Developed Countries
Executive Summary US Treasury yields have surged in response to high US inflation and Fed tightening expectations. However, the move looks overdone in the near-term. Too many Fed hikes are now discounted for 2022, US realized inflation should soon peak, inflation expectations have stabilized, financial conditions have started to tighten, and positioning in the Treasury market is now quite short. These factors will act to stabilize Treasury yields over the next few months, even with the cyclical backdrop remaining bond bearish. Markets Think The Fed Will Hike More Sooner And Less Later – The Opposite Is More Likely Recommendation Inception Level Inception Date Long Dec 2022/Short Dec 2024 3-Month SOFR Future 0.25 Feb 22/22 New Trade: Go long the December 2022 US SOFR interest rate futures contract versus shorting the December 2024 SOFR contract. The former discounts too many Fed hikes for this year and the latter discounts too few hikes over the next three years. Bottom Line: US Treasury yields now discount the maximum likely hawkish scenario for Fed rate hikes in 2022, with risks all pointing in the direction of the Fed delivering less than expected. Upgrade US duration exposure to neutral from below-benchmark on a tactical basis. Feature Chart 1A Near-Term Overshoot For UST Yields During the BCA Research US Bond Strategy quarterly webcast last week, we announced a shift in our recommended US duration stance, moving from below-benchmark to neutral. This move was more tactical (i.e. shorter-term) in nature, as we still strongly believe that bond markets are underestimating the eventual peak for US bond yields over the next couple of years. In the near term, however, we see several good reasons to expect the recent big run-up in US bond yields to pause, warranting a more neutral tactical duration exposure (Chart 1). We discuss those reasons – and the implications for both US duration strategy - in this report published jointly by BCA Research’s US Bond Strategy and Global Fixed Income Strategy services. Reason #1: Too Many Fed Rate Hikes Are Now Discounted For 2022 The US overnight index swap (OIS) curve currently discounts 146bps of Fed rate hikes by the end of 2022. This is a big change from the start of the year when only 77bps of hikes were priced (Chart 2). The OIS curve repricing now puts the path of the funds rate for this year well above the last set of FOMC interest rate projections published at the December 2021 Fed meeting. In other words, the market has already moved to discount a big upward shift in the FOMC “dots” for 2022, and even for 2023, at next month’s FOMC meeting. Chart 2Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely We think a more likely outcome for 2022 is that the Fed lifts rates four or five times, not six or even seven times as some Wall Street investment banks are forecasting. We set out the reasons why we think the Fed will go less than expected in the rest of this report. At a minimum, there is virtually no chance that the Fed will provide guidance to markets that is more hawkish than current market pricing, which would push bond yields even higher in the near term. Reason #2: US Inflation Will Soon Peak The relentless string of upside surprises on US inflation has been the main reason the bond market has moved so rapidly on pricing in more Fed rate hikes. The story is about to change, however, as US inflation should peak sometime in the next few months and begin to rapidly decelerate toward levels much closer to, but still well above, the Fed’s 2% inflation target. Already, the intense global inflation pressures from commodities and traded goods prices over the past year has started to lose potency. The annual growth rate of the CRB Raw Industrials index has eased from a peak of 45% in June to 18%, in line with slowing growth momentum of global manufacturing activity (Chart 3, top panel). The softening of input price pressures is evident in business survey measures like the ISM Manufacturing Prices Paid index, which typically leads US headline CPI inflation by six months and has fallen by 16 points since the peak in June (middle panel). Chart 3Global Inflation Pressures Easing The global supply chain disruptions that have caused inventory shortages in products ranging from new cars to semiconductors also appear to be easing. Supplier delivery times are shortening according to the ISM Manufacturing and Non-Manufacturing surveys (bottom panel). Combined with other indications of the loosening of supply chain logjams, like lower shipping costs, the influence of supply disruptions on inflation should diminish, on the margin. Energy prices should also soon contribute to disinflationary momentum (Chart 4). BCA Research’s Commodity & Energy Strategy service is forecasting the Brent oil price to reach $76/bbl at the end of 2022 and $80/bbl at the end of the 2023. That represents a significant decline from the current $95/bbl price that reflects a large risk premium for the potential oil market supply disruptions in response to a Russian invasion of Ukraine. A war-driven spike in oil prices does risk extending the current period of high US (and global) inflation. However, it should be noted that the annual growth in oil prices has been decelerating even as oil prices have been rising recently, showing the power of base effect comparisons that should lead to a lower contribution to overall inflation from energy prices over the next 6-12 months. Chart 4Oil Prices Will Soon Turn Disinflationary Chart 5A Changing Mix Of US Consumer Spending Will Lower Overall Inflation Looking beyond the commodity space, a shifting mix of US consumer spending should also help push overall US inflation lower. US core CPI inflation hit a 34-year high of 6.0% in January, fueled by 11.7% growth in core goods inflation (Chart 5). We anticipate that overall core inflation will slow to levels more consistent with the trends seen in more domestically focused sectors like core services and shelter, where inflation is running around 4%. US consumers have started to shift their spending patterns away from goods, which was running well above its pre-pandemic trend, back toward services, which was running below its pre-pandemic trend (Chart 6). This will help narrow the gap between goods and services inflation, particularly as easing supply chain disruptions help dampen goods inflation. Chart 6Goods Inflation Should Soon Peak Chart 7There Are Still Pockets Of Available US Labor Market Supply Chart 8US Wage Growth Should Soon Begin To Moderate There is also the potential for some of the pressures stemming from the tight US labor market to become a bit less inflationary in the coming months. While the overall US unemployment rate of 4% is well within the range of full employment NAIRU estimates produced by the FOMC, there are notable differences across employment categories suggesting that there are still sizeable pockets of labor supply. For example, the unemployment rate for managerial and professional workers is a tiny 2.3%, while the unemployment rate for services workers was a more elevated 6.7% (Chart 7, top panel). There are also noteworthy differences in US labor market trends when sorted by wage growth. Employment in industries with lower wages – predominantly in services – has not returned to the pre-pandemic peak, unlike employment in higher wage cohorts (middle panel).1 As the US economy puts the Omicron variant in the rearview mirror, service industries most impacted by pandemic restrictions should see an increase in labor supply as workers return to the labor force. This will help close the one percentage point gap between the labor force participation rate for prime-aged workers (aged 25-54) and its pre-pandemic peak (bottom panel). This will also help to mitigate the current upturn in service sector wage growth, which reached 5.2% at the end of 2021 according to the US Employment Cost Index (Chart 8). When US inflation finally peaks in the next few months – most notably for goods prices and service sector wages – the Fed will be under less pressure to hike rates as aggressively as discounted in current bond market pricing. Reason #3: US Inflation Expectations Have Stabilized Chart 9TIPS Breakevens Are Not Telling The Fed To Be More Aggressive The Fed always pays a lot of attention to inflation expectations, particularly market-based measures like TIPS breakevens, to assess if its monetary policy stance is appropriate. The current message from breakevens is that the Fed does not have to turn even more hawkish than expected to bring inflation back down to levels consistent with the Fed’s 2% target. The 10-year TIPS breakeven is currently 2.4%, down from a peak of 2.8% and within the 2.3-2.5% range that we deem consistent with the Fed’s inflation target. Inflation expectations are even more subdued on a forward basis, with the 5-year TIPS breakeven, 5-years forward now down to 1.95% (Chart 9). Shorter term TIPS breakevens remain elevated, with the 2-year breakeven at 3.7%. We continue to favor positioning for a narrower 2-year TIPS breakeven spread – realized inflation will soon peak and the New York Fed’s Consumer Expectations survey shows that household inflation expectations for the next three years have already fallen significantly (bottom panel). Lower inflation expectations, both market-based and survey-based, suggest that the Fed can be cautious on the pace of rate hikes after liftoff next month. Reason #4: US Financial Conditions Are Tightening Alongside Cooling US Growth Momentum We have long described the link between financial markets and the Fed’s policy stance as “The Fed Policy Loop.” In this framework, the markets act as a regulator on Fed hawkishness (Chart 10). If the Fed comes across as overly hawkish, risk assets will sell off (lower equity prices, wider corporate credit spreads), the US dollar will appreciate, the US Treasury curve will flatten and market volatility measures like the VIX index will increase. All of those trends act to tighten US financial conditions, threatening a growth slowdown that will force the Fed to back off from its previous hawkish bias. Chart 10The Fed Policy Loop Financial conditions have indeed tightened as markets have priced in more Fed rate hikes in 2022 (Chart 11). Since the start of the year, the S&P 500 is down 9% year-to-date, US investment grade corporate spreads have widened 26bps, the 2-year/10-year US Treasury curve has flattened by 34bps and the VIX index has increased 11 pts. In absolute terms, US financial conditions remain highly stimulative and the risk asset selloff so far poses little threat to US economic growth. However, if the Fed were to deliver all of the rate hikes in 2022 that are currently discounted in the US OIS curve, the market selloff would deepen as investors began to worry about a Fed-engineered economic slowdown. This would lead to a more significant tightening of financial conditions, representing an even bigger risk to US growth. The Fed cannot risk appearing too hawkish too soon, with US growth momentum already showing signs of slowing (Chart 12). The Conference Board US leading economic indicator has stopped accelerating and may be peaking, US business confidence is softening and consumer confidence is very depressed according to the University of Michigan survey. Importantly, high inflation is cited as the main reason for weak consumer confidence, as wage increases have not matched price increases. If realized inflation falls, as we expect, this could actually provide a boost to consumer confidence as households would feel an improvement in real incomes and spending power – a development that could eventually lead to more Fed rate hikes in 2023 if consumer spending improves, especially if inflation stays above the Fed’s 2% target. Chart 11Fed Hawkishness Has Already Tightened Financial Conditions Chart 12Not The Best Time For The Fed To Be More Aggressive For now, however, the risk of a preemptive tightening of financial conditions will ensure that the Fed delivers fewer rate hikes than the market expects this year. Reason #5: Treasury Market Positioning Is Now Very Short Chart 13Reliable Bond Indicators Calling For A Pause In The UST Selloff The final reason to increase US duration exposure now is that Treasury market positioning has become quite short and has become a headwind to higher bond yields and lower bond prices. The JP Morgan fixed income client duration survey shows that bond investors are running duration exposures well below benchmark (Chart 13). Speculators are also running significant short positions in longer-maturity US Treasury futures. This suggests limited selling power in the event of more bond bearish news and increased scope for short-covering in the event of risk-off event – like a shooting war in Ukraine – or surprisingly negative US economic data. On that front, the Citigroup US data surprise index, which is typically highly correlated to the momentum of US Treasury yields, has dipped a bit recently but remains at neutral levels (top panel). A similar measure of neutrality is sent by some of our preferred cyclical bond indicators like the ratio of the CRB raw industrials index to the price of gold – the 10-year yield is now in line with that ratio, which appears to be peaking (middle panel). Investment Conclusions Given the five reasons outlined in this report – too many Fed hikes are now discounted for 2022, US realized inflation should soon peak, inflation expectations have stabilized, financial conditions have started to tighten, and positioning in the Treasury market is now quite short – we decided last week to upgrade our recommended US portfolio duration to neutral from below-benchmark. However, this move is only for a tactical investment horizon. We still see the cyclical backdrop as bond bearish, as Treasury yields do not yet reflect how high US interest rates will rise in the upcoming tightening cycle. The 5-year Treasury yield, 5-years forward is currently at 2.0%. This lies at the low end of the range of estimates of the longer-run neutral fed funds rate (Chart 14) from the New York Fed’s survey of bond market participants (2%) and the median FOMC longer-run interest rate projection from the Fed dots (2.5%). We see the Fed having to lift rates faster than markets expect in 2023 and 2024. US inflation this year is expected to settle at a level above the Fed’s 2% target before picking up again next year alongside renewed tightening of labor market conditions once the remaining supply of excess labor is fully absorbed. Chart 14The Cyclical UST Bear Market Is Not Over Yet Chart 15Go Long The Dec/22 SOFR Contract Vs. The Dec/24 Contract As a way to position for the Fed doing fewer rate hikes than expected in 2022, but more hikes than expected in 2023/24, we are entering a new trade this week – going long the December 2022 3-month SOFR US interest rate futures contract versus a short position in the December 2024 3-month SOFR contract. The implied interest rate spread on those two contracts has tightened to 25bps (Chart 15). We expect that trend to reverse, however, with the spread increasing as markets eventually move to price out rate hikes in 2022 and price in much more Fed tightening in 2023 and 2024. We will discuss the implications of the shift in our US duration stance for our views on non-US bond markets in next week’s Global Fixed Income Strategy report. Our initial conclusion is that our country allocation recommendations for government bonds will remain unchanged – underweighting the US, UK, and Canada; overweighting core Europe, peripheral Europe, Japan and Australia – but we will also increase duration exposure within most (if not all) countries. As in the US, we also see markets pricing in too many rate hikes in the UK and Canada for 2022 but too few rate hikes over the next two years. On the other hand, markets are pricing in too many rate cumulative hikes over the next 2-3 years in Europe, Australia and Japan (Table 1). Table 1Markets Have Pulled Forward Rate Hikes Everywhere Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The definitions for the wage cohorts can be found in the footnote of Chart 7. Cyclical Recommendations (6-18 Months) Tactical Overlay Trades
Flash PMIs for February suggest that economic activity is normalizing following the omicron-driven surge in COVID-19 cases. A 4.7 point rebound in the Euro Area Services PMI to 55.8 pulled up the composite PMI to 55.8 from 52.3. Meanwhile, the eurozone…
Market expectations for the Fed Funds rate derived from the OIS curve reveal that investors expect the Fed to embark on an aggressive tightening campaign over the coming year. 167 basis points of rate hikes are currently priced over the coming 12 months.…
BCA Research’s US Investment Strategy service is inclined to side with the Conference Board’s upbeat consumer confidence reading over the University of Michigan’s dismal one. The two leading surveys have wildly different takes on consumer confidence.…
Executive Summary While inflation has unquestionably surprised to the upside, the US will not enter a self-reinforcing spiral unless an inflation mindset takes hold throughout the economy. The two leading surveys have wildly different takes on consumer confidence. The available evidence sides with the Conference Board’s robust reading rather than the University of Michigan’s dismal one. We are not concerned about housing’s near-term outlook. There is an undersupply of homes in America and mortgage rates have not backed up enough to put a meaningful dent in demand. Financial markets are jumpy and will likely remain hypersensitive to speculation about the Fed’s policy choices. We nonetheless continue to favor risk assets over the next twelve months and will look out for tactical buying opportunities whenever volatility is on the cusp of easing. Consumers Aren't Chasing High Prices And That's A Good Sign Bottom Line: The ride is likely to be bumpy for financial markets this year, but we expect it will ultimately be rewarding. Growth will hold up despite recurring fears. Feature Our recent discussions with colleagues and investors indicate that US financial market participants are preoccupied with one of three issues: a potential inflation breakout, a slowdown induced by a consumption shortfall or, worse yet, both. We add to our thoughts on inflation and consumption after digging into some less-watched series, and check in on the housing market following the surge in mortgage rates. Our conclusion remains unchanged: we still expect potent growth in 2022, and we think investors should maintain at least equal weight exposures to risk assets. Amidst elevated volatility brought on by Fed uncertainty, however, investors should be willing to act more opportunistically. Consumers Are Not Adding Fuel To The Fire … We have spoken repeatedly about the inflation mindset, a concept lifted from Japan’s ongoing experience with chronic stagnation. The malaise ailing Japan is in large part attributable to the deflation mindset that has swept consumers, businesses and investors. Economic participants conditioned to expect continuously falling prices change their behavior to adapt to them, so consumers have put off discretionary purchases, anticipating that goods will be cheaper (and better) next year; businesses confronting steadily falling revenue have shunned investment in favor of shrinking their cost bases to preserve profit; and investors have been willing to funnel capital to the lowest-yielding sovereign bonds in the world, content with meager purchasing power accretions. The central theorem of macroeconomics – my spending is your income and your spending is my income – has sentenced the economy to quietly wither in a self-reinforcing loop. Conversely, we believe an inflation mindset in which economic actors expect continually rising prices is a necessary precondition for an upward inflation spiral. The spiral is stoked by a chain reaction of worker and investor demands for increased compensation, wholesale and retail price hikes, and consumers’ rush to maximize their declining purchasing power by buying ahead of the next inevitable increase. Despite all the inflation agita, Treasury investors are untroubled about its long-run prospects, as their 5-year inflation expectations five years from now remain below the bottom end of the Fed’s target range (Chart 1). The hedgers, speculators and market makers who compose the CPI swaps market are also serene (Chart 2). Though all parties see intense price pressures lasting for another year, they expect them to dissipate over time (Table 1). Chart 1Long-Run Inflation Expectations Are Subdued, ... Chart 2... Despite Big Near-Term Swings Per the University of Michigan’s sentiment survey, consumers also anticipate that near-term inflation pressures will fade in the intermediate term (Chart 3). They are consequently wary about making large purchases at a price they’ll later come to regret. Viewing today’s high prices as temporary, they think it is a historically inopportune time to buy cars, houses and large household durables. Their responses suggest that the inflation mindset has yet to make any headway with consumers; for now, there is no danger that shoppers harbor inflation fears that could become self-fulfilling. Table 1The Inflations Expectations Curve Is Sharply Inverted Chart 3Survey Says: Temporary! The share of respondents citing sticky/rising prices as a reason for buying cars now is at very low levels (Chart 4, top panel) while those citing high prices as a reason not to buy continues to make record highs (Chart 4, middle panel). The spread between the two has never been wider (Chart 4, bottom panel) – a sizable majority of consumers with discretion over when they buy is committed to waiting out the conditions that have sent prices zooming higher. Chart 4Resisting A Spiral Michigan respondents have been on the right side of chronically deflating new car prices, as those who think prices won’t come down have been nearly continuously outnumbered for the last 40 years (Chart 5, bottom panel). Since vehicle buying conditions became a regular survey component, there have been only three stretches when consumers reported a net urgency to buy, all of which coincided with real increases in new car prices (Chart 5, top panel). The chart is silent on the direction of causality, though we would suspect that consumer urgency follows from observed price increases, which it then amplifies and/or extends. Chart 5Just Say No The Michigan surveyors also ask consumers about the timeliness of buying houses and major household durables. Charts for houses (not shown) and durables (Chart 6) look much like cars, though the Good-Won’t Come Down/Bad-Prices Are High spread for houses is as persistently negative as it is for cars (ex-the 2012 to 2015 recovery from the aftermath of the housing bust). Consumer demand for the biggest-ticket items is apparently more elastic than it is for major appliances. Chart 6Consumers Aren't Chasing Household Durables Prices Higher,Either Bottom Line: Consumers are disinclined to go along with surging prices on big-ticket items. An inflationary spiral will not take hold while they are committed to putting off major purchases with the expectation that they will get a better deal in the future. … But Could They Be Losing Their Nerve? Consumers’ discipline has positive inflation implications, but the bombed-out vehicle buying conditions chart in the Executive Summary could be sending a worrisome growth signal. Foregone spending is lost income, and if enough buyers defer purchases, a recession could be just around the bend. True enough, but investors should keep in mind that the buying conditions indexes measure demand urgency, not overall demand. Those with discretion over the timing of their purchases may be holding off, but American consumers are not turning Japanese. Surging home and new and used car prices eloquently testify to fierce competition among buyers. We do not therefore see cause for concern in the diverging consumer confidence surveys. Over time, the indexes produced by the Conference Board and the University of Michigan have tended to send similar messages (Chart 7). The relationship has frayed over the last five years, however, and the two series completely diverged last spring. That would be of no more than passing interest if the composite average of both surveys’ expectations component had not formerly been such a reliable coincident indicator of real consumption growth (Chart 8). Chart 7Parting Company Chart 8The Confidence-Consumption Link Has Been Severed Investors may wonder whether consumption will take its lead from the Conference Board’s cheer or Michigan’s gloom. The Conference Board survey consists of just five questions asking respondents to assess current business and employment conditions and offer their six-month expectations about business conditions, employment conditions and their family’s income. The more extensive Michigan survey runs to twelve full pages, touching on business conditions; personal finances; economic policy; unemployment, interest-rate, inflation and home-price expectations; and buying conditions for homes, household durables and motor vehicles. A layperson reading through the Michigan survey might think it was designed to provoke anxiety in unsuspecting respondents – what are the chances your income will keep pace with inflation, that you or your spouse will involuntarily lose a job over the next five years, that you will have enough money for retirement, etc. – but its readings are not uniformly bleak. Since the financial crisis, it has tended to be cheerier than the Conference Board survey when inflation is low or negative while its relative nosedive has coincided with inflation’s breakout (Chart 9). The relationship would logically follow from the Michigan survey’s explicit focus on inflation and one’s personal relation to it. The Conference Board survey is linked much more closely to perceptions of the job market (Chart 10) and it may therefore be expected to lag during disinflationary/deflationary periods but outperform when inflation accelerates. Chart 9The Michigan Survey Is Sensitive To Inflation, ... Chart 10... While The Conference Board's Tracks Strength In The Labor Market Bottom Line: Given the robust growth outlook, we are inclined to side with the Conference Board’s upbeat consumer confidence reading. We do not expect that flush households with pent-up demand will turn into misers. The 2,400-Square-Foot Gorilla Chart 11Level Trumps Direction The sharp backup in mortgage rates so far this year has many observers concerned about the potential consequences of a housing slowdown. A major slump would idle construction workers, pressure housing industry suppliers, and dampen demand for the furnishings and major appliances that fill homes. We think the concerns are overdone and believe that the housing market will be well supported through the rest of the year. Affordability concerns come back to the level-versus-direction debate that has flared ever since real economic growth began to decelerate from its torrid 6.5% pace in the first half of last year. 3% or 4% is nothing to sneeze at for an economy with a long-run trend growth rate of 1.75 – 2%, however. Deceleration from an extremely high level to a very high level still leaves room for ample corporate earnings gains and risk assets duly delivered chunky excess returns across last year’s second half. 30-year fixed mortgage rates have risen 100 basis points from their pandemic low but remain extremely low relative to history (Chart 11, middle panel). As a result, homes remain quite affordable (Chart 11, top panel), despite the relative increase in median home prices (Chart 11, bottom panel). The horizontal line across the affordability series puts its level into a fuller context. Except for a few years in the early seventies, when the median home price was just two-and-a-half times median household income, affordability never exceeded 140 before the global financial crisis ushered in zero interest rate policy. A supply shortfall will bolster the market. Household formations have outstripped housing starts by a wide margin over the last two years (Chart 12, top panel) and available inventory (Chart 12, middle panel) and vacant units (Chart 12, bottom panel) are at all-time lows. Homebuilder sentiment is firing on all cylinders (Chart 13, top panel), as current sales are strong (Chart 13, second panel), buyer traffic remains elevated (Chart 13, third panel) and future sales expectations are rosy (Chart 13, bottom panel). Chart 12There Isn't Enough Supply ... Chart 13... And Builders Know It Bottom Line: Despite the backup in mortgage rates and twelve months of turbo-charged home price appreciation, housing will do just fine this year. A slump weighing on employment and activity is not in store. Investment Implications 2022 has so far been characterized by the serial emergence of issues that have roiled financial markets. Rising rates/falling tech stocks, impending Fed rate hikes, persistent upside inflation surprises and Ukraine have combined to push the VIX into the 20s and 30s, knock the S&P 500 down 9% and drive losses in Treasuries and spread product. We expect that concerns about Fed policy, growth and inflation will linger throughout the year and across the entirety of the Fed’s rate hiking cycle, waxing and waning with the news and data flow. Our base case is that 2022 growth will be quite strong, boosted by avid consumption and investment underpinned by savings and wealth gains, easy monetary conditions, and a tight job market. We expect that stout macro fundamentals will support earnings gains and that a dearth of alternatives to equities that can be expected to generate positive inflation-adjusted returns will keep earnings multiples elevated. If the mildness of Omicron variant infections points to a future in which COVID-19 becomes no more than a nuisance, global growth will get an additional fillip and some supply-chain pressures should ease, allowing inflation to come off the boil. While we reiterate our constructive view on financial markets and the economy, however, we do not expect a smooth ride to our year-end destination. Most investors lack first-hand experience managing against an inflation backdrop that has not been in place since the early ‘80s and volatility will likely be elevated as they find their footing. We are therefore adopting a more tactical perspective, seeking out opportunities to exploit temporary volatility, and we advise that clients consider shortening timeframes and increasing turnover to the extent their individual mandates will allow it. We do not think that the major inflection point marked by a shift from accommodative to restrictive monetary policy settings will arrive until the second half of 2023 at the earliest, but the run-up to it will likely be bumpy. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com
Executive Summary A Swedish Warning Stocks are oversold but downside risks persist. The Fed is on the verge of beginning a tightening cycle, which creates a process often linked to deeper and longer equity corrections around the world. Global economic activity is decelerating, as growth transitions away from splurging on consumer goods to a return to trend in the service sector. Equities are more levered to industrial than services activity, which creates a risk window. Ukraine remains another near-term hurdle. Equity risk premia are not elevated enough to compensate for these threats. Despite near-term risks, the equity bull market will recover and Europe stocks will ultimately outperform. Bottom Line: Investors need to continue to hold portfolio hedges as the near-term outlook remains treacherous for equities. Nonetheless, a wholesale portfolio liquidation is unwarranted as we face a mid-cycle slowdown, not a recession. Feature Last week’s pattern of relaxation and renewed tensions in Ukraine is an acute reminder that markets remain fragile in the near-term. Investors must still contend with an imminent monetary tightening cycle in the US. Additionally, a few cracks are emerging on the global growth picture as a transition from spending on goods to services takes place. Under this light, we worry that risk premia remain too low, and that equities are still vulnerable to further near-term pullbacks. The situation is particularly complex for Europe, which is most exposed to the Ukrainian problems and to the global manufacturing cycle. We thus continue to recommend investors exposed to Europe hold protections. Oversold Enough? Many commentators argue that following the January equity sell-off, the mood of investors soured enough to warrant buying equities anew and closing our eyes. Most famously, the AAII Bull/Bear ratio is once again flirting with its 2018 and 2020 lows, two periods that, in hindsight, proved to be selling climaxes (Chart 1). The picture is complex. BCA’s Equity Capitulation Index is indeed becoming oversold (Chart 2). However, its reading is murky. It can either decline further, which would imply greater weaknesses in stocks, or rebound. Our first instinct is to look at the indicator’s behavior at the onset of Fed tightening cycles, which constitute close historical analogues: Chart 2... But Maybe Not Enough Chart 1Stocks Are Oversold... In late 2015, when the last Fed tightening cycle began, the Capitulation Index plunged to much lower levels as stocks collapsed. In the background, the global economy was weakened by EM countries hammered by China’s slowdown and balance of payments crises. Around the hiking cycle that begun in June 2004, the Capitulation Index never plunged considerably, but the S&P 500 fell more than 8% between March and August 2004, in a volatile pattern. Back then, both US and global growth was very robust. In 1999, once the Fed resumed hiking rates after the 75bps of cuts following the LTCM debacle, the Capitulation Index and equities were very resilient. This strength persisted until the Nasdaq peaked in March 2000. The S&P 500 formed a complex top between March and August before starting a relentless collapse that September. Following the onset of the 1994-1995 tightening cycle, the Capitulation Index collapsed to much more oversold readings than current ones and equities entered a range-bound volatile episode that lasted until Q1 1995, as the Fed stopped hiking rates. The economy was replete with inflation fears and a mid-cycle slowdown was descending upon the US. The hiking cycle that started in 1988 did not witness significant downside in the Capitulation Index and stocks, but it took place soon after the 1987 crash when equities had become exceptionally oversold. Black Monday itself happened as inflation fear rose as a result of a weak dollar and as the Fed hiked rates through 1987. In 1984, the rate hike cycle was accompanied by a collapse in the Capitulation Index. The tightening in financial conditions caused by the Fed was exacerbated by the surge in the dollar that hurt US profitability and increased EM borrowing costs tremendously. After the 1981 hiking cycle, the Capitulation Index plunged as the US economy entered the second leg of the early 1980s double-dip recession. The latter was an economic crisis prompted by Federal Chairman Paul Volcker’s willingness to put an end to the inflation mentality of the 1970s. These historical experiences highlight one thing: Economic conditions were key to periods when the beginning of a tightening cycle caused a deeper correction in stocks than the one witnessed until now. Economic Clouds Today, the big question shaping the investment world is inflation. BCA expects inflation to peak over the coming months, whether in the US or in Europe. However, this process will take more time. CPI will not crest until after the Fed has begun to hike rates. In the meantime, there are plenty of factors that could easily fan inflation worries and, consequently, a continued upward repricing of the Fed’s interest rate path in the next few weeks. As Arthur Budaghyan highlighted in the most recent Emerging Market Strategy Report, US labor costs are rapidly rising, with the Atlanta Fed Median Wage growth measure up 5.1% annually and the Employment Cost Index (ECI) expanding at a 4.5% annual rate. Of particular worry, this surge in wages does not reflect underlying productivity and unit labor costs, which are up 3.2% annually (Chart 3), their highest rate since 2001, when the Fed funds rate was 4% and 10-year Treasurys yielded 5.4%. Chart 3US Wage-Price Spiral? Elevated unit labor costs are a powerful inducement for inflation and, thus, are likely to continue to fan inflation fears among market participants. Of particular concern today, the rise in unit labor costs is not counterbalanced by a decline in US import prices and foreign deflationary pressures. Inflation fears remain a major risk for the market. As our BCA Monetary Indicator highlights, the liquidity backdrop is not supportive of equities anymore (Chart 4). Moreover, the technical picture is deteriorating, while speculation remains elevated. With investors fretting about the threat of inflation, the danger is that they start to anticipate a greater deterioration in monetary conditions. The problem is not unique to the US. At the global level, 75% of central banks are tightening policy and those that have not yet done so are gearing up to remove monetary accommodation. Adding to inflation fears are signs of a slowdown in the global goods sector. This slowdown reflects a natural transition from the spending binge on goods that took place during the pandemic, which is ebbing, to service spending, which is accelerating (Chart 5). This pattern is particularly evident for US consumers, the largest spenders in the world. Chart 5Transitioning From Goods To Services Chart 4Deteriorating Liquidity Conditions One of the world’s most sensitive economies to the global industrial cycle is already feeling the pinch from this adjustment: Sweden. Swedish economic numbers have been weakening and Swedish assets are particularly soft (Chart 6), which heralds poorly for the global manufacturing sector. This deceleration in goods spending and industrial activity is a problem for equities because stock market profits are more geared toward the evolution of the industrial cycle than the service sector (Chart 7). Chart 6A Swedish Warning Chart 7Manufacturing, Not Services, Drives Profits Investment Conclusions In this context, it is prudent to maintain hedges to protect stock holdings. It is commonly argued that stocks are expensive, but if one considers the low level of bond yields, these valuations can be justified. Chart 8 challenges this notion. Yes, the earnings yield is still very elevated relative to 30-year Treasury bond yields; however, it is at its lowest in 42 years against core inflation. Why would core inflation be relevant? In a context in which investors are worried about the impact of inflation on both profit margins (higher labor costs) and the direction of policy, they are unlikely to remain unmoved by inflation fears, especially as the perception of higher policy rates may lift rates higher. Moreover, with many investors anxious that the Fed is falling far behind the curve, the marginal market players could easily become the individuals concerned that a catch up by the Fed will lead the economy into a recession. Considering the risks linked to Ukraine, the potentially negative impact on profitability of slowing goods spending, the growing policy uncertainty globally and in the US, and the inversion of many segments of the yield curve, prudence remains appropriate (Chart 9). Chart 8Value Is In The Eye Of The Beholder Chart 9Rising Policy Uncertainty Chart 10The Importance Of Manufacturing To Europe The problem for European equities is their elevated beta and pro-cyclicality. A pullback in US stocks will automatically drag down European stocks. Moreover, the region’s heavy reliance on manufacturing activity is reflected in the sectoral tilt of European benchmarks. As a result, the performance of European stocks is particularly sensitive to the evolution of the global industrial cycle (Chart 10). Add the fact that European economies are much more exposed to potential energy market disruptions emanating from Ukraine and the recent rebound in Europe’s relative equity performance becomes tenuous at best. Why would these dynamics be temporary and only warrant hedges, not a cyclical underweight in stocks and Europe? First, the inflation fear will recede in the second half of 2022. Our Global Supply Disruption Index has peaked and suggests that inflation surprises will soon ebb. Moreover, a measure of suppliers’ constraints based on the ISM Supplier Delivery Times, Backlog of Orders, Prices Paid, and Inventories is also rolling over (Chart 11). Second, a deepening of the stock market correction will tighten financial conditions and push credit spreads higher. This is a deflationary process that will cause inflation fears to recede and, thus, the pricing of expected Fed rate hikes to lessen. Third, the slowdown in the goods sector is concentrated among consumer goods. Capex will firm up. Capex intentions are elevated in Europe and the US, and global capital goods orders remain robust, despite having decelerated from their extraordinary rebound following the Q1 2020 shutdowns (Chart 12). Moreover, the political and corporate demand to build greater redundancy in global supply chains following the disruptions caused by the Sino-US trade war and COVID-19 will also boost corporate investments for a few more years. This means that many industrial sectors will recover globally and propel industrial equities higher. Chart 11Apex Bottlenecks? Chart 12Capex Will Stay Strong Fourth, Matt Gertken, BCA’s geopolitical strategist, continues to see a limited Ukrainian conflict as the most likely outcome of the current tensions. As a result, any dislocation to global stocks and European assets caused by a conflict will be transitory. Finally, the business cycle has further to run. In 1994/95 and in 2015/16, the Fed tightening cycle materialized around the time of a mid-cycle slowdown. The economy recovered and profit firmed up anew, which allowed stocks to rebound. The Fed Funds rate is rising but remains below the neutral rate. Interest rates in Europe also have ample scope to rise before monetary policy becomes tight. Simultaneously, the recovering service sector will continue to support employment and, thus, final demand. Equity bear markets rarely materialize outside of recessions (Chart 13). Chart 13Bear Markets Demand A Recession Bottom Line: Global equities are oversold, but the combination of rising inflation, Fed tightening, Ukrainian risks, and a transition from a goods-driven recovery to a service sector-led economy means that stocks risk becoming even more oversold in the near term. European equities are not immune to these threats. While rising rates are a lesser problem for Europe than the US, the developments in Ukraine and a manufacturing transition represent greater hurdles. Ultimately, the difficulties faced by stocks reflect a mid-cycle slowdown taking place alongside a period of policy tightening. It will be, therefore, temporary. Consequently, investors should not abandon stocks, but rather continue to hold protections. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades
Executive Summary The Market Thinks The Fed Will Be Unable To Raise Rates Much Above 2% The Fed tightening cycle is likely to proceed in two stages. In the first stage, which is now well anticipated, the Fed will seek to restore its credibility by raising rates to 2% – the lower bound of what it regards as “neutral” – by early next year. The decline in goods inflation over the next 12 months, facilitated by the easing of supply-chain bottlenecks, will allow the Fed to take a break from tightening for most of 2023. Unfortunately, the respite from rate hikes will not last. The neutral rate of interest is around 3%-to-4%, significantly higher than what either the Fed or investors believe. A wage-price spiral will intensify starting in late 2023, setting the stage for the second, and more painful, round of tightening. Trade Inception Level Initiation Date Stop Loss Long June 2023 3-month SOFR futures contract (SFRM3) / December 2024 (SFRZ4) -8 bps Feb 17/2022 -30 bps New Trade: Go short the December 2024 3-month SOFR futures contract versus the June 2023 contract. Investors expect the fed funds rate to be somewhat higher in mid-2023 than at end-2024. They are wrong about that. Bottom Line: The market has priced in the first stage of the Fed’s tightening cycle, which suggests that bond yields will stabilize over the next few quarters. However, the market has not priced in the second stage. Once it starts to do so, the bull market in equities will end. Investors should remain bullish on stocks for now but look to reduce equity exposure by the middle of 2023. Dear Client, Instead of our regular report next week, we will be sending you a Special Report written by Matt Gertken, BCA Research’s Chief Geopolitical Strategist, discussing Russia’s geopolitical outlook over the long run. I hope you will find it insightful. Best regards, Peter Berezin Chief Global Strategist Who’s the Boss? Who sets interest rates: The economy or the Fed? The answer is both. In the short run, the Fed has complete control over interest rates. In the long run, however, the economy calls the shots. If the Fed sets rates too high, unemployment will rise, forcing the Fed to cut rates. If the Fed sets rates too low, the opposite will happen. Chart 1The Fed's Estimate Of The Neutral Rate Is Still Quite Low By Historical Standards Thus, over the long haul, it all boils down to where the neutral rate of interest – the interest rate consistent with full employment and stable inflation – happens to be. In the latest Summary of Economic Projections, released on December 15th, 9 out of 17 FOMC participants penciled in 2.5% as their estimate of the appropriate “longer run” level of the federal funds rate. Six participants thought the neutral rate was lower than 2.5%, while two participants thought it was higher (both put down 3%). Back in 2012, when the Fed began publishing its dot plot, the median FOMC participant thought the neutral rate was 4.25%. Investors have revised up their estimate of the neutral rate over the past two months. But at 2.09%, the 5-year/5-year forward bond yield – a widely-used proxy for the neutral rate – is still exceptionally low by historic standards (Chart 1). Desired Savings and Investment Determine the Neutral Rate Chart 2The Savings-Investment Balance Determines The Neutral Rate Of Interest One can think of the neutral rate as the interest rate that equates aggregate demand with aggregate supply at full employment. If interest rates are above neutral, the economy will suffer from inadequate demand; if interest rates are below neutral, the economy will overheat. As Box 1 explains, the difference between aggregate demand and aggregate supply can be expressed as the difference between how much investment an economy needs to undertake and the savings it has at its disposal. Savings can be generated domestically by deferring consumption or imported from abroad via a current account deficit. Anything that reduces savings or raises investment will lead to a higher neutral rate of interest (Chart 2). With this little bit of theory under our belts, let us consider the forces shaping savings and investment in the United States. Desired Savings Are Falling in the US There are at least six reasons to expect desired savings to trend lower in the US over the coming years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and generous government transfer payments (Chart 3). While some of that money will remain sequestered in bank deposits, much of it will eventually be spent. Household wealth has soared. Personal net worth has risen by 128% of GDP since the start of the pandemic, the largest two-year increase on record (Chart 4). Conservatively assuming that households will spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by 3.8% of GDP. Chart 3Plenty Of Pent-Up Demand Chart 4Net Worth Has Soared The household deleveraging cycle is over (Chart 5). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. Banks are easing lending standards on consumer loans across the board. Corporate profit margins are peaking. As a share of GDP, corporate profits are near record-high levels (Chart 6). Despite a tight labor market, wage growth has failed to keep up with inflation over the past two years. Real wages should recover over time. To the extent that households spend more of their income than businesses, a rising labor share should translate into lower overall savings. Chart 5US Household Deleveraging Pressures Have Abated Chart 6Corporate Profits Are Near Record Highs... But Wage Growth Has Failed To Keep Up Baby boomers are retiring. Baby boomers are leaving the labor force en masse. They hold over half of US household wealth, considerably more than younger generations (Chart 7). As baby boomers transition from net savers to net dissavers, national savings will decline. Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 8). Chart 7Baby Boomers Have Amassed A Lot Of Wealth Chart 8Fiscal Policy: Tighter But Not Tight Investment Will Not Decline to Offset the Reduction in Savings A favorite talking point among those who espouse the secular stagnation thesis is that slower trend growth will curb investment demand, leading to an ever-larger savings glut. There are a number of problems with this argument. For one thing, most of the decline in US potential GDP growth has already occurred, implying less need for incremental cuts to investment spending in the future. According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today, mainly due to slower labor force growth. The CBO expects potential growth to edge down to 1.7% over the next few decades (Chart 9). Moreover, US investment spending has been weaker over the past two decades than one would have expected based on the evolution of trend GDP growth. As a consequence, the average age of both the residential and nonresidential capital stock has risen to the highest level in over 50 years (Chart 10). Chart 9Most Of The Deceleration In US Potential Real GDP Growth Has Already Taken Place Chart 10The Aging Capital Stock As the labor market continues to tighten, firms will devote greater efforts to automating production. Already, core capital goods orders have broken out to the upside (Chart 11). On the housing front, the NAHB reported this week that despite rising mortgage rates, foot traffic and prospective sales remain at exceptionally strong levels (Chart 12). Building permits also surprised on the upside. Chart 11The Outlook For US Capex Is Bright Chart 12Homebuilder Confidence Remains Strong Overseas Appetite for US Assets May Wane A larger current account deficit would allow the US to spend more than it earns without the need for higher interest rates to incentivize additional domestic savings. The problem is that the US current account deficit is already quite large, having averaged 3.1% of GDP over the past four quarters. Furthermore, as a result of the accumulation of past current account deficits, external US liabilities now exceed assets by 69% of GDP (Chart 13). It is far from clear that foreigners will want to maintain the current pace of US asset purchases, let alone increase them from current levels. Chart 13The US Has Become Increasingly Indebted To The Rest Of The World The Two-Stage Path to Neutral Chart 14The Market Thinks The Fed Will Be Unable To Raise Rates Much Above 2% Investors expect the Fed to raise rates seven times by early next year and then stop hiking (and perhaps even start cutting!) in late 2023 and beyond (Chart 14). However, if we are correct that the neutral rate of interest is higher than widely believed, the Fed will eventually need to lift rates to a higher level than what is currently being discounted. It is impossible to be certain what this level is, but a reasonable estimate is somewhere in the range of 3%-to-4%. This is about 100-to-200 basis points above current market pricing. The path to the “new neutral” will not follow a straight line. As we have argued in the past, inflation is likely to evolve in a “two steps up, one step down” fashion. We are presently at the top of those two steps. Inflation will decline over the next 12 months as goods inflation falls sharply and services inflation rises only modestly, before starting to move up again in the second half of 2023. Falling Goods Inflation in 2022 Chart 15Goods Inflation Should Fade Chart 15 shows that the current inflationary episode has been driven by rising goods prices, particularly durable goods. This is highly unusual since goods prices, adjusting for quality improvements, usually trend sideways-to-down over time. As economies continue to reopen, the composition of consumer spending will shift from goods to services. At the same time, supply bottlenecks should abate. The combination of slowing demand and increasing supply will cause goods inflation to tumble. Investors are underestimating the extent to which goods inflation could recede over the remainder of the year as pandemic-related distortions subside. For example, used vehicle prices have jumped by over 50% during the past 18 months (Chart 16). Assuming automobile chip availability improves, we estimate that vehicle-related prices will go from adding 1.6 percentage points to headline inflation at present to subtracting 0.9 points by the end of the year – a swing of 2.5 percentage points (Chart 17). Chart 16AVehicle, Food, And Energy Prices Could All Retreat From Extended Levels (I) Chart 16BVehicle, Food, And Energy Prices Could All Retreat From Extended Levels (II) Chart 17Even If Underlying Core Inflation Does Not Change, Inflation Will Fall This Year As Goods Prices Come Back Down To Earth Along the same lines, we estimate that energy inflation will go from raising inflation by 1.7 points at present to lowering inflation by 0.3 points by the end of the year. This is based on the WTI forward curve, which sees oil prices retreating to $80/bbl by the end of 2022 from $91/bbl today. A normalization in food prices should also help keep a lid on goods inflation. Service Inflation Will Rise Only Modestly in 2022 Could rising service inflation offset the decline in goods inflation this year? It is possible, but we would bet against it. While certain components of the CPI services basket, such as rents, will continue to trend higher, a major increase in service inflation is unlikely unless wages rise more briskly. As Chart 18 underscores, the bulk of recent wage growth has occurred at the bottom end of the income distribution. That is not especially surprising. Whereas employment among medium-and-high wage workers has returned to pre-pandemic levels, employment among low-wage workers is still 6% below where it was in early 2020 (Chart 19). Chart 18The Bulk Of Recent Wage Growth Has Occurred At The Bottom End Of The Income Distribution Chart 19Employment Among Low-Wage Workers Still Lagging Chart 20Workers Are Starting To Return To Their Jobs Following The Omicron Wave Looking out, labor participation among lower-paid workers will recover now that enhanced unemployment benefits have expired. A decline in the number of life-threatening Covid cases should also help bring back many lower-paid service workers. According to the Census Bureau’s Household Pulse Survey, a record 8.7 million employees were absent from work in the middle of January either because they were sick or looking after someone with Covid symptoms. Consistent with declining case counts, February data show that fewer employees have been absent from work (Chart 20). Predicting Wage-Price Spirals: The Role of Expectations A classic wage-price spiral is one where self-fulfilling expectations of rising prices prompt workers to demand higher wages. Rising wages, in turn, force firms to lift prices in order to protect profit margins, thus validating workers’ expectations of higher prices. For the time being, such a relentless feedback loop has yet to emerge. Market-based measures of long-term inflation expectations have actually fallen since October and remain below the Fed’s comfort zone (Chart 21). Survey-based measures have moved up, but not by much (Chart 22). To the extent that US households are reluctant to buy a new vehicle, it is because they expect prices to decline (Chart 23). Chart 21Market-Based Expectations Remain Below The Fed's Comfort Zone Chart 22Survey-Based Measures Of Long-Term Inflation Expectations Have Ticked Up, But Not By Much Still, if it turns out that the neutral rate of interest is higher than widely believed, then monetary policy must also be more stimulative than widely believed. This raises the odds that, at some point, the economy will overheat and a wage-price spiral will develop. It is impossible to definitively say when that point will arrive. Inflationary processes tend to be highly non-linear: The labor market can tighten for a long time without this having much impact on inflation, only for inflation to surge once the unemployment rate has fallen below a critical threshold. The Sixties as a Template for Today? The sudden jump in inflation in the 1960s offers an interesting example. The unemployment rate in the US fell to NAIRU in 1962. However, it was not until 1966, when the unemployment rate had already fallen nearly two percentage points below NAIRU, that inflation finally took off. Within the span of ten months, both wage growth and inflation more than doubled. US inflation would end up finishing the decade at 6%, setting the stage for the stagflationary 1970s (Chart 24). Chart 23The Expectation of Lower Prices Is Keeping Many People From Buying A Car Chart 24Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Our guess is that we are closer to 1964 than 1966, implying that the US economy may still need to overheat for another one or two years before a true wage-price spiral emerges. When the second wave of inflation does begin, however, investors will find themselves in a world of pain. Stay overweight stocks for now but look to reduce equity exposure by the middle of next year. This Week’s Trade Idea Given our expectation that inflation will come down sharply in 2022 before beginning to rise again in late 2023 and into 2024, we recommend shorting the December 2024 3-month SOFR futures contract versus the June 2023 contract. Current market pricing provides an attractive entry point for the trade, with the implied interest rate for the June 2023 contract 8 bps higher than that of the December 2024 contract. We expect the interest rate spread to eventually widen substantially in favor of higher rates (lower futures contract prices) in 2024. Box 1The Neutral Rate Through The Lens Of The Savings-Investment BalancePeter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Executive Summary Lots Of Pent-Up Demand The yen is unlikely to meaningfully appreciate until global bond yields stabilize. That said, very cheap valuations and a large net short position provide ample ammunition for an explosive rebound should macroeconomic conditions fall into place. The macro catalyst is likely to come from a domestic growth rebound. Unlike other developed economies, private consumption in Japan has been rather anemic on the back of cascading lockdowns. Inflation in Japan will remain contained in 2022, meaning the Bank of Japan will stay dovish. That said, the Japanese economy is also one of the best candidates for generating non-inflationary growth, a bullish backdrop for the currency. Our 2022 target for the yen is 104. Our sense is that most of the downside risks are well understood by markets, while upside surprises are much underappreciated. Recommendations Inception Level Inception Date Return Short CHF/JPY 125.05 2022-02-17 - Bottom Line: Real rates are likely to remain quite attractive in Japan. While that has not been a key driver of the currency in the short term, it remains an anchor over a longer horizon. According to our in-house PPP models, an investor who buys the yen today can expect to make 6% a year over the next decade, based on the historical correlation between valuation and subsequent currency returns. Feature Chart 1Anemic Passenger Volumes The Japanese economy grew by 1.7% in 2021. For an economy with a potential growth rate of only 0.5%, this is an impressive feat. Even more remarkable is that this growth occurred within the context of very anemic domestic demand. The external sector in Japan has been benefiting from a global trade boom, while the domestic sector has been under siege from the pandemic. Anecdotally, the situation on the ground remains rather dire. Shinkansen passenger volumes are still down 35% this year after an even bigger collapse last year. According to Nikkei Asia, the waiting list to enter Japan continues to grow, as border restrictions are enforced. Of the 626,000 individuals approved for residence in Japan since January 2020, only 35% have filtered through. More broadly, at the peak, tourist arrivals (a meaningful source of demand) represented 25% of the overall Japanese population. Today, that number remains near zero (Chart 1). Amidst the gloom, pockets of Japanese financial markets are beginning to suggest a turnaround in economic conditions. The yield curve in Japan is steepening, usually a sign that monetary conditions remain very conducive to growth. Historically, that has been a bullish signal for the yen (Chart 2). Meanwhile, despite the surge in global bond yields, Japanese bank stocks are outperforming. The banking sector is usually one of the first to sniff out an improvement in economic fortunes (Chart 3). Chart 2The Yen And The Japanese Yield Curve Chart 3Japanese Banks Are Outperforming Outside financials, with inflation surging around the world, the Japanese economy is one of the best candidates for generating non-inflationary growth. This is bullish for the currency as real rates rise. Our bias is that while it might be too early to go long the yen today, conditions are gradually falling into place for a coiled spring rebound. The Case For Japanese Growth While the manufacturing PMI in Japan hit an 8-year high of 55.4 in January, the services PMI sits at 47.6, the lowest in the G10. The number of daily new COVID-19 cases breached 100,000 this month, the highest since the pandemic began two years ago. Hospitalizations and deaths are also rising acutely. However, there is rising evidence that Japan is beginning to put the worst of the pandemic behind it. 79.5% of the population is fully vaccinated, versus just about 50% six months ago. Booster shots are being ramped up quickly. The effective reproduction rate of the virus has dropped sharply, from 2.29 at the end of last year to 1.19 currently. According to government officials, there will be sufficient progress made on the virus front to begin relaxing border requirements and restrictions by next month. Optimism on the COVID-19 front will be a welcome fillip to much subdued consumer and business sentiment. Consumption outlays in Japan remain well below the pre-pandemic trend, especially towards services (Chart 4). As the economy reopens, and the labor market recovery continues, the war chest of Japanese savings that have been built in recent years should be modestly unwound. The job-to-applicants ratio is inflecting higher and workers’ propensity to consume has been improving (Chart 5). Chart 5A Labor Market Recovery Will Boost Spending Chart 4Lots Of Pent-Up Demand Wage increases remain very modest in Japan. Fumio Kishida, the Japanese prime minister has called for wage increases above 3%. His government also wants to raise the minimum wage from ¥930 to ¥1000, after a 3% increase last year. As the Shuntō (spring wage negotiations) begin, unions are likely to become more vocal in demanding wage increases. However, with a large share of temporary workers in Japan, and company preferences for one-time bonuses versus permanent pay increases, overall wage growth in Japan should remain in the 1-2% range, in line with BoJ forecasts. This puts Japan miles away from a wage inflation price spiral. From a contrarian perspective, it also means that falling unit labor costs are making the currency extremely competitive (Chart 6). Chart 6Japanese Workers Are Both Productive And Competitive Chart 7A Smaller Fiscal Drag In 2022 In a nutshell, Japan has had cascading shocks from the consumption tax hike in 2019 to six waves of COVID-19 over the last two years. These have led to a massive build in pent-up demand, which should be unleashed in the coming quarters. Government outlays will also go a long way towards boosting aggregate demand. A supplementary budget of ¥36tn was put together last year and approved for the fiscal year that ends this April. The even bigger 2022 budget of ¥107.6tn should also help ease the fiscal drag in 2022 (Chart 7). For a low-growth economy like Japan, with ultra-loose monetary settings, the fiscal multiplier tends to be much larger. The Export Machine Continues To Hum A boom in external demand has been a much welcome cushion for Japanese growth. Rising energy prices are hurting the nominal trade balance, but real net exports remain firm. Foreign machinery orders are still rising over 30% year on year, boosting industrial production in Japan (Chart 8). Demand from China has been an important component of foreign sales. As monetary policy is eased in Beijing, domestic demand should start to improve, preventing Japanese exports from collapsing. One of the most cyclical components of Japanese exports is machine tool orders, which remain firm (Chart 9). Chart 9A Chinese Recovery Will Cushion Export Growth Chart 8Machinery Orders Remain Robust Monetary Policy And Inflation The Bank of Japan is unlikely to adjust monetary settings aggressively, amidst a recovery in demand. It could widen the target band for yield curve control, while bringing short rates back to zero, but this will require a vigorous rebound in demand and inflation. It could also scrap its 0% bank loan scheme but given these are targeted (especially towards renewable industries, and small/medium-sized firms), that is unlikely. Remarkably, the BoJ has not had to increase its holdings of government securities over the last year, as markets have viewed its policy as credible (Chart 10). Doing little is likely the best path of action for the BoJ in 2022. Chart 112% Inflation = Mission Impossible? Chart 10Not Much QE By The BoJ The key variable for the BoJ remains its 2% inflation target, which seems elusive for the time being. Inflation does not tend to accelerate in Japan until the output gap is fully closed. That has yet to occur. Meanwhile, the political push to cut mobile phone prices has been a drag on CPI. Mobile phone charges alone have cut around 1.2%-1.5% from the core core measure of Japanese inflation, according to the BoJ (Chart 11). Moreover, the decline in phone charges has been structural, even though it is usually touted as a one-off. A falling yen would allow some pass-through inflation, but this is unlikely to be sticky. The yen needs to fall 20% every year to generate 2% inflation in Japan (Chart 12). The pass-through is likely to be much higher for price-volatile items such as food and energy, which is likely to create angst among the rapidly ageing population. Chart 122% Inflation = 20% Yen Depreciation Putting it all together, real rates are unlikely to fall very much in Japan. This is very positive for the yen in a world with deeply negative real rates. As demand recovers, and the Japanese economy generates non-inflationary growth, the currency should find a solid footing. The Yen And Portfolio Flows It will be very difficult for the yen to rally if global yields continue to rise aggressively (Chart 13). With yield curve control in Japan, the nominal spread with foreign yields has been narrowing. However, the cost of hedging those foreign yields has also risen dramatically, which has prevented Japanese investors from aggressively flocking to overseas fixed income markets (Chart 14). That said, the weakness in the yen also suggests speculators have been borrowing in JPY to bet on carry strategies. Chart 13Global Yields Need To Stabilize To Cushion The Yen Chart 14No Massive Outflows From Japan Yet The rise in Treasury yields has yet to hit exhaustion from a technical perspective. Our bond strategists expect the 10-year yield to reach 2.25%, which will also enter the zone where we have historically seen some consolidation. The J.P. Morgan survey shows that most of its clients are short duration, but speculators are only modestly short 10-year or 30-year Treasurys (Chart 15). Chart 16USD/JPY And DXY Tend To Move Together Chart 15Modest Upside In Treasury Yields? Once yields stabilize, and the dollar starts to weaken, the positive real rate spread between Japan and the US should attract yen inflows, or at least nudge speculators to start liquidating massive short positions. As a counter-cyclical currency, the yen usually weakens against other developed market currencies, but USD/JPY tends to fall, on broad dollar weakness (Chart 16). Finally, the recent turbulence in markets has seen the yen begin to shine as a safe haven, more so than the US dollar and the Swiss franc (Chart 17). In the near term, this is a catalyst for long yen positions. With US interest rates having risen significantly versus almost all G10 countries in recent quarters, the dollar has become a carry currency. It is difficult for any currency to act as both a safe haven and carry currency, due to opposing driving forces. A rise in volatility will be a boost for the yen. Chart 17The Yen Is The Better Hedge Valuations And A Trade Idea In a report titled “A Short Note On US Dollar Valuations,” we suggested that the yen was the most undervalued G10 currency. According to our in-house PPP models, an investor who buys the yen today can expect to make 6% a year over the next decade, based on the historical correlation between valuation and subsequent currency returns (Chart 18). This will especially be the case if Japanese inflation keeps lagging inflation in the US. As a play on rising volatility, cheaper valuations, and a positive carry, we suggest investors short CHF/JPY today, with a stop at 127, and a target of 115. Historically, these currencies have tended to move together. However, more recently, CHF has risen substantially versus JPY, suggesting some mean reversion is due (Chart 19). Chart 18The Yen Is Very Cheap Chart 19Sell CHF/JPY Housekeeping We are closing our long AUD/NZD trade for a modest profit of 2.5%. We introduced this tactical trade over 6 months ago and are now cognizant of the negative carry as global yields rise. As a reminder we usually hold tactical trades for 6 months, and cyclical trades for 6-18 months. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary
Executive Summary Oil-Price Risk Skewed Upward The $10-$15/bbl risk premium in Brent prices will dissipate over the next month. Russia's best outcome is to follow the off-ramp offered by the US. President Biden's call to KSA's King Salman last week will result in higher oil output from the Kingdom, the UAE and Kuwait, in return for deeper US defense commitments. The Biden administration and Iran are in a hurry to get a deal done: The US wants lower oil prices, and Iran needs the revenue. Our Brent forecasts for 2022 and 2023 are revised slightly to $81.50 and $79.75/bbl, respectively, reflecting supply-demand adjustments. Price risks are tilted to the upside: A miss on any of the above assumptions will keep prices above $90/bbl, and push them higher. Bottom Line: Oil demand will remain robust this year and next. To keep prices from surging from current levels into demand-destruction territory, additional supply is needed. Most of this will come from KSA, the UAE and the US shale-oil producers. We expect prices to fall from current prompt levels this year and next. This will support sovereign budgets and oil producers' free cashflow goals. We remain long the XOP ETF. Feature The $10-$15/bbl risk premium in Brent crude oil prices will dissipate, as the following supply-side events are ticked off: 1) Russia gets on the off-ramp offered by the US last week to de-escalate the threat of another invasion of Ukraine by withdrawing its troops from the border;1 2) OPEC 2.0's core producers – the Kingdom of Saudi Arabia (KSA), the United Arab Emirates (UAE), and Kuwait – increase supply in return for deeper US security commitments; 3) Iran restores its remaining 1.0 – 1.2mm b/d of production to the market, following the restoration of its nuclear deal with Western powers; and 4) US shale-oil producers step up production in response to higher WTI prices. Politics, Then Economics The first three assumptions above are political in nature, requiring a bargain be struck among contending interests to resolve. We do not believe Russia's endgame is to jeopardize its future oil and gas exports to the West, particularly to the EU (Chart 1). The US is warning that another invasion of Ukraine will put the use of the Nord Stream 2 pipeline to deliver gas to Germany at risk.2 It also is worthwhile noting NATO is aligned with the US on this stance. Russia derived 40-50% of its budget revenues from oil and gas production, and ~ 67% of its export revenue from oil and gas over the decade ended in 2020.3 Of course, only President Putin can determine whether oil and gas sales can be diversified enough – e.g., via higher shipments to China – to offset whatever penalties the West imposes. But, in a game-theoretic sense, the stakes are very high, and taking the US off-ramp is rational. Chart 1Russia's Critical Exports: Oil + Gas We expect the second assumption to play out in the near term, following US President Joe Biden's call to KSA's King Salman last week. The outreach stressed the US commitment to defend KSA and, presumably, its close allies in the Gulf (the UAE and Kuwait).4 KSA already has increased its production to 10.15mm b/d under the OPEC 2.0 agreement to restore 400k b/d beginning in August 2021. We estimate the coalition had fallen behind on this effort by ~ 1mm b/d, as only KSA, the UAE and Kuwait presently have the capacity to lift production and sustain it (Table 1). KSA's reference production level agreed at OPEC 2.0's July 2021 meeting will rise to 11.5mm b/d in June, up 500k b/d from its current level (Table 2). This means KSA could flex into another 850k b/d between now and the end of May; and another 500k b/d after that. The UAE's and Kuwait's reference production levels will rise 330k and 150k b/d in June to 3.5mm b/d and 3.0mm b/d, respectively. Markets will need these incremental volumes as demand continues to recover and non-core OPEC 2.0 production continues to fall (Chart 2). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Table 2Baseline Increases For Core OPEC 2.0 Our third assumption reflects our reading of the signaling by Iran over the past few weeks, which indicate growing confidence a deal with the US to restore the Joint Comprehensive Plan of Action (JCPOA) is in the offing.5 The politics here converge with the economics: the Biden Administration wants to increase oil supply ahead of mid-term elections in the US to keep gasoline prices under control; Iran needs to increase its revenues. Both sides get an immediate need satisfied. However, the risks to KSA and its Gulf allies will increase as Iran's revenues grow, because it will be able to fund proxy-war operations against the Gulf states. This is why deepening the US defense commitment to the region is critical to KSA and its allies. The last assumption reflects our view US E+P companies are being incentivized to lift production by high prompt and deferred prices. We continue to expect these companies – particularly those in the US shales, where the majority of the production increase will occur – to husband their capital resources closely, and to continue to prioritize shareholder interests. As capital availability declines – primarily due to reduced investor interest in investing in hydrocarbon production – these firms will have to focus on reducing operating costs and increasing productivity over the next decade to fund growth. Relative to 2021, we expect US oil production to increase 0.85mm b/d this year and by 0.53mm b/d in 2023 relative to this year, as producers respond to higher prices (Chart 3). Chart 2Increased Core OPEC 2.0 Production Becoming Critical Chart 3US Oil Production Will See Another Up Leg Supply-Demand Balances Are Tight Global oil demand growth this year is reduced slightly in our balances – going to 4.5mm b/d from 4.8mm b/d, mostly reflecting our assessment of slowing growth as central banks remove monetary accommodation. We lifted next year's growth estimate slightly, to 1.7mm b/d. These estimates still leave our growth expectations above the major data providers, the highest of which is OPEC's 4.2mm b/d estimate. We continue to expect DM demand to level off this year and next, and EM demand to retake its position as the global demand growth engine (Chart 4). The supply side remains tight, with average global crude oil and liquid fuels production estimated at 101.5mm b/d for 2022 and 102.8mm b/d for next year. With demand expected to average 101.5mm b/d this year and 103.2mm b/d next year, markets will remain balanced but tight (Chart 5). This means inventories will continue to be strained, leaving little in the way of a cushion to absorb unexpected supply losses (Chart 6). Chart 4EM Demand Retakes Growth-Engine Role Chart 5Markets Remain Balanced But Tight... Chart 6...Keeping Pressure On Inventories Markets Remain Balanced But Tight Our supply-demand analysis indicates markets will remain balanced but tight, with inventories under pressure until supply increases. This will predispose markets to higher price volatility, as low inventories force prices to ration supply. This will increase the backwardation in the Brent and WTI curves, which will bolster the convenience yield in both of these markets (Chart 7).6 We expect implied volatility to remain elevated, as a result (Chart 8). Chart 7Backwardation Will Keep Convenience Yield Elevated Chart 8High Volatility Will Persist Because of these low inventory values, Brent prices for 2022 are higher than our previous estimate. By 2023, the effects of increased supply from KSA, UAE, Kuwait – albeit a marginal increase – and the US kick in to reduce prices. As supply increases, the risk premium currently embedded in Brent prices will decline, pushing them to our forecasted levels for 2022 and 2023 of $81.50/bbl and $79.75/bbl, respectively. For 1H22, we expect Brent prices to average $87.20/bbl, and in 2H22 we're forecasting a price of $75.80/bbl on the back of increased production. Next year, higher output will keep prices close to $80/bbl, with 1H23 Brent averaging $79.85 and 2H23 averaging $79.70/bbl. Word Of Caution Our analysis is predicated on strong assumptions regarding the incentives of oil producers taking a rational view of the need for stability and supply in markets. The bottom panel of Chart 9 provides an indication of how tenuous markets are if our assumptions are mistaken, and core OPEC 2.0 does not increase production, Iranian barrels are not returned to the market, or the US shale supply response is less vigorous than we expect. The highest price trajectory occurs when all of our assumptions prove wrong, which takes Brent prices above $140/bbl by the end of 2023. It goes without saying this is non-trivial. But we'll say it anyway: This is non-trivial. We can reasonably expect feedback loops in such a case – e.g., US and Canadian production kicks into high gear, and once-idled North Sea are brought back into service. However, this takes time, and will cause demand destruction on a global scale. Chart 9Scenarios For Oil Prices Investment Implications Oil markets will remain tight and volatile until additional supplies are forthcoming. We are expecting core OPEC 2.0 to lift output by 3.2mm b/d this year, and for the US Lower 48 production to average 9.8mm b/d. The US production increase will be led by higher shale-oil output, which we expect to average 7.4mm b/d this year and 7.8mm b/d in 2023. Given the tight markets we expect, we remain long the XOP ETF, and commodity index exposure in the form of the S&P GSCI and the COMT ETF, an optimized version of the S&P GSCI. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish Marketed volumes of US natural gas are expected to hit a record high of just under 107 Bcf/d next year as prices stabilize close to $4/MMBtu, in the EIA's latest estimate. This is up from just over 104 Bcf/d of marketed production this year, which itself was a 3 Bcf/d increase over 2021 levels. Almost all of this will come from the Lower 48 (97%). We expect US LNG exports to increase on the back of rising production and further investment in export terminals. Most of this will be shipped to Europe, in our estimation, as EU states seek to diversify LNG sources in the wake of the Russia-Ukraine standoff currently underway. LNG imports accounted for roughly one-fifth of all natural gas supplied to the UK and EU-27 in 2020, according to the EIA, which notes, "Growing volumes of flexible LNG supplies, primarily from the United States, contributed to the notable increases in LNG imports to Europe from 2019 to 2021." Wide price differentials can be expected to support the flow of LNG to Europe from the US (Chart 10). Base Metals: Bullish Iron ore prices took a hit after China’s National Development and Reform Commission (NDRC) stated its intentions to stabilize iron ore markets, crack down on speculation and false price disclosures after prices in 2022 rallied sharply last week. Authorities believe price strength is coming from speculation and hoarding, which is adding to inflationary pressures. However, fundamental factors have been, and likely will keep iron ore prices buoyed. Based on past steel inventory levels and seasonal patterns, steel production will increase and more than double current inventory levels by end-March. Monetary policy easing, and the push by China’s steel industry to become carbon-neutral over the next five years are additional fundamental factors supporting iron ore prices. Precious Metals: Bullish The January print for US CPI jumped 7.5% year-on-year, beating estimates as headline inflation rose to a 40-year high. Markets are expecting around five interest increases this year (Chart 11). BCA’s US Bond Strategy expects rate hikes will be around 100 – 125 bps this year. Gold prices initially fell on the possibility of increasing rate hikes and a hawkish Fed, but in the second half of last week settled at subsequently higher prices on each day. Apart from increased inflation demand, this was likely due to markets’ fear of the possibility of an ultra-hawkish Fed, which could tighten US financial conditions and see a rotation out of US equity markets into safe-haven assets or into other markets ex-US, both of which will be bullish for gold. Chart 10 Chart 11 Footnotes 1 Please see Background Press Call by a Senior Administration Official on the President’s Call with Russian President Vladimir Putin, released by the US White House on February 12, 2022. 2 Please see Long-Term EU Gas Volatility Will Increase, which we published on February 3, 2022 for further discussion. The EU is a huge market for Russia supplies Germany with 65% of its gas. Approximately 78% of total natural gas exports (pipeline + LNG) from Russia went to the EU in 2020. 3 Please see Russia’s Unsustainable Business Model: Going All In on Oil and Gas, published on January 19, 2021 by the Hague Centre for Strategic Studies (HCSS). 4 Please see Readout of President Joseph R. Biden, Jr.’s Call with King Salman bin Abdulaziz Al-Saud of Saudi Arabia, released on February 7, 2022. The readout noted, " issues of mutual concern, including Iranian-enabled attacks by the Houthis against civilian targets in Saudi Arabia." Energy security also was discussed, which we read as code for a deal to increase production in return for a deepening of US defense commitments. This line is followed closely by Gulf media – e.g., It took Biden a year to realize Saudi Arabia’s vital regional role, published by arabnews.com on February 13, 2022, which notes: "If Putin decides to invade Ukraine, the Saudis are the only ones who could help relieve the unsteady oil markets by pumping more crude, being the largest crude exporter in the OPEC oil production group. The White House emphasized that both leaders further reiterated the commitment of the US and Saudi Arabia in ensuring the stability of global energy supplies. 5 Please see Iran 'is in a hurry' to revive nuclear deal if its interests secured -foreign minister, published by reuters.com on February 14, 2022. 6 Please see our November 4, 2021 report entitled Despite Weaker Prices Crude Oil Backwardation Will Persist for additional discussion of convenience yields and volatility. Investment Views and Themes Strategic Recommendations Trades Closed in 2021