Financial Markets
Executive Summary US Equity Drawdowns During Geopolitical Crises/Commodity Shocks The most recent examples of geopolitical and commodity price shocks similar the current one include the Cuban missile crisis in 1962, the oil embargo of 1973 in response to the Yom Kippur War as well as the Gulf War of 1990. The magnitude of the S&P 500 selloff was 28% in 1962, 23% in 1973 and 20% in 1990 (Chart of the week). Neither of our capitulation indicators for the S&P 500 or for EM stocks have reached their previous lows. As for commodity prices, the only thing that is certain in the next couple of months is that volatility will remain very elevated. Having incurred considerable costs, Russia will push to maximize its gains and secure a new, more favorable agreement with NATO. This will keep geopolitical tension elevated. Bottom Line: The drawdown in global and EM stocks in not over yet. The US dollar has more upside in the near term. This is consistent with the S&P500 outperforming and EM stocks underperforming. A rising US dollar bodes ill for EM fixed-income markets. Feature Chart 1US Equity Drawdowns During Geopolitical Crises/Commodity Shocks The world is experiencing geopolitical and commodity price shocks that have not been seen in over a generation. The most recent examples of this kind of shock include the Cuban missile crisis in 1962, the oil embargo of 1973 in response to the Yom Kippur War as well as the Gulf War of 1990. Chart 1 illustrates the current trajectory of the S&P 500 with selloffs that occurred during those three episodes. The magnitude of the S&P 500 selloff was 28% in 1962, 23% in 1973 and 20% in 1990. The S&P 500 is down only 11% from its peak. Based on the above three profiles, the current selloff in US stocks has further to go. This also means that non-US equities, including EM, will continue to suffer. What are the conditions needed for global stocks to bottom? In our opinion, a durable bottom in share prices will occur when measures of capitulation in equity markets reach their previous lows, commodity prices (particularly crude prices) decline and geopolitical tensions peak. We elaborate on each below. Equity Capitulation Neither of our capitulation indicators for the S&P 500 or for EM stocks have reached their previous lows. Chart 2 displays our capitulation indicator for US equities. Its construction is based on four equal-weighted components: the composite momentum indicator, the US equity sentiment indicator, industry group breadth and the advance-decline line (shown individually in Chart 7-8 below). Chart 2US Stocks Have Not Reached Their Selling Climax This indicator has not reached its lows of 2010, 2011, 2018 and 2020. In 2011 and 2018, the S&P500 selloffs were 19.5% and 19.8%, respectively. Hence, our best guess for the magnitude of an equity drawdown in this selloff is about 20%. This puts the potential S&P500 low at 3600-3700. The latter is consistent with the technical support (3-year moving average) that held up in 2011, 2016 and 2018 (Chart 2, top panel). Chart 3 illustrates our EM equity capitulation indicator. Its four equal-weighted components are the composite momentum indicator, EM equity sentiment, industry group breadth and net EPS revisions (shown individually in Chart 9-10 below). We believe that EM share prices will drop until this capitulation indicator comes to the levels reached in the 2011, 2013 and 2018 selloffs. Chart 3The EM Equity Capitulation Has Further To Run Concerning the magnitude of further EM equity selloff, the next technical defense line for the MSCI EM stock index in USD is 10%, or in the worst-case scenario, 25% below current levels (Chart 3, top panel). The Commodity Shock Global share prices have become negatively correlated with commodity (primarily oil) prices and such an inverse relationship will likely persist for now. In fact, an important signal of the bottom in the S&P 500 during the 1990 oil spike was the peak in crude prices (the latter is shown inverted in Chart 4). In the case of the oil embargo of 1973-74, the oil market was not developed, and US share prices were negatively correlated with US 10-year Treasury yields (Chart 5). Chart 4The 1990 Oil Shock Chart 5The 1973 Oil Shock Presently, given that US stocks were reacting negatively to rising US bond yields prior to the Ukraine crisis, it is reasonable to expect American share prices to bottom only when two conditions are satisfied: (1) oil prices start falling on a sustainable basis and (2) US bond yields do not rise much. How much will oil and other commodity prices rise? It is hard to know because multiple forces are in play. First, Russia is the second largest commodity exporter in the world (after the US). Russia’s crude oil exports account for 8.4% of global crude consumption, natural gas exports for 5.9% of global consumption and 3.4% for coal (Table 1). Across metals, Russia is a large producer too – 35.6% for palladium, 4.4% for nickel and 4.2% for copper (Table 1). In turn, Russia and Ukraine production together accounts for 14% of global wheat consumption. Table 1Russia’s Global Share In Various Commodities The West’s official sanctions affect Russian exports of certain commodities but there is also a reluctance on the part of private companies to buy or ship Russian exports. This latter factor makes it nearly impossible to gauge just how much supply of each individual commodity will be curtailed. Assuming in the near term that a considerable share of Russia’s commodity exports will be blocked from global markets, the largest impact will be on oil, palladium, copper, nickel and fertilizer. While ratcheting sales of resources to China is a saving grace for Russia, it might take some time until shipments can be rerouted and reorganized. Second, the US is pressuring allied nations in the Gulf as well as other countries like Venezuela to produce and bring more oil to the market. Finally, the surge in commodity prices is probably already destroying demand. Oil and wheat prices have risen to record highs in many EM currencies (Chart 36 and 37 below). This will push inflation higher and herald more rate hikes from central banks. High interest rates along with tight fiscal policy and eroding discretionary spending (due to high energy and food prices) entail weak demand in developing economies. Bottom Line: In the very short run, risks to many commodity prices are skewed to the upside due to supply constraints. Yet, enormous uncertainty over factors driving their demand and supply makes prices over the next three months impossible to forecast. During this period, individual commodity prices might be driven by idiosyncratic factors. The only thing that is certain in the next couple of months is that volatility in commodity prices will remain very elevated. Price surges might be followed by large drawdowns and vice versa. Geopolitical Tensions The Kremlin will continue its military assault until it establishes firm control over Kyiv and the Black Sea coast, including the city of Odessa. As we wrote in our March 2 report, Putin’s objective is to install a very loyal government in Kyiv and to control the territory east of the Dniepr river. It is not clear to us whether the Kremlin has the appetite to control the Ukraine territory west of the Dniepr river. Western Ukraine has always been very anti-Russian and Putin might realize that it will be too costly to capture and control it. We do not think Putin has ambitions to go beyond Ukraine (Moldova being an exception). That said, there is no doubt that the Kremlin will be presenting more demands to NATO and threatening if those demands are not met. Having incurred considerable costs, Russia will push to maximize its gains and secure a new, more favorable agreement with NATO. It is not clear how many geopolitical concessions or what security guarantees the US is willing to provide to Russia. On the whole, geopolitical tensions between Russia and NATO/the US will continue until there is a new deal between the parties. Investment Strategy Chart 6No Trend Change In EM And US Relative Equity Performance The drawdown in global and EM stocks in not over yet. Within a global equity portfolio, we continue to recommend underweighting EM and Europe and overweighting the US. Interestingly, the EM relative equity performance versus the global stock index has rolled over at its 200-day moving average, while the US’s relative performance has found a support at its 200-day moving average (Chart 6). Such a technical configuration suggests that EM stocks will continue underperforming for now while US equities will have another upleg in relative terms. The US dollar has more upside in the near term. This is consistent with the S&P500 outperforming and EM stocks underperforming. A rising US dollar bodes ill for EM fixed-income markets. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Components Of Our US Equity Capitulation Indicator Not all components of our US Equity Capitulation Indicator have reached their previous lows. Given the backdrop of still expensive US equity valuations, heightened geopolitical risks, very elevated inflation and high inflation expectations as well as the little maneuvering room that the Fed has, odds are that US share prices will drop further. Chart 7Components Of Our US Equity Capitulation Indicator Chart 8Components Of Our US Equity Capitulation Indicator Components Of Our EM Equity Capitulation Indicator Not all components of our EM Equity Capitulation Indicator have reached their previous lows either. The share of industry groups above their 200-day moving average, analysts’ net EPS revisions as well as the momentum and equity sentiment indicators remain above their lows. Further downside in EM share prices is likely. Chart 9Components Of Our EM Equity Capitulation Indicator Chart 10Components Of Our EM Equity Capitulation Indicator US Stocks Have Not Yet Reached Their Selling Climax The NYSE’s advance/decline line has broken down and is dropping, signifying a broadening equity rout. Yet, we doubt the US equity indexes will bottom when 35% of NYSE listed stocks are above their 200-day moving average. Finally, the US median stock has broken below its 200-day moving average. Given the fundamental backdrop, all of these technical signposts point to a larger than 10% correction in the S&P 500. Chart 11US Stocks Have Not Yet Reached Their Selling Climax Chart 12US Stocks Have Not Yet Reached Their Selling Climax Chart 13US Stocks Have Not Yet Reached Their Selling Climax Chart 14US Stocks Have Not Yet Reached Their Selling Climax Global Overall And Global ex-US Equities Although Global ex-US stocks are much more oversold than US stocks, their growth and profit backdrops are worse. As we argued in the front section of this report (Chart 6 above), odds are that US stocks will continue outperforming non-US stocks in the near term. Despite crashing, European stocks might not have found a support yet. Chart 15Global Overall And Global ex-US Equities Chart 16Global Overall And Global ex-US Equities Chart 17Global Overall And Global ex-US Equities Chart 18Global Overall And Global ex-US Equities European Stocks: Is A Support At Hand? Investor sentiment on European stocks has become depressed. Yet, European economies will decelerate due to the energy shock (natural gas prices have shot up two-fold since October 1) as well as falling consumer and business confidence. A bottom for euro area stocks might be lower than current prices. Chart 19European Stocks: Is A Support At Hand? Chart 20European Stocks: Is A Support At Hand? Chart 21European Stocks: Is A Support At Hand? EM Equities: Cheap But Mind The Profit Outlook According to our cyclically adjusted P/E ratio, EM stocks are slightly cheap in absolute terms and are very attractive versus US equities. However, this valuation indicator should be used by long-term investors. In the short run and even from a cyclical perspective, this valuation indicator is not very useful. Besides, investor sentiment on EM equities was neutral in the middle of February. It might take more weakness before bad news get priced in EM share prices. Chart 22EM Equities: Cheap But Mind The Profit Outlook Chart 23EM Equities: Cheap But Mind The Profit Outlook Chart 24EM Equities: Cheap But Mind The Profit Outlook EM Profits In A Soft Spot As projected by our EM narrow money (M1) aggregate, EM corporate earnings will continue to disappoint. This is the key risk to EM share prices. In fact, EM EPS has been broadly flat over the past 15 years. That is why EM stocks appear cheap. Plus, EM ex-TMT stocks have not yet fallen much and downside risks remain. Chart 25EM Profits In A Soft Spot Chart 26EM Profits In A Soft Spot Chart 27EM Profits In A Soft Spot Chinese Investable Stocks Are At Their March 2020 Lows Offshore and onshore Chinese shares prices have been falling hard. Not only have Chinese corporate profit expectations been downshifting but also Chinese Investable stocks have been derating (their multiples have been compressing). This has been due to foreign investors projecting/extrapolating the US-Russia confrontation to a possible future US-China geopolitical standoff, and therefore possible sanctions the West can impose on China. Chart 28Chinese Investable Stocks Are At Their March 2020 Lows Chart 29Chinese Investable Stocks Are At Their March 2020 Lows Chart 30Chinese Investable Stocks Are At Their March 2020 Lows Chart 31Chinese Investable Stocks Are At Their March 2020 Lows China: No "All-In" Stimulus Yet The improvement in China’s total social financing has been entirely due to local government bond issuance. Corporate and household credit have not improved at all. Consistently, traditional infrastructure investment has probably bottomed. Yet, outside this sector the outlook is uninspiring. Property construction remains at risk, consumer spending is very sluggish and private business sentiment is downbeat. Chart 32China: No "All-In" Stimulus Yet Chart 33China: No "All-In" Stimulus Yet Chart 34China: No "All-In" Stimulus Yet Chart 35China: No "All-In" Stimulus Yet EM Woes: Energy And Food Prices Many low-income developing countries will be suffering from elevated food and energy prices. Oil and wheat prices in EM currencies have surged to all-time highs. This will lift headline inflation in many emerging economies, lead to monetary tightening and reduce household income available for discretionary spending. All of these and the lack of fiscal easing in many developing countries entail growth disappointments this year. Chart 36EM Woes: Energy And Food Prices Chart 37EM Woes: Energy And Food Prices Chart 38EM Woes: Energy And Food Prices Chart 39EM Woes: Energy And Food Prices EM Credit Spreads Are Widening Rapidly EM sovereign and corporate spreads have broken out. Such spread widening is not simply due to Russian credit. The pace of spread widening differs among countries. However, directionally, credit spreads seem to have embarked on a widening path. In a nutshell, Chinese USD corporate in general and property bond prices in particular are tanking (see below). This foreshadows the poor outlook for Chinese housing. Chart 40EM Credit Spreads Are Widening Rapidly Chart 41EM Credit Spreads Are Widening Rapidly Chart 42EM Credit Spreads Are Widening Rapidly Chart 43EM Credit Spreads Are Widening Rapidly EM Credit Markets And EM Equities Historically, rising EM corporate USD bond yields led to a selloff in EM share prices. This is the cost of capital that matters for EM equities. Unless EM sovereign and corporate bonds yields start falling on a sustainable basis, EM equities will continue to struggle. Chart 44EM Credit Markets And EM Equities Chart 45EM Credit Markets And EM Equities Chart 46EM Credit Markets And EM Equities Global Resource Stocks The relative performance of global energy and basic materials versus the global equity index has bottomed. In the medium term, odds are that TMT stocks will underperform while resource companies outperform. Yet, the outlook for energy stocks and basic materials in absolute terms is complicated (in line with the elevated volatility in commodity prices we discussed in the front section). Notably, even though commodity prices have skyrocketed, basic materials and energy share prices have not yet broken out. It seems the market is doubting the sustainability of high commodity prices. Chart 47Global Resource Stocks Footnotes
Executive Summary We look at the Ukraine crisis in the broader context of shocks, what we can learn from them, and how we can incorporate them into our strategy for investment, and life in general. Our high-conviction view is that the Ukraine crisis will be net deflationary, because the economic and financial sanctions imposed on Russia will lead to a generalized demand destruction. Bond yields will be lower in the second half of the year. Underweight cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100. Stay structurally overweight the 30-year T-bond. The ultimate low in the 30-year T-bond yield is yet to come, and will be a long way below the current 2.1 percent. Fractal trading watchlist: We focus on banks, add alternative electricity, and review bitcoin. Every Shock Is Always Supplanted By A New Shock Bottom Line: The recent rise in bond yields and the associated outperformance of cyclical sectors such as banks, ‘value’, and value-heavy stock markets such as the FTSE 100 was just a short-lived countertrend move within a much bigger structural downtrend. This structural downtrend is now set to resume. Feature Suddenly, nobody is worried about Covid and everybody is worried about nuclear war. Or as Vladimir Putin warns, “such consequences that you have never experienced in your history.” The life lesson being that every shock is always supplanted by a new shock. Hence, in this report we look at the Ukraine crisis through a wider lens. We look at the broader context of shocks, what we can learn from them, and how we can incorporate them into our strategy for investment, and life in general. The Predictability Of Shocks Shocks are very predictable. This sounds like a contradiction, but we don’t mean the timing or nature of individual shocks. As specific events, Russia’s full-scale invasion of Ukraine and the global pandemic were ‘tail-events’ that did come as shocks. Yet the statistical distribution of such tail-events is very predictable. This predictability of shocks forms the bedrock of the world’s $5 trillion insurance industry, and should also form the bedrock of any long-term strategy for investment, or life in general. The predictability of shocks forms the bedrock of the world’s $5 trillion insurance industry, and should also form the bedrock of any long-term investment strategy. We define a shock as any event that causes the long-duration bond price in a major economy to rally or slump by at least 20 percent, albeit this is just one definition.1On this definition, the Ukraine crisis is not yet a far-reaching economic or financial shock, but it is certainly well-placed to become one. Applying this definition of a shock through the last 60 years, the statistical distribution of shocks over any long period is well-defined and very predictable. For example, over a ten-year period the number of shocks exhibits a Poisson distribution with parameter 3.33 (Chart I-1), while the time between shocks exhibits an Exponential distribution with parameter 3.33. Chart 1The Statistical Distribution Of Shocks Is Very Predictable Many economists and investment strategists present their long-term forecasts for the economy and financial markets, yet completely ignore this very predictable distribution of shocks – making their long-term forecasts worthless! The question to such economists and strategists is why are there no shocks over your forecasting horizon? Their typical answer is that it is not an economist’s job to predict ‘acts of god’ or ‘black swans.’ But if insurance companies can incorporate the very predictable distribution of acts of god and black swans, then why can’t economists and strategists? Over any ten-year period, the likelihood of suffering a shock is a near-certainty, at 95 percent; in any five-year period, it is an extremely high 80 percent; in a two-year period, it is a coin toss at 50 percent; and even in one year it is a significant 30 percent (Chart I-2). Chart I-2On A Multi-Year Horizon, Another Shock Is A Near-Certainty Witness that since just 2016 we have experienced Brexit, and the election of Donald Trump as US president. These were binary-outcome events where we could ‘visualise’ the tail-event in advance, but many dismissed it as implausible. Then we had a global pandemic, and now Russia’s full-scale invasion of Ukraine. Therefore, the crucial question is not whether we will experience shocks. We always will. The crucial question is, will the shock be net deflationary or net inflationary? Our high-conviction view is that the Ukraine crisis will be net deflationary. Meaning that even if it starts as inflationary, it will quickly morph into deflationary. The Danger From Higher Energy Prices: The Obvious And The Not So Obvious Many people have noticed the suspicious proximity of oil price surges to subsequent economic downturns – most recently, the 1999-2000 trebling of crude and the subsequent 2000-01 downturn, and the 2007-2008 trebling of crude and the subsequent 2008-09 global recession. Begging the question, should we be concerned that the Ukraine crisis has lifted the crude oil price to a near-trebling since October 2020, not to mention the massive spike in natural gas prices? Many people have noticed the suspicious proximity of oil price surges to subsequent economic downturns. Of course, we know that the root cause of both the 2000-01 downturn and the 2008-09 recession was not the oil price surge that preceded them. As their names make crystal clear, the 2001-01 downturn was the dot com bust and the 2008-09 recession was the global financial crisis. And yet, and yet… while the oil price surge was not the culprit, it was certainly the accessory to both murders. The obvious way that high energy prices hurt is that they are demand destructive to both energy and non-energy consumption. In this regard, the good news is that the economy is becoming much less energy-intensive – every unit of real output requires about 40 percent less energy than at the start of the millennium (Chart I-3). Nevertheless, even if the scope to hurt is lessening, higher energy prices are still demand destructive. Chart I-3The Economy Is Becoming Less Energy-Intensive The not so obvious way that high energy prices hurt is that they risk driving up the long-duration bond yield and thereby tipping more systemically important economic and financial fragilities over the brink. This was the where the greater pain came from in both 2000 and 2008 (Chart I-4 and Chart I-5). Chart I-4Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 1999 Chart I-5Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 2008 Fortunately, the recent decline in the 30-year T-bond yield suggests that the bond market is looking through the short-term inflationary impulse of higher energy prices (Chart I-6). Instead, it is focussing on the deflationary impulse that will come from the demand destruction that the higher prices will trigger. Chart I-6Today, The Bond Market Is Looking Through The Inflationary Impulse From Higher Energy Prices The economic and financial sanctions imposed on Russia will only lead to additional demand destruction. Sanctions restrict trade and economic and financial activity – therefore they hurt both the side that is sanctioned and the side that is sanctioning. This mutuality of pain caused the West to balk at both the timing and severity of its sanctions. But absent an unlikely backdown from Russia, the sanctions noose will tighten, choking growth everywhere. If bond yields were to re-focus on inflation and move higher, it would add a further headwind to the economy and markets, forcing the 30-year T-bond yield back down again from a ‘line in the sand’ at around 2.4-2.5 percent. So, the long-duration bond yield will go down directly or via a short detour higher. Either way, bond yields will be lower in the second half of the year. Given the very tight connection between bond yields and stock market sector, style, and country allocation, it will become clear that the recent outperformance of cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100 was just a short-lived countertrend move in a much bigger structural downtrend (Chart I-7). This structural downtrend is set to resume. Chart I-7When Bond Yields Decline, Banks Underperform Underweight cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100. Yet, the over-arching message from the anatomy of shocks is that the ultimate structural low in the 30-year T-bond yield is yet to come, and will be a long way below the current 2.1 percent. Stay structurally overweight the 30-year T-bond. Fractal Trading Watchlist This week’s analysis focusses on banks, adds alternative electricity, and reviews bitcoin. Supporting the fundamental arguments in the main body of this report, the recent outperformance of banks has reached the point of fractal fragility that has signalled several important turning-points through the past decade (Chart 1-8). Accordingly, this week’s recommended trade is to go short world banks versus world consumer services, setting the profit target and symmetrical stop-loss at 12 percent. Chart I-8The Recent Outperformance Of Banks May Soon End Alternative Electricity Is Rebounding From An Oversold Position Bitcoin's Support Is Holding Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 20 percent. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5 Indicators To Watch - Interest Rate Expectations Chart II-6 Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Executive Summary Chinese Onshore Stocks Are Less Impacted By External Factors We are upgrading Chinese onshore stocks from underweight to neutral relative to global stocks. At the same time, we are closing our tactical trade of long Chinese investable stocks/short global stocks. In the near term, Russia’s armed invasion of Ukraine will spark a further selloff in global risk assets. Volatility in Chinese onshore stock prices will remain high; A-share prices in absolute terms may also drop but should fall by less than their peers in European and emerging markets. On the other hand, Chinese offshore stocks are more vulnerable to geopolitical risks compared with their onshore counterparts. There are tentative signs that home prices may be stabilizing, although demand for housing remains in deep contraction. Chinese policymakers remain vigilant in preventing the property market from overheating and credit creation from overshooting. However, the ongoing Russia/Ukraine incursion has the potential to catalyze a larger stimulus package in China. If the escalating geopolitical crisis threatens the global economy, China’s authorities will likely strengthen policy supports at home to buttress the country’s domestic political, economic and financial conditions. Bottom Line: Chinese onshore stocks will weather the ongoing geopolitical storm better than their offshore and global peers. China’s economy is also less negatively impacted by the Russia/Ukraine hostilities. If the crisis deepens, China’s leadership will likely step up measures to support its economy and ensure stable domestic financial and political dynamics. Feature The conflict between Russia and Ukraine unnerved global financial markets in the past few weeks. Chinese offshore stocks were not insulated from the geopolitical event; the MSCI China Index declined by about 4% in February, in-line with the selloff in global stocks. Chart 1Chinese Onshore Financial Markets Held Up Relatively Well Last Month The current global geopolitical environment, however, has turned us a bit more positive on Chinese onshore stocks in relative terms. In the near term, the onshore market should hold up better than its offshore and European counterparts. China’s closed capital market prevents panic capital outflows and its large current account surplus as well as favorable real interest rate differentials help to maintain strength in the RMB (Chart 1). On a cyclical basis, China’s domestic economic fundamentals will continue to drive prices in the A-share market. China’s aggregate economy is less affected by the Russia/Ukraine conflict than Europe. Energy supplies from Russia to China will likely continue and may even accelerate, mitigating the risks of energy shock-induced inflation spikes. As such, we are upgrading Chinese onshore stocks from underweight to neutral in a global portfolio, both in tactical and cyclical time horizons. We remain cautious about the size of Chinese stimulus for the year and, therefore, are neutral in our cyclical view on Chinese onshore stocks relative to global equities. Despite some nascent signs of reflation and an easing of housing policy in a few Chinese cities, aggregate property demand remains weak and overall policy easing in the sector has been marginal. Nonetheless, the situation surrounding Ukraine and the global sanctions against Russia are highly fluid and may provide some ground for Chinese policymakers to ramp up stimulus at home. If the conflict intensifies and derails the European/global economy, Beijing will be more inclined to adopt measures to ensure the stability of its domestic economy, financial markets and political dynamics. Meanwhile, we are closing our long MSCI China/short MSCI global tactical trade. Chinese offshore stocks are more vulnerable to geopolitical tensions and risk-off sentiment among global investors. The Russia Incursion Has Limited Direct Impact On China’s Economy Chinese stocks were not immune last week to the global financial market’s gyrations triggered by Russia’s invasion of Ukraine. While Russia’s attack on its neighbor will create short-term disruptions on the prices of global commodities and China’s A-shares, the cyclical performance of Chinese onshore stocks is tied to the country’s domestic economic fundamentals. The military conflict between Russia and Ukraine should have a limited knock-on effect on China’s business cycle dynamics for the following reasons: Russia and Ukraine together account for less than 3% of Chinese total exports as of 2021, limiting the negative impact from reduced demand in the region on China’s current account balance. Chart 2Ukraine: China’s Major Source Of Agricultural Commodity Supplies Russia’s incursion of Ukraine may have consequences on China’s food prices. Ukraine is a major agricultural commodity exporter to China, hence a prolonged military conflict may disrupt agricultural supplies and push up imported food prices in China (Chart 2). In this scenario, we expect that Beijing will provide subsidies to ease pressures on domestic food prices due to supply shocks, rather than tighten monetary policy to reduce demand. China is unlikely to experience shocks linked to possible energy disruptions. Russia is a core exporter of energy to China and supplies of crude oil, natural gas and coal have increased in recent years (Chart 3). We do not expect that Russia’s energy supply to China will be disrupted. Indeed, following the 2014 Russia’s invasion of Crimea, Russia’s crude oil exports to China increased by 40% (Chart 3, top panel). We anticipate that oil prices will fall from the current level in the second half of the year, limiting the upshot from higher oil prices on Chinese inflation. So far, the US and EU have announced tough sanctions on Russia’s non-energy sectors, but they have avoided halting Russia’s energy exports. In the unlikely scenario that energy flows from Russia to Europe are disrupted in any meaningful and long-lasting way, either through European sanctions or a Russian embargo, Russia would probably turn to China to absorb its energy exports. Given that Russia cannot easily replace Europe with any other alternative market, particularly natural gas, China would gain an upper hand in price negotiations with the Russians (Chart 4). Thus, a steady supply of cheap natural gas and other forms of energy would be a net positive for China’s economy. Chart 4Russia Cannot Easily Replace Europe With Any Alternative Consumer Other Than China Chart 3Russia's Ties With China On Energy Supplies Will Likely Strengthen Meanwhile, oil’s current price spike may widen the gap in profits between China’s upstream and downstream industrial enterprises (Chart 5). However, the effect from higher oil prices on Chinese downstream manufacturers should be temporary. Our Commodity and Energy Strategists believe that the Russian invasion will prompt increased production from core OPEC producers. These production increases would reduce prices from last week’s $105 per barrel level to $85 per barrel by the second half of 2022 and keep it at that level throughout 2023 (Chart 6). Chart 6Crude Oil Price Risk Premium Will Abate But Not Disappear Chart 5Rising Oil Prices May Temporarily Widen Profit Gaps Between China's Up- And Downstream Industries Bottom Line: Russia’s invasion of Ukraine should have a limited direct impact on China’s domestic economy, inflation and monetary policy. Tentative Signs Of Home Price Stabilization Although the property market is showing some signs of improvement, the aggregate demand for homes remains very sluggish. Recently released housing data in China show some slight progress, as fewer cities reported a month-on-month drop in new home prices in January (Chart 7). The monthly average new home prices among China’s 70 cities were broadly flat last month following four consecutive months of falling prices. Tier 1 and Tier 2 cities had the largest increases in home prices, whereas prices in other regions continued to contract through January, albeit to a lesser degree (Chart 7, bottom panel). The minor improvement in home prices reflects recently implemented measures to help shore up the flagging market. Last month, the PBoC cut the policy rate by 10 bps and reduced the one- and five-year loan prime rates by 10 bps and 5 bps, respectively. Moreover, last week several regional banks lowered the down payments on mortgages for homebuyers. Chart 8...Demand For Housing Remains In Deep Contraction Chart 7Although There Are Some Early Signs Of Stabilization In Home Prices... Nonetheless, the aggregate demand for housing remains weak. China’s 100 largest developers experienced a roughly 40% year-on-year plunge in total sales in January, indicating that recent easing measures failed to revive the downbeat sentiment among homebuyers (Chart 8). Bottom Line: Policymakers will remain vigilant in not inducing another surge in house prices and will continue to target steady home prices. As such, it is too early to upgrade our cyclical view on China’s property market, stimulus and economic recovery. Investment Conclusions We are upgrading Chinese onshore stocks to neutral relative to global equities (both tactically and in the next 6 to 12 months), while closing our tactical trade of long MSCI China/short MSCI global index. Chart 9Chinese Onshore Stock Prices Are Largely Driven By Domestic Rather Than External Factors... Given the limited impact of the Russia/Ukraine conflict on China’s domestic economy and the low correlation to the global equity index, Chinese onshore stock prices may also fall in absolute terms in the coming weeks, but not by as much as their offshore and European counterparts (Chart 9). Furthermore, while we maintain a cautious cyclical outlook for China’s stimulus, the ongoing geopolitical crisis has the potential to provide a catalyst for Chinese policymakers to stimulate the domestic economy more forcefully. If the clash evolves into a real risk to the European economy and global financial markets, odds are high that Chinese policymakers will step up stimulus measures to ensure domestic stability. In this scenario, Chinese onshore stocks will likely outperform global equities. In the past, Chinese authorities refrained from a credit overshoot when the business cycle slowed in an orderly manner, but they stimulated substantially following an exogenous shock. For example, China rolled out massive stimulus packages after the 2008 Global Financial and the 2011/12 European credit crises. Beijing did not directly respond to Russia’s 2014 annexation of Crimea with additional monetary support to China’s domestic economy. However, the Chinese authorities started to aggressively stimulate when a collapse in domestic demand coincided with a global manufacturing recession in 2015. Chart 10...Whereas Chinese Offshore Stocks Are More Vulnerable To Global Risk-Off Sentiment The PBoC’s outsized liquidity injection in the interbank system last Friday is also a sign that Beijing is willing to accelerate policy easing if the geopolitical backdrop meaningfully worsens. Regarding Chinese investable stocks, we maintain our cyclical underweight stance relative to global equities. In the near term, risk-off sentiment among global investors will undermine the performance of Chinese offshore stocks in both absolute and relative terms (Chart 10). Over a longer time horizon (6 to 12 months), growth stocks will likely underperform value stocks when global stocks recover. Thus, the tech-heavy MSCI China Index is less attractive to investors compared with other emerging and developed market equities that are more value-centric. Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations
Executive Summary The heightened uncertainty of the current situation means it makes sense to keep portfolio duration close to benchmark. The recent market turmoil means that a 50 bps rate hike is off the table for the March FOMC meeting, but the Fed will proceed with a 25 bps rate hike this month and signal a further steady pace of tightening. As of Monday morning, the market is priced for close to 150 bps of tightening during the next 12 months. This is reasonable assuming that inflation moderates in the second half of the year and that long-dated inflation expectations remain well contained. A moderation of inflation in H2 remains our base case, but the war in Ukraine increases the risk that inflation will be sticky and that long-dated inflation expectations will move higher. The Golden Rule Of Bond Investing Bottom Line: An ‘at benchmark’ portfolio duration stance makes sense for now, but the recent drop in Treasury yields could eventually present us with an opportunity to re-initiate a ‘below-benchmark’ portfolio duration position. Stay tuned. Feature The Russian invasion of Ukraine is ongoing and financial markets will surely remain volatile until a resolution is reached. For more details on how we see the crisis evolving please refer to last week’s BCA Special Report.1 As we go to press on Monday, the market is trying to digest the impact of sanctions that will block the access of some Russian banks to the SWIFT financial messaging system and freeze some Russian central bank reserves that are held abroad in USD and EUR. Taken together, the sanctions will impart a large stagflationary impulse to the Russian economy and, as would be expected, the Ruble is depreciating rapidly on Monday morning. The reaction in US bond markets is so far more muted. The 10-year Treasury yield is currently 1.86% - down from 1.99% last Wednesday – and the 2-year Treasury yield is 1.44% - down from 1.58% last Wednesday (Chart 1). Movements in the real and inflation components of US Treasury yields do show that the US market is pricing-in some stagflationary contagion. The real 10-year Treasury yield is down to -0.71% (from -0.54% last Wednesday) and the 10-year TIPS breakeven inflation rate is up to 2.57% (from 2.53% last Wednesday). The same divergence between a falling real yield and rising cost of inflation compensation is seen at the 2-year maturity point (Chart 1, bottom 2 panels). The market has also moved to price-in a shallower path for Fed rate hikes compared to last week (Chart 2). The market-implied odds of a 50 bps rate hike this month are now slim and the market is now looking for only 139 bps of cumulative tightening (just under six 25 basis point rate hikes) by the end of this year. Chart 2Fed Funds Rate Expectations Chart 1A Stagflationary Shock We agree with the market that the heightened uncertainty and tightening of financial conditions takes a 50 bps rate hike off the board for the March FOMC meeting. A 25 bps rate hike this month remains the most likely scenario. However, we also think the market might be over-estimating the extent to which contagion from Russia will limit the pace of Fed tightening later in the year. In fact, we are inclined toward the view that the lasting impact of the crisis on the US economy might be more inflationary than deflationary. Chart 3Expect US/German Yield Differential To Widen The inflationary risk is that a sustained upward shock to the oil price could keep headline inflation higher than it would otherwise be. This could also bleed through into other commodity prices and possibly even to inflation expectations. The textbook central bank response should be to ignore a commodity price shock and set policy based on trends in core inflation. However, in the current environment it will be difficult for the Fed to ignore yet another inflationary shock, especially if long-dated inflation expectations move higher. On the other hand, the economic fallout from a Russian recession will be much worse for Europe than for the United States. European Central Bank (ECB) Chief Economist Philip Lane recently estimated that the Ukrainian war could shave 0.3%-0.4% off Eurozone GDP this year.2 If the shock leads to a wider divergence between Fed and ECB policy expectations, then we would expect to see a widening of US yields versus European yields and upward pressure on the US dollar. Given that US bond yields can only diverge so far from yields in the rest of the world, a stronger dollar may cap any increase in US bond yields and eventually limit the extent of Fed tightening. So far, trends in the dollar and dollar sentiment have been supportive of rising US bond yields, but it will be important to watch this situation in the coming months to see if it changes (Chart 3). Investment Conclusions The heightened uncertainty of the current situation means it makes sense to keep portfolio duration close to benchmark. The Fed is likely to proceed with tightening policy at a steady pace, starting with a 25 bps rate hike this month. Trends in inflation and financial conditions will determine the pace of rate hikes in H2 2022. Right now, our sense is that the lasting impact of the Ukrainian crisis on the US economy will prove to be more inflationary than deflationary. With that in mind, the recent drop in Treasury yields may eventually present us with an opportunity to re-initiate a ‘below-benchmark’ portfolio duration position. Checking In With Our Golden Rule Given the current market turmoil, we think it’s a good time to step back and check in with our Golden Rule of Bond Investing.3 The Golden Rule is a framework that investors can use to implement portfolio duration trades. It states that investors should determine the expected change in the fed funds rate that is priced into markets for the next 12 months and then decide whether the actual change in the funds rate will be greater or less than what is priced in the market. If you expect the fed funds rate to rise by more than what is priced in (a hawkish surprise), you should keep portfolio duration low. If you expect the fed funds rate to rise by less than what is priced in (a dovish surprise), you should keep portfolio duration high. It is admittedly a simple framework, but it does have a strong track record of performance. In general, hawkish surprises coincide with the Bloomberg Barclays Treasury index underperforming cash and dovish surprises coincide with the index outperforming cash (Chart 4). Chart 4The Golden Rule Of Bond Investing More specifically, if we look at rolling 12-month periods going back to 1990, we see that dovish surprises have coincided with positive excess Treasury returns versus cash 85% of the time for an average 12-month excess return of 4.0%. Conversely, hawkish surprises have coincided with negative excess Treasury returns 72% of the time for an average 12-month excess return of -1.5% (Chart 5 & Table 1). Table 112-Month Treasury Excess Returns And Fed Funds Rate Surprises (1990 - Present) Chart 5The Golden Rule’s Track Record As of today, the market is priced for 149 bps of Fed tightening during the next 12 months. That is very close to six 25 basis point rate hikes at the next eight FOMC meetings. Given our view that inflation will moderate in the second half of the year, this seems like a reasonable forecast that is consistent with our ‘at benchmark’ portfolio duration stance. However, as noted above, we believe the war in Ukraine could lead to an increase in inflationary pressures in the United States. Therefore, we see the balance of risks as tilted toward more rate hikes than are currently discounted rather than fewer. It will be vital to monitor long-dated inflation expectations during the next few months to assess how the pace of Fed rate hikes will evolve. Using The Golden Rule To Forecast Treasury Returns One more application of our Golden Rule framework is that we can use it to create forecasts for Treasury index returns. This is done by first looking at the historical correlation between the Fed Funds Surprise – the difference between the expected 12-month change in the fed funds rate and the realized change – and the change in the Treasury index yield (Chart 6). A regression between these two variables allows us to estimate the change in the Treasury index yield based on an assumed Fed Funds Surprise. Chart 6The Correlation Between Treasury Yields And Fed Funds Surprises Once we have an expected 12-month change in the Treasury index yield, we can translate that change into an expected return using the index’s average yield, duration and convexity. The result of this analysis is presented in Table 2. Table 2Using The Golden Rule To Forecast Treasury Returns Table 2 shows that we would expect the Treasury index to deliver a total return of 1.82% in a scenario where the Fed lifts rates by 150 bps during the next 12 months. This would equate to the Treasury index beating a position in cash by between 0.07% and 0.83%, depending on whether rate hikes are front-loaded or back-loaded. A pace of one 25 basis point rate hike per meeting (+200 bps during the next 12 months) would lead to the Treasury index underperforming cash by between -2.35% and -3.02%. Conversely, we can see that the index is expected to beat cash by between 3.25% and 3.92% if the Fed only lifts rates four times during the next 12 months. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see BCA Special Report, “Russia Takes Ukraine: What Next?”, dated February 24, 2022. 2 https://www.reuters.com/business/exclusive-ecb-policymakers-told-ukraine-war-may-shave-03-04-off-gdp-2022-02-25/ 3 Please see US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Treasury Index Returns Spread Product Returns Recommended Portfolio Specification Other Recommendations
Executive Summary Hopes of an imminent peace deal between Russia and Ukraine will be dashed. The conflict will worsen over the coming days. As was the case during the original Cold War, both sides will eventually forge an understanding that allows the pursuit of mutually beneficial arrangements. A stabilization in geopolitical relations, coupled with fading pandemic headwinds, should keep global growth above trend this year, helping to support corporate earnings. The era of hyperglobalization is over. While central banks will temper their plans to raise rates in the near term, increased spending on defense and energy independence will lead to higher interest rates down the road. How Stocks Fared During The Cuban Missile Crisis Bottom Line: The near-term outlook for risk assets has deteriorated. We are downgrading global equities from overweight to neutral on a tactical 3-month horizon. We continue to expect stocks to outperform bonds on a 12-month horizon as the global economic recovery gains momentum. On an even longer 2-to-5-year horizon, equities are likely to struggle as interest rates rise more than expected. Dear Client, Given the rapidly evolving situation in Ukraine, we are sending you our thoughts earlier than normal this week. We will continue to update you as events warrant it. Best regards, Peter Berezin Chief Global Strategist False Dawn In the lead-up to the invasion, Vladimir Putin assumed that Ukrainian forces would fold just as quickly as US-backed Afghan forces did last summer. He also presumed that the rest of the world would reluctantly accept Russia’s takeover of Ukraine. Both assumptions appear to have been proven wrong. Even if Putin succeeds in installing a puppet government in Kyiv, a protracted insurgency is sure to follow. In the initial days of the invasion, Russian troops generally tried to avoid harming civilians, partly in the hope that Ukrainians would see the Russian military as liberators. Now that this hope has been dashed, a more brutal offensive could unfold. This would trigger even more sanctions, leading to a wider gulf between Russia and the West. It is highly doubtful that sanctions will dissuade Putin from trying to subdue Ukraine. Putin made a name for himself by staging a successful invasion of Chechnya in 1999, just three years after the Yeltsin government had suffered a major defeat there. To withdraw from Ukraine now, without having fomented a regime change in Kyiv, would be a humiliating outcome for him. In this light, BCA’s geopolitical team, led by Matt Gertken, has argued that ongoing peace talks taking place on the border of Ukraine and Belarus are unlikely to amount to much. The situation will get worse before it gets better. Market Implications It always feels a bit crass writing about finance during times like this, but as investment strategists, it is our job to do so. With that in mind, we would make the following observations: Global equities are likely to suffer another leg down in the near term as hopes of an imminent peace deal fizzle. Consequently, we are downgrading our view on global stocks from overweight to neutral on a 3-month horizon. Nimble investors with a low risk tolerance should consider going underweight equities. We are shifting our stance on US stocks from underweight to neutral on a 3-month horizon. Europe could face significant pressures from near-term disruptions to Russian gas supplies. It does not make much sense for Russia to export gas if it is effectively barred from accessing the proceeds of its sales. Central and Eastern Europe will be particularly hard hit (Chart 1). Chart 1Central and Eastern Europe Would Suffer The Most From A Russian Energy Blockade For now, we are maintaining an overweight to stocks on a 12-month horizon. While it will take a month or two, both sides will ultimately forge an understanding whereby Russia and the West continue to publicly bad-mouth each other while still pursuing mutually beneficial arrangements. Remember that during the Cold War, the Soviet Union continued to sell oil to the West. Even the Cuban Missile Crisis had only a fleeting impact on equities (Chart 2). Chart 2How Stocks Fared During The Cuban Missile Crisis Chart 3European Fiscal Policy Will Remain Structurally Looser Over The Coming Years Assuming that any reduction in Russian energy exports is temporary, oil prices will eventually recede. BCA’s commodities team, led by Bob Ryan, expects Brent to settle to $88/bbl by the end of 2022 (down from the current spot price of $101/bbl and close to the forward price of $87/bbl). Like oil, gold prices have upside in the near term but should edge lower once the dust settles. Global growth should remain solidly above trend in 2022 as pandemic-related headwinds fade and fiscal policy turns more expansionary. Even before the Ukraine invasion, the structural primary budget deficit in Europe was set to swing from a small surplus to a deficit (Chart 3). The emerging new world order will lead to sizable additional military spending, as well as increased outlays towards achieving energy independence (new LNG terminals, more investment in renewables, and perhaps even some steps towards restarting nuclear power programs). China will also step up credit easing and fiscal stimulus. This will not only benefit the Chinese economy, but it will also provide some much-needed support to European exporters (Chart 4). While credit spreads are apt to widen further in the near term, corporate bonds should benefit from stronger growth later this year. US high-yield bonds are pricing in a jump in the default rate from 1.3% over the past 12 months to 4.2% over the coming year, which seems somewhat excessive (Chart 5). Chart 4Chinese Policy Will Be A Tailwind For Growth Chart 5Credit Markets Are Pricing In An Excessive Default Rate Central banks will temper their plans to raise rates in the near term. Investors and speculators are net short duration at the moment, which could amplify any downward move in bond yields (Chart 6). However, over a multi-year horizon, recent events will lead to both higher inflation and interest rates. Larger budget deficits will sap global savings. The retreat from globalization will also put upward pressure on wages and prices. As defensive currencies, the US dollar and the Japanese yen will strengthen in the near term as the conflict in Ukraine escalates. Looking beyond the next few months, the dollar will weaken. On a purchasing power parity basis, the dollar is amongst the most expensive currencies (Chart 7). For example, relative to the euro, the dollar is 22% overvalued (Chart 8). The US trade deficit has doubled since the start of the pandemic, even as equity inflows have dipped (Chart 9). Speculators are long the greenback, which raises the risk of an eventual reversal in dollar sentiment. Chart 6Short Duration Is A Crowded Trade Chart 7The US Dollar Is Overvalued… Chart 8...Especially Against The Euro The freezing of Russia’s foreign exchange reserves will encourage China to diversify away from US dollars towards hard assets such as land and infrastructure in economies where they are less likely to be seized. It will also encourage the Chinese authorities to bolster domestic demand and permit a further modest appreciation of the RMB since these two steps will reduce the current account surpluses that make foreign exchange accumulation necessary. EM currencies will benefit from this trend. Chart 9The Trade Deficit Is A Headwind For The Dollar In summary, the near-term outlook for risk assets has deteriorated. We are downgrading global equities from overweight to neutral on a tactical 3-month horizon. We continue to expect stocks to outperform bonds on a 12-month horizon as the global economic recovery gains momentum. On an even longer 2-to-5-year horizon, equities are likely to struggle as interest rates rise more than expected. Trade Update: We closed our long Brent oil trade for a gain of 24% last week. Earlier today, we were stopped out of the trade we initiated on September 16, 2021 going long the Russian ruble and the Brazilian real. The BRL leg was up 6.2% at the time of termination while the RUB leg was down 23.1% (based on the Bloomberg RUB/USD Carry Return Index as of 4pm EST today). Peter Berezin Chief Global Strategist peterb@bcaresearch.com View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Executive Summary US Treasury yields have surged in response to high US inflation and Fed tightening expectations. However, the move looks overdone in the near-term. Too many Fed hikes are now discounted for 2022, US realized inflation should soon peak, inflation expectations have stabilized, financial conditions have started to tighten, and positioning in the Treasury market is now quite short. These factors will act to stabilize Treasury yields over the next few months, even with the cyclical backdrop remaining bond bearish. Markets Think The Fed Will Hike More Sooner And Less Later – The Opposite Is More Likely Recommendation Inception Level Inception Date Long Dec 2022/Short Dec 2024 3-Month SOFR Future 0.25 Feb 22/22 New Trade: Go long the December 2022 US SOFR interest rate futures contract versus shorting the December 2024 SOFR contract. The former discounts too many Fed hikes for this year and the latter discounts too few hikes over the next three years. Bottom Line: US Treasury yields now discount the maximum likely hawkish scenario for Fed rate hikes in 2022, with risks all pointing in the direction of the Fed delivering less than expected. Upgrade US duration exposure to neutral from below-benchmark on a tactical basis. Feature Chart 1A Near-Term Overshoot For UST Yields During the BCA Research US Bond Strategy quarterly webcast last week, we announced a shift in our recommended US duration stance, moving from below-benchmark to neutral. This move was more tactical (i.e. shorter-term) in nature, as we still strongly believe that bond markets are underestimating the eventual peak for US bond yields over the next couple of years. In the near term, however, we see several good reasons to expect the recent big run-up in US bond yields to pause, warranting a more neutral tactical duration exposure (Chart 1). We discuss those reasons – and the implications for both US duration strategy - in this report published jointly by BCA Research’s US Bond Strategy and Global Fixed Income Strategy services. Reason #1: Too Many Fed Rate Hikes Are Now Discounted For 2022 The US overnight index swap (OIS) curve currently discounts 146bps of Fed rate hikes by the end of 2022. This is a big change from the start of the year when only 77bps of hikes were priced (Chart 2). The OIS curve repricing now puts the path of the funds rate for this year well above the last set of FOMC interest rate projections published at the December 2021 Fed meeting. In other words, the market has already moved to discount a big upward shift in the FOMC “dots” for 2022, and even for 2023, at next month’s FOMC meeting. Chart 2Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely We think a more likely outcome for 2022 is that the Fed lifts rates four or five times, not six or even seven times as some Wall Street investment banks are forecasting. We set out the reasons why we think the Fed will go less than expected in the rest of this report. At a minimum, there is virtually no chance that the Fed will provide guidance to markets that is more hawkish than current market pricing, which would push bond yields even higher in the near term. Reason #2: US Inflation Will Soon Peak The relentless string of upside surprises on US inflation has been the main reason the bond market has moved so rapidly on pricing in more Fed rate hikes. The story is about to change, however, as US inflation should peak sometime in the next few months and begin to rapidly decelerate toward levels much closer to, but still well above, the Fed’s 2% inflation target. Already, the intense global inflation pressures from commodities and traded goods prices over the past year has started to lose potency. The annual growth rate of the CRB Raw Industrials index has eased from a peak of 45% in June to 18%, in line with slowing growth momentum of global manufacturing activity (Chart 3, top panel). The softening of input price pressures is evident in business survey measures like the ISM Manufacturing Prices Paid index, which typically leads US headline CPI inflation by six months and has fallen by 16 points since the peak in June (middle panel). Chart 3Global Inflation Pressures Easing The global supply chain disruptions that have caused inventory shortages in products ranging from new cars to semiconductors also appear to be easing. Supplier delivery times are shortening according to the ISM Manufacturing and Non-Manufacturing surveys (bottom panel). Combined with other indications of the loosening of supply chain logjams, like lower shipping costs, the influence of supply disruptions on inflation should diminish, on the margin. Energy prices should also soon contribute to disinflationary momentum (Chart 4). BCA Research’s Commodity & Energy Strategy service is forecasting the Brent oil price to reach $76/bbl at the end of 2022 and $80/bbl at the end of the 2023. That represents a significant decline from the current $95/bbl price that reflects a large risk premium for the potential oil market supply disruptions in response to a Russian invasion of Ukraine. A war-driven spike in oil prices does risk extending the current period of high US (and global) inflation. However, it should be noted that the annual growth in oil prices has been decelerating even as oil prices have been rising recently, showing the power of base effect comparisons that should lead to a lower contribution to overall inflation from energy prices over the next 6-12 months. Chart 4Oil Prices Will Soon Turn Disinflationary Chart 5A Changing Mix Of US Consumer Spending Will Lower Overall Inflation Looking beyond the commodity space, a shifting mix of US consumer spending should also help push overall US inflation lower. US core CPI inflation hit a 34-year high of 6.0% in January, fueled by 11.7% growth in core goods inflation (Chart 5). We anticipate that overall core inflation will slow to levels more consistent with the trends seen in more domestically focused sectors like core services and shelter, where inflation is running around 4%. US consumers have started to shift their spending patterns away from goods, which was running well above its pre-pandemic trend, back toward services, which was running below its pre-pandemic trend (Chart 6). This will help narrow the gap between goods and services inflation, particularly as easing supply chain disruptions help dampen goods inflation. Chart 6Goods Inflation Should Soon Peak Chart 7There Are Still Pockets Of Available US Labor Market Supply Chart 8US Wage Growth Should Soon Begin To Moderate There is also the potential for some of the pressures stemming from the tight US labor market to become a bit less inflationary in the coming months. While the overall US unemployment rate of 4% is well within the range of full employment NAIRU estimates produced by the FOMC, there are notable differences across employment categories suggesting that there are still sizeable pockets of labor supply. For example, the unemployment rate for managerial and professional workers is a tiny 2.3%, while the unemployment rate for services workers was a more elevated 6.7% (Chart 7, top panel). There are also noteworthy differences in US labor market trends when sorted by wage growth. Employment in industries with lower wages – predominantly in services – has not returned to the pre-pandemic peak, unlike employment in higher wage cohorts (middle panel).1 As the US economy puts the Omicron variant in the rearview mirror, service industries most impacted by pandemic restrictions should see an increase in labor supply as workers return to the labor force. This will help close the one percentage point gap between the labor force participation rate for prime-aged workers (aged 25-54) and its pre-pandemic peak (bottom panel). This will also help to mitigate the current upturn in service sector wage growth, which reached 5.2% at the end of 2021 according to the US Employment Cost Index (Chart 8). When US inflation finally peaks in the next few months – most notably for goods prices and service sector wages – the Fed will be under less pressure to hike rates as aggressively as discounted in current bond market pricing. Reason #3: US Inflation Expectations Have Stabilized Chart 9TIPS Breakevens Are Not Telling The Fed To Be More Aggressive The Fed always pays a lot of attention to inflation expectations, particularly market-based measures like TIPS breakevens, to assess if its monetary policy stance is appropriate. The current message from breakevens is that the Fed does not have to turn even more hawkish than expected to bring inflation back down to levels consistent with the Fed’s 2% target. The 10-year TIPS breakeven is currently 2.4%, down from a peak of 2.8% and within the 2.3-2.5% range that we deem consistent with the Fed’s inflation target. Inflation expectations are even more subdued on a forward basis, with the 5-year TIPS breakeven, 5-years forward now down to 1.95% (Chart 9). Shorter term TIPS breakevens remain elevated, with the 2-year breakeven at 3.7%. We continue to favor positioning for a narrower 2-year TIPS breakeven spread – realized inflation will soon peak and the New York Fed’s Consumer Expectations survey shows that household inflation expectations for the next three years have already fallen significantly (bottom panel). Lower inflation expectations, both market-based and survey-based, suggest that the Fed can be cautious on the pace of rate hikes after liftoff next month. Reason #4: US Financial Conditions Are Tightening Alongside Cooling US Growth Momentum We have long described the link between financial markets and the Fed’s policy stance as “The Fed Policy Loop.” In this framework, the markets act as a regulator on Fed hawkishness (Chart 10). If the Fed comes across as overly hawkish, risk assets will sell off (lower equity prices, wider corporate credit spreads), the US dollar will appreciate, the US Treasury curve will flatten and market volatility measures like the VIX index will increase. All of those trends act to tighten US financial conditions, threatening a growth slowdown that will force the Fed to back off from its previous hawkish bias. Chart 10The Fed Policy Loop Financial conditions have indeed tightened as markets have priced in more Fed rate hikes in 2022 (Chart 11). Since the start of the year, the S&P 500 is down 9% year-to-date, US investment grade corporate spreads have widened 26bps, the 2-year/10-year US Treasury curve has flattened by 34bps and the VIX index has increased 11 pts. In absolute terms, US financial conditions remain highly stimulative and the risk asset selloff so far poses little threat to US economic growth. However, if the Fed were to deliver all of the rate hikes in 2022 that are currently discounted in the US OIS curve, the market selloff would deepen as investors began to worry about a Fed-engineered economic slowdown. This would lead to a more significant tightening of financial conditions, representing an even bigger risk to US growth. The Fed cannot risk appearing too hawkish too soon, with US growth momentum already showing signs of slowing (Chart 12). The Conference Board US leading economic indicator has stopped accelerating and may be peaking, US business confidence is softening and consumer confidence is very depressed according to the University of Michigan survey. Importantly, high inflation is cited as the main reason for weak consumer confidence, as wage increases have not matched price increases. If realized inflation falls, as we expect, this could actually provide a boost to consumer confidence as households would feel an improvement in real incomes and spending power – a development that could eventually lead to more Fed rate hikes in 2023 if consumer spending improves, especially if inflation stays above the Fed’s 2% target. Chart 11Fed Hawkishness Has Already Tightened Financial Conditions Chart 12Not The Best Time For The Fed To Be More Aggressive For now, however, the risk of a preemptive tightening of financial conditions will ensure that the Fed delivers fewer rate hikes than the market expects this year. Reason #5: Treasury Market Positioning Is Now Very Short Chart 13Reliable Bond Indicators Calling For A Pause In The UST Selloff The final reason to increase US duration exposure now is that Treasury market positioning has become quite short and has become a headwind to higher bond yields and lower bond prices. The JP Morgan fixed income client duration survey shows that bond investors are running duration exposures well below benchmark (Chart 13). Speculators are also running significant short positions in longer-maturity US Treasury futures. This suggests limited selling power in the event of more bond bearish news and increased scope for short-covering in the event of risk-off event – like a shooting war in Ukraine – or surprisingly negative US economic data. On that front, the Citigroup US data surprise index, which is typically highly correlated to the momentum of US Treasury yields, has dipped a bit recently but remains at neutral levels (top panel). A similar measure of neutrality is sent by some of our preferred cyclical bond indicators like the ratio of the CRB raw industrials index to the price of gold – the 10-year yield is now in line with that ratio, which appears to be peaking (middle panel). Investment Conclusions Given the five reasons outlined in this report – too many Fed hikes are now discounted for 2022, US realized inflation should soon peak, inflation expectations have stabilized, financial conditions have started to tighten, and positioning in the Treasury market is now quite short – we decided last week to upgrade our recommended US portfolio duration to neutral from below-benchmark. However, this move is only for a tactical investment horizon. We still see the cyclical backdrop as bond bearish, as Treasury yields do not yet reflect how high US interest rates will rise in the upcoming tightening cycle. The 5-year Treasury yield, 5-years forward is currently at 2.0%. This lies at the low end of the range of estimates of the longer-run neutral fed funds rate (Chart 14) from the New York Fed’s survey of bond market participants (2%) and the median FOMC longer-run interest rate projection from the Fed dots (2.5%). We see the Fed having to lift rates faster than markets expect in 2023 and 2024. US inflation this year is expected to settle at a level above the Fed’s 2% target before picking up again next year alongside renewed tightening of labor market conditions once the remaining supply of excess labor is fully absorbed. Chart 14The Cyclical UST Bear Market Is Not Over Yet Chart 15Go Long The Dec/22 SOFR Contract Vs. The Dec/24 Contract As a way to position for the Fed doing fewer rate hikes than expected in 2022, but more hikes than expected in 2023/24, we are entering a new trade this week – going long the December 2022 3-month SOFR US interest rate futures contract versus a short position in the December 2024 3-month SOFR contract. The implied interest rate spread on those two contracts has tightened to 25bps (Chart 15). We expect that trend to reverse, however, with the spread increasing as markets eventually move to price out rate hikes in 2022 and price in much more Fed tightening in 2023 and 2024. We will discuss the implications of the shift in our US duration stance for our views on non-US bond markets in next week’s Global Fixed Income Strategy report. Our initial conclusion is that our country allocation recommendations for government bonds will remain unchanged – underweighting the US, UK, and Canada; overweighting core Europe, peripheral Europe, Japan and Australia – but we will also increase duration exposure within most (if not all) countries. As in the US, we also see markets pricing in too many rate hikes in the UK and Canada for 2022 but too few rate hikes over the next two years. On the other hand, markets are pricing in too many rate cumulative hikes over the next 2-3 years in Europe, Australia and Japan (Table 1). Table 1Markets Have Pulled Forward Rate Hikes Everywhere Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The definitions for the wage cohorts can be found in the footnote of Chart 7. Cyclical Recommendations (6-18 Months) Tactical Overlay Trades