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Executive Summary Italy’s right-wing alliance, led by Brothers of Italy, will likely outperform in the upcoming election. The new government will prioritize the economy, posing a risk to the EU’s united front against Russia. It is conducive to an eventual ceasefire, which is marginally positive for risk assets in 2023. We recommend investors underweight Italian assets on a tactical basis. China’s political risks will remain elevated until Xi consolidates power this fall, positive news will come after, if at all. Geopolitical risk in the Taiwan Strait will remain high and persistent until China and the US reach a new understanding. Separately, we are booking a 9% gain on our long US equities relative to UAE equities trade. Italy: GeoRisk Indicator Tactical Recommendation Inception Date Return LONG US / UAE EQUITIES (CLOSED) 2022-03-11 9.0% Bottom Line: Italy’s political turmoil suggests a more pragmatic policy toward Russia going forward. Europe’s energy cutoff will also motivate governments to negotiate with Russia. Feature In this report we update our GeoRisk Indicators, with a special focus on Italy’s newest political turmoil. Italy Over the past several months, we have argued that Italy was a source of political risk within the European Union and that the market underestimated the probability of an early Italian election. In the past two weeks, this forecast has become a reality (Chart 1). Chart 1Italy: GeoRisk Indicator The grand coalition under Prime Minister Mario Draghi had fulfilled its two main purposes – to distribute EU recovery funds and secure an establishment politician in the Italian presidency. At the same time, headline inflation hit 8.5% in June, the highest since 1986, even as the Italian and global economy slowed down, Italian government bonds sold off, and Russia induced an energy crisis. The stagflationary economic environment is biting hard and the different coalition members are looking to their individual interests ahead of election season. On July 14, Giuseppe Conte, the former prime minister, pulled its populist Five Star Movement (M5S) out of Mario Draghi’s national unity government, triggering a new round of political turmoil in Italy. Draghi’s first resignation was rejected by Italian President Mattarella later that day. However, on July 21, the League and Forza Italia also defected from the grand coalition. After Draghi’s plan of reviving the coalition collapsed, President Mattarella accepted his resignation and called for a snap election to be held on September 25, ten months ahead of the original schedule. Based on the latest public opinion polls, right-wing political parties are well-positioned for the upcoming election. The far-right Brothers of Italy is now the front runner in the election race and is expected to win around 23% of the votes. Another far-right party, the League, is the third most popular party, with nearly 15% support despite a drop in support during its time within the grand coalition. In addition, the center-right Forza Italia receives 8.5% of the support. Together, the right-wing conservative bloc amounts to 46.5% of voting intentions. There is still positive momentum for Brothers of Italy to harvest more support given that they are the flag-bearer for anti-incumbent sentiment amid the stagflationary economy. By contrast, the left-wing parties – the Democrats, the Left, and the Greens – only command about 27%. The possibility of an extended left-wing coalition, even with the inclusion of the M5S, is looking slim. On July 25, Enrico Letta, the leader of the Democratic Party, publicly expressed his anger against party leader Giuseppe Conte and ruled out any electoral pact with the M5S because of the recent political chaos they caused. He stressed that the Democratic Party would seek ties with parties that had remained loyal to Draghi’s national unity. However, there are not many parties left for the Democrats to partner with. Apart from the Left and the Greens, the Democrats’ best chance would be the center-left Action Party and Italia Viva, which is led by Matteo Renzi, who served as the secretary of the Democratic Party from 2013 to 2018. However, these four parties are small and will not enable the Democrats to form a government. Courting M5S is the Democrats’ only chance to set up an alternative to the right-wing bloc, but that will require the election to force the two parties together. Related Report Geopolitical StrategyLe Pen And Other Hurdles (GeoRisk Update) The Democratic Party was the biggest supporter of Draghi’s government, while the Brothers of Italy were the sole major opposition. Thus the September 25 election will be a race between these two major parties. Both are expected to outperform current polling, as they will attract the most supporters from each side. The other right-wing parties, Forza Italia and the League, will at least perform in line with their polling, while the other left-wing parties will underperform. In the meantime, M5S’ popularity will continue to decline – the party is bruised over its role in Draghi’s coalition and divided over how to respond to the Ukraine war. Foreign policy is a major factor in this election. Italy has the highest share of citizens in the Eurozone who support solving the Russia-Ukraine conflict through peaceful dialogue (52% versus the Eurozone average of 35%). Italy has long maintained pragmatic relations with Russia, including the Putin administration, as it imported 40% of its natural gas from there prior to 2022. The EU is struggling to maintain a united front against Russia, and war policy will be a key focal point among the different parties. Draghi and the Democratic Party are the strongest supporters of the EU’s oil embargo on Russia and decision to send arms to support Ukraine. On the other side, the right-wing Forza Italia and the League have been more equivocal due to their traditional friendship with Russia. What’s more important is the stance of the Brothers of Italy on Russia, as it is the largest party now and will probably lead a right-wing government after the election. On July 27, the three right-wing parties struck a deal to officially form an alliance in the upcoming election and whichever party wins the most votes would determine the next prime minister if the alliance wins. This deal puts Giorgia Meloni, the leader of Brothers of Italy, one step closer to becoming Italy’s first female PM. Giorgia Meloni, unlike her right-wing peers, has endorsed Draghi’s hawkish stance towards Russia. Recently, she stressed that Italy would keep sending arms to Ukraine if her party forms a government after the election. However, Meloni’s speech could be a tactical move to win the election more than an unshakeable policy position. First, like the other two right-wing parties, the Brothers of Italy have had close connections with Russia. After the 2018 Russian presidential election, Meloni congratulated Putin and claimed his victory was “the unequivocal will of Russians.” In addition, she is close to Prime Minister Viktor Orban of Hungary and National Rally leader Marine Le Pen of France, both of whom have criticized the EU’s decision to provide military support to Kyiv. Hence her sharp change of stance this year seems calculated to avoid accusations of being pro-Russian. But that does not preclude a more pragmatic approach to Russia once in office. Second, Meloni has compromised other far-right positions to broaden her voter base. She has reversed the party’s original anti-EU stance and claimed it does not seek to leave the EU, as most European anti-establishment parties have had to do in order to make themselves electable. Being the only female in the election race, Meloni also pledged to protect women’s access to safe abortions in Italy, also a softer stance than before. Even if the Brothers of Italy distance themselves from some unpopular right-wing positions, including on Ukraine, they probably cannot form a government on their own. They will need to court Forza Italia and the League. These two parties prefer a more pragmatic approach to Russia and a peaceful resolution to the war. Thus while it will be hard to find a middle ground on the issue of Ukraine, the election will likely prevent Italy from taking a more confrontational stance toward Russia. It will probably do the opposite. Consider the context in which the next Italian government will operate. Russia declared on July 25 that it will further reduce natural gas supplies to Europe through Nord Stream 1, as we expected, bringing pipeline flows to 20% of its full capacity. Energy prices will go up even as European economic activity and industry will suffer greater strains. If Meloni is elected as the new prime minister this September, she will have to keep talking tough on Russia while simultaneously seeking a solution to soaring energy prices and economic crisis. This solution will be diplomacy – unless Russia seeks to expand its invasion all the way to Moldova. A right-wing victory is the most likely outcome based on opinion polling, the negative cyclical economy, and the underlying structural factors supporting populism in Italy that we have monitored for years. Such a coalition will not be pro-Russian but it will be pragmatic and focused on salvaging Italy’s economy, which means it will be highly inclined toward diplomacy. If Russia halts its military advance – does not attempt to conquer southwestern Ukraine to Moldova – then this point will be greatly reinforced. Italy will become a new veto player within the European Union when it comes to any major new sanctions on Russia. While Europeans will continue diversifying their energy mix away from Russia, it will be much harder for the EU to implement a natural gas embargo in the coming years if Italy as well as Hungary oppose it. Even if we are wrong, and the Democratic Party or other left-wing parties surprise to the upside in the election, the new coalition will most likely have to focus on mitigating the economic crisis and thus pursuing diplomacy with Russia. That is, as long as Russia pushes for a ceasefire after it achieves its military aims in Donetsk, the last holdout within the south-southeastern territories Russia is trying to conquer. Bottom Line: Due to persistent political uncertainty, we recommend investors underweight Italian stocks and bonds at least until a new government takes shape, which could take months even after the election. However, government bonds will remain vulnerable if a right-wing coalition assumes power, since it will pursue loose fiscal policies and will eschew structural reforms. Overall Italy’s early elections will lead to a new government that is focused on short-term economic growth, likely including pragmatism toward Russia. From an investment point of view that will not be a negative development, though much depends on whether Russia expands its invasion or declares victory after Donetsk. Russia Market-based measures of Russian geopolitical risk are rebounding after subsiding from peak levels hit during the invasion of Ukraine in February (Chart 2). Chart 2Russia: GeoRisk Indicator Russia’s continued tightening of natural gas supplies (and food exports) this week is precisely what we predicted would happen despite a wave of wishful thinking from investors over the past month. The optimists claimed that Russia would resume Nord Stream 1 pipeline flows after a regular “maintenance” period. They also said that Canada’s cooperation in resolving some “technical” issues around turbines would stabilize natural gas supply. The truth is that Russia is seeking to achieve its war aims in Ukraine. Until it has achieved its aims, it will use a range of leverage, including tightening food and energy supplies. Most likely Russia will halt the advance after completing the conquest of the Donbas region and land-bridge to Crimea. Then it will seek to legitimize its conquests through a ceasefire agreement. However, it could launch a new phase of the war to try to take Odessa and Transniestria, which would cement European resolve, even in Italy, and trigger a new round of sanctions. Bottom Line: Russia faces a fork in the road once it completes the conquest of Donetsk. Most likely it will declare victory and start pushing for a ceasefire late this year or early next year. Movement toward a ceasefire would reduce geopolitical risk for global financial markets in 2023. But there is still a substantial risk that Russia could expand the invasion to eastern Moldova, which would escalate the overarching Russia-West conflict and sustain the high level of geopolitical risk for markets. China Chinese political and geopolitical risk will continue to rise and the bounce in Chinese relative equity performance is faltering as we expected (Chart 3). Chart 3China: GeoRisk Indicator China’s leaders will hold their secretive annual meeting at Beidaihe in August ahead of the critical Communist Party national congress this fall. General Secretary Xi Jinping is attempting to cement himself as the paramount leader in China, comparable to Chairman Mao Zedong, transforming China’s governance from that of single-party rule to single-person rule. The reversion to autocratic government is coinciding with a historic economic slowdown consisting of cyclical factors (weak domestic demand, weakening foreign demand, draconian Covid-19 restrictions) and structural factors (labor force contraction, property sector bust, social change and unrest). Both Xi and US President Biden face major domestic political challenges in the coming months with the party congress and the US midterm election. Hence they are holding talks to try to stabilize relations. But we do not think they will succeed. China cannot reject Russia’s strategic overture, while the US cannot afford to re-engage with a China that is partnering with Russia in a challenge to the liberal-democratic world order. In addition, US policies are erratic and the US cannot credibly promise China that it will not pursue a containment strategy even if China offers trade concessions. Bottom Line: China-related political and geopolitical risks will remain very high until at least after the twentieth party congress. At that point we expect President Xi to loosen a range of policies to stabilize the economy and foreign trade relations. These policies may bring positive news in 2023, though China’s biggest macroeconomic and geopolitical problems remain structural in nature and we remain underweight Chinese assets. Taiwan For many years we have warned of a “fourth Taiwan Strait crisis” due to the unsustainable geopolitical situation between China, Taiwan, and the United States. After the war in Ukraine we argued that the US would try to boost its strategic deterrence around Taiwan, since it failed to deter Russia from invading Ukraine, but that the increased commitment to Taiwan would in fact provoke China (Chart 4). Chart 4Taiwan: GeoRisk Indicator Until the US and China reach a new understanding over Taiwan, we argued that the region would be susceptible to rising tensions and crisis points that would send investors fleeing from risky assets, especially risky regional assets. It is possible that we have arrived at this crisis now, with House Speaker Nancy Pelosi making preparations to visit Taiwan, China pledging “forceful” countermeasures if she does, President Biden suggesting that the US military thinks Pelosi should not visit, and Biden and Xi preparing for a phone conversation. In essence China is giving an ultimatum and setting a new bar, and a very low bar, for taking some kind of action on Taiwan, i.e. the mere visit of a US House speaker, which has happened before (House Speaker Newt Gingrich in 1997). China’s purpose is to lay the groundwork for preventing the US from upgrading Taiwan relations in any more substantial way, whether political or military. If the Biden administration calls off the Pelosi visit, then American relations with Taiwan will have been curtailed, at least for this administration. If Biden goes forward with the visit, then Beijing will need to respond with an aggressive show of force to prevent any future president from repeating the exercise or building on it. And if this show threatens US personnel or security, a full-blown diplomatic or military crisis could ensue. While we doubt it would lead to full-scale war, it could lead to a frightening confrontation. Biden may want to stabilize relations with China, since he is primarily focused on countering Russia, but his options are limited. China cannot save him from inflation but it can solidify the public perception that he is weak. Hence he is more likely to maintain his administration’s hawkish approach. Biden’s approval rating is 38% and his party faces a drubbing in the midterm elections. A confrontation with Russia, China, Iran, or anyone else would likely help his party by producing a public rally around the flag. Any unilateral concessions will merely strengthen Xi’s power consolidation at the party congress, which is detrimental to US interests. Only if the Biden administration pursues a dovish policy of re-engagement that is subsequently confirmed by the 2024 presidential election will there be potential for a substantial US-China economic re-engagement. We are pessimistic. Bottom Line: Taiwan-related geopolitical risk will rise in the short run. If there is a new US-China understanding over Taiwan, then regional and global geopolitical risk will decline over the medium term. But we remain short Taiwanese assets. Investment Takeaways Investors should remain defensively positioned until the US midterm election ends with congressional gridlock; the Chinese party congress is over and Xi Jinping launches a broad pro-growth policy; and Russia starts pushing for a ceasefire in Ukraine. We also expect that markets will need to get over new, unexpected oil supply shocks arising from the failure of US-Iran nuclear negotiations, which remains off the radar and therefore a source of negative surprises. Any US-Iran nuclear deal would be a major positive surprise that postpones this risk for a few years. Having said that, we are booking a 9% gain on our long US versus UAE equity trade for technical reasons. Democrats have reached a deal to pass a budget reconciliation bill in an effort to mitigate midterm election losses. This development reinforces the 65% odds of passage that we have maintained for this bill’s passage in our US Political Strategy reports since last year. Yushu Ma Research Analyst yushu.ma@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Appendix UK Chart 5UK: GeoRisk Indicator Germany Chart 6Germany: GeoRisk Indicator France Chart 7France: GeoRisk Indicator Spain Chart 8Spain: GeoRisk Indicator Canada Chart 9Canada: GeoRisk Indicator Australia Chart 10Australia: GeoRisk Indicator Korea Chart 11Korea: GeoRisk Indicator Brazil Chart 12Brazil: GeoRisk Indicator Turkey Chart 13Turkey: GeoRisk Indicator South Africa Chart 14South Africa: GeoRisk Indicator Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades Geopolitical Calendar
Executive Summary EU Will Prioritize Natgas Storage Russia’s reduction in natural gas flows through the Nord Stream 1 (NS1) pipeline to 20% of capacity will test the EU’s ability to keep the lights on going into winter. The EU’s plan to voluntarily reduce natgas consumption by 15% has a higher likelihood of becoming mandatory, following Russia’s cut in NS1 flows. Coal-fired generation in the EU will come online sooner on the back of the NS1 cutoff. This will allow more natgas supplies to be directed to storage injection ahead of winter. Global natgas supplies will remain tight until 2025, as liquified natural gas (LNG) export capacity is developed ex-EU. Bottom Line: EU energy security will be paramount going into the winter, particularly if Russia keeps gas flows through NS1 at or below 20% of capacity going into winter. Russia most likely is seeking a significant reduction or the complete elimination of EU oil sanctions, which were imposed after it invaded Ukraine. If fully enacted, the EU’s embargo will remove more than 3mm b/d of Russian oil exports to the continent by 1Q23. The EU’s coal reserves and its 15% cut in demand could allow the bloc to get through the winter without a massive recession. If, as we believe, these measures are successful, a strong rally in European equities and bonds could ensue. Feature Following Russia’s halving of NS1 gas flows to 20% of capacity yesterday – taking shipments to ~ 33mm cm/d – the EU will be forced to increase its reliance on coal-fired electricity generation sooner than expected, to ensure as much natgas as possible is directed to filling storage ahead of the coming winter. And it will have to count on high levels of cooperation in reducing natgas demand between August and March by 15%.1 There is nothing that more dramatically illustrates the bind the EU finds itself in than rolling over its ESG agenda to ensure it has sufficient gas supplies to heat homes, hospitals and other critical services over the course of the coming winter. Russia’s cutoff of NS1 supplies is being done to focus EU member states on their precarious energy position just as they are scrambling to fill natgas storage. The sense of urgency in this effort is heightened by relatively high odds (67%) of another La Niña event, which usually is accompanied by colder-than-normal winter temperatures in the Northern Hemisphere.2 Russia appears to be seeking a significant reduction or the complete elimination of EU oil import sanctions, which were imposed after it invaded Ukraine. If fully enacted as approved, this will embargo more than 3mm b/d of Russian oil exports to the continent by 1Q23. The EU was Russia’s largest oil customer prior to the sanctions being approved.3 Russia Deploys Its Gas Weapon The EU is aiming to have 80% of its gas storage capacity filled by November, to ensure it has sufficient supplies for the coming winter (Chart 1).4 Achieving this target will prove difficult and uncertain, since it hinges on 1) gas flows from Russia not dropping precariously low or completely cutting off; 2) higher non-Russian flows; and 3) reduced gas consumption, which, as we noted above, likely will become mandatory. We ran different simulations altering these variables to see how inventories could move for the rest of 2022 and into the winter (Chart 2). Chart 1EU Will Prioritize Natgas Storage Chart 2The EU Could Face A Cold Winter In the simulations, if a variable changes more than we expect – e.g. Russian supplies drop by more than projected – one or both of the other variables will need to adjust to ensure the EU can sufficiently fill gas storage. This adjustment is not guaranteed, since all three variables will likely not move in accordance with policymakers’ expectations, especially gas flows from Russia as it seeks to imperil the bloc’s energy security. On the supply side, Russian flows can drop with little or no warning, while non-Russian supplies will need to remain ~ 30-35% higher relative to 2021, for the rest of the year to get natgas inventories to or slightly above 80%. On the demand side, the EU deal to cut gas consumption by 15% over the course of August-March was accepted with caveats for some member states. The debate and member states’ dissatisfaction over the initial agreement signals states may not implement this policy until they must, which could be too little too late. Of course, a complete cutoff of natural gas flows on the NS1 pipeline would result in inventories being pulled much harder and earlier, and likely would induce further rationing measures. This would produce a sharper economic contraction, since coal-fired generation and other energy usage likely would have maxed out prior to the sharp fall-off in natgas storage. Higher Coal Usage Buys EU Time Global natural gas markets are expected to remain tight into 2025, given the 5-year lead times required to develop LNG capacity export capacity.5 This is forcing EU member states – particularly Austria, France, Germany and the Netherlands – to place an additional 14 GW of coal-fired generation capacity into its reserve fleet in the event of a complete cutoff of Russian supplies.6 Fossil fuels accounted for 34% of EU generation in 2021, or 1,069 TWh. The largest share of this generation was accounted for by coal (Chart 3). Fossil fuels and renewables provide the largest shares of electricity generation overall in the EU (Chart 4). Chart 3Coal Folded Back Into EU Power Stack The EU would like to see its natgas inventories 80% full by November. This translates to ~ 3.2 TCF of natgas in storage, which would put inventories at the higher end of the 5-year range for November. That’s a big assumption, but it does indicate why the combination of higher coal usage and – critically – the 15% cut in demand (vs. five-year average demand) in our simulations is so important. Together, these measures mean the EU will save almost 1.3 TCF of storage gas from August – March. This assumes, of course, that EU member states pull their weight on the conservation front in this economic war with Russia. If everything goes according to plan for the EU (scenario 2 in the Chart 2), then March 2023 inventories will be at the level of 2.5 Tcf. Compared to last year, that means inventories will be 1.3 Tcf higher. Of course that’s impossible to forecast, but there are realistic outcomes close to this outcome. Chart 4Fossil Fuels, Renewables Provide Most Of EU’s Power Investment Implications The EU and Russia are at a critical juncture as winter approaches. Our analysis indicates the EU can – using its coal reserves and getting full buy-in on the 15% conservation measures adopted this week – weather this storm without experiencing a massive recession. Markets will be watching this evolution carefully. By late January or early February, it will be apparent how well the EU managed this challenge. If, as we believe, these measures are successful, we could expect a strong rally in European equities and bonds. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Commodities Round-Up Energy: Bullish The US became the largest exporter of LNG in 1H22 with outbound shipments averaging 11.2 Bcf/d, according to the EIA (Chart 5). US liquefaction peak capacity is estimated at 13.9 Bcf/d, with average capacity at 11.4 Bcf/d. The EU and UK are receiving most of the US LNG, which averaged 7.3 Bcf/d, or 64% of total exports over the January-May 2022 interval. Over 1H22, US exports accounted for close to half of the 15 Bcf/d imported by the EU and UK, making it the largest single exporter to Europe. Export volumes were dented in June with the loss of volumes from the Freeport LNG facility in Texas; this is expected to be restored by year-end. We are expecting exports to Europe to remain strong in the wake of the Russia-Ukraine war, especially as demand from Europe to replace Russian supplies stays strong. Base Metals: Bullish Chinese property stocks rallied on news that the government created a $44.4 billion fund to help alleviate the state’s property sector woes. Housing accounts for ~ 30% of copper consumption in China, and the fund should provide positive price action for the red metal in the face of slowing global growth this year and next. We remain bullish copper on the back of supply disruptions in Peru; increasing concern higher taxes in Chile will no longer support returns to miners that are sufficient to encourage capex, and extremely low global copper inventories, which have remained more than 25% below year-ago levels for more than a year (Chart 6). We will be updating our copper view next week. Ags/Softs: Neutral Russia and Ukraine signed a deal brokered by Turkey and the United Nations aimed at allowing some 22mm tons of grain exports from Ukraine, and some Russian grain and fertilizers to transit the Black Sea to end-use markets. These grain supplies are critically important to Middle East and North African markets. However, it could take weeks for Ukrainian ports to be cleared of mines and other obstacles – and, importantly, for a true cessation in Russian attacks on Black Sea port facilities – to resume operations.7 Chart 5 Chart 6 Footnotes 1 Please see EU allows get-out clause in Russian gas cut deal - BBC News, published by bbc.co.uk on July 27, 2022. 2 Please see the US Climate Prediction Center's most recent forecast, posted on July 14, 2022. 3 lease see Higher Gasoline, Diesel Prices Ahead, for discussion of the embargo on Russian crude and product imports to the EU. Our assessment was published on June 2, 2022, and is available at ces.bcaresearch.com. 4 As of July 25, EU natgas inventories were ~ 67% full at 2.5 TCF. 5 The IEA estimates growth in global LNG supply will slow over its five-year 2021-25 forecast horizon, due to low capex, and COVID-19-induced delays. Please see the IEA’s Gas Market Report, Q3-2022. 6 Please see Coal is not making a comeback: Europe plans limited increase, published by the European think tank Ember on July 13, 2022. 7 Please see Ukraine, Russia Sign Black Sea Grain Export Deal published by University Of Illinois, July 22, 2022. Investment Views and Themes Strategic Recommendations Trades Closed In 2022
Executive Summary If a loss of wealth persists for a year or more, it hurts the economy. The recent $40 trillion slump in global financial wealth is larger than that suffered in the pandemic of 2020, the global financial crisis of 2008, and the dot com bust of 2000-01. Partly countering this slump in global financial wealth is a $20 trillion uplift in global real estate wealth. However, Chinese home prices are already stagnating. And the recent disappearance of US and European homebuyers combined with a flood of home-sellers warns that US and European home prices will cool over the next 6 months. With the loss of wealth likely to persist, it will amplify a global growth slowdown already in train, aided and abetted by central banks that are willing to enter recession to slay inflation. The optimal asset allocation over the next 6-12 months is: overweight bonds, neutral stocks, and underweight commodities. A variation on this theme is: overweight conventional bonds and stocks versus inflation-protected bonds and commodities. Fractal trading watchlist: US telecoms versus utilities, and copper. We Have Just Suffered The Worst Loss Of Financial Wealth In A Generation Bottom Line: On a 6-12 month horizon, overweight bonds, neutral stocks, and underweight commodities. Feature Since the end of last year, the world has lost $40 trillion of financial wealth, evenly split between the crashes in stocks and bonds (Chart I-1). The slump in financial wealth, both in absolute and proportionate terms, is the worst suffered in a generation, larger than that in the pandemic of 2020, the global financial crisis of 2008, and the dot com bust of 2000-01.1 Chart I-1Global Stocks And Global Bonds Have Both Slumped By $20 Trillion Partly countering this $40 trillion slump in global financial wealth is a $20 trillion uplift in global real estate wealth. But in total, the world is still $20 trillion ‘asset poorer’ than at the end of last year. Given that global GDP is around $100 trillion, we can say that we are asset poorer, on average, by about one fifth of our annual income. Does this loss of wealth matter? A Loss Of Wealth Matters If It Persists For A Year Or More Some argue that we shouldn’t worry about the recent slump in our wealth, because we are still wealthier than we were, say, at the start of the pandemic (Chart I-2). Yet this is a facile argument. Whatever loss of wealth we suffer, there is always some point in the past against which we are richer! Chart I-2We Have Just Suffered The Worst Loss Of Financial Wealth In A Generation Another argument is that people do not care about a short-lived dip in their wealth. This argument has more truth to it. For example, in the extreme event of a flash crash, an asset price can drop to zero and then bounce back in the blink of an eyelid. In this case, most people would be oblivious, or unconcerned, by this momentary collapse in their wealth. But people do care if the slump in their wealth becomes more prolonged. How long is prolonged? The answer is, if the slump persists for a year or more. Why a year? Because that is the timeframe over which governments, firms, and households make their income and spending plans. Governments and firms do this formally in their annual budgets that set tax rates, wages, bonuses, and investment spending. Households do it informally, because their wages, bonuses, and taxes – and therefore disposable incomes – also adjust on an annual basis. Into this yearly spending plan will also come any change in wealth experienced over the previous year. For example, firms often do this formally by converting an asset write-down to a deduction from profits, which will then impact the firm’s future spending. This illustrates that what impacts your spending is not the level of your wealth, but the yearly change in your wealth. Spending Is Impacted By The Change In Wealth The intellectual battle here is between Economics and Psychology. The economics textbooks insist that it is the level of your wealth that impacts your spending, whereas the psychology and behavioural finance textbooks insist that it is the change in your wealth that impacts your spending. (Chart I-3and Chart I-4). In my view, the psychologists and behavioural finance guys have nailed this better than the economists, through a theory known as Mental Accounting Bias. Chart I-3The Change And Impulse Of Stock Market Wealth Are Both Negative Chart I-4The Change And Impulse Of Bond Market Wealth Are Both Negative Nobel Laureate psychologist Daniel Kahneman points out that we categorise our money into different accounts, which are sometimes physical, sometimes only mental – and that there is a clear hierarchy in our willingness to spend these ‘mental accounts’. Put simply, we are willing to spend our income mental account, but we are much less willing to spend our wealth mental account. Still, wealth can generate income through interest payments and dividends, which we are willing to spend. Clearly, the level of income generated will correlate with the amount of wealth – $10 million of wealth will likely generate much more income than $1 million of wealth. So, economists get the impression that it is the level of wealth that impacts spending, but the truth is that it is the income generated by the wealth that impacts spending. We are willing to spend our income ‘mental account’, but we are much less willing to spend our wealth ‘mental account’. What about someone like Amazon founder Jeff Bezos who has immense wealth but seemingly negligible income – Mr. Bezos receives only a token salary, and his huge holding of Amazon shares pays no dividend – how then can we explain his largesse? The answer is that Mr. Bezos’ immense wealth generates tens of billions in trading income. So again, it is his income that is driving his spending. Wealth also generates an ‘income substitute’ via capital gains. For example, you should be indifferent between a $100 bond giving you $2 of income, or a $98 zero-coupon bond maturing in one year at $100, giving you $2 of capital gain. In this case the capital gain is simply an income substitute and fully transferred into the spending mental account. Nowhere is this truer than in China, where the straight-line appreciation in house prices through several decades has allowed homeowners to regard a reliable capital gain as an income substitute (Chart I-5). Which justifies rental yields on Chinese housing that are the lowest in the world and lower even than the yield on risk-free cash. In other words, which justifies a stratospheric valuation for Chinese real estate. Usually though, we tend to transfer only a proportion of our capital gains or losses into our spending mental account. As described previously, a firm will do this formally by transferring an asset write-down into the income statement. And households will do it informally by transferring some proportion of their yearly change in wealth into their spending mental account. The important conclusion is that spending is impacted by the yearly change in wealth. Meaning that spending growth is impacted by the yearly change in the yearly change in wealth, known as the wealth (1-year) impulse, where a negative impulse implies negative growth. Cracks Appearing In The Housing Market Given the recent slump in financial wealth, the global financial wealth impulse is in deeply negative territory. Yet by far the largest part of our wealth comprises housing, meaning the value of our homes2 (Chart I-6). In China, the recent stagnation of house prices means that the housing wealth impulse has turned negative. Elsewhere in the world though, the recent boom in house prices means that the housing wealth impulse is still positive, meaning a tailwind – albeit a rapidly fading tailwind – to spending (Chart I-7 and Chart I-8). Chart I-6Housing Comprises By Far The Largest Part Of Our Wealth Chart I-7Chinese House Prices Have Stagnated, US House Prices Have Surged Chart I-8The Chinese Housing Wealth Impulse Is Negative, The US Housing Wealth Impulse Is Fading In China, the recent stagnation of house prices means that the housing wealth impulse has turned negative. Still, as we explained in The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting, the disappearance of homebuyers combined with a flood of home-sellers is a tried and tested indicator that US and European home prices will cool over the next 6 months. US new home prices have already suffered a significant decline in June (Chart I-9). Some of this is because US homebuilders are building smaller and less expensive homes. Nevertheless, it seems highly likely that the non-China housing wealth impulse will also turn negative later this year. Chart I-9US New Home Prices Fell Sharply In June To be clear, the wealth impulse is just one driver of spending growth. Nevertheless, it does have the potential to amplify the growth cycle in either direction. With global growth clearly slowing, and central banks willing to enter recession to slay inflation, the rapidly fading global wealth impulse will amplify the slowdown. Therefore, the optimal asset allocation over the next 6-12 months is: Overweight bonds. Neutral stocks. Underweight commodities. A variation on this theme is: Overweight conventional bonds and stocks versus inflation-protected bonds and commodities. Fractal Trading Watchlist After a 35 percent decline since March, copper has hit a resistance point on its short-term fractal structure, from which it could experience a countertrend move. Hence, we are adding copper to our watchlist. Of note also, the underperformance of US telecoms versus utilities has reached the point of fragility on its 260-day fractal structure that has signalled previous major turning points in 2012, 2014, and 2017 (Chart I-10). Hence, the recommended trade is long US telecoms versus utilities, setting a profit target and symmetrical stop-loss at 8 percent. Chart I-10US Telecoms Versus Utilities Are At A Potential Turnaround Fractal Trading Watchlist: New Additions Copper’s Selloff Has Hit Short-Term Resistance Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The value of global equities has dropped by $20tn to $80tn, the value of global bonds by $20tn to around $100tn, while the value of global real estate has increased by $20tn to an estimated $370tn. 2 Strictly speaking, housing wealth should be measured net of the mortgage debt that is owed on our homes. But as the wealth impulse is a change of a change, and mortgage debt changes very slowly, it does not matter whether we calculate the impulse from gross or net housing wealth. Chart 1CNY/USD At A Potential Turning Point Chart 2Copper's Selloff Has Hit Short-Term Resistance Chart 3US REITS Are Oversold Versus Utilities Chart 4CAD/SEK Is Reversing Chart 5Financials Versus Industrials Has Reversed Chart 6The Outperformance Of Resources Versus Biotech Has Ended Chart 7The Outperformance Of Resources Versus Healthcare Has Ended Chart 8FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 9Netherlands' Underperformance Vs. Switzerland Has Ended Chart 10The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 11The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 12Food And Beverage Outperformance Is Exhausted Chart 13German Telecom Outperformance Has Started To Reverse Chart 14Japanese Telecom Outperformance Vulnerable To Reversal Chart 15ETH Is Approaching A Possible Capitulation Chart 16The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 17The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 18A Potential Switching Point From Tobacco Into Cannabis Chart 19Biotech Is A Major Buy Chart 20Norway's Outperformance Has Ended Chart 21Cotton Versus Platinum Has Reversed Chart 22Switzerland's Outperformance Vs. Germany Is Exhausted Chart 23USD/EUR Is Vulnerable To Reversal Chart 24The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 25A Potential New Entry Point Into Petcare Chart 26GBP/USD At A Potential Turning Point Chart 27US Utilities Outperformance Vulnerable To Reversal Chart 28The Outperformance Of Oil Versus Banks Is Exhausted Fractal Trading System Fractal Trades 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
The Global Investment Strategy service tactically downgraded equities in February but then upgraded them in May. The decision to upgrade equities to overweight in May was clearly premature, as stocks fell significantly in June. However, the rally in July has brought stocks back above the level where we upgraded them. Hence, we are using this opportunity to shift our recommended equity allocation back to neutral. While our base case forecast still foresees no recession in the US over the next 12 months, the risks to this view have increased. In Europe, we see a recession as more likely than not. China’s economy will remain under pressure due to Covid lockdowns, a shift in global spending away from manufactured goods, and a weakening property market. Even if the US avoids a recession, this could prove to be a bittersweet outcome for stocks: While earnings will hold up, the Fed is unlikely to cut rates next year, as markets are currently discounting. Real bond yields, which have already risen steeply this year, will rise further, weighing on equity valuations. Time to Take Some Chips Off the Table The consensus view among investors these days seems to be that the US is heading into a recession (or may already be in one), which will cause stocks to fall during the remainder of the year as earnings estimates are slashed. Looking out to 2023, most investors expect stocks to recover as the Fed begins to cut rates. I have the opposite view. While the risks to growth have increased, the US will probably avoid a recession over the next 12 months. This will allow stocks to rise modestly from current levels into year-end. However, as we enter 2023, it will become obvious that the Fed has no reason to cut rates. This could cause stocks to give up some of their gains, thus producing a fairly flat profile for equities over a 12-month horizon. In past reports, we have argued that the neutral rate of interest – the interest rate consistent with full employment and stable inflation – is higher than widely believed in the US. The nice thing about a high neutral rate is that it insulates the economy from tighter monetary policy: Even if the Fed raises rates to 3.8% next year, as the dots are currently forecasting, that will only put rates in the middle of our fair value range of 3.5%-to-4% for the US neutral rate. The downside of a high neutral rate is that eventually, investors will need to value stocks using a higher discount rate. The 10-year TIPS yield has already increased from -0.97% at the start of the year to +0.36% today. It will rise to 1%-to-1.5% by the middle of 2023. A higher-than-expected neutral rate also raises inflation risks because it could cause the Fed to inadvertently keep monetary policy too loose. Inflation is likely to fall significantly over the coming months as supply-chain bottlenecks ease. However, this decline in inflation could sow the seeds of its own demise: As inflation falls, real wage growth – which is now negative – will turn positive. Rising real wages will booster consumer confidence and spending. A reacceleration in inflation in the second half of next year could prompt the Fed to start hiking rates again in late 2023, thus producing a recession not in 2022 but in 2024. Outside the US, the outlook is more challenging. In Europe, a recession is more likely than not in the second half of the year. We expect the recession to be fairly short-lived, with European governments moving aggressively to mitigate the fallout from gas shortages through various income support schemes for the private sector. Chinese growth should rebound in the second half of the year. However, the specter of future lockdowns, the shift in global spending away from manufactured goods towards services, and the weakening property sector will continue to weigh on activity. We will have much more to say about this view change early next week. In the meantime, please review our report from last week entitled “The Downside Of A Soft Landing” for further color on some of the points made in this short bulletin. Tomorrow, my colleague Ritika Mankar will be sending you a Special Report making the case that the US economy’s ability to spawn mega-sized companies may become increasingly compromised over the next decade. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn & Twitter.
This year’s US equity selloff has been broad-based. Energy is the only S&P 500 sector that has posted year-to-date gains. The indiscriminate nature of the slump highlights that macro forces are behind the weakness. The Fed’s abrupt hawkish pivot has…
Executive Summary More Tightening To Come In the following report we answer the most asked questions from our recent “Bear Market 2.0” webcast. Macroeconomic backdrop and inflation: While commodity prices falling, the wage-price spiral is in full force, implying that it will take many months to reach the level of PCE inflation palatable to the Fed. The Fed will continue to tighten monetary conditions until entrenched inflation reaches its target, which may take longer than the market expects. Earnings outlook: Q2-2022 results show that an earnings slowdown has already commenced and is bound to get worse over the next couple of quarters. However, earnings forecasts are still too optimistic and a slowdown in earnings growth is not yet priced in. Investment themes: We recommend topping up allocation to Tech as it benefits from rate stabilization. However, be judicious in your choices, staying away from the more cyclical areas, such as Hardware and Equipment, and Semiconductors. We are overweight Software and Services, which is dominated by profitable and stable growth companies. Bottom Line: We continue to recommend that investors remain patient and prudent in range-bound markets. Earnings growth is likely to deteriorate into the year end. Feature Last Monday, July 18, I hosted a webcast called “Bear Market 2.0.” A total of 675 people dialed in, and I was honored. The webcast generated a significant number of client questions which I aim to address in this weekly publication. Broadly speaking, questions fell under each of the three rubrics of the webcast: Macroeconomic backdrop, earnings outlook, and investment themes, with the latter generating the lion’s share of questions. In today’s report, we will discuss inflation and rates, earnings season results, potential S&P 500 targets, whether the S&P 500 rally is sustainable, and if it is a good idea to top up Tech. We will address remaining questions on Energy and Materials, and Semiconductor in the near future. And as always, we are looking forward to more questions! Macroeconomic Backdrop How do you reconcile your inflation outlook with an assumption that long yields may have peaked? In the “Fat and Flat” and “Adaptive Expectations” reports, we outline our view that the market’s focus is shifting away from concerns about inflation and the hawkish Fed toward worries about growth. Indeed, the 10-year rate has stabilized at 2.78% on fears of impending slowdown (Chart 1). How does this reconcile with our view that inflation is entrenched and broadening (Chart 2), especially in light of the recent pullback in energy and commodities prices? Chart 1Yields Are Stabilizing Chart 2Inflation Is Entrenched Even if energy and commodities prices are falling, the latest wage survey from the Atlanta Fed demonstrates wage growth is not letting up, and labor costs, at over 50% of sales as per NIPA accounts, are a more important component of the US corporate cost structure than the cost of energy. Inflation is embedded as, companies pass on wage increases to customers by increasing prices – and, voilà, the wage-price spiral is becoming pervasive. This dynamic implies the following: Even if inflation peaks over the next several months, it will take many months to reach the level of PCE inflation palatable to the Fed. After having mismanaged inflation over the past 18 months, the Fed will err on the side of tighter policy. In fact, in its official statement, the Fed has asserted that its commitment to bringing inflation to its 2% target is unconditional. Therefore, we are still in the early innings of the monetary tightening cycle (Chart 3), where elevated inflation coexists with slowing growth and range-bound long rates. Bottom Line: The Fed will continue to tighten monetary conditions until entrenched inflation reaches its target, which may take longer than the market expects. Chart 3More Tightening To Come Earnings Outlook What are your takeaways from the earnings seasons so far? In the Daily Insight, which we published on July 21, we offer our initial reaction to the results. In short, so far earnings have been good, but margins are under pressure (Chart 4) from rising wages and fading pricing power (Chart 5). We have also heard quite a few negative comments from companies concerning the effects of inflation and rising costs, a strong dollar, and withdrawal from Russia. Some of the largest Technology companies announced slowdowns in hiring as they anticipate falls in demand. Forward guidance has also been concerning. Most companies talk about deteriorating economic conditions. Chart 4Margins Are Expected To Contract Chart 5Pricing Power Turning We are still convinced that street forecasts of earnings growing at about a 10% rate over the next 12 months and 11% into year-end (Table 1), despite ubiquitous negative corporate guidance, are unrealistically high. Even in this reporting season for Q2-22, earnings growth is -3%, excluding Energy. Table 1S&P 500 EPS: Actual And Expected It is unlikely that, over the next several months, macro headwinds, such as slowing growth, the hawkish Fed, stubborn inflation, and rising wages will dissipate. There is little consensus among analysts on forecasts (Chart 6) and downgrades are likely. We take it a step further, and call an earnings recession in three to six months. Chart 6Analysts Have Little Confidence In Their Forecasts Bottom Line: Q2-2022 results show that an earnings slowdown has most likely already commenced and is bound to get worse over the next couple of quarters. However, earnings forecasts are still too optimistic and a slowdown in earnings growth is not yet priced in. Do you think that the slowdown in earnings might trigger multiple expansion? Earnings contraction, everything else equal, translates into multiple expansion, as the denominator of the fraction gets smaller. For example, according to our back-of-the-envelope estimates, earnings contracting by 10% will increase the forward multiple from the current 16x to 19x. Therefore, the key question here is how likely is it that everything else will indeed stay equal, as opposed to the market selling off in line with earnings? Multiples will expand if the market is able to see past negative earnings growth, identifying a catalyst for an imminent rebound. That was the case in 2020 as investors anticipated earnings bouncing back helped by easy monetary and fiscal policy, and COVID receding. What will be a catalyst for earnings rebound in, say, 2023? We can only speculate but one of the potential reasons for faster earnings growth is perhaps normalization of growth outside of the US: A weaker dollar, peace in Ukraine, resolution of the energy crisis, or ultra-loose monetary and fiscal policy in China. At home, the anticipation of a soft landing and a more dovish monetary policy coupled with a positive real wage growth boosting consumers’ spending power may be sufficient to reassure investors that earnings growth turning positive is imminent. However, all of these developments are probably months away. And we expect the market to sell off if earnings growth disappoints. Where do you see the S&P 500 by the end of the year? Broadly speaking, BCA Research does not provide targets but rather aims to offer insights into market trends. However, in the “Is Earnings Recession In The Cards?” report, we presented a matrix outlining different scenarios of earnings growth vs. forward multiples to arrive at a potential range of the outcomes for the index. We assume that the forward multiple stays at 16x, as the multiple contraction stage of the bear market is likely completed, but there is still no clear catalyst for earnings rebound. We will approximate CY 2022 results using the Next Twelve Months Matrix (Table 2). Table 2The S&P 500 Price Target Scenarios We can distill the matrix into three likely scenarios: Earnings growth delivered by companies in line with analyst expectations of 11% over the six months; flat earnings (0% growth) broadly in line with the forecast based on our earnings model; and the worst-case scenario of a severe earnings contraction of -10% into year-end. We assign 25% to both extreme cases and about 50% to earnings staying flat for the next six months (earnings recession commencing in 2023). Best-case scenario: Earnings grow into year-end by 11%, and by 9.7% over the next 12 months. In that case, the S&P 500 will end the year at 3,837 or 3% off the current level. This is what is being priced in. Most likely scenario: Earnings growth trends to zero by the end of the year with the S&P 500 hitting 3500 or downshifting roughly 10% from here. Worst-case scenario: Earnings contract by 10%, and with the multiple staying at 16x, the S&P 500 price target will be 3287 or about 17% lower than today. With “E” falling so much, perhaps the multiple expands to 17x, in which case the market will fall “only” 11% from here. Bottom Line: We expect flagging earnings to cause another leg of the bear market, which is likely to be 5-10% into year-end, and perhaps another 5-10% in 2023. Equity Market Outlook And Key Investment Themes Are investors capitulating? Are we near or even past the bottom? The decline in oil and food prices and the easing of supply-side bottlenecks have alleviated market worries about US inflation. This, coupled with oversold risk assets, and apparent extreme pessimism in investor sentiment, has resulted in the S&P 500 rebounding 8% from its June lows. Sectors that have sold off the most over the past six months have bounced back the hardest (Chart 7). Naturally, the question that is top of mind for investors is whether this rebound is sustainable. Should they add beaten-down cyclicals to their portfolios to partake in the rally? Of course, no one can predict what Mr. Market will do with 100% certainty but here are some thoughts: Chart 7Sector Performance Overview Positives Many risk assets are severely oversold, and for long-term investors, an entry point is attractive valuation-wise. So far, many investors find earnings season results somewhat encouraging: Netflix soared on what its CEO Hawkins called “less bad results.” Multiples have contracted and priced in most of the primary effects of high inflation and rising rates. Negatives The Fed is determined to extinguish inflation, and this hiking cycle may end up much longer and steeper than the market is pricing in. We do not anticipate monetary easing in the first half of 2023. Financial markets are currently underrating the risk of a seriously hawkish Fed. Economic growth is slowing, and consensus forecasts of earnings growth are still overly optimistic. Earnings contraction over the next several quarters is likely but is certainly not priced in, and disappointment may rock markets. The catalyst for this summer’s rebound is two-fold: The market is celebrating the end of inflation worries and is rebounding from severely oversold conditions. Black swan “generators” such as China and Russia, may have more surprises in stock (Table 3). We continue to stick to “fat and down” expectations for the equities outlined in the “Adaptive Expectations” report and anticipate a range-bound market where relief rallies are alternated with pullbacks, mostly triggered by growth disappointments and realizations that the Fed has dug in its heels and is unlikely to let up anytime soon. The “down” leg will ensue if earnings contract. Yet we recommend investors take a granular approach to industry selection and start tilting portfolios away from assets that benefit from rising inflation, such as Energy and Materials, towards the “growthy” assets that benefit from rate stabilization and falling growth. We picked up on the turning point and upgraded Growth to overweight in early July, funding it from Value. Table 3Scorecard Bottom Line: We consider the recent rebound in US equities a bear market rally, and don’t believe that it is sustainable. The Fed and the stock market are on a collision course – easier financial conditions will make the Fed even more aggressive. Is it time to buy Tech? As we have highlighted in the “Are We There Yet?!” report back in January, Tech’s worst performance is two to three months prior to the first rate hike, and the rebound is two to three months after the beginning of the monetary cycle. The slump and a recent rally are perfectly in line with history (Chart 8). Rates have stabilized and “growthy” Tech has pounced (Chart 9). Another issue that was holding the sector back earlier in the year was a slowdown in demand for Tech investment (Chart 10). Recently, business demand for Tech has picked up. However, US consumer spending on Tech is falling, as demand for consumer goods, pulled forward by the pandemic, is fading (Chart 11). Therefore, we need to be judicious in our selection of technology stocks. Chart 8Tech Performance During A Hiking Cycle Chart 9Technology Rebounded On The Back Of Yields Peaking Chart 10Corporate Demand For Tech Has Picked Up… We reiterate our overweight in Software and Services, which is least exposed to consumer demand. Our thesis is that this industry group represents “defensive growth” thanks to the key trends of digitization of the US economy and migration to cloud. Spending on digitization and the cloud are pervasive across non-tech companies and capture a large swath of corporate America by both size and industry. Also, software and services companies tend to have stable earnings growth throughout the cycle, as software improves productivity and cuts costs (Chart 12). Chart 11...But Consumer Spending Slowed Chart 12Software Is Defensive Growth We are underweight more cyclical Hardware and Equipment, and Semiconductors industry groups as they are more exposed to the slowing economy and the flagging demand for hardware and chips. We will take a close look at the Semiconductor Industry Group in the near future. Bottom Line: We recommend topping up allocation to tech as it benefits from rate stabilization. However, be judicious in your choices, staying away from the more cyclical areas, such as Hardware and Equipment, and Semiconductors. We are overweight Software and Services, which is dominated by profitable and stable growth companies. Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com Recommended Allocation Recommended Allocation: Addendum
Listen to a short summary of this report. Executive Summary The odds of a recession in the US are lower than widely perceived. The probability of a recession is higher in Europe, although this week’s partial resumption of gas flows through the Nord Stream 1 pipeline, along with increased use of coal-fired power plants, should soften the blow. Chinese growth should rebound in the second half of the year. However, the specter of future lockdowns, the shift in global spending away from manufactured goods towards services, and the weakening property sector will continue to weigh on activity. With the Twentieth Party Congress slated for later this year, it is increasingly likely that the authorities will open up a firehose of stimulus. Fading recession risks will buoy stocks in the near term. However, a brighter economic outlook also means that the Fed, and several other central banks, may see little need to cut policy rates in 2023, as the markets are currently discounting. The end result is that government bond yields will rise from current levels, implying that stock valuations will not return to last year’s levels even if a recession is averted. After Rapidly Raising Rates, Markets Expect Some DM Central Banks To Start Easing Next Year Bottom Line: We recommend a modest overweight on global equities for now but would turn neutral if the S&P 500 were to rise above 4,050. Dear Client, I am delighted to announce that Ritika Mankar, CFA, has joined the Global Investment Strategy team. Ritika will be writing occasional special reports on a variety of topical issues. Next week, she will make the case that the US economy’s ability to spawn mega-sized companies may become increasingly compromised over the next decade. Best regards, Peter Berezin, Chief Global Strategist The Case for a Soft Landing in the US Chart 1Cyclicals Underperformed Defensives As Recession Risks Intensified Over the last few months, investors have become concerned that the Fed and many other central banks will need to engineer a recession in order to bring inflation down to more comfortable levels. While these fears have abated over the past trading week, they still continue to dominate market action (Chart 1). We place the odds of a US recession at about 40%. This is arguably more optimistic than the consensus view. According to Bank of America, the majority of fund managers saw recession as likely in this month’s survey. Not surprisingly, investors consider recession to be a major risk for equities over the next 12 months (Chart 2). Chart 2Many Investors Now See Recession As Baked In The Cake Even if a recession does occur, we have contended that it will likely be a mild one, perhaps so mild that it will be difficult to distinguish it from a soft landing. A number of things make a soft landing in the US more probable than in the past: Labor supply has scope to increase. The labor participation rate is still 1.2 percentage points below its pre-pandemic level, two-thirds of which is due to decreased participation among workers under the age of 55 (Chart 3). The share of workers holding multiple jobs is also below its pre-pandemic level (Chart 4). The number of multiple job holders has been rising briskly lately. That is one reason why job growth in the payroll survey – which double counts workers if they hold more than one job – has been stronger than job growth in the household survey. Increased labor supply would obviate the need for the Fed to take drastic actions to curtail labor demand in its effort to restore balance to the labor market. Chart 3Labor Supply Has Scope To Rise Chart 4The Number Of Multiple Job Holders Is Still Below Pre-Pandemic Levels A high level of job openings creates a moat around the labor market. There are almost two times as many job openings as there are unemployed workers in the US (Chart 5). Many firms are likely to pull job openings before they cut jobs in response to a slowing economy. A high level of job openings will also allow workers who lose their jobs to find employment more quickly than usual, thus limiting the rise in so-called frictional unemployment. It is worth noting that the job openings rate has declined from a record 7.3% in March to a still-high 6.9% in May, with no change in the unemployment rate over this period. Chart 5A High Level Of Job Openings Creates A Moat Around The Labor Market A steep Phillips curve implies that only a modest increase in unemployment may be necessary to knock down inflation towards the Fed’s target. Just as was the case in the 1960s, the Phillips curve has proven to be kinked near full employment (Chart 6). Unlike in the late 1960s, however, when rising realized inflation caused long-term inflation expectations to reset higher, expectations have remained well anchored this time around (Chart 7). Chart 6The Phillips Curve Is Kinked At Very Low Levels Of Unemployment Chart 7Long-Term Inflation Expectations Are Well Anchored The unwinding of pandemic and war-related dislocations should push down inflation. A recent study by the San Francisco Fed estimates that about half of May’s PCE inflation print was the result of supply-side disturbances (Chart 8). While the ongoing war in Ukraine and the threat of another Covid wave in China will continue to unsettle global supply chains, these problems should fade over time. Falling inflation would allow real wages to start rising again. This would bolster confidence, making a soft landing more likely (Chart 9). Chart 8Supply Factors Explain Half Of The Increase In Prices Over The Past Year Chart 9Positive Real Wage Growth Will Bolster Consumer Confidence A lack of major financial imbalances makes the US economy more resilient to economic shocks. As a share of disposable income, US household debt is 34 percentage points below its 2008 peak (Chart 10). Relative to net worth, household debt is at multi-decade lows. About two-thirds of mortgages carry a FICO score above 760 compared to only one-third during the housing bubble (Chart 11). Non-mortgage consumer credit also remains in good shape, as my colleague Doug Peta elaborated in this week’s US Investment Strategy report. While corporate debt has risen over the past decade, the ratio of corporate debt-to-assets today is still below where it was during the 1990s. Moreover, thanks to stronger corporate profitability, the interest coverage ratio is near an all-time high (Chart 12). Chart 10AUS Household Debt Is Not Especially High Anymore (I) Chart 10BUS Household Debt Is Not Especially High Anymore (II) Chart 11FICO Scores For Residential Mortgages Have Improved Considerably Since The Pre-GFC Housing Bubble Chart 12Corporate Balance Sheets Are In Decent Shape Chart 13Tight Supply Limits The Downside Risks To Housing Just like the US does not suffer from major financial imbalances, it does not suffer from any major economic imbalances either. The homeowner vacancy rate is near a record low, which should put a floor under residential investment (Chart 13). Outside of investment in intellectual property, which is not especially sensitive to the business cycle, nonresidential investment is still below pre-pandemic levels and not much above where it was as a share of GDP during the Great Recession (Chart 14). Spending on consumer durable goods has retraced four-fifths of its pandemic surge, with little ill-effect on aggregate employment (Chart 15). Chart 14Outside Of IP, Nonresidential Investment Is Still Low Chart 15Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Europe: A Deep Freeze Will Likely Be Avoided Chart 16Russia Can Potentially Cause Significant Economic Damage In The EU If It Closes The Taps The macroeconomic picture is less benign outside the US. Four years ago, German diplomats laughed off warnings that their country had become dangerously dependent on Russian energy. They are not laughing anymore. German industry, just like industry across much of Europe, is facing a major energy crunch. The IMF estimates that output losses associated with a full Russian gas shutoff over the next 12 months could amount to as much as 2.7% of GDP in the EU (Chart 16). In Central and Eastern Europe, output could shrink by 6%. Among the major economies, Germany and Italy are the most at risk. Fortunately, Europe is finally stepping up to the challenge. The highly ambitious REPowerEU plan seeks to displace two-thirds of Russian gas by the end of 2022. The plan does not include any additional energy that could be generated by increased usage of coal-fired power plants, a strategy that the European political establishment (including the German Green Party!) has only recently begun to champion. It is possible that EU leaders felt the need to generate a crisis mentality to justify the decision to burn more coal. Dire warnings about how Europe is prepared to ration gas also send a message to Russia that the EU is ready to suffer in order to thwart Putin’s despotic regime. Whether Europe actually follows through is a different story. It is worth noting that the Nord Stream 1 pipeline resumed operations this week after Germany received, over Ukrainian objections, a repaired turbine from Canada. The resumption of partial flows through the pipeline, along with increased fiscal support for households and firms, reduces the risks of a “deep freeze” recession in Europe. The unveiling of the ECB’s new Transmission Protection Instrument (TPI) this week should also help anchor sovereign credit spreads across the euro area. While the exact conditions under which the TPI will be engaged have yet to be fleshed out, we expect the terms to be fairly liberal, reflecting not only the lessons learned from last decade’s euro debt crisis, but also to serve as a powerful bulwark against Putin’s efforts to destabilize the EU economy. China: Government’s Growth Target Looks Increasingly Unrealistic Stronger growth in China would help European exporters (Chart 17). Chinese real GDP grew by just 0.4% in the second quarter from a year earlier as the economy was battered by Covid lockdowns. Activity should pick up in the second half of the year, but at this point, the government’s 5.5% growth target looks completely unachievable. The specter of future lockdowns, the shift in global spending away from manufactured goods towards services, and the weakening Chinese property sector are all weighing on the economy (Chart 18). Chart 17European Exporters Would Welcome A Stronger Chinese Economy The authorities will likely seek to stimulate the economy by allowing local governments to bring forward $220 billion in bond issuance that had been originally slated for 2023. The problem is that land sales – the main source of local government revenue – have collapsed. Worried about the ability of local governments to service their obligations, both retail investors and banks have shied away from buying local government debt. Chart 18A Slowing Property Market And Covid Lockdowns Have Been Weighing On The Chinese Economy Meanwhile, the inability of property developers to secure adequate financing to complete construction projects has left a growing number of home buyers in the lurch. In most cases, these properties were purchased off-the-plan. Understandably, home buyers have balked at the prospect of having to make mortgage payments on properties that they do not possess. With the Twentieth Party Congress slated for later this year, it is increasingly likely that the authorities will open up a firehose of stimulus, including increased assistance for property developers and banks, as well as income-support measures for households. While such measures will not address China’s myriad structural problems, they will help keep the economy afloat. Equity Valuations in a Soft-Landing Scenario A few weeks ago, the consensus view was that stocks would tumble in the second half of the year as the global economy fell into recession but would then rally in 2023 as central banks began lowering rates. We argued the opposite, namely that stocks would likely rebound in the second half of the year as the economy outperformed expectations but would then face renewed pressure in 2023 as it became clear that the Fed and several other central banks had no reason to cut rates (Chart 19). Chart 19After Rapidly Raising Rates, Markets Expect Some DM Central Banks To Start Easing Next Year Chart 20Real Rates Have Jumped This Year In a baseline scenario where a recession is averted, we argued that the S&P 500 could rise to 4,500 (60% odds). In contrast, we noted that the S&P 500 could fall to 3,500 in a mild recession scenario (30% odds) and to 2,900 in a deep recession scenario (10% odds). It is worth stressing that even at 4,500, the S&P 500 would still be 11% lower in real terms than it was on January 4th. At the stock market’s peak in January, the 10-year TIPS yield stood at -0.91%, while the 30-year TIPS yield stood at -0.27%. Today, they stand at 0.58% and 0.93%, respectively (Chart 20). If real rates do not return to their prior lows, it is unlikely that equity valuations will return to their prior highs. This limits the upside for stocks, even in a soft-landing scenario. The sharp rally in stocks over the past week has priced out some of this recession risk, moving equity valuations closer towards what we regard as fair value. As we noted last week, we will turn neutral on equities if the S&P 500 were to rise above 4,050. As we go to press, we are only 1.3% from that level. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn & Twitter Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores