Inflation/Deflation
Highlights Historically, when global growth picks up, the yen weakens. But this is less likely in an environment where global yields remain anchored at low levels. Meanwhile, there is rising risk that consumption in Japan will remain muted. This will limit any pickup in domestic inflation. A modest rise in real rates will lead to a self-reinforcing upward spiral for the yen. That said, cheap yen valuations will buffet Japanese exports. Go short USD/JPY with an initial target of 100. Feature Chart I-1Higher Volatility, Higher Yen The powerful bounce in global markets since the March lows is at risk of a bigger technical correction. As we enter the volatile summer months, it may only require a small shift in market sentiment to trigger this reversal. The yen has tended to strengthen when market volatility rises (Chart I-1). Should this happen, it will provide the necessary catalyst for established long yen positions. On the other hand, if risk sentiment stays ebullient, the yen will surely weaken on its crosses but can still strengthen vis-à-vis the dollar. This places short USD/JPY bets in an enviable “heads I win, tails I do not lose too much” position. Growth And Monetary Policy Like most other economies, Japan entered a recession in the first quarter of this year, with GDP contracting at a 2.2% annualized pace. For the private sector, this is the worst growth rate since the Fukushima crisis in 2011. This is particularly significant, since the structural growth rate of the economy has fallen below interest rates. Going back to Japan’s lost decades, where private sector GDP growth averaged well below nominal rates (due to the zero bound), it is particularly imperative that Japan exits this liquidity trap in fast order (Chart I-2). A strong yen back then, on the back of deficient domestic demand, led to a self-fulfilling deflationary spiral. Chart I-2The Story Of Japan In One Chart The Bank of Japan began to acknowledge this problem with the end of the Heisei era1 last year. For example, with the BoJ owning almost 50% of outstanding JGBs, the supply side puts a serious limitation on how much more stimulus the BoJ can provide. The yen has become extremely sensitive to shifts in the relative balance sheets between the Federal Reserve and the BoJ. If the BoJ continues to purchase securities at the current pace, then the rate of expansion in its balance sheet will severely lag behind the Fed, and could trigger a knee-jerk rally in the yen (Chart I-3). Chart I-3The Yen And QE Inflation And The 2% Target The US is a much more closed economy than Japan, and has not been able to maintain a 2% inflation rate since the Global Financial Crisis. This makes the BoJ’s target of 2% a pipe dream for any timeline in the near future. There are three key variables the authorities pay attention to for inflation: Core CPI, the GDP deflator and the output gap. All three indicators point towards deflationary pressures, with the recent slowdown in the global economy exacerbating the trend. In fact, since the financial crisis, prices in Japan have only been able to really rise during a tax hike (Chart I-4). Always forgotten is that the overarching theme for prices in Japan is a rapidly falling (and ageing) population, leading to deficient demand. The overarching theme for prices in Japan is a rapidly falling (and ageing) population, leading to deficient demand. More importantly, almost 50% of the Japanese consumption basket is in tradeable goods, meaning domestic inflation is as much driven by the influence of the BoJ as it is by globalization. Even for domestically-driven prices, an ageing demographic that has a strong preference for falling prices is a powerful conflicting force. For example, over the years, a strong voting lobby has been able to advocate for lower telecom prices, which makes it difficult for the BoJ to re-anchor inflation expectations upward (Chart I-5). Chart I-4Japan CPI At A Glance Chart I-5Strong Deflationary Pressures In Japan Meanwhile, the BoJ understands that it needs domestic banks to expand the credit intermediation process if any inflation is to take hold. Unfortunately, the yield curve control strategy and negative interest rates have been anathema for Japanese net interest margins and share prices (Chart I-6). This puts the BoJ in a precarious balance between trying to stimulate the economy further and biting the hand that will feed a pickup in inflation. Chart I-6Point Of No Return For Japanese Banks? Japanese Consumption And Fiscal Policy The consumption tax hike last year delivered a severe punch to aggregate demand in Japan. COVID-19 has dealt a fatal blow. In prior episodes of the tax hikes, it took around three to four quarters for growth to eventually bottom. This suggests that a protracted slowdown in Japanese consumption is a fait accompli (Chart I-7). Foreign and domestic machinery orders are slowing, employment growth has gone from over 2% to free fall and the availability of jobs relative to applicants has reversed a decade-long rising trend. The Abe government has passed an additional 117 trillion yen of fiscal stimulus. With overall fiscal announcements near 40% of GDP, could this fully plug the spending gap? Not quite. The consumption tax hike last year delivered a severe punch to aggregate demand in Japan. First, as is usually the case with Japanese stimulus announcements, the timeframe is uncertain for when the funds will be deployed. It could be one year or ten years. Chart I-7A V-Shaped Recovery Might Stall Chart I-8More Jobs, More Savings Second, Japanese consumption has been quite weak for some time. Despite relatively robust economic conditions since the Fukushima disaster, Japanese consumption has trended downward. The reason is that government spending triggered a rise in private savings, because of expectations of higher taxes. In other words, the savings ratio for workers has surged. If consumers were not willing to spend prior to COVID-19 due to Ricardian equivalence,2 they are unlikely to do so with much higher fiscal deficits (Chart I-8). Some of the government’s outlays will certainly go a long way to boosting aggregate demand, since the fiscal multiplier tends to be much larger in a liquidity trap. This will especially be the case for increased social security spending such as child education, construction activity or the move towards promoting cashless transactions (with a tax rebate). However, there are important near-term offsets. In particular, the postponement of the Olympics will continue to be a drag on Japanese construction activity, and the labor (and income) dividend from immigration has practically vanished. The important tourism industry that faced sudden death will only recover slowly. This suggests a much more protracted recovery in many nuggets of Japanese activity. The Yen As A Safe Haven Real interest rates are already higher in Japan, well before any of the above factors began to meaningfully generate a deflationary impulse. As such, the starting point for yen long positions is already favorable (Chart I-9). Real interest rates are already higher in Japan, well before any of the above factors began to meaningfully generate a deflationary impulse. With global growth bottoming, a continued rise in global equity markets is a key risk to our scenario. However, if inflows into Japan accelerate on cheap equity valuations, the propensity of investors to hedge these purchases will be much less today, given how cheap the yen has become. This is especially important since in an era of rising budget deficits, balance of payments dynamics can resurface as the key driver of currencies. This suggests the negative yen/Nikkei correlation will continue to weaken, as has been the case in recent quarters. Chart I-9Real Rates And The Yen Chart I-10USD/JPY And DXY Are Positively Correlated As a low-beta currency, our contention is that the yen will surely weaken on its crosses, but could strengthen versus the dollar. The yen rises versus the dollar not only during recessions, but during most episodes of broad dollar weakness (Chart I-10). This places short USD/JPY trades in an envious “heads I win, tails I do not lose too much” position. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 The Heisei era refers to the period of Japanese history corresponding to the reign of Emperor Akihito from 8 January 8th, 1989 until his abdication on April 30th, 2019. 2 Ricardian equivalence suggests in simple terms that public sector dissaving will encourage private sector savings. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been robust: Nonfarm payrolls increased by 2.5 million in May after declining by a record 20.7 million in April. This was better than expectations of an 8 million job loss. The unemployment rate fell from 14.7% to 13.3%. The NFIB business optimism index increased from 90.9 to 94.4 in May. Headline consumer price inflation fell from 0.3% to 0.1% year-on-year in May. Core inflation fell from 1.4% to 1.2%. Initial jobless claims increased by 1542K for the week ended June 5th. The DXY index fell by 1.3% this week. On Wednesday, the Fed left interest rates unchanged, with a signal that rates might not be increased before the end of 2022. The Fed also stated that it will maintain the current pace of Treasuries and mortgage-backed securities purchases, at minimum. Report Links: DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been improving: The Sentix investor confidence index improved from -41.8 to -24.8 in June. Employment increased by 0.4% year-on-year in Q1. GDP contracted by 3.1% year-on-year in Q1. The euro appreciated by 1.2% against the US dollar this week. At an online seminar held this week, Isabel Schnabel, member of the executive board of the ECB, noted that "evidence is increasingly pointing towards a protracted impact of the crisis on both demand and supply conditions in the euro area and beyond" and that the current PEPP remains appropriate in de aling with the global recession. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: The coincident index fell from 88.8 to 81.5 in April. The leading economic index also decreased from 85.1 to 76.2. The current account surplus shrank from ¥1971 billion to ¥262.7 billion in April. Annualized GDP fell by 2.2% year-on-year in Q1. Machine tool orders plunged by 52.8% year-on-year in May, following a 48.3% decrease the previous month. The Japanese yen appreciated by 2.6% against the US dollar this week. According to a Bloomberg survey, the majority of economists believe that the BoJ has done enough to cushion the economy, and expect the BoJ to leave current monetary policy unchanged next week. We continue to recommend the yen as a safe-haven hedge, especially given a possible second wave of COVID-19. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: Halifax house prices increased by 2.6% year-on-year in May. Retail sales surged by 7.9% year-on-year in May, up from 5.7% the previous month. GfK consumer confidence was little changed at -36 in May. The British pound rose by 1% against the US dollar this week. On Wednesday, BoE governor Andrew Bailey noted that easing lockdown restrictions has been fueling a recovery in the UK, which could be faster than previously anticipated. Our long GBP/USD and short EUR/GBP positions are 4% and 0.2% in the money, respectively. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: The NAB business confidence index increased from -45 to -20 in May. The business conditions index also ticked up from -34 to -24. The Westpac consumer confidence index increased from 88.1 to 93.7 in June. Home loans declined by 4.8% month-on-month in April, down from a 0.3% increase the previous month. That said, expectations were for a fall of 10%. AUD/USD was flat this week. While the RBA has other options in its policy toolkit to combat the global recession, negative interest rates is still on the table and hasn't been totally ruled out. We remain positive on the Australian dollar both against the US dollar and the New Zealand dollar due to cheap valuations and increasing Chinese stimulus. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mixed: Manufacturing sales declined by 1.7% quarter-on-quarter in Q1, down from a 2.8% increase the previous quarter. ANZ business confidence increased from -41.8 to -33 in June. The activity outlook index also ticked up from -38.7 to -29.1. The New Zealand dollar appreciated by 0.8% against the US dollar this week. RBNZ's Deputy Governor Geoff Bascand said that house prices in New Zealand could fall by 9-10% or even worse. Besides disrupting exports and imports for a trade-reliant country like New Zealand, the global health crisis is also likely to further reduce immigration to New Zealand, curbing housing demand. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been positive: The unemployment rate ticked up from 13% to 13.7% in May, versus expectations of a rise to 15%, but this was due to a rise in the participation rate from 59.8% to 61.4%. Average hourly wages increased by 10% year-on-year in May. Net employment increased by 289.6K, up from a 1994K job loss the previous month. Housing starts increased by 193.5K in May, up from 166.5K the previous month. The Canadian dollar fell by 0.2% against the US dollar this week. The labor market has seen some recovery in May with the gradual easing of COVID-19 restrictions and re-opening of the economy. Employment rebounded and absences from work dropped. Notably, Quebec accounts for nearly 80% of overall employment gains in May. Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There was scant data out of Switzerland this week: FX reserves increased from CHF 801 billion to CHF 816 billion in May. The unemployment rate increased from 3.1% to 3.4% in May, lower than the expected 3.7%. The Swiss franc appreciated by 2.3% against the US dollar this week, reflecting a flight back to safety amid concerns over political risks and a second wave of COVID-19. While the euro has been strong recently and EUR/CHF touched 1.09, the franc has lost most of those gains. We are lifting our limit buy on EUR/CHF to 1.055 on expectations we are in a run-of-the-mill correction. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: Manufacturing output shrank by 1.6% month-on-month in April. PPI fell by 17.5% year-on-year in May. Headline consumer prices increased by 1.3% year-on-year in May, up from 0.8% the previous month. Core inflation also increased from 2.8% to 3% in May. The Norwegian krone fell by 1.5% against the US dollar this week. The recent OPEC meeting over the weekend concluded that all members agreed to the extension to curb oil production. We believe that oil prices will continue to recover, and recommend to stay long the Norwegian krone. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mixed: Household consumption plunged by 10% year-on-year in April. The current account surplus increased from SEK 43.2 billion to SEK 80.6 billion in Q1. Headline consumer prices recovered from a 0.4% year-on-year decline to flat in May. The Swedish krona increased by 0.6% against the US dollar this week. Sweden is benefitting economically from a less stringent Covid-19 agenda. With very cheap valuations, we remain short EUR/SEK and USD/SEK. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Please note that yesterday we published Special Report on Egypt recommending buying domestic bonds while hedging currency risk. Today we are enclosing analysis on Hungary, Poland and Colombia. I will present our latest thoughts on the global macro outlook and implications for EM during today’s webcast at 10 am EST. You can access the webcast by clicking here. Yours sincerely, Arthur Budaghyan Hungary Versus Poland: Mind The Reversal Conditions are set for the Hungarian forint to outperform the Polish zloty over the coming months. We recommend going long the HUF against the PLN. Hungarian opposition parties criticized the government about the considerable depreciation in the forint. As a result, we suspect that political pressure from Prime Minister Viktor Orban led monetary authorities to alter their stance since April. Critically, the main architect of super-dovish monetary policy Marton Nagy resigned from the board of the central bank on May 28. In line with tighter liquidity, interbank rates have risen above the policy rate. This is marginally positive for the forint. The Hungarian central bank (NBH) tweaked its monetary policy in April after the currency had plunged to new lows against the euro, underperforming its Central European counterparts. The NBH widened its policy rate corridor by hiking the upper interest band to 1.85% and keeping the policy rate at 0.90%. The wider interest rate corridor makes it more costly for commercial banks to borrow reserves from the central bank. Hence, such liquidity tightening is positive for the forint. For years, Hungary was pursuing a super-easy monetary policy and consumer price inflation rose to 4% (Chart I-1). With the NBH keeping interest rates close to zero, real rates have plunged well into negative territory (Chart I-2, top panel). Chart I-1Hungary: Inflation Could Pause For Now Chart I-2Hungary Vs. Poland: Real Rates Reversal Is Coming In brief, the central bank has been behind the inflation curve. As a result, the forint has been depreciating against both the euro and its central European peers. In such a situation, the key to reversal in the exchange rate trend would be the monetary authority’s readiness to raise real interest rates. The NBH has made a small step in this direction. Going forward, the central bank will be restrained in its quantitative easing (QE) program and will not augment it any further. So far, QE uptake has been slow: around half out of the available HUF 1,500 billion has been tapped by commercial banks and corporates. Importantly, the NBH announced its intention to sterilize its government and corporate bond purchases. Already, the commercial banks excess reserves at the central bank have fallen to zero, which suggests that liquidity is no longer abundant in the banking system (Chart I-3). In line with tighter liquidity, interbank rates have risen above the policy rate. This is marginally positive for the forint. Hungarian authorities have become more cognizant of the economic and financial risks associated with their ultra-accommodative policies. For instance, they initiated a clampdown on real estate speculation, which is leading to dwindling real estate prices. This will lead to a decline in overall inflation expectations and, thereby, lift expected real interest rates. The open nature of Hungary’s economy – whereby exports of goods and services constitute 85% of GDP - makes it much more sensitive to pan-European tourism and manufacturing cycles. With the collapse in its manufacturing and tourism revenues, wage growth in Hungary is bound to decelerate rapidly (Chart I-4). Chart I-3Hungary: Central Bank Has Drained Liquidity Chart I-4Economic Growth: Hungary Is More Vulnerable Than Poland Rapidly deteriorating wage and employment dynamics reduces the odds of an inflation breakout anytime soon. This will cool down inflation and, thereby, increase real rates on the margin. The central bank in Poland will stay super accommodative while the National Bank of Hungary will be a bit less aggressive. Bottom Line: Although this monetary policy adjustment does not entail the end of easy policy in Hungary, generally, it does signal restraint on the part of monetary authorities resulting from a much reduced tolerance for currency depreciation. This creates conditions for the forint to outperform. Poland In the meantime, Polish monetary authorities have switched into an ultra-accommodative mode. Recent policy announcements by the National Bank of Poland (NBP) represent the most dramatic example of policy easing in Central Europe. Such a policy stance in Poland will produce lower real rates than in Hungary, which is negative for the Polish zloty against the forint. The NBP is set to finance the majority of a new 11% of GDP fiscal spending program enacted by the government amid the COVID-19 lockdowns. This amounts to de-facto public debt and fiscal deficit monetization. The latter will not be sterilized unlike in Hungary and will therefore lead to an excess liquidity overflow in the banking system. The Polish central bank has cut interest rates by 140 bps to 10 bps since March. Pushing nominal rates down close to zero has produced more negative real policy rates than in Hungary (Chart I-2, top panel on page 2). Also, Polish prime lending rates in real terms have fallen below those in Hungary (Chart I-2, bottom panel). Chances are that inflation in Poland will also prove to be stickier than in Hungary due to the minimum wage raise at the beginning of the year and very aggressive fiscal and monetary stimulus since the pandemics has erupted (Chart I-5). Critically, the Polish economy is much less open than Hungary’s, and it is therefore less vulnerable to the collapse of pan-European manufacturing and tourism. This will ensure better employment and wage conditions in Poland. All in all, Poland’s final demand outperformance, versus Hungary, will contribute to a higher rate of inflation there. Bottom Line: The central bank in Poland will stay super accommodative while the National Bank of Hungary will be a bit less aggressive. This is producing a U-turn in both countries’ nominal and relative real interest rates, which heralds a reversal in the HUF / PLN cross rate (Chart I-6). Chart I-5Polish Inflation Will Be Sticker Than In Hungary Chart I-6Go Long HUF / Short PLN Investment Strategy For Central Europe A new trade: go long the HUF versus the PLN. Take a 3% profit on the short HUF and PLN / long CZK trade. Close the short IDR / long PLN trade with a 20% loss. Downgrade central European bourses (Polish, Czech and Hungarian) from an overweight to a neutral allocation within the EM equity benchmark. Lower for longer European interest rates disfavor bank stocks that dominate central European bourses. Andrija Vesic Associate Editor andrijav@bcaresearch.com Colombia: Continue Betting On Lower Rates Colombia has been badly hit by two shocks: the precipitous fall in oil prices and the strict quarantine measures to constrain the spread of the COVID-19 outbreak. An underwhelming fiscal stimulus in response to the lockdowns will further weigh on private demand. An underwhelming fiscal stimulus in response to the lockdowns will further weigh on private demand. We have been recommending receiving 10-year swap rates in Colombia since April 23rd and this strategy remains unchanged: While oil prices seem to have rebounded sharply, they will remain structurally low (Chart II-1). The Emerging Markets Strategy team's view is that oil prices will average $40 per barrel this year and next.1 After the recent rally, chances of further upside in crude prices are limited. Chart II-1A Long-Term Perspective On Oil Prices Table II-1Colombia’s Fiscal Package Is The Lowest In The Region Colombia's high sensitivity to oil prices is particularly visible via its current account balance. Indeed, Colombia’s net crude exports cover as much as 50% of the current account deficit, such that low oil prices severely affect the currency and produce a negative income shock for the economy. Fiscal policy remains unreasonably tight, especially in the face of the global pandemic. The government’s fiscal response plan amounts to only a meagre 1.5% of GDP. This is low not only compared to advanced economies but also to the rest of Latin America (Table II-1). Moreover, President Duque’s administration has been running the tightest fiscal budget in almost a decade, with the primary fiscal balance reaching 1% of GDP before the pandemic. The country’s COVID-19 response has been fast and effective. Colombia has managed to achieve the lowest amount of infections and deaths among major economies in Latin America (Chart II-2). Chart II-2COVID-19 Casualties Across Latin America Duque’s administration has taken a pragmatic approach to handling the pandemic by enforcing strict lockdowns and banning international and inter-municipal travel since late March, only three days after the country’s first casualty. Further, the nationwide confinement measures have been extended until July 1st, with particularly stringent rules applying to major cities. These have helped the country avoid a nation-wide health crisis, but they will engender prolonged economic pain. Regarding monetary stimulus, the central bank (Banrep) has cut interest rates by 150 basis points since March of this year. It also embarked on the first and largest QE program in the region. Banrep has committed to purchase 12 trillion pesos worth of government and corporate securities (amounting to a