Inflation/Deflation
Highlights Our baseline view is that inflation will increase only modestly over the next few years before accelerating in the middle of the decade. Nevertheless, the risks are skewed towards an earlier and sharper increase in inflation in the US and, to a lesser extent, in the other major economies. The first round of stimulus left US households with $1.5 trillion in excess savings, equivalent to 10% of annual consumption. The stimulus deal Congress reached in December and President Biden’s proposed package would inject an additional $300 billion per month into the economy through the end of September. According to the Congressional Budget Office, the monthly output gap is $80 billion. The true number may be even lower since the CBO’s estimate does not take into account the temporary disruption to the supply side of the economy from the pandemic or the potential disincentive to work from unusually generous unemployment benefits. In and of itself, inflation is not necessarily bad for stocks. Inflation is only bad for stocks when it triggers monetary policy tightening. The bar for the Fed to raise rates is still very high, which suggests that equities will weather a temporary burst of inflation. Nevertheless, investors should hedge against the risk that inflation will surprise on the upside. This calls for reducing duration in fixed-income portfolios to below-benchmark levels, favoring inflation-protected securities over nominal bonds, and owning more real assets such as gold and farmland. Investors should also favor value stocks over growth stocks. Commodity producers are overrepresented in value indices, while banks will benefit from steeper yield curves. The Austerians Give Up In his 2011 State Of The Union Address, President Obama declared that “Families across the country are tightening their belts and making tough decisions. The federal government should do the same.” And so the government did. According to calculations by the Brookings Institution, tighter fiscal policy subtracted about 1.2 percentage points from annual GDP growth between 2011 and 2014 (Chart 1). Chart 1US Fiscal Easing Gave Way To Fiscal Drag Soon After The Great Recession The US was not alone. As Chart 2 illustrates, most advanced economies tightened fiscal policy not long after the Great Recession officially ended. In the case of countries such as Italy and Spain, the tightening came in response to market duress. In other cases such as those involving Germany and the UK, the tightening occurred against the backdrop of fairly low borrowing costs. Chart 2Fiscal Austerity Was The Favored Post-GFC Policy Prescription After the pandemic struck, most governments were quick to loosen fiscal policy again (Chart 3). However, unlike ten years ago, calls for reducing the flow of red ink have been a lot more muted this time around. Chart 3Fiscal Policy In 2020: Governments Eased Significantly In Response To The Unfolding Crisis Back in 2010, the OECD – the go-to source for conventional thinking on all economic matters – opined that “monetary policy must be normalized” and that “exit from exceptional fiscal support must start now, or by 2011 at the latest.” Today, the OECD admits that it made a “mistake” in pushing for austerity so soon after the recession ended. “The first lesson is to make sure governments are not tightening in the one to two years following the trough of GDP” explained Laurence Boone, the OECD’s current chief economist, to the FT earlier this month. The OECD’s change of heart partly reflects political reality – assistance for businesses and workers who lost income due to lockdowns is more palatable than bailouts for banks and for homeowners who took on more debt than they could afford. Yet, there is an important economic dimension to the policy pivot as well. The huge spike in bond yields that many pundits predicted a decade ago never materialized. Despite soaring debt levels, real bond yields in the US and most other economies are near record lows (Chart 4). Even the Italian 10-year yield stands at a mere 0.68% now that the ECB has effectively promised to backstop European governments. Chart 4Governments Enjoy Low Borrowing Costs The Bondholder Who Cried Wolf Chart 5Generous Government Transfers Boosted Household Savings After many false alarms, could the inflationistas get the last laugh in 2021? The idea is not entirely far-fetched. Consider the case of the US. Chart 5 shows that US households are sitting on $1.5 trillion of excess savings – equivalent to 10% of annual consumption. The amount of dry powder US households have at their disposal will only get larger. Taken together, the stimulus deal Congress reached in December and President Biden’s proposed fiscal package would inject an average of $300 billion per month into the economy through the end of September. Republicans and centrist Democrats in the Senate may force Biden to winnow down his stimulus plans to something closer to $1 trillion. Nevertheless, this still would provide about $200 billion in incremental monthly support. Official estimates made by the Congressional Budget Office last summer imply that the monthly output gap – the difference between what the economy is capable of producing and what it actually is producing – is currently only $80 billion. In fact, the true output gap may be even lower than this. First, GDP has recovered more rapidly than the CBO had projected. Second, official estimates of the output gap do not control for the fact that part of the economy’s productive capacity – certain retail establishments, hotels, airlines, etc. – has been rendered either fully or partly inoperative due to the pandemic. Third, official estimates also do not account for the fact that generous jobless benefits may have made some workers less eager to find work, thus temporarily raising the natural rate of unemployment. Inflation: Movin’ On Up If the demand for goods and services exceeds supply, prices are likely to go up. How much will they rise? In the near term, inflation is certain to increase from very low levels, if only due to base effects. As my colleague Ryan Swift has noted, both core PCE and core CPI inflation will soon spike above 2% on an annualized basis even if consumer prices rise by a meager 0.15% per month, as the deflationary March and April 2020 data points fall out of the rolling 12-month average (Chart 6). Looking beyond the next few months, the trajectory for inflation will depend on the degree to which the economy overheats. In some categories, there is already evidence of excess demand. US core goods inflation is running at 1.6%, the highest level since 2012. The ISM manufacturing Prices Paid index points to further upside for goods inflation. Soaring commodity prices tell a similar tale (Chart 7). Chart 6Base Effects Will Push Inflation Higher Chart 7Further Upside For Goods Inflation And Commodity Prices While services inflation has been more downbeat, that could change as the labor market tightens (Chart 8). Housing inflation is also set to bottom. The National Multifamily Housing Council’s Apartment Market Tightness Index remains in contractionary territory. However, the closely-linked Sales Volume Index recently jumped to the highest level in nine years (Chart 9). Sales volume led the Market Tightness Index coming out of the last recession. If that happens again, shelter inflation should creep up. Chart 8A Pickup In Services Inflation Is Awaiting A Tighter Labor Market Chart 9Shelter Inflation Could Bottom Soon A Self-Fulfilling Prophecy? Like most macroeconomic phenomena, inflation is subject to feedback loops. If households expect prices to increase initially but then fall back down once the stimulus has lapsed, they may defer some of their spending until prices return to normal. This could prevent prices from rising in the first place. In contrast, if households expect prices to rise and then keep rising, they may try to expedite their purchases. This would supercharge spending. One can see that there is a self-fulfilling process at work. If households expect prices to remain broadly stable, then they will remain broadly stable. If households expect prices to rise a lot, then they will rise a lot. Imagine last year’s Great Toilet Paper Shortage but on an economy-wide scale. A similar self-fulfilling process works at the firm level. If firms expect prices to rise only briefly, they will try to run down their inventories as quickly as possible to take advantage of temporarily high profit margins. The additional supply will limit any increase in prices. In contrast, if firms expect selling prices to keep rising, they may hoard inventory to take advantage of future higher prices. Likewise, firms may be reluctant to raise wages in response to a temporary overheating of the economy for fear that this would lock in a higher cost structure. In contrast, firms would be more willing to raise wages if they thought that prices would keep rising. Hence, the expectation of rising inflation could trigger a price-wage spiral. Lifting The Anchor The inflationary scenario described above could play out if long-term inflation expectations become unmoored. Central banks have invested a lot of effort in trying to anchor inflation expectations at around 2%. To the extent that they have fallen short of their goal, it is because prices have risen less than desired (Chart 10). Chart 10Central Banks Have Missed Their Inflation Targets To remedy the shortfall in inflation, the Fed has pledged to allow inflation to rise above 2% for a few years, with the aim of bringing the price level back to its long-term target trend. The risk is that such an inflation overshoot happens sooner and is more pronounced than policymakers desire. Christina Romer, the former chair of the Council of Economic Advisers in the Obama administration, famously wrote a paper entitled “It Takes A Regime Shift.” Using the example of Roosevelt’s decision to take the US off the gold standard in 1933, she argued that major monetary policy decisions could permanently jolt inflation expectations. It is too early to say whether the Fed’s new inflation-targeting framework will go down in history as a “regime shift.” What one can say with more confidence is that the rollout of this framework is coming at a tumultuous time. Policymakers and business leaders routinely talk about the “The Great Reset” – the notion that the pandemic provides a once-in-a-lifetime opportunity to shift policy in a new, rather curious, direction. Central bankers better hope that inflation expectations are not reset too much. Investment Implications Our baseline view is that inflation will increase only modestly over the next few years before accelerating in the middle of the decade. Nevertheless, as highlighted in this week’s report, the risks are skewed towards an earlier and sharper increase in inflation in the US and, to a lesser extent, in the other major economies. The spectre of higher inflation is unsettling to many investors. However, in and of itself, inflation is not necessarily bad for stocks. Inflation is only bad for stocks when it triggers monetary policy tightening. In the absence of rate hikes, rising inflation would push real rates lower. This would be quite good for stocks, as the experience of the past nine months demonstrates (Chart 11). As noted above, the bar for the Fed to withdraw monetary support is fairly high. This suggests that rising inflation is unlikely to derail the bull market in stocks. Of course, if both actual inflation and inflation expectations were to jump too much, the Fed would have to intervene. With that in mind, investors should position their portfolios to withstand rising inflation. This calls for reducing duration in fixed-income portfolios to below-benchmark levels, favoring inflation-protected securities over nominal bonds, and owning more real assets such as gold and farmland. Chart 11Lower Real Yields Have Lifted Equity Prices Chart 12Bank Stocks Tend To Outperform When Inflation Expectations And Bond Yields Are Rising Investors should also favor value stocks over growth stocks. Commodity producers are overrepresented in value indices, and would benefit from rising inflation. Banks are also overrepresented in value indices. Chart 12 shows that banks tend to outperform when inflation expectations and long-term bond yields are rising. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations This table provides trade recommendations that may not be adequately represented in the matrix on the preceding page. Current MacroQuant Model Scores
The forthcoming third round of enormous US fiscal stimulus will likely mark a structural regime shift in global financial markets. Over the past 25 years, the chief concern of US and, hence, global financial markets, has been economic growth. Share prices typically fluctuated with growth expectations. As a result, the S&P 500 and US bond yields have been positively correlated, as shown in Chart 1 of week. Chart 1AUS Share Prices And Treasury Yields Will Soon Become Negatively Correlated Going forward, odds are that the correlation between US equity prices and US bond yields will turn negative and stay there for several years, as was the case prior to 1997. In brief, we are moving from a deflationary to an inflationary backdrop. Share prices will likely start negatively reacting to rising inflation and/or inflation expectations and vice versa. We will discuss these issues in depth in forthcoming reports. A rise in EM corporate bond yields is the key threat to EM share prices, as shown in the charts on page 3. EM corporate and sovereign US bond spreads are so tight that they are unlikely to compress further to offset the rise in US Treasury yields. As a result, EM dollar-denominated corporate and sovereign bond yields will also rise as US Treasurys sell off. Chart 2 of week shows that the distinct breakout in a high-beta American industrial stock price – Kennametal – points to higher US government bond yields. Chart 1BA Super-Strong US Industrial Cycle Points To Higher US Treasury Yields The timing of such a shakeout in risk assets is uncertain but it will likely be sharp and will happen in the first half of this year. The reason is that positioning and sentiment on global risk assets in general and EM risk assets in particular are very elevated as we illustrate in this January issue of Charts That Matter. Our major investment themes remain: US equities will continue underperforming global stocks. Rising bond yields and inflation will hurt the expensive US equity market more than overseas ones. Europe and Japan will outperform and EM will likely be a market performer. For now, maintain a neutral allocation to EM in a global equity portfolio. The US dollar is in a structural bear market but it is presently oversold and will bounce sharply sometime in H1 this year. Continue shorting select EM currencies versus an equal-weighted basket of the euro, CHF and JPY. EM currencies will suffer more than DM currencies during a potential US dollar snapback. A setback in EM fixed-income markets should be used as a buying opportunity. Inflation is much less of a problem in EM than in the US. A long-term bear market in the greenback favors EM fixed-income markets, both dollar-denominated and local currency ones. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Rising EM Corporate Bond Yields Is The Key Threat To EM Share Prices A continuous rise in corporate and sovereign US dollar bond yields (shown inverted) has historically been a negative signal for EM share prices. With no downside to global growth due to US fiscal policy, both US and EM bond yields are crucial variables to monitor. Chart 1Rising EM Corporate Bond Yields Will Be The Key Threat To EM Share Prices Chart 2Rising EM Corporate Bond Yields Will Be The Key Threat To EM Share Prices EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries Rising inflation expectations will help EM stocks to outperform the S&P 500. The latter is more expensive and, thereby, more sensitive to rising interest rates. Chart 3EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries Chart 4EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years In real (inflation-adjusted) terms, US stocks in general and US tech stocks in particular are over-extended relative to their long-term trends. Relative to US equities, but not absolute term, EM stocks are cheap. Chart 5US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years Chart 6US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years Chart 7US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years Chart 8US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years Strategy For An Era Of Inflation Global growth stocks will underperform versus value ones. US equities have broken down relative to the global equity index. US bond yields have more upside. A rise in US corporate bond yields is the main danger to American stocks. Chart 9Strategy For An Era Of Inflation Chart 10Strategy For An Era Of Inflation Chart 11Strategy For An Era Of Inflation Chart 12Strategy For An Era Of Inflation Risk Measures That EM Investors Should Monitor US TIPS yields are very oversold. Any spike will likely trigger a rebound in the US dollar and a correction in EM local currency bonds. Besides, off-shore Chinese property company bond prices have rolled over. This means stress is accumulating in China’s property market and construction activity will slow in H2 this year. Finally, EM HY corporates might begin underperforming EM IG – a sign of poor risk backdrop. Chart 13Risk Measures That EM Investors Should Monitor Chart 14Risk Measures That EM Investors Should Monitor Chart 15Risk Measures That EM Investors Should Monitor The Case For US Inflation US personal disposable income has surged due to fiscal transfers. This is ultimately Modern Monetary Theory (MMT) in action. US consumer spending on goods has been booming, lifting global trade and manufacturing. The vaccination and a reopening of the economy will increase the velocity (turnover) of money supply and lead to higher inflation in H2 2021. Chart 16The Case For US Inflation Chart 17The Case For US Inflation Chart 18The Case For US Inflation Global Trade: The US and China Have Been Epicenters Of Spending China's and the US’ real trade balances (export volume divided by import volume) have been falling, meaning that both economies have been locomotives of global demand. China’s stimulus is tapering off but the US’ fiscal largess continues. Chart 19Global Trade: The US and China Have Been Epicenters Of Spending Chart 20Global Trade: The US and China Have Been Epicenters Of Spending Chart 21Global Trade: The US and China Have Been Epicenters Of Spending US Consumers Could Face High Goods Prices Tradable goods prices are rising in US dollar terms. If export nations’ currencies continue appreciating, US imports prices in US dollar terms will rise much more. This will reinforce inflationary pressures in the US. Chart 22US Consumers Could Face High Goods Prices Chart 23US Consumers Could Face High Goods Prices Chart 24US Consumers Could Face High Goods Prices Chart 25US Consumers Could Face High Goods Prices No Inflation In China In China, supply has been overwhelming demand and deflationary tendencies remain broad-based. Policymakers have become concerned with RMB appreciation, or at least the pace of its strengthening. Authorities have allowed more portfolio capital to leave China. The latter has produced the recent surge in HK-traded Chinese stocks (please refer to page 16). Chart 26No Inflation In China Chart 27No Inflation In China Chart 28No Inflation In China Chart 29No Inflation In China The Chinese Economy: Strong In H1; Slowing In H2 China’s credit and fiscal stimulus peaked in Q4 2020. This and regulatory tightening for banks and ongoing non-banks as well as the property market restrictions will produce a meaningful slowdown in H2 this year. Chart 30The Chinese Economy: Strong In H1; Slowing In H2 Chart 31The Chinese Economy: Strong In H1; Slowing In H2 Chart 32The Chinese Economy: Strong In H1; Slowing In H2 Chart 33The Chinese Economy: Strong In H1; Slowing In H2 Commodities Inventories In China Are Elevated Slowdowns in China’s construction activity and infrastructure spending amid excessive inventories of commodities pose a downside risk in commodities prices this year. Chart 34Commodities Inventories In China Are ElevatedChart 36Commodities Inventories In China Are Elevated Chart 35Commodities Inventories In China Are Elevated A Mania In Full Force Asia’s growth stocks have been rising exponentially. Such parabolic price moves can last for a while but these stocks will experience a major shakeout this year. The trigger will be rising global bond yields as discussed on pages 1 and 2. Chart 37A Mania In Full Force Chart 38A Mania In Full Force Chart 39A Mania In Full Force Chart 40A Mania In Full Force Local Retail Investors Have Been Buying EM Stocks Aggressively These charts show that a retail mania is taking place not only in the US but has become a common phenomenon in many EM stock markets. Amid retail-driven rallies, fundamentals do not matter and momentum is the key variable to monitor. Chart 41Local Retail Investors Have Been Buying EM Stocks Aggressively Chart 42Local Retail Investors Have Been Buying EM Stocks Aggressively Mainland Investors Buying HK-Listed Chinese Stocks To halt yuan appreciation, authorities have recently increased quotas for mainland investors to buy HK-listed equities. Consequently, capital has rushed out of the mainland and Chinese stocks listed in HK have surged. The duration and magnitude of any flow-driven rally is impossible to handicap with any certainty. Chart 43Mainland Investors Buying HK-Listed Chinese Stocks Chart 44Mainland Investors Buying HK-Listed Chinese StocksChart 45Mainland Investors Buying HK-Listed Chinese Stocks Global Investors Are Super Bullish These charts illustrate that based on the Sentix1 survey European investors are record bullish on EM equities and European growth. Chart 46Global Investors Are Super Bullish Chart 47Global Investors Are Super Bullish Investor Sentiment And Positioning Are Very Elevated Investors are bullish on US stocks and copper (a proxy for global growth) and bearish on the US dollar. The ratio of US institutional and retail money market funds’ assets (cash on sidelines) relative to market value of stocks and all US dollar bonds has declined substantially. Chart 48Investor Sentiment And Positioning Are Very Elevated Chart 49Investor Sentiment And Positioning Are Very Elevated Chart 50Investor Sentiment And Positioning Are Very Elevated Several Reflation Gauges Are Facing Resistance Global cyclical versus defensive stocks and several EM reflation plays are facing important technical resistances. Chart 51Several Reflation Gauges Are Facing Resistance Chart 52Several Reflation Gauges Are Facing Resistance Major Equity Indexes Are Attempting A Breakout The EM, global ex-US, global ex-TMT and euro area equity indexes are at their previous highs and are attempting a breakout. Momentum is on their side but positioning and sentiment are against a sustainable breakout. Chart 53Major Equity Indexes Are Attempting A Breakout Chart 54Major Equity Indexes Are Attempting A Breakout Chart 55Major Equity Indexes Are Attempting A Breakout Chart 56Major Equity Indexes Are Attempting A Breakout Outside Asian Growth Stocks, EM Equities Have Been Lagging Reflecting not-so-positive fundamentals, EM share prices, outside Asian growth stocks, have not yet entered a bull market. Chart 57Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 58Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 59Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 60Outside Asian Growth Stocks, EM Equities Have Been Lagging The Outlook For EM Stocks The cyclical EM profit outlook is bullish. However, much of this is already priced in. China’s peak stimulus is a risk to EM later this year. We recommend equity investors to favor EM versus the S&P 500 but not against European or Japanese stocks. Chart 61The Outlook For EM Stocks Chart 62The Outlook For EM Stocks New COVID Cases Are Rising In Several Areas Outside North Asia Many developing countries are facing challenges to contain the pandemic as well as to obtain and conduct broad-based vaccination. Chart 63New COVID Cases Are Rising In Several Areas Outside North Asia Chart 64New COVID Cases Are Rising In Several Areas Outside North Asia Footnotes 1 The Sentix surveys cover several thousand European institutional and individual investors. In the survey, investors are asked about their medium-term expectations. Source: SENTIX.
Highlights Inflation: Additional fiscal stimulus will lead to higher inflation in the goods sector, where bottlenecks are already forming. But stronger services inflation is required (particularly in shelter) before broad price pressures emerge. Some leading indicators of shelter inflation suggest that a bottom may be near. Fed: The Fed will not lift rates or taper asset purchases until the unemployment rate is close to 4.5% and 12-month PCE inflation is firmly above 2%. This could occur in late-2021 if economic growth is very strong, but 2022 is more likely. Investment Strategy: Maintain below-benchmark portfolio duration and stay overweight TIPS versus nominal Treasuries. Nominal curve steepeners, real curve steepeners and inflation curve flatteners all continue to make sense. Feature Biden Goes Big Joe Biden unveiled his economic plan last week and, as expected, the incoming President is setting his sights high. First on the agenda is the American Rescue Plan, a $1.9 trillion package that contains $410 billion for fighting the coronavirus, $1 trillion of income support for households and $440 billion in direct aid to state & local governments. Biden will seek enough Republican support in the Senate to pass this legislation without using the budget reconciliation process. If that can be achieved, Democrats will still have two opportunities to pass reconciliation bills in 2021. Those bills will focus on other priorities such as infrastructure investment and expanding the Affordable Care Act. With households already flush with cash, an influx of new stimulus risks an earlier return of inflation than was previously anticipated. Biden’s announcement was in line with what our political strategists anticipated, and the federal deficit is on track to fall somewhere between the “Democratic Status Quo” and “Democratic High” scenarios shown in Chart 1. This means that the deficit will peak at between 22% and 25% of GDP in fiscal year 2021 before gradually converging back to the baseline. To put this number in context, the federal deficit peaked at just below 10% of GDP at the height of the Great Financial Crisis in 2009. The US economy is now on the cusp of receiving a much greater fiscal injection at a time when nominal GDP is only 2.7% off its prior peak. Chart 1Massive Fiscal Stimulus Is On The Way As mentioned above, the American Rescue Plan contains $1 trillion of income support for households, delivered in the form of one-time $1400 checks and an expansion of unemployment insurance benefits. This is a lot of stimulus, and it looks like even more when you consider the significant income boost that households have already received. Chart 2 shows nominal personal income relative to a pre-COVID trend. Income has been significantly above trend since last spring’s passage of the CARES act, and with fewer spending opportunities than usual, households have been building up a significant buffer of excess savings. Chart 2A Mountain Of Excess Savings The risk here is quite clear. With households already flush with cash, an influx of new stimulus risks an earlier return of inflation than was previously anticipated. The remainder of this report considers the likelihood of this risk materializing and what it might mean for Fed policy and our TIPS and portfolio duration recommendations. Inflation Outlook & TIPS Strategy One complication brought on by the pandemic is the stark divergence between goods and services sectors. The large fiscal response means that households have ample cash to deploy towards consumer goods, but service sectors remain shuttered. This divergence is reflected in the inflation data where price pressures are already emerging in the core goods space but services inflation (excluding shelter and medical care) remains below recent historical levels (Chart 3). Manufacturing indicators, such as the ISM Prices Paid survey and commodity prices, provide further evidence of a bottleneck in manufactured goods (Chart 4). Capacity utilization remains low, but it is rising quickly (Chart 4, bottom panel). Chart 3Goods Vs. Services Inflation Chart 4A Bottleneck In Manufacturing The split between goods and services inflation will persist until vaccination efforts gain enough traction for services to re-open, and it will only be exacerbated as more fiscal stimulus is rolled out. Households will continue to dump cash into goods, but service sector participation is likely needed before broad upward pressure on overall inflation emerges. Specifically, broad upward pressure on overall inflation will not be possible until we see a turnaround in shelter (roughly 40% of core CPI). Shelter inflation plummeted during the past year (Chart 5), but some tentative signals are emerging that suggest a bottom may occur within the next 3-6 months. Shelter inflation tends to fall when the unemployment rate is high and rise as labor slack dissipates. Shelter inflation is highly sensitive to the economic cycle. That is, it tends to fall when the unemployment rate is high and rise as labor slack dissipates. Abstracting from large swings in temporary unemployment, the permanent unemployment rate finally ticked down in December (Chart 6). If this marks an inflection point, then shelter inflation is likely close to its trough. The National Multi Housing Council’s Apartment Market Tightness Index is another excellent indicator of shelter inflation. It remains below 50, consistent with downward pressure on shelter inflation, but the tightly-linked Sales Volume Index recently jumped into “more volume” territory (Chart 6, bottom panel). Sales volume led the Market Tightness Index coming out of the last recession. If that happens again, we could soon see shelter inflation creep up Chart 5Shelter Inflation Near ##br##A Trough? Chart 6Shelter Inflation Is Highly Sensitive To The Economic Cycle It is still too soon to call a bottom in shelter inflation. However, if the permanent unemployment rate continues to fall and the Apartment Market Tightness Index follows sales volume higher, then a bottom in shelter could emerge within the next 3-6 months. TIPS Strategy Chart 7Base Effects Will Push Inflation Higher Our strategy has been to position for higher TIPS breakeven inflation rates by going long TIPS versus nominal Treasuries, with a plan to tactically reverse this position for a time once the inflation narrative reaches a fever pitch in Q1 of this year. One reason for the inflation narrative to take hold is that base effects will naturally lead to a jump in year-over-year inflation rates during the next few months as the March and April 2020 datapoints fall out of the rolling 12-month average. Chart 7 shows that both 12-month core PCE and core CPI will soon spike above 2%, even if a modest 0.15% monthly growth rate is achieved. Our expectation is that inflation pressures will wane after April of this year, potentially giving us an opportunity to position for a drop in TIPS breakeven inflation rates. However, if shelter inflation does indeed reverse course, as leading indicators suggest it might, that opportunity may not present itself. Bottom Line: Stay positioned long TIPS / short duration-equivalent nominal Treasuries and watch for further evidence of a bottom in shelter inflation within the next 3-6 months. The Fed Has Already Told Us What It Will Do It is certainly possible (even likely) that large-scale fiscal stimulus will cause inflation pressures to emerge earlier than would have otherwise been the case. However, any meaningful monetary tightening in 2021 still seems like a long shot. The potential for Fed tightening in 2021 became a hot topic last week when Atlanta Fed President Raphael Bostic said he’s open to the possibility of tapering asset purchases in late-2021, assuming economic growth turns out to be stronger than anticipated. Fed Chair Powell downplayed the odds of a 2021 taper in his remarks later in the week, causing bond prices to regain some lost ground. Year-over-year inflation will peak in April. Our advice is to not get caught up in the different tones of Fed speakers. The Fed has already been very explicit about the economic criteria that will cause it to tighten policy. Any evaluation of when tightening will occur should be based on an assessment of the economic data relative to these criteria, not on whether certain Fed officials sound more or less optimistic about the future. Tapering & The Timing Of Liftoff Chart 8No Liftoff Until We Reach Full Employment Our “Fed In 2021” Special Report laid out the three criteria that must be met before the Fed will consider lifting the funds rate.1 Fed Vice-Chair Richard Clarida reiterated this checklist in a recent speech.2 Before lifting rates: 12-month PCE inflation must be 2% or higher Labor market conditions must have reached levels consistent with the Fed’s assessment of maximum employment PCE inflation must be on track to moderately exceed 2% for some time 12-month core PCE inflation is currently 1.38%. As we already noted, it will likely jump above 2% by April but Fed officials will not view that increase as sustainable. The elevated unemployment rate is a big reason why. At 6.7%, the unemployment rate remains well above the range of 3.5% to 4.5% that Fed officials view as consistent with full employment (Chart 8). In his speech, Vice-Chair Clarida said that when “labor market indicators return to a range that, in the Committee’s judgment, is broadly consistent with its maximum-employment mandate, it will be data on inflation itself that policy will react to.” In other words, liftoff will not occur until the unemployment rate is between 3.5% and 4.5%, no matter what happens with inflation. Then, even when the “full employment” criterion has been met, 12-month PCE inflation must still rise above 2% before a rate hike will be considered. The guidance around the tapering of asset purchases is vaguer than the guidance around liftoff. All we know is that the Fed intends to start tapering asset purchases before it lifts the funds rate. Since Fed officials know that a tapering announcement will send a signal that liftoff is imminent, it is highly likely that tapering will occur only a few months before the Fed expects to raise rates. In all likelihood, the unemployment rate will be close to 4.5% before tapering is considered. This could happen by late-2021 if economic growth is very strong, as President Bostic suggested, but a 2022 tapering seems like a safer bet. The Pace Of Rate Hikes Once liftoff occurs, Vice-Chair Clarida has been very clear that inflation expectations will be the principal factor guiding the pace of policy tightening. Specifically, if long-maturity TIPS breakeven inflation rates are below the 2.3 to 2.5 percent range that has historically been consistent with “well anchored” inflation expectations, policy tightening will proceed more slowly than if breakevens are threatening to break above 2.5% (Chart 9). Other measures of inflation expectations based on surveys and inflation’s long-run trend will also be considered (Chart 10). Chart 9TIPS ##br##Breakevens Chart 10Inflation Expectations: Survey And Trend Measures The indicators of inflation expectations shown in Charts 9 & 10 are currently below “well-anchored” levels. However, this may not be the case when the Fed is finally ready to raise rates off the zero bound. In fact, when we look at the amount of policy tightening currently priced into the yield curve, we see a good chance that it will be exceeded. The market is currently priced for liftoff to occur in mid-2023, followed by only two more 25 basis point rate hikes over the subsequent 18 months (Chart 11). Chart 11Market Priced For Mid-2023 Liftoff With all the fiscal stimulus coming down the pipe, we can easily envision liftoff occurring sometime in 2022, followed by a somewhat quicker pace of tightening. With that forecast in mind, investors should maintain below-benchmark portfolio duration. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Special Report, “The Fed In 2021”, dated December 22, 2020, available at usbs.bcaresearch.com 2 https://www.federalreserve.gov/newsevents/speech/clarida20210113a.htm Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Rising commodity prices and a weaker dollar will lead to higher inflation at the consumer level beginning this year. In the real economy, tighter commodity fundamentals – restrained supply growth, increasing demand, and falling inventories in oil, metals and grain markets – will push prices higher, which will feed US CPI inflation and inflation expectations going forward. Stronger fiscal stimulus, and the expanding budget deficits that will accompany it – along with the Fed’s oft-affirmed willingness to accommodate them – will allow the USD to resume its bear market, and will also boost commodity prices. Policy support will be kicking into a higher gear as COVID-19 vaccines are more widely distributed, contributing to a revival in organic growth globally. This will keep the rate of growth in commodity demand above that of supply. Increasing inflation expectations will be evident in longer-dated CPI swaps markets used by traders, portfolio and pension-fund managers to manage longer-term inflation risks (Chart of the Week). Risks remain elevated to the upside and downside: Fundamentals and policy are supportive; public-health risks are acute, and political risk is elevated, particularly in the US, where tensions remain high following the assault on the Capitol in Washington. Feature In the real economy, industrial commodities – particularly oil and copper – are signaling prices will move higher. The real economy and financial markets are pointing to higher inflation going forward. This will become apparent in the longer-term US CPI swaps markets used by traders, portfolio and pension managers as commodity prices continue to rise and the USD resumes its bear market.1 In the real economy, industrial commodities – particularly oil and copper – are signaling prices will move higher. Production-management in the oil market is keeping the rate of growth in supply below that of demand, a trend we expect will continue this year. In the copper market, demand growth will outstrip supply growth this year and next (Chart 2). As a result, both markets will see physical supply deficits this year. Chart of the WeekReal And Financial Markets Point To Higher Inflation Chart 2Copper Supply-Demand Balances Point To Growing Deficits Physical Deficits in Oil, Copper Indicate Supplies Are Tightening Fiscal stimulus in the US will be accommodated by the Fed, which, despite some dissonant messaging, continues to signal its policy of targeting average inflation can be expected to result in lower real rates, as inflation overshoots its 2% target. Policy support is helping to maintain commodity demand globally. Fiscal policy worldwide continues to be supportive. In the US, it likely will become even more expansionary, following the electoral wins of Democrats in Senate run-off elections last week, which will bolster president-elect Joe Biden's position in stimulus-package negotiations after he takes office next week. This expansion of fiscal stimulus will dwarf the levels seen in the wake of the Global Financial Crisis (GFC) in 2008-09 (Chart 3). This fiscal stimulus in the US will be accommodated by the Fed, which, despite some dissonant messaging, continues to signal its policy of targeting average inflation can be expected to result in lower real rates, as inflation overshoots its 2% target. This continued policy support will lead to a resumption of the USD bear market, following a brief dead-cat bounce over the past few days. This will support demand by lowering the local-currency costs of dollar-denominated commodities, and restrict supply growth at the margin by raising the local-currency cost of production. Chart 3Massive US Fiscal Stimulus Will Grow Real Economy Will Boost Inflation Expectations Global fiscal and monetary policy support will further energize the rebound in industrial activity and trade globally. This will keep the rate of growth in commodity demand generally above that of supply, and keep prices elevated. The top panel in the Chart of the Week shows the relationship between CPI 5-year/5-year (5y5y) swaps and crude oil and copper prices, price indexes like the DJ UBS commodity index and the S&P GSCI index, and EM trade volumes in the post-GFC period (2010 to now). The curve in the top panel shows the average of single-equation regressions that use these variables as to estimate CPI 5y5y swap rates; the average coefficient of determination for these equations is just below 0.81, meaning these real variables explain ~ 81% of the level of the CPI 5y5y swaps level post-GFC. This also illustrates how prices and activity in the real economy feed into inflation expectations, which we have demonstrated in the past.2 There also is a correspondence between our measures of real activity – i.e., BCA’s Global Industrial Activity index, Global Commodity Factor and EM Commodity-Demand Nowcast – and CPI 5y5y swaps can be seen in Chart 4. These gauges are more heavily weighted to industrial, manufacturing and trade activity than the commodity indexes, and have an average correlation of ~51% with the level of CPI 5y5y swaps. These series are not as highly correlated with CPI 5y5y swaps as the real and financial variables we used above, but they are, nonetheless, useful indicators to track. Chart 4Real Economic Activity Feeds Into Inflation Expectations Real Economic Activity Feeds Into Inflation Expectations Financial Markets Point To Higher CPI Swaps The Fed’s oft-affirmed willingness to accommodate expanding fiscal deficit strongly supports a weaker-dollar view. The bottom panel in the Chart of the Week shows the average of single-equation estimates that use dollar-related financial variables as regressors against CPI 5y5y swap rates – i.e., the USD broad trade-weighted index, the DXY index, and DM financial-conditions index; the average coefficient of determination for these equations is just below 0.83, meaning these financial variables explain ~ 83% of the CPI 5y5y swaps levels. The Fed’s oft-affirmed willingness to accommodate expanding fiscal deficits strongly supports a weaker-dollar view, which also will boost commodity prices and feed into the CPI swaps market. This fiscal and monetary support will be kicking into a higher gear as COVID-19 vaccines are more widely distributed, contributing to a revival in organic growth globally. This will keep the rate of growth in commodity demand above that of supply. As CPI swaps rates continue to move higher, longer-maturity TIPS breakevens will follow suit (Chart 5). We remain strategically long TIPS versus nominal US Treasuries. We remain strategically long TIPS. Chart 5Expect TIPS Breakevens To Stay Well Bid Risks Remain Elevated CPI 5y5y swap rates will move higher on the back of rising commodity prices, growth in real economic activity, and a weaker dollar. While fundamentals and policy continue to be supportive – and jibe with our longer-term view that industrial commodity prices will move higher – downside risks remain acute. On the health front, COVID-19 pandemic risks remain high, with public-health officials now warning the risk of a more contagious variant of the virus that emerged in the UK could become the dominant strain by March. Public health officials are considering expanded lockdowns to contain the spread of this strain, which reportedly is 50% to 74% more transmissible, according to the MIT Technology Review.3 Fed policy remains supportive of markets in general and commodities in particular. However, with officials offering conflicting views on the policy stance going forward – specifically re the need to taper sooner rather than later – uncertainty around monetary policy will remain a near-constant feature of the market. Lastly, short-term political risk is elevated, particularly in the US, where tensions are high going into the second impeachment of US President Donald J. Trump, following the assault on the US Capitol. This is an evolving story we will be following closely. Bottom Line: CPI 5y5y swap rates will move higher on the back of rising commodity prices, growth in real economic activity, and a weaker dollar. While risks remain elevated, we expect policy risks to be managed and for organic growth to pick up going into 2H21. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Commodities Round-Up Energy: Bullish Brent prices reached an 10-month high on Tuesday at close to $57/bbl. Saudi Arabia’s surprise cuts will offset the slowdown in demand growth caused by renewed lockdowns in most DM countries, which is expected to be most pronounced in 1Q21. Consequently, in its most recent forecast, the EIA revised its demand estimate for OECD demand by -450k b/d on average in 2021. Separately, cold weather in Asia, combined with supply and shipping constraints, pushed JKM LNG prices close to $20/MMBtu earlier this week (Chart 6). The cold wave will push storage in Europe lower ahead of the summer injection season, as LNG cargoes are redirected towards Asia to meet higher space-heating demand. Base Metals: Bullish Chinese imports of metallurgical coal from Australia fell to 447.5k MT in December, the lowest level since January 2015, when Refinitiv, a Reuters data and analytics service, started tracking them. Met coal imports peaked last year in June 2020 at 9.6mm MT, according to reuters.com. The proximate cause of this collapse is the Chinese retaliation to Australia’s call for an investigation into the source of the COVID-19 pandemic. China’s imports from Indonesia have surged, while India’s imports from Australia have picked up much of the loss in Chinese demand, Reuters notes. Precious Metals: Bullish Gold prices fell by $78/oz to $1,834/oz on Friday – a 2-week low – following Democrats win in run-off elections that gave them both of Georgia’s Senate seats last week. The decline in gold prices largely reflects the rise in US real rates, which rose following an increase in US nominal rates that was not accompanied by higher inflation reports in the short term (Chart 7). Going forward, we expect investors will increasingly focus on inflation risks as fiscal policy in the US expands. Democrats will be able to provide extra COVID relief – increasing monthly income-support payments to individuals to $2,000 from $600 – in a reconciliation bill in 2021. This will pressure real rates down as inflation expectations steadily move higher. Ags/Softs: Neutral In its global supply-demand estimates released earlier this week, the USDA lowered its global grain and soybean production and yields forecasts, which pushed prices sharply higher. CME spot corn prices held sharp price gains, which sent futures limit up Tuesday, on the back of lower production and yields. Soybean and wheat futures also responded to reduced supply estimates in the wake of the WASDE release. Chart 6DECLINE IN GOLD PRICES REFLECTS A RISE IN US REAL RATES Chart 7TIGHTENING MARKETS PUSH UP LNG PRICES Footnotes 1 We focus on US CPI swaps because they are responsive to the perceived stance of US monetary policy, even if the Fed’s preferred inflation gauge is the PCE deflator and not the CPI. US monetary policy has a strong bearing on the trajectory of US interest rates and the USD, which impacts commodity prices directly. Please see Treasury Inflation-Protected Securities (TIPS), posted by the US Treasury, which notes: TIPS “provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.” A fixed interest payment, which changes as the CPI changes, is made twice a year. 2 See, e.g., Trade And Commodity Data Point To Higher Inflation, which we published 27 July 2017. Our approach – i.e., treating inflation expectations as a function of global real variables and financial variables – is consistent with that of the Bank for International Settlements (BIS), which is described in Has globalization changed the inflation process?, posted 4 July 2019. We treat the events of the GFC and central banks’ responses to them as a regime change. In our modeling we estimate dynamic OLS and ARDL equations, to ensure we are modeling cointegrated systems. The average of the coefficients of determination estimated using real variables in DOLS models is pulled lower by the model using COMEX copper futures as an explanatory variable. 3 Please see We may have only weeks to act before a variant coronavirus dominates the US published by the MIT Technology Review 13 January 2021. Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Summary of Closed Trades
Highlights An uninterrupted advance in reflation trades will be possible if the FOMO (fear of missing out) evolves into a full-blown mania. This scenario cannot be ruled out especially with retail investors around the world continuing to flock into equity markets. EM equity valuations are neither cheap in absolute terms nor relative to Europe and Japan. EM is cheap only versus the S&P 500. US relative equity outperformance in common currency terms is breaking down. Go long EM stocks / short the S&P 500. The Blue Wave in the US is very bearish for the greenback and has reduced our expectations of the magnitude and duration of any near-term US dollar rebound. It has in fact reinforced our medium- to long-term negative US dollar view. Feature Financial markets are at a crossroad. On the one hand, the reflation trades have already rallied a great deal and might be at a point of exhaustion. On the other hand, gigantic monetary and fiscal support from authorities worldwide, and the US in particular, could push global share prices into a no gravity zone where major overshoots and manias are possible. The bullish view is well-known: DM central banks’ easy monetary and fiscal policies will endure. Moreover, the global economy will continue its recovery as vaccines are made accessible by mid-year to a large share of the population in advanced economies. Markets will ignore any growth disappointment stemming from the expansion and/or extension of lockdowns as they are forward-looking and expect widespread vaccine deployment to eventually allow for a reopening of the economies. We agree with these points. The negative view is also well-recognized: investor sentiment on global equities in general and EM in particular is very elevated and reflation trades have become overbought. These are valid and correct points as well. Chart I-1 illustrates that the Sentix investor sentiment1 on EM equities is at an all-time high. In the past, when sentiment reached these levels EM share prices experienced either a correction or a bear market. Chart I-1Investor Sentiment On EM Equities Is At A Record High Further, the December issue of the Bank of America/Merrill Lynch survey noted that investor overweights in EM stocks and commodities are the highest since November 2010 and February 2011, respectively. These proved to be the major (structural) tops in EM equities and commodities. Certainly, positioning in EM is even more crowded now than it was four weeks ago. Are EM equities at a point of exhaustion – where the rally runs out – or at a point of no gravity – where nothing will stop them from marching higher? In the near term, either is possible. It truly depends on investor behavior which is impossible to forecast with any high degree of certainty. Chart I-2Korean Stocks Have Benefited From Local Retail Mania For instance, retail mania has been happening not only in the US but also in many developing countries. In particular, the astonishing rally in Korean stocks has been propelled not by foreign investors but by local retail investors (Chart I-2). That is why traditional yardsticks of investment analysis have not been useful. In the medium and long term, the trend in global share prices, and thereby EM, will likely be shaped by issues where there is no consensus among investors. In our opinion, there are two subjects upon which investors disagree: (1) whether global and EM equity valuations are too expensive, and (2) whether US inflation will rise sufficiently so that the Federal Reserve abandons its super-easy monetary policy stance, and when markets will begin to price this in. EM equity valuations are not at all cheap. An uninterrupted advance will be possible if the FOMO (fear of missing out) evolves into a full-blown mania. This scenario cannot be ruled out especially with retail investors around the world continuing to flock into equity markets. Concerning US inflation, the odds are that it will rise sooner and faster than is expected by the market and the Fed. Although the Fed is unlikely to singlehandedly spoil the party, fixed-income markets could start pricing in rate hikes sooner rather than later with ramifications for share prices. We will discuss equity valuations in this report and devote a separate report in the coming weeks to the inflation outlook in the US and China. Market Implications Of The Blue Wave Chart I-3US Consumption Of Industrial Metals Is Too Small We expected US Republicans to maintain their majority in the Senate after Georgia’s Senate elections, thus dimming the likelihood of more large-scale fiscal stimulus. If realized, that would have triggered a rebound in the US dollar from very oversold levels. US Democrats effectively gaining control of the Senate has major implications for financial markets: America’s fiscal policy will be looser than otherwise. Swelling government spending will boost domestic demand and will produce a wider trade deficit and higher inflation. Yet, the Fed is unlikely to tighten policy anytime soon and real interest rates will remain negative. This is very bearish for the US dollar. Any rebound in the greenback, which is possible given its oversold conditions, should be faded. According to our Chief Geopolitical Strategist Matt Gertken, odds are that Democrats will partially repeal the corporate tax cuts enacted during Trump’s administration. This is negative for both the US dollar and for Wall Street. One of the main campaign promises of Democrats has been to address income inequality. Actions on this front are good for Main Street but these policies will weigh on corporate profitability. Big Tech faces a greater threat of taxes from a united Congress as opposed to a divided Congress, but Biden’s executive decrees will not be too harsh given that these companies are a major source of support for Democrats. US nominal interest rates will rise but so will nominal GDP growth. The negative impact of higher US bond yields on EM will be more than offset by two forces: a weaker US dollar and stronger exports to the US. Finally, the shift in US fiscal policy is clearly inflationary. However, the impact on commodities prices will be modest. The US accounts for only 8% of global industrial metals consumption compared to China’s 57% share (Chart I-3). So, a slowdown in China commencing in H2 2021 will more than offset the rise in US metals consumption. Concerning oil, the US is the world’s largest crude consumer. Hence, higher household income and spending are positive for oil prices. However, a forceful Democrat push toward green energy is structurally negative for US oil consumption. These two forces might offset each other leaving oil prices to be determined by other factors. Bottom Line: Democrat control of both houses of Congress is positive for US nominal GDP and, hence, for corporate revenues but is bearish for the US dollar and corporate profit margins. Net-net, this reinforces our view that US relative equity outperformance in common currency terms has already passed its secular top and is breaking down (Chart I-4, top panel). By contrast, this US policy shift is positive for EM financial markets (Chart I-4, bottom panel). We recommend a new trade/strategy: go long EM stocks / short the S&P 500. EM Equity Valuations In our opinion, global stocks, especially US ones, are expensive and EM equities are far from being cheap. Let’s begin with EM equity valuations: Chart I-5 shows our Composite Valuation Indicator (CVI) for the MSCI EM equity benchmark. It is an average of four individual valuation indicators: market cap-weighted, equal-weighted, trimmed mean, and median. Chart I-4US Equity Outperformance Is Over Chart I-5EM Equities: Good News Are Fully Priced In In turn, each of these four indicators incorporates five multiples: forward P/E, trailing P/E, price-to-cash EPS, price-to-book value and price-to-dividend ratios. According to Chart I-5, EM equities are expensive. Not only are trailing P/E and price-to-cash EPS ratios extremely elevated but also the forward P/E ratio is the highest and the dividend yield is the lowest it has been in 18 years (Chart I-6). Even though EM stocks do not appear to be expensive based on a price-to-book value (PBV) ratio, a structural decline in EM return on equity (RoE) entails that the fair value range for the PBV ratio has downshifted over the past decade and the current reading should be taken with a grain of salt. Chart I-7 demonstrates that the RoEs for the entire MSCI EM universe, equal-weighted MSCI EM equity index and MSCI non-financial EM companies have deteriorated structurally. Hence, a decline in return on equity is widespread among EM-listed companies, i.e. it is not a feature unique to only large caps. Chart I-6EM Equity Multiples Chart I-7A Structural Drop In EM RoE Heralds Lower Multiples In brief, the structural decline in EM RoE justifies a lower PBV ratio for EM equities (Chart I-7, bottom panel). Relative to DM, EM equities are not cheap. They are cheap versus their US peers but expensive versus European and Japanese stocks. Chart I-8 exhibits the relative Composite Valuation Indicator for EM relative to DM. For EM, it is the same as in Chart I-5 and for DM we use an identical measure. When discussing equity valuations, one should now distinguish between growth and value stocks. EM growth stocks are grossly overvalued as shown in the top panel of Chart I-9. EM value stocks are close to their fair value, i.e., they are not cheap (Chart I-9, bottom panel). Chart I-8EM Versus DM: Relative Equity Multiples Chart I-9Multiples For EM Growth And Value Stocks A caveat is in order: all of these CVIs do not incorporate interest rates into valuation models. We look at equity multiples in the context of low interest rates in the sections that follow. Incorporating Interest Rates Into Equity Valuations Chart I-10EM Earnings Yields Adjusted For Local Bond Yields There are various ways to incorporate interest rates/the discount factor into equity valuations. One way is to calculate the difference between forward earnings yield (EY) and long-term bond yields. We use forward EY because trailing EPS is still depressed by the pandemic-induced economic crash, i.e., trailing P/Es do not provide a true valuation picture. Chart I-10 demonstrates the gap between EM forward EY and 10-year US bond yields (on the top panel) and the same forward EY and EM local bond yields (Chart I-10, bottom panel). Both measures are not far from their historical means. Hence, adjusted for bond yields, EM stocks are fairly valued. That said, there are two pertinent questions that follow from this: (1) how do EM equities compare to their DM peers; and (2) how well have these interest rate-adjusted valuation measures worked in markets where interest rates had dropped to zero. In other words, do near-zero interest rates warrant a secular bull market? We address this last topic in the section below. As to the first question, Chart I-11 presents the forward EY-local interest rate differential for major equity markets. A higher differential presage cheaper equity valuation relative to lower numbers. Chart I-11US And EM Equities Have Been Chronically Expensive Versus European And Japanese Ones According to this measure, Japanese and Euro Area equities have been and remain cheaper than US and EM equities. Chart I-12 ranks all individual EM equity benchmarks as well as major DM bourses based on the differential between forward EY and local nominal bond yields. Stocks in India, Indonesia, South Africa, Turkey, Mexico and Colombia are expensive, adjusted for local bond yields. Chart I-12Cross Country Valuation Ranking: Forward Earnings Yield Minus Local Bond Yields By contrast, equity markets in Central Europe, core Europe and Russia offer better value, relative to domestic bonds. The EM aggregate index, the Chinese investable benchmark and the S&P 500 fall in the middle of this valuation ranking. Bottom Line: Based on equity multiples, EM equities are expensive. However, when adjusted for interest rates, absolute valuation of EM equities is neutral. Relative to DM, the EM equity benchmark is not cheap. In fact, they are more expensive compared to European and Japanese stocks. Equity Valuation When Rates Are At Zero No doubt, equity prices should be re-rated as interest rates drop. However, what should the equilibrium P/E multiple be when interest rates are close to zero? Japan, the euro area and Switzerland offer a roadmap. Chart I-13Japanese And European Stocks Have Not Entered Structural Bull Markets Despite Negative Rates For some time now, these markets have had to process many of the same features that US and global markets are currently facing. Specifically: They have had negative policy rates and 10-year government bond yields for many years. Their central banks have been conducting some sort of QE programs. The Bank of Japan and the Swiss National Bank have been purchasing equities and the ECB has been buying corporate bonds. Finally, onward from 2012 until the eruption of the pandemic, economic growth in Japan, the euro area and Switzerland was decent. Despite negative interest rates, their broad equity markets have failed to break out into a structural bull market. Their stocks have re-rated, but the upside was capped (Chart I-13). Critically, the forward EY differential with their local government bond yields have stayed wide (Chart I-14). Chart I-14Japanese, Euro Area And Swiss Equities Have Not Re-Rated Despite Negative Bond Yields In sum, the experiences of Japanese, Swiss and other European markets show that zero or negative interest rates alone did not compel a secular bull market in share prices. Rather, equity re-rating in these bourses has been relatively moderate. Investment Considerations The Blue Wave is very bearish for the greenback as we argued above. This development has reduced our conviction regarding the magnitude and duration of any near-term US dollar rebound. It has in fact reinforced our medium- to long-term negative US dollar view. Potential EM currencies that investors should consider buying on a dip versus the US dollar are MXN, SGD, KRW, TWD, CNY, INR and CZK. For now, we continue to recommend a neutral allocation to EM equities and credit within global equity and credit portfolios, respectively. However, we note that odds of EM outperformance have risen with the Blue Wave in the US and ensuing US dollar depreciation. Yet, Europe and Japan presently offer a better risk/reward profile than EM. However, to reflect our strong conviction of a breakdown in US relative performance and a more upbeat view on EM versus US stocks, we recommend the following trade/strategy: long EM stocks / short the S&P 500, currency unhedged. Concerning the absolute performance of EM and DM stocks, they are very overbought, reasonably expensive and sentiment is very bullish. In normal times, this would argue for a pullback. For example, Chart I-15 shows that a rollover in the inverted US equity put-call ratio typically heralds a setback in the S&P500. Chart I-15A Red Flag? Do Indicators No Longer Work? However, if global stocks are moving from a FOMO stage to a mania phase, many traditional relationships and indicators might not work. This and the fact the EM equity index is at a critical juncture entails its outlook is currently highly uncertain – odds of a breakout (FOMO evolving into a mania) and a potential setback are equal. Finally, some housekeeping, we are closing the long Chinese Investable stocks / short Korean stocks recommendation. This trade has generated a massive loss of 33.5% as the KOSPI has taken off in recent weeks. We continue to overweight both Chinese and Korean equities within an EM equity portfolio. We will likely make changes to our recommended country allocations within equity and fixed-income portfolios in the coming weeks. Stay tuned. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1 The Sentix Asset Classes Sentiment Emerging Markets Equities Index is polled among 5,000 European individual and institutional investors. In the survey, investors are asked about their medium-term price expectations for the asset class. Source: SENTIX. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights 2021 Model Bond Portfolio Broad Allocations: Translating our 2021 global fixed income Key Views into recommended positioning within our model bond portfolio results in the following conclusions: target a relatively aggressive level of overall portfolio risk, while maintaining a moderately below-benchmark duration exposure alongside overweight allocations to lower-quality global corporate credit, and inflation-linked debt, versus nominal government bonds. Specific Allocation Changes: We are increasing credit spread risk in the US by upgrading our recommended overall US high-yield allocation to overweight, focused on B- and Caa-rated credit tiers, while downgrading US investment grade corporates to neutral. We are also reducing the size of our underweights in euro area corporates and shifting the overall allocation to emerging market USD-denominated credit to overweight. Feature Happy New Year! Just before our holiday break last month, we published our 2021 “Key Views” report, outlining the thematic implications of the BCA 2021 Outlook for global bond markets.1 In this follow-up report, we translate those themes into specific investment recommendations and changes to the allocations in the Global Fixed Income Strategy (GFIS) model bond portfolio. The main takeaways are that the expected global backdrop of improving economic growth momentum, a reduction in coronavirus uncertainty as vaccines are distributed, highly accommodative monetary policy and a weakening US dollar will all provide an additional reflationary lift to global financial markets after a strong H2/2020. That means moderately higher global government bond yields (led by US Treasuries) along with outperformance of growth-related spread product like corporate bonds – specifically in the riskier credit segments like US high-yield and emerging markets (Table 1). Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months A Review Of The 2020 Model Bond Portfolio Performance Before we look ahead to discuss the details of the changes to our model bond portfolio for 2021, we need to take a final look back at the performance of the portfolio in 2020. Chart 12020 Performance: A Positive Year After A Volatile Start Last year, the model bond portfolio delivered a total return (hedged into US dollars) of 5.9%, which outperformed its custom benchmark index by +20bps (Chart 1).2 That moderately solid return was not delivered without some volatility over the course of the year, particularly during the global market tumult last February and March. Over the full year, the government bond portion of the portfolio underperformed the custom benchmark index by -70bps while the spread product segment outperformed by +90bps. The government bond underperformance occurred entirely in the first quarter of the year, as we began 2020 with a recommended below-benchmark global duration stance and an underweight overall allocation to government bonds versus spread product. For a portfolio that is intended to reflect our strategic investment recommendations, the COVID-19 market volatility in Q1/2020 forced us to change our allocations more frequently and aggressively than usual. In early March, we moved to an overweight recommendation on government bonds and underweight on spread product (particular corporate debt) while also shifting the portfolio duration to above-benchmark. That was a large flip from a pro-risk portfolio construction to a defensive one, but which helped claw back some of the severe underperformance in the month of February as government bonds yields plunged and corporate credit spreads surged higher. After the dramatic easing of monetary policy by the major global central banks in March, most notably the US Federal Reserve’s decision to begin buying corporate bonds, we reverted back to a pro-risk stance by upgrading US investment grade credit and Ba-rated high-yield to overweight – positions that were maintained for the rest of 2021. Those US corporate bond exposures alone accounted for essentially all of the spread product outperformance of our model bond portfolio in 2020 (Table 2). Table 2GFIS Model Bond Portfolio Full Year 2020 Overall Return Attribution In terms of specific country exposures (Chart 2), our underweight stance on US Treasuries (both in allocation and duration exposure) early in 2020 severely hurt the government bond portion of the portfolio (-76bps of underperformance versus the benchmark). This dwarfed the 2020 outperformance from other countries like Italy (+11bps), Japan (+17bps), and the UK (+5bps). Importantly, our move to allocate out of nominal government bonds to inflation-linked debt in the US, Italy and Canada back in June was a positive contributor on the year, boosting the overall portfolio outperformance by a combined +25bps. Chart 2GFIS Model Bond Portfolio Full Year 2020 Government Bond Performance Attribution Within spread product (Chart 3), the biggest gains outside of US investment grade came from UK investment grade (+18bps), euro area investment grade (+12bps) and US CMBS (+11bps). The biggest drags on performance came from underweights in euro area high-yield (-23bps) and US B-rated high-yield (-17bps), as we maintained a relatively cautious stance on those sectors even during the sharp rally in the latter half of 2020 given the lingering risks from COVID-19 and US election year uncertainty. In the end, 2020 proved to be an outstanding year for taking any kind of credit risk, as the majority of spread product sectors in our model bond portfolio universe strongly outperformed government debt. Chart 3GFIS Model Bond Portfolio Full Year 2020 Spread Product Performance Attribution By Sector In the end, 2020 proved to be an outstanding year for taking any kind of credit risk, as the majority of spread product sectors in our model bond portfolio universe strongly outperformed government debt (Chart 4). Given our overweight stance toward credit, the year ended on a strong note, with the portfolio delivering +16bps of outperformance in Q4/2020 – the details of which can be found in the Appendix on pages 19-23. Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In 2020 Top-Down Bond Market Implications Of Our Key Views As a reminder, the main fixed income investment themes from our 2021 Key Views report were the following: Global growth will accelerate over the course of 2021 as COVID-19 vaccines are distributed and economic confidence improves in response. Longer-term global nominal bond yields should see some upward pressure as growth picks up, with US Treasury yields rising the most. Global real bond yields will stay deeply negative with on-hold central banks actively seeking an inflation overshoot. The US dollar will remain soft in 2021, providing an additional reflationary impulse to the global economy. Lower-quality global credit should outperform against a backdrop that will prove positive for risk assets: easy money policies, improving growth momentum and a reduction in virus-related uncertainty. We now present the specific fixed income investment recommendations that derive from those themes, described along the following lines: overall portfolio risk, overall duration exposure, country allocations within government bonds, yield curve allocations within countries, and corporate credit allocations by country and credit rating. Overall Portfolio Duration Exposure: MODERATELY BELOW BENCHMARK Our Global Duration Indicator, comprised of leading economic growth variables, is already signaling that the direction of global bond yields will be higher in 2021 (Chart 5). Successful distribution of COVID-19 vaccines should eventually add additional upward momentum to global growth as confidence improves later in the year. Even if the vaccine rollout does not go as smoothly as expected, that would put pressure for fiscal stimulus policy responses – especially in the US - that can help sustain economic recoveries. Chart 5Global Bond Yields Will Drift Higher In 2021 Chart 6Stay Below-Benchmark On Overall Duration Exposure However, with major central banks like the Fed and ECB likely to keep policy rates unchanged in 2021, so as not to impede a recovery in inflation, any upward lift to bond yields will be moderate and driven overwhelmingly by rising longer-term inflation expectations and not a repricing of future monetary policy tightening. That means developed market yield curves should bearishly steepen, in general, as front-end yields remain anchored. We shifted to a below-benchmark overall portfolio duration stance back at the end of last October, equal to just over 0.5 years of duration versus the custom benchmark index (Chart 6). We are comfortable maintaining that position, in that size, while maintaining a bearish steepening bias to yield curve exposure across all countries in the model portfolio. Government Bond Country Allocation: OVERWEIGHT LOW YIELD BETA MARKETS, OVERWEIGHT PERIPHERAL EUROPE, UNDERWEIGHT THE US In more normal times, we would let our expectations of monetary policy changes guide our recommended government bond country allocations. Yet in 2021, we see almost no chance for any meaningful change in the monetary policy bias of any developed market central bank. Thus, we continue to rely on a “yield beta” framework for making fixed income country allocation decisions in our model bond portfolio. In 2021, we see almost no chance for any meaningful change in the monetary policy bias of any developed market central bank. We expect the largest increase in developed market bond yields in 2021 to occur in the US, thus we recommend favoring countries that have a lower sensitivity to changes in US Treasury yields (i.e. the “yield beta”). The obvious candidates are government bonds in Japan and core Europe, where inflation expectations are likely to see less upward pressure than in the US – especially if the US dollar weakens further (Chart 7). Thus, we begin 2021 by maintaining our existing overweight positions in Germany and France. Chart 7Favor Government Bond Markets Less Correlated To UST Yields In 2021 The UK has been transitioning from a high-beta to low-beta bond market in recent years and we do not see that trend turning in 2021. The Bank of England (BoE) will maintain a dovish policy bias this year as the UK economy begins adjusting to the post-Brexit world and a stronger pound will dampen inflation pressures. We also begin 2021 by staying overweight UK gilts in our model portfolio. We anticipate that the Italy-Germany government bond spread will converge to the lower Spain-Germany spread in 2021. Chart 8Stay Overweight Italian Government Bonds Australia and Canada are two countries where a high yield beta to US Treasuries would make them ideal underweight candidates in a global bond portfolio this year. However, the Reserve Bank of Australia (RBA) and Bank of Canada (BoC) have instituted aggressive quantitative easing (QE) programs that are designed to dampen increases in government bond yields. As a result of these opposing forces on Australian and Canadian bond yields, we begin 2021 with a neutral allocation to both countries. However, we may shift either or both to an underweight stance if we sense any wavering of the commitment of the RBA or BoC to their QE programs amid improving economic growth. We also expect further declines in the risk premia for Italian government bond yields in 2021. The combination of aggressive ECB government bond purchases, which includes greater buying of BTPs than in years past, and signs of a somewhat more supportive backdrop of fiscal unity within the European Union (the €750bn Recovery Fund) reduce both the sovereign credit risk and “redenomination risk” of a potential euro breakup. We anticipate that the Italy-Germany government bond spread will converge to the lower Spain-Germany spread in 2021 – an outcome that last occurred in 2016 (Chart 8). We are not only maintaining our long-held overweight stance on Italy in our model portfolio, we are increasing the size of the allocation to begin 2021. Inflation-Linked Bond Allocations: MAINTAIN EXPOSURE IN THE US, ITALY AND CANADA; ADD A NEW ALLOCATION TO FRANCE Chart 9Stay Overweight Global Inflation-Linked Bonds Inflation-linked bonds had a strong relative performance versus nominal government debt across the developed markets during the second half of 2020, with breakevens widening even in countries with low realized inflation like France and Australia. Dovish central banks, the reflationary impacts of rising commodity prices (also fueled by US dollar weakness), and the V-shaped recovery in global economic growth from the 2020 COVID-19 recession have all played a role in helping lift breakevens from the depressed levels seen last spring. None of those factors is expected to change during at least the first half of 2021, thus allocations to inflation-linked bonds are still justified in several countries. We are adding a new position in French inflation-linked bonds versus nominal French bonds with breakevens below our model-implied fair value. Our fair value models for 10-year inflation breakevens show that valuations are no longer unequivocally cheap in most countries, but only in Australia do breakevens look much too high relative to underlying fundamental drivers (Chart 9). US TIPS breakevens are approaching levels that would appear “expensive”, defined as at least one standard deviation above fair value, but we still see additional upside as the model implied fair value is also rising. We currently have recommended allocations to inflation-linked bonds in the US, Italy and Canada in our model portfolio, and we are maintaining those positions as we begin 2021. We are adding a new position in French inflation-linked bonds versus nominal French bonds with breakevens below our model-implied fair value. Spread Product Allocation: OVERWEIGHT GLOBAL CORPORATES VERSUS GOVERNMENT BONDS, FOCUSED ON US HIGH-YIELD AND EM Our expectation of a combination of improving global economic growth and persistent reflationary monetary policies is a very positive backdrop for global spread product, most notably corporate bonds. However, valuations across the global corporate debt spectrum are not universally cheap after the strong H2/2020 performance. Thus, we are maintaining only a moderate overall overweight stance on spread product versus government bonds in our model bond portfolio, equal to 5% of the portfolio (Chart 10). At the same time, we recommend taking more relative spread risk within that moderate overweight allocation. This is the way we are balancing the competing forces of a pro-risk backdrop and increasingly stretched valuations in many sectors. The biggest change we are making to the credit side of our model bond portfolio is downgrading US investment grade corporate exposure to neutral while upgrading US high-yield to overweight. As we discussed in our 2021 Key Views report, spread valuation measures are more stretched for higher-rated US investment grade corporate debt compared to junk bonds. Chart 10A Moderate Recommended Overweight To Global Spread Product In 2021 Combined with a monetary liquidity backdrop that supports the performance of riskier assets like high-yield (Chart 11), we anticipate that US high-yield will be a relatively strong performer within the US credit markets in 2021. Chart 11Upgrade Lower Rated US High-Yield To Overweight When looking at the relationship between spread valuation (using our preferred metric of 12-month breakeven spreads) and risk (using a standard measure like duration-times-spread), the lower rated credit tiers of US high-yield stand out as having the most attractive risk/valuation tradeoff (Chart 12). Thus, we are focusing our shift to an overweight stance on US high-yield in our model bond portfolio by increasing the allocations to the B-rated and Caa-rated tiers. Chart 12Comparing Value (Breakeven Spreads) With Risk (Duration Times Spread) Outside the US, we are also adding additional spread product exposure by increasing the weightings to euro area high-yield and emerging market USD-denominated sovereign debt. However, we are still maintaining a relatively higher allocation to US high-yield over euro area equivalents, and emerging market USD-denominated corporate debt over sovereigns. The biggest change we are making to the credit side of our model bond portfolio is downgrading US investment grade corporate exposure to neutral while upgrading US high-yield to overweight. Finally, we are entering 2021 with the same relative tilt within US mortgage-backed securities (MBS) we maintained during the latter half of 2020, with an overweight stance on agency commercial MBS and an underweight on agency residential MBS. Overall Portfolio Risk: AGGRESSIVE The net impact of all the changes made to our portfolio allocations is to boost the estimated tracking error – the relative portfolio volatility versus that of the benchmark – from 31bps to 73bps (Chart 13). This is a significant increase in the usage of our portfolio “risk budget”, but the tracking error is still below our self-imposed limit of 100bps. Chart 13Taking A More Aggressive Posture On Overall Portfolio Risk Chart 14Boosting Portfolio Yield Through Selective Overweights After maintaining a cautious stance on overall portfolio risk levels in the latter half of 2020, given the persistent uncertainties over the spread of COVID-19 and the US presidential election, we now deem it appropriate to be more aggressive within our model bond portfolio allocations. The pro-risk positioning changes will also boost the overall yield of the model bond portfolio. The greater allocations to riskier spread product sectors leave the portfolio with a yield that begins 2021 modestly higher than that of the benchmark index (Chart 14). Portfolio Scenario Analysis For The Next Six Months After making the shifts to our model bond portfolio allocations, which can all be seen in the tables on pages 24-25, we now turn to scenario analysis to determine the return expectations for the portfolio for the first half of 2021. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes Table 2BEstimated Government Bond Yield Betas To US Treasuries On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 2A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 2B). For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios, based on the following descriptions and inputs: Base Case The current surge of global COVID-19 cases gives way to increased distribution of vaccines. The result is a steady improvement in global growth. Some additional fiscal stimulus is delivered in the US and the larger countries of Europe. Central banks keep their foot on the monetary accelerator with realized inflation moving only modestly higher. The US Treasury curve bear steepens as US inflation expectations continue drifting higher. The VIX index reaches 23, the US dollar depreciates by -5%, oil prices climb +10% and the fed funds rate remains at 0%. Optimistic Scenario The global distribution of COVID-19 vaccines goes smoothly and rapidly, while the current surge in COVID-19 cases fades in the early weeks of 2021. Global growth quickly accelerates on the back of soaring consumer & business confidence. Global fiscal stimulus surprises to upside, while central banks remain super-dovish even as inflation perks up. The US Treasury curve bear-steepens substantially as US inflation expectations steadily increase. The VIX index falls to 18, the US dollar depreciates by -10% in a pro-risk/pro-growth move, oil prices climb +20% and the fed funds rate remains at 0%. Pessimistic Scenario The vaccine rollout is slower than expected, with COVID-19 restrictions remaining in place for longer. Policymakers deliver inadequate new fiscal and monetary stimulus measures to support underwhelming growth. The US Treasury curve bull-flattens as US inflation breakevens plunge. The VIX index soars to 35, the US dollar appreciates by +5%, oil prices plunge -20% and the fed funds rate remains at 0%. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A. The US Treasury yield assumptions are shown in Table 3B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 15 and Chart 16, respectively. Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis Chart 15Risk Factor Assumptions For The Scenario Analysis Chart 16US Treasury Yield Assumptions For The Scenario Analysis The model bond portfolio is expected to deliver an excess return over its performance benchmark during the next six months of +50bps in the base case and +78bps in the optimistic scenario, but is projected to underperform by -37bps in the pessimistic scenario. These are larger expected relative returns than witnessed during the latter half of 2020, consistent with the larger tracking error we are taking entering 2021. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, "2021 Key Views: Vaccination, Reflation, Rotation," dated December 17, 2020, available at gfis.bcarsearch.com. 2 Our model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt and USD-denominated emerging market debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. Appendix Appendix Chart 1Q4/2020 GFIS Model Bond Portfolio Performance Appendix Table 1GFIS Model Bond Portfolio Q4/2020 Overall Return Attribution Appendix Chart 2GFIS Model Bond Portfolio Q4/2020 Government Bond Performance Attribution Appendix Chart 3GFIS Model Bond Portfolio Q4/2020 Spread Product Performance Attribution By Sector Appendix Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio In Q4/2020 Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns