Demographics

While the housing downturn will be fairly mild in the US, it will be more severe abroad. Continue to favor bonds of countries whose housing fundamentals will limit rate hikes.

The crucial question for 2023 is: will the US and UK Beveridge Curves shift back inwards to their pre-pandemic versions, ushering in a soft landing? Or, will we slide down the new post-pandemic Beveridge Curves into recession? Plus: we reveal the most important chart for Europe and the most important chart for China in early 2023.

The pandemic gave older Americans and Brits a massive carrot and stick to retire early. The carrot being a surge in wealth, the stick being a risk to health. In other major economies, the carrots and sticks were smaller or non-existent. Hence, the shortage of older workers, and the resulting wage inflation, is a specific US and UK problem. We go through the important economic and investment implications for 2023.

Today, we are sending you the BCA annual outlook for 2023. The report is an edited transcript of our recent conversation with Mr. X and his daughter, Ms. X, who are long-time BCA clients with whom we discuss the economic and financial market outlook for the next twelve months toward the end of each year.

Excess job vacancies in the US and UK reflect a labour market that cannot efficiently match unemployed workers with vacant jobs. This is because excess job vacancies reflect the shortage of labour supply in the 50 plus age cohort, whose skills are difficult to replace. In economic jargon, the post-pandemic ‘Beveridge curve’ has shifted outwards. Absent an unlikely shift in the Beveridge curve to its pre-pandemic version, killing US wage inflation will mean killing jobs. And killing jobs will mean killing profits. We go through the investment implications.

A client concerned about the slump in asset prices, the stubbornness of inflation, and rising bond yields asks what went wrong, and what happens next? This report is the full transcript of our conversation.

Older workers have deserted the labour force in the US and the UK, but not so in the Euro area and Japan. The result is that wage inflation is red hot in the US and the UK, but not so in the Euro area and Japan. Hence, the Bank of Japan is right to remain a lone dove, the ECB must pivot from its uber-hawkish stance quite soon, but the Fed and the BoE must not pivot from their uber-hawkish stance too soon. We go through the major investment implications.

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.

Investors should overweight US defense stocks in a world where US war-weariness is declining and the Biden administration is likely to exhibit an increasingly hawkish foreign policy.

Executive Summary Higher Brent Prices, Stronger Upside Bias Higher Brent Prices, Stronger Upside Bias Higher Brent Prices, Stronger Upside Bias The Fed is pacing a globally synchronized monetary-policy tightening cycle as the war in Ukraine escalates, following Russia’s mobilization of 300k reserve forces. Despite central-bank tightening, the intensification of the war increases the odds of higher inflation.  This will keep the USD well bid. Russia’s threat to cut oil supplies to states observing the G7 price cap will test US and EU resolve as winter sets in.  Retaliatory output cuts by Russia could send Brent crude oil prices above $200/bbl. The Biden administration remains fearful its G7 price cap and EU sanctions on Russian oil exports will spike prices.  The US will make 10mm barrels of crude from its SPR available in November as a palliative.  Our base case Brent forecast is slightly lower, averaging $105/bbl this year from $110/bbl, due to weaker realized prices.  On the back of this, we expect 4Q22 Brent to average $106/bbl, and for 2023 to average $118/bbl, up slightly vs. last month.  WTI will trade $3-$5/bbl lower. Bottom Line: The economic war pitting the EU and its allies against Russia could escalate and widen as more Russian troops pour into Ukraine.  This raises the odds of expanded conflict outside Ukraine, and higher war-driven inflation.  Our baseline forecast for 2023 remains intact, with a strong bias to the upside.  We remain long the COMT and XOP ETFs to retain exposure to commodities. Feature The Fed is pacing a globally synchronized monetary-policy tightening cycle at a time when the war in Ukraine is escalating. Russia’s mobilization of a reported 300k reserve forces raises the spectre of an expansion of the Ukraine war – perhaps crossing into a NATO state’s border – if tactical nuclear, biological, or chemical weapons are used. This is a low-probability outcome, but it would increase the odds of significantly higher inflation should it come to pass.1 The US central bank lifted its Fed funds rate 75 bps Wednesday to a range of 3% - 3.25% – and strongly indicated further rate hikes will follow. The Fed is one of numerous banks increasing policy rates. This synchronous monetary-policy tightening has not been observed for 50 years, and raises the odds of a global economic recession, according to the World Bank.2 The World Bank notes that since 1970, recessions have been “preceded by a significant weakening of global growth in the previous year, as has happened recently,” and, importantly, “all previous global recessions coincided with sharp slowdowns or outright recessions in several major economies.” The withdrawal of monetary and fiscal support “are necessary to contain inflationary pressures, but their mutually compounding effects could produce larger impacts than intended, both in tightening financial conditions and in steepening the growth slowdown.” Markets are acting in a manner consistent with this assessment, but, in our view, need to expand the risk set to include a higher likelihood of a war widening beyond Ukraine. While this is not our base case, it is worthwhile recalling the link between war and inflation. Prior to and during the 20th century’s two world wars, then the Korean and Vietnam wars, US CPI inflation rose sharply (Chart 1).3 Price controls and tighter monetary policy were needed to address these inflationary episodes. Chart 1A Wider Ukraine War Would Stoke Inflation Oil Markets Anxiously Enter 4Q22 Oil Markets Anxiously Enter 4Q22 Stronger USD Remains Oil-Demand Headwind Fed policy will continue to push US interest rates higher, which will push the USD higher on the back of continued global demand for dollar-denominated assets. This will keep the cost of most commodities ex-US higher in local currency terms, which, all else equal, will weaken commodity demand in general, and oil demand in particular. This will be compounded if tighter monetary policy at systemically important central banks (led by the Fed) results in a global recession in 2023. This is especially true for EM oil demand: The income elasticity of EM oil consumption is 0.61, which means a 1% decrease (increase) in real EM GDP translates into a 0.61% decrease (increase) in oil demand, all else equal. In our base case, we expect global oil demand to grow 2.2mm b/d this year and 1.91mm b/d next year, roughly in line with the US EIA’s and IEA’s estimates (Chart 2). We expect EM demand will increase 1.25mm b/d this year, and 1.90mm b/d next year, accounting for almost all of global growth. As before, we expect China’s oil demand growth to be de minimus this year, on the back of its zero-tolerance COVID-19 policy. EM remains the key driver of our global oil demand assumptions, which, in our modeling, are a function of real income (GDP). Offsetting the stronger USD effects on demand is gas-to-oil switching demand, resulting from record-high LNG prices this year. This will add 800k b/d to demand globally this winter (November – March). Chart 2Global Oil Demand Holding Up Global Oil Demand Holding Up Global Oil Demand Holding Up Oil Supply Getting Tighter Oil supply will remain challenged this year and next, as core OPEC 2.0 – the Kingdom of Saudi Arabia (KSA) and the United Arab Emirates (UAE) – approaches the limit of what it can supply to the market and still retain sufficient spare capacity to meet unexpected supply shocks (Chart 3). Among the anticipated shocks we believe core OPEC 2.0 is aware of is the loss of 2mm b/d of Russian crude oil output over the next year, due to the imposition of EU embargoes on seaborne crude oil and refined products, which will go into effect 5 December 2022 and 5 February 2023, respectively. The continued inability of non-core OPEC 2.0 states to maintain higher production – “The Other Guys” in our nomenclature – is another foreseeable shock (Chart 4). This is becoming acute for OPEC 2.0, given The Other Guys account for most of the 3.6mm b/d of below-quota output currently registered by the producer coalition.4 This is a record gap between expected production and actual production from OPEC 2.0, which was registered in August. Chart 3Core OPEC 2.0 Conserves Supplies Oil Markets Anxiously Enter 4Q22 Oil Markets Anxiously Enter 4Q22 Chart 4'Other Guys' Production Keeps Falling Oil Markets Anxiously Enter 4Q22 Oil Markets Anxiously Enter 4Q22 Net, demand will continue to outpace supply in our base case (Chart 5, Table 1). This will require continued inventory draws for the next year or so, as core OPEC 2.0 continues to conserve supplies (Chart 6). Chart 5Demand Continues To Outpace Supply Demand Continues To Outpace Supply Demand Continues To Outpace Supply Chart 6Inventory Will Continue Drawing Inventory Will Continue Drawing Inventory Will Continue Drawing Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Oil Markets Anxiously Enter 4Q22 Oil Markets Anxiously Enter 4Q22 Russian Wild Card Battlefield losses in Ukraine are forcing Russia’s military to activate some 300k reserve troops. These losses again are prompting veiled threats to deploy nuclear and perhaps chemical weapons, which drew a sharp warning from US President Biden.5 Further economic losses will begin mounting in a little more than two months, as the first of two major EU oil-import embargoes and a ban on insuring/re-insuring vessels carrying Russian crude and products takes hold. In addition, a US-led G7 price cap on Russian oil purchases will go into effect with the December embargo on seaborne crude imports into the EU.6 We continue to expect Russia will be forced to shut in ~ 2mm b/d of crude oil production by the end of next year – taking output from a little more than 10mm b/d to ~ 8mm b/d.7 Russian’s President Putin already has threatened to cut off oil supplies to anyone abiding by the G7 price cap.8 In our modeling, a unilateral 2mm b/d cut in Russian output – in addition to the lost sales from the EU embargoes and insurance/reinsurance bans – would take Brent prices above $200/bbl (Chart 7). On the downside, a severe global recession that removes 2mm b/d of demand next year could send prices below $60/bbl. Equally plausible cases for either outcome can be made, given current supply-demand fundamentals and the geopolitical backdrop discussed above. This can be seen in the lack of skew in the options markets, which is measured by the difference in out-of-the-money call and put implied volatilities (Chart 8). The skew sits close to zero at present – meaning options buyers are not giving higher odds to a sharp upside or downside move at present.9 Chart 7Higher Brent Prices, Stronger Upside Bias Higher Brent Prices, Stronger Upside Bias Higher Brent Prices, Stronger Upside Bias Chart 8Option Skew Shows Up Or Down Moves Equally Likely Option Skew Shows Up Or Down Moves Equally Likely Option Skew Shows Up Or Down Moves Equally Likely In our modeling and analysis, we continue to believe the balance of risk is to the upside. As can be seen in Chart 6, inventories are below the 2010-14 five-year average – OPEC 2.0’s original target when it was formed – which means KSA and the UAE will be able to respond to any demand shocks that cause unintended inventory accumulation (e.g., the sort that occurred during the COVID-19 pandemic or the OPEC market-share war of 2015-16). Managing the upside risk is more difficult: KSA and the UAE are close to the limits of what they can supply and still carry sufficient spare capacity to meet unexpected production losses. KSA’s crude oil output is just over 11mm b/d, and the UAE’s is at 3.2mm b/d, according to OPEC’s Monthly Oil Market Report. This puts both within 1mm b/d of their max production capacity of 12mm and 4mm b/d. Both got close to producing at these max levels in early 2020, when Russia provoked a market share war; this was quickly reversed as a magnitude of the COVID-19 demand destruction became apparent. The only other large producer outside the OPEC 2.0 coalition capable of increasing and sustaining higher output is the US shales, which are producing at 7.8mm b/d and have pushed total US crude oil output to 12.2mm b/d (Chart 9). Leading producers in the shales have foreclosed any sharp increase in output this year, given tight labor markets and services and equipment markets in the US. Chart 9US Shales Close To Max Output US Shales Close To Max Output US Shales Close To Max Output Investment Implications Global crude oil markets remain tight, with demand continuing to exceed supply. The risk that the economic war pitting the EU and its allies against Russia could expand to a more kinetic confrontation involving additional states is higher, as more Russian troops are called up to serve in Ukraine. If the additional troops do not reverse Russia’s battlefield losses – or if Ukraine looks like it will win this war – Putin likely will feel cornered, and get more desperate.10 We believe Putin will first attempt to impose as much economic pain on the West as possible by cutting off all natural gas and oil flows to the EU and states and firms observing the G7 price cap. However, if that does not force the West to relent on its economic war with Russia, a war with NATO could evolve in which tactical nukes or other weapons of mass destruction are employed. At that point, Putin would have concluded there would be nothing he could do to restore Russia’s standing as a world power. Any plume – nuclear, biological or chemical (NBC) – that crosses a NATO border likely would be treated as an act of war. NATO would have to act at that point. This is not our expectation, nor is it any part of our base case. But it is a higher non-trivial risk than it was last month or last week. This raises the odds of higher war-driven inflation, as well, which will further complicate central-bank monetary policy at a time of war. Our baseline forecast remains intact, with a strong bias to the upside. We remain long the COMT and XOP ETFs to retain exposure to commodities.   Robert P. Ryan  Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Commodities Round-Up Energy: Bullish In its September update, the US EIA reported natural gas consumption will hit record levels in 2022, increasing by 3.6 Bcf/d to just under 87 Bcf/d on average, led by increases in the electric power residential and commercial sectors (Chart 10). US natural gas consumption in the electric power sector will increase in 2022 due to limitations at coal-fired power plants and weather-driven demand. It is expected to decrease in 4Q22 and in 2023, due to more renewable electricity generation capacity. Natural gas consumption in the residential and commercial sectors for 2023 is expected to be similar as 2022 levels. Base Metals: Bullish According to Eurometaux, a consortium of European metal producers, approximately 50% of the EU’s zinc and aluminum production capacity is offline due to high power prices. More operations are expected to shut as European power prices remain elevated and metal prices drop on recessionary fears (Chart 11). The decision to reopen a smelter following a shutdown is expensive and can result in long wait times. This will make the bloc’s manufacturers heavily reliant on metal imports from other states, which likely will lead to higher pollution from these plants. Aluminum supply is particularly vulnerable to this power crisis since one ton needs an eye-watering 15 megawatt-hours of electricity – enough to power five homes in Germany for a year. Precious Metals: Neutral The Fed’s additional 75-bps rate hike will strengthen the USD and weaken gold prices. Geopolitical risk has been a tailwind for the greenback thus far, as investors rush to the USD instead of the yellow metal for safe-haven investments. If this trend continues, along with further Fed rate increases, the additional risk arising from Putin’s reserve force mobilization and possible expansion of the Ukraine war will boost the USD and leave gold in the doldrums.   Chart 10 Oil Markets Anxiously Enter 4Q22 Oil Markets Anxiously Enter 4Q22 Chart 11 Oil Markets Anxiously Enter 4Q22 Oil Markets Anxiously Enter 4Q22   Footnotes 1     Please see Vladimir Putin mobilises army reserves to support Ukraine invasion, published by ft.com on September 21, 2022. 2     Please see Is a Global Recession Imminent?, published by the World Bank on September 15, 2022.  The report notes, “Policymakers need to stand ready to manage the potential spillovers from globally synchronous withdrawal of policies supporting growth. On the supply-side, they need to put in place measures to ease the constraints that confront labor markets, energy markets, and trade networks.” 3    Please see One hundred years of price change: the Consumer Price Index and the American inflation experience, published by the US Bureau of Labor Statistics in April 2014.  4    Please see OPEC+ supply shortfall now stands at 3.5% of global oil demand, published 20 September 2022 by reuters.com. 5    Please see Biden warns Putin over nuclear, chemical weapons, published by politico.eu on September 17, 2022. 6    Please see EU Russian Oil Embargoes, Higher Prices, which we published on August 18, 2022, for discussion. 7    We include Russia among “The Other Guys” in our balances estimates.  8    Please see Explainer: The G7's price cap on Russian oil begins to take shape, published by reuters.com on September 19, 2022. 9    We use the standard measure of skew – i.e., the difference between 25-delta calls and puts – to determine whether option market participants are discounting a higher likelihood of an up or down move, respectively. 10   Please see CIA director warns Putin's 'desperation' over Russia's failures in Ukraine could lead him to use nukes, published by businessinsider.com on April 15, 2022. Investment Views and Themes Strategic Recommendations Trades Closed in 2022