Monetary Policy
This week’s <i>Global Investment Strategy</i> report titled Fourth Quarter 2022 Strategy Outlook: A Three-Act Play discusses the outlook for the global economy and financial markets for the rest of 2022 and beyond.
Listen to a short summary of this report Executive Summary GIS Projection For The EUR/USD We went long the euro early last week, as EUR/USD hit our buy limit price of $0.99. Despite a near cut-off of Russian gas imports, European gas inventories have reached 84% of capacity – above the 80% target that the EU set for November 1st. The latest meteorological forecasts suggest that Europe will experience a warmer-than-normal winter. This will cut heating usage, likely making gas rationing unnecessary. Currencies fare best in loose fiscal/tight monetary environments. This is what Europe faces over the coming months, as governments boost income support for households and businesses, while ramping up spending on energy infrastructure and defense. For its part, the ECB has started hiking rates. Since mid-August, interest rate differentials have moved in favor of the euro at both the short and long end. Rising inflation expectations make it less likely that the ECB will be able to back off from its tightening campaign as it did in past cycles. A hawkish Fed is the biggest risk to our bullish EUR/USD view. We expect US inflation to trend lower over the coming months, before reaccelerating in the second half of 2023. However, as the August CPI report highlights, the danger is that any dip in inflation proves to be shallower and shorter-lived than previously anticipated. Bottom Line: Although significant uncertainty remains, the risk-reward trade-off favors being long EUR/USD. Our end-2022 target is $1.06. Dear Client, I will be meeting clients in Asia next week while also working on our Fourth Quarter Strategy Outlook, which will be published at the end of the month. In lieu of our regular report next Friday, you will receive a Special Report from my colleague, Ritika Mankar, discussing the sources of US equity outperformance over the past 14 years and the likely path ahead. Best Regards, Peter Berezin, Chief Global Strategist It’s Just a Clown Chart 1Investors Are Bullish The Dollar, Not The Euro The scariest part of a horror movie is usually the one before the monster is revealed. No matter how good the special effects, the human brain can always conjure up something more frightening than anything Hollywood can dream up. Investors have been conjuring up all sorts of cataclysmic scenarios for the upcoming European winter. In financial markets, the impact has been most visible in the value of the euro, which has tumbled to parity against the US dollar. Only 23% of investors are bullish the euro at present, down from a peak of 78% in January 2021 (Chart 1). Conversely, 75% of investors are bullish the US dollar. More than half of fund managers cited “long US dollar” as the most crowded trade in the latest BofA Global Fund Manager Survey (“long commodities” was a distant second at 10%). As we discuss below, the outlook for the euro may be a lot better than most investors realize. While my colleagues, Chester Ntonifor, BCA’s chief FX strategist, and Mathieu Savary, BCA’s chief European strategist, are not quite ready to buy the euro just yet, we all agree that EUR/USD will rise over the long haul. Cutting Putin Loose Natural gas accounts for about a quarter of Europe’s energy supply. Prior to the Ukraine war, about 40% of that gas came from Russia (Chart 2). With the closure of the NordStream 1 pipeline, that number has fallen to 9% (some Russian gas continues to enter Europe via Ukraine and the TurkStream supply route). Yet, despite the deep drop in Russian natural gas imports, European natural gas inventories are up to 84% of capacity – roughly in line with past years and above the EU’s November 1st target of 80% (Chart 3). Chart 2Despite A Sharp Drop In Imports Of Russian Natural Gas… Chart 3...Europeans Managed To Stock Up On Natural Gas For The Winter Season Europe has been able to achieve this feat by aggressively buying natural gas on the open market. While this has caused gas prices to soar, it sets the stage for a retreat in prices in the months ahead. European spot natural gas prices have already fallen from over €300/Mwh in late August to €214/Mwh, and the futures market is discounting a further decline in prices over the next two years (Chart 4). Chart 4The Futures Market Is Discounting A Further Decline In Natural Gas Prices Chart 5Futures Prices Of Energy Commodities Provide Some Limited Information On Where Spot Prices Are Heading Follow the Futures? Futures prices are not a foolproof guide to where spot prices are heading. As Chart 5 illustrates, the correlation between the slope of the futures curve and subsequent changes in spot prices in energy markets is quite low. Nevertheless, future spot returns do tend to be negative when the curve is backwardated, as it is now, especially when assessed over horizons of around 12-to-18 months (Table 1). Table 1Energy Commodity Spot Price Returns Tend To Be Negative When The Futures Curve Is Backwardated Our guess is that European natural gas prices will indeed fall further from current levels. The latest meteorological forecasts suggest that Europe will experience a milder-than-normal winter (Chart 6). This is critical considering that natural gas accounts for over 40% of EU residential heating use once electricity and heat generated in gas-fired plants are included (Chart 7). Chart 6Meteorological Models Suggest Above-Normal Temperatures In Europe This Winter Chart 7Natural Gas Is An Important Source Of Energy For Heating Homes In The EU A warm winter would bolster the euro area’s trade balance, which has fallen into deficit this year as the energy import bill has soared (Chart 8). An improving balance of payments would help the euro. Europe is moving quickly to secure new sources of energy supply. In less than one year, Europe has become America’s biggest overseas market for LNG (Chart 9). A new gas pipeline linking Spain with the rest of Europe should be operational by next spring. Chart 8Soaring Energy Costs Have Pushed The Euro Area Trade Balance Into Deficit Chart 9Europe Is America's Largest LNG Customer In the meantime, Germany is building two “floating” LNG terminals. It has also postponed plans to mothball its nuclear power plants and has restarted its coal-fired power plants, a decision that even the German Green Party has supported. France is aiming to boost nuclear capacity, which had fallen below 50% earlier this summer. Électricité de France has pledged to nearly double daily production by December. For its part, the Dutch government has indicated it will raise output from the massive Groningen natural gas field if the energy crisis intensifies. Fiscal Policy to the Rescue On the policy front, European governments are taking steps to buttress household balance sheets during the energy crisis, with nearly €400 billion in support measures announced so far (and surely more to come). Although these support measures will be offset with roughly €140 billion of windfall profit taxes on the energy sector, the net effect will be to raise budget deficits across the region. However, following the old adage that one should “finance temporary shocks but adjust to permanent ones,” a temporary spike in fiscal support may be just what the doctor ordered. The last thing Europe needs is a situation where energy prices fall next year, but the region remains mired in recession as households seek to rebuild their savings. Such an outcome would depress tax revenues, likely leading to higher government debt-to-GDP ratios. Get Ready For a V-Shaped Recovery Stronger growth in the rest of the world should give the euro area a helping hand. That would be good news for the euro, given its cyclical characteristics (Chart 10). The European economy is especially leveraged to Chinese growth. It is likely that the authorities will loosen the zero-Covid policy once the Twentieth Party Congress concludes next month, and new anti-viral drugs and possibly an Omicron-specific booster shot become widely available later this year. That should help jumpstart China’s economy. More stimulus will also help. Chart 11 shows that EUR/USD is highly correlated with the Chinese credit/fiscal impulse. Chart 10The Euro Is A Cyclical Currency Chart 11EUR/USD Is Highly Correlated With The Chinese Credit & Fiscal Impulse All this suggests that the prevailing view on European growth is too pessimistic. Even if Europe does succumb to a technical recession in the months ahead, it is likely to experience a V-shaped recovery. That will provide a nice tailwind for the euro. Loose Fiscal/Tight Monetary Policies: The Winning Combo for Currencies Chart 12Fiscal Policy Has Eased Structurally In The Euro Area More Than In Other Advanced Economies A tight monetary and loose fiscal policy has historically been the most bullish combination for currencies. Recall that the US dollar soared in the early 1980s on the back of Paul Volcker’s restrictive monetary policy and Ronald Reagan’s expansionary fiscal policy, the latter consisting of huge tax cuts and increased military spending. While not nearly on the same scale, the euro area’s current configuration of loose fiscal/tight monetary policies bears some resemblance to the US in the early 1980s. Even before the war in Ukraine began, the IMF was forecasting a much bigger swing towards expansionary fiscal policy in the euro area than in the rest of the world (Chart 12). The war has only intensified this trend, triggering a flurry of spending on energy and defense – spending that is likely to persist for most of this decade. The ECB’s Reaction Function After biding its time, the ECB has joined the growing list of central banks that are hiking rates. On September 8th, the ECB jacked up the deposit rate by 75 bps. Investors expect a further 185 bps in hikes through to September 2023. While US rate expectations have widened relative to euro area expectations since the August US CPI report (more on that later), the gap is still narrower than it was on August 15th. Back then, investors expected euro area 3-month rates to be 233 bps below comparable US rates in June 2023. Today, they expect the gap to be only 177 bps (Chart 13). Real long-term bond spreads, which conceptually at least should be the more important driver of currency movements, have also moved in the euro’s favor. In the past, ECB rate hikes were swiftly followed by cuts as the region was unable to tolerate even moderately higher rates. While this very well could happen again, the odds are lower than they once were, at least over the next 12 months. Chart 13Interest Rate Differentials Have Moved In Favor Of The Euro Since Mid-August Chart 14Euro Area: Inflation Expectations Have Risen Briskly For one thing, median inflation expectations three years ahead in the ECB’s monthly survey have risen briskly (Chart 14). The Bundesbank’s own survey paints an even more alarming picture, with median expected inflation over the next five years having risen to 5% from 3% in mid-2021 (Chart 15). Expected German inflation over the next ten years stands at a still-elevated 4%. Whether this reflects Germans’ heightened historical sensitivity to inflation risks is unclear, but it is something the ECB cannot ignore. Structurally looser fiscal policy has raised the neutral rate of interest in the euro area, giving the ECB more leeway to lift rates. A narrowing in competitiveness gaps across the currency bloc has also mitigated the need for the ECB to set rates based on the needs of the weakest economies in the region. Chart 16 shows that collectively, unit labor costs among the countries most afflicted by the sovereign debt crisis a decade ago have completely converged with Germany. Chart 15German Inflation Expectations Are Elevated Chart 16Europe's Periphery Has Closed The Competitiveness Gap With Germany While Italy is still a laggard in the competitiveness rankings, the ECB’s new Transmission Protection Instrument (TPI) – which allows the central bank to buy sovereign debt with less stringent conditionality than under the Outright Monetary Transactions (OMT) program – should keep a lid on sovereign spreads. This, in turn, will allow the ECB to raise rates more than it otherwise could. Hawkish Fed is the Biggest Risk to Our Bullish EUR/USD View Chart 17Supplier Delivery Times Have Fallen Sharply Tuesday’s hotter-than-expected August US CPI report pulled the rug from under the euro’s incipient rally, pushing EUR/USD back to parity. We have been flagging the risks of high inflation for several years (see, for example, our February 19, 2021 report, 1970s-Style Inflation: Yes, It Could Happen Again). Our thesis is that inflation will follow a “two steps up, one step down” pattern. We are probably near the top of those two steps now, with the next leg for inflation likely to be to the downside, driven by ebbing pandemic-related supply side-dislocations. Perhaps most notably, supplier delivery times have fallen sharply in recent months (Chart 17). These pandemic-related dislocations extend to the housing rental market. Rent inflation dropped after rent moratoriums were put in place, only to rebound forcefully once the moratoriums were lifted and the labor market tightened. Although official measures of rent inflation will remain elevated for some time, owing to lags in how they are constructed, timelier data on new rental units coming to market already point to a sharp decline in rent inflation (Chart 18). This is something that the Fed is sure to notice. Ironically, falling inflation could sow the seeds of its own demise. Nominal wage growth is currently very elevated, yet because of high inflation, real wages are still shrinking. As inflation comes down, real wage growth will turn positive. This will lift consumer sentiment, helping to buoy consumption (Chart 19). A pickup in consumer spending will cause the economy to overheat again, leading to a second wave of inflation in the back half of 2023. Chart 18Timelier Measures Of Rent Inflation Have Rolled Over Chart 19Falling Inflation Will Boost Real Wages And Consumer Confidence As we discussed in our August 18th Special Report Dispatches From The Future: From Goldilocks To President DeSantis, the Fed will respond to this second inflationary wave by hiking the Fed funds rate to 5%. This will temporarily push up the value of the dollar, a process that will only stop once the US falls into recession in 2024 and the Fed is forced to cut rates again. Our projected rollercoaster ride for EUR/USD is depicted in Chart 20. We see the euro rising to $1.06 by year-end, peaking at $1.11 in the spring of 2023, falling back to $1.05 by late 2023, and then beginning a prolonged rally in 2024. Chart 20GIS Projection For The EUR/USD Chart 21The Dollar Is Very Overvalued Against The Euro Based On PPP Chart 21 shows that the dollar is 30% overvalued against the euro based on its Purchasing Power Parity (PPP) exchange rate. Thus, there is significant long-term upside to EUR/USD. Implications for Other Currencies and Regional Equity Allocation Chart 22Stock Markets Outside The US Tend To Fare Best When The Dollar Is Weakening The strengthening in the euro that we envision over the next six months or so will be part of a broad-based dollar decline. While BCA’s Foreign Exchange Strategy service sees more upside for the euro than the pound, GBP/USD will likely follow the same trajectory as EUR/USD. The yen is one of the cheapest currencies in the world and should finally gain some traction. If China abandons its zero-Covid policy and increases fiscal support for its economy, the RMB and other EM currencies should strengthen. Stock markets outside the US tend to fare best when the dollar is weakening. This includes Europe. As Chart 22 illustrates, there is a close correlation between EUR/USD and the relative performance of European versus US stocks. Thus, an above-benchmark exposure to international markets is appropriate during the coming months. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn & Twitter Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
In lieu of next week’s report, I will host the monthly Counterpoint Webcast on Thursday, September 22 (9:00 AM EDT, 2:00 PM BST). In this Webcast, I will discuss the near-term and longer-term prospects for all the major asset classes: stocks, bonds, sectors, commodities, currencies, and real estate. Please mark the date in your calendar, and I do hope you can join. Executive Summary Analysing the economy as the ‘non-linear system’ that it is leads to profound conclusions about how the economy and inflation are likely to unfold, and reveals that some outcomes are impossible to achieve. It is impossible to lift the unemployment rate by ‘just’ 1-2 percent. Therefore, it is impossible to depress wage inflation by ‘just’ 1 percent. The non-linear choice is to not depress wage inflation at all, or to make wage inflation slump. Presented with this non-linear choice, central banks will likely choose to make wage inflation slump, which will take core inflation well south of the 2 percent target within the next couple of years. The structural low in bond yields, the structural low in commodity prices, the structural high in stock market valuations, and the structural high in the US dollar are yet to come. It Is Impossible To Lift The Unemployment Rate By ‘Just’ 1-2 Percent Bottom Line: Inflation will slump to well below 2 percent within the next couple of years. Feature Our non-linear world often surprises our linear minds. If we discover that a small cause produces a small effect, we think that double the cause produces double the effect, and that triple the cause produces triple the effect. But in our non-linear world, double the cause could produce no effect, or half the effect, or ten times the effect. Just as important, in a non-linear world, some outcomes turn out to be impossible. In a non-linear system, some outcomes are impossible to achieve. As I will now discuss, analysing the economy as the non-linear system that it is leads to profound conclusions about how the economy and inflation are likely to unfold, and reveals that some outcomes are impossible to achieve. In A Non-Linear System, Some Outcomes Are Impossible A good physical example of a non-linear system that we can apply to inflation is to attach an elastic band to the front of a brick. And then to try pulling the brick across a table at a constant speed, say 2 mph. It’s impossible! First, nothing happens. The brick is held in place by friction. Then, at a tipping point of pulling, it starts to accelerate. Simultaneously, the friction decreases, self-reinforcing the acceleration to well above 2 mph. Meanwhile, your response – to stop pulling – happens with a lag. The result is that, the brick refuses to budge, and then it hits you in the face. Try as you might, it is impossible to pull the brick at a constant 2 mph (Figure 1 and Figure 2). Figure 1The Forces On A Brick Pulled By An Elastic Band Figure 2The Net Forces On A Brick Pulled By An Elastic Band In mathematical terms, the reduction in friction as the brick starts to move is known as ‘self-reinforcing feedback’. The lag in applying the brakes is called ‘delayed corrective feedback’. Their combined effect is to make it impossible to pull the brick at a constant 2 mph. Now, to model inflation, attach an elastic band to both the front and the back of the brick, and find a friend. Your task, ‘policy loosening’, is to accelerate the stationary brick to a steady 2 mph. The analogy being to run inflation at 2 percent. On the opposite side, your friend’s task, call it ‘policy tightening’, is what central banks are desperate to do now – to rein back an out-of-control brick heading towards your face at 10 mph. But without slowing it to a standstill, or worse, reversing direction. The analogy being to avoid outright deflation. You will discover that you can move the brick sharply forwards (and sharply backwards), but you cannot move it forwards at a steady 2 mph! The brick-on-an-elastic-band analogy explains why it is impossible for policymakers to run inflation at a constant 2 percent. Inflation either careers out of control, as now, or stays stuck below 2 percent, as it did through the 2010s. Inflation cannot run ‘close to 2 percent’. It Is Impossible To Lift The Unemployment Rate By ‘Just’ 1-2 Percent Central to the non-linearity of inflation is the non-linearity of the jobs market, in which some outcomes are impossible. Specifically, it has proved impossible to lift the unemployment rate by ‘just’ 1-2 percent. It has proved impossible to lift the unemployment rate by ‘just’ 1-2 percent. Through the past 75 years, whenever the US unemployment rate has increased by 0.6 percent, it has then gone on to increase by at least 2.1 percent from the trough. In no case has the unemployment rate risen by ‘just’ 0.6-2.1 percent. In other words, the unemployment rate nudges up by 0.5 percent or less, or it surges by 2.1 percent or more. There is no middle ground. Indeed, through more recent history the surge has been 2.5 percent or more (Chart I-1 and Chart I-2). Chart I-1It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent Chart I-2It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent As with the brick-on-an-elastic-band, we can explain this non-linearity through the concepts of self-reinforcing feedback combined with delayed negative feedback. At a tipping point of rising unemployment, consumers pull in their horns and slow their spending, while banks slow their lending. This constitutes the self-reinforcing feedback which accelerates the downturn. Meanwhile, as it takes time for this downturn to appear in the data, policymakers respond with a lag, and when their response eventually comes, it also acts with a lag. This constitutes the delayed negative feedback, by which time the unemployment rate has surged, with every 1 percent rise in the unemployment rate depressing wage inflation by 0.5 percent (Chart I-3 and Chart I-4). Chart I-32001-02: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent Chart I-42008-09: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent All of which brings me to a crucial point: The non-linearity in the jobs market implies a non-linearity in inflation control. Given that it is impossible to lift the unemployment rate by ‘just’ 2 percent, it is also impossible to depress wage inflation by ‘just’ 1 percent. The choice is to not depress wage inflation at all, or to make wage inflation slump. This presents a major dilemma for policymakers in their current battle against inflation. If they choose to not depress wage inflation at all, core inflation will remain north of 3 percent and destroy central banks’ already tattered credibility to achieve and maintain price stability (Chart I-5). In the medium term, this would un-anchor long-term inflation expectations, push up bond yields, and further destabilise the financial and housing markets. Chart I-5Wage Inflation Is Running Too Hot For The 2 Percent Inflation Target On the other hand, if central banks do choose to depress wage inflation, the non-linearity of the jobs market implies that wage inflation will slump, taking core inflation south of the 2 percent target. Central banks could pray that a surge in productivity growth might save their skins. If productivity growth surged, elevated wage inflation might still be consistent with 2 percent inflation, as it was in the early 2000s. But we wouldn’t bet on this outcome (Chart I-6). Chart I-6Don't Bet On A Repeat Of The Early 2000s Productivity Miracle Inflation Will Not Run ‘Close To 2 Percent’ To summarise then, the economy is a non-linear system, and should be analysed as such. In uniquely doing so in this report, we reach a profound conclusion. The non-linearity of the jobs market and inflation control means that it is impossible for core inflation to run ‘close to 2 percent’. Depending on which of the non-linear options that policymakers choose – to not depress wage inflation at all, or to make wage inflation slump – inflation will either remain well above 2 percent, or slump to well below 2 percent within the next couple of years. Which option will the central banks choose? My answer is that they will make wage inflation slump. This is not just to save their own skins, but a genuine belief that the worse long-term outcome for the economy would be if central banks’ credibility to maintain price stability was destroyed. To prevent this outcome, a recession is a price that they are willing to pay. Central banks will choose to make wage inflation slump. Not just to save their own skins, but because the worse long-term outcome for the economy would be if price stability was destroyed. But what if I am wrong, and they choose not to depress wage inflation? In this case, long-term inflation expectations would become un-anchored, pushing up bond yields, and crashing the financial and housing markets. In turn, this would unleash a massive deflationary impulse which would end up creating an even deeper recession. So, we would end up at the same place, albeit later and via a more circuitous route. All of which confirms some long-held views. The structural low in bond yields, the structural low in commodity prices, the structural high in stock market valuations, and the structural high in the US dollar are yet to come. Chart 1Hungarian Bonds Are Oversold Chart 2Copper Is Experiencing A Tactical Rebound Chart 3US REITS Are Oversold Versus Utilities Chart 4FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 5Netherlands' Underperformance Vs. Switzerland Has Ended Chart 6The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 7Food And Beverage Outperformance Is Exhausted Chart 8German Telecom Outperformance Has Started To Reverse Chart 9Japanese Telecom Outperformance Vulnerable To Reversal Chart 10The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 11The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 12The Outperformance Of Tobacco Vs. Cannabis Is Ending Chart 13Biotech Is A Major Buy Chart 14Norway's Outperformance Has Ended Chart 15Cotton Versus Platinum Has Reversed Chart 16Switzerland's Outperformance Vs. Germany Is Exhausted Chart 17USD/EUR Is Vulnerable To Reversal Chart 18The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 19US Utilities Outperformance Vulnerable To Reversal Chart 20The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com 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
Executive Summary US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins China needs lower interest rates and a weaker currency to battle deflationary pressures. In the US, the main problem is elevated inflation. This heralds higher interest rates and a stronger currency. Hence, the Chinese yuan will depreciate against the greenback. When the RMB weakens versus the US dollar, commodity prices usually fall, and EM currencies and asset prices struggle. Faced with surging unit labor costs, US companies will continue to raise their prices to protect their profit margins and profitability. This will lead to one of the following two possible scenarios in the months ahead. Scenario 1: If customers are willing to pay considerably higher prices, nominal sales will remain robust, profits will not collapse, and a recession is unlikely. However, this also implies that the Fed will have to tighten policy by more than what is currently priced in by markets. Scenario 2: If customers push back against higher prices and curtail their purchases, then the economy will enter a recession. In this scenario, inflation will plummet, corporate margins will shrink, and their profits will plunge. In both scenarios, the outlook for stocks is poor. However, one key difference is that scenario 1 is bearish for US Treasurys while scenario 2 is bond bullish. Bottom Line: On the one hand, the US has a genuine inflation problem. The upshot is that the Fed cannot pivot too early. The Fed’s hawkish rhetoric will support the US dollar. A strong greenback is bad for EM financial markets. On the other hand, the Chinese economy and global trade are experiencing deflation/recession dynamics. Cyclical assets underperform and the US dollar generally appreciates in this environment. This is also a toxic backdrop for EM financial markets. Financial markets have been caught in contradictions. The reason is that investors cannot decide if the global economy is heading into a recession with deflationary forces prevailing, or whether a goldilocks economy or a period of inflation or stagflation will emerge in the foreseeable future. There are also plenty of contradictory data to support all the above scenarios. As such, financial markets are volatile, swinging wildly as market participants absorb new economic data points. The S&P 500 index has rebounded from its 3-year moving average, which had previously served as a major support (Chart 1). Yet, the rebound has faltered at its 200-day moving average. Its failure to break decisively above this 200-day moving average entails that a new cyclical rally is not yet in the cards. Chart 1The S&P 500 Is Stuck Between Technical Resistance And Support Lines The S&P 500 index will remain between these resistance and support lines until investors make up their minds about the economic outlook. The EM equity index has been unable to rebound strongly alongside US stocks. A major technical support that held up in the 1998, 2001, 2002, 2008, 2015 and 2020 bear markets is about 15% below the current level (Chart 2). Hence, we recommend that investors remain on the sidelines of EM stocks. Chart 2EM Share Prices Are Still 15% Above Their Long-Term Technical Support Level BCA’s Emerging Markets Strategy team’s macro themes and views remain as follows: Related Report Emerging Markets StrategyCharts That Matter In China, the main economic risk is deflation and the continuation of underwhelming economic growth. Core and service consumer price inflation are both below 1% and property prices are deflating. Falling prices amid high debt levels is a recipe for debt deflation. We discussed the government’s stimulus – including measures enacted for the property market – in the August 11 report. The latest announcement about the RMB 1 trillion stimulus does not change our analysis. In fact, we expected an additional RMB 1.5 trillion in local government bond issuance for the remainder of the current year. Yet, the government authorized only an additional RMB 0.5 trillion. This is substantially below what had been expected by analysts and commentators in recent months. In Chinese and China-related financial markets, a recession/deflation framework remains appropriate. Onshore interest rates will drop further, the yuan will depreciate more, and Chinese stocks and China related plays will continue experiencing growth/profit headwinds. Meanwhile, the US economy has been experiencing stagflation this year. Chart 3 shows that even though the nominal value of final sales has expanded by 8-10%, sales and output have stagnated in real terms (close to zero growth). Hence, nominal sales and corporate profits have so far held up because companies have been able to raise prices by 8-9.5% (Chart 4). Is this bullish for the stock market? Not really. Chart 3US Stagflation: Strong Nominal Growth, But Small In Real Terms Chart 4US Corporate Profits Have Held Up Because Of Pricing Power/Inflation The fact that companies have been able to raise their selling prices at this rapid pace implies that the Fed cannot stop hiking rates. Besides, US wages and unit labor costs are surging (Chart 9 below). The implication is that inflation will be entrenched and core inflation will not drop quickly and significantly enough to allow the Fed to pivot anytime soon. Overall, US economic data releases have been consistent with our view that although real growth is slowing, the US economy is experiencing elevated inflations, i.e., a stagflationary environment. Critically, wages and inflation lag the business cycle and are also very slow moving variables. Hence, US core inflation will not drop below 4% quickly enough to provide relief for the Fed and markets. Is a US recession imminent? It depends. One thing we are certain of is that faced with surging unit labor costs, US companies will attempt to raise their prices to protect their profit margins and profitability. Our proxy for US corporate profit margins signals that they are already rolling over (Chart 5). Hence, business owners and CEOs will attempt to raise selling prices further. Chart 5US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins This will lead to one of two possible scenarios for the US economy in the months ahead. Scenario 1: If customers (households and businesses) are willing to pay considerably higher prices, nominal sales will remain very robust, and profits will not collapse, reducing the likelihood of a recession. Yet, this means that inflation will become even more entrenched, and employees will continue to demand higher wages. A wage-price spiral will persist. The Fed will have to raise rates much more than what is currently priced in financial markets. This is negative for US share prices. Scenario 2: If customers push back against higher prices and curtail their purchases, output volume will relapse, i.e., the economy will enter a recession. In this scenario, inflation will plummet, corporate margins will shrink (prices received will rise much less than unit labor costs) and profits will plunge. Suffering a profit squeeze, companies will lay off employees, wage growth will decelerate, and high inflation will be extinguished. In this scenario, bond yields will drop significantly but plunging corporate profits will weigh on share prices. We are not certain which of these two scenarios will prevail: it is hard to determine the point at which US consumers will push back against rising prices. Nevertheless, it is notable that in both scenarios, the outlook for stocks is poor. Finally, as we have repeatedly written, global trade is about to contract. Charts 10-18 below elaborate on this theme. This is disinflationary/recessionary. Investment Conclusions On the one hand, the Chinese economy and global trade are experiencing deflation/recession dynamics. Cyclical assets struggle and the US dollar does well in this environment. This constitutes a toxic backdrop for EM financial markets. On the other hand, the US has a genuine inflation problem. The upshot is that the Fed cannot pivot too early. The Fed’s hawkish rhetoric will support the US dollar. A strong greenback is also bad for EM financial markets. Thus, we do not see any reason to alter our negative view on EM equities, credit and currencies. Investors should continue underweighting EM in global equity and credit portfolios. Local currency bonds offer value, but further currency depreciation and more rate hikes remain a risk to domestic bonds. We continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN and IDR. In addition, we recommend shorting HUF vs. CZK, KRW vs. JPY, and BRL vs. MXN. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Messages From Various US High-Beta / Cyclical Stock Prices US high-beta consumer discretionary, industrials, tech and early cyclical stocks have not yet broken out. The rebounds in high-beta tech and industrials have been rather muted. We are watching these and many other market signs and technical indicators to gauge if the recent rebounds can turn into a cyclical bull market. Chart 6 Chart 7 Falling Global Trade + Sticky US Inflation = US Dollar Overshot On the one hand, US household spending on goods ex-autos is already contracting and will drop further. The same is true for EU demand. The reasons are excessive consumption of goods over the past two years and shrinking household real disposable income. As a result, global trade is set to shrink, which is positive for the US dollar. On the other hand, surging US unit labor costs entail that core CPI will be very sticky at levels well above the Fed’s target. Hence, the Fed will likely maintain its hawkish bias for now, which is also bullish for the greenback. In short, the US dollar will continue overshooting. Chart 8 Chart 9 Chinese Exports Will Contract, And Imports Will Fail To Recover Chinese export volume growth has come to a halt. Shrinking imports of inputs used for re-export (imports for processing trade) are pointing to an imminent contraction in the mainland’s exports. Further, Chinese import volumes have been contracting for the past 12 months. The value of imports has not plunged only because of high commodity prices. As commodity prices drop, import values will converge to the downside with import volumes. This is negative for economies/industries selling to China. Chart 10 Chart 11 Global Manufacturing / Trade Downtrend Is Intact China buys a lot of inputs from Taiwan that are used in its exports. That is why the mainland’s imports from Taiwan lead the global trade cycle. This is presently heralding a considerable deterioration in global trade. In addition, falling freight rates and depreciating Emerging Asian (ex-China) currencies are all currently pointing to a further underperformance of global cyclicals versus defensive sectors. Chart 12 Chart 13 Chart 14 Taiwan Is A Canary In A Coal Mine Taiwanese manufacturing companies have seen their export orders plunge and their customer inventories surge. This has occurred in its overall manufacturing and semiconductor companies. This corroborates our thesis that global export volumes will contract in the coming months. Chart 15 Chart 16 Korean Exporters Are Struggling Korean export companies are experience the same dynamics as their Taiwanese peers. Semiconductor prices and sales are falling hard in Korea. Export volume growth has come to a halt and will soon shrink. Chart 17 Chart 18 EM Equities: Cheap And Unloved? The EM cyclically adjusted P/E (CAPE) ratio has fallen to one standard deviation below its mean. Based on this measure, EM stocks are currently as cheap as they were at their bottoms in 2020, 2015 and 2008. EM share prices in USD deflated by US CPI are now at two standard deviations below their long-term time-trend. This is as bad as it got when EM stocks bottomed in the previous bear markets. The reason for EM stocks poor performance and such “cheapness” is corporate profits. EM EPS in USD has been flat, i.e., posting zero growth in the past 15 years. Besides, EM narrow money (M1) growth points to further EM EPS contraction in the months ahead. Chart 19 Chart 20 Chart 21 Chart 22 Commodity Prices Remain At Risk China needs lower interest rates and a weaker currency to battle deflationary pressures. In the US, the problem is inflation, which heralds higher interest rates and a stronger currency to fight rising prices. Hence, the yuan will depreciate versus the greenback. When the RMB depreciates versus the US dollar, commodity prices usually fall. Further, commodity currencies (an average of AUD, NZD and CAD) continue drafting lower. This indicator correlates with commodity prices and also presages further relapse in resource prices. Chart 23 Chart 24 Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Chinese crude oil imports have been contracting for almost a year. Global (including US) demand for gasoline has relapsed. Meantime, Russia’s oil and oil product exports have fallen only by a mere 5% from their January level. This explains why oil prices have recently fallen. Oil lags business cycles: its consumption will shrink as global growth downshifts. However, geopolitics remain a wild card. Hence, we are uncertain about the near-term outlook for oil prices. That said, oil has made a major top and any rebound will fail to last much longer or push prices above recent highs. Chart 25 Chart 26 Chart 27 Chart 28 What Is Next For The Chinese RMB? The Chinese yuan will continue depreciating versus the US dollar. China needs lower interest rates and a weaker currency to battle deflationary pressures. While currency is moderately cheap, exchange rates tend to overshoot/undershoot and can remain cheap/expensive for a while. The CNY/USD has technically broken down. Interestingly, the periods of RMB depreciation coincide with deteriorating global US dollar liquidity and, in turn, poor performance by EM assets and commodities. Chart 29 Chart 30 Chart 31 Stay Put On Chinese Equities Odds are rising that Chinese platform companies will likely be delisted from the US as we have argued for some time. Hence, international investors will continue dampening US-listed Chinese stocks. The outlook for China’s economic recovery and profits is downbeat. This will weigh on non-TMT stocks and A shares. Within the Chinese equity universe, we continue to recommend the long A-shares / short Investable stocks strategy, a position we initiated on March 4, 2021. Chart 32 Chart 33 Chart 34 Chart 35 Messages For Stocks From Corporate Bonds Historically, rising US and EM corporate bond yields led to a selloff in US and EM share prices, respectively. Corporate bond yields are the cost of capital that matters for equities. Unless US and EM corporate bond yields start falling on a sustainable basis, their share prices will struggle. Corporate bond yields could increase because of either rising US Treasury yields or widening credit spreads. Chart 36 Chart 37 EM Currencies And Fixed-Income: An Unfinished Adjustment The profiles of EM FX and credit spreads suggest that their adjustment might not be complete. We expect further EM currency depreciation and renewed EM credit spread widening. EM domestic bond yields have risen significantly and offer value. However, if and as US TIPS yields rise and/or EM currencies continue to depreciate, local bond yields are unlikely to fall. To recommend buying EM local bonds aggressively, we need to change our view on the US dollar. Chart 38 Chart 39 Chart 40 Chart 41 Footnotes Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)
Dispatches From The Future: From Goldilocks To President DeSantis
Executive Summary More Regional Divergences Within Our Global LEI The BCA global leading economic indicator (LEI) is still in a downtrend, but its diffusion index – which tends to lead the overall global LEI at major cyclical turning points – has crept higher since bottoming in January. The diffusion index is rising in part because of very marginal increases in the LEIs of a few countries, but there have been more decisive increases in the LEIs of two major countries outside the developed world – China and Brazil. There is not yet enough evidence pointing to a true bottoming of the BCA global LEI anytime soon, but an improvement in the LEI diffusion index above 50 (i.e. a majority of countries with a rising LEI) would be a more convincing signal that global growth momentum is set to rebound. Bottom Line: Given the uncertain message on growth from our global LEI, and with inflation rates still too high for central banks to pivot dovishly, we recommend staying close to neutral on overall global fixed income duration and modestly defensive on overall spread product exposure. Feature Investors can be forgiven for being a bit confused by some conflicting messages in recent global economic data. For example, US real GDP contracted in both the first and second quarter of this year – a so-called “technical recession” – and consumer confidence is at multi-decade lows, yet the US unemployment rate fell to 3.5%, the lowest level since 1969, in July. A similar story is playing out across the Atlantic, where a historic surge in energy prices was supposed to have already tipped the euro area into recession, yet real GDP expanded in both Q1 and Q2 at an above-trend pace and unemployment continues to decline. At times like the present, when market narratives do not always line up with hard data, we always believe it important to look within our vast suite of indicators to help clear the fog. One of our most trusted growth indicators, the BCA Global Leading Economic Indicator (LEI), is still falling and, thus, signaling a continued deceleration of global growth over at least the next 6-9 months. However, there are some signs of more optimistic news embedded within our global LEI stemming from outside the developed economies, which could be a potential early sign of a bottoming in global growth momentum. In this report, we dig deeper into the guts of our global LEI to assess the odds of an imminent turning point in the LEI and, eventually, global growth. This has important implications for global bond yields, which are likely to remain rangebound until there is greater clarity on global growth momentum (and inflation downside momentum). What Leads The Leading Indicator? The BCA global LEI is a composite index that combines the LEIs of 23 individual countries using GDP weights. The underlying list of countries differs from that of the widely followed OECD LEI, which is comprised of data from 33 countries but with a heavy weighting on developed market economies. The overall OECD LEI excludes important exporting countries such as Taiwan and Singapore, which are highly sensitive to changes in global growth. Most importantly, the OECD LEI omits the world’s largest economy, China. For our global LEI, we prefer to use a smaller set of countries but one that includes China and a bigger weighting on emerging market (EM) economies. For most of the nations in our global LEI, we do use the country-level LEIs produced by the OECD.1 That also includes several large and important non-OECD EM countries for which the OECD calculates LEIs - a list that includes China, Brazil, India, Russia, Indonesia and South Africa. For a few selected countries, however, we use the following data: US, Korea, Taiwan and Singapore: LEIs produced by national government data sources or, in the case of the US, the Conference Board. Argentina, Malaysia and Thailand: LEIs are produced in-house at BCA, a necessary step given the lack of domestically-produced LEIs in those countries at the time our global LEI was first constructed. We find that our global LEI leads global real GDP growth by around six months, and leads global industrial production growth by around twelve months (Chart 1). Chart 1A Gloomy Message From Our Global LEI The latest reading on the global LEI from July is pointing to a further deceleration of global GDP into a “growth recession” where GDP is expanding slower than the pace of potential global GDP growth (less than 2%). The global LEI is also pointing to an outright contraction of global industrial production, a path also signaled by the JPMorgan global manufacturing PMI index which hit a two-year low of 51.1 – closing in on the 50 level that signifies expanding industrial activity – in July. Chart 2A Ray Of Hope On Global Growth? The momentum of our global LEI is largely influenced by its breadth. Specifically, we have found that when a growing share of countries within the global LEI have individual LEIs that are rising, the overall LEI will eventually follow suit. Thus, the diffusion index of our global LEI, which measures the percentage share of countries with rising individual LEIs, is itself a fairly good leading indicator of the global LEI at major cyclical turning points. We may be approaching such a turning point, as our global LEI diffusion index has increased from a low of 9 back in January of this year to the level of 30 in July (Chart 2). In past business cycles, the diffusion index has tended to lead the global LEI by around 6-9 months, which suggests that a bottom in the actual global LEI could occur sometime in the next few months – although that outcome is conditional on the magnitude of the rise in the diffusion index. In the top half of Table 1, we list previous episodes since 1980 where the global PMI diffusion index followed a similar path to that seen in 2022 – bottoming out below 10 and then rising to at least 30. We identified nine such episodes. In the table, we also show the subsequent change in the level of the global LEI after the increase in the diffusion index. Table 1Global LEI Diffusion Index Greater Than 50 Typically Signals LEI Uptrend The historical experience shows that an increase in the diffusion index to 30 was only enough to trigger a decisive rebound in the global LEI over a 6-12 month horizon in the 2000-01 and 2008 episodes. In several episodes, the global LEI actually contracted despite the pickup in the diffusion index. Related Report Global Fixed Income StrategyDovish Central Bank Pivots Will Come Later Than You Think In the bottom half of Table 1, we run the same analysis but define the episodes as when the diffusion index rose from a low below 10 to at least 50. Unsurprisingly, periods when at least half of the countries have a rising LEI tend to result more frequently in the overall global LEI entering an uptrend within one year – although the two most recent episodes in 2010 and 2018-19 were notable exceptions. Bottom Line: After looking at past experience, the latest pickup in the global LEI diffusion index has not been by enough to confidently forecast a rebound in the LEI – and, eventually, faster global growth. No Broad-Based Improvement In Our Global LEI When grouping the countries within our global LEI by geographical region, it is clear that there is still no sign of improvement in North America or Europe, but some signs of bottoming in Asia and Latin America (Chart 3). Typically, the regional LEIs tend to be very positively correlated during major cyclical moves in the overall LEI, with no one region being particularly better than the others at consistently leading the global business cycle. Chart 3More Regional Divergences Within Our Global LEI Table 2Country Weightings In Our Global LEI Of course, the global LEI is a GDP-weighted index that is dominated by the US and China (Table 2). When looking at individual country LEIs, the recent improvement in the LEI diffusion index looks less impressive. Some countries, like the UK and Korea, have only seen a tiny fractional uptick in the most recent LEI reading – moves small enough to qualify as statistical noise, even though the tiniest of positive moves still register as an “increase” when calculating the diffusion index. When looking at all the individual country LEIs within our global LEI, only two countries stand out as having meaningful increases over the past few months – China and Brazil (Chart 4). In the case of China, the idea that there could be signs of improving growth runs counter to the broad swath of recent data that highlight slowing momentum of Chinese consumer spending, business investment and residential construction. However, the production-focused components of the OECD’s China LEI, which we use in our global LEI, have shown some improvement of late (Chart 5). For example, motor vehicle production grew at a 32% year-over-year rate in July according to the OECD’s data, while total construction activity (based on OECD aggregates of production by industry) rose 9% year-over-year. Chart 4LEI Improvement In China & Brazil, Sluggish Elsewhere Chart 5Improvement In Some Components Of The OECD's China LEI The OECD’s LEI methodology is designed to include the minimum number of data series to optimize the fit of the LEI to the growth rate of each country’s industrial production index, which does lead to some peculiar series being included in the LEIs. However, there are signs of a potential rebound in Chinese economic growth evident in indicators preferred by our emerging market strategists, like the change in overall credit and fiscal spending as a share of GDP, a.k.a. the credit and fiscal impulse (Chart 6). The latter has shown a modest improvement that is hinting at faster Chinese growth in 2023, similar to the OECD’s China LEI. Turning to Brazil, the improvement in the OECD’s LEI there is focused on more survey-based data, like confidence among manufacturers and expectations on the demand for services. However, some hard data that the OECD includes in its Brazil LEI, namely net exports to Europe, have also shown clear improvement (Chart 7). Chart 6China Credit/Fiscal Impulse Signaling A Growth Rebound Bottom Line: The modest improvement in our global LEI diffusion index is even less than meets the eye, as only China and Brazil have seen LEI increases that are meaningfully greater than zero. Chart 7Improvement In Many Components Of The OECD's Brazil LEI Investing Around The Global LEI Chart 8Global Financial Conditions Not Signaling An LEI Rebound Investors spend a sizeable chunk of their time focused on the future growth outlook to make investment decisions. This would, presumably, give leading economic indicators a useful role in any investment process. However, when looking at the relationship between our global LEI and the returns on risk assets like equities and corporate credit, the correlation is highly coincident (Chart 8). In other words, risk assets are themselves leading indicators of future economic growth – so much so that equity indices are often included as a component of the leading indicators of individual countries. On that front, the recent rebound in global equity markets, and the pullback in global credit spreads from the mid-June peak, could be signaling a more stable growth outlook that would be reflected in a bottoming of our global LEI. However, the monetary policy cycle matters, as evidenced by the correlation between the shape of government bond yield curves and our global LEI (bottom panel). That relationship is less strong than that of the LEI and equity/credit returns, but there are very few examples where yield curves are flat, or even inverted as is now the case in the US, and leading indicators are rising. Chart 9Stay Neutral On Overall Duration Exposure In the current environment where more central banks are worrying more about overshooting inflation than slowing growth, a turnaround in our global LEI will be difficult to achieve until inflation is much closer to central bank target levels, allowing policymakers to loosen policy and steepen yield curves. We do not expect such a scenario to unfold over at least the next 12-18 months, given broad-based entrenched inflation pressures in global services and labor markets. While leading indicators may not be of much value in forecasting risk assets, we do find value in using them to forecast moves in government bond yields. Regular readers of BCA Research Global Fixed Income Strategy will be familiar with our Global Duration Indicator, comprised of growth-focused measures that have historically had a leading relationship to the momentum (annual change) in developed market bond yields (Chart 9). The Duration Indicator contains both the global LEI and its diffusion index, as well as the ZEW expectations indices for the US and Europe. Three of those four indicators remain at depressed levels suggesting waning bond yield momentum. Overshooting global inflation has weakened the correlation between bond yield momentum and our Duration Indicator over the past year. However, with global commodity and goods inflation now clearly decelerating, we expect bond momentum to begin tracking growth dynamics more closely again. This leads us to expect bond yields to remain trapped in ranges over at least the balance of 2022, defined most prominently by the 10-year US Treasury yield trading between 2.5% and 3%. Bottom Line: Given the uncertain message on growth from our global LEI, and with inflation rates still too high for central banks to pivot dovishly, we recommend staying close to neutral on overall global fixed income duration and modestly defensive on overall spread product exposure. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Details on how the OECD calculates the individual country leading economic indicators can be found here: http://www.oecd.org/sdd/leading-indicators/compositeleadingindicatorsclifrequentlyaskedquestionsfaqs.htm\ 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* Cyclical Recommendations (6-18 Months)
Listen to a short summary of this report. Executive Summary Significant Savings Provide A Moat Around Consumers Three mega moats will protect the US economy over the next 12 months: 1) A high number of job openings; 2) Significant pent-up demand; and 3) Strong Fed credibility, which has kept bond yields from rising more than they otherwise would have in response to higher inflation. Ironically, a recession will only occur when investors start believing that a recession will not occur. Without more economic optimism, real yields will not rise into restrictive territory. The double-dip 1980/82 recessions, the 1990-91 recession, the 2001 recession, and the 2007-09 Great Recession were all preceded by an almost identical 21-to-23-month period of a flat unemployment rate. The unemployment rate has been fairly stable since March when it hit 3.6%. Given the three moats, we suspect that it will move sideways well into next year. At that point, the trajectory of inflation will determine the path for the unemployment rate and the broader economy. Inflation will fall significantly over the coming months thanks to lower food and energy prices and easing supply-chain pressures. However, falling inflation could sow the seeds of its own demise. As prices at the pump and the grocery store decline, real wage growth will turn positive. This will bolster consumer confidence, leading to more spending, and ultimately, a reacceleration in core inflation. Bottom Line: Stocks will rise over the next six months as recession risks abate, but then decline over the subsequent six months as it becomes clear that the Fed has no intention of cutting rates in 2023 and may even need to raise them further. On balance, we recommend a neutral exposure to global equities over a 12-month horizon. Don’t Bet on a US Recession Just Yet Many investors continue to expect the US economy to slip into recession this year. The OIS curve is discounting over 100 basis points in rate cuts starting in 2023, something that would probably only happen in a recessionary environment (Chart 1). In contrast to the consensus view, we think that the US will avoid a recession. This is good news for stocks in the near term because it means that earnings estimates, which have already fallen meaningfully this year, are unlikely to be cut any further (Chart 2). It is bad news for stocks down the road because it means that rather than cutting rates in 2023, the Fed could very well have to raise them. Chart 1Investors Expect Fed Tightening To Give Way To An Easing Cycle In 2023 These two conflicting considerations lead us to expect stocks to rise over the next six months but then to fall over the subsequent six months. As such, we recommend an above-benchmark exposure to global equities over a short-term tactical horizon but a neutral exposure over a 12-month horizon. Three mega moats will protect the US economy over the next 12 months: 1) A high number of job openings; 2) Significant pent-up demand; and 3) Strong Fed credibility, which has kept bond yields from rising more than they otherwise would have in response to higher inflation. Let’s explore each in turn. Moat #1: A High Number of Job Openings While job openings have fallen over the past few months, they are still very high by historic standards (Chart 3). In June, there were 1.8 job openings for every unemployed worker, up from 1.2 in February 2020. At the peak of the dotcom bubble, there were 1.1 job openings per unemployed worker. A high job openings rate means that many workers who lose their jobs will have little difficulty finding new ones. This should keep the unemployment rate from rising significantly as labor demand cools on the back of higher interest rates. Some investors have argued that the ease with which companies can advertise for workers these days has artificially boosted reported job openings. We are skeptical of this claim. For one thing, it does not explain why the number of job openings has risen dramatically over the past two years since, presumably, the cost of job advertising has not changed that much. Moreover, the Bureau of Labor Statistics bases its estimates of job openings not on a tabulation of online job postings but on a formal survey of firms. For a job opening to be counted, a firm must have a specific position that it is seeking to fill within the next 30 days. This rules out general job postings for positions that may not exist. We are also skeptical of claims that increased layoffs could significantly push up “frictional” unemployment, a form of unemployment stemming from the time it takes workers to move from one job to another. There is a great deal of churn in the US labor market (Chart 4). In a typical month, net flows in and out of employment represent less than 10% of gross flows. In June, for example, US firms hired 6.4 million workers. On the flipside “separations” totaled 5.9 million in June, 71% of which represented workers quitting their jobs. Chart 3A High Level Of Job Openings Creates A Moat Around The Labor Market Chart 4Labor Market Churn Tends To Increase As Unemployment Falls In fact, total separations (and hence frictional unemployment) tend to rise when the labor market strengthens since that is when workers feel the most emboldened to quit. The reason that the unemployment rate increases during recessions is not because laid-off workers need time to find a new job but because there are simply not enough new jobs available. Fortunately, that is not much of a problem today. Moat #2: Significant Pent-Up Demand US households have accumulated $2.2 trillion (9% of GDP) of excess savings since the start of the pandemic, most of which reside in highly liquid bank deposits (Chart 5). Admittedly, most of these savings are skewed towards middle- and upper-income households who tend to spend less out of every dollar of income than the poor (Chart 6). Nevertheless, even the top 10% of income earners spend about 80% of their income (Chart 7). This suggests that most of these excess savings will be deployed, supporting consumption in the process. Chart 5Significant Savings Provide A Moat Around Consumers Chart 6Unlike The Poor, Middle-To-Upper Income Households Still Hold Much Of Their Pandemic Savings Some commentators have argued that high inventories will restrain production, even if consumer spending remains buoyant. We doubt that will happen. While retail inventories have risen of late, the retail inventory-to-sales ratio is still near all-time lows (Chart 8). Moreover, real retail sales have returned to their pre-pandemic trend (Chart 9A). Overall goods spending is still above trend, but has retraced two-thirds of its pandemic surge with little ill-effect on the labor market (Chart 9B). Chart 7Even The Wealthy Spend Most Of Their Income Chart 8Retail Inventory-To-Sales Ratios Have Rebounded, But Remain Low Chart 9ASpending On Goods Has Been Normalizing (I) Chart 9BSpending On Goods Has Been Normalizing (II) The latest capex intention surveys point to a deceleration in business investment (Chart 10). Nevertheless, we doubt that capex will decline by very much. Following the dotcom boom, core capital goods orders moved sideways for two decades (Chart 11). The average age of the nonresidential capital stock rose by over two years during this period (Chart 12). Excluding investment in intellectual property, business capex as a share of GDP is barely higher now than it was during the Great Recession. Not only is there a dire need to replenish the existing capital stock, but there is an urgent need to invest in new energy infrastructure and increased domestic manufacturing capacity. Chart 10Capex Intentions Have Dipped Chart 11Capex Has Been Moribund For The Past Two Decades (I) With regards to residential investment, the homeowner vacancy rate has fallen to a record low. The average age of US homes stands at 31 years, the highest since 1948. Chart 13 shows that housing activity has weakened somewhat less than one would have expected based on the significant increase in mortgage rates in the first six months of 2022. Given the recent stabilization in mortgage rates, the chart suggests that housing activity should rebound by the end of the year. Chart 12Capex Has Been Moribund For The Past Two Decades (II) Chart 13Housing Activity Should Rebound On The Back Of Low Vacancy Rates, An Aging Housing Stock, And Stabilizing Mortgage Rates Moat #3: Strong Fed Credibility Even though headline inflation is running at over 8% and most measures of core inflation are in the vicinity of 5%-to-6%, the 10-year bond yield still stands at 2.87%. Two things help explain why bond yields have failed to keep up with inflation. First, investors regard the Fed’s commitment to bringing down inflation as highly credible. The TIPS market is pricing in a rapid decline in inflation over the next two years (Chart 14). The widely-followed 5-year, 5-year forward TIPS inflation breakeven rate is still near the bottom end of the Fed’s comfort zone. Chart 14AWell-Anchored Long-Term Inflation Expectations Have Kept Bond Yields From Rising More Than They Would Have Otherwise Chart 14BWell-Anchored Long-Term Inflation Expectations Have Kept Bond Yields From Rising More Than They Would Have Otherwise Households tend to agree with the market’s assessment. While households expect inflation to average over 5% over the next 12 months, they expect it to fall to 2.9% over the long term. As Chart 15 illustrates, expected inflation 5-to-10 years out in the University of Michigan survey is in line with where it was between the mid-1990s and 2015. This is a major difference from the early 1980s, when households expected inflation to remain near 10%. Back then, Paul Volcker had to engineer a deep recession in order to bring long-term inflation expectations back down to acceptable levels. Such pain is unlikely to be necessary today. Chart 15Households Expect Inflation To Come Back Down Chart 16Markets Think That The Real Neutral Rate Is Low The second factor that is suppressing bond yields is the market’s perception that the real neutral rate of interest is quite low. The 5-year, 5-year TIPS yield – a good proxy for the market’s estimate of the real neutral rate – currently stands at 0.40%, well below its pre-GFC average of 2.5% (Chart 16). Ironically, a recession will only occur when investors start believing that a recession will not occur. Without more economic optimism, real yields will not rise into restrictive territory. When Will the Moats Dry Up? The US unemployment rate is a mean-reverting series. When unemployment is very low, it is more likely to rise than to fall. And when the unemployment rate starts rising, it keeps rising. In the post-war era, the US has never avoided a recession when the unemployment rate has risen by more than one-third of a percentage point over a three-month period (Chart 17). Chart 17When Unemployment Starts Rising, It Usually Keeps Rising With the unemployment rate falling to a 53-year low of 3.5% in July, it is safe to say that we are in the late stages of the business-cycle expansion. When will the unemployment rate move decisively higher? While it is impossible to say with certainty, history does offer some clues. Remarkably, the double-dip 1980/82 recessions, the 1990-91 recession, the 2001 recession, and the 2007-09 Great Recession were all preceded by an almost identical 21-to-23-month period of a flat unemployment rate (Chart 18 and Table 1). Coincidentally, the Covid-19 recession was also preceded by 22 months of a stable unemployment rate. To the extent that the economy was not showing much strain going into the pandemic, it is reasonable to assume that the unemployment rate would have continued to move sideways for most of 2020 had the virus never emerged. Chart 18The Bottoming Phase Of The Unemployment Rate Has Only Begun Inflation is the Key The unemployment rate has been fairly stable since March when it hit 3.6%. Given the three moats discussed in this report, we suspect that it will move sideways well into next year. At that point, the trajectory of inflation will determine the path of the unemployment rate and the broader economy. As this week’s better-than-expected July CPI report foreshadows, inflation will fall significantly over the coming months, thanks to lower food and energy prices and easing supply-chain pressures. The GSCI Agricultural Index has dropped 24% from its highs and is now below where it was before Russia’s invasion of Ukraine (Chart 19). Retail gasoline prices have fallen 19% since June, with the futures market pointing to a substantial further decline over the next 12 months. In general, there is an extremely strong correlation between the change in gasoline prices and headline inflation (Chart 20). Supplier delivery times have also dropped sharply (Chart 21). Chart 19Agricultural Prices Have Started Falling Chart 20Headline Inflation Tends To Track Gasoline Prices Falling inflation could sow the seeds of its own demise, however. As prices at the pump and the grocery store decline, real wage growth will turn positive. That will bolster consumer confidence, leading to more spending (Chart 22). Core inflation, which is likely to decrease only modestly over the coming months, will start to accelerate in 2023, prompting the Fed to turn hawkish again. Stocks will falter at that point. Chart 21Supplier Delivery Times Have Declined Chart 22Falling Inflation Will Boost Real Wages And Consumer Confidence Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn and Twitter Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Executive Summary Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation Inflation is not about oil, food or used car prices. Looking at prices of individual components of a consumer basket is akin to missing the forest for the trees. Despite the latest drop in US headline inflation, various core CPI measures continue trending up and registered considerable month-on-month rises in July. Wages and, more specifically, unit labor costs are the true measure of genuine and persistent inflation. US wage growth is very elevated, and the pace of unit labor cost gains has surged to a 40-year high. The conditions for sustainable and persistent disinflation in the US are not yet present. US inflation will prove to be much stickier and more entrenched than many market participants presently believe. The recovery in China will be U- rather than V-shaped, with risks tilted to the downside. The mainland’s property market breakdown is structural, not cyclical. Excesses are very large, and problems are snowballing, rendering the enacted policy stimulus insufficient. Bottom Line: US core inflation lingering above 4% and easing financial conditions will compel the Fed to continue hiking rates. This will cap global risk asset prices and put a floor under the US dollar. We continue to recommend an underweight allocation to EM in global equity and credit portfolios. Consistently, we are also reluctant to chase EM currencies higher. Feature The bullish macro narrative circulating in the investment community is that conditions for a cyclical rally in global risk assets have fallen into place. Specifically: US inflation will drop sharply as US growth has crested and commodity prices have plunged; The Fed is nearing the end of a tightening cycle; China has stimulated sufficiently, and its economy is about to recover, which will boost economic conditions among its trading partners in general and EM in particular. These assumptions along with the fact that the S&P 500 index has found support at a 3-year moving average – a proven line of defense – suggest that US share prices have likely bottomed (Chart 1). Are we witnessing déjà vu of the 2011, 2016, 2018 and 2020 market bottoms? Chart 1Déjà Vu? Is 2022 Like The 2011, 2016 And 2018 Bottoms In The S&P 500? We have reservations about all of the above fundamental conjectures. We elaborate on these reservations in this report. On the whole, we contend that the current environment is different, and the roadmaps of all post-2009 equity market bottoms are not necessarily currently applicable. BCA’s Emerging Markets Strategy team believes that (1) US consumer price inflation is much more entrenched and will prove stickier than is commonly believed; and (2) the Chinese property market’s breakdown is structural, not cyclical; hence, the recovery will not gain traction easily. Is This The End Of The US Inflation Problem? Not Quite This week’s US inflation data confirmed that headline CPI inflation has probably peaked: prices in several categories plunged. However, inflation is not about oil, food or used car prices. Chart 2 reveals that historically there have been several episodes whereby core inflation remains elevated despite plunging oil prices. Chart 2US Core Inflation Does Not Always Follow Oil Prices Looking at price dynamics among the individual components of the CPI basket is akin to missing the forest for the trees. Inflation is a very inert and persistent phenomenon. Underlying inflation does not change its direction often and/or quickly. That is why we believe that it is premature to celebrate the end of the US inflation problem. A few observations on this matter: Despite the drop in US headline inflation, various core CPI measures − like trimmed-mean CPI, median CPI and core sticky CPI − all continue trending up and registered substantial month-on-month rises in July (Chart 3). The range of core inflation based on these annual and month-month annualized rates is between 4-7%. In brief, the rate of genuine/sticky inflation is well above the Fed’s 2% target. Given its unconditional commitment to bringing inflation down to 2%, the Fed will continue hiking interest rates ceteris paribus. Chart 3US Core CPI Measures Are Still Very High Chart 4US Wages Growth Has Been Surging We continue to emphasize that wages and, more specifically, unit labor costs are the true measures of persistent and genuine inflation. We have written at length about why wages and unit labor costs are more important to inflation than oil or food prices. US wage growth is very elevated and is accelerating (Chart 4). Unit labor costs, calculated as hourly wages divided by productivity, have also been surging to a 40-year high (Chart 5, top panel). Chart 5Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation The reason for this very strong wage growth and swelling unit labor costs is the very tight labor market. The bottom panel of Chart 5 demonstrates that labor demand is still outpacing labor supply by a wide margin. Hence, wage inflation will not subside until the unemployment rate rises meaningfully. Bottom Line: Conditions for sustainable and persistent disinflation in the US are not yet present. Inflation will prove to be much stickier and more entrenched than many market participants presently believe. Core inflation lingering above 4% and easing financial conditions will compel the Fed to continue hiking rates. This will cap risk asset prices and put a floor under the US dollar. China: Is This Time Different? If one believes that China’s current business cycle is similar to all previous ones seen since 2009, odds are that a buying opportunity in China-related financial markets is at hand. Chart 6 illustrates that the credit and fiscal spending impulse leads the business cycle by about nine months. Given that this impulse bottomed late last year, a trough in the Chinese business cycle is due. Chart 6Is A Recovery In China's Business Cycle Imminent? It is always risky to suggest that this time is different. Nevertheless, at the risk of being wrong, we contend that a combination of (1) property markets woes, (2) an impending export contraction, and (3) the dynamic zero-COVID policy will reduce the multiplier effect of current stimulus measures. Hence, a meaningful recovery in economic activity will likely fail to materialize in the coming months. The challenges facing the mainland property market are now well known. Yet, excesses are very large, and problems are snowballing, making policy stimulus insufficient. In particular: Authorities are contemplating bailout funds for property developers in the range of RMB 300-400 billion to enable them to complete housing that has been pre-sold. This is not sufficient financing for overall property construction. Table 1How Large Are Property Developers Bailout Funds? Table 1 illustrates that these amounts are equal to just 3-4% of annual fixed-asset investment in real estate excluding land purchases, 1.5-2% of total financing of developers, and 3-4% of the advance payments that property developers received for pre-sold housing in 2021. Property developers will not be receiving any cash upon the completion and delivery of presold housing units because they were paid in advance. Hence, without liquidating their other assets, homebuilders cannot repay the bailout financing. Consequently, only state financing can work here because, from the viewpoint of providers of this financing, this scheme de-facto means throwing good money after bad. The property industry in China is extremely fragmented. This makes bailouts difficult to organize and execute. There are officially about 100,000 property developers in China. The overwhelming majority of them are not state-owned companies. Plus, the two largest property developers, Evergrande (before defaulting) and Country Garden, had only 3.8% and 3.3% of market share respectively in 2020. The failure of homebuilders to complete and deliver pre-sold housing units could unleash a death spiral for them. In recent years, 90% of housing units have been pre-sold, i.e., buyers made advance payments/prepayments, often taking out mortgages (Chart 7, top panel). Witnessing the inability of developers to deliver on presold units, a rising number of people may decide to wait to buy. The largest source of developers’ financing – advance payments for pre-sold housing units – might very well dry up. This source has accounted for 50% of real estate developers’ total financing in recent years (Chart 7, bottom panel). In brief, a vicious cycle is possible. The lack of financing for homebuilders bodes ill for construction activity (Chart 8). Chart 7China: Housing Presales And Pre-Payments Are Critical To Developers Chart 8Lack Of Homebuilder Financing = Shrinking Construction Activity Chart 9Chinese Property Developers Are Extremely Leveraged Besides, property developers are very leveraged with an assets-to-equity ratio close to nine (Chart 9). They have grown accustomed to borrowing heavily to accumulate real estate assets. They have been starting but not completing construction (Chart 10, top panel). We have been referring to this phenomenon as the biggest carry trade in the world. The bottom panel of Chart 10 shows two different measures of residential floor space inventories held by property developers. One measure subtracts completed floor space from started floor space, and another one deducts sold floor space from started floor space. On both measures, residential inventories are enormous. In theory, they could raise funds by selling their real estate assets. However, if they all try to sell simultaneously, there will not be enough buyers, and asset prices will plunge, which could lead to a full-blown debt deflation spiral. The last time the real estate market was similarly distressed in 2014-15, the central bank launched the Pledged Supplementary Lending (PSL) facility. This was effectively a QE program to monetize housing. This was the reason why housing recovered strongly in 2016-2017. There is currently no such program up for discussion. On the whole, odds are that the current property market breakdown is structural, not cyclical. Financial markets – the prices of stocks and USD bonds of property developers – convey a similar message and continue to plunge (Chart 11). Chart 10Excessive Property Inventories Chart 11No Green Light From Property Stocks And Corporate Bond Prices Chart 12There Has Been No Recovery In China Without A Revival in Real Estate Without an improvement in the housing market, a meaningful business cycle recovery is unlikely in China. Chart 12 illustrates that all recoveries in the Chinese broader economy since 2009 occurred alongside a revival in property sales. The importance of the property market goes beyond its size. Rising property prices lift household and business confidence, boosting aggregate spending and investment. The sluggish housing market and falling house prices will impair consumer and business confidence. This, along with uncertainty related to the dynamic zero-COVID policy, will dent consumer spending and private investments. Finally, the upcoming contraction in Chinese exports will dampen national income growth. Taken together, the multiplier effect of stimulus in the upcoming months will be lower than it has been in previous periods of stimulus. There are two areas that will see meaningful improvement in the coming months: infrastructure spending and autos. BCA’s China Investment Strategy service discussed the outlook for auto sales in a recent report. Chart 13Green Shoots In China's Infrastructure Investment On the infrastructure front, there has been mixed evidence of an improvement in activity. The top and middle panels of Chart 13 demonstrate that Komatsu machinery’s operational hours and the number of approved infrastructure projects might be bottoming. However, the installation of high-power electricity lines has fallen to a 15-year low (Chart 13, bottom panel). As we elaborated in last month’s report, the new financing/stimulus for infrastructure development will not result in new investments. Rather, it will by and large offset the drop in local government (LG) revenues from land sales this year. In short, there is little new stimulus for infrastructure beyond what was approved in the budget plan earlier this year. Bottom Line: The recovery in China will be U- rather than V-shaped, with risks tilted to the downside. Investment Recommendations Our bias is that the rebound in global risk assets could last for a few more weeks. The basis is that investor positioning in risk assets was very light when this rebound began. Plus, falling oil prices could reinforce the idea among investors that US inflation is no longer a problem. Looking beyond the next several weeks, the outlook for global and EM risk assets is dismal. Markets will realize that the Fed cannot halt its tightening with core inflation well above 4-5%. Hawkish Fed policy and contracting global trade will boost the US dollar and weigh on cyclical assets. We continue to recommend an underweight allocation to EM in global equity and credit portfolios. Consistently, we are also reluctant to chase EM currencies higher. EM local bonds offer value, as we have argued over the past couple of months, but for now we prefer to focus on yield curve flattening trades. We continue betting on yield curve flattening/inversion in Mexico and Colombia and are long Brazilian 10-year domestic bonds while hedging the currency risk. In addition, we recommend investors continue receiving 10-year swap rates in China and Malaysia. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)
Executive Summary Realized Real Interest Rates Must Rise Policymakers must continue engineering higher real interest rates, and tighter financial conditions, to help cool off growth and bring down overshooting inflation. This will inevitably lead to inverted yield curves across most of the developed world, following the recent trend of US Treasuries. US growth expectations remain overly pessimistic, which opens up the potential for more near-term bond-bearish upside data surprises like the July employment and ISM Services reports. The Bank of England – under increasing political pressure for its relatively timid response to the massive UK inflation overshoot – is now forecasting a long policy-induced recession as the only way to tame UK inflation expected to reach 13% by year-end. Expect UK Gilts to be a relative outperformer within developed bond markets over the next 12-18 months. Bottom Line: Stay overweight UK Gilts versus US Treasuries in global bond portfolios, but increase exposure to yield curve flattening in both countries. The Fed and Bank of England are both on course to push monetary policy into restrictive, growth-damaging territory. Don’t Get TOO Comfortable Taking Risk In a bit of a summer surprise, global financial markets have been staging a mild recovery from the stagflationary doom that prevailed during the first half of 2022. In the US, the S&P 500 index is up 14% from the year-to-date intraday low reached on June 16, with the VIX index back down to low-20s zone last seen in April (Chart 1). High-yield corporate bond spreads in the US and euro area are down 97bps and 36bps, respectively, since that mid-June trough in US equities. Even emerging market equities and credit – the most unloved of asset classes in 2022 – have stabilized. Related Report Global Fixed Income StrategyIt’s Time To Flip The Script - Upgrade UK Gilts Some of this risk rally is surely short-covering, but there are some valid reasons to be less pessimistic on growth-sensitive risk assets. In the US, where the back-to-back contractions in GDP in the first two quarters of the year have stoked recession fears, the latest data releases have seen upside surprises suggesting an expanding, not contracting, economy (Chart 2). The July ISM non-manufacturing (services) index rose +1.4 points in July to 56.7, a broad-based move that included increases in Production, New Orders and New Export Orders. Core durable goods orders rose +0.5% in June for the second straight month. The biggest surprise was the July Payrolls report, which showed a whopping +528,000 increase in employment – over twice the expected gain of +250,000 – with a downtick in the unemployment rate to 3.5%. Chart 1Stepping Back From The Recessionary Abyss Chart 2The US Recession Talk May Have Been Premature Chart 3Goods Inflation Pressures Easing There was also some good news on the inflation front in the latest US data. The Prices Paid components of both the ISM manufacturing and non-manufacturing indices showed big declines, 18.5pts and 7.8pts respectively, in July, continuing the downtrends that began in the latter half of 2021 (Chart 3). This is not just a US story. The Prices Paid components of the S&P Global manufacturing PMIs in the euro area, the UK, Japan and China have also been falling. Lower global commodity prices, particularly for oil, are playing a large role in the pullback in reported business input costs. The Supplier Deliveries components of both ISM reports also fell on the month, continuing a trend seen throughout 2022 as global supply chain pressures have eased. Combined with the drop in the Prices Paid data, global PMIs are sending a strong message - inflationary pressures on the traded goods side of the global economy are finally easing. Slower goods inflation, however, does not provide an all-clear for risk assets on a cyclical basis. Non-goods price pressures are showing little sign of peaking across most of the developed world. Labor markets remain tight, and both wage inflation and services inflation rates continue to accelerate in the major economies of the US, UK and euro area at a pace well above central bank inflation targets (Chart 4). Until these domestic sources of inflation show signs of peaking, central banks will continue to push up policy rates to slow growth, generate higher unemployment and, eventually, bring domestically driven inflation back down to central bank targets. Expect the so-called Misery Index, summing headline inflation and the unemployment rate, to remain elevated across the major developed economies until negative real interest rates begin to rise through a combination of more nominal rate hikes and, eventually, slower inflation (Chart 5). Chart 4Domestic Inflation Pressures Accelerating Chart 5Realized Real Interest Rates Must RiseAs we discussed in last week’s report, bond markets were getting way ahead of themselves in pricing in aggressive rate cuts in 2023, especially in the US. This was setting up for a potential move higher in yields on any positive data news. Within the “Big 3” developed economies, US Treasuries look most vulnerable to a rebound in bond yield momentum, judging by what looks like a true bottom in the mean-reverting Citigroup US Data Surprise Index (Chart 6). The flow of data surprises is more mixed in the euro area and UK and is not yet at the stretched extremes that would signal a sustainable increase in bond yields. Taken at face value, this fits with our current recommendation to underweight the US, and overweight core Europe and the UK, within global government bond portfolios. With central banks now on track to push policy rates into restrictive territory, there is the potential for additional flattening of already very flat yield curves across the Big 3. Forward rates are not priced for additional curve flattening in those markets, looking at both the 2-year/10-year and 5-year/30-year government bond curves (Chart 7). This makes positioning for more curve flattening in the US, UK and euro area a positive carry trade by leaning against the pricing of forward rates. Chart 6Greater Potential For Bond-Bearish Data Surprises In The US Chart 7Increase Exposure To Curve Flattening In The 'Big 3' We are adjusting the positioning within the BCA Research Global Fixed Income Strategy Model Bond Portfolio this week to benefit from the trend towards additional curve flattening in the US, the UK and core Europe (Germany and France). With the 2-year/10-year curve already inverted by -45bps in the US, we see better value by adding flattening exposure between the 5-year and 30-year points – a curve segment that is not yet in inversion. In the UK and euro area, we see a case for positioning for flattening across the entire yield curve. Bottom Line: Stay overweight both UK Gilts and core European government bonds versus US Treasuries in global bond portfolios, but increase exposure to yield curve flattening in all countries. The Fed and Bank of England are both clearly on course to push monetary policy into restrictive, growth-damaging territory, and the ECB may be forced to do the same. Painful Honesty From The Bank Of England The Bank of England (BoE) delivered its largest rate hike since 1995 last week, raising Bank Rate by 50bps to 1.75%. Planned sales of UK Gilts accumulated by the BoE during the quantitative easing phase of pandemic stimulus, at a pace of £10bn per quarter starting in September, were also announced. While those moves were largely expected by markets, the BoE’s new set of economic forecasts contained quite a shocker – an expectation of recession starting in Q4 of this year, running through the end of 2023 (Chart 8). The UK unemployment rate is expected to rise substantially from the current 3.8% to 6.3% by Q3/2025. Chart 8Brutal Honesty In The Latest BoE Forecasts Chart 9Energy Prices Driving BoE Inflation Forecasts We are hard pressed to remember the last time a major central bank announced a forecast of a prolonged economic downturn as part of its baseline scenario to bring inflation to its target. Such is the predicament that the BoE finds itself in, with headline UK inflation expected to soar to 13% by the end of 2022 – a mere 11 percentage points above the central bank’s inflation target. The BoE has been forced to sharply ratchet up that expected peak in UK inflation at both the May and August policy meetings this year. This is largely due to the massive increase in UK energy prices with the Energy component of the UK CPI index up over 50% in year-over-year terms. According to analysis published in the BoE August 2022 Monetary Policy Report, the direct impact of higher energy prices was projected to account for roughly half of that expected 13% peak in UK inflation this year (Chart 9). At the same time, falling energy prices embedded into futures curves are expected to full unwind that effect in 2023. The BoE’s recession call is also conditioned on a market-implied path for interest rates, with a 2023 peak in Bank Rate of just over 3% priced into the UK OIS curve. Looking beyond the energy price surge, there are signs that the BoE will not have to tighten as aggressively as interest rate markets are currently expecting. Our BoE Monitor, constructed using growth, inflation and financial market variables that would typically pressure the central bank to tighten or loosen monetary policy, has clearly peaked (Chart 10). All three components of the Monitor have rolled over, although inflation pressures remain the strongest contributor to the elevated absolute level of the Monitor. From a growth perspective, there are many reasons to expect the UK economy to enter a recession without much more prodding from BoE rate hikes (Chart 11): Chart 10Our BoE Monitor Sees Easing Cyclical Pressure To Raise Rates Chart 11A Broad-Based Slowing Of UK Growth Both the S&P Global manufacturing and services PMIs are on target to soon fall below the 50 level that indicates positive growth (top panel) Consumer confidence has collapsed as surging inflation has overwhelmed household income growth, leading to a contraction in retail sales volume growth (middle panel) The BoE’s Agents’ Survey of individual businesses shows a sharp deterioration in business investment spending plans (bottom panel). Yet even with growth clearly slowing already, the sheer magnitude of the inflation overshoot is forcing markets to discount a fairly aggressive path for UK interest rates over the next year. This is not only evident in the OIS curve, but also in the BoE’s own Market Participants Survey (MPS) of UK investors. According to the just released August MPS, the median expectation is for Bank Rate to peak at 2.5% next year (Chart 12). This is a sizeable increase from the previous expected peak of 1.75% from the last MPS in May, but is still below the discounted peak in rates from the OIS curve of 3.1%. The bigger news is that the, according to the August MPS, the median survey participant now believes that the neutral range for Bank Rate is now 2-2.5%, up from the 1.5-2.0% range in the May MPS. Therefore, the August MPS forecasted peak Bank Rate of 2.5% is only at the high end of neutral and not restrictive. Yet both the OIS curve and the August MPS expect the BoE to immediately pivot from rate hikes to rate cuts in the second half of 2023. Chart 12UK Interest Rate Markets Have Adjusted Neutral Rate Expectations Chart 13The BoE Is Facing Severe Public Scrutiny The notion that the BoE would pivot so quickly next year, when their own forecasts still call for UK inflation to be over 9% in the third quarter of 2023, seem somewhat optimistic. Especially with the BoE under tremendous public and political pressure because of runaway UK inflation. The leading candidate to become the next UK Prime Minister, Foreign Secretary Liz Truss, has already gone on record stating that she would look to change the BoE’s remit as Prime Minister to focus solely on keeping inflation low. Meanwhile, the latest BoE Inflation Attitudes Survey shows more respondents are now dissatisfied with the BoE than satisfied (Chart 13). 1-year-ahead inflation expectations from that same survey are now at 4.6%, while 5-year/5-year forward breakevens from UK index-linked Gilts are still at 3.8%. With inflation expectations still so elevated, and with the BoE’s own forecasts calling for headline UK inflation to not fall back to the 2% BoE target until Q3/2024, it is unlikely that the BoE will revert to rate cuts as quickly as markets expect – especially given the accelerating wage dynamics in the UK labor market. According to the BoE’s measure of “underlying” wage growth, which adjusts headline wage inflation data for pandemic effects from furloughs and shifting labor composition, wages are growing at a 4.2% year-over-year rate (Chart 14). The BoE’s own modeling work indicates that 2.9 percentage points of that wage growth is due to the level of short-term inflation expectations, with only 0.9 percentage points coming from productivity growth. Thus, the BoE cannot let its foot off the monetary brake until short-term inflation expectations fall substantially from current elevated levels – especially with employment indicators still pointing to a very tight supply-constrained, post-COVID UK labor market. Chart 14A Wage-Price Spiral In The UK? Given that interplay of rising headline inflation, elevated inflation expectations and tight labor markets, the BoE will likely be forced to begin unwinding the current rate hiking cycle later than markets expect. This will eventually lead to an inversion of the UK Gilt yield curve as the BoE pushes policy rates to restrictive territory and the UK economy falls into recession faster than other countries (like the US). Chart 15Stay Overweight UK Gilts, With A Curve Flattening Bias We still believe that the Fed is more likely than the BoE to fully follow through on market-discounted rate hikes over the next year, which was a major reason why we upgraded our cyclical recommendation on UK Gilts to overweight back in May. However, with the BoE now under more pressure to wring high inflation out of the UK economy by keeping policy tighter for longer, we also see value in positioning for that eventual inversion of the UK Gilt curve (Chart 15). We see the sequencing as being inversion first, and relative Gilt outperformance later, although we do not expect the relative performance of Gilts to worsen with the UK economy set to enter recession before other major economies. Importantly, the forward rates in the Gilt curve are still priced for a somewhat steeper yield curve, making curve flattening trades along the entire curve attractive as positive carry trades that pay you to wait for the eventual policy driven inversion. The 2-year/10-year and 2-year/30-year flatteners look particularly attractive from that carry-focused perspective. Bottom Line: The BoE– under increasing political pressure for its relatively timid response to the massive UK inflation overshoot – is now forecasting a long policy-induced recession as the only way to tame UK inflation expected to reach 13% by year-end. Expect UK Gilts to be a relative outperformer within developed bond markets over the next 12-18 months, and enter positive carry Gilt curve flatteners now to benefit from the inevitable inversion of the curve. Robert Robis, CFA Chief Fixed Income Strategist rrobis@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* Cyclical Recommendations (6-18 Months)