genuine inflation outbreak. The annual inflation rate is too high, and will likely drop in H2 this year. Chart 2Super Core US Consumer Inflation Is At 5% However, US inflationary pressures are genuine and broad-based. If these pressures are not contained, they will spiral out of control. Our measure of US average core inflation is currently around 5% (Chart 2). This series is an average of seven measures of core consumer price inflation from the Fed: core CPI and PCE, median CPI, market-based core PCE, trimmed-mean CPI and PCE, and sticky core CPI. Hence, this measure is not influenced by price movements of individual components. The annual rate of core CPI will drop in the US but we do not expect core CPI and PCE to fall below 3.5% unless the economy slows considerably below its potential for a few quarters, and labor market conditions deteriorate leading to lower wage growth. The reasoning is that underlying inflationary pressures have spilled over into the labor market, and the wage-price spiral has probably unraveled. Therefore, inflation cannot be contained without bringing economic growth down below potential growth and weakening the labor market.  Chart 3US Wage Growth Is Between 4.3% and 7.7% The labor market is presently very tight, and wage growth will continue accelerating. Given that real wages have shrunk dramatically in the past 12 months, labor will be demanding wage increases that are on par or above the inflation rate. With sales still strong, companies will have to pay higher wages to maintain and attract skilled employees. US nominal wage growth is presently ranging between 4.3-7.7%, depending on the measure (Chart 3). With US underlying productivity growth unlikely to be more than 2% at best, unit labor costs are therefore rising at a rate of 2.5-5.5% and will accelerate further. Chart 4 illustrates that unit labor costs have been a major driver of core consumer price inflation in the US over the past 60 years. If unit labor costs accelerate, core inflation will not drop much from its current elevated levels. As core inflation proves to be sticky and does not fall rapidly below 3.5%, the Fed will have no choice but to keep raising interest rates… until something breaks. Chart 4Unit Labor Costs Are The Key To Core Inflation Question: What will be the first thing to break? Do you think Fed rate hikes will push the US economy into recession? Answer: Equity markets will be the first to break. It is hard to make a judgement about whether US real GDP will contract, but odds are high that US/global share prices will drop as the Fed tightens. The S&P 500 can drop 20-25% from its early January high without a recession in the American economy. Drivers of this selloff will be compressing equity multiples and shrinking profit margins. Chart 5Rising Rates = Lower Equity Multiples First, there are three drivers of equity returns – the top line, profit margins and valuation multiples. We believe that two of these three – profit margins and multiples – will be negative for the US market in the coming months. Valuation multiples will compress as US interest rates rise further (Chart 5).  Profit margins will shrink as wage growth accelerates well above productivity gains, i.e., unit labor costs spike. Even if corporates’ top-line growth stays robust, the negative impact of compressing valuation multiples and lower profit margins will be overwhelming for equities. Hence, corporate profits could shrink mildly and share prices would drop materially even as real GDP does not contract. Second, it is important to mention that equity returns could be negative outside reccessions. Let’s recall what happened in 2000-2001 in the US. Nominal growth was robust, real GDP contracted only slightly, household spending in real terms did not contract at all, and the housing market was booming (Chart 6, top panel). Yet, the S&P 500 EPS plunged by 30% and the stock index was down by 50% (Chart 6, bottom two panels). We do not mean that US profits are about to crash by 30% and share prices will plunge by 50% like they did in the bear market of 2000-2002. The point is that profits could experience a mild contraction despite solid consumer spending. Chart 6S&P 500 EPS Can Shrink Even If Nominal GDP Growth Is Solid, As Happened In 2001 Chart 7US Real Consumption Of Goods: A Mean Reversion Ahead? Third, there is chance of a stagflation scare. US purchases of goods ex-autos have been extremely strong due to generous fiscal transfers to households and pandemic dynamics that discouraged service spending and boosted goods purchases. Americans’ real spending on goods ex-autos has been running well above its pre-pandemic trend and is likely to experience some sort of mean reversion (Chart 7).  A shift in consumption away from goods ex-autos will weigh down on goods producers globally. Notably, manufacturers rather than service providers dominate equity markets outside the US. Hence, a period when US inflation is sticky, and the Fed is tightening while the global manufacturing cycle is slowing is a possibility. This will upset investors and lead them to pare back their equity holdings. Question: As we all know, the US dollar is very important for EM economies and financial markets. So, what is the outlook for the greenback? Answer: As long as the Fed sounds hawkish and continues tightening, the US dollar will strengthen. The motive is that when the central bank is willing to tighten and the economy does not collapse, the currency tends to appreciate. Even as the S&P 500 sells off, the risk-off phase is also positive for the US currency. The