Real Estate
Long-term deflationary forces in Japan are weakening, setting the stage for inflation to make a comeback over the remainder of the decade. Investors should prepare to structurally reduce exposure to Japanese bonds starting early next year. Higher Japanese bond yields will lift an extremely undervalued yen. To the extent that global growth should surprise on the upside over the next 12 months, Japanese equities could see some modest outperformance.
The kinked supply framework helps explain why US inflation rose so suddenly shortly after the pandemic began and why the economy is likely to experience a benign disinflation over the next six months.
As the FOMC explicitly acknowledged this week, monetary policy operates with substantial lags. We see the risks to stocks as tilted to the upside over the next 6 months but are neutral on global equities over a 12-month horizon.
Falling inflation will allow bond yields to decline in the major economies over the next few quarters. As such, we recommend that investors shift their duration stance from underweight to neutral over a 12 month-and-longer horizon and to overweight over a 6-month horizon. Structurally, however, a depletion of the global savings glut could put upward pressure on yields.
This week’s <i>Global Investment Strategy</i> report titled Fourth Quarter 2022 Strategy Outlook: A Three-Act Play discusses the outlook for the global economy and financial markets for the rest of 2022 and beyond.
Executive Summary For the first time in a decade, it is much less attractive to buy than to rent a home. In both the UK and US, the mortgage rate is now almost double the average rental yield. To reset the equilibrium between buying and renting a home, either mortgage rates must come down by around 150 bps, or house prices must suffer a large double-digit correction. Or some combination, such as mortgage rates down 100 bps and house prices down 10 percent. In the US, a 10-year upcycle in housing investment has resulted in overinvestment relative to the number of households. Falling house prices coming hot on the heels of a combined stock and bond market crash will unleash a deflationary impulse in 2023, which will return economies to 2 percent inflation. This reiterates our ‘2022-23 = 1981-82’ template for the markets. A coordinated global recession will cause bond prices to enter a sustained rally in 2023, in which the 30-year T-bond yield will fall to sub-2.5 percent. Meanwhile, the S&P 500 will test 3500, or even 3200, before a strong rally will lift it through 5000 later in 2023. It Now Costs Twice As Much To Buy Than To Rent A UK Home! Bottom Line: Falling house prices coming hot on the heels of a combined stock and bond market crash will unleash a deflationary impulse in 2023, which will return economies to 2 percent inflation. Feature Mortgage rates around the world have skyrocketed. The UK 5-year fixed mortgage rate which started the year at under 2 percent has more than doubled to over 5 percent. And the US 30-year mortgage rate, which began the year at 3 percent, now stands at an eyewatering 7 percent, its highest level since the US housing bubble burst in 2008. This raises a worrying spectre. Is the recent surge in mortgage rates about to trigger another housing crash? (Chart I-1 and Chart I-2). Chart I-1UK Mortgage Rate Has Doubled Chart I-2US Mortgage Rate Has Doubled A good way to answer the question is to compare the cashflow costs of buying versus renting a home. This is because home prices are set by the volume of homebuyers versus home-sellers. If would-be homebuyers decide to rent rather than to buy – because renting gets them ‘more house’ – then it will drag down home prices. Here’s the concern. For the first time in a decade, it is much less attractive to buy than to rent a home. In both the UK and US, the mortgage rate is now almost double the average rental yield. Put another way, whatever your monthly housing budget, you can now rent a home worth twice as much as you can buy (Chart I-3 and Chart I-4). Chart I-3It Now Costs Twice As Much To Buy Than To Rent A UK Home! Chart I-4It Now Costs Twice As Much To Buy Than To Rent A US Home! The Universal Theory Of House Prices Buying and renting a home are not the same thing, so the head-to-head comparison between the mortgage rate and rental yield is a simplification. Buying and renting are similar in that they both provide you with somewhere to live, a roof over your head or, in economic jargon, the consumption service called ‘shelter’. But there are two big differences. First, unlike renting, buying a home also provides you with an investment whose value you expect to increase in the long run. Second, unlike renting, buying a home incurs you the costs of maintaining it and keeping it up-to-date. Studies show that the annual cost averages around 2 percent of the value of the home.1 So, versus renting, buying a home provides you with an expected capital appreciation, but incurs you a ‘depreciation’ cost of around 2 percent a year. Which results in the following equilibrium between buying and renting: Mortgage rate = Rental yield + Expected house price appreciation - 2 But we can simplify this. In the long run, the price of any asset must trend in line with its income stream. Therefore, expected house price appreciation equates to expected rental growth. Also, rents move in lockstep with wages (Chart I-5). Understandably so, because rents must be paid from wages. And wage growth itself just equals consumer price inflation plus productivity growth, which averages around 1 percent (Chart I-6). Pulling all of this together, the equilibrium simplifies to: Chart I-5Rents Track Wages Chart I-6Rent Inflation = Wage Inflation = Consumer Price Inflation + 1 Mortgage rate = Rental yield + Expected consumer price inflation - 1 So, here’s our first conclusion. Assuming central banks achieve their long-term inflation target of 2 percent, the equilibrium becomes: Mortgage rate = Rental yield + 1 Under this assumption, to justify the current UK rental yield of 3 percent, the UK mortgage rate must plunge to 4 percent. But given that the government has just triggered an incipient balance of payments and currency crisis, the mortgage rate is likely to head even higher. In which case the rental yield must rise to at least 4 percent. Meaning either house prices falling 25 percent, or rents rising 33 percent. Meanwhile, to justify the current US rental yield of 3.7 percent, the US mortgage rate must plunge to 4.7 percent. Alternatively, to justify the current mortgage rate of 7 percent, the rental yield must surge to 6 percent. Meaning either house prices crashing 40 percent, or rents surging 60 percent. More likely though, all variables will correct. The equilibrium between buying and renting will be re-established by some combination of lower mortgage rates, lower house prices, and higher rents. The Housing Investment Cycle Is Turning Down The relationship between buying and renting a home raises an obvious counterargument. What if central banks cannot achieve their goal of price stability? In this case, expected inflation in the equilibrium would be considerably higher than 2 percent. This would justify a much higher mortgage rate for a given rental yield. Put differently, it would justify rental yields to stay structurally low (house prices to stay structurally high), even if mortgage rates marched higher. In an inflationary environment, houses would become the perfect foils against inflation. In an inflationary environment, houses would become the perfect foils against inflation because expected rental growth would track inflation – allowing rental yields to stay depressed versus much higher mortgage rates. This is precisely what happened in the 1970s. When the US mortgage rate peaked at 18 percent in 1981, the US rental yield barely got above 6 percent (Chart I-7). Chart I-7In The Inflationary 70s, The Rental Yield Remained Well Below The Mortgage Rate... If the market fears another such inflationary episode, would it make the housing market a good investment? In the near term, the answer is still no, for two reasons. First, even if rental yields do not track mortgage rates higher point for point, the yields do tend to move in the same direction – especially when mortgage rates surge as they did in the 1970s (Chart I-8). Some of this increase in rental yields might come from higher rents, but some of it might also come from lower house prices. Chart I-8...But Even In The 70s, The Rental Yield And Mortgage Rate Moved Directionally Together Second, based on the US, it is a bad time in the housing investment cycle. Theoretically and empirically, residential fixed investment tracks the number of households in the economy. But there are perpetual cycles of underinvestment and overinvestment – the most spectacular being the overinvestment boom that preceded the 2007-08 housing crisis. US housing investment has just experienced a 10-year upcycle in which it has overshot its relationship with the number of households. Therefore, contrary to the popular perception, there is not an undersupply of homes, but a marked oversupply relative to the number of households. (Chart I-9). This is important because, as the cycle turns down now – as it did in 1973, 1979, 1990, and 2007 – the preceding overinvestment always weighs down housing valuations (Chart I-10). Chart I-9The US Housing Investment Cycle Has Moved Into Overinvestment Chart I-10A Housing Investment Downcycle Always Weighs On Housing Valuations The Investment Conclusions Let’s sum up. If the market believes that economies will return to price stability, then to reset the equilibrium between buying and renting a home, either mortgage rates must come down by around 150 bps, or house prices must suffer a large double-digit correction. Or some combination, such as mortgage rates down 100 bps and house prices down 10 percent. If the market believes that economies will not return to price stability, then house prices are still near-term vulnerable to rising mortgage rates – especially in the US, as a 10-year upcycle in housing investment has resulted in overinvestment relative to the number of households. US housing investment has just experienced a 10-year upcycle in which it has overshot its relationship with the number of households. Falling