whopping 8% of GDP). Consumer price inflation is falling across various core measures and will drop below the low end of Banrep’s target range (Chart II-3). This will push the central bank to continue cutting rates. Despite the monetary easing, nominal lending rates are still restrictive. Real lending rates (deflated by core CPI) remain elevated at 7% (Chart II-4). Chart II-3Colombia: Inflation Will Fall Below Target Chart II-4Colombia: Real Lending Rates Are Still High Chart II-5The Colombian Economy Was Already Under Pressure Importantly, there has not been an appropriate amount of credit support and debt waving programs for SMEs, as there has been in many other countries. Given that SMEs employ a large share of the workforce, and that household spending accounts for about 70% of GDP, consumer spending and overall economic growth will contract substantially and be slow to recover. Employment rates had already been contracting, and wage growth downshifting, before the pandemic started (Chart II-5). Household income is now certainly in decline as major cities are in full lockdown and economic activity is frozen. Investment Recommendations Even though we are structurally positive on the country due to its orthodox macroeconomic policies, positive structural reforms, and low levels of debt among both households and companies, we maintain a neutral allocation on Colombian stocks within an EM equity portfolio. This bourse is dominated by banks and energy stocks. The lack of both fiscal support and bank loan guarantees amid the recession means that banks will carry the burden of ultimate losses. They will suffer materially due to loan restructuring and defaults. For fixed income investors, we reiterate our call to receive 10-year swap rates and recommend overweighting local currency government bonds versus the EM domestic bond benchmark. The yield curve is steep and real bond yields are elevated (Chart II-6). Hence, long-term interest rates offer great value. Additional monetary easing, including quantitative easing, will suppress yields much further. Chart II-6A Great Opportunity In Colombian Rates Chart II-7The COP Has Depreciated Considerably We are upgrading Colombia sovereign credit from neutral to overweight within an EM credit portfolio. General public debt (including the central and state governments) stands at 59% of GDP. Conservative fiscal policy and the central bank’s large purchases of local bonds will allow the government to finance itself locally. Presently, 40% of public debt is foreign currency and 60% local currency denominated. As a result, sovereign credit will outperform the EM credit benchmark. In terms of the currency, we recommend investors to be cautious for now. Even though the peso is cheap (Chart II-7), another relapse in oil prices or a potential flare up in social protests could cause further downfall in the currency. Juan Egaña Research Associate juane@bcaresearch.com 1 This differs from the view of BCA’s Commodities and Energy Strategy service. We believe structural forces such as the lasting decline in air travel and commuting will impede a recovery in oil demand while, at the same time, US shale production will rise again considerably if crude prices rise and remain well above $40 Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights Rising Bond Yields: Global risk assets are discounting a V-shaped economic recovery. With economic data starting to revive as more economies emerge from virus-related shutdowns, bond yields are showing signs of following suit. Duration Strategy: Even with global yields showing signs of a cyclical bottom, we continue to recommend a neutral duration stance. Central banks will remain highly accommodative given the lack of inflationary pressures after the deep COVID-19 recessions. There are still significant risks in the coming months from a potential second wave of coronavirus after economies reopen, worsening US-China relations and domestic US sociopolitical turmoil. Duration Proxy Trades: Given those lingering uncertainties, we prefer to focus on “duration-lite” trades in the developed economies, like overweighting inflation-linked government bonds versus nominals as inflation expectations will drift higher over the next 6-12 months. Feature Dear Client, Next week, instead of publishing a regular Weekly Report, we will hold a webcast on Tuesday, June 16 at 10:00 am ET, discussing our latest views on global fixed income markets. The format will be a short presentation, followed by a Q&A session. We hope you will join us, armed with interesting questions. Kind regards, Rob Robis, Chief Fixed Income Strategist Chart of the WeekBond Yields Bottoming, But Backdrop Not Yet Bearish Bond yields around the world awoke from their COVID-19 induced slumber last week, responding to a growing body of evidence indicating that global growth has bottomed. Over a span of four days, benchmark 10-year government bond yields rose in the US (+20bps), Germany (+13bps), Canada (+20bps), China (+14bps), Japan (+4bps), Mexico (+13bps) and the UK (+12bps). There is potential for yields to continue drifting higher over the next few months, as more countries reopen from virus-related shutdowns. The bounce already seen in survey data like manufacturing and services PMIs, as well as economic sentiment measures like the global ZEW index, should soon translate into real improvements in activity data. This comes at a time when rising commodity prices, most notably oil, suggest that depressed inflation expectations can lead bond yields higher. The cyclical bottom for global yields has likely passed, based on the improvement already seen in our own Global Duration Indicator (Chart of the Week). However, economic policy uncertainty remains elevated as devastated economies try to reopen from lockdowns. In addition, our Central Bank Monitors continue to indicate pressure on policymakers to keep interest rates as low as possible to maintain easy financial conditions as easy as possible. Tighter monetary policies remain a distant prospect, given very high unemployment rates. The cyclical bottom for global yields has likely passed, based on the improvement already seen in our own Global Duration Indicator. Amid those uncertainties, we recommend maintaining a neutral strategic (6-12 months) and tactical (0-6 months) stance on overall duration exposure in fixed income portfolios. Instead, we prefer focusing on lower volatility trades that will benefit from improving global growth and policy reflation, like going long inflation-linked bonds versus nominal government debt throughout the developed markets with breakevens looking too low on our models. Why Are Bond Yields Rising Now? We see five main reasons why global bond yields have started to move higher: 1) Investor risk aversion is declining There has been a sharp recovery in global risk appetite since late March, diminishing the demand for risk-free global government debt. In the US, the S&P 500 is up 43% from its March lows, while the NASDAQ index is back to the all-time highs reached before the coronavirus turned into a global pandemic (Chart 2). US corporate debt has also performed well since the March 23rd peak in spreads, with investment grade and high-yield spreads down -227bps and -564bps, respectively. Non-US assets are also flying, with emerging market (EM) equities up 29% and EM USD-denominated corporate debt up 14% in excess return terms over US Treasuries since the March trough. Even severely lagging assets like European bank stocks are showing a pulse, up 38% since the lows of May 15. Commodity prices are also improving, led not only by gains in oil after the April crash by recoveries in the prices of growth-sensitive commodities like copper (+17%) and lumber (+42%). Add it all up, and the message is clear: investors now prefer risk to safety, which has tempered the demand for government bonds. The flipside of the boom in risk appetite is weakening prices for safe haven assets (Chart 3). The price of gold in US dollar terms is down -4% from the 2020 high on May 20, while the euro price of gold is down –6%. Safe haven currencies like the Japanese yen and Swiss franc have underperformed, while interest rate volatility measures like the US MOVE index and long-dated euro swaption volatility are back to the pre-coronavirus lows. Chart 2Risk Assets Are Booming Worldwide Chart 3Safe Haven Trades Losing Luster Add it all up, and the message is clear: investors now prefer risk to safety, which has tempered the demand for government bonds that helped drive yields lower when risk assets were tanking in late February and March. 2) Global growth is improving One of the reasons for the improvement in investor risk appetite is belief that the world economy has exited from the severe COVID-19 global recession. While timely real data is still coming in slowly given reporting lags, there has been a notable bounce in survey data in many countries. PMIs for both manufacturing and services climbed higher in May (Chart 4). The expectations components of economic confidence measures like the ZEW indices have also recovered the losses seen in February and March. Data surprises have also been increasingly on the positive side of late in China, Europe and the US, including the shocking 2.5 million increase in US employment in May. However, the US unemployment rate remains very high at 13.3%, indicating abundant spare capacity that will likely take years, not months, to work off – a problem that most of the world will continue to deal with post-recession. 3) Central bank liquidity is booming The other main reason for the boom in risk asset performance that has started to put upward pressure on bond yields is the extremely accommodative stance of global monetary policy. This is occurring through 0% policy rates in the developed economies but, even more importantly, the aggressive expansion of central bank balance sheets through quantitative easing (QE). The Fed has its foot firmly on the monetary accelerator, with year-over-year growth in its balance sheet of 87% (Chart 5). The European Central Bank (ECB) is no slouch, though, with its balance sheet up 19% from a year ago and having expanded its Pandemic Emergency Purchase Program (PEPP) by another €600 billion last week. Chart 4Signs Of Life In The Global Economy Chart 5'QE Forever' Driving Money From Bonds To Risk Assets The combined annual growth of the central bank balance sheets for the “G4” (the Fed, ECB, Bank of Japan and Bank of England) is now up to 26%. The rate of G4 balance sheet expansion has been a reliable leading indicator of global risk asset performance since the 2008 financial crisis (with about a 12-month lead), and the current boom in “liquidity” suggests that the current rise in global equity and corporate bond markets can continue over the next year. Easing global financial conditions are now returning to levels that should support economic growth in the coming months, helping to mitigate (but not eliminate) the potential credit stresses from companies that have suffered during the COVID-19 recession. This recovery remains fragile, however, and policymakers will continue to maintain an extremely dovish policy bias – even with significant fiscal stimulus measures also in place to help economies climb out of recession. This suggests that the current rise in global bond yields is not the start of a new bond bear market driven by expectations of tighter monetary policies. The current rise in global bond yields is not the start of a new bond bear market driven by expectations of tighter monetary policies. Chart 6Global Bond Sentiment Is Still Very Bullish 4) Bullish sentiment for bonds is at extremes From a contrarian perspective, another factor helping put a floor underneath bond yields is investor sentiment towards fixed income, which remains bullish. The widely followed ZEW survey of economic forecasters also contains a question on the expected change in bond yields over the next year. The latest read on the surveys shows a net balance still expecting lower bond yields in the US, Germany, the UK and Japan, nearing levels seen prior to the end of the recessionary bond bull markets in the early 2000s and after the 2008 financial crisis (Chart 6). In addition, the Market Vane survey of bullish sentiment on US Treasuries is nearing past cyclical peaks, suggesting limited scope for new bond buyers that could drive US yields to new lows. 5) Inflation expectations are moving higher Finally, global yields are rising because the inflation expectations component of yields has started to move higher. The hyper-easy stance of monetary policy is playing a role here. Market-based inflation expectations measures like the breakevens on inflation-linked bonds (or CPI swap rates) are a vote of confidence by investors in the “appropriateness” of policy settings. The fact that inflation expectations are now drifting higher suggests that bond markets now believe that central banks are now "easy" enough to give inflation a shot at rising sustainably as growth recovers. Global yields are rising because the inflation expectations component of yields has started to move higher. Chart 7Oil Prices & Breakeven Inflation Rates Are Both Recovering This move higher in inflation expectations can continue in the coming months, particularly with global oil prices likely to move even higher. Our colleagues at BCA Research Commodity & Energy Strategy are quite bullish on oil prices, forecasting the benchmark Brent oil price to rise to around $50/bbl by the end of 2020 and continuing up to $78/bbl by the end of 2021. Such an outcome would push up market-based inflation expectations, and likely put more upward pressure on nominal bond yields, given the strong correlation between oil and inflation breakevens in the developed economies that has existed over the past decade (Chart 7). Bottom Line: Global risk assets are discounting a V-shaped economic recovery. With economic data starting to revive as more economies emerge from virus-related shutdowns, bond yields are showing signs of following suit. Duration Strategy For The Next Few Months The trends in growth, inflation and financial conditions all suggest bond yields can continue to drift higher over at least the next 3-6 months. Yet given the potential for a negative shock from a second wave of coronavirus infection, or geopolitical uncertainties in a volatile US election year, a below-benchmark global duration stance is not yet warranted. This is especially true with unemployment rates in most countries remaining elevated even as growth rebounds from recession, forcing central banks to maintain a very dovish policy posture. Our “Risk Checklist” that we have been monitoring to move to a more aggressive recommended investment stance on global spread product – the US dollar, the VIX and the number of new COVID-19 cases - can also be helpful in helping us determine when to shift to a more defensive bias on global duration. On that note, the Checklist still argues for a neutral duration stance, rather than positioning for a big move higher in yields. The US dollar has started to soften, but remains at a very high level relative to interest rate differentials (Chart 8). A weaker greenback is a source of global monetary reflation, primarily through changes in the prices of commodities and other traded goods that are denominated in dollars, but also by helping alleviate funding pressures for companies that have borrowed heavily in US dollars (especially in the emerging world). The dollar is also an “anti-growth” currency that appreciates during periods of slowing global growth, and vice versa, so some depreciation should unfold as more of the world economy emerges from lockdown (middle panel). The VIX index – a measure of investor uncertainty - continues to climb down from the massive surge in February and March, now sitting at 26 after peaking around 80. This is the one part of our Risk Checklist that argues for reducing duration exposure now. We prefer trades that will benefit from the combination of continued global policy reflation and growing investor risk appetite. We call these “duration-lite” trades. The daily number of new reported cases of COVID-19 (using data from the World Health Organization) has come down dramatically in Europe, but in the US the decline in new cases has stalled over the past month – a worrisome sign as the country continues to reopen amid mass protests in major cities (Chart 9). New cases outside the US and Europe are rapidly moving higher, however, primarily in major Latin American countries like Brazil and Mexico. This suggests that while there is a concern about a “second wave” of coronavirus later in the year, the risks from the first wave are far from over. Chart 8Still Not Much Reflationary Push From A Weaker USD Chart 9The COVID-19 Threat Has Not Gone Away Instead of shifting to a below-benchmark recommended stance on overall portfolio duration too soon in the cycle, we prefer trades that will benefit from the combination of continued global policy reflation and growing investor risk appetite. We call these “duration-lite” trades. Specifically, we like owning inflation-linked government bonds versus nominal debt, while also positioning for steeper government yield curves (on a duration-neutral basis). Longer-dated breakeven inflation rates within the major developed markets are becoming increasingly correlated to both the level of 10-year government bond yields (Chart 10) and the slope of the 2-year/10-year yield curve (Chart 11). Chart 10Rising Inflation Expectations Will Lead To Higher Bond Yields ... Chart 11... And Steeper Yield Curves In terms of country selection for these trades, we look to the valuations on inflation-linked bond breakevens from our modeling framework that we introduced back in late April.1 In that framework, we model 10-year breakevens as a function of oil prices, exchange rates and the long-run trend in realized inflation. Chart 12Global Inflation Breakevens Look Cheap On Our Models In Chart 12, we show the deviation of 10-year inflation breakevens from the model-implied fair value, shown both terms of standard deviations and basis points. The “cheapest” breakevens from our models are for inflation-linked bonds in Italy and Canada, although almost all counties (outside of the UK) have breakevens to look far too low. This suggests that global bond investors should consider a multi-country portfolio of inflation-linked bonds versus nominal paying equivalents – or in countries where the inflation-linked bond markets are small and illiquid, duration-neutral yield curve steepeners - as a more efficient way to play for a continuation of the current reflationary global backdrop without taking duration risk. Bottom Line: Even with global yields showing signs of a cyclical bottom, we continue to recommend a neutral duration stance. Given the lingering uncertainties about a second wave of coronavirus, and the rising political and social tensions in the US only five months before the presidential election, we prefer to focus on “duration-lite” trades in the developed economies - like overweighting inflation-linked government bonds versus nominals as inflation expectations will drift higher over the next 6-12 months. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Global Inflation Expectations Are Now Too Low", dated April 28, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
A profligate US government where $3 trillion + fiscal packages are passed with a strong bipartisan consensus, rising odds of increased defense and infrastructure spending, a renewed focus on protecting America’s industrial champions from competition (foreign or domestic), and a robust protectionist agenda (again, on both sides of the aisle), are all inherently inflationary and negative for bonds, ceteris paribus. A whiff of inflation would be a positive for the broad equity market, further fueling the “risk on”, liquidity-driven, melt-up phase. However, historically when inflation has entered the 3.7%-4% zone in the past, the broad equity market has stumbled (see chart). Despite these powerful longer-term inflationary forces, our working assumption is that, in the next 9-12 months, headline CPI inflation will only renormalize, rather than surge, as the coronavirus-induced deficient demand and excess supply dynamic will take time to reach a new equilibrium. Bottom Line: We remain constructive on the prospects of the broad equity market on a cyclical 9-12 month time horizon. For a detailed discussion on inflationary forces and their effects on the S&P 500 GICS1 sectors, please refer to this Monday’s Special Report.
Dear Client, In lieu of our regular report next week, we will be sending you a Special Report from my colleague Jonathan LaBerge. Jonathan will be examining the global effectiveness of recent pandemic containment measures to judge both the odds of a second infection wave and what policy responses are likely to be effective in countering one were it to occur. I hope you find the report insightful. Best regards, Peter Berezin, Chief Global Strategist Highlights Fiscal deficits have soared in the wake of the pandemic, putting government debt-to-GDP ratios on a trajectory to reach post-WWII highs in many countries. Contrary to popular belief, there is little reason to think that fiscal relief will make it more difficult for governments to repay their obligations down the road. Larger budget deficits tend to increase overall national savings when the economy is depressed because private savings rise more than enough to compensate for the decline in government savings. The end result is a higher level of national wealth that governments can tax in the future. That said, there is more than one way to tax national wealth. For political reasons, higher inflation coupled with financial repression may prove to be more feasible than other forms of taxation. While inflation is not an imminent risk, it could become a formidable problem in two-to-three years. Investors should maintain below-benchmark levels of duration in fixed-income portfolios and favor inflation-linked securities over nominal bonds. Gold prices will rise over the long haul. The yellow metal should perform well even in the near term if the dollar weakens during the remainder of this year, as we anticipate. Real estate investors should reallocate capital away from densely populated urban areas towards suburbs and farmland. Stay Cyclically Overweight Equities Global equities continued to climb higher this week, as more countries reopened their economies. As we discussed three weeks ago in our report entitled “Risks To The U,” the main downside risk facing stocks is a second wave of the disease.1 While the number of new COVID-19 cases has declined in many countries, it continues to rise in others. As a result, the global tally of new cases remains broadly flat. The daily number of deaths seems to be trending lower, but that could easily reverse if social distancing measures are abandoned too quickly (Chart 1). Chart 1COVID-19: Global New Cases Remain Broadly Flat, While Deaths Seem To Be Trending Slightly Lower Chart 2Joined At The Hip Given this risk, we do not have a strong near-term (3-month) view on the direction of equities. Google searches for the “coronavirus” have closely correlated with equity prices and credit spreads (Chart 2). If fears of a new outbreak were to escalate, risk assets would suffer. Looking at a cyclical (12-month) horizon, we still recommend a modest overweight to stocks. Even if a vaccine does not become available later this year, increased testing should allow for a more economically palatable approach to containment strategies. Ample fiscal support will also help. As we provocatively asked in a report entitled “Could The Pandemic Lead To Higher Stock Prices?”,2 one can easily imagine a scenario where central banks keep rates near zero for the foreseeable future, while ongoing fiscal stimulus enables the labor market to reach full employment. Such an outcome could allow corporate profits to return to pre-pandemic levels, but leave the discount rate lower than before. The end result would be a higher fair value for the stock market. Although we would not counsel investors to bank on such a fortuitous outcome, the probability of it occurring is reasonably high – probably in the range of 30%-to-40%. This makes us inclined to favor stocks over a cyclical horizon. Will Indebted Governments Spoil The Party? One potential flaw in this bullish thesis is that massive government deficits could push up interest rates, crowding out private-sector investment in the process. As we argue below, such worries are misplaced for now. For the time being, bigger budget deficits will likely lead to an increase in overall savings, thus raising investment relative to what would have happened in the absence of any stimulus. That said, as we conclude towards the end of this report, there will come a time – probably in two-to-three years – when most economies are back to full employment. If budget deficits are still high at that point, inflation and long-term bond yields could end up rising substantially. Keynes To The Rescue The IMF expects budget deficits in advanced economies to exceed 10% of GDP in 2020, significantly higher than during the financial crisis. The sea of red ink is projected to push government debt-to-GDP ratios to fresh highs in many economies (Chart 3). Chart 3AGovernment Debt Levels Have Surged In The Wake Of The Pandemic Chart 3BGovernment Debt Levels Have Surged In The Wake Of The Pandemic Chart 4The Paradox Of Thrift: Not Just A Theory Should bond investors be worried? Not for now. One of John Maynard Keynes’ great insights was that an individual’s attempt to increase savings could lead to a collective decline in savings, a phenomenon he called the paradox of thrift. Keynes argued that if everyone tried to save more, the resulting contraction in spending would cause total employment to fall by so much that overall income would decline by more than spending. As a result, aggregate savings would fall. This is precisely what happened during the Great Depression and in the aftermath of the Global Financial Crisis (Chart 4). The paradox of thrift implies that bigger budget deficits in a depressed economy will lead to an increase in overall savings, as private savings rise more than one dollar for every dollar decline in government savings. S-I=CA One can see this point using the familiar macroeconomic accounting identity which says that the difference between what a country saves and invests should equal its current account balance.3 In the absence of a change in the current account balance, any increase in investment will translate into an increase in savings. If the government stimulates aggregate demand by increasing spending, cutting taxes, or boosting transfer payments, companies are likely to respond by investing more (or at least not cutting capital expenditures as much as they would otherwise). Thus, if fiscal stimulus raises investment, it will also raise aggregate savings. Chart 5Huge Spike In The US Personal Savings Rate This conclusion has important implications for bond yields. If bigger budget deficits lead to an increase in overall savings, there is no reason to expect real bond yields to rise very much, at least in the short term. The failure of bond yields to rise since March, when governments began to trot out one fiscal stimulus package after another, is a testament to this fact. So too is the stimulus-induced surge in the US personal saving rate, which reached a record high of 33% in April (Chart 5). All That Money Printing If bigger government budget deficits are, in some sense, self-financing, why are so many people convinced that the Fed and other central banks are effectively “monetizing” deficits by buying up bonds? Part of the answer has to do with how one defines monetization. Governments create money whenever they purchase goods or services or make transfers to the public by running down their deposits at the central bank. In theory, the public could use that money to buy government bonds, which would allow the government to replenish its account at the central bank. In practice, it is usually a bit more circuitous than that. Chart 6Commercial Banks Deposits, Bank Reserve Held At The Fed, And Fed Holdings Of Treasuries Have All Expanded This Year What normally happens is that the public places the money in a commercial bank deposit and the commercial bank then transfers the money to its account at the central bank. Next, the central bank buys the bonds from the government, crediting the government’s deposit account at the central bank in the process. Chart 6 shows that this is precisely what has happened this year: Commercial bank deposits, bank reserves held at the Fed, and the Fed’s holdings of Treasuries have all risen by roughly the same amount. Granted, there is a bit more to the story. If the central bank buys bonds, it will push down bond yields at the margin, allowing the government to finance itself more cheaply than it could otherwise. However, this is a far cry from the sort of “money printing” that many people have in mind. True debt monetization occurs when governments lose all access to outside financing, forcing the central bank to pick up the tab. Such situations invariably involve accelerating inflation and a collapsing currency, which often culminates in hyperinflation. This is clearly not the case today. Back To Full Employment The idea that bigger budget deficits can generate enough private savings to more than fully compensate for any loss in government savings is applicable only for economies with spare capacity. Once the economy reaches full employment, fiscal stimulus will not lead to more income or production since everyone who wants a job already has one. At that point, bigger budget deficits will cause the economy to overheat and inflation to rise, potentially forcing the central bank to raise rates. Higher interest rates will reduce investment. Higher rates will also put upward pressure on the currency, leading to a reduction in net exports and a corresponding deterioration in the current account balance. If investment and the current account balance both decline, then savings, which is just the sum of the two, must also fall. Strategies For Alleviating A Debt Burden Once the free lunch from fiscal stimulus disappears, the question of how to address the government debt accumulated during the downturn becomes paramount. There are four ways to reduce the ratio of government debt-to-GDP: 1) outgrow the debt burden; 2) tighten fiscal policy; 3) default; and 4) inflate away the debt. Outgrowing It At the end of the Second World War, many governments found themselves saddled with high levels of debt. In the US, the government debt-to-GDP ratio stood at 121% in 1945. In the UK, it hit 270%. In Canada, it reached 155%. For the most part, these governments did not repay the debt they incurred during the war. As Chart 7 shows, the nominal value of debt outstanding either rose or remained broadly constant following the war. What happened was that rapid GDP growth led to a shrinkage in debt-to-GDP ratios. Compared with the post-war period, the two drivers of an economy’s growth potential, labor force and productivity growth, are both weaker now. Thus, outgrowing the debt by raising the denominator of the debt-to-GDP ratio will be more difficult than in the past. It’s About g-r That said, the trajectory of the debt-to-GDP ratio does not depend solely on GDP growth; it also depends on the interest rate that the government pays to service its debt. Conceptually, it is the difference between the two that determines whether the level of any given budget deficit is sustainable or not. While trend GDP growth in advanced economies has declined since the 1950s, equilibrium interest rates have also fallen. As a consequence, the spread between growth rates and interest rates is only somewhat smaller in advanced economies today than it was in the 1950s and 60s and notably higher than it was in the 1980s and 90s (Chart 8). Indeed, as Chart 9 shows, g-r has been trending higher for hundreds of years! Chart 7The Case Of Outgrowing The Debt Burden Post-WWII Chart 8The Rate Of Economic Growth Has Been Higher Than Interest Rates Chart 9A Multi-Century Trend In The Spread Between Growth And Interest Rates Today, government borrowing rates in most economies are well below trend growth rates. No matter the size of the budget deficit, the ratio of debt-to-GDP will converge to a stable level as long as the interest rate the government pays on the debt is below the growth rate of the economy.4 A Gordian Fiscal Knot Of course, there is no guarantee that real rates will remain below the rate of trend growth. As we have discussed before, the exodus of baby boomers from the labor force, a peak in globalization, and rising political populism could all curtail aggregate supply, leading to a depletion of national savings.5 What would happen if governments allowed debt levels to reach very high levels only to find that the neutral rate of interest — the interest rate consistent with full employment and stable inflation — has risen above the growth rate of the economy? Raising the policy rate would be very painful in a high-debt environment because even a small increase in interest rates would lead to a large rise in interest payments. Faced with this reality, some governments might elect to tighten fiscal policy. An increase in taxes or a decline in government spending would not only create some resources to pay back debt, but it would also reduce aggregate demand, pushing down the neutral rate of interest in the process. Don’t Blame The Stimulus Ironically, all the fiscal relief efforts that governments have carried out over the past few months have probably left them better placed to pay back debt than if no stimulus had been undertaken in the first place. Box 1 illustrates this point with a numerical example, but the intuition for this claim can be seen easily enough. As noted earlier, fiscal stimulus in a depressed economy will raise overall savings. This means that after the pandemic is over, governments will have a larger tax base available to them than they would have had in the absence of any stimulus (although, obviously, the tax base would be even larger if the pandemic had never occurred). The Inflation Solution Chart 10Long-Term Inflation Expectations Remain Very Depressed Still, any decision to tighten fiscal policy down the road is going to be an inherently political one. What if governments do not have the political will to tighten fiscal policy even if the economy begins to overheat? Defaulting on the debt is always an option in that case, but not one that any sensible government would choose given the devastating impact this would have on the financial system and broader economy. Rather, it is conceivable that governments will lean on central banks to keep rates low and let inflation accelerate. While higher inflation will not boost real GDP, it will raise nominal GDP, allowing the ratio of government debt-to-GDP to decline. Investors currently assign very low odds to such an outcome. Long-term market-based inflation expectations remain very depressed (Chart 10). Yet, we think such an eventuality is more plausible than widely believed. As long as inflation does not spiral out of control, central banks are likely to welcome rising prices. A higher inflation rate would make monetary policy more effective by allowing central banks to bring real rates deeper into negative territory whenever the economy falls into recession. Higher inflation would also result in steeper yield curves, reoxygenating commercial banks’ profitability. Profiting From Higher Inflation The path to higher interest rates is paved with lower rates. In order to generate inflation, central banks will need to keep rates at very low levels even once the economy has returned to full employment. Given that unemployment is quite high today, inflation is not an imminent risk. However, it could become a formidable problem in two-to-three years. Investors should maintain below-benchmark levels of duration in fixed-income portfolios and favor inflation-linked securities over nominal bonds. While gold is no longer super cheap, it remains a good hedge against inflation. The yellow metal should also do well if the dollar weakens during the remainder of this year, as we anticipate. As a countercyclical currency, the dollar tends to fall whenever global growth picks up (Chart 11). Chart 11Gold Will Do Well When The Dollar Weakens As Global Growth Picks Up Chart 12Farmland Would Benefit From High Inflation Lastly, land will gain from low interest rates in the near term and higher inflation in the long term. Farmland and suburban land are particularly appealing. The pandemic has made remote working more commonplace. It has also highlighted the potential dangers of living in densely populated cities. Since most suburbs are built on top of land that was previously zoned for agriculture, farmland should benefit from the retreat from urban living, much like it did during the inflationary period of the 1970s (Chart 12). Box 1Saving More By Spending More Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Weekly Report, “Risks To The U,” dated May 7, 2020. 2 Please see Global Investment Strategy Weekly Report, “Could The Pandemic Lead To Higher Stock Prices?” dated April 23, 2020. 3 Gross Domestic Product (GDP) can be computed as the sum of consumption (C), investment (I), government spending (G), and net exports (X-M). Gross National Product (GNP) is equal to GDP except that the former includes net income from abroad (which is included in the current account balance). Thus, GNP=C+I+G+CA, or GNP-C-G=I+CA. Savings (S) is equal to GNP-C-G. Taken together, the two expressions imply S-I=CA, or S=I+CA. 4 Please see Global Investment Strategy Weekly Report, ”Is There Really Too Much Government Debt In The World?” dated February 22, 2019. 5 Please see Global Investment Strategy Weekly Report, “A Structural Bear Market In Bonds,” dated February 16, 2018. Global Investment Strategy View Matrix Current MacroQuant Model Scores
Highlights Duration: The easing of shelter-in-place restrictions and resultant improvement in economic growth will cause US bond yields to rise somewhat during the next couple of months. However, the magnitude of economic improvement will be modest, and the Fed’s dovish rate guidance will temper the severity of any yield back-up. Municipal Bonds: The less-than-generous pricing offered through the Fed’s Municipal Liquidity Facility will not help push muni yields lower from current levels. However, very attractive valuations and the expectation of federal government relief justify an overweight allocation to the sector. Inflation & TIPS: We are not worried about significant inflation pressures any time soon. But equally, we don’t see 12-month headline CPI falling much below zero this year. This means that TIPS are cheap relative to nominal Treasuries. Treasury Yield Outlook Chart 1Taking A Breather Bond yields have been relatively stable since early April, and the Treasury index has performed roughly in-line with cash for most of the second quarter. This of course follows on the heels of massive outperformance in Q1 (Chart 1). Nonetheless, the recent stabilization in yields raises the question of whether bond returns are approaching a cyclical peak, or merely experiencing a temporary lull. Yields Are Biased Higher In The Near-Term … Our view is that a modest bond sell-off is likely during the next couple of months for four reasons. First, high-frequency global growth indicators are finally starting to hook up (Chart 2). Specifically, we like to track the CRB Raw Industrials commodity price index, emerging market currencies and the relative performance of cyclical versus defensive US equities. All three indicators track bond yields closely, and all three are showing signs of bottoming. Chart 2High-Frequency Global Growth Indicators Second, FLASH PMI estimates for May showed broad-based improvement compared to the April lows. Specifically, FLASH Manufacturing PMIs for the United States, Euro Area and United Kingdom all increased compared to April (Chart 3A). Of countries that have FLASH PMI estimates, only Japan saw a continued decline in May. If these numbers are to be believed, they suggest that April might indeed represent the global economic trough. We are still waiting for May data from China and the rest of the emerging world, important economic blocs that together account for 47% of the Global Manufacturing PMI. But China’s PMI, at least, has already rebounded off its February low (Chart 3B). China’s number will likely pressure the global index higher when it is released next week. Chart 3APMI Estimates For May Chart 3BChina's PMI Is Close To Neutral Third, high-frequency US economic data are consistent with an economy that is close to, or perhaps already passed, its economic trough. Initial jobless claims are still very high but have printed successively lower since peaking seven weeks ago. Similarly, the New York Fed’s Weekly Economic Index remains at its all-time low but is no longer in free fall (Chart 4).1 Chart 4US Economic Indicators Finally, but also most importantly, the slightly better data noted above are the result of economies that are slowly starting to re-open as daily new COVID cases roll over. This is particularly the case in Europe and North America (Chart 5). Restrictions will probably continue to ease during the next couple of months, meaning that both the economic data and bond yields are biased higher. Chart 5Global COVID-19 Cases … But Don’t Expect Anything More Than A Modest Sell-Off Chart 6Fed's Forward Guidance Quickly Dampened Vol However, there are also a few reasons to not get too bearish on US bonds. First, it is entirely possible – and even likely – that COVID cases will start to increase as shelter-in-place restrictions are lifted. If these second waves of the infection aren’t adequately suppressed via testing and contact tracing then restrictions could be re-instated by the fall, putting renewed downward pressure on bond yields. Also, while new COVID cases are declining in many parts of Europe and North America, several large emerging markets are still seeing cases accelerate. Brazil and India, for example, have yet to see a peak in new cases, while Russia’s new cases have just started to roll over (Chart 5, bottom 2 panels). Together, Brazil, Russia and India account for 8% of the Global Manufacturing PMI. Slow growth in those nations will significantly dampen any global economic recovery. On top of uncertainty surrounding the speed of any nascent global economic recovery, bond yields will also be held down by the Fed’s highly credible zero-lower-bound interest rate guidance. As we discussed in last week’s report, large bond sell-offs are almost always associated with a significant hawkish shift in monetary policy.2 This will not occur any time soon. In fact, the New York Fed’s latest Survey of Market Participants, taken just prior to the April 28-29 FOMC meeting, reveals that the median market participant expects the fed funds rate to stay at its current level at least until the end of 2022!3 On the one hand, such depressed expectations suggest scope for a massive re-pricing at some point in the future, but this will not occur until inflation forces the Fed to act. We agree with the survey respondents that this is a long way off. While new COVID cases are declining in many parts of Europe and North America, several large emerging markets are still seeing cases accelerate. It’s also interesting to note the speed at which the market has bought into the Fed’s zero-lower-bound rate guidance during the past two months. Chart 6 shows that after the Fed first cut rates to zero in December 2008, it still took several years for implied interest rate volatility to reach historically low levels. That is, the market was not initially convinced that rates would stay at zero for the long haul. In contrast, interest rate volatility has plunged dramatically since the Fed cut rates to zero on March 15. This time around, the market has been quick to buy into the Fed’s dovish message. Bottom Line: The easing of shelter-in-place restrictions and resultant improvement in economic growth will cause US bond yields to rise somewhat during the next couple of months. However, the magnitude of economic improvement will be modest, and the Fed’s dovish rate guidance will temper the severity of any yield back-up. Additionally, we can’t rule out the resumption of lockdown restrictions in the fall, should COVID cases rise during the summer. In terms of strategy, nimble investors may want to position for higher yields in the near-term. However, given the risks involved, we prefer to keep portfolio duration close to benchmark while implementing duration-neutral curve steepeners that will profit from rising yields. Specifically, we recommend going long the 5-year note and short a duration-matched barbell consisting of the 2-year and 10-year notes.4 Munis Carry Some Risk, But Offer A Lot Of Value Chart 7Munis Cheap Versus Treasuries Our spread product investment strategy during the recession has been to favor those sectors that: a) Offer attractive yields/spreads b) Benefit from one or more of the Fed’s emergency lending facilities Municipal bonds check both of those boxes. In terms of value, Aaa-rated municipal bond yields are consistently above Treasury yields across the entire maturity spectrum (Chart 7), a yield advantage that becomes especially pronounced when you factor in munis’ tax-exempt status. There is even a strong case for tax-exempt municipal bonds relative to corporate bonds. Table 1A shows the yield differential between tax-exempt municipal bonds and corporate bonds that carry the same credit rating and maturity. Not surprisingly, municipal bond yields are below corporate yields in most cases, with A-rated yields and longer-maturity Baa-rated yields being glaring exceptions. To put those yield differentials in context, Table 1B shows the breakeven effective tax rate for each muni/corporate combination. For example, the breakeven effective tax rate between Aaa-rated 5-year municipal and corporate bonds is 23%. This means that an investor will earn more after-tax yield in the municipal bond if his effective tax rate is above 23%, and less if it is below. It is apparent that breakeven effective tax rates are quite low, especially at the bottom-end of the credit spectrum. Table 1ASpread Between Municipal Bonds & Credit Index Yields* (BPs) Table IBMuni/Credit Breakeven Effective Tax Rate* (%) As for our second criterion, the municipal sector clearly benefits from the Fed’s Municipal Liquidity Facility (MLF). Through this facility, the Fed lends directly to eligible state & local governments for up to three years.5 However, there is a problem with the MLF: The cost. The Fed recently revealed that it will charge a rate of OIS + 150 bps for new loans taken out by Aaa-rated issuers through the MLF. That fixed spread rises as the issuer’s credit rating declines. Aa2 issuers are charged OIS + 175 bps, A2 issuers are charged OIS + 250 bps, etc…6 Chart 8MLF Pricing Doesn't Help Muni Investors For each credit rating, the rate available through the MLF is significantly higher than the actual market yield (Chart 8). This means that the MLF currently places a cap on how high municipal yields can rise, but it doesn’t actively pressure them lower. This stands in stark contrast to the rates offered through the Term Asset-Backed Securities Loan Facility (TALF) that are considerably below market yields on Aaa-rated CMBS and similar to market yields on Aaa-rated consumer ABS. Uncharitable MLF pricing structure aside, we think there are several reasons to remain overweight municipal bonds within US fixed income portfolios. First, the Fed is already facing criticism about the MLF rates and it could lower them in the near future. It has already shown a willingness to alter its facilities in response to market pressure. The MLF initially only made loans with maturities of 2 years or less, now it offers loans of up to 3 years. Second, direct federal aid to state & local governments was the centerpiece of the relief bill that recently passed through the House of Representatives. That bill will not get through the Senate in its current form, but another federal government relief package is forthcoming and it will almost certainly include money for state & local governments. There is even a strong case for tax-exempt municipal bonds relative to corporate bonds. Third, despite the massive challenges ahead, state governments entered the present crisis with relatively strong budget positions and well stocked rainy day funds (Chart 9). State & local governments will obviously be forced to make some tough budget decisions in the coming months, but there is no doubt that they are in a better position to do so than they were prior to the last two recessions. Chart 9State Rainy Day Funds Bottom Line: The less-than-generous pricing offered through the Fed’s Municipal Liquidity Facility will not help push muni yields lower from current levels. However, very attractive valuations and the expectation of federal government relief justify an overweight allocation to the sector. Deflation A Bigger Risk Than Inflation, But TIPS Still Make Sense Chart 10Energy Inflation May Have Troughed April’s CPI report saw year-over-year headline inflation fall to 0.4%, the lowest level since 2015. Deflation is clearly a bigger risk than inflation this year, but we would argue that TIPS prices are so beaten down that the sector still offers value. This is true over investment horizons as short as one year. We calculate that headline CPI inflation would have to come in below -0.85% over the next 12 months for a hold-to-maturity position in TIPS to underperform a similar position in nominal Treasuries (Chart 10). Could we actually see that much deflation during the next 12 months? It is possible, but we’d bet against it. First, the collapse in oil prices and energy inflation has been an important driver of falling inflation during the past couple of months (Chart 10, panel 2). But with oil prices having already dipped into negative territory and massive production cuts about to come on board, energy inflation may have already troughed for the year.7 At the very least, with oil prices already so low there is much less room for them to decline and thus less scope for further energy CPI deceleration. Second, the Great Financial Crisis (GFC) was the last time that headline CPI inflation went significantly below zero. Year-over-year core inflation had to get to 0.6% for that to happen. This year, 12-month core CPI dropped to 1.4% in April from 2.1%, but the trimmed mean measure only fell from 2.4% to 2.2% (Chart 10, bottom panel). During the GFC, both core and trimmed mean inflation fell in tandem. This gives us some reason to doubt the persistence of core CPI’s recent drop. Headline CPI inflation would have to come in below -0.85% over the next 12 months for a hold-to-maturity position in TIPS to underperform a similar position in nominal Treasuries. Finally, shelter accounts for roughly one third of headline inflation. Year-over-year shelter CPI troughed at -0.6% during the GFC. It also dropped sharply in April – from 3.0% to 2.6% – but it still has a long way to go to get back to GFC levels (Chart 11). We don’t think that shelter inflation will move back into negative territory, and without that drag it is hard to see 12-month headline CPI falling much below zero. Chart 11Shelter Is One Third Of CPI Rental vacancies are the number one driver of shelter CPI. The rental vacancy rate has only been updated through the end of March, and April’s data will definitely show a spike. However, the vacancy rate is starting from below 7%. The vacancy rate needed to spend several years hovering around 10% or higher before shelter CPI saw its big drop in 2008/09 (Chart 11, panel 2). The National Multifamily Housing Council (NMHC)’s Apartment Market Diffusion Index also does a good job predicting shelter inflation. Shelter inflation tends to fall when the index is below 50 and rise when it is above 50 (Chart 11, bottom panel). The Diffusion Index experienced a massive drop in April, back to GFC levels. However, it remains to be seen whether it will recover rapidly or remain below 50 for ten consecutive quarters like it did between 2007 and 2010. In fact, there is some reason to believe that the recovery might be fairly quick. Other data released by the NMHC show that as of May 20 2020, 90.8% of renters had made their monthly payments for May. In April 2020, 89.2% of renters had made their monthly payments by the 20th of the month. Unsurprisingly, both of these figures are below what was seen last year: In 2019, about 93% of renters had made their April and May monthly payments by the 20th of the month. But the fact that May 2020 data show a small increase compared to April indicates that the situation is not worsening, and it may in fact be getting better. Bottom Line: We are not worried about significant inflation pressures any time soon. But equally, we don’t see 12-month headline CPI falling much below zero this year. This means that TIPS are cheap relative to nominal Treasuries. We recommend overweighting TIPS versus nominal Treasuries across the entire maturity spectrum. We also recommend implementing TIPS curve steepeners.8 Appendix - Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. Right now, that means we are overweight corporate bonds rated Ba and higher, Aaa-rated Agency and non-agency CMBS, Aaa-rated consumer ABS and municipal bonds. We are underweight residential mortgage-backed securities and corporate bonds rated B and lower. The below Table tracks the performance of these different bond sectors since the Fed’s March 23 announcement. We will use this Table to monitor bond market correlations and evaluate our strategy's success. Table 2Performance Since March 23 Announcement Of Emergency Fed FacilitiesRyan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 The Weekly Economic Index is a composite of 10 daily and weekly indicators of real economic activity. For more details on its construction please see https://www.newyorkfed.org/research/policy/weekly-economic-index 2 Please see US Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 3 https://www.newyorkfed.org/medialibrary/media/markets/survey/2020/apr-2020-smp-results.pdf 4 For more details on our recommended yield curve positioning please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 5 For more details on the MLF and the Fed’s other emergency lending facilities please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 6 For full pricing details please see https://www.federalreserve.gov/newsevents/pressreleases/files/monetary20200511a1.pdf 7 For more details on BCA’s outlook for oil prices please see Commodity & Energy Strategy Weekly Report, “US Politics Will Drive 2H20 Oil Prices”, dated May 21, 2020, available at ces.bcaresearch.com 8 For more details on our recommendation for TIPS curve steepeners please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Fear of deflation – especially at current debt levels – will keep central-bank policy looser for longer. As a result, monetary authorities will do whatever it takes to revive inflation and inflation expectations to move policy rates away from the zero lower bound. EM income growth will rebound, and the US dollar will weaken as monetary and fiscal stimulus reach the real economy. This will be bullish for commodities, including gold. Over the medium to long term, the reversal in globalization and the atrophy of working-age populations will be inflationary: Labor markets will tighten as economic growth recovers and baby-boomers continue to retire, pushing wages higher and savings lower. Over the short term, we are neutral gold from a pricing standpoint, and believe $1,700/oz is close to fair value. When gold pushes through $1,800/oz, longer-term demographic and economic trends will become apparent and will catalyze gold’s rally. We continue to favor gold as a portfolio hedge, as it has held value throughout the COVID-19 pandemic and the re-emergence of geopolitical tensions, particularly the return of Sino-US trade acrimony. Feature Gold will remain at ~ $1,700/oz after rallying 15% from its mid-March bottom, as markets consolidate over the short term. This new equilibrium has been fueled by North American retail investors and is slightly above our model’s fair value (Chart of the Week). While gold’s short-term price drivers appear to have stabilized over the past few weeks – i.e. real rates, US dollar, and equity uncertainty are holding fairly steady – a temporary pullback is likely. Strategically, however, the balance of risks is skewed to the upside. Chart of the WeekRetail Investment Demand Supports Gold Above Our Fair-Value Estimates Our usual framework classifies gold’s drivers into three broad categories: Demand for inflation hedges; Monetary and financial aggregates; and Demand for portfolio-diversification assets. In this report, we are narrowing our focus to concentrate on the tactical vs. strategic drivers of gold prices, to assess the metal’s upside potential over the short- and long-term horizons (Table 1). Table 1Short- vs. Long-Term Drivers Of Gold Prices Over the short-term, gold prices fluctuate mostly with changes in risk aversion, opportunity costs and relative prices vis-à-vis other assets. Longer term, gold prices trend with income and inflation cycles, along with structural changes in households’ savings rates. Short- and Medium-term Drivers Elevated global uncertainty and falling US real rates are keeping total gold demand resilient in the West. Western Buyers To The Rescue The COVID-19 pandemic greatly altered the composition of gold demand in 1Q20. Jewellery and bar-and-coin demand dropped 42% and 11% y/y in the wake of a collapse of Chinese and Indian demand (Chart 2, panel 1). This was offset by sharp inflows to ETF products – mainly from DM investors. ETF inflows increased by ~ 300 tons in 1Q20, and by 170 tons in April 2020 (Chart 2, panel 3). Elevated global uncertainty and falling US real rates are keeping total gold demand resilient in the West. However, the short-term outlook for gold could be volatile as investment and jewellery demand normalize. As economies reopen, we expect economic uncertainty will fade, which will bring retail and speculative gold demand down in the West, while a recovery in EM economic activity will revive jewellery, bar and coin demand. Chart 2Weak EM Consumer Demand Offset By Strong North America ETF Inflows Chart 3Investment Demand Overtakes Jewellery's Since 2010, investment and jewellery demand represented ~ 33% and ~ 58%, respectively, of total gold demand – excluding central bank net purchases (Chart 3). As economies reopen, we expect economic uncertainty will fade, which will bring retail and speculative gold demand down in the West, while a recovery in EM economic activity will revive jewellery, bar and coin demand – albeit at a slower pace (Chart 4). NB: A large mismatch in the speed of these adjustments could lead to an undershoot in prices – especially at current elevated positioning. Chart 4Elevated Interests In Gold From Retail Investors Chart 5Investors Allocation To Gold Is Close To 2012 Levels We’ve argued in February there was still an opportunity for investment-led growth to support prices based on the low value of investors’ total holdings of gold compared to global equities on a market-cap basis. This measure is now approaching its 2012 peak and moving toward unknown territory in terms of portfolio and wealth allocation to gold (Chart 5). This is flagging up a risk that short-term traders will want to take profits on their speculative positions, if virus-related uncertainty diminishes. On the other hand, retail buyers could hold on to their hedges. Historically, profound economic dislocations and persistent uncertainty have been complemented by shifts in investors’ behavior, leading to higher average saving rates – e.g. 1929, WWII, 2008’s GFC – (Chart 6). Additionally, downside risks to the reopening of economies worldwide remain significant, particularly given the uncertainty of the COVID-19 pandemic’s evolution: A second wave of contagion would trigger a massive flight to safety and further central bank actions to keep rates depressed. Chart 6Precautionary Savings Rise In Highly Uncertain Periods Awaiting A Setback To The USD The Fed and other systemically important central banks have taken decisive action to keep money markets functioning and to prevent a solvency crisis (Chart 7, panel 1). Ample liquidity, low economic growth, and collapsing inflation expectations pushed bond yields lower globally, which, in large measure, powered the rally in gold prices (Chart 7, panel 2). The protection offered by US bonds is much weaker at the lower bound. This will benefit gold as a safe-haven asset if uncertainty intensifies this year. In recent weeks, US yields have stabilized, meaning this factor will not provide much support to gold at current levels – assuming, again, no major second wave in COVID-19 contagion. The upside to rates is also limited over the short term as the increase in Treasury supply will be offset by the Fed’s dovish forward rate guidance. Still, the protection offered by US bonds is much weaker at the lower bound. This will benefit gold as a safe-haven asset if uncertainty intensifies this year (e.g., ahead of the US elections). Moreover, the Fed appears to be willing to risk remaining behind the curve for the foreseeable future. Bonds' protection would suffer if the Fed allows inflation overshoot (more on this below). In 2H20, we expect the USD to weaken as virus-related safe-haven demand – which fueled its 14% rally ytd vs. EM currencies – abates and the Fed’s and the US government’s responses to the crisis floods markets globally with USD liquidity.1 Relative balance-sheet and interest-rate dynamics will reassert themselves as important drivers of currency movements (Chart 8). Chart 7QE Infinity Will Keep Bond Yields Depressed Chart 8USD Deviating From Interest Rate Differentials The tailwinds from declining US real rates ended and a decline in virus-related uncertainty will be offset by the positive effect of a weaker dollar. A temporary pullback is likely. Bottom Line: The sum of gold’s short-term drivers are neutral at the current $1,700/oz equilibrium. The tailwinds from declining US real rates ended and a decline in virus-related uncertainty will be offset by the positive effect of a weaker dollar. A temporary pullback is likely. Long-term Drivers The underlying trend in gold prices will remain positive, supported by accelerating EM income growth over the next 12 months. Stimulative Policies To Boost EM Income Growth Global income growth is one of the core drivers of gold prices over long horizons (Chart 9, panel 1). As countries get wealthier, the pool of savings rises, which benefits gold, along with most financial assets. Because gold-mining production growth is relatively stable and inelastic to prices in the short-term, changes in income growth above production growth have a crucial influence on gold’s trajectory over the long run. EM countries – chiefly China and India – are the largest buyers of jewellery, bars and coins, and remain among the fastest-growing economies on the planet. Hence, since 2000, gold’s annual price change correlates strongly with their income growth (Chart 9, panel 2). In addition, central banks’ net gold purchases – which have been increasingly positive since 2009 – effectively reduce available supply to consumers. We include net purchases in our measure of total supply to separate it from consumer and investor demand – which respond to entirely different incentives (Chart 9, panel 3). We expect EM central banks will continue diversifying part of their US dollar reserves to gold.2 Chart 9Global Income Growth Drives Long Term Gold Returns Chart 10China's Economic Activity Close To Pre-COVID-19 Levels The underlying trend in gold prices will remain positive, supported by accelerating EM income growth over the next 12 months. China’s economic activity appears to have partly recovered from the COVID-19 shock (Chart 10). Going forward, the country’s surging fiscal and monetary stimulus, in addition to a weakening US dollar, will revive growth in neighboring Asian economies this year. Structural Deflationary Pressures Are Easing We do not believe the lack of inflationary pressure post-GFC will be repeated this time. The stimulus is radically larger and geared more toward the real economy as opposed to rescuing the banking system. As we’ve argued in previous reports, gold acts as a good inflation hedge when there is an increase in perceived risks of significant overshoots.3 In normal times, inflation expectations move slowly and trend more or less with past inflation prints (Chart 11). However, the unprecedented global fiscal and monetary stimulus deployed to combat the COVID-19-induced recession could shift expectations rapidly and profoundly. We do not believe the lack of inflationary pressure post-GFC will be repeated this time. The stimulus is radically larger and geared more toward the real economy as opposed to rescuing the banking system (Chart 12). Moreover, a combination of deflationary structural factors – i.e. trade globalization, expanding global value chains, and demographics – are reversing, and will gradually become inflationary.4 This is a stark difference to the post-GFC quantitative easing. Chart 11Inflation Expectations Trend Along Past Realized Inflation Rates Chart 12Surging US Broad Money Supply Firstly, globalization’s deflationary impulse – thru increasing trade and expanding global value chains – stalled a few years ago (Chart 13). Recently, ramping anti-globalization policies amidst the Sino-US trade tensions exposed vulnerabilities in the current trade infrastructure. The COVID-19 pandemic risks accelerating these trends. Following widespread quarantine measures in China, US imports from China fell sharply in February and March, and firms without pre-established supply chain relationships with other Asian countries that could backstop supply disruptions were left unable to find alternative suppliers (Table 2). Firms will likely continue diversifying their supply sources and insource critical activities to the US, post-COVID-19.5 Additionally, our Geopolitical strategists see increasing risks of renewed US pressures on China ahead of the election.6 An acceleration in de-globalization trends post-COVID-19 will disrupt international supply chains and amplify inflationary pressures. Chart 13The Structural Reversal In Globalization Trends Will Be Inflationary Table 2Vulnerability In US Supply Chains China’s declining support ratio also means the pool of cheap offshore labor for DM economies is shrinking. Secondly, structural demographic trends are reversing. The world’s support ratio – i.e. the number of workers per dependent – has been trending downward since 2015 (Chart 14, panel 1). As more people around the world reach retirement age, this trend is expected to continue. This trend is especially powerful in China, whose workforce was one of the great deflationary demographic factors in previous decades. Effectively, this implies aggregate demand is likely to exceed aggregate supply as more workers become consumers. In theory, this also implies lower global savings and a higher neutral rate of interest. Consequently, a rising neutral rate, combined with our belief central bankers will be behind the curve in raising rates, increases the risks of inflation moving sharply above target. Chart 14Demographic Trends Will Become Inflationary China’s declining support ratio also means the pool of cheap offshore labor for DM economies is shrinking – the country could lose ~ 400 million workers over the remainder of the century (Chart 14, panel 2). The integration of the Chinese – and other EM countries – workforce during the 2000s led to a doubling of the global pool of labor supply and reduced the average labor cost. Investment Conclusion Asset markets are not positioned for higher inflation, thus, investors seeking refuge ahead of a widespread re-pricing of inflation risk likely will benefit from current relatively inexpensive hedges. Investors need to assess the long-term consequences of these trends and policies vs. the short-term deflationary COVID-19 shock. Asset markets are not positioned for higher inflation, thus, investors seeking refuge ahead of a widespread re-pricing of inflation risk likely will benefit from current relatively inexpensive hedges (Chart 15). While we expect higher US inflation expectations and headline rates in 2H20 – driven by the decline in the USD and the increase in oil and base-metals’ prices – we do not expect meaningful inflation-overshoot risks until late 2021. Core inflation rates will remain depressed until the large labor-supply overhang clears – in the US and globally – and the effect of the lower USD pass-through to higher prices emerges (Chart 16). Chart 15Gold Is Not Relatively Expansive, Except Vs. Commodities Chart 16The COVID-19-Induced Deflationary Effects Will Last Until Next Year Re-anchoring expectations will necessitate periods of above-target inflation rates. The short-term drivers of gold are neutral at the current $1,700/oz equilibrium, as inflation pressure won’t surface until 2H21. Moreover, there is a non-negligible risk of a short-term pullback if DM economies are successfully reopened without significant increases in COVID-19 infection rates. This should serve as a buying opportunity, as the medium- and long-term outlook remains bullish for the yellow metal. EM income growth is poised to rebound as global monetary and fiscal stimulus reach the real economy and the USD depreciates. The reversal in globalization and demographic trends will become inflationary. Policymakers will do whatever it takes to revive inflation and inflation expectations to move away from the zero lower bound. Re-anchoring expectations will necessitate periods of above-target inflation rates. Thus, real rates should be contained as QE continues to depress the term premium and inflation starts to move higher. Fear of deflation – especially at current debt levels – will keep central banks too easy for too long. Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Commodities Round-Up Energy: Overweight Oil production globally is falling faster than expected, based on anecdotal press reports showing the Kingdom of Saudi Arabia (KSA) took an additional 1mm b/d of production off the market, bringing its total shut-in level to 7.5mm b/d for next month. The Saudi government urged OPEC 2.0 member states to follow its lead and reduce production further. The US EIA this week reported it expects Russia’s production to fall more than 800k b/d, while in the US production is expected to decline by a similar amount this year, and another 600k b/d in 2021. Canada’s production is expected to fall 400k b/d. Non-OPEC production overall is expected to fall 2.4mm b/d this year. We will be updating our supply-demand balances and prices forecasts in next week’s report. Base Metals: Neutral Steel markets are becoming concerned COVID-19-induced production declines will reduce iron-ore shipments. Earlier this month, 10 cities in the Brazilian state of Para, an ore-producing region, were placed under lockdown, according to FastMarkets MB, a sister publication of BCA Research. Even though ore mining and shipping have been exempted, concern that COVID-19 could reach the producing regions and affect output is growing. Benchmark 62% Fe ore is down 6.2% from its January highs (Chart 17). Precious Metals: Neutral A forecast by Australia’s Department of Industry, Science, Energy and Resources (ISER) that Australia would become the world’s largest gold producer in 2021 was seconded this week by a private forecaster, Resources Monitor. The ISER forecast Australia would overtake China as the top gold producer in its March 2020 forecast, with output reaching 383 tons next year. Australia produced 326 tons last year, vs. China’s 380 tons. Ags/Softs: Underweight The USDA released its first estimate for the 2020/2021 marketing year, projecting corn ending stocks at 3.318 Bn bushels for the season, the largest stockpile since 1987/1998 (Chart 18). Huge planting projections will outweigh increases in exports demand of 35 Mn bushels and in usage for ethanol biofuel of 5.2 Bn bushels compared to the current season. Nonetheless corn futures hedged higher on Tuesday, rising 5.25 cents/bu, as the weak outlook was offset by downward revisions to old crop inventories. Finally wheat’s ending stocks were moderately revised up for the current season, but futures still fell to the lowest in a week due to better than expected weather in the US and higher global stocks expectations. Chart 17Supply Constraints Could Boost Prices Chart 18USDA Expects Large US Corn Stocks Increase Footnotes 1 We’ve outlined our view on the dollar for 2020 in our April 23, 2020 Weekly Report. Please see USD Strength Restrains Commodity Recovery, available at ces.bcaresearch.com 2 The U.S. dollar remains the reserve currency of the world today, but that exorbitant privilege is fading. 3 Please see our Weekly Report titled "All That Glitters ... And Then Some," published July 25, 2019. It is available at ces.bcaresearch.com 4 For more details on these structural factors please see The Bank Credit Analyst Special Reports titled "Troubling Implications Of Global Demographic Trends," and "Three Demographic Megatrends," published 28 February, 2019 and October 26, 2017. 5 Please see Sebastian Heise, “How Did China’s COVID-19 Shutdown Affect U.S. Supply Chains?,” Federal Reserve Bank of New York Liberty Street Economics, May 12, 2020. 6 Please see BCA's Geopolitical Strategy Special Alert titled "#WWIII," published May 1, 2020. It is available at gps.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q1 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades