Monetary
Executive Summary Bonds sold off dramatically in response to Friday’s surprisingly high CPI number. Markets are now pricing in a much more rapid increase in the fed funds rate, with some probability of a 75 bps move this week. We think a 75 bps rate hike at any one FOMC meeting is possible, but unlikely. Rather, we see the Fed continuing to hike by 50 bps per meeting until inflation shows signs of rolling over. The guts of the CPI report were less concerning than the headline figure, and it is still more likely than not that core CPI will trend down during the next 6-12 months. Contribution To Month-Over-Month Core CPI Bottom Line: Investors should maintain benchmark portfolio duration as it is unlikely that the Fed will deliver a more aggressive pace of tightening than what is already in the price. Investors should also underweight TIPS versus nominal Treasuries as a play on a hawkish Fed and moderating consumer prices. The May CPI Print Ensures An Ultra-Hawkish Fed The “peak inflation” narrative took a blow last week when core CPI came in well above expectations for May. While the annual rate ticked down due to base effects, monthly core CPI saw its largest increase since last June (Chart 1). The bond market reacted to the news with an abrupt bear-flattening of the Treasury curve. The 2-year Treasury yield rose above 3% for this first time this cycle and the 10-year yield hit 3.27% on Monday morning (Chart 2). The 2-year/10-year Treasury slope flattened sharply, and it now sits at just 5 bps (Chart 2, bottom panel). Chart 1Strong Inflation In May Chart 2A Big Bear-Flattening With core inflation not showing any signs of slowing, the Fed will maintain its ultra-hawkish tone when it meets this week. While there’s an outside chance that the Fed will try to shock markets with a 75 basis point rate hike, we think it’s more likely that it will deliver the 50 basis point rate increase that Jay Powell teased at the last meeting while signaling that further 50 basis point rate increases are likely at both the July and September FOMC meetings. While inflation is not falling as quickly as either we or the Fed had previously anticipated, a look through the guts of the CPI report still leads to the conclusion that core inflation is more likely to fall than rise in the second half of this year. The main reason for this conclusion is that we aren’t seeing much evidence that inflation is transitioning from the goods sectors that were most heavily impacted by the pandemic to non-impacted service sectors. Rather, the main issue is that core goods inflation remains stubbornly high. Chart 3 shows the breakdown of core CPI into its three main components: (i) goods, (ii) shelter, and (iii) services excluding shelter. We can see that after only one month of decline in March, core goods prices accelerated to +0.69% in May, the largest monthly increase since January. The bulk of the May increase in goods inflation came from new and used cars (Chart 4), a sector where we should see price declines in the second half of this year now that motor vehicle production is ramping back up. Chart 3Contribution To Month-Over-Month Core CPI Chart 4Contribution To Month-Over-Month Core Goods CPI Turning to services, we observe a deceleration in May relative to April (Chart 3), and also notice that airfares continue to account for an outsized chunk of services inflation (Chart 5). Excluding airfares, core services inflation was just 0.36% in May. Chart 5Contribution To Month-Over-Month Core Services CPI (Excluding Shelter) Finally, we see that shelter CPI increased by 0.61% in May, up from 0.51% in April. Shelter is the most cyclical component of CPI and as such it tends to closely track the unemployment rate. The unemployment rate has been flat at 3.6% for three consecutive months and it is more likely to rise than fall going forward. Therefore, we don’t anticipate further acceleration in shelter inflation during the next 6-12 months. Monetary Policy & Investment Implications At the last FOMC meeting, Chair Powell went out of his way to guide market expectations toward 50 basis point rate hikes at both the June and July FOMC meetings. After which, Powell hinted that the Fed would re-assess the economic outlook and would likely continue to lift rates at each meeting in increments of either 50 bps or 25 bps, depending on the outlook for inflation. Powell clearly wanted to set a firm marker down for the pace of rate hikes so that Fed policy doesn’t “add uncertainty to what is already an extraordinarily uncertain time.”1 For this reason, we don’t expect the Fed to lift rates by more than 50 basis points at any single meeting. However, May’s elevated CPI number will likely cause Powell to tease an additional 50 basis point rate hike for September. After September, if inflation finally does soften, the Fed will likely downshift to a pace of 25 bps per meeting. Taking a look at market expectations, we see that fed funds futures are fully priced for a 50 bps rate hike this week and are even discounting a small chance of a 75 bps hike (Chart 6A). Meanwhile, the market is almost fully priced for 125 bps of tightening by the end of the July FOMC meeting, i.e., one 50 bps hike and one 75 bps hike (Chart 6B). Looking out to the September FOMC meeting, we see the market priced for 180 bps of cumulative tightening (Chart 6C). This is consistent with a little more than two 50 basis point rate increases and one 75 basis point rate increase at the next three FOMC meetings. Chart 6AJune FOMC Expectations Chart 6BJuly FOMC Expectations Chart 6CSeptember FOMC Expectations Looking even further out, we find the market priced for the fed funds rate to hit 3.28% by the end of the year and to peak at 3.88% in June 2023 (Chart 7).2 Chart 7Rate Expectations Our own expectation is that the Fed will deliver three or four more 50 basis point rate increases this year, followed by a string of 25 basis point hikes. This will bring the fed funds rate up to a range of 2.75% to 3.25% by the end of 2022, slightly below what is currently priced in the yield curve. As for portfolio duration, we recommend keeping it close to benchmark for the time being. Many indicators – such as economic data surprises, the CRB Raw Industrials/Gold ratio and the relative performance of cyclical versus defensive equities – suggest that bond yields are too high.3 That said, with inflation surprising to the upside and the Fed in a hawkish frame of mind, it is not wise to bet too aggressively on bonds. We also reiterate our view that investors should underweight TIPS versus nominal Treasuries. It’s notable that long-maturity TIPS yields moved higher and that the 10-year TIPS breakeven inflation rate was close to unchanged on Friday, despite the surprisingly high CPI number. This tells us that the market is not pricing-in a scenario where the Fed is losing control of long-dated inflation expectations. Rather, the market is discounting a scenario where the Fed does what is necessary to bring inflation back down. Softish Or Volckerish? Chart 8The Everything Selloff Of course, the big question for financial markets is whether the Fed will be forced to cause a recession to bring inflation down, or whether it will achieve what Jay Powell called a “softish” landing.4 The Fed’s hoped for “softish landing” scenario is one where inflation recedes naturally as we gain further distance from the pandemic. This outcome would limit the speed at which the Fed is forced to lift rates and push back the expected start date of the next recession. Unfortunately, trends in financial markets suggest that investors are putting less faith in the softish landing scenario. Our BCA Counterpoint Strategy recently observed that stocks, bonds, industrial metals and gold have recently all sold off in concert (Chart 8).5 It is rare for all four of these assets to sell off at the same time, but they did in 1981 when Paul Volcker was in the midst of dramatically lifting rates to conquer inflation. If we truly are on the cusp of the Fed tightening the economy into recession, then it makes sense for all four of those assets to perform poorly. Bond yields rise because the Fed is hiking much more quickly than was previously anticipated. Stocks and industrial metals sell off because of an increase in recession fears. Finally, gold sells off because of rising expectations that the Fed will do what it takes to bring inflation back down. And it’s not just financial markets that are warning that the Fed will be forced to repeat Chairman Volcker’s aggressive tightening. Two influential macroeconomists, Larry Summers and Olivier Blanchard, recently put out papers suggesting that the Fed needs another Volcker moment.6 Summers’ paper (with two co-authors) notes that changes in how the Bureau of Labor Statistics calculates shelter inflation make historical comparisons using CPI problematic. The authors estimate what core CPI would look like prior to 1983 if the current methodology had been employed and find that year-over-year core CPI peaked at 9.9% in 1980 well below the originally published figure of 13.6% and much closer to today’s 6% (Chart 9). The implication is that inflation is already almost as out of control now as it was in the early-1980s, and it will take a similar amount of monetary policy tightening to conquer it. In his paper, Olivier Blanchard makes a similar point by noting that the gap between the real fed funds rate and 12-month core CPI is as wide today as it was in 1975. The implication is that the Fed must play a similar amount of catch-up to bring inflation back down. Chart 9Properly Measured, Core CPI Was Much Lower In 1980 We think comparisons to the early-1980s are mistaken for three reasons. First, the Fed targets PCE inflation not CPI and PCE inflation does not suffer from the methodological inconsistencies that Summers et al identified. If we look at core PCE inflation, of which data only go to April, we see that 12-month core PCE inflation is currently 4.9% compared to a peak of 9.8% in 1980 (Chart 10). In other words, there is still a fair amount of distance between today’s PCE inflation and what was seen in the early 1980s. Chart 10The Fed Targets PCE Inflation Second, inflation was more broadly distributed in the 1970s/80s than it is today. At different points in the 1970s and early-1980s all three of the major components of core inflation – goods, shelter and services excluding shelter – were above 10% in year-over-year terms (Chart 11). Today, only core goods inflation has moved above 10% and year-over-year shelter and services ex. shelter inflation sit at 5.4% and 4.8%, respectively. Chart 11Inflation Is Less Broad-Based Than In The 1970s/80s Finally, wages had been accelerating rapidly for a full decade before inflation peaked in 1980 and this led to the emergence of a wage/price spiral (Chart 12). Firms increased prices to compensate for rising labor costs and then employees demanded further wage gains to compensate for rising consumer prices. Today, the evidence of a wage/price spiral is far less convincing. Wage growth has just recently moved above 5%, and we have seen recent indications that it is already starting to moderate.7 Typically, it takes a prolonged period of rapid wage growth for long-dated inflation expectations to rise and for a wage/price spiral to take hold. At present, we have seen only a modest move up in long-dated inflation expectations (Chart 13) and, as noted above, market-based measures of long-dated inflation expectations barely budged in response to last Friday’s inflation report. Chart 12No Wage/Price Spiral Yet Chart 13Inflation Expectations The bottom line is that inflation is still more likely to fall than rise during the next 6-12 months, and this will prevent the Fed from tightening more quickly than what is already priced in the yield curve. That said, while inflation is likely to dip, it will remain above the Fed’s 2% target and a recession will eventually be required to restore price stability. That recession, however, may not occur until late-2023 and it will likely be preceded by far less aggressive monetary tightening than what Paul Volcker delivered in the early-1980s. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on the Fed’s forward guidance please see US Bond Strategy Weekly Report, “On A Dovish Hike And A 3% Bond Yield”, dated May 10, 2022. 2 These numbers are as of last Friday’s close. 3 For details on these indicators please see US Bond Strategy Webcast, “Will The Fed Get Its Soft Landing?”, dated May 17, 2022. 4 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20220504.pdf 5 Please see BCA Counterpoint Weekly Report, “Markets Echo 1981, When Stagflation Morphed Into Recession”, dated May 19, 2022. 6 Please see Bolhius, Cramer, Summers, “Comparing Past and Present Inflation”, June 2022. https://www.nber.org/papers/w30116. And also Blanchard, “Why I worry about inflation, interest rates, and unemployment”, March 2022. https://www.piie.com/blogs/realtime-economic-issues-watch/why-i-worry-about-inflation-interest-rates-and-unemployment. 7 Please see US Bond Strategy Portfolio Allocation Summary, “The Case For A Soft Landing”, dated June 7, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns
Executive Summary ECB & Inflation: Whatever It Takes? Inflation is the European Central Bank’s single focus. This single-mindedness heightens the risks to Euro Area growth, especially because wider peripheral spreads do not seem to worry the ECB yet. Italian spreads will widen further, which will contribute to weaker financials, especially in the periphery. The money market curve already prices in the path of the ECB; the upside in Bund yields is therefore capped. Cyclical assets, including stocks, are vulnerable to the confluence of weaker growth and tighter monetary policy. Industrials are fragile. Downgrade to neutral for now. German industrials will outperform Italian industrials. Bottom Line: The ECB will do whatever it takes to slow inflation, which will further hurt an already brittle European economy. This backdrop threatens European stocks and peripheral bonds. Downgrade industrials to neutral and go long German / short Italian industrials. Feature Last week, the European Central Bank’s Governing Council sided with the hawks. The doves have capitulated. This development creates mounting risks this summer for European assets, especially when global growth is slowing. Worryingly, the ECB has given speculators the green light to widen peripheral and credit spreads in the near term. Cyclical assets remain at risk. We are downgrading industrials and financials. Hawkish Chart 1Higher Inflation Forecast = Hawkish ECB The ECB’s forward guidance proved more hawkish than anticipated by the market, as highlighted by the 16bps increase in the implied rate of the December 22 Euribor contract following the press conference. The ECB also refused to sooth investors’ nerves regarding fragmentation risk in the periphery. A large part of the ECB move was already anticipated. The ECB will lift its three interest rate benchmarks by 25bps at its July meeting. It also increased its headline inflation forecasts to 6.8% from 5.1% in 2022, to 3.5% from 2.1% in 2023, and most importantly, it raised its long-term HICP forecast to 2.1% from 1.9% (Chart 1). The ECB now expects medium-term inflation to be above its 2% target. The true hawkish shock came in response to the higher-than-target medium-term inflation forecast. By September, if the 2024 inflation forecast does not fall back below 2%, then a 50bps hike that month will be inevitable. The whole interest rate curve moved up in response to that guidance. The most concerning part of the statement was the lack of clarity about the fragmentation fighting tool. The ECB specified that it will re-invest the principal of its holdings under the APP and PEPP until 2024, at least. However, the program to prevent stress in peripheral bond markets was not revealed and was presented as an eventuality to be deployed only if market conditions deteriorate further. Investors may therefore assume that the ECB is still comfortable with Italian bond yields above 3.5% and high-yield spreads of 464bps (Chart 2). Ultimately, the ECB’s single-minded focus is inflation, even though it is mostly an imported shock. The ECB cares little for the effect of its actions on growth. It will therefore remain very hawkish until it sees enough evidence that the medium-term inflation outlook will fall back below 2%. Before the ECB can tabulate a decline in the inflation outlook, the following developments must take place: The economy must slow in order to extinguish domestic inflationary pressures. The labor market, to which President Christine Lagarde referred often in the press conference, must cool. Specifically, the very elevated number of vacancies must decline relative to the low number of unemployed persons (Chart 3). A weaker economy will cause this shift. Energy inflation must recede to choke secondary effects on prices. Chart 2Tight But Not Tight Enough For The Hawks Chart 3The Labor Market Must Cool The good news is that the decline in commodity inflation is already underway. Last week, we argued that if energy prices remain at their current levels, (or if Brent experiences the additional upside anticipated by BCA’s Commodity and Energy strategists), then energy inflation will decelerate significantly. Already, the inflationary impact of commodities is dissipating (Chart 4). European growth has not slowed enough to hurt the labor market, but it will decline further. Real disposable income is falling, and the manufacturing sector is decelerating globally. Moreover, European terms of trade are tumbling, which hurts the Euro Area’s growth outlook, especially compared to the US where the terms of trade are improving (Chart 5). Chart 4Dwindling Commodity Impulse Chart 5Europe's Terms-of-Trade Problem The European periphery, especially Italy, faces particularly acute problems. We argued two months ago that Italian yields of 4.5% would not cause a sovereign debt crisis if economic activity were strong. As we go to press, Italian yields stand at 3.7%, or higher than those in Canada and Australia. Yet, Italy suffers from poor demographic and productivity trends; its neutral rate of interest is lower than that of both Canada and Australia. Moreover, Canada and Australia today enjoy robust terms-of-trades. Meanwhile, Italy is among the European economies most hurt by surging energy prices. Consequently, a vicious circle of higher yields and lower growth is likely to develop. Chart 6The BTP-EUR/USD Valse Italy’s economic problems imply that investors will continue to push Italian spreads higher until the ECB provides a clear signal of support for BTPs, which could happen after spreads reach 300bps over German 10-year yields. Italy’s weakness is a major handicap for the monetary union as well. The higher Italian spreads widen, the weaker the euro will be (Chart 6). However, a depreciating euro is inflationary, which invites higher rates for the Euro Area and tighter financial conditions. The great paradox is that, if the ECB were more pro-active about the fragmentation risk, it could fight inflation with less danger to the economy and thus, the Eurozone could achieve higher rates down the road. Weaknesses in global and European growth, risks of higher Italian and peripheral spreads, and an ECB solely focused on inflation will harm European risk assets further. Specifically, credit spreads will widen more and cyclical stocks will remain vulnerable. Within cyclical stocks, Italian and Spanish financials are the most exposed to the fragmentation threat in Euro Area bond markets. We have held an overweight recommendation on industrial equities. We maintain a positive long-term bias toward this sector, but a neutral stance is warranted in the near term. Finally, Bund yields have limited upside from here. The curve already anticipates 146bps of tightening by the end of this year and 241bps by June 2023. The ECB is unlikely to increase rates more than is anticipated, which caps German yields. Instead, the ECB is likely to undershoot the €STR curve pricing if it increases interest rates once a quarter after the September 50bps hike. Bottom Line: Don’t fight the ECB. The Governing Council is single-mindedly focused on fighting inflation. Growth must slow significantly to cool the labor market and allow the ECB to cut back its medium-term inflation forecast to 2%. Therefore, European assets will remain under stress in the coming months as global growth deteriorates. Italian and peripheral spreads are particularly vulnerable, which will also weigh on financials because of Spanish and Italian banks. Chart 7Pricey Industrials Neutral On Industrials Industrials stocks have outperformed other cyclicals and have moved in line with the Euro Area broad market. However, relative forward EPS have not tracked prices; industrials are now expensive and vulnerable to shocks (Chart 7). The increase in the relative valuations of industrials reflects their robust pricing power. Normally, the economic weakness pinpointed by the Global Growth Expectations component from the ZEW Survey results in falling valuations for industrials, since it is a growth-sensitive sector (Chart 8). However, this year, the earnings multiples of industrials relative to the broad market have followed inflation higher (Chart 8, bottom panel). This paradox reflects the strong pricing power of the industrial sector, which allows these firms to pass on a greater share of their increasing input-costs and protect their profits (Chart 9). Chart 8Ignore Growth, Loving Inflation Chart 9Pricing Power Is The Savior The ability of industrials to weather a growth slowdown is diminishing: European inflation will peak in response to the decline in commodity inflation (see Chart 4, on page 4). Already, the waning inflation of metal prices is consistent with lower relative multiples for industrials (Chart 10) Last week, we argued that global PMIs have greater downside because of the tightening in global financial conditions. Weaker global manufacturing activity hurts the relative performance of industrials. Capex in advanced economies is likely to drop in the coming quarters. US capex intentions are rapidly slowing, which has hurt European industrials. European capex intentions have so far withstood this headwind; however, the outlook is worsening. European final domestic demand is weakening, and European inventories are growing rapidly (Chart 11). Capex is a form of derived demand; the challenges to European growth translate into downside for investment. Chart 10The Commodity Paradox Chart 11The Inventory Buildup Threat The Euro Area Composite Leading Economic Indicator is already contracting and will fall further. The ECB’s focus on inflation and its neglect of financial conditions will drag the LEI lower. Moreover, central banks across the world are also tightening policy, which will filter through to weaken global and Europe LEIs. A declining LEI hurts industrials (Chart 12). The relative performance of European industrials is positively correlated to that of US industrials (Chart 13). BCA’s Global Asset Allocation has recently downgraded industrials to neutral from overweight. Chart 12Weaker LEIs Spell Trouble Chart 13Where the US Goes, So Does Europe Despite these risks, we are reluctant to go underweight industrials because financials are more exposed to the ECB’s neglect of financial conditions. Moreover, the headwinds against the industrial complex are temporary, especially when it comes to China. Chinese authorities have greatly stimulated their economy, and Beijing is softening its stance on the tech sector. A loosening of the regulatory crackdown would revive animal spirits and credit demand. Moreover, the aerospace and defense industry, which is a large component of the industrial sector, still offers attractive prospects. Instead, we express our concerns for industrials via the following pair trade: Long German industrials / short Italian Industrials. This is a relative value trade. German industrials have underperformed their relative earnings, while Italian ones have moved significantly ahead of their earning power. Thus, German industrials are very cheap and oversold relative to their southern neighbors (Chart 14). Interestingly, this derating took place despite the widening in Italian government bond spreads, which normally explains this price ratio well (Chart 15). This disconnect presents a trading opportunity. Chart 14A Relative Value Trade Chart 15An Unusual Disconnect Chart 16German Industrials And Growth Expectations While global growth has yet to bottom, the performance of German relative to Italian industrials fluctuates along growth expectations (Chart 16). Germany seats earlier in the global supply chain than Italy. The Global Growth Expectations component from the ZEW Survey is extremely depressed and approaching levels where a rebound would be imminent. German industrials suffer more from the energy crunch than Italian ones. They will therefore benefit more from the decline in energy inflation. Historically, German industrials outperform Italian ones when commodity prices rise, but this relationship normally reflects the strong global demand that often lifts natural resource prices (Chart 17). Today, commodities are skyrocketing because of supply constraints, not strong demand. Therefore, they are hurting rather than mimicking growth. This inversion in the relationship between the performance of German compared to Italian industrials and natural resources prices is particularly evident when looking at European energy prices (Chart 18). Consequently, once the constraint from commodities and global supply chains ebb, German industrials will outshine their Italian counterparts. Chart 17Commodities: From Friends To Foes Chart 18Energy: From Friend To Foe German industrials suffer when stagflation fears expand (Chart 19). The ECB’s focus on inflation will assuage the apprehension of entrenched inflation in Europe. The recent improvement in our European Stagflation Sentiment Proxy will continue to the advantage of German industrials. Additionally, a firm ECB stance will push European inflation expectations lower, which will help German industrials compared to their Italian competitors (Chart 20). Chart 19Stagflation Hurts Germany More Chart 20The ECB"s Inflation Focus Helps German Industrials German PMIs are improving relative to Italian ones. The trend in Germany’s industrial activity compared to that of Italy dictates the evolution of industrials relative performance between the two countries (Chart 21). The tightening in financial conditions in Italy due to both wider BTP spreads and their negative impact on the Italian banking sector will accentuate the outperformance of Germany’s manufacturing sector. German industrials are more sensitive than Italian ones to the gyrations of the Chinese economy. BCA’s Geopolitical Strategy service anticipates an improvement in China’s economy for the next 18 months or so in response to previous stimuli and the easing regulatory burden. The close link between the performance of German industrials relative to Italian ones and the yuan’s exchange rate indicates that a stabilizing Chinese economy will undo most of the valuation premium of Italian industrials (Chart 22). An improvement in China’s economy will also lift its marginal propensity to consume (which the spread between the growth rate of M1 and M2 approximates). A rebound in Chinese marginal propensity to consume will boost comparative rates of returns in favor of Germany (Chart 22, bottom panel). Chart 21Relative Growth Matters Chart 22The China Factor Bottom Line: Industrials have become expensive relative to the rest of the market, but they are still too exposed to the global economy’s downside risk. This tug-of-war warrants a downgrade to neutral for now. Going long German industrials / short Italian industrials is an attractive pair trade within the sector. German industrials are cheap and they will benefit from both the ECB’s policy tightening and the upcoming decline in European inflation. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades
Executive Summary Hiring is slowing and layoffs have begun to rise, but today's robust net increases in non-farm payrolls are inconsistent with an approaching recession. The demise of the American consumer has been greatly exaggerated. Households have lots of savings to spend and the capacity to borrow against them if they choose. The extensive forward guidance that the Fed has been at pains to provide to markets may have fueled a sharp preemptive tightening in financial conditions that might prove premature if it reduces the Fed's need to cool the economy itself. None of the three components of our simple recession indicator (the slope of the yield curve, the year-over-year change in the Leading Economic Index and our assessment of monetary policy settings) is sounding the alarm, or even flashing yellow. No Recession Warning In This Series Bottom Line: Although gloom is increasingly pervasive among investors, we remain constructive on risk assets and the economy over the next twelve months, and reiterate our recommendation to overweight equities in a balanced portfolio. Feature Per the mosaic theory of security analysis, analysts, portfolio managers and independent investors piece together fragments of publicly available information to form a thesis about a company’s prospects. After appraising the company’s securities based on that thesis, the analyst/PM/investor determines whether they’re overvalued, undervalued or fairly valued and takes the appropriate action in his/her portfolio. All market participants are in a race to be among the first to see the outline of the complete picture as the opportunities to exploit mispricings are inversely related to the available share of relevant data. Security fair values become more apparent as more bits of colored glass begin to circulate and alpha-seeking investors have to move on to the next mostly incomplete puzzle to find an edge. Related Report US Investment StrategyAll The Way To Ticker Symbols The same framework applies to macroeconomic analysis. It’s especially apt now, given the lack of a close precedent for the monetary and fiscal support policy makers lavished on the economy to protect it from COVID-19’s potential ravages and the way that data flows have refused to conform to a well-defined trend supported by a stable narrative theme. Macro data and news from individual companies are stuck in a one-step-forward, one-step-back pattern as embodied by stagnant stock indexes. The S&P 500 paced the same 100-point path between 4,075 and 4,175 for two full weeks before tumbling through the bottom of the range last Thursday and losing contact with it on Friday after the May CPI report showed that inflation remains stubbornly high (Chart 1). Chart 1Stocks See The Glass As Half-Empty The details of the May CPI report weren’t as bad as the headlines, though we were surprised and disappointed by its failure to confirm our view that inflation is peaking. From the full range of puzzle pieces we already have, however, we continue to think the picture for risk assets and the economy one year from now will be encouraging. We spent last week speaking and mingling at a conference and meeting with clients one-on-one last week, confirming that our sanguine view is decidedly in the minority as investors have become increasingly resigned to the idea that inflation cannot be brought down to a tolerable level without squeezing the economy. We think there is a middle way, at least over the next twelve months, as we highlight below by reviewing some of the largest and most important factors. Employment If a recession were imminent, we would expect to see hiring begin to sputter. Year-over-year payrolls growth has slowed, but it remains more than a standard deviation above the mean (Chart 2, top panel), at its highest level in 38 years. Annualized month-over-month growth is strong as well, if not as much of an outlier as year-over-year growth (Chart 2, bottom panel). Going forward, payrolls growth is poised to remain strong (Chart 3, top panel), as small businesses’ hiring intentions are very high (Chart 3, second panel), temporary employment is still elevated (Chart 3, third panel) and initial unemployment claims, while rising, are extremely low (Chart 3, bottom panel). Chart 2Payrolls Are Growing At A Nice Clip ... Chart 3... And Will Continue To Do So Consumption Chart 4Solid Footing We have stressed that households’ massive pandemic savings have provided them with ample ability to consume. They have worked down the debt they took on ahead of the financial crisis, restoring the household debt-to-GDP ratio to its 2002 level (Chart 4, second panel), which is much more lightly borne today than it was then, thanks to interest rates that remain extremely low despite their recent backup (Chart 4, bottom panel). It is an open question, subject to occasionally fierce debate within BCA, if households have the willingness to consume the mountain of savings they have amassed since COVID-19 reached the US. Our answer has been an unequivocal yes, and we have been working under the purposely conservative assumption that households will spend just half of their $2 trillion-plus stash. So far, the data are on our side: consumers have not lost their appetite for dining out, returning to restaurants at their pre-pandemic pace once the Omicron coast was clear (Chart 5, top panel). Travelers are returning to the skies, as well, undeterred by soaring airfares (Chart 5, bottom panel). Although passenger levels have not made it all the way back to their 2019 levels, nearly 60% more passengers have passed through TSA checkpoints so far this year than they did at this point in 2021, and credit card usage indicates that reduced business travel is responsible for the shortfall, as individuals have eagerly sought to cure their cabin fever (Chart 6). Chart 5Back To Restaurants, Bars ... Chart 6... And The Friendly Skies Private Investment/Credit Spreads Although consumption accounts for two-thirds of overall US output, or three-and-a-half times more than investment, the latter is slightly more likely to bring about a contraction in GDP because it is considerably more volatile.1 Nonresidential investment accounts for the lion’s share of private investment and BCA’s capex model projects that it will remain robust over the next two quarters (Chart 7). Residential investment will have to grapple with the housing slowdown imposed by the sudden and significant increase in mortgage rates, but we agree with our Bank Credit Analyst colleagues’ assessment that housing is unlikely to tank the economy.2 Homes remain undersupplied after several years of insufficient construction and the spread between the baseline 30-year fixed mortgage rate and the 10-year Treasury yield has become so stretched that it appears that the mortgage rate may have already reached its 2022 peak (Chart 8). Chart 7Capex Prospects Are Good ... Wider corporate bond spreads and intimations that banks are becoming less eager to lend could signal a further tightening of financial conditions. There have been three major spread-widening episodes in the high yield era (Chart 9, top panel) and none began until three preconditions had been met. Chart 8... And Mortgage Borrowers Are Due For A Break The Fed had to have completed its rate hiking cycle (Chart 9, second panel), our proprietary Corporate Health Monitor (CHM) had to have crossed into deterioration (Chart 9, third panel) and the Fed’s quarterly Senior Loan Officer survey had to indicate that a majority of banks was imposing tighter credit standards on business borrowers (Chart 9, bottom panel). None of those conditions is in place yet, though banks' lending appetites may be shrinking and the first quarter was not great for corporate health. Chart 9Perhaps Forward Guidance Was TMI Broad Recession Probability Pulling back to 30,000 feet, none of the key recession prerequisites we constantly monitor is yet signaling any distress. The 3-month bill/10-year note segment of the Treasury yield curve remains solidly upward sloping (Chart 10). The Leading Economic Index (LEI) is nowhere close to contracting on a year-over-year basis (Chart 11), and the target fed funds rate is far below our estimate of the equilibrium fed funds rate (Chart 12). Each series has issued its own false signal – an above-equilibrium fed funds rate has been a necessary, but hardly sufficient, recession condition – but they have a perfect track record when considered together. Chart 10When The Yield Curve Inverts, ... Chart 11... Year-Over-Year LEI Contracts ... Chart 12... And Monetary Policy Settings Are Restrictive, A Recession Soon Follows Investment Implications The May CPI report only strengthened the conviction of those holding bearish views and will at least temporarily fuel a barrage of gloomy headlines that might sway the uncommitted. It has reduced the marginal probability that the Fed will be able to thread the needle and meet its price stability mandate without taking direct aim at its full employment goals. We still expect that the Fed will be able to maintain its balancing act for another twelve months because we think inflation will begin to come down on its own once the fevers in new and used auto prices and airfares finally break. The more remote that prospect seems to investors, the more stock prices will fall and bond yields will rise if the bullish view, or something slightly less bearish than discounted, comes to pass. The University of Michigan’s consumer sentiment survey made an all-time low in the preliminary June data released Friday morning. We are less concerned about the headline number – Open Table reservations and busy TSA security lines suggest investors are better served by focusing on what consumers do than how they feel, and the Michigan gloom is contradicted by the Conference Board survey's modest optimism – than we are about the upward turn in consumers’ long-run inflation expectations. Respondents to the Michigan survey increased their median estimate for inflation in five to ten years to 3.3% from 3% over the previous four months (the estimate had been between 2.9 and 3.1% for ten months beginning last August). If workers’, businesses’, investors’ and consumers’ long-run inflation expectations become unmoored, an inflation mindset in which high prices beget still higher prices could threaten to take hold, forcing the Fed to channel its inner Paul Volcker, shattering our temporary thread-the-needle thesis. For now, the term structure of inflation expectations remains sharply inverted. That’s to say that TIPS breakevens, CPI swaps and survey respondents continue to expect that intermediate- and long-term inflation will slow considerably from its currently elevated levels. If they begin to lose faith that very high inflation readings are a temporary phenomenon, we will have to revisit our glass-half-full perspective. We are not irresolute, but like Lord Keynes, when the data change, we change our minds. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 The probability that investment could decline enough in any given quarter to zero out 2% growth in consumption and government spending is 23%, based on its historical distribution. The probability that consumption could wipe out 2% growth in investment and government spending is 17.6%. Government spending, which is one-fourth the size of consumption and considerably more stable than comparably sized investment, has just a 2.3% probability of negating trend growth in the other components. (All calculations disregard net exports.) 2 "Is The US Housing Market Signaling An Imminent Recession?" Bank Credit Analyst Special Report, June 2022.