house prices coming hot on the heels of a combined stock and bond market crash will unleash a deflationary impulse in 2023, which will return economies to 2 percent inflation – even if the markets do not believe it now. This reiterates our ‘2022-23 = 1981-82’ template for the markets, as recently explained in Markets Still Echoing 1981-82, So Here’s What Happens Next. In summary, a coordinated global recession will cause bond prices to enter a sustained rally in 2023, in which the 30-year T-bond yield will fall to sub-2.5 percent. Meanwhile, the S&P 500 will test 3500, or even 3200, before a strong rally will lift it through 5000 later in 2023. Analysing The Pound’s Crash Through A Fractal Lens Finally, the incipient balance of payments and sterling crisis triggered by the UK government’s unfunded tax cuts has collapsed the 65-day fractal structure of the pound (Chart I-11). This would be justified if the Bank of England does not lean against the fiscal laxness with a compensating tighter monetary policy. But if, as we expect, monetary policy adjusts as a short-term counterbalance, then sterling will experience a temporary, but playable, countertrend bounce. Chart I-11The Pound Usually Turns When Its Fractal Structure Has Collapsed On this assumption, a recommended tactical trade, with a maximum holding period of 65 days, is to go long GBP/CHF, setting a profit target and symmetrical stop-loss at 4 percent. Chart 1Hungarian Bonds Are Oversold Chart 2Copper's Tactical Rebound Maybe Over Chart 3US REITS Are Oversold Versus Utilities Chart 4FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable Chart 5Netherlands' Underperformance Vs. Switzerland Has Ended Chart 6The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 7Food And Beverage Outperformance Is Exhausted Chart 8German Telecom Outperformance Has Started Is Fragile Chart 9Japanese Telecom Outperformance Vulnerable To Reversal Chart 10The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 11The Strong Downtrend In The 3 Year T-Bond Is Fragile Chart 12The Outperformance Of Tobacco Vs. Cannabis Is Fragile Chart 13Biotech Is A Major Buy Chart 14Norway's Outperformance Has Ended Chart 15Cotton Versus Platinum Has Reversed Chart 16Switzerland's Outperformance Vs. Germany Is Exhausted Chart 17USD/EUR Is Vulnerable To Reversal Chart 18The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 19US Utilities Outperformance Vulnerable To Reversal Chart 20The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The Rate of Return on Everything, 1870–2015 (frbsf.org) Fractal Trading System Fractal Trades 6-12 Month Recommendations 6-12 MONTH RECOMMENDATIONS EXPIRE AFTER 15 MONTHS, IF NOT CLOSED EARLIER. Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Executive Summary Liquidity Will Shrink Further In Hong Kong The HKD is facing its most critical test in several decades. While the peg is likely to survive (Feature Chart), the economic costs for Hong Kong SAR will be far reaching. Critically, monetary policy in Hong Kong SAR is being tailored behind a hawkish Fed, while economic ties with China increasingly warrant easier policy settings. This tug of war will be resolved via a reset in domestic spending and asset prices. Equity shares have been the first shoe to drop. Real estate values and consumer spending will be next. A hypothetical delinking of the peg will see the HKD depreciate since it is expensive on a real effective exchange rate basis. Longer term, the rising use of the RMB in Hong Kong SAR will render the peg a relic. It will also fit with China’s aims to internationalize the RMB.. Bottom Line: The HKD peg is likely to survive in the near term, but the economic repercussions from maintaining the linked exchange-rate system will trigger a rethinking by the Hong Kong Monetary Authority (HKMA) and mainland authorities. Eventually, HKD could be replaced by the CNY. For now, HKD interest rates are slated to rise further, which will have ramifications for domestic spending and asset prices. Feature Chart 1HKD Has Been Tracking Interest Rates The Hong Kong dollar (HKD) has been trading on the weak side of its convertibility band since May. In theory, this suggests there is intense pressure for the peg to be delinked, which should lead to a much weaker exchange rate. In practice, interest rates in Hong Kong have failed to keep up with the surge in US rates, which has led to widening interest rate differentials between Hong Kong and the US. As a result, investors have embarked on a massive carry trade, funding USD purchases with HKDs (Chart 1). HKD’s weakness has raised questions about whether the exchange rate could face a crisis of confidence. This will be a severe blow to the HKMA whose sole role is currency stability, with the HKD being the underlying bedrock of Hong Kong’s financial system. In this report, we suggest that the HKD will survive this crisis, just as it has navigated previous shocks since 1983. The brunt of the adjustment will be domestic, first from Hong Kong equities, but spreading to real estate and consumer spending. Longer term, the HKD might become a relic as transactions in Hong Kong are increasingly conducted in RMB. Will The Peg Be Sustained? Historically, currency pegs more often than not fail. Specific to the HKD, the peg is facing its most critical test in decades but is likely to survive for a few reasons. First, every HKD that the region of Hong Kong has ever printed is backed by USD reserves, to the tune of 1.8 times. Quite simply, FX reserves are much higher than the Hong Kong monetary base (Chart 2). This suggests the HKMA’s “convertibility promise” remains credible. Second, Hong Kong also ranks favorably when looking at the ratio of broad money supply to FX reserves. Every 42.3 cents of broad money creation can be backed by foreign currency, a ratio much higher than China and on par with Singapore (Chart 3). With a monetary base fully backed by FX reserves and a broad money-to-FX reserve ratio largely in line with other linked exchange rate systems, our bias is that the peg will remain in place at least over a cyclical horizon (12-18 months). Chart 2In Theory, The HKMA Can Defend The Peg Chart 3The HKMA Ranks Favorably To The PBoC This credibility will come at a huge cost to the domestic economy, however. By having a fixed exchange rate system and an open capital account, Hong Kong has given up control over domestic monetary policy. Consequently, it must import monetary policy from the US. As interest rates rise in the US, demand for US dollar deposits from Hong Kong concerns goes up, putting downward pressure on the exchange rate. To maintain the convertibility ratio, the HKMA must drain the system of Hong Kong dollars to lift domestic interest rates. This is quite visible not only from the drop in foreign exchange reserves, but also the drawdown in the aggregate balance of domestic banks parked at the HKMA (Chart 4). From May 11 through August, the HKMA has absorbed a total of HKD 213 billion, shrinking the aggregate balance in the banking system by more than 60%. Chart 4Liquidity Will Shrink Further In Hong Kong Historically, the aggregate balance has had to drop much more to restore an equilibrium between interest rates in the US and Hong Kong SAR. The implication is that liquidity will continue to be drained from the system to ultimately defend the peg, and local interest rates will rise. There is one important caveat: Hong Kong SAR’s net international investment position stands at 580% of GDP, much higher than broad money supply. As such, the Hong Kong SAR does not have a solvency problem. What it faces is too much domestic liquidity, which is pushing HKD interest rates lower (Chart 5). Chart 5The HKD Is Facing A Liquidity, Rather Than A Solvency Crisis Ramifications Of The USD Peg When the HKD was tied to the US dollar in 1983, it made economic sense. Hong Kong SAR’s economy was more linked via trade to the US, compared to China (Chart 6). As such, stability vis-à-vis the US dollar was a vital appeal for traders, financiers, and all industries tied to the Hong Kong hub. Since then, there has been a tectonic shift in economic dependence. Exports to China now account for almost 60% of the total, while those to the US have fallen well below 8%. Quite simply, Hong Kong SAR still imports monetary policy from the US, while it is increasingly dependent on the Chinese economy. Nonetheless, there have been a few adjustments. The use of the RMB in Hong Kong SAR has been gradually gaining momentum. RMB deposits have risen to over HKD 800bn. As a share of narrow money supply (M1), it is almost 50% (Chart 7). There are also over 140 licensed banks in Hong Kong allowed to engage in RMB-based business. Chart 6Hong Kong And China Are Tied To The Hip Chart 7Hong Kong Is Transitioning Into A Defacto RMB System These links extend beyond just banking turnover. First introduced in 2014, the southbound trading links between China and Hong Kong SAR have become a major conduit for mainland investors to gain exposure to foreign firms. The China-Hong Kong stock connect has now handled over 2.6tn RMB in cumulative flows. This represented as high as 40% of the equity turnover in Hong Kong SAR (Chart 8). Capital account transactions have also been progressively relaxed, and the issuance of RMB bonds has been rising rapidly since 2008. Chart 8Lots Of Financial Links Between The HKD and RMB Hong Kong SAR’s strengthening ties with China comes with some good news. The increase in Chinese domestic liquidity is lowering the cost of capital for local enterprises. At the same time, it might also be fuelling very low domestic interest rates, forcing locals to chase higher rates elsewhere. This does not affect the peg if people sell the RMB to buy other currencies, including the dollar or maybe even the HKD. The bad news is that Hong Kong has now become a high-beta play on China as both economies are inexorably interlinked. Chart 9 shows that consumers in Hong Kong SAR tend to have much more volatile spending patterns compared to China, especially when economic growth is about to slow. One reason is that Hong Kong concerns are highly levered notably to the property market (Chart 10). For example, the debt service ratio in Hong Kong SAR sits at 32% of disposable income, much higher than China or other indebted economies (Chart 11). This makes the economy very vulnerable to rising interest rates. Chart 9Hong Kong Is Economically More Volatile Than China Chart 10Hong Kong Cannot Escape A Hard Landing (Part 1) Chart 11Hong Kong Cannot Escape A Hard Landing (Part 2) The bottom line is that as the HKMA withdraws domestic liquidity, this will reassert downward pressure on business activity and asset prices, particularly real estate. With private consumption a whopping 65% of GDP, household deleveraging will also prove to be a formidable headwind for domestic spending. Outside interest rates, Hong Kong SAR remains a trade hub. If global trade slows down meaningfully, this will lead to a deterioration in the current account. This triple whammy from slowing global trade, rising interest rates and consumer deleveraging could prove indigestible for Hong Kong assets. Policy Options Chart 12The Government Could Bail Out Hong Kong As highlighted above, the HKD peg will remain in place for the foreseeable future, but this will come at a huge cost. The advantage of the HKD peg is that the choice of the nominal anchor, the US dollar, renders it credible. As a financial hub, this is crucial for Hong Kong. Meanwhile, such an anchor also imposes fiscal discipline since government deficits cannot be monetized by money printing. In the case where the government tries to be profligate, the rise in inflation will lower real rates and lead to capital outflows. This will force the HKMA to sell US dollars and absorb local currency. Indeed, over the past several years, government debt in Hong Kong has been close to nil (Chart 12). The drawback of a fixed exchange-rate regime is that Hong Kong SAR has relinquished control over independent monetary policy. Such a union was justified when the economic cycles between the US and Hong Kong SAR were in sync, but now the region needs easier policy settings. The roadmap of the late 1990s could be what is in store for Hong Kong SAR. In short, the peg survived but the region went through a severe internal devaluation. During the Asian crisis, property prices fell by more than 60%. If that were to occur today, it would herald a prolonged period of high unemployment and stagnant wages to realign the region’s competitiveness with its trading partners. Hong Kong SAR stocks have already borne the brunt of an internal adjustment and are trading at very cheap multiples (Chart 13). The MSCI Hong Kong stock index is composed of mostly financials (47% of market cap) and property stocks (21% of market cap). As HKD rates are rising, loan growth in Hong Kong SAR is contracting and net interest margins have collapsed (Chart 14). This does not bode well for the near-term performance of financials. Chart 13Markets Have Already Discounted A Pessimistic Scenario For Hong Kong Shares Chart 14Banks In Hong Kong Are Facing A Tough ##br##Reckoning The good news is that similar to the late 1990s, banks are unlikely to go bust. Hong Kong SAR banks are well capitalized and delinquency rates are quite low, suggesting a banking crisis is unlikely to be a source of pain for the HKD peg (Chart 15). In fact, Hong Kong SAR banks rank favorably among their global peers in terms of capital adequacy (Chart 16). Chart 15Banks In Hong Kong Are Well Capitalized (Part 1) Chart 16Banks In Hong Kong Are Well Capitalized (Part 2) Specific to the currency, Hong Kong is also running recurring current account surpluses. This is boosting its FX reserves (Chart 17). That lends credibility to the peg in the near term. The bad news is that as the domestic economy slows down, and global trade comes close to a standstill, these surpluses could evaporate. One cost to Hong Kong is that the peg to the US dollar has made HKD incrementally expensive. Our model shows that the real effective exchange for HKD is about 2.5 standard deviations above fair value (Chart 18). Our view on the US dollar is that we could see depreciation over a 12-to-18-month horizon, but an overshoot in the near term is quite likely. A drop in the US dollar will help realign competitiveness in the HKD. Meantime, the market has also been pushing the currency towards the weaker side of its convertibility band. Chart 17Balance Of Payments Remain Favorable For The HKD Chart 18The HKD Is Expensive Longer term, as Hong Kong SAR continues to become more entwined with China, a peg to the CNY will make sense. This process will be the initial step in the region’s official embrace of the RMB system. That said, the process will be gradual since the US dollar remains very much a reserve currency, and the relevance of Hong Kong SAR as a financial center hinges upon easy access to the USD. What is more likely is that any re-pegging to the RMB will come many years down the road, when the yuan has become a fully convertible currency. The de-pegging of the HKD from the USD or adjusting the peg is as much a political discussion as an economic one. Political conditions for this change are not yet present given such a change will have major ramifications for the economy of Hong Kong SAR and will likely also reverberate through financial asset prices. One can imagine a scenario where HKD yields are forced to adjust to a new nominal anchor. Investors have been convinced through almost 30 years of history to treat the HKD as a proxy for the US dollar. That said, the economic pain associated with maintaining the HKD-USD peg will ensure authorities accelerate the use of RMBs in Hong Kong, with a goal of eventually adopting the yuan as the de facto currency. Adopting a currency board akin to Singapore is another option that makes sense, especially since this would give the HKMA scope to link to cheaper currencies, such as the yen and euro. That said, this is unlikely to be politically palatable, especially for Beijing. A link to the yuan that already does this job makes sense. Finally, there is always the option to fully float the peg, but this would probably increase currency volatility. This is unlikely in the near term. The Goldilocks scenario for policymakers is when the US dollar eventually depreciates against major currencies, easing financial conditions for Hong Kong SAR concerns. This will dovetail nicely with the goals of the monetary authorities, maintain credibility while easing financial concerns for a very levered economy. Investment Conclusions The HKD peg will remain in place, but the financial dislocations will lead to significant internal devaluation in Hong Kong SAR. As US interest rates rise, the HKD will be under considerable pressure. The HKMA will have no choice but to allow HKD interest rates to rise. This will tip the property market and thrust the economy into deflation and a recession. Chinese bonds are the best hedge against this risk. Avoid property and financial shares for the time being. Were the peg to break today, the HKD will depreciate according to our valuation models. This suggests markets are right to push the HKD-linked rate towards the weaker end of the convertibility band. Despite the economic and financial pain, the HKMA will not abandon the peg. That means carry trades will continue to make money. Using the HKD as a funding currency still makes sense in the near term. In long run, the economic pain associated with maintaining the HKD-USD peg will make authorities in Beijing accelerate the use of the RMB in Hong Kong’s special administrative region. The eventual goal will be for Hong Kong SAR to adopt the yuan as its currency. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com
Listen to a short summary of this report Executive Summary On the eve of the pandemic, most developed economies were operating at close to full capacity – the aggregate supply curve, in other words, had become very steep (or inelastic). Not surprisingly, in such an environment, pandemic-related stimulus, rather than boosting output, simply stoked inflation. Looking out, the inverse may turn out to be true: Just as an increase in aggregate demand did more to lift prices than output during the pandemic, a decrease in aggregate demand may allow inflation to fall without much loss in production or employment. Skeptics will argue that such benign disinflations rarely occur, pointing to the 1982 recession. But long-term inflation expectations were close to 10% back then. Today, they are broadly in line with the Fed’s target. Equities will recover from their recent correction as headline inflation continues to fall and the risks of a US recession diminish. Go long EUR/USD on any break below 0.99. Contrary to the prevailing pessimistic view, Europe is heading for a V-shaped recovery. The Aggregate Supply Curve Becomes Very Steep When Spare Capacity Is Exhausted Bottom Line: The US economy is entering a temporary Goldilocks period of falling inflation and stronger growth. The latest correction in stocks will end soon. Investors should overweight global equities over the next six months but look to turn more defensive thereafter. Dear Client, I will be attending BCA’s annual conference in New York City next week. Instead of our regular report, we will be sending you a Special Report written by Mathieu Savary, BCA’s Chief European Strategist, and Robert Robis, BCA’s Chief Fixed Income Strategist, on Monday, September 12. Their report will discuss estimates of global neutral interest rates. We will resume our regular publication schedule on September 16. Best Regards, Peter Berezin, Chief Global Strategist The Hawks Descend On Jackson Hole Chart 1Markets Still Think The Fed Will Start Cutting Rates Next Year Jay Powell’s Jackson Hole address jolted the stock market last week. Citing the historical danger of allowing inflation to remain above target for too long, the Fed chair stressed the need for “maintaining a restrictive policy stance for some time.” Powell’s comments were consistent with the Fed’s dot plot, which expects rates to remain above 3% right through to the end of 2024. However, with the markets pricing in rate cuts starting in mid 2023, his remarks came across as decidedly hawkish (Chart 1). While Fedspeak can clearly influence markets in the near term, our view is that the economy calls the shots over the medium-to-long term. The Fed sees the same data as everyone else. If inflation comes down rapidly over the coming months, the FOMC will ratchet down its hawkish rhetoric, opting instead for a wait-and-see approach. The Slope of Hope Could inflation fall quickly in the absence of a deep recession? The answer depends on a seemingly esoteric concept: the slope of the aggregate supply curve. Economists tend to depict the aggregate supply curve as being convex in nature – fairly flat (or “elastic”) when there is significant spare capacity and becoming increasingly steep (or “inelastic”) as spare capacity is exhausted (Chart 2). The basic idea is that firms do not require substantially higher prices to produce more output when they have a lot of spare capacity, but do require increasingly high prices to produce more output when spare capacity is low. Chart 2The Aggregate Supply Curve Becomes Very Steep When Spare Capacity Is Exhausted When the aggregate supply curve is very elastic, an increase in aggregate demand will mainly lead to higher output rather than higher prices. In contrast, when the aggregate supply curve is inelastic, rising demand will primarily translate into higher prices rather than increased output. In early 2020, most of the developed world found itself on the steep side of the aggregate supply curve. The unemployment rate in the OECD stood at 5.3%, the lowest in 40 years (Chart 3). In the US, the unemployment rate had reached a 50-year low of 3.5%. Thus, not surprisingly, as fiscal and monetary policy turned simulative, inflation moved materially higher. Goods inflation, in particular, accelerated during the pandemic (Chart 4). Perhaps most notably, the exodus of people to the suburbs, combined with the reluctance to use mass transit, led to a surge in both new and used car prices (Chart 5). The upward pressure on auto prices was exacerbated by a shortage of semiconductors, itself a consequence of the spike in the demand for electronic goods. Chart 3The Pandemic Began When The Unemployment Rate In The OECD Was At A Multi-Decade Low Chart 4With Supply Unable To Meet Demand, Goods Prices Surged During The Pandemic The supply curve for labor also became increasingly inelastic over the course of the pandemic. Once the US unemployment rate fell back below 4%, wages began to accelerate sharply. The kink in the Phillips curve had been reached (Chart 6). Chart 5Car Prices Went On Quite A Ride During The Pandemic Chart 6Wage Growth Soared When The Economy Moved Beyond Full Employment Chart 7Job Switchers Usually See Faster Wage Growth Faster labor market churn further turbocharged wage growth. Both the quits rate and the hiring rate rose during the pandemic. Typically, workers who switch jobs experience faster wage growth than those who do not (Chart 7). This wage premium for job switching increased during the pandemic, helping to lift overall wage growth. A Symmetric Relationship? All this raises a critical question: If an increase in aggregate demand along the inelastic side of the aggregate supply curve mainly leads to higher prices rather than increased output and employment, is the inverse also true – that is, would a comparable decrease in aggregate demand simply lead to much lower inflation without much of a loss in output or employment? If so, this would greatly increase the odds of a soft landing. Skeptics would argue that disinflations are rarely painless. They would point to the 1982 recession which, until the housing bubble burst, was the deepest recession in the post-war era. The problem with that comparison is that long-term inflation expectations were extremely high in the early 1980s. Both consumers and professional forecasters expected inflation to average nearly 10% over the remainder of the decade (Chart 8). To bring down long-term inflation expectations, Paul Volcker had to engineer a deep recession. Chart 8Long-Term Inflation Expectations Are Much Better Anchored Now Than In The Early 1980s Chart 9Real Long Terms Bond Yields Are Currently A Fraction Of What They Were Four Decades Ago Jay Powell does not face such a problem. Both survey-based and market-based long-term inflation expectations are well anchored. Whereas real long-term bond yields reached 8% in 1982, the 30-year TIPS yield today is still less than 1% (Chart 9). The Impact of Lower Home Prices Chart 10Supply-Side Constraints Limited Home Building During The Pandemic, Helping To Push Up Home Prices While falling consumer prices would boost real incomes, helping to keep the economy out of recession, a drop in home prices would have the opposite effect on consumer spending. As occurred with other durable goods, a shortage of building materials and qualified workers prevented US homebuilders from constructing as many new homes as they would have liked during the pandemic. The producer price index for construction materials soared by over 50% between May 2020 and May 2022 (Chart 10). As a result, rising demand for homes largely translated into higher home prices rather than increased homebuilding. Real home prices, as measured by the Case-Shiller index, have increased by 25% since February 2020, rising above their housing bubble peak. As we discussed last week, US home prices will almost certainly fall in real terms and probably in nominal terms as well over the coming years. Chart 11Despite Higher Home Prices, Households Have Not Been Using Their Homes As ATMs How much of a toll will falling home prices have on the economy? It took six years for home prices to bottom following the bursting of the housing bubble. It will probably take even longer this time around, given that the homeowner vacancy rate is at a record low and reasonably prudent mortgage lending standards will limit foreclosure sales. Thus, while there will be a negative wealth effect from falling home prices, it probably will not become pronounced until 2024 or so. Moreover, unlike during the housing boom, US households have not been tapping the equity in their homes to finance consumption (Chart 11). This also suggests that the impact of falling home prices on consumption will be far smaller than during the Great Recession. Inelastic Commodity Supply While inelastic supply curves had the redeeming feature of preventing a glut of, say, new autos or homes from emerging, they also limited the output of many commodities that face structural shortages. Compounding this problem is the fact that the demand for many commodities is very inelastic in the short run. When you combine a very steep supply curve with a very steep demand curve, small shifts in either curve can produce wild swings in prices. Nowhere is this problem more evident than in Europe, where a rapid reduction in oil and gas flows has caused energy prices to soar, forcing policymakers to scramble to find new sources of supply. Europe’s Energy Squeeze At this point, it looks like both the UK and the euro area will enter a recession. In continental Europe, the near-term outlook is grimmer in Germany and Italy than it is in France or Spain. The latter two countries are less vulnerable to an energy crunch (Spain imports a lot of LNG while France has access to nuclear energy). Both countries also have fairly resilient service sectors (Spain, in particular, is benefiting from a boom in tourism). The good news is that even in the most troubled European economies, the bottom for growth is probably closer at hand than widely feared. Despite the fact that imports of Russian gas have fallen by more than 60%, Europe has been able to rebuild gas inventories to about 80% of capacity, roughly in line with prior years (Chart 12). It has been able to achieve this feat by aggressively buying gas on the open market, no matter the price. While this has caused gas prices to soar, it sets the stage for a possible retreat in prices in 2023, something that the futures market is already discounting (Chart 13). Chart 12Europe: Squirrelling Away Gas For The Winter Chart 13Natural Gas Prices In Europe Will Come Back Down To Earth Europe is also moving with uncharacteristic haste to secure new sources of energy supply. In less than one year, Europe has become America’s biggest overseas market for LNG. A new gas pipeline linking Spain with the rest of Europe should be operational by next spring. In the meantime, Germany is building two “floating” LNG terminals. Germany has also postponed plans to mothball its nuclear power plants and has approved increased use of coal-fired electricity generators. Chart 14The Euro Is Undervalued France is seeking to boost nuclear capacity. As of August 29, 57% of nuclear generation capacity was offline. Electricité de France expects daily production to rise to around 50 gigawatts (GW) by December from around 27 GW at present. For its part, the Dutch government is likely to raise output from the massive Groningen natural gas field. All this suggests that contrary to the prevailing pessimistic view, Europe is heading for a V-shaped recovery. The euro, which is 30% undervalued against the US dollar on a purchasing power parity basis, will rally (Chart 14). Go long EUR/USD on any break below 0.99. Investment Conclusions Chart 15Falling Inflation Should Boost Real Wages And Buoy Consumer Confidence On the eve of the pandemic, most developed economies were operating at close to full capacity – the aggregate supply curve, in other words, had become very steep (or inelastic). Not surprisingly, in such an environment, pandemic-related stimulus, rather than boosting output, simply stoked inflation. Looking out, the inverse may turn out to be true: Just as an increase in aggregate demand did more to lift prices than output during the pandemic, a decrease in aggregate demand may allow inflation to fall with little loss in production or employment. Will this be the end of the story? Probably not. As inflation falls, US real wage growth, which is currently negative, will turn positive. Consumer confidence will improve, boosting consumer spending in the process (Chart 15). The aggregate demand curve will shift outwards again, triggering a “second wave” of inflation in the back half of 2023. Rather than cutting rates next year, as the market still expects, the Fed will raise rates to 5%. This will set the stage for a recession in 2024. Investors should overweight global equities over the next six months but look to turn more defensive thereafter. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn & Twitter Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores