Emerging Markets
Executive Summary India’s annual consumer price inflation will rise a notch from current levels but is unlikely to surpass 8% in a sustained manner. Demand-driven price pressures are absent in the Indian economy. So are wage pressures. That leaves commodity prices as the sole source of inflation. Global industrial commodity prices dictate India’s producer price inflation, but not consumer price inflation. The latter is determined by domestic factors. Higher import costs on fertilizer and edible oils will push up India’s food inflation a bit, but food inflation is mainly affected by the ‘Minimum Support Price’ that the government pays to farmers for food procurement. The central bank is making a policy mistake by raising interest rates to suppress commodity price-driven inflation when domestic demand is quite weak. The Indian profit outlook has deteriorated meaningfully due to falling margins. Higher interest rates will add to the headwinds. This bourse is also very expensive relative to its EM peers. India: Consumer Price Inflation Is A Function Of Broad Money Supply Bottom Line: Absolute return investors should avoid this bourse. Asset allocators should stay underweight India in EM and Emerging Asian equity portfolios. Bond investors should stay neutral India in EM and Emerging Asian domestic bond portfolios. Feature In much of the developed world, inflation has risen to 40-year highs. Inflation has surged in many developing countries as well. India has been one major exception in the latter group − where both headline and core consumer inflation have remained rangebound so far (Chart 1). The question is, if and for how long will India be able to buck the tide of higher global inflation? On a related note, what would be the likely effects of higher inflation on Indian markets? We believe headline and core CPI in India will rise from the current levels of around 6.5%; but will not go past 8% on a sustainable basis. This is much below the double digit levels the country often witnessed in the 1990s and 2000s. The main reason behind our optimism is that demand-driven price pressures are absent in the current cycle. The sole source of inflation is higher global commodity prices, which could be peaking on a rate of change basis. The commodity-led nature of inflation in India also makes monetary policy a less effective tool to control it in this cycle. In fact, considerable monetary tightening will be a policy error as it could nip the already weak domestic demand in the bud. We turned bearish on Indian stocks in March this year, and believe they have more downside in absolute terms. Their recent relative outperformance will also fizzle out sooner rather than later, as this was partially due to investors forsaking the Chinese market. This caused a sharp fall in the latter boosting other bourses’ relative performances (Chart 2). Chart 1India Has So far Been An Exception To The Global Trend Of Surging Inflation Chart 2Indian Stocks Will Weaken More And Underperform EM Investors would therefore do well to stay underweight Indian stocks in EM and Emerging Asian equity portfolios for now. Local currency bond investors should stay neutral India in the respective EM and Emerging Asian bond portfolios. Why Has Inflation Stayed Downbeat? Just like in other economies, labor productivity trends set the tone of India’s structural inflation backdrop. Up until the early 2000s, India’s average productivity gains used to be rather low: of the order of 3% annually. Thereafter, a surge in capital spending on infrastructure and other productive capacity propelled India’s average annual productivity growth rate to twice as high. This has helped improve India’s structural inflation backdrop considerably. That said, over a cyclical horizon, it is the ebbs and flows of broad money supply (M3) that determines India’s consumer inflation trajectory (Chart 3). Chart 3India: Consumer Price Inflation Is A Function Of Broad Money Supply Chart 4Money Supply Will Stay Tame As Its Sources Are Rather Muted Broad money supply in India has decelerated over the past year and a half. This is in sharp contrast to most developed economies and many emerging economies in Latin America and EMEA; and it is the main reason why inflation prints have diverged between those countries and India. In the foreseeable future, there is little indication that India’s broad money supply will accelerate by any meaningful measure. This is because the major sources of money creation – bank credit origination and the central bank and commercial banks’ purchases of non-bank securities − have all remained rather muted in the recent past. Bank credit has grown only at a 7% nominal annualized rate over the past three years. In real terms (deflated by headline CPI), they have barely risen. Commercial banks’ purchases of government bonds are growing at only 5%. The central bank’s monetization of government debt, the other source of money creation, has also decelerated since early 2020 (Chart 4). The decelerating broad money supply means the odds of a demand-driven surge in consumer price inflation is also quite low. What About Commodity-Led Inflation? Elevated commodity prices have pushed up India’s consumer price inflation by a notch. Yet, given that much of the rally in global industrial commodities is probably already behind us, it’s effect on future inflation in India will likely be limited: Global industrial commodity prices drive India’s producer price inflation1 (PPI). But the correlation with India’s consumer price inflation is only tenuous (Chart 5). Moreover, given that India’s PPI tracks global commodity prices with a few months lag, this is also set to decelerate in the coming months. Consistently, the pass-through effect from high global crude prices to local gasoline and diesel prices in India has also rolled over on a rate of change basis (Chart 6, top panel). Chart 5Global Commodity Prices Dictate India's Producer Prices, But Not Consumer Prices Chart 6Domestic Fuel Price Inflation Is Much Lower Than Crude Price Would Suggest Notably, Indian authorities did not reduce local gasoline and diesel prices back in 2020-21 when global crude prices had slumped. Hence, the incremental rise in local fuel prices in the past several months has not been as steep as they might have been (Chart 6, bottom panel). As a result, energy-related inflation prints in India are not as high as crude oil prices would suggest. In fact, CPI for Fuel & Light and Transport & Communication2 have both decelerated from 12%+ YoY rate to 8% and are slowing further. That means the pass-through from higher fuel prices to the rest of the economy going forward will also be receding. Fertilizer (mostly potash) and edible oil3 are the two other major commodities that India imports. The import bill of these two items has almost doubled in dollar as well as in rupee terms in the past year due to surging prices globally. Together, they now account for 5% of India’s total imports. Higher import costs of these items will lead to slightly higher food prices in future. That said, India’s food inflation moves more with the “Minimum Support Price” (MSP). This is the price that the government pays to farmers for procuring various food grains every year (Chart 7, top panel). Since the government is by far the single largest purchaser, the price it pays sets the floor in the market. In recent years, authorities did not hike procurement prices by much. Unless authorities announce a much higher MSP for the current year, both food and headline CPI will likely stay under control. Finally, India is largely self-reliant when it comes to food. The buffer stock of the country’s food grains, currently at 74 million tons, far exceeds the estimated requirements (Chart 8). Short of any logistics debacle therefore, it’s hard to imagine that food prices could soar sustainably. Chart 7The Government's Support Prices Have A strong Bearing On Food Inflation And Rural Wages Chart 8India's Buffer Stock Of Food Grains Is Quite Robust All that said, food inflation is the main risk on India’s inflation horizon. The reason for that is rising food prices often unmoor household inflation expectations, and eventually lead to higher realized inflation. Chart 9 shows that higher food prices in India do leak into non-food prices, albeit to a limited extent. As such, marginally higher food prices owing to higher import costs of fertilizer and edible oils will see India’s core inflation also rise a bit. Chart 9Higher Food Inflation Leaks Into Core Inflation, But Only So Much How High Can Core CPI Rise? As discussed, India’s core inflation will likely remain mostly under control. A crucial reason for that is wage pressures are absent in India. This is in stark contrast to the US, where high wage pressures are threatening to morph into a wage-inflation spiral. In rural India, both farm and non-farm nominal wages have been growing at an average sub-5% rate since 2016, which is below CPI inflation. One reason rural wages have stayed low is that authorities have not raised the MSP much in recent years. A lower MSP not only reins in food prices, but it also keeps a tab on wages (Chart 7, bottom panel). As such, unless the government decides to raise the MSP meaningfully this year, it will be difficult for rural wages to rise materially. On the urban side, the RBI survey on expectations for industrial salary and remunerations also depicts a similarly subdued outlook (Chart 10). Going forward, as tens of millions of young people continue to join the workforce every year, the broader wage picture in India is unlikely to change much. Subdued wage pressures will help keep a tab on the general inflationary pressures in the economy. On its own, India’s core CPI (i.e., CPI ex-food and ex-fuel) is largely a function of domestic money and credit trends. Global crude oil prices also matter to some extent. However, as discussed above, few of these variables are accelerating sharply. That means odds are low that core CPI will rise much more from the current levels. Indeed, our in-house model for core CPI, based on the variables just mentioned, points to a rather benign outlook (Chart 11). Chart 10Wage Pressures Are Absent, Entailing Core Inflation Will Stay Under Control Chart 11India's Inflation Outlook Is Sanguine Does Inflation Hurt Indian Stocks? The primary drivers of Indian stocks are economic growth and corporate profits. Stock prices do not usually get hurt as long as CPI stays in low and mid-single digits. However, once CPI breaches the 8% mark sustainably, stocks typically sell off (Chart 12). Chart 12Indian Stocks Face Major Headwinds When CPI Breaches The 8% Mark Chart 13Indian Stocks Have A Positive Correlation With PPI, As Both Benefit From Global Growth The reason is that when inflation is sustainably high, meaningful monetary tightening ensues. Higher interest rates make it costlier to borrow for either consumption or investment purposes, and therefore depresses demand in the economy. That leads to a squeeze in profit margins, which in turn weighs on equity multiples and thus equity prices. Interestingly, unlike CPI, which has no stable correlation with Indian stock prices, PPI has a robust positive correlation with stocks. The link is via corporate earnings. Indian PPI tracks the ebbs and flows in global commodity prices, and therefore global growth. Strong global growth boosts all corporate earnings, including that of India. Accelerating PPI is therefore a harbinger of higher Indian earnings and stock prices. Going forward, however, a decelerating PPI is pointing to lower stock prices in India (Chart 13). Is RBI Making A Policy Mistake? India’s central bank seems to be committing a policy mistake by raising interest rates to suppress commodity price-driven inflation when domestic demand is already very weak. This is negative for the economy and share prices. Chart 14Household Consumption Is Quite Weak; Domestic Production Is Far Below Trend The Reserve Bank of India surprised the market last week by raising policy rates by 40 basis points to 4.4%. They also raised commercial banks’ cash reserve ratio by 50 basis points to 4.5% in order to tighten banking sector liquidity. Monetary tightening, as a policy tool, works by stifling domestic demand. It makes borrowing for the purpose of investments and consumption more costly. It is, however, rather ineffective in resolving inflation caused by higher food and fuel prices – as is the case in India presently. Notably, high commodity inflation itself forces consumers to spend a lower amount on other core items – leading to weaker demand for the latter. Further monetary tightening would exacerbate that weakness. As explained before, Indian consumer prices are driven mostly by domestic factors, such as money supply and productivity (Chart 3, above), rather than global commodity prices. This distinction is important given that the central bank’s mandate is to manage CPI, not PPI. As such, monetary policy should ideally be based on mostly domestic dynamics. India’s domestic demand is extremely soft compared to the US where inflation has skyrocketed. Given the massive negative output gap that opened up in the Indian economy during the pandemic-related lockdowns, it will take a while before this economy sees genuine, sustained overheating. In view of this softness, any meaningful hike in interest rates (say another 100 basis points) could have a material negative impact on the recovery, and by extension, on stock prices: Household consumption is quite weak − as is evident in local car and 2-wheeler sales (Chart 14, top panel). One reason for that is the subdued wage growth mentioned above. Pandemic-era fiscal stimulus, at less than 2% of GDP, has not been nearly enough to compensate for lost household income during the lockdowns. Consistent with lackluster household demand, manufacturing and other industrial productions are also languishing at far below the pre-pandemic trend (Chart 14, bottom panel). Robust capex is what spearheaded India’s post-pandemic recovery. But, now with decelerating corporate profits, capital investments have begun to slow. Higher costs of borrowing will further discourage capex plans. If so, lower investments will do more than shave off GDP growth in the coming quarters. If continued, this could be a major risk for India’s sustainable growth story, and its ill-effects may linger. Chart 15Higher Interest Rates Are A Headwind For Stock Prices All in all, given the nature of inflation in India in the current cycle, it will be a mistake to raise policy rates by any meaningful measure. Both consumption and investments will be hurt. Stock prices, which clearly benefit from lower interest rates, will be facing higher rates, and will therefore sell off (Chart 15). As such, it will be difficult for the RBI to continue to tighten monetary policy without causing a significant bear market in Indian stocks. Investment Conclusions Equities: The Indian profit outlook has deteriorated meaningfully as a result of falling margins and an impending growth slowdown. This bourse is also very expensive relative to its EM peers. Higher interest rates will add to the headwinds. Absolute return investors should avoid this market. Asset allocators should stay underweight in EM and Emerging Asian equity portfolios. Currency And Bonds: The Indian rupee could depreciate marginally along with a likely sell-off in Indian stocks. Given that higher interest rates will likely be detrimental to a growth recovery, it will discourage capital inflows, and will therefore be negative for the rupee. As the rupee could be weaker, and bond yields could rise marginally with tighter banking sector liquidity, investors should stay neutral on India in EM and Emerging Asian bond portfolios. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1 Also called ‘wholesale prices.’ 2 CPI for Fuel & Light has a 6.8% weight in the CPI basket. Transportation & Communication has 8.6% weight. 3 Edible oil has a weight of 3.6% in India’s CPI basket.
Executive Summary EM Credit Spreads Correlate With The EM Business Cycle A buying opportunity in EM local bonds and sovereign credit (EM USD bonds) will open up once US Treasury yields roll over and the US dollar begins its descent. US 10-year Treasury yields will likely peak at around 3.3-3.4%. The US dollar will roll over soon after that. Although we are getting closer to a buying opportunity in EM local currency bonds, it is not imminent. EM sovereign and corporate credit spreads fluctuate with their exchange rates and the EM/global business cycle. The near-term outlook for EM currencies and EM/global growth remains unfavorable. Bottom Line: For now, continue shorting a basket of EM currencies versus the US dollar: ZAR, COP, PEN, PLN, HUF, PHP and IDR. Maintain a defensive tilt within an EM local bond portfolio. Our only outright long has been Brazilian 10-year domestic bonds but we recommend that investors hedge currency risk over the near term. Continue underweighting EM credit relative to US credit, quality adjusted. Feature Bond yields are surging around the world. How advanced are the bond selloffs in the US and in EM? Our short answer is that while the global bond selloff is fairly advanced, volatility will remain high in the near term and yields might rise further. A buying opportunity in EM local bonds and sovereign credit (EM USD bonds) will emerge when US bond yields roll over and the US dollar begins its descent. For now, investors should continue shorting EM currencies versus the US dollar and stay defensive in their EM domestic bond and credit portfolios. US Inflation And Bond Yields Since the top in US bond prices in 2020, US 10-year Treasurys have experienced their second largest drawdown of the past 42 years (Chart 1). The bond rout has pushed net bullish sentiment on US Treasurys to extremely low levels (Chart 2, top panel). From a contrarian perspective, depressed sentiment is positive for the outlook for bonds. Chart 1US 10-Year Treasurys Are Experiencing Their Second Worst Drawdown In 45 years Chart 2Traders Are Very Bearish On Bonds However, the term premium on 10-year bonds is still too low (Chart 2, bottom panel). Extremely high inflation uncertainty warrants a higher risk premium on US bonds. Given that the term premium is a gauge of the risk premium embedded in bonds, it will likely rise further due to inflation and policy uncertainty. Moreover, the tight labor market and surging wages imply that the fundamental outlook for US bonds is also unfavorable. Chart 3 displays that the US labor market has not been this tight since the late 1960s when inflation rose sharply, got embedded in consumer and business expectations and stayed structurally elevated util the early 1980s. The bottom panel of Chart 3 shows the US employment cost index and the Atlanta wage tracker. Both are high and accelerating. Chart 3The US Labor Market Is Very Tight And Wage Growth Is Accelerating Critically, US unit labor costs (ULC) – which have a significant impact on core inflation’s medium-term trends – are accelerating (Chart 4). Productivity growth will not be able to keep up with the pace of wage increases, which implies that unit labor costs will continue to rise at a rapid rate. As a result, any decline in core and headline CPI will be technical and limited in nature. US headline and core inflation rates will drop from the current extremely high levels as transitory forces – which exacerbated price pressures over the past 12 months – ebb. Trimmed-mean core PCE and median core CPI measures suggest that underlying US core consumer price inflation is probably in the 3.5% to 4% range (Chart 5). These two measures strip out outliers like used auto prices. Chart 4Unit Labor Costs Drive Core CPI Chart 5US Core Inflation Will Roll Over But Stay Above 3.5-4% Thus, core PCE and CPI will drop in H2 this year but will stay above 3.5-4%. That is well above the Fed’s 2-2.25% target range for core inflation. Hence, the Fed will maintain its hawkish stance and continue to tighten monetary policy for now. That is why we have been arguing that the Fed and US stocks are on a collision course. The Fed will adopt a dovish tilt only after financial conditions tighten dramatically, i.e., when the S&P500 is down more than 20% from its January high. Bottom Line: Even though headline and core inflation measures will decline later this year, genuine price pressures will remain intense. US government bond yields might be approaching a turning point. Odds are that US 10-year yields will roll over when they reach 3.3-3.4% (Chart 6). EM Domestic Bonds The current drawdown in the total return of EM domestic bonds is the largest on record in local currency terms, but not in US dollar terms (Chart 7, top and middle panels). The basis is that in the current cycle, EM currencies have depreciated less than they did during previous bond selloffs in 2014-15 and 2020. Chart 6The Next Technical Resistance For 10-Year Treasurys Yields Is Around 3.4% Chart 7EM Local Currency GBI Bond Index: Total Return And Yields However, historical comparisons do not take into account changes to the composition of the JP Morgan GBI-EM index. Specifically, China was included in 2020 and it now makes up 10% of the index. Chinese onshore government bond yields have been falling and are now very low (comparable with the yields on US Treasurys). Plus, the Chinese yuan is a low beta currency in the EM universe. In brief, Chinese onshore bonds have been supporting the GBI-EM index’s performance over the past 12 months. However, even after considering this favorable compositional change to the GBI-EM index, the recent drawdowns in both local currency and US dollar terms have been significant (Chart 7, middle panel). From a valuation point of view, EM bonds are beginning to offer value (Chart 7, bottom panel). However, risks to ex-China EM local currency bond yields remain to the upside over the near term. First, as long as EM exchange rates depreciate versus the US dollar, EM ex-China central banks will hike their policy rates because weak currencies will aggravate domestic inflationary pressures. Odds are that the greenback’s rally will continue in the near term. Net bullish sentiment on the US dollar is not yet at a peak level (Chart 8). Plus, investors’ net long positions in high-beta EM currencies was elevated as of April 29 (Chart 9). Chart 8Bullish Sentiment On US Dollar Is Not Extreme Chart 9EM Currencies Have Near-Term Downside Critically, the Chinese yuan’s depreciation versus the US dollar will continue to exert downward pressure on commodity prices and other EM currencies. Besides, EM ex-China currencies have failed to break above the falling trendline (Chart 10). This is a sign that the rebound has been exhausted and a new downleg is in the offing. Second, the pass-through effect of high food and energy prices into core inflation is higher among EM economies than DM ones. Given that food prices are surging and oil prices are elevated, mainstream EM central banks will continue hiking interest rates. Finally, EM local bond yields will not drop until US TIPS yields roll over (Chart 11). TIPS yields are still low, and their path of least resistance would be up. Chart 10Stay Short EM Currencies for Now Chart 11EM Local Yields Correlate With US TIPS Yields Bottom Line: A buying opportunity in EM domestic bonds will likely occur when US Treasury yields and the US dollar roll over. These are not imminent. EM local currency bond investors should stay defensive for now. EM Credit Spreads EM sovereign and corporate credit spreads fluctuate with their exchange rates and the EM/global business cycle, as was discussed in A Primer on EM USD Bonds and illustrated in Chart 12 and 13. Chart 12EM Credit Spreads Correlate With EM Currencies Chart 13EM Credit Spreads Correlate With The EM Business Cycle As we discussed above, the outlook for EM currencies remains unfavorable. Risks to EM/global business cycle are also to the downside. China’s growth remains weak. The favorable impact of fiscal and monetary stimulus is being offset by the harsh lockdowns. Copper prices seem to be breaking down in line with China’s economic weakness (Chart 14). This is negative for many EM economies that export raw materials. Domestic demand in many emerging economies is subdued (Chart 15). Monetary tightening and negative fiscal thrust will cause domestic demand in the majority of EM economies to slow further. Chart 14Copper Prices Have Broken Down Chart 15EM Domestic Demand Has Been Very Weak Finally, global trade volumes will shrink as DM consumption of goods ex-autos declines. Bottom Line: A combination of weakening growth and depreciating currencies will cause EM sovereign and credit spreads to widen further. Investment Recommendations Chart 16EM Credit Spreads Will Widen Further US Treasury yields will likely peak at around 3.3-3.4%. The US dollar will roll over soon after. For now, continue shorting a basket of EM currencies versus the US dollar: ZAR, COP, PEN, PLN, HUF, PHP and IDR. Be patient before buying EM local currency bonds. Our current positions are as follows: receiving 10-year swap rates in China and Malaysia, betting on yield curve inversion in Mexico and Colombia (receiving 10-year/paying 1-year and 6-month swap rates, respectively) and paying Polish/receiving Czech 10-year rates. Our only outright long has been Brazilian 10-year bonds but we recommend that investors hedge currency risk in the near term. EM sovereign and credit spreads will widen further (Chart 16). Continue underweighting EM credit relative to US credit, quality adjusted. Our country allocation for EM domestic bond and sovereign credit portfolios is presented in the tables below. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)
Strong domestic growth and sky-high oil prices have supported the rally in Colombian equities and the currency this year. However, a business cycle slowdown, an uncertain outlook for oil prices, and rising political risk will weigh down on Colombian stocks…
Executive Summary More Chinese Households Intend To Save Than To Invest The Politburo meeting last Friday signaled that China is determined to achieve the 5.5% annual growth target set earlier this year. Policymakers vowed to accelerate the implementation of existing pro-growth measures and hinted that they may scale up stimulus due to domestic challenges and external uncertainties. However, Chinese policymakers are facing an “impossible trinity” of eliminating domestic COVID cases and avoiding an overshoot as they stimulate the economy, while trying to achieve a high rate of economic expansion. The Politburo did not mention any plans to boost income and consumption via direct fiscal transfers to households, a sector that has been a weak link in China’s economy in the past two years. China’s consumption growth and demand for housing will not recover any time soon without meaningful aids to shore up household income. Bottom Line: Policy stimulus measures announced so far fall short of what is required to lift the economy. Given constraints on household consumption and the property market, China’s economic growth is set to underwhelm and Chinese stock prices will underperform their global counterparts. China’s top leaders have pledged to provide more support to the economy. The Politburo meeting last week indicated that the 5.5% growth target set for 2022 will be maintained and stimulus measures will be accelerated. Chinese stocks in both on- and offshore markets rebounded sharply following the positive rhetoric. Related Report Emerging Markets StrategyA Whiff Of Stagflation? In our view, however, Chinese authorities are facing an “impossible trinity” as they simultaneously attempt to achieve three goals: (1) pursuing a dynamic zero-Covid policy, (2) delivering decent economic growth, and (3) not resorting to “irrigation-style” massive stimulus. The pro-growth measures announced last week by the government lack the needed elements to generate a quick and strong rebound in the economy, particularly in the household and property sectors. Hence, the rebound in Chinese stock prices will unlikely progress into a cyclical rally (over a 6- to 12-month time span). We maintain our neutral allocation in Chinese onshore stocks and an underweight stance on the MSCI China Index, within a global portfolio. An “Impossible Trinity” The messages from the Politburo meeting highlight policymakers’ determination to shore up the economy. However, the authorities are not backing away from the zero-COVID policy, which is taking a heavy toll as cities are forced into lockdown to contain outbreaks. In addition, the Politburo reiterated the housing policy principle that “housing is for living, not for speculation” and did not mention concrete measures to boost household consumption. Thus, the biggest challenge for China to achieve its growth target this year is how to normalize economic activity without resorting to another round of “irrigation-style” stimulus while keeping domestic COVID cases at bay. In an environment of frequent lockdowns, monetary and fiscal easing have limited effect as the private and household sectors are averse to taking risks. China’s zero-COVID policy comes with hefty economic costs. April’s PMI showed sharp declines in a wide range of business activities due to the prolonged lockdown in Shanghai and several other cities (Chart 1). The new orders, new export orders, and imports subindexes in the manufacturing PMI and services PMI, all fell to their lowest levels since Q1 2020 when COVID first hit China (Chart 2). Chart 1April PMIs Show Widespread Declines In Business Activities Chart 2PMI Subindexes Fell To Lowest Levels Since Q1 2020 Going forward, even if China manages to avoid a Shanghai-style month-long lockdown, the dynamic zero-COVID policy will have devastating ramifications on the economy. Notably, March economic data from the city of Shenzhen, China’s technology center, suggests that even a week-long lockdown has had large impact on the local economic activity. Chart 3Severe Economic Disruptions In Shenzhen Due To A Week-Long City Lockdown In contrast with the extensive outbreak in Shanghai, Shenzhen was able to contain its COVID cases at an early stage and endured a citywide lockdown for only one week in mid-March. However, Shenzhen’s export growth contracted by 12.8% year-on-year (YoY) in March, a stark contrast from the 14.7%YoY increase in exports on a national level. The city’s imports fell by 11.9%YoY, also significantly lower than China’s total import growth, which was flat (Chart 3). Retail sales of consumer goods in Shenzhen shrank by 1.6%YoY in March and home sales plummeted by a stunning 90%YoY during the week of March 13-20. On the national level, the Politburo has called for an acceleration in infrastructure investment through frontloading local government special purpose bonds (SPB) and fast-tracking infrastructure project approvals. However, the lack of details has created questions regarding the magnitude of incremental stimulus, or whether the stepped-up policy effort will involve an increase in SPB or a general bond quota for local governments. Chart 4Construction Activity Started Softening In March, Before Shanghai Lockdown The stringent COVID containment methods will also undermine the effectiveness of China’s pro-growth measures. As expected, China’s construction activity PMI tumbled in April amid the lockdowns, but the new orders and business expectations components in the construction PMI had already started to slide in March (Chart 4, top and middle panels). Moreover, employment in the labor-intensive construction sector also declined substantially in March and April (Chart 4, bottom panel). The deterioration in these indicators is consistent with our view that even short and less draconian lockdowns spark considerable disruptions in business activities. Bottom Line: There is a low likelihood that China will deviate from its existing zero-COVID policy for the rest of this year. As such, boosting the economy via stimulus will be challenging due to frequent interruptions to economic activities. No Bazooka For Consumers China’s household consumption, which accounts for about 40% of the country’s aggregate demand, has been a weak link in the economy during the past two years. Last week’s Politburo meeting pledged to stabilize employment, create new jobs and encourage hiring from small and medium enterprises (SMEs). However, there was no mention of any large-scale fiscal transfer to households via cash or subsidy payments, which suggests that pro-consumer measures are not in the stimulus package. Chart 5Retail Sales In China Have Been The Weak Link In The Economy In The Current Cycle China’s retail sales growth has been muted in the current business cycle, a deviation from past economic recoveries when a revival in the general economy and moderate pro-consumption stimulus helped to lift household spending growth substantially above the rate of nominal GDP expansion (Chart 5). Since the pandemic, however, government stimulus to the household sector has been insufficient to revive consumption, due to the negative impact lockdowns have on both labor market demand and the service sector activities. Compared with the US and Europe, China’s fiscal transfer to the household sector has been very limited since the first wave of COVID in early 2020 (Chart 6). Local governments handed out vouchers in Q2 2020 aimed at boosting consumption, but the amounts were dismal and have had a minimal effect on the sector. Chart 6IMF Fiscal Monitor Database: Fiscal Response To The COVID-19 Pandemic Presently the RMB value in direct payments to the household sector is even smaller: some cities including Shenzhen distributed consumption vouchers ahead of the May holiday week. Nonetheless, the total value of consumption vouchers this year is estimated at around RMB 2billion. The amount, even with a multiplier effect of 3 on consumption, will be less than 0.1% of China’s monthly retail sales in nominal value. Hence, the coupons are unlikely to make any significant difference to the aggregate household spending. Bottom Line: Household consumption will be severely curtailed as lockdowns wreak havoc on the economy and household income, and the government so far has not provided meaningful direct transfers to the public. Rebound In Housing Demand Doubtful The Politburo encouraged local governments to further relax local housing policies, such as lowering mortgage rates and down payment ratios, and easing restrictions on home sales and purchases. However, we do not expect that these policies alone will restore homebuyers’ confidence amid short-term factors such as COVID outbreaks/lockdowns, and longer-term factors like slowing household income growth, high household debt and poor demographics (Chart 7A and 7B). Chart 7AProperty Market Is Challenged By Slower Household Income Growth, High Household Income Debt And Poor Demographics Chart 7BProperty Market Is Challenged By Slower Household Income Growth, High Household Income Debt And Poor Demographics China’s household sector was struggling prior to recent lockdowns. The growth rate of national disposable income per capita slowed by more than two percentage points (in nominal terms) in Q1 this year compared with Q4 2019 (Chart 7A, top panel). In addition, the PBoC’s quarterly urban depositor survey (released before the Shanghai lockdown) in Q1 showed subdued confidence in future household income (Chart 8). Households’ willingness to save hit a record high and is even more elevated than in early 2020; on the other hand, the propensity to invest has dropped to a multi-year low (Chart 9). Chart 8Chinese Households' Subdued Confidence In Future Income Chart 9More Households Intend To Save Than To Invest Chart 10Chinese Households' Declining Appetite For Purchasing Real Estate Assets Despite lower interest rates and easier monetary conditions, Chinese consumers’ medium- to long-term loans continued to trend down in Q1, which indicates a declining appetite for purchasing real estate assets and durable goods (Chart 10). COVID-related restrictions have exacerbated matters and weighed heavily on the demand for housing. Home sales from 30 Chinese cities were down by 56% in April from a year ago (Chart 11). House prices have started to deflate in tier-3 cities. Deflation will likely spread to tier-1 and -2 cities due to a pandemic-driven decline in income and confidence. Furthermore, the unemployment rate has picked up, especially among younger workers (Chart 12). Job and income dynamics normally improve after the overall economic cycle bottoms. Therefore, without any measures to boost household income, the demand for housing will remain a drag on the economy in the near term. Chart 11Home Sales Worsened In April Amid COVID Flareups In Major Cities Chart 12Labor Market Dynamics Deteriorated Rapidly Bottom Line: The real estate market has been vital to business cycle recoveries in China since 2009. However, the property market will not recover anytime soon without a substantial boost to household income and a normalization in social and economic activities. Investment Conclusions The policy rhetoric from the Politburo meeting helped to shore up market confidence last Friday. Nevertheless, we do not think that the stimulus measures will be sufficient to produce a rapid business cycle recovery or a sustainable stock market rally (Chart 13A and 13B). Chart 13AIt Is Too Early To Call A Bottoming In Chinese Stocks Chart 13BIt Is Too Early To Call A Bottoming In Chinese Stocks Given the negative forces from rolling lockdowns and shrinking demand, China’s economy requires a massive government stimulus via direct transfers to households and SMEs. Yet, Beijing is neither ready to abandon its dynamic zero-Covid policy nor provide “irrigation-type” stimulus, especially for households and the property market. The policy stimulus measures announced so far still fall short of what is required to lift the economy. In light of the constraints on household consumption and the property market, economic growth in China is set to underwhelm and stock prices will likely underperform their global counterparts. Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations
Highlights Chart 1Past Peak Inflation The Fed is all set to deliver a 50 basis point rate hike when it meets this week and with inflation still well above target Chair Powell will be keen to re-affirm the Fed’s commitment to tighter policy. However, with the market already priced for a 3% fed funds rate by the end of this year – 267 bps above the current level – we don’t see much scope for further hawkish surprises during the next eight months. Core PCE inflation posted a monthly growth rate of 0.29% in March. This is consistent with an annual rate of 3.6%, below the Fed’s median 4.1% forecast for 2022. Slowing economic activity between now and the end of the year will also weigh on inflation going forward (Chart 1). All in all, we see the Fed delivering close to (or slightly less) than the amount of tightening that is already priced into the curve for 2022. US bond investors should keep portfolio duration close to benchmark. Feature Table 1 Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Underweight Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 140 basis points in April, dragging year-to-date excess returns down to -292 bps. The average index option-adjusted spread widened 19 bps on the month to reach 135 bps, and our quality-adjusted 12-month breakeven spread moved up to its 48th percentile since 1995 (Chart 2). In a recent report we made the case for why investors should underweight investment grade corporate bonds on a 6-12 month horizon.1 First, we noted that while investment grade spreads had jumped off their 2021 lows, they remained close to the average level from 2017-19 (panel 2). Spreads have widened even further during the past two weeks, but they are not sufficiently attractive to entice us back into the market given the stage of the economic cycle. The 2-year/10-year Treasury slope has un-inverted, but it remains very flat at 19 bps. The flat curve tells us that we are in the mid-to-late stages of the economic cycle. Corporate bond performance tends to be weak during such periods unless spreads start from very high levels. Finally, we noted in our recent Special Report that corporate balance sheets are in excellent shape. In fact, total debt to net worth for the nonfinancial corporate sector has fallen to its lowest level since 2008 (bottom panel). Strong corporate balance sheets will prevent spreads from rising dramatically during the next 6-12 months, but with profit growth past its cyclical peak, balance sheets will look considerably worse by this time next year. 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 187 basis points in April, dragging year-to-date excess returns down to -281 bps. The average index option-adjusted spread widened 54 bps on the month to reach 379 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 up to 4.7% (Chart 3). As we discussed in our recent Special Report, a very flat yield curve sends the same negative signal for high-yield returns as it does for investment grade.2 However, we maintain a neutral allocation to high-yield bonds compared to an underweight allocation to investment grade bonds for three reasons. First, relative valuation remains favorable for high-yield. The spread advantage in Ba-rated bonds over Baa-rated bonds continues to trade significantly above its pre-COVID low (panel 3). Second, 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. Finally, we calculate that the junk index spread embeds an expected 12-month default rate of 4.7%. Given our macroeconomic outlook, we expect the high-yield default rate to be in the neighborhood of 3% during the next 12 months. This would be consistent with high-yield outperforming duration-matched Treasuries. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 105 basis points in April, dragging year-to-date excess returns down to -178 bps. We discussed the incredibly poor performance of Agency MBS in last week’s report.3 We noted that MBS’ poor performance has been 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 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. Emerging Market Bonds (USD): Underweight Chart 5Emerging Markets Overview Emerging Market (EM) bonds underperformed the duration-equivalent Treasury index by 92 basis points in April, dragging year-to-date excess returns down to -592 bps. EM Sovereigns underperformed the Treasury benchmark by 181 bps on the month, dragging year-to-date excess returns down to -779 bps. The EM Corporate & Quasi-Sovereign Index underperformed by 37 bps, dragging year-to-date excess returns down to -474 bps. The EM Sovereign Index underperformed duration-equivalent US corporate bonds by 2 bps in April. The yield differential between EM sovereigns and duration-matched US corporates remains negative. As such, we continue to recommend a maximum underweight allocation (1 out of 5) to EM sovereigns. The EM Corporate & Quasi-Sovereign Index outperformed duration-matched US corporates by 79 bps in April (Chart 5). This index continues to offer a significant yield advantage versus US corporates (panel 4). As such, it makes sense to maintain a neutral allocation (3 out of 5) to the sector. The EM manufacturing PMI fell into contractionary territory in March (bottom panel). The wide divergence between US and EM PMIs will pressure the US dollar higher relative to EM currencies. This argues for the continued underperformance of hard currency EM assets. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 17 basis points in April, dragging year-to-date excess returns down to -139 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. Trailing 4-quarter 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 into 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 94%, 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 94%. The same measure for 17-year+ Revenue bonds stands at 99%, 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 rose dramatically and steepened in April. The 2-year/10-year Treasury slope steepened 15 bps, from 4 bps to 19 bps. Meanwhile, the 5-year/30-year slope steepened 2 bps, from 2 bps to 4 bps. 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.4 For example, the 5-year/10-year Treasury slope is -3 bps while the 3-month/5-year slope is 209 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 (with another 50 bps due tomorrow) 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, as is our expectation. 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 outperformed the duration-equivalent nominal Treasury index by 113 basis points in April, bringing year-to-date excess returns up to +387 bps. The 10-year TIPS breakeven inflation rate rose 3 bps on the month to reach 2.90% and the 5-year/5-year forward TIPS breakeven inflation rate rose 12 bps to reach 2.47%. The 10-year TIPS breakeven inflation has moved up to well above the Fed’s 2.3%-2.5% comfort zone (Chart 8) and the 5-year/5-year forward breakeven rate is at the top-end of that range. Concurrently, our TIPS Breakeven Valuation Indicator has shifted into “expensive” territory (panel 2). In a recent report we made the case for why inflation has already peaked for the year.5 Given that outlook and the message from our valuation indicator, it makes sense to underweight TIPS versus nominal Treasuries on a 6-12 month horizon. In addition to trending down, we expect the TIPS breakeven inflation curve to steepen as inflation heads lower between now and the end of the year. This is because short-maturity inflation expectations are more tightly linked to the incoming inflation data than long-maturity expectations. Investors can position for this outcome by entering inflation curve steepeners or real (TIPS) yield curve flatteners. We also continue to recommend holding an outright short position in 2-year TIPS. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 7 basis points in April, dragging year-to-date excess returns down to -38 bps. Aaa-rated ABS underperformed by 5 bps on the month, dragging year-to-date excess returns down to -32 bps. Non-Aaa ABS underperformed by 16 bps on the month, dragging year-to-date excess returns down to -67 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 underperformed the duration-equivalent Treasury index by 6 basis points in April, dragging year-to-date excess returns down to -84 bps. Aaa Non-Agency CMBS underperformed Treasuries by 2 bps on the month, dragging year-to-date excess returns down to -69 bps. Non-Aaa Non-Agency CMBS underperformed by 18 bps on the month, dragging year-to-date excess returns down to -128 bps. CMBS spreads remain wide compared to other similarly risky spread products. Further, last week’s Q1 GDP report confirmed that commercial real estate (CRE) investment remains weak (Chart 10, panel 4). Weak investment will continue to support CRE price appreciation (panel 3) which will benefit CMBS spreads. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 4 basis points in April, dragging year-to-date excess returns down to -43 bps. The average index option-adjusted spread widened 2 bps on the month. It currently sits at 50 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 296 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 April 29, 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 April 29, 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 -56 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 56 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 April 29, 2022) Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds”, dated April 12, 2022. 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 Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 4 Please see US Bond Strategy / US Investment Strategy / US Equity Strategy Special Report, “The Yield Curve As An Indicator”, dated March 29, 2022. 5 Please see US Bond Strategy Weekly Report, “Peak Inflation”, dated April 19, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns
The recent outperformance of Indonesian stocks has masked a budding macro issue in the country: a deteriorating balance of payments. Capital inflows into the country are dwindling at a time when the current account balance is set to slip back into deficit,…
Executive Summary Three Problems For European EPS The Chinese economic slowdown in response to COVID lockdowns represents a major headwind for European profits in 2022. Weaker global growth creates another hurdle. The energy crisis is the third major problem for European profit growth this year. European profits must be revised downward for 2022, but the impact on 2023 EPS will be small. Cyclical sectors are particularly exposed to these three headwinds, which will hurt profitability this year. The recent relative strength in industrials and materials earnings is likely to buckle in response to weaker global growth, while the defensive characteristics of healthcare and communication services will shine. Within defensive sectors, favor healthcare and communication services versus utilities and consumer staples. Bottom Line: A downward revision of European profits will constrain the ability of European equities to rally in the coming quarters; however, it does not portend another major down leg in European stocks. Nonetheless, the downward revision still points to further underperformance of cyclical equities. Within the defensive sectors, healthcare and communication services are more appealing than utilities and consumer staples shares. The earnings season has begun. According to the MSCI index, Eurozone profit margins are at a 14-year high following a sharp rebound in profits after the pandemic-induced collapse of 2020. Faced with a war in Ukraine and surging inflation, investors worry that this robust profit picture will not last. We share these worries. The near-term outlook for European profits has deteriorated significantly. While the inflation surge amplified by the Ukrainian crisis is an important problem for European firms, it is not the only one. European businesses must also cope with the effect of a growth slowdown in the US goods sector. Moreover, Chinese growth is likely to plunge in response to the tightening lockdowns across the country. As a result, we fear that current earnings estimates for 2022 are too optimistic. Nonetheless, European stocks are unlikely to collapse further. The valuation cushion amassed during the first quarter market shake-out already embeds some downside for 2022 earnings. Additionally, 2023 earnings have much more limited downside than this year’s EPS. Three Problems For European EPS Chart 1European Earnings Profile Three major problems indicate that the current European earnings estimates for 2022 are too optimistic: namely, China’s economic slowdown, a global economic deterioration, and the consequences of the Ukrainian war on the European economy (Chart 1). China’s Slowdown This publication has regularly highlighted that, even if the Chinese credit impulse is already trying to bottom, the lagged effect of the previous slowdown in credit flows would continue to hurt European growth in the first half of 2022. China’s COVID outbreak and Beijing’s severe policy response only accentuate this headwind. European profits are even more sensitive to Chinese economic fluctuation than European economic activity, which points to a meaningful drag on profitability. Many relationships highlight our concerns: So far, the weakness in the Chinese credit impulse is still consistent with a rapid deterioration of forward earnings growth and could lead to a contraction in forward EPS (Chart 2, top panel). The Chinese new orders index is falling rapidly. The elevated likelihood that China endures even more lockdowns in the coming months implies a sharper drop in orders and further weakness in European EPS (Chart 2, second panel). The CNY is depreciating again, which often coincides with a deflationary shock in global industrial goods that Europe produces. Unsurprisingly, a weaker RMB correlates well with narrowing operating profit margins in the Eurozone (Chart 2, bottom panel). Korean business conditions are deteriorating in response to the softening of the Chinese economy. A weaker RMB will further hurt business sentiment in the peninsula, especially if Chinese lockdowns broaden. The Korean economy is a key barometer of global business conditions because of its high cyclicality. BCA’s EM strategy team anticipates an additional softening in Korea, which portends weaker European profits and margins (Chart 3). Chart 2China's Troubles Trouble Europe Profits Chart 3Listen to Korea Global Economic Weakness The global growth weakness goes beyond China’s troubles. US economic activity is slowing down in response to higher yields, higher inflation, and the disappearance of pent-up demand following a splurge on goods by consumers during the pandemic. As a result, Q1 GDP growth fell to -1.4% from a quarterly annualized rate of 5.5% in Q4 2021. The weakness in the ISM New Orders-to-Inventory ratio points to continued softness through Q2. EM are not immune to these vulnerabilities either. EM consumers are suffering greatly from surging food and fuel costs. Moreover, EM interest rates continue to rise briskly and the ensuing liquidity removal points to fainter growth ahead. Chart 4The Weaker ISM NOI Is Worrisome The impact of weaker global economic activity on European earnings is straightforward: A falling US ISM New Orders-To-Inventories ratio is a prelude both to slower earnings growth and to narrower profit margins in the Eurozone (Chart 4). Global exports growth has collapsed to 5.5% from more than 20% prior year and is likely to deteriorate further. Historically, weaker global shipments are associated with a slowdown in European forward earnings growth (Chart 4, third panel). Global economic surprises have rebounded this year, but, as we showed two weeks ago, they are likely to move back below zero in the near future. This is a noisy series, but negative surprises often prompt downward revisions to earnings estimates. The Energy Shock Europe is facing an exceptional energy shock that is hurting the region’s growth prospects. Now that Russia is curtailing gas shipments to Poland and Bulgaria, more energy disruptions are likely, which will further hamper domestic growth prospects across the region, while simultaneously elevating the cost of goods sold for firms. However, not all countries will be hit equally by a Russian energy embargo among the major economies. Germany and Italy have the most to lose, while France and the UK are the least at risk (Chart 5). The impact of an oil supply shock on European earnings is negative. When oil prices rise because of strong global aggregate demand, European earnings handle rising energy prices well because the increasing sales volume creates a powerful offset. However, our simple model that accounts for the evolution of oil demand and global policy uncertainty highlights that we do not face a demand shock, but rather a supply shock (Chart 6), which implies that most sectors will suffer from higher energy prices. Chart 5Varying Vulnerabilities To Russia’s Energy Showdown Chart 6Oil's Rally Is Supply-Driven Chart 7European Margins Under Pressure The inflation passthrough from energy to everything else is not strong enough to protect profit margins. Yes, HICP is elevated, but European PPIs are rising much more rapidly. Historically, such an inability to pass on higher production costs results in slower European profits growth and contracting operating profit margins (Chart 7). The current weakness in consumer confidence and the expected drag on business confidence underscore that pricing power will likely deteriorate from here, which will accentuate the negative impact on profits from the current energy shock. Wage Costs: Not A Problem For Now Wage costs are the one bright spot for European profit margins. European negotiated wages are expanding at a very low rate of 1.6%. Unit labor costs are only expanding at 2.4%, a rate similar to last decade when European core inflation averaged 1%. Chart 8Wages Do Not Hurt Margins Historically, rising wage rates correlate with rising profitability, not declining margins (Chart 8). This relationship seems paradoxical, but European wages only increase when global aggregate demand is very strong. Due to the degree of operating leverage of European equities, the impact of robust aggregate demand on revenues swamps the impact of accelerating wage growth on production costs. Hence, it will probably take a wage growth rate much higher than the experience of the past 20 years for salaries to start hurting margins. While this is possible, we are many quarters away from this risk becoming reality. Bottom Line: European forward earnings estimates for 2022 are far too elevated in view of the headwinds European businesses are currently facing. The combination of weaker Chinese economic activity, slowing global growth, and a supply-driven energy shock will force significant downward revisions to this year’s EPS. Related Report European Investment StrategyPlenty Of Risks For Cyclical Stocks 2023 EPS should fare better. Chinese authorities are increasingly supporting their economy and this stimulus will impact activity when the lockdowns end. This process will prompt a boom later this year. Global growth will recover once the energy shock recedes. Decelerating European PPI will also help profit margins recover. Following their severe decline in the first quarter, European equities have already embedded a significant valuation cushion to compensate for the transitory shock to earnings. European stocks will not be able to advance meaningfully while 2022 earnings estimates weaken, but they are unlikely to make new lows either. Three Problems For Cyclicals vs Defensives The same three factors that hurt the outlook for European profits for 2022 also confirm that cyclical equities should underperform defensives in the near term. China’s Slowdown Cyclicals are extremely sensitive to a Chinese economic slowdown: The past weakness in the Chinese credit impulse is consistent with a further downgrade of the profit expectations for European cyclicals stocks compared to that of their defensive peers (Chart 9). A deterioration in China’s PMI New Orders heralds a period of weakness in the earnings of cyclical equities. A weak Chinese yuan leads to poor relative earnings (Chart 9). The deterioration in Korean business confidence and the poor performance of Korean equities also leads to weakness in both the earnings and profit margins of cyclical equities relative to those of defensive stocks (Chart 9). Global Growth Weakness The earnings outlook for cyclical sectors relative to defensives is negatively affected by slowing global economic activity: A deterioration in global economic surprises often results in a period of anemic cyclicals’ earnings (Chart 10). The rapidly declining ISM New Orders-to-Inventories ratio is synonymous with underperforming cyclicals’ earnings as well as a contraction in their relative profit margins because of their heightened degree of operating leverage (Chart 10). Weaker global exports confirm the continued risks to cyclicals’ earnings. Chart 9China Is A Threat To Cyclical Equities Chart 10Global Growth Threatens Cyclical Stocks The Energy Shock There is no clear relationship between energy prices and the outlook for the profits of cyclical equities relative to those of defensive stocks. Nonetheless, we may deduce that, if elevated energy prices hurt aggregate profits, they will also hurt cyclical profits, since the latter exacerbate the fluctuation of the former. Moreover, Europe’s elevated stagflation risk is consistent with sagging profits for cyclicals relative to those of defensives, because cyclicals experience greater pain from deteriorating economic activity than the benefit they enjoy from higher inflation. Bottom Line: The problems faced by the Chinese economy as well as the risks to global growth are consistent with an underperformance of the profits of cyclical stocks compared to those of defensive equities. Moreover, while higher energy prices are not necessarily a problem for cyclical equities, the elevated perceived stagflation risk is consistent with downward revisions for the relative earnings of cyclicals. This picture indicates that cyclical equities are still vulnerable to some downside relative to the broad market in the near term. A Look at Individual Sectors Chart 11Sectoral Degrees Of Operating Leverage We may distill the impact of China’s problems, the global economic slowdown, and the energy shock on sectoral earnings. A simple starting point is to look at their degree of operating leverage. Based on this observation, financials and consumer discretionary stocks are the sectors most at risk from weaker revenue growth, while utilities are the least exposed (Chart 11). A more complete picture may be gleaned from each sector’s pricing power. Energy Chart 12Improving Energy Margins The energy sector enjoys a significant margin tailwind from the oil supply shock (Chart 12). Nonetheless, this boost is long in the tooth and a pullback is likely if Brent falls toward the $94/bbl level expected by BCA’s Commodity & Energy team in the second half of 2022, and $88/bbl level in 2023. Hence, it is likely that the near-term benefits for the energy sector’s profits are already fully discounted and that the sector could suffer a significant setback in the coming quarters. Industrials The pricing power of industrials (as approximated by the gap between CPI and PPI) is still strong, which creates a tailwind for relative earnings (Chart 13). However, this robustness is under threat in the current environment in which global industrial production, global trade, and global capital goods orders are decelerating (Chart 14). Hence, a period of downgrade for the earnings of industrials relative to the broad market is likely in the coming months. Chart 13Robust Pricing Power For Industrials... Chart 14...But For How Long? Financials Chart 15Financials Are Under Siege The relative pricing power1 of financials is rapidly deteriorating, despite the recent increase in German yields (Chart 15). Moreover, it is likely to remain weak in a context in which core CPI has yet to decrease. Finally, the potential for a European recession in 2022, or at least, a severe growth slowdown, should lift non-performing loans. As a result, this sector’s earnings could experience a significant downgrade in the near term. Tech The sector’s pricing power was in an uptrend, but it has started to deteriorate in recent quarters (Chart 16). This evolution indicates that that tech earnings and profit margins are likely to suffer relative to the broad market, especially in light of the sector’s high degree of operating leverage. Consumer Discretionary Stocks This sector is suffering from a complete collapse of its pricing power (Chart 17). Additionally, tumbling consumer confidence in Europe and around the world is a significant drag on near-term sales. Consequently, earnings growth as well as profit margins are likely to lag the overall market. Chart 16Crucial Tech Tailwind Dwindling Chart 17A Problem For Consumer Discretionary Stocks Materials European materials sector’s profit margins stand at a 19-year high compared to that of the broad market. However, relative profit growth has collapsed. The bad news for the sector is that its pricing power is rapidly deteriorating because of surging input costs. It suggests that relative profit growth will become negative as relative profit margins contract (Chart 18). Utilities The pricing power of utilities is plunging because retail electricity prices are not rising as fast as input costs. The negative impact of this adverse pricing on profit margins is consequential (Chart 19). Governments around Europe are likely to continue to pressure this sector to limit the increase in electricity prices to households, which means that utilities are likely to lag other defensive sectors. Chart 18Materials' Outlook Deteriorating Materially Chart 19Crunch Time For Utilities Consumer Staples Chart 20Staples Under Duress The consumer staples sector is facing a similar pricing power problem to that of consumer discretionary stocks: input costs are rising rapidly relative to selling prices (Chart 20). Nonetheless, the earnings of staples will prove more resilient than that of their discretionary counterparts because the staples’ sales volumes are less sensitive to both deteriorating global consumer confidence and falling household real incomes. However, consumer staples equities have already greatly outperformed consumer discretionary stocks. Thus, much of the good news in terms of relative earnings is well discounted and the additional outperformance will be limited. Healthcare Chart 21Healthcare Stocks Still Have Pricing Power The pricing power of the healthcare sector remains positive, but it is not as strong as it was ten years ago. Hence, profits growth has scope to improve further compared to the rest of the market (Chart 21). Beyond favorable pricing power dynamics, the industry is insulated from weaker global growth relative to the rest of the broad market. Importantly, the healthcare sector sports one of the lowest degrees of operating leverage in Europe, which will also boost its relative profitability in the current environment. Healthcare is our top defensive sector right now, despite its valuation premium. Communication Services Chart 22Telecom Will Prove Resilient The profit growth and profit margins of the European communication services sectors are already under duress because pricing power remains negative. Nonetheless, the contraction in relative growth rates of earnings is extended (Chart 22). Telecom revenues did not benefit from a boost when the economy rebounded after the economic contraction in 2020. This stability is now an asset because the sector will not struggle from slowing global economic activity. In this context, the cheap communication services sector remains an attractive defensive play in Europe. Bottom Line: Looking at sectors individually confirms that the outlook for profit growth is worse for cyclicals than it is for defensive stocks. The recent relative strength in industrials and materials earnings is likely to buckle in response to weaker global growth, while the defensive characteristics of healthcare and communication services will shine. Utilities are under stress, as they stand at the confluence of higher energy prices and the explicit desire of politicians to limit the impact of these higher energy costs on households. Favor healthcare and communication services versus utilities and consumer staples. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Footnotes 1 In the case of financials, we use core CPI as a proxy for the sector’s costs. Eurostat does not publish a PPI for the sector and the main costs are related to labor costs. Tactical Recommendations Cyclical Recommendations Structural Recommendations