Economy

Highlights Despite strong economic activity throughout most of 2021, economic surprises have decreased considerably. This helped the US equity market outperform Europe. It also significantly contributed to the euro’s depreciation versus the dollar. Even though growth will slow in 2022, economic surprises should increase. Growth expectations are much lower than they were entering 2021, and some key headwinds will fade. This picture is not without risks. China’s credit slowdown and the US’s elevated inflation represent the greatest threats. Based on the outlook for economic surprises, the euro will stage a rebound next year and small-cap stocks are attractive. Feature Global economic activity has been exceptionally robust this year, boosted by the re-opening of the world economy, as well as by the considerable fiscal and monetary stimuli injected globally over the past 20 months. However, market participants also anticipated such a rebound; as a result, global economic surprises peaked in September 2020, and they are now in negative territory. Unanticipated developments have a substantial effect on market prices. Under this lens, the deterioration in economic surprises has had a strong impact on financial markets. It helps explain why the defensive US market has outperformed, why the dollar has been strong, and why bond yields have been flat since March 2021, even though inflation has risen, growth has been high by historical standards, and many major central banks have been eschewing their accommodative biases. Going forward, the evolution of economic surprises will remain crucial to market trends. While we anticipate global economic activity will decelerate in 2022, it will likely remain above trend and surprise to the upside, which will allow global economic surprises to recover. There are significant risks to this view, with large unanswered questions about the Chinese economy and the outlook for inflation in the US. In this context, despite near-term risks, we continue to expect EUR/USD to appreciate in 2022 and European small-cap stocks to outperform large-cap equities. Deteriorating Surprises Matter This year, the underperformance of global equities (both EM and Europe) relative to the US, the weakness in the euro, and the limited increase in yields have all caught investors off guard. At the beginning of 2021, investors were massively short the greenback and duration, while surveys showed a large preference for non-US equities. These views grew out of the expectation that global growth would be strong. Global growth turned out to be strong but began to disappoint expectations by the middle of the year. Expectations had become extremely lofty, suggesting that the bar had been set too high. Additionally, the tightening credit conditions in China and the growing supply constraints around the world caused growth to decelerate somewhat. The deterioration in short-term economic momentum and in surprises harmed European equities relative to the US. As Chart 1 highlights, the relative performance of European stocks is greatly affected by the earnings revision ratio of cyclicals stocks vis-à-vis defensive ones. This relationship reflects the greater pro-cyclicality of European equities compared to those of the US. Moreover, the earnings revision ratio of cyclical stocks relative to that of defensive equities mimics the fluctuations in economic surprises (Chart 1, bottom panel), as weaker-than-expected growth invites analysts to lower their relative earning expectations. The dynamics in the economic surprise index also weighed heavily on the FX market. The dollar is a highly counter-cyclical currency; therefore, it performs poorly when growth is not only increasing, but also doing so at a rate faster than anticipated. However, economic surprises did the exact opposite this year, which boosted the dollar’s appeal and pushed EUR/USD lower (Chart 2). While the strength in the dollar was accentuated by the increasingly aggressive pricing of Fed hikes in the OIS curve, relative interest rate expectations between the US and the Euro Area are also influenced by global economic activity because of the European economy’s greater cyclicality than that of the US. Chart 1Where Surprises Go, European Stocks Follow Chart 2Surprises Matter For The Dollar And The Euro Bottom Line: Global growth has been very strong in 2021, but it has begun to decelerate. Moreover, economic surprises are now in negative territory. The evolution of economic surprises this year was a key component of the strength in the dollar, the weakness of the euro, and the underperformance of European equities. Improving Surprises In 2022? We anticipate economic surprises to pick up in 2022. First, investors and analysts around the world rightfully expect a slowdown in global growth next year. This means that the bar for the economy to generate positive surprises is lower than it was in 2021. Second, we are already seeing signs that global economic surprises are trying to stabilize. A GDP-weighted aggregate of 48 countries is forming a trough at a low level, which historically precedes a pick-up in broader aggregate measures (Chart 3). Third, economic surprises move closely with the global PMI diffusion index. The diffusion index has fallen to levels historically associated with a rebound (Chart 4). Moreover, the share of countries whose Leading Economic Indicator is rising is still very depressed for a mid-cycle slowdown (Chart 4, bottom panel). As vaccination rates are improving around the world, including those in emerging markets, and as the global economy continues to re-open, we anticipate both the PMI and LEI diffusion indexes to improve next year, which will boost economic surprises. Chart 3A Budding Rebound? Chart 4The dispersion Of Growth Matters or Surprises Fourth, the global capex outlook remains very positive. Capex intentions in the US and in the Euro Area are highly elevated and cash flows are strengthening. Moreover, US and European credit standards are very loose (Chart 5). This combination suggests that companies have the desire and the wherewithal to increase their investments next year, especially as capacity constraints limit their ability to meet final demand. Additionally, companies around the world need to rebuild inventory levels, which are depressed relative to sales, while customer inventories are still woefully low (Chart 6). Chart 5Capex Tailwinds Chart 6Not Enough Inventories Chart 7Households Are Rich Fifth, households globally also have ample firepower to support their spending, despite some weakness in real income caused by rising inflation. As Chart 7 shows, household net worth in the US is up by 128% of GDP since December 2019. Additionally, the accumulated stocks of household excess savings have reached USD2.4 trillion in the US, EUR150 billion in German, EUR130 billion in France and GBP180 billion in the UK. With respect to the Eurozone specifically, fiscal and monetary policy will remain very accommodative. The fiscal thrust in 2022 will be negative 2.1%, which is significantly less onerous than the US’s -5.9% of GDP. Moreover, economies like Italy and Spain may have a negligible fiscal thrust because of the NGEU program’s disbursements. In addition, while the fiscal thrust will be slightly negative next year, government deficits will remain wide, which indicates that fiscal policy in Europe continues to support demand. Meanwhile, monetary policy still generates deeply negative interest rates on the continent, which sustains demand further. This view is not without risks. The first threat stems from the Chinese credit slowdown. BCA’s China strategists expect credit flows to bottom out by the second quarter of 2022, which implies that Chinese domestic activity should accelerate meaningfully in the second half of the year.  Already, we are seeing tentative signs that authorities in China are trying to curb the credit slowdown. For example, Beijing cut the reserve requirement ratio last summer and excess reserves in the banking system are moving back up as liquidity injections grow (Chart 8). The problem is that, so far, Chinese credit demand is not responding to these small measures designed to ease policy. More will be needed as the tightening in financial conditions for real estate developers points to significant downside ahead in construction activity (Chart 9). For now, it is difficult for Beijing to ease policy much more than it has done so far: PPI has reached a 25-year high at 13.5%. Chart 8Not Enough... Chart 9... Especially With Such A Drag These Chinese inflationary pressures are likely to decline in the first months of 2022, which will allow Beijing to become more aggressive in its support to economic activity. First, Chinese demand is weak, unlike demand in the US. Second, the surge in the PPI is mostly driven by a 17% increase in the energy PPI and a 66% surge in the mining component. These jumps are unlikely to repeat themselves, which will reduce overall inflationary numbers in that economy. The second major risk is global inflation, which is hurting real wages. As a case in point, US real wages are contracting at a 3.2% annual rate, or their deepest cut in six decades. In Europe too, real wages are weak because of the increase in inflation. While these inflationary pressures have had limited effect on European consumer confidence so far, US consumer confidence is breaking down (Chart 10), driven by a collapse in the willingness to buy. If this trend continues, we might see a significant deceleration in global real consumer spending. Chart 10Not All Is Dark On The Inflation Front We still expect the European inflationary risk to start dissipating in the first half of 2022. Unlike in the US, the spike in core CPI mostly reflects an increase in VAT and remains narrow, with trimmed-mean CPI lingering near record lows. Moreover, the 24-month rate of change of core CPI remains within the historical norm, which is not the case in the US. The US situation is more tenuous. Last week’s inflation data showed a broadening of inflationary pressures across major sectors of the economy unaffected by the pandemic, with shelter inflation being of particular concern. However, there are positives. Long-term inflation expectations, as approximated by the 5-year/5-year forward inflation breakeven rate, are still below the levels that prevailed before the oil price crash of 2014 (Chart 11, top panel). Additionally, shipping costs have started to ebb, with global container freight rates losing steam and the Baltic Dry index collapsing by 50% since beginning of October (Chart 11, bottom panel). Moreover, as health restrictions are being relaxed in Asia, Asian PMI’s are improving, while the production of semiconductors is rising again in the region (Chart 12). As a result, although there is still significant inflation risk over the next five years, 2022 is likely to witness a temporary pullback in CPI growth. Chart 11Not All Is Dark On The Inflation Front Chart 12Semiconductor Production Is Picking Up Bottom Line: Global investors are right to anticipate a decline in global growth next year. However, even if growth slows, it will remain above trend. Moreover, the considerable stimuli in the global economy and the decreased expectations of investors improve the odds that global economic surprises will increase in 2022. China’s domestic weakness and the rise in US inflation constitute the two greatest risks to this view. Investment Implications The level of the global economic surprise index as well as its evolution have important implications for many key European assets. Table 1 highlights the performance of various financial markets at three months, six months, and a year following various ranges of readings of the surprise index (the categories are based on one standard-deviation intervals from the mean). We highlight this methodology, because there remains significant uncertainty about the near-term outlook of the surprise index. Table 1Level Of Surprises And Subsequent Returns Currently, the global economic surprise index stands at -20, or between its -1-sigma and its historical average. This level offers limited clear results for investors when it comes to the performance of the Eurozone benchmark relative to the MSCI All Country World Index (ACWI), and no clear results in terms of the performance of value stocks relative to growth. However, the current reading of the surprise index is consistent with an outperformance of growth stocks relative to momentum over both the three- and six-month horizons. It is also showing a 74% probability of small-cap equities beating large-cap ones over a 12-month basis. Table 2 shows the performance of the same assets over the same windows, following three consecutive months or more of an improving global economic surprise index. This is consistent with our main hypothesis that global economic surprises are set to increase by early next year. Table 2Surprise Upticks And Subsequent Returns Using this method again shows no strong call for the Euro Area equity benchmark relative to the ACWI. There is a small improvement in performance, but Europe on average still underperforms, which reflects the thirteen years of a relative bear market in European equities. Similarly, results for European value stocks compared to growth equities are limited, as the sample is dominated by the structurally poor performance of value equities. However, this method highlights that the euro is likely to appreciate against the USD on both the three- and six-month investment horizon. This message is consistent with that of our Intermediate-Term Timing Model. Finally, this approach once again underscores the attractiveness of European small-cap equities on a three-, six-, and twelve-month investment horizon. Consequently, we maintain our buy recommendation on the euro. As we wrote three weeks ago, the near-term outlook for the common currency is fraught with risks and the low readings of the global economic surprise index confirm this reality.  Moreover, markets might enter a phase when they aggressively discount Fed rates hikes next year, which would further hurt the euro. However, the outlook for global growth will ultimately put a floor under EUR/USD. Chart 13Small-Caps: Almost There We also view European small-cap stocks as the premier equity vehicle in Europe over the coming 18 months because of their heightened pro-cyclicality.  However, the timing around shifting toward overweighing small-cap remains risky in the near-term, as they have not fully worked out the overbought conditions we flagged four weeks ago (Chart 13). Thus, we maintain small-cap equities on an upgrade alert, and we are looking to pull the trigger very soon.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com     Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance

Highlights US growth will slow next year, not because demand will falter, but because supply-side constraints will prevent the economy from producing as much output as households and businesses want to buy. If aggregate demand exceeds aggregate supply, the price level will rise. We argue that the US aggregate demand curve is currently quite steep. This implies that the price level may need to rise a lot to restore balance to the economy. In fact, if the aggregate demand curve is not just steep but upward-sloping, which is quite possible, there may be no price level that brings aggregate demand in line with supply; the US economy could go supernova. When supply is the binding constraint to growth, investors need to throw the old playbook for dealing with growth slowdowns out the window. Rather than positioning for lower bond yields, investors should position for higher yields. Rather than expecting a stronger dollar, investors should expect a weaker one. Rather than favoring growth stocks, large caps, and defensives, investors should favor value stocks, small caps, and cyclicals. The Binding Constraint To Growth Is Now Supply After a post-Delta wave rebound in Q4, the US economy is expected to slow over the course of 2022. The Bloomberg consensus is for US growth to decelerate from 4.9% in 2021Q4 to 4.1% in 2022Q1, 3.9% in 2022Q2, 3.0% in 2022Q3, and 2.5% in 2022Q4. Growth in the first quarter of 2023 is expected to dip further to 2.3%. We agree that US growth will slow next year but think the market narrative around this slowdown is misguided. Chart 1Plenty Of Pent-Up Demand The standard market playbook for dealing with an economic slowdown is to position for lower bond yields, a stronger US dollar, and a decline in commodity prices. On the equity side, the playbook calls for shifting equity exposure from cyclicals to defensives, favoring large caps over small caps, and growth stocks over value stocks. There are two major problems with this narrative. First, growth is peaking at much higher levels than before and is unlikely to return to trend at least until the second half of 2023. Second, and more importantly, US growth will slow due to supply-side constraints rather than inadequate demand. US final demand will remain robust for the foreseeable future. Households are sitting on $2.3 trillion in excess savings, equivalent to 15% of annual consumption (Chart 1). The household deleveraging cycle is over. After initially plunging during the pandemic, credit card balances are rising (Chart 2). Banks are falling over themselves to make consumer loans (Chart 3). Chart 2Revolving Credit On The Rise Again Chart 3Banks Are Easing Credit Standards For Consumers Chart 4A Record Rise In Household Net Worth Household net worth has risen by over 100% of GDP since the start of the pandemic (Chart 4). As we discussed two weeks ago, the wealth effect alone could boost annual consumer spending by up to 4% of GDP. Investment demand should remain strong. Business inventories are near record low levels (Chart 5). Core capital goods orders, a leading indicator for corporate capex, have soared (Chart 6). Chart 5Business Inventories Are Near Record Low Levels Chart 6Rise In Durable Goods Orders Bodes Well For Capex Chart 7The Homeowner Vacancy Rate Is Signaling The Need For More Homebuilding The Dodge Momentum Index, which tracks planned nonresidential construction, rose to a 13-year high in October. The home­owner vacancy rate is at multi-decade lows, signifying the need for more homebuilding (Chart 7). While increased investment will augment the nation’s capital stock down the road, the short-to-medium term effect will be to inflate demand. Policy Won’t Tighten Enough To Cool The Economy What is the mechanism that will push down aggregate demand growth towards potential GDP growth? It is unlikely to be policy. While budget deficits will narrow over the next few years, the IMF still expects the US cyclically-adjusted primary budget deficit to be nearly 3% of GDP larger between 2022 and 2026 than it was between 2014 and 2019 (Chart 8). Chart 9The Fed And Investors Still Believe In Secular Stagnation   As Matt Gertken, BCA’s Chief Geopolitical Strategist, writes in this week’s US Political Strategy report, the passage of the $550 billion infrastructure bill has increased, not decreased, the odds of President Biden and the Democrats passing their social spending bill via the partisan budget reconciliation process. On the monetary side, the Federal Reserve will finish tapering asset purchases next June and begin raising rates shortly thereafter. However, the Fed has no intention of raising rates aggressively. Most FOMC members see the Fed funds rate rising to only 2.5% this cycle (Chart 9). The “dots” call for only one rate hike in 2022 and three rate hikes in both 2023 and 2024. Investors expect rates to rise even less by end-2024 than the Fed foresees (Chart 10).   The Inflation Outlook Hinges On The Slope Of The Aggregate Demand Curve If policy tightening will not suffice in cooling demand, the economy will overheat and inflation will rise. But by how much will inflation increase? The answer is of great importance to investors. It also hinges on a seemingly technical question: What is the slope of the aggregate demand curve? As Chart 11 illustrates, prices will rise more if the aggregate demand curve is steep than if it is flat. Chart 12Wages Rose Faster Than Prices During The Inflationary Late-60s and 70s It is tempting to think of the aggregate demand curve in the same way one might think of the demand curve for, say, apples. When the price of apples rises, there is both a substitution and an income effect. An increase in the price of apples will cause shoppers to substitute away from apples towards oranges. In addition, if apples are so-called “normal goods,” shoppers will buy fewer apples in response to lower real incomes. This chain of reasoning breaks down at the aggregate level. When economists say the price level has risen, they are referring to all prices; hence, there is no substitution effect. Moreover, since one person’s spending is another’s income, rising prices do not necessarily translate into lower overall real incomes. Granted, if nominal wages are sticky, as they usually are in the short run, an unanticipated increase in prices will reduce real wage income. However, this will be offset by higher business income. Over time, wages tend to catch up with prices. In fact, wage growth usually outstrips price growth during inflationary periods. For example, real wages rose during the late-1960s and 70s but fell during the disinflationary 1980s (Chart 12). Textbook Reasons For A Downward-Sloping Aggregate Demand Curve According to standard economic theory, there are three main reasons why aggregate demand curves are downward-sloping: The Pigou Effect: Higher prices erode the purchasing power of money, resulting in a negative wealth effect. The Keynes Effect: Higher prices reduce the real money supply. This pushes up real interest rates, leading to lower investment spending. The Mundell-Fleming Effect: Higher real rates push up the value of the currency, causing net exports to decline. None of these three factors are particularly important for the US these days. Chart 13Base Money Has Swollen Since The Subprime Crisis Strictly speaking, the Pigou wealth effect applies only to “base money,” also known as “outside money.” Outside money includes cash notes, coins, and bank reserves. Inside money such as bank deposits are not included in the Pigou effect because while an increase in consumer prices decreases the real value of bank deposits, it also decreases the real value of commercial bank liabilities.1  In the US, the monetary base has swollen from 6% of GDP in 2008 to 28% of GDP as a result of the Fed’s QE programs (Chart 13). Nevertheless, even if one were to generously assume a wealth effect of 10% from changes in monetary holdings, this would still imply that a 1% increase in consumer prices would reduce spending by only 0.03% of GDP. Simply put, the Pigou effect is just not all that big. In contrast to the Pigou effect, the Keynes effect has historically had a significant impact on the business cycle. However, the importance of the Keynes effect faded following the Global Financial Crisis as the Fed found itself up against the zero lower bound on interest rates. When interest rates are very low, there is little to distinguish money from bonds. Rather than holding money as a medium of exchange (i.e., for financing transactions), households and businesses end up holding money mainly as a store of wealth. In the presence of the zero bound, the demand for money becomes perfectly elastic with respect to the interest rate (Chart 14). As a result, changes in the real money supply have no effect on interest rates, and by extension, interest-rate sensitive spending. And if a decline in the real money supply does not push up interest rates, this undermines the Mundell-Fleming effect as well. Could The Aggregate Demand Curve Be Upward-Sloping? The discussion above, though rather theoretical in nature, highlights an important practical point: The aggregate demand curve may be quite steep. This means that the price level might need to rise a lot to equalize aggregate demand with aggregate supply. Chart 15US Real Bond Yields Hitting Record Lows In fact, one can easily envision a scenario where a rising price level boosts spending; that is, where the demand curve is not just steep but upward-sloping. One normally assumes that higher inflation will prompt central banks to raise rates by more than inflation has risen, leading to higher real rates. However, if the Fed drags its feet in hiking rates, as it is wont to do given its concerns about the zero bound, rising inflation will translate into a decline in real rates. Lower rates will boost demand, leading to higher inflation, and even lower real rates. In addition, lower real rates will benefit debtors, who tend to have a higher marginal propensity to spend than creditors. This, too, will also boost aggregate demand. It is striking in this regard that real bond yields hit a record low this week, with the 10-year TIPS yield falling to -1.17% and the 30-year yield drooping to -0.57% (Chart 15). Black Holes Vs. Supernovas In the case where the aggregate demand curve is upward-sloping, there is no stable equilibrium (Chart 16). If demand falls short of supply, demand will continue to shrink as the price level declines, leading to ever-rising unemployment. Unless policymakers intervene with stimulus, the economy will sink into a deflationary black hole. In contrast, if demand exceeds supply, demand will continue to rise as the price level increases exponentially. The economy will go supernova. Tick Tock Young stars fuse hydrogen into helium, releasing excess energy in the process. After the star has run out of hydrogen, if it is big enough, it will start fusing helium into heavier elements such as carbon and oxygen. The process of nucleosynthesis continues until it reaches iron. That is the end of the line. Fusing elements heavier than iron requires a net input of energy. Unable to generate enough external pressure through fusion, the star loses its battle to gravity. The core collapses, spewing material deep into interstellar space (a good thing since your body is mainly made from this stardust). Observing the star from afar, one would be hard-pressed to see anything abnormal until it explodes. The path to becoming a supernova is highly non-linear. The same is true for inflation. Just like a star with an ample supply of hydrogen, the Fed can burn through its credibility for a while longer. During the 1960s, it took four years for inflation to take off after the economy had reached full employment (Chart 17). By that time, the unemployment rate was two percentage points below NAIRU. Most of today’s inflation is confined to durable goods. This is not a sustainable source of inflation. The durable goods sector is the only part of the CPI where prices usually fall over time (Chart 18). Chart 17Inflation Spiked In The 1960s Only Once The Unemployment Rate Had Fallen Far Below Equilibrium Chart 18Inflation Has Been Concentrated In Durable Goods, A Sector Where Prices Usually Fall Over Time To get inflation to go up and stay up in modern service-based economies, wages need to rise briskly. While US wage growth has picked up, the bulk of the increase has been among low-wage workers, particularly in the services and hospitality sector (Chart 19). Chart 19Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution The most likely scenario for next year is that firms will simply ration output, fearful that raising prices too quickly will hurt brand loyalty and trigger accusations of price gouging. Shortages will persist, but this time they will be increasingly concentrated in the service sector. Such a state of affairs will not last, however. Competition for workers will cause wages to rise much more than they have so far. Keen to protect profit margins, firms will start jacking up prices. A wage-price spiral will develop. The US economy could go supernova. Investment Conclusions Chart 20Long-Term Inflation Expectations Are Near The Bottom End Of The Fed's Comfort Zone US growth will slow next year, not because demand will falter, but because supply-side constraints will prevent the economy from producing as much output as households and businesses want to buy. This means that the old playbook for dealing with growth slowdowns needs to be thrown out the window. Rather than positioning for lower bond yields, investors should position for higher yields. Rather than expecting a stronger dollar, investors should expect a weaker one. Rather than favoring growth stocks, large caps, and defensives, investors should favor value stocks, small caps, and cyclicals. While inflation expectations have recovered from their pandemic lows, the 5-year/5-year forward TIPS breakeven inflation rate is still near the bottom end of the Fed’s comfort zone (Chart 20). Rising inflation expectations will lift long-term bond yields, justifying a short duration stance in fixed-income portfolios. Higher bond yields will benefit value stocks. Chart 21 shows that there has been a strong correlation between the relative performance of growth and value stocks and the 30-year bond yield this year. Rising input prices will make the US export sector less competitive, leading to a weaker dollar. Historically, non-US stocks have done well when the dollar has been weakening (Chart 22). Chart 21The Relative Performance of Value Stocks Has Closely Tracked Bond Yields This Year Chart 22Non-US Stocks Tend To Do Best When The US Dollar Is Weakening As for the overall stock market, with the Fed still in the dovish camp, it is too early to turn negative on equities. An equity bear market is coming, but not until rising inflation forces the Fed to step up the pace of rate hikes. That will probably not happen until mid-2023. Short Gilt Trade Activated We noted last week that we would go short the 10-year UK Gilt if the yield broke below 0.85%. Our limit order was activated on November 5th and we are now short this security.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1  To distinguish between inside and outside money, one should ask where the liability resides. If the liability resides within the private sector, it is inside money. By convention, central bank reserves are classified as outside money. However, one could argue that since taxpayers ultimately own the central bank, an increase in the price level will benefit taxpayers by eroding the real value of the central bank’s liability. If one were to take this view, the Pigou effect would be even weaker. 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