Sectors
Highlights 2022 has had a rough start for equity investors: the S&P 500 is now down 8% from its peak, and NASDAQ is officially in correction territory. The question on everyone’s mind is how long this correction will last, and whether it is the right time to start buying beaten-up Tech stocks. Looking “under the hood” of the NASDAQ, we observe that with the technology space being top-heavy and dominated by the likes of Microsoft and Apple, index returns mask the heavy losses of some of the smaller, and less profitable, constituents, with many down 40-50% from their peaks. Analysis of the market breadth shows that three-quarters of NASDAQ names are trading below their one-week highs, which, according to our analysis, indicates that Tech is (almost) ripe for a bounce back. However, the sector is currently under duress from rising rates and imminent monetary tightening. Historically, Tech’s worst performance was two to three months prior to the first rate hike – the current pullback is a “textbook” behavior. It will take another couple of months after the rate hike for a sustainable rebound. In addition to headwinds from rising rates, there is also an ongoing slowdown in demand for tech products and services, which translates into a deceleration of earnings and sales growth. On the valuations front, Technology is trading with a significant premium to the market, while its expected earnings growth is on par with that of the S&P 500. We recommend investors to be patient: While Tech appears oversold, and recent volatility is a function of market panic, the stars have not yet aligned for the sector. We are tactically bearish but structurally bullish. Feature 2022 has had a rough start for equity investors: Since the beginning of January, the S&P 500 has pulled back 8%. Market consensus is that this violent rotation is a repricing of risk, triggered by the Fed’s new hawkish stance aimed at taming the runaway inflation that has surged to a nearly 40-year high. The market expects the first rate hike as soon as March, followed by three more into the year-end. It is also grappling with the timing and degree of quantitative tightening (QT), which will follow on the heels of tapering. Energy and Financials are the only sectors in the green so far this year, with Real Estate, Healthcare, and Tech being hit the hardest (Chart 1). Internet Retail is down almost 20% from its local peak in mid-2021 and Interactive Media, home of Facebook, is down 11%. NASDAQ is officially in correction territory (Chart 2). Rising rates have hit growth and interest-rate-sensitive areas of the market the hardest. While these negative returns indicate a sharp pullback, they don’t do justice to how painful this correction has been, as much of it was happening under the radar. The S&P 500 and many of its tech-related sectors and industries are top-heavy, being home to FAANG+M, which has proven to be more immune to rising rates. It is the smaller growth companies that have fallen much more than the top-line number indicates, with many down 40-50% from their peaks. However, now with more than 58% of stocks in the NASDAQ trading below their 30-week moving average, the natural question is: “Are we there yet?” or how much longer will this sell-off last? There are early signs of bottom-fishing among the stocks and industries hit hardest. Yet most days, both the S&P 500 and the NASDAQ start in the green, only to finish splattering to a new low (Chart 3). Chart 3Mega-cap Tech Has Fallen But Less Than Small-cap Brethren In this report, we will aim to gauge when the sell-off in tech names will have run its course by focusing on the S&P 500 Technology sector. Also in today’s publication, we will reverse our usual course of analysis: We will start from the technicals as they are most helpful for timing entry points, and we will follow with macro and fundamentals. Tech Sector Is Top Heavy The S&P 500 Technology sector is top-heavy, with each industry group dominated by one of the tech giants, such as Microsoft in Software and Services, Apple in Hardware and Equipment, and Nvidia in Semiconductors. We call this trio “MAN.” The MAN accounts for 50% of the S&P 500 Technology sector market capitalization (Chart 4). As a result, both sector performance and valuation are heavily affected by index composition. To unpack what is going on within the Tech sector, we plotted the dispersion of last month’s performance within the sector through a market cap bucket, with the first bucket containing the MANs. The last couple of buckets, 10 and 11, contain some of the smallest stocks in the index. Unsurprisingly, the largest stocks in the sector have not fallen that much. The correction has most affected stocks in buckets 7 through 11, with a market cap of between $8 to $33 billion, and these are the names that may be most tempting for “bottom-fishing.” Technicals It Is A Blood Bath Out There A useful indicator of market breadth, allowing us a look under the hood”, is the percentage of stocks making new lows – which currently stands at nearly 75% (Chart 5). This is a high reading which has happened only 11% of the months since 2000. However, once this metric rises above 85%, it indicates that the market is oversold. When that happens, the Tech sector outperforms the S&P 500 by around 7% over the next six months, and returns are positive every month (Chart 6). Based on this indicator, the NASDAQ in general, and Tech in particular, are close to the oversold conditions and are ready for a bounce. Chart 5Pullback In Tech Stocks Is Broad-based However, the BCA Technical Indicator for the sector (Chart 7) is still in neutral territory. It is driven primarily by momentum components: It gauges the trend in equities and determines if the market is at an extreme in terms of momentum or investor psychology. This indicator is highly affected by the performance of the largest index constituents. All in all, we conclude that from a technical standpoint, the Tech sector is getting closer to a rebound. Chart 7The Technical Indicator Is In The Neutral Territory Macroeconomic Backdrop New Rate Hiking Cycle Will Take Time Getting Used To Ok, Tech is oversold. Yet there is still the not-so-small matter of a new, tighter monetary regime. How does Tech fare in the environment of rising rates? Clearly, not so good so far. However, the question is, how long will it take for the higher rates to be priced in, and for Tech to rebound. To answer this question, we have run another empirical study, anchoring the performance of the Tech sector to the beginning of each hiking cycle since 1996 (Charts 8 and 9). According to our analysis, Tech’s worst performance is two to three months prior to the first rate hike – the current pullback in Tech is a perfect illustration. While we may expect a rebound rally “when the second shoe drops” and the Fed announces the first hike, it appears that a sustainable rally may still be a couple of months away. Based on this analysis, we conclude that it will pay off to be patient and wait until the summer. It Is The Economy, Stupid! Apart from the headwind from rising rates, there is also an ongoing slowdown in demand for Tech Business Investment (Chart 10). Moreover, the Tech New Orders Index peaked at a high level at the end of 2021 and has recently turned (Chart 11). So has Private Tech Investment (Chart 12). This indicates that demand is waning following the surge that accompanied the most recent push to digital transformation—which was accelerated by the onset of the pandemic. Chart 10Slowdown In Tech Business Investment Chart 11Tech New Orders Have Peaked Chart 12Private Tech Investment Is Also Slowing The macroeconomic backdrop is unfavorable for the Tech Sector Fundamentals Sales And Earnings Growth Are Slowing While the Tech sector enjoyed a fantastic sales recovery in 2021, with sales growth exceeding pre-pandemic levels, this year may be different. Waning demand for tech products and services translates into a sales growth slowdown (Chart 13). Chart 13The Tech Sector Sales Growth Is Slowing... Chart 14... So Is Earnings Growth With sales growth slowing, earnings growth is bound to follow (Chart 14), which is no different from the broad market. Technology sector earnings growth for the next 12 months is converging with that of the S&P 500: 10% vs. 9% respectively (Chart 15). Margins are expected to compress in 2022, albeit from the high levels (Chart 16). Chart 15Tech And The S&P 500 Expected Earnings Growth Has Converged Chart 16Margins Are Expected To Compress Of course, the Q4-2021 earnings results could bring a respite. So far blended the year-on-year earnings growth rate is 15.8%: However, only 5 companies out of 71 have reported, beating expectations by 4.6%. Will these results save the day? Possibly – expectations are a low bar to clear. Time will tell. But to prop up the sector, results from the MAN have got to be stellar. Valuations: Better But Not Good Enough While Tech earnings are expected to grow in line with the S&P 500, the sector is trading with a 28% premium to the market at 27x vs. 21x forward PE (Table 1). Relative PE NTM currently stands at 1.7 standard deviations above the five-year average. Although this may seem high, the froth has come off as, only two months ago, Tech was trading at 2.4 standard deviations. This is a significant change, but the sector is not yet cheap enough for bargain hunting. Adjusting for the growth rate differential between Tech and the S&P 500, we divide PE NTM over EPS Growth NTM, to arrive at PEG: Even so, Tech is still more expensive trading at 2.7 for a percentage of future growth, compared to 2.3 for the S&P 500. However, Tech is a growth sector, and perhaps by looking at only one-year-ahead earnings growth, we are being myopic. Let’s take a look at longer-term growth expectations. Curiously, over the next five years, Tech earnings are expected to grow at about an 18% annualized rate, while the S&P 500 is expected to grow at 21% (Chart 17). As a result, the PE/Long-Term Earnings Growth Rate for Tech is 1.5 vs. 1.0 for the S&P 500. Table 1Tech Valuation Premium Is Still Too High Chart 17Long-term Earnings Growth Does Not Justify Valuation Premium Either Of course, we need to keep in mind that since this sector is so top-heavy, the forward PE of the MAN affects overall sector valuations. As you can see in the table below (Table 2), MAN is trading with a premium to the sector. However, within the sector, companies with sky-high valuations are easier to find among smaller constituents (Chart 18). Valuations are elevated, while fundamentals are deteriorating Table 2The Largest Tech Companies Are Trading With A Premium To The Sector Investment Implications While it is tempting to add to Technology on the back of this pullback, we recommend caution. Tech is oversold and recent volatility is a function of market panic, yet the stars have not yet aligned for the sector. Historically, Tech has delivered negative returns several months prior to rate hikes and underperformed the broad market. Economic normalization also brings a slowdown in demand for tech goods and services, which translates into less exciting sales and earnings growth, and margin compression. Although some froth has come off, valuations for the sector remain elevated, and the premium over the S&P 500 is not justified. The scorecard summarizes each of these points, and it is clear that, on balance, the sector has quite a few challenges ahead (Table 3). Table 3Technology Sector Scorecard On a more optimistic note, this sell-off has been fast and furious, and the worst is most likely behind. We are underweight the Technology sector. Within the sector, we are underweight Semiconductors, and Hardware and Equipment. We are still overweight Software and Services for portfolio diversification purposes. The Software sector will be one of our next “deep dives.” Stay tuned. Are we there yet? No, we still have a few months to go. Structural Positioning While we reiterate our tactical underweighting of the Tech sector, we are bullish on it over the longer investment horizon. This sector is at the heart of US technological innovation, such as cloud computing, artificial intelligence, cybersecurity, chip design that powers EV and AV, and many others. The sector is home to some of the best American companies, which have powered US equities throughout the past decade, and will continue to do so for decades ahead. Bottom Line Despite a sell-off of NASDAQ and the Technology sector, we are not yet recommending increasing cyclical allocation to Tech: While technicals appear attractive, tighter monetary policy, the slowdown in demand for tech goods and services, pressures on profitability, and elevated valuations remain headwinds. We reiterate our underweight to the Technology sector on a tactical basis. We are structurally bullish. Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com Recommended Allocation
US defense stocks have been on a tear of late (outperforming SPX by 10% since late November), benefiting from both macro and geopolitical trends. From a macro standpoint, the Defense industry has been neglected by investors for a while, and now trades at 15.4x forward earnings, with a 27% discount to S&P 500. As a “value” industry, it is likely to outperform in the environment of rising rates. On a geopolitical front, there is a secular rise in geopolitical risks due to a great power rivalry, hypo-globalization, and rising nationalism across the globe. The recent rise in commodity prices also means that countries will get back to active competition over resources and territory, in the Middle East, the South China Sea, the Mediterranean, Central Asia. As such, the US refocusing on great power competition means Democrats and Republicans both support larger defense budgets, and Biden’s Congress already confirmed this with a large 2021 defense spending bill ($780bn, an increase of 5% from the peak during Trump’s presidency). China is increasing defense spending for the same reason, attempting to carve out a sphere of influence in East Asia, secure supply chains, and deter America in the event of a conflict in China’s neighborhood such as over Taiwan. There is also a rise in defense spending among other emerging powers, such as India, which is coming into its own as a geopolitical force and expanding its military to meet the China challenge as well as the ongoing Pakistan threat. The US allied states, that were formerly dovish, such as Germany and Japan, are also ramping up their defense spending. Bottom Line: Changing world order will inevitably bring a military buildup between major powers benefiting US defense stocks on a secular basis. The US defense industry is represented by the following companies: LMT, NOC, GD, LHX, AXON, HII.
Highlights The bond market assumes that when recent inflation has been high, it will be higher than average for the next ten years. Yet the reality is the exact opposite. High inflation is followed by lower than average inflation. This means that the ex-post real yield delivered by 10-year T-bonds will turn out to be much higher than the negative ex-ante real yield that 10-year Treasury Inflation Protected Securities (TIPS) are now offering. Long-term investors should overweight 10-year T-bonds versus 10-year TIPS. Underweight (or outright short) US TIPS. Underweight commodities, and especially underweight those commodities that have not yet corrected. Fractal trading watchlist: the US dollar, alternative energy, biotech, nickel versus silver, and an update on semiconductors. Feature Chart of the WeekThe Real Yield Turns Out To Be Higher Than Expected Real interest rates are negative. Or are they? Given that real interest rates form the foundation of most asset prices, getting this question right is of paramount importance. Over the short term, yes, real interest rates are negative. Policy interest rates in the major developed economies are unlikely to rise quickly from their current near-zero levels. So, they will remain below the rate of inflation. But what about over the longer term, say ten years – are long-term real interest rates truly negative? The Real Bond Yield Is The Mirror Image Of Backward-Looking Inflation The negative US real 10-year bond yield of -0.7 percent comprises the nominal yield of 1.8 percent minus an expected inflation rate of 2.5 percent. This means that the negativity of the real bond yield hinges on the expectation for inflation over the next ten years. Therein lies the big problem. Many people believe that the bond market’s expected 10-year inflation rate is an independent and forward-looking assessment of how inflation will evolve. Yet nothing could be further from the truth. The bond market’s expected inflation is just the result of an algorithm that uses historic inflation. And at that, an extremely short period of historic inflation, just six months.1 The bond market’s expected inflation is just the result of an algorithm that uses historic inflation. Specifically, in the pandemic era, the bond market has derived its expected 10-year inflation rate from the historic six month (annualized) inflation rate, which it assumes will gradually converge to a long-term rate of just below 2 percent during the first four years, then stay there for the remaining six years2 (Figure I-1). We recommend that readers replicate this simple calculation for themselves to shatter any illusion that there is anything forward-looking about the bond market’s inflation expectation! (Chart I-2). Chart I-2Expected 10-Year Inflation Is Just Based On The Last 6 Months Of Inflation! The upshot is that when the backward-looking six month inflation rate is low, like it was in the depths of the global financial crisis in late 2008 or the pandemic recession in early 2020, the market assumes that the forward-looking ten year inflation rate will be low. And when the backward-looking six-month inflation rate is high, like now or in early-2008, the bond market assumes that the forward-looking ten year inflation rate will be high. In other words, the bond market extrapolates the last six months of inflation into the next ten years. This observation leads to an immediate investment conclusion. The US six-month inflation rate has already peaked. As it cools, it will also cool the expected 10-year inflation rate, thereby putting upward pressure on the mirror image Treasury Inflation Protected Securities (TIPS) real yield. It follows that investors should underweight (or outright short) US 10-year TIPS (Chart I-3). Chart I-3As Inflation Cools, TIPS Will Underperform The Real Bond Yield Is Based On A False Expectation There is a more fundamental issue at stake. The market assumes that when recent inflation has been low, it will be lower than average for the next ten years. And when recent inflation has been high, it will be higher than average for the next ten years. Yet the reality is the exact opposite. Low inflation is followed by higher than average inflation, and high inflation is followed by lower than average inflation. The price level is lower than the 2012 expectation of where it would stand in 2022! Another way of putting this is that the market assumes that any breakout of the consumer price index (CPI) will be amplified over the following ten years (Chart I-4). Yet the reality is that any breakout of the price level tends to trend-revert over the following ten years. This means that after the CPI’s decline in late 2008, the market massively underestimated where the price level would be ten years later. But earlier in 2008, when the CPI had surged, the market massively overestimated where the price level would be ten years later. Chart I-4The Market Exaggerates Any Deviations In The CPI Into The Distant Future Today in 2022, the price level seems to be uncomfortably high. But the remarkable thing is that it is still lower than the 2012 expectation of where it would stand in 2022! (Chart I-5). Chart I-5The Market Overestimates Where The Price Level Will Stand 10 Years Ahead The crucial point is that after surges in the price level, realised 10-year inflation turns out to be at least 1 percent lower than the bond market’s expectation (Chart I-6). This means that the ex-post real yield delivered by 10-year T-bonds turns out to be at least 1 percent higher than the ex-ante real yield that 10-year TIPS offered at the start of the ten year period (Chart of the Week). Chart I-6Actual Inflation Turns Out To Be Lower Than Expected It follows that after the current surge in the price level, the (actual) real yield that will be delivered by 10-year T-bonds over the next ten years will not be the -0.7 percent indicated by the TIPS 10-year real yield. Instead, if history is any guide, it will be at least +0.3 percent. Therefore, in answer to our original question, the real long-term interest rate is almost certainly not negative. Of course, the obvious comeback is that ‘this time is different’. But we really wouldn’t bet the farm on it. Many people thought this time is different during the price level surge in early 2008 as well as the lows in late 2008 and early 2020. But those times were not different. And our bet is that this time isn’t any different either. This means that the real yield on T-bonds will turn out to be much higher than that on TIPS. Long-term investors should overweight T-bonds versus TIPS. Commodities Are Vulnerable A final important observation relates to commodities. Commodity prices have been tightly tracking the 6-month inflation rate, but which way does the causality run in this tight relationship? At first glance, it might seem that the causality runs from commodity prices to the inflation rate. Yet on further consideration, this cannot be right. It is not the commodity price level that drives the overall inflation rate, it is the commodity inflation rate that drives the overall inflation rate. And in the past year, overall inflation has decoupled (upwards) from commodity inflation (Chart I-7 and Chart I-8). Chart I-7Inflation Is Tracking ##br##Commodity Prices... Chart I-8...But Inflation Should Be Tracking Commodity Inflation Therefore, the causality in the tight relationship between the 6-month inflation rate and commodity prices must run from backward-looking inflation to commodity prices. And the likely explanation is that investors are bidding up commodity prices as a hedge against the backward-looking inflation which they are incorrectly extrapolating into the future. Low inflation is followed by higher than average inflation, and high inflation is followed by lower than average inflation. It follows that as 6-month inflation cools, so will commodity prices. The investment conclusion is to underweight commodities, and especially to underweight those commodities that have not yet corrected. Fractal Trading Watchlist This week’s observations relate to the US dollar, alternative energy, biotech, nickel versus silver, and an update on semiconductors. The US dollar reached a point of fragility in early December, from which it experienced a classic short-term countertrend sell-off. As such, the countertrend sell-off is mostly done. Alternative energy versus old energy is approaching a major buying point. Biotech versus the market is very close to a major buying point. Nickel versus silver is very close to a major selling point. Semiconductors versus technology was on our sell watchlist last week, and has now hit its point of maximum fragility (Chart I-9). Therefore, the recommended trade is to short semiconductors versus broad technology, setting a profit target and symmetrical stop-loss at 6 percent. Chart 9Semiconductors Are Due A Reversal Fractal Trading Watchlist Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The expected 10-year inflation rate = (deviation of 6-month annualized inflation from 1.6)*0.2 + 1.6. 2 Inflation is based on the PCE deflator. 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
Highlights We reformatted and added three sections to our existing trade tables: strategic themes, cyclical asset allocations and tactical investment recommendations. An extensive audit of our current trade book shows that our country and sector allocation recommendations have been successful. Of the eight open trades in our book, six have so far generated positive returns. We now recommend closing three out of the eight positions, based on a review of the original basis and subsequent performance of our trades. We have also added one cyclical and two tactical trades. We will look for opportunities to propose new trades to our book in the coming months. Feature In this week's report, we introduce our newly formatted trade tables (on Page 15), which include the following: Strategic themes (structural views beyond 18 months) Cyclical asset allocations within Chinese financial markets (in the next 6 to 18 months) Tactical trades (investment recommendations for the next 0 to 6 months) We revisited the original basis and subsequent performance of our open trades as part of an audit of our trade book. We maintain five of the eight trades and will add one cyclical and two tactical trades. Our new features and the rationale for retaining or closing each trade are presented below. Strategic Themes The new Strategic Themes section now includes the following market relevant structural forces: President Xi Jinping’s “common prosperity” policy initiative, which is intended to narrow the nation’s wealth gap; a demographic shift of a shrinking population by 2025; and secular disputes between the US and China (Table 1). Table 1 These structural aspects will have a macro impact on China’s policy landscape, economy and financial markets. Investors should consider whether the themes point toward a reflationary policy bias; whether they will have a medium- to long-term effect on corporate earnings; and whether these themes will, on a structural basis, warrant higher/lower risk premiums for owning Chinese stocks. Cyclical Equity Index Allocation Recommendations (Relative To MSCI All Country World) Table 2 is a summary of our cyclical recommendations for Greater China equity indexes. We recommend the following equity index allocations within a global equity portfolio, for the next 6 to 18 months: Table 2 Underweight MSCI China (Chinese investable stocks). Underweight MSCI China A Onshore (Chinese onshore or A-share stocks). Neutral stance on MSCI Hong Kong Index. Overweight MSCI Taiwan Index. Chart 1Chinese Stocks Substantially Underperformed Global Equities Our recommendation to underweight MSCI China Index and MSCI China A Onshore Index were extremely successful in 2021 (Chart 1). We will continue to maintain an underweight stance for the time being, based on our concern that the current policy easing measures will be insufficient to revive China’s slowing economy. We expect policy stimulus to step up in the coming months and economic growth to start improving by mid-2022. However, corporate profits are set to disappoint in the first half of the year. This implies that Chinese share prices will remain volatile with substantial downside risks. Chinese investable stocks are in oversold territory and will likely rebound in the near term in both absolute and relative terms (discussed in the Tactical Recommendations section on Page 14) (Chart 2). Nonetheless, on a cyclical basis, they face challenges both from the impact of a slowing economy on earnings growth and ongoing regulatory and geopolitical risks. Our model suggests high odds (70%) of a considerable earnings contraction in Chinese investable stocks in the next 6 to 12 months. We recommend investors upgrade their allocation to the MSCI Hong Kong Index from underweight to neutral within a global equity portfolio. The MSCI Hong Kong equity index appears to be very cheap compared with global equities (Chart 3). Chart 2Chinese Investable Stocks Are Oversold Chart 3MSCI HK Equities Are Cheap The MSCI Hong Kong equity index includes Hong Kong-domiciled companies and not mainland issuers listed in Hong Kong. Rising US Treasury yields will be a headwind to Hong Kong-domiciled company stock performance because the HKD is pegged to the USD and therefore Hong Kong bond yields tend to follow the direction of bond yields in the US. Chart 4MSCI HK Index Is Defensive In Nature However, an offsetting factor is that due to composition changes over time, the MSCI Hong Kong equity index has become much more defensive and tends to perform better than the emerging Asian and EM equity benchmarks during turbulent times (Chart 4). The weight of insurance companies and diversified financials account for over 40% of the MSCI Hong Kong Index, compared with property stocks, which take up 20% of the equity market cap. The insurance and diversified financials subsectors are less vulnerable to escalating short-term interest rates compared with property stocks. During risk-off phases, the defensive nature in the MSCI Hong Kong Index will support its performance relative to the some of the more industrial- and tech-heavy EM and global equity indexes. We maintain an overweight stance on the MSCI Taiwan Index relative to global equities. The trade (see discussion in the Cyclical Equity And Sector Trades section) has brought an impressive 40% rate of return since its inception in 2019. Cyclical Recommended Asset Allocation (Within Chinese Onshore Assets) We recommend an underweight position in equities in China’s onshore multi-asset portfolios (Table 3). Chinese onshore stocks are not cheap and will likely underperform onshore government bonds as the economy struggles to regain its footing. Chart 5Total Returns In Chinese Onshore Stocks Have Barely Kept Up With Onshore GB Chart 5 shows that in the past decade total returns in Chinese onshore stocks have barely kept up with that in onshore long-duration government bonds. During policy easing cycles Chinese onshore stocks generated positive excess returns over government bonds, however, the outperformance has been extremely volatile and very brief. Given that we do not expect Beijing to allow a significant overshoot in stimulus this year, there is a good chance that the returns in Chinese onshore stocks will underperform onshore government bonds. Cyclical Equity And Sector Trades Our rationale for retaining or closing each trade is described below. Chart 6Chinese Onshore Stocks Outperformance Has Been Passive Long China A-Shares/Short Chinese Investable Stocks (Maintain) We initiated this trade in March 2021. The recommendation has been our most successful trade, generating a 40+% return since then (Chart 6). China’s internet platform giants have a large weight in the MSCI Investable index and they remain vulnerable (Chart 7). Although China’s antitrust regulations may have passed the peak of intensity, they will not be rolled back and multiple compression in these stocks will likely continue in 2022. In contrast, the A-share index is heavily weighted in value stocks. The trade is in line with our view that the global investment backdrop has shifted in favor of global value versus growth stocks due to an above-trend US expansion and climbing US bond yields in the next 6 to 12 months. The relative ratio between China A-shares and investable stocks is overbought and will likely pull back in the near term (Chart 8). However, the cyclical and structural outlook continues to favor onshore stocks versus the investable universe. Chart 7Sizable Underperformance In Investable Consumer Discretionary Stocks Chart 8A Near-Term Pullback In Relative Ratio Is Likely Long CSI500/Short Broad A-Share Market (Maintain) The CSI500 index, which comprises 500 SMID-cap companies, has outperformed the broad A-share market by 32% since mid-February (Chart 9). We think the outperformance in SMID stocks has not fully run its course. Historically, SMID-caps tend to outperform large caps in the late phase of an economic recovery and the valuation premia in small cap stocks remains near decade lows (Chart 10). In addition, the government’s increasing efforts to support small- and medium-sized corporates will help to shore up confidence in those companies. Therefore, SMID will probably continue to outperform large cap stocks this year. Chart 9A Low Valuation Premia And More Policy Support Will Help Lift Prices Of SMID-Caps Chart 10SMID-Caps Tend To Outperform Large-Caps In Late Business Cycle Long MSCI Taiwan Index/Short MSCI All Country World (Maintain) The MSCI Taiwan equity index has consistently outperformed global equities since mid-2019, mostly driven by the rally in Taiwanese semiconductor stocks. Global chip supply shortages since the COVID pandemic have further boosted the sector’s outperformance (Chart 11). Furthermore, Chart 12 highlights improvements in the cyclical case for Taiwanese stocks as an aggregate. Panels 1 & 2 show an uptick in the new export orders component of Taiwanese manufacturing PMI. The new export orders component has historically coincided with both Taiwanese exports to China and the relative Taiwanese manufacturing PMI on a cyclical basis. As such, the economic fundamentals also support a continued outperformance in Taiwanese stocks. Chart 11A Great Run In MSCI Taiwan Equity Index And Semis Chart 12Exports To China, 12-Month Forward EPS, And Relative Stock Prices: All Likely To Improve Long Chinese Onshore Industrial Stocks/Short MSCI China A Index (Maintain) This trade, initiated in September last year, has brought a slightly positive return as of today. Our view was based on improving manufacturing investment and policy support for the sector, even though China’s business cycle had already peaked. Chart 13China Onshore Industrials Closely Track Economic Fundamentals While we maintain the trade for now, we will monitor credit growth in Q1 to assess whether to close the trade. The sector’s performance is highly correlated with our BCA China Activity Index and the Li Keqiang Leading Indicator (Chart 13). A bottoming in both indicators in mid-2022 would suggest that investors should maintain the trade. The caveat, however, is that the sector’s valuations have already become extreme, indicating that the bar may be higher for the sector to outperform even when economic fundamentals improve in 2H22. We will watch for signs of an overshoot in stimulus in the coming three to six months. Conversely, credit growth in Q1 that is at or below expectations will warrant closing this trade. Long Domestic Semiconductor Sector/Short Global Semiconductor Benchmark (Close) Replace with: Long Domestic Semiconductor Sector/Short MSCI China A Onshore The trade has been our biggest loser since its inception in August 2020. Although Chinese onshore semiconductor stocks outperformed the broad A-share market by a large margin, they have underperformed their global peers (Chart 14). Thus, we are closing the trade and replacing it with long Chinese onshore semis relative to the broad A-share market. We remain bullish on Chinese semi stocks, on both a structural and cyclical basis. Secular pressures from the US and the West to curb the advancement of Chinese technology will encourage China’s authorities to double down on supporting state-led technology programs. Moreover, prices of Chinese onshore semis have plummeted since November last year, bringing their lofty valuations closer to long-term trend and providing a better cyclical risk-reward profiles for these stocks (Chart 15). Chart 14Chinese Onshore Semis Underperformed Global... Chart 15...But Outperformed Domestic Broad Market Long Domestic Consumer Discretionary/Short Broad A-Share Market (Close) Chart 16A Trend Reversal In Chinese Onshore Consumer Discretionary Stocks Performance We placed the trade in May 2020 when China’s economy and household discretionary consumption showed a strong rebound from the deep slump in Q1 2020. As strength waned in the country’s domestic demand for housing, housing-related durable goods and automobiles, the sector’s relative performance also started to dwindle from its peak in the fall of last year (Chart 16). Going forward, even though China’s economy will start to improve on a cyclical basis, domestic consumer discretionary sector will face non-trivial headwinds. The performance of its subsectors, such as hotels, restaurants, and services, will remain subdued due to China’s zero tolerance COVID policy that leads to frequent lockdowns and travel restrictions (Chart 17). Moreover, the internet and direct-marketing retail subsectors are facing tighter regulations, which lowers the sector’s profitability and valuations (Chart 18). Chart 17Domestic COVID Flareups Pose Significant Threat To Chinese Consumer Services Sector Performance Chart 18Online Retailing Also Faces Regylatory Pressures Short Hong Kong 10-Year Government Bond/Long US 10-Year Treasury (Maintain) In the past decade, Hong Kong's 10-year government bond yield has been consistently below that of the US, even though Hong Kong has an exchange rate pegged to the US dollar and its monetary policy is directly tied to that of the US. Chart 19The US-HK Yield Gap Should Widen In The Coming Months The US-Hong Kong 10-year yield spread has substantially narrowed since early 2020 when the US Fed aggressively cut its policy rate. In the coming 6-12 months, however, the spread will likely widen given that the Fed will start to normalize rates (Chart 19, top panel). Chart 19 (bottom panel) highlights that the relative total return profile of the trade (in unhedged terms) trends higher over time due to the carry advantage. Although cyclically the relative total return will likely reverse to its trend line and argues for a short stance on US Treasury, we think it is too early to close the trade. The USD will likely remain strong in the near term, and we have yet to turn positive on Chinese and Hong Kong assets over a 6 to 18-mont time horizon. Therefore, we maintain this trade until the USD starts to weaken, and foreign investment flows into China and Hong Kong shows sustainable momentum. Long USD-CNH (Close) We are closing this trade, which we initiated in May 2020 when tensions between the US and China were rising. The trade has lost more than 10% since its inception because the RMB exchange rate was boosted in 2021 by China’s record current account surplus, wide interest rate differentials and speculation that tension between the US and China would abate. Chart 20A Weaker USD Will Prevent Sizable RMB Depreciation We expect all three favorable conditions supporting the RMB to start reversing in 1H22, suggesting downward pressure on the RMB. However, over a longer period of 6 to 18 months the US dollar also has the potential to trend lower, preventing the RMB from any sizable depreciation (Chart 20). The dollar strength in the past year has been the result of both speculative flows into the US dollar based on rising interest rate expectations and portfolio inflows into the US equity markets. In the next 6 to 18 months, however, our Foreign Exchange Strategist Chester Ntonifor predicts that the dollar could begin a paradigm shift, whereby any actions by the Fed could eventually lead to a weakening of the US dollar. Higher rates than the market expects will initially boost the US dollar, but will also undermine the US equity market leadership, reversing the substantial portfolio inflows from recent years. On the flip side, fewer rate hikes will severely unwind higher rate expectations in the US relative to other developed markets. Chester further predicts that the DXY could touch 98 in the near term but will break below 90 in the next 12-18 months. Tactical Recommendations (0-6 months) We are initiating two tactical trades to go long on the MSCI China Index and MSCI Hong Kong Index relative to global equities. Relative to global stocks, Chinese investable equities are very oversold and offer value. In addition, while US tech stocks are entering a rollercoaster phase due to higher bond yields in the US, Chinese tech stocks will also fall but by a lesser degree because China’s monetary policy cycle is less affected by the Fed’s policy decisions. In other words, Chinese investable stocks may passively outperform global equities. Nonetheless, as noted in our previous reports, Chinese investable stocks face both cyclical and structural challenges. Hence the overweight stance on these stocks is strictly a tactical play rather than a cyclical one. We favor the MSCI Hong Kong Index versus global equities for similar reasons as Chinese investable stocks. The Hong Kong equity index is also technically oversold. Since the composition of the index has become more defensive, it will likely outperform in risk-off phases. In addition, if the US dollar rallies in the near term, share prices of Hong Kong-domiciled companies will materially outperform. Jing Sima China Strategist jings@bcaresearch.com Strategic View Cyclical Recommendations Tactical Recommendations
Dear Client, Next week there will be no regular strategy report. Instead, we will hold our quarterly webcast which will discuss the outlook for the European economy and assets in 2022. I look forward to this interaction. Best regards, Mathieu Savary Highlights European and global yields have considerable upside over the coming year, even if inflation peaks in 2022. The post-World War II experience is instructive: massive war-time fiscal and monetary stimulus allowed for an upward re-estimation of the neutral rate as trend nominal growth improved. A similar development is likely to result in an improvement in nominal growth and the neutral rate compared to the post-GFC decade. China and a financial accident outside the US constitute the greatest risks this year to higher yields. European stocks and value stocks will benefit from this rise in yields. Cyclicals in general and industrials in particular are the European sectors most levered to higher yields. Overweight these assets. Defensives will underperform meaningfully if yields rise further. Long Sweden and the Netherlands / Short Switzerland is an appealing trade to bet on higher yields, especially if inflation peaks in 2022. Feature Last week, US Treasury yields finally reached levels that prevailed before the pandemic started. In Europe, German 10-year yields flirted with the symbolic 0% level, rising to their highest reading since May 2019. With the Fed preparing to increase interest rates in March, and global inflation remaining perky, do yields already reflect all the bearish bond news or will they continue to climb higher on a cyclical basis? Moreover, what would be the implications for equity prices of higher yields? BCA expects yields to rise further, for which German Bunds will not be an exception. This process will continue to generate volatility in stock prices, but ultimately, higher equities will prevail. Increasing yields will help European stocks and are strongly associated with an outperformance of cyclical equities. What’s Moving Yields Up? Not all yield increases are created equal. A breakdown of yields helps us understand what investors are pricing in for the future. In the US, the upside in 10-year yields mostly reflects the increase in 5-year yields. This maturity has moved back to levels that prevailed prior to the pandemic, while the 5-year/5-year forward yield remains below its spring 2021 peak (Chart 1, top panel). Moreover, these shifts mirror higher real interest rates, which are rising across maturities, while inflation expectations have been declining in recent weeks or have been flat since mid-2021 on a 5-year/5-year forward basis (Chart 1, middle and bottom panels). This breakdown confirms investors are driving yields higher because they expect more Fed tightening. However, this upgraded view of the Fed’s policy path is limited to the next few years, and long-term policy expectations approximated by the forward rates are not rising as much. In other words, markets do not expect that the Fed will be able to push up interest rates on a long-term basis. In Germany, the breakdown of the most recent shift in yield paints a different picture (Chart 2). As in the US, real yields, not inflation expectations, drove the latest bond selloff. This points toward pricing in an eventual policy tightening in Europe. However, unlike what is happening in the US, 5-year/5-year forward rates are the main force driving yields higher; investors are therefore expecting the ECB to have to follow the Fed later on. Chart 1Near-Term Tightening Is Driving Treasurys Chart 2longer-Term Tightening Is Driving Bunds Can the Yield Upside Continue? While BCA’s target for the 10-year Treasury yield in 2022 stands at 2.25% and the Bund yield at 0.25%, the coming two to three years should witness significantly higher yields. The period after World War II offers an interesting historical equivalent. During the War, government spending as a share of GDP exploded, lifting US gross federal debt from 52% of GDP at the dawn of the conflict to 114% at the end of 1945. However, the Fed kept a lid on interest rates during this period to help finance the war effort. T-Bill rates were pegged at 3/8th of a percent and the Fed also capped T-Bond yields at 2.5%. Chart 3The Post WWII Experience As a consequence of this policy effort, the Fed balance sheet increased significantly and continued to do so after the war (Chart 3). The stimulative fiscal and monetary policy, as well as the capacity constraints associated with shifting production from military goods to consumer and capital goods, contributed to an inflation spike to 20% in March 1947. Moreover, the Korean War boosted government spending between 1950 and 1953, resulting in another inflation spike to 9.5% in 1951. The Fed’s cap on yields ended after the March 1951 Treasury-Fed Accord. It was followed by the beginning of a multi-decade uptrend in bond yields, which culminated in 1981 with T-Bond yields above 15% following the inflationary surge of the 1970s. Nonetheless, the yield increase from 2.5% in 1951 to 4% at the end of the 1950s happened after the inflation peak of the Korean War. This original inflection reflected economic vigor and a normalization of the neutral rate after the trauma of the Great Depression. The current situation is not dissimilar. The neutral rate and the market-based estimates of the terminal rate of interest are still very low in the US and in Europe (Chart 4). However, the vast amount of monetary and fiscal stimulus injected in the economy has jolted a recovery. It has also caused a massive wealth transfer to households and the private sector in general that is likely to increase consumption permanently. As a result, growth in the coming decade will be stronger than it was in the past decade, in both the US and Europe. This process will allow the neutral rate to rise over time, which in turn will lift the terminal rate of interest and yields. In this context, even if inflation were to cool in 2022 because some of the supply constraints that marked 2021 dissipate, yields may continue to rise and do so for the remainder of the decade. This is also true in Europe where the household savings rate still towers near 19% of disposable income and may fall by 6% to reach its pre-pandemic levels, as the US experience presages (Chart 5). Chart 4Terminal Rates Proxies Are Too Low Chart 5European Savings Rate Has Downside A simple modeling exercise confirms that yields will have greater upside over the coming year. Conceptually, yields are anchored by policy rates and the terminal rate, which is somewhere above the neutral rate of interest. One of the key determinants of the nominal neutral rate is the trend growth rate of nominal GDP. While the market cannot know precisely where that growth rate stands, recent experience influences the perception of market participants. Thus, a long-term moving average of nominal GDP growth constitutes a rough proxy of this measure and will relate to investors’ assessment of the neutral rate and the terminal interest rates. Chart 6Bond Yields Are Too Low, Especially If Trend Nominal Growth Picks Up Using this approach reveals two important bearish forces for bonds. Even after accounting for the slow growth rate of both the US and Eurozone economies over the past ten years, as well as extraordinarily low policy rates, T-Notes and Bunds yields are too low (Chart 6). More importantly, if nominal GDP growth is higher this decade than next, this alone will push up the equilibrium level of yields in Advanced Economies. The upside in yields is not without risks. China is still going through a deflationary shock whereby growth is slowing. As China eases policy, Chinese yields will continue to fall, bucking the global trend (Chart 7). In recent years, Chinese yields have rarely diverged from global yields. If Chinese growth plummets from here, the divergence will not be resolved via higher Chinese yields. However, Chinese authorities do not want growth to collapse. Reports from the State Council suggest an acceleration of the implementation of major spending projects under the 14th Five-year plan and that the credit impulse is trying to bottom. Nonetheless, China remains a risk to monitor closely. The second major risk stems from the intertwined nature of the global financial system. The US economy is able to withstand higher Treasury yields, but is the rest of the world? As Chart 8 highlights, US private debt-servicing costs are low today, as a result of minimal interest rates and the decline in debt loads after the GFC. The same is not true for the G-10 outside the US, let alone EM economies. These differences suggest that the US will be much more resilient to rising yields than the rest of the world. A major financial accident outside the US would prompt a wave of risk aversion that would decrease yields around the world. Chart 7An Unusual Divergence Chart 8Will The Rest Of The World Withstand Higher US Yields? Bottom Line: Global yields have much greater upside for the years ahead, even if inflation slows in 2022. While BCA targets 2.25% and 0.25% for, respectively, Treasurys and Bund yields this year, the multi-year upside is much greater as neutral rates are re-adjusted upward. The change will not move in a straight line, but the trend will not be friendly for bondholders. In the near-term, the main culprits preventing higher yields are a further slowdown in China as well as a financial accident outside the US. Investment Implications The most obvious investment implication is that investors should use any pullback in yields to sell duration. As a corollary, investors should maintain an overweight stance on equities relative to bonds. The equity risk premium, especially in Europe, remains elevated, and European dividend yields stand near record highs compared to Bund yields (Chart 9). Moreover, when yields rise because of a higher neutral rate, this also means that the expected long-term growth rate of earnings is firming, which negates some of the adverse impacts on valuations of higher discount rates. Nonetheless, if inflation does not stabilize, the increase in yields could become much more painful for stocks, as the negative correlation between stock prices and bond yields would reassert itself—a possibility we described five weeks ago. A rising neutral rate and terminal rate are also associated with an outperformance of European stocks compared to the US and an outperformance of value stocks over growth stocks in Europe (Chart 10). These relationships reflect the greater procyclicality of European equities and value stocks. Chart 9A Valuation Cushion For Stocks Chart 10Higher Terminal Rates Favor Europe And Value Finally, we looked at the performance of European sectors based on the trend in yields. Table 1 highlights that industrials are the great winner when yields rise, which is a testament to their pro-cyclicality. They beat the market on 3-month, 6-month and 12-month horizons by 1.6%, 2.9% and 5.8%, respectively. The regularity of their benchmark-beating performance is extremely high. When yields rise, financials also see a marked improvement of their relative returns compared to their historical average returns. Surprisingly, so do European tech firms, which reflect the more hardware focus of European tech compared to the US. Table 1Rising Yields & Sector Relative Performance Table 2 repeats the same exercise, but, this time, we control for the slope of the yield curve, focusing on periods when the yield curve is positively sloped. Again, industrials are the star sector, but other cyclicals such as materials and consumer discretionary also stand out. European tech remains dominated by its cyclical properties, while the outperformance of financials becomes more marked. Table 2Rising Yields & Sector Relative Performance With Postive Yield Curve Slope As A Control Variable Table 3 looks at the behavior of sectors when yields rise and when the Euro Area PMI Manufacturing improves, which is a scenario we expect for most of 2022 once the winter passes. Industrials win more clearly than materials or consumer discretionary. The European tech sector continues to generate a very strong outperformance, while the excess return of financials firms up as well. This scenario also shows a particularly steep underperformance for all the defensive sectors. Table 3Rising Yields & Sector Relative Performance With Improving Manufacturing PMI As A Control Variable Table 4 completes the picture, focusing on rising yields when core CPI decelerates, another development we foresee in 2022. Once again, industrials stand out as a result of the extent and regularity of their outperformance. However, under this controlling variable, the performance of materials and consumer discretionary stocks deteriorates significantly. Financials also see a large downgrade to their relative performance. Tech performs best under these circumstances. Here, staples suffer the worst fate, closely followed by utilities and healthcare. Table 4Rising Yields & Sector Relative Performance With Falling Core CPI As A Control Variable Based on these observations, the highest likelihood scenario is that European cyclicals will outperform defensive equities significantly this year after a period of consolidation since last spring. A more targeted approach would be to overweight industrials and tech at the expense of staples and utilities. Geographically, investors should buy a basket of Swedish (overweight industrials) and Dutch stocks (overweight tech), while selling Swiss stocks (overweight healthcare). Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance
Underweight In the recent Semiconductors: Aren’t They Fab report, we have downgraded the S&P Semis & Semi Equipment index from overweight to neutral on a cyclical basis (3-6 months) on the back of tightening financial conditions that will weigh on the performance of this hypersensitive cyclical industry. So far, the rise in global bond yields has not been fully priced in and remains a headwind (see chart, top panel). Further, semis also face deceleration in manufacturing activity: The ISM New Orders/Inventories ratio has turned sharply down. Historically, it has been a leading indicator for the Global Semiconductor sales, and the relative performance of the industry index (see chart, middle & bottom panels). Last, the sector commands a higher multiple than the S&P 500, while its growth expectations are in line with the market: This suggests that the valuation premium is hardly justified, and there isn’t a valuation cushion to absorb the blow from the global economic slowdown. The combination of these three factors compels us to downgrade semis to underweight. Bottom Line: Today we downgrade the S&P semis & semi equipment index from neutral to underweight. As a reminder, we have recently booked 14% in gains after closing our long semis recommendation (we were overweight Semis from July to December 2021).
Highlights This week we highlight key charts for US Political Strategy themes and views in the New Year. For H1 2022, we maintain a pro-cyclical, risk-on approach. We favor industrials, energy, infrastructure, and cyclicals. Foreign supply kinks will persist due to Omicron. The US Congress will pass one more spending bill as Democrats try to save their skin ahead of the midterm election. Yet other trends are not so inflationary: Fed rate hikes, an 8% of GDP fiscal drag, and a looming return to congressional gridlock. Midterm elections usually see defensive and growth stocks outperform cyclical and value stocks. This is a risk to our view and may require adjustments later this year. Feature This week we offer our updated US Political Strategy chart pack for the new year. Inflation and stagflation are the top concerns. But the Federal Reserve is kicking into gear, with the market now expecting three-to-four interest rate hikes in 2022 alone. We doubt that will come to pass but it is possible and there is no question that a 12-month core PCE print of 4.7% is forcing the Fed to move. Since the mega-stimulus of March 2020, markets have seen a 91% rally in the S&P 500 and a 114% rally in the tech sector. Ultra-low interest rates and stay-at-home policies created a paradise for tech stocks. But the 10-year Treasury yield surged from 1.45% in December, when Omicron emerged and the Fed turned hawkish, to 1.76% today. An inflation-induced pullback and rotation out of tech stocks was to be expected and has been our most consistent sectoral view. Long-term inflation expectations have not taken off, however. Many investors see secular stagnation over the long run – and even in the short run the resilient dollar should work against inflation. Not only will the Fed wind down asset purchases by $30bn a month starting January 2022 and start hiking rates in March, but also the budget deficit is contracting, making for an 8% of GDP fiscal drag in 2022. In addition the market no longer has any confidence that Congress will pass President Biden’s “Build Back Better” plan. We still think a reconciliation bill will pass, albeit in watered down form. But ultimately the looming midterm election will paralyze Congress, as we argued in our 2022 outlook report, “Gridlock Begins Before The Midterms.” Gridlock will ensure that whatever passes only modestly expands the long-term deficit and then that fiscal taps will be turned off in 2023. In the context of Fed hikes, this should reduce fears of inflation later in 2022, though we still see inflation as a persistent long-term problem. If history is any guide, stocks and bond yields will be flattish for most of the year due to election uncertainty. The difference between this year and other midterm years is that the US consumer is in better financial shape and yet foreign supply kinks will persist due to Omicron. The takeaway is to prefer industrials, energy, small caps, and cyclicals, even though we may not maintain these recommendations for the whole year. We are hedging by staying long health care stocks. Omicron: Less Relevant At Home, More Relevant Abroad American economic growth is declining but will likely settle at or above trend (Chart 1A). Money growth, a proxy for stimulus, is also coming off its peaks while credit growth is rising moderately. The long deleveraging of the American consumer since 2008 appears to have come to an end. But it is too soon to say how aggressively Americans will lever back up and whether a new private sector “debt super cycle” will begin (Chart 1B). Chart 1AEconomic Growth Peaked, Will Slow To Trend Chart 1BEconomic Growth Peaked, Will Slow To Trend The Omicron variant of COVID-19 will have a modest negative impact early in the year. Hospitalizations are picking up in the wake of a surge in new cases following Christmas gatherings. Only 61% of Americans are fully vaccinated and only 23% have received the booster shot that is most effective against Omicron (Chart 2A & Chart 2B). Yet new deaths from the disease remain subdued and only about a fifth of those hospitalized go to the intensive care unit today. Chart 2BCOVID-19 Continues But Relevance Wanes Pharmaceuticals, both vaccines and anti-viral medications, are saving the day and Americans are becoming resigned to the likelihood of getting the virus at some point. Social mobility has dropped off since summer 2021 but will boom in the springtime and consumer confidence is already picking back up (Chart 3A & Chart 3B). The Biden administration is not likely to impose unpopular social restrictions during an election year unless a variant is deadlier, more contagious, and resistant to vaccines, which is not the case with Omicron. Chart 3AOmicron Not A Major Setback For Recovery The resilience of the US will come with persistent inflation in goods given that Omicron will still cause supply disruptions abroad. Not all countries have as effective vaccines when it comes to Omicron – if they maintain tighter social restrictions, prices of imported goods will continue to rise. The Fed cannot resolve foreign bottlenecks. While manufacturing surveys show bottlenecks easing from last year’s highs, foreign supply constraints will remain a problem throughout the year. Chart 3BOmicron Not A Major Setback For Recovery Buy The Rumor, Sell The News Of “Build Back Better” The Biden administration and Democratic Party are still likely to pass one last blast of fiscal spending – the “Build Back Better” budget reconciliation act, a social welfare bill. The output gap is virtually closed and the economy does not need new demand stimulus. However, the Democratic Party needs a legislative win ahead of the midterm election. Thin majorities in both chambers of Congress enable a single senator to derail the bill. But the bill’s provisions are popular among political independents and especially the Democratic Party’s base, which is lacking in enthusiasm about the election as things stand (Charts 4A & 4B). Moderate Democrats in the Senate are still negotiating: their goal is to chop the plan down to size and pass only the most popular provisions, rather than to sink the president and their own party. This means the bill’s top-line spending will be further reduced. The final size should fall from the earlier range of $2.5-$4.7 trillion to $2.3 trillion or less. Add a few tax hikes, like the minimum corporate tax, and the deficit impact will be around $600 billion (Table 1). Table 1"You’ve Gotta Pass It To See What’s In It" Ultimately we cannot have high conviction on the BBB plan because we cannot predict what a single senator will do. That is a matter of intelligence, not macro analysis. But subjectively we still give 65% odds that the Democratic Party will circle the wagons and pass the bill. The party views itself as surrounded by populism on both its right and left flanks – a failure to compromise will whet the appetites of both the Sanderistas (left-wing populists) and the Trumpists (right-wing populists) (Chart 5A). The Republicans still have a better position in the states, and the states have constitutional control of elections, so establishment Democrats are more terrified than usual of flopping in the midterm elections (Chart 5B). Otherwise the midterms – which are already likely to be bad for the Democrats – will deal a devastating blow. Republicans are recovering in party affiliation and tentatively surpassing Democrats among independent voters (Chart 6A). Biden and the Democrats lashed out at former President Trump and the Republican Party on the anniversary of the January 6, 2020 rebellion, but this tactic will not lift their popularity in polls. Their current polling is not much better than that of Republicans in 2018, when the latter suffered a bruising defeat in the midterms (Chart 6B). Chart 6ADemocrats Need A Win Before The Midterm Biden’s legislation would reduce the fiscal drag marginally in fiscal year 2023 but overall the budget deficit will shrink and then lie flat over 2022-24 regardless of what Congress does (Chart 7). New spending would be marginally inflationary over the long run since the budget deficit is expected to expand again beyond fiscal year 2024. Republicans will not be able to slash the budget until they control both Congress and the White House, but in that case they are likely to prove big spenders as in the past. Populism will persist on all sides: the political establishment will keep trying to use fiscal profligacy to peel voters away from populists, who are even more fiscally profligate. Only an inflation-induced recession will restore some fiscal discipline – and that is a way off. Ultimately the significance of the BBB bill is to verify whether establishment politicians – fiscal authorities – are capable of moderating their spending plans according to the threat of inflation, as Modern Monetary Theory maintains. Otherwise the implication is that polarization and populism will produce fiscal overshoots regardless of near-term inflation, even with the narrowest of possible majorities in Congress. The latter, a BBB fiscal overshoot, is what we expect. If it happens it will probably be received negatively by the equity market, fearing faster Fed rate hikes, and it would add credibility to long-term concerns about inflation, because it would reveal that fiscal authorities are not good at adjusting in real time. The former, a BBB failure and a halt to fiscal spending, would suggest that fiscal extravagance remains a crisis-era phenomenon and will be reined in by Congress after a crisis passes, which is probably positive for equities. It would at least suggest that fiscal authorities will adjust when the facts change. Of course, how investors respond to any legislative outcome will depend on a range of factors. But the takeaway is this: Inflation fears may or may not peak in the short run but they will persist over the long run. The Fed: Focus On The Framework In the wake of the Great Recession the Federal Reserve as an institution – both the Federal Open Market Committee and the Board of Governors – shifted in a more accommodative or dovish direction (Chart 8). The shift culminated in the review of monetary policy strategy in August 2020, which produced average inflation targeting. In practice the dovish policy shift is apparent in a real Fed funds rate at -4%, the lowest level since the inflationary 1970s under Fed Chair Arthur Burns. But what is more remarkable is the simultaneous surge in the budget deficit, unlike anything since World War II, and unlike anything in peacetime (Chart 9). Chart 9Inflation And Stagflation Risks The massive increase in federal debt, from 34% of GDP in 2000 to 75% before COVID-19 and 106% today, acts as a constraint on any future Fed hawkishness (Chart 10). A Fed chair who drives interest rates too high amid high debt levels will cause a recession and force the debt-to-GDP ratio up even higher. Yet the result of low rates is to stimulate indebtedness. While the private debt super cycle has subsided, a public debt super cycle is thriving. Chart 10A Major Check On Fed Hawkishness This brings us to today’s predicament. The Fed’s criteria for raising interest rates have mostly been met: 12-month core PCE inflation is running at 4.7% while the inflation breakeven rate in the Treasury market suggests that inflation is well anchored and likely to persist above the 2% inflation target for some time (Chart 11A). The economy is virtually at “maximum employment” (Table 2) – the Fed has set aside concerns about low labor force participation to focus on the collapsing unemployment rate, which is now within the range at which it will feed inflation (Chart 11B). Chart 11AThe Fed's Criteria For Liftoff Table 2The Fed’s Criteria For Liftoff Chart 11BThe Fed's Criteria For Liftoff The takeaway is that the Fed is suddenly restoring the credibility of its 2% inflation target, with headline PCE rapidly coming up on the trajectory established in the wake of the Great Recession (Chart 12), as our US bond strategist Ryan Swift has demonstrated. Chart 12Lo And Behold: Debt Monetization Generates Inflation The explosion of fiscal spending played a critical role in generating this new trajectory. The combination of monetary and fiscal accommodation has worked wonders. Assuming the BBB passes, Chairman Powell will face even greater pressure to prevent this correction of the inflation trajectory from overshooting and turning into a wage-price spiral. The unexpected risk would be if the BBB bill fails, the Fed hikes aggressively, global growth sputters, the dollar surges, and Republicans retake Congress — then Powell may yet see disinflationary challenges in his term in office. Our sense is that the BBB will pass, reinforcing Powell’s less dovish pivot, and yet the Fed’s framework will not permit too hawkish of a stance, resulting in persistent inflation risks over the long run. Three Strategic Themes In our annual strategic outlook, we highlighted three structural or strategic themes that are not beholden to the 12-month forecasting period: 1. Rise Of Millennials And Generation Z: The sharp drop in labor force participation will gradually mend in the wake of the crisis but the aging of the population ensures that the general trend will decline over time as the dependency ratio rises (Chart 13A). Chart 13AStrategic Theme #1: Rise Of Millennials/Gen Z Politically the millennials and younger generations are gaining clout over time, although their partisan identity will also evolve as they mature and gain a greater stake in the economy and become asset owners (Chart 13B). 2. Peak Polarization: US political polarization stands at historic highs and will likely remain so over the 2022-24 political cycle (Chart 14A). Polarization coincides with the transformation of society amid falling bond yields and technological revolution (Chart 14B). Chart 14AStrategic Theme #2: Peak Polarization Chart 14BStrategic Theme #2: Peak Polarization The pandemic era has been especially polarized due to the 2020 election and controversies over vaccination (Chart 15). Domestic terrorism of whatever stripe is possible (Chart 16). But any historic incidents will generate a majority opposed to political violence. Chart 16Risk Of Domestic Terrorism True, former President Trump is still likely to run on the Republican ticket, which will ensure that polarization remains elevated (Diagram 1). However, US elections hinge on structural factors, not individuals. Diagram 1GOP 2024 Is Up To Trump So far structural factors point to policy continuity: not only are Democrats still slated to retain the White House, but President Biden has coopted many of Trump’s key policies, including infrastructure, protectionism, and big budget deficits (Chart 17). If Democrats falter, Trump’s policies will be reaffirmed. The implication is that a new national policy consensus is taking shape beneath the surface. 3. Limited “Big Government”: Americans have been turning away from “small government” and toward “big government” since the 1990s. Voters no longer worry so much about budget discipline and instead look for the “visible hand” of government to support the economy (Charts 18A & 18B). Both domestic populism and geopolitical challenges encourage this shift. Industrial policy and domestic manufacturing are making a comeback (Table 3). Table 3Strategic Theme #3: Limited “Big Government” With extremely robust fiscal policy, the US has avoided the policy mistake of the period after the Global Financial Crisis, when premature fiscal tightening undermined the economic recovery (Chart 19). Policy uncertainty will increase as gridlock returns to Congress and fiscal policy will be frozen. But investors need not fear a slide back into deflation. The Republican Party’s populist base may prevent more Democratic social spending but they will not be able to repeal what is done. Chart 19Even With Looming Gridlock, The US Is Far From Tightening Fiscal Policy Too Soon This Time Three Key Views For 2022 The key views for the 12-month period are connected with the above but of a more short-term or cyclical duration: 1. From Single-Party Rule To Gridlock: Republicans are highly likely to win back control of the House of Representatives and likely the Senate (Charts 20A & 20B). President Biden’s approval rating suggests that Democrats could lose 40 seats in the House (Chart 21) and three in the Senate (Chart 22), whereas they only need to lose five and one to lose control. Our quantitative Senate election model shows an even split but the model’s trend favors Republicans, as does the political cycle and partisan enthusiasm (Chart 23). 2. From Legislative To Executive Power: Biden may still pass one more spending bill but otherwise the legislature will be frozen. Democrats will not succeed in ramming legislation through by abolishing the Senate filibuster. Biden will turn to executive decree, where he is already on track to make a historic increase in regulation, which will increase concerns among small business (Chart 24A & Chart 24B). Anti-trust laws are unlikely to be overhauled and Democrats will struggle to bring back the tough anti-trust posture of the 1900s-1950s without new legislation, meaning that Big Tech faces a bigger threat from inflation than regulation (Table 4). The green transition will continue but primarily in the form of any subsidies passed in the reconciliation bill, rather than new taxes or any carbon pricing scheme (Chart 25A & Chart 25B). Chart 24AKey View #2: From Legislative To Executive Power Table 4Key View #2: From Legislative To Executive Power Chart 25BGreen Energy: Subsidies But No Carbon Tax 3. From Domestic To Foreign Policy Risks: Biden faces a slew of foreign policy and external risks that could damage the Democrats in the midterms. The surge in illegal immigration on the southern border is truly historic and will have significant policy ramifications over the long run (Chart 26A & Chart 26B). The surge in inflation will force Biden to contend with foreign policy challenges with one hand tied behind his back, since energy supply disruptions could derail his party ahead of the midterm election (Chart 27). While Biden could ease some inflationary pressure via reduced trade tariffs, protectionist impulses will prevail during an election year (Chart 28). Chart 26AKey View #3: External Risks For Biden Chart 26BKey View #3: External Risks For Biden Chart 27Foreign Policy Could Hit Prices At Pump Chart 28Tariff Relief In 2022? Don't Bet On It Investment Takeaways The stock market tends to be flat, with risks skewed to the downside, during midterm election years due to policy uncertainty. The same is true for bond yields (Chart 29). Chart 29Stocks And Bond Yields Trend Lower Before Midterms ... When united or single-party governments approach midterms, stocks tend to perform worse than for divided governments in midterm years, while bond yields tend to be a bit higher (Chart 30). This trend is supercharged in 2022 due to the inflationary effects of the pandemic. Chart 30... But United Govts See Higher Bond Yields And Weaker Stocks ... Assuming Republicans regain at least the House, the US will transition from united to divided government (gridlock). In previous such transitions, stocks tend to perform in line with the average for a midterm election year, but bond yields skew higher – reinforcing the previous point (Chart 31). Chart 31... Shift From United To Divided Govt Implies Higher Bond Yields Than Otherwise We will update our US Sector Political Risk Matrix to bring it better into line with our views, particularly in light of Table 5 below regarding sector relative performance during midterm election years. Normally defensives and growth stocks outperform in midterm years, Table 5ConDisc, Tech, Health Do Best During Midterms …But Waning Pandemic Makes An Exception while cyclicals and value stocks underperform, but 2022 looks to be different due to inflation. Still over the course of the year we would expect the historic trend to reassert itself. Investors should favor cyclicals even though they probably cannot outperform defensives for much longer (Chart 32A). We recommend health care stocks as a hedge given that the dollar should still be resilient this year, Fed hikes should moderate inflation expectations, and midterm policy uncertainty will eventually weigh on risk appetite (Chart 32B). Chart 32AFavor Cyclicals, Though They May Not Outperform Defensives Much Longer Chart 32BLong Health Care As Hedge Value stocks are forming a bottom relative to growth stocks, although this trend is less clear in the US, especially among US large caps, than it is abroad (Chart 33). We favor value over growth on a cyclical basis but midterm election uncertainties will pull the other way, making for a choppy bottom. Chart 33Favor Value And Small Caps, Though Bottom Formation Remains Choppy The same process is visible on a sector basis, where energy and materials continue to outperform tech (Chart 34A). We recommend staying long energy on a cyclical basis, though its outperformance against tech could abate later in 2022. Infrastructure stocks – such as building and construction materials – also continue to outperform. Since Biden’s honeymoon period ended, the outperformance is largely relative to tech rather than the S&P as a whole. We still favor infrastructure stocks as the fiscal policy theme will continue even beyond the current legislation, which will barely start to be implemented in 2022 (Chart 34B). Chart 34AFavor Energy, Materials, And Infrastructure Versus Tech Chart 34BFavor Energy, Materials, And Infrastructure Versus Tech Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)
Highlights The markets are already looking past Omicron. Now they have new worries – the Fed battling inflation. In the past, the Fed moved because of confidence that strong economic growth can withstand rates normalization. This time around, the Fed’s hand is forced by inflation, which is no longer deemed “transitory”. So far, fear of an inflation-induced tightening cycle manifests in expectations of a steeper trajectory for rates, and violent and indiscriminate rotation out of the tech names. Companies have set aside record amounts of cash for wage increases. This is sure to cut into corporate profitability and validates our thesis that peak margins are in the rear-view window. Supply bottlenecks are easing, so is the ISM activity index, which we interpret as a normalization. When it comes to our style recommendations, we continue preferring small caps over large caps on the back of attractive valuations and favorable economic backdrop. Today, we also upgrade Value / Growth from neutral to OW - rising rates are a tailwind for Value. Recommended Allocation Feature December was a good month for equities (Chart 1). While the beginning of the month was marred by turbulence, induced by the arrival of Omicron, and the Fed shifting to a more hawkish stance, Santa Claus did deliver a rally to close the month, with the S&P 500 rising by 6% and lifting its 2021 gains to an impressive 27%. But 2021 was a wild year for active investors, as only 15% of funds and strategies outperformed the S&P 500. Hence, many investors had to watch the S&P 500 gains from the sidelines: The year was characterized by rotation across sectors and styles. December brought about a sell-off in the most speculative names in the equity market (EEM, IWM, ARKK, BTC, IPO), which has continued unabated into January: The Fed’s imminent monetary tightening is a culprit. Capital has also rotated away from Cyclicals and towards Defensives (the MSCI Cyclicals / Defensive ratio was down 7% in December). However, Cyclicals are starting to rebound from the Omicron slump. Overarching Macroeconomic Themes Omicron or “Omicold”? Either Way, The US Market Is Looking Past It… Little was known about the Omicron variant when it took us all by surprise at the end of November. Fortunately, an expectation that this variant is more contagious but less virulent has come to pass: While the number of cases has surged (nearly, every family I know in the tri-state area has had it by now), the number of hospitalizations has remained contained (Chart 2). The economic damage, at least in the US, has been minor, and mostly due to people being away from work sick or quarantined. It also appears that this COVID wave is close to a peak, which explains the recent outperformance of Cyclicals (Chart 3): The markets are already looking past Omicron. Now they have new worries – the Fed battling inflation. Chart 2Omicron Wave Is Close To A Peak... Chart 3...And Cyclicals Are Rebounding Inflation Is Forcing The Fed’s Hand Into An Aggressive Tightening Cycle Fed rate hikes are now all but certain: The market is pricing in four rate hikes in 2022 with a probability of nearly 90% (Chart 4), a noticeable increase from the three rate hikes expected in December 2021. The Fed’s December meeting minutes indicate that the first rate hike may come as soon as March. What is different this time is the inflation backdrop: In the past, the Fed moved because of confidence that strong economic growth can withstand rates normalization. This time around, the Fed’s hand is forced by inflation, which is no longer deemed “transitory”. The Fed is raising rates to squish growth to tame inflation, giving rate rises a different context: The Fed is behind the curve, and while in the past the stock market took rate hikes in its stride (after a short-lived slump in performance), now market reaction may be much more negative. So far, fear of an inflation-induced tightening cycle manifests in expectations of a steeper trajectory for rates (Chart 5), and violent and indiscriminate rotation out of the tech names. Chart 4Market Is Expecting Four Hikes In 2022 Chart 5Rates Made A Vertical Move More Wage Raises Are On The Way – A Headwind To Corporate Profitability According to the NIPA, wages constitute about 50% of sales of US companies. Over the past year, nominal wages increased by 5.8% but still could not keep up with rising prices – real wage growth is running at -2.3% (Chart 6). Considering that in 2021 only a minor share of workers got raises – those rejoining the workforce, starting a new job, or members of a few labor unions, the majority of Americans have had no change in income and have been bewildered by prices in the supermarkets. As the new calendar year rolls on, many of these workers will negotiate their salaries to get inflation adjustments (Chart 7). In fact, according to the WSJ, companies have set aside record amounts of cash for wage increases. This is sure to cut into corporate profitability and validates our thesis that peak margins are in the rearview window. Chart 6Wages Are Not Keeping Up With Inflation Chart 7Wage-Price Spiral? Another concern is a wage-price spiral, leading to rampant inflation, making the Fed’s job harder, and calling for more aggressive monetary tightening, striking a blow to the stock market. Supply Bottlenecks Are Easing, So Is The ISM Activity Index The ISM Manufacturing index has turned from 64.7 to 58.7 (Chart 8A). Part of the decline in the top-line numbers is due to the resolution of supply-chain bottlenecks: The ISM Supplier Index has fallen from 78.6 to 64.9 (Chart 8B), indicating a reduction in delivery times. On the other hand, the New Orders index has also declined from 68 to 60.4, suggesting that bottlenecks are clearing thanks to the reduction in business activity, which we interpret as a normalization. Of course, zero-tolerance to COVID policy in China and other countries may lead to new production and shipping delays, and another leg up for the inflation readings. Chart 8AISM PMI Has Turned... Chart 8BAnd Not Only Because Of Shorter Delivery Times Styles Comments Small Vs. Large Cap: Sticking To Our Overweight In Small Valuations: Small caps are cheap and unloved, trading at 16x forward earnings with a 25% discount to Large. The BCA Valuation Indicator for Small vs. Large is standing more than two standard deviations below its long-term average. Profitability: Since 2019, Small has delivered 47% annualized profit growth compared to 14% from Large. The small companies have demonstrated resilience and successfully navigated the economic landscape, plagued with supply bottlenecks, labor shortages, and surging prices (Chart 9A). Small-cap margins have exceeded the historical average and have likely peaked, just like the margins of their larger brethren. According to the NFIB Small Business Survey, a core concern is inflation, but 54% of small companies intend to raise prices, passing on costs to customers. Like all other American companies, they experience labor shortages and are planning to raise wages too. On balance, we believe that small caps will remain profitable and their earnings will continue to grow, albeit at a slower pace, i.e., at 15% (Chart 9B), which is significantly less than 88% in 2021, but more than the 10% growth expected of larger companies. Chart 9ASmall Businesses Are Worried About Inflation And Are Raising Prices Chart 9BEarnings Growth Expectations Have Normalized Macroeconomic Backdrop: Historically, small caps have outperformed large caps in the environment of rising rates (Chart 10), because of higher allocations to Cyclicals, such as Financials and Industrials. Also, while rising rates take the froth off the high-flying growth stocks, smaller companies are cheap and have moderate growth expectations. Overweight Small vs. Large: Attractive valuations and fundamentals, and a high likelihood to perform well when rates are rising, make overweighting Small vs Large an attractive proposition. Risks: While we stay with the call, there are a few caveats: Small caps’ margins are narrow, and continued cost pressures, especially surging labor costs, have the potential to dent their profitability. Further, while empirical analysis indicates that Small outperforms during the rate-hiking cycle, we are concerned that surging inflation may render this analysis less useful – can this time really be different? Growth Vs. Value: Shifting Towards Value Valuations: Over the course of 2021, Growth outperformed Value by 23% (trough to peak), and by 5% over just the last 26 weeks. As a result of such a strong run, Growth has become very expensive, trading at 29x forward multiples, which is which is a 70% premium to Value (which is trading at 17x). The Growth/Value BCA Valuation Indicator corrected below the 2 standard deviation mark and is mean reverting. Profitability: Despite significant valuation discrepancy between Growth and Value, both asset classes are set to deliver roughly the same earnings growth over the next year, suggesting that the premium for Quality and Growth may be excessive (Chart 11A). Macroeconomic Backdrop: Since the beginning of the pandemic, performance of Value vs. Growth has been strongly linked to the direction of change in yields (Chart 11B). Growth is overweight long-duration Technology stocks, while Value is highly exposed to Financials, which appear to thrive in the environment of rising rates. Chart 11AGrowth Expectation Are Similar, But Value Is Cheaper Chart 11BRising Rates Are A Tailwind For Value Overweight Value: As we stated in our 2022 Outlook, “Our neutral position [in Growth vs. Value] will be a great launching pad towards overweighting value stocks at the first whiff of rising long rates.” Now, with rate hikes drawing nearer and Omicron peaking, we are changing our neutral allocation to a cyclical overweight in Value, and underweight in Growth. Valuations and the macroeconomic backdrop are at the core of the call. Risks: We may be early with our presumption that Omicron is just an uber-contagious “Omicold” – hospitalizations may still surge, while global lockdowns may cause much economic damage. In that case, rates may remain range-bound, while the Fed may delay rate hikes. Then Growth would be bound to outperform Value. Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com S&P 500 Chart 12Macroeconomic Backdrop Chart 13Profitability Chart 14Valuations And Technicals Chart 15Uses Of Cash Cyclicals Vs Defensives Chart 16Macroeconomic Backdrop Chart 17Profitability Chart 18Valuation And Technicals Chart 19Uses Of Cash Growth Vs Value Chart 20Macroeconomic Backdrop Chart 21Profitability Chart 22Valuations And Technicals Chart 23Uses Of Cash Small Vs Large Chart 24Macroeconomic Backdrop Chart 25Profitability Chart 26Valuations and Technicals Chart 27Uses Of Cash Recommended Allocation Footnotes .
Highlights In this week’s report we update our Chart Pack, updating familiar charts that underscore our strategic themes and cyclical/tactical views. Social unrest in Kazakhstan points to two of our strategic themes: great power struggle and populism/nationalism. A sneak preview of our Black Swan risks for the year: Iran crisis, Russian aggression, and a massive cyber attack. Recent market moves reinforce the BCA House View that investors will rotate out of US growth stocks and into global cyclicals and value plays. We are sticking with our current tactical and cyclical views and trades. Feature Since releasing our key views for 2022, bond yields have surged, tech shares have sold off, and social unrest has erupted in Central Asia. These developments have both structural and cyclical drivers and are broadly supportive of our investment strategy. First, a brief word about Kazakhstan. The surge in unrest this week is a new and urgent example of one of our strategic themes: populism and nationalism. Long-accumulating Kazakh nationalism is blowing up and forcing the autocratic regime to complete an unfinished political leadership transition that began three years ago. Russia is now forced to intervene militarily to maintain stability in this important satellite state. If instability is prolonged, Russia will be weakened in its high-stakes standoff against the United States and the West over Ukraine. China’s interest in Kazakhstan is also threatened by the change in political orientation there. We will provide a full report on this topic soon but for now the investment implication is to stay short Russian equities. In the rest of this report we offer our newly revised chart book for investors to consider as they gird for a year that promises to be anything but dull. The purpose of the chart book is to update a succinct series of charts that underpin our key themes and views. Many of these charts will be familiar to regular readers but here they are updated with some notable points highlighted in the text. A Waning Pandemic And Global Growth Falling To Trend The Omicron variant of COVID-19 is causing a surge of new cases and hospitalizations around the world, which will weigh on economic activity in the first quarter. However, this variant does not appear to be a game changer. While it is highly contagious, not as many people who go to the hospital end up in the intensive care unit (Chart 1). China is in a difficult predicament that will continue to constrict the global supply side of the economy. Chinese authorities maintain a “zero COVID” policy that emphasizes draconian social restrictions to suppress COVID cases and deaths to minimal levels (Chart 2A). But Chinese-made vaccines are not as effective as western alternatives, particularly against Omicron, as discussed in our flagship Bank Credit Analyst. Hence China cannot open its economy without risking a disastrous wave of infections. When China shuts down activity, as at the Yantian port last spring, the rest of the world suffers higher costs for goods (Chart 2B). Chart 3Global Growth Will Fall Back To Trend Global economic growth is decelerating from the peaks of the extreme rebound (Chart 3). The historic fiscal stimulus of 2020 (Chart 4A) is giving way to negative fiscal thrust, or a decline in budget deficits, that will take away from growth (Chart 4B). Chart 5Inflation Will Moderate But Remain A Long-Term Risk Yet a recession is not the likeliest scenario since growth is expected to stabilize given the resumption of activity across the world due to an improved ability to live with the virus. The Federal Reserve is considering hiking interest rates faster than the market had expected given that the unemployment rate is collapsing and core inflation is surging. The persistence of the pandemic’s supply disruptions adds to concerns. At the same time, a wage-price spiral is not yet taking shape, as our bond strategist Ryan Swift shows. Productivity is growing faster than real wages and long-term inflation expectations remain within reasonable ranges, at least for now (Chart 5). Three Strategic Themes In our annual outlook (“2022 Key Views: The Gathering Storm”) we revised our long-term mega themes: 1. Great Power Struggle The US’s relative decline as a share of global geopolitical power, despite a brief respite last year, is indicated in Charts 6-8. Chart 8America's Global Role Persists (If Lessened) 2. Hypo-Globalization An ongoing globalization process, yet one that falls short of potential, is shown in Charts 9-10. A tentative improvement in our multi-century globalization chart is misleading – it is due to lack of data reporting by several countries, which artificially suppresses the denominator. Chart 9Hypo-Globalization And Hegemonic Instability Chart 10AFrom 'Hyper-Globalization' To Hypo-Globalization While trade sharply rebounded from the pandemic, the global policy setting is now averse to ever-deeper dependency on international trade. Chart 10BFrom 'Hyper-Globalization' To Hypo-Globalization 3. Populism and Nationalism The post-pandemic cycle will see these structural trends reaffirmed. Charts 11-12 shows a rising Misery Index, or sum of unemployment and inflation, a source of political turmoil that will both reflect and feed these trends. Chart 11Misery Indexes Signal More Unrest, Populism, And Nationalism Chart 12EM Populism/Nationalism Threatens Negative Surprises In 2022 Chart 12 highlights major markets that have local or nationwide elections in 2022-23, where policy fluctuations are already occurring with various investment implications. We are tactically bullish on South Korea and Brazil, strategically but not tactically bullish on India, and bearish on Turkey. Russia’s domestic sociopolitical problems are not all that different from Kazakhstan’s and its response may be outwardly aggressive, so we are bearish. Three Key Views For 2022 Our annual outlook also outlined three key views for this year: 1. China’s Reversion To Autocracy The government will ease policy to secure the economic recovery so that President Xi Jinping can clinch his personal rule for at a critical Communist Party personnel reshuffle this fall (Chart 13). Chart 13China Will Easy Policy Ahead Of Political Reversion To Autocracy A stabilization of Chinese demand in 2022 will be positive for commodities, cyclical equity sectors, and emerging markets. Policy easing will not lead to a sustainable rally in Chinese equities, as internal and external political risks remain high (Charts 14A & 14B). A “fourth Taiwan Strait Crisis” is likely in the short run while a military conflict is not unlikely over the long run. 2. America’s Policy Insularity The Biden administration is focused on domestic legislation and the midterm elections, due November 8, 2022. Biden’s approval rating has deteriorated further, putting the Democrats in line for a loss of around 40 seats in the House and four seats in the Senate, judging by historic patterns (Chart 15). But our sense is that the Senate is still in play – Democrats probably will not lose four Senate seats – but they are likely to lose control of both chambers as things stand. However, the Democrats still have a subjective 65% chance of passing a partisan budget reconciliation bill, which would be a badly needed victory. The “Build Back Better” plan would include a minimum corporate tax and various social programs. Another round of fiscal reflation would reinforce the Federal Reserve’s less dovish pivot. Chart 16US Still At Peak Polarization Polarization will remain at historic peaks leading up to the election, as the Democrats will need “wedge issues” to drive enthusiasm among their popular base in the face of Republican enthusiasm. For decades polarization has correlated with falling Treasury yields and US tech sector equity outperformance (Chart 16). Midterm election years tend to see flat equity performance and falling yields, albeit with yields higher when a single party controls government, as is the case this year. 3. Petro-State Leverage Globally, commodity markets continue to tighten on the supply side. Our Commodity & Energy Strategist Bob Ryan outlines the situation admirably: The supply side is tightening in oil markets, where OPEC 2.0 producers have been unable to restore output under their agreement to return 400,000 barrels per day each month since August 2021. It is true in base metals, where the energy crisis in Europe and Asia are constricting supplies, particularly in copper. And it is true in agricultural commodities, where high natural gas prices are driving fertilizer prices higher, which will push food prices up this year. Demand for these commodities will increase as Omicron becomes the dominant COVID-19 strain, keeping consumption above production, particularly in oil. These are long-term trends. Oil and natural gas markets will probably remain tight throughout the decade, as will base metal markets. This is going to put enormous stress on the global energy transition to renewable energy over the next 10 years. The ascendance of left-of-center political parties in critical base-metal exporting states, and rising ESG initiatives, will increase costs for energy and metals producers; and global climate activism in boardrooms and courtrooms will push costs higher as well. Higher prices will be necessary to recover these cost increases. In this context, energy producers gain geopolitical leverage. Their treasuries become flush with cash and they see an opportunity to pursue foreign policy objectives. Conflicts involving oil producers are more likely when oil prices are swinging up (Chart 17). This trend is on display in Russia’s dispute with the West, where Europe is struggling with a surge in natural gas prices due to Russian supply constraints that weaken its resolve in the showdown over Ukraine (Chart 18, top panel). Chart 18Energy Prices: Biden's And Europe's Problem Yet even in the energy-independent US, the Biden administration is wary of pursuing policies against Russia or Iran that would ignite a bigger spike in prices at the pump during an election year (Chart 18, bottom panel). Biden will have to attend to foreign policy this year but will be defensive. Petro-states are not immune to domestic problems, including social unrest. Many of them are poor, unequal, misgoverned, and suffering from inflation. Iran is a prime example. Yet Iran has not collapsed under sanctions so far, the world is recovering, and Tehran has the advantage in its negotiations with the US because it can stage attacks across the Middle East, including the Persian Gulf and Strait of Hormuz. Military incidents could drive oil prices into politically punitive territory. Three Black Swans For 2022 This brings us to three “Black Swans” or low-probability, high-impact events for 2022. We will publish our regular annual report on this year’s black swans soon. For now we offer a sneak preview: 1. Iran Crisis In Middle East The fear of being abandoned by the US has kept Israel from acting unilaterally so far (Chart 19A). But an attack is not impossible if Iran reaches “breakout” levels of highly enriched uranium – and the global impact of an attack could be catastrophic (Chart 19B). The news media have been conspicuously quiet about Iran. Taken together, this scenario is pretty much the definition of a black swan. 2. Russian Aggression Abroad There is a 50% chance that Russia will stage a limited re-invasion of Ukraine to secure its control of territory in the east or along the Black Sea coast. Chart 20Black Swan #2: Russian Aggression Abroad Within this risk, there is a small chance (less than 5%) that Russia would invade all of Ukraine. We do not expect this and neither do other analysts. The total conquest of Ukraine is unlikely when Russia’s domestic conditions are weak and it faces so much unrest in other parts of its sphere of influence (including Belarus and Kazakhstan). As we go to press, Russia is staging a military intervention in Kazakhstan, which could expand. Kazakhstan could create a way for Russia to avoid its self-induced pressure to take military action against Ukraine. But most likely Russia and Kazakhstan will quell the unrest, enabling Russia to sustain the threat of a partial re-invasion of Ukraine. Putin’s low approval rating often triggers new foreign adventures and financial markets are pricing higher risks (Chart 20). 3. Massive Cyber Attack Amid the pandemic and inflation surge, investors have forgotten about the huge risks facing businesses and individuals from their extreme dependency on remote work and digital services. A cyber war is also raging behind the scenes. So far it has not spilled into the physical realm. Yet Russia-based ransomware attacks in 2021 showed that vital US infrastructure is vulnerable. Cyber stocks have topped out amid the recent tech selloff (Chart 21A). But the global average cost of data breaches is skyrocketing. Governments are devoting more resources to network security and cyber-security (Chart 21B), which should be positive for earnings. Chart 21ABlack Swan #3: Massive Cyber Attack Chart 21BBlack Swan #3: Massive Cyber Attack Investment Takeaways The revised Geopolitical Risk Index does not show as pronounced of an uptrend as the version published last year but it is still higher than in the late 1990s (Chart 22). Our reading of all available evidence points to rising geopolitical risk – at least until the current challenge to US global supremacy leads to a new equilibrium. Global policy uncertainty is also rising on a secular basis and maintaining its correlation with the trade-weighted dollar, which has rebounded despite the global growth recovery and rise in inflation (Chart 23). We remain neutral on the dollar. Chart 23A Secular Rise In Global Uncertainty Gold has fallen from its peaks during the onset of the pandemic and real rates suggest it will fall further. But we hold it as a hedge against geopolitical risk as well as inflation (Chart 24). Chart 24Stay Long Gold As Hedge Against Geopolitical Crisis As Well As Inflation The evidence is inconclusive about whether global investors will rotate away from US assets this year. The US share of global equity capitalization is stretched. Long-dated Treasuries will eventually reflect higher inflation expectations (Chart 25). Chart 25No Substitute For The USA Yet Chart 26Waiting For Rotation US equity outperformance continues unabated and emerging market equities are still underperforming their developed peers (Chart 26). Cyclically investors should take the opposite side of these trends but not tactically. The renminbi is tentatively peaking against both the dollar and euro. As expected, China’s policymakers are shifting toward preserving economic stability (Chart 27). Stabilization may require a weaker renminbi, though producer price inflation is also a factor for the People’s Bank to consider. Chart 27Strategically Short Renminbi And Taiwanese Dollar Taiwanese stocks continue to outperform Korean stocks (to our chagrin) but they have not broken above previous peaks relative to global equities. Nor has the Taiwanese dollar broken above previous peaks versus the greenback (Chart 28). So far Taiwan has avoided the fate of semiconductor stocks, which have sold off. This situation presents a buying opportunity for semi stocks but we remain short Taiwan as a bourse because it is central to US-China strategic conflict. Chart 28Strategically Short Taiwan Chart 29Strategically Short Russia And EM Europe Chart 30Safe Havens Look Attractive Russia and eastern European assets continue to underperform developed market peers as geopolitical risks mount across the former Soviet Union (Chart 29). Russia’s negotiations with the US, NATO, and the EU in January will help us to gauge whether tensions will break out to new highs. Assuming Russia succeeds in quashing Kazakh unrest, it will be necessary for the US to offer concessions to Russia to prevent the Ukraine showdown from worsening Europe’s energy crisis. Safe havens caught a bid in early 2021 and have not yet broken down. Our geopolitical views support building up safe-haven positions (Chart 30). Presumably one should favor global cyclical equities as the pandemic wanes and global growth stabilizes. But cyclicals are struggling to outperform defensives (Chart 31A). Chart 31AFavor Cyclicals On China's Stabilization Chart 31BFavor Cyclicals On China's Stabilization China’s policy easing is positive in this regard, although the new wave of fiscal-and-credit support is only just beginning and financial markets will remain skeptical until the dovish policy pivot is borne out in hard data (Chart 31B). Global value stocks have ticked up again versus growth stocks, suggesting that the choppy process of bottom formation continues (Charts 32A & 32B). Chart 32AValue’s Choppy Bottom Versus Growth Stocks Chart 32BValue’s Choppy Bottom Versus Growth Stocks Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)