Sectors
Executive Summary In this first of a regular series of ‘no holds barred’ conversations with a concerned client we tackle the hot topic of inflation. Month-on-month US core inflation has already peaked, 12-month US core inflation is about to peak, and demand destruction will ultimately pull down headline inflation too. Given modest and slowing growth in unit labour costs, there is no imminent risk of a wage-price spiral. Surging inflation expectations are just capturing the frothiness in inflation protected bond prices that massive hedging demand is creating. This recent massive demand for inflation hedges such as inflation protected bonds and commodities will recede and take the frothiness out of their prices. On a 6-12 month horizon, underweight inflation protected bonds and commodities… …overweight conventional bonds and stocks… …and tilt towards healthcare and biotech. The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price Bottom Line: US core inflation is about to peak, demand destruction will ultimately pull down headline inflation, and there is no imminent risk of a wage-price spiral. On a 6-12 horizon, overweight stocks and conventional bonds versus commodities and inflation protected bonds. Feature Welcome to the first of a regular series of Counterpoint reports that takes the form of a ‘no holds barred’ conversation with a concerned client. Roughly once a month, our open and counterpoint conversations will address a major question or concern for investors. This inaugural conversation tackles the hot topic of inflation. On Peak Inflation Client: Thank you for addressing my worries. Like many people right now, I am concerned about inflation. My first question is, when is inflation going to peak? CPT: The good news is that, in an important sense, inflation has already peaked. Month-on-month core inflation in the US reached a high of 0.9 percent through April-June last year. In the more recent pickup through October-January it reached a ‘lower peak’ of 0.6 percent. And in March it dropped to 0.3 percent. Client: Ok, but inflation usually refers to the 12-month inflation rate – when will that peak? CPT: The 12-month inflation rate is just the sum of the last twelve month-on-month rates. So, when the big numbers of April-June of last year drop off to be replaced by the smaller numbers of April-June of this year, the 12-month inflation rate will fall sharply (Chart I-1). Chart I-1Month-On-Month Core Inflation Has Already Peaked, And 12-Month Core Inflation Is About To Peak Client: Even if the 12-month inflation rate does peak soon, it will still be far too high. When will it return to the 2 percent target? CPT: In the pandemic era, monthly core inflation has been non-linear. Meaning it has been either ‘high-phase’ of 0.5 percent and above, or ‘low-phase’ of 0.3 percent and below. In March it returned to low-phase. If it stays in low-phase, then as an arithmetic identity, the 12-month core inflation rate will be close to its target twelve months from now. Client: So far, you have just talked about core inflation which excludes energy and food prices. What about headline inflation? Specifically, isn’t the Ukraine crisis a massive supply shock for Russian and Ukrainian sourced energy and food? Demand destruction will ultimately pull down headline inflation too. CPT: Yes, headline inflation may take longer to come down than core inflation. But supply shocks ultimately resolve themselves through demand destruction. Client: Could you elaborate on that? CPT: Sure. With fuel and food prices surging, many people are asking: do I really need to make that journey? Do I really need to keep the heating on? Can I buy a cheaper loaf of bread? So, they will cut back, and to the extent that they can’t cut back on energy and food, demand for other more discretionary items will come down, and eventually weigh on prices. Client: At the same time, the pandemic is still raging – look at what’s happening in Shanghai right now. Won’t further disruptions to supply chains just add further fuel to inflation? CPT: Yes, but to repeat, inflation that is entirely due to a supply shock ultimately resolves itself through demand destruction. On The Source Of The Inflation Crisis Client: I am puzzled. If supply shock generated inflation resolves itself, then what has caused the post-pandemic inflation to be anything but ‘transitory’? CPT: The simple answer is the pandemic’s draconian lockdowns combined with massive handouts of government cash unleashed a massive demand shock. But it wasn’t a shock in the magnitude of demand, it was a shock in the distribution of demand (Chart I-2). Chart I-2The Pandemic's Draconian Lockdowns Combined With Massive Government Stimulus Unleashed A Massive Shock In The Distribution Of Demand Client: Could you explain that? CPT: Well, we were all locked at home and flush with government supplied cash, and we couldn’t spend the cash on services. So, we spent it on what we could spend it on – namely, durable goods. This created a massive shock in the distribution of demand, out of services whose supply could easily adjust downwards, and into goods whose supply could not easily adjust upwards. Client: Can you give me some specific examples? CPT: Sure. Airlines could cut back their flights, but auto manufacturers couldn’t make more cars. So, airfares didn’t collapse but used car prices went vertical! The result being the surge in inflation. Client: Do you have any more evidence? Inflation is highest in those economies where the cash handouts and furlough schemes were the most generous, like the US and the UK. CPT: Yes, the three separate surges in month-on-month core inflation all occurred after surges in durable goods demand (Chart I-3). Additionally, inflation is highest in those economies where the cash handouts and furlough schemes were the most generous – like the US and the UK. Chart I-3The Three Surges In Month-On-Month Core Inflation All Occurred After Surges In Durable Goods Demand Client: If we get more waves of Covid, what’s to stop all this happening again? CPT: Nothing, so we should be vigilant. That said, we now have coping strategies for Covid that do not necessitate massive handouts of government cash. Also, we have already binged on durable goods, making it much harder to repeat that trick. On Wages And Inflation Expectations Client: I am still worried that if workers can negotiate much higher wages in response to higher prices, then it would threaten a wage-price spiral. CPT: Agreed, but it is technically incorrect to focus on wage inflation. The correct metric to focus on is unit labour cost inflation – which is wage growth in excess of productivity growth. In the US, this was 3.5 percent through 2021, slowing to just a 0.9 percent annual rate in the fourth quarter. So, it is not flashing danger, at least yet. Client: Ok, but what about the surge in inflation expectations. Isn’t that flashing danger? CPT: We should treat inflation expectations with a huge dose of salt, as they simply track the oil price, and therefore provide a nonsensical prediction of future inflation! (Chart I-4) Chart I-4The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Nonsense Client: What can explain this nonsense? CPT: Simply that when the oil price is high, investors flood into inflation hedges such as inflation protected bonds. So, the surge in inflation expectations is just capturing the frothiness in inflation protected bond prices that this massive hedging demand is creating. We can see similar frothiness in some commodity prices. The recent massive demand for inflation hedges such as inflation protected bonds and commodities will recede and take the frothiness out of their prices. Client: How so? CPT: Well to the extent that commodity prices drive headline inflation, the apples-for-apples relationship should be between commodity price inflation and headline inflation, and this is what we generally see (Chart I-5). But recently, this relationship has broken down and instead we see a tighter relationship between headline inflation and commodity price levels (Chart I-6 and Chart I-7). The likely causality here is that, just as for inflation protected bonds, massive inflation hedging demand has created frothiness in some commodity prices. Chart I-5Commodity Price Inflation Usually Drives Headline Inflation, But Recently The Relationship Broke Down Chart I-6Recently, We See A Weak Relationship Between Commodity Price Inflation And Headline Inflation... Chart I-7...But A Tight Relationship Between Headline Inflation And Commodity Price Levels On The Investment Implications Client: To sum up your view then, month-on-month US core inflation has already peaked, 12-month US core inflation is about to peak, and demand destruction will ultimately pull down headline inflation. Given modest and slowing growth in unit labour costs, there is no imminent risk of a wage-price spiral, and surging inflation expectations are just capturing the frothiness in inflation protected bond prices that massive hedging demand is creating. What does this view mean for investment strategy? On a 6-12 horizon, overweight stocks and conventional bonds versus commodities and inflation protected bonds. CPT: Well given that inflation is peaking, one obvious implication is that the massive demand for inflation hedges will recede and take the frothiness out of their prices. On a 6-12 month horizon this means underweighting inflation protected bonds and commodities (Chart I-8). Chart I-8The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price Client: What about the surge in bond yields – when will that reverse? CPT: Empirically, we have seen that bond yields turn just ahead of the turn in the 12-month core inflation rate. Hence, on a 6-12 month horizon this means overweighting bonds. Client: Finally, what does all this mean for stock markets? CPT: The weakness of stock markets this year has been entirely due to falling valuations, rather than falling profits. If the headwind to valuations from rising bond yields turns into a tailwind from falling bond yields, it will boost stocks – especially long-duration stocks with relatively defensive profits. On a 6-12 month horizon this means overweighting stocks, and our favourite sectors are healthcare and biotech. Client: Thank you very much for this open and counterpoint conversation. Fractal Trading Watchlist Due to the Easter holidays, there are no new trades this week. However, the full updated watchlist of 20 investments that are experiencing or approaching turning points is available on our website: cpt.bcaresearch.com Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Vulnerable To Reversal Chart 5Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal Chart 7Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 8A Potential Switching Point From Tobacco Into Cannabis Chart 9Biotech Is A Major Buy Chart 10CAD/SEK Reversal Has Started Chart 11Financials Versus Industrials To Reverse Chart 12Norway's Outperformance Could End Chart 13Greece's Brief Outperformance To End Chart 14BRL/NZD At A Resistance Point Chart 15The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 16The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Chart 17Cotton's Outperformance Is Vulnerable To Reversal Chart 18US Homebuilders' Underperformance Is At A Potential Turning Point Chart 19Fractal Trading Watch List Chart 20Fractal Trading Watch List Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Last week marked the beginning of the 2021 Q1 earnings season, with the largest money center banks reporting. We will publish an in-depth analysis of the bank earnings on Monday, April 25, 2022, together with our colleagues from the US Investment Strategy team. This week, 69 companies are reporting. In terms of market expectations: Quarter-on-Quarter earnings growth is expected to be -5% (Chart 1). Similar to previous quarters, we may expect a high number of earnings and sales beats. However, it is forward guidance that will matter. Chart 1 Year-on-year earnings growth is expected to be 6.3% and 0.7% excluding the Energy sector Year-on-year revenue is expected to be 10.9%. Excluding the energy sector, the growth estimate is 8.3%. Clearly, analysts expect increasing cost pressures to take their toll on corporate profitability. There is a wide dispersion in sector-level expectations (Table 1). Commodity sectors, such as Energy and Materials are expected to deliver the highest rates of earnings growth, driven by the shortages, exacerbated by the indirect effects of the war in Ukraine. These are also the best-performing sectors YTD. Technology and Healthcare are expected to deliver strong earnings and sales growth, and so far appear to be immune to slowing growth and inflationary pressures. Earnings of the Consumer Discretionary sector are expected to contract as a result of soaring prices of food and energy, that sap consumer confidence and cut into discretionary spending. In addition, demand for durable goods was pulled forward by the pandemic and is now waning. The Financials sector is expected to experience a sharp drop in earnings. Based on the earnings commentary of the largest banks that have reported so far (JPM, BAC, WFC, C, and MS), there are significant headwinds, which were widely anticipated. A major drought in deal flow and slowing growth decreased demand for loans. On the bright side, banks with sizeable loan books announced that they expect net interest margins to expand. Table 1 Bottom Line: We continue monitoring 2022 Q1 earnings season for any anomalous results to gauge the health of the US corporations.
The US economy is in the midst of an economic growth slowdown, exacerbated by the nascent monetary tightening cycle, a war in Ukraine, and COVID-19 lockdowns in China. To protect our portfolio against the negative economic backdrop, we have been gradually shifting exposure away from cyclicals and towards more defensive allocations. Recent downgrades of the Consumer Durables and Retail, and upgrades of the S&P Consumer Staples sector, are a case in point. Today, we downgrade the S&P Transportation industry group from overweight to underweight. As the Fed proceeds with an aggressive tightening cycle to combat inflation, and China's and Ukraine's human tragedy continues to unfold, economic growth is likely to disappoint while supply disruptions become entrenched, making transportation of goods one of the early casualties. Already, intermodal rail freight, which is a major rail traffic category, is showing major signs of weakness (Chart 1). Finally, Chart 2 illustrates the tight relationship between the broad economic activity and the performance of the overall transportation industry we are alluding to. Given that ISM Manufacturing PMI is likely headed to the low 50s, it will continue weighing on transportation stocks. When it comes to valuations, there is only a marginal discount for the industry group that is currently trading at 17.4x compared to the 19.3x forward P/E multiple for the S&P 500: Risk premium does not justify owning the sector, and further multiple contraction is likely. Bottom Line: Today we downgrade the S&P Transportation index from overweight to underweight on the back of the economic slowdown and relentless supply chain disruptions. Chart 1 Chart 2
Executive Summary The structural downtrend in Chinese bond yields has a lot further to go, because it is helping to let the air out gently of stratospheric valuations in the real estate sector, and thereby preventing a hard landing for the Chinese economy. In the US, flagging mortgage and housing market activity is weighing on an already slowing economy. Buy US T-bonds. The long T-bond yield is close to a peak. Switch equity exposure into long-duration sectors such as healthcare and biotech. Go overweight US homebuilders versus US insurers. The peak in bond yields will also take pressure off US homebuilder shares whose recent collapse has been the mirror-image of the surge in the 30-year mortgage rate. Fractal trading watchlist: Basic resources; Switzerland versus Germany; and USD/EUR. The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate Bottom Line: The global bond yield cannot rise much further before it destabilises the $350 trillion global real estate market and thereby destabilises the global economy. Feature Quietly and largely unnoticed, Chinese long-dated bond yields have been drifting lower (Chart I-1 and Chart I-2). At a time that surging bond yields elsewhere in the world have grabbed all the attention, the largely unnoticed contrarian move in Chinese bond yields through the past year is significant because of something else that has gone largely unnoticed: Chinese real estate has become by far the largest asset-class in the world, worth $100 trillion.1 Chart I-1The Contrarian Downdrift In The Chinese 30-Year Bond Yield Chart I-2The Contrarian Downdrift In The Chinese 10-Year Bond Yield Chinese Real Estate Is Trading On A Stratospheric Valuation The $100 trillion valuation of Chinese real estate market is greater than the $90 trillion global economy, is more than twice the size of the $45 trillion US real estate market and the $45 trillion US stock market, and dwarfs the $18 trillion Chinese economy. Suffice to say, Chinese real estate’s pre-eminence as the world’s largest asset-class is mostly due to its stratospheric valuation. Prime residential rental yields in Guangzhou, Shanghai, Hangzhou, Shenzhen and Beijing have collapsed to 1.5 percent, the lowest rental yields in the world and less than half the global average of 3 percent. Versus rents therefore, Chinese real estate is now twice as expensive as in the rest of the world (Chart I-3). Chart I-3Versus Rents, Chinese Real Estate Is The Most Expensive In The World To corroborate this point, while the US real asset market is worth around two times US annual GDP, the Chinese real estate market is worth more than five times China’s annual GDP! The structural downtrend in Chinese bond yields has a lot further to go. Crucially, the downward drift in Chinese bond yields is alleviating some of the pressure on the extremely highly valued Chinese real estate market – as it helps to let the air out gently of the stratospheric valuations, and thereby avoid a hard landing for the Chinese economy. Hence, the structural downtrend in Chinese bond yields has a lot further to go. The Surge In US Mortgage Rates Is Taking Its Toll Meanwhile, in the rest of the world, the surge in bond yields poses a major threat to the decade long housing boom. Versus rents, US house prices are the most expensive ever – more expensive even than during the early 2000s so-called ‘housing bubble’. For the first time since 2008, the US 30-year mortgage rate is higher than the prime residential rental yield. Until recently, the historically low rental yield on US real estate was justified by an extremely low bond yield. But the recent surge in the bond yield has changed all that. For the first time since 2008, the US 30-year mortgage rate is higher than the prime residential rental yield2 (Chart I-4). Chart I-4The US 30-Year Mortgage Rate Is Now Higher Than The Prime Residential Rental Yield The surge in US mortgage rates is taking its toll. Since the end of January, US mortgage applications for home purchase have fallen by almost a fifth (Chart I-5), and the lower demand for home purchase mortgages is starting to weigh on home construction (Chart I-6). Building permits for new private housing units were already falling in February, but a more up-to-date sign of the pain is the 35 percent collapse in US homebuilder shares. Chart I-5US Mortgage Applications For Home Purchase Have Fallen By Almost A Fifth Chart I-6The Lower Demand For Home Purchase Mortgages Is Starting To Weigh On Home Construction $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields Mortgage rates drive real estate rental yields because of the arbitrage between buying versus renting a similar home. Given a fixed annual budget for housing, I must choose between how much home I can buy – which depends on the mortgage rate, versus how much home I can rent – which depends on the rental yield. The arbitrage should make me indifferent between the two options. As a simple example of this arbitrage, let’s assume my annual budget for housing is $10k, and both the mortgage rate and rental yield are 4 percent. I will be indifferent between spending the $10k on interest on a $250k mortgage loan to buy the home, or spending the $10k to rent a similar $250k home. If the mortgage rate rises to 5 percent, then the maximum loan that my $10k of interest payment will afford me falls to $200k, reducing my maximum bid to buy the home. If I am the marginal bidder, then the home price will fall to $200k, so that the $10k rent on the similar valued home will also equate to a higher rental yield of 5 percent. In practice, the simple arbitrage described above is complicated by several factors: the maximum loan-to-value that a lender will offer on the home; the different transaction costs of buying versus renting; and the fact that people prefer to buy than to rent because buying a home is an investment which also provides a consumption service – shelter, whereas renting a home only provides the consumption service. Nevertheless, these complications do not diminish the overarching connection between mortgage rates and rental yields. The lion’s share of the real estate boom has come from a massive valuation uplift, which in turn has come from structurally lower bond yields. All of which brings us to the decade long global real estate boom that has doubled the value of global real estate market to an eye-watering $350 trillion, four times the size of the $90 trillion global economy. During this unprecedented boom, global rents have risen by 40 percent, tracking world nominal GDP, as they should. This means that the lion’s share of the real estate boom has come from a massive valuation uplift, which in turn has come from structurally lower bond yields (Chart I-7). Chart I-7The Lion's Share Of The Global Real Estate Boom Has Come From A Massive Uplift In Valuations Since the global financial crisis, there has been an excellent empirical relationship between the global long-dated bond yield (US/China average) and the global rental yield. The important takeaway is that the global bond yield cannot rise much further before it destabilises the $350 trillion global real estate market and thereby destabilises the global economy (Chart I-8). Chart I-8The Global Bond Yield Cannot Rise Much Further Before It Destabilises The $350 Trillion Global Real Estate Market Some Investment Conclusions The good news is that the recent rise in the global bond yield has been limited by the downdrift in Chinese bond yields. Given the massive overvaluation of Chinese real estate, the structural downtrend in Chinese bond yields has a lot further to go. Meanwhile in the US, unless bond yields back down quickly, flagging mortgage and housing market activity will weigh on an already slowing economy. If US bond yields don’t back down quickly, the feedback from consequent slowdown in the economy will ultimately bring yields down anyway. As I explained last week in Fat-Tailed Inflation Signals A Peak In Bond Yields I do expect the long T-bond yield to back down relatively quickly. The sharp drop in US core inflation to just 0.3 percent month-on-month in March signals that inflation is peaking. Hence, medium to long term investors should be buying US T-bonds, and switching equity exposure into long-duration sectors such as healthcare and biotech. Finally, a peak in bond yields will also take pressure off US homebuilder shares whose recent collapse has been the mirror-image of the surge in the 30-year mortgage rate (Chart I-9). Hence, go overweight US homebuilders versus US insurers. Chart I-9The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate Fractal Trading Watchlist Given that inflation hedging investment demand has driven at least part of the strong rally in basic resources, a peak in inflation and bond yields threatens to unwind the recent outperformance of basic resources shares. This is corroborated by the extremely fragile 130-day fractal structure (Chart I-10). Accordingly, the recommended trade is to short basic resources (GNR) versus the broad market, setting the profit target and symmetrical stop-loss at 11.5 percent. This week we are also adding to our watchlist: Switzerland versus Germany; and USD/EUR. The full list of 20 investments that are experiencing or approaching turning points is available on our website: cpt.bcaresearch.com Chart I-10The Outperformance Of Basic Resources Is Vulnerable To Reversal Switzerland's Outperformance Vs. Germany Could End The Rally In USD/EUR Could End Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Vulnerable To Reversal Chart 5Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal Chart 7Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 8A Potential Switching Point From Tobacco Into Cannabis Chart 9Biotech Is A Major Buy Chart 10CAD/SEK Reversal Has Started Chart 11Financials Versus Industrials To Reverse Chart 12Norway's Outperformance Could End Chart 13Greece's Brief Outperformance To End Chart 14BRL/NZD At A Resistance Point Chart 15The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 16The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Chart 17Cotton's Outperformance Is Vulnerable To Reversal Chart 18US Homebuilders' Underperformance Is At A Potential Turning Point Chart 19Fractal Trading Watch List Chart 20Fractal Trading Watch List Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 We estimate the value of Chinese real estate at the end of 2021 to be $97 trillion, comprising residential $85 trillion, commercial $6 trillion, and agricultural $6 trillion. The source is: the Savills September 2021 report ‘The total value of global real estate’, which valued the global real estate market to the end of 2020; and the February 2022 report ‘Savills Prime Residential Index: World Cities’ which allowed us to update the valuations to the end of 2021. 2 The US prime residential rental yield is the simple average of the prime residential rental yields in New York, Miami, Los Angeles and San Francisco. Source: Savills. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-5Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Executive Summary To understand the economy and the market we must think of them as non-linear systems which experience sudden phase-shifts. The pandemic introduced phase-shifts in our lives, which led to phase-shifts in our goods demand, which led to phase-shifts in monthly core inflation. As our lives phase-shift back to normality, goods demand will phase-shift back to low growth, and monthly core inflation prints will phase-shift from ‘high phase’ to ‘low phase’. With the 12-month core US inflation rate likely to peak by June at the latest, the long bond yield is likely to peak at some point in April/May, justifying a cyclical overweight position in T-bonds. Go overweight healthcare and biotech versus resources and financials. The leadership of the equity market will once more flip from short-duration sectors to long-duration sectors. Fractal trading watchlist additions: JPY/CHF, non-life insurance versus homebuilders, US homebuilders (XHB), cotton versus platinum, healthcare versus resources, and biotech versus resources. Bottom Line: With the 12-month core US inflation rate likely to peak by June at the latest, the long bond yield is likely to peak at some point in April/May, and the leadership of the equity market will flip back to long-duration sectors such as healthcare and biotech. Feature Inflation is a non-linear system, meaning that you cannot just dial it up or down gradually like the volume on your music system. Instead of gradual changes, non-linear systems suddenly phase-shift from quiet to loud, from cold to hot, from solid to liquid, or from stability to instability (Box I-1). Box 1: A Classic Non-Linear System – A Brick On An Elastic Band To experience the sudden phase-shift in a non-linear system, attach an elastic band to a brick and try pulling it across a table. As you start to pull, the brick doesn’t move because of the friction with the table. But as you increase your pull there comes a tipping point, at which the brick does move and the friction simultaneously decreases, self-reinforcing the brick’s acceleration. Meanwhile, your pull on the elastic continues to increase as you react with a time-lag. The result is that this non-linear system suddenly phase-shifts from stability – the brick doesn’t move – to instability – the brick hits you in the face! Try as hard as you might, it is impossible to pull the brick across the table smoothly. In this non-linear system, the choice is either stability or instability. Back in 2017, in Mission Impossible: 2% Inflation – An Update, I posed a crucial question: “Given that price stability could phase-shift to instability, when should we worry about it?” I answered that “the risk remains low until the next severe downturn – when policymakers may be forced into desperate measures for a desperate situation.” The words proved prescient. Three years later, the desperate situation was a global pandemic, and the desperate measures were economic shutdowns combined with fiscal stimuluses of unprecedented scope and size. A Phase-Shift In Our Lives Produced A Phase-Shift In Inflation Developed economy inflation has just experienced a stark non-linearity. Since 2007, the US core month-on-month inflation rate remained consistently below 3.5 percent.1 Then came the pandemic’s shutdowns combined with policymakers’ massive response, and month-on-month inflation didn’t just rise to above 3.5 percent, it phase-shifted to well over 6 percent. Developed economy inflation has just experienced a stark non-linearity. The remarkable fact is that since 2007, there have been over a hundred monthly core inflation prints below 4 percent, and nine prints above 6 percent, but just one solitary print between 4 and 6 percent! In other words, monthly core inflation shows the classic hallmark of a non-linear system. It can be cold or hot, but not warm (Chart I-1). Chart I-1Monthly Core Inflation Shows The Classic Hallmark Of A Non-Linear System So, what caused the phase-shift in core inflation? The simple answer is a phase-shift in durable goods spending, which itself was caused by the pandemic’s shutdown of services combined with massive fiscal stimulus. Again, this is supported by a remarkable fact. Since 2007, the monthly increase in US (real) spending on durables remained consistently below 3.5 percent. Then came the pandemic’s shutdowns and stimulus checks, and the growth in durables demand didn’t just rise to above 3.5 percent, it phase-shifted to well over 8 percent. In other words, the growth in durable goods demand also shows the classic hallmark of a non-linear system. It can be cold or hot, but not warm (Chart I-2). Chart I-2Goods Demand Shows The Classic Hallmark Of A Non-Linear System The connection between the phase-shifts in goods demand and the phase-shifts in core inflation is staring us in the face – because the three separate phase-shifts in inflation have each been associated with a preceding or contemporaneous phase-shift in goods demand, which themselves have been associated with the separate waves of the pandemic (Chart I-3). Chart I-3Phase-Shifts In Core Inflation Have Been Associated With Phase-Shifts In Goods Demand Pulling all of this together, the pandemic introduced phase-shifts in our lives – lockdown or freedom. Which led to phase-shifts in our goods demand – above 8 percent or below 3.5 percent. Which led to phase-shifts in monthly core inflation – above 6 percent or below 4 percent. The key question is, what happens next? Bond Yields Are Close To A Peak As we learn to live with the pandemic, and assuming no imminent ‘super variant’ of the virus, our lives are phase-shifting back to a semblance of normality. Which means that our spending on goods is phase-shifting back to low growth. If anything, the recent overspend on goods implies an imminent corrective underspend. At the same time, it will be difficult to compensate a phase-shift down on goods spending with a phase-shift up on services spending. This is because the consumption of services is constrained by time and biology. There is a limit to how often you can eat out, go to the theatre, or even go on vacation. The upshot is that monthly core inflation prints are likely to phase-shift from ‘high phase’ to ‘low phase’ – even if the monthly headline inflation prints are kept up longer by the commodity price spikes that result from the Ukraine crisis. Monthly core inflation prints are likely to phase-shift from ‘high phase’ to ‘low phase’. Meanwhile central banks and markets focus on the 12-month core inflation rate – which, as an arithmetic identity, is the sum of the last twelve month-on-month inflation rates.2 To establish the 12-month core inflation rate, the crucial question is: how many of the last twelve month-on-month inflation prints will be high phase versus low phase? As just discussed, the new month-on-month core inflation prints are likely to phase-shift to low phase. At the same time, the historic high phase prints will disappear from the last twelve month window. Specifically, by June 2022, the three high phase prints of April, May, and June 2021 – 10 percent, 9 percent, and 10 percent respectively – will no longer be included in the 12-month core inflation rate, with the arithmetic impact of pulling it down sharply (Chart I-4). Chart I-4The High Phase Monthly Inflation Prints Of April, May, And June 2021 Will Disappear From The 12-Month Core US Inflation Rate, Thereby Pulling It Down. Clearly, the bond market anticipates some of this ‘base effect’ on 12-month inflation. This explains why turning points in the bond yield have led by 2-3 months the turning points in the 12-month core inflation rate (Chart I-5). With the 12-month core inflation rate likely to peak by June at the latest, this suggests that – absent some new shock – the long bond yield is likely to peak at some point in April/May. Reinforcing our cyclical overweight position in T-bonds. Chart I-5The Bond Yield Turns About 2-3 Months Before Core Inflation This also carries important implications for equity investors. Rising bond yields favour short-duration equity sectors such as resources and financials versus long-duration equity sectors such as healthcare and biotech. And vice-versa. Indeed, the recent performance of resources versus healthcare and financials versus healthcare is indistinguishable from the bond yield (Chart I-6 and Chart I-7). Chart I-6The Performance of Resources Versus Healthcare Is Indistinguishable From The Bond Yield Chart I-7The Performance of Financials Versus Healthcare Is Indistinguishable From The Bond Yield With bond yields likely to peak soon, the leadership of the equity market will once more flip from short-duration sectors to long-duration sectors. Go overweight healthcare and biotech versus resources and financials. Fractal Trading Watchlist Reinforcing the fundamental analysis in the previous section, the 130-day outperformance of resources versus healthcare and biotech has reached the point of fractal fragility that has marked previous trend exhaustions, suggesting that the recent outperformance of resources is nearing an end. Also new on our watchlist is a commodity pair, cotton versus platinum, whose strong outperformance is vulnerable to reversal. And US homebuilders (XHB), whose recent underperformance is at a potential turning point. There are two new trade recommendations. First, the massive outperformance of world non-life insurance versus homebuilders is at the point of fractal fragility that has consistently marked previous turning points (Chart I-8). Hence, go short non-life insurance versus homebuilders, setting a profit target and symmetrical stop-loss at 14 percent. Second, the strong underperformance of the Japanese yen is also at the point of fractal fragility that has marked several previous turning points (Chart I-9). Accordingly, go long JPY/CHF, setting a profit target and symmetrical stop-loss at 4 percent. Please note that our full watchlist of 19 investments that are experiencing or approaching turning points is now available on our website: cpt.bcaresearch.com Chart I-8The Massive Outperformance Of Non-Life Insurance Is Vulnerable To Reversal Chart I-9Go Long JPY/CHF The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Cotton’s Outperformance Is Vulnerable To Reversal US Homebuilders’ Underperformance Is At A Potential Turning Point Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Annualized month-on-month inflation rate. 2 Strictly speaking, the 12-month inflation rate is the geometric product of the last 12 month-on-month inflation rates. Chart I-1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart I-2The Strong Trend In The 3 Year T-Bond Is Fragile Chart I-3AUD/KRW Is Vulnerable To Reversal Chart I-4Canada Versus Japan Is Vulnerable To Reversal Chart I-5Canada's TSX-60's Outperformance Might Be Over Chart I-6US Healthcare Providers Vs. Software Approaching A Reversal Chart I-7The Euro's Underperformance Could Be Approaching a Resistance Level Chart I-8A Potential Switching Point From Tobacco Into Cannabis Chart I-9Bitcoin's 65-Day Fractal Support Is Holding For Now Chart I-10Biotech Approaching A Major Buy Chart I-11CAD/SEK Reversal Has Started Chart I-12Financials Versus Industrials Is Reversing Chart I-13Norway's Outperformance Could End Chart I-14Greece's Brief Outperformance Has Ended Chart I-15BRL/NZD At A Resistance Point Chart I-16The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart I-17The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Chart I-18Cotton's Outperformance Is Vulnerable To Reversal Chart I-19US Homebuilders' Underperformance Is At A Potential Turning Point Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Today we upgrade the S&P Metals & Mining industry from underweight to neutral: This industry is one of the few beneficiaries of the war in Ukraine, as the military action and global sanctions take offline copious amounts of metals produced by Russia and Ukraine. It also enjoys increased demand resulting from a shift toward green energy and offers inflation protection. The West’s official sanctions affect Russian exports of certain commodities but there is also a reluctance on the part of private companies to buy or ship Russian exports. In addition, Putin has announced his decision to suspend some commodity exports at least until 2023. Assuming that in the near term a considerable share of Russia’s commodity exports will be blocked from global markets, the largest impact will be on oil, palladium, copper, nickel, fertilizer, and grains (Table 1). Russia’s standoff with the West is still in the early innings and further disruption of the international supply chains is to be expected. The last round of sanctions against Russia is a case in point. Table 1Russia’s Global Share In Various Commodities In addition, the West’s shift toward green energy further exacerbates metal shortages as clean technologies require astronomical amounts of metals. It will take years and billions of dollars in investments for the other metals producers to fill the void left by Russia and Ukraine. As a result, a supply squeeze is a likely outcome. Rampant inflation is another tailwind for the mining names, which are quintessential real assets, and offer substantial inflation protection. All of these structural trends will enhance the profitability of the miners and metals producers and will translate into gains for the S&P 500 Metals & Mining index. Overall, we are structurally bullish on the sector and will be looking to upgrade the Mining and Metals industry to an overweight once a compelling entry point presents itself. Bottom Line: Upgrade the S&P Metals & Mining index to neutral. Look for a compelling entry point to increase exposure to an overweight.
Executive Summary Shanghai Is Extending Lockdowns Due To Exponentially Rising COVID Cases The economic impact of China’s struggle with another wave of COVID outbreaks is showing up in March’s PMI and high-frequency data. The highly contagious nature of the Omicron variant suggests that Shanghai’s battle against the virus spread may last longer than the market has priced in. Chinese authorities will continue playing whack-a-mole in efforts to eliminate the country’s COVID cases. The zero-COVID approach and the virus’ mutating to more contagious variants mean that the country may have to impose more frequent mobility restrictions going forward than in the past two years. Although Chinese policymakers are determined to stabilize the economy, the ongoing combat with COVID will weigh down the effectiveness of the stimulus. In relative terms, we maintain a neutral position on Chinese onshore stocks. However, downshifting corporate profits and the economic shock from lockdowns remain significant risks to the absolute performance of Chinese stocks. Bottom Line: China’s combat against the current COVID-19 outbreaks may last longer than the market has priced in. In the near term, the lockdowns will weigh down the effectiveness of the stimulus. In the second half of the year, the more contagious virus mutations and China’s sticking to zero-COVID strategy may lead to more frequent disruptions to business activity. Chart 1China Is Bracing For The Worst COVID Outbreak Since Early 2020 China’s efforts to stabilize economic growth are facing new challenges, dampening an already fragile recovery. The current wave of COVID-19 outbreaks — the worst since early 2020 — has infected more than 100,000 (TK) people across the country, and the number of new cases is still rising at an exponential rate (Chart 1). Measures to contain the spread of the virus have led to city lockdowns, halted factory production and have dragged down the tourism and catering industries. In previous reports, we noted that it is challenging for China to reach this year’s 5.5% growth target due to downbeat private-sector sentiment and subdued demand for housing. The outlook for China’s economy is grimmer now. The highly contagious COVID virus mutations, including the emerging Omicron BA.2 variant, will make it more difficult for China to control its domestic outbreaks going forward. We do not expect that China will fundamentally change its zero-COVID policy throughout the rest of this year. Therefore, the country will probably see more frequent regional and city lockdowns this year than in the past two years. The leadership will calibrate its handling of these lockdowns to minimize damage to the economy, and Beijing will continue stepping up its growth support policies. However, the whack-a-mole strategy to eliminate domestic COVID cases will be disruptive to business activity and dampen the effectiveness of policy easing. A One-Two Punch… Related Report China Investment StrategyA Choppy Bottom The downside risks to China’s economy stemming from the ongoing domestic COVID outbreaks are adding to the difficulties the country is already facing due to subdued domestic demand. As we have been highlighting in our previous reports, weak private sector sentiment has been weighing down the effectiveness of authorities’ efforts to stimulate the Chinese economy. The sluggish PMI data released last week in part reflects the impact of restrictions imposed to control the latest wave of COVID-19 infections, but also highlights the bleak domestic demand conditions. Notably, the March PMI survey does not capture the full impact of the Shanghai lockdown as the data collection period ended before the restrictions went into effect on March 28. The official composite PMI fell from 51.2 to 48.8 – below the 50 boom-bust threshold and the lowest reading since February 2020. The drop reflects a slump in the manufacturing and – to a greater extent – the non-manufacturing sectors, which both fell into a contractionary territory. The manufacturing PMI slid 0.7 points to 49.5, while the non-manufacturing PMI dropped 3.2 points to 48.4 (Chart 2). The new orders sub-index of the manufacturing PMI lost nearly two percentage points and deteriorated more sharply than the production index (Chart 3). Moreover, the spread between the new orders component and new export orders – a proxy for domestic demand – ticked down in March (Chart 3, bottom panel). This indicates that weak production does not just stem from COVID-related supply-side issues, but also from poor domestic demand conditions. Chart 2Chinese PMIs Slide Into Contractionary Territory Chart 3Economic Shock From Lockdowns Compounds An Already Weak Domestic Demand Chart 4Auto Inventory Index Jumped To Highest Since Early 2020 In addition, high-frequency data from the China Automobile Dealers Association shows that the Vehicle Inventory Alert Index (VIAI) – a survey that measures destocking pressures in the automobile industry – jumped to the highest level since the first wave of COVID-19 hit China in early 2020 (Chart 4). A rising VIAI above the 50-percent threshold indicates that auto inventories are cumulating at a faster pace than demand. Importantly, the cities and regions that have been worst hit by this round of COVID outbreaks are mostly coastal metropolises and business hubs such as Shanghai, Shenzhen and cities in Jiangsu and Zhejiang provinces. These cities and provinces represent more than 20% of China’s aggregate GDP and almost 30% of the country’s total import and export volume. As such, the negative impact on China’s overall economy from the lockdowns will be more substantive than during the previous waves. Measures to contain Shanghai’s worst-ever COVID outbreak are also disrupting operations at the world’s busiest container port, adding strains to the already overstretched global shipping industry (Chart 5). The supplier delivery times subindex of the manufacturing PMI dropped to 46.5 in March, the lowest reading since March 2020 (Chart 6). This suggests that suppliers’ delivery times have lengthened with near-term supply chain pressure, since lower readings reflect longer delivery times. Chart 5Shanghai Lockdowns Will Disrupt The Already Overstretched Global Shipping Industry Chart 6Chinese Suppliers' Delivery Times Have Lengthened Bottom Line: The economic shock from the current COVID outbreaks is compounding an already weak domestic demand in China. Since the cities and regions that are affected by this round of lockdowns are some of China’s most developed metropolitan areas, the negative impact will likely be larger than during the past two years. How Long Will The Battle Last? China’s struggle to contain the current round of domestic COVID outbreaks will likely last longer than the market has priced in. There is also a non-trivial risk that during the rest of the year, the country will need to shutter large parts of its economy more frequently to combat the spread of COVID variants, which appear to become more contagious as the mutation continues. The lockdowns in Shanghai have already been extended beyond the originally announced two-phased, eight-day restriction plan (Chart 7). The first phase of the lockdown, for which restrictions were due to be lifted on the morning of April 1, has now been extended to anywhere between 3 to 10 days. It may take Shanghai, a city of 25 million residents, between four to six weeks to bring the number of new cases down to a level that is acceptable to the authorities. Chart 7Shanghai Is Extending Its Two-Phased, Eight-Day Lockdowns Shenzhen, a dynamic metropolitan city bordering Hong Kong, seems to have successfully contained its COVID outbreaks after only one week of a city-wide lockdown. However, Shenzhen imposed lockdowns at an early stage of the outbreak, when both confirmed and asymptomatic case numbers in the city were in the low double digits. Shanghai, on the other hand, took more stringent measures when the number of asymptomatic cases had already reached nearly a thousand. The Omicron variant is four times more transmissible than the earlier Delta mutation, which means it will generate an explosive rise in cases and make containing the virus spread much more difficult than with Delta. In a fully susceptible (unvaccinated and uninfected) population, one person with Delta would on average infect five other people, while one person with Omicron could transmit the virus to about 20 others. As a result, despite a relatively low number of newly confirmed cases, the surging asymptomatic cases in Shanghai imply that a larger population in the city might have already been infected (Chart 8). China’s struggle with the current wave of COVID outbreaks may be an example of what lies ahead, as continuously mutating variants become more contagious and will pose fresh new challenges to China’s zero-COVID approach. The latest strain of Omicron BA.2 appears to be 40% more contagious than the original Omicron strain and is quickly spreading around the world. The number of cases has spiked across much of Europe, parts of Asia, and has begun to rise in North America (Chart 9). It took only two months from when China reported its first local Omicron BA.1 case in early January to the outbreaks of Omicron BA.2 in March. Chart 8Surging Asymptomatic Patients In Shanghai Imply More Confirmed Cases Still To Come Chart 9Covid Cases Are On The Rise Again Globally This presents the Chinese authorities with a difficult dilemma: impose severe mobility restrictions when domestic cases pop up, or let the virus run rampant and develop a herd immunity among much of its population. China’s leadership has recently reiterated that the country will stick to its zero-COVID strategy. The success that China has had in suppressing the virus in the past two years has left its population with little natural immunity. Moreover, while China’s overall vaccination rate is high at 85%, less than 50% of people over the age of 80 in the country are fully vaccinated. The authorities have been fine tuning their measures to control the virus spread while sticking to a zero-COVID approach. The recently calibrated measures include allowing residents to take rapid antigen tests at home, quarantining people with asymptomatic COVID cases at dedicated isolation centers rather than hospitals, and monitoring patients for shorter periods than previously required. China has also fast-tracked the approval for the importing and domestic manufacturing of Paxlovid, which is highly effective at preventing hospitalization if taken within five days of the onset of symptoms. In addition, the global production of antiviral drugs is starting to ramp up (Chart 10). Nonetheless, China will probably wait until the antiviral drugs are in sufficient supply before fundamentally relaxing its zero-COVID policy. In the meantime, while the country’s economic growth will rebound when the current wave of COVID cases subsides, disruptive outbreaks and lockdowns may become more frequent as the authorities continue to play whack-a-mole with COVID (Chart 11). As a result, business activity in China will suffer. Chart 10Production Of New COVID Drugs Is Picking Up Chart 11China Has The Most Stringent COVID-Control Measures Among Large Economies Bottom Line: Shanghai’s current battle with COVID outbreaks will likely continue in the coming weeks. Before China can relax its zero-COVID policy, the more contagious COVID virus mutations in the future will see Chinese authorities adopt even harsher quarantine and control measures, which will disrupt economic activity further. Investment Conclusion Chinese stocks in both onshore and offshore markets have recovered some ground from their deeply oversold conditions in mid-March (Chart 12A). While the risk-reward profile for the A-share market warrants a neutral position in a global portfolio, in absolute terms both on- and offshore Chinese stock prices have probably not reached their bottom (Chart 12B). Chart 12AChinese Stocks Will Likely Fall Further In Q2 Chart 12BIn Relative Terms, Stay Neutral On Chinese Onshore Stocks The private sector’s downbeat sentiment, households’ subdued demand for housing, and the ongoing COVID-19 lockdowns pose significant near-term downside risks to China’s economy and corporate profits. February’s credit impulse shows that corporate and household demand for credit has been weakening. Without a major reversal in corporate credit and the property market, a strong business cycle recovery is unlikely in China. Moreover, the March PMI readings suggest that the lockdowns in China’s business and manufacturing hubs will have substantial negative impacts on the economy. As such, we maintain our neutral stance on Chinese onshore stocks and continue to recommend underweight Chinese offshore stocks in a global portfolio. Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations
Highlights Chart 1Reduce Credit Exposure Corporate bond spreads staged a nice rally during the past month. The average index spread for investment grade corporates is only 22 bps above its pre-COVID low and 33 bps above last year’s trough. The average High-Yield index spread is 5 bps above its pre-COVID low and 49 bps above last year’s trough (Chart 1). This rally occurred even as inflation data continued to surprise to the upside and employment data confirmed that the US labor market is extremely tight. With the economic data justifying the Fed’s hawkish pivot, the Treasury curve has flattened dramatically, and both the 2-year/10-year and 3-year/10-year slopes are now inverted (Chart 1, bottom panel). An inverted yield curve is a reliable late-cycle indicator, and we think current spread levels offer a good opportunity to reduce corporate bond exposure. This week, we downgrade investment grade corporates from neutral (3 out of 5) to underweight (2 out of 5) and high-yield corporates from overweight (4 out of 5) to neutral (3 out of 5), placing the proceeds into Treasuries. We also downgrade our recommended allocations EM Sovereigns (see page 8) and TIPS (see page 11), upgrade our recommended allocation to CMBS (see page 13) and adjust our recommended yield curve positioning (see page 10). Feature Table 1Recommended 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 86 basis points in March, bringing year-to-date excess returns up to -154 bps. Our quality-adjusted 12-month breakeven spread shifted down to its 21st percentile since 1995 (Chart 2). As noted on the first page of this report, corporate spreads have rallied to within striking distance of their pre-COVID lows at the same time as the yield curve has become inverted beyond the 2-year maturity. We showed in last week’s report that an inversion of the 2-year/10-year Treasury slope is not necessarily a harbinger of imminent recession, but it does typically coincide with very low (and often negative) excess corporate bond returns.1 The combination of reasonably tight spreads and an inverted yield curve causes us to recommend downgrading investment grade corporate bond allocations from neutral (3 out of 5) to underweight (2 out of 5). It’s important to note that corporate balance sheets remain healthy (bottom panel) and we see no indication that a recession or default cycle will unfold during the next 6-12 months. That said, we must acknowledge that an inverted yield curve signals that the economic recovery is entering its late stages. Economic growth will be slower going forward and corporate spreads are unlikely to tighten much, especially from current depressed levels. Against this backdrop it makes sense to be more cautious on credit, sacrificing small positive excess returns in the near-term to ensure that we aren’t invested when the next downturn hits. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 119 basis points in March, bringing year-to-date excess returns up to -96 bps. 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 – shifted down to 3.7% (Chart 3). An inverted yield curve sends the same negative signal for high-yield excess returns as it does for investment grade. However, high-yield valuation is currently more attractive. The option-adjusted spread differential between Ba-rated bonds and Baa-rated bonds remains elevated at 86 bps, 41 bps above its pre-COVID low (panel 3). It is also likely that economic growth will remain sufficiently strong for defaults to come in below the spread-implied threshold of 3.7% during the next 12 months (bottom panel). The greater attractiveness of high-yield valuations relative to investment grade causes us to maintain a higher allocation to the sector, even as we downgrade our portfolio’s overall credit risk exposure. We therefore recommend a neutral (3 out of 5) allocation to high-yield corporates. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in March, dragging year-to-date excess returns down to -74 bps. The zero-volatility spread for conventional 30-year agency MBS tightened 3 bps on the month as a 4 bps tightening of the option-adjusted spread (OAS) was partially offset by a 1 bp increase in the compensation for prepayment risk (option cost) (Chart 4). We wrote in a recent report that MBS’ poor performance in 2021 was attributable to an option cost that was too low relative to the pace of mortgage refinancings, noting that the MBA Refinance Index was slow to fall in 2021 despite the back-up in yields.2 This valuation picture is starting to change. The option cost is now up to 40 bps, its highest level since 2016, and refi activity is slowing as the Fed lifts rates. At 28 bps, the index OAS remains unattractive. However, the elevated option cost raises the possibility that the OAS may be over-estimating the pace of mortgage refinancings for the first time in a while. If these trends continue, it may soon make sense to increase exposure to agency MBS. Emerging Market Bonds (USD): Underweight Chart 5Emerging Markets Overview Emerging Market bonds underperformed the duration-equivalent Treasury index by 23 basis points in March, dragging year-to-date excess returns down to -505 bps. EM Sovereigns outperformed the Treasury benchmark by 40 bps on the month, bringing year-to-date excess returns up to -609 bps. The EM Corporate & Quasi-Sovereign Index underperformed by 62 bps, dragging year-to-date excess returns down to -439 bps. The EM Sovereign Index underperformed the duration-equivalent US corporate bond index by 7 bps in March. This comes on the heels of a sharp underperformance in February that was driven by Russian bonds which have since been removed from the index. Russian bonds have also been purged from the EM Corporate & Quasi-Sovereign Index, and this index underperformed duration-matched US corporates by 11 bps in March (Chart 5). The yield differential between EM sovereigns and duration-matched US corporates remains negative. As such, we downgrade our recommended allocation to EM sovereigns from underweight (2 out of 5) to maximum underweight (1 out of 5). In sharp contrast, the EM Corporate & Quasi-Sovereign Index continuous to offer a significant yield advantage (panel 4). We retain our neutral (3 out of 5) recommendation for EM Corporates & Quasi-Sovereigns. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 5 basis points in March, bringing year-to-date excess returns up to -122 bps (before adjusting for the tax advantage). While the war in Ukraine has introduced a great deal of uncertainty into the economic outlook, the municipal bond sector should be better placed than most to deal with the fallout. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and 2021’s federal spending splurge will continue to support state & local government coffers for some time. On the valuation front, munis have cheapened up relative to both Treasuries and corporates during the past two months. The 10-year Aaa Muni / Treasury yield ratio is currently at 94%, up significantly from its 2021 trough of 55%. The yield ratios between 12-17 year munis and duration-matched corporate bonds are also up significantly off their 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 93%. The same measure for 17-year+ Revenue bonds stands at 101%, meaning that Revenue bonds carry a before-tax yield advantage versus duration-matched corporates. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve’s bear-flattening trend continued through March. The 2-year/10-year Treasury slope flattened 35 bps on the month and the 5-year/30-year Treasury slope flattened 44 bps. These slopes are now both inverted, sitting at -6 bps and -12 bps respectively. In last week’s report we noted the unusually wide divergence between very flat slopes at the long end of the yield curve and very steep slopes at the front end.3 For example, the 5-year/10-year Treasury slope is -18 bps but the 3-month/5-year slope is 204 bps. This divergence is happening because the market has moved quickly to price-in a rapid near-term pace of rate hikes that will end in roughly one year. However, so far, the Fed has only delivered 25 bps of those hikes 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 in the market but lasts longer, as is our expectation. By entering our new 5-year bullet over 2-year/10-year barbell trade we also close our previous 2-year bullet over cash/10-year barbell trade at a loss. We 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 outperformed the duration-equivalent nominal Treasury index by 143 basis points in March, bringing year-to-date excess returns up to +271 bps. The 10-year TIPS breakeven inflation rate rose 22 bps on the month and the 5-year/5-year forward TIPS breakeven inflation rate rose 21 bps. Since last May we have been recommending that clients maintain a neutral allocation to TIPS versus nominal Treasuries at the long end of the curve and an underweight allocation to TIPS at the front end. This recommendation was premised on the view that the breakeven curve would steepen as falling inflation put downward pressure on short-maturity TIPS breakevens and long-dated breakevens remained at levels close to the Fed’s target. Recently, the 10-year TIPS breakeven inflation rate has shot up to levels well above the Fed’s 2.3%-2.5% target range (Chart 8) and our TIPS Breakeven Valuation Indictor has shifted into “expensive” territory (panel 2). Further, while inflation has remained high for longer than we expected, it still seems more likely than not that it will roll over between now and the end of the year as pandemic fears fade and consumers shift their spending patterns away from goods and toward services. As such, we think investors should take this opportunity to further reduce exposure to TIPS versus nominal Treasuries at both the short and long ends of the curve. That is, within our overall underweight allocation to TIPS we continue to recommend positioning in breakeven curve steepeners and in real yield curve flatteners. We also continue to recommend an outright short position in 2-year TIPS. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 26 basis points in March, dragging year-to-date excess returns down to -31 bps. Aaa-rated ABS underperformed by 21 bps on the month, dragging year-to-date excess returns down to -27 bps. Non-Aaa ABS underperformed by 49 bps on the month, dragging year-to-date excess returns down to -51 bps. During the past two years, substantial federal government support for household incomes has caused US households to build up an extremely large buffer of excess savings. During this period, many households have used their windfalls to pay down consumer debt and credit card debt levels have fallen to well below pre-COVID levels (Chart 9). Though consumer credit growth has rebounded, debt levels are still low. This indicates that the collateral quality backing consumer ABS remains exceptionally strong. This also indicates that while surging gasoline prices will weigh on consumer activity in the coming months, household balance sheets are starting from such a good place that we don’t expect a meaningful increase 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 outperformed the duration-equivalent Treasury index by 20 basis points in March, bringing year-to-date excess returns up to -78 bps. Aaa Non-Agency CMBS outperformed Treasuries by 25 bps on the month, bringing year-to-date excess returns up to -67 bps. Non-Aaa Non-Agency CMBS underperformed by 5 bps on the month, dragging year-to-date excess returns down to -110 bps. CMBS spreads remain wide compared to other similarly risky spread products. Further, commercial real estate (CRE) lending standards have recently shifted into “net easing” territory and demand for CRE loans is strengthening (Chart 10). In light of today’s downgrade of corporate credit, non-agency CMBS look like an attractive alternative to add some spread to a portfolio. Increase exposure from neutral (3 out of 5) to overweight (4 out of 5). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 17 basis points in March, dragging year-to-date excess returns down to -39 bps. The average index option-adjusted spread widened 5 bps on the month. It currently sits at 48 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 255 basis points of rate hikes during the next 12 months. Chart 11The Golden Rule's Track Record We 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 March 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 March 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 -55 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 55 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 March 31, 2022) Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / US Investment Strategy / US Equity Strategy Special Report, “The Yield Curve As An Indicator”, dated March 29, 2022. 2 Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. 3 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