Inflation/Deflation
Listen to a short summary of this report. Executive Summary Tighter Financial Conditions May Affect Growth It is still possible that equities can outperform bonds over the next 12 months, but the risks to this are rising. Inflation may surprise further to the upside, amid rising commodity prices, pushing the Fed to tighten aggressively. Tighter financial conditions augur badly for growth (see Chart). We cut our recommendation for global equities to neutral and increase our allocation to cash. We continue to prefer the lower-beta US stock market over the euro zone and Emerging Markets. We are overweight defensive and structural growth sectors: Healthcare, Consumer Staples, IT and Industrials. Government bond yields have limited upside from here to year-end. We are neutral duration. US high-yield bonds are attractive: They are pricing in a big rise in defaults this year, which we see as unlikely. Recommendation Changes Bottom Line: Rising uncertainty warrants a more defensive stance. Prudent investors should have only a benchmark weight in equities, and look for other hedges against downside risk. Overview Recommended Allocation Rather like Arnold Toynbee’s definition of history, markets in the past few months have been hit by “just one damned thing after another”. But, despite war in Ukraine, big upward surprises to inflation, and a swift aggressive turn by the Fed, global equities are only 6% off their all-time high. It is still possible that equities may outperform bonds over the next 12 months and that the global economy will avoid recession (Chart 1). But the risks to this are rising. We recommend, therefore, that prudent investors reduce their equity holdings to benchmark weight and generally have somewhat defensive portfolio positioning. We put the money raised from going neutral on equities into cash, not bonds. What are the risks? Inflation could surprise further to the upside. Inflation has spread beyond a few pandemic-related items to goods where prices are usually sticky (Chart 2). There are now clear signs that price rises are feeding through to wage increases in the US, UK and Canada – though not yet in the euro area, Japan or Australia (Chart 3). The supply response that we expected to see emerge later this year may be delayed because of Covid lockdowns in China and disruptions in supply from Russia and Ukraine (Chart 4). Consensus forecasts for US core PCE inflation see it coming down to 2.5% by next year. The risk is that it could exceed that. The Fed has got way behind the curve. In retrospect, it should have raised rates last summer – and it now understands its error. Its first hike this cycle came only when the economy had already overheated (Chart 5). The Fed may, therefore, be tempted to get rates up very quickly – something the futures market is now pricing in, since it implies that the year-end Fed Funds Rate will be 2.5%. An aggressive Fed cycle – propelled by inflation fears – is not a good environment for risk assets. Chart 1Can Stocks Keep On Outperforming Bonds? Chart 2Even Sticky Prices Are Now Rising Chart 3Price Rises Feeding Through To Wages In Some Regions Chart 4Supply Chains Remain Disrupted Financial conditions had already tightened before the Fed hiked because of higher long-term rates, widening credit spreads, and a strengthening dollar. The Goldman Sachs Financial Conditions Index points to the ISM Manufacturing Index falling below 50 later this year (Chart 6). That is the level that historically has been the dividing line between stocks outperforming bonds year-over-year (Chart 7). In particular, the sharp rise in long-term rates (the US 10-year Treasury yield has risen by 110 BPs, and the German yield by 93 BPs over the past seven months) could start to put some pressure on housing markets (Chart 8). Chart 5The Fed Hiked Too Late Chart 6Tighter Financial Conditions May Affect Growth Chart 7Will PMIs Fall Below 50? Chart 8Rising Rates Might Dampen The Housing Market The war in Ukraine is unlikely to be a risk in itself. BCA Research’s geopolitical strategists think it very improbable that the conflict will spill beyond the borders of Ukraine – though there remains tail risk of a mistake. But the war is having a big impact on energy prices, especially electricity prices in Europe (Chart 9). The oil price could remain high while Russian oil, which used to be consumed in Europe, is diverted elsewhere. Our Commodity & Energy Strategy service expects that increased supply from OPEC members will bring Brent crude down to around $90 a barrel by year-end. But, as our Client Question on page 14 details, that calculation relies on many assumptions, and the risk is that the oil price stays high. A doubling of the oil price year-on-year (which currently equates to $120/barrel) has historically often been followed by recession (Chart 10). Chart 9Europe's Electricity Prices Have Soared Chart 10Oil Price Is Close To The Risk Level China has been easing fiscal and monetary policy. But it is questionable how effective its stimulus will be this time. Confidence in the real estate market remains damaged. And the pick-up in credit growth has been limited to local government bond issuance; there is little sign that the private sector has appetite to borrow (Chart 11). Already some of these risks are affecting economic data. Consumer confidence has collapsed, presumably because of the rising cost of living (Chart 12). Although US activity indicators such as the manufacturing ISM remain elevated (see Chart 6 above), data in Europe is showing notable weakness (Chart 13). Chart 11China's Stimulus Not Helping The Private Sector Chart 12Consumer Confidence Has Been Hit The yield curve is also getting close to signaling recession. There has been much debate of late about which yield curve to use, with Fed Chair Jerome Powell arguing for the 3-month/3-month 18-month forward curve, rather than the more usual 2/10 year or 3 month/10 year curves (Chart 14). The 2/10 is close to inverting, while the others are still a long way away. All measures of the yield curve have historically given reliable recession signals; the difference is simply a matter of timing, with the 2/10 giving the longest lead time.1 If the Fed ends up tightening as much as it intends, all the yield curves will likely invert within the next year or so. Chart 13European Data Starting To Weaken Chart 14It Depends On Which Yield Curve You Look At And, despite all these warning signals, forecasts for economic and earnings growth have not been revised down much. Economists still expect 3.4-3.5% real GDP growth in the US and euro zone this year, well above trend (Chart 15). And, despite the drop in GDP forecasts, earnings forecasts have actually been revised up since the start of the year, with analysts now expecting 9.6% EPS growth in the US and 8.2% in the euro zone (Chart 16). Chart 15GDP Growth Is Still Expected To Be Above Trend... Chart 16...And Earnings Have Not Been Revised Down At All This all seems too much uncertainty for most asset allocators to want to stay fully risk-on. There are valid arguments that equities and other risk assets can continue to perform (which we outline in the following section, Risks To Our View). But the risks have shifted enough since the start of the year that a more defensive stance is now warranted. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Risks To Our View Chart 17Fed Feedback Loop Back In Action? Since our main scenario is somewhat cautious – and sentiment towards risk assets pretty pessimistic – we need to consider what could cause upside surprises to the economy and market. The most likely would be if the Fed were to turn more dovish. But the main trigger for this would be if the stock market fell sharply or growth showed clear signs of slowing – which would obviously be negative for stocks first. This scenario could produce the sort of Fed feedback loop we saw in 2015-17, when tightening financial conditions caused the Fed to ease back on rate hikes (Chart 17). More benign would be a gradual easing of inflation over the summer which would mean that the Fed could eventually hike a little less than the market currently expects. The economy may also not be as vulnerable to higher energy prices and higher rates as we fear. Food and energy are now a much smaller part of the consumption basket than they were in the 1970s (Chart 18). Rates may have a limited impact on the housing market, given the low inventory of new houses, strong household formation, and the fact that, in the US at least, some 90% of mortgages are 30-year fixed rate. Consumers continue to hold large amounts of excess savings – more than $2 trillion in the US alone. This should keep retail sales growth strong, though there might be some shift from spending on goods to spending on services as Covid fears recede (Chart 19). Chart 18Consumers Are Less Sensitive To Food And Energy Prices... Chart 19...And So May Keep On Spending Other upside risks include: A ceasefire and settlement in Ukraine (unlikely soon, since Russia will not withdraw without taking over Crimea and the Donbass, something Ukraine could not accept); more aggressive stimulus in China (possible, but only if Chinese growth weakened much further); and a sharp fall in the oil price caused by new supply coming onto the market from Saudi Arabia and North American shale fields, and possibly also Iran and Venezuela. What Our Clients Are Asking What Is The Risk Of Stagflation? Chart 20The Combination Of High Inflation And High Unemployment Was The Key Problem In The 1970s Several clients have asked about the risk of stagflation, and how the current episode compares to the 1970s. We can begin by dispelling some myths about the 1970s. There is a notion that this was a decade of poor growth for the US. That is simply not true. Real GDP grew by a solid 3.3% annual rate during the 1970s, higher than in any post-WW2 decade other than the 1990s and the 1960s (Chart 20, panel 1). The underlying problem during the 1970s was the combination of high inflation and a poor labor market. Despite solid growth, the unemployment rate kept grinding higher as inflation was increasing, never dropping below 4.5% even at the peaks of the expansions (Chart 20, panel 2). This situation went against the commonly held belief that it was not possible for both these variables to remain high at the same time for an extended period. With the economy plagued by both high inflation and high unemployment, the Fed faced a difficult dilemma: Keep interest rates too high and the already weak labor market would worsen; keep interest rates too low and inflation would spiral out of control. Throughout the decade, the Fed chose the latter option, causing inflation expectations to become unmoored. Chart 21Demographic Shocks And The Structure Of The Labor Force Led To A Weak Labor Market Why was there so much slack in the labor market? Demographics were one of the main culprits. The entrance of baby boomers into the workforce dramatically increased the pool of workers. At the same time, prime-age female participation rose at the fastest pace on record, adding additional supply to the labor force (Chart 21, panel 1). The structure of the labor market also played a key role. Almost a third of employees belonged to a union and most of their salaries were indexed to inflation (Chart 21, panels 2 & 3). This made for a rigid labor market where neither employment nor wages could adjust properly to the economic cycle. True, the oil shocks of 1974 and 1979 exacerbated inflationary pressures. But what made inflation truly pernicious during the 1970s was the inability of the Fed to fight it without compromising its employment mandate. Today the economic picture is very different. Union membership stands at only 10% and cost of living adjustments have essentially disappeared. There is also no labor supply shock on the horizon comparable to the baby boomers or women entering the labor force. This makes the calculus for the Fed easy. With its employment mandate already met, it will simply keep raising rates until inflation is back under control. As a result, the risk that it keeps policy too easy and unleashes further inflationary pressures is relatively low over the next 12 months. How Will The War In Ukraine Affect The World Economy? Chart 22The Ukrainian War Has Impacted The Global Economy Global growth, monetary policy, and employment were projected to return to pre-pandemic trends in 2023. In January, the IMF projected global growth of 4.4% in 2022, but now it is poised to cut its forecast due to the war in Ukraine. According to OECD estimates, global economic growth could be 1% lower than what was previously predicted (Chart 22, panel 1). The conflict is putting fresh strain on overstretched global supply chains, causing the price of many commodities to surge. Russia and Ukraine are relatively small in terms of economic output (together they comprise only 1.9% of global GDP in US dollar terms). But they are very big producers and exporters of energy, metals, and key food items. Russia, for example, produces 12% of global oil, one-third of palladium, and (with Belarus) 40% of potash (used in fertilizers). Ukraine is also a major producer of auto parts, such as wire harnesses. Some European car manufacturers have had to idle factories due to a lack of components. Global central banks have been increasing interest rates to battle inflation. But higher energy and food prices will require additional rate hikes to ensure price stability. The war in Ukraine could push up world inflation by around 2.5% this year, according to the OECD. Developing economies are in a particularly tight spot, being hit with high inflation in food and basic commodities. Their consumer price indices are very sensitive to these items. Russia and Ukraine are the main global exporters of several agricultural items (for example, they together account for a quarter of global wheat exports) which could cause global food insecurity to increase (Chart 22, panel 2). International sanctions on Russia create a risk for foreign companies with operations there. Withdrawal could have a meaningful effect on earnings. Most multinationals have only limited exposure to Russia, but a small number of prominent names make more than 5% of global revenues from the country (Chart 22, panel 3). Chart 23AOPEC Is Able To Cover Supply Shortages... Chart 23B...Unlike Other Countries...Chart 23CTo Restore A Balanced But Tight Market What Is The Risk That The Oil Price Stays High? Our Commodity & Energy strategists see 1.3mm b/d of supply from OPEC coming onto the market beginning in May. Because of this, they expect the price of Brent crude to fall back, to average $93 per barrel this year and next. OPEC core producers fear that low inventories and an oil price above $100 per barrel will lead to demand destruction. They will therefore aim to bring prices down. They have enough spare capacity (approximately 3.2mm b/d) to cover physical deficits in global markets (Chart 23A). However, the risk to this view is tilted to the upside. The key question is whether OPEC producers will in fact ramp up production. The OPEC meeting held on March 2, 2022 noted that current market volaility is a function of geopolitical developments and does not reflect changes in market fundamentals: This could imply a reluctance to increase production as quickly as we expect. Saudi Arabia’s interest in exploiting yuan-settled oil trades with China adds an element of uncertainty. With OPEC’s intention to increase production in question, and Russian oil sanctioned and unlikely to be rerouted easily and quickly, there remains little alternative supply: Countries such as Iraq and Venezuela are unlikely to make up for supply deficits (Chart 23B). The US-Iran talks also add downside uncertainty to our price outlook. Our commodity strategists have recently ended their forecast of a return of 1-1.3mm b/d of Iranian oil (Chart 23C). A no-deal scenario is likely to lead to an escalation in tensions and volatility, warranting higher oil prices in the short term. Nevertheless, there remains the possibility that the US administration will be keen on striking a deal with Iran to reduce the risk of a global oil supply shock. This would, in turn, reduce the risk of military conflict, at least in the short-term, and remove some risk premium from oil prices. It might also lead to further increases in production from the Gulf states to prevent Iran from stealing market share, putting further downward pressure on the oil price. Chart 24Is It Time To Favor EMU Equities? When Will Euro Area Stocks Rebound? Chinese policy makers have sounded more aggressive of late in terms of supporting the Chinese economy and stock market, especially property and tech shares. This is a positive development for euro area equities given the region’s strong reliance on the Chinese economy (Chart 24, panel 1). Euro area equities have been in a structural downtrend relative to US equities, but have historically staged occasional counter-trend rallies (Chart 24, panel 2). It’s possible that stocks in this region may stage another short-term rebound at some point because they are technically oversold, and valuation is extremely cheap (Chart 24, panel 3). Investors with a longer-term investment horizon, however, should remain underweight euro area stocks until there are more signs that the region is out of its stagflation state. As we argue in the Global Equities section on page 18, the key factor to watch over the next 9-12 months is profitability. Global earnings growth will slow significantly this year in response to higher input costs and lower revenue growth. As a net importer of energy and industrial metals, euro area earnings growth will continue to slow more than in the US (Chart 24, panel 4). In addition, in times of high uncertainty, we prefer to shelter in less volatile markets. The euro area has a much higher beta than the US (Chart 24, panel 5). Bottom Line: While there could be an opportunity to overweight euro area stocks versus the US tactically, long-term investors should continue to favor the US. Global Economy Chart 25Global Growth Remains Robust... Overview: Global growth has been strong. But this has triggered a surge in inflation, which is pushing central banks to tighten policy more quickly than was expected even three months ago. At the same time, higher prices – and falling real wages – have started to hurt consumer confidence. This raises the risk of stagflation, particularly if disruptions caused by the war in Ukraine push commodity prices up further. A recession is still unlikely over the next 12-18 months, but the risk of one has clearly risen. US economic growth has remained robust, led by consumption and capex. GDP growth in Q4 was 5.6% QoQ annualized. The ISMs remain strong, with manufacturing at 58.5 and services 58.9 (Chart 25, panel 2). However, there are some early signs of slowdown. The Atlanta Fed Nowcast points to only 0.9% annualized growth in Q1. The effect of higher inflation (with headline CPI at 7.9% YoY) might hurt consumer confidence, since average hourly earnings growth lags behind inflation at only 5.1%. Higher rates could also dampen the housing market. With the average mortgage rate rising to 4.5%, from 3.3% at the end of last year, there are signs of a slowdown in house sales (which fell 9.5% YoY in January). Euro Area: Growth remains decent, with Q4 GDP 4.6% QoQ annualized, and robust PMIs (manufacturing at 57.0 and services at 54.8). However, wage growth lags that in the US (negotiated wages rose only 1.5% YoY in Q4), and the impact of a sharp jump in energy prices (exacerbated by the war in Ukraine) could dent consumption. Recent data have deteriorated noticeably: Consumer confidence collapsed to -18.7 in March, and the March ZEW survey (Chart 26, panel 1) fell to -38.7 (from +48.6 in February). With weak underlying growth, and core CPI inflation a relatively modest 2.7%, the ECB will not need to rush to raise rates. Chart 26...But Higher Inflation Is Starting To Damage Confidence Japan: Economic growth remains rather anemic. Manufacturing is supported by exports (which rose by 19.1% YoY in January), helping the manufacturing PMI to stay in positive territory at 53.2. But wage growth remains stagnant (0.9% YoY) and the rise in oil prices has pushed up headline inflation to 0.9%, leading to a weakening of consumer sentiment. The services PMI is a weak 48.7. There are hopes that this year’s shunto wage round will lead to strong wage rises (the government is lobbying businesses to raise wages by 3%) but this seems unlikely. With inflation ex food and energy languishing at -1.9% (even if that is distorted by cuts in mobile phone charges), there seems little need for the Bank of Japan to tighten policy. Emerging Markets: Chinese economic indicators remain depressed (Chart 26, panel 3), even though global demand for manufactured goods means exports are rising 16.4% YoY. The authorities have been easing policy, which has led to a mild uptick in credit growth. But there are questions on how effective stimulus will be, since the housing market has been damaged by the problems at Evergrande and other developers, and because China seems to be sticking to its zero-Covid policy. Some other EMs will be helped by the rise in commodity prices: South Africa, for example, saw 4.9% annualized GDP growth in Q4. But many developed countries were forced to raise rates sharply last year because of inflation and this may slow growth in 2022. Brazil’s policy rate, for example, has risen to 11.75% from 2% last April, and that has dampened activity: Brazilian industrial production is falling 7.2% YoY, and retail sales are -1.9% YoY. Interest Rates: Recorded inflation and inflation expectations (Chart 26, panel 4) have risen sharply everywhere. Slowing demand for manufactured goods and a supply-side response should allow monthly inflation to peak over the next few months – although the risks remain to the upside if commodity prices continue to rise. The surge in inflation has pushed up long-term rates, with the US 10-year Treasury yield rising by 82 BPs year-to-date and that in Germany by 73 BPs. However, the market is now pricing in very aggressive tightening by central banks through year-end: 214 BPs of further hikes by the Fed, and even 75 BPs by the ECB. The probability is that neither will do quite that much, and therefore the upside for long-term government bond yields is probably capped around its current level for the next 6-9 months. Global Equities Chart 27Watch Earnings Revisions Closely Watch Earnings Closely: Global equities suffered a loss of 4% in Q1/2022 despite strong earnings growth. Except for the Utilities sector, all other sectors have positive 12-month trailing and forward earnings growth. Consequently, overall equity valuation, based on forward PE, is no longer stretched (Chart 27). Going forward, however, the macro backdrop of rising inflation and a slowing economy does not bode well for earnings growth, with the profit margin in developed markets already at a historical high. Rising input costs from both materials and wages will put downward pressure on profit margins while revenue growth slows. BCA Research’s global earnings model suggests that earnings growth will slow significantly this year. As such, we downgrade equities to neutral from overweight at the asset class level (see Overview section on page 2). Within equities, we maintain our already cautious country allocation, which served us well in both 2021 and Q1/22. The out-of-consensus overweight on the US and underweight on the euro area panned out well in Q1 2022, as the US outperformed the euro area by 5.9%. After the more defensive adjustment between the UK and Canada in the March Monthly Update, our country allocation portfolio has been well positioned, with overweights in the US and UK, underweights in the euro area, Canada and emerging markets excluding China, while neutral Australia, Japan, and China. In line with the shift of our structural view on industrial commodities, we upgrade the Materials sector to neutral from underweight at the expense of Real Estate and Communication Services. After these adjustments and the added defensive tilt that we took in the February Monthly Update, our global sector portfolio has a tilt towards defensive and structural growth by being overweight Tech, Industrials, Healthcare and Consumer Staples, underweight Consumer Discretionary, Utilities, and Communication Services, while neutral Materials, Financials, Energy and Real Estate. Chart 28Sector Adjustments Sector Allocation: Upgrade Materials To Neutral, Downgrade Real Estate to Neutral, Downgrade Communication Services to Underweight. Russia’s war on Ukraine is a watershed moment for industrial metals. It has altered the dynamics of the metals market which used to be dominated by Chinese demand. We had a structural underweight in the Materials sector because China was undergoing a deleveraging process. Now the Russian-Ukrainian war has demonstrated how dangerous it is for Europe to rely on Russia for energy supply and how important it is for Europe to have a strong military defense system. Rebuilding Europe’s defense will compete with energy diversification initiatives to boost demand for metals. Such a structural shift no longer warrants an underweight in Materials (Chart 28, panel 1). In addition, relative valuation in the Materials sector is as low as it was in the early 2000s, right before the multi-year upcycle in Materials’ relative performance (Chart 28, panel 2). Why not go overweight then? The concern is that the sector is technically overbought due to the sharp rises in metal price. Covid lockdowns in China have disrupted the supply chain in metals, and the Russian-Ukrainian war has further intensified the rise in metals prices due to extremely low inventories. We will watch closely for a better entry point to upgrade this sector to overweight. To finance this upgrade, we downgrade Real Estate to neutral from overweight, and Communication Services to underweight from neutral. Both downgrades are driven by a deteriorating relative earnings growth outlook as shown in Chart 28, panels 4 and 5. Rising mortgage rates do not bode well for the Real Estate sector. “Reopening from Covid lockdowns” reduces the “work from home” tailwind for the Communication Services sector, where relative valuation is also stretched. Government Bonds Chart 29WILL INFLATION COME DOWN IN 2022? Maintain At-Benchmark Duration. The first quarter of 2022 had seen a steady rise in global bond yields even before the Russian-Ukrainian war, in response to a higher inflation outlook. The negative shock to bond yields from the war was quickly reversed and bond yields continued to march higher as the supply shortage in the commodity complex further pushed up commodity prices and inflation expectations. The US 10-year TIPS breakeven inflation rate has risen above the 2.3-2.5% range that is consistent with the Fed’s 2% PCE target. However, the 5-year/5-year forward breakeven inflation rate, the measure that the Fed pays more attention to, is only slightly above 2.3% (Chart 29, panel 2). The base case of BCA Research’s Fixed Income Strategists is that inflation will moderate in the coming months so that there should be limited upside for bond yields. We already upgraded duration to at-benchmark from below-benchmark, and government bonds to neutral from underweight within the bond asset class in the March Portfolio Update. These are still appropriate going forward with the US 10-year Treasury yield currently standing at 2.33%. Inflation-linked bonds are not cheap anymore. We maintain a neutral stance to hedge against the tail risk of a further rise in inflation. Corporate Bonds Chart 30Continue To Favor High-Yield Credit Since the beginning of the year, investment-grade bonds have underperformed duration-matched Treasurys by 191 basis points, while high-yield bonds have underperformed duration-marched Treasurys by 173 basis points. Even with spreads widening, we continue to underweight investment-grade credits within the fixed-income category. Spreads currently do not offer enough value to warrant a neutral shift. Moreover, investment-grade corporate bonds have been performing poorly compared to high-yield corporate bonds (Chart 30, panel 1). But shouldn’t one expect lower-rated bonds to perform worse in bear markets, and better in bull markets? Our US Bond Service believes that one explanation for the poor performance of investment-grade compared to high-yield bonds is that the industry composition of the two categories is quite different. High-yield has a large concentration in the Energy sector while investment-grade bonds have a larger weighting in Financials. And with the recent surge in oil prices, it’s possible that the strong performance of Energy credits is the reason behind that return divergence. We continue to overweight high-yield bonds, as there is likely to be no material increase in corporate default risk. The market currently implies that defaults will rise to 3.7% during the next 12 months, from 1.2% over the past 12 months (Chart 30, panel 2). That seems too high. What about European credit? The ECB’S hawkish turn and then the Ukranian crisis made yields almost double this year. The spreads for both investment-grade and high-yield corporate bonds have been widening since the beginning of the year (Chart 30, panel 3). Their valuations seem to offer an attractive entry point but investors should be cautious as spreads could continue to widen in response to the negative news from the Ukranian crisis. Commodities Chart 31Risks To Oil Price Are To The Upside Energy (Overweight): Oil prices surged to $120 – the highest level since 2013 – in the aftermath of Russia’s invasion of Ukraine, pricing in sanctions against the nation’s oil producers and an estimated 3-5 mm b/d of supply disruptions (Chart 31, panel 1). While the actual hit to Russian production might end up being lower, Russia accounts for over 10% of global production, almost half of which is exported (Chart 31, panel 2). The price shock was slightly offset by a marginal demand weakness from China amid another outbreak of Covid-19. However, uncertainty regarding how quickly core OPEC producers will ramp up production to fill supply shortages – as well as the breakdown in the US-Iranian talks – continue to keep oil prices jittery. Our Commodity & Energy strategists see 1.3mm b/d of increased supply from OPEC coming onto the market beginning in May. This should bring the price of Brent crude down to average $93 per barrel this year and next. The risks to this view however remain tilted to the upside. For more details, see What Our Clients Are Asking on page 14. Industrial Metals (Neutral): Russia is a major player in the metals market, providing more than a third of the world’s palladium output; it is also the third biggest producer of nickel (Chart 31, panel 3). The prices of those metals, as well as the broad industrial metals complex, have shot up following the invasion: Industrial metals had the largest weekly price change since 1990 in the week following the invasion. The outlook for industrial metals prices is tilted to the upside. Inventories for some of the industrial metals required for the energy transition are low. Moreover, if China implements significant stimulus – and supply remains tight – prices are likely to stay elevated. Precious Metals (Neutral): Gold prices reacted in line with the moves in US real rates over the first quarter of this year, initially relatively flat, before rising in the past few weeks as real rates came down. The upward move in gold prices was further amplified by Russia’s invasion of Ukraine, which pushed the bullion’s price close to $2040, just shy of its all-time high in late 2020. This comes as no surprise: The metal is known (despite its volatility) for its safe-haven and inflation-hedging characteristics. We maintain our neutral exposure to gold. Real rates should start to rise as inflation pressures abate in the second half of the year. Gold is also somewhat expensively valued, with the price in inflation-adjusted terms close to its record high (Chart 31, panel 4). Currencies Chart 32Don't Turn Bearish On The Dollar Yet US Dollar: The DXY index has risen by 2.3% this quarter. We are maintaining our neutral stance on the US dollar. While the dollar is expensive by more than 20% according to purchasing power parity (PPP), positive momentum continues to be too strong to take an outright bearish position (Chart 32, panels 1 and 2). We will look to downgrade the dollar to underweight when momentum starts to weaken and when there is clear evidence that the Fed will have to back off from its tightening path. Japanese Yen: With stock markets rebounding and expectations of interest-rate hikes rising in the US, the yen has fallen by more than 18% since the beginning of the year. Still, we reiterate the overweight that we placed at the beginning of March. The yen should act as a hedge if global stock markets sell off anew. Moreover, we believe there is now limited upside for US yields, given that there are now more than 250 basis points of Fed hikes priced over the next 12 months. This should put a cap on USDJPY, as this cross is closely tied to the relative expectations of tightening between the US and Japan (Chart 32, panel 3). Canadian Dollar: We are currently underweight the Canadian dollar. Our Commodity and Energy Strategists believe that oil should come down to around $90/barrel by the end of the year. Additionally, the BoC won’t be able to follow along with the Fed in its tightening cycle, given that household debt is much higher in Canada than in the US. Both developments should put downward pressure on the CAD over the next 12 months. Alternatives Chart 33Prepare To Turn To Defensive Alternatives Return Enhancers: We previously suggested that private equity tends to outperform other alternative assets in the early years of expansions as it benefits from cheaper financing opportunities and attractive entry valuations. This view has been correct: Following the large drawdown in Q1 2020 due to Covid, PE returns have significantly outperformed those of hedge funds (Chart 33, panel 1). However, financing conditions are tightening and could weigh down on economic activity and PE returns going forward (Chart 33, panel 2). Preliminary results for Q3 2021 show PE funds returning only around 6% compared to an average quarterly return of 10% since the beginning of the pandemic. Given the time it takes to move allocations in the illiquid space, investors should prepare to pare back exposure from PE, and look for more defensive alternative assets, such as macro hedge funds. Inflation Hedges: We have been of the view that inflation will follow a “two steps up, one step down” trajectory: More likely than not, we are near the top of those two steps. Accordingly, we were positioned to favor real estate over commodities; real estate tends to outperform when inflation is more subdued (close to 2%-3%). Inflation, globally, however has turned out to be stickier than expected and recent economic and political developments have propelled another surge in commodity prices. Scarce inventories, lingering inflation, and a potential significant Chinese stimulus imply, at least in the short-term, that commodity prices have room to run (Chart 33, panel 3). Volatility Dampeners: Timberland and Farmland remain our long-time favorite assets within this bucket. We have previously shown that both assets outperform other traditional and alternative assets during recessions and equity bear markets. Farmland particularly continues to offer an attractive yield of approximately 2.8% (Chart 33, panel 4). Footnotes 1 Please see BCA Research Special Report, "The Yield Curve As An Indicator," for a detailed analysis of this. Recommended Asset Allocation Model Portfolio (USD Terms)
Executive Summary Europe Is Russia's Key Gas Customer Full-on rationing of natural gas by Germany took a step closer to reality, as the standoff with Russia over its insistence on being paid in roubles for gas plays out. News that Germany initiated its first step toward rationing spiked European and UK natgas prices by more than 12% on Wednesday. Higher prices for coal, oil and renewable energy will follow, as these energy sources compete at the margin with natgas in Europe. Inflation and inflation expectations will move higher if Germany ultimately rations scarce natgas supplies. We are watching to see who blinks first – Germany or Russia. The risk of aluminum-smelter shut-downs in Europe once again is elevated. Other metals-refining operations also are at risk of shutdown if rationing is invoked. Trade difficulties arising from Russia's invasion of Ukraine and related sanctions will lead to further bottlenecks on base-metal exports from Russia, as Rusal warned this week. This will further confound the energy transition. Western governments will be forced to accelerate investments and subsidies in carbon-capture technology as fossil-fuel usage and prospects revive. Bottom Line: Fast-changing EU natural gas supply-demand dynamics are impacting competing energy and base metals markets. This is throwing up confusion around the global renewable-energy transition and extending its timetable. Fossil fuels fortunes are being revived, as a result. We remain long commodity index exposure and the equities of oil-and-gas producers and base-metals miners. Feature Events in the EU natural gas markets are changing rapidly in the wake of fast-changing developments in the Russia-Ukraine war. In the wake of these changes, economic prospects for Europe and Russia are rapidly evolving – both potentially negatively over the short run. Full-on rationing of natural gas by Germany took a step closer to reality, as its standoff with Russia over payment for gas in roubles plays out. News Germany is preparing its citizens for rationing spiked European and UK natgas prices by more than 12% Wednesday. It's not clear whether Russia or Germany are bluffing on this score. Russia's oil and gas exports last year accounted for close to 40% of the government's budget. According to Russia's central bank, crude and product revenue last year amounted to just under $180 billion, while pipeline and LNG shipments of natgas generated close to $62 billion last year. Europe is Russia's biggest natgas market, accounting for ~ 40% of its exports. However, as the relative shares of revenues indicate, natgas exports are less important to Russia than crude and liquids exports. Losing this revenue stream for a year would amount to losing ~ $25 billion of revenue, all else equal. In the event, however, the net loss might be lower, since this would put a bid under the natgas market ex-Europe, which would offset part or most of the lost natgas sales to Europe. If Russia is able to re-market those lost volumes, it could offset the loss of European sales. Knock-On Effects The immediate knock-on effect of this news turns out to be higher prices for oil, UK and European natgas. This is not unexpected, as gasoil competes at the margin with natgas in space heating markets, while competition across regions also can be expected to increase. Once again, the risk of aluminum-smelter shut-downs in Europe is elevated if rationing is imposed by Germany. Other metals-refining operations also are at risk of shutdown if rationing is invoked. Lastly, fertilizer production in Europe would be materially impacted, given some 70% of fertilizer costs are accounted for by natgas. In addition to these endogenous EU effects, trade difficulties arising from Russia's invasion of Ukraine and related sanctions will lead to further bottlenecks on base-metal exports from Russia, as Rusal warned this week.1 This will further confound the energy transition as the world's third-largest aluminum smelter faces sanctions – official and self-imposed – and the loss of inputs from Western suppliers, along with reduced access to capital and funding from the West. If, over time, Russia's base metals industries are degraded by the lack of access to capital and technology as oil and gas will be, the global renewable-energy transition will be slowed considerably. We already expect Russia's oil and gas production to fall over time due to the economic isolation created by Russia's invasion of Ukraine, rendering it a diminished member of OPEC 2.0. Russia accounts for ~ 10% of global crude oil supplies, and is the second largest producer of crude oil in the coalition. A long-term degradation of its production profile will exacerbate the persistent imbalance between demand relative to supply globally, which continues to force oil inventories lower (Chart 1). On the metals side, Russia accounts for 6%, 5% and 4% of global primary aluminum, refined nickel and copper production. Persistent supply deficits have left inventories in these markets – particularly nickel and copper – tight and getting tighter (Chart 2).2 Chart 1Oil Inventories Remain Tight... Chart 2… As Do Metals Inventories Europe's Radical Pivot In a little over a month's time, the EU has been forced to abandon once-immutable post-Cold War beliefs shared by the electorate and politicians of all stripes. Ever-deepening commercial ties with Russia did not ensure EU energy security, nor did they obviate what arguably is any state's primary responsibility: Protecting and defending its citizens. Because of its failed engagement policy with Russia over the post-Cold War interval, the EU is forced to scramble to restore its energy production and expand its sources of energy imports. In addition, it is repeatedly asserting its intent to "double down" of the speed of its renewable-energy transition. And, last but certainly not least, it is forced to rapidly rearm itself in industrial commodity markets that are in the midst of prolonged physical deficits and inventory drawdowns.3 The Russian invasion of Ukraine spurred the EU to action on both the energy and defense fronts. It is rushing head-long into eliminating its dependence on Russia for fuel, particularly natural gas, and will pursue re-arming its member states forthwith (Chart 3). Chart 3Weaning EU Off Russian Gas Will Prove Difficult On the energy front, the EU adopted a two-prong approach to cleave itself from Russian natgas: 1) Diversify its sources of natural gas, which largely will be in the form of liquified natural gas (LNG), and 2) doubling down on renewable energy generation. EU officials are aiming to replace two-thirds of their Russian gas imports by the end of this year, which is an ambitious target. Over the next two years or so, EU officials hope to fully wean themselves from Russian natgas via a combination of infrastructure buildouts and a renewed push to increase domestic production, which was being throttled back by earlier attempts to secure increased Russian supplies, and a strong focus on renewables. EU's US LNG Deal The EU signed a deal with the US to receive an additional 15 Bcm of natural gas in 2022, and 50 Bcm annually by 2030, which is equal to ~ 30% of the EU’s 2020 Russian gas imports. How exactly this will be done is unknown. In 2021, the EU imported 155 bcm of natgas from Russia, or more than 3x the amount being discussed with the US; 14 bcm of that was LNG.4 Just exactly what meeting of the minds was achieved between the EU and US government is totally unclear at this point. The US is not an LNG supplier, nor can it order private companies to renege on existing contacts. The US government likely will use its good offices to attempt to persuade Asian buyers to allow their contracted volumes to be diverted to European buyers, but that would, in all likelihood, mean they would switch to another fuel (e.g., coal) as an alternative if they take that deal. This would, we believe, require some sort of financial incentive to induce such behavior. US liquefaction capacity is also running at near full capacity (Chart 4). While there are projects in the pipeline, in the medium-term (2 – 5 years) the lack of export capacity will act as a constraint to the amount of LNG that can be shipped to the EU. Chart 4Europe Critical To Russia's Gas Industry For Russia, its shipments of gas to OECD-Europe represent more than 70% of its exports (Chart 5). Arguably, Europe is just as important to Russia as Russia is to Europe. With the EU set on a course to sever ties completely, Russia will be forced to invest in pipeline capacity to take more of its gas to China via the Power of Siberia 2 pipeline. In the short-term, US LNG exports to the EU will face headwinds since much of Central and Eastern Europe rely on piped gas from Russia. As a result, many countries within Europe are not equipped with sufficient regasification facilities and are running at near peak utilization rates (Chart 6). Germany does not have any such capacity. Chart 5Not Much Room For US LNG Exports To Grow… Chart 6…Or For Additional European LNG Imports LNG import facilities that have additional intake capacity in the Iberian Peninsula and Eastern Europe do not have sufficient pipeline capacity to move gas inland. This will require additional infrastructure investment as well. To deal with this lack of infrastructure, Germany, Italy and the Netherlands are moving quickly to procure Floating Storage and Regasification (FSRUs) to convert LNG back to its gaseous state. While not the five-year proposition a dedicated LNG train requires to bring on line, setting up FSRUs still could be a years-long process.5 How quickly these assets can be mobilized, and the volumes they can deliver remain to be seen. Investment Implications Fast-changing EU natural gas supply-demand dynamics are impacting competing energy and base metals markets. This is throwing up confusion around the global renewable-energy transition and extending its timetable. Fossil fuels fortunes are being revived, as a result. At this point it is impossible to handicap the odds of a cut-off of Russian natgas to Europe, or its duration if it does occur. Either way, competitive suppliers to Russia – particularly US shale-gas producers selling into the LNG market and the vessels that transport it – will benefit regardless of the course taken by Germany and Russia on rationing. We remain long commodity index via the S&P GSCI and COMT ETF, and the equities of oil-and-gas producers and base-metals miners via the PICK, XME and XOP ETFs. Commodity Round-Up Energy: Bullish Oil prices were whipsawed by new reports suggesting Russia would substantially reduce its military operations in Kyiv ahead of ceasefire talks with Ukraine, only to have that speculation dashed by US officials indicating nothing had changed in the status quo to warrant such a view. Markets restored the risk premium that fell out of prices on the unwarranted speculation, with Brent prices once again above $110/bbl this week. At present, the fundamental oil picture remains tight. In the run-up to a decision from OPEC 2.0's March meeting today, we continued to expect KSA, the UAE and Kuwait to increase production by up to 1.6mm b/d this year, and another 600k b/d next year. To date, OPEC 2.0 has fallen short by ~ 1.2mm b/d since it started returning production taken off line during the pandemic. In return for higher output, we continue to expect the US to deepen its commitment to defending the Gulf Co-operation Council (GCC) states making up core-OPEC 2.0. If we do not see an increase in core-OPEC 2.0 production, we will have to re-assess our fundamental outlook on KSA's, the UAE's and Kuwait's ability to increase production. We also will have to determine whether – even if the supply is available to return to the market – these states have embraced a revenue-maximization strategy, given the fiscal breakeven price for these states now averages ~ $64/bbl. It also is possible that heavily discounted Russian crude oil – trading more than $30/bbl below Brent (vs. the standard $2.50/bbl Urals normally commands) – convinces core-OPEC 2.0 states that oil prices are not so high for large EM buyers like India and China as to create demand destruction. We believe the latter view likely is prevailing at present. We continue to expect Brent to average $93/bbl this year and next (Chart 7). Base Metals: Bullish BHP Group Ltd. will invest more than $10 billion to expand metals production over the next 50 years in Chile. The metals giant aims to stay ESG compliant, provided there is a supportive investment environment provided by the Chilean government. Resource-rich Latin American countries such as Chile and Peru have elected left-leaning governments intent on redistributing mining profits and ensuring companies comply with the ESG framework. As Chile considers raising mining royalties and redrafts its constitution, mining investment in the country has stalled. Political uncertainty in these countries has coincided with low global copper inventories (Chart 8) and high demand. Chart 7 Chart 8 Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Footnotes 1 Please see Aluminum Giant Rusal Flags Stark Risks Triggered by War in Ukraine published by Bloomberg on March 30, 2022. 2 Please see our Special Report entitled Commodities' Watershed Moment, published on March 10, 2022. It is available at ces.bcaresearch.com. 3 Please see footnote 2. 4 Please see How Deep Is Europe's Dependence on Russian Oil? published by the Columbia Climate School on March 14, 2022. 5 Please see Europe battles to secure specialised ships to boost LNG imports published by ft.com 28 March 2022. Germany appears to be most advanced in its procurement of FSRU capacity, and is close to concluding a deal that would allow it to regasify 27 bcm annually. Investment Views and Themes Strategic Recommendations Trades Closed in 2021
Executive Summary Refreshing Our Tactical Trade List Our current list of tactical trade recommendations centers around two broad themes that predate the Ukraine conflict – rising global inflation expectations and relatively stronger upward pressure on US interest rates. Both themes have been strengthened by the spillovers from the war in Eastern Europe, most notably the link between soaring commodity prices and rising inflation. We still see value in holding our recommended cross-country spread trades that will benefit from continued US bond underperformance (short US Treasuries versus government bonds in Germany, Canada and New Zealand, all at the 10-year maturity). We also maintain our bias to lean against the yield curve flattening trend in the US, but we now prefer to do it solely via our existing SOFR futures calendar spread position. Finding attractively valued inflation breakeven spread trades is more difficult after the latest oil-fueled run-up in developed market inflation expectations. Canadian breakevens, however, stand out as having the greatest upside potential according to our Comprehensive Breakeven Indicators. Bottom Line: Remain in US-Germany, US-Canada an US-New Zealand 10-year government bond yield spread widening trades. Maintain our recommended position in the US SOFR futures curve (long Dec/22 futures, short Dec/24 futures). Add a new inflation-linked bond trade, going long 10-year Canadian breakevens. Feature One month has passed since Russia invaded Ukraine, and investors are still struggling to sort out the financial market implications. Equity markets in the US and Europe have recovered the losses incurred immediately after the conflict began. Equity market volatility has also fallen back to pre-invasion levels according to the VIX index (and its European counterpart, the VStoxx index). That decline in equity volatility has also coincided with a narrowing of corporate credit spreads in both the US and Europe, with the former now fully back to pre-invasion levels. Yet while credit spread volatility has calmed down, government bond yield volatility remains elevated thanks to rising commodity prices putting upward pressure on expectations for inflation and monetary policy (Chart 1). Chart 1Global Bond Yields Are Above Pre-Invasion Levels Table 1Refreshing Our Tactical Trade List We have already made some “wartime” adjustments to our global bond market cyclical recommendations, with those changes reflected in our model bond portfolio. This week, we review our shorter-term tactical trade recommendations. Our current list of tactical trades revolves around two broad themes that predate the Ukraine conflict – rising global inflation expectations and relatively stronger cyclical upward pressure on US interest rates. Both themes have been strengthened by the spillovers from the war in Eastern Europe, most notably the link between soaring commodity prices and rising inflation. We continue to see the value in holding on to most of our existing tactical trades, with only a couple of adjustments to be made to our US yield curve and global inflation-linked bond positions (Table 1). US Yield Curve Tactical Trades: Shift Focus To SOFR Steepeners We have recommended trades that lean against the aggressive flattening of the US Treasury curve discounted in forward rates since late 2021. Our view has been that markets were discounting too rapid a pace of Fed rate increases in 2022. With the Fed likely delivering fewer hikes than expected, Treasury curve steepening trades would benefit as the spot Treasury curve would flatten by less than implied by the forwards. Related Report Global Fixed Income StrategyFive Reasons To Tactically Increase US Duration Exposure Now Needless to say, that view has not panned out as we anticipated. The spread between 10-year and 2-year US Treasury yields now sits at a mere +13bps, down from +104bps when we initiated our 2-year/10-year steepener trade last November. The forwards now discount an inversion of that curve starting in June of this year, which would be an extraordinary outcome by historical standards. Typically, the US Treasury curve inverts only after the Fed has delivered an extended monetary tightening cycle that delivers multiple rate hikes over at least a 1-2 year period (Chart 2). Today, the curve has nearly inverted with the Fed having only delivered only a single 25bp rate increase earlier this month. Chart 2The UST Curve Is Unusually Flat Right Now Of course, the Fed’s reaction function in the current cycle is different compared to the past. The Fed now follows an average inflation targeting framework that tolerates temporary inflation overshoots after periods when US inflation ran below the Fed’s 2% target. Now, however, the Fed has no choice but to respond to surging US inflation, which has been accelerating since September and is now at levels last seen in 1982. Chart 3Our SOFR Trade Is Similar To Our UST Curve Trade We still see the market pricing in too much Fed tightening this year and too few rate hikes in 2023/24. The US overnight index swap (OIS) curve now discounts 218bps of rate hikes in 2022, but 44bps of rate cuts between June 2023 and December 2024. We think a more likely scenario is the Fed doing less than discounted this year, as US inflation should show some deceleration in the latter half of 2022, but then continuing to raise rates in 2023 into 2024. We have expressed this view more specifically through an additional tactical trade that was initiated last month, going long the December 2022 3-month SOFR futures contract versus shorting the December 2024 3-month SOFR futures contract. This new trade is essentially a calendar spread trade between two futures contracts, but with a return profile that has looked quite similar to our 2-year/10-year US Treasury curve flattening trade (Chart 3). Having two tactical trades that are highly correlated, and which both are driven by the same theme of the Fed doing less this year and more over the next two years, is inefficient. We see the SOFR calendar spread trade as a more precise expression of our Fed policy view compared to the 2-year/10-year Treasury curve steepener. In addition, the SOFR trade now offers slightly better value after it has lagged the performance of the Treasury curve trade over the past couple of weeks. Thus, we are keeping this trade in our Tactical Overlay portfolio (see the table on page 15), while closing out our 2-year/10-year steepener at a loss of -92bps.1 Cross-Country Spread Trades: Keeping Betting On Relatively Higher US Yields In our Tactical Overlay portfolio, we currently have three recommended cross-country government bond spread trades that all have one thing in common – a sale of 10-year US Treasuries. The long side of the three trades are different (Germany, New Zealand and Canada), but the logic underlying all three trades is the same. The Fed will deliver more rate hikes than the central banks in the other countries. 10-year US Treasury-German Bund spread Chart 4UST-Bund Spread Is Too Low Expecting a wider US Treasury-German Bund spread remains our highest conviction view in G-10 government bond markets. This is a trade we have described as a more efficient way to position for rising US bond yields than a pure below-benchmark US duration stance. We have maintained that recommendation in both our model bond portfolio and our Tactical Overlay portfolio. For the latter, that trade was implemented using 10-year bond futures in both markets and is up 3.9% since initiation back in October 2021. The case for expecting even more Treasury-Bund spread widening remains strong, for several reasons: Underlying inflation remains higher in the US, particularly when looking at domestic sources of inflation like wages and service sector prices. Europe, which relies more heavily on Russia for its energy supplies than the US, is more at risk of a negative growth shock from the Ukraine conflict. Our fundamental model of the 10-year Treasury-Bund spread shows that the current level of the spread (+197bps) is about one full standard deviation below fair value, which itself is rising due to stronger US economic growth, faster US inflation and a more aggressive path for monetary tightening from the Fed relative to the ECB (Chart 4). The spread between our 24-month discounters in the US and Europe, which measure the amount of rate hikes priced into OIS curves for the two regions over the next two years, has proven to be good leading indicator of the 10-year Treasury-Bund spread. That discounter spread is currently at 99bps, levels last seen when the 10-year Treasury-Bund spread climbed to the 250-300bps range in 2017/18 (Chart 5). With the relative forward curves now discounting a slight narrowing of the US-German 10-year spread over the next year, betting on a wider spread does not suffer from negative carry. We are maintaining this trade in our Tactical Overlay portfolio with great conviction. 10-year US Treasury-Canada government bond spread We entered another cross-country spread trade involving a US Treasury short position earlier this month, in this case versus 10-year Canadian government bonds. This trade is a bet on relative monetary policy moves between the Fed and the Bank of Canada (BoC). Like the Fed, the BoC is facing a problem of high inflation and tight labor markets. Canadian core CPI inflation hit a 19-year high of 3.9% in January, while the Canadian unemployment rate is at a 3-year low of 5.5%. The US is facing even higher inflation and even lower unemployment, but one major difference between the two nations is the degree of household sector debt loads. Canada’s household debt/income ratio now stands at 180%, 55 percentage points higher than the equivalent US ratio, thanks to greater residential mortgage borrowing in Canada (Chart 6). Chart 5Stay Positioned For More UST-Bund Spread Widening The Canadian OIS curve is now discounting a peak policy rate of 3.1% in 2023, which is at the high end of the BoC’s estimated 1.75-2.75% range for the neutral policy rate. Chart 6The BoC Will Have Trouble Matching Fed Hawkishness Elevated household debt will limit the BoC’s ability to lift rates that high, as this would trigger a major retrenchment of housing demand and a significant cooling of house prices. While the US is also facing issues with robust housing demand and high house prices, this is less of a factor that would limit Fed tightening relative to the BoC because US household balance sheets are not as levered as their Canadian counterparts. We are keeping our short US/long Canada spread trade (implemented using bond futures) in our Tactical Overlay portfolio, with the BoC unlikely to keep pace with the expected Fed rate increases over the next year (Chart 7). Chart 7Stay Positioned For A Narrower Canada-US Spread 10-year US Treasury-New Zealand government bond spread The third cross-country trade in our Tactical Overlay is 10-year New Zealand-US spread widening trade. Chart 8A Big Gap In NZ-US Relative Interest Rate Expectations Like the Germany and Canada spread trades, we expect the Fed to deliver more rate hikes than the Reserve Bank of New Zealand (RBNZ) which should push up US Treasury yields versus New Zealand equivalents. In the case of this trade, however, interest rate expectations in New Zealand are far more aggressive. Chart 9Stay Positioned For NZ-US Spread Tightening The RBNZ has already lifted its Official Cash Rate (OCR) by 75bps since starting the tightening cycle in mid-2021. The New Zealand OIS curve is now discounting an additional 253bps of rate hikes in this cycle, eventually reaching a peak OCR of 3.5% in June 2023. This would put the OCR into slightly restrictive territory based on the range of neutral rate estimates from the RBNZ’s various quantitative models (Chart 8). This contrasts to the pricing in the US OIS curve that places the peak in the fed funds rate at 2.8% next year before falling back to the low end of the FOMC’s 2.0-3.0% range of neutral estimates in 2024. Both the US and New Zealand are suffering from similarly high rates of inflation, with New Zealand headline inflation reaching 5.9% in the last available data from Q4/2021. However, while markets are already pricing in restrictive monetary settings in New Zealand, markets are yet to price in a similarly restrictive move in the fed funds rate. We continue to see scope for a narrowing of the New Zealand-US 10-year bond yield spread over at least the next six months. There has already been meaningful compression of the 2-year yield spread as US rate expectations have converged towards New Zealand levels (Chart 9) – we expect the 10-year spread to follow suit. Inflation Breakeven Trades: Swap Canada For Australia We currently have one inflation-linked bond (ILB) trade in our Tactical Overlay portfolio, betting on higher inflation breakevens in Australia. We initiated this trade last October, largely based on the signal from our suite of Comprehensive Breakeven Indicators (CBI) for the major developed economy ILB markets. The CBIs contain three components: the deviation from fair value from our 10-year breakeven spread models, the distance between realized headline inflation and the central bank target, and the gap between the 10-year breakeven and survey-based measures of longer-term inflation expectations. Those three measures are standardized and aggregated to form the CBI. Countries with lower CBIs have more upside potential for breakevens, and their ILBs should be favored over those from nations with higher CBIs. Chart 10Breaking Down Our Comprehensive Breakeven Inflation Indicators Chart 11Favor Canadian Inflation-Linked Bonds Vs. Australia Given the latest run-up in global inflation breakevens on the back of soaring oil prices, there are now no countries in our CBI universe that have a negative CBI (Chart 10). Canada has the lowest CBI, and thus the highest upside potential for breakeven spread widening. We are taking a modest profit of +40bps in our Australian breakeven trade, as we are approaching the self-imposed six-month holding period limit on our tactical trades and our Australian CBI is not indicating major upside for Australian breakevens.2 Based on the message from our indicators, we see a better case for entering a new tactical spread widening position in 10-year Canadian ILBs. A comparison of the CBIs between Canada and Australia shows that the Canadian 10-year inflation breakeven is well below our model-implied fair value, which incorporates both oil prices and currency levels (Chart 11). This contrasts to the Australian breakeven which is now well above fair value. A similar divergence appears when comparing breakeven spreads to survey-based measures of inflation expectations, with Canadian breakevens looking too “undervalued” compared to Australia. While realized headline inflation is above the respective central bank targets, especially in Canada, the valuation cushion makes the ILBs of the latter the better bargain of the two. The details of our new Canadian 10-year breakeven trade, where we go long the cash ILB and sell 10-year Canadian bond futures against it, are shown in our Tactical Overlay table on page 15. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The Treasury curve trade is actually a “butterfly” trade, where we have included an allocation to US 3-month Treasury bills (cash) to make the curve steepener duration-neutral. Thus, the trade is more specifically a position where we are long a 2-year US Treasury bullet and short a cash/10-year US Treasury barbell with a duration equal to that of the 2-year. 2 We have recently discovered an error in our how we have calculated the returns on the 10-year Australian futures leg of our Australian 10-year inflation breakeven widening trade. The final total return for our trade shown in the Tactical Overlay table on page 15 corrects for our error, and fortunately shows a significantly higher return than we have published in past reports. GFIS Model Bond Portfolio Recommended Positioning Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Tactical Overlay Trades
Due to travel commitments, there will be no Counterpoint report next week. Instead, we will send you a timely update and analysis of the Ukraine Crisis written by my colleague Matt Gertken, BCA Chief Geopolitical Strategist. Executive Summary The tight connection between the oil price and inflation expectations is intuitive, appealing… and wrong. The inflation market is tiny, and its principle function is not to predict inflation per se, but to serve as a hedging investment in an inflation scare, such as that which follows an oil price spike. Hence, we should treat inflation expectations and the real bond yield that is derived from them with extreme care – especially after an oil price spike, which will give the illusion that the real bond yield is lower than it really is. In the near term, the Ukraine crisis has added to already elevated fears about inflation, which will pressure both bonds and stocks. However, looking beyond the next few months, the Ukraine crisis triggered supply shock will cause demand destruction, while central banks also choke demand, and the recent massive displacement of demand into goods, and its associated inflationary impulse, reverses. The 12-month asset allocation conclusion is to overweight stocks and bonds, and to underweight TIPS and commodities. Fractal trading watchlist: The sell-off in some T-bonds is approaching capitulation. The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Wrong Bottom Line: In the near term, an inflationary impulse will dominate, but on a 12-month horizon, a disinflationary impulse will dominate. Feature In his seminal work Thinking Fast And Slow, Nobel Laureate psychologist Daniel Kahneman presented the bat-and-ball puzzle. A bat and ball cost $1.10. The bat costs one dollar more than the ball. How much does the ball cost? “A number came to your mind. The number, of course, is 10: 10 cents. The distinctive mark of this easy puzzle is that it evokes an answer that is intuitive, appealing, and wrong. Do the math, and you will see. If the ball costs 10 cents, then the total cost will be $1.20 (10 cents for the ball and $1.10 for the bat), not $1.10. The correct answer is 5 cents. It is safe to assume that the intuitive answer also came to the mind of those who ended up with the correct number – they somehow managed to resist the intuition.” Kahneman’s crucial finding is that many people are prone to place too much faith in an intuitive answer, an intuitive answer that they could have rejected with a small investment of effort. The Connection Between The Oil Price and Inflation Expectations Is Intuitive, Appealing… And Wrong Today, the financial markets are presenting their very own bat-and-ball puzzle. The surging price of crude oil is driving up the market expectation for inflation over the next ten years (Chart I-1). This tight relationship is intuitive and appealing, because we associate a high oil price with a high inflation rate. But the intuitive and appealing relationship is wrong, and it requires just a small investment of effort to prove the fallacy. Chart I-1The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Wrong Inflation over the next ten years equals the price in ten years’ time divided by the current price. So, to the extent that there is any relationship between the current price and expected inflation, dividing by a higher price today means a lower prospective inflation rate. Empirically, the last fifty years of evidence confirms this very clear inverse relationship (Chart I-2). Chart I-2A High Oil Price Means Lower Subsequent Inflation This raises an obvious question: while many people accept the intuitive (wrong) relationship between the oil price and expected inflation, how can the market make such a glaring error? The answer is that the inflation market is relatively tiny, and that its principle function is not to predict inflation per se, but to serve as a hedging investment in an inflation scare. Compared to the $25 trillion T-bond market, the Treasury Inflation Protected Securities (TIPS) market is worth just $1.5 trillion, slightly more than the market capitalisation of Tesla. Just as we do not expect Tesla to represent the view of the entire stock market, we should not expect TIPS to represent the view of the entire bond market. A high oil price means lower subsequent inflation. A recent paper by The Oxford Institute For Energy Studies explains: “the tight relationship between the oil price and inflation expectations defies not only the thesis of economics, but the norms of statistics as well, with a correlation that has reached 90 percent over the last ten years and a corresponding r-squared of 82 percent (Chart I-3 and Chart I-4). The root cause of this phenomenon should probably be searched for in the behaviour of another large group of market participants, the systematic portfolio allocators, and factor investors.”1 Chart I-3Inflation Expectations Are Just A Mathematical Function Of The Oil Price... Chart I-4...Therefore 'The Real Bond Yield' Is Just A Mathematical Function Of The Oil Price So, here’s the explanation for the intuitive, appealing, but wrong connection between the oil price and inflation expectations. In the inflation scare that a surging oil price unleashes, the two main asset-classes – bonds and equities – are vulnerable to sharp losses, leaving TIPS as one of the very few assets that can provide a genuine hedge against inflation. But given that bonds and equities dwarf the $1.5 trillion TIPS (and other inflation) markets, the inflation hedger quickly becomes the dominant force in this tiny market. This large volume of hedging demand chasing limited supply drives down the real yields on TIPS to artificial lows, both in absolute terms and relative to T-bond yields. And as the difference between nominal and real yields defines the ‘market’s expected inflation’, it explains the surge in expected inflation. Be Careful How You Use ‘The Real Bond Yield’ It is an unfortunate reality that we often close the stable door after the horse has bolted, meaning that we react after, rather than before, the event. In financial market terms, this means that we demand inflation protection after, rather than before, it happens, and end up overpaying for it. A high oil price unleashes a massive hedging demand for the tiny TIPS market, driving down the real TIPS yield versus the nominal T-bond yield. To repeat, a high oil price unleashes a massive hedging demand for the tiny TIPS market, driving down the real TIPS yield versus the nominal T-bond yield. The upshot is that the performance of TIPS versus T-bonds is nothing more than a play on the oil price (Chart I-5). Chart I-5The Performance Of TIPS Versus T-Bonds Is Just A Play On The Oil Price A bigger message is that we should interpret the oft-quoted ‘real bond yield’ with extreme care. The real bond yield is nothing more than the nominal bond yield less a mathematical function of the oil price. So, when the oil price is high, it will give the illusion that the real bond yield is low. The danger is that if we value equities against the real bond yield when the oil price is high – such as through 2011-14 or now – equities will appear cheaper than they really are (Chart I-6). Chart I-6When The Oil Price Is High, 'The Real Bond Yield' Will Appear Lower Than It Really Is In The Case Against A ‘Super Bubble’ (And The Case For) we explained the much better way to value equities is versus the product of the nominal bond price and current profits. This valuation approach perfectly explains the US stock market’s evolution both over the long term (Chart I-7) and the short term. Specifically, over the past year, the dominant driver of the US stock market has been the 30-year T-bond price (Chart I-8). Chart I-7The US Stock Market = Profits Times The 30-Year T-Bond Price (Long-Term Chart) Chart I-8The US Stock Market = Profits Times The 30-Year T-Bond Price (Short-Term Chart) 12-Month Asset Allocation Conclusion The current inflation scare comes not from an aggregate demand shock, but from a massive displacement of demand (into goods) followed by the more recent supply shock for energy and food triggered by the Ukraine crisis. In response, central banks are trying to douse the inflation in the only way they can – by choking aggregate demand. Hence, there is a dangerous mismatch between the malady and the remedy. In the near term, the Ukraine crisis has added to already elevated fears about inflation – and this will pressure both bonds and stocks. However, looking beyond the next few months, the near-term inflationary impulse will unleash a disinflationary response from three sources. First, a supply shock means higher prices without stronger demand, which causes an inevitable demand destruction that then pulls down prices. Second, central banks are explicitly trying to pull down prices – or at least price inflation – by choking demand. And third, the massive displacement of demand into goods, and its associated inflationary impulse, is reversing. On a 12-month horizon, the disinflationary impulse will outweigh the inflationary impulse. Therefore, on a 12-month horizon, the disinflationary impulse will outweigh the inflationary impulse. The asset allocation conclusion is to overweight stocks and bonds, and to underweight TIPS and commodities. Is The Bond Sell-Off Close To Capitulation? Finally, several clients have asked if the recent sell-off in bonds is close to capitulation, based on the fragility of its fractal structures. The answer is yes, but only for the shorter maturity T-bonds. Specifically, the 5-year T-bond has reached the point of fragility on its composite 130-day/260-day fractal structure that marked the bottom of the sell-off in 2018, as well as the top of the rally in 2020 (Chart I-9). Chart I-9The Sell-Off In Shorter-Dated T-Bonds Is Close To Capitulation Accordingly, this week’s trade recommendation is to buy the 5-year T-bond, setting the profit target and symmetrical stop-loss at 4 percent, and with a maximum holding period of 1 year. Please note that our full fractal trading watchlist is now available on our website: cpt.bcaresearch.com Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 https://www.oxfordenergy.org/wpcms/wp-content/uploads/2021/08/Is-the-Oil-Price-Inflation-Relationship-Transitory.pdf Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Vulnerable To Reversal Chart 5Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Vs. Software Approaching A Reversal Chart 7The Euro’s Underperformance Could Be Approaching a Resistance Level Chart 8A Potential Switching Point From Tobacco Into Cannabis Chart 9Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 10Biotech Approaching A Major Buy Chart 11CAD/SEK Reversal Has Started Chart 12Financials Versus Industrials Is Reversing Chart 13Norway's Outperformance Could End Chart 14Greece's Brief Outperformance Has Ended Chart 15BRL/NZD At A Resistance Point Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Executive Summary Tracking Inflation In 2022 Our base case view is that inflation will moderate in the coming months, allowing the Fed to deliver a steady pace of tightening (25 bps per meeting). A 50 bps rate hike is possible at some point this year, but only if long-maturity inflation expectations become un-anchored or core PCE inflation prints consistently above 0.30%-0.35% per month. Historical evidence suggests that Treasury securities perform best when the yield curve is very steep or very flat. All else equal, an inversion of the 2-year/10-year Treasury slope would make us more bullish on bonds. High-yield corporates have performed better than investment grade corporates during the recent sell-off. Investors should continue to favor high-yield corporates over investment grade. Bottom Line: Investors should maintain “at benchmark” portfolio duration and buy Treasury curve steepeners. We also maintain an overweight allocation to high-yield corporate bonds and a neutral allocation to investment grade corporates. We Have Liftoff The Fed followed through on its earlier promise and lifted the funds rate by 25 basis points last week. FOMC participants also sharply revised up their expectations for the future pace of tightening, though this revision mostly just made the Fed’s forecast more consistent with what was already priced in the yield curve. Market rate hike expectations, as inferred from the overnight index swap curve, shifted up only slightly after the Fed’s announcement (Chart 1). Chart 1Rate Expectations As of Monday morning, the bond market is priced for 208 bps of tightening during the next 12 months and 174 bps between now and the end of the year. This is close to the median FOMC forecast which calls for 150 bps of further tightening this year followed by an additional 92 bps in 2023. Last week’s report highlighted the tricky situation faced by the Fed.1 On the one hand, the Fed must tighten quickly enough to keep long-dated inflation expectations anchored. On the other hand, the Fed wants to avoid tightening so quickly that it causes a recession. For investors, we think it makes sense to assume that the Fed will try to split the difference by lifting rates at a pace of 25 bps per meeting for at least the next 12 months. However, there are significant risks to both the upside and downside of this projection. The Odds Of A 50 bps Hike The upside risk is that inflation is sufficiently sticky that the Fed will feel the need to deliver a 50 bps rate hike at some point this year. Last week’s Fed interest rate projections show that 7 out of 16 FOMC participants think that at least one 50 bps rate hike will be necessary. Meanwhile, market prices are consistent with one 50 basis point rate hike and five 25 basis point rate hikes at this year’s six remaining FOMC meetings. We think the Fed will only deliver a 50 bps rate hike if inflation looks to be tracking above the committee’s 2022 forecast or if long-maturity inflation expectations become un-anchored to the upside. Related Report Global Investment StrategyIs A Higher Neutral Rate Good Or Bad For Stocks? On the inflation front, the FOMC’s central tendency forecast calls for core PCE inflation of between 3.9% and 4.4% in 2022, with a median of 4.1%. To match this forecast, core PCE will have to average a monthly growth rate of between 0.30% and 0.35% in each of this year’s eleven remaining months (Chart 2).2 Every monthly inflation print above that range increases the odds of a 50 bps Fed move, every print below that range brings the odds down. As for long-maturity inflation expectations, the Fed likely views them as “well anchored” for the time being. The 10-year TIPS breakeven inflation rate has broken meaningfully above the Fed’s target range but the 5-year/5-year forward TIPS breakeven inflation rate remains consistent with the Fed’s goals (Chart 3). The University of Michigan’s survey measure of 5-10 year household inflation expectations has risen sharply, but it has not yet broken meaningfully above recent historical levels (Chart 3, bottom panel). Chart 2Tracking Inflation In 2022 Chart 3Inflation Expectations Our sense is that inflation is very close to peaking and that lower inflation in the back half of the year will apply downward pressure to inflation expectations and prevent the Fed from delivering a 50 bps hike at any single FOMC meeting. However, we will be closely tracking the evolution of Charts 2 and 3 to see if this situation changes. The Odds Of Skipping A Meeting Chart 4Financial Conditions The downside risk to the Fed’s expected rate hike path results from the fact that financial conditions have already responded aggressively to the Fed’s actions and communications. While it’s certainly true that financial conditions remain extremely accommodative in level terms (Chart 4), we must also acknowledge that, historically, the sort of rapid tightening of financial conditions that we have already seen is almost always followed by a significant slowdown in economic activity (Chart 4, panel 2). On top of all that, the yield curve is now completely flat beyond the 5-year maturity point and the 2-year/10-year Treasury slope is a mere 22 bps away from inversion (Chart 4, bottom panel). The Fed’s new interest rate projections show the median expected interest rate moving above estimates of the long-run neutral rate in 2023 and 2024. This sort of rate hike path is consistent with a mild inversion of the yield curve, and the Fed will likely downplay the yield curve’s recession signal during the next few months. That said, a deepening inversion of the yield curve will only increase market worries about an over-tightening of monetary policy. This could lead to a sell-off in risk assets that would accelerate the tightening of financial conditions and lead to expectations of even slower economic growth. The next section of this report explores what an inverted 2-year/10-year yield curve has historically meant for Treasury returns. Investment Implications Our base case view is that inflation will moderate in the coming months, allowing the Fed to deliver a steady pace of tightening (25 bps per meeting). We also see economic growth slowing but remaining solid enough to prevent a significant sell-off in risk assets and a deep inversion of the yield curve. We also acknowledge, however, that the risks to this view (in both directions) are unusually high. Given all that, our recommended investment strategy is to keep portfolio duration close to benchmark. The market is already well priced for a steady 25 bps per meeting pace of tightening and bond yields will merely keep pace with forwards if that pace is delivered. We also see yield curve steepeners profiting during the next 6-12 months as the yield curve’s flattening trend takes a pause now that market expectations have fully adjusted to the likely path of Fed rate increases. We remain neutral TIPS versus nominal Treasuries at the long-end of the curve, but underweight TIPS versus nominal Treasuries at the front-end. Short-maturity TIPS will underperform as inflation moderates in H2 2022. The Yield Curve And Treasury Returns The historical relationship between the slope of the yield curve and Treasury returns is very interesting. To examine it, we first looked at historical data on excess Treasury index returns versus cash since 1989 (Table 1). Table 112-Month Treasury Excess Returns* Given Different Starting Points For 2-Year / 10-Year Treasury Slope Specifically, we show 12-month excess Treasury returns given different starting points for the 2-year/10-year Treasury slope. For example, when the 2-year/10-year Treasury slope has been between 0 bps and 25 bps, the Bloomberg Barclays Treasury Index has historically outperformed a position in cash by an average of 2.75% during the next 12 months. A 90% confidence interval places expected returns between 1.75% and 3.73%, and excess Treasury returns were positive in 73% of historical observations. The first big conclusion that jumps out from Table 1 is that Treasuries perform best when the yield curve is either very steep or very flat. The worst periods for Treasury returns have tended to occur when the slope is between 25 bps and 100 bps. It’s easy to understand why a very steep yield curve would lead to strong Treasury returns. A steep curve means that Treasuries offer a large yield advantage versus cash, or put differently, an extremely rapid pace of rate hikes would be necessary for cash returns to overcome the carry advantage in bonds. It’s more difficult to understand why Treasury returns have been strong after instances of curve inversion. The most likely reason is that market participants have tended to overestimate the odds of the Fed achieving a “soft landing” and have underestimated the odds of an upcoming recession and rate cuts. The data used in Table 1 are limited in that observations only begin in 1989. As such, the table misses the Paul Volcker period of the early 1980s when Treasuries continued to sell off well after the curve inverted. Chart 5 extends the historical period back to the mid-1970s and uses shading to indicate periods of 2-year/10-year yield curve inversion. Chart 5Yields Tend To Peak Shortly After Curve Inversion Chart 5 reveals a pretty clear pattern. With the exception of the late-1970s/early-1980s episode, the 10-year Treasury yield tends to peak right around the time of 2-year/10-year yield curve inversion, or shortly after in the case of 1989. What can we take away from this analysis? First, the evidence suggests that we should have a bias toward taking more duration risk in our portfolio if and when the yield curve inverts. A more deeply inverted yield curve should also be viewed as a stronger bond-bullish signal than a modestly inverted yield curve. Second, we must acknowledge the major risk to this strategy. Specifically, the risk that inflation will be so high that the Fed will continue to tighten aggressively even after the yield curve inverts, as Paul Volcker did in the early-1980s. Our sense is that the odds of a repeat “Volcker moment” are low. Inflation will naturally fall as the pandemic’s impact wanes and the Fed won’t be forced to deliver another hawkish shock to market expectations. Therefore, we maintain our “at benchmark” recommendation for portfolio duration for now, but we may turn more bullish on bonds if the yield curve inverts. The Poor Performance Of Investment Grade Bonds Chart 6IG Has Lagged HY One notable aspect of recent bond market moves has been that the performance of investment grade corporate bonds has significantly lagged the performance of high-yield corporate bonds during the recent period of spread widening (Chart 6). This is highly unusual. Typically, we expect bonds with more credit risk to behave like “higher beta” securities. That is, we expect lower-rated bonds to perform better in bull markets and worse in bear markets.3 The typical relationships held earlier in the cycle. Chart 7A shows that high-yield corporate bonds delivered stronger excess returns than investment grade corporate bonds from the March 2020 peak in spreads through the end of that year. Chart 7B shows that high-yield continued to outperform investment grade throughout the bull market for spreads in 2021. Chart 7ACorporate Bond Excess Returns* Versus DTS: March 2020 To December 2020 Chart 7BCorporate Bond Excess Returns* Versus DTS: January 2021 To September 2021 Chart 7CCorporate Bond Excess Returns* Versus DTS: September 2021 To Present Based on that relationship, we would expect high-yield to perform worse than investment grade since spreads troughed in September 2021, but that has not been the case (Chart 7C). How do we explain the relatively weak performance of investment grade corporates relative to high-yield? One possible explanation is that the industry composition of the investment grade and high-yield bond universes is different. High-yield has a large concentration in the Energy sector while investment grade is more geared toward Financials. Given the recent surge in oil prices, it’s possible that the strong performance of Energy credits is driving the return divergence between investment grade and high-yield. Chart 8 shows the performance of each individual industry group within both investment grade and high-yield since the September 2021 trough in spreads. It shows that Energy bond returns have indeed been stronger than for other sectors. In fact, high-yield Energy excess returns have been positive! Chart 8Corporate Bond Excess Returns* Versus DTS: September 2021 To Present However, Chart 8 mainly reveals that industry composition only explains part of the divergence between investment grade and high-yield returns. Notice that every single high-yield industry group has outperformed its investment grade counterpart since September 2021. This suggests that there is a more fundamental reason for the divergence between investment grade and high-yield performance. Chart 9Following The 2018 Roadmap Our own sense is that the corporate bond market is following the roadmap from early 2018 (Chart 9). At that time, Fed tightening pushed the Treasury slope below 50 bps and investment grade corporates started to perform poorly, presumably because the removal of monetary accommodation justified somewhat wider corporate bond spreads. However, high-yield performed well in early 2018 as there was no material increase in corporate default risk, even though the Fed was tightening. A similar market narrative could easily be applied to today. Back in 2018, the market narrative shifted late in the year when investors suddenly decided that Fed tightening had gone too far. High-Yield sold off sharply and caught up with investment grade. The Fed was then forced to end its tightening cycle and corporate bonds rallied in early 2019. We see this 2018 roadmap as a significant risk, but not destiny. While there’s a chance that the market will soon decide that the Fed has over-tightened, leading to a sharp sell-off in high-yield. There’s also a chance that gradual Fed rate hikes will continue for much longer than the market anticipates without meaningfully slowing the economy. In that case, high-yield returns would remain solid for some time and the recent spread widening in investment grade would probably abate. For the time being, we find ourselves more inclined toward the latter scenario. Bottom Line: Investors should maintain an overweight allocation to high-yield and a neutral allocation to investment grade corporate bonds within a US bond portfolio. We may soon get a chance to upgrade our corporate bond allocation if inflationary pressures abate and the war in Ukraine shows signs of de-escalation. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “A Soft Landing Is Still Possible”, dated March 15, 2022. 2 PCE data is so far only updated to January 2022. 3 In this report we use Duration-Times-Spread (DTS) as a simple measure of a bond index’s credit risk. A higher DTS means that a bond has greater credit risk and vice-versa. Treasury Index Returns Spread Product Returns Recommended Portfolio Specification Other Recommendations
Executive Summary Fed Chair Powell is attempting to steer the US economy between the Scylla of a recession and the Charybdis of entrenched high inflation. In the benign soft-landing outcome, the economy will continue to grow well above trend while inflation abates as spending transitions from goods to services, supply chains are untangled and base effects offer arithmetic relief. Entrenched high inflation would yield the most bearish outcome as it would leave the Fed with no choice but to squash the economy to stuff the inflation genie back into the bottle. We expect that rate hikes will eventually short-circuit the expansion and the equity bull market, but not for at least another year. Disruptions from the Ukraine conflict and China’s COVID surge place the most bullish case out of reach but the bearish end of the continuum is overly defeatist. The biggest threats to our constructive view are worsening Russia-Ukraine shortages, a conflict with Russia beyond Ukraine, new COVID obstacles and a consumer retreat. The Rates Market Thinks The Fed's Overly Ambitious Bottom Line: We continue to recommend overweighting equities and credit over our cyclical 6-12-month timeframe, but risks are heightened and we will change course if conditions dictate. Feature As telegraphed, the Fed began its rate hiking campaign at last week’s FOMC meeting. It lifted its target range for the fed funds rate 25 basis points (bps) from 0 – 0.25% to 0.25 – 0.5%. In addition to making the nearly unanimously expected 25-bps hike, it indicated that the median FOMC participant expects the funds rate to rise by 25 bps at each of the year’s six remaining meetings and by 87.5 bps in 2023, though Chair Powell stressed the projections are merely a baseline expectation subject to change as economic conditions evolve. Both projections slightly exceeded market expectations going into the meeting. After it ended, the fed funds rate implied by the December 2022 futures contract rose 15 bps to align with the median FOMC voter and the rate implied by the December 2023 fed funds contract rose 18 bps, though it remains about a quarter-point hike shy of the median FOMC projection (Chart 1). Chart 1It Looks Like The Fed Can Only Surprise Hawkishly Chart 2The Dots Turn More Hawkish Widening the lens to consider the entire distribution of projected rate hikes (the Fed’s dots), and considering the mean value instead of the median, the dots get slightly more ambitious, revealing that disappointingly high inflation readings would prod the committee to ramp up the pace of its 2022 hikes. Seven of the sixteen FOMC participants expect at least 200 bps of hikes in 2022, with the mean funds rate projection nudging up to 2.05% (Chart 2, top panel). The rates market has the funds rate topping out between 2½ and 2⅝%, about one 25-bps hike below the average participant’s 2.81% and 2.75% year-end 2023 (Chart 2, middle panel) and 2024 (Chart 2, bottom panel) projections. With five FOMC voters expecting a terminal rate of 3% or above, there is scope for an upside surprise if inflation comes in hotter or lasts longer than anticipated. The other changes in the Summary of Economic Projections related to the committee’s GDP and inflation outlook. Participants marked down their median real 2022 GDP growth projection to 2.8% from 4% while increasing their headline and core PCE price index projections about one-and-a-half percentage points to 4.3% and 4.1%, respectively. 2023 and 2024 real GDP growth forecasts were unchanged while inflation expectations were bumped a little higher. The FOMC’s outlook has dimmed slightly, though it is still calling for a soft landing with the economy growing at an above-trend rate and supporting full employment while inflation eases to near its target level. You Can’t Get There From Here Any central bank’s long-run projections will show the economy moving toward its desired target conditions. One probably wouldn’t toil as a central banker if s/he didn’t think the bank’s tools would work and couldn’t say it out loud (even when voting anonymously) if s/he doubted that they might. An investor should therefore never place too much stock in the FOMC’s projections for key economic indicators two and three years out. “[A]ppropriate[ly] firming … monetary policy” is easier said than done, even in the best of times. Related Report US Investment StrategyThe Last Line Of Inflation Defense (Is Holding Fast) The combination of monetary and fiscal largesse almost certainly staved off a COVID recession, at the cost of fostering some asset-market excesses while quite possibly overstimulating aggregate demand over the intermediate term. The Fed is now left to confront the aftermath with blunt policy tools that work with long and variable lags. It is always a tall order to steer an economy smoothly through the ups and downs of the business cycle; sticking the landing after the pandemic’s emergency monetary and fiscal routines involves a much higher degree of difficulty. Chair Powell put on a brave face in his post-meeting press conference, but he and his colleagues are embarking on this rate hiking cycle under less-than-ideal conditions. “In hindsight, yes, it would have been appropriate to move [to hike rates] earlier. … No one wants to have to put really restrictive monetary policy on in order to get inflation back down. So, frankly, [we] need … [to] … get rates back up to more neutral levels as quickly as we practicably can and then mov[e] beyond [neutral], if [it] turns out to be appropriate.” Bottom Line: Having to move as quickly as is practicable implies that the committee and financial markets might be in for some white-knuckle moments in the months ahead. Soft landings are more common in theory than in practice and it will be especially hard to pull one off now. A Recession Is Not Likely … A narrow margin for error does not mean the Fed is walking a tightrope over two negative extremes, however, and we believe the risks of a growth shortfall are modest. We share Powell’s view that “the probability of a recession within the next year is not particularly elevated.” Aggregate demand is strong and will be supported by households’ and businesses’ fortified balance sheets while the labor market has strength to burn. We think the chair had it just right when he said, “all signs are that this is a strong economy and, indeed, one that will be able to flourish … in the face of less accommodative monetary policy.” Our simple recession indicator, built from components that have reliably provided advance warning, reinforces Powell’s conclusion. The 3-month/10-year segment of the yield curve is not yet close to inverting1 (Chart 3). The year-over-year change in the Conference Board’s Leading Economic Index is way above the zero line that has signaled past recessions (Chart 4). The fed funds rate is nowhere near its equilibrium/neutral level, which we judge to be north of 3%, and it is highly unlikely to get there by the end of the year (Chart 5). Ex-the pandemic, recessions over the last 50-plus years have only occurred when all three components sound the alarm; not one is flashing red now and not one is likely to do so during 2022. Chart 3Recessions Occur When The Yield Curve Inverts, ... Chart 4... The Year-Over-Year Change In The LEI Turns Negative ... Chart 5... And The Target Fed Funds Rate Is Above Its Equilibrium Level … But Inflation Is A Pressing Concern The Fed is right to take action to try to stem inflation, which has found especially fertile soil. Extraordinary monetary and fiscal stimulus have given demand a persistent tailwind; social distancing funneled spending to goods while rolling global COVID surges slowed production and hampered transport, crimping supply; and domestic COVID infections limited labor force participation, tightening the labor market and exerting upward pressure on wages. Just when COVID was finally relaxing its grip, Russia invaded Ukraine, taking major sources of crude oil, natural gas, wheat, corn and several base metals offline while creating new cargo and shipping bottlenecks. The Omicron variant’s emergence in China could bring new supply disruptions. The upshot is that the Ukraine invasion and COVID’s Asian revival could keep inflation elevated, obscuring mitigating factors like a consumption shift from goods to services (Chart 6), diminishing shipping backlogs (Chart 7), increasing labor force participation and more forgiving year-over-year comparisons (base effects). Upside inflation surprises could open the door to a faster pace of rate hikes than markets have already discounted, especially if stubbornly high inflation begins to push up longer-run inflation expectations. Despite their recent rise, long-run expectations remain well anchored for now (Chart 8), while households’ sizable savings cushion better positions them to withstand higher prices. Chart 6A Transitory Inflation Catalyst Chart 7Shipping Bottlenecks Had Been Easing Chart 8Long-Run Inflation Expectations Are Still Manageable Financial Market Impacts Equities took heart from Powell’s talk of the Fed’s commitment to prevent high inflation from becoming entrenched, but his comments were not uniformly reassuring. He specifically called out the red-hot labor market, a key pillar of the favorable growth outlook, as a source of concern. “[I]f you take a look … at today’s labor market, what you have is 1.7-plus job openings for every unemployed person (Chart 9). So that’s a very, very tight labor market, tight to an unhealthy level, I would say.” The Phillips Curve trade-off between growth and inflation still applies after all, but after a dozen years when policymakers and investors were able to ignore it, equity multiples, credit spreads and Treasury yields may no longer account for it. They seem to still be discounting a have-your-cake-and-eat-it-too environment in which growth, even when it’s above trend, is continuously goosed by accommodative policy. Chart 9Too Tight For The Fed Chair There’s also the issue that the Fed’s tools are not suited to fine-tuning economic outcomes. One does not have to be a card-carrying Austrian to harbor some skepticism about central bankers' ability to make targeted tweaks. “[I]n principle, … the idea is we’re trying to better align demand and supply[.] [I]n the labor market, … if you were just moving down the number of job openings so that they were more like one to one, you would have less upward pressure on wages. You would have a lot less of a labor shortage. … And basically across the economy, we’d like to slow demand so that it’s better aligned with supply. … Of course, the plan is to restore price stability while also sustaining a strong labor market. That is our intention, and we believe we can do that. But we have to restore price stability.” It’s a happy circumstance when attaining a goal doesn’t involve a sacrifice, but no pain, no gain is adulthood’s default condition. To paraphrase Powell’s press conference guidance, price stability with full employment would be really nice, but if push comes to shove, price stability has to take precedence. The tight monetary policy needed to restore lost price stability would constitute a major headwind for risk assets and the economy. It would spell the end of the equity and credit bull markets while ushering in the next recession. It is our view that the perception that price stability sacrifices are inevitable is still far away enough that risk assets have roughly nine to twelve good months ahead of them, although we hold it with less conviction than we did before Russia attacked Ukraine and Omicron reached China. Both events have the potential to hasten the end of monetary accommodation and drive investors to reconsider their terminal (peak) fed funds rate expectations. We do not expect that investors will revisit their terminal rate expectations until they can glean some empirical evidence of how the economy behaves when the funds rate exceeds 2.25%. If it takes the FOMC at least a year to get to that level, we expect that any major repricing of longer-term Treasury yields is over a year away. The bottom line is that we remain constructive on financial markets and the US economy over our six-to-twelve-month cyclical timeframe, but the clock is ticking and European fighting and Asian COVID infections are threats to our view. We believe that the decline in equity prices and the widening of high-yield credit spreads adequately compensate investors for the increased potential pitfalls, but we remain vigilant and are maintaining our tactically cautious ETF portfolio positioning until some of the clouds lift. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 We use the 3-month/10-year segment instead of the more common 2-year/10-year because the 3-month bill is a cleaner proxy for short rates than the 2-year note, which embeds estimates of the Fed’s future actions. 2s/10s also fail to measure up empirically, inverting even earlier than the habitually premature 3-month/10-year.
Executive Summary Ebbing Stagflation Fear Will Prompt Rerating European inflation will rise further before peaking this summer. Core CPI will reach between 2.8% and 3.2% by year-end before receding. The combination of stabilizing growth and the eventual peak in inflation will cause stagflation fears to recede. European assets have greater upside. Cyclicals, small-caps, and financials will be major beneficiaries of declining stagflation fears. The underperformance of UK small-cap stocks is nearing its end. UK large-cap equities are a tactical sell against Eurozone and Swedish shares. TACTICAL INCEPTION DATE RETURN SINCE INCEPTION (%) COMMENT EQUITIES Buy European & Swedish Equities / Sell UK Large Caps Stocks 03/21/2022 Bottom Line: Stagflation fears are near an apex as commodity inflation recedes. A peak in these fears will allow European asset prices to perform strongly over the coming quarters. Despite a glimmer of hope that Ukraine and Russia may find a diplomatic end to the war, the reality on the ground is that the conflict has intensified. Although the hostilities are worsening and the European Central Bank (ECB) surprised the markets with its hawkish tone, European assets have begun to catch a bid. The crucial question for investors is whether this rebound constitutes a new trend or a counter-trend move? Our view about Europe is optimistic right now. The path is not a direct line upward. The recent optimism about the outcome of the Russia-Ukraine talks is premature; however, we are getting to the point when markets are becoming desensitized to the war and energy prices are losing steam. Moreover, the increasing number of statements by Chinese economic authorities pointing toward greater stimulus and support to alleviate the pain created by China’s stringent zero-COVID policy are another positive omen. Higher Inflation For Some Time European headline inflation is set to exceed 7% this summer and core CPI will increase between 2.8% and 3.2% by the end of 2022. Related Report European Investment StrategySpring Stagflation The main force that will push inflation higher in Europe remains commodity prices. Energy inflation is extremely strong at already 32% per annum (Chart 1). It will increase further because of both the recent jump in Brent prices to EUR122/bbl on March 8 and the upsurge in natural gas prices, which were as high as EUR212/MWh on the same day before settling to EUR106/MWh last Friday. The impact of energy prices will not be limited to headline inflation and will filter through to core CPI (Chart 1, bottom panel). The average monthly percentage change in the Eurozone core CPI inflation stands at 0.25% for the past six months (compared to an average of 0.09% over the past ten years), or the period when energy-prices inflation has been the strongest. Assuming monthly inflation remains at such an elevated level, annual core CPI will hit 3.3% in the Eurozone by the end of 2022 (Chart 2). Chart 2Core CPI to Rise Further Chart 1Energy Inflation: Alive And Well The picture is not entirely bleak. Many forces suggest that these inflationary forces will recede before year-end in Europe. Energy prices are peaking, which is consistent with a diminishing inflationary impulse from that space. We showed two weeks ago that the massive backwardation of oil curves, the heavy bullish sentiment, and the high level of risk-reversals were consistent with a severe but transitory adjustment in the energy market. Oil markets will experience further volatility, as uncertainty around peace/ceasefire negotiations continues to evolve in Ukraine. Nonetheless, the peak in energy prices has most likely been reached. BCA’s energy strategists expect Brent to average $93/bbl in 2022 and in 2023. The potential for a decline in headline CPI after the summer is not limited to energy prices. Dramatic moves in the commodity market, from metals to agricultural resources, have made headlines. Yet, the rate of change of commodity prices is decelerating, hence, the commodity impulse to inflation is slowing sharply. As Chart 3 shows, this is a harbinger of a slowdown in European headline CPI. Related Report European Investment StrategyFallout From Ukraine Looking beyond commodity markets, the recent deceleration in European economic activity also suggests weaker inflation in the latter half of 2022. Germany will likely suffer a recession because it already registered a negative GDP growth in Q4 2021. Q1 2022 growth will be even worse because of the country’s high exposure to both China and fossil fuel prices. More broadly, the recent deceleration in the rate of change of both the manufacturing and services PMIs is consistent with an imminent peak in the second derivative of goods and services CPI (Chart 4). Chart 3Commodity Impulse Is Peaking Chart 4Inflation's Maximum Momentum Is Now Underlying drivers of inflation also remain tame in Europe. European negotiated wages are only expanding at a 1.5% annual rate, which translates into unit labor costs growth of 1% (Chart 5). This contrast with the US, where wages are expanding at a 4.3% annual rate. A peak in inflation, however, does not mean that CPI readings will fall below the ECB’s 2% threshold anytime soon. The European economy continues to face supply shortages that the Ukrainian conflict exacerbates (Chart 6). Moreover, the recent wave of COVID-19 in China increases the risk of disruptions in supply chains, as highlighted by the closure of Foxconn factories in Shenzhen. Finally, inflation has yet to peak; mathematically, it will take a long time before it falls back below levels targeted by Frankfurt. Chart 5The European Labor Market Is Not Inflationary Chart 6Not Blemish-Free Bottom Line: European headline inflation will peak this summer, probably above 7%. Additionally, core CPI is likely to reach between 2.8% and 3.2% in the second half of 2022. As a result of a decline in the commodity impulse, inflation will decelerate afterward, but it will remain above the ECB’s 2% target for most of 2023. Hopes For Growth Two weeks ago, we wrote that Europe was facing a stagflation episode in the coming one to two quarters, but that, ultimately, economic activity will recover well. Recent evidence confirms that assessment. Chart 7A Coming Chinese Tailwind? The tone of Chinese policymakers is becoming more aggressive, in favor of supporting the economy. On March 16, Vice-Premier Liu He highlighted that Beijing was readying to support property and tech shares and that it will do more to stimulate the economy. True, this response was made in part to address the need to close cities affected by the sudden spike of Omicron cases around China. Nonetheless, the global experience with Omicron demonstrates that, as spectacular and violent the surge in cases may be, it is short-lived. Meanwhile, the impact of stimulus filters through the economy over many months. As a result, Europe will experience the impact of China’s Omicron-induced slowdown, while it also suffers from the growth-sapping effects of the Ukrainian conflict; however, it will also enjoy the positive effect on growth of a rising credit impulse over several subsequent quarters (Chart 7). Beyond China, the other themes we have discussed in recent weeks remain valid. First, European fiscal policy will become looser, as governments prepare to fight the slowdown caused by the war, while also increasing infrastructure spending to wean Europe off Russian energy. Moreover, European military spending is well below NATO’s 2% objective. This will not remain the case, as military expenditure may leap from less than EUR100bn per year to nearly EUR400bn per year over the coming decade. Second, European spending on consumer durable goods still lags well behind the trajectory of the US. With the energy drag at its apex today, consumer spending on durable goods will be able to catch up in the latter half of the year, especially with the household savings rate standing at 15% or 2.5 percentage points above its pre-COVID level. Bottom Line: European growth will be very low in the coming quarters. Germany is likely to face a technical recession as Q1 2022 data filters in. Nonetheless, Chinese stimulus, European fiscal support, pent-up demand, and a declining energy drag will allow growth to recover in the latter half of the year. As a result, we agree with the European Commission estimates that European growth will slow markedly this year. Market Implications In the context of a transitory shock to European economic activity and a coming peak in inflation, European stock prices have likely bottomed. Chart 8Depressed Sentiment To Help Beta Sentiment has reached levels normally linked with a durable market floor. The NAAIM Exposure Index has fallen to a point from which global markets often recover. Europe’s high beta nature increases the odds that European equities will greatly benefit in that context (Chart 8). Valuations confirm that sentiment toward European assets has reached a capitulation stage. The annual rate of change of the earnings yields in the earnings yields has hit 73%, which is consistent with a market bottom (Chart 9). More importantly, the change in European forward P/E tracks closely our European Stagflation Sentiment Proxy (ESSP), based on the difference between the Growth and Inflation Expectations’ components of the ZEW survey (Chart 10). For now, our ESSP indicates that stagflation fears in Europe have never been so widespread, but these fears will likely dissipate as energy inflation declines. This process will lift European earnings multiples. Chart 9Bad News Discounted? Chart 10Ebbing Stagflation Fear Will Prompt Rerating Earnings revisions will likely bottom soon as well. The ESSP is currently consistent with a dramatic decline in European net earnings revisions (Chart 10, bottom panel). It will take a few more weeks for lower earnings revisions to be fully reflected. However, they follow market moves and, as such, the 17% decline in the MSCI Europe Index that took place earlier this year already anticipates their fall. Consequently, as stagflation fears recede, earnings revisions will rise in tandem with equity prices. Chart 11Maximum Pressure On Corporate Spreads A decline in stagflation fears is also consistent with a decrease in European credit spreads in the coming months (Chart 11). This observation corroborates the analysis from the Special Report we published jointly with BCA’s Global Fixed-Income Strategy team last week. In terms of sectoral implications, a decline in stagflation fears is often associated with a rebound in the performance of small-cap equities relative to large-cap ones (Chart 12, top panel). This reflects the greater sensitivity of small-cap equities to domestic economic conditions compared to large-cap stocks. Moreover, small-cap equities had been oversold relative to their large-cap counterparts but now, momentum is improving (Chart 12). As a result, it is time to buy these equities. Similarly, financials have suffered greatly from the recent events associated with the Ukrainian conflict. European financial institutions have not only been penalized for their modest exposure to Russia, they have also historically declined when stagflation fears are prevalent (Chart 13). This relationship reflects poor lending activity when the economy weakens, and the risk of a policy-induced recession caused by high inflation. Financials will continue their sharp rebound as stagflation fears dissipate. Chart 13Financials Have Suffered Enough Chart 12Small-Caps Time To Shine The dynamics in inflation alone are very important. As Table 1 highlights, in periods of elevated inflation over the past 20 years, financials underperform the broad market by 11.3% on average. It is also a period of pain for small-cap equities and cyclicals. Logically, exiting the current environment will offer opportunities in European cyclical equities and for financials in particular. Table 1Who Suffers From High Inflation? Chart 14Long Industrials & Materials / Short Energy Finally, a pair trade buying industrials and materials at the expense of energy makes sense today. Materials and industrials suffer relative to energy equities when stagflation rises, especially in periods when these fears reflect rising energy pressures (Chart 14). A reversal in relative earnings revisions in favor of materials and industrials will propel this position higher. Bottom Line: Sentiment toward European assets reached a selling climax in recent weeks. Stagflation fears in Europe have reached an apex, and their reversal will lift both multiples and earnings revisions in the subsequent quarters. Diminishing stagflation fears will also boost the appeal of European corporate credit, contributing to an easing in financial conditions. Small-cap stocks, cyclicals, and financials will reap the greatest benefits from this adjustment. Going long materials and industrials at the expense of energy stocks is an attractive pair trade. Key Risk: A Policy Mistake The view above is not without risks. The number one threat to European growth and assets is a policy mistake from the ECB. On March 10, 2022, the ECB’s policy statement and President Christine Lagarde’s press conference showed that the Governing Council (GC) will decrease asset purchases faster than anticipated. Chart 15Will The ECB Repeat It Past Mistakes? It is important to keep in mind the dynamics of 2011. Back then, the ECB opted to increase interest rates as European headline CPI was drifting toward 2.6% on the back of rising energy prices. According to our ESSP, the April 2011 interest rates hike took place at the greatest level of stagflation fears recorded until the current moment (Chart 15). Lured by rising inflation, the ECB ignored underlying weaknesses in European economic activity, which wreaked havoc on European financial markets and growth. If the ECB were to increase rates as growth remains soft, a similar outcome would take place. For now, the ECB’s communications continue to de-emphasize the need for rate hikes in the near term, which suggests that the GC is cognizant of the risk created by weak growth over the coming months. Waiting until next year, when activity will be stronger and the output gap will be closed, will offer the ECB a better avenue to lift rates durably. This risk warrants close monitoring of the ECB’s communication over the coming months. If headline inflation does not peak by the summer, the ECB is likely to repeat its past error, which will substantially hurt European assets. Our optimism is tempered by this threat. UK Outperformance Long In The Tooth? Last week, the Bank of England (BoE) increased the Bank Rate by 25bps to 0.75%, in a move that was widely expected. Yet, the pound fell 0.7% against the euro and gilt yields fell 6 bps. This market reaction reflected the BoE’s choice to temper its forward guidance. The central bank is now expected to increase interest rates to 2.2% next year, before they decline in 2024. The dovish projection of the BoE shows the MPC’s concerns over the impact of higher energy costs and rising National Insurance contributions on household spending. In the BoE’s opinion, the economy is very inflationary right now, but it will slow, which will mitigate the inflationary impact down the road. We share the BoE’s worries about the UK’s near-term economic outlook. The combination of higher taxes, higher interest rates, and rising energy costs will have an impact on growth. However, the rapid decline in small-cap stocks, which have massively underperformed their large cap-counterparts, already discounts considerable bad news (Chart 16). Additionally, small-cap equities relative to EPS have begun to stabilize, while relative P/E and price-to-book ratios have also corrected their overvaluations. In this context, UK small-cap equities are becoming attractive. Chart 17UK vs Eurozone: A Stagflation Bet Chart 16UK Small-Cap Stocks Have Purged Their Excesses In contrast to small-cap stocks, UK large-cap equities have greatly benefited from the global stagflation scare. The UK large-cap benchmark had the right sector mix for the current environment, overweighting defensive names as well as energy and resources. It is likely that when stagflation fears recede, UK equities will undo their outperformance (Chart 17). Technically, UK equities are massively overbought against Euro Area and Swedish stocks, both of which have been greatly impacted by stagflation fears and their pro-cyclical biases (Chart 18 & 19). An attractive tactical bet will be to sell UK large-cap stocks while buying Eurozone and Swedish equities, as energy inflation declines and as China’s stimulus boosts global industrial activity in the latter half of 2022 Bottom Line: Move to overweight UK small-cap stocks within UK equity portfolios. Go long Euro Area and Swedish equities relative to UK large-cap stocks as a tactical bet. Chart 18UK Overbought Relative To Euro Area... Chart 19… And Sweden Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades
Executive Summary Investors Think The Fed Will Not Be Able To Raise Rates Much Above 2% The neutral rate of interest is 3%-to-4% in the United States. This is substantially higher than the market estimate of around 2%. It is also higher than the central tendency range for the Fed’s terminal interest rate dot, which remained at 2.3%-to-2.5% following this week’s FOMC meeting. If the neutral rate turns out to be higher than expected, this is arguably good news for stocks over the short-to-medium term because it lowers the risk that the Fed will accidentally induce a recession this year by bringing rates into restrictive territory. Over a longer-term horizon of 2-to-5 years, however, a higher neutral rate is bad news for stocks because it means that investors will eventually need to value equities using a higher discount rate. It also means that the Fed could find itself woefully behind the curve in normalizing monetary policy. Bottom Line: Global equities will rise over the next 12 months as the situation in Ukraine stabilizes, commodity prices recede, and inflation temporarily declines. Stocks will peak in the second half of 2023 in advance of a second, and currently unexpected, round of Fed tightening beginning in late-2023 or 2024. Dear Client, Instead of our regular report next week, we will be sending you a Special Report written by Matt Gertken, BCA Research’s Chief Geopolitical Strategist, discussing the geopolitical implications of the war in Ukraine. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. As always, I will hold a webcast discussing the outlook the week after, on Thursday, April 7th. Best regards, Peter Berezin Chief Global Strategist https://www.linkedin.com/in/peter-berezin-1289b87/ https://twitter.com/BerezinPeter A Two-Stage Fed Tightening Cycle The FOMC raised rates by 25 basis points this week, the first of seven rate hikes that the Federal Reserve has telegraphed in its Summary of Economic Projections for the remainder of 2022. We expect the Fed to follow through on its planned rate hikes this year, but then go on pause in early-2023, as inflation temporarily comes down. However, the Fed will resume raising rates in late-2023 or 2024 once inflation begins to reaccelerate and it becomes clear that monetary policy is still too easy. This second round of monetary tightening is currently not anticipated by market participants. If anything, investors think the Fed is more likely to cut rates than raise rates towards the end of next year (Chart 1). The Fed’s own views are not that different from the markets’: The central tendency range for the Fed’s terminal interest rate dot remained at 2.3%-to-2.5% following this week’s FOMC meeting, with the median dot actually ticking lower to 2.4% from 2.5% (Chart 2). Chart 2The Fed Is Still In The Secular Stagnation Camp A Higher Neutral Rate Our higher-than-consensus view of where US rates will eventually end up reflects our conviction that the neutral rate of interest is somewhere between 3% and 4%. One can think of the neutral rate as the interest rate that equates the amount of investment a country wants to undertake at full employment with the amount of savings that it has at its disposal.1 Anything that reduces savings or increases investment would raise the neutral rate (Chart 3). As we discussed last month, a number of factors are likely to lower desired savings in the US over the next few years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and the receipt of generous government transfer payments (Chart 4). Household wealth has soared since the start of the pandemic (Chart 5). Conservatively assuming that households spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by nearly 4% of GDP. Chart 5Net Worth Has Soared Since The Pandemic The household deleveraging cycle has ended (Chart 6). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. Banks are easing lending standards on consumer loans across the board. Baby boomers are retiring. They hold over half of US household wealth, considerably more than younger generations (Chart 7). As baby boomers transition from savers to dissavers, national savings will decline. Chart 6US Household Deleveraging Pressures Have Abated Chart 7Baby Boomers Have Amassed A Lot Of Wealth Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 8). On the investment front: The deceleration in trend GDP growth, which depressed investment spending, has largely run its course.2 According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today. The CBO expects potential growth to edge down only slightly to 1.7% over the next few decades (Chart 9). Chart 8Fiscal Policy: Tighter But Not Tight Chart 9Much Of The Deceleration In Potential Growth Has Already Happened After moving broadly sideways for two decades, core capital goods orders – a leading indicator for capital spending – have broken out to the upside (Chart 10). Capex intention surveys remain upbeat (Chart 11). The average age of the nonresidential capital stock currently stands at 16.3 years, the highest since 1965 (Chart 12). Chart 10Positive Signs For Capex (I) Similar to nonresidential investment, the US has been underinvesting in residential real estate (Chart 13). The average age of the housing stock has risen to a 71-year high of 31 years. The homeowner vacancy rate has plunged to the lowest level on record. The number of newly finished homes for sale is half of what it was prior to the pandemic. Chart 11Positive Signs For Capex (II) Chart 12An Aging Capital Stock Chart 13Housing Is In Short Supply The New ESG: Energy Security and Guns The war in Ukraine will put further pressure on the neutral rate, especially outside of the United States. Chart 14European Capex Should Recover After staging a plodding recovery following the euro debt crisis, European capital spending received a sizable boost from the launch of the NextGenerationEU Recovery Fund (Chart 14). Capital spending will rise further in the years ahead as European governments accelerate efforts to make their economies less reliant on Russian energy. Meanwhile, European governments are trying to ease the burden from rising energy costs. France has introduced a rebate on fuel starting on April 1st. It is part of a EUR 20 billion package aimed at cutting heating and electricity bills. Other countries are considering similar measures. European military spending will also rise. Germany has already announced that it will spend EUR 100 billion more on defense. European governments will also need to boost spending to accommodate potentially several million Ukrainian refugees. A Smaller Chinese Current Account Surplus? Chart 15Will China Be A Source Of Excess Savings? The difference between what a country saves and invests equals its current account balance. Historically, China has been a major exporter of savings, which has helped depress interest rates abroad. While China’s current account surplus has declined as a share of its own GDP, it has remained very large as a share of global ex-China GDP, reflecting China’s growing weight in the global economy (Chart 15). Many analysts assume that China will double down on efforts to boost exports in order to offset the drag from falling property investment. However, there is a major geopolitical snag with that thesis: A country that runs a current account surplus must, by definition, accumulate assets from the rest of the world. As the freezing of Russia’s foreign exchange reserves demonstrates, that is a risky proposition for a country such as China. Rather than increasing its current account surplus, China may seek to bolster its economy by raising domestic demand. This could be achieved by either boosting domestic investment on infrastructure and/or consumption. Notably, the IMF’s latest projections foresee China’s current account surplus falling by more than half between 2021 and 2026 as a share of global ex-China GDP. If this were to happen, the neutral rate in China and elsewhere would rise. The Path to Neutral: The Role of Inflation If one accepts the premise that the neutral rate in the US is higher than widely believed, what will the path to this higher rate look like? The answer hinges critically on the trajectory of inflation. If inflation remains stubbornly high, the Fed will be forced to hike rates by more than expected over the next 12 months. In contrast, if inflation comes down rapidly, then the Fed will be able to raise rates at a more leisurely pace. As late as early February, one could have made a strong case that US inflation was set to fall. The demand for goods was beginning to moderate as spending shifted back towards services. On the supply side, the bottlenecks that had impaired goods production were starting to ease. Chart 16 shows that the number of ships anchored off the coast of Los Angeles and Long Beach has been trending lower while the supplier delivery components of both the ISM manufacturing and nonmanufacturing indices had come off their highs. Since then, the outlook for inflation has become a lot murkier. As we discussed last week, the war in Ukraine is putting upward pressure on commodity prices, ranging from energy, to metals, to agriculture. BCA’s geopolitical team, led by Matt Gertken, expects the war to worsen before a truce of sorts is reached in a month or two. Meanwhile, a new Covid wave is gaining momentum. New daily cases are rising across Europe and have exploded higher in parts of Asia (Chart 17). In China, the number of new cases has reached a two-year high. The government has already locked down parts of the country encompassing 37 million people, including Shenzhen, a major high-tech hub adjoining Hong Kong. Chart 17Covid Cases Are On The Rise Again In Some Countries Most new cases in China and elsewhere stem from the BA.2 subvariant of Omicron, which appears to be at least 50% more contagious than Omicron Classic. Given its extreme contagiousness, China may be forced to rely on massive nationwide lockdowns in order to maintain its zero-Covid strategy. While such lockdowns may provide some relief in the form of lower oil prices, the overall effect will be to worsen supply-chain disruptions. Watch For Signs of a Wage-Price Spiral As the experience of the 1960s demonstrates, the relationship between inflation and unemployment is inherently non-linear: The labor market can tighten for a long time with little impact on prices and wages, only for a wage-price spiral to suddenly develop once unemployment falls below a certain threshold (Chart 18). Chart 18A Wage-Price Spiral Was Ignited By Very Low Unemployment Levels In The 1960s Chart 19Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution For the time being, a wage-price spiral does not appear imminent. While wage growth has picked up, most of the increase in wages has occurred at the bottom end of the income distribution (Chart 19). Chart 20More Low-Wage Employees Should Return To Work Low-wage workers have not returned to the labor force to the same extent as higher-wage workers (Chart 20). However, now that extended unemployment benefits have lapsed and savings deposits are being drawn down, the incentive to resume work will strengthen. An influx of workers back into the labor market will cap wage growth, at least for this year. Long-Term Inflation Expectations Still Contained A sudden increase in long-term inflation expectations can be a precursor to a wage-price spiral because the expectation of higher prices can induce consumers to shop now before prices rise further, while also incentivizing workers to demand higher wages. Reassuringly, long-term inflation expectations have not risen that much. Expected inflation 5-to-10 years out in the University of Michigan survey registered 3.0% in March, down a notch from 3.1% in February (Chart 21). While the widely followed 5-year, 5-year forward TIPS inflation breakeven rate has climbed to 2.32%, it is still at the bottom of the Fed’s comfort zone of 2.3%-to-2.5% (Chart 22).3 Chart 21Long-Term Inflation Expectations Remain Contained (I) Chart 22Long-Term Inflation Expectations Remain Contained (II) Chart 23The Magnitude Of Damage Depends On How Long The Commodity Price Shock Lasts Moreover, the jump in market-based inflation expectations since the start of the war in Ukraine has been fueled by rising oil prices. The forwards are pointing to a fairly pronounced decline in the price of crude and most other commodity prices over the next 12 months (Chart 23). If that happens, inflation expectations will dip anew. Investment Implications The neutral rate of interest is higher in the United States than widely believed. A higher neutral rate is arguably good for stocks over the short-to-medium term because it lowers the risk that the Fed will accidentally induce a recession this year by bringing rates into restrictive territory. Over a longer-term horizon of 2-to-5 years, however, a higher neutral rate is bad news for stocks because it means that investors will eventually need to value stocks using a higher discount rate. It also means that the Fed could find itself woefully behind the curve in normalizing monetary policy. While the war in Ukraine and yet another Covid wave could continue to unsettle markets for the next month or two, global equities will be higher in 12 months than they are now. With inflation in the US likely to temporarily come down in the second half of the year, bond yields probably will not rise much more this year. However, yields will start moving higher in the second half of next year as it becomes clear that policy rates still have further to rise. The bull market in stocks will end at that point. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 These savings can either by generated domestically or imported from abroad via a current account deficit. 2 Theoretically, there is a close relationship between trend growth and the equilibrium investment-to-GDP ratio. For example, if real trend growth is 3% and the capital stock-to-GDP ratio is 200%, a country would need to invest 6% of GDP net of depreciation to maintain the existing capital stock-to-GDP ratio. In contrast, if trend growth were to fall to 2%, the country would only need to invest 4% of GDP. 3 The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. View Matrix Special Trade Recommendations Current MacroQuant Model Scores