Labor Market
Highlights The latest “dot plot” from the Fed reaffirmed the FOMC’s intention to keep rates near zero for at least the next two years, despite evidence that the US economy will recover from the pandemic much faster than expected. The Fed’s reluctance to telegraph any rate hikes stems in part from its conviction that the neutral rate of interest has declined. A lower neutral rate implies that monetary policy may not be as accommodative as widely believed. Whereas Fed officials have argued that the neutral rate has fallen due to structural factors outside their control, critics insist that the Fed’s own actions have painted it into a corner. By cutting rates at every opportunity, so the argument goes, the Fed has inflated a massive asset bubble. Moreover, low rates have encouraged governments and the private sector to take on more debt. All this has locked the Fed into a low interest-rate trap: Any attempt to tighten monetary policy would cause asset prices to plunge and debt-servicing costs to rise. This would result in financial distress and rising unemployment – the exact two things the Fed wants to avoid. While we disagree with the view that easier monetary policy has made things worse, we do agree that elevated asset prices and high debt levels limit the Fed’s room for maneuver. In this week’s report, we contend that the low interest-rate trap will likely be resolved through an extended period of easy money, ultimately culminating in significantly higher inflation starting by the middle of this decade. Growth Dots Up, Rate Dots Not The FOMC released its latest Summary of Economic Projections (aka the “dot plot”) this week. As widely anticipated, the Fed upgraded its view on growth following the passage of the $1.9 trillion American Rescue Plan Act. The Fed now expects real GDP to rise by 6.5% in the fourth quarter of 2021 from a year ago, up from its December 2020 estimate of 4.2%. The Fed also sees the unemployment rate falling to 4.5% by the fourth quarter of this year. Back in December, the Fed thought the unemployment rate would end this year at 5% (Chart 1). Chart 1The Fed Sees Faster Recovery, Same Rate Path Chart 2The Fed Has Been Lowering Its Estimate Of The Neutral Rate The Fed’s unemployment rate projection of 3.9% for 2022 is slightly below the “longer run” estimate of 4.0%. This suggests that the Fed believes the US will have reached full employment by the end of next year. Yet, despite the Fed’s sanguine view on the pace of the economic recovery, the median dot for the expected fed funds rate in 2023 remained at 0.1% (although seven members did pencil in a hike for that year, up from five last December). The median “longer run” dot stayed at 2.5%, with not a single Fed member putting in an estimate above 3%. The Fed regards this longer-run dot as its estimate of the neutral rate of interest – the interest rate consistent with full employment and stable inflation. When the Fed introduced the “dots” back in early 2012, its estimate of the neutral rate stood at 4.3%. It has been trending lower ever since (Chart 2). Explanations For The Falling Neutral Rate What accounts for the steady decline in the Fed’s estimate of the neutral rate in recent years? Fed officials have generally argued that structural forces have dragged down the equilibrium interest rate for the economy. These forces include slower trend growth, an aging population, the shift to a capital-lite economy, high levels of overseas savings, and as we recently discussed, increased income inequality. There is another interpretation, however. Rather than casting the Fed as a helpless observer responding to structural forces beyond its control, some commentators have argued that the Fed’s own actions explain why rates are so chronically low today. By cutting interest rates at every opportunity, so the argument goes, the Fed has inflated a massive asset bubble, stretching from equities to commercial real estate to cryptocurrencies. Moreover, low rates have encouraged governments and the private sector to take on more debt. Chart 3The Correlation Between Swings In Mortgage Rates And Housing Activity All this has locked the Fed into a low interest-rate trap: Any attempt to tighten monetary policy would cause asset prices to plunge and debt-servicing costs to rise. This would result in financial distress and rising unemployment – the exact two things the Fed wants to avoid. The Fed Is Not The Culprit It is a provocative argument, but is the Fed really to blame? For the most part, the answer is “’no.” To see why, consider the counterfactual: Suppose the Fed did not cut rates. If rates had stayed elevated, the recovery in the cyclical sectors of the economy following the Global Financial Crisis would have been even slower. Housing, in particular, would have remained in the doldrums. Chart 3 shows that there is a strong correlation between housing activity and the 30-year mortgage rate. Lower home prices would have reduced spending via the wealth effect channel, while making it more difficult for banks to recapitalize their balance sheets. In addition, relatively high US rates would have put upward pressure on the dollar, leading to a larger trade deficit (Chart 4). All of this would have reduced aggregate demand. Chart 4The Dollar And The Trade Balance Chart 5Rising Labor Share Of Income Occurring Alongside Labor Market Tightening The share of national income flowing to workers tends to rise when the labor market tightens (Chart 5). A chronic shortfall in aggregate demand would have exacerbated income inequality. Since the poor spend more of every dollar of disposable income than the rich, this would have further dampened overall spending. The Fed has been like a doctor administering a life-saving medicine that comes with some notable side effects. These side effects include increased sensitivity of asset prices to changes in interest rates.1 They also include higher debt levels, at least in those sectors of the economy that had the ability to lever up in response to lower interest rates. Side Effect Triage How dangerous are these side effects? To the extent that today’s low policy rates stem from the fact that structural forces have depressed the neutral rate of interest, they are not especially dangerous at the moment. Yes, debt-servicing costs would balloon, and asset prices would tumble, if the Fed raised rates significantly. However, there’s no reason for the Fed to do that in a setting where the neutral rate is very low. The problem is that the neutral rate may rise over time. Baby boomers are leaving the labor force en masse. They accumulated a lot of wealth while working. According to the Federal Reserve, they currently own more than half of all US wealth (Chart 6). In fact, Americans over the age of 55 controlled 70% of household wealth as of the third quarter of 2020, up from 54% in 1989. As baby boomers retire, their consumption will no longer be backed by income. The resulting depletion of savings will push up the equilibrium rate of interest. Chart 6Baby Boomers Have Accumulated A Lot Of Wealth While US fiscal policy will tighten next year, it will remain highly pro-cyclical by historic standards. BCA’s geopolitical strategists expect Congress to pass a $4 trillion spending bill this fall focusing on infrastructure, health care, and clean energy. They anticipate that only half of the bill will be financed through higher taxes. Big budget deficits will drain private-sector savings. There Will Be Political Pressure To Keep Rates Low Debt is not a major problem for governments when the interest rate they pay is below the growth rate of the economy. As we have discussed before, when trend GDP growth exceeds the borrowing rate, the more debt a government carries, the more fiscal support it can provide without putting the debt-to-GDP ratio on a runaway trajectory. If interest rates were to rise meaningfully, however, what had previously been a virtuous fiscal circle would become a vicious one. Needless to say, governments would resist such an outcome. Faced with the prospect of having to reallocate tax revenue from social programs to bondholders, politicians would put political pressure on central banks to refrain from raising rates. Central banks would probably oblige, at least initially. By keeping interest rates below their equilibrium level, central banks could engineer higher inflation – something they have been striving to do for quite some time. Higher inflation, in turn, could pave the way for an exit from the low interest-rate trap. Rising prices would lift nominal GDP, thereby reducing the debt-to-GDP ratio. As inflation rose, real rates would fall. This would provide relief to overextended private-sector borrowers. Once enough debt had been inflated away, central banks could bring interest rates to their equilibrium level. In the end, bondholders would suffer while borrowers would prosper. This leads us to our key macroeconomic conclusion: Today’s low interest-rate trap will likely be resolved through an extended period of easy money, ultimately culminating in significantly higher inflation. Investment Implications Equities face some near-term risks stemming from the recent rise in bond yields. Nevertheless, as we have argued in past reports, stocks will shrug off their losses provided that bond yields do not rise to a level that chokes off economic growth. With the Fed still on hold, we do not expect that to happen anytime soon. As such, our best bet is that the Goldilocks environment for risk assets – where growth is strong, inflation is contained, and monetary policy is accommodative – will last another two years. Investors operating on a 12-month horizon should continue to favor stocks over bonds. Within the fixed-income category, investors should overweight spread product relative to safer government bonds. Value stocks will lead the equity market higher over the next 12 months. The pandemic benefited growth names, especially in the tech realm. The cessation of lockdown measures will favor value names. Not only is value still exceptionally cheap in relation to growth, but traditional value sectors such as banks and energy companies have seen stronger upward earnings revisions than tech stocks since the start of the year (Chart 7). Chart 7 Earnings Revisions And Valuations Favor Value Stocks (I) Chart 7Earnings Revisions And Valuations Favor Value Stocks (II) Recent upgrades to economic growth forecasts have favored the US, which could help the dollar in the near term. Nevertheless, we expect the greenback to fall modestly over a 12-month horizon. The US trade deficit has ballooned in recent quarters, while the dollar remains overvalued on a purchasing power parity basis (Chart 8). Despite improving US growth prospects, real yield differentials have not moved significantly in favor of the dollar (Chart 9). Chart 8The Dollar Is Expensive Based On Its PPP Fair Value And Growing Trade Deficit (I) Chart 8The Dollar Is Expensive Based On Its PPP Fair Value And Growing Trade Deficit (II) Chart 9Real Yield Differentials Have Not Moved Significantly In Favor Of The Dollar (I) Chart 9Real Yield Differentials Have Not Moved Significantly In Favor Of The Dollar (II) Moreover, the growth outlook outside the US should improve later this year as more countries ramp up their vaccination campaigns. US growth should also come down from its highs due to the expiration of various stimulus measures. Meanwhile, China will continue to stimulate its economy, albeit at a slower pace. Jing Sima, BCA’s chief China strategist, expects the rate of credit expansion to fall by only 2-to-3 percentage points in 2021. The general government deficit should remain broadly stable at 8% of GDP this year, ensuring adequate fiscal support for growth. A strong Chinese economy will bolster the RMB and other EM currencies. Looking further ahead, the cyclical bull market in stocks will end when inflation rises so high that central banks are forced to tighten monetary policy. While this is not a near-term risk, it is a major danger for the middle of the decade and beyond. As we discussed last week, inflation is often slow to rise in response to an overheated economy, but when it does rise, it can do so precipitously. Investors looking to hedge long-term inflation risk should reduce duration exposure in fixed-income portfolios while favoring inflation-protected securities over nominal bonds. In addition to gold, they should own some property. The best inflation hedge is simply to buy a nice house financed with a high loan-to-value fixed-rate mortgage. In a few decades you will still own the nice house, but the value of the mortgage will be greatly reduced in real terms. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1 For example, suppose the earnings yield is 4% – as it approximately is now for global equities – and the real bond yield is zero, implying an equity risk premium (ERP) of 4%. A one percentage-point increase in real bond yields would require that stock prices fall by 20% in order to keep the ERP unchanged (e.g., the earnings yield would have to rise from 4/100=4% to 4/80=5%). In contrast, if the earnings yield were initially 7% and the real bond yield were 3%, stock prices would need to fall by only 12.5%, taking the earnings yield from 7/100=7% to 7/87.5=8%. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Highlights Duration: The Fed will revise up its interest rate forecasts at this week’s meeting, but the new forecasts will remain dovish compared to current market pricing. This could pressure bond yields down in the near-term. However, any downside in yields could prove temporary given that economic growth continues to beat expectations. Corporates: The macro environment of strong economic growth and accommodative monetary policy will persist for some time yet. In this environment, bond portfolio managers should minimize exposure to interest rate risk and maximize exposure to credit risk. In particular, a strategy of favoring high-yield corporate bonds over investment grade corporate bonds makes a lot of sense. Inflation & TIPS: Core inflation will be relatively strong during the remainder of 2021, with 12-month core PCE likely ending the year close to the Fed’s 2% target. Investors should remain overweight TIPS versus nominal Treasuries and continue to hold inflation curve flatteners and real yield curve steepeners. Expect Some Pushback From The Fed The continuing bond market selloff will be the top item on the agenda at this week’s FOMC meeting. Meeting participants will debate whether the sharp rise in long-maturity bond yields represents a threat to the economic recovery and Chair Powell will no doubt be peppered with questions on the topic at his post-meeting press conference, as he was when he sat down with a Wall Street Journal reporter two weeks ago.1 But for our part, we’ll be focused more on the front-end of the yield curve this week. Specifically, we’ll be looking to see whether the Fed revises up its funds rate forecasts by enough to justify current market pricing or whether it uses its forecasts to push back against the bond bears. The market’s fed funds rate expectations have moved a lot since the Fed last published its own forecasts in December (Chart 1on page 1). In December, the market was priced for fed funds liftoff in December 2023 and then only one more 25 basis point rate hike through the end of 2024. Now, the market is looking for liftoff in January 2023, followed by two more rate hikes before the end of that year. Chart 1Market Priced For 3 Rate Hikes Before The End Of 2023 As for the Fed, at last December’s meeting only 5 out of 17 FOMC participants anticipated raising rates before the end of 2023. It’s logical to expect the Fed to increase its rate expectations this week as the economic outlook is much brighter than it was at the time of the December FOMC meeting. Back in December, we still didn’t know whether the Democrats would win control of the Senate, enabling passage of President Biden’s $1.9 trillion stimulus bill. Doubts also remained about how quickly COVID vaccination would occur. Chart 2The Data Can't Disappoint The Fed will probably respond to these pro-growth developments by revising up its interest rate expectations, but we doubt that these revisions will bridge all of the gap with the market. Employment and inflation both remain far from where the Fed would like them to be, and the Fed will want to send the message that its policy stance remains highly accommodative. We could see the Fed’s median fed funds rate forecast shifting to call for one rate hike by the end of 2023, but not the three currently priced into the yield curve. In this scenario, the Fed’s pushback could prompt some near-term downside in bond yields. The question is how long the Fed’s messaging will impact the market in the current environment of surging economic growth. The Economic Surprise Index shows that the economic data can’t even manage to disappoint expectations, a development that usually coincides with rising yields (Chart 2). Bottom Line: The Fed will revise up its interest rate forecasts at this week’s meeting, but the new forecasts will remain dovish compared to current market pricing. This could pressure bond yields down in the near-term. However, any downside in yields could prove temporary given that economic growth continues to surpass expectations. We maintain below-benchmark portfolio duration and we will continue to use our Checklist (see last week’s report)2 to determine an appropriate time to increase duration. The Spread Buffer In Corporate Credit Treasury yields troughed last August, and since then returns have been hard to come by in the US bond market. This is not too surprising. Fixed income is hardly the ideal asset class for a reflationary economic environment. However, there are steps a bond portfolio manager can take to maximize profits in an economic environment that is characterized by (i) rapid economic growth, (ii) rising inflation expectations and (iii) monetary policy that remains accommodative. Specifically, bond investors should minimize their exposure to interest rate risk (i.e. duration) and maximize exposure to credit risk. That is, shy away from long duration assets with little-to-no credit spread and favor shorter duration assets where the credit spread makes up a large proportion of the yield. This sort of strategy has worked well since the August trough in Treasury yields. The Investment Grade Corporate Bond Index – an index with relatively long duration and a small credit spread – is down 4.08% since August 4th (Chart 3). Notably the worst returns have come from the highest rated credit tiers where the credit spread makes up a smaller proportion of the yield. Notice that Aaa-rated Corporates have lost 9% while Baa-rated bonds are only down 2.52% (Table 1). In contrast, total returns from the High-Yield Index – an index with lower duration where the credit spread makes up a much larger proportion of the yield – have held up nicely. The overall index has returned 6.65% since August 4th with the lowest credit tiers once again performing best. Chart 3Move Down In ##br##Quality Table 1Corporate Bond Returns Since The Aug. 4 2020 Trough In Treasury Yields Performance for both the Investment Grade and High-Yield indexes improves if we look at excess returns relative to a duration-matched position in Treasury securities. That is, if we hedge out the interest rate risk and focus purely on spread movements. Though even here, we find that the lowest rated credits with the widest spreads deliver the best returns. If we assume that this reflationary economic environment persists for the next 12 months, can we expect the same low rate risk/high credit risk strategy to succeed? One way to investigate this question is to look at the 12-month breakeven yields and spreads for different segments of the corporate bond market (Table 2). The 12-month breakeven yield is the yield increase that the index can tolerate over the next 12 months before it delivers negative total returns. Similarly, the 12-month breakeven spread is the spread widening that an index can tolerate over the next 12 months before it delivers negative excess returns (where excess returns are measured versus a duration-matched position in Treasury securities). Table 2Corporate Bond 12-Month Breakeven Yields And Spreads The overall Investment Grade Corporate Index, for example, has an average maturity of 12 years and a 12-month breakeven yield of 27 bps. This means that, if we assume that the investment grade corporate bond spread holds steady, then the odds of the index delivering negative total returns over the next 12 months are the same as the odds of a 12-year Treasury yield rising by more than 27 bps. An assumption of flat investment grade corporate bond spreads seems reasonable given that spreads are already historically tight (Chart 4). Moving down in quality within investment grade helps a bit, the Baa credit tier has a 12-month breakeven yield of 30 bps compared to a 12-month breakeven yield of 21 bps for the Aa credit tier. A similar benefit is observed if we look at the 12-month breakeven spread: 14 bps for Baa and only 6 bps for Aa. However, the real improvement comes when we move out of investment grade entirely and into high-yield. To calculate fair breakeven yields and spreads for high-yield bonds we need to incorporate default loss expectations. The current macro environment of strong growth and accommodative monetary policy should lead to relatively low default losses. That being the case, we assume a base case of a 2.5% default rate and 40% recovery rate for the next 12 months. Using this assumption, we calculate a 12-month breakeven yield of 75 bps for the High-Yield Index and a 12-month breakeven spread of 46 bps. This represents a significant extra buffer compared to what is offered by even the lowest investment grade credit tier. Not only that, but the 75 bps 12-month breakeven yield from the High-Yield Index looks even better when we consider that high-yield spreads are not as overvalued relative to history as investment grade spreads, and have more room to tighten as the economic recovery progresses (Chart 5). Chart 4Investment Grade Valuation Chart 5High-Yield Valuation Table 2 also presents two other default loss scenarios, and it shows that we need fairly pessimistic default loss expectations to make high-yield breakeven yields and spreads comparable to what is offered by investment grade bonds. Even if we assume a 4.5% default rate and 30% recovery rate for the next 12 months, we still get a 32 bps breakeven yield from the High-Yield Index, comparable to what we get from the Baa credit tier. Bottom Line: The macro environment of strong economic growth and accommodative monetary policy will persist for some time yet. In this environment, bond portfolio managers should minimize exposure to interest rate risk and maximize exposure to credit risk. In particular, a strategy of favoring high-yield corporate bonds over investment grade corporate bonds makes a lot of sense. Inflation & The Inverted TIPS Curve Chart 6Inflation Will Peak In April February’s Consumer Price Index was released last week, and it showed that core CPI managed only a 0.1% increase on the month. This caught some off guard given that “rising inflation” has become a popular market narrative during the past few months. Our view is that core inflation will rise significantly between now and the end of the year, and that 12-month core PCE inflation will end the year close to the Fed’s 2% target. We arrive at this view for three reasons. First, base effects will lead to a large jump in 12-month inflation measures in March and April. Chart 6 illustrates the paths for both 12-month core PCE and core CPI assuming modest 0.15% monthly gains between now and the end of the year. Because the severely negative inflation prints from last March and April are about to fall out of the rolling 12-month sample, 12-month core inflation is on the cusp of rising to levels considerably above the Fed’s target. This means that after 12-month inflation peaks in April, the question will be how much it declines during the remainder of the year. One reason why we think it might not fall that dramatically is that bottlenecks are already emerging in both the goods and services sectors, and prices will come under upward pressure as the economy re-opens and consumers are encouraged to deploy some of the excess savings they’ve built up during the pandemic. Producer prices are currently surging, as are survey responses about price pressures from the NFIB Small Business Survey and the ISM Manufacturing and Non-Manufacturing Surveys (Chart 7). Finally, shelter is the largest component of core inflation (accounting for almost 40% of core CPI). It would be difficult for overall core inflation to rise significantly without at least some participation from shelter. With that in mind, we now see evidence that shelter inflation will soon put in a trough (Chart 8). Chart 7Price Pressures Are Building Chart 8Shelter Inflation About To Bottom The permanent unemployment rate and Apartment Market Tightness Index are both tightly correlated with shelter inflation. The permanent unemployment rate has stopped climbing and will move lower during the next few months as increased vaccination rates allow for more of the economy to re-open (Chart 8, panel 2). The Apartment Market Tightness Index is also well off its lows, and it will soon jump above the 50 line, joining the Sales Volume Index (Chart 8, panel 3). Consumers are also increasingly seeing signs of rental inflation. A question from the New York Fed’s Survey of Consumer Expectations showed a very sharp increase in expected rents in February (Chart 8, bottom panel). Chart 9Stay Long TIPS As for TIPS strategy, we are hesitant to back away from our overweight TIPS/underweight nominal Treasuries position with inflation on the cusp of a such a significant move higher, especially with the 5-year/5-year forward TIPS breakeven inflation rate still below where the Fed would like it to be (Chart 9). We are also not yet willing to exit the inflation curve flattening and real yield curve steepening positions that we have been recommending since last April, even though the 5/10 TIPS breakeven inflation slope has become inverted (Chart 9, bottom panel).3 With the Fed targeting an overshoot of its 2% inflation target, an inverted inflation curve is more natural than a positively sloped one. This is because the Fed will be trying to hit its inflation target from above, rather than from below. Further, the short-end of the inflation curve is more sensitive to the actual inflation data than the long-end. This means that the curve could flatten even more as inflation rises in the coming months. Bottom Line: Core inflation will be relatively strong during the remainder of 2021, with 12-month core PCE likely ending the year close to the Fed’s 2% target. Investors should remain overweight TIPS versus nominal Treasuries and continue to hold inflation curve flatteners and real yield curve steepeners. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on the implications of what Powell said in this interview please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Duration: Only 2 of the 5 items on our Checklist For Increasing Portfolio Duration have been checked. We will heed this message and stick with below-benchmark portfolio duration for the time being. We will have an opportunity to re-assess the items on our Checklist after the March FOMC meeting when the Fed’s interest rate forecasts will be updated. The Fed & Financial Conditions: The recent dip in the stock market is not the result of investors pricing-in worse economic outcomes. Rather, it is a sector rotation driven by extreme economic optimism. It is certainly not a concern for the Fed. The Fed & The Labor Market: We need to see monthly nonfarm payroll growth coming in consistently above 419 thousand before we can be confident that the Fed will hike rates by the end of 2022. Feature Chart 1Bearish Trend Intact The bond bear market rages on. The Bloomberg Barclays Treasury Index returned -1.8% in February, its worst monthly performance since 2016. The sell-off then continued through the first week of March, culminating with the 10-year Treasury yield touching 1.56% as of Friday’s close (Chart 1). The 5-year/5-year forward Treasury yield ended the week at 2.41%, near the top-end of primary dealer estimates of the long-run neutral fed funds rate (Chart 1, bottom panel). We don’t want to catch a falling knife, but eventually, yields will look attractive enough for us to increase our recommended portfolio duration. To help us make that decision, we unveiled a Checklist For Increasing Portfolio Duration in our February Webcast (Table 1).1 Table 1Checklist For Increasing Portfolio Duration This week, we check-in with our Checklist, concluding that it is still too early to increase portfolio duration. Checking-In With Our Duration Checklist Chart 2Cyclical & Valuation Indicators The first item on our Checklist is the 5-year/5-year forward Treasury yield reaching levels consistent with survey estimates of the long-run neutral fed funds rate. As noted above, this condition has been met. Second, we would like to see survey-derived measures of the 10-year term premium reach extended levels. Specifically, we’d like to see them approach their 2018 peaks (Chart 2). Currently, our two measures are sending diverging signals. The term premium derived from the New York Fed’s Survey of Market Participants is 60 bps, only 15 bps off its 2018 peak. However, the term premium derived from the New York Fed’s Survey of Primary Dealers is only 22 bps, 53 bps off its 2018 peak. For now, our assessment is that this condition has not been met. It’s important to note that the surveys used to construct our two term premium measures and to obtain our fair value range for the 5-year/5-year forward Treasury yield have not been updated since January, and that they will be revised ahead of this month’s FOMC meeting. If primary dealers and market participants revise up their fed funds rate expectations, then our valuation measures will give the 10-year yield more room to rise. Third, we continue to track high-frequency cyclical economic indicators like the CRB/Gold ratio (Chart 2, panel 3) and the relative performance of cyclical versus defensive equity sectors (see section titled “The Fed’s Approach To Financial Conditions” below). These measures have yet to show any signs of deterioration, consistent with an environment where bond yields should be rising. Fourth, if current trends continue, we are concerned that US yields may rise too far compared to yields in the rest of the world. This could entice foreign inflows into the US bond market, sending yields back down. Historically, bullish sentiment toward the US dollar is a good indicator of when US yields have risen too far. At present, dollar sentiment remains extremely bearish (Chart 2, bottom panel). This suggests that we are not yet close to the point when foreign purchases will push US yields lower. Finally, we consider the market’s fed funds rate expectations relative to the Fed’s most recent forecast, as inferred from its quarterly “dot plot”. Currently, the market is priced for Fed liftoff to occur in January 2023, with a second rate hike delivered in May 2023 and a third in October 2023 (Chart 3). This is considerably more hawkish than the Fed’s median forecast from December, which called for no rate hikes until at least 2024! Chart 3Market Expects Liftoff In January 2023 We think it’s conceivable that economic conditions could warrant Fed liftoff in late-2022 (see section titled “Tracking Payrolls And The Countdown To Fed Liftoff” below), but the Fed will probably be more cautious about how quickly it brings its expected liftoff date forward. FOMC participants will have an opportunity to push back against the market when they update their funds rate forecasts at this month’s meeting. The Fed will likely bring forward its anticipated liftoff date, but probably not all the way to January 2023. This could halt the uptrend in bond yields, at least for a while. Bottom Line: Only 2 of the 5 items on our Checklist For Increasing Portfolio Duration have been checked. We will heed this message and stick with below-benchmark portfolio duration for the time being. We will have an opportunity to re-assess the items on our Checklist after the March FOMC meeting when the Fed’s interest rate forecasts will be updated. Other surveys used in the construction of our term premium estimates and 5-year/5-year yield targets will also be updated around this time. The Fed’s Approach To Financial Conditions Chart 4Financial Conditions Are Easy Remarks from Fed Chair Jay Powell were a catalyst for higher bond yields last week. Apparently, there had been some expectation in the market that Powell would use his platform to express concern about the recent increase in long-maturity bond yields. In fact, many expected him to foreshadow changes to the Fed’s balance sheet policy, either extending the maturity of its ongoing asset purchases or initiating an Operation Twist, where the Fed sells short-dated securities and buys long-dated ones.2 Powell didn’t announce any of these things. In fact, he didn’t even express concern about the recent rise in long-dated yields despite being given several opportunities to do so. To understand why, we need to understand how the Fed thinks about financial conditions. The Fed only cares about conditions in financial markets to the extent that they are expected to influence the real economy. This means that the Fed takes a broad view of financial conditions, including bond yields, credit spreads and equity prices. From this perspective, financial markets do not currently pose a risk to the economy (Chart 4). Yes, long-dated bond yields have risen, but short-dated yields remain low. Credit spreads also remain very tight and equity prices have only dipped modestly from high levels. The Chicago Fed’s broad index of financial conditions shows that they are extremely accommodative (Chart 4), and thus support continued economic recovery. This financial market back-drop is not one that will cause the Fed to take additional actions to ease policy. Even the recent drop in the stock market appears to be more a reflection of economic optimism than a cause for concern. Looking at the performance of different equity sectors, we find that the sectors that stand to benefit from the end of the pandemic and economic re-opening are surging. Meanwhile, the sectors that are performing poorly are simply giving back some of the huge gains that were realized when the pandemic was raging last year. For example, cyclical sectors (Industrials, Energy and Materials) are soaring while defensive sectors (Healthcare, Communications, Consumer Staples and Utilities) have hooked down (Chart 5A). The ratio between the two remains tightly correlated with the 10-year Treasury yield. Similarly, Bank stocks have exploded higher since bond yields troughed last fall while the Technology sector has had difficulty making further gains (Chart 5B). Last year, the Tech sector benefited from low bond yields and surging demand. This year, Banks stand to profit from higher yields and an improving labor market. Finally, our US Equity Strategy team put together a basket of “COVID-19 Winners” designed to profit from the pandemic and a basket of “Back To Work” stocks designed to benefit from economic re-opening. Not surprisingly, the former is dragging the S&P 500 lower while the latter is on a tear (Chart 5C). Chart 5ASector Rotation: Cyclicals Vs. Defensives Chart 5BSector Rotation: Banks Vs. Tech Chart 5CSector Rotation: COVID Winners Vs. Re-Open Winners The bottom line is that the recent dip in the stock market is not the result of investors pricing-in worse economic outcomes. Rather, it is a sector rotation driven by extreme economic optimism. It is certainly not a concern for the Fed. Other Reasons For The Fed To Change Its Balance Sheet Policy In addition to concerns about a drop in the stock market, several other reasons have been given for why the Fed might consider either increasing its asset purchases or shifting them toward the long end of the curve. 1) Treasury Market Liquidity Chart 6Treasury Market Liquidity First, there is an ongoing tension in the Treasury market between imposing stricter capital regulations on dealer banks and ensuring that they have enough balance sheet capacity to maintain Treasury market liquidity during periods of stress.3 This delicate equilibrium broke down last March when Treasury market liquidity evaporated at a time when both equities and bonds were crashing. The Fed was forced to step into the Treasury market to sustain market functioning. Last week’s Treasury sell-off had a whiff of illiquidity about it as well. One liquidity index that measures the average curve fitting error across all government bond yields increased slightly, but not nearly as much as it did last March (Chart 6). Treasury bid/ask spreads also widened a touch, but unlike last March, Treasury ETFs continued to trade close to their net asset values. A significant deterioration in Treasury liquidity would prompt a quick response from the Fed. That is, the Fed would quickly ramp up purchases to restore market functioning. However, last week’s blip was not nearly severe enough to raise alarm bells. Other periods of Treasury market stress that have prompted the Fed to step in have occurred during periods of extreme economic deterioration and market panic, such as in March 2020 and 2008. With economic growth accelerating rapidly, we place low odds on a major Treasury market liquidity event occurring this year. 2) Expiry Of The SLR Exemption Chart 7Reserve Supply Is Massive A second possible reason for the Fed to change its balance sheet policy is the upcoming expiry of the exemption to the Supplementary Leverage Ratio (SLR). The SLR is a regulation that requires large banks to hold common equity capital totaling at least 5% of assets. Assets are not risk-weighted for the purposes of the SLR. A problem arose with the SLR last March when the Fed bought massive amounts of bonds, flooding the banking system with reserves (Chart 7). The problem is that banks are forced to hold those reserves, and this makes it more difficult for them to meet their SLR requirement. To alleviate the problem, the Fed announced that reserves and Treasury securities would be exempted from the SLR calculation. Today, the issue is that this exemption is scheduled to expire at the end of March and the Fed has yet to announce whether it will be extended or allowed to lapse. Table 2US Bank Supplementary Leverage Ratios If the exemption lapses, then banks may try to unload Treasury securities to remain compliant with the SLR. In theory, this could lead to upward pressure on Treasury yields that the Fed could mitigate by ramping up its asset purchases. However, it’s unclear how much of an impact a lapsing of the SLR exemption would actually have on the Treasury market. Even adjusting for a lapsing of the exemption, all major US banks remain compliant with the 5% SLR (Table 2). Also, banks could always decide to increase their SLRs by reducing share buybacks rather than by shedding Treasuries. In any event, an increase in Fed asset purchases to lean against rising Treasury yields driven by bank selling would be counterproductive. It would only flood the banking system with more reserves, making the SLR even more difficult to meet. Our view is that a fair compromise would be for the Fed to continue the SLR exemption for bank reserves, but to allow the Treasury security exemption to lapse. But even if the SLR exemption is allowed to lapse completely, we doubt that it will lead to enough market turmoil to prompt a change in the Fed’s balance sheet strategy. 3) Supply/Demand Imbalance In Money Markets Finally, some have noted that the large and growing supply of bank reserves could lead to problems in money markets. Specifically, with the Treasury Department now in the process of paying down its cash account (Chart 7, bottom panel), there is a lot of cash flooding into money markets and coming up against limited T-bill supply. In theory, the Fed could try to mitigate this problem by engaging in an Operation Twist – selling some T-bills and buying some coupon bonds. But we doubt this will occur. The Fed already has tools in place to maintain control over short rates in such circumstances. For example, the same situation arose in 2013 when an over-supply of bank reserves pushed short rates down toward the bottom of the Fed’s target range (Chart 8A). The Fed’s response was to create the Overnight Reverse Repo Facility (ON RRP). This facility allows counterparties to park excess cash at the Fed in exchange for a security off the Fed’s balance sheet. This proved to be an effective floor on repo rates and the fed funds rate, and we expect it will be again (Chart 8B). Chart 8AFed Created ON RRP In 2013... Chart 8B... It Remains A Firm Floor On Rates T-bill yields remained below the ON RRP rate for some time in 2014 and 2015, and the same thing could happen again this year. But this will not be a major concern for the Fed as long as it maintains control over the fed funds rate and the overnight repo rate. Eventually, the Treasury Department can deal with the lack of bill supply by increasing the amount of T-bill issuance. Bottom Line: Treasury market liquidity remains an ongoing concern for the Fed, and the possible expiry of the SLR exemption and lack of T-bill supply present additional near-term technical challenges. We think it’s unlikely that any of these things will prompt the Fed to deviate from its current pace and composition of asset purchases in 2021. Tracking Payrolls And The Countdown To Fed Liftoff Chart 9The Fed's Maximum Employment Targets Employment growth surprised to the upside in February as 379 thousand jobs were added to nonfarm payrolls. This sent bond yields higher, but we caution that even stronger employment growth will be required to keep bond yields rising going forward. The Fed needs to see a return to “maximum employment” before it will lift rates off the zero bound. This means not only that the unemployment rate will have to fall to a range of 3.5% to 4.5%, but also that the labor force participation rate must make a full recovery to pre-pandemic levels (Chart 9). We calculate that average monthly employment growth of 419 thousand will be required to achieve this goal by the end of 2022 (Table 3). In other words, to justify the market’s January 2023 expected liftoff date, we will need to see average monthly payroll growth of at least 419 thousand going forward. Table 3Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% By The Given Date This number seems high, but it may be attainable. With vaccine distribution kicking into high gear, many service sectors of the economy will soon be able to re-open. This already started to happen last month when the Leisure & Hospitality sector added 355 thousand jobs. Even after last month’s gains, Leisure & Hospitality still accounts for 36% of the net job loss since last February (Table 4). This means that there is scope for extremely large employment gains this year if the coronavirus can be contained. Table 4Employment By Industry Bottom Line: We need to see monthly nonfarm payroll growth coming in consistently above 419 thousand before we can be confident that the Fed will hike rates by the end of 2022. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.bcaresearch.com/webcasts/detail/387 2 https://www.bloomberg.com/news/articles/2021-03-01/treasury-curve-dysfunction-ignites-talk-of-federal-reserve-twist?sref=Ij5V3tFi 3 For more details please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup, Part 2: Shocked And Awed”, dated July 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights US inflation is set to increase sharply over the coming months as base effects kick in. Higher fuel prices, fiscal stimulus, and the partial relaxation of lockdown measures should also boost inflation. The Fed is unlikely to react hawkishly to higher inflation, arguing that it is largely transitory in nature. While the Fed’s relaxed attitude towards inflation risks may be justified in the near term, there is a high probability that inflation will get out of hand later this decade. Contrary to conventional wisdom, many of the factors that led to high inflation in the 1970s could reassert themselves. Investors should overweight stocks for now, but be prepared to reduce equity exposure in about two years. US Inflation Has Bottomed US inflation surprised on the downside in January. The core CPI was flat on the month, compared with the consensus estimate for an increase of 0.2%. We expect US inflation to move higher over the coming months. The weakness in January’s inflation print was concentrated in sectors of the economy that have been hard hit by the pandemic. Airline fares dropped 3.2%, hotel rates fell 1.9%, and entertainment admission prices declined 5.5%. Prices in these sectors should rise on a year-over-year basis as base effects kick in (Chart 1). The relaxation of lockdown measures should also help to partially restore demand in these areas. WTI crude prices have risen 70% since the end of October. Rising energy prices should push up headline inflation, with some bleed-through to core prices. Chart 2 shows that there is a strong correlation between gasoline prices and headline inflation. If gasoline prices evolve in line with what is predicted by the futures market, headline inflation could temporarily rise to 4% this spring. Chart 1Base Effects Will Push Inflation Higher Chart 2Strong Link Between Gasoline Prices And Headline Inflation In addition, the lagged effects from a weaker dollar should translate into higher goods prices in the US (Chart 3). A stronger labor market and a slower pace of rent forgiveness should also boost housing inflation (Chart 4). Chart 3A Weaker Dollar Will Be A Tailwind For Inflation Chart 4Stronger Labor Market Will Boost Housing Inflation Fiscal stimulus should further supercharge demand, adding to inflationary pressures. Ironically, Republican unwillingness to offer modest, politically palatable cuts to President Biden’s proposed aid bill has opened the door to the Democrats ramming through the entire $1.9 trillion package via the reconciliation process. As we discussed last week, the amount of stimulus in the pipeline easily dwarfs the size of the output gap. From Reflation To Inflation? Deflation is bad for stocks, just as is high and accelerating inflation. Somewhere between deflation and inflation, however, lies reflation. Reflation is good for stocks. Chart 5Inflation Expectations Have Recovered But Are Still Below Levels That Would Cause Concern For The Fed We are currently in a reflationary Goldilocks zone, where inflation expectations have risen but not by enough to force the Fed’s hand. There is a high probability we will stay in this Goldilocks zone for the remainder of the year. The 5-year/5-year forward TIPS breakeven rate is still below the level that the Fed regards as consistent with its long-term inflation objective, and even farther below the level that would cause the Fed to panic (Chart 5). Jay Powell told The Economic Club of New York last week that the Fed is unlikely to “even think about withdrawing policy support” anytime soon. The Fed minutes released on Wednesday echoed this view. That ‘70s Show? The path to higher interest rates is lined with lower interest rates. A period of ultra-easy monetary policy can sow the seeds for economic overheating, rising inflation, and ultimately, much higher interest rates. Since this is precisely what happened during the 1970s, it is prudent to ask whether something like that could happen again. Investors certainly do not believe a replay of the 70s is in the cards, at least if long-term CPI swaps are any guide (Chart 6). Yet, we think that a 1970s-style inflationary episode is a greater risk than most investors realize. As we discuss below, much of what investors believe about how inflation emerged during that period is either based on myths, or at best, half-truths. Let’s examine each of these misconceptions in turn. Myth #1: High inflation in the 1970s was primarily driven by supply disruptions, with oil shocks being the most prominent. Fact: Oil shocks exacerbated the inflation problem in the 1970s, but it was an overheated economy that permitted inflation to rise in the first place. Inflation took off in 1966, seven years before the first oil shock. By 1969, core CPI inflation was running at close to 6% (Chart 7). Chart 6Investors Do Not Expect Inflation To Vault Higher Chart 7Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Similar to today, fiscal policy was exceptionally accommodative in the mid-1960s. The escalation of the Vietnam War produced a surge in military expenditures. Social spending rose dramatically with the introduction of Lyndon Johnson’s “Great Society” programs. Medicare and Medicaid took effect in July 1966. Amy Finkelstein has estimated that Medicare, the larger of the two health care programs, led to a 37% increase in real hospital expenditures between 1965 and 1970. Johnson’s “guns and butter” policies caused government spending to surge in the second half of the decade. The budget deficit, which was broadly balanced during the first half of the 60s, swelled to 4% of GDP (Chart 8). As fiscal policy was loosened, the economy began to overheat. The unemployment rate fell to 3.8% in 1966, two percentage points below what economists later concluded had been its full-employment level. Chart 8US "Guns And Butter" Policies In The 1960s Caused Government Spending To Swell Myth #2: The Phillips curve is much flatter today. Chart 9The Increase In Inflation In 1966 Was Broad-Based Fact: The Phillips curve was also flat during the 1960s. Core inflation was remarkably stable during the first half of the 60s, averaging about 1.5%, even as the unemployment rate steadily declined. Then, starting in 1966, core inflation more than doubled within the span of ten months. As Chart 9 illustrates, the sudden spike in inflation in 1966 was fairly broad-based. A “kink” in the Phillips curve had been reached. That the relationship between inflation and unemployment turned out to be non-linear is not surprising. As long as there is some slack in the labor market, employers are likely to resist raising wages. Thus, a decline in unemployment from a high level to a merely moderate level is unlikely to lead to meaningful wage inflation. It takes a truly overheated labor market – one that forces firms to engage in a tit-for-tat battle to entice workers – for the relationship between unemployment and inflation to reassert itself. In the near term, there is little risk that the US economy will reach a kink in the Phillips curve. Jason Furman estimates that the unemployment rate stood at 8.3% in January if one adjusts for the drop in labor force participation and methodological problems with how the BLS defines temporarily furloughed workers. This is well above the level that could trigger a price-wage spiral. Chart 10Is The Phillips Curve Really Dead? Yet, it would be naïve to think that such a spiral could not materialize in a few years. As Chart 10 shows, over the past 40 years, every time the US labor market was on the cusp of overheating, something would invariably come along to push up unemployment. Last year, it was the pandemic. In 2008, it was the Global Financial Crisis. In 2000, it was the dotcom bust. In the early 1990s, it was the collapse in commercial real estate prices following the Savings and Loan Crisis. Admittedly, only the pandemic qualifies as a truly exogenous shock. The preceding three recessions were fomented by growing economic imbalances, which were ultimately laid bare by a Fed hiking cycle. One can debate the degree to which the US economy is suffering from non-pandemic related imbalances today, but one thing is certain: The Fed is not keen on raising rates anytime soon. Thus, whatever imbalances exist today may not be exposed before the economy has had the chance to overheat. Myth #3: Inflation expectations are better anchored these days. Chart 11Long-Term Bond Yields Lagged Inflation During The 1960s Fact: Inflation expectations certainly became unmoored in the 1970s. However, there is not much evidence that expectations were adrift prior to the sudden increase in inflation in 1966. At the time, the US had not experienced a major episode of inflation since the Civil War. While long-term bond yields did rise in the second half of the 60s, they generally lagged inflation, suggesting that investors were caught off-guard (Chart 11). It should also be noted that the US and other major economies operated under the Bretton Woods system of fixed exchange rates during the 1960s. Each US dollar was convertible into gold at the official rate of $35 per ounce. The existence of this quasi-gold standard helped anchor inflation expectations. The system began to fall apart in the late 1960s as inflation rose. When President Nixon suspended the dollar’s convertibility into gold in August 1971, the US CPI had already increased by nearly 30% from its 1965 level. While the collapse of the Bretton Woods system in the early 1970s undoubtedly caused inflation expectations to become further unhinged, the breakdown of the system would not have occurred if inflation had not risen in the first place. Myth #4: Widespread wage indexation and powerful trade unions fueled an acceleration in the 1960s. Fact: Just as was the case with the unmooring of inflation expectations, wage indexation was more a response to rising inflation than a cause of it. Chart 12 shows that the share of workers covered by cost of living adjustments only jumped after inflation had accelerated. Chart 12Higher Inflation Led To More Inflation-Indexed Wage Contracts, Not The Other Way Around As far as unions are concerned, the US unionization rate peaked by the end of the 1950s and was already on a downward path when inflation began to rise. Revealingly, Canada experienced a similar decline in inflation as the US in the early 1980s even though unionization rates remained elevated (Chart 13). This suggests that union power was not a dominant driver of inflation. Chart 13Inflation Fell In Canada, Despite A High Unionization Rate Myth #5: Today’s globalized economy will limit inflationary pressures. Fact: The empirical evidence generally suggests that the impact of globalization on US inflation has been smaller than widely supposed.1 This is not surprising. The US is a fairly closed economy. Imports account for only 15% of GDP. As a result, a fairly large change in relative prices is necessary to prompt Americans to shift a meaningful fraction of their expenditures towards foreign-made goods. Such a shift in spending would require a real appreciation of the US dollar. A real appreciation could occur either if US inflation exceeds inflation abroad or if the nominal value of the dollar strengthens against other currencies. (Admittedly, the standard terminology can be a bit confusing; just think of a real US dollar appreciation as anything that makes the US economy less competitive). Here’s the thing though: The US dollar is unlikely to strengthen unless the Federal Reserve starts to sound more hawkish. If the Fed remains in the dovish camp, real rates could fall as inflation edges higher. This will put downward pressure on the dollar, leading to a smaller trade deficit and even more aggregate demand. Myth #6: Demographics are much more deflationary now than they were in the past. Fact: Demographic trends arguably did help push down inflation over the past few decades. However, population aging is likely to boost inflation going forward. Chart 14 shows that the ratio of workers-to-consumers in the US and around the world – the so-called “support ratio” – rose steadily in the 1980s, 1990s, and 2000s as more women entered the labor force and the number of dependent children per household declined. An increase in the ratio of workers-to-consumers is equivalent to an increase in the ratio of production-to-consumption. A rising support ratio is thus deflationary. More recently, however, the support ratio has begun to decline as baby boomers retire but continue to spend. Consumption actually increases in old age once health care spending is included in the tally (Chart 15). As production falls in relation to consumption, inflation could rise. Chart 14Support Ratios Are Declining Globally After Rising Steadily For Three Decades Chart 15Consumption Increases In Old Age Once Health Care Spending Is Factored In Myth #7: Today’s fast pace of technological innovation will keep inflation down. Chart 16Total Factor Productivity Growth Is Lower Than It Was During The Great Inflation Fact: Total factor productivity growth – a broad measure of innovation – is not just low by historic standards today; it is lower than during the period of the Great Inflation spanning from 1966 to 1982 (Chart 16). Some have argued that productivity growth is mismeasured. We have examined this argument in the past and found it wanting. In any case, economic theory does not necessarily say that technological innovation should be deflationary. Economic theory states that faster innovation should lead to higher real incomes. It does not say whether the increase in real income should come via rising nominal income or falling inflation. Indeed, to the extent that faster innovation leads to higher potential GDP growth, it could fuel inflation. This is because stronger trend growth will tend to raise the neutral rate of interest, implying that monetary policy will become more stimulative for any given policy rate. Myth #8: Policymakers have learned from their mistakes. It is easy to dismiss this claim, but it is worth considering it seriously. Some of the mistakes that policymakers made during the 60s and 70s were far from obvious at the time. Athanasios Orphanides, who formerly served as a member of the ECB’s Governing Council, has documented that central banks in the US and other major economies systematically overestimated the amount of slack in their economies (Chart 17). They also overestimated trend growth, with the result that they came to see the combination of sluggish growth and seemingly high unemployment as evidence of inadequate demand. Chart 17Central Banks Overestimated The Degree Of Slack In Their Economies During The Great Inflation Is it possible that economic analysis has improved so much over the past 40 years that such mistakes would not be repeated today? Perhaps, but it is worth noting that not only did most economists fail to predict the productivity boom in the late 1990s, most were not even aware that it had happened until after it had ended. Knowing what is happening to the economy in real time is hard enough. Predicting what will happen to such things as trend growth and the natural rate of unemployment is even more difficult. Myth #9: The Fed is a lot more independent now. Fact: We will only know for sure when this independence is tested. History clearly shows that inflation tends to be higher in countries which lack independent central banks (Chart 18). The Fed’s independence was compromised in the 1970s. In his exhaustive study of the Nixon tapes, Burton Abrams documented how Richard Nixon sought, and Fed Chairman Arthur Burns obligingly delivered, an expansionary monetary policy in the lead-up to the 1972 election. Chart 18Inflation Is Higher In Countries Lacking Independent Central Banks Starting with the appointment of Paul Volcker, the Fed sought to regain its independence. Most recently, Jay Powell publicly resisted Donald Trump’s efforts to prod the Fed to ease monetary policy. Yet, the Fed’s independence may turn out to be illusory. The Fed wasted little time in slashing rates and relaunching its QE program once the pandemic began. But will it be as quick to tighten monetary policy if inflation starts getting out of hand? Jay Powell’s four-year term as chair runs through February 2022. He will need to stay in Joe Biden’s good graces if he hopes to be reappointed to a second term. The fact that government debt levels are so high further complicates matters. Higher interest rates would force the government to shift funds from social programs towards bond holders. Will the Fed raise rates even if it faces strong political opposition? Time will tell. Investment Conclusions Chart 19Social Unrest Can Fuel Inflation While no two periods are exactly the same, there are a number of striking similarities between the late 1960s and the present day. As is the case today, fiscal policy was highly expansionary back then. The same goes for monetary policy: Just like today, the Fed kept interest rates well below the growth rate of the economy. In the 1960s, the Federal Reserve was still focused on avoiding a repeat of the Great Depression and the deflationary wave that accompanied it. Today, the Fed is equally focused on reflating the economy. The 1960s was a decade of rising political and social unrest. Crime rates went through the roof, a trend that was eerily matched by rising inflation rates (Chart 19). Early estimates suggest that the US homicide rate jumped by 37% in 2020 – easily the largest one-year increase on record. As was the case in the 1960s, most of the news media has ignored this disturbing development. What should investors do? Our tactical MacroQuant model is flagging some near-term risks for stocks. Nevertheless, as long as the economy is growing solidly and the Fed remains on the sidelines, it is too early for investors with a 12-month horizon to bail on equities. Instead, equity investors should favor sectors that could benefit from higher inflation. Commodity producers are a natural choice. Banks could also gain from an uptick in inflation. Chart 20 shows the remarkably strong correlation between the performance of US banks relative to the S&P 500 and the 10-year Treasury yield. Higher bond yields would boost bank net interest margins, leading to higher profits. Banks are also very cheap and have started to see their earnings estimates rise faster not only relative to the broader market but even relative to tech stocks (Chart 21). Chart 20Bank Shares Are A Buy (I) Fixed-income investors should keep duration risk low. They should also favor inflation-protected securities over nominal bonds. Chart 21Bank Shares Are A Buy (II) Looking further out, the secular bull market in stocks will end when inflation rises to a high enough level that even the Fed cannot ignore. That day will arrive, but probably not for another two years. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1 Globalization is often cited as a potential reason behind low inflation in advanced economies, including the US. However, a number of empirical studies have found that globalization did not play a major role. In general, domestic economic conditions are seen as the main factor in the inflation process. Please see Jane Ihrig, Steven B. Kamin, Deborah Lindner, and Jaime Marquez, “Some Simple Tests of the Globalization and Inflation Hypothesis,” Board of Governors of the Federal Reserve System (International Finance Discussion Papers No. 891) (April 2007); Laurence M. Ball, “Has Globalization Changed Inflation?” National Bureau of Economic Research Working Paper Series 12687 (November 2006), and associated blog post “Has Globalization Changed Inflation?” National Bureau of Economic Research, (June 2007); Janet. L. Yellen, 'Panel discussion of William R. White “Globalisation and the Determinants of Domestic Inflation”,' Presentation to the Banque de France International Symposium on Globalisation, Inflation and Monetary Policy (March 2008); Fabio Milani, “Global Slack And Domestic Inflation Rates: A Structural Investigation For G-7 Countries,” Journal of Macroeconomics, (32:4) (2010); and and Lei Lv, Zhixin Liu, and Yingying Xu, “Technological progress, globalization and low-inflation: Evidence from the United States,” PLoS ONE, (14:4), (April 2019). Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Highlights Duration: Long-maturity Treasury yields are closing in on our intermediate-term targets. On balance, cyclical and valuation indicators continue to support an outlook for higher yields, but a few are sending warning signs that the bearish bond move is due for a correction. We maintain our recommended below-benchmark 6-12 month duration stance for now, but are keeping a close eye on the indicators shown in this report. Ba Versus Baa Corporates: From a risk-adjusted perspective, the Ba credit tier still looks like the sweet spot for positioning within corporate bonds. Fallen Angels have performed exceptionally, but no longer look cheap compared to the Baa and Ba corporate indexes. Labor Market: If the current pace of monthly employment growth is maintained, it will be a very long time before the economy reaches full employment. Vaccine effectiveness and distribution rate are the two most important factors that will determine employment growth going forward. We are optimistic that we will see a 4.5% unemployment rate sometime in 2022. Feature Chart 1Uptrend Intact Bond yields moved higher last week, maintaining their post-August uptrend despite a brief lull in the second half of January (Chart 1). The 30-year yield even touched 1.97%, its highest level since last February. Given the sharp up-move, the first section of this week’s report considers whether bond yields look stretched. More broadly, we discuss several factors that will help us decide when to increase portfolio duration. How Much Higher Can Yields Rise? We have maintained a recommended below-benchmark duration stance since October and have been targeting a range of 2% to 2.25% for the 5-year/5-year forward Treasury yield.1 That target range is based on median estimates of the long-run equilibrium fed funds rate from the New York Fed’s surveys of market participants and primary dealers (Chart 2). The rationale is that in an environment of global economic recovery where the Fed is expected to eventually lift the funds rate back to equilibrium, long-dated forward yields should reflect expectations of that long-run equilibrium. At present, the 5-year/5-year forward Treasury yield is 1.97% meaning that there is between 3 bps and 28 bps of upside before our target is met. Chart 2Almost At Target A 5-year/5-year forward Treasury yield between 2% and 2.25% would not automatically trigger an increase in our recommended portfolio duration, but it would mean that further increases in yields would need to be justified by upward revisions to survey estimates of the long-run equilibrium fed funds rate. In a similar vein, the 5-year/5-year forward TIPS breakeven inflation rate has risen considerably in recent months, but at 2.15%, it remains below the 2.3% to 2.5% range that the Fed would consider “well anchored” (Chart 2, bottom panel). In other words, there is still some running room for reflationary economic outcomes to be priced into bond yields. Cyclical Growth Indicators Treasury yields may be encroaching on the lower bounds of our target ranges, but cyclical economic indicators suggest further increases ahead. The CRB Raw Industrials / Gold ratio remains in a solid uptrend, and encouragingly, it is being driven by a surging CRB index and not just a falling gold price (Chart 3). Separately, the outperformance of cyclical equity sectors over defensives has moderated in recent weeks, but not yet by enough to warrant reversing our duration call (Chart 3, bottom panel). Chart 3Cyclical Bond Indicators Value Indicators Chart 4Bond Valuation Indicators While cyclical indicators point to further bond weakness ahead, a couple valuation measures show yields starting to look stretched. Two survey-derived estimates of the 10-year zero-coupon term premium have moved up sharply. The estimate derived from the New York Fed’s Survey of Market Participants has jumped into positive territory and the estimate derived from the Survey of Primary Dealers is close behind (Chart 4). These surveys ask respondents to estimate what they think the fed funds rate will average over the next ten years. By comparing the median survey response to the current spot 10-year Treasury yield we get a measure of how much term premium the median investor expects to earn. These term premium estimates have typically been negative during the past few years, though they did rise to about +50 bps before Treasury yields peaked in 2018. In other words, a positive term premium estimate, on its own, is no reason to extend duration. All it tells us is that if the median investor is correct about the future path of the fed funds rate, then there is more money to be made at the long-end of the curve than in cash. This doesn’t rule out investors revising their funds rate expectations higher, or the term premium becoming even more stretched. Another related bond valuation indicator is the difference between the market’s expected path for the fed funds rate and the path projected by the FOMC (Chart 4, bottom panel). Here we see that, for the first time since 2014, the market is priced for a faster pace of tightening over the next two years than the median FOMC participant anticipates. Again, this is not a decisive signal to buy bonds. The FOMC could revise its funds rate projections higher when it meets next month. However, the longer that market pricing remains more hawkish than the Fed, the stronger the case to increase duration becomes. The Dollar Chart 5Dollar Still Supports Higher Yields Finally, we should note that the trade-weighted dollar appreciated last week as bond yields rose (Chart 5). A stronger dollar certainly supports the case for extending duration, the only question is whether the dollar has strengthened enough to dent US economic growth and pull US yields back down. Our sense is that we haven’t reached that breaking point yet, but we could if US real yields continue to rise relative to real yields in the rest of the world (Chart 5, panels 2 & 3). We think of the relationship between US bond yields and the dollar as a feedback loop. A weaker dollar supports economic reflation, which eventually sends yields higher. However, once higher US yields de-couple too far from yields in the rest of the world, the dollar appreciates. A stronger dollar impairs the economic outlook and sends US yields back down, the dollar then depreciates and the cycle repeats. At present, we appear to be in the stage of the feedback loop where US yields are rising relative to the rest of the world, putting upward pressure on the dollar. However, we don’t think the dollar is yet strong enough to prevent US yields from climbing. Dollar bullish sentiment, for example, remains below 50% suggesting that most investors remain dollar bears. A sub-50 reading on this index also tends to coincide with rising US Treasury yields (Chart 5, bottom panel). A move above 50 in the dollar sentiment index would be another signal that the bond bear market is becoming stretched. Bottom Line: Long-maturity Treasury yields are closing-in on our intermediate-term targets. On balance, cyclical and valuation indicators continue to support an outlook for higher yields, but a few are sending warning signs that the bearish bond move is due for a correction. We maintain our recommended below-benchmark 6-12 month duration stance for now, but are keeping a close eye on the indicators shown in this report. Comparing Baa- And Ba-Rated Corporate Bonds Chart 6The Ba Index OAS Is Unusually High We have previously written that the macro environment is extremely positive for credit risk and we recommend moving down in quality within corporate bonds. We have also pointed out that the incremental spread pick-up earned from moving out of Baa-rated bonds and into Ba-rated bonds is elevated compared to typical historical levels. As such, the Ba-rated credit tier looks like the sweet spot for corporate bond allocation from a risk/reward perspective.2 In this week’s report we delve a little deeper into the relative valuation between Baa- and Ba-rated bonds. First, we note the difference between the average option-adjusted spread (OAS) of the Ba index and the average OAS of the Baa index. The Ba index OAS is 126 bps above the Baa index OAS, a level that looks high compared to recent years (Chart 6). One problem with this simple comparison of index OAS is that the average duration of the Ba index is much lower than the average duration of the Baa index (Chart 6, bottom panel). However, after doing our best to match the duration between the two indexes, we still find that Ba offers an attractive yield advantage, particularly compared to levels seen in 2017 and 2018 (Chart 6, panel 2). Going back to our simple OAS differential, we conducted a small study looking at calendar year excess returns between 1989 and 2020. Our results show that the differential between the Default-Adjusted Ba OAS and the Baa OAS does a good job predicting relative excess returns between the two sectors (Table 1).3 The Default-Adjusted Ba OAS is the Ba index OAS at the beginning of the calendar year minus realized Ba default losses that occurred during the year in question. We also use the Baa index OAS from the beginning of the year, but don’t make any adjustments for Baa default losses. Table 1Annual Excess Return Differential & Relative Spreads: Ba Corporates Over Baa Corporates Our results show that Ba excess returns outpaced Baa excess returns in every calendar year for which the Adjusted Ba/Baa OAS differential exceeds 100 bps. The raw Ba/Baa OAS differential is currently 126 bps. This means that we should be very confident that Ba-rated bonds will outperform Baa-rated bonds in 2021, as long as Ba default losses come in below 0.26%. This seems likely. For context, Ba default losses came in at 0.09% in 2020, despite the 12-month default rate spiking to almost 9%. Fallen Angels Another interesting issue to consider when looking at the intersection between the Baa and Ba credit tiers is the presence of fallen angels – bonds that were initially rated investment grade but have been downgraded to junk. The 2020 default cycle coincided with a huge spike in ratings downgrades and the number of outstanding fallen angels jumped dramatically (Chart 7). Not only that, but fallen angels also performed exceptionally well in 2020. Fallen angels outperformed duration-matched Treasuries by 800 bps in 2020 compared to 431 bps for the Ba-rated index, -10 bps for the Baa-rated index and -13 bps for the B-rated index (Chart 7, bottom panel). All that outperformance has compressed fallen angel valuations a lot. The incremental spread pick-up in fallen angels over duration-matched Baa-rated bonds is 201 bps, about one standard deviation below its post-2010 average (Chart 8). Fallen angels look even worse compared to the Ba index, offering only a 30 bps spread advantage (Chart 8, panel 2). Chart 7Fallen Angels Dominated In 2020 Chart 8Fallen Angels No Longer Look Cheap Bottom Line: From a risk-adjusted perspective, the Ba credit tier still looks like the sweet spot for positioning within corporate bonds. Fallen Angels have performed exceptionally, but no longer look cheap compared to the Baa and Ba corporate indexes. Labor Market Update Chart 9Employment Growth Has Slowed Last week’s January employment report was a disappointment with nonfarm payrolls growing only 49k after having contracted by 227k in December (Chart 9). Two weeks ago, we calculated the average monthly nonfarm payroll growth that will be required for the unemployment rate to reach 4.5% by certain future dates.4 In our view, an unemployment rate of 4.5% would meet the Fed’s definition of maximum employment, making it an important pre-condition for monetary tightening. Revising our calculations to incorporate January’s report, a 4.5% unemployment rate by the end of 2021 still looks like a long shot. Nonfarm payroll growth would have to average between +328k and +705k per month to meet that target, depending on the path of the participation rate (Table 2). That said, we still view a 4.5% unemployment rate by the end of 2022 as achievable. Table 2Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% ##br##By The Given Date Yes, even that will require average monthly payroll growth of between +210k and +411k, but we are likely to see a re-opening of certain shuttered sectors – Leisure & Hospitality, for example – during that timeframe. When it occurs, this re-opening will lead to a surge in employment growth that will push average monthly payroll growth dramatically higher. Notice that almost 40% of the 9.9 million drop in overall employment since February 2020 has come from the Leisure & Hospitality sector (Chart 10). Chart 10Waiting For The Post-COVID Snapback Bottom Line: If the current pace of monthly employment growth is maintained, it will be a very long time before the economy reaches full employment. Vaccine effectiveness and distribution rate are the two most important factors that will determine employment growth going forward. We are optimistic that we will see a 4.5% unemployment rate sometime in 2022. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Beware The Bond-Bearish Blue Sweep”, dated October 20, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 Excess returns are calculated relative to duration-matched Treasury securities in all cases. 4 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Increased fiscal assistance in the US and other advanced economies will support economic activity until the practice of social distancing durably ends later this year. The US is not yet vaccinating at a pace that is consistent with herd immunity, but that pace is likely to quicken over the coming weeks. A September herd immunity milestone should allow for a significant increase in public “contacts” over the summer and for a substantial closure of the output gap in the second half of the year. The spending of accumulated household savings in the US would rapidly push the output gap into positive territory if those savings were fully deployed upon reopening. But expectations of eventual tax increases and some permanent reduction in services spending suggests that some of those savings will not be spent, and that major economic overheating this year is not likely. The market has largely priced in the most likely economic outcome over the coming year, suggesting that investors should not expect outsized returns in 2021. But our base case view still favors equities relative to bonds, and implies mid-to-high single-digit returns from stocks in absolute terms. An aggressively hawkish deviation in monetary policy later this year is unlikely, barring a sharp and sustained rise in inflation back to target levels. Still, a closure of the output gap this year will push long-dated bond yields higher, suggesting that fixed-income investors should be short duration. Investors should favor global over US and value over growth stocks over the coming year. The US dollar will continue to trend lower, albeit at a slower pace. Feature Chart I-1The Near-Term Outlook For Economic Growth Is Poor The outlook for growth in the US and other developed economies remains poor over the very near term. The combination of another major wave of the COVID-19 pandemic, at least partially driven by more transmissable variants of the virus, as well as the lagged effects of diminished US fiscal support in the second half of last year have led to a slowdown in economic activity that is likely to linger for the coming several weeks (Chart I-1). Outside of the US, the pressure on the medical system has led to the re-imposition of heavy control measures that mechanically weigh on consumer spending. Within the US, some restrictions have been re-imposed, but spending has also slowed due to the exhaustion of the stimulative benefits of last year’s CARES act for a sizeable portion of recipients. There are early signs suggesting that the second wave is cresting in advanced economies: hospitalizations appear to have peaked in the US and a few major European economies, and the number of new cases is either trending lower or has plateaued (Chart I-2). However, even if this is the beginning of the end of the latest wave, the gains in the war against COVID-19 have clearly been won through changes in policy and human behavior, not through inoculation. Chart I-2Infections Are Slowing Because Of Policy And Behavior (Not Vaccinations) For example, in the US, some market commentators have highlighted the fact that hotbed midwestern states such as North and South Dakota have administered more doses of the vaccine and that the Midwest is experiencing the largest decline in new cases in the country, inferring a causal relationship. This ignores the fact that new confirmed cases peaked in the Midwest almost a month before the Pfizer/BioNTech vaccine was approved by the CDC. This suggests that a decline in cases there, which led the overall US trend, much more likely occurred in response to an exponential rise in hospitalizations in October and early November. We cannot identify a specific policy change in Midwestern states that catalyzed a peak in cases, but we hypothesize that residents of these states took it upon themselves to reduce their contacts as the threat of medical system collapse and health care rationing increased sharply. A cresting second wave is certainly positive from a health perspective, and should reduce the pressure on the medical system. But the fact that additional restrictions and/or growth-negative consumer behavior were required yet again to “flatten the curve” underscores that many of these measures will likely remain in place for the coming few weeks to durably end the wave, and thus will weigh on Q1 growth. They will also likely remain the only viable response to combat future outbreaks until vaccination reaches levels that are sufficient to reduce the impact of the pandemic on economic activity. More Fiscal Support On The Way In Europe and Canada, the fiscal response to the second wave has generally been to extend wage subsidy and income support programs. In the US, after having let unemployment benefit payments lapse in the second half of 2020, the US congress passed a US$900 billion aid bill in late December that provides US$300 per week in supplemental unemployment benefit payments and US$600 in direct checks to most Americans. Chart I-3 highlights that these payments have already begun to reach US households. In addition, following the Democratic Senate wins in Georgia earlier this month, President Biden announced a $1.9 trillion emergency relief package that topped up individual direct payments to US$2,000, assistance to small businesses, aid to state & local governments, and funding for pandemic-related expenses such as testing and the rollout of vaccines. While the size and contents of Biden’s proposal may get scaled down, our geopolitical strategists expect most of the plan to gain approval in Congress early this year. That implies that the federal deficit is on track to fall somewhere between the “Democratic Status Quo” and “Democratic High” scenarios shown in Chart I-4, meaning that the deficit will peak at between 22% and 25% of GDP in fiscal year 2021. Chart I-3Unemployment Benefit Payments Are Rising Again Chart I-4A Very Significant Amount Of Stimulus Is Still To Come This is a very significant amount of stimulus, and will provide a substantial reflationary bridge to help counter the negative impact on Q1 growth from the pandemic. But in the aggregate, some portion of the fiscal stimulus is unlikely to be spent by households until there is no longer a need for social distancing and the economy fully reopens. How long it takes to arrive at that moment depends enormously on the US’ progress at vaccinating its population. Vaccines, Herd Immunity, And Reopening For now, the news on the vaccine front is mixed. Israel, which has vaccinated over 40% of its population with at least one dose (Chart I-5), has demonstrated that it is technically possible to deploy the vaccine at an extremely rapid pace. But it is not clear that Israel’s experience is applicable to other countries, given aggressive efforts by the Israeli government to obtain early access to vaccine doses (which cannot, by definition, be achieved by everyone). While Chart I-5 shows that the US currently ranks highly among other countries at administering vaccines, Chart I-6 highlights that the pace must quicken for herd immunity to be reached later this year. The chart shows the number of actual US doses administered per 100 people, alongside the range that would need to be followed for 50-80% of the US population to be fully immunized by the end of September. Note that more than 100 doses per 100 people will be required in order to vaccinate most of the US population, given that two vaccine doses will need to be administered per person. Chart I-5Israel Is Winning The Vaccine Race Because Of Preferential Access Chart I-6Although It Likely Will, The Pace Of US Vaccinations Must Quicken The “X” on the chart highlights the Biden administration’s previous goal of 100 million doses administered in the first 100 days following inauguration, which was too timid of an objective to be on any of the herd immunity paths shown in the chart. The administration’s new goal of 1.5 million injections administered per day starting by the middle of February is more promising and suggests that the US will be within the herd immunity range by late April. Chart I-6 is somewhat daunting, in that it highlights the risk that the US may not actually achieve herd immunity this year, and that investors are overestimating the odds of true economic reopening. However, that would be an overly pessimistic assessment, for three reasons: Due to the scaling up of vaccine production, the pace of vaccine dose deliveries will likely soon grow at an exponential rather than linear rate. This implies that the “underperformance” of actual vaccine doses administered versus the herd immunity paths shown in Chart I-6 is temporary. Private industry is likely to help the government meet its new vaccination goals. Amazon has recently offered the federal government assistance at distributing vaccine doses, and CVS, the retail pharmacy chain, has recently suggested that its stores could provide 1 million injections per day. These estimates do not include the likely establishment of large-scale, federally-funded vaccination sites. Despite what health professionals may advise, wide-ranging re-opening of economic activity and the end of social distancing policies will likely occur before herd immunity is technically reached. From the perspective of a health care professional, case minimization should be the objective of policy as it stands to minimize the number of deaths linked to the pandemic. But given the tremendous economic, emotional, and mental health toll inflicted by social distancing, from the perspective of politicians and many members of the public, the objective of policy should instead be to ensure that the medical system remains functional and that rationing of critical care is not required. The fact that vaccines are being administered to those most likely to become hospitalized suggests that the peak impact on the health care system will occur before herd immunity is achieved, which should allow for an increase in public “contacts” over the summer. What Happens When The Economy Re-Opens? In the US and in most advanced countries, the gap in spending is focused entirely on the services side of the economy. Table I-1 presents a simple estimate of the US spending gap for real personal consumption expenditures, broken down by type. The table highlights that goods spending is currently above not just pre-pandemic levels, but also above what would have been expected if the pandemic had not occurred. The only exceptions to this are nondurable goods categories that have been highly impacted by working-from-home policies, such as clothing and footwear and gasoline and other energy goods. The household services consumption gap, on the other hand, was deeply negative in Q3, concentrated within transportation, recreation, and food/accommodation services. Table I-1The Spending Gap Is Almost Entirely On The Services Side My colleagues Peter Berezin and Doug Peta have recently estimated that US households are sitting on roughly $1.4-1.5 trillion in excess savings as a combined result of the CARES act and the massive services spending gap noted above (Chart I-7). That amounts to approximately 7% of GDP, which significantly exceeds an estimated output gap of roughly 3% at the end of Q4 (Chart I-8). Chart I-7A Massive Horde Of Excess Savings Has Been Accumulated Chart I-8Excess Savings Of 7% Of GDP Dwarf A -3% Output Gap At first blush, this suggests that the deployment of those savings, which seems likely once the pandemic is over and the need for social distancing measures are no longer required, could rapidly push the output gap into positive territory. But that calculation assumes that all excess savings will be spent, which will probably not occur given that some holders of those savings will expect future tax increases. An enormous budget deficit combined with Democratic control of government means that individual and corporate tax increases are highly likely over the coming 12-24 months, suggesting that higher-income individuals will expect some of those excess savings to ultimately be taxed away. In addition, even once social distancing is no longer required, it seems likely that some small portion of the spending on services that has been “missing” over the past year will never return. While it seems reasonable to expect that the gap in spending on hospitality and travel will close quickly and even potentially exceed pre-pandemic levels once the health situation allows, it also seems reasonable to expect that some service areas, particularly retail, will experience a permanent loss in demand owing to durable shifts in consumer behavior that occurred during the pandemic (greater familiarity and use of online shopping, a permanent reduction of some magnitude in commuting, etc). Chart I-9So Far, There Is Little Evidence Of Major Permanent Labor Market Damage It remains unclear how much of a permanent decline will occur, and it is very difficult to forecast because of its dependency on the pace at which vaccination occurs. The faster that economic circumstances return to normal, the less permanent changes are likely to occur. For now, evidence from the labor market remains encouraging, in that permanent job loss has not surged beyond that experienced during a typical income-statement recession (Chart I-9). But the bottom line is that some of the mountain of savings that has been accumulated over the past year has occurred due to a reduction in spending on certain services that may not return once the pandemic is over, meaning that those funds may be permanently saved. This suggests that meaningful output gap closure, rather than major overheating of the economy, is the more likely scenario later this year. Is Re-Opening Priced In? Charts I-10 and I-11 highlight market expectations for growth and earnings over the next 12 months. The charts highlight that expectations are already in line with a meaningful closure of the output gap later this year: consensus growth expectations suggest that real GDP will only be about half a percentage point below potential output by the end of 2021, and bottom-up analysts expect that S&P 500 earnings per share will be approximately 3% higher in 12 months’ time than they were at the onset of the pandemic. Chart I-10Meaningful Output Gap Closure Is Likely This Year Chart I-11Analysts Already Expect A Complete Earnings Recovery Does the fact that market expectations already reflect what is likely to occur over the coming year mean that stock prices have nowhere to go? At a minimum it suggests that strong, double-digit returns are unlikely, especially given that equities are more technically stretched to the upside than they have been at any point over the past decade and that investor sentiment is very bullish (Chart I-12). However, even if earnings grow exactly in line with analyst expectations over the coming year, it is not correct to say that stocks offer no return potential. Chart I-13 illustrates this point by showing the historical relationship between earnings surprises and the price performance of the S&P 500. Chart I-12US Equities Are Extremely Overbought Chart I-13Positive Stock Returns Almost Always Accompany In-Line Earnings Performance The first point to note from the chart is that positive earnings surprises are quite rare, in that actual earnings tend to underperform expectations of earnings 12 months prior. As such, earnings performance over the coming 12 months that is exactly in line with expectations would be a better fundamental result than what investors can typically expect. The second point to note is that it is rare for stocks to fall when earnings meet or exceed prior expectations, unless faced with a significant growth shock. Earnings met or exceeded expectations in 1995, from 2004-2007, from 2010-2011, and in 2018, and in all four cases, stocks delivered either high single-digit or low double-digit price returns. Negative year-over-year returns occurred only briefly in two of these episodes and were tied to major changes to the economic outlook: the euro area sovereign debt crisis in 2011-2012, and the onset of the Sino-US trade war in 2018. Conclusions And Investment Recommendations Chart I-14Investors Should Favor Global Ex-US and Value Stocks This Year For investors focused on the coming 6-12 months, the key conclusions of our analysis are as follows: The outlook for economic growth is negative over the very near term, but additional fiscal support will likely provide enough of a reflationary bridge to avoid a serious contraction in activity. The achievement of herd immunity and the end of social distancing must occur this year for consensus 2021 expectations for economic growth and earnings to be realized. The US is not yet vaccinating at a pace that is consistent with herd immunity later this year, but credible projections from the new administration suggest that the pace will meaningfully quicken by the end of February. Some US households have accumulated significant savings over the past year, which would rapidly push the output gap into positive territory were they to all be deployed following full economic reopening. The expectation of eventual tax increases and a permanent reduction in some services spending means that not all of these savings will be spent, suggesting that the output gap will close meaningfully this year – but not overshoot into positive territory. Consensus market expectations already reflect what is likely to occur over the coming year, but the realization of these expectations still implies mid-to-high single-digit returns from equities. Chart I-15The Dollar Is A Counter-Cyclical Currency, And Will Continue To Trend Lower Given these conclusions, we recommend the following investment stance over the coming 6-12 months: Stock prices are likely to rise in absolute terms despite already elevated multiples, and investors should remain overweight equities relative to government bonds. A meaningful closure of the output gap is consistent with the Fed’s economic projections, suggesting that an aggressively hawkish deviation in monetary policy later this year is unlikely, barring a sharp and sustained rise in inflation back to target levels. Still, a closure of the output gap this year will push long-dated bond yields higher, suggesting that fixed-income investors should be short duration. The “reopening trade” favors global over US stocks, and value over growth stocks. Chart I-14 highlights that global ex-US stocks are now in a clear uptrend versus their US peers, whereas value stocks have yet to decisively break out. We expect the latter will occur over the coming 6-12 months. The US dollar is a reliably counter-cyclical currency, and has behaved exactly as a counter-cyclical currency should have over the past year (Chart I-15). We thus expect a further, albeit less sharp, decline in the dollar over the coming year. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst January 28, 2021 Next Report: February 25, 2021 II. Surging US Money Growth: Should Investors Be Concerned? Generally-speaking, an increase in bank deposits occurs due to either Fed asset purchases, bank asset purchases, or bank loan creation. Deposits have grown massively over the past year because the Treasury has issued an enormous amount of bonds, and these bonds have been purchased both by the Fed and US banks. Relative to the 2008-2009 period, the comparatively better health of US bank balance sheets last year has been an even more important factor than Fed asset purchases in accounting for the difference in money growth between the two periods. Money growth used to be a good predictor of economic activity, but today it makes more sense to focus on interest rates rather than monetary aggregates as a leading economic indicator. Over the past 20 years, only the collapse in velocity that occurred after 2008 is meaningful for investors, and it appears to reflect already “known” information: the persistent household deleveraging that occurred following the global financial crisis, and the effect of Fed asset purchases on the stock of money at several points over the past decade. Our base case view is that a portion of the significant amount of household savings that have accumulated will not be spent, and that the US output gap will close but not move deeply into positive territory this year. But the enormous growth in money over the past year reflects unprecedented fiscal and monetary support, which could eventually change investor expectations about long-term interest rates (even absent rapid overheating). Rising long-term rate expectations could threaten the equity bull market, given the impact the secular stagnation narrative has had in keeping long-term rate expectations low and the extent to which easy money has boosted equity valuation multiples over the past year. Broad money growth has exploded higher over the past year, to a pace that has not been seen since WWII (Chart II-1). This growth in the money supply has vastly exceeded what investors witnessed during and immediately following the global financial crisis of 2008-2009, raising concerns among many investors of the potential cyclical and structural consequences. Chart II-1A Nearly Unprecedented Surge In Money Growth In this report we revisit the deposit creation process, and explain the specific factors that have led to surging money growth over the past year. We also review the usefulness of money growth as an economic indicator, and provide some perspective on the 20-year decline in money velocity. We conclude by noting that the surge in money growth is potentially concerning for investors for two reasons. First, if US households ignore likely future tax increases and decide to fully spend the vast amount of savings that have accumulated over the past year, then the US economy is likely to overheat rather quickly. The second, more likely, threat to investors is if the sharp increase in the money supply ends up changing market expectations about the neutral rate of interest. It remains too early to conclude whether investors will significantly revise up their long-term rate expectations, in large part because the scale of permanent damage in the wake of the pandemic is still unknown. But investors should remain vigilant, given the impact the secular stagnation narrative has had on keeping long-term rate expectations low and the extent to which easy money has boosted equity valuation multiples over the past year. Reviewing The Money And Bank Deposit Creation Process In order to fully understand the spectacular growth of the money supply over the past year and its potential implications for the economy and financial markets, it is important to revisit how money is created in a modern economy. My colleague Ryan Swift, BCA’s US Bond Strategist, reviewed this question in detail in a June 2020 Strategy Report and we summarize the report’s key points below.1 In the US, most of the stock of broad money aggregates is composed of bank deposits. Following the global financial crisis, the textbook view of how banks act purely as intermediaries, taking in deposits from the public and lending them out, was revealed to be a mostly inaccurate description of the financial system in the aggregate. Rather, while individual banks often compete for deposits as a source of funding, bank deposits in the aggregate are typically created by making loans. Central banks can also create money, by purchasing financial assets and crediting the banking system with reserve assets (central bank money). Table II-1 highlights the link between the Fed’s balance sheet and that of US banks in the aggregate, and highlights how changes in deposits – a liability of the banking system – must be offset by increases in bank assets or decreases in other bank liabilities. Table II-1The Link Between The Fed’s Balance Sheet And The Aggregate US Banking System The typical mechanics of three money-creating operations are described below, alongside the corresponding change in balance sheet items: Fed Asset Purchases: When the Federal Reserve purchases financial assets in the secondary market, it increases securities held (Fed asset) and typically increases reserves (Fed liability). In the increase in reserves (banking system asset) matches the increase in deposits (banking system liability), as the previous holders of the assets purchased by the Fed deposit the proceeds of the sale. Bank Asset Purchases: When banks purchase government securities from non-bank holders they credit the sellers with bank deposits.2 This increases bank holdings of securities or other assets (banking system asset) and increases deposits (banking system liability). Bank Loan Creation: When banks create a loan, they increase their holdings of loans & leases (banking system asset) and deposit the loan amount into the borrowers’ account (banking system liability). At the individual bank level, if Bank A creates a loan and the borrower withdraws the funds to pay someone with an account at Bank B, there will be an asset-liability mismatch relating to that loan transaction between those two banks if no other actions are taken. The result will be that Bank A experiences an increase in equity capital and Bank B experiences a decline. But for the banking system as a whole, the increase in bank assets exactly matched the increase in bank liabilities, and Bank A created the deposits that ended up as a liability of Bank B. The issuance or retirement of long-term bank debt and equity instruments can also create or destroy deposits but, for the purpose of understanding the difference in money growth during the pandemic compared with the 2008-2009 experience, it is sufficient to focus on the three money-creating operations described above. Explaining The Recent Surge In Money Growth The prevalent view among many financial market participants is that the money supply has surged in the US due to the fiscal stimulus provided by the CARES act. But an increase in the government’s budget deficit does not in and of itself create money, because the Treasury issues bonds to finance the difference between revenue and expenditures. If those bonds are purchased entirely by the nonfinancial sector, then an increase in deposits of stimulus recipients is offset by a decrease in deposits of those who purchased the bonds. A more precise answer is that deposits have grown massively over the past year because the Treasury has issued an enormous amount of bonds and these bonds have been purchased both by the Fed and US banks. Charts II-2A and II-2B highlight this by showing the change in the main items on the aggregate banking system balance sheet since the end of 2019. The charts show that the increase in deposits on the liability side of bank balance sheets have been matched by large increases in reserves and other cash (caused by the Fed’s asset purchases) and banks’ securities holdings (caused by bank asset purchases). Chart II-2AOver The Past Year, Fed And Bank Asset Purchases… Chart II-2B…Account For Most Of The Surge In Deposits But this does not explain why money growth has been so much larger over the past year than it was in 2008-2009, when total Federal Reserve assets increased from $920 billion to $2.2 trillion. Chart II-1 on page 15 highlighted that growth in M2 has risen to a whopping 25% year-over-year growth rate, a full 15 percentage points above the strongest rate that prevailed following the global financial crisis. Charts II-3A and II-3B explain the discrepancy, by showing the change in the main items on the aggregate banking system balance sheet as a percent of the money supply during each of the two periods, as well as the difference. The charts show that while changes in bank reserves and cash assets – caused by Fed asset purchases – were significantly larger in 2020 than they were on average from 2008 to 2009, changes in loans & leases and securities in bank credit, as well as other assets were also quite significant and account for two-thirds of the difference when added together. Chart II-3ARelative To 2008/2009, The Health Of The Banking System… Chart II-3B…Helped Facilitate More Money Creation Last Year Thus, while it is true that the Fed’s accommodation of extraordinary fiscal easing has helped create a sizeable amount of money over the past year, relative to the 2008-2009 period the comparatively better health of US bank balance sheets has been an even more important factor – in the sense that balance sheet restrictions did not prevent US banks from facilitating the creation of money as appears to have been the case in the aftermath of the global financial crisis. Money And Growth We noted above that fiscal easing does not create money in and of itself unless the bonds issued to finance an increase in the deficit are purchased either by banks or the Fed. Yet most investors would not disagree that significant increases in budget deficits boost short-term economic growth, particularly during recessions. This implies that the link between money and economic growth may not be particularly strong over a cyclical time horizon, which is in fact what the data shows – at least over the past 30 years. Charts II-4A and II-4B illustrate the historical relationship between real GDP and real M2 growth, pre- and post-1990. The chart makes it clear that the relationship between real money and GDP growth used to be strong, with real money growth somewhat leading economic activity. This relationship completely broke down after the 1980s, and is now mostly coincident and negative. There are three reasons behind the breakdown: 1. The money supply used to be the Federal Reserve’s monetary policy target, meaning that money growth directly reflected monetary policy shifts. Today, the Fed targets interest rates, and the portion of money created through loans simply mirrors the change in interest rates as loan demand rises (falls) and interest rates fall (rise). Specifically, Chart II-4A shows that the ability of money growth to lead economic activity seems to have ended in the late 1980s, when the Fed stopped providing targets for monetary aggregates. Chart II-4AMoney Growth Used To Predict Economic Activity… Chart II-4B…But Ceased To Do So Once The Fed Stopped Targeting The Money Supply Chart II-5US Banks Provide Meaningfully Less Private Sector Credit Than In The Past 2. The share of total US credit provided by US banks has fallen significantly over time – especially during the early 1990s – as corporate bond issuance, securitized loans, and mortgages backed by agency bonds issued to the private sector rose as a proportion of total credit (Chart II-5). 3. Since 2000, a Chart II-4B shows that a clearly negative correlation has emerged between money growth and economic activity during recessions. In 2008-2009 and again last year, money growth reflected emergency Fed asset purchases in the face of a sharp decline in economic activity. In 2000, the Fed did not expand its balance sheet, but the economy diverged from money growth due to the lingering impact of management excesses, governance failures, and elevated debt in the corporate sector in the 1990s. The conclusion for investors is straightforward: while money growth used to be a good predictor of economic activity, today it makes more sense to use interest rates than monetary aggregates as a leading indicator for growth. Money Velocity And Its Implications When discussing the impact of money on the economy, one point often raised by investors is the fact that money velocity has declined significantly over the past two decades. This observation is frequently followed by the question of whether the absence of this decline would have caused real growth, inflation, or both to have been higher over the past 20 years than they otherwise were. It is difficult to prove or refute the point, as monetary velocity is not a well-understood concept – investors do not have a good, reliable theory upon which to predict changes in velocity or understand their economic significance. Velocity is calculated from the equation of exchange as a ratio of nominal GDP to some measure of the money supply (typically a broad measure such as M2) and theoretically represents the turnover rate of money. But long-term changes in velocity do not seem to correlate well with measures of growth or inflation. Short-term changes in velocity correlate extremely well with inflation, but this simply reflects the fact that velocity tends to be driven by the numerator (nominal GDP) over short periods of time (see Box II-1). BOX II-1 Money Velocity Over The Short-Term Some investors have pointed to the relationship shown in Chart II-B1 to argue that M2 money velocity is a significant cyclical predictor of inflation. But Chart II-B2 illustrates that nearly two-thirds of annual changes in velocity since 1990 have been accounted for by changes in the numerator – nominal GDP – rather than the denominator. This underscores that the apparent explanatory power of short-term changes in money velocity at predicting inflation is simply capturing the normal relationship between real growth and inflation, as well as the naturally positive correlation between the implicit GDP price deflator and core consumer prices. Chart Box II-1Velocity Seemingly Predicts Inflation Over The Short-Term… Chart Box II-2…Because Short-Term Changes In Velocity Are Driven By Nominal Output The bigger question is why velocity has declined so significantly over the past 20 years, and what this means for investors. Chart II-6Large Declines In Velocity Are Linked To Prolonged Periods Of Deleveraging Panel 1 of Chart II-6 shows a long-dated history of M2 velocity, and highlights that the average or “normal” level of M2 velocity has historically been just under 1.8. Over the past century, there have been just four major deviations from this level: A major decline that began at the start of the Great Depression and prevailed until the Second World War (WWII) Significant volatility during and in the years immediately following WWII A sharp rise in velocity during the 1990s to a record level A downtrend beginning in the late 1990s that remains intact today Abstracting from the war period in which the economy was heavily distorted by government intervention, Chart II-6 also highlights that persistent declines in velocity appear to be explainable by major deleveraging events. The second panel of the chart shows a measure of the duration of private sector deleveraging, and highlights that the two periods of low velocity have been strongly (negatively) correlated with the prevalence of deleveraging. This explanation is simple but intuitive: excessive leveraging eventually causes households and firms to redirect a larger portion of their income to servicing or paying down debt, which weighs on real growth and, by extension, prices. While it is true that the recent 20-year downtrend in velocity began in the late 1990s and thus well before household deleveraging began in 2008, this seems to mostly reflect the reversal of an anomalous rise in velocity in the late 1990s. We largely view the decline in velocity from the late 1990s to 2008 as a “reversion to the mean.” It remains an option question why velocity rose so sharply in the 1990s. Some evidence seems to point to financial innovation and technological change: Chart II-7 highlights that the number of automated bank teller and point-of-sale payment terminals rose massively in the 1990s, alongside a significant acceleration in real cash in circulation. This is theoretically consistent with an increased “turnover” rate of money. But Chart II-8 highlights that a substantial portion of the rise in velocity during this period was attributable to denominator effects (persistently weak money growth), rather than numerator effects. Chart II-7Some Evidence Of Increased Money Turnover In The 1990s Chart II-8The Rise In Velocity In The 1990s Was Driven By Slow Money Growth Regardless of the cause, velocity was clearly anomalous on the upside in the 1990s, suggesting that it is not the downtrend in velocity over the past 20 years that is significant to investors. Rather, it is the collapse in velocity that has occurred since 2008 that is meaningful, and from the perspective of investors it appears to reflect already “known” information: the persistent household deleveraging that occurred following the global financial crisis, and the effect of Fed asset purchases on the stock of money at several points over the past decade. In the future, any meaningful increases in velocity are only likely to occur due to a significant reduction in the size of the Fed’s balance sheet, which is two to three years away at the earliest. The Fed could decide to taper its asset purchases sometime later this year or in early 2022, but tapering would merely slow the pace at which the Fed’s assets are increasing (and would thus not cause velocity to rise via a meaningful slowdown in money growth). Money And Future Inflation The final question to address is the issue of whether the enormous rise in money growth over the past year is likely to lead to higher, potentially much higher, inflation over the coming 6-12 months. This has been the main question from investors who have been unnerved by the surge in money growth and the collapse in the US government budget balance. Any link between money and inflation has to come through spending, so the question of whether a surge in money will lead to higher inflation is akin to asking whether the massive amount of savings that have been accumulated over the past year are likely to be spent, and over what period. We discussed this question in Section 1 of this month’s report, and noted that expectations of future tax increases and a permanent decline in some services spending will likely prevent all of these savings from being deployed once the practice of social distancing durably ends later this year. This implies that a substantial closure of the output gap is likely to occur in the second half of the year, but that major economic overheating will be avoided. Moreover, even if the output gap does rise into positive territory over the coming 6-12 months, this does not necessarily suggest that inflation will rise quickly back above the Fed’s target. In last month’s Special Report, we highlighted two important points about inflation that are often overlooked by investors. First, inflation’s long-term trend is determined by inflation expectations. Second, if inflation expectations are largely formed based on the experience of past inflation, then inflation is ultimately determined by three dimensions of the output gap: whether it is rising or falling, whether it is above or below zero, and how long it has been above or below zero. While market-based expectations of long-term inflation have risen well above the Fed’s target, both our adaptive expectations model for inflation as well as a simple five-year moving average are between 30-60 basis points below the 2% mark (Chart II-9). This may suggest that a persistent period of output above potential may be required in order to raise inflation relative to expectations and to raise expectations themselves above the Fed’s target unless the Fed’s efforts at “jawboning” them higher prove to be highly successful. Measured as a year-over-year growth rate of core prices, inflation is set to spike higher in April and May in the order of 50-60 basis points simply due to base effects (Chart II-10). However, inflation will only sustainably rise to an above-target rate over the coming 6-12 months if demand is even stronger than implied by consensus expectations, which is not our base case view. Chart II-9Adaptive Inflation Expectations Measures Are Still Well Below The Fed's Target Chart II-10The Fed Will Look Through Base Effects On Consumer Prices Investment Conclusions Investors can draw two conclusions from our analysis above. First, there is reason to be concerned about the enormous rise in the money supply if we are wrong in our assessment that some portion of the savings accumulated over the past year will not ultimately be spent. If US households ignore likely future tax increases and decide to fully spend their savings windfall, then the US economy is likely to overheat rather quickly. The second, more likely, threat to investors is if the sharp increase in the money supply, reflecting monetized fiscal stimulus and a meaningfully healthier financial system compared with the global financial crisis, ends up changing market expectations about the neutral rate of interest. Chart II-11The Pandemic Response May Raise Long-Term Rate Expectations Chart II-11 that while 5-year/5-year forward Treasury yields are not much lower than they were pre-pandemic, that is an artificially low bar. Long-dated bond yields fell over 100 basis points in 2018 and 2019, in response to a global growth slowdown precipitated by the Trump administration’s trade war. While President Biden will pursue some protectionist policies, they are likely to be meaningfully less damaging to global growth than under President Trump and are extremely unlikely to act as the primary driver of macroeconomic activity over the course of Biden’s term (as they were during the period that long-dated bond yields fell). As such, if the pandemic ends this year with seemingly minimal lasting damage to the US economy, long-dated bond yields could re-approach their late 2018 levels or higher towards the end of the year. This would cause a meaningful rise in 10-year Treasury yields, even with the Fed on hold until the middle of 2022 or later. A significant rise in bond yields would be quite unwelcome to stock investors given how stretched equity multiples have become. Table II-2 presents a set of year-end scenarios to gauge the potential impact of an eventual rise in 10-year yields. We assume that forward earnings grow at 5% this year, and we allow the spread between the 12-month forward earnings yield and the 10-year yield (a proxy for the equity risk premium) to return to its 2003-2007 average as part of an assumed “normalization” trade. Table II-2Current Multiples Are Justified Only If The 10-Year Treasury Yield Does Not Rise Above 2.5% The table suggests that a 10-year Treasury yield of 2.5% will be the most that the interest rates could rise before the fair value of the S&P 500 falls below current levels. That roughly equates to a return to the late-2018 levels that prevailed for 5-year/5-year forward Treasury yields, given that the short-end of the curve will remain pinned close to the zero lower bound for some time. For now, it remains too early to conclude whether investors will significantly revise their long-term rate expectations, in large part because the scale of permanent damage in the wake of the pandemic is still unknown. But investors should remain vigilant and attentive to the fact that interest rates may pose a threat to financial markets later this year even in a scenario where the US economy is not immediately overheating, given the impact the secular stagnation narrative has had in keeping long-term rate expectations low and the extent to which easy money has boosted equity valuation multiples over the past year. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators are very extended, highlighting that a near-term pullback in stock prices remains a significant risk. Our monetary indicator is in a clear downtrend, reflecting a reduced intensity of monetary support, but it remains above the boom/bust line. The upshot is that while the marginal stimulus provided by monetary policy is falling, the level of stimulus from easy monetary conditions remains significant. Forward equity earnings already price in a complete earnings recovery, but for now there is no sign of waning forward earnings momentum. Net revisions and positive earnings surprises remain solidly positive. Within a global equity portfolio, the US underperformance that we noted last month continues, led by strong gains in emerging markets (including China). Euro area stocks have significantly underperformed EM over the course of the pandemic, are likely to emerge as the new regional leader within a global ex-US portfolio at some point later this year. The US 10-Year Treasury yield has broken convincingly above its 200-day moving average. Long-dated yields are technically stretched to the upside, but our valuation index highlights that bonds are still extremely expensive and that yields have room to move higher over the cyclical investment horizon. The technical and valuation profile is similar for the US dollar. The USD is technically oversold, but it remains expensive according to our models. We noted in Section 1 of this month’s report that the dollar has traded almost exactly in line with what one would expect from a counter-cyclical currency, suggesting that USD will continue to trend lower, at a more moderate pace, over the coming year. Raw industrials prices have recovered not just back to pre-pandemic levels, but also back to 2018 levels (i.e., before the Sino/US trade war). This underscores that many commodity prices are extended, and are likely due for a breather. US and global LEIs remain in a solid uptrend. A peak in our global LEI (GLEI) diffusion index suggests that the pace of advance in the GLEI will moderate, but the diffusion index has not yet fallen to a level that would herald a meaningful decline in the LEI. The waning US payroll momentum that we flagged in last month’s Section 3 culminated in a slowdown in economic activity that is likely to linger for the coming several weeks. However, the very significant amount of stimulus that is still set to arrive will provide a substantial reflationary bridge to help counter the negative impact on Q1 growth from the pandemic. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Please see USBS Strategy Report "The Case Against The Money Supply," dated June 30, 2020, available at usbs.bcaresearch.com 2 Please see “Money creation in the modern economy,” Bank of England, Q1 2014 Quarterly Bulletin.
Highlights A positive backdrop still supports a cyclical bull market in Chinese stocks, but the upside in prices could be quickly exhausted. Investors may be overlooking emerging negative signs in China’s onshore equity market. The breadth of the A-share price rally has sharply declined since the beginning of this year; historically, a rapid narrowing in breadth has been a reliable indicator for pullbacks in the onshore market. Recent stock price rallies in some high-flying sectors of the onshore market are due to earnings multiples rather than earnings growth. Overstretched stock prices relative to earnings risk a snapback. We remain cautious on short-term prospects for China’s onshore equity markets. Feature Market commentators remain sharply divided about whether Chinese stocks will continue on their cyclical bull run or are in a speculative frenzy ready to capitulate. Stock prices picked up further in the first three weeks of 2021, extending their rallies in 2020. The positives that support a bull market, such as China’s economic recovery and improving profit growth, are at odds with the negatives. The downside is that the intensity of post-pandemic stimulus in China has likely peaked and monetary conditions have tightened. In addition, China’s stock markets may be showing signs of fatigue. While aggregate indexes have recorded new highs, the breadth of the rally—the percentage of stocks for which prices are rising versus falling—has been rapidly deteriorating. In the past, a sharp narrowing in breadth led to corrections and major setbacks in Chinese stock prices. Timing the eventual correction in stock prices will be tricky in an environment where plentiful cash on the sidelines from stimulus invites risk-taking. For now, there is little near-term benefit for investors to chase the rally in Chinese stocks. While we are not yet negative on Chinese stocks on a cyclical basis, the risks for a near-term price correction are significant. Investors looking to allocate more cash to Chinese stocks should wait until a correction occurs. Positive Backdrop On a cyclical basis, there are still some aspects that could push Chinese stocks even higher. The question is the speed of the rally. The more earnings multiples expand in the near term, the more earnings will have to do the heavy lifting in the rest of the year to pull Chinese stocks higher. The following factors have provided tailwinds to Chinese stocks, but may have already been discounted by investors: Chart 1Chinas Economic Recovery Continues China’s economic recovery continues. China was the only major world economy to record growth in 2020. The massive stimulus rolled out last year should continue to work its way through the economy and support the ongoing uptrend in the business cycle (Chart 1). China’s relative success containing domestic COVID-19 outbreaks also provides confidence for the country’s consumers, businesses and investors. Chinese consumers have saved money—a lot of it. Although the household sector has been a laggard in China’s aggregate economy, much of the consumption weakness has been due to a slower recovery in service activities, such as tourism and catering (Chart 2). More importantly, Chinese households have accumulated substantial savings in the past two years. Unlike investors in the US, Chinese households have limited investment choices. Historically, sharp increases in household savings growth led to property booms (Chart 3, top panel). Given that Chinese authorities have become more vigilant in preventing further price inflation in the property market, Chinese households have been increasingly investing in the domestic equity market (Chart 3, middle and bottom panels). Reportedly, there has been a sharp jump in demand for investment products from households; mutual funds in China have raised money at a record pace, bringing in over 2 trillion yuan ($308 billion) in 2020, which is more than the total amount for the previous four years. The equity investment penetration remains low in China compared with developed nations such as the US.1 Thus, there is still room for Chinese households to deploy their savings into domestic stock markets. Chart 2Consumption Has Been A Laggard In Chinas Economic Recovery Chart 3But Chinese Households Have Saved A Lot Of Dry Powder Global growth and the liquidity backdrop remain positive. The combination of extremely easy monetary policy worldwide and a new round of fiscal support in the US will provide a supportive backdrop for both global economic growth and liquidity conditions. Foreign investment has flocked into China’s financial markets since last year and has picked up speed since the New Year (Chart 4). On a monthly basis, portfolio inflows account for less than 1% of the onshore equity market trading volume, but in recent years foreign portfolio inflows have increasingly influenced China’s onshore equity market sentiment and prices (Chart 5). Chart 4Foreign Investors Are Piling Into The Chinese Equity Market Chart 5And Have Become A More Influential Player In The Chinese Onshore Market Geopolitical risks are abating somewhat. We do not expect that the Biden administration will be quick to unwind Trump’s existing trade policies on China. However, in the near term, the two nations will likely embark on a less confrontational track than in the past two and a half years. Slightly eased Sino-US tensions will provide global investors with more confidence for buying Chinese risk assets. Lastly, localized COVID-19 outbreaks have flared up in several Chinese cities, prompting local authorities to take aggressive measures, including community lockdowns and stepping up travel restrictions. A deterioration in the situation could delay the recovery of household consumption; however, any negative impact on China’s aggregate economy will more than likely be offset by market expectations that policymakers will delay monetary policy normalization. Domestic liquidity conditions could improve, possibly providing a short-term boost to the rally in Chinese stocks. Bottom Line: Much of the positive news may already be priced into Chinese stocks. Non-Negligible Downside Risks There is a consensus that Chinese authorities will dial back their stimulus efforts this year and continue to tighten regulations in sectors such as real estate. Investors may disagree on the pace and magnitude of policy tightening, but the policy direction has been explicit from recent government announcements. However, the market may have ignored the following factors and their implications on stock performance: Deteriorating equity market breadth. In the past three weeks, the rally in Chinese stocks has been supported by a handful of blue-chip companies. The CSI 300 Index, which aggregates the largest 300 companies listed on both the Shanghai and Shenzhen stock exchanges (i.e. the A-share market) outperformed the broader A-share market by a large margin (Chart 6). Crucially, stock market breadth has declined rapidly (Chart 7). In short, the majority of Chinese stocks have relapsed. Chart 6Large Cap Stocks Outperform The Rest By A Sizable Margin Chart 7The Breadth Of Onshore Stock Price Rally Has Narrowed Sharply Chart 8Narrowing Market Breadth Has Historically Led To Price Pullbacks Previously, Chinese stocks experienced either price corrections or a major setback as the breadth of the rally narrowed (Chart 8). However, the relationship has broken down since October last year; the number of stocks with ascending prices has fallen, while the aggregate A-share prices have risen. In other words, breadth has narrowed and the rally in the benchmark has been due to a handful of large-cap stocks. Top performers do not have enough weight to support the broad market. An overconcentration of returns in itself may not necessarily lead to an imminent price pullback in the aggregate equity index. The five tech titans in the S&P 500 index have been dominating returns since 2015, whereas the rest of the 495 stocks in the index barely made any gains. Yet the overconcentration in just a few stocks has not stopped the S&P 500 from reaching new highs in the past five years. Unlike the tech titans which represent more than 20% of the S&P index, the overconcentration in the Chinese onshore market has been more on the sector leaders rather than on a particular sector. China’s own tech giants such as Alibaba, Tencent, and Meituan, represent 35% of China’s offshore market, but most of the sector leaders in China’s onshore market account for only two to three percent of the total equity market cap (Table 1). Given their relatively small weight in the Shanghai and Shenzhen composite indexes, it is difficult for these stocks to lift the entire A-share market if prices in all the other stocks decline sharply. The CSI 300 Index, which aggregates some of China’s largest blue-chip companies and industry leaders, including Kweichow Moutai, Midea Group, and Ping An Insurance, is not insulated from gyrations in the aggregate A-share market. Historically, when investors crowded into those top performers, the weight from underperforming companies in the broader onshore market would create a domino effect and drag down the CSI 300 Index. In other words, the magnitude of returns on the CSI 300 Index can deviate from the broader onshore market, but not the direction of returns. Table 1Top 10 Constituents And Their Weights In The CSI 300, Shanghai Composite, And Shenzhen Composite Indexes Chinese “groupthinkers” are pushing the overconcentration. With the explosive growth in mutual fund sales, Chinese institutional investors and asset managers have started to play important roles in the bull market. Unlike their Western counterparts, Chinese fund managers’ performances are ranked on a quarterly or even monthly basis by asset owners, including retail investors. As such, they face intense and constant pressure to outperform the benchmarks and their peers, and have great incentive to chase rallies in well-known companies. In a late-state bull market when uncertainties emerge and assets with higher returns are sparse, fund managers tend to group up in chasing fewer “sector winners,” driving up their share prices. Chart 9Forward Earnings Growth Has Stalled Earnings outlook fails to keep up with multiple expansions. Despite the massive stimulus last year and improving industrial profits, forward earnings growth in both the onshore and offshore equity markets rolled over by the end of last year (Chart 9). Earnings from some of China’s high-flying sectors have been mediocre (Chart 10). Even though the ROEs in the food & beverage, healthcare and aerospace sectors remain above the domestic industry benchmarks, the sharp upticks in their share prices are largely due to an expansion of forward earnings multiples rather than earnings growth (Chart 11). The stretched valuation measures suggest that investors have priced in significant earnings growth, which may be more than these industries can deliver in 2021. Chart 10Other Than Healthcare, High-Flying Sectors Have Seen Mediocre Earnings Chart 11Too Much Growth Priced In Cyclical stocks may be sniffing out a peak in the market. The performance in cyclical stocks relative to defensives in both the onshore and offshore equity markets has started to falter, after outperforming throughout 2020 (Chart 12). Historically, the strength in cyclical stocks relative to defensives corresponds with improving economic activity (and vice versa). Therefore, the recent rollover in the outperformance of cyclical stocks versus defensives indicates that China’s economic recovery and the equity rally could soon peak. An IPO mania. New IPOs in China reached a record high last year, jumping by more than 100% from 2019. IPOs on the Shanghai, Shenzhen and Hong Kong stock exchanges together were more than half of all global IPOs in 2020. The previous rounds of explosive IPOs in China occurred in 2007, 2010/11, and 2014/15, most followed by stock market riots (Chart 13). Chart 12Cyclical Stocks May Be Sniffing Out A Peak In The Market Chart 13IPO Manias In The Past Have Led To Market Riots Bottom Line: Investors may be neglecting some risks and pitfalls in the Chinese equity markets, which could lead to near-term price corrections. Investment Conclusions We still hold a constructive view on Chinese stocks in the next 6 to 12 months. Yet the equity market rally has been on overdrive for the past several weeks. The higher Chinese stock prices climb in the near term, the more it will eat into upside potentials and thus push down expected returns. The divergence between forward earnings and PE expansions in Chinese stocks is reminiscent of the massive stock market boom-bust cycle in 2014/15 (Chart 14A and 14B). This is in stark contrast with the picture at the beginning of the last policy tightening cycle, which started in late 2016 (Chart 15A and 15B). Valuation is a poor timing indicator and investor sentiment is hard to pin down. Nevertheless, the wide divergence between the earnings outlook and multiples indicates that Chinese stock prices are overstretched and at risk of price setbacks. Chart 14AA Picture Looking Too Familiar Chart 14BA Picture Looking Too Familiar Chart 15AAnd A Sharp Contrast From The Last Policy Tightening Cycle Chart 15BAnd A Sharp Contrast From The Last Policy Tightening Cycle We remain cautious on the short-term prospects for the broad equity market. Investors looking to allocate more cash to Chinese stocks should wait until a price correction occurs. Jing Sima China Strategist jings@bcaresearch.com Footnotes 1Only 20.4% of Chinese households’ total net worth is in financial assets versus the US, where the share is 42.5%. PBoC, “2019 Chinese Urban Households Assets And Liabilities Survey.” Cyclical Investment Stance Equity Sector Recommendations
Highlights Fed: We will use the monthly US employment data to track progress toward the first Fed rate hike. At present, our base case outlook calls liftoff in late-2022 or the first half of 2023. Investors should maintain below-benchmark portfolio duration. Corporate Bonds: The macro environment is supportive for spread product returns, but there are better opportunities than in investment grade corporate bonds. We prefer high-yield over investment grade within the US corporate space, particularly the Ba credit tier. Munis: Muni value has deteriorated markedly, but the sector still looks attractive compared to investment grade corporate bonds. EM Sovereigns: We recommend owning investment grade USD-denominated EM Sovereign bonds instead of investment grade US corporates. Within high-yield, US corporates still offer a better opportunity than EM Sovereigns. Using Employment Data To Time Fed Liftoff The current debate raging in fixed income circles revolves around whether large-scale fiscal stimulus will cause inflation to flare this year, possibly leading to a much earlier fed funds liftoff date than is currently priced into the yield curve (Chart 1). Chart 1Fed Liftoff Priced For July 2023 Last week’s report discussed our outlook for inflation in 2021.1 In short, our base case calls for 12-month PCE inflation to peak above the Fed’s 2% target in April but to then fall back below 2% by the end of the year. However, there is a compelling case to be made that inflation could rise more quickly. Table 1A Checklist For Liftoff Last week, our Global Investment Strategy service pointed out that the combined effect of December’s fiscal stimulus deal and President Biden’s newly proposed American Rescue Plan would inject an average of $300 billion per month into the economy through the end of September.2 The Congressional Budget Office estimates that the monthly output gap – the difference between what the economy is capable of producing and what it is actually producing – is currently $80 billion. In that environment, it’s not hard to see how excess demand could lead to price increases in certain sectors. Chart 2How Far From "Maximum Employment"? Of course, for bond investors what matters is not just the path of inflation but how the Fed responds. If rising inflation prompts the Fed to lift rates before July 2023 – the liftoff date currently priced into the market – then bonds will sell off. If liftoff occurs later, then yields will fall. This makes timing the liftoff date critical, and fortunately, the Fed has given us three explicit criteria that must be met before liftoff will occur (Table 1). This week’s report focuses, not on inflation, but on the condition related to “maximum employment.” Our sense is that if the Fed does not think the economy is at “maximum employment” it will ignore modest overshoots of its 2% inflation target on the view that the large amount of labor market slack will eventually cause inflationary pressures to wane. We define “maximum employment” as an unemployment rate of 4.5%, consistent with the upper-bound of the Fed’s most recent range of NAIRU estimates (Chart 2). Using that assumption, and an assumption for the path of the labor force participation rate (Chart 2, bottom panel), we can calculate the average monthly payroll gains that must occur for the unemployment rate to hit the 4.5% target by specific future dates. Our results are shown in Table 2. We use four different scenarios for the labor force participation rate. The lowest estimate assumes that the participation rate remains at its current level. The highest estimate assumes that it re-converges to its pre-COVID level at the same time as the unemployment rate hits 4.5%. The two middle estimates assume smaller increases of 1% and 0.5%, respectively. Table 2Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% Over The Given Horizon We expect the participation rate to rise as the economy recovers and people are drawn back into the labor force, but some workers have likely been permanently displaced by the pandemic and a full convergence back to pre-COVID levels may not occur until well after the unemployment rate reaches 4.5%, if at all. With that in mind, the “Convergence To Pre-COVID” scenario probably overstates the monthly payroll gains necessary to hit full employment and the “Stays At 61.5%” scenario almost certainly understates them. If we focus on the two middle scenarios, we see that average monthly payroll gains of between 472k and 572k are required for the unemployment rate to hit 4.5% by the end of this year. This range falls to 346k - 413k if we push the liftoff date out until mid-2022 and to 283k – 334k if we move out until the end of 2022. At first blush, these numbers look unattainable. Between 2010 and 2019, average monthly payroll growth averaged a mere +97k. But, given the downturn that just occurred, employment growth will likely be much stronger going forward. Our research into past economic cycles has found that the two main determinants of average monthly employment growth during the first year following a recession are: The drawdown in employment that occurred during the recession (a larger drawdown correlates with greater payroll growth in the first 12 months of recovery) Real GDP growth during the first 12 months of recovery Chart 3 shows the correlation between the peak-to-trough decline in nonfarm payrolls during the past eight US recessions and the average monthly payroll gains seen during the first 12 months of economic recovery. The correlation is quite linear except for the 2008 recession where the peak-to-trough decline in payrolls was 8.7 million but the bounce-back was incredibly weak. Chart 4 explains why the 2008 recession looks like such an outlier in Chart 3. Real GDP growth during the first 12 months of recovery coming out of the 2008 recession was very low, only 2.6%. Chart 3Large Payroll Drawdowns Tend To Be Followed By Strong Gains… Chart 4…And Occur Alongside Strong Economic Recovery Thinking about the current recovery from the COVID recession. Nonfarm payrolls fell by about 22 million from peak to trough in 2020. This is literally off the charts (looking at Chart 3), about 2.5 times the job loss seen in 2008. Then, the Fed’s most recent median estimate for real GDP growth in 2021 is a robust 4.2%, and this estimate was made before Democrats took control of the Senate and proposed a massive new stimulus bill. Considering both the large drawdown in employment and the outlook for rapid GDP growth in 2021, average monthly payroll gains should be quite strong this year. A return to a 4.5% unemployment rate by the end of 2021 is probably a long shot, but we can easily envision average monthly payroll gains on the order of 300k to 400k per month, enough to prompt Fed tightening by late-2022 or the first half of 2023. Whatever transpires, we will monitor monthly payroll growth in the coming months and use this analysis to continuously reassess our liftoff expectations. For the time being, investors should keep portfolio duration low. Alternatives To Investment Grade Corporates Another conclusion that falls out of the above analysis is that the runway for spread product outperformance remains long. With Fed tightening unlikely until late-2022 or the first half of 2023, monetary conditions will remain accommodative for some time. This will drive a continued search for yield, supporting the outperformance of spread product relative to Treasuries. But despite the supportive macro environment, bond investors face a problem that the most popular US spread sector – investment grade corporate bonds – looks very expensive. The average option-adjusted spread for the Bloomberg Barclays investment grade corporate index is only 2 bps above its pre-COVID low, and the spread on Baa-rated bonds is exactly equal to its pre-COVID low. Aa- and A-rated bonds appear somewhat cheaper (Chart 5). The valuation picture is even bleaker after adjusting the index to ensure a constant average credit rating and average duration over time. The 12-month breakeven spread for the credit rating-adjusted corporate index has only been tighter 3% of the time since 1995 (Chart 6). Chart 5IG Spreads Are Tight... Chart 6...Especially After Adjusting For Risk The remainder of this report discusses potential alternatives to investment grade corporate bonds. Specifically, we’re looking for spread products that will benefit from the same macro environment as investment grade corporates, but where investors can pick up some additional risk-adjusted value. Candidate #1: Junk Bonds Chart 7Ba-Rated Corporates Are Cheap One obvious thing investors might consider is a move down the quality spectrum into high-yield bonds. This move comes with greater credit risk, but we believe the incremental spread pick-up provides more than fair additional compensation. The Bloomberg Barclays High-Yield index’s average option-adjusted spread is still 33 bps above its pre-COVID low, and the spread pick-up in the Ba credit tier relative to the Baa credit tier looks particularly compelling (Chart 7). The supportive macro environment makes us less worried about taking additional credit risk in a portfolio, and we recommend that investors pick up the additional spread offered in the high-yield space. The elevated incremental spread pick-up in Ba bonds makes that credit tier look like the best risk-adjusted opportunity. Candidate #2: Tax-Exempt Municipal Bonds Municipal bond spreads have tightened dramatically during the past couple of months and Aaa-rated Munis no longer look cheap compared to Treasuries (Chart 8). That said, if we match the duration and credit rating between the Bloomberg Barclays Municipal bond indexes and the US Credit index, we find that both General Obligation (GO) and Revenue Munis appear attractive compared to US investment grade Credit. Both GO and Revenue Munis offer a before-tax spread pick-up relative to US Credit for maturities above 12 years (Chart 9), the same goes for Revenue bonds with 8-12 year maturities. Revenue bonds in the 6-8 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate of 10% or higher. GO bonds in the 8-12 year and 6-8 year maturity buckets offer breakeven effective tax rates of 14% and 26%, respectively. Chart 8Muni / Treasury Yield Ratios Chart 9Munis Still Attractive Versus Corporates All in all, municipal bond value has deteriorated markedly in recent months and we therefore downgrade our recommended allocation slightly from “maximum overweight” (5 out of 5) to “overweight” (4 out of 5). Investors should still prefer tax-exempt municipal bonds relative to investment grade corporate bonds with the same credit rating and duration. Candidate #3: USD-Denominated Emerging Market Sovereigns For all of last year we advised investors to favor investment grade corporate bonds over USD-denominated EM Sovereigns of equivalent credit rating and duration. This positioning worked out well. Since the March 23rd peak in credit spreads, the A3/Baa1-rated EM Sovereign index has only outperformed the duration-matched A-rated US Credit index by 159 bps while it has underperformed the Baa-rated US Credit index by 571 bps (Chart 10). In the high-yield space, the B1/B2-rated EM Sovereign index has significantly underperformed both the Ba and B-rated US junk bond indexes. Chart 10EM Sovereigns Underperformed US Corporates In 2020 But now, after nine months of poor relative performance, value is starting to look more compelling in the EM Sovereign space. Chart 11 shows that EM Sovereigns offer a yield pick-up versus duration-matched US corporate bonds for all credit tiers except Ba. At the country level, the yield advantage in the A and Aa credit tiers is attributable to opportunities in Qatar, UAE and Saudi Arabia (Chart 12). In the Baa credit tier, investors should look for opportunities in Mexico, Russia and Colombia, while avoiding the Philippines. Chart 11USD-Denominated EM Sovereign Spreads Versus Credit Rating And Duration-Matched US Credit: By Credit Rating Chart 12USD-Denominated EM Sovereign Spreads Versus Credit Rating And Duration-Matched US Credit: By Country All in all, investors should shift some allocation away from investment grade corporates and into USD-denominated EM Sovereigns with equivalent duration and credit rating, focusing on the countries that offer a yield pick-up. Turning to high-yield, we would rather own junk-rated US corporate bonds than junk-rated EM Sovereigns. US corporates offer a yield pick-up over EM Sovereigns in the Ba credit tier, and the sky-high spreads offered by B and Caa-rated EMs are due to overly risky opportunities in Turkey and Argentina. We don’t see these countries benefiting from the supportive US macro environment in the same way as US corporate credit, and therefore recommend overweighting US corporate junk bonds over EM Sovereign junk bonds. Bottom Line: Investors should continue to overweight spread product versus Treasuries in US fixed income portfolios but should look for opportunities outside of investment grade corporate bonds. We recommend owning municipal bonds and USD-denominated EM Sovereign bonds in place of investment grade US corporate bonds with the same credit rating and duration. We also recommend taking additional credit risk in US junk bonds, particularly in the Ba credit tier. Investors should prefer US junk bonds over junk-rated EM Sovereigns. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Trust The Fed’s Forward Guidance”, dated January 19, 2021, available at usbs.bcaresearch.com 2 Please see Global Investment Strategy Weekly Report, “Stagflation In A Few Months?”, dated January 22, 2021, available at gis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification