Equities
Highlights China’s slowdown will deepen, and US bond yields will likely rise. This augurs well for the US dollar but will produce a toxic cocktail for EM. The recent weakness in the commodity complex will continue. EM markets are at risk in absolute terms and will continue to underperform their DM counterparts. From a global macro perspective, the US dollar’s appreciation will be a re-balancing act. In a world where China is exporting economic weakness/deflation and the US is experiencing genuine inflation, a strong US dollar is desirable. The latter will redistribute inflation away from the US to the rest of the world and will redirect disinflationary pressures from the rest of the world to the US. Feature Chart 1DXY Breakout, EM FX Breakdown The US dollar is breaking out and EM currencies are breaking down (Chart 1). This will set in motion a number of responses in global financial markets. These include but are not limited to selloffs in EM equities, domestic bonds and EM credit markets and a setback in the commodity complex. Hence, we reiterate our negative stance on EM stocks and fixed-income markets. We continue to recommend shorting a basket of EM currencies versus the US dollar. Please refer to the end of this report for detailed investment recommendations. Why The Greenback Is Set To Strengthen Since early in the year, our investment strategy has been based on two macro themes: China’s slowdown and rising US inflation. We concluded early on that these dynamics are positive for the US dollar. Both macro themes have played out fairly well, yet until recently the broad trade-weighted US dollar’s advance has been hesitant. Odds are that the rally in the greenback is about to accelerate. Chart 2China's Slowdown = US Dollar Rally The fundamental case for the US dollar rally remains as follows: China’s slowdown will weigh more on emerging Asia, Japan, Europe, and/or commodity producing, developing and developed economies than it will on the US. The basis is that US exports to China make up only 0.7% of its GDP. The same ratio is much higher for the rest of the world. Hence, the US economy will outperform many advanced and emerging economies. Chart 2 illustrates that, historically, whenever China has slowed down, the US dollar has rallied. The mainland’s property construction is shrinking, and traditional infrastructure investment is also extremely weak (Chart 3). Beijing is easing its regulatory and macro policies but only by degrees. For now, policy support will be insufficient to reverse the business cycle downturn. In the meantime, the US economy is overheating. Specifically, all core type inflation measures have surged to well above 2% (Chart 4). Critically, nominal wages are rising at the fastest rate seen in the past 35 years (Chart 5). Chart 3China: Infrastructure Investment Is Very Weak Chart 4US Core Inflation Is Broad-Based And High Given that the employee quit rate is very high, employers will have to grant notable wage increases to both new and current employees. Thus, wage growth will accelerate further. Recent wage gains have not been offset by productivity growth. As a result, unit labor costs are rising (Chart 6). This will push businesses to raise their selling prices. So long as household income and consumption remain robust, businesses will likely succeed in raising their prices. In short, US inflation is acute and genuine, and, hence, it will persist unless the economy slows considerably. Chart 5US Nominal Wage Growth Is At Its Fastest In 35 Years Chart 6US Unit Labor Costs Are Rising Fast The rise in US inflation will initially be bullish for the US dollar. The reason is that fixed-income markets will move to price in higher Fed funds rates and the Fed will also acknowledge the need to hike rates given that core inflation is well above its target range. At some point in future, however, high inflation will start hurting the US dollar. This will happen when the Fed eschews rate hikes and falls behind the inflation curve. We believe we are still in a window where US bond yields could rise further. Rising US interest rates will support the dollar. Finally, the US economy, but not necessarily its equity and credit markets, is better positioned to handle central bank tightening than are other DM and EM economies. American consumers have substantially deleveraged and there are shortages in US housing and cars. Even as US borrowing costs rise, interest rate sensitive sectors like housing and autos will still do well because of pent-up demand. In particular, the US housing market is sensitive to long-term (30-year) mortgage rates and not the front end of curve. On the contrary, many EM and other DM economies and their housing sectors are sensitive to domestic short-term rates. In percentage terms, the rise in US mortgage rates will likely be smaller than those in DM and EM economies. In short, the US economy will not slow sharply in the response to rates while EM and other DM economies will. This augurs well for the dollar. The key US vulnerability from higher interest rates stems from its equity and credit markets, not the real economy. US equities and credit markets are very richly priced, so the rising cost of capital could trigger a major selloff. In turn, wealth effects and tightening financial conditions will pose a risk to the real economy. However, even in this case, the US dollar will initially appreciate because it always rallies during risk-off phases. The greenback’s depreciation will resume when the Fed turns dovish again. From a big picture macro perspective, the US dollar’s appreciation will be a re-balancing act. In a world where China is exporting economic weakness/deflation and the US is experiencing genuine inflation, a strong US dollar is desirable. The latter will redistribute inflation away from the US to the rest of the world and will redirect disinflationary pressures from the rest of the world to the US. In this period of US dollar strength, EM financial markets will be hurt because foreign investors always flee EM when their currencies depreciate. Bottom Line: China’s slowdown will deepen, and US bond yields will likely rise. This will produce a toxic cocktail for EM. Watch Out Commodity Prices Chart 7Reduced Financing For Property Developers = Less Construction The downturns in China’s property construction and traditional infrastructure spending are bad for raw material prices. The following points offer an explanation as to why commodity prices will relapse in spite of the fact that they have thus far resisted China’s slowdown. Although Chinese property sales and starts have been shrinking, floor area completed (construction work) has been very strong. However, the liquidity crunch that many real estate developers are experiencing will lead them to halt or cut back on their construction work (Chart 7, top panel). The latter will weigh on raw material prices (Chart 7, bottom panel). Taiwan’s new export orders PMI for the basic materials sector has dropped below 50, indicating plunging regional demand for raw materials (Chart 8). Ongoing weakness in Chinese demand is the culprit behind this drop. Due to electricity shortages, mainland production of industrial metals has plunged (Chart 9, top panel). Yet, the prices of these metals have recently corrected (Chart 9, bottom panel). Falling prices amid shrinking supply are a sign of major demand relapse. Chart 8Greater China: Orders For Basic Materials Are Already Shrinking Chart 9Base Metal Price Falling Despite Production Shutdowns In China The Baltic Dry index – the price of shipping bulk commodities – has rolled over decisively. It has reasonable correlation with industrial metal prices. Oil is much less exposed than base metals to China’s property and infrastructure contraction. In the case of crude, the key risks are the US and China releasing their strategic reserves and the US dollar strength. Bottom Line: The recent weakness in the commodity complex will continue. Other Considerations Chart 10China's Onshore Stock-to_Bond Ratio Is Breaking Down There are a number of other considerations and indicators that lead us to maintain a negative stance on EM financial markets: China’s onshore stock-to-bond ratio has broken below its 200-day moving average (Chart 10). This signifies a deepening growth slump in China. EM equity underperformance has been broad-based. Both the market cap-weighted and equal-weighted EM equity indexes have been underperforming their respective DM indexes. Further, not only have TMT (technology, media and telecom) stocks been underperforming their DM peers, but non-TMT stocks have also lagged their counterparts substantially (Chart 11). Last but not least, EM TMT stocks remain at risk. First, share prices of Chinese internet companies will continue derating due to structurally lower profitability going forward as the government exercises more control over them. We have discussed this in previous reports. In addition, consumer spending online has slowed sharply while smartphone sales are plunging (Chart 12). Chart 11EM Equity Underperformance Is Broad-Based Chart 12China: Online Spending Is Very Weak Second, DRAM (memory chip) prices are deflating and the value of DRAM sales is shrinking (Chart 13). This is weighing on Korean semiconductor share prices like Samsung and SK Hynix. These stocks have a large market cap in the KOSPI index. Finally, demand for semiconductors produced by Taiwanese companies has been booming but it is presently showing signs of moderation (Chart 14). Chart 13Falling DRAM Prices Are Weighing On Korean Semi Stocks Chart 14Taiwanese Semiconductor Industry: Moderating Orders Importantly, geopolitical risks around Taiwan in general and TSMC in particularly are enormous. The latter is literally at the center of the US-China confrontation. The timing of a diplomatic or even military crisis is uncertain but our Geopolitical Strategy team expects geopolitical risks over Taiwan to escalate substantially. The recent summit between Presidents Joe Biden and Xi Jinping does not change this assessment. Investment Recommendations Chart 15EM Credit Markets: Prepare For A Broad Selloff Continue underweighting EM equities in a global equity portfolio. Within the EM space, our overweights are Korea, Singapore, China (favoring A shares over investable stocks), Vietnam, Russia, central Europe and Mexico. Concerning EM equity sectors, we reiterate the short EM banks / long DM banks and short EM banks / long EM consumer staples positions. In line with our US dollar breakout thesis, we continue to recommend a short position in a basket of the following EM currencies versus the US dollar: BRL, CLP, COP, PEN, ZAR, TRY, THB, PHP and KRW. EM exchange rate depreciation is bad for EM domestic bonds. Currency weakness could lead central banks in Latin America to hike rates further. In brief, the risk-reward of EM local currency bonds is still unattractive. In this space, we recommend the following positions: bet on yield curve flattening in Mexico and Russia (pay 1-year/receive 10-year swap rates); pay Czech 10-year swap rates; receive Chinese and Malaysian 10-year swap rates. We reiterate our underweight in EM credit (both sovereign and corporate) markets versus US corporate credit, quality adjusted. As EM exchange rates depreciate, EM credit spreads will widen (Chart 15). Chinese high-yield corporate US dollar bonds are not yet a buy because the mainland property market’s travails are far from over, as was discussed in our recent Special Report. For a complete list of our recommendations across all asset classes and country strategy within each asset class, please see below or visit our web site. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights On a 2-3 year horizon, stay overweight the US stock market, in absolute terms and relative to the non-US stock market… …and stay overweight the US dollar. A good model for the US stock market is the 30-year T-bond price multiplied by US profits. A good model for the non-US stock market is the 2-year T-bond price multiplied by non-US profits. A major long-term risk to the US stock market comes from the blockchain, which is set to return the ownership and control of our data and digital content back to us – from Facebook, Google, and the other tech behemoths that currently control, manipulate, and monetise it… …but this risk is only likely to manifest itself on a 5-10 year horizon. Fractal analysis: The Israeli shekel is overbought. Feature Chart of the WeekThe US Stock Market = The 30-Year T-Bond Multiplied By US Profits Fears that inflation will stay stubbornly high have lit a fuse under short-dated bond yields. But further along the curve, longer-dated bonds have remained an oasis of relative calm. Indeed, the 30-year T-bond yield stands 50 bps lower today than it stood in March. Given that long-duration bonds underpin the valuation of long-duration stocks, the relative calm of the 30-year bond yield explains the relative calm of the stock market in the face of higher short-term bond yields. The corollary is that substantially higher 30-year yields would threaten that calm. Inflation Will Crash Back To Earth In 2022 The relative calm of the 30-year bond yield is telling central banks: go ahead and hike rates if you want. You’ll just have to slash them again and, on average, keep them lower than you would if you didn’t hike them so soon. Rate hikes work by choking aggregate demand, but aggregate demand doesn’t need choking. Aggregate demand is barely on its pre-pandemic trend in the US, and remains far below its pre-pandemic trend in other major economies, such as the UK, Germany, and France. The pre-pandemic trend is important because it is our best estimate of potential supply. On this best estimate, aggregate demand is still below potential supply (Chart I-2). Chart I-2The 30-Year T-Bond Yield Sees That Aggregate Demand Is Fragile If aggregate demand is below potential supply, then what can explain the recent surge in inflation? The answer is the massive and unprecedented displacement of demand from services to goods, combined with modern manufacturing processes unable to meet even a 5 percent excess demand, let alone the 26 percent excess demand for durables recently experienced in the US (Chart I-3). Chart I-3The Booming Demand For Goods Is Crashing Back To Earth While Services Remain In Shortfall Yet as we highlighted last week in The Global Demand Shortfall Of 2022, the recent booming demand for goods is crashing back to earth while the demand for some services will remain structurally below the pre-pandemic trend. Combined with a tsunami of supply that will hit the global economy with a lag, inflation is also likely to crash back to earth by late 2022. The US Stock Market = The 30-Year T-Bond Multiplied By US Profits An important characteristic of any investment is its duration. If all an investment’s cashflows were converted into one ‘lump-sum’ cashflow, then the duration of the investment quantifies how far into the future that lump-sum cashflow would be. For a bond, the duration also equals the percentage change in its price for every 1 percent change in its yield.1 Interestingly, the durations of the US stock market and the 30-year T-bond are very similar, at around 25 years. Therefore, all else being equal, the US stock market should track the 30-year T-bond price. Of course, all else is not equal. The 30-year T-bond has fixed cashflows, whereas the stock market has cashflows that track profits. Allowing for this key difference, the US stock market should track: (The 30-year T-bond price) multiplied by (US profits) multiplied by (a constant) In which the constant connects current profits to the theoretical lump-sum payment 25 years ahead, thereby quantifying the structural growth of profits. But to the extent that the constant does not change, we can ignore it. Simplistic as this model appears, it does provide an excellent explanation for the US stock market’s evolution through the past 40 years (Chart of the Week and Chart I-4) – with deviations from the ‘fair-value’ giving a good gauge of the market’s over- or under-valuation. Chart I-4The US Stock Market = The 30-Year T-Bond Multiplied By US Profits Looking ahead, there are three ways in which the structural bull market could end: If the overvaluation (deviation from fair-value) became so extreme that a substantial decline in price was required to re-converge with the 30-year T-bond price multiplied by profits. If the 30-year T-bond price could no longer rise to counter a substantial decline in profits. If the constant that links current profits to future profits phase-shifted down, implying that the growth rate of US stock market profits had phase-shifted down – as happened for non-US stock market profits after the dot com bust (Chart I-5). Going through each of these, the US stock market’s current overvaluation of around 10 percent is not so extreme as to be a structural impediment. Chart I-5The Valuation Of The Non-US Stock Market Phase-Shifted Down Meanwhile, the 30-year T-bond yield has scope to decline by at least 150 bps, equating to a 40 percent counterweight to a decline in profits. Hence, this is not a structural impediment either, but will become one once the 30-year T-bond yield reaches 0.5 percent in the next deflationary shock. As for a phase-shift down in profit growth, this is a genuine long-term risk. The main risk comes from the blockchain and its threat to the pseudo-monopoly status that the US tech behemoths have in owning, controlling, manipulating, and monetising our data and the digital content that we create. The blockchain is set to return that ownership and control back to us, to the detriment of Facebook, Google, and the other behemoths of the US stock market. However, this is a long-term risk, likely to manifest itself on a 5-10 year horizon. We conclude that on a 2-3 year horizon, investors should own the US stock market. The Non-US Stock Market = The 2-Year T-Bond Multiplied By Non-US Profits We can extend the preceding analysis to the non-US stock market, with two differences. First, the non-US stock market has a much shorter duration given its much lower exposure to growing cashflows. A higher weighting to financials – which underperform when long yields are falling – further lowers the effective duration to just 2 years (empirically). Second, and obviously, the non-US stock market depends on non-US profits (Chart I-6). Chart I-6The Non-US Stock Market = The 2-Year T-Bond Multiplied By Non-US Profits It follows that the non-US stock market tracks: (The 2-year T-bond price) multiplied by (non-US profits) We can now decompose the post dot com performance of the US and non-US stock markets into their underlying structural components. The US stock market has received a massive tailwind: a 60 percent increase in the 30-year T-bond price plus a 200 percent increase in profits (Chart I-7). While the non-US stock market has received a lesser tailwind: a 10 percent increase in the 2-year T-bond price plus a 60 percent increase in profits (Chart I-8).2 Chart I-7The US Stock Market Has A Powerful Tailwind... Chart I-8...The Non-US Stock Market Has A Weak Tailwind Therefore, over the past two decades, the non-US stock market has been hampered by its low duration and by its profits that are fossilised, both metaphorically and literally. Metaphorically fossilised, because the non-US stock market is over-exposed to industries that are in structural decline such as financials and basic resources. And literally fossilised, because it is also over-exposed to the dying fossil fuel industry. Looking ahead, there are three ways that non-US stocks could outperform US stocks: If the relative valuation (deviation from respective fair-values) became extreme in favour of non-US stocks. If the 2-year T-bond price outperformed the 30-year T-bond price – effectively meaning that the 30-year T-bond price would have to fall far given that the 2-year T-bond is like cash. If non-US profits outperformed US profits. Going through each of these: both the US and non-US stock markets appear similarly overvalued versus their respective fair-values; the 30-year T-bond is unlikely to fall far given that it would destabilise the global financial system; and fossilised non-US profits are unlikely to outperform those in the US in the next few years. We conclude that on a 2-3 year horizon, investors should stay overweight the US stock market relative to the non-US stock market. One final consideration is the US dollar. Successive deflationary shocks – the 2008 GFC, the 2015 EM recession, and the 2020 pandemic – have taken the greenback to new highs as capital flows have flooded into US T-bonds (Chart I-9). It follows that the ultimate high in the dollar will coincide with the ultimate low in the 30-year T-bond yield. Chart I-9Successive Deflationary Shocks Take The Dollar To New Highs Stay structurally overweight the US dollar. The Israeli Shekel Is Overbought In this week’s fractal analysis, we note that the strong recent rally in ILS/GBP has reached the point of maximum fragility on its 130-day fractal structure that has signalled several previous reversals (Chart I-10). Chart I-10The Israeli Shekel Is Overbought On this basis, a recommended trade would be short ILS/GBP, setting a profit target and symmetrical stop-loss at 4.2 percent. Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Defined fully, the duration of an investment is the weighted average of the times of its cashflows, in which the weights are the present values of the cashflows. 2 From January 1, 2005. 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 ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- 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
Over the past few weeks, we have received numerous questions on the interplay between the S&P 500 earnings and the forward P/E multiple. The clients are asking how much earnings need to grow for the S&P 500 forward multiple to come down from the hefty 21.5x towards a historical average of 18x. To answer this question, we have created a matrix that summarizes permutations of changes in the index price and earnings growth and their effects on the resulting forward multiple. If we assume that the price of the S&P 500 does not budge, and investors get a 0% return over the next 12 months, earnings will have to grow by about 30% over the next 12 months for the multiple to come down to 18x – hardly a realistic scenario. If the S&P 500 returns 5%, then 30% earnings growth will result in the 19.6x multiple. The sell-side analysts currently expect a 10% earnings growth over the next twelve months: With no change in the price of the index, the resulting multiple will be 21.5x. If the S&P 500 returns 5%, the multiple will move to 23.2x. Bottom Line: Strong earnings growth does not justify elevated valuations, and re-rating is hardly in the cards.
BCA Research’s Global Asset Allocation and Equity Analyzer services conclude that traditional valuation metrics may no longer be an accurate measure of intrinsic value in intangible-heavy companies or industries. Intangible investment has become a much…
Highlights Despite strong economic activity throughout most of 2021, economic surprises have decreased considerably. This helped the US equity market outperform Europe. It also significantly contributed to the euro’s depreciation versus the dollar. Even though growth will slow in 2022, economic surprises should increase. Growth expectations are much lower than they were entering 2021, and some key headwinds will fade. This picture is not without risks. China’s credit slowdown and the US’s elevated inflation represent the greatest threats. Based on the outlook for economic surprises, the euro will stage a rebound next year and small-cap stocks are attractive. Feature Global economic activity has been exceptionally robust this year, boosted by the re-opening of the world economy, as well as by the considerable fiscal and monetary stimuli injected globally over the past 20 months. However, market participants also anticipated such a rebound; as a result, global economic surprises peaked in September 2020, and they are now in negative territory. Unanticipated developments have a substantial effect on market prices. Under this lens, the deterioration in economic surprises has had a strong impact on financial markets. It helps explain why the defensive US market has outperformed, why the dollar has been strong, and why bond yields have been flat since March 2021, even though inflation has risen, growth has been high by historical standards, and many major central banks have been eschewing their accommodative biases. Going forward, the evolution of economic surprises will remain crucial to market trends. While we anticipate global economic activity will decelerate in 2022, it will likely remain above trend and surprise to the upside, which will allow global economic surprises to recover. There are significant risks to this view, with large unanswered questions about the Chinese economy and the outlook for inflation in the US. In this context, despite near-term risks, we continue to expect EUR/USD to appreciate in 2022 and European small-cap stocks to outperform large-cap equities. Deteriorating Surprises Matter This year, the underperformance of global equities (both EM and Europe) relative to the US, the weakness in the euro, and the limited increase in yields have all caught investors off guard. At the beginning of 2021, investors were massively short the greenback and duration, while surveys showed a large preference for non-US equities. These views grew out of the expectation that global growth would be strong. Global growth turned out to be strong but began to disappoint expectations by the middle of the year. Expectations had become extremely lofty, suggesting that the bar had been set too high. Additionally, the tightening credit conditions in China and the growing supply constraints around the world caused growth to decelerate somewhat. The deterioration in short-term economic momentum and in surprises harmed European equities relative to the US. As Chart 1 highlights, the relative performance of European stocks is greatly affected by the earnings revision ratio of cyclicals stocks vis-à-vis defensive ones. This relationship reflects the greater pro-cyclicality of European equities compared to those of the US. Moreover, the earnings revision ratio of cyclical stocks relative to that of defensive equities mimics the fluctuations in economic surprises (Chart 1, bottom panel), as weaker-than-expected growth invites analysts to lower their relative earning expectations. The dynamics in the economic surprise index also weighed heavily on the FX market. The dollar is a highly counter-cyclical currency; therefore, it performs poorly when growth is not only increasing, but also doing so at a rate faster than anticipated. However, economic surprises did the exact opposite this year, which boosted the dollar’s appeal and pushed EUR/USD lower (Chart 2). While the strength in the dollar was accentuated by the increasingly aggressive pricing of Fed hikes in the OIS curve, relative interest rate expectations between the US and the Euro Area are also influenced by global economic activity because of the European economy’s greater cyclicality than that of the US. Chart 1Where Surprises Go, European Stocks Follow Chart 2Surprises Matter For The Dollar And The Euro Bottom Line: Global growth has been very strong in 2021, but it has begun to decelerate. Moreover, economic surprises are now in negative territory. The evolution of economic surprises this year was a key component of the strength in the dollar, the weakness of the euro, and the underperformance of European equities. Improving Surprises In 2022? We anticipate economic surprises to pick up in 2022. First, investors and analysts around the world rightfully expect a slowdown in global growth next year. This means that the bar for the economy to generate positive surprises is lower than it was in 2021. Second, we are already seeing signs that global economic surprises are trying to stabilize. A GDP-weighted aggregate of 48 countries is forming a trough at a low level, which historically precedes a pick-up in broader aggregate measures (Chart 3). Third, economic surprises move closely with the global PMI diffusion index. The diffusion index has fallen to levels historically associated with a rebound (Chart 4). Moreover, the share of countries whose Leading Economic Indicator is rising is still very depressed for a mid-cycle slowdown (Chart 4, bottom panel). As vaccination rates are improving around the world, including those in emerging markets, and as the global economy continues to re-open, we anticipate both the PMI and LEI diffusion indexes to improve next year, which will boost economic surprises. Chart 3A Budding Rebound? Chart 4The dispersion Of Growth Matters or Surprises Fourth, the global capex outlook remains very positive. Capex intentions in the US and in the Euro Area are highly elevated and cash flows are strengthening. Moreover, US and European credit standards are very loose (Chart 5). This combination suggests that companies have the desire and the wherewithal to increase their investments next year, especially as capacity constraints limit their ability to meet final demand. Additionally, companies around the world need to rebuild inventory levels, which are depressed relative to sales, while customer inventories are still woefully low (Chart 6). Chart 5Capex Tailwinds Chart 6Not Enough Inventories Chart 7Households Are Rich Fifth, households globally also have ample firepower to support their spending, despite some weakness in real income caused by rising inflation. As Chart 7 shows, household net worth in the US is up by 128% of GDP since December 2019. Additionally, the accumulated stocks of household excess savings have reached USD2.4 trillion in the US, EUR150 billion in German, EUR130 billion in France and GBP180 billion in the UK. With respect to the Eurozone specifically, fiscal and monetary policy will remain very accommodative. The fiscal thrust in 2022 will be negative 2.1%, which is significantly less onerous than the US’s -5.9% of GDP. Moreover, economies like Italy and Spain may have a negligible fiscal thrust because of the NGEU program’s disbursements. In addition, while the fiscal thrust will be slightly negative next year, government deficits will remain wide, which indicates that fiscal policy in Europe continues to support demand. Meanwhile, monetary policy still generates deeply negative interest rates on the continent, which sustains demand further. This view is not without risks. The first threat stems from the Chinese credit slowdown. BCA’s China strategists expect credit flows to bottom out by the second quarter of 2022, which implies that Chinese domestic activity should accelerate meaningfully in the second half of the year. Already, we are seeing tentative signs that authorities in China are trying to curb the credit slowdown. For example, Beijing cut the reserve requirement ratio last summer and excess reserves in the banking system are moving back up as liquidity injections grow (Chart 8). The problem is that, so far, Chinese credit demand is not responding to these small measures designed to ease policy. More will be needed as the tightening in financial conditions for real estate developers points to significant downside ahead in construction activity (Chart 9). For now, it is difficult for Beijing to ease policy much more than it has done so far: PPI has reached a 25-year high at 13.5%. Chart 8Not Enough... Chart 9... Especially With Such A Drag These Chinese inflationary pressures are likely to decline in the first months of 2022, which will allow Beijing to become more aggressive in its support to economic activity. First, Chinese demand is weak, unlike demand in the US. Second, the surge in the PPI is mostly driven by a 17% increase in the energy PPI and a 66% surge in the mining component. These jumps are unlikely to repeat themselves, which will reduce overall inflationary numbers in that economy. The second major risk is global inflation, which is hurting real wages. As a case in point, US real wages are contracting at a 3.2% annual rate, or their deepest cut in six decades. In Europe too, real wages are weak because of the increase in inflation. While these inflationary pressures have had limited effect on European consumer confidence so far, US consumer confidence is breaking down (Chart 10), driven by a collapse in the willingness to buy. If this trend continues, we might see a significant deceleration in global real consumer spending. Chart 10Not All Is Dark On The Inflation Front We still expect the European inflationary risk to start dissipating in the first half of 2022. Unlike in the US, the spike in core CPI mostly reflects an increase in VAT and remains narrow, with trimmed-mean CPI lingering near record lows. Moreover, the 24-month rate of change of core CPI remains within the historical norm, which is not the case in the US. The US situation is more tenuous. Last week’s inflation data showed a broadening of inflationary pressures across major sectors of the economy unaffected by the pandemic, with shelter inflation being of particular concern. However, there are positives. Long-term inflation expectations, as approximated by the 5-year/5-year forward inflation breakeven rate, are still below the levels that prevailed before the oil price crash of 2014 (Chart 11, top panel). Additionally, shipping costs have started to ebb, with global container freight rates losing steam and the Baltic Dry index collapsing by 50% since beginning of October (Chart 11, bottom panel). Moreover, as health restrictions are being relaxed in Asia, Asian PMI’s are improving, while the production of semiconductors is rising again in the region (Chart 12). As a result, although there is still significant inflation risk over the next five years, 2022 is likely to witness a temporary pullback in CPI growth. Chart 11Not All Is Dark On The Inflation Front Chart 12Semiconductor Production Is Picking Up Bottom Line: Global investors are right to anticipate a decline in global growth next year. However, even if growth slows, it will remain above trend. Moreover, the considerable stimuli in the global economy and the decreased expectations of investors improve the odds that global economic surprises will increase in 2022. China’s domestic weakness and the rise in US inflation constitute the two greatest risks to this view. Investment Implications The level of the global economic surprise index as well as its evolution have important implications for many key European assets. Table 1 highlights the performance of various financial markets at three months, six months, and a year following various ranges of readings of the surprise index (the categories are based on one standard-deviation intervals from the mean). We highlight this methodology, because there remains significant uncertainty about the near-term outlook of the surprise index. Table 1Level Of Surprises And Subsequent Returns Currently, the global economic surprise index stands at -20, or between its -1-sigma and its historical average. This level offers limited clear results for investors when it comes to the performance of the Eurozone benchmark relative to the MSCI All Country World Index (ACWI), and no clear results in terms of the performance of value stocks relative to growth. However, the current reading of the surprise index is consistent with an outperformance of growth stocks relative to momentum over both the three- and six-month horizons. It is also showing a 74% probability of small-cap equities beating large-cap ones over a 12-month basis. Table 2 shows the performance of the same assets over the same windows, following three consecutive months or more of an improving global economic surprise index. This is consistent with our main hypothesis that global economic surprises are set to increase by early next year. Table 2Surprise Upticks And Subsequent Returns Using this method again shows no strong call for the Euro Area equity benchmark relative to the ACWI. There is a small improvement in performance, but Europe on average still underperforms, which reflects the thirteen years of a relative bear market in European equities. Similarly, results for European value stocks compared to growth equities are limited, as the sample is dominated by the structurally poor performance of value equities. However, this method highlights that the euro is likely to appreciate against the USD on both the three- and six-month investment horizon. This message is consistent with that of our Intermediate-Term Timing Model. Finally, this approach once again underscores the attractiveness of European small-cap equities on a three-, six-, and twelve-month investment horizon. Consequently, we maintain our buy recommendation on the euro. As we wrote three weeks ago, the near-term outlook for the common currency is fraught with risks and the low readings of the global economic surprise index confirm this reality. Moreover, markets might enter a phase when they aggressively discount Fed rates hikes next year, which would further hurt the euro. However, the outlook for global growth will ultimately put a floor under EUR/USD. Chart 13Small-Caps: Almost There We also view European small-cap stocks as the premier equity vehicle in Europe over the coming 18 months because of their heightened pro-cyclicality. However, the timing around shifting toward overweighing small-cap remains risky in the near-term, as they have not fully worked out the overbought conditions we flagged four weeks ago (Chart 13). Thus, we maintain small-cap equities on an upgrade alert, and we are looking to pull the trigger very soon. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance
BCA Research’s Global Investment Strategy service concludes that investors need to throw the old playbook for dealing with growth slowdowns out the window. US growth will slow next year, not because demand will falter, but because supply-side constraints…
Highlights US growth will slow next year, not because demand will falter, but because supply-side constraints will prevent the economy from producing as much output as households and businesses want to buy. If aggregate demand exceeds aggregate supply, the price level will rise. We argue that the US aggregate demand curve is currently quite steep. This implies that the price level may need to rise a lot to restore balance to the economy. In fact, if the aggregate demand curve is not just steep but upward-sloping, which is quite possible, there may be no price level that brings aggregate demand in line with supply; the US economy could go supernova. When supply is the binding constraint to growth, investors need to throw the old playbook for dealing with growth slowdowns out the window. Rather than positioning for lower bond yields, investors should position for higher yields. Rather than expecting a stronger dollar, investors should expect a weaker one. Rather than favoring growth stocks, large caps, and defensives, investors should favor value stocks, small caps, and cyclicals. The Binding Constraint To Growth Is Now Supply After a post-Delta wave rebound in Q4, the US economy is expected to slow over the course of 2022. The Bloomberg consensus is for US growth to decelerate from 4.9% in 2021Q4 to 4.1% in 2022Q1, 3.9% in 2022Q2, 3.0% in 2022Q3, and 2.5% in 2022Q4. Growth in the first quarter of 2023 is expected to dip further to 2.3%. We agree that US growth will slow next year but think the market narrative around this slowdown is misguided. Chart 1Plenty Of Pent-Up Demand The standard market playbook for dealing with an economic slowdown is to position for lower bond yields, a stronger US dollar, and a decline in commodity prices. On the equity side, the playbook calls for shifting equity exposure from cyclicals to defensives, favoring large caps over small caps, and growth stocks over value stocks. There are two major problems with this narrative. First, growth is peaking at much higher levels than before and is unlikely to return to trend at least until the second half of 2023. Second, and more importantly, US growth will slow due to supply-side constraints rather than inadequate demand. US final demand will remain robust for the foreseeable future. Households are sitting on $2.3 trillion in excess savings, equivalent to 15% of annual consumption (Chart 1). The household deleveraging cycle is over. After initially plunging during the pandemic, credit card balances are rising (Chart 2). Banks are falling over themselves to make consumer loans (Chart 3). Chart 2Revolving Credit On The Rise Again Chart 3Banks Are Easing Credit Standards For Consumers Chart 4A Record Rise In Household Net Worth Household net worth has risen by over 100% of GDP since the start of the pandemic (Chart 4). As we discussed two weeks ago, the wealth effect alone could boost annual consumer spending by up to 4% of GDP. Investment demand should remain strong. Business inventories are near record low levels (Chart 5). Core capital goods orders, a leading indicator for corporate capex, have soared (Chart 6). Chart 5Business Inventories Are Near Record Low Levels Chart 6Rise In Durable Goods Orders Bodes Well For Capex Chart 7The Homeowner Vacancy Rate Is Signaling The Need For More Homebuilding The Dodge Momentum Index, which tracks planned nonresidential construction, rose to a 13-year high in October. The homeowner vacancy rate is at multi-decade lows, signifying the need for more homebuilding (Chart 7). While increased investment will augment the nation’s capital stock down the road, the short-to-medium term effect will be to inflate demand. Policy Won’t Tighten Enough To Cool The Economy What is the mechanism that will push down aggregate demand growth towards potential GDP growth? It is unlikely to be policy. While budget deficits will narrow over the next few years, the IMF still expects the US cyclically-adjusted primary budget deficit to be nearly 3% of GDP larger between 2022 and 2026 than it was between 2014 and 2019 (Chart 8). Chart 9The Fed And Investors Still Believe In Secular Stagnation As Matt Gertken, BCA’s Chief Geopolitical Strategist, writes in this week’s US Political Strategy report, the passage of the $550 billion infrastructure bill has increased, not decreased, the odds of President Biden and the Democrats passing their social spending bill via the partisan budget reconciliation process. On the monetary side, the Federal Reserve will finish tapering asset purchases next June and begin raising rates shortly thereafter. However, the Fed has no intention of raising rates aggressively. Most FOMC members see the Fed funds rate rising to only 2.5% this cycle (Chart 9). The “dots” call for only one rate hike in 2022 and three rate hikes in both 2023 and 2024. Investors expect rates to rise even less by end-2024 than the Fed foresees (Chart 10). The Inflation Outlook Hinges On The Slope Of The Aggregate Demand Curve If policy tightening will not suffice in cooling demand, the economy will overheat and inflation will rise. But by how much will inflation increase? The answer is of great importance to investors. It also hinges on a seemingly technical question: What is the slope of the aggregate demand curve? As Chart 11 illustrates, prices will rise more if the aggregate demand curve is steep than if it is flat. Chart 12Wages Rose Faster Than Prices During The Inflationary Late-60s and 70s It is tempting to think of the aggregate demand curve in the same way one might think of the demand curve for, say, apples. When the price of apples rises, there is both a substitution and an income effect. An increase in the price of apples will cause shoppers to substitute away from apples towards oranges. In addition, if apples are so-called “normal goods,” shoppers will buy fewer apples in response to lower real incomes. This chain of reasoning breaks down at the aggregate level. When economists say the price level has risen, they are referring to all prices; hence, there is no substitution effect. Moreover, since one person’s spending is another’s income, rising prices do not necessarily translate into lower overall real incomes. Granted, if nominal wages are sticky, as they usually are in the short run, an unanticipated increase in prices will reduce real wage income. However, this will be offset by higher business income. Over time, wages tend to catch up with prices. In fact, wage growth usually outstrips price growth during inflationary periods. For example, real wages rose during the late-1960s and 70s but fell during the disinflationary 1980s (Chart 12). Textbook Reasons For A Downward-Sloping Aggregate Demand Curve According to standard economic theory, there are three main reasons why aggregate demand curves are downward-sloping: The Pigou Effect: Higher prices erode the purchasing power of money, resulting in a negative wealth effect. The Keynes Effect: Higher prices reduce the real money supply. This pushes up real interest rates, leading to lower investment spending. The Mundell-Fleming Effect: Higher real rates push up the value of the currency, causing net exports to decline. None of these three factors are particularly important for the US these days. Chart 13Base Money Has Swollen Since The Subprime Crisis Strictly speaking, the Pigou wealth effect applies only to “base money,” also known as “outside money.” Outside money includes cash notes, coins, and bank reserves. Inside money such as bank deposits are not included in the Pigou effect because while an increase in consumer prices decreases the real value of bank deposits, it also decreases the real value of commercial bank liabilities.1 In the US, the monetary base has swollen from 6% of GDP in 2008 to 28% of GDP as a result of the Fed’s QE programs (Chart 13). Nevertheless, even if one were to generously assume a wealth effect of 10% from changes in monetary holdings, this would still imply that a 1% increase in consumer prices would reduce spending by only 0.03% of GDP. Simply put, the Pigou effect is just not all that big. In contrast to the Pigou effect, the Keynes effect has historically had a significant impact on the business cycle. However, the importance of the Keynes effect faded following the Global Financial Crisis as the Fed found itself up against the zero lower bound on interest rates. When interest rates are very low, there is little to distinguish money from bonds. Rather than holding money as a medium of exchange (i.e., for financing transactions), households and businesses end up holding money mainly as a store of wealth. In the presence of the zero bound, the demand for money becomes perfectly elastic with respect to the interest rate (Chart 14). As a result, changes in the real money supply have no effect on interest rates, and by extension, interest-rate sensitive spending. And if a decline in the real money supply does not push up interest rates, this undermines the Mundell-Fleming effect as well. Could The Aggregate Demand Curve Be Upward-Sloping? The discussion above, though rather theoretical in nature, highlights an important practical point: The aggregate demand curve may be quite steep. This means that the price level might need to rise a lot to equalize aggregate demand with aggregate supply. Chart 15US Real Bond Yields Hitting Record Lows In fact, one can easily envision a scenario where a rising price level boosts spending; that is, where the demand curve is not just steep but upward-sloping. One normally assumes that higher inflation will prompt central banks to raise rates by more than inflation has risen, leading to higher real rates. However, if the Fed drags its feet in hiking rates, as it is wont to do given its concerns about the zero bound, rising inflation will translate into a decline in real rates. Lower rates will boost demand, leading to higher inflation, and even lower real rates. In addition, lower real rates will benefit debtors, who tend to have a higher marginal propensity to spend than creditors. This, too, will also boost aggregate demand. It is striking in this regard that real bond yields hit a record low this week, with the 10-year TIPS yield falling to -1.17% and the 30-year yield drooping to -0.57% (Chart 15). Black Holes Vs. Supernovas In the case where the aggregate demand curve is upward-sloping, there is no stable equilibrium (Chart 16). If demand falls short of supply, demand will continue to shrink as the price level declines, leading to ever-rising unemployment. Unless policymakers intervene with stimulus, the economy will sink into a deflationary black hole. In contrast, if demand exceeds supply, demand will continue to rise as the price level increases exponentially. The economy will go supernova. Tick Tock Young stars fuse hydrogen into helium, releasing excess energy in the process. After the star has run out of hydrogen, if it is big enough, it will start fusing helium into heavier elements such as carbon and oxygen. The process of nucleosynthesis continues until it reaches iron. That is the end of the line. Fusing elements heavier than iron requires a net input of energy. Unable to generate enough external pressure through fusion, the star loses its battle to gravity. The core collapses, spewing material deep into interstellar space (a good thing since your body is mainly made from this stardust). Observing the star from afar, one would be hard-pressed to see anything abnormal until it explodes. The path to becoming a supernova is highly non-linear. The same is true for inflation. Just like a star with an ample supply of hydrogen, the Fed can burn through its credibility for a while longer. During the 1960s, it took four years for inflation to take off after the economy had reached full employment (Chart 17). By that time, the unemployment rate was two percentage points below NAIRU. Most of today’s inflation is confined to durable goods. This is not a sustainable source of inflation. The durable goods sector is the only part of the CPI where prices usually fall over time (Chart 18). Chart 17Inflation Spiked In The 1960s Only Once The Unemployment Rate Had Fallen Far Below Equilibrium Chart 18Inflation Has Been Concentrated In Durable Goods, A Sector Where Prices Usually Fall Over Time To get inflation to go up and stay up in modern service-based economies, wages need to rise briskly. While US wage growth has picked up, the bulk of the increase has been among low-wage workers, particularly in the services and hospitality sector (Chart 19). Chart 19Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution The most likely scenario for next year is that firms will simply ration output, fearful that raising prices too quickly will hurt brand loyalty and trigger accusations of price gouging. Shortages will persist, but this time they will be increasingly concentrated in the service sector. Such a state of affairs will not last, however. Competition for workers will cause wages to rise much more than they have so far. Keen to protect profit margins, firms will start jacking up prices. A wage-price spiral will develop. The US economy could go supernova. Investment Conclusions Chart 20Long-Term Inflation Expectations Are Near The Bottom End Of The Fed's Comfort Zone US growth will slow next year, not because demand will falter, but because supply-side constraints will prevent the economy from producing as much output as households and businesses want to buy. This means that the old playbook for dealing with growth slowdowns needs to be thrown out the window. Rather than positioning for lower bond yields, investors should position for higher yields. Rather than expecting a stronger dollar, investors should expect a weaker one. Rather than favoring growth stocks, large caps, and defensives, investors should favor value stocks, small caps, and cyclicals. While inflation expectations have recovered from their pandemic lows, the 5-year/5-year forward TIPS breakeven inflation rate is still near the bottom end of the Fed’s comfort zone (Chart 20). Rising inflation expectations will lift long-term bond yields, justifying a short duration stance in fixed-income portfolios. Higher bond yields will benefit value stocks. Chart 21 shows that there has been a strong correlation between the relative performance of growth and value stocks and the 30-year bond yield this year. Rising input prices will make the US export sector less competitive, leading to a weaker dollar. Historically, non-US stocks have done well when the dollar has been weakening (Chart 22). Chart 21The Relative Performance of Value Stocks Has Closely Tracked Bond Yields This Year Chart 22Non-US Stocks Tend To Do Best When The US Dollar Is Weakening As for the overall stock market, with the Fed still in the dovish camp, it is too early to turn negative on equities. An equity bear market is coming, but not until rising inflation forces the Fed to step up the pace of rate hikes. That will probably not happen until mid-2023. Short Gilt Trade Activated We noted last week that we would go short the 10-year UK Gilt if the yield broke below 0.85%. Our limit order was activated on November 5th and we are now short this security. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1 To distinguish between inside and outside money, one should ask where the liability resides. If the liability resides within the private sector, it is inside money. By convention, central bank reserves are classified as outside money. However, one could argue that since taxpayers ultimately own the central bank, an increase in the price level will benefit taxpayers by eroding the real value of the central bank’s liability. If one were to take this view, the Pigou effect would be even weaker. 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Highlights Geopolitical conflicts point to energy price spikes and could add to inflation surprises in the near term. However, US fiscal drag and China’s economic slowdown are both disinflationary risks to be aware of. Specifically, energy-producers like Russia and Iran gain greater leverage amid energy shortages. Europe’s natural gas prices could spike again. Conflict in the Middle East could disrupt oil flows. President Biden’s $1.75 trillion social spending bill is a litmus test for fiscal fatigue in developed markets. It could fail, and even assuming it passes it will not prevent overall fiscal drag in 2022-23. However, it is inflationary over the long run. China’s slowdown poses the chief disinflationary risk. But we still think policy will ease to avoid an economic crash ahead of the fall 2022 national party congress. We are closing this year’s long value / short growth trade for a loss of 3.75%. Cyclical sectors ended up being a better way to play the reopening trade. Feature Equity markets rallied in recent weeks despite sharp upward moves in core inflation across the world (Chart 1). Inflation is fast becoming a popular concern and we see geopolitical risks that could drive headline inflation still higher in the short run. We also see underrated disinflationary factors, namely China’s property sector distress and economic slowdown. Several major developments have occurred in recent weeks that we will cover in this report. Our conclusions: Biden’s domestic agenda will pass but risks are high and macro impact is limited. Congress passed Biden’s infrastructure deal and will probably still pass his signature social spending bill, although inflation is creating pushback. Together these bills have little impact on the budget deficit outlook but they will add to inflationary pressures. Energy shortages embolden Russia and Iran. Winter weather is unpredictable, the energy crisis may not be over. But investors are underrating Russia’s aggressive posture toward the West. Any conflict with Iran could also cause oil disruptions in the near future. US-China relations may improve but not for long. A bilateral summit between Presidents Joe Biden and Xi Jinping will not reduce tensions for very long, if at all. Climate change cooperation is an insufficient basis to reverse the cold war-style confrontation over the long run. Chart 1Inflation Rattles Policymakers The investment takeaway is that geopolitical tensions could push energy prices still higher in the short term. Iran and Russia need to be monitored. However, China’s economic slowdown will weigh on growth. China poses an underrated disinflationary risk to our views. US Congress: Bellwether For Fiscal Fatigue While inflation is starting to trouble households and voters, investors should bear in mind that the current set of politicians have long aimed to generate an inflation overshoot. They spent the previous decade in fear of deflation, since it generated anti-establishment or populist parties that threatened to disrupt the political system. They quietly built up an institutional consensus around more robust fiscal policy and monetary-fiscal coordination. Now they are seeing that agenda succeed but are facing the first major hurdle in the form of higher prices. They will not simply cut and run. Inflation is accompanied by rising wages, which today’s leaders want to see – almost all of them have promised households a greater share of the fruits of their labor, in keeping with the new, pro-worker, populist zeitgeist. Real wages are growing at 1.1% in the US and 0.9% across the G7 (Chart 2). Even more than central bankers, political leaders are focused on jobs and employment, i.e. voters. Yet the labor market still has considerable slack (Chart 3). Almost all of the major western governments have been politically recapitalized since the pandemic, either through elections or new coalitions. Almost all of them were elected on promises of robust public investment programs to “build back better,” i.e. create jobs, build infrastructure, revitalize industry, and decarbonize the energy economy. Thus while they are concerned about inflation, they will leave that to central banks, as they will be loathe to abandon their grand investment plans. Chart 2Higher Wages: Real Or Nominal? Still, there will be a breaking point at which inflation forces governments to put their spending plans on hold. The US Congress is the immediate test of whether today’s inflation will trigger fiscal fatigue and force a course correction. Chart 3Policymakers Fear Populism, Focus On Employment President Biden’s $550 billion infrastructure bill passed Congress last week and will be signed into law around November 15. Now he is worried that his signature $1.75 trillion social spending bill will falter due to inflation fears. He cannot spare a single vote in the Senate (and only three votes in the House of Representatives). Odds that the bill fails are about 35%. Democratic Party leaders will not abandon the cause due to recent inflation prints. They see a once-in-a-generation opportunity to expand the role of government, the social safety net, and the interests of their constituents. If they miss this chance due to inflation that ends up being transitory then they will lose the enthusiastic left wing of the party and suffer a devastating loss in next year’s midterm elections, in which they are already at a disadvantage. Biden’s social bill is also likely to pass because the budget reconciliation process necessary to pass the bill is the same process needed to raise the national debt limit by December 3. A linkage of the two by party leaders would ensure that both pass … and otherwise Democrats risk self-inflicting a national debt default. The reconciliation bill is more about long-term than short-term inflation risk. The bill does not look to have a substantial impact on the budget outlook: the new spending is partially offset by new taxes and spread out over ten years. The various legislative scenarios look virtually the same in our back-of-the-envelope budget projections (Chart 4). However, given that the output gap is virtually closed, this bill combined with the infrastructure bill will add to inflationary pressures. The fiscal drag will diminish by 2024, not coincidentally the presidential election year 2024, not coincidentally the presidential election year. The deficit is not expected to increase or decrease substantially between 2023 and 2024. From then onward the budget deficit will expand. The increased government demand for goods and services and the increased disposable income for low-earning families will add to inflationary pressures. Other developed markets face a similar situation: inflation is picking up, but big spending has been promised and normalizing budgets will marginally weigh on growth in the next few years (Chart 5). True, growth should hold up since the private economy is rebounding in the wake of the pandemic. But politicians will not be inclined to renege on campaign promises of liberal spending in the face of fiscal drag. The current crop of leaders is primed to make major public investments. This is true of Germany, Japan, Canada, and Italy as well as the United States. It is partly true in France, where fiscal retrenchment has been put on hold given the presidential election in the spring. The effect will be inflationary, especially for the US where populist spending is more extravagant than elsewhere. The long run will depend on structural factors and how much the new investments improve productivity. Bottom Line: A single vote in the US Senate could derail the president’s social spending bill, so the US is now the bellwether for fiscal fatigue in the developed world. Biden is likely to pass the bill, as global fiscal drag is disinflationary over the next 12 months. Yet inflation could stay elevated for other reasons. And this fiscal drag will dissipate later in the business cycle. Russia And Iran Gain Leverage Amid Energy Crunch The global energy price spike arose from a combination of structural factors – namely the pandemic and stimulus. It has abated in recent weeks but will remain a latent problem through the winter season, especially if La Niña makes temperatures unusually cold as expected. Rising energy prices feed into general producer prices, which are being passed onto consumers (Chart 6). They look to be moderating but the weather is unpredictable. There is another reason that near-term energy prices could spike or stay elevated: geopolitics. Tight global energy supply-demand balances mean that there is little margin of safety if unexpected supply disruptions occur. This gives greater leverage to energy producers, two of which are especially relevant at the moment: Russia and Iran. Russia’s long-running conflict with the West is heating up on several fronts, as expected. Russia may not have caused the European energy crisis but it is exacerbating shortages by restricting flows of natural gas for political reasons, as it is wont to do (Chart 7). Moscow always maintains plausible deniability but it is currently flexing its energy muscles in several areas: Chart 6Energy Price Depends On Winter ... And Russia/Iran! Ukraine: Russia has avoided filling up and fully utilizing pipelines and storage facilities in Ukraine, where the US is now warning that Russia could stage a large military action in retaliation for Ukrainian drone strikes in the still-simmering Russia-Ukraine war. Belarus: Russia says it will not increase the gas flow through the major Yamal-Europe natural gas pipeline in 2022 even as Belarus threatens to halt the pipeline’s operation entirely. Belarus, backed by Russia, is locked in a conflict with Poland and the EU over Belarus’s funneling of migrants into their territory (Chart 8). The conflict could lead not only to energy supply disruptions but also to a broader closure of trade and a military standoff.1 Russia has flown two Tu-160 nuclear-armed bombers over Belarus and the border area in a sign of support. Moldova: Russia is withholding natural gas to pressure the new, pro-EU Moldovan government. Russia’s main motive is obvious: it wants Germany and the EU to approve and certify the new Nord Stream II pipeline. Nord Stream II enables Germany and Russia to bypass Ukraine, where pipeline politics raise the risk of shortages and wars. Lame duck German Chancellor Angela Merkel worked with Russia to complete this pipeline before the end of her term, convincing the Biden administration to issue a waiver on congressional sanctions that could have halted its construction. However, two of the parties in the incoming German government, the Greens and the Free Democrats, oppose the pipeline. While these parties may not have been able to stop the pipeline from operating, Russia does not want to take any chances and is trying to force Germany’s and the EU’s hand. The energy crisis makes it more likely that the pipeline will be approved, since the European Commission will have to make its decision during a period when cold weather and shortages will make it politically acceptable to certify the pipeline.2 The decision will further drive a wedge between Germany and eastern EU members, which is what Russia wants. EU natural gas prices will likely subside sometime next year and will probably not derail the economic recovery, according to both our commodity and Europe strategists. A bigger and longer-lasting Russian energy squeeze would emerge if the Nord Stream II pipeline is not certified. This is a low risk at this point but the next six months could bring surprises. More broadly, the West’s conflict with Russia can easily escalate from here. First, President Vladimir Putin faces economic challenges and weak political support. He frequently diverts popular attention by staging aggressive moves abroad. There is no reason to believe his post-2004 strategy of restoring Russia’s sphere of influence in the former Soviet space has changed. High energy prices give him greater leverage even aside from pipeline coercion – so it is not surprising that Russia is moving troops to the Ukraine border again. Growing military support for Belarus, or an expanded conflict in Ukraine, are likely to create a crisis now or later. Second, the US-Germany agreement to allow Nord Stream II explicitly states that Russia must not weaponize natural gas supply. This statement has had zero effect so far. But when the energy shortage subsides, the EU could pursue retaliatory measures along with the United States. Of course, Russia has been able to weather sanctions. But tensions are already escalating significantly. After Russia, Iran also gains leverage during times of tight energy supplies. With global oil inventories drawing down, Iran is in the position to inflict “maximum pressure” on the US and its allies, a role reversal from the 2017-20 period in which large inventories enabled the US to impose crippling sanctions on Iran after pulling out of the 2015 nuclear deal (Chart 9). Iran is rapidly advancing on its nuclear program and a new round of diplomatic negotiations may only serve to buy time before it crosses the “breakout” threshold of uranium enrichment capability as early as this month or next. In a recent special report we argued that there is a 40% chance of a crisis over Iran in the Middle East. Such a crisis could ultimately lead to an oil shock in the Persian Gulf or Strait of Hormuz. Chart 9Now Iran Can Use 'Maximum Pressure' Bottom Line: Russia’s natural gas coercion of Europe could keep European energy prices high through March or May. More broadly Russia’s renewed tensions with the West confirm our view that oil producers gain geopolitical leverage amid the current supply shortages. Iran also gains leverage and its conflict with the US could lead to global oil supply disruptions anytime over the next 12 months. Until Nord Stream II is certified and a new Iranian nuclear agreement is signed, there are two clear sources of potential energy shocks. Moreover in today’s inflationary context there is limited margin of safety for unexpected supply disruptions regardless of source. Xi’s Historical Rewrite China continues to be a major source of risk for the global economy and financial markets in the lead-up to the twentieth national party congress in fall 2022. While Chinese assets have sold off this year, global risk assets are still vulnerable to negative surprises from China. The five-year political reshuffle in 2022 is more important than usual since President Xi Jinping was originally supposed to step down but will instead stick around as leader for life, like China’s previous strongmen Mao Zedong and Deng Xiaoping.3 Xi’s rejection of term limits became clear in 2017 and is not really news. But Xi will fortify himself and his faction in 2022 against any opposition whatsoever. He is extremely vigilant about any threats that could disrupt this process, whether at home or abroad. The Communist Party’s sixth plenary session this week highlights both Xi’s success within the Communist Party and the sensitivity of the period. Xi produced a new “historical resolution,” or interpretation of the party’s history, which is only the third such resolution. A few remarks on this historical resolution are pertinent: Mao’s resolution: Chairman Mao wrote the first such resolution in 1945 to lay down his version of the party’s history and solidify his personal control. It is naturally a revolutionary leftist document. Deng’s revision of Mao: General Deng Xiaoping then produced a major revision in 1981, shortly after initiating China’s economic opening and reform. Deng’s interpretation aimed to hold Mao accountable for “gross mistakes” during the Cultural Revolution and yet to recognize the Communist Party’s positive achievements in founding the People’s Republic. His version gave credit to the party and collective leadership rather than Mao’s personal rule. Two 30-year periods: The implication was that the party’s history should be divided into two thirty-year periods: the period of foundations and conflict with Mao as the party’s core and the period of improvement and prosperity with Deng as the core. Jiang’s support of Deng: Deng’s telling came under scrutiny from new leftists in the wake of Tiananmen Square incident in 1989. But General Secretary Jiang Zemin largely held to Deng’s version of the story that the days of reform and opening were a far better example of the party’s leadership because they were so much more stable and prosperous.4 Xi’s reaction to Jiang and Deng: Since coming to power in 2012, Xi Jinping has shown an interest in revising the party’s official interpretation of its own history. The central claim of the revisionists is that China could never have achieved its economic success if not for Mao’s strongman rule. Mao’s rule and the Communist Party’s central control thus regain their centrality to modern China’s story. China’s prosperity owes its existence to these primary political conditions. The two periods cannot be separated. Xi’s synthesis of Deng and Mao: Now Xi has written himself into that history above all other figures – indeed the communique from the Sixth Plenum mentions Xi more often than Marx, Mao, or Deng (Chart 10). The implication is that Xi is the synthesis of Mao and Deng, as we argued back in 2017 at the end of the nineteenth national party congress. The synthesis consists of a strongman who nevertheless maintains a vibrant economy for strategic ends. What are the practical policy implications of this history lesson? Higher Country Risk: China’s revival of personal rule, as opposed to consensus rule, marks a permanent increase in “country risk” and political risk for investors. Autocratic governments lack institutional guardrails (checks and balances) that prevent drastic policy mistakes. When Xi tries to step down there will probably be a succession crisis. Higher Macroeconomic Risk: China is more likely to get stuck in the “middle-income trap.” Liberal or pro-market economic reform is de-emphasized both in the new historical resolution and in the Xi administration’s broader program. Centralization is already suppressing animal spirits, entrepreneurship, and the private sector. Higher Geopolitical Risk: The return to autocracy and the withdrawal from economic liberalism also entail a conflict with the United States, which is still the world’s largest economy and most powerful military. The US is not what it once was but it will put pressure on China’s economy and build alliances aimed at strategic containment. Bottom Line: China is trying to escape the middle-income trap, like Taiwan, Japan, and South Korea, but it is trying to do so by means of autocracy, import substitution, and conflict with the United States. These other Asian economies improved productivity by democratizing, embracing globalization, and maintaining a special relationship with the United States. China’s odds of succeeding are low. China will focus on power consolidation through fall 2022 and this will lead to negative surprises for financial markets. China Slowdown: The Disinflationary Risk While it is very unlikely that Xi will face serious challenges to his rule, strange things can happen at critical junctures. Therefore the regime will be extremely alert for any threats, foreign or domestic, and will ultimately prioritize politics above all other things, which means investors will suffer negative surprises. The lingering pandemic still poses an inflationary risk for the rest of the world while the other main risk is disinflationary: Inflationary Risk – Zero COVID: The “Covid Zero” policy of attempting to stamp out any trace of the virus will still be relevant at least over the next 12 months (Chart 11). Clampdowns serve a dual purpose since the Xi administration wants to minimize foreign interference and domestic dissent before the party congress. Hence the global economy can suffer more negative supply shocks if ports or factories are closed. Inflationary Risk – Energy Closures: The government is rationing electricity amid energy shortages to prioritize household heating and essential services. This could hurt factory output over the winter if the weather is bad. Disinflationary Risk – Property Bust: The country is still flirting with overtightening monetary, fiscal, and regulatory policies. Throughout the year we have argued that authorities would avoid overtightening. But China is still very much in a danger zone in which policy mistakes could be made. Recent rumors suggest the government is trying to “correct the overcorrection” of regulatory policy. The government is reportedly mulling measures to relax the curbs on the property sector. We are inclined to agree but there is no sign yet that markets are responding, judging by corporate defaults and the crunch in financial conditions (Chart 12). Chart 12China Has Not Contained Property Turmoil Evergrande, the world’s most indebted property developer, is still hobbling along, but its troubles are not over. There are signs of contagion among other developers, including state-owned enterprises, that cannot meet the government’s “three red lines.” 5 Credit growth has now broken beneath the government’s target range of 12%, though money growth has bounced off the lower 8% limit set for this year (Chart 13). China is dangerously close to overtightening. China’s economic slowdown has not yet been fully felt in the global economy based on China’s import volumes, which are tightly linked to the combined credit-and-fiscal-spending impulse (Chart 14). The implication is that recent pullbacks in industrial metal prices and commodity indexes will continue. Chart 13China Tries To Avoid Over-Tightening Chart 14China Slowdown Not Yet Fully Felt Until China eases policy more substantially, it poses a disinflationary risk and a strong point in favor of the transitory view of global inflation. It is difficult for China to ease policy – let alone stimulate – when producer prices are so high (see Chart 6 above). The result is a dangerous quandary in which the government’s regulatory crackdowns are triggering a property bust yet the government is prevented from providing the usual policy support as the going gets tough. Asset prices and broader risk sentiment could go into free fall. However, the party has a powerful incentive to prevent a generalized crisis ahead of the party congress. So we are inclined to accept signs that property curbs and other policies will be eased. Bottom Line: The full disinflationary impact of China’s financial turmoil and economic slowdown has yet to be felt globally. Biden-Xi Summit Not A Game Changer As long as inflation prevents robust monetary and fiscal easing, Beijing is incentivized to improve sentiment in other ways. One way is to back away from the regulatory crackdown in other sectors, such as Big Tech. The other is to improve relations with the United States. A stabilization of US ties would be useful before the party congress since President Xi would prefer not to have the US interfering in China’s internal affairs during such a critical hour. No surprise that China is showing signs of trying to stabilize the relationship. The US is apparently reciprocating. Presidents Biden and Xi also agreed to hold a virtual bilateral summit next week, which could lead to a new series of talks. The US Trade Representative also plans to restart trade negotiations. The plan is to enforce the Phase One trade deal, issue waivers for tariffs that hurt US companies, and pursue new talks over outstanding structural disputes. The Phase One trade deal has fallen far short of its goals in general but on the energy front it is doing well. China will continue importing US commodities amid global shortages (Chart 15). The summit alone will have a limited impact. Biden had a summit with Putin earlier this year but relations could deteriorate tomorrow over cyber-attacks, Ukraine, or Belarus. However, there is some basis for the US and China to cooperate next year: Iran. Xi is consolidating power at home in 2022 and probably wants to use negotiations to keep the Americans at bay. Biden is pivoting to foreign policy in 2022, since Congress will not get anything done, and will primarily focus on halting Iran’s nuclear program. If China assists the US with Iran, then there is a basis for a reduction in tensions. The problem is not only Iran itself but also that China will not jump to enforce sanctions on Iran amid energy shortages. And China is not about to make sweeping structural economic concessions to the US as the Xi administration doubles down on state-guided industrial policy. Meanwhile the US is pursuing a long-term policy of strategic containment and Biden will not want to be seen as appeasing China ahead of midterm elections, especially given Xi’s reversion to autocracy. What about cooperation on climate change? The US and China also delivered a surprise joint statement at the United Nations climate change conference in Scotland (COP26), confirming the widely held expectation that climate policy is an area of engagement. These powers and Europe have a strategic interest in reducing dependency on Middle Eastern oil (Chart 16). Climate talks will begin in the first half of next year. However, climate cooperation is not significant enough alone to outweigh the deeper conflicts between the US and China. Moreover climate policy itself is somewhat antagonistic, as the EU and US are looking at applying “carbon adjustment fees” to carbon-intensive imports, e.g. iron and steel exports from China and other high-polluting producers (Chart 17). While the EU and US are not on the same page yet, and these carbon tariffs are far from implementation, the emergence of green protectionism does not bode well for US-China relations even aside from their fundamental political and military disputes. Bottom Line: Some short-term stabilization of US-China relations is possible but not guaranteed. Markets will cheer if it happens but the effect will be fleeting. Chinese assets are still extremely vulnerable to political and geopolitical risks. Investment Takeaways Gold can still go higher. Financial markets are pricing higher inflation and weak real rates. Gold has been our chief trade to prepare both for higher inflation and geopolitical risk. We are closing our long value / growth equity trade for a loss of 3.75%. We are maintaining our long DM Europe / short EM Europe trade. This trade has performed poorly due to the rally in energy prices and hence Russian equities. But while energy prices may overshoot in the near term, investors will flee Russian equities as geopolitical risks materialize. We are maintaining our long Korea / short Taiwan trade despite its being deeply in the red. This trade is valid over a strategic or long-term time horizon, in which a major geopolitical crisis and/or war is likely. Our expectation that China will ease policy to stabilize the economy ahead of fall 2022 should support Korean equities. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Over the past year President Alexander Lukashenko’s repression of domestic unrest prompted the EU to impose sanctions. Lukashenko responded by organizing an immigration scheme in which Middle Eastern migrants are flown into Belarus and funneled into the EU via Poland. The EU is threatening to expand sanctions while Belarus is threatening to cut off the Yamal-Europe pipeline amid Europe’s energy crisis. See Pavel Felgenhauer, “Belarus as Latest Front in Acute East-West Standoff,” Jamestown Foundation, November 11, 2021, Jamestown.org. 2 Both Germany and the EU must approve of Nord Stream II for it to enter into operation. The German Federal Network Agency has until January 8, 2022 to certify the project. The Economy Ministry has already given the green light. Then the European Commission has two-to-four months to respond. The EU is supposed to consider whether the pipeline meets the EU’s requirement that gas transport be “unbundled” or separated from gas production and sales. This is a higher hurdle but Germany’s clout will be felt. Hence final approval could come by March 8 or May 8, 2022. The energy crisis will put pressure for an early certification but the EU Commission may take the full time to pretend that it is not being blackmailed. See Joseph Nasr and Christoph Steitz, “Certifying Nord Stream 2 poses no threat to gas supply to EU – Germany,” Reuters, October 26, 2021, reuters.com. 3 Xi is not serving for an “unprecedented third term,” as the mainstream media keeps reporting. China’s top office is not constant nor were term limits ever firmly established. Each leader’s reign should be measured by their effective control rather than technical terms in office. Mao reigned for 27 years (1949-76), Deng for 14 years or more (1978-92), Jiang Zemin for 10 years (1992-2002), and Hu Jintao for 10 years (2002-2012). 4 See Joseph Fewsmith, “Mao’s Shadow” Hoover Institution, China Leadership Monitor 43 (2014), and “The 19th Party Congress: Ringing In Xi Jinping’s New Age,” Hoover Institution, China Leadership Monitor 55 (2018), hoover.org. 5 Liability-to-asset ratios less than 70%, debt-to-equity less than 100%, and cash-to-short-term-debt ratios of more than 1.0x. Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Open Trades & Positions
Weekly Performance Update For the week ending Thu Nov 11, 2021 The Market Monitor displays the trailing 1-quarter performance of strategies based around the BCA Score. For each region, we construct an equal-weighted, monthly rebalanced portfolio consisting of the top 3 stocks per sector and compare it with the regional benchmark. For each portfolio, we show the weekly performance of individual holdings in the Top Contributors/Detractors table. In addition, the Top Prospects table shows the holdings that currently have the highest BCA Score within the portfolio. For more details, click the region headers below to be redirected to the full historical backtest for the strategy. BCA US Portfolio Total Weekly Return BCA US Portfolio S&P500 TRI 0.49% -0.62% Top Contributors TX:US TNET:US MPLX:US NFG:US DELL:US Weekly Return 21 bps 15 bps 14 bps 13 bps 9 bps Top Detractors AMN:US MC:US FB:US HE:US GOOG.L:US Weekly Return -12 bps -10 bps -8 bps -7 bps -5 bps Top Prospects GOOG.L:US MC:US MPLX:US DELL:US TX:US BCA Score 97.33% 97.04% 96.01% 94.91% 94.78% BCA Canada Portfolio Total Weekly Return BCA Canada Portfolio S&P/TSX TRI 1.10% 1.13% Top Contributors RUS:CA CRON:CA ATZ:CA CS:CA DSG:CA Weekly Return 21 bps 17 bps 17 bps 14 bps 12 bps Top Detractors PXT:CA DIR.UN:CA SMU.UN:CA WPK:CA AND:CA Weekly Return -13 bps -11 bps -11 bps -6 bps -4 bps Top Prospects TPZ:CA LNF:CA CS:CA PXT:CA TOY:CA BCA Score 99.58% 98.41% 98.01% 96.62% 95.00% BCA UK Portfolio Total Weekly Return BCA UK Portfolio FTSE 100 TRI 0.86% 1.54% Top Contributors AAF:GB TUNE:GB RIO:GB TEP:GB ROSN:GB Weekly Return 60 bps 49 bps 11 bps 11 bps 10 bps Top Detractors INDV:GB CKN:GB NFC:GB DRX:GB DEC:GB Weekly Return -32 bps -21 bps -17 bps -10 bps -9 bps Top Prospects VVO:GB FDM:GB WHR:GB INDV:GB SVST:GB BCA Score 98.33% 97.69% 97.50% 97.50% 97.06% BCA Eurozone Portfolio Total Weekly Return BCA EMU Portfolio MSCI EMU TRI 0.65% 0.30% Top Contributors FSKRS:FI MVV1:DE SOL:IT JMT:PT TL5:ES Weekly Return 27 bps 19 bps 14 bps 14 bps 12 bps Top Detractors DLG:IT KESKOB:FI ARTO:FR FDJ:FR VETO:FR Weekly Return -38 bps -11 bps -10 bps -8 bps -7 bps Top Prospects 094124453:BE MVV1:DE VRLA:FR DVT:FR ROTH:FR BCA Score 99.08% 98.83% 97.97% 96.49% 96.44% BCA Japan Portfolio Total Weekly Return BCA Japan Portfolio TOPIX TRI -2.60% -2.01% Top Contributors 4628:JP 9422:JP 4553:JP 8066:JP 9945:JP Weekly Return 5 bps 5 bps 5 bps 2 bps 1 bps Top Detractors 4694:JP 7958:JP 9543:JP 1835:JP 8850:JP Weekly Return -30 bps -24 bps -23 bps -19 bps -15 bps Top Prospects 9639:JP 9436:JP 6960:JP 3738:JP 4553:JP BCA Score 99.96% 99.78% 98.54% 98.11% 98.10% BCA Hong Kong Portfolio Total Weekly Return BCA Hong Kong Portfolio Hang Seng TRI -1.76% 0.13% Top Contributors 486:HK 3600:HK 856:HK 369:HK 1883:HK Weekly Return 16 bps 9 bps 9 bps 8 bps 7 bps Top Detractors 6118:HK 746:HK 1816:HK 506:HK 855:HK Weekly Return -59 bps -33 bps -29 bps -18 bps -14 bps Top Prospects 1277:HK 746:HK 1576:HK 1088:HK 486:HK BCA Score 100.00% 99.61% 99.57% 98.55% 98.02% BCA Australia Portfolio Total Weekly Return BCA Australia Portfolio S&P/ASX All Ord. TRI 0.79% -0.37% Top Contributors BLX:AU MHJ:AU GRR:AU CVW:AU ZIM:AU Weekly Return 62 bps 43 bps 26 bps 20 bps 14 bps Top Detractors PL8:AU RDY:AU SHL:AU MMS:AU RIC:AU Weekly Return -29 bps -25 bps -16 bps -12 bps -11 bps Top Prospects MHJ:AU PL8:AU RIC:AU ZIM:AU GRR:AU BCA Score 99.50% 99.20% 98.03% 97.91% 97.51%