Executive Summary Is Relative Inflation Peaking In The US? The dollar has likely peaked in the near term. An unwinding of speculative bets, based on structurally higher inflation in the US, is the key driver (Feature Chart). Our theme of central bank convergence continues to play out. Rates in the euro area are headed higher. The next bet for higher rates is in Japan. The key for picking currency winners will be global growth barometers. The US dollar embeds a huge safety premium that will be eroded as we get more clarity on global growth and inflation. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short DXY 104.80 2022-05-13 2.22 Bottom Line: We are short the DXY index as of 104.8. We recommend sticking with this position. Feature The dollar very much remains well bid (Chart 1). But the macroeconomic environment that has helped the dollar is likely to reverse. As inflation in the US cools, especially relative to other DM economies, the policy divergence between the US and other economies will move in the opposite direction (Chart 2 and Chart 3). Chart 1Long Dollar Positions Still Profitable Chart 2Is Relative Inflation Peaking In The US Chart 3The Dollar And Interest Rates Last month, we posited that interest rate differentials played a key role in pushing the dollar higher but have not been the sole factor. The safe-haven premium in the DXY is around 8-10%. That premium will remain if growth concerns are at the forefront of investors’ minds but will evaporate otherwise. Over the last few weeks, we have had a few surprises from central banks, notably the ECB and the RBA. In this Month-In-Review, we go over our current currency thinking, and implications for portfolio strategy. US Dollar: Peak Hawkishness? Chart 4Is Inflation Peaking In The US The dollar DXY index is up 7.4% year to date. However, over the last month, there has been a big reversal in the dollar, down 1.5% month-to-date. As a momentum currency, technical forces are moving against the greenback. Incoming data for the US remains robust, but a peak in inflation expectations, that will temper the pace of Fed interest rate hikes, has been driving dollar momentum. Headline CPI is expected to come in at 8.3% in May, while the core measure should decelerate to 5.9%. It is possible that these numbers surprise to the downside. For example, used car prices, an important contribution to US CPI, are rolling over sharply (panel 2). Overall, supply-side price pressures appear to be easing (panel 3). The US added 390K jobs in May, so the employment report remains robust. Encouragingly, the participation rate is also picking up. This suggests the US can absorb more willing workers before we see additional upward pressure in wage growth. We are closely watching the Atlanta Fed wage growth tracker (panel 4). The ISM manufacturing index had a solid print of 56.1 in May, but the prices paid index dipped from 84.6 to 82.2. As we highlighted above, these developments have sapped market expectations for aggressive interest rate increases in the US relative to other G10 countries. Speculative froth in the dollar is also unwinding (panel 5). We went short the DXY index at 104.8, with a stop loss at 107. We recommend sticking with this position. The Euro: A European Soft Landing? Chart 5The Euro Has Priced A Recession The euro is down 6.6% year-to-date. Over the last month, the euro is up 0.7%. The ECB cemented the fact that interest rates are headed higher this week. With a mandate of taming inflation, the central bank faces a tough job of reigning in price pressures, while engineering a soft landing in the economy. From the perspective of the euro, it is our view that most of the downside risks to this scenario have been priced in, while upside surprises have not (panel 1). Incoming data from the euro area has been improving. The Sentix Investor Confidence index ticked up in June. Energy prices remain high, but momentum has been softening. The ZEW expectations survey also delivered an upside surprise in May. The key point from an FX perspective is that the euro has already priced a recession in the European economy, but no prospect of a soft landing. That is positive from a contrarian perspective. With HICP inflation at 8.1% (panel 2), emergency monetary settings are no longer required, and the ECB should lift rates. As we suggested last month, a “least regrets” approach will gently nudge rates higher to address inflationary pressures but pay attention to cyclical sectors of the economy (panel 3). It is important to remember that interest rates in the eurozone are still at -0.5%. Related Report Foreign Exchange StrategyMonth In-Review: A Hefty Safe-Haven Premium In The Dollar We remain long EUR/GBP on the prospect that the ECB could better engineer a soft landing, compared to the BoE. We also remain sellers of the EUR/JPY cross. In a risk-off environment, EUR/JPY will collapse. In a Goldilocks scenario, the cross has already priced in a much stronger global economy (panel 4). This is also a perfect hedge for a pro-cyclical currency positioning. The Japanese Yen: Back To Carry Trades Chart 6The Yen Will Soon Bottom The Japanese yen is down 14.3% year-to-date, the worst performing G10 currency this year. Over the last month, the yen is down 2.9%. The yen is a classic case of the risks of fighting the trend in currency markets (panel 1). That said we remain buyers, rather than sellers, on weakness. The drivers of the yen have been very clear and absolute. First, rising interest rates abroad, as we saw this week, have put selling pressure on the JPY (panel 2), given the BoJ will maintain yield curve control. Second, the pickup in energy prices continues to deflate the Japanese trade balance. These are negative shocks that are likely to continue inflicting pain on yen long positions in the near term. From a contrarian perspective, there is solace for yen bulls. First, it is the cheapest G10 currency according to our PPP models. It also happens to be one of the most heavily shorted currencies, according to CFTC data (panel 4). In terms of data, there have also been positive surprises over the last month. The Eco Watcher’s Survey surprised to the upside. PMIs have rebounded above 50. Inflation is above the 2% target and should keep rising. Machinery orders are picking up. The Bank of Japan is likely to stay dovish next week but that is largely priced in. Meanwhile, the BoJ will have no choice but to pivot if inflationary pressures prove stronger than they anticipate, and/or the output gap in Japan closes much faster as demand recovers. We have no active position on the yen right now but will be buyers on weakness. British Pound: Sterling And A Policy Mistake Chart 7Cable Is At Risk Near Term The pound is down 7.6% year to date. Over the last month, the pound is up by 1.3%. We wrote a report on sterling last week. In our view, sterling faces headwinds in the near term but is likely to be a profitable long position for investors with a more structural view. First, the deterioration in the UK’s trade balance is cyclical and not structural. Fuels constitute 11% of UK imports so higher energy prices are affecting the balance of trade. This will soon reverse. Second, goods imports have picked up, but it is encouraging that a huge share has been machinery and transport equipment. Inflation remains a problem in England, with CPI at 9%. In our view, while sterling is pricing in a policy mistake by the BoE – tightening too fast into a slowing economy, our bias is that the BoE can engineer a soft landing for the economy. Only one-third of the rise in UK inflation has been driven by demand-side pull, with the balance related to supply-side factors. The latter have been the usual suspects – rising energy costs, supply shortages, and even legacies of the Brexit shock (Chart 10). These could ease going forward. We are currently long EUR/GBP. This cross still heavily underprices the risks to the UK economy in the near term. However, if recession fears ease, our suspicion is that cable is poised for a coiled spring rebound. Canadian Dollar: The BoC Will Stay Hawkish Chart 8CAD Should Benefit From Terms Of Trade The CAD is down 0.6% year to date. Over the last month, it is up 2.4%. The CAD has been the best performing G10 currency this year after the DXY, and the key drivers of loonie strength will persist. First, the CAD will benefit from a terms-of-trade boost, given it is trading at a discount to prevailing oil prices. Second, the BoC will stay hawkish, having hiked interest rates by 50 bps last month, and telegraphing more tightening going forward. Economic data out of Canada suggests tighter monetary policy is warranted. Both headline and core inflation remain strong, with headline inflation at 6.8% in April. The common, trim, and median inflation prints were at 3.2%, 5.1%, and 4.4%, respectively, well above the BoC’s target. This continues to suggest inflationary pressures in Canada are broad based (panel 2). House prices are rolling over so the wealth effect could temper hawkishness from the BoC. However, recent speeches from policy officials have highlighted a need to tame housing price pressures in Canada (panel 4). We remain buyers of the CAD on a lower dollar but are monitoring risks from a tightening in financial conditions. New Zealand Dollar: Will Weaken At The Crosses Chart 9The RBNZ Is Trying To Engineer A Soft Landing The NZD is down 6.6% this year. Over the last month, the kiwi is down 1.0%. The RBNZ hiked interest rates by 50 bps in May, taking the overnight rate to 2%. This seems to be having the intended effect, with house price inflation rolling over as mortgage rates adjust higher. This “least regrets” approach is likely to continue in the short term. The labor market is extremely tight, with a shortage of high skilled labor given immigration has slowed. This is leading to substantial wage increases. As such, the RBNZ has been increasing guidance for annual CPI inflation, and therefore, interest rates, raising its overnight projection for June 2023 to 3.9% from 2.8%. There is reason to believe the RBNZ will tone down its hawkish rhetoric. For one, terms of trade are softening. Dairy prices, circa 20% of exports, are down 1% this month after reaching a 10-year high in May. A domestic slowdown is also likely to nudge the RBNZ toward more accommodation. In a nutshell, the kiwi has upside versus the dollar, but will underperform at the crosses. Australian Dollar: Our Top Pick Against The Dollar Chart 10The RBA Will Continue To Hike The Australian dollar is down 2.3% year to date. Over the last month, the AUD is up 2%. The Reserve Bank of Australia raised interest rates by 50 bps this week, a surprise to markets, but in line with the hawkish tone telegraphed in prior meetings. Inflation in Australia is surprising to the upside. Meanwhile, unemployment remains well below NAIRU. As a result, an exit from emergency monetary settings makes sense. The key will be whether the RBA can engineer a soft landing in the Aussie economy. Job gains remain robust, and both the unemployment rate and the participation rate are at healthy levels. Terms of trade are holding up, and wage gains are improving. Home prices are rolling over, but it is a welcome development as the RBA is trying to calibrate financial conditions. We are long the AUD as of 72 cents. The big concern for this trade is China, and the potential for renewed lockdowns that will hurt the external balance. As such, we expect this trade to be volatile near-term, but pay off over a longer horizon. Swiss Franc: A Safe Haven Chart 11The SNB Will Stay Constructive On The Franc The Swiss franc is down 7% year-to-date, but up versus the dollar over the last month. Swiss economic conditions have been rather resilient. GDP expanded by 0.5% in Q1, slightly above expectations, while industrial production also rose 2.4% in the same period. In April, Switzerland’s trade surplus widened to CHF 3.8bn, boosted by demand for machinery and chemicals. In May, the KOF leading indicator clocked 96.8 and the manufacturing PMI stood at 60, a slowdown month-on-month but still a very healthy reading. Inflation is surprising to the upside in Switzerland. Headline and core CPI growth came in at 2.9% and 1.7% year-on-year in May, respectively. Recently, several SNB board members have voiced the primacy of price stability and preparedness to hike rates if inflation becomes broad based. This has helped support the franc. The market now expects SNB to follow the ECB in removing the NIRP starting in September. But it is always good to remember that the Swiss franc is a defensive currency, so a path to policy normalization still presents upside for EUR/CHF. In our trading book, we are short CHF/SEK, but will take profits if Thomas Jordan proves to be more of an inflationary hawk. Norwegian Krone: Bullish On A 12-to-18 Month Horizon Chart 12The Norges Bank Will Stay Hawkish NOK is down 8.1% year to date and up 1.5% over the last month. In the three months through March, Norway’s GDP contracted by 1% quarter on quarter, led by drops in private consumption (1.5%), government spending (1.4%), and exports (3.5%). The decline largely reflects restriction measures imposed at the start of the year. That said, economic growth is rebounding and GDP growth will be around 3% in the next 12 months. Meanwhile, the trade surplus remains very healthy at 92.6bn NOK. As a result, the current account surplus hit at an all-time high of 341bn NOK in Q1. From a broader perspective, incoming numbers in Norway reflect a slowdown in global growth. Consumer confidence dropped to the lowest levels since 2016. The manufacturing PMI fell sharply to 54.9 in May, the lowest reading in over a year. Industrial production also decreased by 0.5% month-on-month in April. That said, the labor market continues to tighten. The unemployment rate fell to 1.7% in May, significantly below Norge Bank’s 2% projection. Renewed immigration might help alleviate some of the labor market tightness, but the strength in employment trends is very evident. As a result, our bias is that the committee will stick to its quarterly 25bps hikes, but upside surprises to this baseline are non-trivial. Terms of trade are a tailwind for Norway. In particular, NOK/SEK can be an attractive bet on a 12-month horizon, should oil prices remain firm. Swedish Krona: Into A Capitulation Phase Chart 13More Hawkish Surprises From The Riksbank The SEK is down 8.7% year to date and up 1.6% over the last month. Sweden sits right at the crosshairs of the Russia-Ukraine conflict. As a result, inflation remains a problem with CPIF at 6.4%, year-over-year in April, above updated projections from Riksbank. The issue is that there are rising risks that inflation will not be transitory, raising the prospect of a policy surprise from the Riksbank. The OIS curve is now pricing in a 1.75% policy rate by year-end. In our view, this will be a baseline scenario. The critical point is whether the Riksbank is on the verge of making a policy mistake. Economic growth is slowing. Swedish GDP contracted by 0.8% in Q1 from the previous quarter. However, if policymakers are overly fixated on inflation, the prospect of grinding the Swedish economy to a halt becomes a rising risk. Major rounds of collective wage negotiations early next year, affecting as much of as 40% of total labor force, is a risk to monitor. There is already some evidence of a slowdown in economic activity. Consumers reported the lowest level of confidence since the Global Financial Crisis. PMIs remain resilient, well above 50 but the risk is to the downside. Should the Chinese credit impulse bottom and supply constraints ease, economic activity will pick up in the second half of the year, but the risk of downside surprises are worth monitoring. The bottom line is that SEK has already priced in much of the negative news and remains undervalued in our models. We are short CHF/SEK on these grounds, a position 1.5% in the money. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary
Executive Summary Competing Forces On Global Bond Yields Bond yields in the developed world have ticked higher recently, due to a renewed increase in oil prices and the spillover effect from more hawkish policy expectations out of Europe. The competing forces of slowing global growth momentum and geopolitical uncertainty on one side, and high inflation with tightening monetary policies on the other, will keep global government bond yields rangebound over the next several months. UK investment grade corporate bonds now offer an intriguing combination of higher yields, attractive spread valuations and strong financial health. By maturity, shorter-maturity corporates offer the best value. At the industry level, spreads look most attractive for Financials. A hawkish Bank of England, both through rate hikes and upcoming outright sales of corporate debt the central bank has purchased via quantitative easing, remains a major headwind to UK corporate bond returns. Sectors most at risk to central bank sales are Water, Consumer Cyclicals and Consumer Non-Cyclicals. Bottom Line: Stay neutral on overall duration exposure in global bond portfolios. Maintain a neutral stance on UK corporates, favoring shorter-maturity bonds and Financial names, but look to upgrade once UK inflation peaks and the Bank of England pauses on tightening. Trendless, Friendless Bond Markets Chart 1Recovering From The Ukraine War Shock... Although it may not feel like it given the ferocity of some daily price swings, many important financial markets have not moved all that much, cumulatively, since the first major shock of 2022 – the start of the Russian invasion of Ukraine on February 24. For example, the S&P 500 is only down around -2% from the pre-invasion level, while the VIX index of equity option volatility is at 24, seven points below the closing level on February 23 (Chart 1). The Bloomberg US investment grade corporate bond index spread is only 12bps above its pre-invasion level, down 20bps from the peak seen in mid-May. More recently, even US bond yields have shown signs of stabilization. The 10-year US Treasury yield has traded in a 2.70-3.15% range since the start of April, while the MOVE index of US Treasury option volatility has fallen by one-quarter since its most recent peak in early May. Not all markets, however, have seen this kind of relative stability. Global oil prices are trading close to post-invasion highs, as are government bond yields in Germany and the UK. High-yield credit spreads in the US and Europe are both still around 50bps above where they were pre-invasion. The DXY US dollar index is 6% above the pre-invasion level, led by the USD/JPY currency pair that has appreciated to levels last seen in 2002. Given the mix of slowing global growth momentum and ongoing geopolitical uncertainty, but with persistent high inflation and tightening global monetary policy, it is unsurprising that financial markets are having a difficult time formulating a consistent message. This is especially true for global government bond yields. Chart 2Competing Forces On Global Bond Yields Even as market-based inflation expectations have eased a bit in recent weeks, bond yields across the developed world have been unable to decline because markets continue to discount more rate hikes (Chart 2). Yet with such a significant amount of monetary tightening now priced in across all countries, global bond yields are more likely to stay rangebound over the next 3-6 months than begin a new trend. Chart 3DM Bond Yields Discounting Tight Monetary Policy 10-year government bond yields and 2-year-ahead interest rate expectations in overnight index swap (OIS) curves are trading in lockstep in the US, Europe, UK, Canada and Australia (Chart 3). This correlation indicates that longer-term bond yields have become a pure play on future policy rate expectations, rather than a reflection of rising inflation expectations as was the case in 2021. However, both yields and rate expectations are now trading close to, or even well above, plausible estimates of neutral nominal policy rates in all regions - including estimates provided by central bankers themselves. For example, in Australia, where the RBA just delivered a 50bp rate hike this week, markets are pricing in a peak Cash Rate between 3.5-4%, even with RBA Governor Philip Lowe stating that the neutral rate is likely in the 2-3% range – a view that we agree with. The situation is even more extreme in the euro area, with the euro area OIS curve now pricing in a peak policy rate between 1.5-2%, with most of that increase coming over the next 12 months. While we expect the ECB to fully exit the negative (deposit) rate era by September, rate hikes beyond that are far less likely given slowing euro area growth momentum and still-moderate euro area inflation beyond the spillover effects from energy costs. Only in the US are markets potentially underestimating the potential peak in the fed funds rate for this tightening cycle. Estimates of the longer-run (neutral) funds rate from the latest set of FOMC projections back in March ranged from 2.0-3.0%. Thus, the current level of 10-year bond yields, and 2-year-ahead rates discounted in the US OIS curve, are only at the top end of that range. It is possible that the Fed will have to raise rates to restrictive levels (i.e. above 3%) given the size of the current US inflation overshoot. More importantly, the US neutral rate is likely higher than the Fed thinks it is, possibly as high as 4% according to BCA Research’s Chief Global Strategist, Peter Berezin. We continue to see the US as the one major government bond market where there is a risk that markets are underestimating the neutral policy rate. For that reason, we remain underweight US Treasuries in the BCA Research Global Fixed Income Strategy model bond portfolio. Don’t Dismiss The QT Effect One other factor that has likely kept global bond yields elevated, even as global growth has softened, has been the shift away from central bank asset purchases towards quantitative tightening (QT). As policymakers have moved to slow, or even stop, the buying of government bonds, the term premium component of longer-term bond yields has risen. The moves have been quite large. Using our own in-house estimates, the term premium on 10-year government bond yields have jumped by about 100bps on average in the US, UK, Canada, Australia and Europe since the lows seen during the 2020 COVID global recession (Chart 4). The jump in term premiums is occurring at the same time as markets have moved to price in more rate hikes and a higher path for real interest rates (bottom panel). Chart 4Yields Repricing As QE Moves To QT Chart 5Stay Neutral Global Duration Exposure That combined effect of the upward repricing of term premiums – especially as more price-sensitive private investors replace the demand for bonds from price-insensitive central banks - but with less upward movement in already elevated interest rate expectations will keep longer-term bond yields in trading ranges during the “Global QT Phase” over at least the next six months and likely longer. That message is reinforced by our Global Duration Indicator, which is heralding a peak in global bond yield momentum over the latter half of 2022 (Chart 5). Bottom Line: Stay neutral on overall duration exposure in global bond portfolios, with yields in the major developed markets likely to stay rangebound over the next few months. Assessing The Value In UK Investment Grade Corporates Chart 6A Big Jump In UK Investment Grade Corporate Yields Global credit markets have had a rough time in 2022, and UK corporate debt is no exception. The Bloomberg UK Corporate index of investment grade corporate debt has delivered a year-to-date total return of -11%, as the index yield-to-maturity rose 174bps to 4% - the highest level since 2014 (Chart 6). Relative to UK Gilts, the results have also been grim as corporate credit spreads have widened, with the Bloomberg UK corporate index realizing an excess return of -3% since the start of the year. We have maintained a neutral stance on UK corporate bond exposure in our global model bond portfolio during the selloff. This was the result of a relative value opinion, as we have concentrated our more defensive view on global investment grade corporate debt with an underweight to US corporates. However, after the significant repricing of UK investment grade credit, it is now a good time to reassess our opinion on the asset class. Spread Valuation From a pure spread valuation perspective, UK investment grade now looks more attractive. Our preferred valuation metric – 12-month breakeven spreads - shows that the UK investment grade corporate index spread, on a duration-adjusted basis, is now in the 75th percentile of its history over the past 25 years (Chart 7). Chart 7UK Corporate Spreads Now Offer Some Value We find 12-month breakevens to a useful spread valuation measure, as they show how much spreads would need to widen to make the expected one-year-ahead return on a credit product equal to that of a duration-matched position in government bonds. In other words, breakevens measure the spread “cushion” against excess return losses from spread widening. What makes the current attractive reading on UK investment grade spread valuation so interesting is that the absolute level of spreads is still relatively low. The Bloomberg UK investment grade corporate index spread is currently 170bps, but during previous episodes where the 12-month breakeven as near the top quartile ranking – as is currently the case – the index spread ranged from 200-350bps. The reason for that relates to the index duration which, at 7.3 years, is down 1.5 years from the 2020 peak and at the lowest level since 2011. Some of that lower duration is related to the convexity effect from higher corporate bond yields. But there has also been a reduction in the average maturity of the UK investment grade corporate bond universe, with the index average maturity now at 10.4 years, down a full year lower over the past 12 months and the lowest average maturity since 1999. UK companies appear to have shortened up the maturity profile of their bond issuance, which helped reduce the riskiness (duration) of corporate bond returns to rising yields. Thus, the message from the 12-month breakevens is correct – UK investment grade corporate bond yields are attractive from a historical perspective, on a duration-adjusted basis. Chart 8UK Credit Curves Are Relatively Flat When looking within the UK investment grade universe, the messages on valuation are a bit more mixed. The UK credit curve is not particularly steep, when looking at the spread differences by credit rating within the benchmark index universe (Chart 8). There is a similar message when looking at 12-month breakevens broken down by credit rating, where there is little difference between the percentile rankings (Chart 9). However, the 12-month breakeven percentile rankings broken down by maturity buckets show that shorter-maturity bonds have noticeably higher percentile rankings than longer-maturity UK corporates (top panel). From a cross-country perspective, UK corporate breakeven percentile rankings are much higher than equivalent rankings for US corporates, but are lower than those of the euro area. Chart 9Shorter-Maturity UK Spreads Are More Attractive Corporate Financial Health Our top-down UK Corporate Health Monitor (CHM) - which uses data on non-financial corporate sector revenues, expenses and balance sheets taken from GDP accounts – has shown a very strong improvement in UK corporate financial health over the past few years (Chart 10). The biggest improvements are in the categories related to debt service, with interest coverage at the highest level since 2002 and debt coverage is at the highest level since 1999. Chart 10UK Corporates Can Withstand Higher Borrowing Rates Chart 11Stay Neutral UK Corporates Until The BoE Is Done The message from our top-down UK CHM is similar to the conclusions from an October 2021 BoE report that analyzed the UK corporate sector from a financial stability perspective. In that report, the BoE used a bottom-up sample of 500 UK companies and concluded that corporate borrowing rates could rise as much as 400bps before the share of companies with a “distressed” interest coverage ratio below 2.5 would rise to the past historical peak. Within our top-down UK CHM, relatively wide corporate profit margins are also contributing to the strong reading on UK corporate health. Like the interest/debt coverage ratios, those margins provide some cushion to profits in the current environment of high inflation and elevated input costs for businesses. The all-in message from our UK CHM is that financial health is a fundamental tailwind for UK corporate bond performance. Monetary Policy Attractive spread valuations and strong financial health metrics would normally justify an overweight stance on any corporate bond market. However, the monetary policy cycle is also an important factor that drives corporate bond performance. Currently, with the BoE not only hiking rates but also moving to QT on asset purchases, monetary policy is a severe headwind to UK corporate bond returns. Related Report Global Fixed Income StrategyIt’s Time To Flip The Script - Upgrade UK Gilts The annual growth rate of the BoE’s balance sheet has proven to be a reliable leading indicator of UK corporate bond annual excess returns. With the growth in the balance sheet set to turn negative in the latter half of 2022 (Chart 11), it will prove difficult for UK credit spreads to narrow in a way that will boost excess returns. The BoE’s aggressive (by its standards) rate hiking cycle, in response to UK inflation that is nearing 10% alongside a very tight labor market, remains a threat to UK economic growth that is already losing some momentum. As we discussed in a recent Special Report, the UK neutral interest rate is likely no more than 1.5-2%. If the BoE were to follow current market pricing and push Bank Rate toward 2.5%, this would be a restrictive policy stance that would likely result in a sharp growth slowdown if not a full-blown recession. Importantly, our UK Central Bank Monitor is showing signs of peaking (bottom panel), due to signs of slower economic growth and tightening financial conditions. A peak in UK inflation would help reduce the Monitor even further, and would likely correspond to a pause on BoE rate hikes – a necessary condition before we would upgrade our recommended stance on UK investment grade corporates to overweight. Some Final Thoughts On Industry Sector Valuation Our UK investment grade corporate sector valuation model is a cross-sectional analysis of individual industry/sector corporate credit spreads, after controlling for differences in duration, convexity and credit rating. The model is currently signaling that there are few compelling valuation stories with positive “risk-adjusted” spreads (Chart 12). Only Financials look cheap, while Consumer Cyclicals, Consumer Non-Cyclicals and Capital Goods are all trading at expensive risk-adjusted spreads. Chart 12Not Many Compelling Values Within UK Corporates By Industry An additional risk to UK corporate bond performance relates to the BoE’s decision to unwind its corporate bond portfolio. The BoE has announced that there will be outright sales from the corporate holdings accumulated over the past couple of years, with a goal of having the stock of debt fully unwound by the end of 2023. This is important for much of the UK investment grade corporate bond universe, where the BoE holds between 8-10%, on average, of outstanding debt (Chart 13).1 Chart 13The BoE Has Become An Important Corporate Bondholder When we compare our risk-adjusted spreads versus the BoE ownership share by sector, we conclude that Consumer Cyclicals, Consumer Non-Cyclicals and Other Utilities offer the most unattractive combination of expensive spreads and high BoE concentration (Chart 14). We recommended underweight allocations to those sectors within an overall neutral allocation to UK corporates. Chart 14BoE Asset Sales Are A Major Risk For Some UK Corporate Sectors Bottom Line: Maintain a neutral stance on UK corporates, given the mix of attractive valuations but tighter monetary policy. Favoring shorter-maturity bonds and Financial names, but look to upgrade once UK inflation peaks and the Bank of England pauses on tightening. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 In Chart 13, we use the market capitalization of each sector from the Bloomberg UK corporate bond index in the numerator of all ratios shown, as a proxy for outstanding debt. GFIS Model Bond Portfolio Recommended Positioning Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months)
Highlights Chart 1Wage Growth Is Cooling In a speech last week, Fed Governor Christopher Waller presented the theoretical underpinnings for how the Fed plans to achieve a soft landing for the US economy.1 The Fed’s hope is that tighter monetary policy will slow demand enough to reduce the number of job openings – of which there are currently almost two for every unemployed person – without leading to a significant increase in layoffs and the unemployment rate. A reduction in the ratio of job openings to unemployed will lead to softer wage growth and lower inflation. The May employment report – released last Friday – provides some evidence that the Fed’s plan may be working. In May, an increase in labor force participation led to strong employment gains and kept the unemployment rate flat. We also saw continued evidence of a deceleration in average hourly earnings (Chart 1). Fifty basis point rate hikes are all but assured at the June and July FOMC meetings, but softer wage growth and falling inflation make it more likely that the Fed will downshift to a pace of 25 bps per meeting starting in September. Feature Table 1 Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Underweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 79 basis points in May, bringing year-to-date excess returns up to -215 bps. The average index option-adjusted spread tightened 5 bps on the month and it currently sits at 131 bps. Similarly, our quality-adjusted 12-month breakeven spread downshifted to its 45th percentile since 1995 (Chart 2). A recent report made the case for why investors should underweight investment grade corporate bonds on a 6-12 month horizon.2 The main rationale for this recommendation is that the slope of the Treasury curve is very flat, signaling that we are in the mid-to-late stages of the credit cycle. Corporate bond performance tends to be weak during such periods unless spreads start from very high levels. Despite our underweight 6-12 month investment stance, we see a high likelihood that spreads will narrow during the next few months as inflation falls and the Fed tightens by no more than what is already priced in the curve. That said, the persistent removal of monetary accommodation and flatness of the yield curve will limit how much spreads can compress. Last week’s report dug deeper into the corporate bond space and concluded that investment grade-rated Energy bonds offer exceptional value on a 6-12 month horizon.3 That report also concluded that long maturity investment grade corporates are attractively priced relative to short maturity bonds. Table 3A Corporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 35 basis points in May, dragging year-to-date excess returns down to -316 bps. More specifically, high-yield sold off dramatically early in the month – the junk index lagged Treasuries by 368 bps between May 1 and May 20 – but then staged a rally near the end of May, outperforming Treasuries by 333 bps between May 20 and May 31. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – moved higher in May. It currently sits at 5.1% (Chart 3). Last week’s report reiterated our view that investors should favor high-yield over investment grade within an overall underweight allocation to spread product versus Treasuries.4 Our main rationale for this view is that there are historical precedents for high-yield bonds outperforming investment grade during periods when the yield curve is very flat but when corporate balance sheet health is strong. The 2006-07 period is a prime example. With that in mind, our outlook for corporate profit and debt growth is consistent with a default rate of 2.7% to 3.7% during the next 12 months, well below the 5.1% that is currently priced in the index. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 70 basis points in May, bringing year-to-date excess returns up to -109 bps. We discussed the outlook for Agency MBS in a recent report.5 We noted that MBS’s poor performance in 2021 and early-2022 was driven by duration extension. Fewer homeowners refinanced their loans as mortgage rates rose, and the MBS index’s average duration increased (Chart 4). But now, the index’s duration extension is at its end. The average convexity of the MBS index is close to zero (panel 3), meaning that duration is now insensitive to changes in rates. This is because hardly any homeowners have the incentive to refinance at current mortgage rates (panel 4). The implication is that excess MBS returns will be stronger going forward. That said, we still don’t see enough value in MBS spreads to increase our recommended allocation. The average index spread for conventional 30-year Agency MBS remains close to its lowest level since 2000 (bottom panel). At the coupon level, we observe that low-coupon MBS have much higher duration than high-coupon MBS and that convexity is close to zero for the entire coupon stack. This makes the relative coupon trade a direct play on bond yields. Given that we see some potential for yields to fall somewhat during the next six months, we recommend favoring low-coupon MBS (1.5%-2.5%) within an overall underweight allocation to the sector.ext 12 months, well below the 5.1% that is currently priced in the index. Emerging Market Bonds (USD): Underweight Chart 5Emerging Markets Overview Emerging Market (EM) bonds outperformed the duration-equivalent Treasury index by 29 basis points in May, bringing year-to-date excess returns up to -565 bps. EM sovereigns outperformed the Treasury benchmark by 125 bps on the month, bringing year-to-date excess returns up to -664 bps. The EM Corporate & Quasi-Sovereign Index underperformed by 28 bps, dragging year-to-date excess returns down to -501 bps. The EM Sovereign Index underperformed the duration-equivalent US corporate bond index by 27 bps in May. The yield differential between EM sovereigns and duration-matched US corporates remains negative (Chart 5). As such, we continue to recommend a maximum underweight allocation to EM sovereigns. The EM Corporate & Quasi-Sovereign Index underperformed duration-matched US corporates by 109 bps in May, but it continues to offer a significant yield advantage (panel 4). As such, we maintain our neutral allocation (3 out of 5) to the sector. Despite modest weakness in the trade-weighted US dollar in May, EM currencies continue to struggle (bottom panel). If the Fed tightens no more quickly than what is already priced in the curve for the next six months – as we expect – it could limit the upward pressure on the US dollar and benefit EM spreads in the near term. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 61 basis points in May, bringing year-to-date excess returns up to -78 bps (before adjusting for the tax advantage). We view the municipal bond sector as better placed than most to cope with the recent bout of spread product volatility. As we noted in a recent report, state & local government revenue growth has been strong and yet governments have also been slow to hire.6 The result is that net state & local government savings are incredibly high (Chart 6) and it will take some time to deplete those coffers even as economic growth slows and federal fiscal thrust turns to drag. On the valuation front, munis have cheapened up relative to both Treasuries and corporates during the past few months. The 10-year Aaa Muni/Treasury yield ratio is currently 83%, up significantly from its 2021 trough of 55%. The yield ratio between 12-17 year munis and duration-matched corporate bonds is also up significantly off its lows (panel 2). We reiterate our overweight allocation to municipal bonds within US fixed income portfolios, and we continue to have a strong preference for long-maturity munis. The yield ratio between 17-year+ General Obligation Municipal bonds and duration-matched corporates is 85%. The same measure for 17-year+ Revenue bonds stands at 92%, just below parity even without considering municipal debt’s tax advantage. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bull-steepened in May. The 2-year/10-year Treasury slope steepened 13 bps on the month and the 5-year/30-year slope steepened 22 bps. The 2/10 and 5/30 slopes now stand at 30 bps and 16 bps, respectively. In a recent Special Report we noted the unusually large divergence between flat slopes at the long end of the curve and steep slopes at the front end.7 For example, the 5-year/10-year Treasury slope is currently 1 bp while the 3-month/5-year slope is 178 bps. The divergence is happening because the market has moved quicky to price-in a rapid near-term pace of rate hikes. However, so far, the Fed has only delivered 75 bps of tightening and this is holding down the very front-end of the curve. The oddly shaped curve presents us with an excellent trading opportunity. Specifically, we recommend buying the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. This trade looks attractive on our model (Chart 7) and will profit if the rate hike cycle moves more slowly than what is currently priced but lasts longer. We also continue to recommend a position long the 20-year bullet versus a duration-matched 10/30 barbell as an attractive carry trade. TIPS: Underweight Chart 8TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 144 basis points in May, dragging year-to-date excess returns down to +237 bps. The 10-year TIPS breakeven inflation rate fell 25 bps last month, but it remains above the Fed’s 2.3% - 2.5% comfort zone (Chart 8). Our TIPS Breakeven Valuation Indicator shows that TIPS remain “expensive”, but not as expensive as they were a month ago (panel 2). While TIPS have become less expensive during the past month, we think TIPS breakeven inflation rates will continue to fall during the next few months as inflation moves lower. This will be particularly true at the front-end of the curve where breakevens remain disconnected from the Fed’s target (panel 4) and where breakevens exhibit a stronger correlation with the incoming inflation data. To take advantage of falling inflation between now and the end of the year, investors should position for a steeper TIPS breakeven curve (bottom panel) and/or a flatter real (TIPS) curve. We also recommend that investors hold outright short positions in 2-year TIPS. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 26 basis points in May, dragging year-to-date excess returns down to -63 bps. Aaa-rated ABS underperformed by 26 bps on the month, dragging year-to-date excess returns down to -59 bps. Non-Aaa ABS underperformed by 22 bps on the month, dragging year-to-date excess returns down to -88 bps. During the past two years, substantial federal government support for household incomes caused US households to build up an extremely large buffer of excess savings. Nowhere is this more evident than in the steep drop in the amount of outstanding credit card debt that was witnessed in 2020 and 2021 (Chart 9). In 2022, consumers have started to re-lever. The personal savings rate was just 4.4% in April, the lowest print since September 2008, and the amount of outstanding credit card debt has almost recovered its pre-COVID level. But while household balance sheets are starting to deteriorate, they remain exceptionally strong in level terms. In other words, it will be some time before we see enough deterioration to cause a meaningful uptick in consumer credit delinquencies. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones. Non-Agency CMBS: Overweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 105 basis points in May, dragging year-to-date excess returns down to -189 bps. Aaa Non-Agency CMBS underperformed Treasuries by 84 bps on the month, dragging year-to-date excess returns down to -152 bps. Non-Aaa Non-Agency CMBS underperformed by 165 bps on the month, dragging year-to-date excess returns down to -290 bps. CMBS spreads remain wide compared to other similarly risky spread products. However, after several quarters of easing, commercial real estate lending standards shifted closer to ‘net tightening’ territory in Q1 (Chart 10). This trend will bear monitoring in the coming quarters. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 19 basis points in May, bringing year-to-date excess returns up to -23 bps. The average index option-adjusted spread tightened 2 bps on the month. It currently sits at 49 bps, not that far from its average pre-COVID level (bottom panel). Agency CMBS spreads also continue to look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 251 basis points of rate hikes during the next 12 months. Chart 11The Golden Rule's Track RecordWe can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with excess returns for a front-loaded and a back-loaded rate hike scenario. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of May 31, 2022) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of May 31, 2022) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -51 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 51 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of May 31, 2022) Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.federalreserve.gov/newsevents/speech/waller20220530a.htm 2 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds”, dated April 12, 2022. 3 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Looking For Opportunities In US & European Corporates After The Recent Selloff”, dated May 31, 2022. 4 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Looking For Opportunities In US & European Corporates After The Recent Selloff”, dated May 31, 2022. 5 Please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 6 Please see US Bond Strategy Weekly Report, “Echoes Of 2018”, dated May 24, 2022. 7 Please see US Bond Strategy / US Investment Strategy / US Equity Strategy Special Report, “The Yield Curve As An Indicator”, dated March 29, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns
Listen to a short summary of this report. Executive Summary Sentiment On Sterling Is Depressed The pound will suffer in the short term, setting the stage for a coiled-spring rebound. Cable is extremely cheap by most measures (Feature chart). The BoE could engineer a soft landing in the UK economy. If successful, it will annihilate sterling vigilantes, in a volte-face of the ERM crisis. We are cognizant of near-term risks. As such, we are long EUR/GBP with a target of 0.90, but will be buyers of cable at 1.20. Ultimately, the pound is undervalued on a longer-term basis. GBP/USD should touch 1.36 over the next 12-18 months. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN long eur/gbp 0.846 2021-10-15 0.27 Bottom Line: The pound will likely face pressure in the near term, but will fare well over a cyclical horizon. Our 12-month target is 1.36. This target is based on a modest reversion towards PPP fair value, and some erosion in the “crisis” discount. Admittedly, sentiment on the pound is very depressed, and we could be wrong in our near-term assessment and cable has indeed bottomed. Feature Chart 1A Play On Cable Downside There has been much discussion around the premise that the pound could enter a capitulation phase, akin to an emerging market-style currency crisis. With inflation sitting at 9%, well above the Bank of England’s 2% target, the narrative is that interest rates need to rise substantially but will, at the same time, kill any recovery. The result will be a sharp fall in the pound. We began to highlight the near-term risks to cable in October of last year, going long EUR/GBP in the process, as a way to play sterling downside (Chart 1). That said, our longer-term view on the pound remained positive. In this report, we review what has changed since, and if a negative longer-term view is now warranted. UK Balance Of Payments Almost all currency crises are rooted in a deterioration of the external balance, and this is certainly true for the UK. The trade deficit sits at 7.9% of GDP, the worst among G10 countries (Chart 2). As a result, the current account is also in deficit. That said, there are reasons for optimism. Related Report Foreign Exchange StrategyAn Update On Sterling The Office for National Statistics (ONS) suggests that a change in methodology in January 2022 could be exarcebating the deterioration in the latest release of the trade balance. In our view, there are two key reasons why the UK’s balance of trade is worsening. The first is the oil shock – fuels constitute 11% of UK imports. Second, unprecedented fiscal stimulus led to an overshoot in goods imports. These negative forces are likely cyclical in nature, rather than structural. It is also noteworthy that most of the goods imported into the UK are machinery and transport equipment, which could go a long way in improving its productive capacity (Chart 3). Chart 2The UK Trade Balance Has Deteriorated Chart 3Goods Imports Have Been A Hit To The UK Trade Balance In parallel, there has been a structural improvement in the UK’s current account balance. This has mostly been driven by a rising primary income balance. In short, investments abroad are earning more, relative to domestic liabilities (Chart 4). The UK runs a large negative international investment position. Despite this, it has maintained the ability to issue debt bought by foreigners, while investing in high-return assets abroad. Secondary income has admittedly been in a structural deficit, but a falloff in transfer payments under the Brexit agreement will significantly improve this balance (Chart 5). Chart 4The UK Current Account Is Improving Chart 5A Fall In Brexit Payments Will Mend Secondary Income Finally, the pound’s share of global foreign exchange turnover is 12.8%, just behind the dollar, euro, and yen. That said, London dwarfs New York, Hong Kong, and Tokyo as a hub for foreign exchange trading (Chart 6). The pound also very much remains among the most desirable global currencies. Global allocation of FX reserves in sterling have been rising over the last decade (Chart 7). It currently stand at 4.8%, higher than the RMB at 2.8%, and all other emerging market currencies combined. Chart 6London Remains An Important Financial Center Chart 7The Pound Is Still A Reserve Currency It is noteworthy to revisit the period the pound experienced an EM-style crisis – under the European Exchange Rate Mechanism (ERM), when cable was effectively pegged to the German mark at an expensive level. At the time, UK inflation was running hot, while German inflation was more subdued. By importing monetary policy from the Bundesbank, the BoE was able to tame inflation, but at a high cost to growth. In Germany, the reunification boom warranted much higher interest rates, which was not appropriate for the UK . Cable eventually collapsed by 32.9% peak-to-trough, as the UK ran out of foreign currency reserves. Chart 8Cable Is Very Cheap There are three key differences between that episode and today: The pound is freely floating. Foreign exchange markets are extremely fluid and adjust to expectations quite quickly. A collapse in the pound seems unlikely, unless the UK faces a new large exogenous shock. Inflation is running hot in many countries, not just the UK. The pound is extremely cheap, and stimulative for the economy. On a real effective exchange rate basis, the pound is at record lows (Chart 8). Will The BoE Make A Policy Mistake? Sterling is pricing in a policy mistake by the BoE. First, inflation is well above its 2% target. Second, the labor market has tightened significantly. The unemployment rate hit a 47-year low of 3.7%, and job vacancies are low, pushing wages higher. As such, either the BoE allows inflation expectations to become unmoored, destroying the purchasing power of the pound, or kills the recovery to maintain credibility (Chart 9). Chart 9The UK Labor Market Is Tight While difficult, there are reasons to believe the BoE can achieve a soft landing. According to an in-house study, only one-third of the rise in UK inflation has been driven by demand-side pull, with the balance related to supply factors.1 The latter have been the usual suspects – rising energy costs, supply shortages, and even legacies of the Brexit shock (Chart 10). UK electricity prices have cratered since the opening of the 1,400MW undersea cable with Norway (Chart 11). Chart 10Most Of The Increase To UK Prices Is Supply-Driven Chart 11A Sharp Drop In Electricity Prices Second, it is likely that the neutral rate of interest in the UK is lower in a post-Brexit, post-COVID-19 world. This is visible in trend productivity growth, but even the size of the labor force has shrunk significantly. The UK workforce is down by 560,000 people since the start of the pandemic. This has been partly due to less immigration and more retirees, but the vast majority has been due to health side-effects from the pandemic, and delays in getting adequate medical care. As a result, there has barely been a recovery in the UK participation rate (Chart 12). Chart 12AThe Participation Rate In The UK Is Below Trend Chart 12BA Low Participation Rate Across Many Regions In hindsight, a least-regrets strategy to policy tightening – lift rates faster now, and then back off if financial conditions tighten sufficiently – seems appropriate. Frontloading the pace of tightening will flatten the UK gilts curve further. With most borrowing costs in the UK tied to the longer end of the curve, refinancing costs might not edge up that much, while inflation expectations will be well contained. The real canaries in the coal mine from this strategy are the economies of Australia, New Zealand, and Canada, where household debt is much more elevated (Chart 13), and the percentage of variable rate mortgages are higher. Chart 13Household Debt Is Not Alarming In The UK Larger fiscal stimulus will partially offset the near-term hit from tighter monetary policy. The additional £15 billion cost-of-living package announced last month is quite substantial at 0.7% of GDP. This gives the BoE breathing room to tighten policy in the near term. The redistributionist nature of the plan – taxing windfall profits from large energy companies, and using that to subsidize consumers most in need – could be what is required to achieve a soft landing, if the energy shock is temporary. Our Global Fixed Income colleagues upgraded UK gilts to overweight last month, on the basis that market pricing further out the SONIA curve was too aggressive. In our prior report on sterling, we also suggested that market expectations for interest rate increases may have overshot. Money markets are discounting a peak in the bank rate at 2.8%. The BoE’s new Market Participants survey suggests it will peak at 1.75%. While the BoE will deliver sufficient monetary tightening to lean against near-term inflationary pressures, it will be very wary to overdo it. This is especially true if the neutral rate in the economy is much lower. What Next For The Pound? Our view is that the pound faces near-term risks but is a buy longer term. There is an old adage that credibility is hard to earn, but easy to lose. For the UK in particular, this hits the mark. The Bank of England is the oldest central bank in the world, after the Riksbank. Yes, the BoE can make a policy mistake (as it has in the past), but treating the pound as an emerging market asset is a stretch (Chart 14). That said, our Chief European Strategist, Mathieu Savary, believes stagflation is not fully priced into UK assets. In the near term, he might be right. The UK’s large trade deficit puts the onus on foreigners to dictate movements in the pound. The pound does well when animal spirits are fervent. So far, markets have bid up a substantial safe-haven premium into the dollar (Chart 15). As a proxy, the pound has been sold. Northern Ireland could also return as a thorn in the side of sterling. Chart 14The Pound Is A Risk-On Currency Cable And EM Stocks Chart 15The Dollar Has A Hefty Safe-Haven Premium From a bird’s eye view, three factors tend to drive currencies – the macroeconomic environment, valuation, and sentiment. For now, markets have latched on to the GBP’s vulnerability to an EM-style crisis. That said, cable is very cheap, even accounting for elevated UK inflation. Our in-house PPP model suggests the pound could appreciate by 4% per year, over the next 10 years, just to revert to fair value (Chart 16). Chart 16Cable Is Cheap Admittedly, the UK desperately needs an improvement in productivity growth for further currency gains. To encourage capital inflows that the pound depends on, the UK needs to be at the forefront of disruptive technologies such as electric cars, digital currencies, 3D printing, and even innovations in gene therapy. High finance and fashion will remain relevant for London, but the need for innovation is high. Investment Conclusions Chart 17Sentiment On Sterling Is Depressed The pound will likely face pressure in the near term, but will fare well over a cyclical horizon. Our 12-month target is 1.36. This target is based on a modest reversion towards PPP fair value, and some erosion in the “crisis” discount. Admittedly, sentiment on the pound is very depressed, and we could be wrong in our near-term assessment if cable has indeed bottomed. Our intermediate-term timing model suggests that GBP is undervalued and has bottomed. Technical indicators also warn that cable is ripe for a fervent rebound (Chart 17). Particularly, our intermediate-term technical indicator is rebounding from oversold levels. The Aussie would outperform the pound in the long term, but AUD/GBP is vulnerable to a commodity relapse in the shorter term. Housekeeping We were stopped out of our short EUR/JPY trade for a loss of -2.78%, as oil prices and bond yields rebounded. This trade is a hedge to our pro-cyclical portfolio, so we will look to reenter it at more attractive levels. We are also lowering the stop-loss on our short RUB trade. This is a speculative bet many clients will not be able to play, but we expect it to payoff over the longer term. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Michael Saunders, "The route back to 2% inflation," (Speech given at the Resolution Foundation), May 9, 2022. Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary
Executive Summary Investors face a dilemma. The faster that inflation comes down, the better it will be for valuations via a stronger rally in the bond price. But if a collapse in inflation requires a sharp deceleration in growth, the worse it will be for profits. Bond yields are likely in a peaking process, but the sharpest declines may come a few months down the road, after an unambiguous roll-over in food and energy inflation. The stock market’s valuation-driven sell-off is likely over, but the danger is that it morphs into a profits-driven sell-off. As such, the stock market will remain under pressure through 2022, though it is likely to be higher 12 months from now in June 2023. High conviction recommendation: Overweight healthcare versus basic resources. In other words, tilt towards sectors that benefit the most from rising bond prices and that suffer the least from contracting profits. New high conviction recommendation: Go long the Japanese yen. As bond yield differentials re-tighten, the yen will rally. Additionally, the yen will benefit from its haven status in a period of recessionary risk. Fractal trading watchlist: JPY/USD, GBP/USD, and Australian basic resources. If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market Bottom Line: The risk is that the valuation-driven sell-off morphs into a profits-driven sell-off. Feature In May, many stock markets reached the drawdown of 20 percent that defines a technical bear market. Yet what has caught many people off guard is that the bear market in stocks has happened during a bull market in profits. Since the start of 2022, US profits are up by 5 percent.1 The bear market in stocks has happened during a bull market in profits… so far. This shatters the shibboleth that bear markets only happen when there is a profits recession. The 2022 bear market has been a valuation-driven bear market. US profits rose 5 percent, but the multiple paid for those profits collapsed by 25 percent, taking the market into bear territory. None of this should come as any surprise to our regular readers. As we have pointed out many times, a stock market can be likened to a bond with a variable rather than a fixed income. So, just as with a bond, every stock market has a ‘duration’ which establishes which bond it most behaves like. It turns out that that long-duration US stock market has the same duration as a 30-year bond. This means that: The US stock market = (The 30-year T-bond price) multiplied by (US profits) It follows that if the 30-year bond price falls by more than profits rise, then the stock market will sell off. And if the 30-year bond price falls by much more than profits rise, then the stock market will enter a valuation-driven bear market. Therein lies the story of 2022 so far (Chart I-1). Chart I-1The Bear Market Is Valuation-Driven. Profits Are Up... For Now Just As In 1981-82, Will The Sell-Off Morph From Valuation-Driven To Profits-Driven? In Markets Echo 1981, When Stagflation Morphed Into Recession, we argued that a good template for what happens to the economy and the markets in 2022-23 is the experience of 1981-82. Does 2022-23 = 1981-82? Then, just as now, the world’s central banks were obsessed with ‘breaking the back’ of inflation, and piloting the economy to a ‘soft landing’. Then, just as now, the central banks were desperate to repair their badly damaged credibility in managing the economy. And then, just as now, an invasion-led war between two major commodity producers – Iran and Iraq – was disrupting commodity supplies and adding to inflationary pressures. In 1981, just as now, the equity market sell-off started as a valuation sell-off, driven by a declining 30-year T-bond price. Profits held up through most of 1981, just as they have so far in 2022. In September 1981, US core inflation finally peaked, with bond yields following soon after. In the current experience, March 2022 appears to have marked the equivalent peak in US core inflation (Chart I-2 and Chart I-3). Chart I-2Does September 1981... Chart I-3...Equal March 2022? In late 1981, when the 30-year T-bond price rebounded, the good news was that beaten-down equity valuations also reached their low point. The bad news was that just as the valuation-driven sell-off ended, profits keeled over, and the valuation-driven sell-off morphed into a profits-driven sell-off (Chart I-4). In 2022-23, could history repeat? Chart I-4In September 1981, The Sell-Off Morphed From Valuation-Driven To Profits-Driven Recession Or No Recession? That Is Not The Question History rhymes, it rarely repeats exactly. What if the 2022-23 experience can avoid the outright economic recession of the 1981-82 experience? This brings us to another shibboleth that needs to be shattered. You don’t need the economy to go into recession for profits to go into recession. To understand why, we need to visit the concept of operational leverage. Profits is a small number that comes from the difference of two large numbers: sales and the costs of generating those sales. As any company will tell you, sales can be volatile, but costs – which are dominated by wages – are sticky and much slower to change. The upshot is that if sales growth exceeds costs growth, there is a massively leveraged impact on profits growth. This is the magic of operational leverage. But if sales growth falls below sticky cost growth, the magic turns into a curse. The operational leverage goes into reverse, and profits collapse. Using US stock market profits as an example, the magic turns into a curse at real GDP growth of 1.25 percent, above which profits grow at six times the difference, and below which profits shrink at six times the difference (Chart I-5). Chart I-5A Model For US Profits Growth: (Real GDP Growth - 1.25) Times 6 Strictly speaking, we should compare US profits growth with world GDP growth because multinationals generate their sales globally rather than domestically. But to the extent that the US has both the world’s largest stock market and the world’s largest economy, it is a reasonable comparison. We should also compare both profits and sales in either nominal or real terms, rather than a mixture. But even with these tweaks, we would still find that the dominant driver of profit growth is operational leverage. ‘Recession or no recession?’ is a somewhat moot question, because even non-recessionary low growth is enough to tip profits into contraction. Therefore, the conclusion still stands – ‘recession or no recession?’ is a somewhat moot question, because even non-recessionary low growth is enough to tip profits into contraction. Such a period of low growth is now likely. If 2022-23 = 1981-82, What Happens Next? To repeat: The US stock market = (The 30-year T-bond price) multiplied by (US profits) This means that investors face a dilemma. The faster that inflation comes down, the better it will be for valuations via a stronger rally in the bond price. But if a collapse in inflation requires a sharp deceleration in growth, the worse it will be for profits. This was the precise set-up in December 1981, the equivalent of June 2022 in our historical template. In which case, what can we expect next? 1. Bond yields are likely in a peaking process, but the sharpest declines may come a few months down the road, after an unambiguous roll-over in food and energy inflation (Chart I-6). Chart I-6If 2022-23 = 1981-82, Then This Is What Happens To The Bond Yield 2. The stock market’s valuation-driven sell-off is likely over, but the danger is that it morphs into a profits-driven sell-off. As such, the stock market will remain under pressure through 2022, though it is likely to be higher 12 months from now in June 2023 (Chart I-7). Chart I-7If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market 3. Long-duration defensive sectors will outperform short-duration cyclical sectors. In other words, tilt towards sectors that benefit the most from rising bond prices and suffer the least from contracting profits. As such, a high conviction recommendation is to overweight healthcare versus basic resources (Chart I-8). Chart I-8If 2022-23 = 1981-82, Then This Is What Happens To Healthcare Versus Resources 4. In foreign exchange, the setup is very bullish for the Japanese yen through the next 12 months. The yen’s recent sell-off is explained by bond yields rising outside Japan. As these bond yield differentials re-tighten, the yen will rally. Additionally, the yen will benefit from its haven status in a period of recessionary risk. A new high conviction recommendation is to go long the Japanese yen (Chart I-9). Chart I-9The Yen's Sell-Off Is Due To Bond Yields Rising Outside Japan Fractal Trading Watchlist Supporting our bullish fundamental case for the Japanese yen, the sell-off in JPY/USD has reached the point of fragility on its 260-day fractal structure that marked previous major turning points in 2013 and 2015 (Chart 10). Hence, a first new trade is long JPY/USD, setting the trade length at 6 months, and the profit target and symmetrical stop-loss at 5 percent. Chart I-10The Sell-Off In JPY/USD Has Reached A Potential Turning Point Supporting our bearish fundamental case for resources stocks, the outperformance of Australian basic resources has reached the point of fragility on its 130-day fractal structure that marked previous turning points in 2013, 2015, and 2021 (Chart I-11). Hence, a second new trade is short Australian basic resources versus the world market, setting the trade length at 6 months, and the profit target and symmetrical stop-loss at 10 percent. Chart I-11The Australian Basic Resources Sector Is Vulnerable To Reversal Finally, we are adding GBP/USD to our watchlist, given that its 260-day fractal structure is close to the point of fragility that marked major turns in 2014, 2015, and 2016. Our full watchlist of 29 investments that are at, or approaching turning points, is available on our website: cpt.bcaresearch.com Fractal Trading Watchlist: New Additions GBP/USD At A Turning Point Chart 1AUD/KRW Is Vulnerable To Reversal Chart 2Canada Versus Japan Is Reversing Chart 3Canada's TSX-60's Outperformance Might Be Over Chart 4US Healthcare Providers Vs. Software At Risk of Reversal Chart 5BRL/NZD At A Resistance Point Chart 6Homebuilders Versus Healthcare Services Has Turned Chart 7CNY/USD Has Reversed Chart 8CAD/SEK Reversal Has Started Chart 9Financials Versus Industrials To Reverse Chart 10The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 11The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 12FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing Chart 13Netherlands Underperformance Vs. Switzerland Has Been Exhausted Chart 14The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 15The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 16Food And Beverage Outperformance Has Been Exhausted Chart 17The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 18The Strong Trend In The 3 Year T-Bond Is Fragile Chart 19A Potential Switching Point From Tobacco Into Cannabis Chart 20Biotech Is A Major Buy Chart 21Norway's Outperformance Could End Chart 22Cotton Versus Platinum Is Reversing Chart 23Switzerland's Outperformance Vs. Germany Has Started To End Chart 24The Rally In USD/EUR Has Ended Chart 25The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 26A Potential New Entry Point Into Petcare Chart 27Czech Outperformance Near Exhaustion Chart 28US REITS Are Oversold Versus Utilities Chart 29GBP/USD At A Turning Point Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Defined as 12-month forward earnings per share. 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