Financial Markets

Executive Summary The US economy is experiencing a period of stagflation: booming nominal economic growth amid a lack of volume expansion. Very strong nominal growth (due to high inflation), a tight labor market, and more evidence of a wage-price spiral will cause the Fed to err on the side of hawkishness. Global trade volumes will contract and commodity prices will drop further. The former is bearish for Emerging Asian financial markets and the latter is negative for Latin American markets. Equities are currently rallying from very oversold levels and the rebound could continue in the coming weeks. However, if we are correct about our outlook on US inflation, Fed policy and global trade, then risk assets will resume their decline and the US dollar will rally. Strong Nominal, Weak Real Growth = Stagflation Bottom Line: Stay defensive and continue underweighting EM in global equity and credit portfolios. The greenback will resume its uptrend sooner rather than later. This will depress EM share prices and fixed-income markets.     Financial markets interpreted Fed chairman Powell’s comments in last Wednesday’s (July 27) FOMC press conference as a dovish pivot, catalyzing a sharp rebound in the S&P500. Is the bear market over? Should investors buy risk assets, including EM ones? Chart 1No Strong Rebound In EM Share Prices We are hesitant to declare an end to the bear market and to recommend higher exposure to EM risk assets and currencies. In fact, the rebound in EM stocks has been feeble (Chart 1, top panel). As a result, the relative performance of EM equities versus their DM peers has fallen back to its lows of earlier this year (Chart 1, bottom panel). Overall, we reiterate what we wrote two weeks ago “…our macro themes of Fed tightening amid slowing global growth, the US dollar overshooting, and China’s disappointing recovery remain intact. These factors still warrant a defensive investment strategy, despite a possible near-term rebound in the S&P 500. EMs will lag and underperform in this rebound.” Can The Fed Afford To Pivot? With entrenched and persistent inflation in the US running well above the Fed’s target, the Fed cannot afford to – and will not – pivot for now. A simple rollover in inflation that reflects falling commodity and goods prices will not be sufficient for the Fed to make a policy U-turn and cut rates by 50 basis points next year (as fixed-income markets expect). We have been arguing that the US is already experiencing broad-based genuine inflation and has developed a wage-price spiral. Chart 2US Wage Growth Is At Its Fastest Rate In 40 years US wage growth has surged to a 40-year high of 5.7% (Chart 2). Even though the labor market is set to soften on the margin, its tightness will keep wage growth elevated. Importantly, real wages have fallen significantly, and employees will be demanding higher wages to offset lost purchasing power. US companies have been raising their prices at the fastest rate in decades. Prices charged by non-farm businesses rose at an annual rate of 8-9% in Q2, the highest in the past 40 years (Chart 3). Chart 3US Companies Are Raising Their Prices At Their Fastest Rate In 40 years Chart 4Strong Nominal, Weak Real Growth = Stagflation Even though volumes have stagnated, corporate profits have been holding up because companies have been able to raise prices. Final sales to domestic purchasers in real terms registered zero growth in Q2 from Q1(Chart 4). This entails that the US economy is currency experiencing stagflation. Given that companies are able to raise prices (generating strong nominal sales) and are facing very tight labor market conditions, they might be willing to raise wages further. In brief, a wage-price spiral is unfolding in the US. US core inflation is running well above the Fed’s 2% target. The average of seven core PCE and CPI measures – our “super core” gauge of consumer price inflation − stands at 5.5% (Chart 5). Although falling commodity and goods prices (Chart 6) could cap the upside in core inflation, they are unlikely to bring it down below 4%. Hence, core inflation will remain well above the Fed’s target of 2%. This will lead the Fed to keep tightening monetary policy. Chart 5US Super Core Inflation Is At 5.5% and Rising Chart 6US Import Prices From Asia Will Fall Finally, in our opinion, financial markets are underappreciating how entrenched and persistent US inflation has become and are overlooking the unfolding wage-price spiral. The latest easing in US financial conditions will cause the Fed to refocus on inflation rather than growth. That is why we maintain our theme that the Fed and US equity markets remain on a collision course.  We are open to the idea that the Fed could ultimately pivot earlier than required and eventually cut rates. However, odds are that the Fed has not yet pivoted and will ramp up its hawkishness in the coming months. The bar for the Fed to turn dovish is currently much higher than at any other time in the past 35 years, as inflation is much more entrenched and higher today. In our view, Powell would not like to be remembered as the chairman under whose watch inflation became enduring. He would prefer to be remembered as Paul Volcker, and not as Arthur Burns. Under the latter’s watch in the 1970s, the US experienced a devastating era of high and persistent inflation. Global equities, credit markets and US Treasurys were very oversold a few weeks ago. That is why even a minor hint from the Fed of a possible end to the hiking cycle produced such a strong rebound in stocks and fixed-income markets. This rally could persist in the coming weeks. However, if we are correct about the outlook on US inflation, Fed policy and global trade (see the section below), then risk assets will resume their decline and the US dollar will rally. Bottom Line: The US economy is experiencing a period of stagflation: booming nominal economic growth amid a lack of volume expansion. Very strong nominal growth (due to high inflation) a tight labor market, and more evidence of a wage-price spiral will cause the Fed to err on the side of hawkishness. As a result, the current rally in risk assets is unsustainable. Global Manufacturing / Trade Contraction Global manufacturing and trade are entering a period of contraction: According to manufacturing PMI data for July, Taiwanese new export orders for overall manufacturing and the semiconductor industry have plunged to 37 and 34, respectively (Chart 7). Meanwhile, their customer inventories have surged to a 10-year high (Chart 8). Taiwan is a major supplier of semiconductors and other inputs to many industries around the world. Hence, these data suggest that industrial companies globally have stopped ordering chips and other inputs. This development is a sign of broad-based industrial weakness. Therefore, we believe that global trade volumes are set to shrink in H2 this year. Chart 7Taiwan: Overall And Semiconductor New Orders Have Plunged... Chart 8...And Customer Inventories Have Surged A similar situation is unfolding in the Korean semiconductor sector. The DRAM DXI index (revenue proxy) is falling, and DRAM and NAND spot prices are deflating (Chart 9). Notably, Korea’s overall export sector is also reeling. Business confidence among Korean exporters is plunging – this includes the latest datapoint from August (Chart 10, top panel). The nation’s export volume growth is already close to zero and export value growth is only holding up because of higher prices (Chart 10, bottom panel). Chart 9Korea: Semiconductor Prices Are Deflating Chart 10Downside Risks For Korean Exports Chart 11US Goods Imports Are Set To Contract US import volumes are set to shrink in the coming months. This will deepen the global trade slump. Chart 11 illustrates that US consumption of goods-ex autos has been contracting and retail inventory of goods ex-autos has skyrocketed. Together, these developments foreshadow a major contraction in US imports and global trade volumes. Commodity prices are heading south. Chinese commodity consumption will remain in the doldrums, and US/EU demand for commodities will weaken as global manufacturing contracts.  The sanctions imposed on Russia initially led buyers to increase their precautionary and speculative purchases of various commodities, creating a tailwind for prices earlier this year. However, these precautionary and speculative purchases have since been halted or reversed, causing commodity prices to plunge. We made the case for falling oil prices in our July 21 report, and BCA’s China Investment Strategy’s Special Report on copper from July 27 concludes that  copper prices will decline further. Chart 12China: Has The Post-Reopening Bounce Ran Its Course? Finally, the Chinese manufacturing PMI rolled over in July following the rebound in May and June. New orders, backlog orders and import subcomponents have relapsed anew (Chart 12). The Chinese economy is facing considerable headwinds from the property market, rolling lockdowns resulting from the dynamic zero-COVID policy and a contraction in exports. As we argued in our July 13 report, policy stimulus has so far been insufficient. Bottom Line: Global trade volumes will contract and commodity prices will drop further. The former is bearish for Emerging Asian financial markets and the latter is negative for Latin American markets. Investment Strategy Although the rebound in global risk assets could persist for several weeks, their risk-reward profile is not attractive. Stay defensive and continue underweighting EM in global equity and credit portfolios. The Fed’s hawkish bias as well as contracting global trade are bullish for the US dollar. As a result, the greenback will resume its uptrend sooner rather than later. This will cap the upside in EM stocks and fixed-income markets. We continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN, PHP, and IDR. In addition, we recommend shorting HUF vs. CZK, KRW vs. JPY, and BRL vs. MXN. Although we find good value in many EM local yields, we do not yet recommend buying them aggressively. The basis is our view on EM currencies versus the US dollar. For now, we prefer to bet on flattening yield curves. Our current favorite markets for flatteners are Mexico and Colombia. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)