Equities
The year-to-date equity selloff has been particularly painful for Growth stocks. The S&P 500 Growth index’s 30% drawdown dwarfs the Value index’s 15% decline. The sharp increase in bond yields has weighed more heavily on the performance of Growth stocks,…
Executive Summary Surge In Yields Tanked Equities In this week’s report, we conduct a post-mortem analysis of the past week’s market panic and probe the effect of the new developments on US equities. Inflation is embedded. US equities won’t find a bottom until inflation turns decisively. The Fed will continue to tighten monetary policy, and rates will rise until inflation rolls over. The Fed “put” is also no longer at play as the Fed has signaled that it cares far more about combating inflation than about the performance of the stock market. Economic growth is decelerating and is already surprising on the downside. Watch rates. With rates stable, the S&P 500 performance will be a function of earnings growth. With rates rising, the multiple will contract and will exacerbate the damage done by the earnings recession. Bottom Line: The S&P 500 is unlikely to find a bottom until inflation turns and monetary conditions stabilize. In addition, economic growth is slowing and an earnings recession is likely. We believe US equities will follow a “fat and down” trajectory in light of the recent developments. We recommend that investors “not be heroes” and keep sector allocation close to the benchmark. Overweight defensives vs. cyclicals. Feature The May CPI reading showed that despite the Fed’s “heroic actions,” inflation has not yet peaked—a data point that has shocked both the market and Fed officials. In an unprecedented move, the Fed, which prides itself on its transparent communication style and its ability to move the market by guiding its expectations, leaked its intention to raise rates by 75 bps to the WSJ despite the communications blackout period. Since last Friday, equity markets around the globe have been in turmoil, with the S&P 500 falling 8%. The NASDAQ is down 7%. Is this just a leg down of the “Fat and Flat” market we have called for with a rebound waiting in the wings, or is there a structural change in the inflationary backdrop and a relentless bear market set to continue? To answer these questions, we will revisit our macroeconomic calls to better understand what expectations need to be adapted to the new reality and what we should expect for US equities over the next three to six months. Sneak Preview: US equities are likely to fall further as monetary conditions continue to tighten and earnings growth is set to contract. We believe that equities will trade in a wide “channel” with multiple rallies and pullbacks, but the general direction is down until inflation turns decisively, and fears of recession dissipate. Why Did Equities Tank? The last few days in the markets were simply brutal. What were investors (and the Fed) panicking about? Here is our hunch: Inflation is not abating, while growth is slowing. Are we in the early innings of stagflation? We believe that stagflation is certainly a high risk. The Fed’s aggressive tightening of monetary conditions is bound to further slow economic growth and taper demand. However, the Fed has no means of controlling the supply side of the equation such as prices of food or energy, which surge because of constrained supply. Will monetary tightening be even more aggressive than expected? Will 75-bps rate rises become the Fed’s new normal? During the press conference, Chairman Powell reassured the market that a 75-bps rate hike is an extraordinary measure. However, both 50-bps and 75-bps rate hikes will be on the table in July. Are the markets on the cusp of a new monetary regime, and is the easy money of the past 12 years a thing of the past? The Fed’s balance sheet has increased from $2 trillion in 2009 to an unprecedented $9 trillion in 2022. This ultra-easy monetary policy has lifted asset values both in private and public markets. The new monetary regime of liquidity being drained from the financial markets to combat inflation is bound to be a major headwind for most asset classes. We believe that it will take a while to bring inflation back to the 2% target, and easy money in the near future is no longer in the cards. It is also unlikely that such a major Fed balance sheet expansion will ever be repeated. The Fed’s tightening via both rising rates and QT will result in a dearth of liquidity in the fixed income space— a credit/counterparty “black swan” may materialize, with MBS most exposed to this risk yet again. Withdrawal of liquidity is a hit to many asset classes, from private markets to unprofitable small-cap growth companies to fixed income markets. This is a serious concern that should be monitored. Incorporating New Data Into Macro And Market Calls We have been writing about these calls for a few months—let’s revisit them here to consider what may have changed recently. Peak Inflation Is Elusive We have never quite bought the argument of transitory inflation. To us, inflation is a product of excessive demand fueled by ultra-easy fiscal and monetary policy and supply chains hobbled by the pandemic. Recently, the situation has been exacerbated by shortages of food and energy. Inflation has spread from pandemic-related goods to “stickier” service items and is broad-based (Chart 1). The wage/price spiral is relentless (Chart 2), as consumer inflation expectations are on the rise, and the job market is on fire. Chart 1Inflation Is Entrenched And Broad-based While we always believed that it would take inflation a long time to reach the coveted 2% level, we assumed that peak inflation was behind us. Our view that inflation was going to roll over was more down to a base effect rather than the Fed’s actions. In addition, we observed that demand for goods pulled forward by the pandemic had started fading, suppressed by rising prices and negative real wage growth. The Citigroup Inflation Surprise Index had also turned (Chart 3). Chart 2Wage-Price Spiral Is Relentless Chart 3Inflation Was Surprising On The Downside It is little consolation that we were in good company when rattled by the May headline inflation reading, which came in at 8.5% year on year, and 1% higher than in April. Headline inflation was certainly affected by the price of food and energy, while core inflation was down to a higher price of shelter and goods (Chart 4). While energy is excluded from core inflation, it permeates all aspects of the economy, increasing costs of raw materials, manufacturing, and transportation, which eventually get passed through to the prices of goods and services. The same is the case with the rising wage bill. Chart 4Inflation Picked Up Because Of Prices Of Shelter And Core Goods Importantly, what is next? It would help if US shale producers ramped up production, and the Saudis opened their oil spigots, bringing the price of energy down. Short of that, the price of oil should become a function of a slowing economy and fading demand for goods as interest rates rise (Chart 5). While the Fed has little control over food and energy prices, wage-price dynamics fall squarely in its court. The key channel through which the Fed controls inflation is by cooling the economy and reducing the demand for labor. Rising unemployment is the only way to extinguish inflation in a decisive way. Chart 5Rates Surged Eventually, inflation will turn but it may be in fits and starts, and each data point will have a heavy effect on the pace of monetary tightening and the direction of equity markets, with lower inflation readings igniting rallies and higher readings triggering sell-offs. Inflation is embedded. Of course, sooner or later, it will abate but until then we expect a much more aggressive monetary policy. Monetary Conditions Have Tightened Dramatically As we summarized in our “Market Capitulation Scorecard,” one of the key conditions of an equity market bottom, and potentially, even a sustainable rebound, is stabilization in monetary conditions. We hypothesized that this could happen as the Fed tightens monetary conditions and growth slows and inflation turns, pulling down long rates. We also believed that the market focus is going to start shifting away from concerns about inflation to concerns about economic growth. Friday’s inflation reading has changed that – now investors worry about inflation and growth. Rates have initially skyrocketed, with the 10-year Treasury yield moving by 30bps points over the course of three days from 3.18 to 3.48. Real rates increased from 0.38% to 0.63%. US financial conditions have tightened sharply (Chart 6), moving to the neutral level. What’s next is the most difficult question of this report. It is likely this fast and furious move in rates has accomplished in five days what usually takes weeks. Tighter monetary policy, as it stands now, until more data comes in, is priced in. These moves capture changes in dot-plot expectations revised by the Fed, with the peak rate moving from around 3% to 4%. And, of course, that move got priced into the equity space with the S&P 500 pulling back sharply (Chart 7). Chart 6Financial Conditions Are Moving Into Restrictive Territory Chart 7Surge In Yields Tanked Equities The Fed will continue to tighten monetary policy and rates will rise until inflation rolls over. However, once inflation abates, long rates are likely to stabilize, signaling slower growth ahead. The Fed Won’t Come To The Rescue The Fed “put” is no longer at play as the Fed has signaled that it cares far more about combating inflation than the performance of the stock market. In fact, falling equities will play into Powell’s hand as a negative wealth effect is likely to put a lid on inflationary pressures, with wealthier Americans paying the toll. Kansas City Fed President Esther George, the only member of the FOMC that voted against a 75bps rate hike in the June meeting (she was in favor of 50 bps) said in May: “The Federal Reserve is not targeting equity markets in its battle against inflation, but that is "one of the avenues" where the impact of tighter monetary policy will be felt".1 Further, the Fed is very concerned about a recent pick-up in the long-term consumer inflation expectations (Chart 8) and will likely err on the side of caution to manage these expectations and avoid a self-fulfilling prophecy. Chart 8The Fed Is Worried About Inflation Expectations Economic Growth Is Slowing Fast, Both At Home And Abroad A tighter monetary policy is designed to slow economic growth. The World Bank has downgraded global GDP growth expectations from 4.1% to 2.9%, and import volumes are declining. The Atlanta GDPNow forecast is hovering around zero (Chart 9). The Philly Fed survey has just crossed into negative territory (Chart 10). Retail sales are contracting both in nominal and real terms. According to the Citi Economic Surprise Index, economic growth is surprising on the downside (Chart 11). While the probability of a recession has picked up over the past few weeks, it is earnings growth disappointment that will have an adverse effect on equities in the near term. Chart 9Consensus Expectation Are Still Too High Chart 10Many Signs That Economy Is Slowing Sharply Chart 11Economic Growth Disappoints We maintain our view that economic growth is decelerating and is already surprising on the downside. Earnings Growth Will Contract And Take The Market With It We stated in last week’s “Is An Earnings Recession In The Cards?” report that this year’s sell-off has been triggered by fears of an aggressive Fed, tighter monetary policy, and rising rates. However, the decom- position of the total return demonstrates that the pullback was all about multiple contraction, while strong earnings growth helped absorb the blow. We hypothesized that the multiple contraction phase is complete and that the next leg of the bear market will be all about growth, and earnings growth in particular (Chart 12). Hence if rates stabilize, then multiples will stay at the current level, and returns will be a function of earnings growth. However, the 10-year Treasury rate increasing from 3.18 has resulted in the S&P 500 multiple contracting from 16.7 to 15.6 over the course of just three days, while earnings growth expectations have remained mostly intact. Currently, according to our very simple model (Chart 13), a 3.5% 10-year Treasury yield corresponds to the S&P 500 forward multiple of 16.8x, which is close to where the S&P 500 stands today. If rates rise further, the forward multiple will fall. Chart 12Multiple Contraction Will Be Followed By Earnings Growth Deceleration Chart 13Higher Rates Translate Into Lower Equity Multiples Our earnings growth model predicts that earnings growth will trend towards zero over the next three months (Chart 14). Chart 14Earnings Growth Will Trend To Zero And Then Contract Our scenario analysis matrix shows that if multiples stay stable around 17x forward earnings, while earnings contract by zero to five percent next quarter, the index will be flat to slightly down (Table 1). Broadly speaking, with a stable multiple, the market will move in line with earnings growth. If rates continue to rise and the multiple falls to 16x, going another 11% down is likely. Table 1The S&P 500 Target Scenario Analysis Watch rates. With rates stable, the S&P 500 performance will be a function of earnings growth, and the market is likely to be range-bound. With rates rising, a multiple will contract further, and equities will fall. Investment Implications: “Fat And Down” The SPX has discounted plenty of negative news now that it is officially in bear market territory. However, we believe that the S&P 500 is not yet close to the bottom. The market is again pricing in tighter monetary policy and rising rates, which is accompanied by multiple contraction. It is hard to see equities bottoming without inflation peaking. In addition, we are predicting that the next leg of the bear market will be driven by earnings growth, which is likely to contract due to an economic slowdown both at home and abroad. As such, “fat and down” may be a more likely outcome than just “fat and flat.” Bottom Line Equities will move in a wide range over the next three to six months. However, if rates are to rise further and earnings growth is to contract, they may be trading in a downward sloping “channel,” or “fat and down.” We recommend that investors “not be heroes” and keep sector allocation close to the benchmark. Overweight defensives vs. cyclicals. Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com Footnotes 1 https://www.reuters.com/business/feds-george-policy-not-aimed-equity-markets-though-it-will-be-felt-there-cnbc-2022-05-19/#:~:text=WASHINGTON%2C%20May%2019%20(Reuters),Esther%20George%20said%20on%20Thursday. Recommended Allocation Recommended Allocation: Addendum
Executive Summary Structural Tailwinds For The Franc Volatility in FX markets is likely to remain elevated, as witnessed by the reaction of a full circle of central bank meetings this week.Policy convergence remains a good bet for interest rate curves and currency pairs. The SNB surprised markets by raising interest rates by 50 bps, to -0.25%, the first hike since 2007.Higher volatility will continue to buoy the Swiss franc in the short run.Structural appreciation in the franc is also likely over the coming decades (Feature Chart). Swiss stocks often perform well during economic downturns, but they are not particularly cheap, and are vulnerable to higher interest rates. Investors should only overweight Swiss stocks if they expect more significant downside to global stocks.Valuation favors the franc versus the dollar. However, EUR/CHF and GBP/CHF are closer to fair value. CHF/JPY is expensive; hence, the yen is a better hedge for downside economic surprises. Go short CHF/JPY as a trade.BCA’s Foreign Exchange Strategy was short CHF/SEK at 10.2 with stop loss at 10.5. That stop was hit overnight, triggering a loss of -3.3%. Stand aside for now.Bottom Line: Favor the franc over the short term against other pro-cyclical currencies, with a view to downgrade CHF when it becomes evident that economic growth is bottoming. Any further bout of Swiss equity outperformance, prompted by global risk aversion, offers an attractive selling opportunity versus Eurozone stocks.Feature Chart 1The SNB Has Capitulated To Rising Inflation Volatility in FX markets is likely to remain elevated. This week, the Fed delivered its first 75 bps interest rate hike since 1994. It also increased its expected year-end level for the Fed Funds rate to 3.4% from 1.9%, and to 3.8% from 3.4% at the end of 2023. The FX market had been warming up to a hawkish surprise, but the dollar surged on the news, hitting a fresh two-decade high of 105.5, before later reversing gains.Meanwhile, the European Central Bank (ECB) held an emergency meeting on Wednesday, to try to mitigate the rise in Italian yields, which hit as high as 4.2% on Tuesday, or 243 bps over German 10-year yields. The subsequent statement released by the Governing Council offered no concrete details. Yes, the reinvestments of the proceeds from maturing debt in the Pandemic Emergency Purchase Program (PEPP) will flow mostly to peripheral markets, but investors want clarity on the nature of the long-awaited policy plan to tackle fragmentation risk in the Euro Area. As a result, peripheral bond markets will remain fragile until a bold program comes to fruition.To cement currency volatility this week, SNB Governor Thomas Jordan surprised markets by raising interest rates by 50 bps in Switzerland, to -0.25%, the first hike since the Global Financial Crisis (Chart 1). The negative interest rate threshold for sight deposits was also lowered, a move encouraging banks to pack reserves at the SNB. The Bank of England also raised interest rates in line with market expectations. The move initially disappointed GBP bulls, but sterling is holding above our 1.20 floor.An environment of monetary policy uncertainty, rising recession risks in response to high inflation, and the potential for central bank policy mistakes bodes well for safe-haven assets. In Europe, the market with the strongest defensive profile is Switzerland. In this report, we address whether investors should bet on continued appreciation of the franc and an outperformance of Swiss stocks, especially now that the SNB has turned hawkish.Switzerland Versus The WorldGlobal economic growth is slowing and a small/open economy like Switzerland’s has not been spared. The KOF economic barometer, a key leading indicator for Swiss GDP growth, has collapsed over the past twelve months from 144 to 97 as global industrial activity decelerated (Chart 2). Despite softening growth, global inflation refuses to decline, forcing central banks worldwide to lean into the slowdown. This threatens to cut the post-pandemic business cycle expansion short. Chart 2The SNB Is Tightening Into A Slowing Economy Surprisingly, the Swiss economy is generally performing better than the rest of Europe. Historically, Swiss economic performance is procyclical due to the large share of exports within its GDP. Hence, a slowdown in global manufacturing often creates a large threat to Swiss growth. Going forward, can the Swiss economy diverge from that of the rest of the world (Chart 3)? Such a divergence is not probable, but a few factors will protect the Swiss economy:Switzerland still has one of the lowest policy rates in the G10, even after today’s 50bps interest rate increase. This has tremendously helped ease monetary conditions. Our monetary gauge is at its most accommodative level in over two decades (Chart 4). Chart 3The Swiss Economy Is Procyclical Chart 4Swiss Monetary Conditions Are Still Accommodative Swiss inflation remains the lowest in the G10 outside Japan. In Switzerland, the main driver of price increases has been goods, while services inflation remains subdued. Consequently, the SNB has been tolerating an appreciating franc to temper imported inflation (Chart 5), while keeping domestic borrowing costs at very accommodative levels. In its updated forecasts, the SNB now expects a -0.25% interest rate to allow Swiss inflation to moderate to 1.9% in 2023 and 1.6% in 2024. Chart 5Swiss Inflation Is Surprising To The Upside Part of the reason Switzerland has low inflation has been the tremendous productivity gains, especially relative to its trading partners (Chart 6). Swiss income-per-capita is elevated, but wage growth has lagged output gains, which limits the risk of a wage-inflation spiral. It is notable that part-time employment continues to dominate job gains, implying that the need for precautionary savings will remain high in Switzerland. Chart 6A Productivity Profile For Switzerland Higher productivity growth and the elevated national savings leave their footprint on the trade data. The Swiss trade balance is hitting fresh highs, unlike Europe or Japan (Chart 7). This could potentially create a problem for the Swiss economy as it puts upward pressure on the CHF at a time when global manufacturing output is slowing. However, Switzerland specializes in high value-added exports with an elevated degree of complexity, that stand early in global supply chains. These type of goods are likely to remain in high demand in a global environment marked by supply-chain bottlenecks and high-capacity utilization. Chart 7Structural Tailwinds For The Franc Finally, Switzerland does not import energy to fulfill its electricity production. Hydropower accounts for roughly 61.4% of electricity generation, followed by nuclear power at 28.5%. This has partially insulated Switzerland from the energy shock hurting economic activity and trade balances in the EU. For example, German electricity generation is 28.8% coal and 14.7% natural gas.Bottom Line: The Swiss economy is reopening and is relatively insulated from the Russia-Ukraine conflict. This limits to some degree how closely Switzerland will track the global and European economic slowdown. It creates a departure from the traditional pro-cyclicality of the Swiss economy.The SNB, The SARON Curve, And The Swiss FrancIf the Swiss economy surprises to the upside, the case for the SNB to tolerate a rising franc becomes even stronger. The pace of foreign exchange reserve accumulation is already decelerating (Chart 8). Governor Thomas Jordan has been very clear: as global prices rise, the fair value of the franc is also rising, which implies a willingness to tolerate currency strength. In a purchasing power parity framework, higher external inflation makes Swiss goods relatively cheaper. This allows foreigners to bid up the currency.Even