Euro Area
Highlights Portfolio Duration: The decline in US bond yields is overdone. We anticipate that strong US employment data will catalyze a jump in bond yields this fall and that the 10-year US Treasury yield will reach a range of 2% - 2.25% by the time that the Fed is ready to lift rates, likely by the end of 2022. Maintain below-benchmark duration in bond portfolios. US Yield Curve: Investors should position for a rebound in bond yields but not a reversal of recent US Treasury curve flattening. In fact, we advocate owning 2/10 flatteners on the US Treasury curve as we see ample room for further curve flattening as Fed rate hikes approach in late-2022. ECB: The ECB’s new forward interest rate guidance has moved it that much closer to the Fed’s ultra-accommodative stance. This reinforces the defensive nature of the European bond market. Investors should overweight European bonds within global fixed income portfolios with a particular emphasis on peripheral European bond markets like Italy and Spain. Feature Chart 1Can The Bond Rally Continue? The bond rally continues to rip. The selloff that started last August when Jay Powell officially announced the Federal Reserve’s adoption of an Average Inflation Target ended on March 31st 2021. Since then, the 10-year US Treasury yield has retraced from 1.74% to 1.29% and the Bloomberg Barclays US Treasury index has clawed back 285 bps of excess return versus cash, partially offsetting the 465 bps that were lost between August 2020 and March 2021 (Chart 1). The US Bond Strategy Weekly Report from two weeks ago and last week’s Global Fixed Income Strategy Weekly Report both discuss the reasons for recent bond market strength.1 We won’t re-hash those arguments this week except to reiterate our conclusion that the decline in US bond yields is overdone. We anticipate that strong US employment data will catalyze a jump in bond yields this fall and that the 10-year US Treasury yield will reach a range of 2% - 2.25% by the time that the Fed is ready to lift rates, likely by the end of 2022. The first section of this week’s report looks at whether correlations between different asset classes have held up during the recent bond rally, with a focus on whether those relationships give us any information about the near-term direction for bond yields. The second section considers the outlook for the slope of the US Treasury curve and the third section discusses the recently released results of the European Central Bank’s strategy review. Cross-Market Correlations During The Bond Rally The bond rally has been just as intense as the prior sell-off. The US Treasury index has outperformed a position in cash by an annualized 9% since March 31st, matching the annualized losses of 9% seen between August 2020 and March 2021 (Chart 2). An important question to answer is whether this bond market performance is consistent with other asset classes. If it is, then it may suggest that the economy is experiencing a deflationary episode and that bond yields have further downside. If it isn’t, then it is more likely that the drop in bond yields will be temporary. Chart 2Bonds Versus Credit And Equities Bonds Versus Equities And Corporate Credit Chart 3Equity Sector Performance Consistent With Yields Looking first at corporate bonds, we find that – consistent with stronger Treasury performance – excess US corporate bond returns have slowed since March 31st. Baa-rated corporates have been outperforming at an annualized rate of 3% since March 31st compared to an annualized rate of 12% between August 2020 and March 2021 (Chart 2, panel 2). Equities, on the other hand, have maintained their strong performance. The S&P 500 returned an annualized 30% between August 2020 and March 2021 and has returned an even greater 42% (annualized) since the end of March (Chart 2, panel 3). Extremely tight spreads are the most likely explanation for lower corporate bond excess returns. Meanwhile, the fact that equities continue to perform well is an indication that the drop in bond yields may be overdone. Interestingly, while overall equity returns haven’t dropped in line with bond yields, the relative performance of equity sectors has been totally consistent with the movement in yields (Chart 3). Cyclical equity sectors (Industrials, Energy and Materials) have underperformed defensive equity sectors (Healthcare, Telecoms, Consumer Staples and Utilities) and Banks have underperformed the overall index. The correlation between long-maturity real Treasury yields and the relative performance of value and growth stocks has also held up, with growth stocks outperforming since the end of March (Chart 3, bottom panel). Bonds Versus Commodities Chart 4Commodities And Bonds Have Diverged We see the biggest divergence in relative performance between bond yields and commodities. Historically, the ratio between the CRB Raw Industrials commodity price index and Gold is tightly correlated with the 10-year US Treasury yield. However, the CRB/Gold ratio has increased since the end of March while bond yields have fallen (Chart 4). In our view, this is the strongest piece of evidence suggesting that bond yields have overshot to the downside. Bonds Versus Currencies Chart 5Bonds Versus Currencies Finally, we observe that the US dollar has strengthened as bond yields have dropped. This is not that unusual. There are other periods when significant declines in US bond yields have coincided with dollar strength, 2019 and 2014/15 immediately come to mind (Chart 5). The common theme of those prior episodes is that the global economy was experiencing a deflationary shock. Commodity prices also fell during those periods and Emerging Market (EM) currencies depreciated versus the dollar. However, so far this year, EM currencies have held firm versus the dollar (Chart 5, bottom panel) and commodity prices continue to rise. On balance, financial markets don’t appear to be pricing-in a deflationary economic shock. In summary, since US Treasury yields peaked on March 31st, we have observed a sector rotation within US equities, but overall stock market performance has been strong. Corporate bonds continue to outperform Treasuries, though gains are limited by tight valuations. Commodity prices have held up and while the US dollar has firmed, dollar strength has not bled into EM currency weakness. All in all, we don’t view financial market performance as consistent with a deflationary economic episode. This suggests that bond yields are an outlier within the financial landscape and that the recent drop in yields won’t persist. A Quick Word On Sentiment And Positioning Chart 6A Rebound In Yields May Require A Shift In Sentiment One possible reason why bond performance has been inconsistent with some other markets is that there had simply been too much consensus around the “bond-bearish trade”. It’s certainly true that portfolio managers have been running large net-short positions and that the MarketVane survey of bond bullish sentiment is much less bullish than it was last year (Chart 6). We suspect that we may need to see bond market positioning and sentiment get more bullish before yields move meaningfully higher. Chart 6 shows that major troughs in the 30-year US Treasury yield often occur when portfolio manager positioning is “net long” bonds and when bond bullish sentiment is significantly higher than current levels. For this reason, we don’t anticipate an immediate rebound in bond yields. Rather, we suspect that yields will remain near current levels for the next month or two before strong employment data in the fall sets off the next phase of bearish bond action. Position For A Rebound In Bond Yields, But Don’t Expect Much Curve Steepening Chart 7The 5-Year/5-Year Yield Remains Close To Target We see bond yields re-gaining their March 2021 highs, and then some, on a 6-12 month investment horizon. However, we don’t think this rebound in yields will coincide with a significant re-steepening of the US Treasury curve. For context, the 2/10 US Treasury slope peaked at 159 bps near the end of March. It is currently 51 bps lower, at 108 bps. We can categorize periods of yield curve steepening as falling into two categories. Bull-steepening: The curve steepens as yields fall. This tends to occur when the Fed is cutting interest rates. Bear-steepening: The curve steepens as yields rise. We can identify these periods as being when the 5-year/5-year forward Treasury yield rises from low levels toward its fair value range. Since 2012, we can identify a fair value range for the 5-year/5-year forward US Treasury yield using survey estimates of the long-run neutral fed funds rate. At present, the fair value range from the New York Fed’s Survey of Primary Dealers is from 2.06% to 2.50%, with a median of 2.31%. The fair value range from the New York Fed’s Survey of Market Participants is from 1.75% to 2.50%, with a median of 2.00%. The 5-year/5-year forward US Treasury yield is currently 1.93% (Chart 7). We identify seven significant periods of 2/10 Treasury curve steepening since 2009 (Table 1). Six of those episodes were bear-steepening episodes that coincided with an increase in the 5-year/5-year yield, the other was a bull-steepening episode that coincided with Fed rate cuts in 2019/20. If we assume that our fair value ranges provide a reasonable target for how high the 5-year/5-year forward US Treasury yield can rise during the next bear-steepening move, it means that – at most – we could see an increase of 57 bps in the 5-year/5-year yield as it moves all the way up to the 2.50% top-end of our target ranges. A linear regression of changes in the 2/10 slope versus changes in the 5-year/5-year forward yield during the six bear-steepening episodes we identified suggests that a 57 bps increase in the 5-year/5-year yield would lead to 12 bps of 2/10 curve steepening (Chart 8). In fact, we can see in both Table 1 and Chart 8 that it would take about 100 bps of upside in the 5-year/5-year yield to bring the 2/10 slope back to its March highs. This is extremely unlikely. Table 1Periods Of US Treasury Curve Steepening In The Zero-Lower-Bound Era Chart 8Bear-Steepening Episodes Since 2009 In fact, if the 5-year/5-year forward Treasury yield only rises back to the middle of its fair value range – somewhere between 2% and 2.31% - then our regression suggests that the yield curve slope will probably stay close to its current level. The bottom line is that while investors should position for a rebound in bond yields by keeping portfolio duration low, they should avoid US Treasury curve steepeners. In fact, we advocate owning 2/10 flatteners on the US Treasury curve as we see ample room for further curve flattening as Fed rate hikes approach in late-2022. The ECB’s New Guidance Solidifies The Defensive Nature Of European Bonds Last week, the European Central Bank (ECB) revised its forward rate guidance in light of its recently concluded Strategy Review.2 The ECB’s new rate guidance is as follows: In support of its symmetric two per cent inflation target and in line with its monetary policy strategy, the Governing Council expects the key ECB interest rates to remain at their present or lower levels until it sees inflation reaching two per cent well ahead of the end of its projection horizon and durably for the rest of the projection horizon, and it judges that realised progress in underlying inflation is sufficiently advanced to be consistent with inflation stabilising at two per cent over the medium term. This may also imply a transitory period in which inflation is moderately above target.3 This may sound familiar, and it should. Though not explicitly an Average Inflation Target, the ECB has moved a long way toward the Federal Reserve’s new dovish reaction function. Specifically, both the ECB and Federal Reserve now acknowledge that a temporary period of above-2% inflation will be tolerated, if not explicitly sought. Also, both central banks have linked the timing of the first rate increase to some form of outcome-based forward guidance. The Federal Reserve has explicitly said that it will not lift rates until inflation is above 2% and the economy has reached “maximum employment”. The ECB now claims that interest rates won’t rise until inflation is seen reaching 2% “well ahead of its projection horizon”, a criterion that Christine Lagarde described as having an element of outcome-based guidance.4 The ECB’s new forward guidance may not be as explicitly dovish as the Fed’s. The ECB has no “maximum employment” target and its inflation trigger for lifting rates still relies on the Governing Council’s forecasts. But for investors, the big signal is that the ECB has recognized that the risk of tightening policy prematurely is greater than the risk of remaining on hold for too long. This gives us even more confidence that there will be no ECB tightening on the horizon, and we should continue to view European bond markets as being highly defensive. This is hardly news. European bond markets performed relatively well during the bearish bond episode that lasted from August 2020 to March 2021, they have then gained less than cyclical bond markets (like US and Canada) since March (Table 2). The ECB’s new reaction function ensures that this relationship will remain place for many years to come. Table 27-10 Year Government Bond Returns (In USD, %) The new reaction function is also a boon for peripheral European bond markets (like Italy and Spain) where yields trade at a spread above German bunds. The ECB’s commitment to staying dovish will only reinforce the downward pressure on peripheral European bond spreads versus Germany (Chart 9). Chart 9Grab The Extra Spread In Spanish And Italian Bonds The bottom line is that investors should continue to overweight European bonds within global fixed income portfolios, with a particular emphasis on peripheral European bond markets like Italy and Spain. The defensive nature of European bonds will protect investors from losses during the next move higher in global yields. Italian and Spanish bond markets may not perform quite as well during the next bond bear market as they did between August 2020 and March 2021, as spreads have already compressed a lot. But ultra-accommodative ECB policy will limit the amount of spread widening that can occur, making any additional spread worth grabbing. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Overreaction”, dated July 13, 2021 and Global Fixed Income Strategy Weekly Report, “The Message From Falling US Bond Yields”, dated July 21, 2021. 2 The results of the Strategy Review itself are discussed in Global Fixed Income Strategy Weekly Report, “The Reflationary Backdrop Is Still In Place”, dated July 14, 2021. 3 https://www.ecb.europa.eu/press/pr/date/2021/html/ecb.mp210722~48dc3b436b.en.html 4 https://www.ecb.europa.eu/press/pressconf/2021/html/ecb.is210722~13e7f5e795.en.html Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns
ECB messaging indicates that the central bank is in no rush to tighten policy. ECB President Christine Lagarde highlighted in a Bloomberg Television interview over the weekend that the pandemic remains a threat and that the central bank will continue to…
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Highlights Q2/2021 Performance Breakdown: Our recommended model bond portfolio underperformed the custom benchmark index by -6bps during the second quarter of the year. Winners & Losers: The government bond side of the portfolio underperformed by -21bps, led overwhelmingly by our underweight to US Treasuries (-18bps). Spread product allocations outperformed by +15bps, primarily due to overweights on US high-yield (+11bps) and US CMBS (+3bps). Portfolio Positioning For The Next Six Months: We are maintaining an overall below-benchmark portfolio duration stance, against a backdrop of persistent above-trend global growth and a highly stimulative fiscal/monetary policy mix. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield where valuations look the least stretched. We are making two changes to the portfolio allocations heading into Q3: shifting the Treasury curve exposure to have more of a flattening bias, while downgrading EM USD-denominated corporates to neutral. Feature The trend in global bond yields so far in 2021 has been a tale of two quarters. The first three months of the year saw a surge in yields worldwide on the back of rapidly improving economic data, the rollout of COVID-19 vaccines and supply squeezes triggering rapid increases in inflation. During the second three months of the year, however, global yields drifted a bit lower in response to more mixed economic data, the spread of the Delta variant and slightly hawkish shifts from a few key central banks – most notably, the Fed – even with economic confidence measures remaining upbeat across the developed economies. The decline in yields has not been seen across the maturity spectrum, though. The yield-to-maturity of the Bloomberg Barclays Global and US Treasury 10+ year indices fell by -12bps and -30bps, respectively, from recent peaks. At the same time, shorter term bond yields have been relatively stable as central banks continue to signal that interest rate hikes are still well off into the future. In contrast to government bonds, credit markets have remained calm with spreads tight for developed market corporates and emerging market (EM) debt. With that in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the second quarter of 2021. We also present our recommended positioning for the portfolio for the next six months (Table 1), as well as portfolio return expectations for our base case and alternative investment scenarios. The latter half of 2021 should prove to be even more challenging for bond investors, who must disentangle less consistent messages across countries on the Delta variant, vaccinations, inflation and the outlook for both monetary and fiscal policy. Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q2/2021 Model Bond Portfolio Performance: Mixed Returns Chart 1Q2/2021 Performance: Credit Gains & Duration Losses The total return for the GFIS model portfolio (hedged into US dollars) in the second quarter was +1.13%, slightly underperformed the custom benchmark index by -6bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -21bps of underperformance versus our custom benchmark index while the latter outperformed by +15bps. We have remained significantly underweight US Treasuries and positioned for a bearish steepening of the US Treasury curve since just before last year's US presidential election. That tilt was a big contributor to the excess return of the portfolio in Q1 (+63bps) that was partially given back (-18bps) in Q2 as longer maturity Treasury yields fell during the quarter. Our inflation-linked bond allocations in the US and Europe (+5bps) helped mitigate the loss on the government bond side from our below-benchmark duration stance and general curve steepening bias in most countries in the portfolio (Table 2). Table 2GFIS Model Bond Portfolio Q2/2021 Overall Return Attribution The sum of excess returns during the quarter from countries that we overweighted (Germany, France, Italy, Spain, and Japan) was zero. Improving growth momentum and stronger economic confidence helped push yields higher in those countries. Therefore, those positions could not offset the losses from the underweight to US Treasuries. We did make two shifts in the country allocation within the government bond portion of the portfolio during Q2, downgrading Canada to underweight on April 20 and upgrading Australia to overweight on June 9. Neither change meaningfully contributed to the return of the portfolio. Meanwhile, our moderate overall overweight tilt on spread product versus government bonds fueled the outperformance from the credit side of the portfolio, led by US high-yield (+11bps) and US CMBS (+3bps). Overall gains from spread product were impressive in both USD-hedged total return terms (+95bps) and relative to our custom benchmark (+15bps), despite spreads entering Q2 at fairly tight levels. In the second quarter, improving economic confidence and easing credit conditions allowed spreads to narrow even further for corporate debt in the US and Europe, as well as for EM USD-denominated credit. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q2/2021 Government Bond Performance Attribution Chart 3GFIS Model Bond Portfolio Q2/2021 Spread Product Performance Attribution By Sector Biggest Outperformers: Overweight US high-yield: Ba-rated (+5bps), B-rated (+4bps), and Caa-rated (+3bps) Overweight US TIPS (+4bps) Overweight US CMBS (+3bps) Overweight Euro Area high-yield (+1bps) Biggest Underperformers: Underweight US Treasuries with a maturity greater than 10 years (-17bps), Underweight US Treasuries with a maturity between 7 and 10 years (-3bps) Underweight US Treasuries with a maturity between 5 and 7 years (-2bps) Underweight EM USD sovereigns (-1bps) Underweight UK GIlts with a maturity greater than 10 years (-1bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q2/2021. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q2 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q2/2021 Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. In Q2, the picture on that front was mixed. We were only neutral some of the biggest outperformers like UK Gilts (+312bps in USD-hedged duration-matched total return terms) and investment grade credit in the US (+430bps) and UK (+231bps). Our relative value allocation within EM, overweight corporates (+430bps) versus sovereigns (+527bps), also underperformed during Q2. We remained overweight government debt markets in the euro area which were the worst performers during the quarter (Germany: -25bps, Spain: -59bps, Italy: -67bps, and France: -83bps). The news was better on the credit side, where our significant overweight to US high-yield (+146bps) was a big positive contributor, as were overweights to US CMBS (+137bps) and euro area high-yield (+92bps). Bottom Line: Our model bond portfolio slightly underperformed its benchmark index in the second quarter of the year by -6bps – a negative result mainly driven by our underweight allocation to the US Treasury market but with an overweight to US high-yield providing a meaningful offset. Future Drivers Of Portfolio Returns & Scenario Analysis Looking ahead, the performance of the model bond portfolio will continue to be driven primarily by swings in global government bond yields, most notably US Treasuries. Our most favored cyclical indicators for global bond yields are still, in aggregate, signaling more upside potential over at least the next six months, although the nature of the signal is changing (Chart 5). Our Global Duration Indicator, comprised of leading economic indicators and measures of future economic sentiment, remains elevated but appears to have peaked. At the same time, the global manufacturing PMI, which typically leads global real bond yields by around six months, continues to climb to new cyclical highs. This suggests that the recent downdraft in global real bond yields could prove to be short-lived. Our Global Central Bank Monitor is climbing steadily, indicating greater upward pressure on bond yields from the combination of strong growth, rising inflation and loose financial conditions. Admittedly, bond yields are lagging the upward trajectory implied by the Monitor with central banks deliberately responding far more slowly to the cyclical pressures that would have triggered bond-bearish monetary tightening in the past. Nonetheless, the Monitor, the Global Duration Indicator and the global manufacturing PMI and all sending the same message – global bond yields remain too low, suggesting a below-benchmark overall portfolio duration stance remains appropriate. With regards to country allocation within the government bond side of our model portfolio, we continue to overweight countries where central banks are less likely to begin normalizing pandemic-era monetary policy quickly (Germany, France, Italy, Spain, Japan, Australia), while underweighting countries where normalization is expected to begin within the next 6-12 months (the US and Canada). We remain neutral the UK, although we have them on “downgrade watch” until there is greater clarity on how severely the spread of the Delta variant is impacting UK growth. The US remains the biggest underweight. The modestly hawkish turn by the Fed at the June FOMC meeting likely marked the end of the cyclical bear-steepening trend of the US Treasury curve. A full-blown turn to a bear-flattening of the US curve will be slow to develop, but we fully expect the cyclical pressures that drove the underperformance of longer-maturity US Treasuries over the past year to begin leaking into shorter-maturity bonds. That trend already appears to be underway with 5-year US yields starting to drift upward at a faster pace compared to other developed market peers (Chart 6). Chart 5Cyclical Indicators Suggest Global Yields Still Have More Upside Chart 6UST Underperformance Will Shift To Shorter Maturities This leads us to make a change to our model portfolio allocations this week, reducing the exposure to the belly of the US Treasury curve (the 3-5 year and 5-7 year maturity buckets), while modestly increasing the allocation to the 7-10 year bucket. To neutralize the duration-extending implication of that marginal shift, we added a new allocation to US Treasury bills, thus turning this US Treasury shift into a “butterfly” trade, essentially selling the 5-year bullet for a cash/10-year barbell. Longer-term Treasury yields, however, are still in the process of working off an oversold condition that developed in Q1 (Chart 7). Duration positioning remains quite short, according to the JP Morgan survey of bond investors, while speculators are still working off a huge net short position in 30-year Treasury futures according to data from the CFTC. We anticipate that it will take another month or two to work off such an extreme oversold condition for US Treasuries, based on similar episodes over the past two decades. After that, longer-maturity Treasury yields will begin to begin climbing again, to the benefit of the US underweight (and below-benchmark duration stance) in our model portfolio. Chart 7Longer-Maturity USTs Working Off Oversold Condition Chart 8A Sharply Diminished Impulse From Global QE Outside the US, the bond-friendly impact of quantitative easing programs is fading, on the margin, with the growth of central bank balance sheets slowing (Chart 8). While outright tapering of bond buying has only occurred in Canada and the UK (within our model bond portfolio universe), we expect the Fed to begin tapering in early 2022. Financial stability concerns are expected to play an increasingly important role in future tapering decisions, with house prices booming in many countries, most notably Canada which supports our underweight stance on Canadian government debt. Australia is the notable exception to this trend towards slowing balance sheet growth, with the Reserve Bank of Australia (RBA) maintaining a healthy pace of bond buying given underwhelming realized inflation. The recent wave of COVID-19 cases, which has left half of Australia under lockdowns that were largely avoided in 2020, will ensure that the RBA stays dovish for longer, to the benefit of our overweight stance on Australian government bonds. We continue to see the overall dovish stance of global central bankers as being conducive to the outperformance of inflation-linked bonds versus nominal government debt. However, inflation breakevens in most countries have largely completed the rebound from the depressed levels reached during the 2020 COVID-19 global recession. Our Comprehensive Breakeven Indicators combine three measures to determine the upside potential for 10-year inflation breakevens: the distance from fair value based on our models, the spread between headline inflation and central bank target inflation, and the gap between market-based and survey-based measures of inflation expectations. Those indicators suggest that the most attractive markets to position for further upside potential for breakevens are in Italy and France, with breakevens looking more stretched in the US, Canada and Australia (Chart 9). On the back of this, we are maintaining our allocations to inflation-linked bonds in the euro area in our model portfolio. Chart 9Less Scope For Wider Global Inflation Breakevens Chart 10Fading Support For Credit Markets From Global QE Moving our attention to the credit side of our model portfolio, we feel that a moderate overweight stance on overall global corporates versus governments remains appropriate. However, the slowing trend in developed market central bank balance sheets, as an indicator of the incremental shift away from the COVID-era monetary policies from 2020, is flashing a warning sign for the performance of global spread product. The annual growth rate of the combined balance sheets of the Fed, ECB, Bank of Japan and Bank of England has been an excellent leading indicator of the excess returns of both global investment grade and high-yield corporates over the past decade (Chart 10). That growth rate peaked back in February of this year, suggesting a peak of global corporate bond excess returns around February 2022 Although given the current tight level of global corporate bond spreads, both for investment grade and high-yield, we expect future return outperformance from corporates versus government debt to come from carry rather than spread compression. Our preferred measure of the attractiveness of credit spreads is the historical percentile ranking of 12-month breakeven spreads, which measure how much spreads would need to widen to eliminate the carry advantage over duration-matched government bonds on a one-year horizon. Currently, only the lower-rated high-yield credit tiers in the US and euro area offer 12-month breakeven spreads above the bottom quartile of their history, within the credit sectors of our model portfolio (Chart 11). Chart 11Lower-Rated High-Yield Offers Relatively Attractive Spreads Given the sharply reduced default risks on both sides of the Atlantic, and with nominal growth in good shape amid low borrowing rates, we are maintaining our overweights to high-yield bonds in both the US and euro area. At the same time, we are sticking with only a neutral stance on investment grade corporates in the US, euro area and the UK. We do anticipate starting to reduce the overall corporate bond exposure later this year, however, based on the ominous leading signal from the growth of central bank balance sheets – and what that signals about the future path for global monetary policy. Within the euro area, we continue to prefer owning Italian government bonds (and to a lesser extent, Spanish government debt) over investment grade corporates, given the more explicit support for the sovereigns through ECB quantitative easing (Chart 12). We expect the ECB to be the most accommodative central bank within our model portfolio universe over at least the next year, with even tapering of any kind unlikely in 2022. Chart 12Favor Italian BTPs Over Euro Area Investment Grade One area of the spread product universe where we are starting to reduce risk in the model portfolio is EM USD-denominated credit. EM debt has benefited from a bullish combination of global policy stimulus, a weakening US dollar and rising commodity prices over the past year. We have positioned for that in our model portfolio through an overall overweight stance on EM USD-denominated debt, but one that favors investment grade corporates over sovereigns. Now, all of those supportive factors for EM credit are fading. Chinese policymakers have reigned in both credit stimulus and fiscal stimulus this year, with the combined impulse suggesting a slower pace of Chinese economic growth in the latter half of 2021 (Chart 13). Given China’s huge share of the global consumption of industrial commodities, slowing Chinese growth should cool the momentum of commodity prices over the next few quarters. A slowing liquidity impulse from global central bank asset purchases is also a negative for EM debt performance, on the margin. The same can be said for the US dollar, which is no longer depreciating as markets start to pull forward the expected future path for US interest rates (Chart 14). A stronger US dollar typically correlates with softer commodity prices and wider EM credit spreads. Chart 13Major EM Risks: China Tightening & Global QE Tapering Chart 14EM Supportive USD Weakness Is Fading In response to these growing risks to the bullish EM backdrop - including the rapid spread of the Delta variant made worse by the less-effective vaccines available in those countries - we are downgrading our overall EM USD credit exposure in the model bond portfolio to underweight from neutral. We are doing this by cutting the EM corporate exposure from overweight to neutral, while maintaining an underweight tilt on EM USD sovereigns. We expect to further cut the EM exposure in the coming months by moving to a full underweight on EM corporates. Summing it all up, our overall allocations and risks in our model portfolio leading into Q3/2021 look like this: An overall below-benchmark stance on global duration, equal to nearly one full year versus the custom index (Chart 15) A moderate overweight stance on global spread product versus government debt, equal to five percentage points of the portfolio (Chart 16). This overweight comes almost entirely from overweight allocations to US and euro area high-yield corporate debt. Chart 15Overall Portfolio Duration: Stay Below Benchmark Chart 16Overall Portfolio Allocation: Small Spread Product Overweight After the changes made to our US Treasury and EM positions, the tracking error of the portfolio, or its expected volatility versus that of the benchmark index, is quite low at 34bps (Chart 17). The main reason for this is that our positioning remains focused heavily on the US (Treasury underweight, high-yield overweight), with much of the other positioning close to neutral or largely offsetting other positions in a relative value sense (overweight Australia vs underweight Canada, overweight US CMBS versus underweight US Agency MBS). This fits with our desire to maintain only a moderate level of overall portfolio risk. The yield of the portfolio is now slightly higher than that of the benchmark, with a small “positive carry”, hedged into USD, of 13bps (Chart 18). Chart 17Overall Portfolio Risk: Moderate Chart 18Overall Portfolio Yield: Small Positive Carry Vs. Benchmark Scenario Analysis & Return Forecasts After making the shifts to our model bond portfolio allocations in the US and EM, we now turn to scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 2A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 2B). For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios. We see global growth momentum and the Fed monetary policy outlook as the two most important factors for fixed income markets in the second half of 2021, thus our scenarios are defined along those lines. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes Table 2BEstimated Government Bond Yield Betas To US Treasuries Base Case Global growth stays above-trend in both Q3 and Q4, putting downward pressure on unemployment rates and keeping realized inflation elevated. Ongoing global vaccinations lead to more of the global economy fully reopening, with the Delta variant not having serious widespread impact on economic confidence outside of parts of the emerging world. Excess savings built up during the pandemic are run down by both consumers and businesses as optimism stays ebullient within the developed economies. China credit tightening slows growth enough to cool off upward commodity price momentum. At the same time, falling US unemployment and surprisingly “sticky” domestic US realized inflation embolden the Fed to signal a move to begin tapering its bond purchases starting in January 2022. Real bond yields globally bottom out, while inflation expectations recover some of the pullback seen in Q2/2021. The entire US Treasury curve shifts higher, led by the 10-year reaching 1.65% and a modest bear-flattening of the 5-year/30-year curve. The VIX stays near 15, the US dollar rises +3%, the Brent oil price goes nowhere and the fed funds rate is unchanged at 0% Upside Growth Surprise The Delta variant proves to be far less deadly than feared. A rapid pace of global vaccinations leads to booming growth led by the US but including a fully reopened euro area. Chinese policymakers begin to reverse some of the H1/2021 credit tightening. Unemployment rates rapidly fall worldwide, while supply bottlenecks persist, keeping upward pressure on realized inflation. Markets pull forward the timing and pace of future central bank interest rate hikes, most notably in the US when the Fed begins tapering bond purchases sooner than expected before year-end. Real bond yields drift higher globally, but inflation breakevens stay elevated with the earlier surge in realized inflation proving not to be “transitory”. The US Treasury curve modestly bear-flattens, with the 10-year reaching 1.9% and the 5-year/30-year spread narrowing by 25bps. The VIX rises to 25 as risk assets struggle in response to rising bond yields even with faster growth. The US dollar falls -5% on the back of improving global growth expectations, the Brent oil price climbs +5% and the fed funds rate stays unchanged. Downside Growth Surprise The global economy gets hit on multiple fronts: the rapid spread of the Delta variant overwhelms the positive momentum on vaccinations, most notably in EM countries; Europe struggles to fully reopen; China policy tightening results in a larger-than-expected drag on global growth; and US households are reluctant to draw down on excess savings after government income support measures expire in September. Diminished economic optimism leads to a pullback in global equity values, lower government bond yields and wider global credit spreads. The US Treasury curve bull flattens as longer-maturity yields fall in a risk-off move, with the 10-year yield moving back down to 1.25% alongside lower inflation breakevens. The VIX rises to 30, the safe-haven US dollar rises +5%, the Brent oil price falls -10% and the fed funds rate stays at 0%. Chart 19Risk Factor Assumptions For The Scenario Analysis Chart 20US Treasury Yield Assumptions For The Scenario Analysis The inputs into the scenario analysis are shown in Chart 19 (for the USD, VIX, oil and the fed funds rate), while the US Treasury yield scenarios are in Chart 20. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A (the scenarios for the changes in US Treasury yields are shown in Table 3B). Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis The model bond portfolio is expected to deliver a positive excess return over the next six months of +46bps in the base case scenario and +28bps in the optimistic growth scenario, but is projected to underperform by -36bps in the pessimistic growth scenario. Bottom Line: We are maintaining an overall below-benchmark portfolio duration stance, against a backdrop of persistent above-trend global growth and a highly stimulative fiscal/monetary policy mix. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield where valuations look the least stretched. We are making two changes to the portfolio allocations heading into Q3: shifting the Treasury curve exposure to have more of a flattening bias, while downgrading EM USD-denominated corporates to neutral. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high-quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
The French presidential election is nine months away, and it is already starting to catch investors’ attention as one of the main political events in Europe in 2022. According to BCA Research’s European Investment Strategy & Geopolitical Strategy…
Highlights The US is withdrawing from the Middle East and South Asia and making a strategic pivot to Asia Pacific. The third quarter will see risks flare around Iran and the US rejoin the 2015 Iranian nuclear deal. The result is briefly negative for oil prices but the rise of Iran is a new geopolitical trend that will increase Middle Eastern risk over the long run. The geopolitical outlook is dollar bullish, while the macroeconomic outlook is getting less dollar-bearish due to China’s risk of over-tightening policy. Stay neutral USD and be wary of commodities and emerging markets in the third quarter. European political risk is bottoming. The German and French elections are at best minor risks. However, the continent is ripe for negative black swans, especially due to Russian aggression. Go tactically long global large caps and defensives. Feature Chart 1Three Key Views On Track (So Far) We chose “No Return To Normalcy” as the theme of our 2021 outlook. While the COVID-19 vaccine promised economic recovery, we argued that normalization would create complacency regarding fundamental changes that have taken place in the geopolitical environment. A contradiction between an improving macroeconomic backdrop and a foreboding geopolitical backdrop would develop in 2021 and beyond. The “reflation trade” has begun to lose steam as we go to press. However, global recovery will still be the dominant story in the second half of the year as vaccination spreads. The question for the third quarter and the rest of the year is whether reflation will continue. As a matter of forecasting, we think it will. But as a matter of investment strategy, we are taking a more defensive stance until China relaxes economic policy. In our annual outlook we highlighted three key geopolitical views: (1) China’s headwinds, both at home and abroad (2) US détente with Iran and pivot to Asia (3) Europe’s opportunity. All three trends are broadly on track and can be illustrated by looking at equity performance in the relevant regions for the year so far: Chinese stocks sold off, UAE stocks rallied, and European stocks rallied (Chart 1). However, these trends are not exclusively tied to absolute equity performance. The most important question is what happens to global growth and the US dollar as these three key views continue. Stay Neutral On The Dollar It paid off for us to maintain a neutral stance on the dollar. True, the global recovery and exorbitant US trade and budget deficits are bearish for the dollar and bullish for other currencies. But the greenback’s “counter-trend bounce” is proving more formidable than many investors expected. The fundamentals of the American economy and global position remain strong. Since the outbreak of COVID-19, the US has secured its recovery with fiscal policy, maintained rule of law amid a contested election, innovated and distributed vaccines, benefited from more flexible social restrictions, refurbished global alliances, and put pressure on its geopolitical rivals. In essence, the combined effect of President Trump’s and Biden’s policies has been to make America “great again” (Chart 2). From a geopolitical perspective, the dollar is appealing. Chart 2Trump-Biden Make America Great Again? In addition, the first two geopolitical views mentioned above – China’s headwinds and the US-Iran détente – imply a negative environment for China and the renminbi. The reason for the US to do a suboptimal deal with Iran, both in 2015 and 2021, is to reduce the risk of war and buy time to enable a strategic pivot to Asia Pacific. Three US presidents have been elected on the pledge to conclude the “forever wars” in the Middle East and South Asia. Biden is withdrawing US troops from Afghanistan in September. There can be little doubt Biden is committed to an Iran deal, which is supposed to free up the US’s hands (Chart 3). Meanwhile the US public and Congress are unified in their desire to better defend US interests against China’s economic and military rise. There has not yet been a stabilization of US-China policies. Biden is not likely to hold a summit with Chinese President Xi Jinping until late October at earliest – and that is a guess, not a confirmed summit. The Biden administration has completed its review of China policy and is maintaining the Trump administration’s hawkish posture, as predicted. The US and China may resume their strategic and economic dialogue at some point but it is impossible to go back to the status quo ante 2015. That was the year the US adopted a more confrontational stance toward China – a stance later supercharged by Trump’s election and trade tariffs. The hawkish consensus on China is one of the rare unifying factors in a deeply divided America. The Biden administration explicitly says the US-China relationship is now defined by “competition” instead of “engagement.”1 One exception to this neutral view on the dollar has been our decision to go long the Japanese yen and Swiss franc, which has not panned out so far. Our reasoning is that geopolitical risk will boost these currencies but otherwise the reduction of geopolitical risk will weigh on the dollar in the context of global growth recovery. So far geopolitical risk has remained subdued while the US dollar has outperformed. We are still sympathetic to these safe-haven currencies, however, as they are attractively valued as long as one expects geopolitical risks to materialize (Chart 4). Chart 3US Pivot To Asia Runs Through Iran Our third key view, that EU was the real winner of the US election last year, remains on track. This is marginally positive for the euro at the expense of the dollar. Given the above points, we favor an equal-weighted basket of the euro and the dollar relative to the renminbi (Chart 5). Chart 4Safe-Haven Currencies Attractive Chart 5Favor Euro And Dollar Over Renminbi The geopolitical outlook is dollar-bullish. The macroeconomic outlook is dollar-bearish, except that China’s economy looks to slow down. We expect China to ease policy in the second half of the year but it may come late. We remain neutral dollar in the third quarter. Wait For China To Relax Policy July 1 marks the centenary of the Communist Party of China. The main thing investors should know is that the Communist Party predates China’s capitalist phase by sixty years. The party adopted capitalism to improve the economy – it never sacrificed its political or foreign policy goals. This poses a major geopolitical problem today because the Communist Party’s consolidation of power across Greater China, symbolized by Beijing’s revocation of Hong Kong’s special status in 2019, has convinced the western democracies that China is no longer compatible with the liberal world order. China launched a 13.8% of GDP monetary-and-fiscal stimulus over 2018-20 due to the trade war and COVID-19 pandemic. So the economy is stable for the hundredth anniversary celebration. The centenary goals are largely accomplished: GDP is larger, poverty is nearly extinguished, although urban incomes are still lagging (Chart 6). General Secretary Xi Jinping will mark the occasion with a speech. The speech will contribute to his governing philosophy, Xi Jinping Thought, a synthesis of communist Mao Zedong Thought and the pro-capitalist “socialism with Chinese characteristics” pioneered by General Secretary Deng Xiaoping in the 1980s-90s. The effect is to reassert Communist Party and central government primacy after the long period of decentralization that enabled China’s rapid growth phase. It is also to endorse an inward economic turn after the four-decade export-manufacturing boom. The Xi administration’s re-centralization of policy has entailed mini-cycles of tightening and loosening control over the economy. The administration leans against the country’s tendency to gorge itself on debt and grow at any cost – until it must lean the other way for fear of triggering a destabilizing slowdown. For this reason Beijing tightened policy proactively last year, producing a sharp drop in money, credit, and fiscal expansion in 2021 that now threatens to undermine the global recovery. By our measures, any further tightening will result in undershooting the regime’s money and credit targets, i.e. overtightening, and hence threaten to drag on the global recovery (Chart 7). Chart 6China's Communist Party Centenary Goals Chart 7China Verges On Over-Tightening Policy Overtightening would be a policy mistake with potentially disastrous consequences. So the base case should be that the government will relax policy rather than undermine the post-COVID recovery. However, investors cannot be confident about the timing. The 2015 financial turmoil and renminbi devaluation occurred because policymakers reacted too slowly. One reason to believe policy will be eased is that after July 1 the government will turn its attention to the twentieth national party congress in 2022, the once-in-five-years rotation of the Central Committee and Politburo. The party congress begins at the local level at the beginning of next year and culminates in the fall of 2022 with the national rotation of top party leaders. Xi Jinping was originally slated to step down in 2022. So he needs to squash any last-minute push against him by opposing factions of the party. He may have himself named chairman of the Communist Party, like Mao before him. Most importantly he will put his stamp on the “seventh generation” of China’s leaders by promoting his followers into key positions. All of this suggests that the Xi administration cannot risk triggering a recession, even if its preferences remain hawkish on economic policy. Policy easing could come as early as the end of July. As a rule of thumb, we have noticed that the Politburo’s July meeting on economic policy is often an inflection point, as was the case in 2007, 2015, 2018, and 2020 (Table 1). Some observers claim the April Politburo meeting already signaled an easing in policy, although we do not see that. If July clearly signals relaxation, global investors will cheer and emerging market assets and commodities will rise. Table 1China’s Politburo Often Hits Inflection Point On Economic Policy In July Still we maintain a defensive posture going into the third quarter because we do not have a high level of confidence that policymakers will act preemptively. A market riot may precede and motivate the inflection point in policy. Also the negative impact of previous policy tightening will be felt in the third quarter. China plays and industrial metals are extremely vulnerable to further correction (Chart 8). Chart 8China Plays And Metals Vulnerable To Further Correction The earliest occasion for a Biden-Xi summit comes at the end of October, as mentioned. While US-China talks will occur at some level, relations will remain fundamentally unstable. While a Biden-Xi summit may improve the atmosphere and lead to a new round of strategic and economic dialogue, or Phase Two trade talks, the fact is that the US is seeking to contain China’s rise and China is seeking to break out of the strictures of the US-led world order. The global elite and mainstream media will put a lot of emphasis on the post-Trump return to diplomatic “normalcy” and summits. But this is to overemphasize style at the expense of substance. Note that the positive feelings of the Biden-Putin summit on June 16 fizzled in less than a week when Russia allegedly dropped bombs in the path of a British destroyer in the Black Sea. The US and UK were training Ukraine’s military. Britain denies any bombs were dropped but Russia says next time they will hit their target. (More on this below.) This episode is instructive for US-China relations: summitry is overrated. China is building a sphere of influence and the US no longer believes dialogue alone is the answer. Tit-for-tat punitive measures and proxy battles in China’s neighboring areas, from the Korean peninsula to the Taiwan Strait to the South and East China Seas, are the new normal. Bottom Line: Tactically, stay defensive on global risk assets, especially China plays. Strategically, maintain a constructive outlook on the cycle given the global recovery and China’s need eventually to relax monetary and fiscal policy. US-Iran Deal Likely – Then The Real Trouble Starts The US will likely rejoin the 2015 Iranian nuclear deal (Joint Comprehensive Plan of Action) by August and pull out of its longest-ever war in Afghanistan in September. The US is wrapping up its “forever wars” to meet the demands of a war-weary public. Ironically, the long-term consequence is to create power vacuums that invite new geopolitical conflicts in the context of the US’s great power struggle with China and Russia. But for now a deal with Iran – once it is settled – reduces geopolitical risk by reducing the odds of military escalation in the region. The Iran talks are more significant than the Afghanistan pullout. We are confident in a deal because Biden can rejoin the 2015 deal unilaterally – it was never approved by the US Senate as a formal treaty. The Iranians will not support any militant action so aggressive as to scupper a deal that offers them the chance of reviving their economy at a critical time in the regime’s history. Reviving the deal poses a downside risk for oil prices in the third quarter though not over the long run. It is negative in the short run because investors will have to price not only Iran’s current and future production (Chart 9) but also any resulting loss of OPEC 2.0 discipline. Brent crude is trading at $76 per barrel as we go to press, above the $65-$70 per barrel average that our Commodity & Energy Strategy service expects to see over the coming five years (Chart 10). Chart 9Iran's Oil Production Will Return Chart 10Brent Price Faces Short-Term Downside Risk From Iranian Crude The oil price ceiling is enforced by the cartel of oil producers who fear that too high of prices will incentivize US shale oil production as well as the global shift to renewable energy. The Russians have always dragged their feet over oil production cuts and are now pushing for production hikes. The government needs an oil price of around $50-55 per barrel for the budget to break even. The Saudis need higher prices to break even, at $70-75 per barrel. Moscow must coordinate various oil producers, led by the country’s powerful oligarchs and their factions, which is inherently more difficult than the Saudi position of coordinating one producer, Aramco. The Russians and Saudis have maintained cartel discipline so far in 2021, as expected, because the wounds of the market-share war last year are still raw. They retreated from that showdown in less than a month. However, a major escalation in Saudi Arabia’s strategic conflict with Iran could push the Saudis to seek greater market share at Iran’s expense, as occurred before the original Iran deal in 2014-15. Hence our view that the risk to oil prices will shift from the upside to the downside in the second half of the year if the US-Iran deal is reconstituted. Over the long run, the deal is not negative for oil prices. The deal is a tradeoff for lower geopolitical risk today but higher risk in the future. The reason is that Iran’s economic recovery will strengthen its strategic hand and generate a backlash in the region. The global oil supply and demand balance will fluctuate according to circumstances but regional conflict will inject a risk premium over time. Biden’s likely decision to rejoin the 2015 deal should be seen as a delaying tactic. It is impossible to go back to 2015, when the US had mustered a coalition of nations to pressure Iran and when Iran’s “reformist” faction stood to receive a historic boost from the opening of the country’s economy. Now the US lacks a coalition and the reformists are leaving office in disgrace, with the hardliners (“principlists”) taking full power for the foreseeable future. Iran is happy to go back to complying with a deal that consists of sanctions relief in exchange for temporary limits on its nuclear program. The 2015 deal’s restrictions on Iran’s nuclear program begin expiring in 2023 and continue to expire through 2040. Biden has no chance of negotiating a newer and more expansive deal that extends these sunset clauses while also restricting Iran’s ballistic missile program and regional militant activities. He will say that easing sanctions is premised on a broader “follow on” deal to achieve these US goals. But the broader deal is unlikely to materialize anytime soon. The Iranians will commit to future talks but they will have no intention of agreeing to a more expansive deal unless forced. The country’s leaders will never abandon their nuclear program after witnessing the invasions of non-nuclear Libya and Ukraine – in stark contrast with nuclear-armed North Korea. Moreover Biden cannot possibly reassemble the P5+1 coalition with Russia and China anytime soon. The US is directly confronting these states. They could conceivably work with the US when Iran is on the brink of obtaining nuclear weapons but not before then. They did not prevent North Korea. The Supreme Leader Ali Khamenei, the soon-to-be-inaugurated President Ebrahim Raisi, the Iranian Revolutionary Guard Corps, the Ministry of Intelligence, and other pillars of the regime are focused exclusively on strengthening the regime in advance of Khamenei’s impending succession sometime in the coming decade. The succession could easily lead to domestic unrest and a political crisis, which makes the 2020s a critical period for the Islamic Republic. With Tehran focused on a delicate succession, it is not a foregone conclusion that Iran will go on the offensive to expand its sphere of influence immediately after the US deal. But sooner or later a major new geopolitical trend will emerge: the rise of Iran. With sanctions removed, trade and investment increasing, and Chinese and Russian support, Iran will be capable of pursuing its strategic aims in the region more effectively. It will extend its influence across the “Shia Crescent,” including Iraq. The fear that this will inspire in Israel and the Gulf Arab states has already generated a slow-boiling war in the region. This war will intensify as the US will be reluctant to intervene. The purpose of the deal is to enable the war-weary US to reduce its active involvement in the region. The US foreign policy and defense establishment do not entirely see it this way – they emphasize that the US will remain engaged. But US allies in the Middle East will not be convinced. The region already has a taste for the way this works after the US’s precipitous withdrawal from Iraq in 2011, which lead to the rise of the Islamic State terrorist group. Biden will try not to be so precipitous but the writing is on the wall: the US will reduce its focus and commitment. A scramble for power in the region will begin the moment the ink dries on Biden’s signature of the JCPA. Israel and the Arab states are forming a de facto alliance – based on last year’s Abraham Accords – to prepare for Iran’s push to dominate the region. Even if Iran is not overly aggressive (a big if), Israel and the Gulf Arabs will overreact as a result of their fear of abandonment. They will also seek to hedge their bets by improving ties with the Chinese and Russians, making the Middle East the scene of a major new proxy battle in the global great power struggle. As a risk to our view: if the Biden administration changes course this summer and refuses to lift sanctions or rejoin the Iran deal – low but not zero probability – then tensions with Iran will explode almost instantaneously. The Iranians will threaten to close the Strait of Hormuz and a crisis will erupt in the third or fourth quarter. Bottom Line: The US will most likely rejoin the Iranian nuclear deal by August to avoid an immediate crisis or war. The Biden administration will wager that it can lend enough support to regional allies to keep Iran contained. This might work, as the Iranians will focus on fortifying the regime ahead of its leadership succession. However, Iran’s hardline leadership will see an opportunity in America’s withdrawal from its “forever wars.” Iran will increasingly cooperate with Russia and China. Iran’s conflict with Israel and Saudi Arabia will be extremely difficult to manage and will escalate over time, quite possibly creating a revolution or war in Iraq. The Gulf Arabs are already under immense pressure from the green energy revolution. Thus while oil prices might temporarily fall on the return of Iranian exports, they will later see upward pressure from a new wave of Middle Eastern instability. European Political Risk Has (Probably) Bottomed By contrast with all the above we have viewed Europe as a negligible source of (geo)political risk in 2021. European policy uncertainty is falling in Europe relative to these other powers and the rest of the world (Chart 11). Chart 11Europe's Relative Policy Uncertainty Bottoming Chart 12EU Break-Up Risk Hits Floor (Again) The risk of a break-up of the European Union has wilted and remains at historic lows (Chart 12). There is no immediate threat of any European countries emulating the UK and attempting to exit. Even Italian support for the euro has surged. Immigration flows have plummeted. European solidarity is not on the ballot in the upcoming German and French elections. Germany is choosing between the status quo and a “green revolution” that would not really be a revolution due to the constraints of coalition politics. The Greens have lost some momentum relative to their polling earlier this year but underlying trends suggest they will surprise to the upside in the September 26 vote (Charts 13A and 13B). They embrace EU solidarity, robust government spending, weariness with the Merkel regime, and concerns about climate change, Russia, China, and social justice. Chart 13AGerman Greens Will Surprise To Upside Chart 13BGerman Greens Will Surprise To Upside We expect the Greens to surprise to the upside. But as they are forced into a coalition with the ruling Christian Democrats then they will be limited to raising spending rather raising taxes (Table 2). The market will cheer this result. Table 2German Greens’ Ambitious Tax Hike Proposals If the Greens disappoint then a right-leaning government and too early fiscal tightening could become a risk – but it is a minor risk because Merkel’s hand-picked successor, the CDU Chancellor Candidate Armin Laschet, will be pro-Europe and fiscally dovish, just like the mainstream of his party under Merkel. The only limitation on this dovishness is that it would take another global shock for there to be enough votes in the Bundestag to loosen the schuldenbremse or “debt brake.” In France, President Emmanuel Macron is likely to win re-election – the populist candidate Marine Le Pen remains an underdog who is unlikely to make it through France’s two-round electoral system. In Italy, Prime Minister Mario Draghi is overseeing a national unity coalition that will dole out EU recovery funds. An election cannot be held ahead of the presidential election in January, which will be secured by the establishment parties as a major check on any future populist ruling coalition. The risk in these countries, as in Spain and elsewhere, is that neoliberal structural reform and competitiveness are falling by the wayside. Fiscal largesse is positive for securing the recovery but long-term growth potential will remain depressed (Chart 14). Chart 14European And Global Fiscal Stimulus (Updated June 2021) Europe remains stuck in a liquidity trap over the long run. It depends on the rest of the world for growth. This is a problem given that China’s potential growth is slowing and there is no ready substitute that will prop up global growth. Europe is increasingly ripe for negative “black swan” events. The power vacuum in the Middle East described above will lead to instability and regime failures that will threaten European security. Russia will remain aggressive, a reflection of its crumbling structural foundations. The Putin administration has not changed its strategy of building a sphere of influence in the former Soviet Union and pushing back against the West, as signaled by the threat to bomb ships that sail in Crimean waters – a unilateral expansion of Russia’s territorial waters following the Crimean invasion. The Biden administration is not seeking anything comparable to the diplomatic “reset” with Russia from 2009-11, which ended in acrimony. In other words, European political risk may be bottoming as we speak. Investment Takeaways Chart 15Limited Equity Upside From Likely US Infrastructure Bill US Peak Fiscal Stimulus: The Biden administration is highly likely to pass an infrastructure package through Congress, either as a bipartisan deal with Republicans or as part of the American Jobs Plan. The result is another $1-$1.5 trillion fiscal stimulus, albeit over an eight-year period, with infrastructure funding taking until 2024-25 to ramp up. Biden’s other plans probably will not pass before the 2022 midterm election, which will likely bring gridlock. Investors are well aware of these proposals and the policy setting will probably be frozen after this year. Hence there is limited remaining upside for global materials sector and US infrastructure plays (Chart 15). The extravagant US fiscal thrust of 2020-21 will turn into a huge fiscal drag in 2022 (Chart 16). The Federal Reserve, however, will remain ultra-dovish as long as labor market slack persists – regardless of who is at the helm. Chart 16US Fiscal Drag Very Large In 2022 Chart 17Go Long Large Caps And Defensives China’s Headwinds Persist: China may or may not ease policy in time to prevent a market riot. China plays and industrial metals are highly exposed to a correction and we recommend steering clear. US-Iran Deal Weighs On Oil Price: Tactically we are neutral on oil and oil plays. An Iran deal could depress oil prices temporarily – and potentially in a major way if the Saudis agree with the Russians on increasing production. Fundamentals are positive but depend on the OPEC 2.0 cartel. The cartel faces the risk that higher prices will incentivize both alternative oil providers and the green revolution. Europe’s Opportunity: We continue to see the euro and European stocks offering value. Given the troubles with Russia we favor developed Europe plays over emerging Europe. The German election would be a bullish catalyst for European assets but headwinds from China will prevail, which is negative for cyclical European stocks. The Russian Duma election, also in September, creates high potential for Russia to clash with the West between now and then. Tactically, go long global large caps and defensives (Chart 17). Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Independent Vermont Senator Bernie Sanders recently felt it was necessary to warn against a second cold war. Sanders, a democratic socialist, is a reliable indicator of the left wing of the Democratic Party and a dissenter who puts pressure on the center-left Biden administration. His fears underscore the dominance of the new hawkish consensus. Appendix China Russia UK Germany France Italy Canada Spain Taiwan – Province Of China Korea Turkey Brazil Australia
The first round of French regional elections was a disappointment for both Marine Le Pen’s Rassemblement National (RN) as well as President Emmanuel Macron’s La République En Marche (LREM). RN obtained 19% of the national vote and LREM won only 11% of the…
Euro Area industrial production surprised to the upside in April. IP surged 39.3% y/y, following an 11.5% y/y increase in March. However, most of this acceleration reflects the impact of last year’s base effect. On a monthly basis, eurozone IP is up 0.8% m/m…