US Dollar
Highlights The Biden administration’s early actions suggest it will be hawkish on China as expected – and the giant Microsoft hack merely confirms the difficulty of reducing strategic tensions. US-China talks are set to resume and piecemeal engagement is possible. However, most of the areas of engagement touted in the media are overrated. Competition will prevail over cooperation. Cybersecurity stocks have corrected, creating an entry point for investors seeking exposure to a secular theme of Great Power conflict in the cyber realm and beyond. Global defense stocks are even more attractive than cyberstocks as a “back to work” trade in the geopolitical context. Continue to build up safe-haven hedges as geopolitical risk remains structurally elevated and underrated by financial markets. Feature The Biden administration passed its first major law, the $1.9 trillion American Rescue Plan, on March 10. This gargantuan infusion of fiscal stimulus accounts for about 2% of global GDP and 9% of US GDP, a tailwind for risky assets when taken with a receding pandemic and normalizing global economy. The US dollar has perked up so far this year on the back of this extraordinary pump-priming and the rapid rollout of COVID-19 vaccines, which have lifted relative growth expectations with the rest of the world. Hence the dollar is rising for fundamentally positive reasons that will benefit global growth rather than choke it off. Our Foreign Exchange Strategist Chester Ntonifor argues that the dollar has 2-3% of additional upside before relapsing under the weight of rising global growth, inflation expectations, commodity prices, and relative equity flows into international markets. We agree with the dollar bear market thesis. But there are two geopolitical risks that investors must monitor: Cyclically, China’s combined monetary and fiscal stimulus is peaking, growth will decelerate, and the central government runs a non-negligible risk of overtightening policy. However, China’s National People’s Congress so far confirms our view that Beijing will not overtighten. Structurally, the US-China cold war is continuing apace under President Biden, as expected. The two sides are engaging in normal diplomacy as appropriate to a new US administration but the Microsoft Exchange hack (see below) underscores the trend of confrontation over cooperation. Chart 1Long JPY / Short KRW As Geopolitical Risk Is Underrated The second point reinforces the first since persistent US pressure on China will discourage it from excessive deleveraging at home. In a world where China is struggling to cap excessive leverage, the US is pursuing “extreme competition” with China (Biden’s words), and yet the US rule of law is intact, global investors will not abandon the US dollar in a general panic and loss of confidence. They will, however, continue to diversify away from the dollar on a cyclical basis given that global growth will accelerate while US policy will remain extremely accommodative. Reinforcing the point, geopolitical frictions are rising even outside the US-China conflict. A temporary drop in risk occurred in the New Year as a result of the rollout of vaccines, the defeat of President Trump, and the resolution of Brexit. But going forward, geopolitical risk will reaccelerate, with various implications that we highlight in this report. While we would not call an early end to the dollar bounce, we will keep in place our tactical long JPY-USD and long CHF-USD hedges. These currencies offer a good hedge in the context of a dollar bear market and structurally high geopolitical risk. If the dollar weakens anew on good news for global growth then the yen and franc will benefit on a relative basis as they are cheap, whereas if geopolitical risk explodes they will benefit as safe havens. We also recommend going long the Japanese yen relative to the South Korean won given the disparity in valuations highlighted by our Emerging Markets team, and the fact that geopolitical tensions center on the US and China (Chart 1). “Our Most Serious Competitor, China” Why are we so sure that geopolitical risk will remain structurally elevated and deliver negative surprises to ebullient equity markets? Our Geopolitical Power Index shows that China’s rise and Russia’s resurgence are disruptive to the US-led global order (Chart 2). If anything this process has accelerated over the COVID-19 crisis. China and Russia have authoritarian control over their societies and are implementing mercantilist and autarkic economic policies. They are carving out spheres of influence in their regions and using asymmetric warfare against the US and its allies. They have also created a de facto alliance in their shared interest in undermining the unity of the West. The US is meanwhile attempting to build an alliance of democracies against them, heightening their insecurities about America’s power and unpredictability (Chart 3). Chart 2Great Power Struggle Continues Massive fiscal and monetary stimulus is positive for economic growth and corporate earnings but it reduces the barriers to geopolitical conflict. Nations can pursue foreign and trade policies in their self-interest with less concern about the blowback from rivals if they are fueled up with artificially stimulated domestic demand. Chart 3Biden: ‘Our Most Serious Competitor, China’ Total trade between the US and China, at 3.2% and 4.7% of GDP respectively in 2018, was not enough to prevent trade war from erupting. Today the cost of trade frictions is even lower. The US has passed 25.4% of GDP in fiscal stimulus so far since January 1, 2020. China’s total fiscal-and-credit impulse has risen by 8.4% of GDP over the same time period. The Biden administration is co-opting Trump’s hawkish foreign and trade policy toward China, judging by its initial statements and actions (Appendix Table 1). Specifically, Biden has issued an executive order on securing domestic supply chains that demonstrates his commitment to the Trumpian goal of diversifying away from China and on-shoring production, or at least offshoring to allied nations. The Democratic Party is also unveiling bipartisan legislation in Congress that attempts to reduce reliance on China.1 These executive decrees are partly spurred on by the global shortage of semiconductors. China, the US, and the US’s allies are all attempting to build alternative semiconductor supply chains that bypass Taiwan, a critical bottleneck in the production of the most advanced computer chips. The Taiwanese say they will coordinate with “like-minded economies” to alleviate shortages, by which they mean fellow democracies. But this exposes Taiwan to greater geopolitical risk insofar as it excludes mainland China from supplies, either due to rationing or American export controls. The surge in semiconductor sales and share prices of semi companies (especially materials and equipment makers) will continue as countries will need a constant supply of ever more advanced chips to feed into the new innovation and technology race, the renewable energy race, and the buildout of 5G networks and beyond (Chart 4). It takes huge investments of time and capital to build alternative fabrication plants and supply lines yet governments are only beginning to put their muscle into it via stimulus packages and industrial policy. Chart 4Semiconductor Supply Shortage Supply shocks have geopolitical consequences. The oil shocks of the 1970s and early 1990s motivated the US to escalate its interventions and involvement in the Middle East. They also motivated the US to invest in stockpiles of critical goods and alternative sources of production so as to reduce dependency (Chart 5). Although semiconductors are not fungible like commodities, and the US has tremendous advantages in semiconductor design and production, nevertheless the bottleneck in Taiwan will take years to alleviate. Hence the US will become more active in supply security at home and more active in alliance-building in Asia Pacific to deter China from taking Taiwan by force or denying regional access to the US and its allies. China faces the same bottleneck, which threatens its technological advance, economic productivity, and ultimately its political stability and international defense. Chart 5ASupply Shortages Motivate Strategic Investments Chart 5BSupply Shortages Motivate Strategic Investments Semiconductor and semi equipment stock prices have gone vertical as highlighted above but one way to envision the surge in global growth and capex for chip makers is to compare these stocks relative to the shares of Big Tech companies in the communication service sector, i.e. those involved in social networking and entertainment, such as Twitter, Facebook, and Netflix. On a relative basis the semi stocks can outperform these interactive media firms which face a combination of negative shocks from rising interest rates, regulation, economic normalization, and ideologically fueled competition (Chart 6). Chart 6Long Chips Versus Big Tech What about the potential for the US and China to enhance cooperation in areas of shared interest? Generally the opportunity for re-engagement is overrated. The Biden administration says there will be engagement where possible. The first high-level talks will occur in Alaska on March 18-19 between Secretary of State Antony Blinken, National Security Adviser Jake Sullivan, Central Foreign Affairs Commissioner Yang Jiechi, and Foreign Minister Wang Yi. Presidents Biden and Xi Jinping may hold a bilateral summit sometime soon and the old strategic and economic dialogue may resume, enabling cabinet-level officials to explore a range of areas for cooperation independently of high-stakes strategic negotiations. However, a close look at the policy areas targeted for engagement reveals important limitations: Health: There is little room for concrete cooperation on the COVID-19 pandemic given that the pandemic is already receding, the Chinese have not satisfied American demands for data transparency, Chinese officials have fanned theories that the virus originated in the US, and the US is taking measures to move pharmaceutical and health equipment supply chains out of China. Trade: Trade is an area of potential cooperation given that the two countries will continue trading while their economies rebound. The Phase One trade deal remains in place. However, China only made structural concessions on agriculture in this deal so any additional structural changes will have to be the subject of extensive negotiations. Secretary of Treasury Janet Yellen says the US will use the “full array of tools” to ensure compliance and will punish China for abuses of the global trade system. Cybersecurity: On cybersecurity, China greeted the Biden administration by hacking the Microsoft Exchange email system, an even larger event than Russia’s SolarWinds hack last year. Both hacks highlight how cyberspace is a major arena of modern Great Power struggle, making it unlikely that there will be effective cooperation. The hack suggests Beijing remains more concerned about accessing technology while it can than reducing tensions. The Americans will make demands of China at the Alaska meetings. Environment: As for the environment, the US is a net oil exporter while China imports 73% of its oil, 42% of its natural gas and 7.8% of its coal consumption, with 40% and 10% of its oil and gas coming from the Middle East. The US wants to be at the cutting edge of renewable energy technology but it has nowhere near the impetus of China (or Europe), which are diversifying away from fossil fuels for the sake of national security. Moreover China will want its own companies, not American, to meet its renewable needs. This is true even if there is success in reducing barriers for green trade, since the whole point of diversifying from Middle Eastern oil supplies is strategic self-sufficiency. The Americans would have to accept less energy self-sufficiency and greater renewable dependence on China. Nuclear Proliferation: Cooperation can occur here as the Biden administration will seek to return to a deal with the Iranians restraining their nuclear ambitions while maintaining a diplomatic limiting North Korea’s nuclear weapons stockpile and ballistic missile development. China and Russia will accept the US rejoining the 2015 Iranian nuclear deal but they will require significant concessions if they are to join the US in forcing anything more substantial on the Iranians. China may enforce sanctions on North Korea but then it will expect concessions on trade and technology that the Biden administration will not want to give merely for the sake of North Korea. Bottom Line: The Biden administration’s China strategy is taking shape and it is hawkish as expected. It is not ultra-hawkish, however, as the key characteristic is that it is a defensive posture in the wake of the perceived failures of Trump’s strategy of “attack, attack, attack.” This means largely maintaining the leverage that Trump built for the US while shifting the focus to actions that the US can take to improve its domestic production, supply chain resilience, and coordination with allied producers. Punitive measures are an option, however, and if relations deteriorate over time, as expected, they will be increasingly relied on. Buy The Dip In Cybersecurity Stocks A linchpin of the above analysis is the Microsoft Exchange hack, which some have called the largest hack in US history, since it confirms the view that the Biden administration will not be able to de-escalate strategic tensions with China much. China has been particularly frantic to acquire technology through hacking and cyber-espionage over the past decade as it attempts to achieve a Great Leap Forward in productivity in light of slowing potential growth that threatens single-party rule over the long run. The breakdown in ties between Presidents Barack Obama and Xi Jinping occurred not only because of Xi’s perceived violation of a personal pledge not to militarize the South China Sea but also because of the failure of a cybersecurity cooperation deal between the two. When the Trump administration arrived on the scene it sought to increase pressure on China and cybersecurity was immediately identified as an area where pushback was long overdue. Cyber conflict is highly likely to persist, not only with Russia but also with China. Cyber operations are a way for states to engage in Great Power struggle while still managing the level of tensions and avoiding a military conflict in the real world. The cyber realm is a realm of anarchy in which states are insecure about their capabilities and are constantly testing opponents’ defenses and their own offensive capabilities. They can also act to undermine each other with plausible deniability in the cyber realm, since multiple state and quasi-state actors and a vast criminal underworld make it difficult to identify culprits with confidence. Revisionist states like China, North Korea, Russia, and Iran have an advantage in asymmetric warfare, including cyber, since it enables them to undermine the US and West without putting their weaker conventional forces in jeopardy. Cybersecurity stocks have corrected but the general up-trend is well established and fully justified (Chart 7). It is not clear, however, that investors should favor cybersecurity stocks over the general NASDAQ index (Chart 8). The trend has been sideways in recent years and is trying to form a bottom. Cybersecurity stocks are volatile, as can be seen compared to tech stocks as a whole, and in both cases the general trend is for rising volatility as the macro backdrop shifts in favor of higher interest rates and inflation expectations (Chart 9). Chart 7Cyber Security Stocks Corrected Chart 8Major Hacks Failed To Boost Cyber Vs NASDAQ Chart 9Volatility Of Cyber & Tech Stocks Rising Great Power struggle will not remain limited to the cyber realm. There is a fundamental problem of military insecurity plaguing the world’s major powers. Furthermore the global economic upturn and new energy and industrial innovation race will drive up commodity prices, which will in turn reactivate territorial and maritime disputes. Turf battles will re-escalate in the South and East China Seas, the Persian Gulf and Indian Ocean basin, the Mediterranean, and even the Baltic Sea and Arctic. One way to play this shift is as a geopolitical “back to work” trade – long defense stocks relative to cybersecurity stocks (Chart 10). The global defense sector saw a run-up in demand, capital expenditures, and profits late in the last business cycle. That all came crashing down with the pandemic, which supercharged cybersecurity as a necessary corollary to the swarm of online activity as households hunkered down to avoid the virus and obey government social restrictions. Cybersecurity stocks have higher EV/EBITDA ratios and lower profit margins and return on equity compared to defense stocks or the broad market. Chart 10Long Defense / Short Cyber Security: 'Back To Work' For Geopolitics The trade does not mean cybersecurity stocks will fall in absolute terms – we maintain our bullish case for cybersecurity stocks – but merely that defense stocks will make relative gains as economic normalization continues in the context of Great Power struggle. Bottom Line: Structurally elevated geopolitical risks will continue to drive demand for cybersecurity in absolute terms. However, we would favor global defense stocks on a relative basis. The US Is Not As War-Weary As People Think America is consumed with domestic divisions and distractions. Since 2008 Washington has repeatedly demonstrated an unwillingness to confront foreign rivals over small territorial conquests. This risk aversion has created power vacuums, inviting ambitious regional powers like China, Russia, Iran, and Turkey to act assertively in their immediate neighborhoods. However, the US is not embracing isolationism. Public opinion polling shows Americans are still committed to an active role in global affairs (Chart 11). The 2020 election confirms that verdict. Nor are Americans demanding big cuts in defense spending. Only 31% of Americans think defense spending is “too much” and only 12% think the national defense is stronger than it needs to be (Chart 12). Chart 11No Isolationism Here True, the Democratic Party is much more inclined to cut defense spending than the Republicans. About 43% of Democrats demand cuts, while 32% are complacent about the current level of spending (compared to 8% and 44% for Republicans). But it is primarily the progressive wing of the party that seeks outright cuts and the progressives are not the ones who took power. Chart 12Americans Against ‘Forever Wars’ But Not Truly Dovish Biden and his cabinet represent the Washington establishment, including the military-industrial complex. Even if Vice President Kamala Harris should become president she would, if anything, need to prove her hawkish credentials. Defense spending cuts might be projected nominally in Biden’s presidential budgets but they will not muster majorities in the two narrowly divided chambers of Congress. Biden has co-opted Trump’s (and Obama’s) message of strategic withdrawal and military drawdown. He is targeting a date of withdrawal from Afghanistan on May 1, notwithstanding the leverage that a military presence there could yield in its priority negotiations with Iran. Yet he is not jeopardizing the American troop presence in Germany and South Korea, much more geopolitically consequential spheres of action in a long competition with Russia and China. While it is true (and widely known) that Americans have turned against “forever wars,” this really means Middle Eastern quagmires like Iraq and Afghanistan and does not mean that the American public or political establishment have truly become anti-war “doves.” The US public recognizes the need to counter China and Russia and Congress will continue appropriating funds for defense as well as for industrial policy. The Biden administration will increase awareness about the risks of a lack of deterrence and alliance-building. This is especially apparent given the military buildup in China. The annual legislative session has revealed an important increase in military focus in Beijing in the context of the US rivalry. Previously, in the thirteenth five-year plan and the nineteenth National Party Congress, the People’s Liberation Army aimed to achieve “informatization and mechanization” reforms by 2020 and total modernization by 2035. However, at the fifth plenum of the central committee in October, the central government introduced a new military goal for the PLA’s 100th anniversary in 2027 – a “military centennial goal” to match with the 2021 centennial of the Communist Party and the 2049 centennial goal of the founding of the People’s Republic. While details about this new military centenary are lacking, the obvious implication is that the Communist Party and PLA are continuing to shift the focus to “fighting and winning wars,” particularly in the context of the need to deter the United States. The official defense budget is supposed to grow 6.8% in 2021, only slightly higher than the 6.6% goal in 2020, but observers have long known that China’s military budget could be as much as twice as high as official statistics indicate. The point is that defense spending is going up, as one would expect, in the context of persistent US-China tensions. Bottom Line: Just as US-China cooperation will be hindered by mutual efforts to reduce supply chain dependency and support domestic demand, so too it will be hindered by mutual efforts to increase defense readiness and capability in the event of military conflict. The beneficiary of continued high levels of US defense spending and Chinese spending increases – in the context of a more general global arms buildup – will be global arms makers. Investment Takeaways Geopolitical risk remains structurally elevated despite the temporary drop in tensions in late 2020 and early 2021. The China-backed Microsoft Exchange hack reinforces the Biden administration’s initial foreign policy comments and actions suggesting that US policy will remain hawkish on China. While Biden will adopt a more defensive rather than offensive strategy relative to Trump, there is no chance that he will return to the status quo ante. The Obama administration itself grew more hawkish on China in 2015-16 in the face of cyber threats and strategic tensions in the South China Sea. Cybersecurity stocks will continue to benefit from secular demand in an era of Great Power competition where nations use cyberattacks as a form of asymmetric warfare and a means of minimizing the risks of conflict. The recent correction in cybersecurity stocks creates a good entry point. We closed our earlier trade in January for a gain of 31% but have remained thematically bullish and recommend going long in absolute terms. We would favor defense over cybersecurity stocks as a geopolitical version of the “back to work” trade in which conventional economic activity revives, including geopolitical competition for territory, resources, and strategic security. Defense stocks are undervalued and relative share prices are unlikely to fall to 2010-era lows given the structural increase in geopolitical risk (Chart 13). Chart 13Global Defense Stocks Oversold Chart 14Global Defense Stocks Profitable, Less Indebted Defense stocks have seen profit margins hold up and are not too heavily burdened by debt relative to the broad market (Chart 14). Defense stocks have a higher return on equity than the average for non-financial corporations and cash flow will improve as a new capex cycle begins in which nations seek to improve their security and gain access to territory and resources (Chart 15). Chart 15Defense Stocks: High RoE, Capex Will Revive Chart 16Discount On Global Defense Stocks Valuation metrics show that global defense stocks are trading at a discount (Chart 16). Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Appendix Table 1 Appendix Table 1Biden Administration's First 100 Days: Key Statements And Actions On China Footnotes 1 See Federal Register, "America’s Supply Chains", Mar. 1, 2021, federalregister.gov and Richard Cowan and Alexandra Alper, "Top U.S. Senate Democrat directs lawmakers to craft bill to counter China", Feb. 23, 2021, reuters.com.
Please note that we will be presenting a webcast on Thursday March 11 at 10:00 AM EST for the Americas and EMEA regions and on March 12 at 9:00 HKT/12:00 AEDT for APAC clients. We will be discussing macro themes and investment strategies. Highlights EMs (ex-China, Korea and Taiwan) are better positioned to handle higher US bond yields today than they were in 2013. Yet better does not mean they will be unscathed. The combination of rising US bond yields and a firming US currency will suffocate EM risk assets in the near-term. A neutral allocation is warranted in EM stocks and credit markets within global equity and credit portfolios, respectively. Feature Ever since the US elections concluded in January with a Blue Sweep, we have been warning that rising US bond yields could trigger a setback in global markets in general, and in EM markets in particular. EM equities, currencies and fixed-income markets have recently experienced a correction (Chart 1). The question now is: Is the market rout over? Or is there more to come? We are inclined to believe that the correction is not over. Rising US Treasury yields have been the culprit of the shakeout in global growth stocks, EM equities, as well as EM currencies. Therefore, taking a stance on US bond yields and on the US dollar is critical for assessing the outlook for EM financial markets. Odds are that the selloff in US long-term bonds and the rebound in the US dollar are not yet over because: Positioning and sentiment on US long-dated Treasuries is neutral, as illustrated in Chart 2. Chart 1Rising US Real Yields Have Caused A Shakeout In EM Chart 2Investor Sentiment And Positioning In US Treasurys Are Neutral Typically, US bond yields do not reverse their ascent until investor sentiment becomes downbeat and bond portfolios are of materially short duration. These conditions for a top in bond yields are not yet present. US government bond yields would have been much higher if it were not for the Federal Reserve and US commercial banks’ massive bond-buying spree. The Fed has bought $2.8 trillion and US commercial banks have purchased about $300 billion of Treasurys in the past 12 months (Chart 3). One of the main motives for commercial banks to buy US Treasurys has been the SLR relief initiative which commenced on April 1, 2020.1 This SLR relief is due to terminate on March 31, 2021. Unless it is extended, commercial banks will drastically curtail their net government bond purchases. This will exert upward pressure on Treasury yields. Regarding the greenback, investor sentiment remains quite bearish (Chart 4). From a contrarian perspective, this heralds further strength in the US dollar. Chart 3Surging Purchases Of US Treasurys By The Fed And Commercial Banks Chart 4Investors Are Still Bearish On The US Dollar From a cyclical perspective, US growth will be stronger relative to its potential, and vis-à-vis other DMs, EMs and China. Growth differentials moving in favor of the US foreshadows near-term strengthening of the dollar. Structurally, the bearish case for the US currency hinges on both the Federal Reserve falling behind the inflation curve and ballooning US twin deficits. In our view, this will ultimately be the case. Hence, the long-term outlook for the US dollar remains troublesome. That said, twin deficits alone are insufficient to produce a continuous currency depreciation. The twin deficits must also be accompanied with low/falling real interest rates – in order to generate sufficient conditions for currency depreciation. As long as US real rates continue rising, the dollar’s rebound will be extended. The USD/EUR exchange rate has been correlated with the 10-year real yield differential and this relationship will persist (Chart 5). Bottom Line: US government bonds will continue selling off. Rising bond yields (including rising real yields) will support the dollar in the near-term. The combination of rising US bond yields and a firming US currency will cause global macro volatility to rise (Chart 6). This will suffocate EM risk assets and EM currencies. Chart 5US Real Yields (TIPS) Will Continue Driving The US Dollar Chart 6Aggregate Financial Market Volatility: Higher Lows Impact On EM: 2013 Versus Now Are we entering another Taper Tantrum episode as in the spring of 2013 when many EMs were devastated? There are both similarities and differences between the current period of rising US bond yields and the 2013 episode. Similarities: Today, as in early 2013, investor sentiment on EM is very bullish and investors are long EM (Chart 7). Chart 7Investor Sentiment On EM Stocks Was At A Record High In January In early 2013, as is the case today, EM local currency bond yields were very low and EM credit spreads were too tight. When US Treasury yields spiked in the spring of 2013, EM assets tanked. Many commentators blamed it on the Fed. We disagree with that interpretation. Remarkably, the rise in US TIPS yields in 2013 had little impact on equity indices such as the S&P 500 and Nasdaq, or on US corporate spreads (Chart 8). The correction in the US equity market lasted about a week. Yet, EM equities, fixed income markets and currencies experienced a prolonged slump, and in many cases, a bear market. There is no basis to believe that the Fed’s policy and US bond yields are more important to EM than they are to US credit and equity markets. The core rationale for the EM bear market in 2013 was poor domestic fundamentals. The Fed’s tapering was the trigger, not the cause. Differences: The key difference between the current episode and the 2013 Taper Tantrum is EM macro fundamentals. Specifically: EM economies (ex-China, Korea and Taiwan) entered 2013 with booming bank loans and strong domestic demand as well as high inflation (Chart 9). Chart 8US Markets Were Not Hit By The Taper Tantrum In 2013 Chart 9EM (ex-China, Korea And Taiwan): 2013 Vs Now Chart 10EM (ex-China, Korea And Taiwan): 2013 Vs Now Presently, EM bank credit is subdued, domestic demand is dismal, and inflation is tame. Besides, EMs (ex-China, Korea and Taiwan) had a very large trade deficits in 2013 and were financing them via foreign borrowing, which was roaring prior to 2013 (Chart 10). Presently, their trade balances are in surplus and foreign indebtedness has not increased in recent years. Bottom Line: In 2013, EM economies (ex-China, Korea and Taiwan) were overheating and were addicted to foreign funding. These were the reasons why EM currencies and fixed income markets teetered when US bond yields spiked in 2013. Presently, the majority of EM economies (ex-China, Korea and Taiwan) have different types of malaises: domestic bank loan origination is too timid, consumer spending and capital expenditures are moribund, inflation is low and fiscal policy is tight. Consequently, EMs (ex-China, Korea and Taiwan) are better positioned to handle higher US bond yields today than they were back in 2013. Yet better does not mean they will be unscathed. Investment Strategy Equities: The key variable to watch to assess the vulnerability of both US and EM equity markets is their respective corporate bond yields. Historically, rising corporate bond yields (shown inverted in both panels of Chart 11) heralds lower share prices. Chart 11Rising Corporate Bond Yields Are Bad For Share Prices Given that both EM and US corporate credit spreads are too tight, they are unlikely to narrow further to offset rising US Treasury yields. Instead, EM and US corporate bond yields are likely to rise with US Treasury yields. This will trigger more weakness in share prices. Besides, rising EM local currency government bond yields also point towards more downside in EM equities (yields are shown inverted on the chart) (Chart 12). Chart 12Rising EM Local Currency Bond Yields Heralds Weaker Equity Prices Concerning equity style, global growth stocks have peaked versus global value stocks. In the EM equity space, we have less conviction on growth versus value. As to regional allocation in a global equity portfolio, we continue recommending a neutral allocation to EM, underweighting US and overweighting Europe and Japan. Commodities: Investors’ net long positions in commodities are very elevated (Chart 13). As US bond yields rise and the US dollar continues rebounding, there will be a de-risking in the commodities space resulting in a pullback in commodities prices. Currencies: We continue shorting a basket of EM currencies – including BRL, CLP, ZAR, TRY and KRW versus the euro, CHF and JPY. Several EM currencies have failed to break above their technical resistance levels, suggesting that a pullback could be non-trivial (Chart 14). Chart 13Investors Are Record Long Commodities Chart 14Asian Currencies Hit Technical Resistances In central Europe, we are closing the long CZK/short USD trade with a 3.8% gain. Continue holding the long CZK/short PLN and HUF position. Local fixed income markets: EM local bond yields have risen in response to rising US treasury real yields and the setback in EM currencies. This might persist in the near-term, but we continue to recommend receiving 10-year swap rates in selected countries where inflation risks are low and monetary and fiscal policies are tight. These countries include Mexico, Colombia, Russia, China, India and Malaysia. A further rise in their swap rates would represent an overshoot and hence, should not be chased. EM currencies are more vulnerable to a selloff than local rates are. We continue to wait for a better entry point in currencies to recommend buying cash domestic bonds instead of receiving swap rates. EM Credit: A neutral allocation to EM sovereign and corporate bonds is warranted in a global credit portfolio. Our sovereign credit overweights are Mexico, Russia, Malaysia, Peru, Colombia, the Philippines and Indonesia, while our sovereign credit underweights are Brazil, South Africa and Turkey. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1 The Supplementary Leverage Ratio (SLR) is equivalent to Basel III Tier-1 leverage ratio and varies from 3-5% for US banks. Under the relief program last April, the Fed allowed US banks to exclude holdings of US Treasury Bonds and cash kept in reserves at the Fed from their assets when calculating this ratio. The SLR relief is planned to end March 31, 2021. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights China’s economic recovery is in a later stage than the US. A rebound in US Treasury yields is unlikely to trigger upward pressure on government bond yields in China. Imported inflation through mounting commodity and oil prices should be transitory and does not pose enough risk for Chinese authorities to further tighten policies. Historically, Chinese stocks have little correlation with changes in US Treasury yields; Chinese equity prices are primarily driven by the country’s domestic credit growth and economic conditions. We maintain our tactical (0 to 3 months) neutral position on Chinese stocks, in both absolute and relative terms. However, the near-term pullbacks are taking some air out of Chinese equities' frothy valuations, providing room for a cyclical upswing. Chinese offshore stocks, which are highly concentrated in the tech sector, are facing multiple challenges. We are closing our long investable consumer discretionary/short investable consumer staples trade and we recommend long A-shares/short MSCI China Index. Feature Chinese stocks extended their February losses into the first week of March. Market participants fear that escalating real government bond yields in the US and elsewhere will have a sustained negative impact on Chinese risk assets, reinforced by ongoing policy normalization in China. Global equity prices have been buffeted by crosscurrents. An acceleration in the deployment of vaccines and increased economic reopenings provide a positive backdrop to the recovery of corporate profits. At the same time, optimism about global growth and broadening fiscal stimulus in the US has prompted investors to expect higher policy rates sooner. The US 10-year Treasury yield is up by 68bps so far this year, depressing US equity valuations and sending ripple effects across global bourses. In this report, we examine how rising US and global bond yields would affect China’s domestic monetary policy and risk-asset prices. Will Climbing US Treasury Yields Push Up Chinese Rates? Chart 1Chinese Gov Bond Yields Have Led The US Counterpart Since 2015 Increasing bond yields in the US will not necessarily lead to higher bond yields in China. Chart 1 shows that the direction of China’s 10-year government bond yield has a tight correlation with its US counterpart. It is not surprising because business cycles in these giant economies have become more synchronized. Interestingly, China’s 10-year Treasury bond yield has led the US one since 2015. This may be due to China’s growing importance in the world economy. China’s credit and domestic demand growth leads the prices of many industrial metals and in turn, business cycles in many economies. China’s rising long-duration government bond yields reflect expectations of an improving domestic economy, and these expectations often spill over to the rest of the world, including the US. Although the recent sharp rebound in the US Treasury yield is mainly driven by domestic factors, the rebound is unlikely to spill over to their Chinese peers, because the countries are in different stages of their business and policy cycles. America is still at its early stage of economic recovery and fresh stimulus measures are still being rolled out, whereas China has already normalized its policy rates back to pre-pandemic levels and its credit growth peaked in Q4 last year. Chinese fixed-income markets will soon start pricing in moderating growth momentum in the second half of this year, suppressing the long-end of China’s Treasury yield curve (Chart 2). Importantly, none of the optimism that has lifted US Treasury yields - a vaccine-led global growth recovery and a massive US fiscal stimulus – would warrant a better outlook for China. Reopening worldwide economies will likely unleash pent-up demand for services, such as travel and catering, rather than merchandise trade. Chart 3 shows that since the pandemic US spending on goods, which benefited Chinese exports, has soared relative to spending on services. The trend will probably reverse when the US and world economy fully opens, limiting the upside for China’s exports and its contribution to growth this year. Chart 2China And The US Are In Different Stages Of Their Economic Recoveries Chart 3US Consumers Have Been Spending Much More On Goods Than Services During The Pandemic Bottom Line: China’s waning growth momentum will insulate Chinese bond yields from higher US Treasury yields. Do Rising Inflation Expectations In The US Pose Risks Of Policy Tightening In China? Chart 4Imported Inflation Shouldnt Constrain The PBoC While China’s monetary policymaking is not entirely insulated from exogenous shocks, it is primarily driven by domestic economic conditions and inflation dynamics. We are not complacent about the risk of a meaningful uptick in global inflation, but we do not consider imported inflation a major policy constraint for the PBoC this year (Chart 4). Furthermore, at last week’s National People’s Congress (NPC), China set the inflation target in 2021 at 3%, which is a high bar to breach. Mounting commodity prices, particularly crude oil prices, may put upward pressures on China’s producer prices, but their impact on China’s overall inflation will be limited for the following reasons: China accounts for a large portion of the world’s commodity demand. Given that the country’s credit impulse has already peaked, domestic demand in capital-intensive sectors (such as construction and infrastructure spending) will slow this year. Reinforced policy restrictions on the property sector will also restrain the upside price potential in industrial raw materials such as steel and cement (Chart 5). For producers, the main and sustained risk for imported inflation will be concentrated in crude oil. The PPI may spike in Q2 and Q3 this year due to advancing oil prices and the extremely low base factor from the same period last year. The PBoC will likely view a spike in the PPI as transitory. Moreover, the recent improvement in producer pricing power appears to be narrow. The output price for consumer goods, which accounts for 25% of the PPI price basket, remains subdued (Chart 6). Chart 5Chinas Demand For Raw Materials Will Slow Chart 6Output Price For Consumer Goods Remains In Contraction Importantly, when oil prices plummeted in the first half of 2020, China’s crude oil inventories showed the fastest upturn on record (Chart 7). It suggests that China’s inventory restocking from last year may help to partially offset the impact from elevated oil prices this year. For consumers, oil prices account for a much smaller percentage of China’s CPI basket than in the US (Chart 8). Food prices, particularly pork, drive China’s headline CPI and can be idiosyncratic. We expect food price increases to be well contained this year due to improved supplies and the high base effect from last year. Chart 7Massive Buildup in Chinas Crude Oil Inventory In 2020 Chart 8Oil Prices Account For A Small Portion In China's Consumer Spending Importantly, China’s inflation expectations have not recovered to their pre-pandemic levels and consumer confidence on future income growth also remains below its end-2019 figure (Chart 9). If this trend holds, then it will be difficult for producers to pass through escalating input costs to end users. Although China’s economy has strengthened, it is far from overheating (Chart 10). Without a sustained above-trend growth rebound, it is difficult to expect genuine inflationary pressures. The pandemic has distorted the balance of global supply and demand, propping up demand and price tags attached to it. In China’s case, however, production capacity and capital expenditures rebounded faster than demand and consumer spending, constraining the upsides in inflation (Chart 11). Chart 9Consumer Inflation Expectations Have Not Fully Recovered Chart 10Chinese Economy Is Not Yet Overheating China’s CPI is at its lowest point since 2009, making China’s real yields much greater than in the US. Rising real US government bond yields could be mildly positive for China because they help to narrow the Sino-US interest rate differential and temper the pace of the RMB’s appreciation (Chart 12). A breather in the RMB’s gains would be a welcome reflationary force for Chinese exporters and we doubt that Chinese policymakers will spoil it with a rush to hike domestic rates. Chart 11And Production Has Recovered Faster Than Demand Chart 12Narrowing Real Rate Differentials Helps To Tamper The RMB Appreciation Bottom Line: It is premature to worry about an inflation overshoot in China. The current environment is characterized as easing deflation rather than rising inflation. Our base case remains that inflationary pressures will stay at bay this year. Are Higher US Treasury Yields Headwinds For Chinese Stocks? Historically, Chinese stocks have exhibited a loose cyclical correlation with US government bond yields, particularly in the onshore market (Chart 13). Equity prices in China are more closely correlated with domestic long-duration government bond yields, but the relationship is inconsistent (Chart 14). Chart 13Chinese Stocks Have Little Correlation With US Treasury Yields Chart 14Correlations Between Chinese Stocks And Domestic Gov Bond Yields Are Inconsistent Chinese stocks are much more sensitive to changes in the quantity of domestic money supply than the price of money. A sharp rebound in China’s 10-year government bond yield in the second half of last year did not stop Chinese stocks from rallying. The insensitivity of Chinese stocks to changes in the price of money is particularly prevalent during the early stage of an economic recovery. As we pointed out in a previous report, since 2015 the PBoC has shifted its policy to target interest rates instead of the quantity of money supply. Thus, credit growth, which propels China’s business cycle and corporate profits, can still trend higher even as bond yields pick up. This explains why domestic credit growth, rather than China’s real government bond yields, has been the primary driver of the forward P/E of Chinese stocks (Chart 15A and 15B). This contrasts with the S&P, in which the forward P/E ratio moves in lockstep with the inverted real yield in US Treasuries (Chart 16). Chart 15ACredit Growth Has Been Driving Up Chinese Stock Valuations Chart 15BCredit Growth Has Been Driving Up Chinese Stock Valuations Credit growth in China peaked in Q4 last year and the intensity of the economic recovery has started to moderate. Hence, regardless of the changes in bond yields, Chinese stocks will need to rely on profit growth in order to sustain an upward trend (Chart 17). Chart 16Falling Real Rates Were Propping Up US Equity Valuations Chart 17Earnings Growth Needs To Accelerate To Support Chinese Stock Performance The good news is that recent gyrations in the US equity market, coupled with concerns about further tightening in China’s domestic economic policy have triggered shakeouts in China’s equity markets. The pullback in stock prices has helped to shed some excesses in frothy Chinese valuations and has opened a door for more upsides in Chinese stock on a cyclical basis. Bottom Line: Rising Treasury yields in the US or China will not have a direct negative impact on Chinese equities. Last year’s massive credit expansion has lifted both earnings and multiples in Chinese stocks and an acceleration in earnings growth is now needed to support stock performance. Investment Implications The key message from last week’s NPC meetings suggests that policy tightening will be gradual this year. While the 6% growth target was lower than expected, it represents a floor rather than a suggested range and it will likely be exceeded. Bond yields and policy rates are already at their pre-pandemic levels, indicating that there is not much room for further monetary policy tightening this year. The announced objectives for the fiscal deficit and local government bond quotas are only modestly smaller than last year. The economic and policy-support targets support our view that policymakers will be cautious and not overdo tightening. We will elaborate on our takeaways from this year’s NPC in next week’s report. Chart 18Chinese Cyclicals Can Still Benefit From An Improving Global Economic Backdrop Meanwhile, there is still some room for Chinese cyclical stocks to run higher relative to defensives, given the current Goldilocks backdrop of global economic recovery and accommodative monetary policy (Chart 18). We maintain a tactical (0 to 3 months) neutral position on Chinese stocks, in both absolute and relative terms. The market correction has not fully run its course. However, the near-term pullbacks are taking some air out of Chinese equities' frothy valuations, providing room for a cyclical upswing. We are closing our long investable consumer discretionary/short investable consumer staples trade. Instead, we recommend the following trade: long A-share stocks/short MSCI China Index. Investable consumer discretionary sector stocks, which are concentrated in China’s technology giants, face a confluence of challenges ranging from the ripple effects of falling stock prices in the US tech sector and tightened antitrust regulations in China (Chart 19). In contrast, the A-share index is heavily weighted in value stocks while the MSCI China investable index has a large proportion of expensive new economy stocks (Chart 20). The trade is in line with our view that the investment backdrop has shifted in favor of global value versus growth stocks due to a strong US expansion, rising US bond yields and a weaker US dollar. Chart 19Chinese Investable Tech Sector Is Facing Strong Headwinds Chart 20Overweight A Shares Versus Chinese Investable Stocks Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Dear client, In addition to this week’s abbreviated report, we are also sending you a Special Report on currency hedging, authored by my colleague Xiaoli Tang. Xiaoli’s previous work mapped out a dynamic hedging strategy for developed market equity investors in various home currencies. In this report, she extends the work to emerging market exposure. I hope you will find the report insightful. Next week, in lieu of our weekly report on Friday, we will be sending you a joint Special Report on the UK on Tuesday, together with our Global Fixed Income colleagues. Kind regards, Chester Highlights The DXY index is up for the year, but further gains will be capped at 2-3% from current levels. Long yen positions are offside amid the dollar rally. This should wash out stale longs, and underpin the bull case. Lower the limit-sell on the gold/silver ratio to 68. We were stopped out of our short AUD/MXN position amidst a broad-based selloff in EM currencies. We are reinitiating the trade this week. Feature Chart I-1The Dollar Has Been Strong In 2021 The DXY index has once again kissed off the 90 level and is gaining momentum in March. Year-to-date, the DXY index is up 1.1%. This performance has been particularly pronounced against other safe haven currencies, such as the Swiss franc and the Japanese yen. GBP and AUD have fared rather well in this environment (Chart I-1). As the “anti-dollar,” the euro has also suffered. Our technical indicators continue to warn that the dollar still has upside. Net speculative positions are at very depressed levels, consistent with many sentiment indicators that are bearish USD. However, this time around, any dollar rally could be capped at 2-3%, in sharp contrast to the bounce we witnessed in March 2020. The Message From Dollar Technical Indicators Our dollar capitulation index has bounced from very oversold levels, and is now sitting above neutral territory (Chart I-2). The index comprises a standardized measure of sentiment, net speculative positioning and momentum. It is very rare that a drop in this index below the -1.5 level does not trigger a rebound in the dollar. This time around, the bounce has been rather muted. Chart I-2BCA Dollar Capitulation Index Suggests Some Upside Part of the reason has been concentration around dollar short positions. Investors throughout most of the pandemic executed their bearish dollar bets through the euro, yen and the Swiss franc (countries that already had negative interest rates). Positioning on risk on currencies such as the Australian dollar and the Mexican peso were neutral. This also explains the underperformance of the yen, as the dollar rises. From a sizing standpoint, ever since the dollar peaked in March 2020, counter-trend moves have been in the order of 2-3%. We expect this time to be no different. What To Do About The Yen The yen has been one of our core holdings on three fundamental pillars: it is cheap, it tends to rise during dollar bear markets and the economy in Japan is more hostage to deflation than the US. This bodes well for real rates in Japan, relative to the US. Over the last month, our long yen position has been put offside. First, demand for safe havens has ebbed as US interest rates have gapped higher (Chart I-3, panel 1). King dollar has once again become the safe haven of choice. As Chart I-1 illustrates, low beta currencies such as the Swiss franc and yen, that tend to do relatively well when the dollar is rallying, have underperformed. Yield curve control (YCC) in Japan is also negative for the yen as interest rates rise (panel 2). Economic momentum in Japan is also rolling over (panel 3). Prime Minister Yoshihide Suga’s mulling to extend the state of emergency in the Tokyo region could further cripple any Japanese economic recovery. Chart I-3A Healthy Reset In The Yen Chart I-4USD/JPY Support Should Hold For short-term investors, USD/JPY is very overbought and is approaching strong resistance (Chart I-4). In our view, a washing out of stale shorts would provide a healthy reset for the bear market to resume. Meanwhile, USD/JPY and the DXY change correlations during risk-off periods, where the yen appreciates versus the dollar. Therefore, a market reset is also positive for the yen. Housekeeping Chart I-5Remain Short AUD/MXN We were stopped out of our short AUD/MXN trade last week for a loss of 6.1%. We are reinitiating the trade this week. The case for the trade, made a month ago, remains intact. A short-term recovery in the US economy, relative to the rest of the world, argues for an AUD/MXN short. In fact, a divergence has occurred between the BRL/MXN and the AUD/MXN exchange rate (Chart I-5). Domestic factors have certainly tempered the Brazilian real, but the underperformance of metal prices relative to oil in recent months is also a factor. We expect some convergence to occur, with MXN appreciating much faster than the AUD. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have stepped up: Personal income rose by 10% in January, while personal spending rose by 2.4% month-on-month. The ISM report was stellar. The manufacturing PMI improved from 58.7 to 60.8 in February. Prices paid rose to 86. Factory orders were slightly above expectations at 2.6% month-on-month in January. The DXY index rose by 165 bps this week. The narrative of a counter-trend reversal in the DXY index isn playing out. As the story unfolds, it will be important to establish targets. Our bias is that the DXY stalls before 93-94 is reached. Report Links: Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 Portfolio And Model Review - February 5, 2021 Sizing A Potential Dollar Bounce - January 15, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area remain weak: Core CPI in the Eurozone came in at 1.1%, in line with expectations. The unemployment rate declined from 8.3% to 8.1% in January. January retail sales were weak at -6.4% year-on-year. The euro fell by 1.7%% against the US dollar this week. It will be almost impossible for the euro to rise in an environment where the dollar is in a broad-based decline. Given elevated sentiment on the euro, a healthy reset is necessary for the bull market to resume. Report Links: Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan has been marginally positive: The employment report was positive, with the unemployment rate dipping to 2.9% and an improvement in the jobs-to-applicants ratio in January. Consumer confidence in February is rebounding from very low levels. The Japanese yen fell by 1.5% against the US dollar this week. The recovery in the Japanese economy is fragile, and tentative signs of a renewed lockdown will knock down confidence. In this transition phase, yen long positions could be hostage to losses. Longer-term, the yen is cheap and will benefit from a broad-based dollar decline. Report Links: On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data out of the UK have been in line: Mortgage approvals rose 99K in January, in line with expectations. The construction PMI rose from 49.2 to 53.3 in February. Nationwide house prices are soaring, rising 6.9% in February on a year-on-year basis. The pound fell by 0.8% against the dollar this week. It is however the best performing currency this year. Our short EUR/GBP trade has benefited from faster vaccination in the UK (that could give way to a faster reopening of the economy) and a nice valuation starting point. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia was robust: Home lending remained in an uptrend. Owner-occupied loans increased by 11% in January, while investor loans increased by 9.4%. Terms of trade are soaring, rising 24% year-on-year in February. The current account surplus came in near a record A$14.5 billion in Q4. GDP grew by 3.1% QoQ in Q4. The Aussie fell by 1.8% his week. Terms of trade will continue being a tailwind for the AUD/USD. We also like the AUD/NZD cross, as a valuation and terms-of-trade bet. However, we expect that any positive surprises in the US will hurt AUD relative to the Americas. One way to play this is by shorting AUD/MXN. Report Links: Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 An Update On The Australian Dollar - September 18, 2020 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There was scant data out of New Zealand this week: Terms of trade rose by 1.3% in Q4. CoreLogic home prices rose 14.5% in February. The New Zealand dollar fell by 2.4% against the US dollar this week. The kiwi ranks as the most unattractive currency in our FX framework. For one, it has catapulted itself to the most expensive currency in our PPP models. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data from Canada was positive: The Nanos confidence index rose from 58.2 to 59.4 in February. Annualized 4Q GDP came in at 9.6%, above expectations. Building permits rose 8.2% month-on-month in January. The Canadian dollar fell 0.4% against the US dollar this week. Oil prices remain very much in an uptrend, which is underpinning the loonie. Better US economic performance in the near term should also help the CAD. Report Links: Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data out of Switzerland have been improving: Swiss GDP rose by 0.3% quarter-on-quarter in 4Q. The KOF leading indicator rose from 96.5 to 102.7 in February. The February manufacturing PMI rose from 59.4 to 61.3. Switzerland remains in deflation, with the core CPI that came in at -0.3% year-on-year in February. The Swiss franc fell by 2.6% against the US dollar this week. Safe -haven currencies continue to be laggards, as rates rise and gold falls to the wayside. This is bullish on procyclical currencies, and negative the Swiss franc. We are long EUR/CHF on this basis, but short USD/JPY purely as portfolio insurance. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The data out of Norway has been robust: The unemployment rate fell from 4.4% to 4.3% The manufacturing PMI increased from 51.8 to 56.1 in February. The current account balance was robust in Q4. It should increase significantly in Q1 this year given the large trade balance in January. Being long the Norwegian krone is one of our high-conviction bets in the FX portfolio. The Norwegian krone fell by 1% against the US dollar this week, but outperformed the euro, amongst other currencies. The NOK ticks all the boxes of an attractive currency – cheap valuations, a liquidity discount, and primed to benefit from a global growth rebound. Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Most Swedish data releases were in line with expectations: GDP came in at -0.2% quarter-on-quarter, below expectations. Retail sales rose 3.1% year-on-year, above expectations. The trade balance came in at a surplus of SEK 5.2 billion in January. The manufacturing PMI remained elevated at 61.6 in February. The Swedish krona fell by 2.4% against the US dollar this week. Manufacturing data is improving in Sweden but the economy remains hostage to COVID-19, compared to Norway. That is weighing on the krona. That said, Sweden is a highly levered play on the global cycle. Therefore, once the pandemic is behind us, the SEK will outperform. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Highlights A rise in global bond yields has rarely been a reliable precursor of a stronger dollar. This is because the dollar reacts to interest-rate differentials, rather than the level of global yields. Changes in the dollar correlate with both the level and the rate of change in relative yields. A definitive shift to a bullish dollar stance will require a rise in relative US real rates in the order of 50-to-75 bps. Meanwhile, negative/low interest rates could have caused a swing in the currency/yield correlation, especially at the short end of the curve. In aggregate, the dollar responds to relative rates of return. This includes not only fixed income flows, but equity flows as well. As such, the US equity market also needs to outperform foreign bourses to make the case for a stronger dollar. The dollar is oversold and remains ripe for a countertrend bounce. This noise could be confused for a durable bullish signal. Feature Chart I-1No Rise In Real Yields Global bond yields are on the rise, driven by the long end of the curve. This has included US yields, where the 10-year rate has bounced from a low of 36 bps last March to 130 bps today. Rising yields have important ramifications for equity prices (through the discount rate) and exchange rates. A rise in yields can be driven by prospects of either better growth, higher inflation expectations, or a combination of the two. This could bring forward expectations that the central bank will tighten monetary policy faster. In the case of the US and Eurozone, the culprit behind higher yields has been higher inflation expectations (Chart I-1). What does this mean for exchange rates? Are rising yields positive or negative for the dollar? Also, does it matter which component is driving yields higher – growth or inflation expectations? Finally, which currencies have historically benefited the most from an uptick in global yields? Correlation Between Yields And Exchange Rates Chart I-2Bond Yields And Currencies Often Diverge The historical evidence is that there is little correlation between the dollar and the level or direction of global bond yields. Since the end of the Bretton Woods system in the 1970s, the trade-weighted dollar has appreciated while global bond yields have collapsed (Chart I-2). More important has been the path of relative interest rates. For example, the ebb and flow of EUR/USD has tracked the yield differential between Bund and Treasury yields since the 1970s (bottom panel Chart I-2). Currencies react more to the path of relative real rates than nominal rates. In theory, rising inflation is negative for a currency since its purchasing power is reduced. In a globally competitive system, the currency adjusts lower to equalize prices across borders. However, rising growth expectations allow policy rates to catch up with a higher neutral rate. This improves the relative rate of return for bond investors, allowing for capital inflows. Across the G10, there has been a longstanding relationship between real interest rate differentials and the path of the currency (Chart I-3A and Chart I-3B). Chart I-3ACurrencies Move With Relative Real Rates Chart I-3BCurrencies Move With Relative Real Rates Importantly, US real rates have not risen much against the rest of the world with the latest uptick in global bond yields. In fact, compared to countries such as Australia, the UK, Switzerland, and New Zealand, they have declined. This is negative for the dollar on the margin. While the direction of relative real rates is important, the absolute level of real yield spreads also matters for currency and bond investors. Chart I-4 shows that the dollar tends to respond to the level of real rates in the US, compared to the rest of the world. When US real rate differentials are positive, the dollar tends to appreciate on a year-over-year basis. Looking at a snapshot of global real yields, the US sits below the median (Chart I-5). Commodity-producing countries fare much better. So do Japan and Switzerland. Based on the historical precedent, US real rates will have to improve by about 50-to-100 bps to set the dollar up for structural upside. Chart I-4US Real Rates Are ##br##Still Low Chart I-5US Real Rates Need 50-75 Bps Upside To Make Them Attractive Bonds Versus Equities There are multiple drivers of exchange rates. Bond yields are just one of them. Equity flows also matter. One way to square the circle on whether the level of US real rates makes a difference for the dollar is through flow data. Foreign inflows into US Treasuries remain negative. This suggests that despite the rise in US nominal rates since March of last year, foreign investors are still not convinced they are sufficiently high to compensate for the rising US twin deficits. Rather, inflows into equities have been rather strong. This raises the prospect that the equity market has become an important driver of currency returns and will become the dominant driver going forward (Chart I-6). Importantly, the correlation between bond yields and exchange rates at very low rates is not straightforward. Bond investors span the duration spectrum, and 1-year, 2-year and even 5-year yield differentials are not meaningfully different across countries (Chart I-7). This is particularly the case if hedging costs are taken into consideration. It explains why currencies have not moved much in light of the violent moves at the long end of the yield curve, as shown in Chart I-3A and Chart I-3B. At times, the moves have been opposite to what economic theory would suggest. Chart I-6Foreign Investors Like US Equities, ##br##Not Bonds Chart I-7A Regime Shift For Interest Rates And Currencies? Chart I-8The CAD Is Not Driven By Relative Interest Rates, But Terms Of Trade If a central bank explicitly targets a bond yield, that makes it difficult for that same yield to send a reliable signal about the economy. That is why at very low rates, markets start to gravitate to other indicators of growth. These include, but are not limited to, differences in PMI surveys or even commodity prices. For example, the performance of the Canadian dollar can be perfectly explained by the rise in Canadian terms of trade, even though real interest rate differentials between Canada and the US have not done much (Chart I-8). Rising oil prices are usually bullish for Canadian national income, on a relative basis. They are also bullish for Canadian equities that are more resource based. Inflows into these sectors tend to be positive for the currency. In the case of Europe, the euro has rolled over on the drop in relative real rates, but the gap in economic data surprises with the US has provided a far better explanation of euro underperformance in recent weeks. With domestic European economies in various lockdowns, economic data is becoming relatively weaker (Chart I-9). This is curbing growth, inflation, and interest rate expectations. Chart I-9Economic Divergences Explain EUR/USD, Rather Than Real Interest Rates This brings up a bigger point. Flows tend to gravitate to capital markets with the highest expected returns, and this is certainly the case when cyclical versus defensive style tilts are concerned. This is important for currency strategy, since sector composition can drive a country’s equity returns. Higher yields tend to be beneficial for cyclical stocks, especially banks. In the case of Europe, the bourses are heavily weighted toward banks, industrials, and consumer discretionary sectors. Not only do these sectors need to do well for the equity market to outperform, they are also strongly tied to the performance of the domestic economy. That is why for the most part, both equity and currency relative performances tend to be in sync (Chart I-10). The bottom line is, to get the USD call right, investors should broaden their scope from relative bond yields to other drivers of currency returns. With most developed market interest rates near zero at the short end, relative bond yields matter less. More importantly, flows will be dictated by investors’ perceptions of where to find higher relative rates of return. This, in turn, will be based on relative growth fundamentals. Our bias is as follows: The US equity market has become very tech-heavy. Rising interest rates tend to hurt higher duration sectors such as tech and health care. At the margin, this hurts the relative performance of US equities. As such, rising rates will negatively impact the US equity market more, and will not derail our bearish dollar view (Chart I-11). Chart I-10The Dollar And Relative Stock Markets Chart I-11Global Defensives And Interest Rates The Signal And The Noise Chart I-12The Dollar Could Be Seasonally Strong There are a few conclusions from the insights made above. First, US real interest rates have not meaningfully improved relative to the rest of the world. Second, a rise in US real rates of 50bps above the rest of the world would be required in order to seriously question our bearish dollar view, from a fixed income angle. Finally, sector performance matters a great deal, which means that the current rise in global bond yields is bearish for US stocks compared to non-US bourses. This places the US dollar at a very critical juncture. On the one hand, the dollar is still very oversold. Every time the dollar bounces from these oversold levels, the bulls rage forward, taking it as vindication that the uptrend has resumed. As we have highlighted, the DXY could hit 94 before working off oversold conditions. February and March tend to be excellent months for a rise in the DXY (Chart I-12). On the other hand, a rise in the dollar could be genuine confirmation that the US is leading the recovery both in terms of rates and equity performance. Weakness in the euro will not be particularly surprising, given the lopsided level of optimism. We remain bullish until the euro hits 1.35. The reality is that no one knows the trajectory of global growth in 2021, let alone how the relative growth profile between countries will play out. The euro area is heavily levered to global growth, hence we remain bullish EUR/USD. However, this view will change if the facts change. Meanwhile, in a higher inflationary environment, the outperformers tend to be the Norwegian krone and commodity currencies. This makes sense since commodity prices (and ultimately producer prices) tend to outperform in a period of rising inflation. It dovetails nicely with our high-conviction view to heavily overweight the Scandinavian currencies (Chart I-13). Chart I-13Rising Inflation Is Bullish For The NOK Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been rather robust: Inflation expectations are well anchored. The February 5-10 year survey from the University of Michigan pinned inflation expectations at 2.7% year-on-year. Core PPI came in at 2% year-on-year in January, blowing out expectations of a 1.1% rise. Retail sales galloped above expectations. The control group printed 6% month-on-month in January compared to expectations of a 1% rise. Housing starts declined month-on-month in January, but building permits rose so it’s a wash if rising rates are affecting cyclical spending in the US. The DXY index rose by around 30 bps this week. There is a clear tug-of-war in markets, with the Fed signaling that policy will remain easy as far as the eye can see, but bond markets pushing up longer-term rates. Our bias is that any pickup in inflation will prove transitory, vindicating Fed policy in 2021. Report Links: Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 Portfolio And Model Review - February 5, 2021 Sizing A Potential Dollar Bounce - January 15, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area remain weak: The trade surplus widened to €27.5 billion in December. 4Q GDP slowed by 5% year-on-year, in line with expectations. The ZEW survey was a very positive surprise. The expectations component for February jumped from 58.3 to 69.6. The euro fell by 0.4% against the US dollar this week. The markets will keep oscillating between how deep the euro area slowdown will be for now, and the magnitude of any potential rebound. We are bullish on euro area growth, especially given tentative signs of a revival in animal spirits (proxied by the expectations component of the surveys). Report Links: Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan has been positive: 4Q GDP surprised to the upside, rising an annualized 12.7% quarter-on-quarter. Exports are booming, rising 6.4% year-on-year in December. The rise in machinery orders by 11.8% in December corroborated the positive contribution from CAPEX to GDP. The Japanese yen fell by 0.9% against the US dollar this week. As Japanese data surprised to the upside, inflation expectations also rose and depressed real rates. The drop in the yen signals the market might be pricing in that the BoJ will not fight strength in economic data with more tapering. We are long the yen as a portfolio hedge, but that view has been shaken by recent weakness. Report Links: On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data out of the UK have been in line: 4Q GDP in the UK was slightly better than expected at 1% quarter-on-quarter. Core CPI for January came in at 1.4%, in line with expectations. House prices are soaring, rising 8.5% in December on a year-on-year basis. The pound was the best performing currency this week, rising about 1%. Our short EUR/GBP trade has benefited from faster vaccination in the UK (that could give way to a faster reopening of the economy) and a nice valuation starting point. We are tightening stops this week to protect profits. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The most important data this week from Australia was the employment report: There were 29.1K new jobs in January, in line with expectations. More importantly, there were 59K new full-time jobs, while part-time jobs fell by 29.8K. The unemployment rate declined from 6.6% to 6.4%. The Aussie was flat this week. When it comes to Covid-19, Australia ranks extremely well on a global scale. The number of new cases are low, the government has secured enough vaccines for the entire population and economic activity has rebounded given very close ties to China. We like the AUD, and are long versus the NZD. However, we expect that any positive surprises in the rest of the world will hurt AUD relative to the Americas. As such, we are short AUD/MXN. Report Links: Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 An Update On The Australian Dollar - September 18, 2020 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There was scant data out of New Zealand this week: Net migration remained at a very low level of 415 individuals in December. The New Zealand dollar fell by 0.3% against the US dollar this week. The kiwi has catapulted itself to the most expensive currency in our PPP models. According to our attractiveness ranking, it is also the worst. We are already long AUD/NZD but are looking for more opportunities to short the kiwi at the crosses. Stay tuned. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data from Canada was positive: Housing starts rose by 282.4K, well above expectations for a January level of 228.3 K. Foreigners continued to by C$5 billion of securities in December. CPI was in line with expectations. The core median came in at 1.4% but the core trim was 1.8%, a nudge below the BoC range of 1-3%. The Canadian dollar was flat against the US dollar this week. The path of the CAD will be dictated by two factors – 1) relative economic growth between the US and the rest of the world (CAD benefits more from better US growth); and 2) the path of commodity prices, especially oil. Both remain positive for the CAD, as we alluded to last week. Report Links: Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data out of Switzerland have been flat: Core CPI came in at 0% in January, suggesting Switzerland has tentatively exited deflation (the print was -0.4% in December). January exports rebounded, even as watch sales remained quite weak. The Swiss franc fell by 0.7% against the US dollar this week. Safe-haven currencies were laggards, with only the Swiss franc lagging the Japanese yen. This is clearly a signal that the market remains very much in risk-on mode. We are long EUR/CHF on this basis, but short USD/JPY purely as portfolio insurance. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The data out of Norway has been robust: 4Q mainland GDP came in at 1.9% quarter-on-quarter. Expectations were for a 1.3% rise. The trade balance exploded to NOK 23.1 billion in January. The Norwegian krone was flat against the US dollar this week, but outperformed the euro. The NOK is the perfect example of a currency on a coiled spring – cheap valuations, a liquidity discount, and primed to benefit from the global economic rebound. We are long the NOK against the euro, loonie, and USD. Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The most important data from Sweden this week was the CPI: The headline measure for January came in at 1.6%, in line with expectations. The core measure at 1.8% was also in line with expectations. The Swedish krona was flat against the US dollar this week. The Swedish COVID-19 experiment is coming home to roost. On the one hand, much higher cases compared to Norway have dampened economic activity as people voluntarily try to avoid infection. Sweden chose to keep its economy largely open. On the other hand, Sweden is a highly levered play on the global cycle. We think the latter will dominate, and so are positive on the krona. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Highlights US inflation is set to increase sharply over the coming months as base effects kick in. Higher fuel prices, fiscal stimulus, and the partial relaxation of lockdown measures should also boost inflation. The Fed is unlikely to react hawkishly to higher inflation, arguing that it is largely transitory in nature. While the Fed’s relaxed attitude towards inflation risks may be justified in the near term, there is a high probability that inflation will get out of hand later this decade. Contrary to conventional wisdom, many of the factors that led to high inflation in the 1970s could reassert themselves. Investors should overweight stocks for now, but be prepared to reduce equity exposure in about two years. US Inflation Has Bottomed US inflation surprised on the downside in January. The core CPI was flat on the month, compared with the consensus estimate for an increase of 0.2%. We expect US inflation to move higher over the coming months. The weakness in January’s inflation print was concentrated in sectors of the economy that have been hard hit by the pandemic. Airline fares dropped 3.2%, hotel rates fell 1.9%, and entertainment admission prices declined 5.5%. Prices in these sectors should rise on a year-over-year basis as base effects kick in (Chart 1). The relaxation of lockdown measures should also help to partially restore demand in these areas. WTI crude prices have risen 70% since the end of October. Rising energy prices should push up headline inflation, with some bleed-through to core prices. Chart 2 shows that there is a strong correlation between gasoline prices and headline inflation. If gasoline prices evolve in line with what is predicted by the futures market, headline inflation could temporarily rise to 4% this spring. Chart 1Base Effects Will Push Inflation Higher Chart 2Strong Link Between Gasoline Prices And Headline Inflation In addition, the lagged effects from a weaker dollar should translate into higher goods prices in the US (Chart 3). A stronger labor market and a slower pace of rent forgiveness should also boost housing inflation (Chart 4). Chart 3A Weaker Dollar Will Be A Tailwind For Inflation Chart 4Stronger Labor Market Will Boost Housing Inflation Fiscal stimulus should further supercharge demand, adding to inflationary pressures. Ironically, Republican unwillingness to offer modest, politically palatable cuts to President Biden’s proposed aid bill has opened the door to the Democrats ramming through the entire $1.9 trillion package via the reconciliation process. As we discussed last week, the amount of stimulus in the pipeline easily dwarfs the size of the output gap. From Reflation To Inflation? Deflation is bad for stocks, just as is high and accelerating inflation. Somewhere between deflation and inflation, however, lies reflation. Reflation is good for stocks. Chart 5Inflation Expectations Have Recovered But Are Still Below Levels That Would Cause Concern For The Fed We are currently in a reflationary Goldilocks zone, where inflation expectations have risen but not by enough to force the Fed’s hand. There is a high probability we will stay in this Goldilocks zone for the remainder of the year. The 5-year/5-year forward TIPS breakeven rate is still below the level that the Fed regards as consistent with its long-term inflation objective, and even farther below the level that would cause the Fed to panic (Chart 5). Jay Powell told The Economic Club of New York last week that the Fed is unlikely to “even think about withdrawing policy support” anytime soon. The Fed minutes released on Wednesday echoed this view. That ‘70s Show? The path to higher interest rates is lined with lower interest rates. A period of ultra-easy monetary policy can sow the seeds for economic overheating, rising inflation, and ultimately, much higher interest rates. Since this is precisely what happened during the 1970s, it is prudent to ask whether something like that could happen again. Investors certainly do not believe a replay of the 70s is in the cards, at least if long-term CPI swaps are any guide (Chart 6). Yet, we think that a 1970s-style inflationary episode is a greater risk than most investors realize. As we discuss below, much of what investors believe about how inflation emerged during that period is either based on myths, or at best, half-truths. Let’s examine each of these misconceptions in turn. Myth #1: High inflation in the 1970s was primarily driven by supply disruptions, with oil shocks being the most prominent. Fact: Oil shocks exacerbated the inflation problem in the 1970s, but it was an overheated economy that permitted inflation to rise in the first place. Inflation took off in 1966, seven years before the first oil shock. By 1969, core CPI inflation was running at close to 6% (Chart 7). Chart 6Investors Do Not Expect Inflation To Vault Higher Chart 7Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Similar to today, fiscal policy was exceptionally accommodative in the mid-1960s. The escalation of the Vietnam War produced a surge in military expenditures. Social spending rose dramatically with the introduction of Lyndon Johnson’s “Great Society” programs. Medicare and Medicaid took effect in July 1966. Amy Finkelstein has estimated that Medicare, the larger of the two health care programs, led to a 37% increase in real hospital expenditures between 1965 and 1970. Johnson’s “guns and butter” policies caused government spending to surge in the second half of the decade. The budget deficit, which was broadly balanced during the first half of the 60s, swelled to 4% of GDP (Chart 8). As fiscal policy was loosened, the economy began to overheat. The unemployment rate fell to 3.8% in 1966, two percentage points below what economists later concluded had been its full-employment level. Chart 8US "Guns And Butter" Policies In The 1960s Caused Government Spending To Swell Myth #2: The Phillips curve is much flatter today. Chart 9The Increase In Inflation In 1966 Was Broad-Based Fact: The Phillips curve was also flat during the 1960s. Core inflation was remarkably stable during the first half of the 60s, averaging about 1.5%, even as the unemployment rate steadily declined. Then, starting in 1966, core inflation more than doubled within the span of ten months. As Chart 9 illustrates, the sudden spike in inflation in 1966 was fairly broad-based. A “kink” in the Phillips curve had been reached. That the relationship between inflation and unemployment turned out to be non-linear is not surprising. As long as there is some slack in the labor market, employers are likely to resist raising wages. Thus, a decline in unemployment from a high level to a merely moderate level is unlikely to lead to meaningful wage inflation. It takes a truly overheated labor market – one that forces firms to engage in a tit-for-tat battle to entice workers – for the relationship between unemployment and inflation to reassert itself. In the near term, there is little risk that the US economy will reach a kink in the Phillips curve. Jason Furman estimates that the unemployment rate stood at 8.3% in January if one adjusts for the drop in labor force participation and methodological problems with how the BLS defines temporarily furloughed workers. This is well above the level that could trigger a price-wage spiral. Chart 10Is The Phillips Curve Really Dead? Yet, it would be naïve to think that such a spiral could not materialize in a few years. As Chart 10 shows, over the past 40 years, every time the US labor market was on the cusp of overheating, something would invariably come along to push up unemployment. Last year, it was the pandemic. In 2008, it was the Global Financial Crisis. In 2000, it was the dotcom bust. In the early 1990s, it was the collapse in commercial real estate prices following the Savings and Loan Crisis. Admittedly, only the pandemic qualifies as a truly exogenous shock. The preceding three recessions were fomented by growing economic imbalances, which were ultimately laid bare by a Fed hiking cycle. One can debate the degree to which the US economy is suffering from non-pandemic related imbalances today, but one thing is certain: The Fed is not keen on raising rates anytime soon. Thus, whatever imbalances exist today may not be exposed before the economy has had the chance to overheat. Myth #3: Inflation expectations are better anchored these days. Chart 11Long-Term Bond Yields Lagged Inflation During The 1960s Fact: Inflation expectations certainly became unmoored in the 1970s. However, there is not much evidence that expectations were adrift prior to the sudden increase in inflation in 1966. At the time, the US had not experienced a major episode of inflation since the Civil War. While long-term bond yields did rise in the second half of the 60s, they generally lagged inflation, suggesting that investors were caught off-guard (Chart 11). It should also be noted that the US and other major economies operated under the Bretton Woods system of fixed exchange rates during the 1960s. Each US dollar was convertible into gold at the official rate of $35 per ounce. The existence of this quasi-gold standard helped anchor inflation expectations. The system began to fall apart in the late 1960s as inflation rose. When President Nixon suspended the dollar’s convertibility into gold in August 1971, the US CPI had already increased by nearly 30% from its 1965 level. While the collapse of the Bretton Woods system in the early 1970s undoubtedly caused inflation expectations to become further unhinged, the breakdown of the system would not have occurred if inflation had not risen in the first place. Myth #4: Widespread wage indexation and powerful trade unions fueled an acceleration in the 1960s. Fact: Just as was the case with the unmooring of inflation expectations, wage indexation was more a response to rising inflation than a cause of it. Chart 12 shows that the share of workers covered by cost of living adjustments only jumped after inflation had accelerated. Chart 12Higher Inflation Led To More Inflation-Indexed Wage Contracts, Not The Other Way Around As far as unions are concerned, the US unionization rate peaked by the end of the 1950s and was already on a downward path when inflation began to rise. Revealingly, Canada experienced a similar decline in inflation as the US in the early 1980s even though unionization rates remained elevated (Chart 13). This suggests that union power was not a dominant driver of inflation. Chart 13Inflation Fell In Canada, Despite A High Unionization Rate Myth #5: Today’s globalized economy will limit inflationary pressures. Fact: The empirical evidence generally suggests that the impact of globalization on US inflation has been smaller than widely supposed.1 This is not surprising. The US is a fairly closed economy. Imports account for only 15% of GDP. As a result, a fairly large change in relative prices is necessary to prompt Americans to shift a meaningful fraction of their expenditures towards foreign-made goods. Such a shift in spending would require a real appreciation of the US dollar. A real appreciation could occur either if US inflation exceeds inflation abroad or if the nominal value of the dollar strengthens against other currencies. (Admittedly, the standard terminology can be a bit confusing; just think of a real US dollar appreciation as anything that makes the US economy less competitive). Here’s the thing though: The US dollar is unlikely to strengthen unless the Federal Reserve starts to sound more hawkish. If the Fed remains in the dovish camp, real rates could fall as inflation edges higher. This will put downward pressure on the dollar, leading to a smaller trade deficit and even more aggregate demand. Myth #6: Demographics are much more deflationary now than they were in the past. Fact: Demographic trends arguably did help push down inflation over the past few decades. However, population aging is likely to boost inflation going forward. Chart 14 shows that the ratio of workers-to-consumers in the US and around the world – the so-called “support ratio” – rose steadily in the 1980s, 1990s, and 2000s as more women entered the labor force and the number of dependent children per household declined. An increase in the ratio of workers-to-consumers is equivalent to an increase in the ratio of production-to-consumption. A rising support ratio is thus deflationary. More recently, however, the support ratio has begun to decline as baby boomers retire but continue to spend. Consumption actually increases in old age once health care spending is included in the tally (Chart 15). As production falls in relation to consumption, inflation could rise. Chart 14Support Ratios Are Declining Globally After Rising Steadily For Three Decades Chart 15Consumption Increases In Old Age Once Health Care Spending Is Factored In Myth #7: Today’s fast pace of technological innovation will keep inflation down. Chart 16Total Factor Productivity Growth Is Lower Than It Was During The Great Inflation Fact: Total factor productivity growth – a broad measure of innovation – is not just low by historic standards today; it is lower than during the period of the Great Inflation spanning from 1966 to 1982 (Chart 16). Some have argued that productivity growth is mismeasured. We have examined this argument in the past and found it wanting. In any case, economic theory does not necessarily say that technological innovation should be deflationary. Economic theory states that faster innovation should lead to higher real incomes. It does not say whether the increase in real income should come via rising nominal income or falling inflation. Indeed, to the extent that faster innovation leads to higher potential GDP growth, it could fuel inflation. This is because stronger trend growth will tend to raise the neutral rate of interest, implying that monetary policy will become more stimulative for any given policy rate. Myth #8: Policymakers have learned from their mistakes. It is easy to dismiss this claim, but it is worth considering it seriously. Some of the mistakes that policymakers made during the 60s and 70s were far from obvious at the time. Athanasios Orphanides, who formerly served as a member of the ECB’s Governing Council, has documented that central banks in the US and other major economies systematically overestimated the amount of slack in their economies (Chart 17). They also overestimated trend growth, with the result that they came to see the combination of sluggish growth and seemingly high unemployment as evidence of inadequate demand. Chart 17Central Banks Overestimated The Degree Of Slack In Their Economies During The Great Inflation Is it possible that economic analysis has improved so much over the past 40 years that such mistakes would not be repeated today? Perhaps, but it is worth noting that not only did most economists fail to predict the productivity boom in the late 1990s, most were not even aware that it had happened until after it had ended. Knowing what is happening to the economy in real time is hard enough. Predicting what will happen to such things as trend growth and the natural rate of unemployment is even more difficult. Myth #9: The Fed is a lot more independent now. Fact: We will only know for sure when this independence is tested. History clearly shows that inflation tends to be higher in countries which lack independent central banks (Chart 18). The Fed’s independence was compromised in the 1970s. In his exhaustive study of the Nixon tapes, Burton Abrams documented how Richard Nixon sought, and Fed Chairman Arthur Burns obligingly delivered, an expansionary monetary policy in the lead-up to the 1972 election. Chart 18Inflation Is Higher In Countries Lacking Independent Central Banks Starting with the appointment of Paul Volcker, the Fed sought to regain its independence. Most recently, Jay Powell publicly resisted Donald Trump’s efforts to prod the Fed to ease monetary policy. Yet, the Fed’s independence may turn out to be illusory. The Fed wasted little time in slashing rates and relaunching its QE program once the pandemic began. But will it be as quick to tighten monetary policy if inflation starts getting out of hand? Jay Powell’s four-year term as chair runs through February 2022. He will need to stay in Joe Biden’s good graces if he hopes to be reappointed to a second term. The fact that government debt levels are so high further complicates matters. Higher interest rates would force the government to shift funds from social programs towards bond holders. Will the Fed raise rates even if it faces strong political opposition? Time will tell. Investment Conclusions Chart 19Social Unrest Can Fuel Inflation While no two periods are exactly the same, there are a number of striking similarities between the late 1960s and the present day. As is the case today, fiscal policy was highly expansionary back then. The same goes for monetary policy: Just like today, the Fed kept interest rates well below the growth rate of the economy. In the 1960s, the Federal Reserve was still focused on avoiding a repeat of the Great Depression and the deflationary wave that accompanied it. Today, the Fed is equally focused on reflating the economy. The 1960s was a decade of rising political and social unrest. Crime rates went through the roof, a trend that was eerily matched by rising inflation rates (Chart 19). Early estimates suggest that the US homicide rate jumped by 37% in 2020 – easily the largest one-year increase on record. As was the case in the 1960s, most of the news media has ignored this disturbing development. What should investors do? Our tactical MacroQuant model is flagging some near-term risks for stocks. Nevertheless, as long as the economy is growing solidly and the Fed remains on the sidelines, it is too early for investors with a 12-month horizon to bail on equities. Instead, equity investors should favor sectors that could benefit from higher inflation. Commodity producers are a natural choice. Banks could also gain from an uptick in inflation. Chart 20 shows the remarkably strong correlation between the performance of US banks relative to the S&P 500 and the 10-year Treasury yield. Higher bond yields would boost bank net interest margins, leading to higher profits. Banks are also very cheap and have started to see their earnings estimates rise faster not only relative to the broader market but even relative to tech stocks (Chart 21). Chart 20Bank Shares Are A Buy (I) Fixed-income investors should keep duration risk low. They should also favor inflation-protected securities over nominal bonds. Chart 21Bank Shares Are A Buy (II) Looking further out, the secular bull market in stocks will end when inflation rises to a high enough level that even the Fed cannot ignore. That day will arrive, but probably not for another two years. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1 Globalization is often cited as a potential reason behind low inflation in advanced economies, including the US. However, a number of empirical studies have found that globalization did not play a major role. In general, domestic economic conditions are seen as the main factor in the inflation process. Please see Jane Ihrig, Steven B. Kamin, Deborah Lindner, and Jaime Marquez, “Some Simple Tests of the Globalization and Inflation Hypothesis,” Board of Governors of the Federal Reserve System (International Finance Discussion Papers No. 891) (April 2007); Laurence M. Ball, “Has Globalization Changed Inflation?” National Bureau of Economic Research Working Paper Series 12687 (November 2006), and associated blog post “Has Globalization Changed Inflation?” National Bureau of Economic Research, (June 2007); Janet. L. Yellen, 'Panel discussion of William R. White “Globalisation and the Determinants of Domestic Inflation”,' Presentation to the Banque de France International Symposium on Globalisation, Inflation and Monetary Policy (March 2008); Fabio Milani, “Global Slack And Domestic Inflation Rates: A Structural Investigation For G-7 Countries,” Journal of Macroeconomics, (32:4) (2010); and and Lei Lv, Zhixin Liu, and Yingying Xu, “Technological progress, globalization and low-inflation: Evidence from the United States,” PLoS ONE, (14:4), (April 2019). Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
2021 has not been easy on the Japanese yen. USD/JPY bottomed on January 5, reflecting underwhelming dynamics in Japan’s domestic economy. The manufacturing PMI which was contracting for all of 2020, finally reached the 50 mark in December only to dip below it…
Highlights US inflation expectations will continue to grind higher as commodity markets tighten, and financial markets price to an ultra-accommodative Fed over the next 2-3 years. The US stock-market rally is reducing equity yields and squeezing equity risk premiums, which acts as a drag on gold prices. Higher earnings, lower stock prices or both are needed to reduce this effect. Pandemic uncertainty continues to fuel safe-haven demand for the USD, which remains a headwind for gold and silver. Vaccination availability needs to reach a level that convinces markets global contagion risk has been minimized. Until then, this remains the dominant downside risk to gold and commodities. The balance of risks continues to favor gold: US real rates will remain weak as the Fed remains behind the inflation-vs-rates curve, and the USD will be pushed lower (Chart of the Week). We continue to expect gold prices to push to $2,000/oz. We remain bullish silver, and view the recent retail-spec price blip as transitory. Fundamentally, silver supply growth is weakening, and demand is strengthening as the renewable-energy buildout accelerates and consumer spending revives. We expect silver's price to trade back to $30/oz. Feature US inflation expectations will continue to grind higher, as tightening markets for industrial commodities push oil and base metals prices higher (Chart 2).1 As is apparent in Chart 2, these real-economy factors feed directly into five-year inflation expectations, which are important to policy makers and portfolio managers managing risk in trading markets.2 Continued Fed accommodation of massively expansive US fiscal policy also will stoke inflation expectations, and keep real rates negative or weak at low positive levels as realized inflation and inflation expectations increase. These real and financial effects will be positive for gold prices, as the Chart of the Week illustrates. Chart of the WeekRising Inflation Expectations vs. Falling Risk Premiums Restrain Gold Chart 2Tightening Commodity Markets Push Inflation Expectations Higher Battling against this tailwind is the historic US equity rally, which has crushed stock yields and the equity risk premium vs bond yields.3 Gold prices are positively correlated with equity risk premiums – the positive economic forces that push dividend yields higher also tend to push gold and commodity prices higher – which means the falling risk premiums are acting as a headwind to gold prices (Chart 3).4 If, as the global economy recovers, the rate of growth in earnings is greater than that of equity prices, stock yields will expand, which will be supportive of gold prices. That said, we do not expect the contraction of the equity risk premium to dominate the evolution of gold prices. Tightening fundamentals in the real economy and continued monetary accommodation at the Fed will dominate gold- and silver-pricing dynamics. Chart 3Falling Stock Yields Pressure Equity Risk Premiums Balance of Risks Favors Gold Fed policy pronouncements point to continued accommodation of massive fiscal stimulus in the US, with the central bank strongly indicating it will, as a matter of policy, remain behind the inflation-vs-rate-hikes curve for at least another 2-3 years. Taking the Fed at its word, this means US real rates will remain weak, and the USD will be pushed lower as the central bank continues to accommodate higher US budget deficits at the federal level. However, as we have repeatedly noted, the broad trade-weighted USD has found strong support at current levels following a precipitous fall from its COVID-19-induced highs in 1Q20: As pandemic uncertainty feeds into global policy uncertainty, USD safe-haven demand remains elevated (Chart 4).5 While we concentrate on five-year inflation expectations in our modeling, indications of price pressures are showing up in the manufacturing sector in the US (Chart 5), as our colleagues in BCA Research’s US Bond Strategy note in their report this week.6 This confirms that the price strength seen in commodity markets for raw materials used in manufacturing are showing up in the economy as a whole. Chart 4Lower USD, Stronger GDP Bullish For Copper Prices Chart 5Inflation Indicators Hook Up Our price target for gold remains $2,000/oz. The sooner vaccines are deployed globally – so that markets can reasonably assign lower odds to a resurgence of COVID-19 and its more insidious variants forcing new lockdowns – the sooner the pandemic uncertainty keeping the USD well bid will dissipate as a fundamental factor restraining a continuation of gold’s rally. Silver Is Not GameStop The Reddit-powered surge in retail silver trading this past week, which lifted silver prices some ~ 11% on Monday to $30/oz, is all but a memory now that the white metal is again pricing in line with fundamentals. We turned bullish silver in July of last year, arguing fundamentals suggested silver could outperform gold in 2H20, which it did.7 Supportive fundamentals remain in place, with total supply (mine output and recycling) falling, demand rising and balances tightening (Chart 6). We expect the supply side of the market to remain under pressure this year and the next, given the physical deficits we are forecasting for the copper market over the next two year: The supply side of silver is a function of copper, zinc and lead mine output (i.e., silver largely is a byproduct). On the demand side, continued recovery of consumer spending and the decade-long buildout of renewable-energy generation – which is heavily reliant on copper and silver to a lesser degree – will force prices higher. We remain bullish silver. However, given our expectation its price will trade again to $30/oz, we do not expect any dramatic tightening of the gold/silver ratio this year (Chart 7). Chart 6Silver Market Tightens, Along With Other Commodities Chart 7Expect Gold/Silver Ratio To Continue To Narrow Bottom Line: Tightening commodity fundamentals and continued monetary accommodation at the Fed will dominate gold- and silver-pricing dynamics this year and the next. The contraction of the equity risk premium will not dominate the evolution of gold prices. At the margin, if earnings growth exceeds equity-price increases, equity yields will expand, which will support gold prices. We expect gold and silver to trade to $2,000/oz and $30/oz this year – i.e., close to ~ 10% gains for both. Therefore, we do not expect much movement in the gold/silver ratio this year Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Commodities Round-Up Energy: Bullish OPEC 2.0’s Joint Technical Committee (JTC) lowered its estimated demand growth for 2021 to 5.6mm b/d from its 5.9mm b/d estimate last month, at its Tuesday meeting. The JTC also is expecting the oil market to be in a deficit this year, which will, by the Committee’s estimate, peak at 2mm b/d in May 2021, according to reuters.com. This is in line with our maintained hypothesis that the producer coalition led by Saudi Arabia and Russia will continue to calibrate production in line with demand to keep global storage levels drawing. The JTC was not expected to recommend any change in production policy to oil ministers on Wednesday when they met. We expect OECD oil inventories to hit their rolling five-year average in 1H21, largely because of OPEC 2.0’s production discipline and production losses outside the coalition (Chart 8). Base Metals: Bullish Battery-grade lithium carbonate soared 40% y/y in January in China to $9,450/MT, according to mining.com. The reporting service noted strong demand for lithium iron phosphate (LFP) batteries used to power subsidized short-range autos, public transport infrastructure electrification, and power generation. Precious Metals: Bullish COVID-19-induced demand destruction pushed gold demand down 14% y/y in 2020, to just under 3,760 tons, according to the World Gold Council’s 2020 supply-demand tallies. At 4,633 tons, gold supply lost 4% y/y, the most since 2013, according to the WGC. Supplies were disrupted by COVID-19 as well. (Chart 9). Ags/Softs: Neutral Despite poor weather conditions in South America, US farmers are beginning to worry about record or near-record crops in the current growing season, according to farmprogress.com. grains are trading lower following recent rallies on concerns the upcoming harvest could be better than expected. Tomorrow’s USDA WASDE report will be eagerly awaited for the Department’s latest assessments. Chart 8OPEC 2.0 Keeps Supply Growth Below Demand Growth Chart 9Gold Below 200 Day Moving Average Footnotes 1 Our most recent reports on copper and oil prices – Copper's Supply Challenges and Brent Forecast: $63 This Year, $71 Next Year published 10 December 2020 and 21 January 2021 – highlight the tightening of industrial-commodity markets globally. 2 While we do find strong relationships between gold prices and 5- and 10-year US real rates, we do not find any relationship with the slope of the US rates forward curve. 3 For a discussion of equity risk premiums, please see Asness, Clifford S. (2000) “Stocks versus Bonds: Explaining the Equity Risk Premium.” Financial Analysts Journal. March/April 2000: pp. 96-113. 4 In the post-GFC period 2010-2020, the S&P 500 equity risk premium is borderline insignificant in a cointegrating regression that includes other real and financial variables (i.e., copper prices, US Fed Funds, and global economic policy uncertainty). We therefore to not treat it as determinant to the evolution of gold prices in the same way as the real and financial variables we use as regressors. 5 We expect this pandemic uncertainty to break, but not until markets are convinced sufficient supplies of vaccines will be available globally to control COVID-19 infections, hospitalizations and deaths. Please see Pandemic Uncertainty Will Fall, Weakening USD, Boosting Metals, which we published last week, for further discussion. It is available at ces.bcaresearch.com. 6 For the first time 2011, the Prices Paid component in last month’s ISM Manufacturing PMI came in above 80, signaling for the first time since 2011. Please see No Tightening In 2021, published by BCA’s US Bond Strategy 2 February 2021. It is available at usbs.bcaresearch.com. 7 Please see Silver Likely Outperforms Gold In 2H20, which we published 2 July 2020. It is available at ces.bcaresearch.com. We recommended a long silver position then at $18.51/oz and closed it 23 September 2020 at $26/oz. Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Summary of Closed Trades