Geopolitics
Listen to a short summary of this report. Executive Summary Global Equities Are More Attractively Valued After The Recent Sell-Off We tactically downgraded global equities in late February but see the current level of stock prices as offering enough upside to warrant an overweight. Global equities are now trading at 15.6-times forward earnings, and only 12.6-times outside the US. More importantly, the forces that pushed down stock prices are starting to abate: The war in Ukraine no longer seems likely to devolve into a broader conflict; the number of new Covid cases in China has fallen by half; and global inflation has peaked. The next 18 months of falling inflation and receding recession fears could see stocks recover much of their losses. The “Last Hurrah” for equities is coming. We continue to think that over a 5-year horizon, bond yields will rise from current levels, value stocks will outperform growth stocks, and crypto prices will fall. However, countertrend rallies are likely. To express this view, we recommend taking partial profits on our short 10-year Treasury trade recommendation (up 9.3% from an initial entry yield of 1.45% on June 30, 2021). We are also halving our long global value/growth position (up 20.1% since inception on December 10, 2020) and our short Bitcoin position (up 98% based on our exponential shorting technique). Bottom Line: Global equities are heading towards a “last Hurrah” starting in the second half of this year. Tactically upgrade stocks to overweight. Feature Dear Client, We published a Special Alert early this afternoon tactically upgrading global equities to overweight. As promised, the enclosed report elaborates on our view change. Best regards, Peter Berezin Restore Tactical Overweight On Global Equities Chart 1Global Equities Are More Attractively Valued After The Recent Sell-Off We tactically downgraded global equities from overweight to neutral on February 28th. The war in Ukraine, the Covid outbreak in China, and most importantly, the rise in bond yields have kept us on the sidelines ever since. At this point, however, the outlook for stocks has brightened, and thus we are restoring our tactical (3-month) overweight to stocks so that it is consistent with our bullish 12-month cyclical view. First, valuations have discounted much of the bad news. After the recent sell-off, global equities are trading at 15.6-times forward earnings (Chart 1). Outside the US, they trade at only 12.6-times forward earnings. Second, the forces that pushed down stock prices are starting to abate. The war in Ukraine is approaching a stalemate, with Russian troops unable to take much of the country, let alone seriously threaten regional neighbours. A European embargo on Russian oil is likely but will be watered down significantly before it is implemented. European officials have shied away from banning Russian natural gas, an action that would have much more severe economic implications. While still very high in absolute terms, December-2022 European natural gas futures are down 36% from their peak on March 7 (Chart 2). The 7-day average of new Covid cases in China has fallen by more than half since late April (Chart 3). Considering that a significant fraction of China’s elderly population is unvaccinated, the authorities will continue to play whack-a-mole with the virus for the next few months (Chart 4). Fortunately, Chinese domestic production of Pfizer’s Paxlovid anti-Covid drug is starting to ramp up, which should allow for some easing in lockdown measures later this year. Chart 2European Natural Gas Futures Have Come Off The Boil Chart 3Covid Cases Are Falling In China… The 20th Chinese National Party Congress is slated for this fall. In the lead-up to the Congress, it is likely that the government will move to diffuse social tensions over its handling of the pandemic by showering the economy with stimulus funds. Of note, the credit impulse has already turned higher, which bodes well for both Chinese growth and growth abroad (Chart 5). Chart 4… But Low Vaccination Rates Among The Elderly Remain A Risk Chart 5A Rebound In China's Credit Impulse Bodes Well For China And The Rest Of The World Inflation Is Peaking On the inflation front, the data flow has gone from unambiguously bad to neutral (and perhaps even slightly positive). In the US, core goods inflation fell by 0.4% month-over-month in April, the first outright decline in core goods prices since February 2021. The Manheim Used Vehicle Value Index has crested and is now 6.4% below its January peak (Chart 6). Global shipping rates have moved up a bit recently on the back of Chinese port shutdowns but remain well below their highs earlier this year (Chart 7). Chart 6Used Car Prices Appear To Have Peaked Chart 7Global Shipping Rates Are Well Off Their Highs It Is The Composition Of Spending That Is Distorted Despite the often-heard claim that US consumer spending is well above trend, the reality is that spending is more or less in line with its pre-pandemic trend (Chart 8). It is the composition of spending that is out of line: Goods spending is well above trend while services spending is well below. One might think that only the overall level of spending should matter for inflation, and that the composition of spending is irrelevant. However, this ignores the reality that services prices are generally stickier than goods prices. Companies that sold fitness equipment during the pandemic had no qualms about raising prices. In contrast, gyms barely cut prices, figuring that lower membership fees would do little to drive new business through the door (Chart 9). Chart 8Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Chart 9Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices This asymmetry matters, and it suggests that goods inflation should continue to fall over the coming months as the composition of spending shifts back to services. A Lull In Wage Growth Wages are the most important determinant of services inflation. While it is too early to be certain, the latest data suggest that wage growth has peaked. The 3-month annualized growth rate in average hourly earnings for production and nonsupervisory workers slowed from 7.2% in the second half of 2021 to 3.8% in April (Chart 10). Assuming productivity growth of around 1.5%, this is consistent with inflation of only slightly more than 2%. Nominal wage growth is a function of both labor market slack and expected inflation. Slack should increase modestly during the rest of the year as labor participation recovers. Chart 11 shows that the labor force participation rate is still about 0.9 percentage points below where one would expect it to be, even adjusting for an aging population and increased early retirements. Chart 10Wage Growth Seems To Be Topping Out Chart 11Labor Participation Has Further Scope To Recover Employment has been particularly depressed among lower-wage workers (Chart 12). This should change as more low-wage workers exhaust their savings and are forced to seek employment. According to the Fed, the lowest-paid 20% of workers are the only group to have seen their bank deposits dwindle since mid-2021 (Chart 13). Chart 12More Low-Wage Employees Will Return To Work Chart 13The Savings Of Low-Wage Workers Are Dwindling Inflation expectations should come down as goods inflation recedes and oil prices come off their highs (Chart 14). Bob Ryan, BCA’s Chief Commodity Strategist, sees the price of Brent averaging $86/bbl in the second half of this year, down 16% from current levels. Central Banks Will Dial Back The Hawkishness With inflation set to fall over the remainder of the year, and financial markets showing increasing signs of stress, the Fed and other central banks will adopt a softer tone. It is worth noting that the median terminal dot for the Fed funds rate actually declined from 2.5% to 2.4% in the March Summary of Economic Projections (Chart 15). Given that markets expect US interest rates to rise to 3.25% in 2023, the Fed may not want investors to further rachet up rate expectations. Chart 14US Inflation Expectations Should Recede If Oil Prices Drop Chart 15Rate Expectations Have Moved Well Above The Fed's Estimate of Neutral The Bank of England has already veered in a more dovish direction. Its latest forecast, released on May 5, showed real GDP contracting slightly in 2023. Based on market interest rate expectations, the BoE sees headline inflation falling to 1.5% by end-2024, below its target of 2%. Even assuming that interest rates remain at 1%, the BoE believes that inflation will only be slightly above 2% at the end of 2024, implying little need for incremental policy tightening. Not surprisingly, the pound has sold off. We have been tactically short GBP/USD but are using this opportunity to turn tactically neutral. Given favorable valuations, we like the pound over the long run. Chart 16Spending In The Euro Area Is Well Below Its Pre-Pandemic Trend The euro area provides a good example of the dangers of focusing too much on short-term inflation dynamics. Supply-side disruptions stemming from the pandemic and the war in Ukraine have weighed on European growth this year. Yet, those very same factors have also pushed up inflation. Harmonized inflation across the euro area reached 7.5% in April, the highest since the launch of the common currency. The ECB is eager to put some distance between policy rates and the zero bound. However, there is little need for significant tightening. Unlike in the US, spending in the euro area is well below its pre-pandemic trend (Chart 16). If anything, more inflation would be welcome since that would give the ECB scope to bring real rates further into negative territory if economic conditions warrant it. To its credit, the Bank of Japan has stuck with its yield curve control system, even as bond yields have risen elsewhere in the world. Japan’s currency has weakened but given that inflation expectations are too low, and virtually all of its debt is denominated in yen, that is hardly a bad thing. Too Late? Has the surge in bond yields already done enough damage to the global economy to make a recession inevitable? We do not think so. As noted above, much of the recent harm has been caused by various dislocations, namely the war in Ukraine and the ongoing effects of the pandemic. As these dislocations dissipate, inflation will fall and global growth will recover. Despite the hoopla over how the US economy contracted in the first quarter, real private final sales to domestic purchasers (a measure of GDP growth that strips out the effects of changes in government spending, inventories, and net exports) rose by 3.7% at an annualized rate. As Table 1 shows, this measure of economic activity has the highest predictive power for GDP growth one-quarter ahead. Table 1A Good Sign: Real Final Sales To Private Domestic Purchasers Rose By 3.7% In Q1 Meanwhile, and completely overlooked at this point, S&P 500 earnings have come in 7.3% above expectations so far in Q1, with nearly 80% of S&P 500 companies surprising on the upside. Earnings are up 10.4% year-over-year in Q1. Sales are up 13.6%. Looking out to Q4 of 2022, S&P companies are expected to earn $60.93 in EPS, up 4.3% from what analysts expected at the start of the year. It is also worth noting that homebuilder stocks have basically been flat over the past 30 days, even as the S&P 500 has dropped by nearly 10% over this period. Housing is the most interest rate-sensitive sector of the economy. With the homeowner vacancy rate at record low levels, even today’s mortgage rates may not be enough to push the economy into recession (Chart 17). Economic vulnerabilities are greater outside the US. Nevertheless, there is enough pent-up demand on both the consumer and capital spending side to sustain growth. The Last Hurrah How long will the “Goldilocks” period of falling inflation and supply-side driven growth last? Our guess is about 18 months, starting this summer and lasting until the end of 2023. Unfortunately, as is often the case, the benign environment that will emerge in the second half of this year will sow the seeds of its own demise. Real wages are currently falling across the major economies (Chart 18). That has dampened consumer confidence and spending. However, as inflation comes down, real wage growth will turn positive. This will stoke demand, leading to a reacceleration in inflation, most likely in late 2023 or early 2024. Chart 17Tight Supply Makes Housing More Resilient Chart 18Real Wages Are Falling In Most Countries In the end, central banks will discover that the neutral rate of interest is higher than they thought. That is good news for stocks in the short-to-medium run because it means that forthcoming rate hikes will not induce a recession. Down the road, however, a higher neutral rate means that investors will eventually need to value stocks using a higher discount rate. It also means that the disinflation we envision over the next 18 months will not last. All this puts us in the rather lonely “transitory transitory” camp: We think much of today’s high inflation will prove to be transitory, but the transitory nature of that inflation will itself be transitory. Be that as it may, the next 18 months of falling inflation and receding recession fears could see stocks recover much of their losses. For most investors, that is too long a period to sit on the sidelines. The “Last Hurrah” for equities is coming. Taking Partial Profits On Our Short Treasury, Long Value/Growth, And Short Bitcoin Trades We continue to think that over a 5-year horizon, bond yields will rise from current levels, value stocks will outperform growth stocks, and crypto prices will fall. However, with the “Last Hurrah” approaching, countertrend rallies are likely. To express this view, we recommend taking half profits on our short 10-year Treasury trade recommendation (up 9.3% from an initial entry yield of 1.45% on June 30, 2021). We are also halving our long global value/growth position (up 20.1% since inception on December 10, 2020), and our short Bitcoin position (up 98% based on our exponential shorting technique). Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Executive Summary Stocks Not Linked To Presidential Approval President Kennedy’s performance in 1962 would be ideal for the Biden administration in this year’s midterm elections – but today the Russian conflict is less likely to help the Democrats. A threat to the homeland could lift President Biden’s job approval. But most likely inflation and foreign crises will weigh on his approval. A contrarian stock rally would not help Biden’s approval but Biden’s attempts to boost his rating could deliver negative surprises for stocks. US “peak polarization” and Democratic Party policies are negative for the stock market and investor risk appetite over the next zero-to-six months. Our quantitative election models suggest Republicans will win the Senate, though uncertainty will rise as a result of the controversy over the Supreme Court and abortion. Democratic odds of keeping the White House in 2024 are 54.6% but eroding. CLOSE Recommendation (Cyclical) CLOSING Level CLOSING Date RETURN Long Municipal Bonds Vs. Duration Matched Treasuries 93.53 2-MAY-22 -1.50% Bottom Line: Overall Biden policies plus global events are neutral or bullish for US Treasuries while neutral or bearish for US stocks over a tactical time horizon (zero-to-six months). Feature President Biden is doubling down on his support for Ukraine and thus adopting the John F. Kennedy foreign policy playbook of confronting Russia ahead of the US’s midterm elections. Related Report US Political StrategyWar Not Helping Biden So Far Biden’s position today is weaker than Kennedy’s in 1962, so his reaction to Russian aggression will create more market hurdles than it removes. Bad news will come before good news, compounding bearish investor sentiment in the near term. Policy uncertainty should decline after the midterm election on November 8, which is positive for equities in 2023. Democrats Scramble Amid Recession Fear The US economy contracted unexpectedly in the first quarter at an annualized 1.4% rate. The underlying data contained some silver lining – personal consumption grew at 2.7%. But the contraction is bad news for the economy and the ruling Democratic Party. Public approval of Biden’s handling of the economy has fallen to -16.2%. The global economy continues to sputter. Risks to growth are high in Europe and China as well (Chart 1). The US policy response will take shape on the monetary and fiscal level but also on the foreign policy level. First, global risks will not dissuade the Federal Reserve from normalizing interest rates. Chairman Jerome Powell signaled on April 21 that he is willing to hike interest rates 50 basis points at a time to combat core PCE inflation at 5.2%. The market currently expects core inflation to peak at 5.2% while the Fed funds rate will hit 3.3% in 2023 before falling in 2024. The implication is that monetary policy will tighten quickly, even as the economy stutters, which is negative for the US equity market and investor sentiment. However, Fed hawkishness is largely priced. US long-duration treasuries are at or near fair value at 3%, according to our US Bond Strategy. Our US Investment Strategy believes that with the S&P500 already down by 13% so far this year, stocks can begin to grind upward, barring other negative surprises. Chart 1US Slows Amid Global Growth Risks Second, the White House will scramble to try to limit the damage to the Democratic Party in the midterms – with the unintentional result that negative surprises could arise from fiscal policy and especially foreign policy. On the fiscal front, congressional Democrats will redesign their budget reconciliation bill to try to gain a legislative victory. They will need to make it as close to deficit-neutral as possible to avoid fanning inflation. The odds of passage are higher than consensus expectations (26% on PredictIt). But the stock market does not want more government spending or higher taxes in a stagflationary environment. Fiscal policy is still a significant source of uncertainty in 2022, if not in 2023. On the foreign policy front, the greatest trouble looms. Russian aggression has prompted the US and its NATO allies to double down on their support for Ukraine, providing additional arms and aid. Biden’s Secretary of Defense Lloyd Austin said that the US wants to see Ukraine “a democratic country able to protect its sovereign territory … [and] Russia weakened to the point where it can't do things like invade Ukraine.”1 Finland and Sweden are increasingly likely to join NATO, which will antagonize Russia. Russia’s response is not yet known but it has issued aggressive warnings. By cutting off natural gas to Poland and Bulgaria, Moscow is warning that it may cut off natural gas to all Europe. Meanwhile Germany is embracing an oil embargo. A larger energy shock is increasingly likely. Chart 2More Bad News Before Good News Bottom Line: Monetary policy hawkishness is largely priced whereas additional fiscal uncertainty and America’s reactive foreign policy are not fully priced. This news is neutral or bullish for US Treasuries while neutral or bearish for US stocks over a tactical time horizon (zero-to-six months) (Chart 2). Biden Can Hurt Stocks, Stocks Cannot Help Biden Before addressing how Biden will try to boost his job approval, we should ask whether approval ratings have any direct impact on financial markets. The answer is largely no – or fleeting at best. During the Trump administration it was easy to get the impression that the president’s approval rating had a substantive impact on the stock market, or at least benefited stocks relative to bonds. After the first year, a correlation developed between presidential approval and the stock-to-bond ratio (Chart 3A, top panel). The passage of tax cuts juiced corporate profits but also suggested that President Trump could get things done, boosting his approval rating. Oddly, however, the relationship continued even after Republicans lost Congress in 2018. Spurious or not, the correlation persisted until Covid-19 erupted. At that point Trump’s approval tanked while the stock market roared on the back of gargantuan monetary and fiscal stimulus. President Biden’s administration started off the same way, with presidential approval falling (the usual honeymoon ended) while stocks rallied relative to bonds (Chart 3A, bottom panel). But Biden’s passage of the American Rescue Plan Act and the bipartisan Infrastructure Investment and Jobs Act in 2021 did not boost his approval rating. Going forward, Biden’s approval rating will probably stabilize at a low level in an inflationary or stagflationary context. Stocks may continue to underperform bonds over a tactical time frame but will not underperform bonds over the cyclical time frame as long as the US avoids a recession. Thus there is not likely to be close correlation between Biden’s approval and the stock-to-bond ratio. From the sector and style perspective, there is also no clear relationship with presidential approval. There may be some basis for seeing Trump’s tax cuts as positive for cyclicals relative to defensives. His term coincided with the second half of a business cycle when growth expanded. But ultimately cyclicals vacillated and went sideways. Moreover growth stocks outperformed value stocks, in accordance with President Obama’s term in office. Yet there was no correlation between Trump’s approval and growth stocks relative to value (Chart 3B, top two panels). In Biden’s case, presidential job approval has no clear correlation with cyclicals relative to defensives. There may be some relationship with value relative to growth stocks but it is far from convincing. Most likely the underlying macroeconomic dynamics that favored value stocks (i.e. recovery, inflation) coincided with Biden’s honeymoon period and then outlasted it. However, if Biden passes a reconciliation bill with tax hikes, the implication should be positive both for value versus growth stocks and for his approval rating (Chart 3B, bottom two panels). Chart 3AStocks Not Linked To Presidential Approval Chart 3BStocks Not Linked To Presidential Approval From the above data we can draw a few conclusions. On one hand, the stock-to-bond ratio and cyclicals-versus-defensives could rally again on the back of a resilient global economy and yet Biden’s approval rating could fail to recover. The distribution of wealth means that inflation and rising mortgage rates hit low-to-middle income groups who comprise the bulk of voters. Cyclical assets will rise if the global economy improves relative to the US economy, whereas presidential approval may not. Inflation could subside incrementally with limited benefit to the president. On the other hand, if stocks and cyclical sectors continue to underperform, it will probably be due to even worse economic outcomes that will simultaneously prevent Biden’s approval from recovering. If the economy slows further and inflation remains persistent, disapproval will rise. The problem for investors is that the latter is the likeliest scenario based on the energy supply risks in Europe and China’s difficulties stabilizing growth. The US economy cannot entirely avoid the knock-on effects of slower global growth over the next six months. Bottom Line: There is no stable relationship between presidential approval and the stock market, whether regarding bonds, sectors, or styles. There are occasional correlations that reflect coincidences of macro, market, and political cycles or major policy changes. In today’s context a rebound in cyclical assets may not help the president while a further downturn would hurt him. But the president’s attempts to boost his approval rating could hurt stocks. Inflation And Foreign Wars Tend To Hurt Presidents What can Biden do to boost his approval rating and his party’s odds in the midterm election? Not much. Foreign policy is his best option, though he is limited to a defensive or reactive foreign policy and even then the underlying economy will drive voters the most. Looking at presidential approval over time, upswings occur during periods of economic prosperity and peaks occur amid foreign belligerence that threatens the homeland. Presidential approval has slumped since the subprime mortgage crisis and today it is even lower than under President Obama (Chart 4A). Chart 4APresidential Approval Follows Peace And Prosperity, Not War And Poverty Similarly presidential disapproval rises during recessionary and inflationary periods as well as wars and scandals (Chart 4B). The Obama/Trump era saw a rise in disapproval that could resume due to inflation. Foreign wars that do not present a threat to the homeland can increase disapproval. Chart 4BPresidential Approval Follows Peace And Prosperity, Not War And Poverty The takeaway is that a homeland threat from abroad could temporarily lift the president’s approval but it will not last for long unless the underlying economic malaise is cured. The problem for Biden is that the most immediate foreign policy challenges emanate from oil producers whose reactions exacerbate the inflation problem (Russia, Iran). Biden may or may not keep relations steady with China, where disputes could drive up import prices. Bottom Line: A reactive foreign policy could provoke a threat to the homeland that boosts the president’s job approval. But more likely the weakening economy, high inflation, and foreign crises that add to inflation will hurt the president. Biden And The Kennedy Playbook President Kennedy’s experience in 1962 presents the best case for Democrats but the underlying economic and political context are different and damaging for Biden. Comparing today’s situation to comparable midterm election years, the negative outlook for Biden and the Democrats becomes clear. Comparable midterm elections feature high international tensions, high inflation, or low presidential approval on a net basis. Today the “Misery Index” (unemployment plus inflation) is comparable to the minimum levels in midterm years in the 1970s – and higher than the maximum levels in other midterm years (Table 1). The House and Senate losses during periods of high misery and low presidential approval are substantial. Table 1Misery And Midterms The 1962 midterm election is a notable exception. The Cuban Missile Crisis and Kennedy’s handling of it minimized the Democratic Party’s losses that year, with only four seats lost in the House, plus a gain of three seats in the Senate. Compare this to the typical midterm election, with an average of 27 lost seats in the House (31 for Democrats) and four seats lost in the Senate (five for Democrats) (Table 2). Table 2Kennedy’s Cuban Missile Crisis Midterm, 1962 Kennedy’s net approval averaged 55% that year, whereas Biden’s today stands at -11%. A threat to the homeland could boost Biden’s approval but today’s likeliest conflicts would worsen inflation if they occurred. The Misery Index stands at 11% this year compared to 6% in 1962. Most importantly, in the Cuban Missile Crisis, the Russians recognized that America would always care about Cuba’s status more than Russia because it posed a proximate strategic threat. Americans had more at stake and could take greater risks to prevent Cuba from hosting nuclear arms. Today, while the US is not trying to supply Ukraine or Finland with nuclear weapons, NATO membership would expand the US nuclear umbrella. Americans do not seem prepared to recognize that Russia will always care more about Ukraine’s and Finland’s status than Americans will. Russians have more at stake and can take greater risks. Thus while Biden’s foreign policy could easily provoke a crisis with Russia, Biden may not get the better end of the crisis like Kennedy did. Meanwhile financial markets will suffer from the spike in tensions. Bottom Line: Biden’s doubling down on support for Ukraine and NATO enlargement suggest that he does not have an interest in reducing tensions with Russia ahead of the midterm election. Yet Biden is unlikely to get the better of any reactive foreign policy that escalates tensions – at least not in time for the midterms. This dynamic is negative for US and global stocks and risk assets. Election Quant Model Updates The Philadelphia Federal Reserve released a second update to its state-level coincident indicators in April, enabling us to update our quant models for the Senate election in 2022 and presidential election in 2024. The model still predicts that Democrats will lose two Senate seats, producing a Republican majority of 52-48 (Chart 5). Arizona and Georgia are the two states in which Democrats won Senate seats in 2022 but are expected to flip to the Republican side. Arizona and Pennsylvania remain toss-up states (odds of Democratic victory range from 45%-55%) but are inching downward toward likely Republican victories. Chart 5GOP Tipped To Take The Senate (Quant Election Model, April 2022) Democrats shed probability in all states once again. Odds fell the most in Arizona (-1.08 percentage point since the last update in early April) followed by North Carolina (-1.03ppt) and Pennsylvania (-0.98ppt). In seven states the Democratic odds of victory fell by more than 0.5ppts, including Arizona and Nevada (Chart 6). Overall the probability for Democrats retaining control of the Senate now stands at 48.2% (down 0.2ppt). These odds are higher than consensus even though they agree with the consensus on expecting Republican victory. Online betting markets like PredictIt are pricing in Republican control at around 79%, up 3ppt from our last update. This is overstated and the new controversy over the Supreme Court and abortion will fire up Democratic voters, making the Senate race closer to what our model suggests. Chart 6Democrats Falter Across Senate Races: AZ, PA, NC Looking ahead to 2024, our presidential election model still predicts 308 Electoral College votes for the Democratic Party, a number that has not changed since the 2020 election (Chart 7). Democrats have a 54.6% chance overall of retaining the White House. Chart 7Biden Still Tipped For 2024 (Quant Election Model, April 2022) The trend is negative for the incumbent party. North Carolina slipped out of the toss-up category and into Republican category – i.e. Democrats now have only a 44% chance of winning it. Democrats’ odds of winning Florida moved lower – it is now in toss-up territory at 54%, which comes closer to our subjective judgment that Republicans are favored there. The toss-up states have remained well anchored in the range of 40%-60% since 2020 and will play a pivotal role in future predictions. Generally the trend is for falling odds that Democrats will win these states (PA, FL, NC, AZ, and GA). Both Pennsylvania and Florida account for a combined 49 electoral votes and Florida is probably more Republican-leaning than the model says. If the three critical Rust Belt states (Pennsylvania, Wisconsin, Michigan) slip into toss-up territory then the model will be flagging serious trouble for Democrats. But a lot can happen between now and 2024. In the latest update Democrats are shedding probability of winning in all states, although to a lesser degree than the past two updates. Economic data, while still negative for the incumbent party, may be deteriorating less rapidly. Biden’s approval rating improved marginally since our last update and we expect it to stabilize, albeit at a low level. Michigan recorded the largest decline in Democratic odds of victory (-1.07ppt) followed by Minnesota (-0.79ppt) and New Hampshire (-0.78ppt). Democrats shed more than 0.5ppts from their odds of victory in twelve states, nine of which they won in 2022 (Chart 8). Chart 8Democrats Shedding Odds Of Winning States In 2024 Bottom Line: Republicans are favored to take the Senate (as well as the House) in 2022. Democrats are slightly favored to retain the White House in 2024, though the model is optimistic by granting Florida to the Democrats and the election odds look to be razor-thin yet again. Investment Takeaways As we go to press, the unusual leak of a draft opinion of Supreme Court Justice Samuel Alito has roiled US politics. The draft argues that the landmark court case of Roe Versus Wade should be overturned. This incident reflects our “Peak Polarization” theme – that polarization will remain very disruptive in the short term yet subside over the long term. It also suggests an activist effort to escalate the culture wars ahead of the midterm election, which we have argued would be the case and implies that more unrest will follow from this event. Whether the Supreme Court overturns the landmark Roe versus Wade ruling of 1973, the battle for women voters will help sustain election-year policy uncertainty, as women’s approval for Democrats will start to recover (Chart 9). Investor sentiment will remain bearish in the very near term. A series of hurdles need to be cleared before we close our tactical long DXY trade and defensive sector tilt. We are closing our long municipal bond relative to Treasury trade for a loss of 1.5% (Chart 10). Chart 9Women Are Key Constituencies In The Midterm Chart 10Municipal Trade Fizzled Out Despite Strong Local Government Finance The overall analysis of US politics is neutral or bullish for US Treasuries while neutral or bearish for US stocks over a tactical time horizon (zero-to-six months). If recession is avoided at the critical juncture this year, then 2023 will see a rising stock market as the economy expands and political risks fall. Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Footnotes 1 Peter Weber, “Defense Secretary Lloyd Austin says U.S. believes Ukraine can win, wants to 'see Russia weakened,'” The Week, April 25, 2022, theweek.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 A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets
Executive Summary German GeoRisk Indicator Russia and Germany have begun cutting off each other’s energy in a major escalation of strategic tensions. The odds of Finland and Sweden joining NATO have shot up. A halt to NATO enlargement, particularly on Russia’s borders, is Russia’s chief demand. Tensions will skyrocket. China’s reversion to autocracy and de facto alliance with Russia are reinforcing the historic confluence of internal and external risk, weighing on Chinese assets. Geopolitical risk is rising in South Korea and Hong Kong, rising in Spain and Italy, and flat in South Africa. France’s election will lower domestic political risk but the EU as a whole faces a higher risk premium. The Biden administration is doubling down on its defense of Ukraine, calling for $33 billion in additional aid and telling Russia that it will not dominate its neighbor. However, the Putin regime cannot afford to lose in Ukraine and will threaten to widen the conflict to intimidate and divide the West. Trade Recommendation Inception Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 14.2% Bottom Line: Stay long global defensives over cyclicals. Feature Chart 1Geopolitical Risk And Policy Uncertainty Drive Up Dollar The dollar (DXY) is breaking above the psychological threshold of 100 on the back of monetary tightening and safe-haven demand. Geopolitical risk does not always drive up the dollar – other macroeconomic factors may prevail. But in today’s situation macro and geopolitics are converging to boost the greenback (Chart 1). Global economic policy uncertainty is also rising sharply. It is highly correlated with the broader trade-weighted dollar. The latter is nowhere near 2020 peaks but could rise to that level if current trends hold. A strong dollar reflects slowing global growth and also tightens global financial conditions, with negative implications for cyclical and emerging market equities. Bottom Line: Tactically favor US equities and the US dollar to guard against greater energy shock, policy uncertainty, and risk-aversion. Energy Cutoff Points To European Recession Chart 2Escalation With Russia Weighs Further On EU Assets Russia is reducing natural gas flows to Poland and Bulgaria and threatening other countries, Germany is now embracing an oil embargo against Russia, while Finland and Sweden are considering joining NATO. These three factors are leading to a major escalation of strategic tensions on the continent that will get worse before they get better, driving up our European GeoRisk indicators and weighing on European assets (Chart 2). Russia’s ultimatum in December 2021 stressed that NATO enlargement should cease and that NATO forces and weapons should not be positioned east of the May 1997 status quo. Russia invaded Ukraine to ensure its military neutrality over the long run.1 Finland and Sweden, seeing Ukraine’s isolation amid Russian invasion, are now reviewing whether to change their historic neutrality and join NATO. Public opinion polls now show Finnish support for joining at 61% and Swedish support at 57%. The scheduling of a joint conference between the country’s leaders on May 13 looks like it could be a joint declaration of their intention to join. The US and other NATO members will have to provide mutual defense guarantees for the interim period if that is the case, lest Russia attack. The odds that Finland and Sweden remain neutral are higher than the consensus holds (given the 97% odds that they join NATO on Predictit.org). But the latest developments suggest they are moving toward applying for membership. They fear being left in the cold like Ukraine in the event of an attack. Russia’s response will be critical. If Russia deploys nuclear weapons to Kaliningrad, as former President Dmitri Medvedev warned, then Moscow will be making a menacing show but not necessarily changing the reality of Russia’s nuclear strike capabilities. That is equivalent to a pass and could mark the peak of the entire crisis. The geopolitical risk premium would begin to subside after that. Related Report Geopolitical StrategyLe Pen And Other Hurdles (GeoRisk Update) However, Russia has also threatened “military-political repercussions” if the Nordics join NATO. Russia’s capabilities are manifestly limited, judging by Ukraine today and the Winter War of 1939, but a broader war cannot entirely be ruled out. Global financial markets will still need to adjust for a larger tail risk of a war in Finland/Sweden in the very near term. Most likely Russia will retaliate by cutting off Europe’s natural gas. Clearly this is the threat on the table, after the cutoff to Poland and Bulgaria and the warnings to other countries. In the near term, several companies are gratifying Russia and paying for gas in rubles. But these payments violate EU sanctions against Russia and the intention is to wean off Russian imports as soon as possible. Germany says it can reduce gas imports starting next year after inking a deal with Qatar. Hence Russia might take the initiative and start reducing the flow earlier. Bottom Line: If Europe plunges into recession as a result of an immediate natural gas cutoff, then strategic stability between Russia and the West will become less certain. The tail risk of a broader war goes up. Stay cyclically long US equities over global equities and tactically long US treasuries. Stay long defense stocks and gold. Stay Short CNY At the end of last year we argued that Beijing would double down on “Zero Covid” policy in 2022, at least until the twentieth national party congress this fall. Social restrictions serve a dual purpose of disease suppression and dissent repression. Now that the state is doubling down, what will happen next? The economy will deteriorate: imports are already contracting at a rate of 0.1% YoY. The manufacturing PMI has fallen to 48.1 and the service sector PMI to 42.0, indicating contraction. Furthermore, social unrest could emerge, as lockdowns serve as a catalyst to ignite underlying socioeconomic disparities. Hence the national party congress is less likely to go smoothly, implying that investors will catch a glimpse of political instability under the surface in China as the year progresses. The political risk premium will remain high (Chart 3). Chart 3China's Confluence Of Domestic And Foreign Risk Weighs On Stocks And Currency While Chairman Xi Jinping is still likely to clinch another ten years in power, it will not be auspicious amid an economic crash and any social unrest. Xi could be forced into some compromises on either Politburo personnel or policy adjustments. A notable indicator of compromise would be if he nominated a successor, though this would not provide any real long-term assurance to investors given the lack of formal mechanisms for power transfer. After the party congress we expect Xi to “let 100 flowers bloom,” meaning that he will ease fiscal, regulatory, and social policy so that today’s monetary and fiscal stimulus can work effectively. Right now monetary and fiscal easing has limited impact because private sector actors are averse to taking risk. Easing policy to boost the economy could also entail a diplomatic charm offensive to try to convince the US and EU to avoid imposing any significant sanctions on trade and investment flows, whether due to Russia or human rights violations. Such a diplomatic initiative would only succeed, if at all, in the short run. The US cannot allow a deep re-engagement with China since that would serve to strengthen the de facto Russo-Chinese strategic alliance. In other words, an eruption of instability threatens to weaken Xi’s hand and jeopardize his power retention. While it is extremely unlikely that Xi will fall from power, he could have his image of supremacy besmirched. It is likely that China will be forced to ease a range of policies, including lockdowns and regulations of key sectors, that will be marginally positive for economic growth. There may also be schemes to attract foreign investment. Bottom Line: If China expands the range of its policy easing the result could be received positively by global investors in 2023. But the short-term outlook is still negative and deteriorating due to China’s reversion to autocracy and confluence of political and geopolitical risk. Stay short CNY and neutral Chinese stocks. Stay Short KRW South Koreans went to the polls on March 9 to elect their new president for a five-year term. The two top candidates for the job were Yoon Suk-yeol and Lee Jae-myung. Yoon, a former public prosecutor, was the candidate for the People Power Party, a conservative party that can be traced back to the Saenuri and the Grand National Party, which was in power from 2007 to 2017 under President Lee Myung-bak and President Park Geun-hye. Lee, the governor of the largest province in Korea, was the candidate for the Democratic Party, the party of the incumbent President Moon Jae-in. Yoon won by a whisker, garnering 48.6% of the votes versus 47.8% for Lee. The margin of victory for Yoon is the lowest since Korea started directly electing its presidents. President-elect Yoon will be inaugurated in May. He will not have control of the National Assembly, as his party only holds 34% of the seats. The Democratic Party holds the majority, with 172 out of 300 seats. The next legislative election will be in 2024, which means that President Yoon will have to work with the opposition for a good two years before his party has a chance to pass laws on its own. President-elect Yoon was the more pro-business and fiscally restrained candidate. His nomination of Han Duck-soo as his prime minister suggests that, insofar as any domestic policy change is possible, he will be pragmatic, as Han served under two liberal administrations. Yoon’s lack of a majority and nomination of a left-leaning prime minister suggest that domestic policy will not be a source of uncertainty for investors through 2024. Foreign policy, by contrast, will be the biggest source of risk for investors. Yoon rejects the dovish “Moonshine” policy of his predecessor and favors a strong hand in dealing with North Korea. “War can be avoided only when we acquire an ability to launch pre-emptive strikes and show our willingness to use them,” he has argued. North Korea responded by expanding its nuclear doctrine and resuming tests of intercontinental ballistic missiles with the launch of the Hwasong-17 on March 24 – the first ICBM launch since 2017. In a significant upgrade of North Korea’s deterrence strategy, Kim Yo Jong, the sister of Kim Jong Un, warned on April 4 that North Korea would use nuclear weapons to “eliminate” South Korea if attacked (implying an overwhelming nuclear retaliation to any attack whatsoever). Kim Jong Un himself claimed on April 26 that North Korea’s nuclear weapons are no longer merely about deterrence but would be deployed if the country is attacked. President-elect Yoon welcomes the possibility of deploying of US strategic assets to strengthen deterrence against the North. The hawkish turn is not surprising considering that North-South relations failed to make any substantive improvements during President Moon’s five-year tenure as a pro-engagement president. South Koreans, especially Yoon’s supporters, are split on whether inter-Korean dialogue should be continued. They are becoming more interested in developing their own nuclear weapons or at the very least deploying US nuclear weapons in South Korea. Half of South Korean voters support security through alliance with the US, while a third support security through the development of independent nuclear weapons. The nuclear debate will raise tensions on the peninsula. An even bigger change in South Korea’s foreign policy is its policy towards China. President-elect Yoon has accused President Moon of succumbing to China’s economic extortion. Moon had established a policy of “three No’s,” meaning no to additional THAAD missiles in South Korea, no to hosting other US missile defense systems, and no to joining an alliance with Japan and the United States. By contrast, Yoon’s electoral promises include deploying more THAAD and joining the Quadrilateral Dialogue (US, Japan, Australia, India). Polls show that South Koreans hold a low opinion of all of their neighbors but that China has slipped slightly beneath Japan and North Korea in favorability. Even Democratic Party voters feel more negative towards China. While negative attitudes towards China are not unique to Korea, there is an important difference from other countries: the Korean youth dislike China the most, not the older generations. Negative sentiment is less tied to old wounds from the Korean war and more related to ideology and today’s grievances. Younger Koreans, growing up in a liberal democracy and proud of their economic and cultural success, have been involved in campus clashes against Chinese students over Korean support for Hong Kong democrats. Negative attitudes towards China among the youth should alarm investors, as young people provide the voting base for elections to come, and China is the largest trading partner for Korea. Korea’s foreign policy will hew to the American side, at risk to its economy (Chart 4). Chart 4South Korean Geopolitical Risk Rising Under The Radar President-elect Yoon’s policies towards North Korea and China will increase geopolitical risk in East Asia. The biggest beneficiary will be India. Both Korea and Japan need to find a substitute to Chinese markets and labor, which have become less reliable in recent years. South Korea’s newly elected president is aligned with the US and West and less friendly toward China and Russia. He faces a rampant North Korea that feels emboldened by its position of an arsenal of 40-50 deliverable nuclear weapons. The North Koreans now claim that they will respond to any military attack with nuclear force and are testing intercontinental ballistic missiles and possibly a nuclear weapon. The US currently has three aircraft carriers around Korea, despite its urgent foreign policy challenges in Europe and the Middle East. Bottom Line: Stay long JPY-KRW. South Korea’s geopolitical risk premium will remain high. But favor Korean stocks over Taiwanese stocks. Stay Neutral On Hong Kong Stocks Hong Kong’s leadership change will trigger a new bout of unrest (Chart 5). Chart 5Hong Kong: More Turbulence Ahead On April 4, Hong Kong’s incumbent Chief Executive, Carrie Lam, confirmed that she would not seek a second term but would step down on June 30. John Lee, the current chief secretary of Hong Kong, became the only candidate approved to run for election, which is scheduled to be held on May 8. With the backing of the pro-Beijing members in the Election Committee, Lee is expected to secure enough nominations to win the race. Lee served as security secretary from when Carrie Lam took office in 2017 until June 2021. He firmly supported the Hong Kong extradition bill in 2019 and National Security Law in 2020, which provoked historic social unrest in those years. He insisted on taking a tough security stance towards pro-democracy protests. With Lee in power, Hong Kong will face more unrest and tougher crackdowns in the coming years, which will likely bring more social instability. Lee will provoke pro-democracy activists with his policy stances and adherence to Beijing’s party line. For example, his various statements to the news media suggest a dogmatic approach to censorship and political dissent. With the adoption of the National Security Law, Hong Kong’s pro-democracy faction is already deeply disaffected. Carrie Lam was originally elected as a popular leader, with notable support from women, but her popularity fell sharply after the passage of the extradition bill and National Security Law, as well as her mishandling of the Covid-19 outbreak. Her failure to handle the clashes between the Hong Kong people and Beijing damaged public trust in government. Trust never fully recovered when it took another hit recently from the latest wave of the pandemic. Putting another pro-Beijing hardliner in power will exacerbate the trend. Hong Kong equities are vulnerable not merely because of social unrest. During the era of US-China engagement, Hong Kong benefited as the middleman and the symbol that the Communist Party could cooperate within a liberal, democratic, capitalist global order. Hence US-China power struggle removes this special status and causes Hong Kong financial assets to contract mainland Chinese geopolitical risk. As a result of the 2019-2020 crackdown, John Lee and Carrie Lam were among a list of Hong Kong officials sanctioned by the US Treasury Department and State Department in 2020. Now, after the Ukraine war, the US will be on the lookout for any Hong Kong role in helping Russia circumvent sanctions, as well as any other ways in which China might further its strategic aims by means of Hong Kong. Bottom Line: Stay neutral on Hong Kong equities. Favor France Within European Equities French political risk will fall after the presidential election, which recommits the country to geopolitical unity with the US and NATO and potentially pro-productivity structural reforms (Chart 6). France is already a geopolitically secure country so the reduction of domestic political risk should be doubly positive for French assets, though they have already outperformed. And the Russia-West conflict is fueling a risk premium regardless of France’s positive developments. Chart 6France's Domestic Political Risk Will Subside But Russian War Will Keep Geopolitical Risk Elevated The French election ended with a solid victory for the political establishment as we expected. President Emmanuel Macron gaining 58% of the vote to Marine Le Pen’s 42%. Macron beat his opinion polling by 4.5pp while Le Pen underperformed her polls by 4.5pp. A large number of voters abstained, at 28%, compared to 25.5% in 2017. The regional results showed a stark divergence between overseas or peripheral France (where Marine Le Pen even managed to get over half of the vote in several cases) and the core cities of France (where Macron won handily). Macron had won an outright majority in every region in 2017. Macron did best among the young and the old, while Le Pen did best among middle-aged voters. But Macron won every age group except the 50 year-olds, who want to retire early. Macron did well among business executives, managers, and retired people, but Le Pen won among the working classes, as expected. Le Pen won the lowest paid income group, while Macron’s margin of victory rises with each step up the income ladder. Macron’s performance was strong, especially considering the global context. The pandemic knocked several incumbent parties out of power (US, Germany) and required leadership changes in others (Japan, Italy). The subsequent inflation shock now threatens to cause another major political rotation in rapid succession, leaving various political leaders and parties vulnerable in the coming months and years (Australia, the UK, Spain). Only Canada and now France marked exceptions, where post-pandemic elections confirmed the country’s leader. The Ukraine war constitutes yet another shock but it helped Macron, as Le Pen had objective links and sympathies with Russian President Vladimir Putin. Macron’s timing was lucky but his message of structural reform for the sake of economic efficiency still resonates in contemporary France, where change is long overdue – at least compared with Le Pen’s proposal of doubling down on statism, protectionism, and fiscal largesse. The French middle class was never as susceptible to populism as the US, UK, and Italy because it had been better protected from the ravages of globalization. Populism is still a force to be reckoned with, especially if left-wing populists do well in the National Assembly, or if right-wing populists find a fresher face than the Le Pen dynasty. But the failure of populism in the context of pandemic, inflation, and war suggests that France’s political establishment remains well fortified by the economic structure and the electoral system. Whether Macron can sustain his structural reforms depends on legislative elections to be held on June 12-19. Early projections are positive for his party, which should keep a majority. Macron’s new mandate will help. Le Pen’s National Rally and its predecessors may perform better than in the past but that is not saying much as their presence in the National Assembly has been weak. Bottom Line: France is geopolitically secure and has seen a resounding public vote for structural reform that could improve productivity depending on legislative elections. French equities can continue to outperform their European peers over the long run. Our European Investment Strategy recommends French equities ex-consumer stocks, French small caps over large caps, and French aerospace and defense. Favor Spanish Over Italian Stocks Chart 7Italian And Spanish Political Risk Will Rise But Favor Spanish Stocks What about Spain? It is still a “divided nation” susceptible to a rise in political risk ahead of the general election due by December 10, 2023 (Chart 7). In the past few months, a series of strategic mistakes and internal power struggles have led to a significant decline in the popularity of Spain’s largest opposition party, the People’s Party. Due to public infighting and power struggle, Pablo Casado was forced to step down as the leader of the People’s Party on February 23, as requested by 16 of the party’s 17 regional leaders. It is yet to be seen if the new party leader, Alberto Nunez Feijoo, can reboot People’s Party. The far-right VOX party will benefit from the People Party’s setback. The latter’s misstep in a regional election (Castile & Leon) gave VOX a chance to participate in a regional government for the very first time. Hence VOX’s influence will spread and it will receive greater recognition as an important political force. Meanwhile the ruling Socialist Worker’s Party (PSOE) faces anger from the public amid inflation and high energy prices. However, Spanish Prime Minister Pedro Sanchez’s decision to send offensive military weapons to Ukraine is widely supported among major parties, including even his reluctant coalition partner, Unidas Podemos. The People’s Party’s recent infighting gives temporary relief to the ruling party. The Russia-Ukraine issue caused some minor divisions within the government but they are not yet leading to any major political crisis, as nationwide pro-Ukraine sentiment is largely unified. The Andalusia regional election, which is expected this November, will be a check point for Feijoo and a pre-test for next year’s general election. Andalusia is the most populous autonomous community in Spain, consisting about 17% of the seats in the congress (the lower house). The problem for Sanchez and the Socialists is that the stagflationary backdrop will weigh on their support over time. Bottom Line: Spanish political risk is likely to spike sooner rather than later, though Spanish domestic risk it is limited in nature. Madrid faces low geopolitical risk, low energy vulnerability, and is not susceptible to trying to leave the EU or Euro Area. Favor Spanish over Italian stocks. Stay Constructive On South Africa The political and economic status quo is largely unchanged in South Africa and will remain so going into the 2024 national elections. Fiscal discipline will weaken ahead of the election, which should be negative for the rand, but the global commodity shortage and geopolitical risks in Russia and China will probably overwhelm any negative effects from South Africa’s domestic policies. Rising commodity prices have propped up the local equity market and will bring in much-needed revenue into the local economy and government coffers. But structural issues persist. Low growth outcomes amid weak productivity and high unemployment levels will remain the norm. The median voter is increasingly constrained with fewer economic opportunities on the horizon. Pressure will mount on the ruling African National Congress (ANC), fueling civil unrest and adding to overall political risk (Chart 8). Chart 8South Africa's Political Status Quo Is Tactically Positive For Equities And Currency Almost a year has passed since the civil unrest episode of 2021. Covid-19 lockdowns have lifted and the national state of disaster has ended, reducing social tensions. This is evident in the decline of our South Africa GeoRisk indicator from 2021 highs. While we recently argued that fiscal austerity is under way in South Africa, we also noted that fiscal policy will reverse course in time for the 2024 election. In this year’s fiscal budget, the budget deficit is projected to narrow from -6% to -4.2% over the next two years. Government has increased tax revenue collection through structural reforms that are rooting out corruption and wasteful expenditure. But the ANC will have to tap into government spending to shore up lost support come 2024. Already, the ANC have committed to maintaining a special Covid-19 social-grant payment, first introduced in 2020, for another year. This grant, along with other government support, will feature in 2024 and possibly beyond. Unemployment is at 34.3%, its highest level ever recorded. The ANC cannot leave it unchecked. The most prevalent and immediate recourse is to increase social payments and transfers. Given the increasing number of social dependents that higher unemployment creates, government spending will have to increase to address rising unemployment. President Cyril Ramaphosa is still a positive figurehead for the ANC, but the 2021 local elections showed that the ANC cannot rely on the Ramaphosa effect alone. The ANC is also dealing with intra-party fighting. Ramaphosa has yet to assert total control over the party elites, distracting the ANC from achieving its policy objectives. To correct course, Ramaphosa will have to relax fiscal discipline. To this outcome, investors should expect our GeoRisk indicator to register steady increases in political risk moving into 2024. The only reason to be mildly optimistic is that South Africa is distant from geopolitical risk and can continue to benefit from the global bull market in metals. Bottom Line: Maintain a cyclically constructive outlook on South African currency and assets. Tight global commodity markets will support this emerging market, which stands to benefit from developments in Russia and China. Investment Takeaways Stay strategically long gold on geopolitical and inflation risk, despite the dollar rally. Stay long US equities relative to global and UK equities relative to DM-ex-US. Favor global defensives over cyclicals and large caps over small caps. Stay short CNY, TWD, and KRW-JPY. Stay short CZK-GBP. Favor Mexico within emerging markets. Stay long defense and cyber security stocks. We are booking a 5% stop loss on our long Canada / short Saudi Arabia equity trade. We still expect Middle Eastern tensions to escalate and trigger a Saudi selloff. Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Yushu Ma Research Analyst yushu.ma@bcaresearch.com Guy Russell Senior Analyst GuyR@bcaresearch.com Footnotes 1 The campaign in the south suggests that Ukraine will be partitioned, landlocked, and susceptible to blockade in the coming years. If Russia achieves its military objectives, then Ukraine will accept neutrality in a ceasefire to avoid losing more territory. If Russia fails, then it faces humiliation and its attempts to save face will become unpredictable and aggressive. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Geopolitical Calendar
Executive Summary Allies Still Have Faith In USD The Biden administration’s use of sanctions has prompted market speculation about the longevity of the dollar. Yet the DXY has hit 100 and could break out, in the context of rising interest rates and safe-haven demand. The US’s increasingly frequent recourse to economic sanctions is a sign of growing foreign policy challenges. US rivals will continue to diversify away from dollar-denominated reserves. However, from a big picture point of view, there is no clear case that the dollar suffers from US sanctions. When global growth reaccelerates, the dollar can weaken. But until then it will remain resilient. Recommendation (Tactical) Inception Level Inception Date Return Long DXY 96.19 23-FEB-22 5.8% Bottom Line: Tactically stay long DXY and defensives over cyclicals. Feature The US’s aggressive use of sanctions against Russia, in response to its invasion of Ukraine, has prompted market speculation about the future of the global financial and monetary system. Related Report US Political StrategyBiden's Foreign Policy And The Midterms It is helpful to begin with facts – what we really know – before launching into grandiose predictions for the future. For example, while some analysts are predicting the demise of the US dollar’s position as the leading reserve currency, so far global investors have bid up the dollar in the face of rising policy uncertainty (Chart 1). In this report we conduct a short overview of US sanctions policy and draw a few simple investment conclusions. Chart 1US Political Risk And The Dollar US Extra-Territorialism Not Yet Hurting The USD The DXY is now trading at 101.2, above the psychological threshold of 100, suggesting that it could break out above its 2016 102.2 peak. The drivers are an expected sharp rise in real interest rates, in both absolute and relative terms, as the Federal Reserve starts on a rate hike cycle that is expected to add 225 basis points to the Fed funds rate this year alone to combat core inflation of 6.5%. This monetary backdrop must be combined with extreme global political and economic instability to explain the dollar’s potential breakout. The global situation is growing less stable, as EU-Russia energy trade breaks down while China imposes lockdowns to stop the spread of Covid-19. Over the past twenty years, the US has struggled to maintain its global leadership. Washington became distracted by wars in the Middle East and South Asia, a national property market crash and financial crisis, and a spike in political polarization and populism. The US public grew war-weary, while the US faced growing challenges from large and powerful nations that it could not confront militarily. Therefore US policymakers turned to economic tools to try to achieve their objectives: namely sanctions but also tariffs and export controls. Many economists and political scientists have warned that the US’s expanding use of economic sanctions – and broader trend of international, extra-territorial, law enforcement – would drive other countries to sell the US dollar and buy other assets, so as to reduce their vulnerability to US tools. This reasoning is sound, as we can see with Russia, which has reduced its dollar-denominated foreign exchange reserves from 41% to 16% since 2016, while increasing its gold holdings from 15% to 22% over the same period. Other major countries vulnerable to US sanctions could follow in Russia’s footsteps. However, so far, the dollar is not suffering excessively from such moves. On the contrary it is rising. The US started using sanctions aggressively with North Korea in 2005, Iran in 2010, and Russia since 2012. The dollar has fluctuated based on other factors, namely rising when the global commodity and industrial cycle was falling (Chart 2). Chart 2TWUSD And DXY Since 2000 Sanctions are a limited prism through which to examine the dollar. But if there is any observable effect of the US’s turn toward sanctions against major players like Russia in 2012 and China in 2018, it is that it has boosted the dollar rather than hurt it. Obviously that trend could change someday. But for now, as the Ukraine war dramatically heightens the US struggle with its rivals, investors should observe that the dollar is on the verge of a breakout. If the dollar continues to rise, it suggests that the US’s structural turn toward more aggressive economic and financial sanctions is not negative for the dollar. It may be neutral or positive. Cyclically the trade-weighted dollar is nowhere near its 2020 peak and could still fall short of that peak, especially if global tensions subside. But the collapse in the euro has caused the DXY to break above its 2020 peak already. Bottom Line: Stay tactically long DXY while watching whether it can break sustainably above 100 to determine whether our cyclically neutral view should be upgraded. US Sanctions On North Korea In this century, the US began to turn more aggressive in its use of sanctions when it confronted the “Axis of Evil” following the terrorist attacks on September 11, 2001. North Korea withdrew from the Nuclear Non-Proliferation Treaty in 2003 and began to pursue a nuclear and ballistic missile program more intently. The US responded by levying serious sanctions on that state beginning in 2005. Gradually tougher US sanctions never caused a change in the North Korean regime or foreign policy. On the contrary North Korea achieved nuclear weaponization and is today outlining an expansive nuclear doctrine. US sanctions on North Korea were never going to drive global macro trends. However, they could have had an impact on South Korean trends. Initially none of the US sanctions reversed the dollar’s decline against the Korean won. After the global financial crisis in 2008, when the dollar began an uptrend against the won, we observe periods of significant new sanctions in which the won rises and the dollar falls (Chart 3, top panel). The same can be said for the outperformance of US equities relative to South Korean equities – if sanctions had any impact, they simply reinforced the flight to US assets in a globally disinflationary context. The trend was mirrored within the US equity market by the rise of tech versus industrials (Chart 3, bottom panel). Chart 3US Sanctions On North Korea Since Covid-19, the outperformance of US tech is now being overturned by high inflation, which has triggered a vicious selloff in tech. In 2022, global growth is slowing, stagflation is taking shape, and the odds of a recession are rising. Stagflation is negative for both industrials and tech, but more so tech. However, South Korea is still suffering from a deteriorating global macro and geopolitical backdrop, as globalization falters, US-China competition rises, and the US fails to contain North Korean ambitions. Sanctions are a symptom rather than a cause. Bottom Line: US sanctions on North Korea pose no threat to the US dollar. Tactically US industrials can continue to outperform tech but both sectors will suffer in a stagflationary context. US Sanctions On Venezuela The US has slapped sanctions on Venezuela since the early 2000s but these sanctions kicked into high gear in 2015 after President Nicolas Maduro took power and eliminated the last vestiges of democratic and constitutional order. The US recognized the opposition as the legitimate government so sanctions relief will not be easy or convenient. Sanctions have not changed the regime’s behavior, but the regime has all but collapsed and major changes could happen sooner than people expect. Moreover any short-term sanction relief prompted by high oil prices will not be sustainable: the Republican Party will oppose it, hence private US corporations will doubt its durability, and Venezuela’s failing oil industry cannot be revived quickly anyway (Chart 4, top panel). The US has strong relations with Venezuela’s neighbor Colombia. Yet Colombia faces the greatest economic and security risks from Venezuelan instability. The US dollar vastly outstripped the Colombian peso over the past decade, consistent with the US energy sector’s underperformance (Chart 4, bottom panel). Chart 4US Sanctions On Venezuela With Covid-19, this trend reversed because of the global energy squeeze and inflationary environment. The implication was positive for the Colombian peso as well as global (and US) energy sector relative performance. But the peso only marginally improved against the dollar, while US energy outperformance is now stretched. Bottom Line: Energy sector still enjoys macro tailwinds but it is no longer clear that US energy stocks will outperform the broad market for much longer. Favor energy by staying long US energy small caps versus large caps. Also stay long oil and gas transportation and storage sub-sector relative to the broad market. The Biden administration is unlikely to give sanction relief to Venezuela. If it does, it will be ineffective at reducing oil prices in the short term. Either way, there will be little impact on the US dollar. US Sanctions On Iran US policy toward Iran is critical to global stability and energy prices in 2022 and the coming years. US sanctions did not change Iran’s behavior alone, but in league with the P5+1 (the UK, France, China, Russia, plus Germany) sanctions forced Iran to accept limit on its nuclear program in 2015. However, the Trump administration withdrew from that agreement and imposed “maximum pressure” sanctions on Iran in 2018, leading to a sharp depreciation in the market exchange rate of the Iranian toman (Chart 5, top panel). The Saudi Arabian riyal, by contrast, is pegged to the dollar and remains steady except when oil prices collapse (Chart 5, middle panel). The Saudis still rely on the Americans for national security so they are unlikely to abandon the dollar, though they may marginally diversify their foreign exchange reserves. The Biden administration wants to rejoin the 2015 deal but first is trying to extract concessions from Iran. Iran feels limited pressure: while its currency is still weak and inflation high, Iran has not succumbed to social unrest. Iranian oil production and exports are rising amid global high prices (Chart 5, bottom panel). Ultimately Iran wants to continue to advance its nuclear program in line with the North Korean strategy. Hence Biden can rejoin the deal unilaterally if he wants to avoid Middle Eastern instability ahead of the midterm elections. But it would be a short-term, stop-gap agreement and the reduction in oil prices would be fleeting. By contrast, if Biden fails to lift Iran’s sanctions, then the risk of oil disruptions from the Middle East goes way up. Tactically investors should expect upside risks to the oil price, but that would kill more demand and weigh on global growth. Over the past decade the outperformance of US equities relative to Saudi and Emirati equities falls in line with the outperformance of US tech relative to energy sectors. As mentioned, this trend has largely run its course, although it can go further in the short run. But there is a broader trend related to growth versus value styles. The UAE’s stock market is heavily weighted toward financials, while the US is heavily weighted toward tech. The US tech sector has collapsed relative to financials (Chart 6). Chart 5US Sanctions On Iran Chart 6US Sanctions On Iran Bottom Line: US energy and financials sectors can fare reasonably well in a stagflationary context but their outperformance relative to tech is largely priced from a cyclical point of view. US maximum pressure sanctions on Iran never hurt the US dollar. US Sanctions On Russia The US’s extraordinary sanctions against Russia in 2022 – including freezing its dollar-denominated foreign exchange reserves – have sparked market fears that countries will divest from US dollars to protect themselves from any future US sanctions. To be clear, the US has confiscated foreign enemies’ property and foreign exchange reserves in the past. True, Russia is qualitatively different from other countries, such as Iran, because it is one of the world’s great powers. Yet the US closed off all economic and financial linkages with Russia from 1949-1991 because of the Cold War, the very period when the US dollar rose to prominence as the global reserve currency. In 2022, sanctions on Russia have primarily hurt the Russian ruble, not the US dollar (Chart 7). The Russians divested from the dollar after invading Ukraine in 2014 to reduce the impact of sanctions. But they were not able to divest fast enough to prevent the 2022 sanctions from pummeling their financial system and economy. Chart 7US Sanctions On Russia Going forward Russia will be much more insulated from the US dollar but at a terrible cost to long-term productivity. The lesson for other US rivals may be to diversify away from the dollar – but that will be a secondary lesson. The primary lesson will be to take economic stability into account when making strategic security decisions. Economic stability requires ongoing engagement in the global financial system and US dollar system. US sanctions on Russia have benefited US equities and dollar relative to Russian assets as one would expect. Russia’s invasion of Ukraine exacerbated the trend. The takeaway for US investors is that the energy sector’s outperformance sector’s outperformance can continue in the short run but is becoming stretched from a cyclical perspective. Bottom Line: Investors should expect oil and the energy sector to remain strong in the short run, while tech will suffer in an inflationary and stagflationary environment. But energy may not outperform tech for much longer. US Sanctions On China US policy toward China is the critical question today. China holds $1 trillion in dollar-denominated exchange reserves and must recycle around $200 billion in current account surpluses every year into global assets. The US has imposed sweeping sanctions on Iran since 2010, Russia since 2012, and China since 2018. China began diversifying away from dollar-denominated foreign exchange reserves in 2011 in the wake of the Great Recession. The US-initiated trade war in 2018 solidified the change in China’s foreign reserve strategy. The US sanctions against Russia will further solidify it. There are some signs that US punitive measures affected the USD-CNY exchange rate but global economic cycles are far more powerful. The yuan appreciated from 2005 until the global financial crisis, during the height of US-China economic and diplomatic engagement. It depreciated through the manufacturing slowdown of 2015 and the US-China trade war. It appreciated again with the pandemic stimulus and global trade rebound. The yuan was affected by US sanctions and tariffs on the margin amid these larger macro swings (Chart 8, top panel). Still, the overarching trend since 2014 points to a rising dollar and falling yuan. Globalization is in retreat and US-China strategic competition is heating up. As with South Korea, these trends are negative for Chinese assets. US sanctions are a symptom rather than a cause of the underlying macro and geopolitical dynamics. The same point can be made with regard to US equity performance relative to Chinese – and hence US tech outperformance relative to US industrial stocks (Chart 8, bottom panel). However, as with Korea, the cyclical takeaway is to favor industrials over technology in a stagflationary environment. Chart 8US Sanctions On China Bottom Line: Tactically favor US industrials over tech until the world’s stagflationary trajectory is corrected. US-China relations are one area where US sanction policy can hurt the dollar, as China will seek to diversify over time. But so far the evidence is scant. US Sanctions And Foreign Holdings Of Treasuries Having examined US sanctions on a country-by-country basis, we should now turn toward holdings of US dollars and Treasury securities. Are US economic sanctions jeopardizing the willingness of states to hold US assets? First, Americans hold 74% of outstanding treasuries. Foreigners hold the remaining 26% (Chart 9, top panel). This is a large degree of foreign ownership that reflects the US’s openness as an economy, as well as the size of the treasury market, which makes it attractive to foreign savers who need a place to store their wealth. Of this 26%, defense allies hold about 36%. Theoretically up to 17% of treasuries stand at risk of rapid liquidation by non-allied states afraid of US sanctions. But a conservative estimate would be 6%. Notably the share of foreign-held treasuries held by non-allies has fallen from 40% in 2009 to 23% today. Non-allies are reducing their share fairly rapidly (Chart 9, middle panel). What this really means is that China and Hong Kong are reducing their share – from 26% in 2008 to 16% today. Brazil and India have maintained a steady 6% of foreign-held treasuries. Notably the offshore financial centers see a growing share, suggesting that trust in the dollar remains strong even among states and entities that wish to hide their identity. Some of the divestment that has occurred from non-allied states may be overstated due to rerouting through these third parties. Looking at the data in absolute terms, only China – and arguably Brazil – can be said with any certainty to be pursuing a dedicated policy of divesting from US dollar reserves (Chart 10). This makes sense, as China, like Russia, is engaged in geopolitical competition with the US and therefore must take precautions against future US punitive measures. But these measures are not so far generating a worldwide flight from the dollar, either at the micro level or the macro level. Chart 9Foreign Purchases Of US Treasuries Chart 10Foreigners With Large Treasury Holdings In fact, the biggest competitor to the US dollar is the euro. This is clear from looking at the share of global currency reserves – the two are inversely proportional (Chart 11). And yet it is the European Union, not the US, that could suffer a long-term loss of security, productivity, and stability as a result of Russia’s invasion of Ukraine. The euro is losing status as a reserve currency and the war could exacerbate that trend. Chart 11Global Reserve Currency Basket Europe does not provide protection from US sanctions. The EU, like the US, utilizes economic sanctions and the two entities share many similar foreign policy objectives. Europe is also allied with the US through NATO. When the US withdrew from the Iran nuclear deal, the EU did not withdraw, yet EU entities enforced the sanctions, as their economic linkages with the US were much more valuable than those with Iran. In the case of Russia, the two have imposed sanctions in league, as they will likely do toward other small or great powers that attempt to reshape the global order through military force. The next competitors to the dollar and euro are grouped together in Chart 11 above because they are the US’s “maritime allies,” such as Japan, the United Kingdom, and Australia. These countries will pursue a similar foreign policy to the United States and they do not offer protection from US sanctions during times of conflict or war. The true competitor is the Chinese renminbi. The renminbi will grow as a share of global reserves. But it faces serious obstacles from China’s economic policy, currency controls, closed capital account, and geopolitical competition with the United States. Washington’s sanctions have already targeted China yet the US dollar has remained resilient. Bottom Line: The US’s erratic foreign policy in recent decades has potentially weighed on the US’s commanding position as a global reserve currency, with its share of reserves falling from 71% in 2000 to 59% today. But US allies have mostly picked up the slack. And the dollar’s top competitor, the euro, is likely to suffer more than the dollar from the Ukraine war. Still it is true that US sanctions are alienating China, which will continue to diversify away from the dollar. Investment Takeaways Tactically stay long the US dollar (DXY). The combination of monetary policy tightening and foreign policy challenges is driving a dollar rally that could result in a breakout. US sanctions policy is not a convincing reason to sell the dollar in today’s context. Over the medium term dollar diversification poses a risk, although the dollar will still remain the single largest reserve currency over a long-term, strategic horizon. For further discussion see the Special Report by our Foreign Exchange Strategy and Geopolitical Strategy, “Is The Dollar’s Reserve Status Under Threat?” Given US domestic policy uncertainty in an election year, and foreign policy challenges, stay long defensive sectors, namely health care, over cyclical sectors. Tactically our renewable energy trade has dropped sharply. But cyclically it remains attractive, as our recent Special Report with our US Equity Strategy team demonstrates. If Congress fails to succeed in promoting its new climate and energy bill, then this trade could suffer bad news in the near term. Tactically US industrials can continue to outperform the tech sector, given the stagflationary context that is developing. Energy’s outperformance, especially relative to tech, is becoming stretched, at least from a cyclical point of view. But geopolitical trends suggest oil risks are still to the upside tactically. For now, maintain exposure to high energy prices by staying long energy small caps versus large caps and O&G transportation and storage. Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.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 A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets
As expected, French President Emmanuel Macron secured a second term in the final round of the French presidential elections on Sunday, beating far-right rival Marine Le Pen by 58.5% to 41.5%. EUR/USD benefitted from a brief relief rally before reversing…
Listen to a short summary of this report. Executive Summary Small Caps Are Looking Attractive Relative To Their Large Cap Peers Adverse supply shocks have pushed down global growth this year, while pushing up inflation. With the war raging in Ukraine and China trying to contain a major Covid outbreak, these supply shocks are likely to persist for the next few months. Things should improve in the second half of the year. Inflation will come down rapidly, probably even more than what markets are discounting. Global growth will reaccelerate as pandemic headwinds abate. The return of Goldilocks will allow the Fed and other central banks to temper their hawkish rhetoric, helping to support equity prices while restraining bond yields. Unfortunately, this benign environment will sow the seeds of its own demise. Falling inflation during the remainder of the year will lift real incomes, leading to increased consumer spending. Inflation will pick up towards the end of 2023, forcing central banks to turn hawkish again. Trade Inception Level Initiation Date Stop Loss Long iShares Core S&P Small Cap ETF (IJR) / SPDR S&P 500 ETF (SPY) 100 Apr 21/2022 -5% Trade Recommendation: Go long US small caps vs. large caps via the iShares Core S&P Small-Cap ETF (IJR) and the SPDR S&P 500 ETF (SPY). Bottom Line: Global equities are heading towards a “last hurrah” starting in the second half of this year. Stay overweight stocks on a 12-month horizon. Push or Pull? Economists like to distinguish between “demand-pull” and “cost-push” inflation. The former occurs in response to positive demand shocks while the latter reflects negative supply shocks. In order to tell one from the other, it is useful to look at real wages. When real wages are rising briskly, households tend to spend more, leading to demand-pull inflation. In contrast, when wages fail to keep up with rising prices, it is a good bet that we have cost-push inflation on our hands. Chart 1 shows that real wages have been falling across the major economies over the past year. The decline in real wages has coincided with a steep drop in consumer confidence (Chart 2). This points to cost-push forces as the main culprits behind today’s high inflation rates. Chart 1Real Wages Are Declining Chart 2Consumer Confidence Has Soured A close look at the breakdown of recent inflation figures supports this conclusion. The US headline CPI rose by 8.5% year-over-year in March. The bulk of the inflation occurred in supply-constrained categories such as food, energy, and vehicles (Chart 3). Chart 3The Acceleration In Inflation Has Been Driven By Pandemic And War-Impacted Categories The Toilet Paper Economy When the pandemic began, shoppers rushed out to buy essential household supplies including, most famously, toilet paper. Chart 4In A Break From The Past, Goods Prices Soared During The Pandemic The toilet paper used in offices is somewhat different than the sort used at home. So, to some extent, work-from-home (and do other stuff-at-home) arrangements did boost the demand for consumer-grade toilet paper. However, a much more important factor was household psychology. People scrambled to buy toilet paper because others were doing the same. As often occurs in prisoner-dilemma games, society moved from one Nash equilibrium – where everyone was content with the amount of toilet paper they had – to another equilibrium where they wanted to hold much more paper than they previously did. What has gone largely unnoticed is that the toilet paper fiasco was replicated across much of the global supply chain. Worried that they would not have enough intermediate goods on hand to maintain operations, firms began to hoard inputs. Retailers, anxious at the prospect of barren shelves, put in bigger purchase orders than they normally would have. All this happened at a time when demand was shifting from services to goods, and the pandemic was disrupting normal goods production. No wonder the prices of goods – especially durable goods — jumped (Chart 4). Peak Inflation? The war in Ukraine could continue to generate supply disruptions over the coming months. The Covid outbreak in China could also play havoc with the global supply chain. While the number of Chinese Covid cases has dipped in recent days, Chart 5 highlights that 27 out of 31 mainland Chinese provinces are still reporting new cases, up from 14 provinces in the beginning of February. The number of ships stuck outside of Shanghai has soared (Chart 6). Chart 527 Out Of 31 Chinese Provinces Are Reporting New Cases, Up From 14 Provinces In The Beginning Of February Chart 6The Clogged-Up Port Of Shanghai Chart 7Inflation Will Decelerate This Year Thanks To Base Effects Nevertheless, the peak in inflation has probably been reached in the US. For one thing, base effects will push down year-over-year inflation (Chart 7). Monthly core CPI growth rates were 0.86% in April, 0.75% in May, and 0.80% in June of 2021. These exceptionally high prints will fall out of the 12-month average during the next few months. More importantly, goods inflation will abate as spending shifts back toward services. Chart 8 shows that spending on goods remains well above the pre-pandemic trend in the US, while spending on services remains well below. Excluding autos, US retail inventories are about 5% above their pre-pandemic trend (Chart 9). Core goods prices fell in March for the first time since February 2021. Fewer pandemic-related disruptions, and hopefully a stabilization in the situation in Ukraine, could set the stage for sharply lower inflation and a revival in global growth in the second half of this year. How long will this Goldilocks environment last? Our guess is that it will endure until the second half of next year, but probably not much beyond then. As inflation comes down over the coming months, real income growth will rise. What began as cost-push inflation will morph into demand-pull inflation by the end of 2023. The Fed will need to resume hiking at that point, potentially bringing rates to over 4% in 2024. Chart 8Spending On Services Remains Well Below The Pre-Pandemic Trend, While Spending On Goods Is Above It Chart 9Shelves Are Well Stocked In The US Investment Implications Wayne Gretzky famously said that he always tries to skate to where the puck is going to be, not where it has been. Macro investors should follow the same strategy: Ask what the global economy will look like in six months and invest accordingly. The past few months have been tough for the global economy and financial markets. Last week, bullish sentiment fell to the lowest level in 30 years in the American Association of Individual Investors poll (Chart 10). Global growth optimism dropped in April to a record low in the BofA Merrill Lynch Fund Manager Survey. Chart 10AAII Survey: Equity Bulls Are In Short Supply Chart 11The Equity Risk Premium Remains Elevated Yet, a Goldilocks environment of falling inflation and supply-side led growth awaits in the second half of the year. Even if this environment does not last beyond the end of 2023, it could provide a “last hurrah” for global equities. Despite the spike in bond yields, the earnings yield on stocks still exceeds the real bond yield by 5.4 percentage points in the US, and by 7.8 points outside the US (Chart 11). TINA’s siren song may have faded but it is far from silent. Global equities have about 10%-to-15% upside from current levels over a 12-month horizon. We recommend that investors increase allocations to non-US stock markets, value stocks, and small caps over the coming months (see trade recommendation below). Consistent with our view that the neutral rate of interest is higher than widely believed in the US and elsewhere, we expect the 10-year Treasury yield to eventually rise to around 4% in 2024. However, with US inflation likely to trend lower in the second half of this year, we do not expect much upside for yields over a 12-month horizon. If anything, the fact that bond sentiment in the latest BofA Merrill Lynch survey was the most bearish in 20 years suggests that the near-term risk to yields is to the downside. Trade Idea: Go Long US Small Caps Versus Large Caps Small caps have struggled of late. Over the past 12 months, the S&P 600 small cap index has declined 3%, even as the S&P has managed to claw out a 5% gain. At this point, small caps are starting to look relatively cheap (Chart 12). The S&P 600 is trading at 14-times forward earnings compared to 19-times for the S&P 500. Notably, analysts expect small cap earnings to rise more over the next 12 months, as well as over the long term, than for large caps. Chart 12Small Caps Are Looking Attractive Relative To Their Large Cap Peers Chart 13Small Caps Tend To Outperform When Growth Is Picking Up And The Dollar Is Depreciating Small caps tend to perform best in settings where growth is accelerating and the US dollar is weakening (Chart 13). Economic growth should benefit from a supply-side boost later this year as pandemic headwinds fade and more low-skilled workers rejoin the labor market. With inflation set to decline, the need for the Fed to generate hawkish surprises will temporarily subside, putting downward pressure on the dollar. Investors should consider going long the S&P 600 via the iShares Core S&P Small-Cap ETF (IJR) versus the S&P 500 via the SPDR S&P 500 ETF (SPY). Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn Twitter Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Dear Client, Next week, there will not be a written European Investment Strategy report; instead we will host a Webcast on April 26 with Chester Ntonifor, BCA’s Foreign Exchange Strategist. Regards, Mathieu Savary Executive Summary Cyclicals Are Not Cheap Enough Global growth remains fragile as China’s economy becomes increasingly affected by COVID containment measures. The US economy is likely to slow down significantly in the coming months, while Europe flirts with a recession. This time around, monetary policy is unlikely to provide a relief valve. While European equities may inch higher in the coming months, cyclical stocks do not offer the necessary valuation discount relative to defensive equities to compensate investors against these risks. Heed the rotational patterns to guide near-term country and sector allocation. The French election remains an important source of risk, even though President Emmanuel Macron is still the favorite. Bottom Line: Maintain a modest positive bias toward equities, but overweight defensive stocks at the expense of cyclicals. Focus on short-term capital protection by favoring small-cap over momentum stocks, materials over energy, and UK equities over French ones. Chart 1So Far, Defensives Win European equities have experienced a very volatile first quarter, with a maximum drawdown of nearly 23%. Since their March 7th low, they have rebounded 18% but remain 13% below the January 5th high. Apart from the energy sector, defensives have been running the show so far this year (Chart 1). We wrote four weeks ago that the European market is likely to have made its low for the year, but that the volatility of the first quarter of 2022 is likely to continue. We still hold this view. For now, we recommend investors stay long European equities, but defensive sector and country stances are appropriate. Cyclical stocks have corrected, but front-loaded global economic risks create additional downside. Economic Risks Abound The global economic environment remains fragile as headwinds continue to build. Cyclical equities do not seem to have fully discounted this threat. China’s economic outlook constitutes the first hindrance to global growth. COVID cases in Shanghai are surging and many Chinese cities are also witnessing an acceleration in new cases (Chart 2). The Communist Party is still adamant about its zero-tolerance policy, which suggests that these severe lockdowns will become the norm around the country. This situation creates significant downside for Chinese domestic demand, which will prompt a growth slowdown. The service sector is already feeling the pain from the lockdowns. The March import numbers also highlight an abrupt slowdown in the goods sector (Chart 3). In CNY terms, imports contracted 1.7% annually. This is a nominal number. Both global goods and commodity inflation are elevated, and thus, import volumes are weakening sharply. Furthermore, a recent Reuters article indicated that Chinese crude oil imports have already contracted 14% annually. Chart 2China's COVID Problem Chart 3Slowing Chinese Domestic Demand Chart 4Declining Shipping Costs, But For How Long? China’s COVID policy also risks adding new supply chain bottlenecks. Freight within the country is grinding to a halt and ships are queuing up outside the port of Shanghai. As lockdowns multiply around China, risks to global supply chains will increase, hence, the recent decline in shipping rates out of China may soon be undone (Chart 4). This represents a major risk for the global economy, as it would tighten constraints to global economic activity. It also threatens European profitability, as PPI inflation would outpace CPI inflation for longer than anticipated (Chart 4, bottom panel). The US also shows signs of weakness. While a US recession is unlikely, a meaningful deceleration is probable. US consumers are feeling the pinch from surging food and energy prices. Consequently, real wages are contracting 1.8% annually and consumer confidence has plunged (Chart 5). Thankfully, US households have accumulated $185 billion in excess savings since the pandemic began and their net worth has increased by $33 trillion, which should prevent a complete meltdown. Nevertheless, a further deterioration in retail sales is still very likely. Businesses are also increasingly worried. The March NFIB survey shows that Small Business Optimism is falling quickly and that few companies believe it is a good time to expand (Chart 5, bottom panel). Adding to these stresses, the most cyclical sector of the US economy is weakening rapidly. The recent rise in US mortgage rates to 5% is causing a collapse in mortgage applications for house purchases and is behind the 30% tumble suffered by homebuilder stocks (Chart 6). Chart 5US Confidence Is Falling Chart 6Tarnished US Housing Outlook Europe is in a situation worse than the US and is at risk of a recession in the first half of 2022, or, at least, a very severe growth slowdown. As we highlighted six weeks ago, the energy shock in Europe is larger than it is in the US; moreover, Europe does not enjoy the counterweight of a large commodity sector. Recent data confirm that a slowdown is imminent. The ZEW Expectations survey, the German Ifo, and the European Commission’s Consumer Confidence data are all collapsing, which is consistent with a severe shock (Chart 7). To add insult to injury, bond yields continue to rise; therefore, the only relief valve for the region is a weak currency. Global monetary policy is unlikely to come to the rescue of investors anytime soon. The Fed began lifting rates in March and, if the actions of the Bank of Canada and the Reserve Bank of New Zealand are any indication, the FOMC will increase rates by 50bps in May. The OIS curve expects a Fed Funds rate at 2.2% by year-end, which seems appropriate. With a backdrop of weakening growth, a flat yield curve and an additional increase in real rates will feed risk aversion, especially against the cyclical sectors of the market (Chart 8). Chart 7Severe Slowdown In Europe... Or Worse Chart 8Slowing Growth Meets Higher Real Rates The liquidity tightening is not a phenomenon unique to the US. 63% of global central banks have removed monetary accommodation over the past three months (Chart 9). Moreover, our BCA Monetary Index continues to deteriorate. While we cannot characterize global monetary policy as being anywhere close to tight right now, cyclical equities remain vulnerable to the liquidity slowdown. Bottom Line: The global economy is likely to deteriorate in the coming months. The impact of COVID-19 on Chinese growth will only increase, while Europe flirts with a recession in the first half of the year. Meanwhile, US growth faces swelling headwinds. Expect a meaningful deterioration in global economic surprises (Chart 10). In this context, tighter policy will feed risk aversion, which will create a particularly strong headwind for cyclical stocks. Chart 9A Global Tightening Chart 10Economic Surprises Will Fall European Cyclicals Remain Vulnerable This backdrop is not equity-friendly and points to meagre returns over the next three to six months. Nonetheless, European stocks will not generate negative returns over this time frame because European benchmarks already discount a significant portion of the negative news, as illustrated by the surge in their earnings yield (Chart 11). Importantly, inflation in Europe should peak over the summer as the commodity impulse is decelerating (Chart 11, bottom panel). Therefore, fears of stagflation will recede, which will help aggregate European shares (Chart 12). Chart 11European Stocks Already Discount A Lot Chart 12Ebbing Stagflation Fears Will Help European Equities The consequence of the additional slowdown in global growth is likely to be reflected in the relative performance of European cyclical sectors. Already, Swedish economic growth and asset prices have deteriorated (Chart 13). This poor performance does not bode well for cyclical assets, considering the heightened sensitivity of Swedish assets to the global industrial cycle. More signals point to downside for the cyclical/defensive split. While the short-term momentum of the performance of cyclicals relative to defensives is becoming oversold, its 40-week rate of change has yet to reach a paroxysm (Chart 14). Additionally, cyclicals have not experienced the kind of valuation discount associated with a full discounting of the economic and monetary headwinds described in the previous section (Chart 14, bottom panel). Chart 13Heed Sweden's Message Chart 14Cyclicals Are Not Cheap Enough The commodity sector is also at risk of a pullback. China’s economic slowdown is likely to hurt commodity demand. While this will not end the secular commodity bull market underpinned by a lack of supply capacity, it could easily cause a significant correction in commodity prices. If, as we anticipate, inflation slows this summer, the inflation-hedging demand for commodities will also pause. These dynamics would hurt mining stocks, which have avoided a serious pullback, as well as the energy sector. Thus, a correction in commodities would cause additional weaknesses for the cyclicals-to-defensives ratio (Chart 15). Yields create a supplemental risk. Historically, rising US yields and inflation expectations correlate with an outperformance of cyclical shares. However, in 2022, cyclicals have bifurcated from yields and CPI swaps (Chart 16), because higher yields currently do not signal reflation but stagflation. If yields rise further, it will hurt growth prospects and damage cyclicals. If they fall, it will likely reflect increasing growth fears, which is also negative for cyclicals. Moreover, falling yields will hurt the profit margins of financials, which are a large component of cyclicals. Therefore, cyclicals seem stuck in a lose-lose situation with respect to yields. Chart 15The Commodity Link Chart 16Yields and Cyclicals: A Lose-Lose Proposition The strength in the dollar creates the last major hurdle for cyclicals. A strong dollar both tightens global financials conditions and indicates weak growth ahead. Consequently, it often heralds a period of softness in the cyclicals-to-defensives ratio (Chart 17). How should investors position themselves? We have a long-held preference for telecommunication services stocks over consumer discretionary equities and for healthcare relative to tech shares. These trades have respectively generated hefty gains of 32% and 13% since June 2021, but they are becoming long in the tooth (Chart 18). Chart 17A Strong Dollar Hurts Cyclicals Chart 18Hedges Have Performed Strongly Related Report European Investment StrategyThe Great Rotation As an alternative, we recommend investors stay nimble and use our Excess Returns Rotation Approach expanded in a Special Report two months ago. Below, you will find the new trades suggested by this process. Bottom Line: Cyclicals remain vulnerable. They have not reached the kind of valuation discount necessary to compensate investors for weaker growth and tighter monetary policy. To hedge against these risks, we recommended selling consumer discretionary relative to telecom stocks and tech shares relative to healthcare. However, investors should not add to those trades to mitigate against further weaknesses in cyclical stocks. Instead, investors should focus on relative rotational patterns (see next section). Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Excess Returns Rotation Maps: An Update1 European Investment Styles The most noteworthy move comes from small-cap stocks, going from the “Lagging” quadrant to the “Leading” one rapidly (Chart 19). This is consistent with our view that European small-cap equities’ outperformance has further to run. The attractiveness of value stocks is thinning relative to growth stocks (Table 1). Chart 19Relative Rotation Graph: European Investment Styles Table 1European Investment Styles Positioning Trade Recommendations (12-Month Horizon): Volatility stocks relative to momentum (unchanged) Small-cap stocks relative to momentum (new) European Sectors Chart 20 illustrates the wild ride in European equity markets in the wake of the Ukraine/Russia conflict. Most sectors experienced violent swings, moving rapidly across several quadrants. Only consumer discretionary, tech, and utilities stocks have remained in the same quadrant, the former two in “Lagging” and the latter in “Leading.” Interestingly, the European energy sector has moved into the “Weakening” quadrant (Table 2). We are taking profit on our Long Energy / Short Financials recommendation. It delivered 14% returns since mid-February and is getting long in the tooth. Chart 20Relative Rotation Graph: European Sectors Table 2European Sectors Positioning Trade Recommendations (12-Month Horizon): Materials over energy (unchanged) Energy over financials (unchanged) Tech over communication services (unchanged) Utilities over healthcare (new) Communication services over healthcare (new) Consumer discretionary over healthcare (new) European National Markets Sectoral biases dictate the rotational patterns exhibited by European national bourses (Chart 21). The cyclicality of the German, French, and Italian markets caused them to lag behind their European counterparts. Meanwhile, the Dutch market remains solidly in the Lagging quadrant, mirroring tech equities. Only Spain and Sweden have shown signs of improvement over the past twelve weeks and should outperform the European benchmark over the short term (Table 3). Chart 21Relative Rotation Graph: European National Markets Table 3European National Markets Positioning Trade Recommendations (12-Month Horizon): UK stocks over Dutch ones (new) UK stocks over French ones (new) Italian stocks over Swedish ones (new) UK stocks over Swedish ones (new) French Elections: Preparing For The Second Round The first round of the French presidential elections did not surprise. As in 2017, incumbent President Emmanuel Macron will face Marine Le Pen in the second round. Beyond this expected outcome, two important takeaways will be crucial in the second round: The collapse of traditional right-wing (Les Républicains) and left-wing (Parti Socialiste) parties. Far-left candidate Jean-Luc Mélenchon surprised to the upside with 22% of votes, right behind Marine Le Pen. The key implication is that the vote transfer has become more favorable to Macron (Diagram 1). In 2017, Marine Le Pen created the surprise and bested center-right candidate François Fillon by the narrowest of margins. As a result, Le Pen’s attempt to appeal to Fillon’s voters was a real threat. Today, the third largest pool of voters belongs to far-left candidate Mélenchon, who has already called upon his voters “not to give a single vote to Marine Le Pen.” Diagram 1Extrapolating France’s First-Round Election To The Second Round How does it translate into voting intentions for the second round? Assuming a full transfer of votes from the defeated candidates based on the support they made public, Macron will crush Marine Le Pen as he did in 2017. However, this is unlikely, since many voters feel stuck between a rock and a hard place, and may decide not to vote. Related Report European Investment StrategyFrance: Macron And Macro Assuming Macron obtains only half of the voting intentions from other parties, while Marine Le Pen retains the full support from other far-right candidates’ voters, acquires half of the center-right votes, and secures a quarter of Mélenchon’s votes, the outcome will be much narrower at 53.4% vs. 46.6% in favor of Macron. This is in line with national polls. Two weeks ago, we presented the investment implications of a second Macron mandate. Since then, we have received many questions about the market consequences should Marine Le Pen enjoy a surprise victory. While this is not our base-case, we cannot rule out the possibility of a negative shock to the markets. Chart 22A Le Pen Surprise Victory Would Hurt The Euro The only certainty within this very uncertain outcome is that Marine Le Pen would be constrained by a strong opposition in the Assemblée Nationale. Although she has changed her stance on “Frexit,” her presidency would undoubtfully carry an increased geopolitical risk within the European Union (EU) and hurt European unity and integration efforts. Thus, the resulting French isolationism would be synonymous with a weaker euro (Chart 22). French assets would be de-rated because her presidency would reverse previous reform efforts, which would hurt trend GDP growth, productivity, and the role of France within the EU. These trends are not only negative for stocks, but they would also put long-term upward pressure on OATs yields as French public finances would deteriorate meaningfully under a populist Le Pen presidency. In this context, underweighting both French equities and government bonds would be warranted. Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com Footnotes Tactical Recommendations Cyclical Recommendations Structural Recommendations