Sectors
Executive Summary Chinese Onshore Stocks Are Less Impacted By External Factors We are upgrading Chinese onshore stocks from underweight to neutral relative to global stocks. At the same time, we are closing our tactical trade of long Chinese investable stocks/short global stocks. In the near term, Russia’s armed invasion of Ukraine will spark a further selloff in global risk assets. Volatility in Chinese onshore stock prices will remain high; A-share prices in absolute terms may also drop but should fall by less than their peers in European and emerging markets. On the other hand, Chinese offshore stocks are more vulnerable to geopolitical risks compared with their onshore counterparts. There are tentative signs that home prices may be stabilizing, although demand for housing remains in deep contraction. Chinese policymakers remain vigilant in preventing the property market from overheating and credit creation from overshooting. However, the ongoing Russia/Ukraine incursion has the potential to catalyze a larger stimulus package in China. If the escalating geopolitical crisis threatens the global economy, China’s authorities will likely strengthen policy supports at home to buttress the country’s domestic political, economic and financial conditions. Bottom Line: Chinese onshore stocks will weather the ongoing geopolitical storm better than their offshore and global peers. China’s economy is also less negatively impacted by the Russia/Ukraine hostilities. If the crisis deepens, China’s leadership will likely step up measures to support its economy and ensure stable domestic financial and political dynamics. Feature The conflict between Russia and Ukraine unnerved global financial markets in the past few weeks. Chinese offshore stocks were not insulated from the geopolitical event; the MSCI China Index declined by about 4% in February, in-line with the selloff in global stocks. Chart 1Chinese Onshore Financial Markets Held Up Relatively Well Last Month The current global geopolitical environment, however, has turned us a bit more positive on Chinese onshore stocks in relative terms. In the near term, the onshore market should hold up better than its offshore and European counterparts. China’s closed capital market prevents panic capital outflows and its large current account surplus as well as favorable real interest rate differentials help to maintain strength in the RMB (Chart 1). On a cyclical basis, China’s domestic economic fundamentals will continue to drive prices in the A-share market. China’s aggregate economy is less affected by the Russia/Ukraine conflict than Europe. Energy supplies from Russia to China will likely continue and may even accelerate, mitigating the risks of energy shock-induced inflation spikes. As such, we are upgrading Chinese onshore stocks from underweight to neutral in a global portfolio, both in tactical and cyclical time horizons. We remain cautious about the size of Chinese stimulus for the year and, therefore, are neutral in our cyclical view on Chinese onshore stocks relative to global equities. Despite some nascent signs of reflation and an easing of housing policy in a few Chinese cities, aggregate property demand remains weak and overall policy easing in the sector has been marginal. Nonetheless, the situation surrounding Ukraine and the global sanctions against Russia are highly fluid and may provide some ground for Chinese policymakers to ramp up stimulus at home. If the conflict intensifies and derails the European/global economy, Beijing will be more inclined to adopt measures to ensure the stability of its domestic economy, financial markets and political dynamics. Meanwhile, we are closing our long MSCI China/short MSCI global tactical trade. Chinese offshore stocks are more vulnerable to geopolitical tensions and risk-off sentiment among global investors. The Russia Incursion Has Limited Direct Impact On China’s Economy Chinese stocks were not immune last week to the global financial market’s gyrations triggered by Russia’s invasion of Ukraine. While Russia’s attack on its neighbor will create short-term disruptions on the prices of global commodities and China’s A-shares, the cyclical performance of Chinese onshore stocks is tied to the country’s domestic economic fundamentals. The military conflict between Russia and Ukraine should have a limited knock-on effect on China’s business cycle dynamics for the following reasons: Russia and Ukraine together account for less than 3% of Chinese total exports as of 2021, limiting the negative impact from reduced demand in the region on China’s current account balance. Chart 2Ukraine: China’s Major Source Of Agricultural Commodity Supplies Russia’s incursion of Ukraine may have consequences on China’s food prices. Ukraine is a major agricultural commodity exporter to China, hence a prolonged military conflict may disrupt agricultural supplies and push up imported food prices in China (Chart 2). In this scenario, we expect that Beijing will provide subsidies to ease pressures on domestic food prices due to supply shocks, rather than tighten monetary policy to reduce demand. China is unlikely to experience shocks linked to possible energy disruptions. Russia is a core exporter of energy to China and supplies of crude oil, natural gas and coal have increased in recent years (Chart 3). We do not expect that Russia’s energy supply to China will be disrupted. Indeed, following the 2014 Russia’s invasion of Crimea, Russia’s crude oil exports to China increased by 40% (Chart 3, top panel). We anticipate that oil prices will fall from the current level in the second half of the year, limiting the upshot from higher oil prices on Chinese inflation. So far, the US and EU have announced tough sanctions on Russia’s non-energy sectors, but they have avoided halting Russia’s energy exports. In the unlikely scenario that energy flows from Russia to Europe are disrupted in any meaningful and long-lasting way, either through European sanctions or a Russian embargo, Russia would probably turn to China to absorb its energy exports. Given that Russia cannot easily replace Europe with any other alternative market, particularly natural gas, China would gain an upper hand in price negotiations with the Russians (Chart 4). Thus, a steady supply of cheap natural gas and other forms of energy would be a net positive for China’s economy. Chart 4Russia Cannot Easily Replace Europe With Any Alternative Consumer Other Than China Chart 3Russia's Ties With China On Energy Supplies Will Likely Strengthen Meanwhile, oil’s current price spike may widen the gap in profits between China’s upstream and downstream industrial enterprises (Chart 5). However, the effect from higher oil prices on Chinese downstream manufacturers should be temporary. Our Commodity and Energy Strategists believe that the Russian invasion will prompt increased production from core OPEC producers. These production increases would reduce prices from last week’s $105 per barrel level to $85 per barrel by the second half of 2022 and keep it at that level throughout 2023 (Chart 6). Chart 6Crude Oil Price Risk Premium Will Abate But Not Disappear Chart 5Rising Oil Prices May Temporarily Widen Profit Gaps Between China's Up- And Downstream Industries Bottom Line: Russia’s invasion of Ukraine should have a limited direct impact on China’s domestic economy, inflation and monetary policy. Tentative Signs Of Home Price Stabilization Although the property market is showing some signs of improvement, the aggregate demand for homes remains very sluggish. Recently released housing data in China show some slight progress, as fewer cities reported a month-on-month drop in new home prices in January (Chart 7). The monthly average new home prices among China’s 70 cities were broadly flat last month following four consecutive months of falling prices. Tier 1 and Tier 2 cities had the largest increases in home prices, whereas prices in other regions continued to contract through January, albeit to a lesser degree (Chart 7, bottom panel). The minor improvement in home prices reflects recently implemented measures to help shore up the flagging market. Last month, the PBoC cut the policy rate by 10 bps and reduced the one- and five-year loan prime rates by 10 bps and 5 bps, respectively. Moreover, last week several regional banks lowered the down payments on mortgages for homebuyers. Chart 8...Demand For Housing Remains In Deep Contraction Chart 7Although There Are Some Early Signs Of Stabilization In Home Prices... Nonetheless, the aggregate demand for housing remains weak. China’s 100 largest developers experienced a roughly 40% year-on-year plunge in total sales in January, indicating that recent easing measures failed to revive the downbeat sentiment among homebuyers (Chart 8). Bottom Line: Policymakers will remain vigilant in not inducing another surge in house prices and will continue to target steady home prices. As such, it is too early to upgrade our cyclical view on China’s property market, stimulus and economic recovery. Investment Conclusions We are upgrading Chinese onshore stocks to neutral relative to global equities (both tactically and in the next 6 to 12 months), while closing our tactical trade of long MSCI China/short MSCI global index. Chart 9Chinese Onshore Stock Prices Are Largely Driven By Domestic Rather Than External Factors... Given the limited impact of the Russia/Ukraine conflict on China’s domestic economy and the low correlation to the global equity index, Chinese onshore stock prices may also fall in absolute terms in the coming weeks, but not by as much as their offshore and European counterparts (Chart 9). Furthermore, while we maintain a cautious cyclical outlook for China’s stimulus, the ongoing geopolitical crisis has the potential to provide a catalyst for Chinese policymakers to stimulate the domestic economy more forcefully. If the clash evolves into a real risk to the European economy and global financial markets, odds are high that Chinese policymakers will step up stimulus measures to ensure domestic stability. In this scenario, Chinese onshore stocks will likely outperform global equities. In the past, Chinese authorities refrained from a credit overshoot when the business cycle slowed in an orderly manner, but they stimulated substantially following an exogenous shock. For example, China rolled out massive stimulus packages after the 2008 Global Financial and the 2011/12 European credit crises. Beijing did not directly respond to Russia’s 2014 annexation of Crimea with additional monetary support to China’s domestic economy. However, the Chinese authorities started to aggressively stimulate when a collapse in domestic demand coincided with a global manufacturing recession in 2015. Chart 10...Whereas Chinese Offshore Stocks Are More Vulnerable To Global Risk-Off Sentiment The PBoC’s outsized liquidity injection in the interbank system last Friday is also a sign that Beijing is willing to accelerate policy easing if the geopolitical backdrop meaningfully worsens. Regarding Chinese investable stocks, we maintain our cyclical underweight stance relative to global equities. In the near term, risk-off sentiment among global investors will undermine the performance of Chinese offshore stocks in both absolute and relative terms (Chart 10). Over a longer time horizon (6 to 12 months), growth stocks will likely underperform value stocks when global stocks recover. Thus, the tech-heavy MSCI China Index is less attractive to investors compared with other emerging and developed market equities that are more value-centric. Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations
Executive Summary Wars Don’t Usually Affect Markets For Long We expect the war in Ukraine to stay within its borders, and therefore to have little impact on global growth. Markets will be volatile, but we recommend allocators stay invested – with some moderate hedges in place. The Fed won’t tighten as fast as markets expect, and US long rates will not rise much further this year. So, within fixed-income, we raise government bonds to neutral. Flat rates remove a positive for the Financials equity sector, which we lower to neutral. The oil price will fall back to $85 by the second half, as Saudi and others increase supply. We reduce our recommendation for Canadian equities and the CAD. Recommendation Changes Bottom Line: Stay invested in risk assets, but have some hedges. We shift from Financials to the defensive-growth IT sector, raise our weight in UK equities, and suggest long positions in cash, CHF and JPY. Recommended Allocation The war in Ukraine is likely to have only a limited impact on markets beyond the short term. As disturbing as the human tragedy is, Russia’s aims are limited to regime change in Kyiv. The European Union and US face restraints on how draconian sanctions against Russia can be, balking (so far at least) at blocking imports of Russian energy to the EU, given how much this would hurt the economy. The risk of the conflict spreading beyond Ukraine’s borders is low, limited perhaps to cyberattacks on Western targets. A Russian attack on a NATO member, such as Poland or one of the Baltic states, is extraordinarily unlikely – though Moldova and Georgia (not NATO members) might be more vulnerable at some point in the future. For more detailed analysis, please read the two reports on the Ukraine situation by our Geopolitical Service that we have made available to all BCA Research subscribers.1 Asset allocators need to look at these events dispassionately. Markets are likely to remain volatile over the coming months, as events in Ukraine unfold. But the lesson of most major conflicts is that they typically do not have a long-lasting impact on asset performance (Chart 1). There is little chance that the Ukraine war will significantly dent global growth. The only exception would be if the oil price were to rise much further to, say, $120 a barrel as some are forecasting. Certainly, in the past, a jump in the oil price has often been associated with recessions – even though the causality is unclear (Chart 2). But BCA’s Energy strategists expect to see an increase in oil supply by Saudi Arabia and Gulf states which will bring Brent crude back to $85 by the second half (from $98 now). Chart 1Wars Don't Usually Affect Markets For Long Chart 2But A Jump In Oil Prices Would Meanwhile, global growth remains robust, with all major economies expected to continue to grow well above trend this year, supported by robust consumption and capex (Chart 3). And sentiment towards equities has turned very pessimistic since the start of the year, with indicators such the US Association of Individual Investors’ weekly survey at its most bearish level since 2008 (Chart 4). These sort of sentiment levels have typically pointed to a rebound in risk assets. Chart 4Sentiment Is At Rock-Bottom Chart 3Economic Growth Still Above Trend Our advice now would be to stay invested, but with some moderate safe-haven hedges in place – largely as we have recommended since late last year. We continue to recommend an overweight in cash, but will look to allocate this to risk assets when it becomes clearer how the situation in Ukraine will pan out. The trajectory of markets over the rest of this year still largely comes down to what the Fed and other central banks will do. The hawkish turn by the Fed in December has been the driver of markets in the past two months, with the result that none of the major asset classes have produced positive returns year to-date – only inflation hedges such as commodities and gold (Chart 5). Chart 5Most Asset Classes Are Down Year-To-Date The futures market is pricing the Fed to raise rates seven times over the next 12 months, the fastest rate of predicted tightening since the early 2000s (Chart 6). We think that is a little excessive. Inflation, as we have argued previously, is likely to fade over the coming quarters, as the supply response to strong consumer demand for manufactured goods brings down the price of cars, semiconductors, shipping and other major items. The Fed may well start in March with the intention of raising rates by 25bps every meeting, but the slowing of inflation we expect, and the tightening of financial conditions already under way (Chart 7), make it unlikely that it will continue at that pace. And remember that Fed policy will need to be even more hawkish than the market is currently pricing in for it to have an incrementally negative impact on risk assets. Chart 6Market Believes Fed Will Hike Fast Chart 7Financial Conditions Have Already Tightened There are certainly risks to this scenario. The forward yield curve is pointing to inversion one year ahead, something which normally presages recession over the following 1-3 years (Chart 8). Higher prices are starting to hurt consumer confidence, though there is a big disparity between the two main US indicators (Chart 9). Chart 8Will Yield Curve Invert Within A Year? Chart 9Inflation May Be Hurting Consumer Confidence What all this boils down to is how high a level of interest rates the economy is able to withstand. The futures markets imply that, in most countries, central banks will raise rates aggressively this year, but then be forced to stop or even cut rates after that because their actions cause an economic slowdown (Table 1). Our view is that the terminal rate is much higher than what is priced by markets and projected by central banks: In the US perhaps 3-4% in nominal terms.2 Even with seven Fed hikes over the next year, the policy rate would therefore remain well below neutral – an environment in which historically equities have outperformed bonds (Chart 10). Table 1Central Banks Will Hike Aggressively – But Then Stop Soon Chart 10Even In A Year, Rates Will Be Well Below Neutral One final comment: On long-term returns. As a result of the recent moderate equity correction, strong earnings growth, and higher long-term rates, the outlook is somewhat rosier than when we published our most recent report on Return Assumptions in May 2021 – though admittedly forward long-term returns are still likely to be lower than over the past 20 years (Table 2). This is not, then, a time to turn defensive. Table 2Long-Term Return Outlook No Longer Looks So Gloomy Fixed Income: In the short-term, government bonds look oversold (Chart 11). With inflation set to peak and the Fed likely to be less hawkish than the market has priced in, we do not see the 10-year US Treasury yield rising more than another 25 basis points or so above its current level this year. Accordingly, we are changing our duration call from underweight to neutral, and raise our recommendation for government bonds within the (still underweight) fixed-income bucket to neutral. For more cautious investors, a slight increase in government bond holdings might be warranted. Within credit, investment-grade bonds still offer little pickup, despite the moderate rise in spreads this year (from 92 to 121 in the US, for example), and so we lower this asset class to underweight. We continue to prefer high-yield bonds, which in the US now imply a jump in the default rate from 1.2% over the past 12 months to 4.5% over the coming year (Chart 12). As long as the economy grows in line with our expectations, that is very unlikely. Chart 11Government Bonds Look Oversold Chart 12Will Defaults Really Jump This Much? Equities: With the economy continuing to grow above-trend, global earnings should remain robust. This will not be a classic year for equity returns, but we expect them to do better than bonds. We continue to prefer US over European equities. As was seen in the aftermath of the invasion of Ukraine, US stocks are more defensive, and European growth will continue to be under threat from higher energy prices (Chart 13). We also move our recommended portfolio a little in the defensive direction by going overweight UK equities (which have a particularly high weight in defensive growth sectors, such as a 13 point overweight in Consumer Staples); we fund this by lowering Canadian equities to underweight, given their close linkage with oil (Chart 14), and the vulnerability of the Canadian housing market to rising rates. We remain underweight EM, but Chinese stocks (which were very oversold in late 2021) have been a relative safe haven as China started to stimulate, and so we continue with our neutral position for now. Chart 13Higher Energy Prices Threaten Europe Chart 14Canadian Stocks Move With The Oil Price Chart 15Financials Not So Attractive If Rates Don't Rise Our view that long-term rates have limited upside this year makes us more cautious on Financials stocks, which are closely correlated with rates, and so we cut this sector to neutral (Chart 15). A period of slowing growth points towards a preference for defensive growth, and so we raise our recommended weight in the IT sector to overweight from neutral. It is tempting to think of this sector as being composed of ridiculously overvalued speculative internet names, but it is in fact dominated by established hardware and software titans with deep competitive moats (Table 3). While the sector is not exactly cheap, its risk premium over bonds is quite reasonable by historical standards (Chart 16). Table 3Tech Sector Is Not Made Up Of Speculative Stocks Chart 16Tech Is Not Unreasonably Priced Chart 17Relative Rates Suggest Some Upward Pressure On USD Currencies: A neutral position on the US dollar still makes sense. Short-term rates are likely to rise somewhat faster in the US, relative to expectations, than in Europe or Japan (Chart 17). Nevertheless, the USD is expensive, and long-dollar is a consensus trade – reasons why the dollar has risen by less than 1% year-to-date on a trade-weighted basis, despite all the higher rate expectations and geopolitical shocks. Investors looking for hedges against downside risk might look to the Japanese yen, which is particularly cheap, and the Swiss franc. By contrast, the Canadian dollar, like Canadian equities, is closely linked to the oil price and a fallback in the Brent price would be negative; we move underweight. We also raise the CNY to neutral, since it may become a safe haven currency in the current geopolitical situation, though the Chinese authorities won’t let it rise too much since that would slow the economy. Commodities: China’s stimulus remains somewhat halfhearted (Chart 18). Although the credit and fiscal impulse has bottomed, we expect to see it rebound only moderately, with just minor cuts in interest rates and the reserve ratio. This will stabilize Chinese growth, but not cause a boom as in 2020, 2016 or 2013. The rise in industrial commodities prices, therefore, is likely to be limited from here. For oil, as mentioned above, we expect to see Brent crude return to around $85 by the second half, as new supply comes onto the market. Gold has done well, as expected, in the face of a major geopolitical event. But it is expensive by historical standards, vulnerable to a rise in real (as opposed to nominal rates) as inflation eases (Chart 19), and faces cryptocurrencies as a rival. We keep our neutral, as a hedge against the tail-risk of much higher inflation, but would not chase the price at this level. Chart 18China's Stimulus Isn't Enough To Help Metals Prices Chart 19Rising Real Rates Are Negative For Gold Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Footnotes 1 Please see Geopolitical Strategy Special Reports, “Russia Takes Ukraine: What Next?” dated February 24, 2022, and "From Nixon-Mao To Putin-Xi," dated February 25, 2022. 2 Please see Global Investment Strategy, “The New Neutral” dated January 14, 2022. Recommended Asset Allocation Model Portfolio (USD Terms)
Executive Summary US biotech is trading at its greatest discount to the market. Ever. Much of biotech’s underperformance is due to transient factors: specifically, the sell-off in long-duration bonds; the focus on delivering a Covid vaccine; regulatory concerns; a drought in M&A; and a flood of IPOs. Overweight US biotech versus US big-tech, both tactically and structurally. Long-only investors with a time horizon of at least 2 years should go outright long biotech, especially US biotech. If, as we expect, the 30-year T-bond (price) continues to rally, then long-duration sectors and stock markets will resume their outperformance versus shorter-duration sectors and stock markets. Fractal trading watchlist: We focus on biotech, and add US banks versus consumer services, Norway versus China, Greece versus euro area, and BRL/NZD. US Biotech Is Trading At Its Greatest Discount To The Market. Ever Bottom Line: Every now and then comes a rare opportunity to buy a deeply unloved asset at a bargain basement price. We believe that now provides such an opportunity for the beaten-down biotech sector – especially the US biotech sector which is trading at its greatest discount to the market. Ever. Feature Every now and then comes a rare opportunity to buy a deeply unloved asset at a bargain basement price. We believe that now provides such an opportunity for the beaten-down biotech sector – especially the US biotech sector which is trading at its greatest discount to the market. Ever. But before we go into the specifics of biotech, let’s quickly discuss the recent action in the broader market. The Past Year Has Been All About ‘Duration’ A good way to think of any investment is to compress all its cashflows into one future ‘lump-sum payment.’ The length of time to this lump-sum payment is the investment’s ‘duration.’ And the present value of the investment is just the discounted value of this lump-sum payment, where the discount factor will depend on the required return on the investment combined with its duration.1 It follows that, all else being equal, the present value of a long-duration stock must rise and fall in line with the present value of an equally long-duration bond – because their discount factors move in lockstep. And, as we have been banging on in recent weeks, this simple observation is all you need to explain market action over the past year. For the 30-year T-bond, 2.4-2.5 percent is an important resistance level. Given that long-duration indexes such as the Nasdaq, S&P 500 and MSCI Growth have the same duration as the 30-year T-bond, they have been tracking the 30-year T-bond price one-for-one (Chart I-1 and Chart I-2). Hence, when the long-duration bond rallied, these stock markets outperformed shorter-duration indexes such as the FTSE100 and MSCI Value; and when the long-duration bond sold off, they underperformed. Chart I-1The Nasdaq Has Been Tracking The 30-Year T-Bond Price One-For-One Chart I-2MSCI Growth Has Been Tracking The 30-Year T-Bond Price One-For-One The Russian invasion of Ukraine has catalysed a retreat in the 30-year T-bond yield from a ‘line in the sand’ at 2.4-2.5 percent, which we have previously highlighted as an important resistance level. If, as we argued in A Massive Economic Imbalance, Staring Us In The Face, the 30-year T-bond (price) continues to rally, then long-duration sectors and stock markets will resume their outperformance versus shorter-duration sectors and stock markets. US Biotech Is Trading At Its Greatest Discount To The Market. Ever Over the longer term, the bigger driver of the stock price will not be the discount factor on the future lump-sum payment; the bigger driver will be the size of the lump-sum payment itself. For any company, industry, or stock market, this expected lump-sum payment will evolve in line with current profits multiplied by a ‘structural growth multiple.’ It turns out that while current profits are updated every quarter, the structural growth multiple does not change much from quarter to quarter, year to year, or even decade to decade. Yet occasionally, it can phase-shift violently downwards when an event, or realisation, shatters the market’s lofty hopes for structural growth. Occasionally, an event or realisation shatters the market’s lofty hopes for structural growth. For example, after the dot com bubble burst it became clear that the sky-high hopes for non-US tech companies were just pie in the sky. The result was that their structural growth multiple halved, which weighed down non-US tech stocks for the subsequent 10 years (Chart I-3). Chart I-3After The Dot Com Bust, The Structural Growth Multiple For Non-US Tech Collapsed More recently, the realisation that Facebook – or Meta Platforms as it is now known – is losing subscribers was the gestalt moment that shattered hopes for its structural growth. Note that while its 2022 profits are down slightly, the Meta share price has collapsed, indicating a big hit to the structural growth multiple (Chart I-4). Chart I-4Facebook's Structural Growth Multiple Has Collapsed Conversely, there are rare occasions when a phase-shift down in a structural growth multiple is unwarranted or has gone too far. Right now, a case in point is the biotech sector, especially the US biotech sector. Relative to the relationship of the 2010s decade, US biotech’s structural growth multiple has halved (Chart I-5). The result is that US biotech is trading at the greatest valuation discount to the market (-20 percent). Ever. It is also trading at its greatest valuation discount to the broader tech sector (-35 percent). Ever (Chart I-6 and Chart I-7). Chart I-5US Biotech's Structural Growth Multiple Has Halved, But Is Such A Massive De-Rating Justified? Chart I-6US Biotech Is Trading At Its Greatest Ever Discount To The Market... Chart I-7...And Its Greatest Ever Discount To Big-Tech Another way of putting it is that in the post-pandemic era, while the structural growth multiple for the broader tech sector is largely unchanged, the structural growth multiple for biotech has collapsed by 40 percent (Charts I-8, I-11). Begging the question, is such a massive structural de-rating justified? Chart I-8US Tech's Structural Growth Multiple ##br##Is Unchanged... Chart I-9...But US Biotech's Structural Growth Multiple Has Collapsed Chart I-10Global Tech's Structural Growth Multiple##br## Is Unchanged... Chart I-11...But Global Biotech's Structural Growth Multiple Has Collapsed Much Of Biotech’s Underperformance Is Due To Transient Factors We have identified five culprits for biotech’s recent underperformance, but they are largely transient: The sell-off in long-duration bonds: Ironically, though the market has downgraded biotech’s structural growth, it has still behaved like a long-duration sector that has tracked the sell-off in the 30-year T-bond. Hence, if the long-duration bond rallies, it will boost biotech stocks. The focus on delivering a Covid vaccine: While biotech was developing a Covid vaccine, investors became enamoured with the sector, but once the vaccine was delivered, investors fell out of love with the sector. Yet there is more to biotech than a provider of vaccines, and as we show in the final section, the sell-off has gone too far. Regulatory concerns: In the US there has been some concern about the dilution of a biotech company’s intellectual property (IP) rights – known as March-In-Rights – if government funding or research has contributed to an innovation. In practice though, the sophistication of most innovations means that IP would remain with the innovator. There has also been concern about drug pricing reform, but as is normal in any negotiation, the opening extreme position is likely to get watered down. A drought in M&A: The focus on Covid, plus the uncertainty around regulation, has led to a drought in the M&A activity that is usually the mechanism to crystallize value. Still, for long-term investors, value is value, whether it is crystallized or not. Furthermore, the drought in M&A cannot last forever. A flood of IPOs: The more than 100 biotech IPOs in 2021 was double the usual rate, creating an oversupply and indigestion for specialist investors in the sector. But given the poor performance of the sector, the IPO flood is likely to recede through 2022-23 in a self-correction. So, we come back to the question: is it right to price a structural growth outlook for biotech worse than the overall market and much worse than for big-tech? If anything, it is big-tech that faces the much greater existential risk in the form of Web 3.0 – which will remove big-tech’s current ownership of the internet, thereby wiping out its very lucrative business model. Look out for our upcoming Special Report on this major theme. To repeat, the market is valuing US biotech at a record 40 percent discount to big-tech, and at its most unloved versus the broad market, when most of the headwinds it faces are transient. All of which leads to two investment conclusions. The market is valuing US biotech at a record 40 percent discount to big-tech, and at its most unloved versus the broad market. Overweight US biotech versus US big-tech, both tactically and structurally. Long-only investors with a time horizon of at least 2 years should go outright long biotech, especially US biotech. Fractal Trading Watchlist This week’s analysis focusses on our main theme, biotech, and we add US banks versus consumer services, Norway versus China, Greece versus euro area, and BRL/NZD. Reinforcing the arguments in the preceding sections, US biotech is deeply oversold versus broader tech, reaching a point of fractal fragility that signalled several significant turning-points through the past two decades (Chart I-12). Accordingly, this week’s recommended trade is to go long US biotech versus US tech, setting the profit target and symmetrical stop-loss at 17.5 percent. Chart I-12US Biotech Is Deeply Oversold Versus Broader Tech US Banks Are At Risk Of Reversal Norway's Outperformance Could End Greece's Snapback At A Resistance Point BRL/NZD At A Resistance Point Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Defined fully, the duration of an investment is the weighted-average of the times of its cashflows, in which the weights are the present values of the cashflows. 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 ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- 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 Russian Invasion Scenarios And Likely Equity Impact The Ukraine crisis is escalating as predicted. We maintain our odds: 65% limited incursion, 10% full-scale invasion, 25% diplomatic de-escalation. Russia says it will take “military-technical” measures as its demands remain unmet, while the US says an invasion is imminent. Fighting has picked up in the Donbas region. Our Ukraine decision tree highlights that the key to a last-minute diplomatic resolution is a western renunciation of defense cooperation with Ukraine after a verified Russian troop withdrawal. The opposite is occurring as we go to press. Stay long gold, defensives over cyclicals, and large caps over small caps. Stay long cyber security stocks and aerospace/defense stocks relative to the broad market. Trade Recommendation Inception Date Return LONG GOLD (STRATEGIC) 2019-12-06 27.6% Bottom Line: Our 75% subjective odds of a partial Russian re-invasion of Ukraine appear to be materializing. At the same time, we are not as optimistic about an imminent solution to the US-Iran nuclear problem. A near-term energy price spike is negative for global growth so we recommend sticking with our defensive tactical trades. Feature Chart 1Ukraine: Don't Be Complacent Fears about a heightened war in Ukraine fell back briefly this week before redoubling. Russian President Vladimir Putin showed a willingness to pursue diplomacy but then western officials refuted Russian claims that it was reducing troops around Ukraine. US President Biden said Russia is highly likely to invade Ukraine in the next few days. The Russian foreign ministry sent a letter reiterating Russia’s earlier threat that it will take unspecified “military-technical” actions given that its chief demands have not been met by the United States. A worsening security outlook as we go to press will push the dollar up against the euro, the euro up against the ruble, will lead to global equities falling (with US not falling as much as ex-US), and global bond yields falling (Chart 1). To assess the situation we need to weigh the signs of escalation against those of de-escalation. What were the signs of de-escalation? First, the Russian Defense Ministry claimed it is reducing troop levels near Ukraine, although NATO and the western powers have not verified any drawdown. An unspecified number of troops were said to return to their barracks in the Western and Southern Military Regions, according to Russian Defense Ministry spokesman General Igor Konashenkov. A video showed military units and hardware pulling back from Crimea. Officials claimed all troops would leave Belarus after military drills ended on February 20.1 Second, the Kremlin signaled that diplomacy has not been exhausted. In a video released to the public, Putin met with Foreign Minister Sergei Lavrov. He asked whether there was still a chance “to reach an agreement with our partners on key issues that cause our concern?” Lavrov replied, “there is always a chance.” Putin replied, “Okay.” Then, after speaking with German Chancellor Olaf Scholz in Moscow, Putin said: "We are ready to work further together. We are ready to go down the negotiations track.”2 Third, the Ukrainians are supposedly restarting efforts to implement the 2015 Russia-imposed ceasefire, under pressure from Germany and France. Ukraine’s ruling party is expected to introduce three bills to the Rada (parliament) that would result in implementing the terms of the Russian-imposed 2015 ceasefire, the so-called Minsk II Protocols. Ukraine is supposed to change its constitution to adopt a more federal system that grants autonomy to the two Russian separatist regions in the Donbas, Donetsk and Luhansk. Ukraine is also supposed to hold elections.3 The caveats to these three points are already clear: The US said Russia actually added 7,000 troops to the buildup on the Ukrainian border. Without Russia’s reducing troops, the US and its allies cannot offer major concessions. The US cannot allow itself to be blackmailed as that would encourage future hostage-taking and blackmail. Putin’s offer of talks is apparently separate from its “military-technical” response to the West’s failure to meet its three core demands on NATO. Russia’s three core demands are no further NATO enlargement, no intermediate-range missiles within threatening range, and withdrawal of NATO forces from eastern Europe to pre-1997 status. Putin reiterated that these three demands are inseparable from any negotiation and that Russia will not engage endlessly without resolution. Yet the West has consistently rejected these demands. Then came the Foreign Ministry statement pledging Russia’s military-technical response. So talks that focus on other issues – like missile defense and military transparency – are a sideshow. Ukraine is reiterating its desire to join NATO and will struggle to implement the Minsk Protocol. The Minsk format is not popular in Ukraine as it grants influence and recognition to the breakaway ethnic Russian regions. Ostensibly President Volodymyr Zelenskiy has sufficient strength in the Rada to change the constitution, given the possibility of assistance from opposition parties that oppose war or favor Russia. But passage or implementation could fail. The Russian Duma has also advised Putin to recognize the Donetsk and Luhansk People’s Republics as independent countries, which Putin is not yet ready to do, but could do if Ukraine balks, and would nullify the Minsk format.4 Of Russia’s three core demands, investors should bear in mind the following points: Ukraine is never going to join NATO. One of the thirty NATO members will veto its membership to prevent war with Russia. Therefore Russia is either making this demand knowing it will fail to justify military action, or driving at something else, such as NATO defense cooperation with Ukraine. Even if NATO membership is practically unrealistic, the US and NATO are providing Ukraine with arms and training, making it a de facto member. The quality and quantity of western defense cooperation is not sufficient to threaten Russia’s military balance so far but it could grow over time and Russia is insisting that it stop. While there is also a broader negotiation over Europe’s entire security system, immediate progress depends on whether the US and its allies stop trying to turn Ukraine into a de facto NATO ally. NATO is not going to sacrifice all of the strategic, territorial, and military-logistical gains it has made since 1997. Especially not when Russia is attempting to achieve such a dramatic pullback by military blackmail. But NATO could reduce some of the most threatening aspects of its stance if Russia reciprocates and there is more military transparency. Similarly, the US and Russia have a track record of negotiating missile defense deals so this kind of agreement is possible over time. The problem, again, hinges on whether agreement can be found over Ukraine. The opposite looks to be the case. Based on the above points, Diagram 1 provides a “Decision Tree” that outlines the various courses of action, our subjective probabilities, and the sum of the conditional probabilities for each final scenario. Diagram 1Russia-Ukraine Decision Tree, February 9, 2022 We start with the view that there is a 55% chance that the status quo continues: the West will not rule out Ukraine’s right to join NATO and will not halt defense cooperation. If this is true, then the new round of talks will fail because Russia’s core security interests will not be met. However, we also give a 25% chance to the scenario in which Ukraine is effectively barred from NATO but not defense cooperation. This may be the emerging scenario, given Chancellor Scholz’s point that Ukrainian NATO membership is not on the agenda and the White House’s claim that it will not pressure states to join NATO. Basically, western leaders could provide informal assurances that Ukraine will never join. But then the matter of defense cooperation must be resolved in the next round of talks. Given that the US and others have increased arms transfers to Ukraine in recent months and years (with US providing lethal arms for the first time in 2018), it seems more likely (60/40) that they will continue with arms transfers. After all, if they halt arms, Russia can invade anyway, but Ukraine will have less ability to resist. We allot a 15% chance to a scenario in which the US and its allies halt defense cooperation, even if they officially maintain NATO’s “open door” policy. If the Russians withdraw troops in this scenario, then a lasting reduction of tensions will occur. Again, while allied defense cooperation has been limited so far, it is up to Russia whether it poses a long-term threat. Finally, we give a 5% chance that the US and NATO will bar Ukraine from membership and halt defense cooperation. This path would mark a total capitulation to Russia’s demands. So far the allies have done nothing like this. They have insisted on NATO’s open door policy and have continued to transfer arms. No one should be surprised that tensions are escalating. De-escalation could still conceivably occur if Russia verifiably withdraws troops, if Ukraine moves to implement the Minsk II protocol, and if the US and its allies pledge to halt defense cooperation with Ukraine. The first step is for Russia to reduce troops, since that enables the US and allies to make major concessions when they are not under duress. If the US and NATO guarantee they will halt defense cooperation, given that Ukraine is practically unlikely to join NATO, then Russia may not be as concerned with Ukraine’s implementation of Minsk. As we go to press, none of these conditions are falling into place. The security situation is deteriorating rapidly. Bottom Line: Russia is likely to stage a limited military intervention into Ukraine (75%). The odds of a diplomatic resolution at the last minute are the same (25%). A full-scale invasion of all of Ukraine remains unlikely (10%). Market Reaction To Re-Escalation Chart 2 highlights the global equity market response to the Russian invasion of Crimea in 2014, which should serve as the baseline for assessing the market reaction to any renewed attack today. Stocks fell and moved sideways relative to bonds for several months, cyclicals (except energy) underperformed defensives, small caps briefly rose then collapsed against large caps, and value stocks rose relative to growth stocks. The takeaway was to stay invested over the cyclical time frame, prefer large caps, and prefer value. The difference today is that cyclicals and small caps are already performing worse against defensives and large caps than in 2014, while value has vastly outstripped growth (Chart 3). The implication is that once war breaks out, cyclicals and small caps have less room to fall whereas value has limited near-term upside. Chart 2Market Response To Crimea Invasion, 2014 Chart 3Market Response 2022 Versus 2014 If we look closely at global equity gyrations over the past week – when the Ukraine story moved to front and center – we see that stocks are falling relative to bonds, cyclicals are flat relative to defensives, small caps are rising relative to large caps, and value is flat relative to growth but may have peaked (Chart 4). In the short term the geopolitical dynamic will move markets so we expect cyclicals, small caps, and value to underperform. Commodity prices and the energy sector are initially benefiting from tensions as expected – oil prices and energy equities spiked amid the tensions (Chart 5). But assuming war materializes, Russia will at least cut off natural gas flowing through Ukraine, cutting off about 20% of Europe’s natural gas supply and triggering a bigger price shock. Ultimately, however, this price shock will incentivize production, destroy global demand, and drive energy prices down. Chart 4Global Equities Just Woke Up To Ukraine Chart 5Global Energy Sector Just Woke Up To Ukraine Thus we expect energy price volatility. Russia will keep shipping energy to Europe to finance its military adventures. Europe will be loath to slap sanctions on critical energy supplies, assuming Russia’s military action is limited. The Saudis may or may not increase production to prevent demand destruction – in past Russian invasions they have actually reduced production once prices started to fall. A temporary US-Iran nuclear deal could release Iranian oil to the market, though that is not what we expect in the short run (discussed below). Bottom Line: Tactically investors should favor bonds over stocks, the US dollar and US equities over global currencies and equities (especially European), defensive sectors over cyclicals, large caps over small caps, and growth over value stocks. Is Ukraine Already Priced? Not Yet. Chart 6Crisis Events And Peak-To-Trough Market Drawdown The peak-to-trough equity drawdown – in geopolitical crises that are comparable to a Russian invasion of Ukraine – range from 11%-14% going back to 1931. The following research findings are derived from a list of select events, from the Japanese invasion of China to the German invasion of Poland to lesser invasions, all the way down to Russia’s seizure of Crimea in 2014. We used the S&P 500 as it is the most representative stock index over this long period of time. The fully updated and broader list of geopolitical crises can be found in Appendix 1. Geopolitical crises tend to trigger an average 10% equity decline, smaller than economic crises or major terrorist attacks (Chart 6). The biggest geopolitical shocks to the equity market occur when an event is a truly global event, as opposed to regional shocks. Interestingly Europe-only shocks have seen some of the smallest average drawdowns at around 8% (Chart 7). An expanded Ukraine war would be limited to Europe. The average equity selloff is largest, at 14%, if both the US and its allies are directly involved in the geopolitical event. But the range is 11%-14% regardless of whether the US or its allies are involved (Chart 8). Ukraine is not an official ally, which is one reason the markets will tend to play down a larger war there. However, the market is underrating the fact that Ukraine’s neighbors are NATO members and will have a powerful interest in supporting the Ukrainian militant insurgency, which could lead to unexpected conflicts that involve NATO member-state’s citizens. Chart 7Geopolitical Crises And Markets: Where Is The Crisis? Chart 8Geopolitical Crises And Markets: Who Are The Players? Chart 9Russian Invasion Scenarios And Likely Equity Impact The Russians have as many as 150,000 troops on the border with Ukraine, according to President Biden’s latest speech. The Ukrainian active military numbers 215,000. This ratio is not at all favorable for a full-scale invasion. The Russians are contemplating a limited action directed at teaching Ukraine a lesson or encroaching further onto Ukrainian territory, especially coastal territory. History suggests that a limited incursion will produce a 10% total equity drawdown, whereas a full-scale invasion would produce 13% or more (Chart 9). Still, investors should view 11%-14% as the appropriate range for a geopolitically induced crisis. The S&P has fallen by 9% since its peak on January 3, 2022. But Russia has not invaded yet. If war breaks out, there is more downside, given high uncertainty. Markets could still be surprised by the initial force of any Russian military action. The US will impose sweeping sanctions immediately. The Europeans will modify their sanctions according to Russia’s actions, a key source of uncertainty. If a diplomatic resolution is confirmed – with Russia withdrawing troops and the US and its allies cutting defense cooperation with Ukraine – then the market may continue to rally. However, there are other reasons to be cautious: especially inflation and monetary policy normalization, with the Federal Reserve potentially lifting rates by 50 basis points in March. Bottom Line: Stocks can fall further given that investors do not yet know the magnitude of the Russian military action or the US and European sanctions response. However, a buying opportunity is around the corner once this significant source of global uncertainty is clarified. New Iran Deal Is Neither Guaranteed Nor Durable A short note is necessary on the situation with Iran, another major risk this year, which falls under our third 2022 key view: oil-producing states gain geopolitical leverage. The implication is that the Iran risk will not be resolved quickly or easily. The global economy could suffer a double whammy of energy supply shock from Ukraine and energy supply risk in the Middle East this year. The US-Russia showdown is connected to the US-Iran nuclear negotiation. Russia took Crimea in 2014 in part because it saw an opportunity to exact a price from the United States, which sought Russia’s assistance in negotiating the 2015 nuclear deal with Iran. Today a similar dynamic is playing out, in which Russian diplomats cooperate on Iranian talks while encroaching on Ukraine. The Russians do not have an interest in Iran achieving a deliverable nuclear weapon and thus will offer some limited cooperation to this end. Their pound of flesh is Ukraine. According to media reports, the Iranian negotiations have seen some positive developments over the past month. US interest in rejoining the 2015 deal: The Biden administration has an interest in preventing Iran from reaching “breakout” levels of uranium enrichment and triggering a conflict in the region that would drive up oil prices ahead of the midterm election. It is going to be hard for Biden to remove sanctions in the context of Russian aggression but it is likely he would do it if the Iranians recommit to complying with the 2015 restrictions on their nuclear program. Iranian interest in rejoining the 2015 deal: The Iranians have an interest in convincing President Biden to remove sanctions to improve their economy and reduce the risk of social unrest. They are demanding the removal of all sanctions, not only those levied by President Trump. They also know that rejoining the 2015 deal itself is not so bad, since it starts expiring in 2025 and does not limit their missile production or support of militant proxies in the region. However, note that the Iranian regime has suppressed domestic instability since Trump’s “maximum pressure” sanctions, and the economy is improving on oil prices, so the threat of social unrest is not forcing Iran to accept a deal today. Also note that Iran is making demands that cannot be met: Iranian Foreign Minister Hossein Amirabdollahian is asking the US to provide guarantees that the US will not renege on the deal again, for example if the Republicans return to the White House in 2025. President Biden cannot provide these guarantees. The voting margins are too thin for a “political statement,” promising that the US will not renege on a deal, to pass Congress. While House Speaker Nancy Pelosi might be willing to provide such a statement to the Iranians, Senate Majority Leader Chuck Schumer probably will not – he opposed the originally 2015 deal. Even if Congress gave Iran guarantees, the fact remains that the GOP could win the White House in 2025, so the current, hawkish Iranian leadership cannot be satisfied on this front. Furthermore, even if Biden pulls back sanctions and Iran complies with the 2015 deal for a brief reprieve, Iran’s underlying interest is to obtain a deliverable nuclear weapon to achieve regime survival in the future. Iran faces a clear distinction between Ukraine, which gave up nukes and is now being dismembered (like Libya and Iraq), and North Korea, which now has a deliverable nuclear arsenal and commands respect from the US on the national stage. Moreover if the Republicans take back power in 2025, Iran will want to have achieved or be close to achieving a deliverable nuclear weapon. The Biden administration is weak at home and facing a crisis with Russia, which may present a window of opportunity for Iran to make a dash for the nuclear deterrent. Still, we acknowledge the short-term risk to our pessimistic view: It is possible that Iran will rejoin the deal to gain sanctions relief. In this case about 1-1.2 million barrels per day of Iranian crude will hit the global market. The implication, depending on the size of the energy shock, is that Brent crude prices will fall back to the $80 per barrel average that our Commodity & Energy Strategy expects. We also agree with our Commodity & Energy Strategist that global oil production will pick up in the face of supply risks that threaten to destroy demand. Bottom Line: We doubt Iran will rejoin the 2015 nuclear deal quickly. We expect energy prices to continue spiking in the short term due to Ukraine and any setbacks in the Iran negotiations. Yet we also expect oil producers around the world to increase production, which will sow the seeds for an oil price drop. Our tactical trade recommendations rest on falling oil prices and bond yields in the short run. Investment Takeaways Stay long gold. Stay long global defensive equity sectors over cyclicals. Favor global large caps over small caps. Stay long cyber security stocks and aerospace/defense stocks relative to the broad market. Stay long Japanese industrials relative to German and long yen. Stay long British stocks relative to other developed markets excluding the US, and long GBP-CZK. Favor Latin American equities within emerging markets, namely Mexican stocks and Brazilian financials relative to Indian stocks. Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 See "Russia Announces Troop Withdrawal," Russia Today, February 15, 2022, rt.com; "Ukraine crisis: Russian claim of troop withdrawal false, says US," BBC, February 17, 2022, bbc.com. 2 David M. Herszenhorn, “On stage at the Kremlin: Putin and Lavrov’s de-escalation dance,” Politico, February 14, 2022, politico.eu. 3 "Scholz says Zelensky promised to submit bills on Donbass to Contact Group," Tass, February 15, 2022, tass.com; "Scholz in Kyiv confirms Germany won’t arm Ukraine, stays mum on Nord Stream 2," February 15, 2022, euromaidanpress.com. 4 "Kiev makes no secret Minsk-2 is not on its agenda — Russian Foreign Ministry," Tass, February 17, 2022, tass.com; Felix Light, "Russian Parliament Backs Plan To Recognize Breakaway Ukrainian Regions," Moscow Times, February 15, 2022, themoscowtimes.com. Appendix 1: Geopolitical Events And Equity Market Impact Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)
Executive Summary Bull Markets In Malaysian Stocks Are Fully Dependent On Profit Growth The conditions for a major rally/outperformance in Malaysian equities are absent. Profits have been the primary driver of Malaysian equity prices historically, and the corporate earnings outlook is mediocre. Domestic demand is facing headwinds from tightening fiscal policy as well as from impaired credit channels. Muted wage growth and deflating house prices are sapping consumer confidence. This will dent domestic demand going forward. This backdrop is bullish for bonds. Malaysian bonds offer value, as real bond yields are among the highest in Emerging Asia. The yield curve is far too steep given the growth and inflation outlook. The Malaysian ringgit is cheap and has limited downside. Bottom Line: We recommend equity investors implement a neutral stance toward Malaysia in overall EM and Emerging Asian equity portfolios. Absolute return investors should avoid this bourse for now. Fixed-income investors, on the other hand, should stay overweight Malaysia in both EM domestic (local currency) and sovereign credit portfolios. In the rate markets, investors should continue receiving 10-year swap rates or bet on yield curve flattening. Feature Chart 1Malaysian Equity Underperformance May Be Late, But It’s Not Yet Time To Overweight Malaysian stocks are still in search of a stable bottom in absolute terms. Relative to their EM and Emerging Asian counterparts however, a bottom has been forming over the past year (Chart 1). So, could Malaysia’s prolonged underperformance be coming to an end? Our analysis suggests caution. The underlying reasons behind this market’s substantial and protracted underperformance – dwindling earnings both in absolute terms and relative to its peers – are yet to show any signs of a reversal. While cheap, the ringgit is also negatively impacted by the meager corporate profits generated by Malaysian firms. Investors would do well to stay neutral on this bourse for now in EM and Emerging Asian equity portfolios. Fixed income investors, however, should continue to stay overweight Malaysia in both EM domestic (local currency) and sovereign credit portfolios. Also, Malaysia’s yield curve is too steep and offers value given the sluggish cyclical growth outlook. It’s All About Profits Chart 2 shows that the bull and bear markets in Malaysian stocks have been all about the rise and fall in earnings per share (EPS). Stock multiples, the other possible driver of the equity prices, have been remarkably flat over the past two decades, with only brief periods of fluctuations around the GFC and COVID-19 pandemic. The same can be said about Malaysia’s relative performance vis-à-vis EM and Emerging Asian stocks. The trajectory of the relative stock performance was set by the relative earnings (Chart 3). Chart 3Malaysia’s Relative Performance Is Also Dictated By Relative Corporate Profits Chart 2Bull Markets In Malaysian Stocks Are Fully Dependent On Profit Growth Thus, it is reasonable to expect that for this bourse to usher in a new bull market in absolute terms, Malaysian firms need to grow their earnings sustainably. And in order to outperform the rest of the EM stocks, Malaysian earnings need to grow at a faster clip than their peers. The question therefore is, are there signs of profit recovery in Malaysian companies in absolute and relative terms? The short answer is no. Bottom-up analysts do not expect any change in the downward trend in Malaysia’s relative profits over the coming 12 months. This outlook is corroborated by our macro analysis, as is outlined below. Sluggish Growth Malaysian profits are languishing in large part because of subdued topline growth. While profit margins are returning to pre-pandemic levels – thanks to cost cutting – subdued sales are causing the corporate profits to stay low. Chart 4Malaysian Domestic Demand Is Subdued Malaysian gross output as of Q4 last year was barely at pre-pandemic levels. The weak recovery is most evident in the dismal level of capital investments. Gross fixed capital formations – in both real and nominal terms – are still a good 15% below their pre-pandemic levels (Chart 4, top two panels). Apathy among businesses in ramping up productive capacity indicates a lack of confidence in consumer demand going forward. Consumption is indeed weak: Unit sales for passenger vehicles continue to be sluggish, and commercial vehicle sales are not faring any better. Consumer sentiment has ticked down in the latest survey indicating retail sales might decelerate (Chart 4, bottom two panels) Consistently, industrial production in consumer goods-related industries is struggling to surpass previous highs, even though strong export demand has provided a fillip to sales. In more domestic-oriented industries such as construction goods, the weakness is palpable (Chart 5). Meanwhile, unemployment rates have fallen marginally, but are still higher than they were before the pandemic. As a result, wages remain subdued. The resulting weak household income is contributing to depressed consumption. With mediocre household income growth, demand for houses has also slowed meaningfully. This is reflected in dwindling property unit sales. The advent of the pandemic and the resulting loss of household income have further aggravated the situation. In fact, prices of certain types of dwelling units, such as semi-detached houses and high-rise apartments, are deflating outright (Chart 6, top panel). Falling house prices weigh on consumer sentiment and discourage future consumption. Chart 6Contracting House Prices Is Hurting Real Estate Sector And Denting Consumer Confidence Chart 5Weak Domestic Demand Is A Headwind To Industrial Production What’s more, the housing sector does not expect an early recovery in sales and prices either. This is evident in the very depressed level of new construction starts (Chart 6, bottom panel). As such, this sector is likely to remain a drag on Malaysia’s post-pandemic recovery. Fiscal And Credit Headwinds Going forward, the recovery will face other headwinds worth noting. One of them is a restrictive fiscal policy. This is because the “statutory debt” ceiling of the government – at 60% of GDP – has already been reached (Chart 7, top panel). This ceiling for statutory debts was fixed by lawmakers as part of a stimulus bill (COVID-19 Act) passed in 2020; and leaves little room for additional fiscal stimulus. Indeed, the IMF estimates that the ‘fiscal thrust’ this year will be negative at 2% of GDP (Chart 7, bottom panel). The country’s credit channel is also compromised. The reason is that Malaysian banks are still saddled with unresolved NPLs. These NPLs are a legacy of a very rapid expansion of bank loans following the GFC. In just five years (2009 -2014), bank credit doubled in nominal terms to 1500 billion ringgit or from 95% of GDP to 125% (Chart 8, top panel). Such fast deployment of credit was bound to cause significant misallocation of capital. And yet banks were averse to recognize impaired loans in any good measure. In fact, during the years of rapid credit growth, banks were recognizing ever fewer amounts in absolute terms as impaired loans. They were also setting aside ever lower amounts as loan loss provisions (Chart 8, second panel). Chart 7Fiscal Policy Will Stay Constrained As Statutory Debt Has Hit The Ceiling Chart 8Both Demand And Supply Of Bank Credit In Malaysia Remains Compromised While bad debt recognition and provisions have risen modestly over the past year, Malaysia’s reported NPL ratio remained under 1.5% of loans (Chart 8, third panel). Loan loss provisions have been equally meager. This indicates that banks’ balance sheets are far from clean. In reality, Malaysian borrowers never went through any deleveraging process following their last credit binge. The bank credit-to-GDP ratio remains at around the same level as it was in 2015 (125% of GDP). By comparison, during Malaysia’s previous deleveraging phase, bank credit was shed from 150% of GDP to 90% (1998 - 2008). Borrowers already saddled with large amounts of debt are much less likely to borrow more to invest and/or consume. This is therefore going to cap credit demand. Chart 9Banks Are Piling Up On Government Securities By Shunning Loans As for banks, an increase in impaired loans makes them reticent to engage in further lending. Instead, they seek to accumulate safer assets such as government bonds. In fact, this is what Malaysian banks have been doing. They have ramped up their holdings of government securities materially since 2015 at the expense of loans and advances (Chart 9, top panel). After the pandemic-related slowdown in the economy, banks’ loan books are now probably more encumbered with impaired loans. As such, banks are even less likely to ramp up their loan books in any major way. That will be yet another headwind to economic recovery (Chart 9, bottom panel). Value In Fixed Income The headwinds to growth do not entail a bullish outlook for Malaysian equities. The outlook for Malaysian local currency bonds, however, is promising. A tightening fiscal policy amid weak domestic demand and subdued inflation is a bullish cocktail for domestic bonds. There is a good chance that Malaysian bond yields will roll over. At a minimum, they will rise less than most other EM countries or US Treasuries. Notably, Malaysia offers one of the highest real yields (nominal yield adjusted for core inflation) in Emerging Asia (Chart 10, top panel). Given the country’s mediocre growth outlook, odds are high that Malaysian local bonds will outperform their EM / Emerging Asian peers (Chart 10, bottom panel). Chart 10Malaysian Bonds Offer One Of The Best Values In Emerging Aisa Chart 11Steep Yield Curve Indicate Value In Bond Space; But Spell Trouble For Bank Stocks The Malaysian swap curve is also far too steep given the country’s macro backdrop. Going forward, the 10-year/1-year swap curve is set to flatten from its decade-steep level of 130 basis points (Chart 11, top panel). That means investors should continue receiving 10-year swap rates. On a related note, a fall in bond yields will not augur well for Malaysian stocks in general, and bank stocks in particular. The middle panel of Chart 11 shows that bank stocks struggle in absolute terms whenever bond yields decline. Incidentally, at 38% of total, banks are by far the largest sector in the MSCI Malaysia Index. And in recent months bank stocks have been propelling the Malaysian market (Chart 11, bottom panel). Should the bourse begin to miss the tailwind from rising bond yields, Malaysian equity performance will be hobbled. Finally, investors should stay overweight in Malaysian sovereign credit. The country’s orthodox fiscal policy has accorded a defensive nature to this market. As such, periods of global risk-off witness Malaysian sovereign spreads fall relative to their EM counterparts, as they did in 2015 and again in 2020. In the months ahead, rising US inflation and a slowdown in Chinese property markets could cause another such period. That will lead Malaysian sovereign US dollar bonds to continue outperforming their EM peers. What’s With The Ringgit? Chart 12Malaysia Has Not Been Able To Benefit From A Cheap Currency The Malaysian currency is cheap, both in nominal and real terms (Chart 12, top panel). As such, it will likely be one of the most resilient currencies in EM this year. That said, the ringgit has been cheap for a while now (since 2015), and yet the Malaysian economy does not seem to have benefitted much all these years. The inability to take advantage of a cheap currency points to a fundamental malaise in the Malaysian economy: Loss of manufacturing competitiveness, as explained in our previous report on Malaysia. Perhaps equally worryingly, the country has not been able to attract much in the way of capital inflows. What this implies is that global investors did not find Malaysian assets attractive enough despite the benefits of a significantly cheaper currency (Chart 12, bottom panel). A major reason investors have not found the country attractive is because the return on capital on Malaysian assets has continued to deteriorate relative to the rest of the world. The upshot of the above is that, should Malaysian firms be able to improve their profits going forward, Malaysian stocks’ relative performance would get a boost from both higher relative earnings and a stronger currency. However, given the sluggish business cycle outlook as explained above, a sustainable rally in Malaysian stocks or currency is not imminent. Investment Conclusions Chart 13Malaysian Relative Stock Valuations Are On The Cheaper Side Equities: Malaysian stocks have cheapened. Both in terms of P/E ratio and P/book ratio, they are at the lower end of the spectrum relative to their EM counterparts (Chart 13). Yet, given the mediocre growth outlook, we recommend that dedicated EM and Emerging Asian equity portfolios stay neutral on this market for now. Absolute return investors should stay on the sidelines in view of the worsening risk outlook in global markets, and wait for a better entry point later in the year. For local asset allocators in Malaysia, it is too early to overweight stocks relative to bonds over a cyclical horizon. Even though the equity risk premium in general has been much higher since the advent of the pandemic, stocks have struggled to outperform bonds in a total return basis over the past two years. That will likely be the case for several more months given the country’s growth outlook and rising global risks. Fixed Income: Malaysian domestic bonds will outperform their overall EM / Emerging Asian peers. So will Malaysian sovereign credit. Fixed income investors should overweight them in their respective EM / Emerging Asian portfolios. In the rate markets, investors should continue receiving 10-year swap rates. Finally, Malaysian yield curves are set to flatten. Investors should position for a narrowing of the 10-year/1-year yield curve, which is at a decade-high level of 180 basis points. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com
Executive Summary The recent 26 percent overspend on durable goods constitutes one of the greatest imbalances in economic history. An overspend on goods is corrected by a subsequent underspend; but an underspend on services is not corrected by a subsequent overspend. This unfortunate asymmetry means that the recent overspend on goods at the expense of services makes the economy vulnerable to a downturn. And the risk is exacerbated by central banks’ intentions to hike rates in response to inflation. As the spending on durable goods wanes, so too will monthly core inflation and the 30-year T-bond yield. As the 30-year T-bond rallies, so too will other long-duration bonds, long-duration stocks, long-duration sectors, and long-duration stock markets such as the S&P 500 versus short-duration stock markets such as the FTSE 100. Fractal trading watchlist: We focus on emerging markets, add financials versus industrials, and review tobacco versus cannabis, CAD/SEK, and biotech. If A 26 Percent Overspend On Goods Is Not A Massive Economic Imbalance, Then What Is? Bottom Line: As the spending on durable goods wanes, so too will monthly core inflation and the 30-year T-bond yield. Go overweight long-duration bonds, long-duration stocks, and long-duration stock markets such as the US versus non-US. Feature My colleague Peter Berezin recently wrote that recessions tend to happen when: “1) the build-up of imbalances makes the economy vulnerable to downturn; 2) a catalyst exposes these imbalances; and 3) amplifiers exacerbate the slump.” Peter is spot on. Using this checklist, I would argue that right now: There is a massive imbalance that makes the economy vulnerable to a downturn. Specifically, a 26 percent overspend on durable goods constitutes one of the greatest imbalances in economic history – the 26 percent overspend on durables refers to the US, but other advanced economies have experienced similar binges on goods. The catalyst that exposes this massive imbalance is the realisation that durables are, well, durable. They last a long time. So, if you front-end loaded many of this year’s purchases into last year, then you will not buy them this year. If you overspent by 26 percent in 2021, then the risk is that you symmetrically underspend by 26 percent in 2022. If central banks hike rates into this demand downturn, they will amplify and exacerbate the slump. A Massive Imbalance In Spending Makes The Economy Vulnerable To A Downturn Much of the recent overspend on goods was spending displaced from the underspend on services which became unavailable in the pandemic – such as eating out, going to the movies, and going to in-person doctor’s appointments. Raising the obvious question, can a future underspend on goods be countered by a future overspend on services? The answer is no. The consumption of services is constrained by time, opportunity, and biology. For example, there is a limit on how often you can eat out, go to the movies, or go to the doctor. If you are used to eating out and going to the movies once a week, and the pandemic prevented you from doing so for a year, that does not mean you will eat out and go to the movies an extra 52 times for the 52 times you missed! Rather, you will quickly revert to your previous pattern of going out once a week. This constraint on services spending means that the underspend will not become a symmetric overspend. In fact, the underspend on certain services will persist. This is because we have made some permanent changes to our lifestyles – for example, hybrid office/home working and more online shopping and online medical care. Additionally, a small but significant minority of people have changed their behaviour, shunning services that require close contact with strangers. To repeat the crucial asymmetry, an overspend on goods is corrected by a subsequent underspend; but an underspend on services is not corrected by a subsequent overspend (Chart I-1 and Chart I-2). Therefore, the recent massive overspend on goods at the expense of services makes the economy vulnerable to a downturn, and the risk is exacerbated by central banks’ intentions to hike rates in response to inflation. These hikes will prove to be overkill, because inflation is set to cool of its own accord. Chart I-1An Overspend On Goods Can Be Corrected By A Subsequent Underspend... Chart I-2...But An Underspend On Services Cannot Be Corrected By A Subsequent Overspend Durables Are Driving Inflation, And Inflation Is Driving The 30-Year T-Bond The recent binge on goods really comprises three mini-binges, which peaked in May 2020, January-March 2021, and October 2021. With a couple of months lag, these three mini-binges have caused three mini-waves in core inflation. To see the cause and effect, it is best to examine the evolution of inflation granularly – on a month-on-month basis – which removes the distorting ‘base effects.’ The mini-binges in goods lifted the core monthly inflation rate to an (annualised) 7 percent in July 2020, 10 percent in April-June 2021, and 7 percent in January 2022 (Chart I-3). Chart I-3Spending On Durables Is Driving Inflation Worryingly, the sensitivity of inflation has increased in each new mini-binge in goods spending, possibly reflecting more pressure on already-creaking supply chains as well as more secondary effects. Nevertheless, the key driver of the mini-waves in core inflation is the demand for durables, and as that demand wanes, so will core inflation. As monthly core inflation eases back, so too will the 30-year T-bond yield. What about the 30-year T-bond yield? Although it is a long-duration asset, its yield has recently been tracking the short-term contours of core inflation. So, when monthly inflation reached an (annualised) 10 percent last year, the 30-year T-bond yield reached 2.5 percent. At the more recent 7 percent inflation rate, the yield has reached 2.35 percent. It follows that as monthly core inflation eases back, so too will the 30-year T-bond yield (Chart I-4). Chart I-4Inflation Is Driving The 30-Year T-Bond Get The 30-Year T-Bond Right, And You’ll Get Most Things Right For the past year, the story of stocks has been the story of bonds. Or to be more precise, the story of long-duration stocks has been the story of the 30-year T-bond. Through this period, the worry du jour has changed – from the Omicron mutation of SARS-CoV-2 to an Evergrande default to Facebook subscriber losses and now to Russia/Ukraine tensions. Yet the overarching story through all of this is that the long-duration Nasdaq index has tracked the 30-year T-bond price one-for-one (Chart I-5). And the connection between S&P 500 and the 30-year T-bond price is almost as good (Chart I-6). Chart I-5Get The 30-Year T-Bond Right, And You'll Get The Nasdaq Right Chart I-6Get The 30-Year T-Bond Right, And You'll Get The S&P 500 Right The tight short-term connection between long-duration stocks and the 30-year T-bond makes perfect sense. The cashflows of any investment can be simplified into a ‘lump-sum’ payment in the future, and the ‘present value’ of this payment will move in line with the present value of an equal-duration bond. So, all else being equal, a long-duration stock will move one-for-one in line with a long-duration bond. The story of long-duration stocks has been the story of the 30-year T-bond. ‘Value’ stocks and non-US stock markets which are over-weighted to value have a shorter-duration. Therefore, they have a much weaker connection with the 30-year T-bond. It follows that if you get the 30-year T-bond right, you’ll get most things right: The performance of other long-duration bonds (Chart I-7). The performance of long-duration growth stocks (Chart I-8). The performance of ‘growth’ versus ‘value’ (Chart I-9). The performance of growth-heavy stock markets like the S&P 500 versus value-heavy stock markets like the FTSE100 (Chart I-10). Of course, the corollary is that if you get the 30-year T-bond wrong, you’ll get most things wrong. Observe that the 1-year charts of long-duration bonds, growth stocks, growth versus value, and S&P 500 versus FTSE100 are indistinguishable. Proving once again that investment is complex, but it is not complicated! Chart I-7Get The 30-Year T-Bond Right, And You'll Get The 30-Year German Bund Right Chart I-8Get The 30-Year T-Bond Right, And You'll Get Growth Stocks Right Chart I-9Get The 30-Year T-Bond Right, And You'll Get Growth Versus Value Right Chart I-10Get The 30-Year T-Bond Right, And You'll Get S&P 500 Versus FTSE100 Right Our expectation is that as the spending on durable goods wanes, so too will monthly core inflation and the 30-year T-bond yield. Go overweight long-duration bonds, long-duration stocks, long-duration sectors, and long-duration stock markets such as the US versus non-US. Fractal Trading Watchlist This week we focus on emerging markets, add financials versus industrials, and review tobacco versus cannabis, CAD/SEK, and biotech. Emerging markets (EM) have been a big underperformer through the past year, but it may be time to dip in again, at least relative to value-heavy developed market (DM) indexes. Specifically, MSCI Emerging Markets versus MSCI UK has reached the point of fractal fragility that signalled previous major turning-points in 2014, 2018, and 2020 (Chart I-11). Accordingly, this week’s recommended trade is to go long MSCI EM versus UK (dollar indexes), setting the profit-target and symmetrical stop-loss at 10 percent. Chart I-11Time To Dip Into EM Again, Selectively Financials Versus Industrials Is Approaching A Turning-Point CAD/SEK At A Top Awaiting A Major Entry-Point Into Biotech Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations I Indicators To Watch - Interest Rate Expectations III
Executive Summary Foreign And Domestic Politics Won't Stop The Fed Investors woke up to the Ukraine risk this week. It is not yet resolved. Stay defensive. Market reactions to Ukraine suggest investors will favor defensive sectors and growth stocks in the short term, with the notable exception of the energy sector. External risks will not dissuade the Fed from hiking rates in the face of 6% core inflation. Later the Fed might adjust to foreign crises but the stock market faces more downside in the interim. Polarization is reviving ahead of the midterm elections, which will usher in gridlock. Gridlock is disinflationary, reinforcing a tactically defensive market positioning despite our cyclical House View. Bottom Line: Biden’s external risks are not yet subsiding. The Fed will hike rates even in the face of external supply shocks. Stay tactically defensive. Feature Our three key views for the year are: gridlock, executive power, and foreign policy. First, Congress will become gridlocked even prior to the midterm elections. Second, President Biden will have to shift to executive power to achieve policy objectives. Third, Biden’s focus will be forced to engage in foreign policy more than he would prefer due to rising external risks. The Ukraine crisis – covered extensively in our Geopolitical Strategy – is the most pressing external risk but it is not the only one that we think will trouble markets this year. We expect politically induced volatility to persist all year. The cyclical investment view should be driven by the underlying macroeconomic reality. But that macro reality will change if external risks materialize and cause greater supply disruptions or if they alter the US midterm election outlook. We maintain our tactically defensive positioning for now. Mr. Market Wakes Up To Ukraine Risk The reason for the crisis is the historic Russian military buildup on all sides of Ukraine, in the face of US defense cooperation with Ukraine, not the “hysterical” American propaganda over the risk of war. When and if Russian forces withdraw, the crisis will melt away. But for now, Russia’s reported withdrawal of some troops is contradicted by movements of other troops as well as the fact that the Russian navy has effectively blocked off the Black Sea. Investors must judge by capabilities, not intentions, and Russia still has the capability to stage a limited attack at present so investors should maintain a defensive or cautious approach. In this context investors are rightly bidding up the US dollar and bidding down US equities in absolute terms (albeit not relative to European equities). Bond yields have not responded much to the external risk due to the high rate of inflation, which is pushing yields up (Chart 1). If Russia re-invades, stocks and bond yields will fall at least temporarily and the dollar will rise higher. When Russia initially invaded Ukraine eight years ago, in February 2014, the US stock-to-bond ratio moved sideways for several months but cyclicals outperformed defensives. Energy stocks rallied, until the oil crash in summer 2014. Small caps underperformed large caps, yet value outperformed growth stocks (Chart 2). Small caps likely suffered from risk-off sentiment and expectations of a drag on global growth, while value benefited from gently rising interest rates at that time. Chart 1Ukraine Crisis Escalates Chart 2Market Response To Crimea Invasion, 2014 Comparing the situation today, the difference is that cyclicals are trailing defensives and small caps are trailing large caps even more than they were in 2014. Yet value stocks have performed far better against growth now than then, in accordance with higher inflation and bond yields (Chart 3). Further escalation of the Ukraine crisis should drive investors to favor defensives, large caps, and growth stocks on a tactical time frame, even though this decision runs against our BCA House View on a cyclical time frame. The past week’s market moves reinforce the 2014 experience in general, with the stock-to-bond ratio faltering and cyclicals falling back (Chart 4). Small caps and value have benefited but these charts suggest that a negative hit to global growth will hurt small caps, while value is overextended relative to growth in the short term. The market only really began to discount the risk of a new war in Europe this past week, specifically on Friday, February 11 and Monday, February 14. Chart 3Market Response 2022 Versus 2014 Chart 4US Equities Just Woke Up To Ukraine There is not yet a solid diplomatic solution as we go to press on Tuesday, February 15, but some positive signs are fueling a rebound in risk assets. Fade these improvements in risk appetite until Russia makes its decision on whether to use military force and, if so, until Europe makes its decision on whether to impose crippling sanctions. Bottom Line: Tactically stay long growth stocks versus value, but prepare to switch back to overweighting value if the Ukraine crisis abates. The Energy Sector Response To Ukraine So Far Commodity prices and the energy sector are naturally benefitting from rising supply risks. But there is a risk that they will suffer later if a war breaks out and generates a supply shock and energy price shock that weigh on European and global growth. Russia will likely maintain energy production to help pay for its military adventures. The Saudis could increase production to prevent demand destruction. It is also possible that a US-Iran nuclear deal could release Iranian oil to the market. The global economy can handle gradually rising energy prices but maybe not a sharp supply shock. Oil prices are rising on signs of escalating tensions and energy sector equities are generally outperforming the broad market and other cyclical sectors. Domestically oriented small cap energy stocks are rising relative to large caps, suggesting that the market does not believe that global growth will suffer greatly from any conflict. Apparently investors do believe that US energy companies will benefit from shipping more fossil fuels abroad (Chart 5). Bottom Line: Cyclically stay long small cap energy stocks versus their large cap brethren. Chart 5US Energy Sector Just Woke Up To Ukraine Peak-To-Trough Drawdowns Amid Geopolitical Crises The peak-to-trough equity drawdown amid major geopolitical crises ranges from 11%-15%, depending on the magnitude and nature of the crisis (Chart 6). In this case, the US will not be directly involved in any war in Ukraine, but US NATO allies will be right next door and providing aid to Ukraine. For “limited incursion” scenarios we looked at over a dozen crises, from the Berlin Blockade of 1949 to the Russian invasion of Crimea in 2014. The peak-to-trough drawdown averages 10%. For an unlimited or “full-scale” invasion, we looked at the S&P500 reaction to major invasions at the dawn of World War II as well as significant wars in the twentieth century, down to the US invasion of Iraq and NATO’s intervention in Libya in 2011. The peak-to-trough equity drawdown averaged 13%. Chart 6Range Of US Equity Peak-To-Trough Drawdowns Amid Geopolitical Crisis Given that the S&P500 has fallen by 8% since its peak on January 3, 2022, investors should be prepared for more downside. Health care stocks and consumer staples are outperforming the broad market this year so far, though they are underperforming energy where the supply squeeze is happening (Chart 7). The magnitude of war and sanctions will determine whether energy ultimately falls in expectation of demand destruction. Bottom Line: It is too soon to buy the dip in the S&P 500. Stay long health stocks relative to the broad market. Chart 7Health Care And Consumer Staples Will The Fed Respond To External Risks? No. Over the past year, we have argued with investors who tried to differentiate the current bout of inflation from the inflation of the 1970s by arguing that there is no energy supply shock. We argued that an energy shock could transpire by pointing to external risks such as Russia and Iran. While the Biden administration will likely prove risk-averse, for fear that higher prices at the pump will weigh on the Democratic Party in the midterm elections, what about the Federal Reserve? During the Arab oil embargo of late 1973, and the Iranian revolution of 1979, the Federal Reserve continued to hike interest rates, responding to domestic inflation and rising bond yields. Foreign supply shocks threatened to push up inflation, so the Fed was not deterred from hiking rates (Chart 8). When the US itself engages in war, the Fed might react differently (Chart 9). Chart 8The Fed Responds to Oil Shocks by Hiking Rates But... Chart 9... US At War Could Trigger Looser Monetary Policy In 1990, the Fed cut the policy rate once after the US entered the Iraq war, then kept rates flat for a few months before cutting more at the end of the year. Bond yields were falling due to recession. In 2001, the Fed was already cutting rates due to the business cycle and the September 11 terrorist attacks reinforced that process. In 2003, the Fed cut rates after the beginning of the Iraq war and did not start hiking rates until mid-2004 when the initial phase of the war ended. The implication is that Fed Chair Alan Greenspan accommodated both the war and the 2004 presidential election. Most external risks will not prevent the Fed from hiking rates, especially during an inflation bout when the nature of the external risk may be an energy supply disruption that pushes up prices. However, while we do not doubt that the Fed could hike by 50bps in March, we doubt that the consensus of 175bps in hikes in 2022 will pan out. The combination of initial hikes, fiscal drag, and foreign growth shocks would temper the Fed’s enthusiasm. Bottom Line: Stocks face more downside risk in this environment. Bipartisanship And The Return Of Gridlock Polarization and partisanship are recovering. The Philadelphia Fed “Partisan Conflict Index” is now only 0.6% below its 2020 peaks as the midterm election approaches (Chart 10). Interestingly, one of our key views from last year – bipartisan reform – is still taking place beneath the surface. Our 2022 view of gridlock has not yet fully set in. Congress is stealthily cooperating on fiscal spending, the US Postal Service, women’s issues, public servants’ stock trading, and an attempt to revise the Electoral Count Act. Congress is also passing a bipartisan bill to make the US more economically competitive with China and impose sanctions against Russia. Chart 10Foreign And Domestic Politics Won't Stop The Fed The only area where bipartisanship is not happening is Biden’s “Build Back Better” reconciliation bill, which even lacks sufficient support from moderate Democratic senators due to high inflation. Passage is still possible in a partisan, watered-down, and deficit-neutral form. These developments show that Republican lawmakers are demonstrating some pragmatic governing ability and will use their voting records to make a case in the midterms, while pinning the blame for inflation, crime, immigration, and any foreign crises on Democrats. As such they reinforce the market consensus that Republicans are likely to take back Congress this fall. Thus while last year’s bipartisanship is spilling into the current legislative session, gridlock is rapidly approaching. When investors look to the second half of the year and beyond, they should expect to see legislative cooperation dry up, especially if Republicans only take the House and not the Senate. Bottom Line: Gridlock will freeze fiscal policy, which is non-inflationary or disinflationary for 2022-24. As such the midterm election is not fully priced. Midterm dynamics will support an overweight or at least neutral stance toward defensives and growth stocks. Investment Takeaways Tactically stay long defensives, notably health care, and growth stocks. Cyclically remain invested in the bull market – and stay long energy small caps. The chief risks to these views would be a speedy diplomatic resolution to the Ukraine and Iran conflicts or a dramatic revival of the Democratic Party’s popular support ahead of the midterm election. Diplomacy would remove risks to global growth, whereas a Democratic comeback would boost inflation expectations. Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.kuri@bcaresearch.com Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets Footnotes