with today’s updated pricing, the SNB is still expected to remain among the most dovish central banks in the G10 (Chart 9). If inflationary pressures prove sticky, the SNB will step up its hawkish rhetoric. If inflationary fears subside, then global rates will fall as well, which has usually been a boon for the franc. More specifically, this would be negative for the EUR/CHF cross (Chart 10). Chart 8Less Intervention By The SNB Chart 9The SARON Curve Has Adjusted Higher Chart 10EUR/CHF And Bund Yields Can Continue To Diverge The Swiss economy can tolerate an appreciating CHF, but can it withstand higher interest rates? We believe so. Switzerland is a net creditor nation, but its domestic non-financial debt is also extremely elevated. Thus, the Swiss economy is vulnerable to higher rates, especially the housing market (Chart 11). Nonetheless, internal adjustments will soften the blow and increase affordability. Of note, property speculation in Switzerland has decreased in response to macroprudential measures. Growth in rental housing prices, which usually constitute the bulk of investment homes, has collapsed, but the price of owner-occupied homes has proven more robust (Chart 12). A cap on the percentage of secondary homes in any Canton as well as tighter lending standards have also helped. In a renewed update to its Financial Stability Report, Fritz Zurbrügg, Vice Chairman of the Governing Board, suggests that Swiss banks are well capitalized, especially given the recent reactivation of the countercyclical capital buffer. Chart 11Higher Rates Are A Risk For Swiss Real Estate Chart 12Some Adjustment Already In Investment Home Prices In the very near term, demographics might also be a tailwind. The pandemic limited immigration to Switzerland, but the working-age population is rebounding anew (Chart 13), which will create a cushion under housing and support domestic demand. Chart 13A Small Demographic Tailwind For Home Prices Stronger aggregate demand in an inflationary world will justify the need for less monetary accommodation. In a nutshell, the SNB is likely to continue walking the path of “least regrets” like most central banks, by tightening monetary policy to meet its 2% inflation mandate, but pausing if economic conditions warrant.The currency has historically been used as a key tool for calibrating financial conditions. From a fundamental perspective, our PPP models suggest the franc is quite cheap versus the dollar but at fair value versus the euro and sterling. This is echoed by Governor Jordan, who no longer views the franc as expensive. Our models adjusts the consumption basket in Switzerland for an apples-to-apples comparison across both the UK and the eurozone (Chart 14). Chart 14AA CHF Is At Fair Value Versus The EUR And GBP Chart 14BA CHF Is At Fair Value Versus The EUR And GBP Finally, hedging costs for shorting the franc against the dollar have risen substantially (Chart 15). As such, any short bets on the franc are likely being placed naked. If the Fed ends up tempering its pace of rate hikes next year in response to weaker US activity, short-covering activity is likely to accentuate any pre-existing strength in the CHF. Chart 15Hedging Costs For USD/CHF Carry Trades Have Risen Hedging Costs Are Prohibitive Bottom Line: The franc is undervalued against the dollar, and a good hedge against a rise in volatility versus other procyclical currencies. This places the franc in a good “heads I win, tails I don’t loose too much” bet. Swiss interest rates are also likely to climb higher. However, because the franc will do the bulk of the monetary tightening, the SNB is likely to lag the expectations now embedded in the SARON curve.What About Swiss Equities?Despite the cyclical nature of the Swiss economy, Swiss equities are extremely defensive. Swiss stocks have little to do with the domestic economy and are mostly a collection of large multinationals, dominated by the healthcare and consumer staples sectors, which together account for roughly 60% of the Swiss MSCI benchmark.This defensive attribute has created its own problem for Swiss equities. Relative to the Eurozone, the Swiss market has moved massively ahead of profitability, and it is now more expensive than at the apex of the European debt crisis in 2012 (Chart 16). Moreover, the jump in German yields is becoming increasingly problematic for Swiss stocks that historically perform poorly when global interest rates are rising (Chart 17). Chart 16Swiss Stocks Are Expensive Chart 17A Lost Tailwind In the near term, Swiss equities will only be able to defy the gravitational pull created by demanding valuations and higher yields if global risk aversion remains elevated. However, once global stocks find a floor and Italian spreads begin to narrow, Swiss stocks are likely to underperform massively (Chart 18). It could take a few more weeks before the BTP/Bund spreads narrow as the recent ECB announcement was rather tepid. However, the ECB holding an emergency meeting and issuing a formal statement addressing the problem facing peripheral bond markets suggests that a formal program designed to manage fragmentation risk will emerge before the end of the summer.Beyond their defensive attributes, Swiss stocks also correlate to the Quality Factor. The robust performance of this factor since the turn of the millennium, in Europe and globally, has allowed the Swiss market to greatly outperform Eurozone equities (Chart 19). However, the Quality Factor has begun to underperform, which indicates that the Swiss market is losing another of its underpinnings. Chart 18Near-term, Follow Risk Aversion Chart 19Swiss Stocks Are About Quality These observations imply that over the next 12 to 18 months, Swiss equities will underperform their Euro Area counterparts. Materials and consumer staples stand out as the two sectors with the most extended valuations relative to their Euro Area competitors, especially since their relative performances have become dissociated from relative profits (Chart 20). They should carry maximum underweights relative to their European counterparts. The healthcare sector is Switzerland’s largest market weight. It is not as expensive relative to the Eurozone as the materials and consumer staples sectors, but it carries enough of a premium that investors should still underweight this sector relative to its eurozone competitor (Chart 21). Chart 20Dangerous Setup For Swiss Materials and Staples Chart 21The Swiss Heavyweight Is Becoming Pricey Bottom Line: The defensive nature of the Swiss market has allowed for a large outperformance over European equities. However, the Swiss market is now very expensive on a relative basis, and it is vulnerable to higher interest rates. While global risk aversion can still buoy the Swiss market in the near term, conditions are falling into place for Swiss stocks to underperform their Eurozone counterpart over a 12-to-18 month window. Materials and consumer staples are the sectors mostly likely to experience a large underperformance relative to their Euro Area competitors, followed by the healthcare sector. Investment ConclusionsVolatility in FX markets is likely to remain elevated, as witnessed by the reaction of a full circle of central bank meetings this week.Policy convergence remains a good bet for interest rate curves and currency pairs. The SNB surprised markets by raising interest rates by 50 bps, to -0.25%, the first hike since 2007 (Chart 1).Higher volatility will continue to buoy the Swiss franc in the short run.Structural appreciation in the franc is also likely over the coming decades.Swiss stocks often perform well during economic downturns, but they are not particularly cheap, and vulnerable to higher interest rates. Investors should only overweight Swiss stocks if they expect more significant downside to global stocks.Valuation favors the franc versus the dollar. However, EUR/CHF and GBP/CHF are closer to fair value. CHF/JPY is expensive; hence the yen is a better hedge for downside economic surprises. Go short CHF/JPY as a trade.BCA’s Foreign Exchange Strategy was short CHF/SEK at 10.2 with stop loss at 10.5. That stop was hit overnight, triggering a loss of -3.3%. Stand aside for now. Chester NtoniforForeign Exchange Strategistchestern@bcaresearch.comMathieu Savary Chief European StrategistMathieu@bcaresearch.com
Listen to a short summary of this report. Executive Summary Higher Real Yields Have Weighed On Equity Valuations I had the pleasure of visiting clients in Saudi Arabia, Bahrain, and Abu Dhabi last week. In contrast to the rest of the world, the mood in the Middle East was very positive. While high oil prices are helping, there is also a lot of optimism about ongoing structural reforms. Petrodollar flows are increasingly being steered towards private and public equities. EM assets stand to benefit the most. Producers in the region are trying to offset lost Russian output, but realistically, they will not be able to completely fill the gap in the near term. Today’s high energy prices have largely baked in this reality, as reflected in strongly backwardated futures curves. There was no consensus about how high oil prices would need to rise to trigger a global recession, although the number $150 per barrel got bandied about a lot. Given that most Middle Eastern currencies are pegged to the dollar, there was a heavy focus on Fed policy. Market estimates of the neutral rate in the US have increased rapidly towards our highly out-of-consensus view. Nevertheless, we continue to see modest upside for bond yields over a multi-year horizon. Over a shorter-term 6-to-12-month horizon, the direction of bond yields will be guided by the evolution of inflation. While US CPI inflation rose much more than expected in May, the details of the report were somewhat less worrying, as they continue to show significant supply-side distortions. Bottom Line: Inflation should come down during the remainder of the year, allowing the Fed to breathe a sigh of relief and stocks to recover some of their losses. A further spike in oil prices is a major risk to this view. Dear Client, Instead of our regular report next week, we will be sending you a Special Report written by Chester Ntonifor, BCA Research’s Chief Foreign Exchange Strategist, discussing the outlook for gold. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. As always, I will hold a webcast discussing the outlook the following week, on Thursday, July 7th. Best regards, Peter Berezin Chief Global Strategist Peter in Arabia I had the pleasure of visiting clients in Saudi Arabia, Bahrain, and Abu Dhabi last week. This note summarizes my impressions and provides some commentary about recent market turmoil. The Mood in the Region is Very Positive In contrast to the rest of the world, the mood in the Middle East was upbeat. Obviously, high oil prices are a major contributor (Chart 1). Across the region, stock markets are still up for the year (Chart 2). Chart 1Oil Prices Have Shot Up Chart 2Middle Eastern Stock Markets Are Doing Relatively Well This Year That said, I also felt that investors were encouraged by ongoing structural reforms, especially in Saudi Arabia where the Vision 2030 program is being rolled out. The program seeks to diversify the Saudi economy away from its historic reliance on petroleum exports. A number of people I spoke with cited the Saudi sovereign wealth fund’s acquisition of a majority stake in Lucid, a California-based EV startup, as the sort of bold move that would have been unthinkable a few years ago. I first visited Riyadh in May 2011 where I controversially delivered a speech entitled “The Coming Commodity Bust” (oil was $120/bbl then and copper prices were near an all-time high). The city has changed immensely since then. The number of restaurants and entertainment venues has increased exponentially. The ban on women drivers was lifted only four years ago. In that short time, it has become a common-day occurrence. Capital Flows Into and Out of the Region are Reflecting a New Geopolitical Reality In addition to high oil prices and structural reforms, geopolitical considerations are propelling significant capital inflows into the region. The freezing of Russia’s foreign exchange reserves sent a shockwave across much of the world, with a number of other EM countries wondering if “they are next.” Ironically, the Middle East has emerged as a neutral player of sorts in this multipolar world, and hence a safer destination for capital flows. On the flipside, the region’s oil exporters appear to be acting more strategically in how they allocate their petrodollar earnings. Rather than simply parking the proceeds of oil sales in overseas US dollar bank accounts, they are investing them in ways that further their economic and political goals. One clear trend is that equity allocations to both overseas public and private markets are rising. Other emerging markets stand to benefit the most from this development, especially EMs who have assets that Middle Eastern countries deem important – assets tied to food security being a prime example. Assuming that the current level of oil prices is maintained, we estimate that non-US oil exports will rise to $2.5 trillion in 2022, up from $1.5 trillion in 2021 (Chart 3). About 40% of this windfall will flow to the Middle East. That is a big slug of cash, enough to influence the direction of equity markets. Chart 3Oil Exporters Reaping The Benefits Of High Oil Prices Middle Eastern Energy Producers Will Boost Output, But Don’t Expect Any Miracles in the Short Term Russian oil production will likely fall by about 2 million bpd relative to pre-war levels over the next 12 months. To help offset the impact, OPEC has already raised production by 200,000 barrels and will almost certainly bump it up again following President Biden’s visit to the region in July (Chart 4). The decision to raise production to stave off a super spike in oil prices is not entirely altruistic. The region’s oil exporters know that excessively high oil prices could tip the global economy into recession, an outcome that would surely lead to much lower oil prices down the road. There was not much clarity on what that tipping point is, but the number $150 per barrel got bandied around a lot. Politics is also a factor. A further rise in oil prices could compel the US to make a deal with Iran, something the Saudis do not want to see happen. Still, there is a practical limit to how much more oil the Saudis and other Middle Eastern producers can bring to market in the near term. Today’s high energy prices have largely baked in this reality, as reflected in strongly backwardated futures curves (Chart 5). Chart 4Output Trends In The Major Oil Producers Chart 5Energy Prices On Both Sides Of The Atlantic Data on Saudi’s excess capacity is notoriously opaque, but I got the feeling that an extra 1-to-1.5 million bpd was the most that the Kingdom could deliver. The same constraints apply to natural gas. Qatar is investing nearly $30 billion to expand its giant North Field, which should allow gas production to rise by as much as 60%. However, it will take four years to complete the project. The share of Qatari liquefied natural gas (LNG) going to Europe has actually declined this year. About 80% of Qatar’s LNG is sold to Asian buyers under long-term contracts that cannot be easily adjusted. And even if those contracts could be rewritten, this would only bring limited benefits to Europe. For example, Germany has no terminals to accept LNG imports, although it is planning to build two. While there was plenty of sympathy to Europe’s plight in the region, there was also a sense that European governments had been cruising for a bruising by doubling down on strident anti-fossil fuel rhetoric over the past decade without doing much to end their dependence on Russian oil and gas. In that context, few in the region seemed willing to bend over backwards to help Europe. In the meantime, the US remains Europe’s best hope. US LNG shipments to Europe have tripled since last year. The US is now sending nearly three quarters of its liquefied gas to Europe. This has pushed up US natural gas prices, although they still remain a fraction of what they are in Europe. Huge Focus on the Fed Chart 6Most Of The Increase In Bond Yields Has Been In The Real Component Most Middle Eastern currencies are pegged to the dollar, and hence the region effectively imports its monetary policy from the US. Not surprisingly, clients were very focused on the Federal Reserve. Many expressed concern about the abrupt pace of rate hikes. One of our high-conviction views is that the neutral rate of interest in the US has risen as the household deleveraging cycle has ended, fiscal policy has become structurally looser, and a growing number of baby boomers have transitioned from working (and saving) to retirement (and dissaving). The markets have rapidly priced in this view over the course of 2022. The 5-year/5-year forward Treasury yield – a proxy for the neutral rate – has increased from 1.90% at the start of the year to 3.21% at present. Most of this increase in the market’s estimate of the neutral rate has occurred in the real component. The 5-year/5-year forward TIPS yield has climbed from -0.49% to 0.84%; in contrast, the implied TIPS breakeven inflation rate has risen from only 2.24% to 2.37% (Chart 6). Implications of Higher Bond Yields on Equity Prices and the Economy Chart 7Higher Real Yields Have Weighed On Equity Valuations As both theory and practice suggest, there is a strong negative correlation between real bond yields and equity valuations. Chart 7 shows that the S&P 500 forward P/E ratio has been moving broadly in line with the 5-year/5-year forward TIPS yield. The bad news is that there is still scope for bond yields to rise over the long haul. Our fair value estimate of 3.5%-to-4% for the neutral rate is about 25-to-75 basis points above current pricing. The good news is that a high neutral rate helps insulate the economy from a near-term recession. Recessions typically occur only when monetary policy turns restrictive. A few clients cited the negative Q1 GDP reading and the near-zero Q2 growth estimate in the Atlanta Fed GDPNow model as evidence that a US recession is either close at hand or has already begun (Chart 8). Chart 8Underlying US Growth Is Expected To Be Solid In Q2 We would push back against such an interpretation. In contrast to the -1.5% real GDP print, real Gross Domestic Income (GDI) rose by 2.1% in Q1. Conceptually, GDP and GDI should be equal, but since the two numbers are compiled in different ways, there can often be major statistical discrepancies. A simple average of the two suggests the US economy still grew in the first quarter. More importantly, real final sales to private domestic purchasers rose by 3.9% in Q1. This measure of economic activity – which strips out the often-noisy contributions from inventories, government expenditures, and net exports – is the best predictor of future GDP growth of any item in the national accounts (Table 1). Table 1A Good Sign: Real Final Sales To Private Domestic Purchasers Rose By 3.9% In Q1 As far as Q2 is concerned, real final sales to private domestic purchasers are tracking at 2.0% according to the Atlanta Fed model – a clear deceleration from earlier this year, but still consistent with a generally healthy economy. Growth will probably slow in the third quarter, reflecting the impact of higher gasoline prices, rising interest rates, and lower asset prices. Nevertheless, the fundamental underpinnings for the economy – low household debt, $2.2 trillion in excess savings, a dire need to boost corporate capex and homebuilding, and a strong labor market – remain in place. The odds of a recession in the next 12 months are quite low. Gauging Near-Term Inflation Dynamics A higher-than-expected neutral rate of interest implies that bond yields will probably rise from current levels over the long run. Over a shorter-term 6-to-12-month horizon, however, the direction of yields will be guided by the evolution of inflation. While the core CPI surprised on the upside in May, the details of the report were somewhat less worrying, as they continue to show significant supply-side distortions. Excluding vehicles, core goods prices rose 0.3% in May, down from a Q1 average of 0.7% (Chart 9). Recent commentary from companies such as Target suggest that goods inflation will ease further. Chart 9Goods Inflation Is Moderating, While Service Price Growth Is Elevated Stripping out energy-related services, services inflation slowed slightly to 0.6% in May from 0.7% in April. A deceleration in wage growth should help keep a lid on services inflation over the coming months (Chart 10). Chart 10A Deceleration In Wage Growth Should Help Keep Services Inflation Contained During his press conference, Fed Chair Powell described the rise in inflation expectations in the University of Michigan survey as “quite eye-catching.” Although long-term inflation expectations remain a fraction of what they were in the early 1980s, they did rise to the highest level in 14 years in June (Chart 11). Powell also noted that the Fed’s Index of Common Inflation Expectations has been edging higher. The Fed’s focus on ensuring that inflation expectations remain well anchored is understandable. That said, there is a strong correlation between the level of gasoline prices and inflation expectations (Chart 12). If gasoline prices come down from record high levels over the coming months, inflation expectations should drop. Chart 11Consumer Long-Term Inflation Expectations Keep Rising, But Are Still Not At Historically High Levels Chart 12Lower Gasoline Prices Would Help Soothe Consumer Fears Over Inflation The Fed expects core PCE inflation to fall to 4.3% on a year-over-year basis by the end of 2022. This would require month-over-month readings of about 0.35 percentage points, which is slightly above the average of the past three months (Chart 13). Our guess is that the Fed may be highballing its near-term inflation projections in order to give itself room to “underpromise and overdeliver” on the inflation front. If so, we could see inflation estimates trimmed later this year, which would provide a more soothing backdrop for risk assets. Chart 13AUS Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (I) Chart 13BUS Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (II) Concluding Thoughts on Investment Strategy According to Bank of America, fund managers cut their equity exposure to the lowest since May 2020. Optimism on global growth fell to a record low. Meanwhile, bears outnumbered bulls by 39 percentage points in this week’s AAII poll (Chart 14). If the stock market is about to crash, it will be the most anticipated crash in history. In my experience, markets rarely do what most people expect them to do. Chart 14Sentiment Towards Equities Is Pessimistic Chart 15Global Equities Are More Attractively Valued After The Recent Sell-Off Chart 16US And European EPS Estimates Have Been Trending Higher This Year US equities are trading at 16.3-times forward earnings, with non-US stocks sporting a forward P/E ratio of 12.1 (Chart 15). Despite the decline in share prices, earnings estimates in both the US and Europe have increased since the start of the year (Chart 16). The consensus is that those estimates will fall. However, if our expectation that a recession will be averted over the next 12 months pans out, that may not happen. A sensible strategy right now is to maintain a modest overweight to stocks while being prepared to significantly raise equity exposure once clear evidence emerges that inflation has peaked. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn Twitter View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Executive Summary Was FAANGM A Bubble? US inflation has become broad-based, and the labor market is very tight. Wages are a lagging variable, and they will be rising rapidly in the coming months, even as the economy slows. Although US growth will be slowing and global trade will be contracting, the Fed will remain hawkish over the coming months. This is an unprecedented environment and is negative for global and EM risk assets. The US trade-weighted dollar will continue to appreciate as long as the Fed sounds and acts in a hawkish manner and global trade contracts. Consistent with a US dollar overshoot, EM financial markets will undershoot. Even though EM equity and local bond valuations have become attractive, their fundamentals are still negative. A buying opportunity in EM will occur when the Fed makes a dovish pivot and China stimulates more aggressively. We reckon that these conditions will fall into place sometime in H2 this year. Bottom Line: For now, we recommend that investors stay defensive in absolute terms and underweight EM within global equity and credit portfolios. The dollar has more upside in the near term but a major buying opportunity in EM local currency bonds is approaching. Feature Last week, after a two and a half year hiatus, I travelled to Europe to visit clients. I also took the opportunity catch up with Ms. Mea, a global portfolio manager and a long-standing client. Prior to the pandemic, we met regularly to discuss global macro and financial markets. She was happy to resume our in-person meetings, and we met in Amsterdam over dinner last Friday. This report provides the key points of our conversation for the benefit of all clients. Ms. Mea: I am very happy that we are again able to meet in person. Video meetings are good, but in-person meetings are better. One’s body language often gives away their level of confidence regarding investment recommendations. Answer: Agreed. My meetings with clients this week have reminded me of the value of in-person meetings. Chart 1Our Calls On Various EM Asset Classes Ms. Mea: Before our meeting I reviewed the evolution of your investment views since the pandemic erupted. Let me try to summarize them, and correct me if I miss something. Even though you upgraded your medium-term view on Chinese growth in May 2020 due to the stimulus, you remained skeptical of the rally in global risk assets. In Q2 2020, you upgraded your stance on EM bonds and in July 2020 you lifted the recommended allocation to EM equities and currencies from underweight to neutral (Chart 1). In the summer and fall of 2020, you were still wary of a deflationary relapse in developed economies. However, since January 2021, your outlook for the US shifted drastically to overheating and inflation. Since then, you have been very vocal about inflation risks in the US. At the same time, you have been warning about a major slowdown in Chinese growth. Regarding financial markets, in March 2021, you downgraded EM stocks and bonds to underweight and recommended shorting select EM currencies versus the US dollar (Chart 1). I should say that your call on US inflation and China’s slowdown have played out very well over the past 18 months. Let’s zero in on US inflation. It was just last year that many investors and analysts claimed that inflation is good for stocks because it helps their top line growth. Why then have global markets panicked? Chart 2Record Wealth Destruction In US Stocks And Bonds Answer: Not many people have a deep understanding of inflation and its impact on financial markets because most investors lack experience in navigating financial markets during an inflation era. In fact, the US equity and bond market selloffs of the past 12 months have wiped out about $12 trillion and $3.5 trillion off their respective market value. This adds up to a combined $15.5 trillion or about 60% of US GDP and already exceeds the wipeouts during the March 2020 crash and all other bear markets (Chart 2). The way we think about macro and markets must change in an inflation regime. In our seminal February 25, 2021 Special Report titled A Paradigm Shift In The Stock-Bond Relationship, we made the case that the US economy and its financial markets were about to enter a new paradigm of higher inflation. We argued that US core CPI would spike well above 2% and US share prices and US government bond yields would become negatively correlated. A similar paradigm shift occurred in 1966 (Chart 3). In short, we argued that the era of low US inflation was over, and as a result, equities and bonds would selloff simultaneously. This will remain the roadmap for investors as long as core inflation is high. Chart 3A Paradigm Shift: US Stock Prices And Bond Yields Correlation Over Decades Ms. Mea: Do you think the Fed is behind the curve? Answer: Yes, the Fed has fallen behind the curve, and, as we have repeatedly argued over the past 12 months, the US inflation genie is out of the bottle. There is a lot of confusion in the global investment community about how we should think about inflation, and about how and when the various measures of inflation matter. As consumers, we care about headline inflation because it affects our purchasing power. So, changes in all goods and service prices, including energy and food, matter to consumers. However, this does not mean that central banks should target and set policy based on headline inflation. Rather, central banks should target genuine broad-based inflation in the economy before it becomes entrenched. Ms. Mea: Can you explain why in certain cases a surge in energy, food and other prices leads to entrenched inflation but in other cases it does not? Answer: Let me give you an example. When consumers experience rapidly rising food and energy prices, they will likely demand faster wage growth from their employers. If businesses are enjoying strong demand for their goods/services and facing a tight labor market, they might have little choice but to agree to pay raises to sustain their business. Companies will then attempt to protect their profit margins by hiking their selling prices. Households may accept higher prices given their incomes are rising. This dynamic could cause inflation to become broad-based and entrenched. In this case, central banks should lift rates to slow the economy materially and cool off the labor market to end the wage-price spiral. If employees fail to negotiate hefty pay raises, odds are that inflation will not become broad-based. The more households spend on energy and food, the less income they will have to spend on other items, causing their discretionary spending to contract. In this case, there is no rush for central banks to tighten policy. If monetary authorities tighten materially, the economy will experience a full-fledged recession. In short, wage dynamics will determine whether inflation becomes broad-based. Labor market conditions will ultimately dictate this outcome. Ms. Mea: But why are wages more important than the price of fuel or food in determining whether inflation becomes broad-based? Answer: To be technically correct, unit labor costs, not wages, are key to inflation dynamics. Unit labor cost = (wage per hour) / (productivity). Productivity is output per hour. Given that labor is the largest cost component of US businesses, unit labor costs will swell and profit margins will shrink when salaries rise faster than productivity. CEOs and business owners always do their best to protect the their profit margins. Thus, accelerating unit labor costs will lead them to raise their selling prices. In the wake of wage gains, consumers might accept higher goods and service prices. If they do and go on to demand even higher wages, the economy will enter a wage-price spiral. This is why wage costs, more specifically unit labor costs, are the most important variable to monitor. If high energy and food prices lead employees to demand faster wage growth from their employers, and if they are granted wage increases above and beyond their productivity advances, inflation will become more broad-based and genuine. If consumers push back against higher prices, i.e., reduce their spending, corporate profits will plunge, and companies will freeze investment and lay off employees. Wages will slow and inflation will wane. Ms. Mea: Are all economies currently experiencing a wage-price spiral? Answer: The US and some other countries have been experiencing a wage-price spiral over the past 12 months. In other countries, including many developing economies, a wage-price spiral is currently absent. In the US, labor demand exceeds supply by the widest margin since 1950 (Chart 4). The upshot is that wages will continue to rise in response to persistently high inflation (Chart 5). Chart 4US Labor Demand Is Exceeding Labor Supply By The Widest Margin Since 1950 Chart 5US Wage Growth Is Already Very High Wages in the US are currently rising at a rate of 6-6.5% or so. US productivity growth is around 1.5%. As a result, unit labor costs are rising at a 4.5-5% annual rate, the fastest rate for corporate America in the past 40 years (Chart 6). As Chart 6 demonstrates, unit labor costs have been instrumental in defining core CPI fluctuations over the past 70 years in the US. Chart 6US Unit Labor Costs Are Rising At The Fastest Rate Since 1982 Chart 7US Core Of Core Inflation Is High And Not Falling In short, both surging unit labor costs and the acceleration of super core CPI measures like trimmed-mean CPI and median CPI suggest that US inflation has become broad-based and a wage-inflation spiral has taken hold in the US (Chart 7). Critically, wages are a lagging variable and are not reset all at once for all employees. American employees will continue to demand substantial wage hikes both to offset the last 12 months of lost purchasing power and to protect their purchasing power for the next 12 months. Hence, we will be witnessing faster wage growth in the coming months even as the economy slows. For many continental European economies and for several EM economies, wage growth is still weak. Chart 8 illustrates that nominal wage growth in India, Indonesia, China and Mexico are very subdued. Sluggish wage gains in emerging economies are consistent with the profile of their domestic demand. Domestic demand in these large developing economies remains extremely weak. In many cases, the level of domestic demand in real terms is still below its pre-pandemic level (Chart 9). Chart 8EM Wages Are Very Tame Chart 9EM Domestic Demand Is Depressed In China, deflation, rather than inflation, is the main economic threat. Headline and core inflation are within a 1-2% range (Chart 10), domestic demand is very weak, and the unemployment rate has risen in the past 12 months. Chart 10China's Inflation Is Subdued Ms. Mea: Do you expect the US economy to contract? Answer: US growth will decelerate substantially, and certain segments of the economy could shrink for a couple of quarters. My expectation is that US corporate profits will contract materially. Slowing top line growth, narrowing profit margins, shrinking global trade and a strong dollar are all major headwinds for the S&P 500 EPS. EM EPS are also heading towards a major contraction. This is why I view EM fundamentals as negative even though EM valuations have become attractive. Ms. Mea: You have recently written that global trade volumes are about to contract. What is your rationale and is there any evidence that this is already happening? Answer: US and EU demand for consumer goods ex-autos has been booming over the past two years. Households have overspent on goods ex-autos (Chart 11). Given that their disposable income is contracting in real terms and a preference to spend on services, households will markedly curtail their purchases of consumer goods in the coming months. This will hurt global manufacturing in general, and emerging Asia in particular. Some forward-looking indicators are already signaling a contraction in global trade: US retail inventories (in real terms) have swelled (Chart 12, top panel). US retailers will dramatically reduce their orders. Chart 11Global Trade Volumes Will Shrink In H2 2022 Chart 12US Import Volumes Are Set To Contract Besides, US railroad carload is already shrinking, signaling reduced goods shipments (Chart 12, bottom panel). Taiwanese shipments to China lead global trade and they point to an impending slump (Chart 13, top panel). Also, the Taiwanese manufacturing shipments-to-inventory ratio has dropped below 1 (Chart 13, bottom panel). Finally, industrial metal prices are breaking down despite easing lockdowns in China and continued sanctions on Russia (Chart 14). This is a sign of downshifting global manufacturing. Chart 13A Red Flag For Global Trade Chart 14Industrial Metal Prices Are Breaking Down Ms. Mea: Won’t a global trade contraction push down goods prices and help US inflation? Answer: Correct, it will bring down US goods inflation but not services inflation. Importantly, as we discussed above, US inflation has already spilled into wages and has become broad-based. Plus, it is hovering well above the Fed’s target. Hence, the Fed cannot dial down its hawkishness now, even if goods price inflation drops significantly. In brief, even though US growth will be slowing and global trade will be contracting over the coming months, the Fed is likely to remain hawkish. This is an unprecedented environment and is negative for global and EM risk assets. Ms. Mea: What are the financial market implications of entrenched inflation in the US and the lack of genuine inflationary pressures in many emerging economies? Answer: As long as the Fed sounds and acts in a hawkish manner and/or global trade contracts, the US trade-weighted dollar will continue to appreciate. The greenback is a countercyclical currency and rallies when global trade slumps. On the whole, the USD will likely overshoot in the near run. Consistent with a US dollar overshoot, EM financial markets will undershoot. Even though investor sentiment on EM equities and USD bonds is very low (Chart 15), a final capitulation selloff is still likely. In short, EM valuation and positioning are positive for future potential returns yet their fundamentals (business cycle, profits, return on capital, etc.) are still negative. A buying opportunity in EM will emerge when the Fed makes a dovish pivot, China stimulates more aggressively, and EM equity and bond valuations improve further. We reckon that these conditions will fall into place sometime in H2 this year. If the Fed turns dovish early without taming US inflation, it will fall behind the inflation curve and the US dollar will begin its bear market. Investors will respond by embracing EM financial assets. EM local currency bonds in particular offer value (Chart 16). Prudent macro policies and the lack of wage pressures entail a good medium-to-long term opportunity in EM local currency bonds. Chart 15Investor Sentiment On EM Stocks And USD Bonds Is Low Chart 16US TIPS Yields Should Roll Over For EM Local Bond Yields To Decline As EM currencies put in a bottom, local yields will come down. This will help their equity markets. Ms. Mea: Speaking of a capitulation selloff, how far can it go? Both for EM stocks as well as the S&P 500? Chart 17S&P500: Where Is Technical Support Line? Answer: As long as US bond yields and oil prices do not start falling on a consistent basis, the S&P 500 will remain under selling pressure. Technicals can help us gauge the likely magnitude of the move. The S&P 500 has dropped to a major technical support, but it will likely be broken. The next support is around 3100-3200 (Chart 17). The EM equity index is sitting on a technical support now (Chart 18). The next support level is 15-17% below the current one. Chart 18EM Stocks in USD Terms Could Drop Another 15% Critically, US equity investors should also consider whether the US equity bull market that has been in place since 2009 is over. If it is, then the S&P 500 bear market could last long, and prices could drop significantly. Chart 19Was FAANGM A Bubble? A few observations that investors should keep in mind: First, over the past 12 years, FAANGM stocks have followed the profile of the Nasdaq 100 (Chart 19). In short, FAANGM stocks have risen as much as the Nasdaq 100 index did in the 1990s. Second, when retail investors rush into an asset class, it often signals the final phase of the bull market. Once the bull market ends, the ensuing bear market is vicious. The behavior of tech/internet stocks and the broader S&P 500 fits this profile extremely well. For several years after the Lehman crash, individual investors were hesitant to buy US stocks. However, the resilience of US equities led to a buy the dip mentality in 2019-20. Retail investors joined the equity party en masse in early 2020. The post retail frenzy hangover is usually very painful and prolonged. Based on this roadmap, it seems that the 2020-21 retail-driven rally was the final upleg in the S&P 500 bull market. By extension, we have entered a bear market that could be vicious and extended. All the excesses of the 10-year FAANGM and S&P500 bull markets will need to be worked out before a new bull market emerges. Finally, a high inflation regime raises the bar for the Fed to rescue the stock market. This also entails lower equity multiples than we have in the S&P500 now. Ms. Mea: What do you make of EM’s recent outperformance versus DM stocks? When will you upgrade EM versus DM? Answer: Indeed, EM stocks have recently outperformed DM stocks. We might be witnessing a major transition in global equity market leadership. We have held for some time that an equity leadership change from the US to the rest of the world and from TMT stocks to other segments of the global equity market would likely take place during or following a major market selloff. The ongoing equity bear market seems to be exactly that catalyst. Chart 20For EM Equities To Outperform, USD Needs To Weaken If the S&P 500 bull market is over, the global equity leadership will also change away from US and TMT stocks to other stock markets and sectors. That said, to upgrade EM stocks, we need to change our view on the USD because EM relative equity performance versus DM closely tracks the inverted trade-weighted US dollar (Chart 20). In the near term, we believe the greenback has more upside potential. In particular, Asian currencies and equity markets cannot outperform when the Fed is hawkish and global trade is contracting. Latin American currencies have benefited since early this year from the spike in commodity prices. However, worries about a US recession, a strong dollar and a lack of strong recovery in the Chinese economy will push industrial metal prices lower. As shown in Chart 14 above, industrial metal prices are breaking down. This is a bad omen for Latin American markets. On the whole, we will likely be upgrading EM versus DM later this year. For now, we recommend that investors stay defensive and underweight EM within global equity and credit portfolios. We also continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN, PHP and IDR; as well as HUF vs. CZK, and KRW vs. JPY. A major buying opportunity in local currency bonds is approaching. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com
In lieu of next week’s report, I will host a Webcast on Monday, June 27 to explain the recent market turmoil and how to navigate it through the second half of 2022. Please mark the date, and I do hope you can join. Executive Summary The recent sharp underperformance of the HR and employment services sector presages an imminent rise in the US unemployment rate. Central banks have decided that a recession is a price worth paying to slay inflation. In this sense, the current setup rhymes with 1981-82, when the Paul Volcker Fed made the same decision. The correct investment strategy for stocks, bonds, sectors and FX is to follow the template of 1981-82. In a nutshell, an imminent recession will require a defensive strategy for most of 2022, before a strong recovery in markets unfolds in 2023. Go long the December 2023 Eurodollar (or SOFR) futures contract. While interest rates are likely to overshoot in the near term, the pain that they will unleash will require a commensurate undershoot in 2023-24. Cryptocurrencies will rally strongly once the Nasdaq reaches a near-term bottom, which in turn will depend on a peak in long bond yields. Fractal trading watchlist: Czechia versus Poland, German telecoms, Japanese telecoms, and US utilities. The Underperformance Of Human Resources Warns That The US Jobs Market Is Rolling Over Bottom Line: An imminent recession will require a defensive strategy for most of 2022, before a strong recovery in markets unfolds in 2023. Feature Financial markets have collapsed in 2022, but jobs markets have held firm, at least so far. For example, the US economy has added an average of 500 thousand jobs per month1, and the unemployment rate, at 3.6 percent, remains close to a historic low. But now, an excellent real-time indicator warns that cracks are appearing in the US jobs market. The excellent real-time indicator of the jobs market is the performance of the human resources (HR) and employment services sector. After all, with its role to place and support workers in their jobs, what better pulse for the jobs market could there be than HR? What better pulse for the jobs market could there be than the human resources sector? Worryingly, the recent sharp underperformance of the HR and employment services sector warns that the pulse of the jobs market is weakening, and that consumers will soon be reporting that jobs are becoming less ‘plentiful’ (Chart I-1). In turn, consumers reporting that jobs are becoming less plentiful presages an imminent rise in the unemployment rate (Chart I-2). Chart I-1The Underperformance Of Human Resources Warns That The US Jobs Market Is Rolling Over Chart I-2Jobs Becoming Less 'Plentiful' Presages Higher Unemployment 2 Percent Inflation Will Require A Sharp Rise In Unemployment The health of the jobs market has a huge bearing on the big issue du jour – inflation. Specifically, in the US, the unemployment rate (inversely) drives the inflation of rent and owners’ equivalent rent (OER) because, to put it simply, you need a steady job to pay the rent. Furthermore, with rent and OER comprising almost half of the core CPI basket, the ‘rent of shelter’ component is by far the most important long-term driver of core inflation.2 Shelter inflation at 3.5 percent equates to core inflation at 2 percent. For the past couple of decades, full employment has been consistent with rent of shelter inflation running at 3.5 percent, which itself has been consistent with core inflation running at 2 percent (Chart I-3). Hence, the Fed could achieve the Holy Grail of full employment combined with inflation running close to 2 percent. Chart I-3Core Inflation At 2 Percent = Shelter Inflation At 3.5 Percent... But here’s the Fed’s problem. In recent months, there has been a major disconnect between the jobs market and rent of shelter inflation. The current state of full employment equates to rent of shelter inflation running not at 3.5 percent, but at 5.5 percent (Chart I-4). Chart I-4...But Full Employment Now = Shelter Inflation At 5.5 Percent This means that to bring rent of shelter and core inflation back to 3.5 percent and 2 percent respectively, the unemployment rate will have to rise by 2 percent. In other words, to achieve its inflation goal, the Fed will have to sacrifice its full employment goal. Put more bluntly, if the Fed wants to reach 2 percent inflation quickly, it will have to take the economy into recession. The cracks appearing in the HR and employment services sector suggest this process is already underway. There Are Two ‘Neutral Rates Of Interest’. Which One Will Central Banks Choose? The ‘neutral rate of interest rate’, also known as the long-run equilibrium interest rate, the natural rate and, to insiders, r-star or r*, is the short-term interest rate that is consistent with the economy at full employment and stable inflation: the rate at which monetary policy is neither contractionary nor expansionary. But here’s the subtle point that many people miss. The neutral rate is defined in terms of stable inflation without stating what that stable rate of inflation is. Therein lies the Fed’s problem. The near-term neutral rate that is consistent with inflation at 2 percent is much higher than the near-term neutral rate that is consistent with full employment. The near-term neutral rate that is consistent with inflation at 2 percent is much higher than the near-term neutral rate that is consistent with full employment. Now let’s add a third goal of ‘financial stability’, and the message from the ongoing crash in stock, bond, and credit markets is crystal clear. The near-term neutral rate that is consistent with inflation at 2 percent is also much higher than the near-term neutral rate that is consistent with financial stability (Chart I-5 and Chart I-6). Chart I-5Markets Have Crashed Because Valuations Have Crashed. Profits Have Held Up… So Far Chart I-6When The Mortgage Rate Exceeds The Rental Yield, It Spells Trouble For House Prices This leaves the Fed, and other central banks, with a major dilemma. Which neutral rate goal to pursue – full employment and financial stability, or inflation at 2 percent? In the near term, the answer seems to be inflation at 2 percent. This is because the lifeblood of central banks is their credibility. With their credibility as inflation fighters in tatters, this may be the last chance to repair it before it is shredded forever. Taking this long-term existential view, central banks have decided that a recession is a price worth paying to slay inflation and repair their credibility. In this important sense, the current setup rhymes with 1981-82 when the Paul Volcker Fed made the same decision. Therefore, the correct investment strategy for stocks, bonds, sectors and FX is to follow the template of 1981-82, which we detailed in More On 2022-2023 = 1981-82, And The Danger Ahead. In a nutshell, an imminent recession will require a defensive strategy for most of 2022, before a strong recovery in markets unfolds in 2023. Eventually, the central banks’ major dilemma between inflation and growth will resolve itself. The triple whammy of a recession in asset prices, profits, and jobs will unleash a strong disinflationary – or even outright deflationary – impulse, causing inflation to collapse to well below 2 percent in 2023-24. And suddenly, there will be no conflict between the neutral rate that is consistent with full employment and financial stability, and that which is consistent with inflation at 2 percent. Both neutral rates will be ultra-low. Hence, while interest rates are likely to overshoot in the near term, the pain that they will cause will require a commensurate undershoot in 2023-24. On this basis, go long the December 2023 Eurodollar (or SOFR) futures contract (Chart I-7). Chart I-7Go Long The Dec 2023 Eurodollar (Or SOFR) Future Cryptos Will Bottom When The Nasdaq Bottoms The turmoil across financial markets has naturally engulfed cryptocurrencies, and this has generated the usual Schadenfreude among the crypto-doubters. But in the short-term, cryptocurrencies just behave like leveraged tech stocks, meaning that as the Nasdaq has fallen sharply, cryptos have fallen even more sharply (Chart I-8). Chart I-8In the Short Term, Cryptos = A Leveraged Nasdaq Most cryptocurrencies are just the tokens that secure their underlying blockchains, so their long-term value hinges on whether their underlying blockchain technologies will succeed in displacing the current ‘trusted third party’ model of intermediation. In this sense, blockchain tokens are the ultimate long-duration growth stocks, whose present values are highly sensitive to the performance of the blockchain technology sector, which in turn is highly sensitive to the long-duration bond yield. Hence, while the bear markets in bonds, Nasdaq, and cryptos appear to be separate stories, they are just one massive correlated trade! Given that nothing fundamental has changed in the outlook for blockchains, long-term investors should treat this crypto crash, just like all the previous crypto crashes, as a buying opportunity. Cryptos will rally strongly once the Nasdaq reaches a near-term bottom, which in turn will depend on a peak in long bond yields. Fractal Trading Watchlist Amazingly, while most markets have crashed, the financial-heavy Czech stock market is up by 20 percent this year, in sharp contrast to its neighbouring Polish stock market which is down by 25 percent. In fact, over the last year, Czechia has outperformed Poland by 100 percent. From both a fundamental and technical perspective, this outperformance is now vulnerable to reversal (Chart I-9). Accordingly, a recommended trade is to underweight Czechia versus Poland, setting the profit target and stop-loss at 15 percent. Elsewhere, the outperformances of German telecoms, Japanese telecoms, and US utilities are all at, or close, to points of fractal fragilities which make them vulnerable to reversals. As such, these have entered out watchlist. The full watchlist of 27 investments that are at, or approaching turning points, is available on our website: cpt.bcaresearch.com Chart I-9Czechia's Spectacular Outperformance Is Vulnerable To Reversal Fractal Trading Watchlist: New Additions German Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 1BRL/NZD At A Resistance Point Chart 2Homebuilders Versus Healthcare Services Has Turned Chart 3CNY/USD At A Potential Turning Point Chart 4US REITS Are Oversold Versus Utilities Chart 5CAD/SEK Is Vulnerable To Reversal Chart 6Financials Versus Industrials Has Reversed Chart 7The Outperformance Of Resources Versus Biotech Has Ended Chart 8The Outperformance Of Resources Versus Healthcare Has Ended Chart 9FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 10Netherlands' Underperformance Vs. Switzerland Is Ending Chart 11The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 12The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 13Food And Beverage Outperformance Is Exhausted Chart 14German Telecom Outperformance Vulnerable To Reversal Chart 15Japanese Telecom Outperformance Vulnerable To Reversal Chart 16The Strong Downtrend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 17The Strong Downtrend In The 3 Year T-Bond Is Fragile 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 Is At Risk Of Reversal Chart 22Switzerland's Outperformance Vs. Germany Has Ended 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 Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Based on the nonfarm payrolls. 2 Rent of shelter also includes lodging away from home, but the two dominant components are rent of primary residence and owners’ equivalent rent of residences. Fractal Trading System Fractal Trades 6-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 MSCI Emerging Markets equity index is up nearly 7% in USD terms over the past month. Does this latest bounce mark the beginning of a sustainable improvement in the performance of EM risk assets? China’s money and credit cycles drive Chinese imports and…
BCA Research’s US Equity Strategy service’s model indicates that US earnings growth is trending towards zero over the next three months. The model has five factors, each of which has fundamental relevance to earnings growth: ISM PMI is a gauge…
Executive Summary The recent pullback was all about a multiples contraction while strong earnings growth helped absorb the blow. With the multiple contraction phase complete, the S&P 500 performance is now all about earnings. Consensus still expects earnings to grow at 10% over the next 12 months, despite negative corporate guidance and a whole constellation of factors that present challenges to corporate profitability. We need to see downgrades or earnings will disappoint. Our brand-new model predicts that earnings growth will trend towards zero over the next three months. Earnings growth is a tug of war between rising input costs and corporate pricing power. There is a high likelihood of an earnings recession, even if an economic recession is unlikely over the next 12 months. Because growth is slowing not only in the US but also abroad. If an earnings recession does materialize, equities may have another leg down, perhaps another 5-8%. Earnings Growth Is A Tug Of War Between Rising Costs And Pricing Power Bottom Line: We forecast that earnings growth will undershoot consensus expectations and an earnings recession is likely. Since the multiples contraction phase of the bear market is likely over, equities performance will be dictated by earnings growth. In the short run, we expect equities to be range-bound, with rallies and pullbacks alternating. In case of an earnings recession, equities may fall another 5-8%. Feature Related Report US Equity StrategyMarginally Worse Ever since the Fed started hiking interest rates back in March, investors started worrying about the recession. The BCA house view is that a recession is unlikely over the next 12 months. However, to us, of even greater concern is the likelihood of an earnings disappointment or even an outright earnings recession. We believe that earnings growth will slow dramatically. We wrote back in October 2021 report, “Marginally Worse”, that margins will contract at the beginning of the year – indeed, this prediction materialized during the Q1-2022 earnings season (Chart 1). Shrinking profit margins are likely to translate into flat to negative real earnings growth over the next 12 months. However, economic and earnings growth expectations remain elevated. As our readers may recall from the “Have We Hit Rock Bottom?” and “Fat and Flat” reports, we believe that for the markets to begin to heal, growth expectations need to come down and a negative outlook needs to get priced in. Chart 1Margins Are Contracting In this week’s report, we take a close look at the S&P 500 earnings growth expectations and provide our own estimate based on a simple regression model. We will also discuss implications for the US equity market. Sneak Preview: We estimate that earnings growth will trend towards zero over the next three to six months, consistent with current trends in US economic growth, inflation, corporate pricing power, monetary conditions, and the strength of the USD. Sell-off Driven By Multiples Contraction, Not Earnings Growth This year’s sell-off has been triggered by fears of an aggressive Fed, tighter monetary policy, and rising rates. However, decomposition of the total return demonstrates that the pullback was all about multiples contraction, while strong earnings growth helped absorb the blow (Chart 2). A pertinent question is what happens to the market when earnings growth softens? One may wonder whether the bad news has already been priced in, as multiples tend to front-run growth. A case in point is strong market performance in 2020 on the back of multiples expansion in anticipation of a post-pandemic rebound in earnings growth (Chart 3). Chart 2Sell-off Was Driven By A Multiples Contraction Chart 3Multiples Lead Earnings With multiples down from 23x to 17x over the past two years, and the S&P 500 down by 19% from its January 2022 peak, arguably much of the upcoming earnings growth slowdown/contraction is priced in. Much but not all. The next chapter of the bear market will be driven by earnings growth. Earnings Growth Headwinds As we have pointed out on multiple occasions, it is confounding that, despite negative corporate guidance and a whole constellation of factors that present challenges to corporate profitability, earnings estimates for 2022 have been revised up (Chart 4) and stand at about 10% (Chart 5). However, at long last, upgrades are starting to moderate (Chart 6). We need to see downgrades. Chart 42022 Earnings Estimates Are Still Trending Up Chart 5Earnings Are Expected To Grow At 10% Chart 6Analysts Are No Longer Upgrading Chart 7Slowing Global Growth Has An Adverse Effect On The US Earnings Growth Since the beginning of 2022, there have been quite a few developments that will weigh on earnings growth: Slowing growth in the US and globally means sales growth is decelerating. This week, the World Bank downgraded global GDP growth from 4.1% to 2.9%. Global manufacturing PMI is also trending towards 50 (Chart 7). Consumer demand is weakening: Negative real wage growth saps consumers’ confidence and cuts into their purchasing power. Moreover, demand for goods is returning to the pre-pandemic trend, and retail sales, especially in real terms, are flagging (Chart 8). Demand for services remains strong, but the S&P 500 index is dominated by goods producers. Corporate pricing power is still strong but is showing signs of waning as many US consumers, distraught by the negative wage growth, are strapped for cash (Chart 9). Chart 8Retail Sales Are Contracting In Real Terms Chart 9Corporate Pricing Power Is Waning Prices of raw materials have soared and supply disruptions are exacerbated by lockdowns in China and the war in Ukraine. Companies’ COGS (Cost of Goods Sold) bills are skyrocketing. Nominal wage growth is 6% and is on the rise, affecting companies’ bottom lines. The dollar is strong: it has gained 15% since January 2021. This makes US goods more expensive and reduces companies’ earnings via the currency translation effect. These are the reasons why it is increasingly hard for companies to preserve margins and grow earnings – a commentary that we have heard repeatedly during earnings calls. According to Refinitiv, for Q2-2022, there have been 73 negative EPS preannouncements issued by S&P 500 corporations, compared to 42 positive EPS preannouncements (N/P=73/42=1.7). A year ago, in Q2-2021, the N/P ratio was 0.8, with more companies offering positive guidance. All of this points to weakening profitability. Refinitiv also estimates the earnings growth rate for the S&P 500 for Q2-2022 at 5.3%. If the energy sector is excluded, the growth rate declines to -1.9%. We believe growth will come to a halt or contract into the end of the year. We expect slower top-line growth and shrinking profit margins to translate into flat to negative real earnings growth over the next 12 months. Earnings Recessions Often Happen When The Economy Is Still Growing One may wonder if an earnings recession is even possible without an economic recession. In fact, that happened quite a lot in the past. Out of 27 earnings recessions since 1927, 11 did not coincide with economic recessions (Chart 10). Chart 10Earnings Recessions And Economic Recession Often Don't Coincide The S&P 500 does not mirror the US economy, with the former dominated by larger companies, many of which are multinationals and more exposed to global demand and the USD than the broad economy. Also, services and consumer spending constitute roughly 70% of the US economy, while the index overrepresents manufacturing, technology, and goods-producing companies. With the S&P 500 being global in nature, quite a few earnings recessions were triggered by events abroad: The 2016 earnings recession was caused by the devaluation of the Chinese yuan; in 2012, one was triggered by a post-GFC double-dip recession in Europe; and the 1998 one was triggered by an Asian financial crisis. It is also often the case that a profit recession is a harbinger of economic recession. Both the 2000 dot-com crash and GFC economic recessions were preceded by earnings recessions, one starting in December 2000, and the other in August 2007. The 2019 earnings recession was brief and came hand in hand with widespread fears of the end of the business cycle. Hence, we believe that a confluence of factors both at home and abroad, as discussed above, makes an earning recession a high probability event. There is a high likelihood of an earnings recession, even if an economic recession is unlikely over the next 12 months, because of slowing growth not only in the US but also abroad. Modeling Earnings Growth Since we are distrustful of the consensus of 10% expected eps growth, we have built our own simple earnings growth forecast model to gauge what earnings growth rate we may expect over the next quarter. The model has five factors, each of which has fundamental relevance to earnings growth (Table 1): Table 1EPS Growth Forecast Model ISM PMI is a gauge of US economic growth and a proxy for top-line growth. PPI stands for the change in input costs. Pricing Power is a BCA proprietary indicator and captures companies’ ability to pass costs onto their customers. HY Spreads indicate costs of borrowing and also the state of the economy (spreads tend to shoot up in a slowing economy). USD represents the ability of US multinationals to sell goods abroad. Roughly 35% of S&P 500 sales are outside the US. Each factor is calculated on a year-on-year percentage change basis, with a three-month lag to allow the effects of macroeconomic developments to get priced in. Adjusted R2 is 65%, which is a strong fit. All factors are statistically significant at the 1% level. The model forecasts that earnings growth will come down from 6% MoM as of April 2021 to 1.3% as of August 2022 (Chart 11). While this does not map directly to the “next 12 months” of eps growth, it does indicate that earnings growth is trending towards zero in nominal terms and will be outright negative in real terms. Further, while we are unable to predict earnings growth more than three months ahead, we do expect that it will reach zero and then shift into contraction territory into the balance of the year. Chart 11Model Predicts That Earnings Growth Will Be Flat Looking closer at the key drivers of growth (Chart 12), we observe that there is a tug of war between pricing power and rising costs (PPI), with earnings growth falling as pricing power starts to give away ground. The other factors that have an adverse effect on earnings growth are slowing growth (ISM PMI), an appreciating dollar, and rising borrowing costs (HY spreads). Chart 12Earnings Growth Is A Tug Of War Between Rising Costs And Pricing Power The model indicates that earnings growth is trending towards zero over the next three months. Price Target What does all of this mean for US equities? If the multiple contraction phase is complete, the S&P 500 performance is now all about earnings. If we expect earnings to grow only 0-3% in nominal terms, with the forward earnings multiple unchanged at roughly 18x, then the S&P 500 is likely to come down another couple of percentage points. If earnings contract 5%, the index may be down as much as 8%. If multiples contract another point to 17x and earnings contract by 5%, the market may be down as much as 15% (Table 2). Table 2The S&P 500 Target Scenario Analysis For now, we are sticking with our “fat and flat” thesis expecting the S&P 500 performance to continue to trend down as rallies and pullbacks alternate. Earnings growth slowdown/shallow contraction is likely to result in another leg down of roughly 5-8%. Investment Implications Street forward earnings growth expectations are too high at 10% and need to be downgraded. There are multiple reasons why earnings growth will be underwhelming, ranging from slowing growth abroad to weaker demand for goods and rising wages at home. We anticipate that earnings growth will be flat to negative into the balance of the year. The multiple contraction phase of the bear market is over, and now equities performance will be dictated by earnings growth. If an earnings recession does materialize, equities may have another leg down, perhaps another 5-8%. Bottom Line We forecast that earnings growth will undershoot consensus expectations and that an earnings recession is likely. Since the multiple contraction phase of the bear market is likely over, equity performance will be dictated by earnings growth. In the short run, we expect equities to trend down, with rallies and pullbacks alternating. In the case of an earnings recession, equities may fall another 5-8%. Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com Recommended Allocation Recommended Allocation: Addendum