Economy

We will be holding our quarterly webcasts next Monday, November 15th at 10:00 a.m. Eastern time and Tuesday, November 16th at 8:00 a.m. Hong Kong time in lieu of publishing a Weekly Report. Please join us with your questions to make it a fully interactive event. We will resume our regular publication schedule on the 22nd. Highlights Economy – Wages could be on the rise if workers are able to exploit the considerable leverage they now enjoy: The labor market currently has no slack. Workers’ ability to derive a lasting advantage from today’s shortages will determine if the extended decline in labor’s share of income will reverse. Markets – Lengthy agreements in labor’s favor could give inflation an additional impetus: Investors are not prepared for a shift in the balance of power from management to labor and a range of assets will have to reprice if workers can achieve some durable victories. Strategy – Keep an eye on labor agreements, which could hasten a shift to more defensive positioning: The current economic backdrop, along with accommodative monetary and fiscal policy, support risk-friendly portfolio positioning, but a labor revival could prompt the Fed to engage in a disruptive tightening cycle that would halt the bull markets in equities and credit and possibly also short-circuit the expansion. Feature At the end of 2019, tiring of the market debates du jour, we began haunting the New York Public Library, reading all we could about US labor relations history. Several books and rolls of microfilm later, we published a three-part Special Report on workers’ past, present and future. While we concluded that organized labor would not regain the influence it wielded in the fifties, sixties and seventies, we thought that investors were underestimating the potential for workers to reverse the grinding decline in their fortunes that began in the early eighties. Public opinion seemed to be shifting in workers’ favor, especially among the young; the coming election held promise for the Democrats; and the pendulum had swung so far, for so long, that there was little scope for management to gain any more ground. We looked forward to countering the view that organized labor was as dead as a doornail, only to have COVID-19 render the topic irrelevant. Nearly two years later, however, dislocations caused by the pandemic have pushed negotiations over wages and labor conditions to the fore. Amidst a recent flurry of strikes against S&P 500 constituents, clients have been asking what the labor future holds. We refresh the themes we identified in our initial analysis, noting how conditions have shifted since early 2020. The investment takeaway is that increasing labor muscle could stoke inflation and push long-run inflation expectations higher, forcing the Fed to tighten monetary policy more abruptly than markets expect. The 2020 Election Went Labor’s Way A review of the historical record makes it crystal clear that employees cannot gain ground if government sides with employers. The 2020 election, which delivered both the White House and the Senate to Democrats, put some unexpected wind in labor’s sails. They did not mark a revival of the New Deal, however, as Democrats’ legislative majorities are precariously thin and unlikely to survive the 2022 midterms, their control of the presidency may not extend beyond 2024, and the federal judiciary will be inclined to see things management’s way for some time thanks to past conservative appointments. At the state level, the executive and legislative branches remain firmly in Republican control. A friendly executive branch can do a lot to reset the scales nonetheless. The Biden Department of Labor, National Labor Relations Board (NLRB), Occupational Safety and Health Administration (OSHA) and Department of Justice are certain to enforce existing worker protection laws more vigorously than their recent predecessors, while more actively challenging business combinations. Joe Biden began his election campaign at a Pittsburgh union hall and returned to the Steel City to end it, promising to be “the most pro-union president you’ve ever seen.” Labor leaders have generally given him high marks since taking office for supporting legislation to make it easier for workers to organize and he publicly offered moral support to John Deere’s UAW workers when they went on strike last month, saying, “My message is they have a right to strike and they have a right to demand higher wages.” Public Opinion Has Continued To Shift Toward Labor We noted two years ago that young Democratic voters overwhelmingly favored Bernie Sanders’ and Elizabeth Warren’s candidacies, suggesting that solidarity with workers might be on the rise. It is no surprise that students would be the most avid supporters of progressive campaigns, but Millennials, born between 1981 and 1996, and Generation Z might be viewed as the Inequality Generations, having entered the workforce after China’s admittance to the WTO, which coincided with a peak in labor’s share of income (Chart 1). Their lives have spanned the September 11th attacks, the financial crisis, a once-in-a-century pandemic and three equity market crashes, and many of them started adulthood with onerous student debt burdens and dim earnings prospects. They might find the notion of a union buffer from market forces especially alluring and therefore view unions favorably. The 2019 Gallup poll found that public approval for unions had reached nearly 20-year highs; two years on, it’s up to levels last reached over 50 years ago (Chart 2). Chart 1Workers' Share Of The Pie Shrank For 15 Years Chart 2Extreme Makeover Public opinion is crucially important to the outcome of labor negotiations because for-profit employers will seek the most favorable terms they can get, to the extent that they are socially acceptable. In our schematic of the 1980s vicious circle that initiated unions’ 40-year decline, public opinion made it possible for the Reagan administration to take a hard line against the air traffic controllers’ union and emboldened private employers to take more aggressive measures as well (Figure 1). Beyond the private sector, elected officials reliably deliver what their constituents want, and the courts do, too, albeit with a longer lag. The median voter theory advanced by our geopolitical strategists doesn’t just predict future outcomes, it directly influences them. Striketober Another key takeaway from our original study was that successful strikes beget strikes. Strikes are the most potent weapon in workers’ arsenal – withholding their labor threatens to reduce their employer’s output and may halt it altogether – but they are fraught with risk for individual employees. Striking workers don’t get paid beyond the partial support that may be provided by their union strike fund and may find themselves entirely out of work if the strike fails. Workers should only strike when they have a good chance of winning or when their situation has become so intolerable that they have little to lose. Strikes (and lockouts) occur when labor and management cannot reach a mutually acceptable settlement, often because at least one side overestimates its bargaining power. It is easy to agree when labor and management hold similar views about each side’s relative position, as when both perceive that one of them is considerably stronger. In that case, a settlement favoring the stronger side can be reached quickly, especially if the stronger side exercises some restraint and does not seek to impose terms that the weaker side can scarcely abide. Restraint is rational in repeated games like employer-employee bargaining, and when both parties recognize that relative bargaining positions are fluid, they are likely to exercise it. Viewing labor negotiations through a game theory lens, we posit a simple framework in which each side can hold any of five perceptions of its bargaining power, resulting in a total of 25 possible joint perceptions. Labor (L) can believe it is way stronger than Management (M), L >> M; stronger than Management, L > M; roughly equal, L ≈ M; weaker than Management, L < M; or way weaker than Management, L << M. Management also holds one of these five perceptions, and the interaction of the two sides’ perceptions establishes the path negotiations will follow. Limiting our focus to today’s prevailing conditions, Figure 2 displays only the outcomes consistent with labor’s belief that it has the upper hand. For completeness, the exhibit lists all of management’s potential perceptions, but we deem the three away from the extremes to be most likely. Record job openings and job quits rates (Chart 3) should disabuse even the most rabidly anti-union managements from thinking they hold all the cards. On the other hand, four consecutive decades of victories will make it hard for all but the most objective management negotiators to believe that the tables have completely turned and that labor is fully in control. Chart 3It's A Labor Seller's Market ... Strike outcomes turn on which side has overestimated its leverage. The broad factors we use to assess leverage are overall labor market slack; economic concentration; regulatory and legal trends; and the sustainability of either side’s accumulated advantage, which we describe as the labor-management rubber band. Other factors that matter on a case-by-case basis, but are beyond the scope of our analysis, include industry-level slack, a labor input’s susceptibility to automation, and the degree of labor specialization/skill involved in that input. For these micro-level factors, a given group of workers’ leverage is inversely related to the availability of substitutes for their input. Labor Market Slack Though we hold the view that labor force participation is likely to revive in coming months because inequality and a comparatively thin social safety net will compel many lower-income workers to return to the work force, no one knows for sure where the workers have gone or when they will return, if at all. It is abundantly clear from accelerating wage gains (Chart 4), the openings and quits rates, and small businesses’ historic inability to fill job openings (Chart 5) that the labor market is extremely tight right now. A difference of opinion about whether and how long the worker shortages will persist could make finding common ground in contract negotiations a challenge. Chart 4... As Rising Wages ... Chart 5... And Frantic Employers Confirm Economic Concentration We previously noted that the trend toward economic concentration has strengthened management’s hand in labor negotiations as it has made an increasing share of local labor markets tend toward monopsony. A monopsony is a market with a single buyer, the mirror image of a monopoly, which is a market with a single seller. Unfortunately for labor, monopsonies restrain prices just as monopolies inflate them. The trend toward economic concentration is well established and we think the probability that it will reverse is low – Congress may shake its fist at Big Tech and the Biden Justice Department will more vigorously contest mergers on anti-trust grounds, but there is an ocean of liquidity available to support acquisitions and robust CEO confidence suggests it will be deployed. Regulatory And Legal Trends Over the last four decades, unions have endured a near-constant drubbing from statehouses, federal agencies and the courts, as union and labor protections have been under siege from all sides. But the regulatory and legal tide has been such a huge benefit for employers since the beginning of the Reagan administration that it simply cannot continue to maintain its pace. Furthermore, as our Global Investment Strategy colleagues have observed, the Republican party’s lurch toward populism may leave Big Business without a champion in Washington, DC. The regulatory and legal winds are shifting and management teams that have spent their entire careers in an environment in which labor has perpetually been on the back foot may be the last to know, leading to an uptick in the number and contentiousness of labor disputes. A change in Fed policy, as unveiled in the August 2020 revision to the FOMC’s statement on longer-run monetary policy goals, has also tilted the playing field in workers’ favor. The Fed has sworn off preemptively tightening monetary policy when the labor market appears to be getting tight. The new direction contrasts with 40-plus years of Fed policy that were predicated on taking away the punch bowl before upward wage pressures could build momentum. The tacit pledge in the revised statement on monetary policy implies that the Fed will prioritize its full employment mandate over its price stability mandate in the near term. That’s not an unalloyed positive for workers, who will only be better off if their nominal wage gains outpace inflation, but it will help give them more of a head start than they would have gotten if the FOMC had stuck with the proposition that tight labor markets stoke inflation. The Labor-Management Rubber Band Employees and employers have a deeply symbiotic relationship, and we like to think of labor and management as being linked by an elastic tether with a finite range. Since neither side can indefinitely thrive if the other is suffering, the tether pulls the two sides closer together when the gap between them threatens to become too wide. When labor does too well for too long at management’s expense, profit margins shrink and the company’s viability as a going concern is threatened. When management does too well, deteriorating living standards drive the best employees away, undermining productivity and profitability. One does not have to be a card-carrying socialist to believe that the band is near its limit and that some sort of mean reversion is inevitable, given how badly real hourly wages have lagged gains in hourly output over the last 50 years (Chart 6). Chart 6Testing How Far The Labor-Management Rubber Band Can Stretch What Comes Next Steady concentration across industries and a persistently hospitable legal and regulatory climate has given management the upper hand for four decades. Going forward, however, labor should see its fortunes improve as the legal and regulatory climate cannot get materially better for employers, and the labor-management rubber band becomes less stretched in management’s favor (Figure 3). The major uncertainty pertains to the ongoing level of slack in the labor market and how employment agreements should account for it. All parties recognize there is no slack right now and employers are duly offering generous inducements to attract workers. Sign-on bonuses for new employees in unskilled services positions are ubiquitous and negotiations with unionized employees include ratification bonuses for signing new contract packages. Because wages are sticky on the downside – it’s difficult to get employees to swallow outright pay cuts – employers prefer making one-time concessions like bonuses to increasing wage rates across the board, which is tantamount to locking in higher long-term input costs. The duration of concessions appears to be a sticking point in the negotiations to settle the current strikes. Over the last two decades, several large companies with unionized workforces have instituted a two-tier employment track distinguishing legacy employees from new hires. The legacy employees remain on their existing salary path and retain their retirement and health insurance benefits, while new employees are subject to a lower salary scale and are entitled to fewer benefits, if any. The result has been to bend the human resources cost curve lower in the future as natural attrition shrinks the share of employees on the more costly legacy path. The two-tier employment classification has proven to be an effective way for employers to bend the cost curve to their liking, as it protects the interests of a considerable majority of employee voters at the expense of a largely hypothetical future employee constituency. It is presumably difficult to empathize with workers who aren’t yet coming to the plant every day and legacy employees haven’t dwelled on their plight when participating in contract ratification votes. An interesting feature of the ongoing John Deere strike is that the UAW rejected what appeared to be a strikingly generous package partially in the interest of defending current and future employees who have no path to reach legacy employees’ all-in compensation level. The recent strikes against S&P 500 constituents have been concentrated in industries that faced demand spikes during the pandemic. The bakery worker’s union (BCTGM) representing Kellogg’s workers struck against Frito-Lay (owned by Pepsi) for three weeks in July and Nabisco (a unit of Mondelez) for five weeks in August and September. A significant motivation for the BCTGM workers’ actions seemed to be frustration over intense pandemic workloads. Their plants ramped up capacity to fill kitchen cabinets while consumers were cooped up at home and they are now seeking redress for the emergency hours they were asked to work. (All of the bakery workers who struck, as well as the John Deere workers, were considered essential workers.) Management, on the other hand, might take the view that their employees’ sacrifices are in the past, and are not likely to be repeated if product demand settles back into its pre-pandemic trend. Viewing ongoing negotiations from our game theory perspective, there is ample room for divergent perceptions of relative negotiating strength, based on differing opinions about the persistence of pandemic trends. The divergence might make for increasingly contentious labor negotiations going forward, with strikes exacerbating supply bottlenecks and ramping up near-term inflation pressures. If ongoing rounds of labor negotiations result in workers achieving longer-term victories, it will pressure corporate profit margins. Labor gains will also potentially feed into inflation if capacity is not poised to meet the ensuing increase in aggregate demand. We will keep close tabs on labor negotiations as the economy works its way back to a post-pandemic steady state.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com  

Highlights Supply-side pressures should abate over the coming months as semiconductor availability improves, transportation bottlenecks ease, energy prices recede, and more workers enter the labor force. The respite from inflation will be temporary, however. The combination of easy fiscal and monetary policies will cause unemployment to fall below its equilibrium level in the US, and eventually, in most major economies. Unlike in the late 1990s, when rising wages were counterbalanced by robust productivity gains, most of the recent rebound in US productivity growth will prove to be illusory. US inflation will follow a “two steps up, one step down” trajectory. We are currently at the top of those two steps, but rising unit labor costs will eventually drive inflation higher. Rather than fretting that the Federal Reserve will keep rates too low for too long, investors are worried that the Fed will tighten too much. This is a key reason why the 20-year/30-year Treasury slope has inverted. Such an inversion does not make sense to us. Hence, we are initiating a trade going long the 20-year bond versus the 30-year bond. Go short the 10-year Gilt on any break below 0.85%. UK real bond yields are amongst the lowest in the world. The Bank of England will eventually have to turn more hawkish, which will support the beleaguered pound. Structurally higher bond yields will benefit value stocks. Banks stand to gain from rising bond yields while tech could suffer. The eventual re-emergence of supply-side pressures will catalyze more investment spending. This will bolster industrial stocks. The Supply Side Matters, Again Savings glut, secular stagnation; call it what you will, but for the better part of two decades, the global economy has faced a chronic shortfall of aggregate demand. Times are changing, however. The predominant problem these days is not a lack of spending; it is a lack of production. Unlike during the Global Financial Crisis – when worries about moral hazard complicated efforts to bail out homeowners and banks – the victims of the pandemic elicited sympathy. As a result, governments in developed economies rolled out a slew of measures to support workers and businesses. Thanks to bountiful fiscal transfers, households in the US have accrued $2.2 trillion in income since the start of the pandemic, about $1.2 trillion more than one would have expected based on the pre-pandemic trend (Chart 1). With many services unavailable, consumers diverted spending towards manufactured goods. At first, sellers were able to dip into their inventories to meet rising demand. By early this year, however, inventories had been depleted (Chart 2). Shortages began to pop up across much of the global supply chain. Chart 1Stimulus-Supported Income Growth Boosted Goods Consumption Chart 2The Pandemic Depleted Inventories While today’s empty warehouses can be largely attributed to surging demand for goods, supply-side disruptions have also played an important role. Four disruptions stand out: 1) semiconductor shortages; 2) transportation bottlenecks; 3) inadequate energy supplies; and 4) reduced labor force participation. Let us examine all four in turn. Semiconductor Shortages Chart 3Car Prices Have Jumped The global supply chain was not equipped to handle the dislocations caused by the pandemic. The combination of just-in-time inventory systems and far-flung supplier networks ensured that bottlenecks in one part of the global economy quickly filtered down to other parts of the economy. Few industries are as important as semiconductors. The auto sector has felt the brunt of the chip shortage. Both new and used vehicle prices have soared as dealer lots have emptied out (Chart 3). The drop in vehicle spending alone shaved 2.4 percentage points off US real GDP growth in the third quarter. Semiconductor makers have ramped up production to meet growing demand. The US Census Bureau’s Quarterly Survey of Plant Capacity Utilization showed that semiconductor plants operated an average of 73 hours per week in the first half of this year, up from around 45-to-50 hours prior to the pandemic (Chart 4). Chip production in Northeast Asia has rebounded (Chart 5). Southeast Asian production dropped in August due to Covid lockdowns, with semiconductor exports falling by over a third in Malaysia and Vietnam. Fortunately, since then, a decline in Covid cases and rising vaccination rates have spurred a recovery throughout the region. Chart 4Chipmakers Are Working Overtime Chart 5Semiconductor Production Has Accelerated In Northeast Asia Chart 6Memory Chip Prices Are Declining Commentary from semiconductor companies and automakers suggest that the chip shortage will ease over the coming months. In an auspicious sign, US auto sales jumped to 13.1 million in October from 12.3 million in September. Memory chip prices are also falling (Chart 6). Nevertheless, the overall chip market is unlikely to return to balance until 2023. Transportation Bottlenecks Unlike semiconductors and high-end electronics, which usually arrive by air, bulkier items such as furniture, sporting goods, and housing appliances typically arrive by sea. Port congestion, insufficient warehouse capacity, and a lack of truck chassis on which to place containers have all contributed to transportation bottlenecks. Chart 7Transportation Bottlenecks: Past The Worst? As with the semiconductor shortage, we are probably past the worst point in the shipping crisis. Drewry’s composite World Container Index has edged down 11% from its highs, although it is still up more than three-fold from mid-2020 levels (Chart 7). The easing in container shipping costs follows a dramatic 47% decline in the Baltic Dry Index since early October. The number of ships waiting to unload cargo off the coast of Los Angeles and Long Beach remains near record highs (Chart 8). Port congestion should ease over the next few months. US port throughput usually falls starting in the late fall and remains weak during the winter months, bottoming shortly after the Chinese New Year. If throughput remains elevated near current levels this year, this should be enough to clear much of the backlog. Looking further out, shipping costs could face additional downward pressure. Chart 9 shows that the number of container ships on order has risen to a 10-year high; these new ships will be delivered over the next two years. Chart 8Port Congestion Should Ease Over The Coming Months Chart 9Shipbuilders Are Busy Inadequate Energy Supplies After a torrid rally since the start of the year, energy prices have come off their highs. The price of Brent oil has dipped 6% from its October peak. US natural gas prices have retreated 11%. Natural gas prices in Europe have fallen 37%. The biggest move has been in coal prices, which have dropped 36% over the past two weeks alone. Futures curves are pricing in further declines in key energy prices (Chart 10). BCA’s Commodity and Energy Strategy service expects energy prices to soften over the next 12 months, but not as much as markets are discounting. Their latest forecast calls for the price of Brent crude to average $81/bbl in 2021Q4, $80/bbl in 2022 (versus market expectations of $77/bbl), and $81/bbl in 2023 (versus market expectations of $71/bbl). As we discussed a few weeks ago, years of underinvestment have led to tight supply conditions across the entire energy complex (Chart 11). Proven global oil reserves increased by only 6% between 2010 and 2020, having risen by 26% over the preceding decade. Gas reserves followed a similar trajectory, increasing by only 5% between 2010 and 2020 compared to 30% over the prior ten years (Chart 12).   With little spare capacity, energy markets have become increasingly vulnerable to shocks. A cold snap across the Northern Hemisphere this spring depleted natural gas supplies, while a lack of wind reduced energy production by European wind farms. Increased gas imports from Russia could have mitigated the problem, but the dispute over the Nord Stream 2 pipeline prevented that from happening. The pipeline is popular with German voters (Chart 13). BCA’s geopolitical team expects it to be approved, a welcome development given that La Niña is highly likely to lead to colder-than-normal temperatures across northern Europe this winter. China has also restarted 170 coal mines and will probably begin re-importing Australian coal. Beijing is also allowing utilities to charge higher prices, which should help stave off bankruptcies across the sector. These measures should help mitigate China’s energy crisis. Chart 14US Rig Count Has Risen From Low Levels A bit more oil production will also help. The US rig count, while still far below its 2014 highs, has doubled since last year (Chart 14). BCA’s commodity strategists expect output in the Lower 48 states to average 9.5mm b/d in 2022 and 10mm b/d in 2023, versus 2021 production levels of 9.0mm b/d. Nevertheless, shale producers are a lot more disciplined these days. Debt reduction and cash flow generation are now the top priorities. This implies that fairly high oil prices may be necessary to catalyze additional investment in the industry.  Reduced Labor Force Participation Despite the rapid economic recovery, US employment remains 5 million below its pre-pandemic peak. One would not know this from the survey data, however. A record 51% of small businesses expressed difficulty finding qualified workers in the October NFIB survey. The share of households reporting that jobs are plentiful versus hard-to-get has returned to its 2000 highs. Both the quits rate and the job openings rate are well above their pre-pandemic levels (Chart 15). A wave of early retirement accounts for some of the apparent labor market tightness. About 1.3 million more workers have retired since the pandemic began than one would have expected based on demographic trends. Yet, there is more to the story than that. The labor force participation rate for workers aged 25-to-54 has not fully recovered; the employment-to-population ratio for that age cohort is still 2.5 percentage points below pre-pandemic levels (Chart 16). Chart 16Labor Force Participation Has Room To Rise   There is considerable uncertainty about how many workers will re-enter the labor force over the coming months. On the one hand, the expiration of enhanced unemployment benefits could prod more workers into the job market. Diminished anxiety about the virus should help. While the number has fallen by half, there are still 2.5 million people not working due to concerns about getting or spreading Covid-19 (Chart 17). According to Boston College’s Center for Retirement Research, the retirement rate rose more for older lower-income workers than higher-income workers (Chart 18). Some of these retirees may decide to re-enter the labor force. Chart 17Less Anxiety About The Coronavirus Should Increase Labor Supply   On the other hand, the imposition of vaccine mandates could reduce labor supply. About 100 million US workers are currently subject to the mandates. According to the Census Household Pulse Survey, about 8 million of them are unvaccinated and attest that “they will definitely not get the vaccine.” Perhaps the biggest question mark is over whether the pandemic will lead to permanent changes in peoples’ perspectives on the optimal work/life balance. High burnout rates (especially in the health care sector), a reluctance to restart the daily commute to the office, and the desire to spend more time with family have all contributed to what some commentators have dubbed The Great Resignation. Ultimately, the deciding factor may be wages. Wage growth accelerated during the late 1990s as the labor market tightened (Chart 19). This drew a lot of people – especially less-skilled workers – into the labor force. Recently, wage growth has exploded at the bottom end of the income distribution, and our guess is that this will entice more people to seek employment (Chart 20). Chart 19Wage Growth Accelerated During The Late 1990s As The Labor Market Tightened Chart 20Wages At The Bottom End Of The Income Distribution Are Rising Briskly     Will Higher Productivity Growth Mitigate Supply-Side Pressures? The late 1990s saw a resurgence in productivity growth. This helped restrain unit labor costs in the face of rising wages. While US productivity did jump during the pandemic, we are sceptical of claims that this can be attributed to efficiency gains from digitalization and work-from-home practices. A recent study of 10,000 skilled professionals at a major IT company revealed that work-from-home policies decreased productivity by 8%-to-19%, mainly because people ended up working longer. It is telling that productivity outside of the US generally declined during the pandemic (Chart 21). This suggests that last year’s productivity gains stemmed mainly from increased operating leverage, a common feature of post-recession US recoveries (Chart 22). Supporting this view is the fact that productivity growth slowed from 4.3% in Q1 to 2.4% in Q2 on a quarter-over-quarter annualized basis. Productivity declined by 5% in Q3, leading to an 8.3% increase in unit labor costs. Chart 22US Productivity Tends To Jump After Recessions Chart 23Capital Goods Orders Have Soared The only saving grace is that core capital goods orders have soared (Chart 23). This should translate into increased business capital spending next year and higher productivity down the road. Investment Implications Supply-side pressures should abate over the coming months as semiconductor availability improves, transportation bottlenecks ease, energy prices recede, and more workers enter the labor force. The respite from inflation will be temporary, however. The combination of easy fiscal and monetary policies will cause unemployment to fall below its equilibrium level in the US, and eventually, in most major economies. This is consistent with our “two steps up, one step down” projection for US inflation. We are probably near the top of those two steps at present. This implies that the next move for inflation is to the downside, even if the longer-term trend is still to the upside. The US 10-year Treasury yield should stabilize at around 1.8% in the first half of 2022, before moving higher later in the year. As we discussed last week, markets are understating the true level of the neutral rate of interest. Rather than fretting that the Federal Reserve will keep rates too low for too long, investors are worried that the Fed will tighten too much. This is a key reason why the 20-year/30-year Treasury slope has inverted (Chart 24). Such an inversion does not make sense to us. Hence, as of this week, we are initiating a trade going long the 20-year bond versus the 30-year bond. We would also go short the 10-year Gilt on any break below 0.85%. The Bank of England’s “surprising hold” knocked the yield down 14 basis points to 0.93%. UK real bond yields are amongst the lowest in the world (Chart 25). Growth is strong and will remain buoyant as Brexit headwinds fade. The BoE will eventually have to turn more hawkish, which will support the beleaguered pound. Chart 24Go Long US 20-Year Bonds Versus 30-Year Bonds Chart 25UK Real Bond Yields Are Amongst The Lowest In The World   Structurally higher bond yields will benefit value stocks. Chart 26 shows that there has been a close correlation between the US 30-year Treasury yield and the relative performance of global value versus growth stocks. Banks stand to gain from rising bond yields while tech could suffer (Chart 27). Chart 26Higher Bonds Yields Favor Value Stocks     The re-emergence of supply-side pressures could affect companies in a variety of unexpected ways. For example, Facebook and Google both rely heavily on revenue from advertising. But what is the point of trying to boost demand for your product if you already cannot produce enough of it? Companies such as Hershey and Kimberly-Clark are already cutting ad spending in response to supply-chain bottlenecks. Finally, tight supply conditions will catalyze more investment spending. This will benefit industrial stocks. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Special Report

Highlights Japan’s long-term weaknesses – a shrinking population, low productivity growth, excess indebtedness – are very well known. However, it still punches above its weight in the realm of geopolitics. Abenomics – sorry, Kishidanomics – can still deliver some positive surprises every now and then. As the global pandemic wanes, and China faces a historic confluence of internal and external risks, investors should begin buying the yen on weakness. Japanese industrials also are an attractive play in a global portfolio. While the yen will likely fare better than the dollar over the next 6-9 months, it will lag other procyclical currencies. Feature Japan has always been an “earthquake society,”  in which things seem never to change until suddenly everything changes at once. The good news for investors is that that change occurred in 2011 and the latest political events reinforce policy continuity. Why “Abenomics” Remains The Playbook Over ten years have passed since Japan suffered a triple crisis of earthquake, tsunami, and nuclear meltdown. In fact, the Fukushima nuclear crisis merely punctuated a long accumulation of national malaise: the country had suffered two “Lost Decades” and was in the thrall of the Great Recession, a rare period of domestic political change, and a rise in national security fears over a newly assertive China. The nuclear meltdown marked the nadir. The result of all these crises was a miniature policy revolution in 2012 – Prime Minister Shinzo Abe and the Liberal Democratic Party (LDP) returned to power and initiated a range of bolder policies to whip the country’s deflationary mindset and reboot its foreign and trade relations. The new economic program, “Abenomics,” consisted of easy money, soft budgets, and pro-growth reforms. It succeeded in changing Japan. Both private debt and inflation, which had fallen during the lost decades, bottomed after the 2011 crisis and began to rise under Abe (Chart 1). By the 2019 House of Councillors election, however,  Abe was running out of steam. Consumption tax hikes, the US-China trade war, and COVID-19 thwarted his plans of national revival. In particular, Abe hoped to capitalize on excitement over the 2020 Tokyo Olympics to hold a popular referendum on revising the constitution. Constitutional revision is necessary to legitimize the Self-Defense Forces and thus make Japan a “normal” nation again, i.e. one that can maintain armed forces. But the global pandemic interrupted. Until the next heavyweight prime minister comes along, Japan will relapse into its old pattern of a “revolving door” of prime ministers who come and go quickly. For example, the only purpose of Abe’s immediate successor, Yoshihide Suga, was to tie off loose ends and oversee the Olympics before passing the baton (Chart 2). Chart 1Abenomics Was Making Progress The next few Japanese prime ministers will almost inevitably lack Abe’s twin supermajority in parliament, which was exceptional in modern history (Chart 3). It will be hard for the LDP to expand its regional grip given that it holds a majority in all 11 of the regional blocks in which the political parties contend for seats based on their proportion of the popular vote (Table 1). Table 1LDP+ Komeito Regional Performance Short-lived, traditional prime ministers will not be able to create a superior vision for Japan and will largely follow in Abe’s footsteps.   In September Prime Minister Fumio Kishida replaced Suga – a badly needed facelift for the ruling Liberal Democrats ahead of the October 31 election. The LDP retained its single-party majority in the Diet, so Kishida is off to a tolerable start (Chart 4). But he is far from charismatic and will not last long if he fumbles in the upper house elections in July 2022. This gives him a little more than half a year to make a mark. Kishida will oversee a roughly 30-40 trillion yen stimulus package, or supplemental budget, by the end of this year. Japanese stimulus packages are almost always over-promised and under-delivered. However, given the electoral calendar, he will put together a large package that will not disappoint financial markets. His other goal will be to build on recent American efforts to cobble together a coalition of democracies to counter China and Russia. Japan’s Grand Strategy In Brief Chart 5Japan Exposed To China Trade Japan’s grand strategy over centuries consists of maintaining its independence from foreign powers, controlling its strategic geographic approaches to prevent invasion, and stopping any single power from dominating the eastern side of the Eurasian landmass. Originally the hardest part of this grand strategy was that it required establishing unitary political control over the far-flung Japanese archipelago. However, since the Meiji Restoration, Tokyo has maintained centralized government. Since then Japan has focused on controlling its strategic approaches and maintaining a balance among the Asian powers. During the imperialist period it tried to achieve these objectives on its own. After World War II, the United States became critical to Japan’s grand strategy. Through its broad alliance with Washington, Tokyo can maintain independence, make sure critical territories are not hostile (e.g. Taiwan and South Korea), and deter neighboring threats (North Korea, China, Russia). It can at least try to maintain a balance of power in Eurasia. Yet these constant national interests underscore Japan’s growing vulnerabilities today: China’s economy is now two-times larger than Japan’s and Japan is more dependent on China’s trade than vice versa (Chart 5). Under Xi Jinping, Beijing is actively converting its wealth into military and strategic capabilities that threaten Japan’s security. Rising tensions across the Taiwan Strait are fueling nationalism and re-armament in Japan.  Russia’s post-Soviet resurgence entails an ever-closer Russo-Chinese partnership. It also entails Russian conflicts with the US that periodically upset any attempts at Russo-Japanese détente. North Korea’s asymmetric war capabilities and nuclearization pose another security threat. South Korea’s attempts to engage with the North and China, and compete with Japan, are unhelpful.    All of these realities drive Japan closer to the United States. Even the US is increasingly unpredictable, though not yet to the point of causing serious doubts about the alliance. If the US were fundamentally weakened, or abandoned the alliance, Japan would either have to adopt nuclear weapons or accommodate itself to Chinese hegemony to meet its grand strategy. Nuclearization would be the more likely avenue. The stability of Asia depends greatly on American arbitration. Japan’s Strategy Since 1990 Beneath this grand strategy Japan’s ruling elites must pursue a more particular strategy suited to its immediate time and place. Ever since Japan’s working population and property bubble peaked in the early 1990s, the country’s relative economic heft has declined. To maintain stability and security, the central government in Tokyo has had to take on a very active role in the economy and society. The first step was to stabilize the domestic economy despite collapsing potential growth. This has been achieved through a public debt supercycle (Chart 6). Unorthodox monetary and fiscal policy largely stabilized demand, at the cost of the world’s highest net debt-to-GDP ratio. The economic adjustment was spread out over a long period of time so as to prevent a massive social and political backlash. Unemployment peaked in 2009 at 5.5% and never rose above this level. The ruling elite and the Liberal Democrats maintained control of institutions and government. The second step was to ensure continued alliance with the United States. Japan could deal with its economic problems – and the rise of China – if it maintained access to US consumers and protection from the US military. To maintain the alliance required making investments in the American economy, in US-led global institutions, and cooperating with the US on various initiatives, including controversial foreign policies. As in the 1950s-60s, Japan would bulk up its Self-Defense Forces to share the burden of global security with the United States, despite the US-written constitution’s prohibition on keeping armed forces. The third step was to invest abroad and put Japan’s excess savings to work, developing materials and export markets abroad while employing foreign workers and factories to become Japan’s new industrial base in lieu of the shrinking Japanese workforce (Chart 7).  Chart 6Japan's Public Debt Supercycle Japan’s post-1990 strategy has staying power because of the massive pressures on Japan listed above: China’s rise, Russo-Chinese partnership, North Korean threats, and American distractions. Investors tend to underrate the impact of these trends on Japan. Unless they fundamentally change, Japan’s strategy will remain intact regardless of prime minister or even ruling party. Russia’s role is less clear and could serve as a harbinger of any future change. President Vladimir Putin and Abe had the best chance in modern memory to resolve the two countries’ territorial disputes, build on mutual interests, and maybe even sign a peace treaty. But Russia’s clash with the West  proved an insurmountable obstacle. New opportunities could emerge at some later juncture, as Japan’s interest in preventing China from dominating Eurasia gives it a strong reason to normalize ties with Russia. Russia will at some point worry about overdependency on China. But this change is not on the immediate horizon.  Japan’s Tactics Since 2011 Japan is nearly a one-party state. Brief spells of opposition rule, in 1993 and 2009-11, are exceptions that prove the rule. The Liberal Democrats did not fall from power so much as suffer a short “time out” to reflect on their mistakes before voters put them right back into power. However, these timeouts have been important in forcing the ruling party to adjust its tactics for changing times, as with Abenomics. Kishida will not have enough political capital to change direction. The emphasis will still be on defeating deflation and rekindling animal spirits and corporate borrowing (as opposed to relying exclusively on public debt). Kishida has talked about a new type of capitalism and a more active redistribution of wealth, in keeping with the current zeitgeist among the global elite. However, Japan lacks the impetus for dramatic change. Wealth inequality is not extreme and political polarization is non-existent (Chart 8). The LDP is wary of losing votes to the populist Japan Innovation Party, or other regional movements, but populism does not have as fertile ground in countries with low inequality.  The desire to boost wages was a central plank of Abenomics (Chart 9) and an area of success. It will come through in Kishida’s policies as well. But the ultimate outcome will depend on how tight the labor market gets in the upcoming economic cycle. Similarly Kishida can be expected to encourage, or at least not roll back, women’s participation in the labor force, as labor markets tighten (Chart 10). As the pandemic wanes it is also likely that he will reignite Abe’s loose immigration policy, which saw the number of foreign workers triple between 2010 and 2020. This inflow is perhaps the surest sign of any that insular and xenophobic Japan is changing with the times to meet its economic needs.  Chart 9Kishidanomics To Build On Abe's Wage Growth Chart 10Women Off To Work But Fertility ##br##Relapsed The only substantial difference between Kishidanomics and Abenomics is that Abe compromised his reflationary fiscal efforts by insisting on going forward with periodic hikes to the consumption tax. Kishida is under no such expectation. Instead he is operating in a global political and geopolitical context in which ambitious public investments are positively encouraged even at the expense of larger budget deficits (Chart 11). Yet interest rates are still low enough to make such investments cheaply. The stage is set for fiscal largesse. Chart 11Fiscal Largesse To Continue Kishida can be expected to promote large new investments in supply-chain resilience, renewable energy, and military rearmament. The US and EU may exempt climate policies from traditional budget accounting – Japan may do the same. Even more so than China and Europe, Japan has a national interest in renewable energy since it is almost entirely dependent on foreign imports for its fossil fuels. The green transition in Japan is lagging that of Germany but the Japanese shift away from nuclear power has gone even faster, creating an import dependency that needs to be addressed for strategic reasons (Chart 12). Monetary-fiscal coordination began under Abe and can increase under Kishida. What is clear is that public investment is the top priority while fiscal consolidation is not. Military spending is finally starting to edge up as a share of GDP, as noted above. For many years Japanese leaders talked about military spending but it remained steady at 1% of GDP. Now, at the onset of the US-China cold war, the Japanese are spending more and say the ratio will rise to 2% of GDP (Chart 13). Tensions with China, especially over Taiwan, will continue to drive this shift, though North Korea’s weapons progress is not negligible. The Biden administration is prioritizing US allies and the competition with China, which makes the Japanese alliance top of mind. Tokyo’s various attempts to talk with Beijing in recent years have amounted to nothing, with the exception of the Regional Comprehensive Economic Partnership, which is far from ratification and implementation. Japan’s relations with China are driven by interests, not passing attitudes and emotions. If Biden proves too dovish toward China – a big “if” – then it will be Japan pushing the US to take a more hawkish line rather than vice versa. Japan will take various strategic, economic, technological, and military actions to defend itself from the range of external threats it faces. These actions will intimidate and provoke China and other neighbors, which will help to entrench the “security dilemma” between the US and China and their allies. For example, Japan will eagerly participate in US efforts to upgrade its military and its regional alliances and partnerships, including via the Quadrilateral Security Dialogue with India and Australia. The Biden administration might force Japan to play nice with South Korea and patch up their trade war. But that is a price Japan can pay since American involvement also precludes any shift by South Korea fully into China’s camp. If China should invade Taiwan – which we cannot rule out over the long run – Japan’s vital supply lines and national security would fall under permanent jeopardy. Japan would have an interest in defending Taiwan but its willingness to war with China may depend on the US response. However, both Japan and the US would have to draw a stark line in defense of Japanese territory, not least Okinawa, where US troops are based. Both powers would mobilize and seek to impose a strategic containment policy around China at that point. Until The Next Earthquake … For Japan to abandon its post-1990 strategy, it would need to see a series of shocks to domestic and international politics. If China’s economy collapsed, Korea unified, or the US abandoned the Asia Pacific region, then Tokyo would have to reassess its strategy. Until then the status quo will prevail. At home Japan would need to see a split within the Liberal Democrats, or a permanent break between the LDP and their junior partner Komeito, combined with a single, consolidated, and electorally viable opposition party and a charismatic opposition leader. This kind of change would follow from major exogenous shocks. Today it is nowhere in sight – the last two shocks, in 2011 and 2020, reinforced the LDP regime. Theoretically some future Japanese government could adopt a socialist platform that relies entirely on public debt rather than trying to reboot private debt. It could openly embrace debt monetization and modern monetary theory  rather than trying to raise taxes periodically to maintain the appearance of fiscal rectitude. But if it tried to distance itself from the United States and improve relations with Russia and China, such a strategy would not go very far. It would jeopardize Japan’s grand strategy. For the foreseeable future, Japan’s economic security and national security lie in maintaining the American alliance and continuing an outward investment strategy focused on emerging markets other than China. Macroeconomic Developments The key message from an economic context is that fiscal stimulus is likely to be larger in Japan than the market currently expects. The IMF is penciling in a fiscal deficit of around 2% of potential GDP next year, which will be a drag on growth (Chart 14). More likely, Kishida will cobble together a slightly larger package to implement most of the initiatives he has proposed on the campaign trail. Meanwhile, a large share of JGBs are about to mature over the next couple of years, providing room for more issuance, which the BoJ will be happy to assimilate (Chart 15). Chart 14More Fiscal Stimulus In Japan Likely Chart 15Lots Of JGBs Mature In The Next Few Years Real numbers on the size of the fiscal package have been scarce, but it should be around 30-40 trillion yen, spread over a few years. With Japan’s net interest expense at record lows (Chart 16), and a lot of the spending slated for worthwhile productivity-enhancing projects such as supply chains, green energy, education and some boost to the financial sector in the form of digital innovation and consolidation, we expect fiscal policy in Japan will remain moderately loose, with the BoJ staying accommodative. The timing of more fiscal stimulus is appropriate as Japan has managed to finally put the pandemic behind it. The number of new Covid-19 cases is at the lowest recorded level per capita, and Japan now  has more of its population vaccinated than the US. As a result, the manufacturing and services PMIs, which have been the lowest in the developed world, could stage a coiled-spring rebound. This will be a welcome fillip for Japanese assets (Chart 17). Chart 16Little Cost To Issuing More Debt Chart 17The Japanese Recovery Has Lagged Consumption could also surprise to the upside in Japan. With the consumption tax hike of 2019 and the 2020 pandemic now behind us, pent-up demand could finally be unleashed in the coming quarters. Rising wages and high savings underscore that Japan could see a vigorous rebound in consumption, as was witnessed in other developed economies. This will be particularly the case as inflation stays low. The big risk for Japan from a macro perspective is an external slowdown, driven by China. A boom in foreign demand has been a much welcome cushion for Japanese growth, especially amidst weak domestic demand. The risk is that this tailwind becomes a headwind as Chinese growth slows, especially as a big share of Japanese exports go to China. Our view has been that policy makers in China will be able to ring-fire the property crisis, preventing a “Lehman” moment. As such, while China’s slowdown is a reality and downside risks warrant monitoring, we also expect China to avoid a hard landing. Meanwhile, Japanese exports are also diversified, with other developed and emerging markets accounting for the lion’s share of total exports. For example, exports to the US account for 19% of sales while EU exports account for 9%. Both exports and foreign machinery orders remain quite robust, suggesting that the slowdown in China will not crush all external demand (globally, export growth remains very strong).  It is noteworthy that many countries now have “carte blanche” to boost infrastructure spending, especially in areas like renewable energy and supply chain resiliency. Japan continues to remain a big supplier of capital goods globally. This will ensure that an economic recovery around the world will buffer foreign machinery orders. Market Implications Japanese equities have underperformed the US over the last decade, and Kishidanomics is unlikely to change this trend. But to the extent that more fiscal stimulus helps lift aggregate demand, a few sectors could begin to see short-term outperformance. More importantly, the underperformance of certain Japanese equity sectors have not been fully justified by the improving earnings picture (Chart 18). This suggests some room for catch-up. Banks in particular could benefit from a steeper yield curve in Japan, rising global yields and proposed reform in the sector (Chart 19). We will view this as a tactical opportunity however, than a strategic call. Our colleagues in the Global Asset Allocation service have clearly outlined key reasons against overweighting Japan, and are currently neutral.  More importantly, industrials also look poised to see some pickup in relative EPS growth, as global industrial demand stays robust. An improvement in domestic demand should also favor small caps over large caps. Chart 18ADismal Earnings Explain Some Underperformance Of Japanese Equities Chart 18BDismal Earnings Explain Some Underperformance Of Japanese Equities Chart 19Japanese Banks Will Benefit From A Steeper Yield Curve Foreigners have huge sway over the performance of Japanese assets, especially equities. Foreign holders account for nearly 30% of the Japanese equity float. This is important not only for the equity call but for currency performance as well since portfolio flows dominate currency movements. Historically, the yen and the Japanese equity market have been negatively correlated. This was due to positive profit translation effects from a lower currency. However, it is possible that Japanese domestic profits are no longer driven only by translation effects, but rather by underlying productivity gains. This could result in less yen hedging by foreign equity investors, which would restore a positive relationship between the relative share price performance and the currency. As for the yen, the best environment for any currency is when the economy can generate non-inflationary growth. Japan may well be entering this paradigm. Historically, now has been the exact environment where the yen tends to do well, as the economy exits deflation and enters non-inflationary growth (Chart 20). Chart 20The Yen And Japanese Growth Markets have been wrongly focusing on nominal rather than real yields in Japan and the implication for the yen. Therefore the risk to a long yen view is that the Bank of Japan keeps rates low as global yields are rising. However, in an environment where global inflationary pressures normalize (say in the next 6-9 months) and temper the increase in global yields, this could provide room for short covering on the yen. In our view, the yen is already the most underappreciated currency in the G10, as rising global yields have led to a massive accumulation of short positions. Finally, from a valuation standpoint, the yen is the cheapest G10 currency according to our PPP models, and is also quite cheap according to our intermediate-term timing model (Chart 21). With the yen being a risk-off currency, it also tends to rise versus the dollar not only during recessions, but also during most episodes of broad-based dollar weakness. This low-beta nature of the currency makes it a good portfolio hedge in an uncertain world. Chart 21The Yen Is Undervalued Given the historic return of geopolitical risk to Japan’s neighborhood, as the US and Japan engage in active great power competition with China, the yen is an underrated hedge. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Chester Ntonifor Vice President Foreign Exchange Strategy chestern@bcaresearch.com