Financial Markets
Executive Summary Reshoring And FDI Job Creation Have Accelerated After The Pandemic The US is entering a period of an industrial boom thanks to limited manufacturing capacity paired with strong demand for industrial and consumer goods. In addition, a trifecta of positive developments is further boosting US manufacturing: Onshoring, automation, and fiscal stimulus. Onshoring has accelerated after the onset of the pandemic and reshoring announcements are growing steadily. Automation and robotization allow industrial companies to circumvent labor shortages and rising wages and, hence, boost their profit margins. The domestic political landscape in the US is also favorable for industrial stocks given the three major legislative Acts (Infrastructure Investment & Jobs, Inflation Reduction, and National Defense Authorization) that will secure a healthy demand pipeline. While long-term trends are favorable for the sector, a macroeconomic backdrop of slowing growth is a headwind. However, thanks to a confluence of positive long-term trends, most companies are optimistic. Bottom Line: The US industrial sector is in the middle of a boom fueled by onshoring, automation, and favorable government policy. This trifecta of positives helps the sector to defy the gravity of the slowing economy. We remain overweight Industrials on both tactical and strategical time horizons but will continue to monitor it closely, watching out for potential cracks in operating performance. Feature A little over a year ago EMS, GIS, and USES co-published a report “Industrials as equity sector winner in the coming years”. In that report, we posited that the Industrial sector is poised for outperformance as it enjoys a boom thanks to strong new trends in onshoring and automation. In addition to the tectonic shifts described above, the sector has also found itself at the epicenter of the US legislative activity, which will provide a significant tailwind for its performance. Since we published the report on July 30, 2021, Industrials have performed in line with the S&P 500. However, since the beginning of the year, Industrials and Capital Goods outperformed the index by 7%, showing impressive resilience (Chart 1 and Table 1). Chart 1A Resilient Cyclical Sector In this week’s report, we take a close look at the trends highlighted above and conduct a deep dive to evaluate whether the sector is still attractive on a tactical basis considering the backdrop of rising rates and slowing economic activity. Our focus is on the Industrial sector in general, and the Capital Goods Industry Group, in particular. We will also assess which industries are best positioned for outperformance. Table 1Industrials Outperformed On The Way Down And During The Summer Rally Sneak Preview: The US industrial sector is in the middle of a boom fueled by onshoring, automation, and favorable government policy. This trifecta of positives helps the sector to defy the gravity of the slowing economy. For now, we are both strategically and tactically bullish on the sector but remain vigilant. US Manufacturing Capacity Has Been Severely Limited For Years US manufacturing capacity has been stagnant over the past 20 years, and the level of US manufacturing employment has declined by 30% since 2000 (Charts 2 & 3). Presently, manufacturing employment accounts for only 8% of total US employment. Chart 2US Manufacturing Employment Has Been Shrinking For Decades Chart 3US Manufacturing Capacity Has Not Expanded In The Past Two Decades The reason for the lack of capacity expansion over the past 20 years has been the outsourcing and shifting of production to other countries, especially China. The peak in US manufacturing capacity and employment occurred after the massive Asian currency devaluation in 1998 and China’s WTO admission in 2001. The semiconductor sector, which has recently come into the limelight, is a case in point: From 1990 to 2020, the percentage of chips manufactured in the US has fallen from 37% to 10%, with the lion’s share of chips manufactured in Asia. This trend has brought about The Chips Act which seeks to reverse the trend for national security reasons. Notably, more recently, the decline in manufacturing capacity and employment has started to reverse. More about this later. American Manufacturing Is Booming Again Limited manufacturing capacity paired with a strong demand for industrial and consumer goods translates into an industrial boom. Industrial companies are incentivized to expand given they are already operating at nearly full capacity (Chart 4) and enjoying considerable pricing power. Building industrial capacity in itself lifts demand for industrial goods and the US may be in the early innings of the new Capex cycle, unless the trend is derailed by headwinds from a significantly tighter monetary policy. After all, the age of US capital stock, at 24 years, is two years older than at previous peaks, indicating that many companies are overdue for replacing some of their equipment and machinery (Chart 5). Chart 4Industrial Companies Operate At Nearly Full Capacity Chart 5The US Capital Stock Has To Be Renewed Indeed, this may already be happening. According to S&P Dow Jones Indices, which analyzed second-quarter earnings season data, capital expenditures of the companies in the S&P 500, have been growing at a faster pace than stock repurchases for the first time since the first quarter of 2021, rising by 20% from a year earlier. Companies from Pepsi to Google to GM are investing in their production capacity, which in itself may be an encouraging sign that they are comfortable with the demand outlook. Of course, the caveat here is that industrials are late in cycle performance, as companies usually wait towards the end of the cycle to expand, only to find waning demand for their products. You Say “Reshoring,” I Say “Onshoring” A multi-decade decline in US manufacturing employment has started to reverse after the GFC, with the onset of the pandemic and geopolitical tensions accelerating the pace of reshoring and Foreign Direct Investing (FDI). Reshoring and FDI job announcements have increased from 6K in 2010 to 345K in 2022 (Chart 6). The resulting cumulative 950,000 incremental hires represent about 7% of US manufacturing employment. The acceleration of jobs coming back combined with the decline in the rate of offshoring has resulted in a 12-year steady uptrend in US manufacturing jobs. Truly amazing! Onshoring remains on top of mind for companies’ management. According to Statista, mentions of onshoring buzzwords in earnings calls and presentations of US public companies have increased from about 100 throughout 2020 to nearly 200 in Q2-2020. Chart 6Reshoring And FDI Job Creation Have Accelerated After The Pandemic According to Morgan Stanley’s survey of more than 400 executives of large corporations from the US to Germany to Japan, the most important factor in supply chain decisions is geopolitical stability, followed by skilled labor, physical infrastructure, and a developed supply chain ecosystem. On nearly every count, the US outranked Europe, China, and Mexico. Some 18% of the companies planned to significantly expand US manufacturing in the next 12 months, while 36% anticipated doing so within three years. More than 40% of US companies were taking steps to “onshore” supply chains. The reasons are well publicized: The COVID crisis has revealed over-dependence on imports. China’s decoupling from the US, tensions in the Taiwan Strait, and the Russian/Ukraine war have invoked concerns about the reliability of the existing supply chains. Supply chain disruptions have highlighted corporate vulnerabilities and had made companies realize that “just-in-case” trumps “just-in-time.” The US is pursuing protectionist policies that are to benefit companies operating in the US, Mexico, and Canada. According to Reshoring Initiative,1 Industrial and Tech companies are at the forefront of reshoring: Electrical Equipment, Chemicals, Transportation Equipment, Computer, and Electronic Products, and Medical Equipment suppliers are the leaders in onshoring (Table 2). Many large manufacturers such as Caterpillar have implemented or announced plans to bring offshore manufacturing back to the US. Table 2Reshoring Jobs By Top 5 Industries Will onshoring benefit some of the former manufacturing hubs? We believe it will, as Kentucky, North Carolina, Georgia, Ohio, and Alabama are the top five destinations (Table 3). However, there is a hitch. The US unemployment rate, which is at an all-time low of 3.5%, is certainly a speed limit. Moreover, companies that bring their businesses back home do realize that labor costs in this country are many times higher than, say, in Asia. Hence, one of the solutions they pursue is automation. After many years in the making, onshoring is finally gaining pace, benefiting the US manufacturing base. Table 32022 Projected Reshoring Jobs By Top 10 States Automation To The Rescue! The Pace of Robotization And Automation Is Accelerating A critical constraint for the expansion of US manufacturing is the labor shortage. Open vacancies in manufacturing are now at a record high, 100% above the 2018 peak (Chart 7, top panel). Notably, industrial companies have been experiencing difficulties hiring qualified staff over the past 10 years which has led to high wage growth (Chart 7, bottom panel). Chart 7US Manufacturers Cannot Fill Vacant Positions, Wages Are Surging Chart 8Automation Expands Profits Margins Of Global Industrials One remedy is automation. Replacing labor with automation/robots allows companies to produce more and avoid a profit margin squeeze (Chart 8). In a recent report published by the International Federation of Robotics, industrial robots reported record preliminary sales in 2021 with 486,800 units shipped globally, a 27% increase from 2020. The US has been lagging behind other developed countries in terms of automation and robotization (Chart 9). However, labor shortages brought about by the pandemic appear to have “moved the needle.” According to the Association for Advancing Automation (A3),2 the number of robots sold in the US in 2021 rose by 27% over 2020 with 49,900 units installed. 2022 is on pace to exceed previous records, with North American companies ordering a record 11,595 robots. Chart 9US Has Been Lagging Other Developed Nations In Robot Installations Non-automotive sales now represent 58% of the total, demonstrating a broadening reach of automation. Metals, Auto, and Food and Consumer Goods have the highest growth in the purchase of robots (Chart 10). Chart 10In 2021 The Pace Of Robot Installation Has Picked Up Implications For Industrial Companies The Industrials sector is home to companies that create robots and offer automation solutions as well as companies on the receiving end of the trend. Both sellers and buyers are to benefit: Buyers Of Robots: Manufacturing companies automating production and enlisting robots into their operations will enjoy higher operating leverage, lower labor costs, and more resilient margins. It is easier to automate processes in manufacturing than in service sectors. Consequently, we believe profit margins in manufacturing will outperform those of service sector companies, where automation will be slower. Sellers Of Robots: The sizzling demand for robots demonstrates that technological breakthroughs are no longer just about the Tech companies, and many industrial companies are to benefit from these nascent trends. Rockwell Automation, Eaton, and Caterpillar are the leaders in industrial automation. These companies also reach across the aisle to software companies to leverage their expertise in data storage, computing, and artificial intelligence. Rockwell has just recently partnered with Microsoft, while others are acquiring software companies. Deere has acquired GUSS Automation, a pioneer in semi-autonomous springs for high-value crops. These companies are to benefit from strong demand for their products and should exhibit strong sales and profit growth. To meet strong demand, industrial/manufacturing companies will automate their processes. This will allow them to boost volume and cap costs resulting in widening profit margins. Uncle Sam Loves American Manufacturing Both Biden and Trump before him, have stated that their overarching objective is to revive America’s manufacturing. However, their methods were drastically different, with Trump introducing tax cuts and tariffs, while Biden leans heavily on fiscal stimulus. The following is a recap of some of the recent laws passed by Congress and signed by President Biden. Infrastructure Investment And Jobs Act The $1.2-trillion Infrastructure Investment and Jobs Act will increase US government non-defense spending to bring it to around 3% of GDP, a level comparable to the 1980s-90s and larger than the 2010s. The bill’s focus is on traditional infrastructure – roads, bridges, ports, and electrical grid modernization – but also includes more modern elements such as $65 billion for 5G broadband Internet and $36 billion for electric vehicles and environmental remediation (Table 4). Implementation of the bill is delayed to 2023-24. Table 4Itemized Infrastructure Plan However, the market is forward-looking and companies in Construction & Engineering, and Building Products industries are already winners, and are up 12% in relative terms since the bill was passed on November 15, 2021. The potential increase in public construction will help offset a slump in residential construction on the back of the softening housing market (Chart 11). Chart 11The Increase In Public Construction Will Help Offset A Slump In Residential Construction Inflation Reduction Act (IRA) The bill earmarks $370 billion for clean energy spending as well as EV tax credits for both new and used cars. We have written on the topic of “Green and Clean” and the effect of the IRA on renewable energy and EV industries, two industries that are major beneficiaries of the bill. However, the bill also creates an enormous opportunity for industrial companies, which can build and service renewable infrastructure, such as Quanta Services (PWR) and Eaton (ETN). Companies that produce and service wind turbines (GE) and solar batteries will also get a revenue boost from the package. Chips Act Congress has passed the CHIPS+ bill to alleviate the chip shortage and shore up US competitiveness with China. Money is earmarked for domestic semiconductor production and research, and factory construction. While the key beneficiaries are chip foundries, construction of new factories will require equipment and services of a wide range from industrial companies from Construction to Machinery. National Defense Authorization Act In December, the House and Senate Armed Services Committee leadership released the Fiscal Year 2022 National Defense Authorization Act (NDAA). This bill introduces an overall discretionary authorization of $768.2 billion including $740.3 billion for base Department of Defense programs and $27.8 billion for national security programs in the Department of Energy. At a later date, another $37 billion was amended to the bill to include $2.5 billion to help pay higher fuel costs; $550 million for Ukraine, funding for five ships, eight Boeing Co-made F-18 Super Hornet fighter jets, and five Lockheed Martin C-130 Hercules planes; and about $1 billion for four Patriot missile units. For FY 2023, the House has already passed $839 billion, which is $37 billion above the White House request. The Senate will work on the bill after the summer recess. But it is already clear that defense spending has become a bipartisan issue. The increase in the defense budget, as well as additional allocation of funds towards Ukraine, have been a major boost for the Aerospace and Defense industry. We overweighted the sector back in January and it is up 24% in relative terms. Overweight Or Not, That Is The Question Macroeconomic Backdrop Business Cycle: Performance of the Industrial sector tends to lag the business cycle, as sector customers tend to wait until they are sure of recovery and have high utilization of their existing capacity before they expand their own production. However, demand is not entirely cyclical, as the need to replace obsolete or aging equipment or machines is relatively stable. There is also a stark difference in behavior of the largest industrial companies and smaller companies in their ecosystems. Larger manufacturers are long-cycle as it takes months to build machines, planes, or equipment. These companies are less sensitive to the business cycle. On the other hand, their suppliers are “short cycle” as they sell parts to many customers, turn their inventory frequently, and are very sensitive to the economic condition. At present, as economic growth is slowing, long-cycle industrial companies are preferable to short-cycle ones. Despite a bifurcation in demand, Industrials tend to underperform in a generic economic slowdown (Chart 12). This is unsurprising as the relative performance of Industrials is correlated to industrial production and the ISM PMI (Chart 13). Chart 12Historically, Industrials Underperformed During The Slowdown Stage Of The Business Cycle Chart 13Industrials Usually Underperform When IP And ISM PMI Decline Chart 14Survey Of Capex Intentions Is Weakening And while we touted the beginning of the new industrial boom in the US, and a brand new Capex cycle, we need to monitor it carefully, as multiple surveys of Capex intentions are decelerating (Chart 14). Tighter Monetary Policy: Another potential headwind comes from rising rates. After all, the higher cost of corporate borrowing may weigh on demand for industrial goods. However, historically, US industrial stocks outperformed the S&P 500 Index in the past 70 years during periods of rising bond yields, including the inflation decade of the 1970s (Chart 15). Industrial companies are well positioned to withstand inflation as strong pricing power allows them to pass on their costs to customers. Chart 15When Rates Rise, Industrials Outperform The macroeconomic backdrop presents challenges to Industrial companies Fundamentals Are Strong Significant Pricing Power: While dangers are looming in the macroeconomic backdrop, so far industrial companies have been doing well thanks to their significant pricing power (Chart 16), which they enjoy due to high capacity utilization. The relationship between capacity utilization and selling prices is not linear but exponential. When capacity reaches its limit and shortages arise, potential buyers will likely be willing to pay considerably higher prices to secure the supply of goods that they require. High Operating Leverage: In addition to high pricing power, industrial companies enjoy high operating leverage, which implies that while the economy is growing, even if at a slower pace, they can easily convert sales into profits. This will not be the case when the economy is outright contracting – then high operating leverage will become a liability. Chart 16Industrials Enjoy Substantial Pricing Power Strong Q2-2022 Earnings And Sales Results: This explains the strong Q2-2022 sales and earnings results of the Industrial sector. Industrial earnings grew at 17.4%, while its sales increased by 13.3% – a remarkable feat, considering that many companies, especially consumer-facing ones, are struggling with shrinking profitability – earnings growth of the Consumer Discretionary sector was down 12.6%. Clearly, business-to-business companies are faring much better than consumer-facing ones, whose demand was pulled forward by the pandemic, and whose customers are reeling from rising prices and are tightening their belts. Looking ahead, margins are expected to shrink by 0.5% (Chart 17), which is modest compared to the 2.5% contraction expected for the S&P 500. In terms of earnings growth expectations, they have fallen but still exceed the market by an impressive 10% even after a series of downgrades. Importantly, earnings growth in real terms is also positive (Charts 18 & 19). Chart 17Operating Margins Are Expected To Hold Up Well Chart 18Industrial Earnings Will Grow Faster Than The Market Chart 19Earnings Expectations Have Been Re-calibrated What Companies Are Saying All the charts and numbers align well with what we have heard from companies during the earnings season. For instance, nearly every major player within its own respective sub-industry reported healthy demand, low inventories, and a hefty backlog this quarter. Here are a few quotes from the largest players: Caterpillar (CAT): “We expect production and utilization levels will remain elevated, and our autonomous solutions continued to gain momentum … overall demand remained healthy across our segments … was unable to completely satisfy strong customer demand for our machines and engines.” MMM: “Continued strong demand for our solutions in semiconductor, factory automation, and automotive end markets.” GE: “In Renewables, … we are making progress. Our pricing has substantially improved onshore … we're growing our higher-margin businesses, such as grid automation, which delivered double-digit orders growth.” Honeywell (HON): “Orders were up 12% year over year and closing backlog was also up 12% year over year.” The profitability of the Industrial sector is expected to be resilient and to better the market. Valuations And Technicals The Industrial sector and the Capital Goods Industry group trade on par with the S&P 500 on a forward earnings basis (17.7x and 17.9x to 18.0x). The BCA Valuations Indicator signals a neutral level of valuation which is roughly in line with the 10-year average. From the BCA Technical Indicator standpoint, Capitals Goods are also in the neutral zone (Chart 20). Valuations and technicals are moderate for the sector. Chart 20Valuations And Technicals Investment Implications The US industrial sector is in the middle of a boom fueled by a trifecta of positives: Onshoring, automation, and favorable government policy. And while it is hard to fight the Fed and the business cycle, it appears that for now, the sector is defying gravity despite slowing manufacturing surveys and tighter monetary policy. So far fundamentals appear strong, and earnings expectations are robust thanks to the high pricing power and operating leverage of the sector. Within Capital Goods, we favor industries and companies that benefit from these tailwinds: Aerospace and Defense which is to benefit from increased federal defense spending; Robotics and Automation which is overrepresented in the Electrical Equipment industry; and Renewables, i.e., companies that manufacture and service wind turbines and solar panels. Construction and building materials will have a second breath when Infrastructure spending projects will actually get selected and approved. We are both strategically and tactically bullish on the sector but will monitor it closely from a tactical standpoint. After all, industrial surveys are at odds with the resilient earnings expectations. ETFs There are a number of very inexpensive and highly liquid ETFs from Vanguard, iShares, and State Street, that capture the performance of the Industrial sector (Table 5). Table 5Industrial Sector ETFs Bottom Line The US industrial sector is in the middle of a boom fueled by onshoring, automation, and favorable government policy. This trifecta of positives helps the sector to defy the gravity of the slowing economy. Companies are optimistic and earnings growth expectations are both robust and resilient. We are both strategically and tactically bullish on the sector but will continue to monitor it closely, watching out for potential cracks in operating performance. Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com Footnotes 1 Reshoring Initiative reshorenow.org 2 https://www.automate.org/ Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4House Election Model Table A5APolitical Capital: White House And Congress Table A5BPolitical Capital: Household And Business Sentiment Table A5CPolitical Capital: The Economy And Markets
Executive Summary US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins China needs lower interest rates and a weaker currency to battle deflationary pressures. In the US, the main problem is elevated inflation. This heralds higher interest rates and a stronger currency. Hence, the Chinese yuan will depreciate against the greenback. When the RMB weakens versus the US dollar, commodity prices usually fall, and EM currencies and asset prices struggle. Faced with surging unit labor costs, US companies will continue to raise their prices to protect their profit margins and profitability. This will lead to one of the following two possible scenarios in the months ahead. Scenario 1: If customers are willing to pay considerably higher prices, nominal sales will remain robust, profits will not collapse, and a recession is unlikely. However, this also implies that the Fed will have to tighten policy by more than what is currently priced in by markets. Scenario 2: If customers push back against higher prices and curtail their purchases, then the economy will enter a recession. In this scenario, inflation will plummet, corporate margins will shrink, and their profits will plunge. In both scenarios, the outlook for stocks is poor. However, one key difference is that scenario 1 is bearish for US Treasurys while scenario 2 is bond bullish. Bottom Line: On the one hand, the US has a genuine inflation problem. The upshot is that the Fed cannot pivot too early. The Fed’s hawkish rhetoric will support the US dollar. A strong greenback is bad for EM financial markets. On the other hand, the Chinese economy and global trade are experiencing deflation/recession dynamics. Cyclical assets underperform and the US dollar generally appreciates in this environment. This is also a toxic backdrop for EM financial markets. Financial markets have been caught in contradictions. The reason is that investors cannot decide if the global economy is heading into a recession with deflationary forces prevailing, or whether a goldilocks economy or a period of inflation or stagflation will emerge in the foreseeable future. There are also plenty of contradictory data to support all the above scenarios. As such, financial markets are volatile, swinging wildly as market participants absorb new economic data points. The S&P 500 index has rebounded from its 3-year moving average, which had previously served as a major support (Chart 1). Yet, the rebound has faltered at its 200-day moving average. Its failure to break decisively above this 200-day moving average entails that a new cyclical rally is not yet in the cards. Chart 1The S&P 500 Is Stuck Between Technical Resistance And Support Lines The S&P 500 index will remain between these resistance and support lines until investors make up their minds about the economic outlook. The EM equity index has been unable to rebound strongly alongside US stocks. A major technical support that held up in the 1998, 2001, 2002, 2008, 2015 and 2020 bear markets is about 15% below the current level (Chart 2). Hence, we recommend that investors remain on the sidelines of EM stocks. Chart 2EM Share Prices Are Still 15% Above Their Long-Term Technical Support Level BCA’s Emerging Markets Strategy team’s macro themes and views remain as follows: Related Report Emerging Markets StrategyCharts That Matter In China, the main economic risk is deflation and the continuation of underwhelming economic growth. Core and service consumer price inflation are both below 1% and property prices are deflating. Falling prices amid high debt levels is a recipe for debt deflation. We discussed the government’s stimulus – including measures enacted for the property market – in the August 11 report. The latest announcement about the RMB 1 trillion stimulus does not change our analysis. In fact, we expected an additional RMB 1.5 trillion in local government bond issuance for the remainder of the current year. Yet, the government authorized only an additional RMB 0.5 trillion. This is substantially below what had been expected by analysts and commentators in recent months. In Chinese and China-related financial markets, a recession/deflation framework remains appropriate. Onshore interest rates will drop further, the yuan will depreciate more, and Chinese stocks and China related plays will continue experiencing growth/profit headwinds. Meanwhile, the US economy has been experiencing stagflation this year. Chart 3 shows that even though the nominal value of final sales has expanded by 8-10%, sales and output have stagnated in real terms (close to zero growth). Hence, nominal sales and corporate profits have so far held up because companies have been able to raise prices by 8-9.5% (Chart 4). Is this bullish for the stock market? Not really. Chart 3US Stagflation: Strong Nominal Growth, But Small In Real Terms Chart 4US Corporate Profits Have Held Up Because Of Pricing Power/Inflation The fact that companies have been able to raise their selling prices at this rapid pace implies that the Fed cannot stop hiking rates. Besides, US wages and unit labor costs are surging (Chart 9 below). The implication is that inflation will be entrenched and core inflation will not drop quickly and significantly enough to allow the Fed to pivot anytime soon. Overall, US economic data releases have been consistent with our view that although real growth is slowing, the US economy is experiencing elevated inflations, i.e., a stagflationary environment. Critically, wages and inflation lag the business cycle and are also very slow moving variables. Hence, US core inflation will not drop below 4% quickly enough to provide relief for the Fed and markets. Is a US recession imminent? It depends. One thing we are certain of is that faced with surging unit labor costs, US companies will attempt to raise their prices to protect their profit margins and profitability. Our proxy for US corporate profit margins signals that they are already rolling over (Chart 5). Hence, business owners and CEOs will attempt to raise selling prices further. Chart 5US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins This will lead to one of two possible scenarios for the US economy in the months ahead. Scenario 1: If customers (households and businesses) are willing to pay considerably higher prices, nominal sales will remain very robust, and profits will not collapse, reducing the likelihood of a recession. Yet, this means that inflation will become even more entrenched, and employees will continue to demand higher wages. A wage-price spiral will persist. The Fed will have to raise rates much more than what is currently priced in financial markets. This is negative for US share prices. Scenario 2: If customers push back against higher prices and curtail their purchases, output volume will relapse, i.e., the economy will enter a recession. In this scenario, inflation will plummet, corporate margins will shrink (prices received will rise much less than unit labor costs) and profits will plunge. Suffering a profit squeeze, companies will lay off employees, wage growth will decelerate, and high inflation will be extinguished. In this scenario, bond yields will drop significantly but plunging corporate profits will weigh on share prices. We are not certain which of these two scenarios will prevail: it is hard to determine the point at which US consumers will push back against rising prices. Nevertheless, it is notable that in both scenarios, the outlook for stocks is poor. Finally, as we have repeatedly written, global trade is about to contract. Charts 10-18 below elaborate on this theme. This is disinflationary/recessionary. Investment Conclusions On the one hand, the Chinese economy and global trade are experiencing deflation/recession dynamics. Cyclical assets struggle and the US dollar does well in this environment. This constitutes a toxic backdrop for EM financial markets. On the other hand, the US has a genuine inflation problem. The upshot is that the Fed cannot pivot too early. The Fed’s hawkish rhetoric will support the US dollar. A strong greenback is also bad for EM financial markets. Thus, we do not see any reason to alter our negative view on EM equities, credit and currencies. Investors should continue underweighting EM in global equity and credit portfolios. Local currency bonds offer value, but further currency depreciation and more rate hikes remain a risk to domestic bonds. We continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN and IDR. In addition, we recommend shorting HUF vs. CZK, KRW vs. JPY, and BRL vs. MXN. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Messages From Various US High-Beta / Cyclical Stock Prices US high-beta consumer discretionary, industrials, tech and early cyclical stocks have not yet broken out. The rebounds in high-beta tech and industrials have been rather muted. We are watching these and many other market signs and technical indicators to gauge if the recent rebounds can turn into a cyclical bull market. Chart 6 Chart 7 Falling Global Trade + Sticky US Inflation = US Dollar Overshot On the one hand, US household spending on goods ex-autos is already contracting and will drop further. The same is true for EU demand. The reasons are excessive consumption of goods over the past two years and shrinking household real disposable income. As a result, global trade is set to shrink, which is positive for the US dollar. On the other hand, surging US unit labor costs entail that core CPI will be very sticky at levels well above the Fed’s target. Hence, the Fed will likely maintain its hawkish bias for now, which is also bullish for the greenback. In short, the US dollar will continue overshooting. Chart 8 Chart 9 Chinese Exports Will Contract, And Imports Will Fail To Recover Chinese export volume growth has come to a halt. Shrinking imports of inputs used for re-export (imports for processing trade) are pointing to an imminent contraction in the mainland’s exports. Further, Chinese import volumes have been contracting for the past 12 months. The value of imports has not plunged only because of high commodity prices. As commodity prices drop, import values will converge to the downside with import volumes. This is negative for economies/industries selling to China. Chart 10 Chart 11 Global Manufacturing / Trade Downtrend Is Intact China buys a lot of inputs from Taiwan that are used in its exports. That is why the mainland’s imports from Taiwan lead the global trade cycle. This is presently heralding a considerable deterioration in global trade. In addition, falling freight rates and depreciating Emerging Asian (ex-China) currencies are all currently pointing to a further underperformance of global cyclicals versus defensive sectors. Chart 12 Chart 13 Chart 14 Taiwan Is A Canary In A Coal Mine Taiwanese manufacturing companies have seen their export orders plunge and their customer inventories surge. This has occurred in its overall manufacturing and semiconductor companies. This corroborates our thesis that global export volumes will contract in the coming months. Chart 15 Chart 16 Korean Exporters Are Struggling Korean export companies are experience the same dynamics as their Taiwanese peers. Semiconductor prices and sales are falling hard in Korea. Export volume growth has come to a halt and will soon shrink. Chart 17 Chart 18 EM Equities: Cheap And Unloved? The EM cyclically adjusted P/E (CAPE) ratio has fallen to one standard deviation below its mean. Based on this measure, EM stocks are currently as cheap as they were at their bottoms in 2020, 2015 and 2008. EM share prices in USD deflated by US CPI are now at two standard deviations below their long-term time-trend. This is as bad as it got when EM stocks bottomed in the previous bear markets. The reason for EM stocks poor performance and such “cheapness” is corporate profits. EM EPS in USD has been flat, i.e., posting zero growth in the past 15 years. Besides, EM narrow money (M1) growth points to further EM EPS contraction in the months ahead. Chart 19 Chart 20 Chart 21 Chart 22 Commodity Prices Remain At Risk China needs lower interest rates and a weaker currency to battle deflationary pressures. In the US, the problem is inflation, which heralds higher interest rates and a stronger currency to fight rising prices. Hence, the yuan will depreciate versus the greenback. When the RMB depreciates versus the US dollar, commodity prices usually fall. Further, commodity currencies (an average of AUD, NZD and CAD) continue drafting lower. This indicator correlates with commodity prices and also presages further relapse in resource prices. Chart 23 Chart 24 Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Chinese crude oil imports have been contracting for almost a year. Global (including US) demand for gasoline has relapsed. Meantime, Russia’s oil and oil product exports have fallen only by a mere 5% from their January level. This explains why oil prices have recently fallen. Oil lags business cycles: its consumption will shrink as global growth downshifts. However, geopolitics remain a wild card. Hence, we are uncertain about the near-term outlook for oil prices. That said, oil has made a major top and any rebound will fail to last much longer or push prices above recent highs. Chart 25 Chart 26 Chart 27 Chart 28 What Is Next For The Chinese RMB? The Chinese yuan will continue depreciating versus the US dollar. China needs lower interest rates and a weaker currency to battle deflationary pressures. While currency is moderately cheap, exchange rates tend to overshoot/undershoot and can remain cheap/expensive for a while. The CNY/USD has technically broken down. Interestingly, the periods of RMB depreciation coincide with deteriorating global US dollar liquidity and, in turn, poor performance by EM assets and commodities. Chart 29 Chart 30 Chart 31 Stay Put On Chinese Equities Odds are rising that Chinese platform companies will likely be delisted from the US as we have argued for some time. Hence, international investors will continue dampening US-listed Chinese stocks. The outlook for China’s economic recovery and profits is downbeat. This will weigh on non-TMT stocks and A shares. Within the Chinese equity universe, we continue to recommend the long A-shares / short Investable stocks strategy, a position we initiated on March 4, 2021. Chart 32 Chart 33 Chart 34 Chart 35 Messages For Stocks From Corporate Bonds Historically, rising US and EM corporate bond yields led to a selloff in US and EM share prices, respectively. Corporate bond yields are the cost of capital that matters for equities. Unless US and EM corporate bond yields start falling on a sustainable basis, their share prices will struggle. Corporate bond yields could increase because of either rising US Treasury yields or widening credit spreads. Chart 36 Chart 37 EM Currencies And Fixed-Income: An Unfinished Adjustment The profiles of EM FX and credit spreads suggest that their adjustment might not be complete. We expect further EM currency depreciation and renewed EM credit spread widening. EM domestic bond yields have risen significantly and offer value. However, if and as US TIPS yields rise and/or EM currencies continue to depreciate, local bond yields are unlikely to fall. To recommend buying EM local bonds aggressively, we need to change our view on the US dollar. Chart 38 Chart 39 Chart 40 Chart 41 Footnotes Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)
Executive Summary The Fed Versus The Market In today’s report, we summarize the arguments of bulls and bears to examine the possible longevity of the rally. The Bulls’ view is centered around several key themes: Inflation has turned. The Fed is less hawkish than initially assumed, and Jay Powell is not Paul Volcker. The economy is resilient, and consumers are spending. Corporate earnings will surprise on the upside thanks to consumer strength. Meanwhile, the bears argue that: Growth is slowing and a soft landing is elusive, which will lead to earnings disappointment. Valuations and Technicals are no longer attractive – the best part of the rally is likely over, and risk-reward is skewed to the downside. Inflation is embedded and broad-based and it will take many months to reach the level that is palatable to the Fed. Bottom Line: The rally was expected, but its force and durability took us by surprise. Now, after a strong rebound, risks are skewed to the downside and the markets are fragile, but the rally may continue. We offer our take on what can bring this rally to a halt, and the “danger” signs investors need to be on the lookout for. Feature The fast and furious rally off the June 16 lows has taken many investors by surprise. Over the past two months, the S&P 500 has rebounded by 17%, the NASDAQ is up 22%, while Growth has outperformed Value by 9%. Thematic small-cap growth ETFs have fared even better (Chart 1) with Cathie Wood’s ARKG and ARKK up nearly 50%. The Technology and Consumer Discretionary sectors are up 23% and 28% respectively, while Energy and Materials are relatively flat, showcasing a rotation away from the inflation winners to losers. In this week’s report, we will “dissect” the rally and its key drivers to better understand what can bring this rally to a halt. We will also summarize the arguments of the bulls and present our “bearish” rebuttal to some of the assumptions. Sneak Preview: After the powerful rebound, the market is fragile, and risks are skewed to the downside. By summarizing the arguments of bulls and bears, we are offering our take on what can bring this rally to a halt, i.e., hawkish Fed speeches, disappointing inflation readings, rising rates, and bad earnings. However, a positive surprise along each of these dimensions may also result in the next leg up. Chart 1ETF Universe Overview Anatomy Of The Rally To understand what fuels the rally, we need to understand what its key catalysts are. Oversold: First and foremost, in mid-June, US equities were severely oversold – the BCA Capitulation Indicator hit levels last seen in the spring of 2020 (Chart 2). The BoA institutional survey has also reported an extreme level of bearishness. Pull back in the price of energy: This created fertile ground for a rebound, but the catalyst came from the turn in commodities and energy prices. Extreme pessimism about global growth after the Fed’s aggressive response to a disappointing inflation print has triggered a sell-off in oil and metals. Since mid-June, the GSCI Commodities and the GSCI Energy index are in a bear market downtrend, 21% and 25% off their peaks. Inflation moderating: This disinflationary development has unleashed a positive reinforcement loop: Lower energy prices led to a turn in the CPI print. And many still believe that, after all, inflation is transitory: With supply disruptions clearing and prices of energy and commodities turning, inflation will dissipate just as fast as it arrived. We know this because inflation breakevens are currently at levels last seen a year ago (Chart 3). Chart 2Capitulated Chart 3Cooling Off : Back To 2021 Gentler Fed: That is when the market decided that easing price pressures in concert with slowing growth would compel the Fed to pursue a shallower and shorter path of interest rate increases than initially expected – rate increases derived from OIS started to undershoot the “dot plot” (Chart 4). Effectively, the bond market started to forecast that the Fed will end the year at 3.5% and ease as soon as early 2023. In other words, the Fed is nearing the end of the hiking cycle. Naturally, the long end of the Treasury curve has pulled back to April levels, despite a much higher Fed rate. One way or another, yields have stabilized. Lower rates are a boon for equities: As a long-duration asset, equity valuations are inversely correlated with long yields (Chart 5). A better-than-expected Q2 earnings season was the icing on the cake. Chart 4The Market Expects Cuts As Soon As Early 2023 Chart 5Falling Yields Propelled Equities Higher Was The Rally Surprising? The rally itself did not surprise us – after all, we did expect the market to turn on a dime at the earliest whiff of falling inflation (Chart 6). Admittedly, we were taken aback by its strength and longevity. With inflation turning, we also expected a change in leadership from the Energy and Materials sectors to Technology and Consumer Discretionary (Chart 7). We also predicted back in January in our “Are We There Yet?!” report that, based on the previous hiking cycles, Tech would rebound roughly three months after the first rate hike (Chart 8), which was taking us to June. Chart 6When Inflation Turns, Equities Rebound Chart 7Turn in Inflation Triggers A Change In Sector Leadership Chart 8A Closer Look At Technology In early July, we upgraded Growth to overweight as an asset that would benefit from an anticipated turn in CPI, rate stabilization, and slowing growth (Chart 9). We have also reaffirmed our overweight in Software and Services as a way to play Growth on a sector level. We have downgraded Energy to underweight to reduce exposure to Value. Chart 9Growth And Quality Lead Markets Higher When Inflation Abates What The Bulls Think Let’s summarize what the bulls think are the catalysts for the next leg up: Inflation has turned. Looking for further signs that inflation is easing. The Fed is less hawkish than initially assumed, and Jay Powell is not Paul Volcker. Looking for signs that the Fed is getting closer to the end of the hiking cycle. So far, the economy is resilient, and consumers are spending – excess savings and excess demand for labor will soften the blow. Looking for signs that the recession can be avoided. Corporate earnings will surprise on the upside thanks to consumer strength. In the next section, I will juxtapose these optimistic expectations with those of a bear, i.e., of yours truly. A full disclosure – I am not a perma-bear but even eight weeks into the best recovery rally ever, I can’t shake off my pessimism. After all, I am used to the markets going up on injections of liquidity and expect them to shudder when liquidity is mopped out of the system. What The Bears Think, Or A Litany Of Worries Inflation is embedded and broad-based Broad-based: While headline inflation is turning, mostly thanks to prices of energy and materials, it will take a long time for core inflation to revert to the desired 2% as it is broad-based. This is evident from trimmed and median CPI metrics, which continue their ascent. Inflation has also spilled into sticky service items, such as rent (Chart 10). Wage-price spiral: Then there is that pesky wage-price spiral that is manifesting itself in soaring labor costs (Chart 11), which companies pass on to their customers. In the meantime, productivity is falling, and unit labor costs are increasing at 9.5% per year, a rate of growth last seen in 1980s (Chart 12). Demand for labor still exceeds supply with 1.8 job openings for every job seeker, and much more tightening is required to bring supply and demand into balance. Chart 10Entrenched? Chart 11Wage-price Spiral Chart 12ULC Soaring Wages and service inflation are more important to structural inflation than energy. Rent and its equivalents constitute 30% of the CPI basket, while wages are roughly 50% of corporate sales and by far the largest component of the cost structure. Inflation is embedded and broad-based and it will take many months to reach the level that is palatable to the Fed. What Does The Fed Think? Fed minutes: Fortunately, we don’t need to guess. The Fed minutes state that "participants agreed that there was little evidence to date that inflation pressures were subsiding" and that inflation “would likely stay uncomfortably high for some time.” Further, “though some inflation reduction might come through improving global supply chains or drops in the prices of fuel and other commodities … Participants emphasized that a slowing in aggregate demand would play an important role in reducing inflation pressures," the minutes said. The Fed minutes state that in moving expeditiously to neutral and then into restrictive territory, “the Committee was acting with resolve to lower inflation to 2% and anchor inflation expectations at levels consistent with that longer-run goal.” In its previous communications, the Fed emphasized that its commitment to a 2% target is unconditional. Is powell more like burns or volcker? In addition, there is an ongoing debate between bulls and bears on the character of the Fed – is Jay Powell a strong-willed hawk like Paul Volker, or more of a waverer like Arthur Burns, who presided over the relentless march of inflation in the seventies? We think that the Chairman can channel Paul Volcker. After all, the Fed has surprised investors by acting swiftly and decisively. Back in March, the Fed dot plot indicated that by the end of the year, the target rate will reach a mere 1.75%. However, we hit a 2.25%-2.50% rate range as soon as July. Jay Powell is concerned about his legacy: He would not want to be remembered as a Chair who mishandled inflation by keeping rates too low despite historically low unemployment and resilient consumers whose accounts are padded with excess post-pandemic savings. The Fed is more hawkish than what the majority of market participants, unscathed by the inflation of the seventies and eighties, believe. The Fed dot plot, to which the Chairman referred on multiple occasions, projects a Fed funds rate of 4% at year-end and of 4.5-5.0% next year (Chart 13). Meanwhile, Fed funds futures are only pricing a rate of about 3.4% for December 2022, even after the hawkish talk from both ex-dove Kashkari and a hawk Bullard (3.75%-4.0% by year-end and 4.4% by the end of 2023). Further, the Fed itself states in its minutes that rates would have to reach a "sufficiently restrictive level" and remain there for "some time" to control inflation that was proving far more persistent than anticipated. The Chicago Fed President Charles Evans has also affirmed that the Fed is definitely not cutting rates in March 2023. Chart 13The Fed Versus The Market Doves latch on to comments from the meeting that the Fed will be data-driven, and that it is concerned about overtightening. To us, these are just the musings of the “responsible grown-ups.” Quantitative Tightening: Now let’s not forget another leg of the stool – Quantitative Tightening. QT has been very tame so far and, since the program commenced, the size of the Fed’s balance sheet, $8.9 trillion, has barely budged. In September, the Fed is scheduled to step up QT to a maximum pace of $95 billion from $47.5 billion— running off up to $60 billion in Treasuries, and $35 billion of mortgage securities. Shortages of securities available for run-off due to a dearth of refinancing may trigger a shift to outright selling, further tightening financial conditions. Equities are at odds with the Fed: Last, but not least, equity markets are on a collision course with the Fed. Since June, financial conditions have eased as opposed to tightened, making the Fed’s job so much harder (Chart 14). Chart 14The Rally Eased Financial Conditions The Fed may prove to be more hawkish than in the past as it is on a quest to combat inflation and takes its mission very seriously. “Don’t fight the Fed” the adage holds. Economic Growth Is Slowing The BCA Business Cycle Indicator signals that economic growth is slowing (Chart 15), which is also evident from a host of economic data releases, ranging from GDP growth to business surveys to housing data. One of the few data series that has defied gravity so far is the jobs report, but the job creation rate is a coincidental indicator at best, and a lagging one at worst. Jobs are usually lost after the start of a recession (Chart 16). Chart 15Economy Is Slowing Chart 16Unemployment Never "Just Ticks Up" Can consumers save the day? After all, $2.2 trillion in excess savings should help to handle the pressures of negative real wage growth and income growth that is below trend. Yes and no. Gasoline savings can certainly support increases in discretionary spending, all else equal. As for excess savings – adding this money back into the economy may ignite another bout of inflation, working against the Fed, and triggering more rate increases. Many clients ask us if we anticipate a recession. Broadly speaking we do, as the Fed has an arduous task ahead of it in balancing the supply and demand of labor. However, we do not expect a recession in 2022 or even early 2023. Can the Fed succeed by only reducing excess job openings from 1.8 to 1, thus avoiding a rise in unemployment? This is possible, but the probability of such an outcome is low as unemployment never “just ticks up” (Chart 16). However, what the market is pricing is also important. At the moment, the rally shows that it considers the current growth slowdown just a growth scare to be shrugged off. Will there be more disappointments? We think so, as the US economy is facing multiple headwinds from slowing demand for exports due to geopolitical turbulence and payback of overstimulated consumer demand at home. And it is not a recession per se, but a growth disappointment, that may take equities on the next leg down. Growth is slowing and a soft landing is illusive. Earnings Growth Will Continue Its March Towards Zero We believe that earnings growth will continue to slow into year-end – flagging consumer demand at home and abroad, a strong dollar, and soaring unit labor costs that can no longer be fully passed on to stretched consumers, as corporate pricing power is decelerating. Even in Q2-2022, ex-Energy EPS growth is already negative at -1.5%, with Consumer Discretionary, Financials, Communications, and Utilities reporting an earnings contraction. As we predicted back in October, the S&P 500 margins are also compressing, currently at 50bps off their peak, with consensus expecting them to lose another two points within the next 12 months as companies are grappling with rising costs (Chart 17). Analysts are finally in a downgrading mode (Chart 18), with growth over the next 12 months now expected to be 7.7% compared to 10% earlier this summer. Analyst downgrades will continue, and an earnings recession is highly probable as early as Q4-2022. Chart 17Profitability Is Under Pressure Chart 18Earnings Are Finally Being Downgraded In terms of the durability of the rally – earnings growth disappointment will be enough to cause equities to pull back. Earnings growth is slowing and more disappointments may be in store. Valuations And Technicals The S&P 500 is currently trading at 18x forward earnings, which is nearly a two-point rebound off the market trough of 15.8x. This is roughly where PE NTM was in April when the 10-year yield stood at 2.80%. Therefore, the multiple reverted on the back of falling rates, and the market is fairly valued considering where rates are now. And another factor to consider: Analysts are slashing earnings expectations, and with E in a P/E likely to be downgraded further – the “true” forward multiple is likely higher than it appears. The BCA Valuation Indicator is also flashing “overvalued” (Chart 19). From the equity risk premium standpoint, 3% is low by historical standards (Chart 20). And if we consider Shiller PE, it has come down from an eye-watering 38x to a still elevated 29x. Chart 19Pricey Again? Chart 20Equities Are No Longer Cheap By ERP Or Shiller PE Metrics Therefore, it is hard to call equities cheap at this point. But being generous, we will call them “fairly priced.” Regardless – at these levels of valuations, the best part of the rally is likely over, and risk-reward is no longer favorable. From a technical standpoint, this rally is broad-based with nearly 90% of the S&P 500 industries trading above their 50-day moving average (Chart 21). But according to the BCA Technical Indicator, equities are no longer oversold and have just crossed into neutral territory (Chart 22). Interestingly, once the Technical indicator starts to rise, it usually ascends for a while, making us wary to boldly call an immediate end to this rally. Chart 21Thrusting Chart 22No Longer Oversold? Valuations and Technicals are no longer attractive – the best part of the rally is likely over and risk-reward is skewed to the downside. Investment Implications Or Can This Rally Continue? Timing the market is hard at best, impossible at worst. After a 17% rise from the bottom, the S&P 500 is no longer cheap or oversold. Buying equities for valuations or technical reasons is too late – risks are skewed to the downside. Our working assumption is that the rally will pause waiting for the new data that will trigger a new leg up or down. Further, as we pointed out in the Fat and Flat report, the current period is reminiscent of the 1980-1982 Volcker era. So far, the market is following this pattern to a T (Chart 23). The problem is that each leg of the up-and-down market may take months. As such, being (eventually) right and principled does not pay off. After all, the economy is not a market. Therefore, until one of the following happens, the music will continue and the markets can keep dancing, which may be for a while. Chart 23Volcker Era Redux The rally will continue until: There is a communication from the Fed re-emphasizing its hawkish stance and determination to get inflation back to 2%. It may be as one of the FOMC member’s speeches broadcast at Jackson Hole. Long-term Treasury yields pick up either because of the Fed’s actions or speeches or because the economy is overheating. Negative inflation surprise – it may come as either a higher-than-expected inflation reading or evidence that inflation is entrenched, such as rising service or rent inflation, soaring wages, a pick-up in the price of oil or commodities, or a growth surprise out of China, to name but a few. Negative earnings surprise – guidance from a number of companies indicating that economic growth is slowing, and earnings will disappoint. A negative economic surprise may be perceived by the market as “bad news is good news.” We recommend the following: Maintain a well-diversified portfolio, with sufficient allocation to both cyclicals and defensives. Increase exposure to Growth sectors, such as Technology. We particularly favor Software and Services as it leverages the pervasive theme of digitization and migration to the cloud. Reduce allocation to Energy and Materials – these sectors tend to underperform when inflation turns. They are also quintessential value sectors. Maintain some allocation to cyclicals – we are overweight the Industrial sector as it leverages a long-term theme of onshoring and automation. We may be upgrading the Consumer Discretionary sector in the near future. We are also overweight Banks and Insurance for portfolio diversification – these sectors benefit from rising rates and positive growth surprise. Markets turn on a dime and it is good to be prepared. Allocate capital to long-term investment themes: Green and Clean and EV, benefiting from the funds allocated by the IRA bill, Cyber Security, and Defense. Bottom Line: The rally was expected, but its force and durability took us by surprise. Now, after a strong rebound, risks are skewed to the downside and the markets are fragile, but the rally may still continue. We offer our take on what can bring this rally to a halt, and the “danger” signs investors need to be on the lookout for. In the meantime, overweight Growth and maintain a well-diversified portfolio. Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com Recommended Allocation Recommended Allocation: Addendum
Dispatches From The Future: From Goldilocks To President DeSantis
Executive Summary US Support For A Military Coup? A confluence of structural and cyclical factors makes the US highly prone to social and political instability, as in 2020. Today’s stagflationary economic environment further amplifies domestic political risk. The Biden administration’s decision to pursue a criminal investigation of former President Trump will drive political polarization higher, as will the overall 2022-24 political cycle. Investors should expect negative surprises from US politics, including social unrest, political violence, and domestic terrorism of whatever stripe. Such crisis events usually cause only a short-term spike in financial market volatility. A major crisis that affects election results could have a more lasting impact. The base case for US policy in 2023-24 is gridlock, which is marginally disinflationary. It would take an extraordinary surprise to change that. On a relative basis, US assets benefit from domestic political risk because geopolitical risk rises even faster. Recommendation (Tactical) INITIATION DATE Return Long DXY (Dollar Index) Feb 23, 2022 10.8% Bottom Line: Investors should expect volatility and negative “October surprises” in the short term, at least through the midterm elections. US domestic political risk is high and will also amplify global geopolitical risk. Feature The US’s rolling political crisis is escalating again and political violence is likely to rise in the lead up to the midterm elections on November 8 and the presidential election in November 2024. The Department of Justice (DoJ) refused on August 15 to release the affidavit underpinning the Federal Bureau of Investigation’s (FBI) raid on former President Trump’s Mar-a-Lago residence in Florida. Never before has a US president suffered a raid on his home by the country’s federal law enforcement agencies – though presidents have been investigated before. It is not yet clear what charges will be brought against Trump but it is highly likely that he will be indicted for something. The Justice Department released a redacted version of the search warrant suggesting that Trump may be accused of having kept state secrets at his home in violation of the Presidential Records Act and possibly also the 1917 Espionage Act. Speculation says that some information he took back from the White House relates to nuclear weapons.1 The DoJ is pursuing a criminal investigation. The former president could very well end up on trial, or even in jail, but it is also possible that changes in political power will prevent him from going. What are the investment implications, if any? The US will see significant social and political upheaval but the main investment implication is that the US will continue to play an unpredictable and disruptive role abroad, perpetuating a flight to safety in financial markets, at least until the midterm elections are over. Drivers Of US Political Instability The US political crisis should first be seen through the lens of geopolitics: The US is a continent-sized nation that is separated from the other world powers by large oceans. It is therefore highly defensible and economically insulated, with total exports accounting for only 10.2% of GDP. However, this insularity and relative security create space for a fast growing and evolving society that is primarily focused on doing business rather than strengthening the state. The rapid creation of wealth is good but also produces large disparities in region, class, and race that periodically undermine stability. Maintaining domestic stability across the continent would be a constant challenge even if the government were not a federal republic with short political cycles driven by fickle popular opinion. Freedom is a source of political contention as well as wealth creation. Over the past 70 years the society has become less religious and more secular, while the economy has become less manufacturing-oriented and more service-oriented. The shift to a high-tech and information-driven society has empowered the highly educated at the expense of the less educated. Capital owners have benefited from rising asset values, deregulation, and globalization, while labor has witnessed stagnant real wages. Agricultural and manufacturing regions have fallen behind. Social stability is especially hard to maintain during cyclical periods of economic distress, highlighted today by the rising Misery Index (Chart 1). While inflation may subside in the short run, it will probably persist in the long run, and unemployment has nowhere to go but up. There is a demographic and generational factor that is also driving US instability today: The Baby Boom generation did not begin their adult lives with a robust policy consensus, like their parents’ generation, which shared sacrifices during the Great Depression and World War II. Instead the Boomers began with deep divisions due to the Vietnam War and social revolution of the 1960s. As they grew in wealth and power in the 1980s-90s, pro-growth tax policy, deregulation, and rapid socioeconomic changes aggravated these divisions. Inequality surged (Chart 2). The Iraq War and 2008 financial crisis made matters worse. Chart 1US: High Misery Index Chart 2US: High Inequality Now the elites of this generation, who lead the two major parties, are trying to secure their economic and political interests before retirement and death. Bluntly, the pro-business faction is trying to prevent the pro-government faction from clawing back its wealth. Political polarization has reached the highest level since the early twentieth century (Chart 3). While polarization has subsided from the peaks of 2020, it could still exceed those peaks in the 2022-24 political cycle. The US will remain at or near “peak polarization” until generational change and geopolitical conflicts forge a new policy consensus. Bottom Line: The US is geopolitically secure but periodically struggles to maintain domestic stability. Today it is witnessing a confluence of structural and cyclical factors that generate social unrest and historic levels of political polarization. The 2022-24 election cycle will be tumultuous. Chart 3US: Peak Polarization Disaffection Can Lead To Violence Any kind of fanaticism can lead to violent extremism. Militants have emerged from secular movements on the right and left, from communism to fascism, as well as from religious movements.2 In recent years the US has seen a rise in violence, including crime and terrorism. Mass shootings have spiked since the 2008 financial crisis. Terrorism has revived to the highest levels since the 1980s, 96% of which is domestic terrorism (Chart 4). Recent improvements to the social safety net may or may not reduce violence. The stagflationary economic backdrop bodes ill. Opinion polls are of dubious accuracy when they ask people to admit to militant or criminal inclinations, but they still take the temperature of society. Several recent polls suggest that as many as 25% of Americans are willing to consider violence as a means of resolving political problems (Chart 5). Chart 4US: Domestic Terrorism, Political Violence Chart 5US Support For Political Violence? In addition, 55% of Republicans and 40% of independents claim that a military coup could be justified when there is “a lot of corruption,” a subjective standard to say the least (Chart 6). While this number has spiked over the 2020 election cycle, it also shows a substantial pre-existing willingness to entertain authoritarian solutions to political disputes. We do not take these polls at face value given the difficult subject matter. When a major violent event occurs and real people die, popular “support” for political violence will collapse across the United States. Nevertheless these data suggest a high level of disaffection and discontent, which is supported by the structural socioeconomic problems cited above. Chart 6US Support For A Military Coup? The January 6, 2021 incident at the US Capitol was the crescendo of an explosion of social unrest that occurred across the country in 2020, triggered by the aforementioned structural factors, the Covid-19 pandemic, race riots, and political conflict over the 2020 election. The number of homicides rose to 7.4 per hundred thousand people, the highest annual number since the 1990s, higher than in 2001 when the 9/11 terrorist attacks occurred, and reminiscent of the turbulent late 1960s. This year’s midterm elections will be the first major electoral test since the chaotic events of 2020 and none of the underlying drivers of unrest have been resolved. On the contrary, recent signs are pointing to another escalation of social and political upheaval. The 2024 election will also spark unrest and violence. Bottom Line: The number of violent incidents is rising while a substantial minority of public opinion appears willing to entertain violent means of resolving political disputes. From Reality TV To Real Rebellion? The FBI’s raid on Trump’s Mar-a-Lago estate is naturally triggering a backlash from Trump supporters and Republicans. These groups were already distrustful of the federal government and particularly the FBI for spying on the Trump presidential campaign in the 2016 election.3 Republican support for the FBI and DoJ will fall sharply from its current level in opinion polling taken in 2019 (Chart 7, top panel). Trump opponents will argue that Trump is being investigated because of wrongdoing while Trump supporters will think that the Biden administration is trying to prevent him from running for re-election in 2024. Any lack of transparency by the Justice Department will heighten suspicion and acrimony. Chart 7US Views On 2021 Rebellion A fraction of radicalized Trump supporters could be motivated by this extraordinary event to conduct attacks. Already an armed suspect, allegedly linked to a right-wing extremist group and to the January 6 rebellion at the Capitol, attempted to storm an FBI field office in Cincinnati, Ohio. The Department of Homeland Security and FBI have warned about the risk of domestic terrorism for several years and have issued a new warning since the FBI raid on Mar-a-Lago.4 There is no easy way to resolve the dispute over the 2020 election or the January 6 rebellion because these events have taken on mythic status in the eyes of the different factions. For about half of Republicans, the January 6 incident was a patriotic defense of freedom – rather than an insurrection or attempt to prevent the peaceful and democratic transfer of power (Chart 7, bottom panel). Some small portion of those who view the election as stolen could become radicalized and act out violently. Trump received 46% of the popular vote in 2016 and 47% in 2020 (Chart 8). His favorability has suffered since the January 6 events but not as much as one might think. Among Republicans, Trump’s favorability remains largely unperturbed (Chart 9). While the vast majority of these voters are law-abiding, the decision to raid Trump’s home, and any future decision to press criminal charges, will drastically increase the risk of radicalization on the fringes. Chart 8Trump’s Share Of Popular Vote Chart 9Trump’s Popular Support Post-2020 It does not take a social scientist to recognize the potential for an increase in political violence if the federal government is perceived as using the arm of the law to prevent a popular candidate from contesting past or future elections. The risk of political violence cannot be dismissed because the US is a particularly well-armed country. There were 120 civilian-held firearms per 100 persons in the United States as of 2017. By contrast, the nearest country is France, with only 20 firearms per 100 persons (Chart 10). That does not mean that a major incident of violence will necessarily stem from the right wing. Only five years ago an extremist left-wing gunman tried to assassinate a whole group of Republican lawmakers while they were playing baseball. Earlier this year the Department Homeland Security warned about violent reactions to the Supreme Court’s overturning of the Roe v. Wade decision on abortion.5 If and when a major incident of political violence occurs, the public reaction will be a powerful rejection of violence across the political spectrum. For example, President Bill Clinton’s administration benefited from the Oklahoma City bombing in 1995 (Chart 11). Much will depend on the nature of the attack and which faction is most able to capitalize on its victimization. Chart 10Right To Bear Arms Shall Not Be Infringed Chart 11OKC Bombing Spurred Rally Round The Flag Ultimately instability will generate a popular consensus opposed to political violence and supportive of law and order, just as it did in previous periods of American upheaval. The future policy consensus will be “federalist” in orientation due to America’s geopolitics: there will be an increasing need to unify the states to achieve other strategic imperatives like prosperity and national security. We call this theme “Limited Big Government.” This re-centralization process will involve the federal government intervening to stabilize the society. It is not obvious which political party will first capture this consensus. It depends on the nature and timing of any crisis events and the cyclical rotation of parties. Bottom Line: The US is a heavily armed country that is currently prone to social and political instability. The risk of political violence and domestic terrorism of whatever stripe is already very high. In addition, a substantial portion of the country’s right-wing faction believes that the 2020 election was stolen, that the January 6 rebellion was justified, and that the federal government is now abusing its law enforcement powers to prevent a candidate from running in 2024. Domestic terrorism risk will increase. Implications For The 2024 Election Federal agencies were well aware of the risk of a domestic backlash when they decided to raid Mar-a-Lago. Investigators may or may not produce ironclad evidence of wrongdoing by Trump, but polarization will continue to be the overriding dynamic in the short run. It is unlikely that any evidence will convince the different parties to change their opinions of Trump. Assuming Republicans retake the House of Representatives this fall, they will likely impeach Biden, though they will lack the votes in the Senate to remove him from office. US domestic policy will be effectively paralyzed as the partisan conflict continues. The 2024 election will be required to settle the Trump saga and the future direction of US national policy. Trump’s legal troubles could be a blessing or a curse for the Republican Party in the 2024 cycle: If Trump is disqualified or put in jail, then he will become a political martyr for his populist base, motivating Republican voter turnout. At the same time, the Republican Party establishment will gain the advantage of nominating a more favorable candidate who will be eligible to hold the presidency for eight years. Republicans would benefit. If Trump is not disqualified, then he will be even more incentivized to run for the Republican nomination to avoid legal prosecution. In that case he will hinder Republican appeal among moderate and independent voters – leaving them vulnerable to a party split or third-party challenge. Even if he wins, he will only be eligible for the presidency for four years, limiting his party’s prospects. Republicans would suffer. The takeaway from the above is that Trump’s interests continue to be at odds with the interests of the Republican Party elite. If the Democrats aggressively prosecute Trump and try to put him behind bars, they will in fact help unify and motivate the Republican Party opposition. Two further conclusions can be drawn: First, because of the January 6 incident and the political fallout, any future attempt by protesters or rioters to storm a major federal power center will likely be met with overwhelming force rather than accommodation. If that occurs, and state violence is seen as partisan, then the party that uses force will suffer in public opinion. As with domestic terrorism, a major crisis is likely to occur. But it will ultimately be conducive to a new national policy consensus. Second, US domestic instability will incentivize foreign powers to take advantage of US distraction to pursue their national interests aggressively in their own region. At the same time, the US government will also pursue a reactive foreign policy to attempt to divide the opposition and suppress domestic dissent. Therefore US domestic political instability increases global geopolitical instability. Market Response Will Be Volatility What are the investment ramifications of the above? US corporate earnings are heavily insulated from political crises that do not affect either US policy or the structure of the government and economy. Volatility sometimes pops briefly during domestic terrorist events but not in a way that affects the investment outlook (Chart 12). Investors should bear this in mind since another crisis event is coming. True, if the Mar-a-Lago raid affects the midterm election – and hence the composition of the US government in 2023-24 – then financial markets will respond to some extent. However, investors can safely ignore this risk because the stagflationary economy will be the chief factor in the midterms and already favors the opposition party. For the same reason it remains highly likely that Republicans will retake the House of Representatives, producing legislative gridlock in 2023. The result is disinflationary in the short run, though inflation will be a persistent problem over the long run. If Democrats somehow retain control of both houses of Congress, i.e. the “Blue sweep risk,” then investors would see a substantial change in the policy outlook, as Democrats would have a second chance to raise taxes and social spending. But the odds of a blue sweep are low. Our House election model implies that Democrats will lose 22 seats when they only need to lose a net of five seats to lose control. Our Senate model gives 47.5% chance of Democrats retaining control, too close to call at this point (Appendix). The odds of another blue sweep are only 20% according to online betting market PredictIt. Chart 12Market Historically Ignores Domestic Terrorism US political instability has, if anything, supported the US dollar and US equity and bond outperformance for many years. The more unstable the US, the more unstable the world. Indeed, because of the US’s geopolitical position, the US often exports domestic instability to the rest of the world. That is the situation today as the Biden administration’s domestic-focused, reactive foreign policy exacerbates the conflicts with Russia and China. The Biden administration is willing to escalate strategic tensions with both China and Russia in the lead-up to the midterm elections – and this tendency will likely become the Biden Doctrine, lasting into 2024. Investors should remain defensively positioned, and overweight US assets, at least until the midterm election is over. Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Footnotes 1 Read the warrant behind FBI search of Trump’s Mar-a-Lago,” PBS, August 12, 2022, pbs.org. 2 See Katarzyna Jasko et al, “A comparison of political violence by left-wing, right-wing, and Islamist extremists in the United States and the world,” PNAS [Proceedings of the National Academy of Sciences of the United States of America] 119:30 (2022), July 18, 2022, pnas.org. See also Herbert McClosky and Dennis Chong, “Similarities and Differences between Left-Wing and Right-Wing Radicals,” British Journal of Political Science 15:3 (1985), pp. 329-63, jstor.org. 3 See Jessica Lee, “Did Obama Get Caught ‘Spying’ on Trump’s 2016 Campaign?” Snopes, September 29, 2020, snopes.com. See also Wall Street Journal Editorial Board, “Trump Really Was Spied On,” February 14, 2022, wsj.com. 4 See Department of Homeland Security, “Strategic Intelligence Assessment and Data on Domestic Terrorism,” July 11, 2022, dhs.gov; Christopher Wray, “Worldwide Threats to the Homeland,” Federal Bureau of Investigation, September 17, 2020, fbi.gov. See also Ryan Lucas, “FBI, Homeland Security warn about threats to law enforcement after Trump search,” NPR, August 15, 2022, npr.org. 5 See Stef W. Kight, “DHS memo: Violent extremism ‘likely’ in wake of Roe v. Wade decision,” Axios, June 24, 2022, axios.com. Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4House Election Model Table A5APolitical Capital: White House And Congress Table A5BPolitical Capital: Household And Business Sentiment Table A5CPolitical Capital: The Economy And Markets
Chinese credit growth slowed in July with aggregate financing totaling CNY 756 bn, significantly below both June’s CNY 5.17 tn and expectations of CNY 1.35 tn in July. New loans slumped to CNY 679 bn from CNY 2.81 tn, materially below expectations of CNY 1.13…