Developed Countries
Executive Summary The sharp slide in the S&P 500 forward multiple has been painful, but it's only two-thirds of the way to its 1987 and 2002 declines. The inverse correlation between interest rates and the index P/E multiple is well established; if rates stop backing up, the multiple will stop being squeezed. Stocks would really be in trouble if their gains had entirely been a function of multiple inflation, but earnings growth has done the heavy lifting since 2008. Earnings growth will likely decelerate over the rest of the year, but it will remain a tailwind. A model regressing the index's forward multiple against a proprietary measure of inflation expectations and consumer perceptions of the labor market does a good job of explaining past valuation moves. If inflation has peaked and labor demand remains strong, multiples may be able to retrace some of their losses. De-Rating May Have Gone A Little Too Far Bottom Line: Although the 23% de-rating in equity valuations has been severe, it is not unprecedented – larger declines occurred in 1987 and 2002. While we estimate that the forward multiple’s fair value is one or two points above its current level, there is no timetable for when the actual multiple will return to it. Feature Our client conversations over the last few weeks have ultimately found their way to the issue that is front of mind for nearly all investors: Is the equity selloff almost finished, and how far will it go if it’s not? When analyzing equity performance, we find it useful to decompose the S&P 500 into expected earnings and the multiple investors are willing to pay for them. Solid full-year US growth remains our base-case scenario, even if our conviction has declined as inflation has bounded higher, Russia’s invasion of Ukraine has turbo-charged geopolitical tensions while crimping commodity supplies, and China’s response to its COVID surge threatens to undo tentative supply-chain progress. We therefore view moves in the S&P 500’s forward P/E multiple as the key swing factor. This report gathers our responses to several client questions that touch on multiples and presents some new research related to them. Our goal is to bring some fresh insights to the discussion while encouraging more clients to engage with it. Previous De-Rating Episodes Multiples have lost a lot of ground in a short period of time. Is there any precedent for what we’ve seen so far this year? Reliable consensus earnings estimates have only been compiled since 1979, so the entire history of forward multiple data is confined to the last 40-plus years. Over that timeframe, there have been two other periods when the month-end index multiple fell at least as much over a similarly brief stretch (Chart 1, top panel). The first occurred in 1987, when the forward multiple fell five points from 14.8 at the end of August to 9.8 at the end of November, a stunning three-month 33% valuation haircut that largely unfolded during Black Monday’s single-session bear market. The second occurred as the bear market that followed the dotcom bust careened to its conclusion, with the forward multiple again falling by a third, from 21.6 at year-end 2001 to 14.5 at the end of September 2002. Chart 1Multiples Can Reverse Suddenly The year-to-date decline of just under five multiple points, from 21.6 at year-end to 16.7 as of Wednesday’s close, has amounted to a 23% valuation adjustment in four-and-a-half months that has driven the index 18% lower. In standardized terms, the index multiple has matched 1987 with a 1.15-standard-deviation tumble, but it is still a half of a standard deviation shy of 2002’s swoon (Chart 1, bottom panel). The multiple’s 1.5-standard-deviation slide from its August 2020 month-end peak is a full standard deviation less than the 2.5-standard-deviation peak-to-trough flogging it endured during the dotcom bust. Bottom Line: The current selloff has been severe, but it is not unprecedented. Multiples can compress swiftly, especially when they are as elevated as they have been since stocks bottomed amidst the initial shock of the pandemic. Matching 1987's and 2002's 33% haircuts would involve lopping off another two multiple points and knocking the index down to the low 3,400s. Multiples And Interest Rates The history is scary. 3,400 would take us right back to where we were before the vaccines arrived and wipe out a year and a half of gains, but I take some comfort from still-low interest rates. Stocks may not be cheap relative to the whole 43-year history, but am I wrong to think they look pretty appealing given a 3% 10-year Treasury yield? Related Report US Investment StrategyQ&A About Rate Hikes And Stocks Interest rates provide the means for discounting future cash flows back to their present value and the theoretical link between multiples and interest rates is rock solid. When long-dated Treasury yields fall, the present value of a company’s future earnings rises, all else equal, and when yields rise, present value falls. All is not equal, of course, and earnings are prone to moving with interest rates, but the inverse relationship between interest rates and the present value of a fixed series of future cash flows is as constant as the tides. The empirical history shows that the theory holds up in the real world. The inverse relationship between S&P 500 forward multiples and 10-year Treasury yields is robust, with the level of yields explaining 46% of the variation in S&P 500 valuations since the forward multiple series began (Chart 2, top panel). The simple regression fit is undermined by the circled cluster of outlying observations with yields between 4.5 and 6.75% and forward multiples of 18 and above, all of which occurred between January 1997 and May 2002, when the dotcom mania severed the link between valuations and rates. When those observations are removed, the relationship becomes even stronger, with the level of yields explaining 69% of the variation in S&P 500 valuations (Chart 2, bottom panel). Chart 2When Rates Zig, Multiples Zag Removing the dotcom observations from the datasets highlights the variability of forward valuations within the 0.5-4% range of Treasury yields that has prevailed since 2008. The observations well below the best-fit regression line occurred soon after the onset of the global financial crisis, when a growth shortfall loomed as the biggest threat and deflation was a plausible outcome. The observations well above the best-fit line were recorded since the pandemic, as the economy rode a wave of fiscal and monetary steroids whose potentially inflationary side effects were beyond the marginal price-setters’ decision horizon. We note that multiples are most likely headed back below the best-fit line if stagflation risks are perceived to grow in line with many investors’ fears. The equity risk premium (ERP), calculated as the forward earnings yield (the inverse of the forward multiple) less the real 10-year Treasury yield, offers a rosier perspective for viewing the interaction between interest rates and equity valuations. It supports the notion that equity prices are attractive, given the current yield backdrop, and draws a sharp distinction between the pandemic’s 20-plus multiples and the dotcom era’s (Chart 3). Simple regression against the 10-year Treasury yield suggests that the S&P 500 is now fairly valued, while the ERP argues that it’s somewhat cheap. Equity valuations are vulnerable to further yield backups under both approaches, however. Chart 3Compared To Bonds, Equities Are Cheap Bottom Line: Multiples deserve to be elevated, relative to their history, given that long-dated Treasury yields remain near the bottom of their historical range, but they face more de-rating pressure if yields continue to rise. What Goes Around Comes Around The de-rating that’s occurring right now shouldn’t surprise anyone who’s stopped believing in Santa Claus and the tooth fairy. The Fed has manufactured the entire post-crisis rally with zero interest rates and QE and we’re simply witnessing the inevitable unwind. How can you argue that the selloff doesn’t have further to go? We hear the manufactured/manipulated argument a lot but we do not believe that the data support it. The advance in the S&P 500 since January 1, 2008 (Chart 4, top panel) has comfortably surpassed nearly everyone’s contemporaneous expectations and we do not dispute that ample monetary accommodation played a large part in smoothing the way for the US economy’s comparatively rapid recovery. In our view, however, the boost to the economy, as proxied by the potent rise in expected S&P 500 earnings (Chart 4, middle panel), was more important than investors’ increased willingness to pay up for them (Chart 4, bottom panel). Rebasing both series to 100 as of January 1, 2008 shows that consensus earnings estimates have risen by four more times than forward multiples since the onset of the global financial crisis. A similar analysis obtains for the current pandemic era, especially now that the S&P 500’s forward multiple has dipped back below its January 1, 2020 level (Chart 5, bottom panel). The index’s annualized 9.7% return has surpassed most investors’ wildest hopes when stocks were crumbling in the middle of March 2020 (Chart 5, top panel). The gain is entirely attributable to the 12.9% annualized increase in consensus earnings expectations (Chart 5, middle panel). Lavishly generous fiscal and monetary accommodation deserves the credit for the earnings snapback. Though excessive aid may eventually cause the economy to overheat, we disagree with the idea that the pandemic rally has been built on a house of monetary stimulus cards. Chart 4Earnings Have Driven The Post-Crisis ... Chart 5... And Post-Pandemic Bull Markets An Index Valuation Model Where do you think the S&P 500’s forward multiple should be right now? Although no one should expect that any given financial instrument should trade at its fair value at any particular moment in time, it is useful to have approximate fair value estimates to gauge assets’ relative attractiveness and future return prospects. To apply some quantitative rigor to answering this question, we set out to build a regression model that would point the way to an appropriate valuation range. We started with the 10-year Treasury yield as our first independent variable and examined various inflation, equity sentiment and consumer sentiment series to discover other variables that could enhance its explanatory powers. To most nearly isolate the multiple impact, we passed over measures of economic activity for variables that would not be expected to exert an equal or greater impact on S&P 500 earnings. Inflation measures in themselves failed to contribute to the cause, but inflation expectations series proved more availing. None of the major equity sentiment surveys nor BCA’s composite sentiment indicator contributed to the other variables’ explanatory power. Consumer confidence surveys showed some promise, and the difference in the Conference Board’s Jobs Plentiful/Jobs Hard to Find series performed the best in backtests. Much to our surprise, the 10-year Treasury yield lost its statistical significance along the way and we duly jettisoned it, leaving us with a model that regressed the index forward multiple against the exponentially smoothed long-run moving average of measured inflation used by our fixed income strategists to assess Treasury fair values and the net Jobs Plentiful measure. Chart 6 shows the historical path of the S&P 500’s forward four-quarter earnings multiple and the fitted value from our regression. The backtested fit is quite good, as befits the model’s 72% r-squared. Encouragingly, the model suggests that the de-rating has gone too far. It returned an 18.5 value at the end of April, a full point above the actual 17.5 reading and nearly two points above the 16.7 multiple as of Wednesday’s close. Chart 6Estimating What The S&P 500's Forward Multiple Should Be We take any modeled point estimate with a grain of salt and are dyed-in-the-wool skeptics about any quantitative model’s persistence as a practical investment guide. We nonetheless performed this modeling exercise to provide a quantitative historical basis for estimating the fair value of the S&P 500’s forward multiple. The fact that we threw the 10-year Treasury yield overboard does not invalidate Chart 2; multiples and long-maturity yields are plainly inversely related, but our internal inflation expectations measure apparently conveys all of the 10-year yield’s information about the forward multiple’s historical moves and then some. Like every conscientious evidence-based researcher, we will go wherever the data lead us, independent of any preconceptions we might bring to a particular study. The Road Ahead When will the selloff end? We don’t know the date, the time or the level at which the equity selloff will eventually end. If our view that earnings will hold up is correct, however, the answer will turn on when the de-rating ends. The equity risk premium, a simple regression against the level of long Treasury yields and a multi-factor regression incorporating BCA’s proprietary inflation expectations model and consumers’ perceptions of the jobs market all suggest that de-rating has gotten ahead of itself. A 23% haircut over four-and-a-half months seems extreme when we think an adverse inflection point is over a year away. We have never counted on settling down with TINA, figuring that it wasn’t her nature to stick around for the long haul. Sentiment is fickle, and one day investors will discover that she’s left without a by-your-leave. Despite the upheaval so far this year, however, we think equities still hold considerable relative allure. With inflation mauling the value of cash holdings and high-duration bonds, one could argue that the alternatives to equities are even less appealing than they were when she first appeared on the scene. Our Global Investment Strategy service tactically upgraded global equities to overweight from neutral two weeks ago and we are more inclined to add equity exposure than reduce it when we revisit our ETF portfolio holdings in next week’s month-end report. There is no shortage of obvious concerns from Beijing to Moscow to Bentonville, Arkansas, but we think the factors that could go right are getting short shrift. Russian forces bogged down in eastern Ukraine are less likely to pursue expanded military adventures, reducing the potential that western Europe and the US could be drawn into a larger conflict. China’s zero-COVID policy may be doomed to futility, but headway on domestic production of an mRNA vaccine and the global ramp-up of anti-viral medication production could limit future outbreaks’ impact on the supply chain. The bottom line is that we remain constructive over the cyclical 3-to-12-month timeframe, while sharing the house view that the tactical equity outlook has improved. If the backup in bond yields has run its course for the time being, we expect that equity de-rating has as well. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com
Executive Summary Villains Still Lurking European assets and the euro already discount a significant worsening of Europe’s economic outlook. If the global economic situation were to stabilize, then European assets would be a buy at current levels. However, there remain very large risks lurking over the outlook. First, a further deterioration in energy flows between Russia and the EU is a major threat to the European economic outlook. Second, the ECB delivering the seven rate hikes priced in the June 2023 Euribor contract would be painful for the European economy. Third, further selloff in the US equity market could translate into more pain for European equities. And fourth, the weakness in the Chinese economy and aggressive monetary tightening in the broader EM space outside China are additional risks. These risks loom large enough, so that investors should avoid bottom-fishing the market. Wait until greater clarity emerges or valuations improve further. Bottom Line: Don’t be a hero. European assets and the euro are probably in the process of bottoming. However, the probability of a very significant additional decline is large enough that investors should continue to emphasize capital preservation over return maximization. Also, continue to favor defensives over cyclical assets. After declining nearly 8% since its January 2021 peak, the euro is down another 7% so far this year. Meanwhile, the Dow Jones Euro STOXX 50, which has plunged 17% since its January 5, 2022 apex, or 22% in US dollar terms, trades at 11.2 times 2023 earnings estimates. At these valuations, European assets already discount a major growth slump in Europe. Is it time to buy European assets, to favor cyclicals versus defensives, and to buy the euro? At face value, the answer is “yes,” but uncertainty abounds, which means that capital preservation remains paramount. As a result, we recommend investors avoid bottom-fishing European assets. They should wait for a safer entry point, rather than trying to pick through the market trough. Plenty Of Risks Four main risks cast a long shadow on the performance of European assets: The evolution of the energy crisis, the potential for an ECB policy mistake, the threat of a worsening US selloff, and the instability in EM. The Energy Crisis It’s official: Sweden and Finland are applying to join NATO. Turkey’s objection will create delays in the process, but it will not stop it. Turkey needs protection against Russia, and it needs help to support the lira. Turkey’s acquiescence, therefore, will be bought. What is genuinely surprising is Russia’s silence. President Putin threatened to flex Russia’s military muscles if Sweden and Finland were to abandon their neutrality. Yet, he now has “no problem” with their bid to join the alliance. We are skeptical, especially as the EU is aiming to ban Russian oil imports by the end of the year. Based on these observations, we continue to see a further deterioration in energy flows between Russia and the EU as a major threat to the European economic outlook. It is far from a guaranteed outcome, but its probability is elevated enough (more than 30%) and so impactful that any investment strategy must account for it. Chart 1Rebuilding Nat Gas Stocks Is A Must Chart 2Low-Income Households Are At Risk Moreover, European nations continue to pay a premium for their energy and are trying to rebuild their natural gas inventory ahead of winter (Chart 1). Thus, the energy market continues to carry a significant recession risk for the Eurozone. Lower-income households already spend a substantial portion of their income on utilities and transportation costs, and their consumption is highly sensitive to the evolution of energy prices (Chart 2). A Policy Mistake We consider a rate hike in July a policy mistake, but it would be a true error if the ECB ratified the pricing currently embedded in the €STR curve (Chart 3). Why would a rate hike constitute a policy mistake? The EU’s inflation spike is not a reflection of strong domestic demand. It reflects foreign factors over which the ECB has no control. Energy prices drive European inflation and are passing-through to core CPI (Chart 4). Yet, wage growth remains tepid at 2.6%. Hiking rates will not bring about the additional energy supply Europe needs to tame inflation. Chart 3Too Far Too Fast Chart 4European Inflation Is Energy inflation Chart 5The US Is Lifting Prices Around The World Even the analysis of the ECB is conflicted. On May 11, Executive Board Member Isabel Schnabel highlighted the need for an imminent interest rate hike, yet she also underscored the global nature of the current inflation outbreak. Goods prices in Europe not only reflect higher input costs, but they also bear the imprint of the excess demand in the US, which is lifting the price of goods prices around the world (Chart 5). However, an ECB rate hike will do little to tame US demand for manufactured goods. In the monetary policy realm, only aggressive tightening by the Fed will have the desired effect, which will trickle down to lower European inflation. Thus, European interest rate hikes will accentuate consumption weaknesses already visible across the region more than they will slow inflation. While a few rate hikes will not have a major impact, the seven rate hikes priced in the June 2023 Euribor contract would be disastrous as long as Europe is hamstrung by the current relative price shock. We remain long this contract. Worsening US Equity Selloff Investors seem to be waking up to the reality that US consumers are facing the same difficult predicament as European consumers: rising energy and food prices and contracting real incomes. The recent earnings call by Walmart was a shock that caused an 8% drubbing for consumer staples and a 7% fall in consumer discretionary equities. Until US inflation clearly peaks, investors will have to evaluate how much deeper the pain for consumers may run. Moreover, since consumers have begun to cut their discretionary spending in response to strained budgets, the ability of firms to pass on rising input costs is dwindling. Hence, investors will have to handicap the risks to margins as well. Chart 6Fed Put Not Exercised US inflation also impacts the Fed’s outlook. Until inflation has decelerated for a few months, the Fed will remain comfortable with tighter financial conditions. This means that the strike price of the so-called Fed put is inversely proportional to inflation, especially since FCIs are far from tight (Chart 6). As a result, inflation or energy prices must soften before the Fed can begin to send comforting signals to the market. Chart 7Where Walmart Goes, So Does The Market? The US market has cheapened significantly, and a floor should be close; but the risks remain considerable. A very smart investor with whom we regularly chat highlighted that we have not yet seen a full-fledged liquidation. Only once energy stocks have also been purged will the necessary condition for a bottom be met (since only then will all the speculative activity have been cleared). In fact, the recent poor performance of Walmart highlights the risk that the S&P 500 could suffer one last down leg to 3500, since over the past 12 years, WMT often leads the SPX (Chart 7). Another 300 points decline in the US benchmark could translate into significant selling pressure in the Euro STOXX, because it sports an elevated beta. EM Instability EM are still facing ample risks, which could easily dislodge the prospects of European firms servicing these economies. As a result, EM constitute another major threat for European equities. Chart 8Less COVID In Shanghai and Jilin The outlook for China remains fraught with risks. National COVID cases are declining as a result of the collapse in cases in the Shanghai and Jilin provinces (Chart 8). However, Omicron is spreading around the nation, with broadening lockdowns in Beijing and Tianjin. The one certainty is that the Chinese Communist Party remains wedded to its zero-COVID policy. Considering the size of the country and how contagious the various Omicron variants are, rolling lockdowns and their deleterious impact on activity are here to stay. China therefore remains a source of downside risk for global goods demand. Unemployment is surging, and the PMIs are extremely weak, suggesting a contraction in GDP is coming. Moreover, households continue to deleverage (Chart 9). The CNY’s weakness confirms the risks to earnings growth in Europe, and the yield spread between China and the US points to further downside in the RMB (Chart 10, top panel). Interestingly, the weakness of the yen could also drag the CNY lower because of competitive pressures. Chester Ntonifor, BCA’s Chief Foreign Exchange strategist recommends investors sell CNY/JPY. Historically, a depreciating CNY/JPY portends weakness in European stock prices (Chart 10, bottom panel). Chart 9Chinese Growth Problems Chart 10A Weaker CNY Augurs Poorly For European Stocks The broader EM space outside of China is also a source of risk. EM countries are tightening monetary policy, which is slowing economic activity in nations already exposed to declining Chinese imports. Additionally, as Arthur Budaghyan shows, the strength in the dollar is tightening EM financial conditions and invites further increases in EM policy rates because of the inflationary impact of depreciating currencies. An additional tightening in EM financial conditions in response to this toxic mix will invite greater downside for European equities (Chart 11). Bottom Line: European equities already reflect enough of a valuation cushion to compensate for a significant slowdown in European growth. However, ample risks to global growth still lurk in the background. If these risks materialize, European stocks could selloff another 15% or so. Moreover, the overvaluation of cyclical stocks relative to defensive ones has now been purged, but China’s economic weakness remains a major handicap (Chart 12). Consequently, don’t be hero: avoid bottom-fishing European assets, especially cyclical ones. Chart 11Brewing EM Troubles Chart 12Cyclicals At Risk From China Is it Time to Buy the Euro? After falling below 1.04, EUR/USD has rebounded to 1.055. Is it time to buy the euro? The euro now embeds a large discount that reflects fears of a recession and stagflation in the Eurozone. A purchasing power parity model developed by BCA’s Foreign Exchange Strategy team that accounts for the differences in consumption baskets in Europe and the US shows that EUR/USD is trading at its deepest discount to fair value since 2001. Moreover, BCA’s Intermediate-term timing model, which is based on an augmented interest rate parity framework, confirms that EUR/USD is cheap. Additionally, BCA’s Intermediate-Term Technical Indicator is massively oversold (Chart 13). For the euro to bottom durably, the dollar needs to reverse its rally. The combination of net speculative positions on the DXY and BCA’s Dollar Capitulation Index point to elevated chances of an imminent peak (Chart 14). Chart 13The Euro's Large Risk Premium Chart 14The Over Extended Dollar Despite this backdrop, three of the aforementioned risks to European stocks translate into threats to the euro: A Russian energy embargo would cause a much more severe European recession. Two weeks ago, we highlighted a Bundesbank study which showed that such a cutoff would curtail German growth by 5% point for 2022. We also highlighted that this shock would cause a temporary but significant increase in inflation. This combination would be poisonous for the euro, and it carries a roughly 30% probability. A policy mistake in the Euro Area would cause a period of significant spread widening in the periphery. Such shocks often prompt a widening in the breakup risk-premium for the euro. This risk premium pushes EUR/USD lower. Chart 15Chinese Assets Matter To The Euro Chinese growth problems often hurt the euro as well as European stocks. A fall in the Chinese stock-to-bond ratio often leads to a weaker EUR/USD, since both variables are correlated to Chinese economic activity. Additionally, a depreciating CNY is also synonymous with a softer euro because a declining renminbi hurts European exporters (Chart 15). Further weaknesses in the S&P 500 no longer guarantee a fall in EUR/USD. Investors are worried about the US equity outlook because they are extrapolating the impact on consumers of rising energy and food prices. They are applying the template of what is going on in Europe to US households, which means that they are pricing in a convergence of US growth toward European growth (barring the three additional shocks highlighted in the bullet points above). Related Report European Investment StrategyIs UK Stagflation Priced In? Bottom Line: From a technical and valuation perspective, the rebound in the euro that began this week could last longer. However, several exceptional risks could prevent this bounce from morphing into a durable rally. The significant odds of a Russian energy embargo stand at the top of the list of concerns, but so does the possibility of a policy mistake in Europe as well China’s problems. Thus, even if the euro is bottoming, don’t be a hero and wait on a safer entry point to focus on capital preservation. In fact, BCA’s Foreign Strategy team is now selling EUR/JPY. Within a European context, a short GBP/CHF position is attractive as a portfolio hedge. The Swiss National Bank seems more tolerant of a higher CHF as a vehicle to tame growing inflationary pressures, while the UK faces significant risks. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations
Japanese headline inflation increased from 1.2% y/y to 2.5% y/y in April. Similarly, core CPI inflation jumped from 0.8% y/y to 2.1% y/y. The April acceleration in consumer prices mostly reflects the fading effect of cheaper phone fees last year, which…
According to BCA Research’s Global Investment Strategy service, although the unemployment rate has never risen by more than one-third of a percentage point in the US without a recession occurring, there are three reasons to think that a soft landing can be…
Inflation continues to put pressure on the US consumers. Negative real wage growth (Chart 1) and soaring prices of food and energy are pushing many low and middle-class Americans to shift spending away from discretionary items toward necessities (Chart 2). We have written about this here. Chart 1CHART 1 Chart 2 Table 1 The recent earnings commentary from Walmart and Target are attesting the trend. Both noted that consumers are switching from the high-margin items (non-necessities) to the lower-margin necessity items like food. Both companies have also commented on the ongoing supply chain challenges and rising costs of both goods (COGS) and wages. Target reported a 430bps contraction in gross margins. Peak margins for the sector are surely in the rear-view mirror. Both Walmart and Target provided negative guidance. As a result, a retail “carnage” has ensued, WMT is down 20%, COST 15%, and TGT 30% over the past three days. The sell-off was exacerbated by the Powell’s comments that combating inflation is likely to incur economic pain, hinting at a possibility of a recession on the back of the Fed’s actions. These comments have reiterated the Fed’s hawkish stance, and have removed any hope of the Fed’s put, i.e., the Fed coming to the rescue of the spluttering equity market. What’s next? We believe that the markets can continue to fall. A few conditions of our Equity Capitulation scorecard have not been yet met (Table 1). Rate stabilization – The Fed’s hawkish stance and a plan to front-load a rate hiking cycle suggest that monetary conditions will continue to tighten (-1) Economic growth expectations do not yet reflect the deteriorating economic backdrop. US GDP forecasts will be further downgraded (-1) Earnings growth expectations need to come down to reflect supply disruptions, raging input prices, and the stronger dollar (-1) Oil prices have somewhat stabilized (+1) Valuations have retraced, signaling that the market is reasonably priced. However, earnings downgrades will push forward multiples higher (0) Technicals signal that the market is oversold (+2) “Black swans” – headwinds from the war in Ukraine and lockdowns in China (-2) Bottom Line: On balance, risks for US equities slightly outweigh the upside opportunity. A market bottom is still a few weeks, or even months, away.
Listen to a short summary of this report. Executive Summary The US Inflation Surprise Index Has Rolled Over Global equities are nearing a bottom and will rally over the coming months as inflation declines and growth reaccelerates. While equity valuations are not at bombed-out levels, they have cheapened significantly. Global stocks trade at 15.3-times forward earnings. We are upgrading tech stocks from underweight to neutral. The NASDAQ Composite now trades at a forward P/E of 22.6, down from 32.9 at its peak last year. The 10-year Treasury yield should decline to 2.5% by the end of the year, which will help tech stocks at the margin. The US dollar has peaked. A weakening dollar will provide a tailwind to stocks, especially overseas bourses. US high-yield spreads are pricing in a default rate of 6.2% over the next 12 months, well above the trailing default rate of 1.2%. Favor high-yield credit over government bonds within a fixed-income portfolio. Bottom Line: The recent sell-off in stocks provides a good opportunity to increase equity allocations. We expect global stocks to rise 15%-to-20% over the next 12 months. Back to Bullish We wrote a report on April 22nd arguing that global equities were heading towards a “last hurrah” in the second half of the year as a Goldilocks environment of falling inflation and supply-side led growth emerges. Last week, we operationalized this view by tactically upgrading stocks to overweight after having downgraded them in late February. This highly out-of-consensus view change, coming at a time when surveys by the American Association of Individual Investors and other outfits show extreme levels of bearishness, has garnered a lot of attention. In this week’s report, we answer some of the most common questions from the perspective of a skeptical reader. Q: Inflation is at multi-decade highs, global growth is faltering, and central banks are about to hike rates faster than we have seen in years. Isn’t it too early to turn bullish? A: We need to focus on how the world will look like in six months, not how it looks like now. Inflation has likely peaked and many of the forces that have slowed growth, such as China’s Covid lockdown and the war in Ukraine, could abate. Q: What is the evidence that inflation has peaked? And may I remind you, even if inflation does decline later this year, this is something that most investors and central banks are already banking on. Inflation would need to fall by more than expected for your bullish scenario to play out. A: That’s true, but there is good reason to think that this is precisely what will happen. Overall spending in the US is close to its pre-pandemic trend. However, spending on goods remains above trend while spending on services is below trend (Chart 1). Services prices tend to be stickier than goods prices. Thus, the shift in spending patterns caused goods inflation to rise markedly with little offsetting decline in services inflation. To cite one of many examples, fitness equipment prices rose dramatically, but gym membership fees barely fell (Chart 2). Chart 1Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Chart 2Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices As goods demand normalizes, goods inflation will come down. Meanwhile, the supply of goods should increase as the pandemic winds down, and hopefully, a detente is reached in Ukraine. There are already indications that some supply-chain bottlenecks have eased (Chart 3). Q: Even if supply shocks abate, which seems like a BIG IF to me, wouldn’t the shift in spending towards services supercharge what has been only a modest acceleration in services inflation so far? A: Wages are the most important driver of services inflation. Although the evidence is still tentative, it does appear as though wage inflation is peaking. The 3-month annualized growth rate in average hourly earnings for production and nonsupervisory workers slowed from 7.2% in the second half of 2021 to 3.8% in April (Chart 4). Assuming productivity growth of 1.5%, this is consistent with unit labor cost inflation of only slightly more than 2%, which is broadly consistent with the Fed’s CPI inflation target.1 Chart 4Wage Pressures May Be Starting To Ease Moreover, a smaller proportion of firms expect to raise wages over the next six months than was the case late last year according to a variety of regional Fed surveys (Chart 5). The same message is echoed by the NFIB small business survey (Chart 6). Consistent with all this, the US Citi Inflation Surprise Index has rolled over (Chart 7). Chart 6... Small Business Owners Included Chart 7The US Inflation Surprise Index Has Rolled Over Q: What about the “too cold” risk to your Goldilocks scenario? The risks of recession seem to be rising. A: The market is certainly worried about this outcome, and that has been the main reason stocks have fallen of late. However, we do not think this fear is justified, certainly not in the US (Chart 8). US households are sitting on $2.3 trillion excess savings, equal to about 14% of annual consumption. The ratio of household debt-to-disposable income is down 36 percentage points from its highs in early 2008, giving households the wherewithal to spend more. Core capital goods orders, a good leading indicator for capex, have surged. The homeowner vacancy rate is at a record low, suggesting that homebuilding will be fairly resilient in the face of higher mortgage rates. Q: It seems like the Fed has a nearly impossible task on its hands: Increase labor market slack by enough to cool the economy but not so much as to trigger a recession. You yourself have pointed out that the Fed has never achieved this in its history. A: It is correct that the unemployment rate has never risen by more than one-third of a percentage point in the US without a recession occurring (Chart 9). That said, there are three reasons to think that a soft landing can be achieved this time. Chart 9When Unemployment Starts Rising, It Usually Keeps Rising First, increasing labor market slack is easier if one can raise labor supply rather than reducing labor demand. Right now, the participation rate is nearly a percentage point below where it was in 2019, even if one adjusts for increased early retirement during the pandemic (Chart 10). Wages have risen relatively more at the bottom end of the income distribution. This should draw more low-wage workers into the labor force. Furthermore, according to the Federal Reserve, accumulated bank savings for the lowest-paid 20% of workers have been shrinking since last summer, which should incentivize job seeking (Chart 11). Chart 10Labor Participation Has Further Scope To Recover Chart 11Depleted Savings Will Force More Lower-Wage Workers Into The Labor Market Second, long-term inflation expectations remain well contained, which makes a soft landing more likely. Median expected inflation 5-to-10 years out in the University of Michigan survey stood at 3% in May, roughly where it was between 2005 and 2013 (Chart 12). Median expected earnings growth in the New York Fed Survey of Consumer Expectations was only slightly higher in April than it was prior to the pandemic (Chart 13). Chart 12Consumer Long-Term Inflation Expectations Have Risen But Remain Relatively Low Chart 13US Consumers Do Not Expect Wages To Grow At A Much Higher Rate Than In The Pre-Pandemic Period A third reason for thinking that a soft landing may be easier to achieve this time around is that the US private-sector financial balance – the difference between what the private sector earns and spends – is still in surplus (Chart 14). This stands in contrast to the lead-up to both the 2001 and 2008-09 recessions, when the private sector was living beyond its means. Q: You have spoken a lot about the US, but the situation seems dire elsewhere. Europe may already be in recession as we speak! A: The near-term outlook for Europe is indeed challenging. The euro area economy grew by only 0.8% annualized in the first quarter. Mathieu Savary, BCA’s Chief European Strategist, expects an outright decline in output in Q2. To no one’s surprise, the war in Ukraine is weighing on European growth. The Bundesbank estimates that a full embargo of Russian oil and gas would reduce German real GDP by an additional 5% on top of the damage already inflicted by the war (Chart 15). Chart 14The US Private-Sector Financial Balance Remains In Surplus Chart 15Germany’s Economy Will Sink Without Russian Energy While such a full embargo is possible, it is not our base case. In a remarkable about-face, Putin now says he has “no problems” with Finland and Sweden joining NATO, provided that they do not place military infrastructure in their countries. He had previous threatened a military response at the mere suggestion of NATO membership. In any case, there are few signs that Putin’s increasingly insular and dictatorial regime would respond to an oil embargo or other economic incentives. The wealthy oligarchs who were supposed to rein him in are cowering in fear. It is also not clear if Europe would gain any political leverage over Russia by adopting policies that push its own economy into a recession. It is worth noting that the price of the December 2022 European natural gas futures contract is down 39% from its peak at the start of the war (Chart 16). It is also noteworthy that European EPS estimates have been trending higher this year even as GDP growth estimates have been cut (Chart 17). This suggests that the analyst earnings projections were too conservative going into the year. Chart 16European Natural Gas Futures Are High But Below Their Peak Chart 17European And US EPS Estimates Have Been Trending Higher This Year Chart 18Chinese Property Sector: Signs Of Contraction Q: What about China? The lockdowns are crippling growth and the property market is in shambles. A: There is truth to both those claims. The government has all but said that it will not abandon its zero-Covid policy anytime soon, even going as far as to withdraw from hosting the 2023 AFC Asian Cup. While the number of new cases has declined sharply in Shanghai, future outbreaks are probable. On the bright side, China is likely to ramp up domestic production of Pfizer’s Paxlovid drug. Increased availability of the drug will reduce the burden of the disease once social distancing restrictions are relaxed. As far as the property market is concerned, sales, starts, completions, as well as home prices are all contracting (Chart 18). BCA’s China Investment Strategy expects accelerated policy easing to put the housing sector on a recovery path in the second half of this year. Nevertheless, they expect the “three red lines” policy to remain in place, suggesting that the rebound in housing activity will be more muted than in past recoveries.2 Ironically, the slowdown in the Chinese housing market may not be such a bad thing for the rest of the world. Remember, the main problem these days is inflation. To the extent that a sluggish Chinese housing market curbs the demand for commodities, this could provide some relief on the inflation front. Q: So bad news is good news. Interesting take. Let’s turn to markets. You mentioned earlier that equity sentiment was very bearish. Fair enough, but I would note the very same American Association of Individual Investors survey that you cited also shows that investors’ allocation to stocks is near record highs (Chart 19). Shouldn’t we look at what investors are doing rather than what they’re saying? A: The discrepancy may not be as large as it seems. As Chart 20 illustrates, investors may not like stocks, but they like bonds even less. Chart 19Individual Investors Still Hold A Lot Of Stock Chart 20B... But They Like Bonds Even Less Chart 21Global Equities Are More Attractively Valued After The Recent Sell-Off Global equities currently trade at 15.3-times forward earnings; a mere 12.5-times outside the US. The global forward earnings yield is 6.7 percentage points higher than the global real bond yield. In 2000, the spread between the earnings yield and the real bond yield was close to zero (Chart 21). It should also be mentioned that institutional data already show a sharp shift out of equities. The latest Bank of America survey revealed that fund managers cut equity allocations to a net 13% underweight in May from a 6% overweight in April and a net 55% overweight in January. Strikingly, fund managers were even more underweight bonds than stocks. Cash registered the biggest overweight in two decades. Q: Your bullish equity bias notwithstanding, you were negative on tech stocks last year, arguing that the NASDAQ would turn into the NASDOG. Given that the NASDAQ Composite is down 29% from its highs, is it time to increase exposure to some beaten down tech names? A: Both the cyclical and structural headwinds facing tech stocks that we discussed in These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth and The Disruptor Delusion remain in place. Nevertheless, with the NASDAQ Composite now trading at 22.6-times forward earnings, down from 32.9 at its peak last year, an underweight in tech is no longer appropriate (Chart 22). A neutral stance is now preferable. Chart 22Tech Stock Valuations Have Returned To Earth Q: I guess if bond yields come down a bit more, that would help tech stocks? A: Yes. Tech stocks tend to be growth-oriented. Falling bond yields raise the present value of expected cash flows more for growth companies than for other firms. While we do expect global bond yields to eventually rise above current levels, yields are likely to decline modestly over the next 12 months as inflation temporarily falls. We expect the US 10-year yield to end the year at around 2.5%. Q: A decline in US bond yields would undermine the high-flying dollar, would it not? A: It depends on how bond yields abroad evolve. US Treasuries tend to be relatively high beta, implying that US yields usually fall more when global yields are declining (Chart 23). Thus, it would not surprise us if interest rate differentials moved against the dollar later this year. Chart 23US Treasuries Have A Higher Beta Than Most Other Government Bond Markets It is also important to remember that the US dollar is a countercyclical currency (Chart 24). If global growth picks up as pandemic dislocations fade and the Ukraine war winds down, the dollar is likely to weaken. Chart 24The Dollar Is A Countercyclical Currency A wider trade deficit could also imperil the greenback. The US trade deficit has increased from US$45 billion in December 2019 to US$110 billion. Equity inflows have helped finance the trade deficit, but net flows have turned negative of late (Chart 25). Finally, the dollar is quite expensive – 27% overvalued based on Purchasing Power Parity exchange rates. Q: Let’s sum up. Please review your asset allocation recommendations both for the next 12 months and beyond. A: To summarize, global inflation has peaked. Growth should pick up later this year as supply-chain bottlenecks abate. The combination of falling inflation and supply-side led growth will provide a springboard for equities. We expect global stocks to rise 15%-to-20% over the next 12 months. Historically, non-US stocks have outperformed their US peers when the dollar has been weakening (Chart 26). EM stocks, in particular, have done well in a weak dollar environment Chart 26Non-US Stocks Will Benefit From A Weaker US Dollar Chart 27The Market Is Too Pessimistic On Default Risk Within fixed-income portfolios, we recommend a modest long duration stance over the next 12 months. We favor high-yield credit over safer government bonds. US high-yield spreads imply a default rate of 6.2% over the next 12 months compared to a trailing 12-month default rate of only 1.2% (Chart 27). Chart 28Falling Inflation Will Buoy Consumer Sentiment Our guess is that this Goldilocks environment will end towards the end of next year. As inflation comes down, real wage growth will turn positive. Consumer confidence, which is now quite depressed, will improve (Chart 28). Stronger demand will cause inflation to reaccelerate in 2024, setting the stage for another round of central bank rate hikes. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn Twitter Footnotes 1 The Federal Reserve targets an average inflation rate of 2% for the Personal Consumption Expenditures (PCE) 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 2.3%-to-2.5%. 2 The People’s Bank of China and the housing ministry issued a deleveraging framework for property developers in August 2020, consisting of a 70% ceiling on liabilities-to-assets, a net debt-to-equity ratio capped at 100%, and a limit on short-term borrowing that cannot exceed cash reserves. Developers breaching these “red lines” run the risk of being cut off from access to new loans from banks, while those who respect them can only increase their interest-bearing borrowing by 15% at most. 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Listen to a short summary of this report. Executive Summary EUR/JPY And The DXY: Unsustainable Gap Three interrelated themes are likely to play out by the end of 2022 – peak Fed hawkishness, continued central bank convergence, and nascent green shoots in global economic growth. We are playing the first theme via an outright short DXY position. We are also hedging this bet through a short EUR/JPY trade, a corresponding play on the second theme. Betting on nascent green shoots in economic growth can be expressed via a long Aussie position, or more prudently, a short CHF/SEK bet. We are long a CAD and NOK basket against the RUB, a play on an eventual recovery in oil demand, and the premium that these blends will continue to command relative to Russian oil. Finally, most of our trades remain at the crosses due to elevated FX volatility which has boosted safe-haven demand for the dollar. The admission of Sweden and Finland into NATO could increases the risk of miscalculation on the part of Russia, which will continue to prop near-term safe-haven demand for the dollar. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short EUR/JPY 133.28 2022-05-12 -0.73 Bottom Line: Continue to focus on relative value trades at the crosses, until signs emerge that FX volatility is peaking, which will be more conducive for direct USD bets. Feature Chart 1Dollar Capitulation Occurs At Record Valuation And A Record Deficit Last week’s report focused on the key reasons why longer-term investors should begin to fade dollar strength. For one, the dollar already imbeds a hefty safe-haven premium. This premium manifests itself in an overvalued exchange rate (Chart 1). A simple PPP model shows that the dollar is overvalued by 27%. This is higher than the peak in the US dollar which preceded the bear market that began in the early 2000s. While valuations tend to matter little until they trigger a tipping point, such an inflection point could be around the corner. One catalyst has been the widening trade deficit which needs to be financed via foreign capital inflows. The US trade deficit continues to deteriorate, hitting a record low of $109.8bn in March. Over the last few years, it has become increasingly difficult to fund this widening trade deficit through foreign purchases of US Treasuries. That said, FX markets are likely to focus on three interrelated themes in the near term – peak Fed hawkishness, continued central bank convergence, and the potential for nascent green shoots in global economic growth. We are playing the first theme via an outright short DXY position. We are also hedging this bet with a short EUR/JPY trade, a corresponding play on the second theme. In the next few sections, we go through a few trades that would benefit from these themes. Short EUR/JPY: A Defensive Play Most of our trades in the portfolio are pro-risk. As such, a short EUR/JPY position acts as an attractive hedge in the near term. The DXY index has historically traded in perfect inverse correlation to the euro-yen exchange rate, but an unusually wide gap has opened up (Chart 2). In our view, this suggests that the collapse in the yen, relative to the euro, is very much overdone. In a risk-off environment, as we witnessed on Wednesday, EUR/JPY will sell off. Meanwhile, there are also fundamental reasons to suggest that this cross is stretched on a longer-term time horizon. First, the cross is expensive on a PPP basis. Chart 3 shows that EUR/JPY usually peaks when the real effective exchange rate is 1.5 standard deviations above its long-term mean. Today’s valuation pins it close to that, among the highest levels since the 1980s. Standard economic theory suggests that a reversal in the cross will be warranted to realign euro area competitiveness relative to Japan. Chart 2EUR/JPY And The DXY: Unsustainable Gap Chart 3EUR/JPY Is Not Cheap Meanwhile, there is a case to be made that an expensive EUR/JPY exchange rate is already affecting relative competitiveness. European exports are relapsing relative to those in Japan, which usually ensues after a period of euro-yen strength. Case in point: German factory orders are already contracting, while machinery orders in Japan remain relatively robust (Chart 4). Second, the European Central Bank has been relatively hawkish, vis-à-vis the Bank of Japan. The yield on December 2022 Euribor contracts is 78bps above the TIBOR equivalent, suggesting the ECB will hike rates 4-5 times this year versus the BoJ. Granted, inflation is overshooting in Europe relative to Japan (Chart 5). But as we have been witnessing around the world from the UK to Canada, and all the way to Australia, rising inflation is a global problem. If it persists, it will also begin to meaningfully show up in the Japanese numbers. This will nudge the BoJ away from the ultra-dovish camp. More likely, inflation will moderate, which will allow the ECB to dial back its hawkish rhetoric. Chart 4Europe Is Losing Competitiveness To Japan Chart 5Eurozone Inflation Could Subside In The Coming Months Even if inflation moderates in the eurozone, short-term real rates will remain deeply negative compared to Japan. This will be a significant drag for relative fixed income flows and the currency (Chart 6). At the same time, higher inflation in Europe also suggests the fair value for EUR/JPY should continue its structural downtrend. Chart 6Real Rates Are Very Low In The Eurozone Third, oil price volatility will remain high in the near term but will subside longer term. We are cognizant of the fact that, our Chief Commodity Strategist, Robert Ryan, expects the geopolitical risk premium in oil to increase in the near term. When rising oil coincides with rebounding economic activity, the yen tends to lag as a defensive currency (Chart 7). This time around, the premium in energy markets has come from a cutoff in Russian supplies. Japan imports almost all its energy and has structurally been more dependent on fossil fuels than Europe (Chart 8). This has boosted EUR/JPY and is a risk to a short position. Chart 7EUR/JPY Tracks Oil Chart 8Japan Will Accelerate A Shift From Fossil Fuels That said, adjustments are already underway. Japanese and European LNG imports from the US are rising. As a result, the price arbitrage between US Henry Hub prices and the Dutch TTF equivalent are collapsing (Chart 9). The Japanese have already ramped up nuclear power production, reducing their dependence on fossil fuels (Chart 10). That will be a welcome fillip for the Japanese trade balance. In a nutshell, a lot of bad news is already priced in the yen. As such, it has become an attractive hedge. Asian clients not willing to short the euro can short CNY/JPY as a close proxy. Interestingly, CNY/JPY has made a classic double-top and could meaningfully depreciate from current levels (Chart 11), along with EUR/JPY. Chart 9The European And Asian Natgas Premium Is Deflating Chart 10A Nuclear Renaissance In Japan? Chart 11CNY/JPY: A Double Top? Short CHF/JPY: Still Attractive, But Taking Profits We also played a long yen leg via a short CHF position but our trailing stop was triggered this week at 130 for a profit of 3.74%. While we believe the cross still faces meaningful downside, we will opportunistically look to sell CHF/JPY again at 135. First, historically, CHF/JPY has inversely tracked the inflation profiles between Switzerland and Japan. Given the collapse in the yen, and much higher Swiss inflation, CHF/JPY has become incrementally more expensive, especially relative to history (Chart 12). To realign competitiveness, the cross should depreciate. Second, from a technical perspective, CHF/JPY is in a classic double-top formation (Chart 13), akin to CNY/JPY. This suggests the safe-haven premium is much higher in the franc than it is in the yen. Chart 12Swiss Inflation Is Lowering CHF"s Puchasing Power Chart 13CHF/JPY: Look To Go Short Again The key risk to this trade is that the Swiss equity market is more defensive relative to Japanese bourses. As such, the hefty safe-haven premium in the franc could persist (Chart 14), pushing the cross to our initial entry short point at 135. Chart 14Swiss Equities Could See Inflows Near Term Short CHF/SEK: A Play On The Riksbank’s U-Turn Chart 15Short CHF/SEK Is The Great Value/Growth Play Value/Growth Turns Before The Dollar Last month, we argued that the dip in the Swedish krona had already priced a recession in the domestic economy. Meanwhile, with a mandate of price stability, we argued the Riksbank will have no choice but to turn more hawkish or lose credibility. As a play on this trend, we recommended going long the SEK relative to the CHF. In a major policy U-turn, the Riksbank raised rates and announced a faster pace of balance-sheet reduction. Most of the arguments made in the original report remain valid, so we will not revisit them here. The one point we will stress is that Sweden’s small open economy makes the SEK very sensitive to global economic conditions. One benefit of a short CHF/SEK position is that while value has been outperforming growth during this selloff, CHF/SEK remains strong which is a departure from the traditional relationship (Chart 15). Ergo, a major safety discount is imbedded in the SEK. Related Report Foreign Exchange StrategyMonth In-Review: A Hefty Safe-Haven Premium In The Dollar Sweden’s bourse is heavy in cyclicals, with large overweight positions in financials and industrials, that will benefit from a renewed capital spending cycle, and higher global rates. Meanwhile, the outperformance of value during a market riot point suggests a change in market leadership could be underway, even if bond yields temporarily crater. The krona remains vulnerable to geopolitical risk, especially if Russia retaliates against Sweden and Finland joining NATO. So far, Russia’s response has been muted. As such, while this pro-cyclical trade faces near-term risk, it remains a safer way, in our view, to play SEK strength. Long AUD: Bet On An Eventual China Rebound Chart 16The AUD And China We will be discussing Australia in an in-depth report next week, so we will keep our comments brief this week. What we will say is that the Aussie is one of the best candidates to play a rebound in global growth, given that it sits near the epicenter of where that growth will likely emanate from – China (Chart 16). Right now, the picture is not pretty, but it is always dark before dawn. Stay tuned. Long (CAD+NOK)/RUB: A Relative Value Play As many countries reroute their oil supplies from Russia to other countries, Canada and Norway could stand to benefit from a relative perspective. Understandably, many clients might not be able to trade the RUB, so we are filing this trade under speculative. First, both Brent and Western Canadian Select oil are trading at a significant premium to the Urals blend, which is likely to be sustained in the next 6 months. This will benefit NOK and CAD, relative to the ruble (Chart 17). Chart 17CAD And NOK Will Benefit From Premium Oil Second, from an FX point of view, Russia faces the trilemma of the impossible trinity – having decided to limit the free flow of capital, it has chosen independent monetary policy and managing the exchange rate. This will come at a cost, however: As the economy comes grinding to a halt and inflation surges, interest rates will have to stay high to maintain currency stability. This will crush the domestic economy for years to come. Luckily, Russia has a healthy current account surplus, but as production in Canada and Norway improve to offset embargoes on Russian crude, this will also boost their external balance. Long EUR/GBP: The Euro Is More Priced For A Recession We have discussed at length the rationale behind our long EUR/GBP position, so we will not reiterate the arguments here. Our Global Fixed Income colleagues upgraded Gilts to overweight last week, in line with expectations that markets will continue pricing a dovish tilt from the BoE. In our view, the EUR/GBP cross still heavily underprices the risks to the UK economy in the near term. As such, if interest rates in the UK continue to fall relative to those in the eurozone, EUR/GBP will benefit (Chart 18). Chart 18EUR/GBP Has Upside Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary
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