trade-weighted dollar will put a major top and will start depreciating only when the Fed does a dovish tilt. Odds are that this will take place later this year when the S&P 500 is down 25% or so. Yet, US inflation will still be entrenched. In other words, the Fed will fall behind the inflation curve. A central bank falling behind the inflation curve is bearish for the currency. Chart 8Mainstream EM Currencies: An Air Pocket? Concerning mainstream EM (excluding China, Korea and Taiwan) currencies, the total return index (including carry) versus the US dollar has hit a technical resistance (Chart 8). We expect a near-term relapse in EM exchange rates as a mirror image of US dollar strength and the risk-off trade in global markets. However, a major buying opportunity in EM currencies and fixed-income markets as well as EM equity markets will transpire later this year when the US dollar peaks. Question: Let’s turn to China. Growth continues to be disappointing. The COVID-related lockdowns are depressing economic activity. Have authorities stimulated enough for the business cycle to recover soon? Answer: We believe that monetary and fiscal stimulus have so far been insufficient to produce a major economic recovery given the headwinds from the property sector and the harsh lockdowns. The enacted fiscal stimulus is sizable (Chart 9), but it has not yet fully entered the economy. On the monetary front, the credit impulse – excluding local government bond issuance (which is counted in our fiscal spending impulse) – has not yet bottomed (Chart 10). Chart 9China's Fiscal Stimulus Is In The Pipeline Chart 10China: Corporate and Household Credit Impulse Has Not Bottomed Yet With rolling lockdowns impairing service employment and, hence, denting household income, and without sizable fiscal transfers to consumers, the economy will struggle to recover. Local government finances are squeezed by lack of revenues from land sales and their borrowing is limited by quotas set by the central government. So, only the central government is in a position to provide meaningful fiscal support to households, but it has not yet done so. Question: You mentioned that the current geopolitical climate remains a risk to financial markets as Putin will likely escalate before de-escalating. Is this not bullish for commodities? Also, you have argued over the years that commodity prices positively correlate with EM equity performance. Yet, there has been a major decoupling between commodity prices and EM equity absolute and relative performance (Chart 11). How do you explain this phenomenon? Chart 11Decoupling Between EM Stocks And Commodity Prices Answer: Re-escalation on the part of the Kremlin will be bullish for commodities in the short run. In the medium term however, as we argued in a report in early March, commodity prices will be very volatile, with upside risks for some (like wheat) but not for all of them. It all depends on how much of its resource exports Russia can sell/ship abroad. It is hard to forecast this in view of sanctions by Western governments and their private sectors, as well as the breakdown in existing market infrastructures (such as payment systems, freight, insurance, etc.). The breakdown between commodity prices and EM absolute and relative share prices is due to the following: When commodity prices rise due to demand from the real economy, EM stocks tend to rally and outperform. This is especially true when it is China’s demand that is driving commodity prices higher. The reason is that China is important for overall EM economies, and robust demand growth in China is bullish for EM assets. In such a scenario (a demand-driven commodity bull market), not only do commodity producers rally (Latin America) but also commodity consumers (Asia) perform well in absolute terms. The recent spike in commodity prices has been due to supply curtailment rather than demand strength. That has benefited commodity producers (Latin America) but not commodity consumers (Asia). Finally, TMT stocks have come to make up a large share of EM markets in recent years. So wild swings in their performance have distorted the correlation between the EM equity index and commodity prices. Question: Will equity and currency markets of commodity producers continue rallying? Answer: The key signals to monitor are the trend in the US dollar and the global risk-on/risk-off environment. If a risk-off move transpires and the US dollar firms (as we expect), share prices and currencies in commodity-producing countries will relapse in absolute terms. Also, Chart 12 illustrates net long positions in ZAR, BRL and MXN among asset managers and leveraged funds are elevated. In short, investors are already very long, and these currencies could correct. Finally, the prices of some commodities for which Russia and Ukraine are not major producers, like platinum, have already been relapsing. In fact, platinum prices correlate well with EM non-TMT share prices in US dollar terms and are currently pointing to downside risks (Chart 13). Chart 12Investors Are Very Long EM Commodity Currencies Chart 13Not All Commodity Prices Are Rising Question: Could high food and energy prices heighten political risks in some developing countries? How serious is this risk? Answer: This risk has already manifested itself in some countries, with protests in Peru and the 15% devaluation in Egypt. More countries could experience public demonstrations and political turbulence. An overarching theme for many developing nations will be a drag on growth from high food and energy prices. Unlike the US, wages in emerging economies are not rising fast, and labor markets are not tight. As a result, employees have no bargaining power, and their wages will shrink in real terms (adjusted for headline inflation). Given that food and energy make up a larger share of the consumer basket in emerging economies, high energy and food prices will meaningfully reduce household income available for discretionary spending. Consequently, EM household spending will disappoint. In light of lackluster consumer demand, business investment will not pick up much either. Finally, monetary and fiscal policies in EM are reasonably tight. In Latin America, the credit and fiscal spending and monetary impulses are pointing to economic weakness ahead (Chart 14).  Overall, potential political volatility and disappointing domestic demand are risks to EM financial markets. Chart 14Latin American Economies Will Decelerate Chart 15A Buying Opportunity in EM Domestic Bonds Will Occur Later This Year Question: What is your recommended investment strategy for EM overall and country allocation? Answer: We continue recommending an underweight position in EM equities and credit in global equity and credit portfolios, respectively. EM local currency bonds are becoming attractive as their yields have spiked (Chart 15). We are waiting to buy EM local bonds later this year using the potential weakness in their currencies. For now, we have the following positions in individual local rates: long 10-year Brazilian bonds, currency unhedged; receiving 10-year swap rates in China and Malaysia; betting on yield curve flattening in Mexico; receiving 10-year Czech / paying 10-year Polish swap rates. The list of country allocation for EM equity, credit and domestic bond portfolios is presented in Table 1. Table 1Our Country Allocation Across Asset Classes​​​​​​​   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com    

Executive Summary To understand the economy and the market we must think of them as non-linear systems which experience sudden phase-shifts. The pandemic introduced phase-shifts in our lives, which led to phase-shifts in our goods demand, which led to phase-shifts in monthly core inflation. As our lives phase-shift back to normality, goods demand will phase-shift back to low growth, and monthly core inflation prints will phase-shift from ‘high phase’ to ‘low phase’. With the 12-month core US inflation rate likely to peak by June at the latest, the long bond yield is likely to peak at some point in April/May, justifying a cyclical overweight position in T-bonds. Go overweight healthcare and biotech versus resources and financials. The leadership of the equity market will once more flip from short-duration sectors to long-duration sectors. Fractal trading watchlist additions: JPY/CHF, non-life insurance versus homebuilders, US homebuilders (XHB), cotton versus platinum, healthcare versus resources, and biotech versus resources. Bottom Line: With the 12-month core US inflation rate likely to peak by June at the latest, the long bond yield is likely to peak at some point in April/May, and the leadership of the equity market will flip back to long-duration sectors such as healthcare and biotech. Feature Inflation is a non-linear system, meaning that you cannot just dial it up or down gradually like the volume on your music system. Instead of gradual changes, non-linear systems suddenly phase-shift from quiet to loud, from cold to hot, from solid to liquid, or from stability to instability (Box I-1). Box 1: A Classic Non-Linear System – A Brick On An Elastic Band To experience the sudden phase-shift in a non-linear system, attach an elastic band to a brick and try pulling it across a table. As you start to pull, the brick doesn’t move because of the friction with the table. But as you increase your pull there comes a tipping point, at which the brick does move and the friction simultaneously decreases, self-reinforcing the brick’s acceleration. Meanwhile, your pull on the elastic continues to increase as you react with a time-lag. The result is that this non-linear system suddenly phase-shifts from stability – the brick doesn’t move – to instability – the brick hits you in the face! Try as hard as you might, it is impossible to pull the brick across the table smoothly. In this non-linear system, the choice is either stability or instability. Back in 2017, in Mission Impossible: 2% Inflation – An Update, I posed a crucial question: “Given that price stability could phase-shift to instability, when should we worry about it?” I answered that “the risk remains low until the next severe downturn – when policymakers may be forced into desperate measures for a desperate situation.” The words proved prescient. Three years later, the desperate situation was a global pandemic, and the desperate measures were economic shutdowns combined with fiscal stimuluses of unprecedented scope and size.   A Phase-Shift In Our Lives Produced A Phase-Shift In Inflation Developed economy inflation has just experienced a stark non-linearity. Since 2007, the US core month-on-month inflation rate remained consistently below 3.5 percent.1 Then came the pandemic’s shutdowns combined with policymakers’ massive response, and month-on-month inflation didn’t just rise to above 3.5 percent, it phase-shifted to well over 6 percent. Developed economy inflation has just experienced a stark non-linearity. The remarkable fact is that since 2007, there have been over a hundred monthly core inflation prints below 4 percent, and nine prints above 6 percent, but just one solitary print between 4 and 6 percent! In other words, monthly core inflation shows the classic hallmark of a non-linear system. It can be cold or hot, but not warm (Chart I-1).       Chart I-1Monthly Core Inflation Shows The Classic Hallmark Of A Non-Linear System So, what caused the phase-shift in core inflation? The simple answer is a phase-shift in durable goods spending, which itself was caused by the pandemic’s shutdown of services combined with massive fiscal stimulus. Again, this is supported by a remarkable fact. Since 2007, the monthly increase in US (real) spending on durables remained consistently below 3.5 percent. Then came the pandemic’s shutdowns and stimulus checks, and the growth in durables demand didn’t just rise to above 3.5 percent, it phase-shifted to well over 8 percent.  In other words, the growth in durable goods demand also shows the classic hallmark of a non-linear system. It can be cold or hot, but not warm (Chart I-2). Chart I-2Goods Demand Shows The Classic Hallmark Of A Non-Linear System The connection between the phase-shifts in goods demand and the phase-shifts in core inflation is staring us in the face – because the three separate phase-shifts in inflation have each been associated with a preceding or contemporaneous phase-shift in goods demand, which themselves have been associated with the separate waves of the pandemic (Chart I-3). Chart I-3Phase-Shifts In Core Inflation Have Been Associated With Phase-Shifts In Goods Demand Pulling all of this together, the pandemic introduced phase-shifts in our lives – lockdown or freedom. Which led to phase-shifts in our goods demand – above 8 percent or below 3.5 percent. Which led to phase-shifts in monthly core inflation – above 6 percent or below 4 percent. The key question is, what happens next? Bond Yields Are Close To A Peak As we learn to live with the pandemic, and assuming no imminent ‘super variant’ of the virus, our lives are phase-shifting back to a semblance of normality. Which means that our spending on goods is phase-shifting back to low growth. If anything, the recent overspend on goods implies an imminent corrective underspend. At the same time, it will be difficult to compensate a phase-shift down on goods spending with a phase-shift up on services spending. This is because the consumption of services is constrained by time and biology. There is a limit to how often you can eat out, go to the theatre, or even go on vacation. The upshot is that monthly core inflation prints are likely to phase-shift from ‘high phase’ to ‘low phase’ – even if the monthly headline inflation prints are kept up longer by the commodity price spikes that result from the Ukraine crisis. Monthly core inflation prints are likely to phase-shift from ‘high phase’ to ‘low phase’. Meanwhile central banks and markets focus on the 12-month core inflation rate – which, as an arithmetic identity, is the sum of the last twelve month-on-month inflation rates.2  To establish the 12-month core inflation rate, the crucial question is: how many of the last twelve month-on-month inflation prints will be high phase versus low phase? As just discussed, the new month-on-month core inflation prints are likely to phase-shift to low phase. At the same time, the historic high phase prints will disappear from the last twelve month window. Specifically, by June 2022, the three high phase prints of April, May, and June 2021 – 10 percent, 9 percent, and 10 percent respectively – will no longer be included in the 12-month core inflation rate, with the arithmetic impact of pulling it down sharply (Chart I-4). Chart I-4The High Phase Monthly Inflation Prints Of April, May, And June 2021 Will Disappear From The 12-Month Core US Inflation Rate, Thereby Pulling It Down. Clearly, the bond market anticipates some of this ‘base effect’ on 12-month inflation. This explains why turning points in the bond yield have led by 2-3 months the turning points in the 12-month core inflation rate (Chart I-5). With the 12-month core inflation rate likely to peak by June at the latest, this suggests that – absent some new shock – the long bond yield is likely to peak at some point in April/May. Reinforcing our cyclical overweight position in T-bonds. Chart I-5The Bond Yield Turns About 2-3 Months Before Core Inflation This also carries important implications for equity investors. Rising bond yields favour short-duration equity sectors such as resources and financials versus long-duration equity sectors such as healthcare and biotech. And vice-versa. Indeed, the recent performance of resources versus healthcare and financials versus healthcare is indistinguishable from the bond yield (Chart I-6 and Chart I-7). Chart I-6The Performance of Resources Versus Healthcare Is Indistinguishable From The Bond Yield Chart I-7The Performance of Financials Versus Healthcare Is Indistinguishable From The Bond Yield With bond yields likely to peak soon, the leadership of the equity market will once more flip from short-duration sectors to long-duration sectors. Go overweight healthcare and biotech versus resources and financials. Fractal Trading Watchlist Reinforcing the fundamental analysis in the previous section, the 130-day outperformance of resources versus healthcare and biotech has reached the point of fractal fragility that has marked previous trend exhaustions, suggesting that the recent outperformance of resources is nearing an end. Also new on our watchlist is a commodity pair, cotton versus platinum, whose strong outperformance is vulnerable to reversal. And US homebuilders (XHB), whose recent underperformance is at a potential turning point. There are two new trade recommendations. First, the massive outperformance of world non-life insurance versus homebuilders is at the point of fractal fragility that has consistently marked previous turning points (Chart I-8). Hence, go short non-life insurance versus homebuilders, setting a profit target and symmetrical stop-loss at 14 percent. Second, the strong underperformance of the Japanese yen is also at the point of fractal fragility that has marked several previous turning points (Chart I-9). Accordingly, go long JPY/CHF, setting a profit target and symmetrical stop-loss at 4 percent. Please note that our full watchlist of 19 investments that are experiencing or approaching turning points is now available on our website: cpt.bcaresearch.com Chart I-8The Massive Outperformance Of Non-Life Insurance Is Vulnerable To Reversal Chart I-9Go Long JPY/CHF The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Cotton’s Outperformance Is Vulnerable To Reversal US Homebuilders’ Underperformance Is At A Potential Turning Point Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Annualized month-on-month inflation rate. 2 Strictly speaking, the 12-month inflation rate is the geometric product of the last 12 month-on-month inflation rates. Chart I-1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart I-2The Strong Trend In The 3 Year T-Bond Is Fragile Chart I-3AUD/KRW Is Vulnerable To Reversal Chart I-4Canada Versus Japan Is Vulnerable To Reversal Chart I-5Canada's TSX-60's Outperformance Might Be Over Chart I-6US Healthcare Providers Vs. Software Approaching A Reversal Chart I-7The Euro's Underperformance Could Be Approaching a Resistance Level Chart I-8A Potential Switching Point From Tobacco Into Cannabis Chart I-9Bitcoin's 65-Day Fractal Support Is Holding For Now Chart I-10Biotech Approaching A Major Buy Chart I-11CAD/SEK Reversal Has Started Chart I-12Financials Versus Industrials Is Reversing Chart I-13Norway's Outperformance Could End Chart I-14Greece's Brief Outperformance Has Ended Chart I-15BRL/NZD At A Resistance Point Chart I-16The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart I-17The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Chart I-18Cotton's Outperformance Is Vulnerable To Reversal Chart I-19US Homebuilders' Underperformance Is At A Potential Turning Point   Fractal Trading System   Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Executive Summary Long Small Cap Energy Versus Large Cap President Biden has not received a boost in opinion polls from the Ukraine war. If he has not by now then it is increasingly unlikely that he will do so. Yet Biden performs worse in polls for his handling of economic policy than foreign policy, despite falling unemployment and rising real wages. The economy should help stabilize his approval rating but not in time to prevent Democrats from losing the Senate as well as the House this fall.  Biden’s decision to tap the strategic petroleum reserve exemplifies our 2022 trend of executive action. However, the oil outlook still depends on Biden’s Iran talks and OPEC’s reaction. Recommendation Inception Level Inception Date Return Long Small Vs. Large Cap Energy 0.56 26-Jan-22 14.9% Bottom Line: The return of gridlock is bad for stocks in 2022 but good in 2023. Feature Investors need answers to three questions about US policy at the moment: 1.   Will President Biden’s reaction to the Ukraine war exacerbate the hit to the global and US economy? 2.   Will Biden’s domestic agenda revive? If so, how will it impact corporate earnings expectations? 3.   Will Biden’s foreign and domestic policies cause any changes to the midterm election outlook and hence US policy in 2023-24? In recent reports we have answered these questions as follows. Related Report  US Political StrategySecond Quarter Outlook: Gridlock Looms First, Biden will continue to pursue a defensive or reactive foreign policy, meaning that he will not force Europe or other allies to adopt Russia sanctions beyond their near-term economic and political capabilities. If Europe wants to boycott Russian energy then that is fine but it is Europe’s decision. In fact, Europe is pursuing gradual rather than immediate diversification. Russia needs the funds. So Europe is unlikely to experience a sharp energy cutoff that plunges its economy into recession. Nevertheless, the risk is substantial enough that we remain long DXY and defensive US sectors on a tactical time frame. Second, Biden’s congressional agenda is getting back on track, with the war providing Democrats with a basis for redesigning and rebranding their budget reconciliation bill. Therefore we did not downgrade our 65% subjective odds that Congress will pass a bill. The bill will be close to deficit neutral and focused especially on energy policy. The Senate version of the bill is not yet available but we will examine the likeliest policy options in a forthcoming special report with our US Equity Strategy. Third – our focus for this report – current political changes do not substantially alter the midterm election odds, which suggest Republicans will retake Congress. Gridlock will return – and is the norm in US policy. In an inflationary context gridlock may well be positive for equities in 2023 since it will curb fiscal spending. However, uncertainty is negative for equities this year. We remain tactically defensive. We recommend renewable energy, cyber stocks, defense stocks, and infrastructure stocks as cyclical plays. Biden’s Approval Stabilizing At Low Level Foreign policy shocks are likely to hurt the ruling party – especially if the nature of the shock exacts a toll on the voter’s pocketbook. We showed evidence to this effect just before Russia re-invaded Ukraine. We concluded that Biden would experience a bounce in opinion polls as the nation rallied around him in the face of the Russian menace but the likely rise in gasoline prices would end up hurting the Democratic Party in the midterm elections.  Yet 40 days after Russia’s attack Biden’s general job approval is still at the lowest of his presidency, in the 41-42% range, while his disapproval is still high, in the 52-53% range. So far the war has not given him an appreciable boost, outside of his own party (where the boost has still been small). The results are even worse when it comes to his handling of the economy. Here his approval is 39% and disapproval 54%. In foreign policy, Biden’s approval stands at 40% and disapproval at 52% (Chart 1). Presidential approval has a big influence on the midterm election – as does perception of the two parties. Republicans have taken the lead in the generic congressional ballot, at 43.7% support versus 42.2% for Democrats. The war has blunted the Republican rally but nothing more. The economy is the likeliest source of good news for Biden and the Democrats over the coming six months but even here there is not a basis for optimism among Democrats, as we will see in the next section.  Chart 1No ‘War Bounce’ For Biden Jobs And Wages Not Boosting Biden Either Our Political Capital Index shows that the Biden administration now has weak or moderate political capital in every category except economic conditions and financial markets (Appendix). Yet economic conditions are still mixed. While they will likely improve before November, they do not look to improve enough to change the election outlook: Both Republicans and Democrats are viewing the economy more negatively. Republican economic sentiment declined by 16% in March, while Democrat economic sentiment declined by 6%. The partisan gap widened, which means Republicans will remain motivated to vote (Chart 2). Manufacturing activity is slowing down (though not shrinking). The reading slipped lower than its level in November 2020, when Biden took office. This drop is the first sign of the negative effect of inflation and geopolitical risk on the economy. New manufacturing orders declined while inventories increased. The new-orders-to-inventories ratio, which should be a leading indicator of economic activity, fell by 15.7% compared to its February reading. It is now the weakest since May 2020 (Chart 3). Chart 2Economic Sentiment Declines For Both Parties The budget deficit is “normalizing” and weighing on demand. The fiscal thrust – or change in the budget deficit – turned negative as the stimulus of 2020 waned. The intensity of the drag is now lessening, both on the federal and state level, but it would require a massive new crisis for the US to outdo the stimulus of 2020, so the drag will persist for the foreseeable future (Chart 4). Any last-minute reconciliation bill from congressional Democrats would reduce the drag further, but not generate positive thrust, and not in time to affect the election. To pass the bill, Democrats need to reduce the deficit impact in the face of inflation and paper-thin congressional majorities. Chart 3First Sign Of Inflation, Geopolitics Hitting Manufacturing Chart 4US Fiscal Drag In Wake Of 2020 Stimulus Most worrisome for President Biden, his approval rating has suffered despite a tight labor market and real wage growth. The headline unemployment rate declined to 3.6% in March, down 3.1 percentage points since November 2020. The ISM manufacturing employment index stands at the highest point since March of 2021, and 17% higher than in November 2020 (Chart 5). Inflation is apparently eating away the benefits of low unemployment. Real wages grew by 3.3% on an annual basis in February, up from 2.5% in January. This wage growth is higher than that of November 2020, at 2.2%. Biden’s approval rating is probably in the process of stabilizing, if we assume that unemployment stays low and real wages keep growing. But it is stabilizing at a low level and not perking up as a result of the Russian menace. The likeliest culprit for Biden’s troubles is inflation. Fortunately for the Democrats inflation is likely to fall in the coming months. However, voters are likely to respond to year-on-year rather than month-on-month inflation. And voters make up their minds early in midterm election years. Plus, if inflation does not subside, or if Biden is perceived as making a foreign policy mistake, then his approval rating will not stabilize. Bottom Line: Biden’s approval rating is not perking up despite a foreign threat. His approval on economic policy is even worse than on foreign policy, despite low unemployment and real wage growth higher than when he took office. A drop in inflation would improve his fortunes but taken together the evidence suggests that the war has not helped, and may have hurt, the Democrats’ chances this fall. Chart 5Will Jobs And Real Wages Stabilize Presidential Approval? Biden Taps Strategic Oil Reserve But Implications Depend On Iran One of our key views for 2022 (reiterated in our Q2 outlook) is the Biden administration’s transition from congressional to executive action. Biden’s decision to tap the strategic petroleum reserve (SPR) on March 31 exemplifies this trend. Gasoline prices have spiked to $4.20 per gallon, which is more than double the level in November 2020 (Chart 6). Biden’s SPR order aims to mitigate the rise in prices. Biden ordered the release of 1 million barrels per day of crude oil over the next 180 days (six months). This would constitute the largest release since the SPR came into being in 1975 (Chart 7).1 Chart 6Prices At The Pump Trigger Red Alert In White House Chart 7Biden Taps Strategic Petroleum Reserve The Strategic Petroleum Reserve (SPR) originated in the wake of the Arab oil embargo to protect the US from supply shocks. Faced with “severe petroleum supply interruptions” the president can authorize a maximum drawdown of 396 million barrels over 90 days, which begin reaching the market roughly 13 days after the decision. The current inventory is 570 million barrels of sweet and sour crude, which could last 92 days of crude imports and 72 days of crude and petroleum product imports (Chart 8). Unlike during the 1970s, today the US is the world’s largest oil and refined products producer. It is a net exporter as well. However, it is still vulnerable to external shocks. It imports 6.3 million barrels per day and has already cut off 283 thousand barrels per day of imports from Russia (Chart 9). Global price shocks still affect the US prices at the pump, as Chart 6 above shows in the relationship between domestic gasoline prices and Brent crude. Chart 8SPR Can Be Tapped For Six-To-Nine Months Easily Chart 9US Energy Independent But Still Vulnerable To Shocks The Ukraine crisis is just the sort of geopolitical crisis that the SPR was invented to address – but the magnitude of Biden’s action is larger than normal. The SPR was tapped for 21 million barrels in 1990-91, during the Iraqi invasion of Kuwait, and for 30 million barrels in 2011, when Libyan production fell to zero amid the revolution. However, because of US net exporter status, Biden has much more room for maneuver. The SPR would be tapped for 180 million barrels if Biden’s current plan is fully implemented. The SPR can be released at a rate of 4.4 million barrels per day for about 90 days, though after that the drawdown rate begins to decline for technical reasons (e.g. contaminants). Biden’s 180 days would end in early October, a month before the midterm election. If the SPR has at least 282 million barrels left (90 days of US net crude imports in 2021), the president can continue to release oil from it. The minimum storage level is 282 million barrels of crude. Thus at the end of Biden’s current order, he would have 390 million barrels left and would still be able to release 1 million barrels per day for 108 days.  There are various interpretations of Biden’s decision to tap the SPR today: Currently the Russians and Europeans are in a standoff over energy flows. Russia is demanding payment in rubles and Europe is rejecting Russia’s demands while threatening to ban Russian coal imports. Since crude oil is generally interchangeable, an EU-Russia breakdown in crude trade would not prevent Russian barrels from reaching global markets eventually (Chart 10). In short Biden did not tap the SPR in anticipation of a breakdown. Biden could have tapped the SPR because of difficulties convincing the core OPEC states to increase production. Saudi Arabia, the UAE, and Kuwait are rapidly increasing production already, though their 90-day spare capacity enables them to bring out as much as 3.5 million additional barrels per day. But on March 31 they ruled out any massive near-term adjustments. Their relations with the US under the Biden administration have been strained, namely as Biden is still trying to rejoin the 2015 Iranian nuclear deal. If the US and Iran rejoin the 2015 deal, the US would lift sanctions and Iran could quickly bring about 1.3 million barrels per day back to global markets. Biden’s SPR release is roughly equal to this amount, which means it could be insurance for a failure to do a deal (Chart 11). Chart 10Russian Oil Exports To Europe And World An Iran deal on top of the SPR release would add 2.3 million barrels per day in positive supply surprises, while reducing the short-term risk of a military conflict in the Persian Gulf. This would have a significant short-term negative impact on oil prices this year. Chart 11Biden Struggles For Help From OPEC What is clear is that our Geopolitical Strategy’s base case of a failure of US-Iran talks would imply a significantly higher risk of oil disruptions in the Middle East over the short and long run. In that case the OPEC states would need to change their position and increase production or else a new supply shock would be added on top of the Russian shock. Biden’s SPR release would make up for production bottled up in Iran but regional supply disruptions would intensify and Iran would threaten the Strait of Hormuz. Biden’s executive action to tap the SPR removes one option from the table. The ultimate impact of this move depends on whether Biden also uses executive action to do a deal with Iran. We cannot rule it out, because Biden has the authority to lift sanctions unilaterally, but we would not bet on it. Bottom Line: Market fundamentals suggest that Brent prices will fall from their current $105 per barrel toward their likely average of $93 per barrel this year and in 2023. Quant Model Points To Republican Senate Last week we highlighted that our Senate election model flipped from predicting the status quo to predicting a Republican victory, in line with our subjective view of the situation. The latest model findings, using data from the state coincident economic indicators released on April 5, suggests that Republicans have a 51.6% chance of gaining control of the Senate (Chart 12). Democrats only need to lose a single seat to slip from 50 to 49 seats and thus yield the majority. The model suggests they will lose two seats, in Arizona and Georgia. The result is a Republican majority of 52-48 seats. Chart 12Senate Election Model Flips To Republicans Our presidential election model still shows Democrats holding onto the White House in 2024 with 308 electoral college votes but their chances are declining. Specifically Democrats’ odds of retaining the White House have fallen from 54.9% to 54.7% now that the March data is taken into account (Chart 13). North Carolina is still considered a toss-up state, with a 45% probability that Democrats win it, but that means that a single percentage point drop puts it firmly in the Republican camp, along with Arizona and Georgia. Democrats’ odds are falling in Florida, Pennsylvania, and Nevada especially, although they are improving in Wisconsin and Minnesota. Chart 13Presidential Election Model Still Slightly Favors Democrats Florida presents an interesting difference between the two models: the Senate model gives Florida to the Republicans, while the presidential model gives it to the Democrats. This requires some explanation: The incumbent advantage plays a role. Biden did not win Florida in 2020 but that does not stop the model from ascribing Democrats a good chance of winning Florida given that they are the incumbent party. Incumbency would be punished if Democrats held the White House for eight years due to the variable that accounts for the public sentiment that it is “time for change.” The Senate model works differently. The model only helps the party that controls a state Senate seat by means of the partisan leaning of the state in recent elections. This is helpful for Republicans in the model’s 2022 prediction. Meanwhile the model only punishes an incumbent party if it has held control of the US Senate for three or more terms, which is not the case today. Our sample periods across the two election models are the same (1984-2020), but in this period, Democrats only held Senate seats for three out of nine changes. There have been nine different senators from Florida since 1989, three of which have been Democrats. The last Democratic senator was Bill Nelson but he was beaten by Republican Rick Scott in 2018. The other Senate seat has been held by a Republican since around 2004, most recently Marco Rubio, who is up for re-election in 2022. So the model will “lean” more Republican based on total outcomes and how recently recurring they were. Finally, a caveat: we should be careful about explicitly comparing the two election models. Although they are both Probit models, the variables are not all the same. Some are shared but their interaction with one another and the election outcome (dependent variable) should not be assumed to be exactly the same. There can be little doubt in the model’s outlook for the Florida Senate race. Senator Marco Rubio is a young incumbent, has strong name recognition, and is up for re-election in a favorable year for Republicans. As of February he was leading his top Democratic opponent Val Demings by 12 percentage points in opinion polls. Confirming the state’s Republican leaning, Governor Ron DeSantis was leading his Democratic opponent Charlie Crist by 21 percentage points in February polls, with over 50% favoring DeSantis. (Other than former President Trump, DeSantis is currently the favored Republican nominee for 2024.) Moreover the presidential model is catching up to the Senate model, with the odds of a Democratic win in Florida dropping from 59% to 55% over the past month alone. If the odds fall beneath 50% then the model naturally awards all of Florida’s 29 electoral votes to the Republicans. This would leave Democrats hanging by a thread at 279 votes. What is clear is that the 2024 election is a long way off. Democrats benefit from an incumbent advantage as a political party, aside from whether President Biden runs again. Yet the quantitative model suggests that the US will experience another hotly contested presidential election. Bottom Line: Republicans are now tipped to take the Senate in our quantitative model as well as our subjective judgment. Meanwhile Democrats are still favored to win the 2024 election but only slightly, and their odds are falling. These views support the market consensus but in general US investors will remain risk averse ahead of the midterm election.  Investment Takeaways Stay tactically long the US dollar and defensive stocks like in the health care sector. Russia is threatening to cut off energy exports to Europe, which is considering a ban on Russian coal. Until this dispute is resolved, risk appetite will suffer, the euro will be limited, and the dollar will stay strong. Stay long renewable energy, cyber security stocks, infrastructure stocks, defense stocks, oil and gas distribution, and small cap energy stocks (Chart 14). Chart 14Investment Takeaways Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.kuri@bcaresearch.com Guy Russell Senior Analyst guyr@bcaresearch.com   Footnotes 1     See White House, “FACT SHEET: President Biden’s Plan to Respond to Putin’s Price Hike at the Pump,” March 31, 2022, whitehouse.gov; Department of Energy, “Strategic Petroleum Reserve: Providing Energy Security For America,” March 28, 2022, energy.gov; and Heather L. Greenley, “The Strategic Petroleum Reserve: Background, Authorities, and Considerations,” Congressional Research Service, R46355, May 13, 2020, crsreports.congress.gov.   Appendix Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)   Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets