Fixed Income
We have entered a new phase of the cycle, with central banks in most developed markets turning more hawkish (the Bank of England surprisingly hiking in December, and the Fed signaling three rate hikes for 2022). How much does this matter for equities and other risk assets? Our view is that, as long as economic growth continues to be strong (and we think it will), and provided that central banks don’t overdo the tightening (and, with inflation likely to come down this year, we think excess tightening is unlikely), the hawkish turn might temporarily raise volatility and cause the occasional correction, but it does not undermine the case for equities to outperform bonds over the next 12 months. We remain overweight global equities. Economic growth is likely to continue to be well above trend for the next year or two (Chart 1), driven by (1) consumers spending some of the $5 trillion of excess savings they have accumulated in the G10 economies, (2) the unprecedented wealth effect from recent stock and house price rises (Chart 2), and (3) strong capex as companies strive to increase capacity to meet the consumer demand (Chart 3). The upsurge in Covid cases in December (Chart 4) will undoubtedly slow growth temporarily. But the signs are that the now-prevalent Omicron variant is mild, and its rapid spread could help the developed world achieve “herd immunity” thanks to widespread vaccination and natural immunity, though emerging countries – especially China – may continue to struggle. Chart 1Growth Will Continue To Be Above Trend Chart 2Growth Will Be Boosted By The Wealth Effect... Chart 3...And Capex To Increase Production With US growth very strong – the Atlanta Fed Nowcast suggests Q4 QoQ annualized real GDP growth was 7.6% – and core PCE inflation 4.1%, it is hardly surprising that the Fed wants to accelerate the rate at which it withdraws accommodation. The FOMC dots, which see three rate hikes this year and another three in 2023, are unexceptional and close to what the futures market has already been (and still is) pricing in (Chart 5). Chart 4Covid Cases Not Leading to Hospitalizations And Deaths Chart 6Fed Hikes Have Usually Caused Only A Short-Lived Selloff Chart 5The Futures Market Is In Line With The FOMC Dots In the past, the first Fed hike in a cycle has often triggered a mild short-term sell off in stocks (the timing depending on how well the hike was flagged in advance), but the equity market digested the news rapidly, quickly resuming its upward trend as the Fed continued to tighten (Chart 6). The same was true around the tapering and end of asset purchases in 2013-17 (Chart 7). All that depends, though, on whether the Fed is rushed into further rate hikes because inflation surprises even more to the upside. Our view remains that inflation will decline this year. The high inflation prints we are seeing now are mostly the result of exceptional demand for consumer manufactured goods, which the supply side has temporarily been unable to fulfil, causing shortages. This can be seen in the very different pattern of goods and services inflation (Chart 8). As we have argued previously, the supply response is now kicking in for key inputs into manufactured goods, such as semiconductors and shipping and, with demand likely to shift to services this year as the pandemic fades, this should bring inflation down. Chart 7Tapering Didn't Much Affect Stocks Either Chart 8Inflation Probably Will Decline This Year That said, the year-on-year inflation number will continue to look scary for some time, even if month-on-month inflation settles back to its pre-pandemic level of 0.2% (Chart 9). The consensus average forecast of 3.3% core PCE inflation in 2022 is factoring in monthly inflation around this level. The risks to inflation remain to the upside, particularly if wages respond to higher prices (US wage growth is currently 4-6%, significantly lagging behind price inflation – Chart 10), causing companies to raise prices further, triggering a price-wage spiral. Chart 9Year-On-Year Inflation Will Remain High Chart 10Risk Of A Price-Wage Spiral? All this suggests a year of significant volatility and uncertainty. The US stock market has not seen a correction (a drop of more than 10%) in this cycle, and there were no drawdowns last year of more than 5% (Chart 11). This is unusual: There were six 10%-plus corrections in the 2009-2019 bull market. The US equity rally is also looking increasingly narrow, with the run-up to a record-high in December driven by just a few large-cap growth stocks (Chart 12). This – and pricey valuations – makes it vulnerable and, as a hedge to downside risks, we continue to recommend an overweight in cash (rather than government bonds, which offer very asymmetrical returns, with significant downside in the event that inflation proves to be stubborn). Chart 11Where Have All The Corrections Gone? Chart 12Stock Market Has Got Very Narrow The other policy focus remains China. The authorities’ recent cut of the banks’ reserve ratio and more dovish talk does suggest that they are now concerned about how weak growth has become (Chart 13). A slight loosening of monetary policy has probably caused credit growth to bottom (Chart 14). However, our China strategists argue that the easing is likely to be only moderate since policymakers want to continue with structural reforms, such as reducing debt. The next few months may resemble early 2019 when the PBOC engineered a brief injection of liquidity which lasted only a few months. Moreover, the slump in the property market has not run its course (Chart 15), and this will hamper the authorities’ ability to accelerate infrastructure spending, much of which is financed by local governments’ property sales. Even if Chinese credit growth and the property market do pick up a little, the economy – and indeed commodity prices – will not bottom for another 6-9 months (Chart 16). But, when this happens, it would be a signal to turn more risk-on and bullish on cyclical countries and sectors, such as Emerging Markets, Europe, and Value stocks. Chart 13Chinese Data Looks Very Poor Chart 14Is Credit Growth Now Bottoming? Chart 15Slump In China Property Is Not Over Chart 16It Will Take A While For Commodity Prices To Pick Up Equities: While we remain overweight equities, returns this year will be only modest. Returns in 2020 were driven by multiple expansion, and last year by strong margin expansion (Chart 17), as often happens in Years 1 and 2 of a bull market. But this year, while sales growth should remain strong, BCA Research’s US equity strategists’ model points to a small decline in margins, which are at a record high (Chart 18). The PE multiple is likely to fall further too, as it usually does when the Fed is hiking. Even with buybacks and dividends, this amounts to a total return from US equities of only about 8%. Chart 17What Can Drive Returns In 2022? Chart 18Margins Likely To Slip From Record High Chart 19Europe Is More Sensitive To China Slowing... Nonetheless, we continue to prefer the US to other developed markets. Europe is more sensitive to the slowdown in China (Chart 19) and tends to underperform when global growth is slowing and is concentrated in services. Neither is it notably cheap versus the US relative to history (Chart 20). Emerging Markets face multiple headwinds, from the slowdown in China, to rampant inflation that is forcing central banks to hike aggressively (Brazil, for example has raised rates to 9.25% from 2% since April even in the face of weak growth and continuing risks from Covid). Chart 20...And Not Particularly Cheap Chart 22US Treasurys Are Attractive to Europeans And Japanese Chart 21Long Rates Low Given Fed Signaling Fixed Income: Long-term rates are surprisingly low, given the hawkish pivot of the Fed and other central banks (Chart 21). One explanation Fed chair Powell has given is the attractiveness of US Treasurys, after FX hedges, to European and Japanese investors (Chart 22). He is correct about this, but the advantage will wane as the Fed raises rates (while the ECB and BOJ don’t). We continue to forecast the 10-year Treasury yield to rise to 2-2.25% by the time of the first Fed hike. We are underweight duration and expect a moderate steepening of the yield curve. TIPs look richly valued, especially at the short end. We are neutral on US TIPs, where 10-years at least represent a hedge against tail-risk inflation. Inflation-linked bonds in the euro zone are particularly unattractive now (Chart 23). Chart 23Breakevens Already Pricing In A Lot Of Inflation In credit, we continue to see value in riskier high-yield bonds, where US B- and Caa-rated names are trading at breakeven spreads close to historic averages (Chart 24). Our global fixed-income strategists have also recently turned more positive on US dollar-denominated EM debt, which offers a decent spread pickup versus US corporate debt of the same credit rating and maturity (Chart 25). Currencies: Relative monetary policy between the US and Europe and Japan could mean some further upside for the dollar over the next few months (Chart 26). However, the dollar is expensive relative to fair value, long-dollar is an increasingly crowded trade and, in the second half of the year, a rebound in China would boost growth in Europe and Emerging Markets, which would be positive for commodity currencies. Bearing that in mind, we remain neutral on the USD. Chart 25...As Are Some EM Dollar Bonds Chart 26Dollar To Rise On More Hawkish Fed? Chart 28Gold Is Vulnerable To Rising Real Rates Commodities: Metals prices are likely to suffer further in the first half of the year, as China’s growth continues to slow. This would suggest a further decline in the equity Materials sector. Nonetheless, we continue to have a neutral on commodities as an asset class because of the positive long-term story: Demand for metals for use in alternative energy is not being met by increased supply because investor pressure is stymying capex in the mining sector (Chart 27). It makes sense to have long-term exposure to metals such as copper and lithium which are used in electric vehicles. The oil price is mostly determined currently by Saudi supply. Our energy strategists forecast Brent oil to average $78.50 in 2022 and $80 in 2023, roughly the same as the current spot price. We remain neutral on gold: The bullion is not particularly attractively valued currently and will suffer if, as we expect, real long-term rates rise (Chart 28). Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Recommended Asset Allocation
Highlights Global growth will remain above-trend in 2022, although with more divergence between regions than at any time during the pandemic (US strong, Europe steady, China slowing). Global inflation will transition from being driven by supply squeezes towards more sustainable inflation fueled by tightening labor markets - a shift leading to tighter monetary policies that are not adequately discounted in the current low level of bond yields, most notably in the US. Maintain below-benchmark overall global duration exposure. Diverging growth and inflation trends will lead to a varying pace of monetary policy tightening between countries, resulting in greater opportunities to benefit from relative bond market performance and cross-country yield spread moves. Underweight government bonds in countries where central banks are more likely to hike rates in 2022 (the US, the UK, Canada) versus overweights where monetary policy is more likely to remain unchanged (Germany, France, Italy, Australia, Japan). Deeply negative real bond yields reflect an implied path of nominal interest rates that is too low relative to inflation expectations in the majority of developed countries. Real bond yields will adjust higher in countries where rate hikes are more likely, resulting in more stable inflation breakevens compared to 2021. Stay neutral global inflation-linked bonds versus nominal government debt. A tightening global monetary policy backdrop and rising real interest rates will weigh on returns in global credit markets, even as strong nominal economic growth minimizes downgrade and default risks. Like government bonds, global growth and policy divergences will create relative investment opportunities between countries, especially later in 2022 when the Fed begins to hike rates and China begins to ease macro policies. Overweight euro area high-yield and investment grade corporates versus US equivalents. Limit exposure to EM hard-currency debt until there are clear signals of China policy stimulus and upside momentum on the US dollar fades. Feature Dear Client, This report, detailing our global fixed income investment outlook for next year, will be our last for 2021. We wish you a very safe, happy and prosperous 2022. We look forward to continuing our conversation in the new year. Rob Robis, Chief Global Fixed Income Strategist BCA Research’s Outlook 2022 report, “Peak Inflation – Or Just Getting Started?”, outlining the main investment themes for the upcoming year based on the collective wisdom of our strategists, was sent to all clients in late November. In this report, we discuss the broad implications of those themes for the direction of global fixed income markets, along with our main investment recommendations for 2022. A Brief Summary Of The 2022 BCA Outlook The tone of the 2022 Outlook report was quite positive on the prospects for global growth, even with the recent development of the rapid spread of the Omicron COVID-19 variant. It remains to be seen how severe this new variant will be in terms of hospitalizations and deaths compared to previous COVID waves. We assume that any negative economic impacts from Omicron in the developed economies will be contained to the first half of 2022, however, given more widespread vaccination rates (including booster shots) and greater access to anti-viral treatments. The baseline economic scenario in 2022 is one of persistent above-trend growth in the developed world (Chart 1) with a closing of output gaps in the US and euro area. The mix of spending in those economies will shift away from goods towards services, although Omicron may delay that transition until later in 2022. Chart 1Another Year Of Above Trend Growth Expected In 2022 Chart 2Strong Fundamental Support For US Growth Chart 3China In 2022: Deceleration Leading To Policy Easing The US looks particularly well supported to maintain a solid pace of economic activity. The US labor market is very strong. Monetary policy remains accommodative (although that is slowly changing). Financial conditions are still easy, with the lagged impact of elevated equity and housing values providing a robust tailwind to consumer spending that is already well supported by excess savings resulting from the pandemic (Chart 2). China starts the year as a “one-legged” economy supported only by external demand, and policy stimulus later in the year will eventually be needed for the Chinese government to reach its growth targets (Chart 3).That policy shift will have significant implications for the outlook of many financial assets as 2022 evolves, including emerging market (EM) fixed income, industrial commodity prices and the US dollar (as we discuss later in this report). Global inflation will recede from the overheated pace of 2021 as supply chain bottlenecks become less acute. Inflationary pressures in 2022 will come from more “normal” sources like tightening labor markets, rising wage growth and higher housing costs (rents). This constellation of lower unemployment with still-elevated underlying inflation will look most acute in the US, leading the Fed to begin a tightening cycle that is not fully discounted in US Treasury yields. The broad investment conclusions of the BCA 2022 Outlook are more positive for global equity markets relative to bond markets, although with elevated uncertainty stemming from Omicron and future China stimulus. The views are more nuanced for other assets, like the US dollar (stronger to start the year, weaker later) and oil prices (essentially flat from pre-Omicron levels). Our Four Key Views For Global Fixed Income Markets In 2022 The following are the main implications for global fixed income investment strategy based off the conclusions from the 2022 BCA Outlook. Key View #1: Maintain below-benchmark overall global duration exposure. As we have noted in the title of our report, the investment outlook for 2022 is more complicated for investors to navigate than the relatively straightforward story from this time a year ago. Then, the development of COVID-19 vaccines led to optimism on reopening from 2020 lockdowns, but with no threat of the early removal of pandemic monetary and fiscal policy stimulus. The fixed income investment implications at the time were obvious, in the majority of developed countries - expect higher government bond yields, steeper yield curves, wider inflation breakevens and tighter corporate credit spreads. Today, the story is more complicated, but is still one that points to higher global bond yields. Take, for example, global fiscal policy. According to the IMF, the US is expected to see no fiscal drag in 2022 thanks to the Biden Administration’s spending initiatives, while Europe and EM will see significant fiscal drag (Chart 4). However, in the case of Europe, this should not be viewed negatively as it is the result of expiring pandemic era employment and income support programs that are no longer needed after economies emerged from wholesale lockdowns. So less fiscal stimulus is a sign of a healthier European economy that is more likely to put upward pressure on global bond yields, on the margin. The outlook for global consumer spending is also a bit more complicated, but still one that points to higher bond yields. Consumer confidence was declining over the final months of 2021 in the US, Europe, the UK, Canada and most other developed countries. This occurred despite falling unemployment rates and very strong labor demand, which would typically be associated with consumer optimism (Chart 5). High global inflation, which has outstripped wage gains and reduced real purchasing power, is why consumers have become gloomier in the face of healthy job markets. Chart 4Global Fiscal Policy Divergence In 2022 Chart 5Lower Inflation Will Help Boost Consumer Confidence The implication is that the expectation of lower inflation outlined in the 2022 BCA Outlook, which sounds bond-bullish on the surface, could actually prove to be bond-bearish if it makes consumers more confident and willing to spend. On that note, there are already signs that the some of the sources of the global inflation surge of 2021 are fading in potency. Commodity price inflation has rolled over, in line with slowing momentum in manufacturing activity and a firmer US dollar (Chart 6). Measures of global shipping costs, while still elevated, have stopped accelerating. The spread of the Omicron variant may delay a further easing of supply chain disruptions in the short-term, but on a rate of change basis, the upward pressure on global inflation from supply squeezes will diminish in 2022. The inflation story will also be more complicated next year. While there will be less inflation from the prices of commodities and durable goods, there will be more inflation from the elimination of output gaps, tightening labor markets and an overall dearth of global spare capacity. Put another way, expect the gap between global headline and core inflation rates to narrow in most countries, but with domestically generated core inflation rates remaining elevated (Chart 7). Chart 6Some Relief On Supply-Driven Inflation On The Way Chart 7Global Inflation Will Be Lower, But More Sustainable, In 2022 The more complicated investment story for 2022 extends to global bond yields themselves. Longer-maturity government bond yields remain far too low given the mix of very high inflation and very low unemployment in many countries. Chart 8Bond Markets Vulnerable To More Hawkish Repricing Even as major central banks like the Fed are tapering bond purchases and signaling more rate hikes in 2022, and others like the Bank of England (BoE) have actually raised rates, bond yields remain low. The reason for this is that markets are discounting very low terminal rates – the peak level of policy rates to be reached in the next monetary tightening cycle. We proxy this by looking at 5-year overnight index swap (OIS) rates, 5-years forward. A GDP-weighted aggregate of those forward OIS rates for the major developed economies (the US, Germany, the UK, Japan, Canada and Australia) is currently 0.9%. This compares to GDP-weighted 10-year government bond yield of 0.8% (Chart 8). Forward OIS rates and 10-year bond yields are typically closely linked, which suggests upward scope for longer-maturity bond yields as markets begin to discount a higher trajectory for policy rates. We see this as the primary driver of higher bond yields in 2022 – an upward adjustment of interest rate expectations as central banks like the Fed, BoE and Bank of Canada (BoC) promise, and eventually deliver, more rate hikes than markets currently expect. We therefore recommend maintaining a below-benchmark stance on overall interest rate (duration) exposure in global bond portfolios in 2022. Government bond yield curves will eventually see more flattening pressure as central banks tighten, most notably in the US, but not before longer-term yields rise to levels more consistent with the most likely peak levels of central bank policy rates. Key View #2: Underweight government bonds in countries where central banks are more likely to hike rates in 2022 (the US, the UK, Canada) versus overweights where monetary policy is more likely to remain unchanged (Germany, France, Italy, Australia, Japan). The more complicated fixed income investing story for 2022 also extends to country allocation decisions, with more opportunities to take advantage of diverging bond market performance and cross-country spread moves. Current pricing in OIS curves shows a very modest expected path for interest rates in the major developed economies (Chart 9). Some central banks, like the BoE, BoC and the Reserve Bank of New Zealand (RBNZ) are expected to be more aggressive with rate hikes in 2022 compared to the Fed. Yet there are not many rate hikes discounted beyond 2022, even in the US (Table 1). Chart 9Markets Are Pricing Short, Shallow Hiking Cycles Table 1Only Modest Tightening Expected Over The Next Three Years The US OIS curve is currently priced for an expectation that the Fed will struggle to hike the fed funds rate beyond 1.25% by the end of 2024, even with the latest set of FOMC rate forecasts calling for 75bps of rate hikes in 2022 alone. In the case of the UK, markets are pricing in lower rates in 2024 after multiple rate hikes in 2022/23, indicative of an expectation of a policy error of BoE “overtightening” even with the BoE Bank Rate expected to peak just above 1% The relative performance of government bond markets is typically correlated to changes in relative interest rate expectations. That was once again evident in 2021, where the UK, Canada and Australia significantly underperformed the Bloomberg Global Treasury aggregate in the third quarter as markets moved to rapidly price in multiple rate hikes (Chart 10). That volatility of bond market performance was particularly unusual Down Under, as the Reserve Bank of Australia (RBA) did not signal any desire to begin hiking rates in 2022, unlike the BoE and BoC. As rate expectations in those three countries stabilized in the fourth quarter, their government bonds began to outperform. On the other hand, relative government bond performance was more stable in the euro area, Japan and the US for most of 2021 (Chart 11). In the case of the US, rate hike expectations only began to move higher in September after the Fed signaled that tapering of bond purchases was imminent. Even then, markets have moved slowly to discount 2022 rate hikes. Now, the pricing in the US OIS curve is more in line with the median interest rate “dot” from the latest FOMC projections, calling for three rate hikes next year starting in June. Chart 10Rate Hike Expectations Driving Relative Bond Returns Chart 11Stay Underweight US Interest Rate Exposure Looking ahead to next year, we see the widening divergences on growth, inflation and monetary policies between countries leading to the following investible opportunities on country allocation in global bond portfolios. Underweight US Treasuries Chart 12Cyclical Upside Risk To Longer-Dated UST Yields The Fed has already begun to taper its bond buying, which is set to end by March 2022. As shown in Table 1, 79bps of rate hikes are discounted in the US by the end 2022, but only another 41bps are priced over the subsequent two years. Survey-based measures of interest rate expectations are similarly dovish, even with the US unemployment rate now at 4.2% - within the FOMC’s range of full employment (NAIRU) estimates between 3.5-4.5% - and wage inflation accelerating (Chart 12). Markets are underestimating how much the funds rate will have to rise over the next 2-3 years as the Fed belated catches up to a very tight US labor market and inflation persistently above the Fed’s 2% target. Stay below-benchmark on US interest rate risk, through both reduced duration exposure and lower portfolio allocations to Treasuries. Overweight Core Europe While interest rate markets are underestimating how much monetary tightening the Fed will deliver, the opposite is true in Europe. The EUR OIS curve is discounting 39bps of rate hikes to the end of 2024, even with cyclical growth indicators like the manufacturing PMI and ZEW expectations survey well off the 2021 highs (Chart 13). At the same time, there is little evidence to date indicating that the surge in European inflation this year, which has been narrowly concentrated in energy prices and durable goods prices, is feeding through into broader inflation pressures or faster wage growth. We recommend maintaining an overweight allocation to core European government bond markets (Germany, France), particularly versus underweights in US Treasuries. Our expectation of a wider 10-year US Treasury-German bund spread is one of our highest conviction views for 2022, playing on our theme of widening growth, inflation and monetary policy divergences (Chart 14). Chart 13Stay Overweight European Interest Rate Exposure Chart 14Expect More US-Europe Spread Widening In 2022 Overweight European Peripherals Chart 15Stay O/W European Peripheral Exposure To Begin 2022 The ECB will be allowing its Pandemic Emergency Purchase Program, or PEPP, to expire at the end of March 2022. Beyond that, the ECB has announced that the pace of buying in the existing pre-pandemic Asset Purchase Program (APP) will be upsized from €20bn per month to between €30-40bn until at least the third quarter of 2022. This represents a meaningful slowing of the pace of ECB bond purchases, which were nearly €90bn per month under PEPP. Nonetheless, unlike most other developed economy central banks that are ending pandemic-era quantitative easing (QE) programs, the ECB will still be buying bonds on a net basis and expanding its balance sheet in 2022 (Chart 15). The central bank has taken great care in signaling that no rate hikes should be expected in 2022, likely to avoid any unwanted surges in Peripheral European bond yields or the euro. A continuation of asset purchases reinforces that message, leaving us comfortable in maintaining an overweight recommendation on Italian and Spanish government bonds for 2022. Underweight the UK and Canada Chart 16Stay U/W UK & Canadian Interest Rate Exposure A combination of rapidly tightening labor markets and soaring inflation is almost impossible for any inflation-targeting central bank to ignore. That is certainly the case in the UK, where the unemployment rate is 4.2% with two job vacancies available for every unemployed person – a series high for that ratio (Chart 16, top panel). UK headline CPI inflation is at a 10-year high of 5.2% and the BoE expects inflation to peak around 6% in April 2022. Medium-term inflation expectations, both market based and survey based, are also elevated and well above the BoE’s 2% inflation target. The BoE surprised markets a couple of times at the end of 2021, not delivering on an expected hike in November and actually lifting rates in December in the midst of the intense UK Omicron wave. We see the latter decision as indicative of the central bank’s growing concern over high UK inflation becoming embedded in inflation expectation. The BoE will likely have to eventually raise rates to a level higher than the 2023 peak of 1.1% currently discounted in the GBP OIS curve. That justifies an underweight stance on UK interest rate exposure (both duration and country allocation) in 2022. A similar argument applies to Canada. The Canadian unemployment rate now sits at 6.0%, closing in on the February 2020 pre-COVID low of 5.7%. The BoC’s Q3/2021 Business Outlook Survey showed a net 64% of respondents reporting intensifying labor shortages (the highest level in the 20-year history of the survey). Wage growth is accelerating, headline CPI inflation is running at 4.7% and underlying inflation (trimmed mean CPI) is now at 3.4% - the latter two are well above the BoC inflation target range of 1-3%. The CAD OIS curve currently discounts 147bps of rate hikes in 2022, which is aggressively hawkish, but very little is priced beyond that in 2023 (another 19bp hike) and 2024 (a rate cut of 24bps). The BoC estimates that the neutral interest rate in Canada is between 1.75% and 2.75%. Thus, markets do not expect the BoC to lift rates to even the low end of that range over the next three years, despite a very tight labor market and an inflation overshoot. We see this as justifying a continued underweight stance on Canadian interest rate exposure (both duration and country allocation) in 2022, even with markets already discounting significant monetary tightening next year. Overweight Australia and Japan Outside of Europe, we recommend overweights on Australian and Japanese government bonds entering 2022 (Chart 17). The RBA has been quite clear in what needs to happen before it will begin to lift rates. Australian wage growth must climb into the 3-4% range that has coincided with underlying Australian inflation sustainably staying in the RBA’s 2-3% target range. Wage growth and trimmed mean CPI inflation only reached 2.2% and 2.1%, respectively, for the latest available data from Q3/2021. As Australian wage and inflation data is only released on a quarterly basis, the RBA will not be able to assess whether wage dynamics are consistent with reaching its inflation target until the latter half of 2022. The AUD OIS curve is currently discounting 119bps of rate hikes in 2022 and an additional 86bps of hikes in 2023. Those are both far too aggressive for a central bank that is unlikely to begin lifting rates until the end of 2022, at the very earliest. Thus, we recommend an overweight stance on Australian bond exposure in global bond portfolios in 2022. The case for overweighting Japanese government bonds is a simple one. There are none of the inflation or labor market pressures seen in other countries to justify a hawkish turn by the Bank of Japan (bottom panel). Japanese core CPI is shockingly in deflation (-0.7%), bucking the trend seen in other countries and showing no pass-through from rising energy prices of global supply chain disruptions. This makes Japan a good defensive “safe haven” bond market against the backdrop of rising global bond yields that we expect in 2022. Chart 17Stay O/W Australian & Japanese Interest Rate Exposure Chart 18Our Recommended DM Government Bond Country Allocations In summary, our government allocations reflect the growing gap between expected monetary policy changes in 2022. This gives us a bias to favor lower-yielding markets, with Australia being the notable exception (Chart 18). However, in an environment where global bond volatility is expected to increase as multiple central banks exit QE and begin rate hiking cycles, carry/yield considerations play a secondary role in determining optimal country allocations. Key View #3: Stay neutral global inflation-linked bonds versus nominal government debt Another part of the global fixed income universe where the investment story has become more complicated is inflation-linked bonds. Overweighting inflation-linked bonds versus nominal government debt was the right strategy for bond investors as economies reopened from 2020 COVID lockdowns and global growth recovered. Booming commodity prices and supply chain squeezes added to the positive backdrop for linkers in 2021, as realized inflation soared to levels not seen in over a generation in many countries. Yet now, there is much less upside potential for inflation breakevens from current levels. Our Comprehensive Breakeven Indicators (CBI) are one of our preferred tools to assess the attractiveness of inflation-linked bonds versus nominals within the developed markets. For each country, the CBI reflects the distance of 10-year inflation breakevens from three different measures – the fair value from our breakeven spread model, medium-term survey-based inflation expectations and the central bank inflation target. The further breakevens are from these three measures, the less scope there is for additional increases in breakevens. As can be seen in Chart 19, there is limited upside potential for breakevens in almost all countries. Only Canada has a CBI below zero, with the CBIs for the UK, US, Germany and Italy well above zero. With central banks belated starting to respond to high realized inflation with tapering and rate hikes, it is still too soon to move to a full-blown underweight stance on global inflation-linked bond exposure versus nominal government debt. Instead, we recommend no more than a neutral exposure in countries where our CBIs are relatively lower – Canada, Australia, Japan – and underweight allocations where the CBIs are relatively higher – the UK, Germany, Italy and France (Chart 20). One country where we are deviating from our CBI signal is the US. We are keeping the recommended US TIPS exposure at neutral to begin 2022, but we anticipate downgrading TIPS later in 2022 if the Fed begins to lift rates sooner and more aggressively than expected. We do recommend positioning within that neutral overall TIPS allocation by underweighting shorter maturities versus longer-dated TIPS, A more hawkish Fed and some likely deceleration of realized US inflation should result in a steeper TIPS breakeven curve and a flatter TIPS real yield curve. Beyond looking at inflation breakevens, the outlook for real bond yields may be THE most complicated part of the 2022 investment story. Perhaps no single topic generates a greater debate among BCA’s strategists than real bond yields, which remain negative across the developed world (Chart 21). Determining why real yields are negative is critical for making calls across other asset classes beyond just government bonds. Valuations for equities and corporate credit have become more closely correlated with real yields in recent years. Real yield differentials are also an important factor driving currency levels. Chart 20Our Recommended Inflation-Linked Bond Allocations We see negative real yields as a reflection of persistent central bank policy dovishness that looks increasingly unrealistic. Chart 22 should look familiar to regular readers of Global Fixed Income Strategy. We show real central bank policy rates (adjusted for realized inflation) and the market-implied expectations for those real rates derived from the forward curves for OIS rates and CPI swap rates. Chart 21Negative Real Yields: Global Bonds' Biggest Vulnerability In the US, UK and Europe, markets are pricing a future path for nominal short-term interest rates that is consistently lower than the expected path of inflation. If markets believe that central banks will be unwilling (or unable) to ever lift policy rates above inflation, or that neutral medium-term real interest rates are in fact negative in most developed countries, then it should come as no surprise that longer-maturity real bond yields should also be negative. We do not subscribe to the view that neutral real rates are negative across the developed world, especially in the US. Even if we did, however, such a view is already reflected in the future pricing of bond yields and interest rates. As outlined earlier, OIS curves in many countries are underestimating how high nominal policy rates will go in the next 2-3 years. The potential for a “real rate shock”, where central banks tighten policy at a faster pace than markets expect, is a significant risk for global financial markets in the coming years. We see this as more of a risk for markets in 2023, with the Fed likely to become more aggressive on rate hikes and even the ECB likely to begin considering an interest rate adjustment. For 2022, however, we do expect global real yields to stabilize and likely begin to turn less negative as central banks continue to tighten policy. Key View #4: Overweight euro area high-yield and investment grade corporates versus US equivalents. Limit exposure to EM hard-currency debt until there are clear signals of China policy stimulus and upside momentum on the US dollar fades. The outlook for global credit markets in 2022 has also become more complicated, particularly for corporate bonds and EM hard currency debt. On the one hand, the levels of index yields (Chart 23) and spreads (Chart 24) for investment grade and high-yield corporate debt in the US, euro area and UK have clearly bottomed. The Omicron threat to global growth may be playing a role in the recent increases, but the more likely culprit is growing central bank hawkishness and fears of tighter monetary policy. Chart 23Global Corporate Bond Yields Have Reached A Cyclical Bottom Chart 24Global Corporate Bond Spreads Have Reached A Cyclical Bottom On the other hand, the fundamental backdrop for corporate debt is not conducive to major spread widening. As outlined at the start of this report, nominal economic growth in the major developed economies remains solid, which supports the expansion corporate revenues. Combined with still-low borrowing rates, this creates a relatively positive backdrop that limits risks from downgrades and defaults. Chart 25Monetary Policy Backdrop Turning More Negative For Credit Markets Corporate bond performance, both absolute returns and excess returns versus government debt, has worsened on a year-over-year basis for the latter half of 2021 (Chart 25). That has coincided with slowing growth in the balance sheets of the Fed and other major central banks and, more recently, the flattening trend of government bond yield curves as markets have discounted 2022 rate hikes. This suggests that monetary policy tightening expectations are dominating the still relatively positive fundamental backdrop for corporate credit. Looking ahead to 2022, we see a greater need to focus on relative value and cross-country valuation considerations when allocating to developed market corporate debt – particularly when looking the biggest markets in the US and euro area. We see a strong case for favoring euro area corporates over US equivalents, both for investment grade and particularly for high-yield. Our preferred method of corporate bond valuation is looking at 12-month breakevens. Breakevens measure the amount of spread widening that would need to occur over a one year horizon to eliminate the yield advantage of owning corporate bonds over government bonds of similar duration. We calculate this as the ratio of the index spread to the index duration for a particular credit market, like US investment grade. We then take a percentile ranking of those 12-month breakevens to determine the attractiveness of spreads versus its own history. On that basis, the 12-month breakeven for US investment grade corporates looks very unattractive, sitting near the bottom of the historical distribution (Chart 26). This reflects not only tight spreads but also the high durations of investment grade credit. US high-yield corporate spreads are not as stretched, but are also not particularly cheap, with the 12-month breakeven sitting at the 34th percentile of its distribution. In the euro area, the 12-month breakeven for investment grade is not as stretched as in the US, sitting in the 36th percentile (Chart 27). The euro area high-yield 12-month breakeven looks similar to the US, at the 24th percentile of its historical distribution. Chart 26US Corporate Spread Valuations Are Not Compelling Chart 27Euro Area Corporate Spread Valuations Are Also Stretched Our current recommended strategy on US corporate exposure is to be neutral investment grade and overweight high-yield. We see no reason to change that view to begin 2022. However, we do anticipate downgrading US corporate exposure later in the year when the Fed begins to lift interest rates and the US Treasury curve flattens more aggressively. Earlier, we recommended positioning for a wider US Treasury-German bund spread as a way to play for the growing policy divergence between a more hawkish Fed and a still dovish ECB. Another way to do that is to overweight euro area corporate debt versus US equivalents, for both investment grade and especially for high-yield. In terms of potential default losses, the outlook is positive on both sides of the Atlantic. Moody’s is projecting a 2022 default rate of 2.3% in the US and 2.2% in the euro area (Chart 28). The last two times that the default rates were so similar, in 2014/15 and 2017/18, also coincided with a period of euro area high-yield outperforming US high-yield (on a duration-matched and currency-matched performance). We see that pattern repeating in 2022. Chart 28Favor Euro Area High-Yield Over US Equivalents In 2022 When looking within credit tiers, we see the best value in favoring Ba-rated euro area high-yield versus US equivalents when looking at 12-month breakeven percentile rankings (Chart 29). Yet even looking at just yields rather than spread, lower-rated euro area high-yield corporates offer more attractive yields than US equivalents, on a currency-hedged basis (Chart 30). Chart 31Stay Cautious On EM Hard Currency Debt Turning to EM hard currency debt, we recommend a cautious stance entering 2022. EM fundamentals that typically need to in place to produce tighter EM credit spreads are currently not in place. Chinese economic growth is slowing, commodity price momentum is fading and the US dollar is appreciating versus EM currencies (Chart 31). An improvement in non-US economic growth will help turn around all three trends, especially the strengthening US dollar which typically trades off US/non-US growth differentials. The key to any non-US growth acceleration in 2022 will come from China. When Chinese policymakers announce more aggressive stimulus measures in 2022, as we expect, that would represent an opportunity to turn more positive on EM USD-denominated debt. Until that happens, we recommend staying underweight EM hard currency debt, with a slight bias to favor sovereigns over corporates. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index
Dear Client, Thank you for your continued readership and support this year. This is the last European Investment Strategy report for 2021. In this piece, we review ten charts covering important aspects of the European economy and capital markets. We will resume our regular publishing schedule on January 10th, 2022. The European Investment Strategy team wishes you and your loved ones a wonderful holiday season, and a healthy, happy, and prosperous new year. Best regards, Mathieu Savary Highlights European growth continues to face headwinds as it enters 2022. The ECB will be slow to remove more accommodation than what is implied by the end of the PEPP. Value stocks and Italian equities will enjoy a modest tailwind from rising Bund yields. The lower quality of European stocks creates a long-term headwind versus US benchmarks. The outperformance of European cyclicals relative to defensives will resume and financials will have greater upside. The relative performance of small-cap stocks will soon stabilize, but a weak euro will create a near-term risk. President Emmanuel Macron’s real contender is the center-right candidate Valerie Pécresse, not populists. Feature Chart 1: Wave Dynamics The current wave of COVID-19 infections continues to surge in Europe. As Chart 1 highlights, Austria and the Netherlands just witnessed intense waves that eclipsed those experienced earlier this year. However, these waves are already ebbing because of the containment measures implemented in recent weeks. In these two severely hit nations, hospitalization rates also increased significantly; however, they did not reach the degree experienced in France or the UK in the first half of 2021 (Chart 1, right panel). Chart 1Wave Dynamics Chart 1Wave Dynamics Europe will experience another test in the coming weeks as the highly contagious Omicron variant becomes the dominant COVID-19 strain. However, data from South Africa continues to suggest that this mutation is much less pathogenic than previous variants and will not place as much strain on the healthcare system as potential case counts would indicate. Nonetheless, it is too early to make this prognosis with great confidence. Importantly, even if a small proportion of infected people is hospitalized, a large enough a pool of infections could cause a rupture in the healthcare system. As a result, politicians will likely remain cautious until a larger share of the population receives its booster dose. Hence, Omicron still represents a near-term risk to economic activity, albeit one that will prove ephemeral. Chart 2: The Economy Is Not Out Of The Woods Yet European growth remains highly dependent on the fluctuations of the global economy because exports and capex account for a large share of the continent’s output. Consequently, global economic trends remain paramount when considering the European economic outlook. In the near-term, Europe continues to face headwinds beyond the uncertainty caused by the potential effects of the Omicron variant. Global economic activity, for instance, is likely to face some further near-term headwinds caused by the supply shock typified by elevated commodity prices and bottlenecks (Chart 2). Not only does this shock limit the ability of producers to procure important inputs, but it also increases the costs of production. Historically, this combination results in downward pressure on global manufacturing activity. Chart 2The Economy Is Not Out Of The Woods Yet Chart 2The Economy Is Not Out Of The Woods Yet The second problem remains the deceleration in the Chinese economy. Declining credit growth in China results in slower European exports, which also hurts the region’s PMI. The recent Central Economic Work Conference suggests that China is ready to inject more stimulus in its economy, which will help Europe. However, the beginning of 2022 will still witness the lagged impact of previous tightening in credit conditions on European economic indicators. Moreover, BCA’s China Investment Strategy team expects the stimulus to be modest at first and only grow in intensity later. It is unlikely to be as credit-heavy as in the past, which also means it will be less beneficial to Europe. Chart 3: A Careful ECB Last week, the European Central Bank aggressively upgraded its inflation forecast for 2022 and announced the end of the PEPP for March, however, it will increase temporarily the APP program to EUR40bn. Moreover, President Christine Lagarde remains steadfast that the Governing Council will not raise rates in 2022. Our Central Bank Monitor points to the need for tighter policy, yet the ECB continues to adopt a cautious tone, even if the Eurozone HICP inflation has reached 4%—the highest reading in thirteen years. First, the ECB still runs the risk of dislocation in the periphery, where Italian and Spanish spreads may easily explode if monetary accommodation is removed too quickly. Second, European inflationary pressures remain significantly narrower than they are in the US (Chart 3, left panel). Our Eurozone trimmed-mean CPI continues to linger well below core CPI readings, while in the US both measures track each other closely. Third, the decline in energy prices and the ebbing transportation bottlenecks mean that odds are growing that sequential inflation will soon experience an interim peak (Chart 3, right panel). Chart 3A Careful ECB Chart 3A Careful ECB This view of the ECB implies that German yields will not rise as much as US yields next year, which BCA’s US Bond Strategy team expects to reach 2.25% by the end of 2022. Moreover, the more tepid pace of the removal of accommodation and the implicit targeting of peripheral bond markets also warrant an overweight position in Italian bonds. Spreads will be volatile, but any move upward will be self-limiting because of their role in the ECB’s reaction function. As a result, investors should continue to pocket the additional income over German paper. Chart 4: A Murky Outlook For The Euro The market continues to test EUR/USD. Any breakdown below 1.1175 is likely to prompt a pronounced down leg toward 1.07-1.08, near the pandemic lows. The euro suffers from three handicaps. First, Europe’s economic links with China are greater than those of the US with China. Consequently, the Chinese economic deceleration hurts European rates of returns more than it hurts those in the US. Second, the acceleration of US inflation is inviting investors to reprice the path of the Fed’s policy rate, which accentuates the upside pressure on the dollar. Finally, the energy crisis is ramping up anew following Germany’s suspension of the approval of the Nord Stream 2 pipeline and the buildup of Russian troops on Ukraine’s borders. Surging European natural gas prices act as a powerful headwind for EUR/USD because they accentuate stagflation risks in the Eurozone (Chart 4, left panel). While these create downside pressures on the euro, the picture is more complex. Our Intermediate-Term Timing Model shows that EUR/USD is one-sigma oversold (Chart 4, right panel). Over the past 20 years, it was more depressed only in 2010 and in early 2015. Such a reading indicates that most of the bad news is already embedded in EUR/USD and that sentiment has become massively negative. Thus, we are not chasing the euro lower, even though we will respect our stop-loss at 1.1175 if it were triggered. Instead, we will look to buy the euro at lower levels in the first quarter of 2021. Chart 4A Murky Outlook For The Euro Chart 4A Murky Outlook For The Euro Chart 5: German Yields Are Key To Value Stocks And Italian Equities The performance of European value stocks relative to that of growth stocks continues to exhibit a close relationship with the evolution of German Bund yields (Chart 5, left panel). Value stocks are less sensitive than growth stocks to higher yields because they derive a smaller proportion of their intrinsic value from long-term deferred cash flows; which suffer more from rising discount factors than near-term cash flows. Moreover, value stocks overweight financials, whose profitability increases when yields rise. The same relationship exists between the performance of Italian equities relative to the Eurozone benchmark (Chart 5, right panel). This correlation holds because of Italy’s significant value bias and its large exposure to financials. Chart 5German Yields Are Key To Value Stocks And Italian Equities Chart 5German Yields Are Key To Value Stocks And Italian Equities Based on these observations, BCA’s view that German Bund yields will rise toward 0.25% is consistent with a modest outperformance of value and Italian equities in 2022. For a more robust outperformance by value and Italian stocks, the Chinese economy will have to re-accelerate clearly and the dollar will have to fall significantly. However, these two outcomes could take more time to materialize than our bond view. Chart 6: Europe’s Quality Deficit The gyrations in the performance of European equities relative to US stocks continue to be influenced by China’s economic fluctuations. The deterioration in various measures of China’s credit impulse remains consistent with further near-term underperformance of European equities (Chart 6, left panel). Moreover, if Omicron has a significant impact on consumer behavior (via personal choices or government measures), it will once again hurt spending on services and boost the appeal of growth stocks, which Europe underrepresents. These headwinds will not be long lasting. Europe has an opportunity to outperform next year if global yields rise. However, European equity markets continue to suffer from a potent long-term disadvantage relative to those of the US. American benchmarks are composed of higher quality stocks than European ones. As a result of greater market concentration, more innovative applications of research, and the development of greater moats, US stocks generate wider profits margins than European companies and have a higher utilization of their asset base. Consequently, US shares sport significantly higher RoEs and earnings growth than European large-cap names (Chart 6, right panel). Historically, the quality factor has been one of the top performers and is an important contributor to the current strength of growth equities. Thus, even if Europe’s day in the sun arrives before the middle of 2022, it will again be a temporary phenomenon. Chart 6Europe’s Quality Deficit Chart 6Europe’s Quality Deficit Chart 7: Will the Cyclicals Outperformance Resume? For most of 2021, European cyclicals equities have not performed as well against defensive stocks as many investors hoped. In fact, the relative performance of cyclicals is broadly flat since March. Going forward, cyclicals will resume their uptrend against defensive equities and even break out of their range of the past twenty years. From a technical perspective, cyclicals have expunged many of their excesses. By the spring, European cyclicals had become prohibitively expensive compared to their defensive counterparts (Chart 7, left panel). However, their overvaluation has now passed and medium-term momentum measures are not overbought anymore, which creates a much better entry point for cyclical equities. From a fundamental perspective, cyclicals will also enjoy rising yields after being hamstrung by Treasury yields that have moved sideways for more than nine months (Chart 7, right panel). Moreover, the eventual stabilization of the Chinese economy will create an additional tailwind for these stocks. Chart 7Will The Cyclicals Outperformance Resume? Chart 7Will The Cyclicals Outperformance Resume? The biggest risk to cyclical stocks lies in inflation expectations. Ten-year CPI swaps have stopped increasing despite rising inflation. As the yield curve flattens and long-term segments of the OIS curve invert, markets register their fears that the Fed might tighten too much over the next two years. In other words, markets continue to agonize over the effect of a very low perceived terminal rate. These worries may cause the CPI swaps to decline significantly as the Fed hikes rates next year, creating a headwind for cyclicals. Chart 8: Favor Financials Financials in general and banks in particular have outperformed the European benchmark this year. This trend will persist in 2020. More than the positive impact of higher yields on the profitability of financials justifies this view. One of the key drivers supporting our optimism toward this sector is the continued improvement in the balance-sheet health of the European banking sector (Chart 8, left panel). Capital adequacy ratios remain in an uptrend and NPLs continue to be well-behaved. Meanwhile, both the governments’ liquidity support during the pandemic and the nonfinancial sector’s cash buildup over the past 18 months limit the risk that a brisk rise in insolvencies would threaten the viability of the banking system. European bank lending is also likely to remain superior to that of the post-GFC years. Consumer confidence is still sturdy, despite the recent increase in COVID cases and the tax hike created by rapidly climbing energy prices (Chart 8, right panel). Companies also benefit from an environment of low real rates and limited fiscal austerity. Unsurprisingly, capex intentions are elevated, which should support credit demand from businesses going forward. Chart 8Favor Financials Chart 8Favor Financials These factors imply that the current large discount embedded in European financials’ valuations remains excessive (even if a smaller discount is still warranted). As long as peripheral spreads do not blow out durably, financials will have scope to outperform further. Banks should also beat insurance companies. Chart 9: Small-Caps Are Nearly There Despite a sideways move followed by a 4% dip, the performance of European small-cap stocks remains in a pronounced uptrend relative to large-cap equities. The recent bout of underperformance is likely to end soon, unless a recession is around the corner. Small-cap stocks are becoming oversold (Chart 9, left panel) and will benefit from their pronounced procyclicality, especially if the recent improvement in global economic surprises continues next year. Moreover, above-trend European growth as well as an ECB that will maintain accommodative monetary conditions will combine to prevent a significant widening in European high-yield spreads, particularly once natural gas prices are turned down after the winter. This process will also help small-cap equities. The biggest risk for the European small-caps’ relative performance is the currency market. The relative performance of small-cap names is still closely correlated to the euro (Chart 9, right panel). As a result, if EUR/USD were to falter in the coming weeks, the underperformance of small-cap stocks could deepen. At the very least, small-cap stocks would languish before resuming their uptrend later in the year. Chart 9Small-Caps Are Nearly There Chart 9Small-Caps Are Nearly There Chart 10: A Risk to Macron’s Second Term The emergence of the new populist candidate Éric Zemmour has galvanized the media in recent weeks. However, he is very unlikely to pose a credible threat to French President Emmanuel Macron, unlike center-right candidate Valerie Pécresse, who just won the Les Républicains (LR) primary. In a Special Report published conjointly with our geopolitical strategists last summer, we identified the emergence of a single candidate able to unite the center-right as one of the biggest risks to Macron. As Chart 10 shows, Pécresse has made a comeback in the polls and is now expected to face Macron in the second round. According to an Elabe poll conducted after her victory in the primary, if the second round of the elections were held now, she would beat Macron. Will Pécresse manage to keep her momentum going until April 2022? First, she has to ensure the center-right remains united behind her. Up until the primaries, the center-right was divided. While she won the primary by a wide margin, her main opponent Éric Ciotti won the first round (25.6%), and Michel Barnier as well as Xavier Bertrand came close behind, with 23.9% and 22.7% respectively. Second, Pécresse must work hard to prevent voters from succumbing to the siren songs of Zemmour and Marine Le Pen, or to lean toward former Prime Minister Phillippe Edouard, a declared supporter of Macron. Investors should ignore Le Pen and Eric Zemmour. The real threat to Macron lies in Valerie Pécresse’s ability to keep the center-right united under her banner. Considering that the center-left does not represent an option and that the far-right is entangled in a tug-of-war, there is a high probability that Pécresse will reach the second round. Footnotes Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance
Highlights The risk to European stocks from higher yields is overstated for 2022. Not only do equities possess a valuation cushion compared to bonds, but also the stock returns/bond yields correlation remains positive. This positive correlation is only two decades old, and it is a consequence of the stabilization of inflation and inflation expectations, which caused bond yield changes to mostly reflect adjustment in anticipated economic activity. As long as the recent inflation upsurge peters off next year, the equity/yield correlation will remain positive in 2022. Despite this sanguine short-term view, the long-term outlook is fraught with risks because next year’s inflation decline will be temporary; inflation is on a secular uptrend. The equity returns/bond yield correlation will become negative toward the middle of the decade, which will create a major headwind for the secular returns of both stocks and bonds. Feature Extremely low yields and elevated valuations constitute a potentially toxic mix for the equity outlook next year. The logic is straightforward: if yields rise enough, nosebleed multiples will become unjustifiable and the stock market will crash. Chart 1Protection Against Higher Yields The picture is more complex and instead, European equities are likely to withstand higher yields. To begin with, BCA Research’s US Bond strategists anticipate a modest rise in Treasury yields to 2.25% in 2022, and our Global Fixed-Income strategists foresee an even more limited increase in German rates. Moreover, as we showed in our 2022 Key Views piece published last week, European equities embed a large valuation cushion in the form of a significant premium in their dividend yield relative to Bund yields (Chart 1). The correlation between yields and equities is another facet that will impact the effect of higher yields on the equity bull market. For now, it is premature to conclude that the positive correlation between yields and the absolute performance of European equities is poised to turn negative again in 2022. However, over the next couple of years, such a correlation reversal will take place, because inflation expectations are increasingly likely to become unmoored to the upside. Stocks Like Higher Yields Over the past two decades, one of the major financial market paradoxes has been the relationship between equity prices and bonds yields. Since 1998, the weekly returns of the MSCI Euro Area equity benchmark have correlated positively with the change in 10-year German yields (Chart 2). However, prior to the late 1990s, changes in bond yields and stocks prices were negatively correlated. Chart 2For Two Decades, Bond Yields And Stocks Prices Have Moved Together The key to the shifting relationship between stocks and bonds is the link between yields and economic activity. Stock returns have always been procyclical because earnings are the most important driver of equity returns (Chart 3). However, bond yields have become increasingly pro-cyclical over time. Today, Bund yields and the German LEI move in tandem, but, prior to 1986, their five-year rolling correlation was negative (Chart 4). Chart 3Stocks Follow Earnings Who Follow Growth Chart 4Shifting Link Between Bunds And German Growth The positive correlation between German growth and German yields sheds light on why the correlation between yields and stocks is now positive, but it does not explain why this positive link emerged in the late 1990s and not earlier. Financial asset prices reflect global phenomena. Stock indices in advanced economies overrepresent multinationals which are affected by global economic fluctuations. Meanwhile, capital is fungible and flows freely across borders. As a result, German bond yields are not the unique factor that matters to the correlation between equities and stock. Instead, the behavior of global yields and equities is critical. Chart 5Living In The Shadow Of The Asian Crisis According to this logic, the correlation between global yields and global growth becomes important. As Chart 5 illustrates, the relationship between global bond returns and global economic activity became much closer around 1998 than it was prior to this date. The key turning point was the Asian crisis of 1997/98. Why was the Asian crisis so fundamental? It was the end state of the disinflationary trend started under Federal Reserve Chairman Paul Volker. After the Asian crisis, the region’s newly industrialized economies switched from chronic current account deficits to chronic surpluses, which added to the global supply of savings. Moreover, Asian economies became hypercompetitive because of severely devalued exchange rates, which limited pricing power around the world. Finally, the Chinese economy became a force to be reckoned with and its share of global trade expanded massively. Together, these forces amplified competitive pressure around the world and made every inflation uptick self-limiting. The impact of the shock is visible in the inflation data. As Chart 6 shows, core inflation in the US and in the G7 has been stable since 1998, capped near 2.5%, except for 2021. Additionally, after the Asian crisis, the volatility of core inflation collapsed among both the G7 and Eurozone economies (Chart 7). Chart 62.5%, A 20-Year Old Ceiling Chart 71998: RIP CPI Volatility The effect of this steady inflation was to stabilize inflation expectations. Thus, after 1998, the most important driver of bond price annual changes has been fluctuations in anticipated real economic activity, which explains why the relationship between global bond returns and the global LEI became much tighter afterward (Chart 5, on page 4). This result is crucial to understand the impact of higher yields for equities. It suggests that, if rising yields reflect improving economic growth, then the correlation between yields and stocks will remain positive and equities may climb higher along with mounting long-term interest rates. Bottom Line: Higher yields do not necessarily portend the end of the equity bull market. Stock prices and bond yields have been positively correlated since the Asian crisis of 1997/98 because fluctuating growth expectations drive most of the change in yields. As long as this remains the case, equities can handle higher yields. Can The Correlation Shift Sign Again? The correlation between equities and bonds is not static. There are threats that could restore both temporarily or permanently the negative correlation between changes in bond yields and stock returns that prevailed prior to 1998. A Temporary Correlation Shift? Since their March 2020 lows, 10-year yields have increased 94bps and 51bps in the US and Germany, respectively. Meanwhile, the MSCI Eurozone equity benchmark is up 78%. We are clearly not yet in an environment in which rising long-term interest rates hurt stocks. In the short term, the correlation between yield changes and equity returns may turn negative if yield moves into constraining territory—this is to say, if they rise enough to risk a recession. In more academic terms, this equates to rates moving above the neutral rate of interest, or r-star. Chart 8A Long Way To Go Before Policy Becomes Tight There is little indication that interest rates are moving above this level in the short term. US and European policy rates remain well below Taylor rule estimates of equilibrium (Chart 8), which suggests that policies are still highly accommodative. The most worrisome signal comes from the slope of the yield curve. Since March 2021, the US 2-/10-year yield curve has flattened by 76bps to 81bps and, since October 2021, the same yield curve has flattened by 23bps to 35bps in Germany. Moreover, the 20-/30-year US yield curve became inverted in October 2021. These dynamics may indicate that policy is already on the verge of becoming too tight, even if only five interest rate hikes are expected in the US over the next two years. Chart 9Term Premia Are Still Negative A curve flattening episode is the normal course of events when central banks become less accommodative; it is not a sign of impending doom. Instead, an inverted yield curve is the indication that the policy rate is above r-star. After all, if interest rates genuinely constrain growth, they will slow economic activity in the future, which will necessitate lower rates and generate a negative curve slope. We are not there yet. Moreover, the term-premium remains negative across major advanced economies, which suggests that a recessionary signal will come from a deeper yield-curve inversion than in the past (Chart 9). Chart 10Upside To The Terminal Rate Another factor likely to allow yields to rise without killing the equity market is that the expected terminal rate of interest remains too low, as we wrote in our 2022 Key Views piece last week. Historically, it is common for the expected terminal rate to rise as central banks begin to lift interest rates, especially if the economy handles the first hikes well. Today, the expected terminal rate is below the levels that prevailed after the GFC, despite a much firmer economy unburdened by private sector deleveraging and excessive fiscal tightening (Chart 10). As such, we anticipate the expected terminal rate to increase, which will limit how quickly the yield curve will flatten next year even if the Fed elevates interest rates and the ECB aggressively downshifts its pace of asset purchases once the PEPP ends. Chart 11Long-Term Inflation Expectations Are Not A Concern, Yet Under this aperture, the biggest risk for stocks remains inflation. Further acceleration in inflation, especially if it pushes the 5-year/5-year forward inflation breakeven rate above the Fed’s comfort zone (Chart 11), could hurt stocks. Essentially, investors would price in a shift in the monetary policy environment whereby risks of a severe tightening would increase. However, as we recently wrote, the odds are mounting that short-term inflation will soon peak. Oil inflation is ebbing, while transportation costs are declining and supply bottlenecks are beginning to ease. Moreover, money growth in the US and the Eurozone, which proved relevant variables to explain inflation this year, is also waning (Chart 12). Finally, a mounting number of global central banks are tightening policy, which implies that maximum accommodation is behind us (Chart 13) In this context, we expect the positive correlation between stock returns and yield changes to remain broadly positive. A short-term rise in yields could easily contribute to equity market volatility and may even cause a deeper stock market correction than any experienced since April 2020. However, this will prove to be a temporary phenomenon, and thus we remain buyers of the dip. Chart 12Slowing Money Supply Growth, At Last Chart 13Global Policy Is Becoming Less Easy A Longer-Term Correlation Shift? A shift in the long-term correlation between equity returns and bond yield changes is a much more meaningful risk to stocks than short-term changes. BCA expects inflation to peak in the short term, but this will only be part of a stop-and-go process. Inflation is on a structural uptrend and so, any decline in 2022 and early 2023 will morph into renewed pressure, after the global output gap becomes positive again by the end of next year. Chart 14A Deflationary Tailwind Is Gone Many structural forces are moving away from deflationary to inflationary. True, technological progress remains a deflationary anchor. However, this downward pressure on inflation is no longer buttressed by a deepening of globalization (Chart 14). Moreover, because of the rise of populism around the world over the past five years, fiscal policy is unlikely to move back to the austere Washington Consensus that dictated governance from President Reagan up to the moment President Trump took power. Additionally, ageing across advanced economies and China, as well as the so-called “Great Resignation,” will constrain the expansion of the global supply side. This background suggests that the period of flat inflation that prevailed from 1998 to 2020 is ending. As a corollary, inflation expectations will embark on a multi-year upward drift. This process is likely to loosen the correlation between economic activity and yields. As a result, the period of positive correlation between yield changes and equity returns is in its last innings. This will represent a major difficulty for asset allocators over the next ten to twenty years, as it points to poor long-term real returns for both bonds and stocks. Bottom Line: The correlation between stock returns and bond yield changes is likely to remain positive in 2022, which implies that European stocks will eke out another year of positive returns, despite BCA’s house view that yields will rise. However, the long-term outlook is more problematic. The growing likelihood that inflation is making a secular upturn means that the two-decades old positive correlation between equity returns and bond yield change will become negative again around the middle of the decade. This shift will have a profound and deleterious impact on both stocks’ and bonds’ secular returns. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance
Highlights The helicopter drops are over, … : The economic impact payments and supplemental unemployment insurance benefits may have stopped, but their full impact has yet to be felt. … but fiscal and monetary policy will continue to support demand, … : US households are sitting on more than $2 trillion of excess pandemic savings. If they were to spend just half of their stash over the next two or three years, the economy would gain a steady tailwind. … and the macro backdrop will remain equity-friendly, … : Monetary policy will be less accommodative going forward but it will remain solidly supportive of markets and the economy across all of 2022. … so investors should stick around for one last round: Equities and spread product outperform when monetary policy is easy. As long as COVID-19 doesn’t spring a nasty surprise, the expansion will continue and risk assets will once again generate positive excess returns over Treasuries and cash. Feature BCA editors’ annual sit-down with Mr. and Ms. X provides a welcome opportunity to gather our thoughts for the coming year and review how this year’s calls panned out. Looking back to this time last year,1 our risk-friendly recommendations performed well as the rationale behind them proved to be sound. Financial markets thrived in the wake of monetary and fiscal policy measures intended to err on the side of providing too much accommodation. The policy efforts were massive, and their support for markets and the economy has yet to be fully exhausted; indeed, their lengthy half-life is a key pillar of our sanguine 2022 outlook. Unlike last December, investors cannot look forward to peak accommodation in the year ahead; the peak is behind us and monetary and fiscal stimulus will be throttled back. The Fed is currently deliberating how much to accelerate its taper timetable, with an eye toward gaining the flexibility to hike rates sooner than previously planned. The hawkish turn foreshadowed by Chair Powell two weeks ago in Congressional testimony unsettled markets somewhat, but it is important to note that monetary policy settings are merely on track to become less accommodative – they are nowhere near crossing the line to restrictive and will not approach it anytime soon. Investors can be certain that markets will enjoy ample policy support across all of 2022 and we expect that equities will still be in a bull market when Mr. and Ms. X return to discuss the outlook for 2023. We are on board with the BCA consensus as detailed in the Bank Credit Analyst’s 2022 outlook.2 Early indications suggest that the Omicron variant will not be enough of a threat to provoke a negative growth surprise and we expect that the pandemic will recede in importance as the year unfolds. As it fades, supply chains should become less snarled, easing the near-term pressures that have been pushing prices higher. We expect that markets are overestimating inflation in the near term and that growth will be robust in the US and other developed economies. Despite the dialing back of some accommodation, monetary policy will remain easy, supporting economic activity and market valuations. We foresee another year of solidly positive excess returns for risk assets. The Economy Is Firing On All Cylinders You wouldn’t necessarily know it to talk with investors, much less consumer confidence survey respondents, but aggregate demand is surging and ought to remain robust going forward. Households are in fantastic shape. Although their net worth growth slowed in the third quarter, its 13% annualized seven-quarter (1Q20 through 3Q21) pace is within a whisker of all-time highs (Chart 1). They have accumulated $2.3 trillion of excess savings since the pandemic began and have plenty of capacity to borrow to augment their spending power. Just about anyone who wants a job can have one: the ratio of job openings to unemployed workers is making new highs (Chart 2) and the share of people in the labor force filing initial jobless claims is approaching the all-time lows set before the pandemic (Chart 3). Chart 1The Wealth Effect Will Support Consumption Chart 2More Jobs Than People Without Them ... Businesses are on a solid financial footing, as well. Debt as a share of net worth is near the lower end of its typical range since the high yield bond market got going in the late ‘80s (Chart 4). Borrowing costs are scraping all-time lows (Chart 5) and profit margins are wide (Chart 6). Banks and fixed income asset managers are falling all over themselves to lend to businesses and will continue to do so while default rates remain low. Chart 3... And Almost No Layoffs Chart 4Corporations Have Less Debt And More Equity, ... Chart 5... But Debt Has Never Cost Less ... Chart 6... And Profit Margins Are Wide Financial conditions will remain highly accommodative despite the Fed’s and other major developed world central banks’ moves to make them less easy at the margin. Below-equilibrium policy rates will continue to encourage financed purchases of homes, autos and other durable goods and entice investment via low hurdle rates. If sovereign bond yields rise modestly in 2022 in line with our high-conviction base case, governments won’t feel any pressure to tighten the fiscal screws. That may nourish modern monetary theory fantasies to the ultimate detriment of public finances, but it should ensure that all three engines of domestic demand – households, businesses and government – will hum in 2022. Omicron has reminded everyone that the pandemic is not over, but the shadow it casts on public health and economic activity is set to shrink. Booster shots of the Pfizer vaccine apparently provide effective protection, and Omicron’s mutations will not allow it to evade Merck’s and Pfizer’s soon-to-be-approved antiviral pills. The availability of pills to treat those who contract COVID could possibly be a game-changer in terms of neutralizing its global threat. Distributing shelf-stable pills is vastly simpler than delivering vaccines that need to be transported at temperatures below -70 degrees Fahrenheit. The Earnings Bar Has Been Set Very Low Our constructive view would not translate into risk friendly investment strategy if asset prices already discounted it or were expecting something even better. Just as the economy is on a better path than consumers seem to perceive and investors believe can persist, S&P 500 earnings per share are poised to grow over the next four quarters by more than the bottom-up analyst consensus expects. As compared to the simple annualized run rate of last quarter’s earnings ($215.76, or $53.89 times 4), the analyst consensus is calling for effectively no growth ($215.87) over the four quarters through 3Q22. That is a surprising prediction based on two sets of empirical evidence. First, earnings typically rise outside of recessions (Chart 7). Second, analysts have consistently forecast that forward four-quarter earnings would top the run rate of the last reported quarter’s earnings for four decades (Chart 8). This year, though, analysts have repeatedly called for quarter-over-quarter declines in earnings (Table 1), only to have reported numbers shred their estimates by jaw-dropping margins, just as they have in all six full quarters since COVID-19 arrived (Chart 9). We interpret the phase shift in the magnitude of earnings beats as evidence that companies have surprised themselves by how much they’ve been able to increase efficiency and/or cut costs during the pandemic. Our interactions with the investment community suggest that it has also been surprised but views the gains as one-off events that are unlikely to continue. Chart 7Earnings Declines Outside Of Recessions Are Rare Chart 8This Has Been An Odd Time To Expect 40-Year Lows In Earnings Growth Table 1Grim Expectations Expectations of sequentially declining earnings would fit if the economy were flirting with falling below stall speed, as it regularly did during the sluggish post-GFC expansion. But they are completely at odds with the Bloomberg economist consensus that GDP will grow at a 5% real annualized rate this quarter and 3.9% in calendar 2022 (Table 2). Over time, S&P 500 revenue growth should converge with nominal GDP growth, so the current expectations for around 10% and 7% annualized nominal GDP growth in 4Q21 and 2022, respectively, are a decent starting point for estimating S&P 500 revenue growth over those periods. While we expect that S&P 500 profit margins have peaked, we do not foresee a sharp decline in 2022, and operating leverage should ensure that high single-digit revenue growth will translate into healthy earnings gains. Table 2Above-Trend Growth Ahead Bottom Line: The S&P 500 should have no trouble topping consensus estimates that foresee next to no growth in earnings over the next four quarters. There is ample room for corporate earnings to surprise to the upside. Our Major Disagreement With Markets Differences of opinion make markets and our biggest one pertains to the future direction of interest rates. We think the widespread conviction that the Fed will be unwilling or unable to raise the fed funds above 2%, if that, lest it crush financial markets and the real economy is way off base. The majority of investors seem to have taken the decade between the crisis and the pandemic as evidence that rates will remain very low for very long. Many of them must be buying the longer end of the Treasury curve in anticipation that an expedited liftoff date is the first step on the path to the next recession (Chart 10). Chart 10The Bond Market Sees Ice, Not Fire The risk asset selloff that ensued in December 2018 after the FOMC marched the fed funds rate up to 2.5% looms large in the markets’ minds and feeds the widespread view that an ambitious program of rate hikes will pull the rug out from under financial assets and the economy. Many investors have also been conditioned by the post-crisis decade to assume that inflation cannot exceed 2% for a sustained period. The market view is rooted in honest-to-goodness evidence, but we think it is of little relevance now, given the way the massive pandemic fiscal stimulus programs have altered the backdrop. In the space of thirteen months from March 2020 through March 2021, Congress passed bills injecting over $5 trillion of aid – 25% of a year’s GDP – into the economy. The Herculean effort contrasted sharply with the skittish disbursement of less than 5% of GDP on the Bush and Obama administrations’ watch from 2008 through 2010. The aftermath of the crisis demonstrated that even multiple rounds of QE do not by themselves trigger inflation, especially if demoralized households and businesses are disinclined to borrow money to consume or invest, and chastened banks are subjected to regulatory strictures forcing them to maintain sizable new capital buffers and discouraging them from making any but plain-vanilla loans to highly rated borrowers. The Bernanke Fed’s three rounds of QE presumably tamped down interest rates, but the cash that bought the Treasury and agency securities barely tiptoed into the wider world before the primary dealer banks sent it right back to the Fed as excess reserves. With banks hiding their QE money under the mattress, the money supply didn’t expand in any notable way after the crisis. Thanks to Congress’ series of 2020-21 helicopter drops, the money supply has been growing at rates that would make the late Paul Volcker’s head spin (Chart 11). Inflation is fiendishly more complicated than Milton Friedman’s always-and-everywhere dictum suggests, but there’s now a whole lot of money chasing a limited amount of goods, services and assets. We expect that a receding pandemic will allow greater quantities of goods and services to be produced, and that securities underwriters and their clients are hard at work ramping up asset supply, but inflation has far more of a chance to gain traction now than it did in the decade before the pandemic. Chart 11Bringing "Always And Everywhere" Back Into Vogue? We therefore think the lower-for-longer and lower-for-ever crowd will find itself offsides at some point in the next few years. We do not think it will get its comeuppance in 2022, however, as we see long yields rising only modestly, with the 10-year Treasury yield ending next year at 2-2.25%. Though we expect the fed funds rate will end the upcoming hiking cycle well north of 2%, bringing about the end of the bull markets in equities and credit, and quite possibly inducing the next recession, we do not think markets will abandon their new-normal rates view by the end of next year. This story will be continued, likely with a greater sense of urgency, in our 2023 outlook. Investment Recommendations Consistent with the foregoing, we make the following recommendations for 2022: Overweight equities in multi-asset portfolios. Although they are not cheap, and may experience a turbulent ride in 2022 as inflation concerns wax and wane, COVID-19 infections periodically surge and the Fed tries to adjust its messaging and actions on the fly, stocks should continue to generate sizable positive excess returns over Treasuries and cash. Overweight cyclical sectors and underweight defensive sectors within equity portfolios. If we’re right to be constructive on the global economy, Energy, Industrials, Materials and Financials are better positioned to benefit than Health Care, Staples and Utilities. Overweight small-cap equities versus large-cap equities. The S&P 600 SmallCap Index has greater exposure to our cyclicals-over-defensives call and our US Equity Strategy colleagues highlight that its constituents are cheaper than the S&P 500’s and are projected to have better earnings growth. Adding small-cap exposure to equity portfolios aligns with our constructive view on the economy and markets. Underweight fixed income in multi-asset portfolios. Underweight Treasuries within bond portfolios. Maintain below-benchmark duration within bond portfolios. Though we do not expect the bond market to see things entirely our way next year, we think the long end of the yield curve will shift out somewhat. We therefore have little appetite for duration and Treasuries and expect spread product will outperform Treasuries and high-yield corporate bonds will outperform investment-grade corporates. Consider hybrid alternatives to traditional fixed income securities. When we roll out our multi-asset ETF portfolio next month, it will include a hybrid bucket of income-generating assets to help multi-asset investors seeking income find low-beta destinations with a fighting chance of generating positive real total returns. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the December 14, 2020 US Investment Strategy Report, "2021 Key Views: It’s The Policy, Stupid." 2 Please see the December 2021 Bank Credit Analyst, "OUTLOOK 2022: Peak Inflation – Or Just Getting Started?"
Highlights 1. How will the pandemic resolve? 2. Will services spending recover to its pre-pandemic trend? 3. Will we spend our excess savings? 4. How will central banks react to inflation? 5. Will cryptocurrencies continue to eat gold’s lunch? 6. How fragile is Chinese real estate? 7. Will there be another shock? Fractal analysis: Personal goods versus consumer services. Feature Chart of the WeekWill Services Spending Recover To Its Pre-Pandemic Trend? “Judge a man by his questions, not by his answers” The quotation above is often misattributed to Voltaire instead of its true author, Pierre-Marc-Gaston de Lévis. Irrespective of the misattribution, we agree with the maxim. Asking the right questions is more important than finding answers to the wrong questions. In this vein, this report takes the form of the seven crucial questions for 2022 (and our answers). 1. How Will The Pandemic Resolve? As new variants of SARS-CoV-2 have arrived like clockwork, the number of new global cases of infection and the virus reproduction rate have formed a near-perfect mathematical ‘sine wave’. This near-perfect sine wave will propagate into 2022 (Chart I-2). Chart I-2The Pandemic's Sine-Wave Will Propagate Into 2022 But how will this sine wave of infections translate into mortality, morbidity, and stress on our healthcare systems? As we explained in RNA Viruses: Time To Tell The Truth, the answer depends on the specific combination of contagiousness, immuno-evasion, and pathogenicity of each variant. Yet none of this should come as any surprise. Flus and colds also come in waves, which is why we call them flu and cold seasons. And the morbidity of a given flu and cold season depends on the aggressiveness of that season’s flu and cold variant. So, just like the flu and the cold, Covid will become an endemic respiratory disease which comes in waves. The trouble is that our under-resourced health care systems can barely cope with a bad flu season, let alone with an additional novel disease that can be worse than the flu. Hence, until we add enough capacity to our healthcare systems, expect more disruptions to economic activity from periodic non-pharmaceutical interventions such as travel bans, vaccine passports, and face-mask mandates. 2. Will Services Spending Recover To Its Pre-Pandemic Trend? The pandemic has given us a crash course in virology and epidemiology. We now understand antigens, antibodies, and ‘reproduction rates.’ We understand that a virus transmits as an aerosol in enclosed unventilated spaces, and that singing, and yelling eject this viral aerosol. We understand that vaccinations for RNA viruses have limited longevity, do not prevent reinfections, and that certain environments create ‘super-spreader’ events. Armed with this new-found awareness, a significant minority of people have changed their behaviour. Services which require close contact with strangers – going to the dentist or in-person doctors’ appointments, going to the cinema or to amusement parks, or using public transport – are suffering severe shortfalls in demand. Given that this change in behaviour is likely long-lasting, demand for these services is unlikely to regain its pre-pandemic trend in 2022 (Charts I-3 - I-6). Chart I-3Dental Services Are Far Below The Pre-Pandemic Trend Chart I-4Physician Services Are Far Below The Pre-Pandemic Trend Chart I-5Recreation Services Are Far Below The Pre-Pandemic Trend Chart I-6Public Transportation Is Far Below The Pre-Pandemic Trend Therefore, to keep overall demand on trend, spending on goods will have to stay above its pre-pandemic trend. This will be a tough ask. Durables, by their very definition, last a long time. Even clothes and shoes, though classified as nondurables, are in fact quite durable. Meaning that are only so many cars, iPhone 13s, gadgets, clothes and shoes that any person can own before reaching saturation. If, as we expect, spending on goods falls back to its pre-pandemic trend, but spending on services does not recover to its pre-pandemic trend, then there will be a demand shortfall in 2022 (Chart of the Week). 3. Will We Spend Our Excess Savings? If spending falls short of income – as it did through the pandemic – then, by definition, our savings have gone up. Many people claimed that this war chest of savings would unleash a tsunami of spending. Well, it didn’t. And, it won’t. Previous episodes of excess savings in 2004, 2008, and 2012 had no impact on the trend in spending (Chart I-7). The explanation comes from a theory known as Mental Accounting Bias. The theory states that we segment our money into different accounts, which are sometimes physical, sometimes only mental, and that our willingness to spend money depends on which mental account it occupies. This contrasts with standard economic theory which assumes that money is perfectly fungible, meaning that a dollar in a current (checking) account is no different to a dollar in a savings or investment account. In practice, money is not fungible, because we attach different emotions to our different mental accounts. A dollar in our current account we will gladly spend, but a dollar in our savings account we will not spend. Hence, the moment we move the dollar from our current account into our savings account, our willingness to spend it collapses. This explains why consumption trends have no connection with windfall income receipts once those income receipts end up in our savings mental or physical account. Pulling all of this together, the war chest of savings accumulated during the pandemic is unlikely to change the overall trend in spending. 4. How Will Central Banks React To Inflation? The real story of the current ‘inflation crisis’ is that while goods and commodity prices have surged exactly as expected in a positive demand shock, services prices have not declined as would be expected in the mirror-image negative demand shock. The result is that aggregate inflation has surged even though aggregate demand has not (Chart I-8 and Chart I-9). Chart I-8Goods Prices Have Reacted To A Positive Demand Shock... Chart I-9...But Service Prices Have Not Reacted To A Negative Demand Shock Why have services prices remained resilient despite a massive negative demand shock? One answer, as explained in question 2, is that much of the shortfall in services demand is due to behavioural changes, which cannot be alleviated by lower prices. If somebody doesn’t go to the dentist or use public transport because he is worried about catching Covid, then lowering the price will not lure that person back. In fact, the person might interpret the lower price as a signal of greater risk, and might become more averse. In technical terms, the price elasticity of demand for certain services has flipped from its usual negative to positive. This creates a major problem for central banks, because if the price elasticity of services demand has changed, then surging aggregate inflation is no longer a reliable indicator of surging aggregate demand. To repeat, inflation is surging even though aggregate demand is barely on its pre-pandemic trend. Hence in 2022, central banks face a Hobson’s choice. Choke demand that does not need to be choked, or turn a blind eye to inflation and risk losing credibility. 5. Will Cryptocurrencies Continue To Eat Gold’s Lunch? Most of the value of gold comes not from its economic utility as a beautiful, wearable, and electrically conductive metal, but from its investment value as a hedge against the debasement of fiat money. The multi-year investment case for cryptocurrencies is that they are set to displace much of gold’s investment value. Still, to displace gold’s investment value, cryptocurrencies need to match its other qualities: an economic utility, and limited supply. A cryptocurrency’s economic utility comes from its means of exchange for the intermediation services that its blockchain provides. For example, if you issue a bond or smart-contract using the Ethereum blockchain, then you must pay in its cryptocurrency ETH. Which gives ETH an economic utility. Furthermore, the number of blockchains that will succeed as go-to places for intermediation services will be limited, and each cryptocurrency has a limited supply. Thereby, the supply of cryptocurrencies that have a utility is also limited. With an economic utility, a limited supply, and drawdowns that are becoming smaller, cryptocurrencies can continue to displace gold’s dominance of the $12 trillion anti-fiat investment market. Therefore, the cryptocurrency asset-class can continue its strong structural uptrend, albeit punctuated by short sharp corrections (Chart I-10). Chart I-10Cryptocurrencies Will Continue To Displace Gold's Investment Value The corollary is that the structural outlook for gold is poor. 6. How Fragile Is Chinese Real Estate? A decade-long surge in Chinese property prices has lifted Chinese valuations to nosebleed levels. According to global real estate specialist Savills, prime real estate yields in China’s major cities are now barely above 1 percent, and the world’s five most expensive cities are all in China: Hangzhou, Shenzhen, Guangzhou, Beijing, and Shanghai (Chart I-11). Without a social safety net and with limited places to park their money, Chinese savers have for years been encouraged to buy homes, in the widespread belief that property is the safest investment, whose price only goes up. With the bulk of people’s wealth in property acting as a perceived economic safety net, even a modest decline in house prices would constitute a major shock to the household sector’s hopes and expectations of what property is. Therefore, in contrast to the US housing debacle in 2008, the Chinese government will ensure that its property market adjustment does not come from a collapse in home prices. Rather, it will come from a collapse in property development and construction activity. This will have negative implications for commodities, emerging Asia, developing countries that produce raw materials, and machinery stocks worldwide. 7. Will There Be Another Shock? Most strategists claim that shocks, such as the pandemic, are unpredictable. We disagree. Yes, the timing and source of an individual shock is unpredictable, but the statistical distribution of shocks is highly predictable. We define a shock as any event that causes the long-duration bond price in a major economy to rally or slump by at least 20 percent.1 Using this definition through the last 60 years, the statistical distribution of the number of shocks in any ten-year period is Poisson (3.33) and the time between shocks is Exponential (3.33). This means that in any ten-year period, the likelihood of suffering a shock is a near-certain 95 percent; in any five-year period, it is an extremely high 80 percent; in a two-year period it is a coin toss at 50 percent; and even in one year it is a significant 30 percent (Chart I-12). Therefore, on a multi-year horizon, another shock is a near-certainty even if we do not know its source or precise timing. The question is, will it be net deflationary, or net inflationary? Our high-conviction view is that it will be net deflationary. Meaning that even if it starts as inflationary, it will quickly morph into deflationary. The simple reason is that it is not just Chinese real estate that is fragile. Through the past ten years, world prime residential prices are up by 70 percent while rents are up by just 25 percent2 (Chart I-13). Meaning that the bulk of the increase in global real estate prices is due to skyrocketing valuations. The culprit is the structural collapse in global bond yields – which, in turn, is due to persistently ultra-low policy interest rates combined with trillions of dollars of quantitative easing. Chart I-13Property Price Inflation Has Far Exceeded Rent Inflation This means that bond yields have very limited scope to rise before pulling the bottom out of the $300 trillion global real estate market. Given that this dwarfs the $90 trillion global economy, it would constitute a massive deflationary backlash to the initial inflationary shock. Some people counter that in an inflationary shock, property – as the ultimate real asset – ought to perform well even as bond yields rise. However, when valuations start off in nosebleed territory as now, the initial intense headwind from deflating valuations would obliterate the tailwind from inflating incomes. Investment Conclusions To summarise, 2022 will be a year in which: Covid waves continue to disrupt the economy; a persistent shortfall in spending on services is not fully countered by excess spending on goods; China’s construction boom comes to an end; inflation takes time to cool, pressuring central banks to raise rates despite fragile demand; and the probability of another shock is an underestimated 30 percent. We reach the following investment conclusions: Overweight the China 30-year bond and the US 30-year T-bond. There will be no sustained rise in long-duration bond yields, and the risk to yields is to the downside. Long-duration equity sectors and stock markets that are least sensitive to cyclical demand will continue to rally (Chart I-14). Chart I-14The US Stock Market = The 30-Year T-Bond Multiplied By Profits Overweight the US versus non-US. Underweight Emerging Markets. Underweight old-economy cyclical sectors such as banks, materials, and industrials. Commodities will struggle. Underweight commodities that haven’t corrected versus those that have (Chart I-15). Chart I-15Underweight Commodities That Haven't Yet Corrected Overweight the US dollar versus commodity currencies. Cryptocurrencies will continue their structural uptrend at the expense of gold. Goods Versus Services Is Technically Stretched Finally, this week’s fractal analysis corroborates the massive displacement from services spending into goods spending, highlighted by the spectacular outperformance of personal goods versus consumer services. This outperformance is now at the point of fragility on its 260-day fractal structure that has signalled previous reversals (Chart I-16). Therefore, a good trade would be to short personal goods versus consumer services, setting a profit target and symmetrical stop-loss at 12.5 percent. Chart I-16Underweight Personal Goods Versus Consumer Services Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 20 percent. 2 Based on Savills Prime Index: World Cities – Capital Values, and World Cities – Rents and Yields, June 2011 through June 2021. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Omicron vs. The Fed: The new COVID variant has thrown a growth scare into markets, but the bigger concern is the Fed belated playing catch up to high inflation and low unemployment. Fade the Omicron bond rally, and position for higher US Treasury yields over the next year with the Fed threatening to taper faster, and potentially hike sooner, than markets expect. New Zealand: Underlying growth and inflation fundamentals, soaring house prices, and the central bank’s historical reaction function indicate that the Reserve Bank of New Zealand will lift the cash rate to 2% by the end of 2022. However, markets are already priced for this, leaving little room for New Zealand debt to continue underperforming on a relative basis. We are upgrading New Zealand sovereigns to neutral and initiating a long NZ/short US 10-year spread trade. A Year-End Bout Of Uncertainty Chart of the WeekMarkets Have Been Worried About The Fed Since September Over the past two weeks, we have published Special Reports and thus have not had an opportunity to comment on market moves and news. Needless to say, it has been an eventful period! The emergence of the new Omicron variant, and the hawkish shift in the Fed’s guidance on future policy moves, have injected fresh uncertainty and volatility into global financial markets. Since the existence of Omicron was revealed to the world on Nov 26, 30-year US Treasury yields have fallen by as much as -23bps and the S&P 500 index has been down by as much as -4.4%. Yet the evolving Fed stance, with Fed Chair Jerome Powell hinting last week that the end of tapering and start of rate hikes could begin sooner than expected next year, is having a more lasting influence on risk asset performance. Dating back to the September 23 FOMC meeting, when the Fed first signaled an imminent tapering of bond purchases and pulled forward the timing of liftoff into 2022, the 2-year US Treasury yield has gone up from 0.22% to 0.63%. Importantly, there has been little pullback on the pricing at the front-end of the US Treasury curve due to the Omicron shock. That pre-September-FOMC low in the 2-year Treasury yield also marked the peak in riskier fixed income market performance for 2021, with the Bloomberg Global High-Yield and Emerging Market USD-Denominated Sovereign total return indices down -2.0% and -1.8%, respectively, since Sept 23 (Chart of the Week). Other risk assets also appear to be responding more to news about the Fed than Omicron. Equity markets stopped climbing since the Fed announced the first taper of bond purchases at the November 3 FOMC meeting – three weeks before the world knew of Omicron - which also coincided with troughs in the VIX index and corporate credit spreads, not only in the US but in Europe and emerging markets as well (Chart 2). Of course, it is difficult to disentangle which is having a greater impact, the variant or the Fed, when details on both are evolving at the same time. Omicron Investors are understandably right to be nervous about a new COVID variant that can reportedly evade existing vaccines and even infect those who have had COVID previously. The whole idea of “putting COVID in the rearview mirror’ that has helped fuel booming equity and credit markets was predicated on vaccines being both effective and widely available. However, when investors see COVID case numbers start to pick up in the US and Europe, with vaccination rates twice that of South Africa where Omicron was first detected (Chart 3), this raises concern about a return to pre-vaccine economic restrictions and uncertainty. Chart 2A Typical Risk-Off Response To The Emergence Of Omicron Chart 3Omicron Putting A Dent In Vaccine Optimism The “Omicron effect” on fixed income markets has been most evident in the repricing of interest rate expectations. Since the presence of Omicron was revealed on November 26, there has been a reduction in the cumulative amount of tightening discounted to the end of 2024 in the overnight index swap (OIS) curves of the major developed economies (Table 1). The moves were most evident in the US (32bps of hikes priced out), Canada (37bps) and Australia (37bps). Table 1Pricing Out Some Rate Hikes Because Of Omicron Much is still unknown about the dangers of the Omicron variant. The admittedly very early data out of South Africa, however, indicates that there has not been a major surge in hospitalizations related to Omicron cases. A new COVID strain that proves to be more virulent, but that does not strain health care systems, should help allay investor concerns over a major economic hit from Omicron. This presents an opportunity to put on positions that will profit from a rebound in global bond yields led by higher US Treasury yields. The Fed The Omicron threat to date has not been enough to move the Fed off its plans to rein in the monetary accommodation put in place in 2020 to fight the pandemic. If Omicron is to have any impact on the US economy, it will do so at a time when the economy continues to grow well above trend. The November reading on the ISM Manufacturing survey showed strength in the overall index, with a stabilization of the New Orders/Inventory ratio that leads overall growth, and only a very modest reduction in the still-elevated Prices Paid and Supplier Deliveries indices (Chart 4). The Atlanta Fed’s GDPNow model is suggesting that US real GDP growth could come in at a whopping 9.7% in Q4. As further evidence that the US economy is growing at a pace well above trend, just look to labor market data. New US jobless claims are at the lowest level since 1969. The November US Payrolls report showed that the headline unemployment rate fell 0.4 percentage points on the month to 4.2% - within the range of full employment estimates of the FOMC - even with actual job growth falling short of consensus forecasts (Chart 5, top panel). Chart 4Nothing Bond-Bullish In US Manufacturing The improving health of the labor market is being felt more broadly, with big declines seen in unemployment rates for minorities and less-educated Americans (second panel). That point is of critical importance to the Powell Fed that has emphasized reducing racial and educational gaps in US unemployment as part of reaching its goal of “maximum employment”. Chart 5Nothing Bond-Bullish In US Labor Markets Tightening labor markets are also evident in accelerating wage momentum. Excluding the 2020 spike driven by labor force compositional effects related to COVID lockdowns, the year-over-year growth in average hourly earnings reached a 39-year high of 5.9% in November (third panel). The Fed now seems willing to finally confront high US inflation and strong economic growth with some tightening of monetary policy. Chart 6A Near-Term Break From Supply-Fueled Inflation? Powell caused some investor agita last week when he indicated that the taper could end before mid-2022, the previous FOMC guidance, which would open the door for rate hikes. We see Powell’s comments as less about signaling an intensifying hawkishness and more about giving the Fed optionality on when to start lifting rates next year in the event the US economy continues to overheat. The Fed strongly believes that tapering must end before rate hikes can begin, so a more accelerated taper allows for an earlier liftoff date, if necessary. To that end, the supply fueled surge in inflation this year, which has lingered for far longer than the Fed anticipated, may be showing some signs of easing. Several indices of global shipping container prices are off the highs, while there is a reduced backlog of container ships off key US ports like Los Angeles. Overall commodity price momentum has peaked, in line with slower, but still strong, global industrial activity (Chart 6). An easing of supply-driven price pressures would be welcome by the FOMC. It would allow time to evaluate both the Omicron threat and evolving US labor market dynamics, instead of being forced to fight a rearguard action against accelerating inflation. However, a shift away from goods/commodity inflation to more domestically driven inflation would not lessen the need for the Fed to begin lifting rates next year – in fact, it could even strengthen the case for the Fed to hike rates faster, and by more, than currently discounted in markets. Importantly, forward looking indicators are still pointing to solid US growth next year (Chart 7): The Conference Board’s leading economic indicator continues to grow at a pace signaling above-trend growth US financial conditions remain highly accommodative even with the recent market turbulence The New York Fed’s yield curve based recession probability model is indicating that the spread between the 10-year US Treasury yield and the 3-month US Treasury bill rate, currently 138bps, is consistent with only a 9% chance of a US recession over the next year (bottom panel) We continue to recommend a below-benchmark duration stance within US fixed income portfolios, with a yield target on the 10-year benchmark US Treasury yield of 2-2.25% to be reached by the end of 2022. We also continue to recommend positioning in Treasury curve steepening trades. This is admittedly a counter-intuitive suggestion given that the Fed is moving towards a rate hiking cycle, but we see too much flattening priced into the Treasury forward curve over the next year (Chart 8). Chart 7A Positive Message From US Leading Growth Indicators Chart 8Our Favorite Bearish US Rates Trades For global bond investors, our favorite trade that will benefit from higher US bond yields next year is to position for a wider 10-year US Treasury-German Bund spread (bottom panel). We expect the ECB to avoid any rate increases until at least mid-2023, well after the Fed has begun to tighten. Forward curves in the US and Germany currently discount a relatively stable Treasury-Bund spread in 2022, thus there is no negative carry incurred by positioning for a wider spread. Bottom Line: Omicron has thrown a growth scare into markets, but the bigger concern is that the Fed is belated starting to play catch up to high inflation and low unemployment. Fade the Omicron bond rally, and position for higher US Treasury yields over the next year. New Zealand: How Much Further Can The Bond Selloff Go? Chart 9NZ Sovereign Underperformance Has Been Driven By RBNZ Hawkishness Over the past year, New Zealand bonds have sold off much faster than developed market peers (Chart 9). Markets correctly recognized the Reserve Bank Of New Zealand (RBNZ) as a central bank that would move more aggressively to tamp down on inflation and manage the financial stability and political risks arising from soaring house prices. The RBNZ has already delivered back-to-back hikes at its October and November meetings, after its plans to hike at the August meeting were thrown off by the Delta variant. Markets are now pricing in a further 172bps of tightening over the coming year, having largely faded any downside growth risk from the Omicron variant. Expectations of continued tightening have been buoyed by the response of New Zealand policymakers, who are largely looking past the Omicron variant. Restrictions have already begun to ease, with the country having entered its “Traffic Light” COVID-19 Protection Framework. The new variant is also unlikely to affect the RBNZ’s tightening path, with Chief Economist Yuong Ha stating that, given the lifting of restrictions, the RBNZ would have raised rates even if Omicron had become known before its November 24 meeting. Given the bond-bearish backdrop, New Zealand government bonds have underperformed substantially this year. On a relative hedged and duration-matched basis, New Zealand sovereigns have underperformed by -6.6% year-to-date with -4.0 percentage points of that underperformance coming after July 21 when we formally moved to an underweight stance on New Zealand debt within global government bond portfolios (Chart 9, bottom panel). However, with monetary policy entering a new phase, led by an increasingly hawkish Fed, we believe it is appropriate to re-assess our New Zealand call and judge whether this underperformance can continue into 2022. The growth picture is broadly supportive of the RBNZ’s stated policy path. Real GDP as of Q2 was above its pre-Covid trend and 2.6% over the RBNZ’s own estimate of potential GDP, supported by an easing of travel restrictions and strong consumer spending (Chart 10). On a forward-looking basis, however, the risk is now that the economy is running too hot, jeopardizing future growth. Consumer and business sentiment has been worsening as inflation expectations soar, with consumers fearing a hit to purchasing power and businesses concerned about the impact of rising input costs on profit margins. Household and business inflation fears also have a strong basis in the realized inflation data, which has soared to a 10-year high of 4.9% (Chart 11). More troublingly, underlying inflation measures such as the trimmed mean and core (excluding food and energy) are now at series highs of 4.8% and 4%, respectively, indicating that higher inflation could prove to be sticky. The RBNZ now sees headline inflation peaking at 5.7% in Q1/2022 before settling to 2% by the end of its forecast horizon in 2024. Chart 10The NZ Economy Is Overheating Chart 11The RBNZ Will Welcome A Slight Growth Slowdown The RBNZ clearly attributes higher inflation to an economy running above longer-term capacity rather than short-term supply factors. The Bank’s measure of the output gap is now at the most positive level since 2007, and survey measures of capacity utilization remain elevated. In contrast to the Fed, which is still nominally focused on maximum employment, the RBNZ actually believes that employment is above its maximum sustainable level, and sees a rising unemployment rate as necessary to ease capacity constraints. Given that the RBNZ is clearly comfortable with, and will likely welcome, a gradual rise in unemployment, it will take much more than a slight growth shock to deter the RBNZ from its tightening path. Chart 12Higher Rates Necessary To Stabilize The NZ Housing Market The newest, and most politically potent, part of the RBNZ’s remit—house prices – has further supported a bias to tighten monetary policy. However, while still dramatically elevated, house price growth looks to have peaked (Chart 12). The central bank’s hawkish shift earlier in the year has made a clear impact, with house price growth peaking shortly after mortgage rates started picking up in April of this year. Overall household mortgage credit has also begun to decelerate, indicating that the passthrough from monetary policy to credit demand and housing via the mortgage rate is working as intended. However, there is likely further to go. The last time house price growth was somewhat stable around 6.6% in the 2012-2019 period, benchmark 5-year mortgage rates averaged 6.1%. Assuming the spread between the 5-year mortgage and policy rates remains around 4%, history indicates that we would need to see the policy rate rise to at least 2% to cool down the housing market. That 2% level is also the RBNZ’s mean estimate of a “neutral” cash rate—a level at which policy would be neither accommodative nor restrictive (Chart 13). Current market pricing is quite consistent with the RBNZ’s own projected path of rates as of the November meeting—both of which are set to exceed the neutral rate by the end of 2022. Historical experience from the pre-crisis period indicates that this is not uncommon, and that a bout of restrictive policy might be needed to cool down an overheating economy. Indeed, if the RBNZ’s historical reaction to inflation is any guide, it seems likely that policymakers will want to push rates above inflation. The top two panels of Chart 14 show how anomalous deeply negative real policy rates are in New Zealand. Even if we make the case that developed market real rates are in a structural downtrend, as realized real rates have peaked out at successively lower levels with each tightening cycle, the current gap between the cash rate and core inflation seems obviously unsustainable and requires a tightening of policy. Chart 14NZ Real Rates Are Too Low Chart 15Go Long The 10-Year NZ Government Bond/US Treasury Spread Another way to think about where policy rates are in relation to a “neutral” level is to look at the yield curve (Chart 14, bottom panel). Typically, the yield curve inverts when markets judge that monetary policy is too restrictive and that short rates are too high relative to a long-run average. However, the New Zealand government bond curve has historically remained inverted for extended periods of time, troughing at around -100bps. This again indicates that the RBNZ is comfortable raising rates above neutral and keeping policy restrictive when needed. Putting together the four factors we have looked at—growth, inflation, asset prices, and the RBNZ’s reaction function—it looks likely that the RBNZ will continue along the tightening path it has set out and chances of any dovish surprise seem slim. At the same time, markets are priced to perfection in terms of the pace and amount of tightening discounted. For New Zealand sovereigns to continue underperforming, however, we will need to see markets price in, on the margin, even more tightening from the RBNZ relative to its peers. With the Fed and other central banks having become more focused on responding to US inflation dynamics, bond-bearish upside shocks to market rate expectations will increasingly come from outside New Zealand. At the same time, in the event of a negative global growth shock, perhaps relating to COVID-19, there is relatively more room for hikes to be priced out in New Zealand. Given our view that bond and rates markets have appropriately priced in the extent of the RBNZ’s likely tightening cycle, we are upgrading New Zealand sovereign debt to neutral, taking profits on our current underweight stance. While we do not include New Zealand debt in our model bond portfolio, we are expressing our view via a new tactical cross-country spread trade: long New Zealand 10-Year government bonds vs. US 10-Year Treasuries (Chart 15). Forwards are currently pricing in a flat spread between the two countries, meaning that any future spread tightening will put our trade in the black. Given that there is more space for markets to price in increased hawkishness from the Fed, we believe that spread compression is likely. We are implementing this trade by going long New Zealand cash bonds and shorting 10-year US Treasury futures. Details can be found on Page 18. Bottom Line: Underlying growth and inflation fundamentals, soaring house prices, and the central bank’s historical reaction function indicate that the Reserve Bank of New Zealand will lift the cash rate to 2% by the end of 2022. However, markets are already priced for this, leaving little room for New Zealand debt to continue underperforming on a relative basis. We are upgrading New Zealand sovereigns to neutral and initiating a long NZ/short US 10-year spread trade. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com GFIS Model Bond Portfolio Recommended Positioning Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Duration Regional Allocation Spread Product Tactical Overlay Trades
Highlights Chart 1Curve Flattening Is Overdone Fed Chair Jay Powell made big news last month. During Senate testimony, Powell not only signaled that the Fed is likely to accelerate the pace of asset purchase tapering when it meets in December, he also suggested that the Fed won’t necessarily wait until “maximum employment” is achieved before lifting rates. Powell’s comments suggest that the first Fed rate hike could come as early as June 2022 and as late as December 2022, and the exact timing will depend on how inflation and inflation expectations move during the next few months. The front-end of the Treasury curve is fairly priced for either scenario. The 2-year Treasury yield is currently 0.60%. If we assume that the Fed eventually lifts rates at a pace of 100 bps per year until reaching a 2.08% terminal rate, we calculate a fair value range for the 2-year yield of 0.39% to 0.74%, depending on whether Fed liftoff occurs in June or December. In contrast, the same assumptions give us a fair value range of 1.69% to 1.79% for the 10-year Treasury yield, well above its current level of 1.40% (Chart 1). The investment implications are clear. Investors should maintain below-benchmark portfolio duration and put on Treasury curve steepeners, overweight the 2-year note and underweight the 10-year. Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 89 basis points in November, dragging year-to-date excess returns down to +102 bps. The index option-adjusted spread widened 12 bps on the month and our quality-adjusted 12-month breakeven spread is now at its 7th percentile since 1995. This indicates that valuations remain stretched even after the recent widening (Chart 2). The back-up in spreads was driven by the combination of the Fed’s shift toward a more hawkish policy stance and concerns about the new omicron COVID variant. This led to a large flattening of the yield curve in addition to wider corporate bond spreads. The slope of the yield curve is a critical indicator for our corporate bond call. We are very comfortable owning corporate bonds when the 3-year/10-year Treasury slope is above 50 bps, but our work suggests that returns to credit risk take a significant step down once the slope flattens into a range of 0 – 50 bps.1 The 3-year/10-year Treasury slope currently sits at 49 bps, just below our 50 bps threshold. However, our range of fair value estimates suggests that the 3/10 slope should be between 63 bps and 86 bps today, and that it should only break below 50 bps between March and September of next year (bottom panel). All in all, we expect the pace of Treasury curve flattening to abate during the next couple of months and this will allow spreads to tighten back to their recent lows. We will turn more cyclically defensive on corporate bonds next year when the break below 50 bps in the 3/10 slope is confirmed by our fair value readings. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 121 basis points in November, dragging year-to-date excess returns down to +444 bps. The index option-adjusted spread widened 50 bps on the month, leading to a significant rise in the spread-implied default rate. The spread-implied default rate is the 12-month default rate that is priced into the junk index, assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps. At present, the spread-implied default rate sits at 3.8% (Chart 3). For context, defaults have come in at an annualized rate of 1.6% so far this year and we showed in a recent report that corporate balance sheets are in excellent shape.2 Specifically, the ratio of total debt to net worth for the nonfinancial corporate sector has fallen to 41%, the lowest ratio since 2010 (bottom panel). We conclude that the default rate will be comfortably below 3.8% during the next 12 months, allowing high-yield bonds to outperform duration-matched Treasuries. We recommend that investors favor high-yield over investment grade corporate bonds, and we expect that last month’s spread widening will reverse in relatively short order. However, as noted on page 3, we will turn more defensive on credit risk (including high-yield bonds) next year once we are confident that the 3/10 Treasury curve has sustainably moved into a flatter regime (0 – 50 bps). MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 46 basis points in November, dragging year-to-date excess returns down to -90 bps. The zero-volatility spread for conventional 30-year agency MBS widened 13 bps on the month, driven by an 11 bps widening of the option-adjusted spread and a 2 bps increase in the compensation for prepayment risk (option cost) (Chart 4). We wrote in last week’s report that MBS’ recent poor performance is attributable to an option cost that is too low relative to the pace of mortgage refinancings, noting that the MBA Refinance Index has been slow to fall this year despite the back-up in yields.3 The robust pace of home price appreciation has been an important factor boosting refis, as homeowners have been increasingly incentivized to tap the equity in their homes. With no indication that cash-out refi activity is about to slow, we expect refi activity will remain sticky going forward. This will put upward pressure on MBS spreads. We recommend adopting an up-in-coupon bias within an overall underweight allocation to MBS. Higher coupon MBS exhibit more attractive option-adjusted spreads and higher convexity than lower coupon MBS. This makes high-coupon MBS (4%, 4.5%) more likely to outperform low-coupon MBS (2%, 2.5%, 3%) in an environment where bond yields are flat or rising (bottom panel). Government-Related: Neutral Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-neutral Treasury index by 35 basis points in November, dragging year-to-date excess returns down to +33 bps. Sovereign debt underperformed duration-equivalent Treasuries by 157 basis points in November, dragging year-to-date excess returns down to -220 bps. Foreign Agencies underperformed the Treasury benchmark by 9 bps on the month, dragging year-to-date excess returns down to +36 bps. Local Authority bonds underperformed by 16 bps in November, dragging year-to-date excess returns down to +406 bps. Supranationals outperformed by 2 bps, bringing year-to-date excess returns up to +18 bps. The investment grade Emerging Market Sovereign bond index outperformed the equivalent-duration US corporate bond index by 42 bps in November. The Emerging Market Corporate & Quasi-Sovereign index underperformed duration-matched US corporates by 16 bps (Chart 5). Both EM indexes continue to offer significant yield advantages versus US corporate bonds with the same credit rating and duration. We continue to recommend overweighting USD-denominated EM sovereigns and corporates versus investment grade US corporates with the same credit rating and duration.4 Within EM sovereigns, attractive countries include: Russia, Mexico, Indonesia, Saudi Arabia, UAE and Qatar. Municipal Bonds: Maximum Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 29 basis points in November, bringing year-to-date excess returns up to +371 bps (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and 2021’s federal spending splurge will support state & local government coffers for some time. A recent report showed that the average duration of municipal bond indexes has fallen significantly during the past few decades, a trend that has implications for how we should perceive municipal bond valuation.5 Specifically, the trend makes municipal bonds more attractive relative to both Treasury securities and investment grade corporates. Long-maturity bonds are especially compelling. We calculate that 12-17 year maturity Revenue Munis offer a breakeven tax rate of 14% relative to credit rating and duration matched US corporate bonds. 12-17 year General Obligation Munis offer a breakeven tax rate of 22% versus corporates (panel 2). High-yield muni spreads are reasonably attractive compared to high-yield corporates (panel 4), but we recommend only a neutral allocation to high-yield munis versus high-yield corporates. The deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2-Year Bullet Versus Cash/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve flattened dramatically in November. Increasingly hawkish rhetoric from the Fed pushed front-end yields higher as news about the omicron COVID strain pressured long-dated yields lower. The 2-year/10-year Treasury slope flattened 16 bps on the month, it currently sits at 75 bps. The 5-year/30-year Treasury slope flattened 11 bps on the month, it currently sits at 56 bps. As noted on the front page, long-dated Treasury yields have fallen to well below levels consistent with a reasonable Fed rate hike cycle. This drop in long-maturity yields has pushed the 2/5/10 butterfly spread to extremely high levels, both in absolute terms and relative to our model’s fair value (Chart 7). This signals that 2/10 yield curve steepeners are incredibly cheap. Indeed, we observe that the 2/10 slope has already flattened to below the levels that were witnessed on the last two Fed liftoff dates in 2015 and 2004 (panel 4). A trade long the 5-year bullet and short a duration-matched 2/10 barbell does indeed look attractive in this environment. However, we note that the 2/5 Treasury slope has also flattened to below levels seen on the prior two Fed liftoff dates (bottom panel). In other words, the 2/5 slope also has room to steepen during the next 6-12 months, and we prefer to focus our long positions on the 2-year Treasury note rather than the 5-year. This leads us to recommend a position long the 2-year note and short a duration-matched barbell consisting of cash and the 10-year note. We also advise investors to own a position long the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond. This latter position offers a very attractive duration-neutral yield advantage of 24 bps. TIPS: Neutral Chart 8TIPS Market Overview TIPS performed in line with the duration-equivalent nominal Treasury index in November, leaving year-to-date excess returns unchanged at +739 bps. The 10-year TIPS breakeven inflation rate fell 8 bps on the month while the 2-year TIPS breakeven inflation rate rose 17 bps. The 10-year and 2-year rates currently sit at 2.44% and 3.24%, respectively. The Fed’s preferred 5-year/5-year forward TIPS breakeven inflation rate rose 8 bps on the month. It currently sits at 2.16%, below the Fed’s 2.3% - 2.5% target range. Our valuation indicator shows that 10-year TIPS are slightly expensive compared to 10-year nominal Treasuries (Chart 8), and we retain a neutral allocation to TIPS versus nominals at the long-end of the curve. We acknowledge the risk that a prolonged period of high inflation could lead to a break-out in long-dated TIPS breakevens, but this now looks less likely given the Fed’s increasing hawkishness. We see better trading opportunities at the front-end of the TIPS curve, where the 2-year TIPS breakeven inflation rate remains well above the Fed’s target range (panel 4). Short-maturity breakevens are more sensitive to swings in CPI than those at the long-end. Therefore, the 2-year TIPS breakeven inflation rate has considerable downside during the next 6-12 months, assuming inflation moderates as we expect it will. We recommend an underweight allocation to TIPS versus nominals at the front-end of the curve. Given our view that CPI inflation will be lower in 6-12 months, we recommend shorting 2-year TIPS outright, positioning in 2/10 TIPS breakeven inflation curve steepeners (bottom panel) and 2/10 TIPS (real) yield curve flatteners. All three trades will profit from falling short-maturity inflation expectations. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 9 basis points in November, dragging year-to-date excess returns down to +26 bps. Aaa-rated ABS underperformed by 11 bps on the month, dragging year-to-date excess returns down to +13 bps. Non-Aaa ABS performed in line with Treasuries in November, keeping year-to-date excess returns steady at +93 bps. During the past two years, substantial federal government support for household incomes has caused US households to build up an extremely large buffer of excess savings. During this period, many households have used their windfalls to pay down consumer debt and credit card debt levels have fallen to well below pre-COVID levels (Chart 9). The result is that the collateral quality backing consumer ABS is exceptionally high. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 40 basis points in November, dragging year-to-date excess returns down to +155 bps. Aaa Non-Agency CMBS underperformed Treasuries by 30 bps in November, dragging year-to-date excess returns down to +63 bps. Non-Aaa Non-Agency CMBS underperformed Treasuries by 70 bps, dragging year-to-date excess returns down to +469 bps (Chart 10). Though returns have been strong this year and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 47 basis points in November, dragging year-to-date excess returns down to +58 bps. The average index option-adjusted spread widened 9 bps on the month. It currently sits at 40 bps (bottom panel). Though Agency CMBS spreads have recovered to well below their pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight. Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -62 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 62 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of November 30th, 2021) Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of November 30th, 2021) Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Footnotes 1 Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 2 Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 3 Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. 4 Please see US Bond Strategy Weekly Report, “Damage Assessment”, dated September 28, 2021. 5 Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021.