Labor Market
Highlights Chart 1Employment Growth Will Rebound August’s weak employment growth reflects the surge of Delta variant COVID cases in the United States. This is evidenced by the fact that Leisure & Hospitality sector payrolls held flat in August after having grown by 415k in July and 397k in June (Chart 1). While Delta could still be a drag on employment growth for another month or two, there is mounting evidence that the daily new case count is close to its peak. Leisure & Hospitality employment growth will regain its prior pace as new Delta cases trend down. This will lead to a resumption of strong monthly payroll reports (500k – 1000k) as we head into the new year. For monetary policy, we calculate that average monthly nonfarm payroll growth of 414k will be sufficient for the Fed to start rate hikes before the end of 2022 (bottom panel). We anticipate that this threshold will easily be met. The Treasury curve will bear-flatten as employment growth improves and the market prices-in an earlier start and quicker pace of Fed rate hikes. Investors should maintain below-benchmark portfolio duration and stay short the 5-year Treasury note versus a duration-matched 2/10 barbell. Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 5 basis points in August, dragging year-to-date excess returns down to +166 bps. The combination of above-trend economic growth and accommodative monetary policy supports continued positive excess returns for spread product versus Treasuries. At 91 bps, the 3-year/10-year Treasury slope remains steep. This is a strong signal that monetary conditions are accommodative. But despite the positive macro back-drop, investment grade valuations are extremely tight (Chart 2). A recent report looked at what different combinations of Treasury slope and corporate spreads have historically signaled for corporate bond excess returns.1 It shows that tight corporate spreads only correlate with negative excess returns once the 3-year/10-year Treasury slope is below 50 bps. Though we retain a positive view of spread product as a whole, better value can be found outside of the investment grade corporate sector. Specifically, we recommend that investors shift into high-yield corporates, municipal bonds and USD-denominated Emerging Market sovereigns and corporates. We also advise investors to favor long-maturity corporate bonds and those corporate sectors with elevated Duration-Times-Spread.2 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 66 basis points in August, bringing year-to-date excess returns up to +502 bps. A recent report looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.3 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.0% (Chart 3). Using a model of the 12-month trailing speculative grade default rate that is based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we estimate that the 12-month default rate will fall to between 2.3% and 2.8%, below what the market currently discounts. Notably, the corporate default rate is tracking at an annualized rate of roughly 1.7% through the first seven months of the year, well below the estimate generated by our macro model. Another recent report looked at the incremental spread pick-up investors can earn by moving out of investment grade corporates and into junk.4 It concluded that the extra spread available in high-yield is worth grabbing and that B-rated bonds look particularly attractive in risk-adjusted terms. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 3 basis points in August, dragging year-to-date excess returns down to -67 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 4 bps in August. The spread is wide compared to recent history, but it remains tight compared to the pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) widened 2 bps in August (panel 2), and it is now starting to look attractive compared to other similarly risky spread sectors. The conventional 30-year MBS OAS sits at 38 bps, below the 56 bps offered by Aa-rated corporate bonds but above the 20 bps offered by Aaa-rated consumer ABS and the 35 bps offered by Agency CMBS. In a recent report we looked at MBS performance and valuation across the coupon stack.5 We noted that the higher convexity of high-coupon MBS makes them likely to outperform lower-coupon MBS in a rising yield environment. Higher coupon MBS also have greater OAS than lower coupons. This makes the high-coupon MBS more likely to outperform in a flat bond yield environment as well. Given our view that bond yields will be higher in 6-12 months, we recommend favoring high coupons (4%, 4.5%) over low coupons (2%, 2.5%, 3%) within an overall underweight allocation to Agency MBS. Government-Related: Neutral Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 27 basis points in August, bringing year-to-date excess returns up to +84 bps (Chart 5). Sovereign debt outperformed duration-equivalent Treasuries by 122 bps in August, bringing year-to-date excess returns up to +7 bps. Foreign Agencies outperformed the Treasury benchmark by 8 bps on the month, bringing year-to-date excess returns up to +44 bps. Local Authority bonds outperformed by 9 bps in August, bringing year-to-date excess returns up to +382 bps. Domestic Agency bonds outperformed by 3 bps, bringing year-to-date excess returns up to +30 bps. Supranationals outperformed by 5 bps, bringing year-to-date excess returns up to +31 bps. USD-denominated Emerging Market (EM) Sovereign bonds outperformed US corporates in August and relative valuation between the two sectors is starting to equalize (panel 4). That said, we retain a preference for EM sovereigns over US corporates, particularly the bonds of Russia, Mexico, Saudi Arabia, UAE and Qatar where value remains attractive. A recent report looked at valuation within the investment grade USD-denominated EM corporate space.6 It found that EM corporates are attractively priced relative to US corporate bonds across the entire investment grade credit spectrum. It also found that EM corporates are attractive relative to EM sovereigns within the A and Baa credit tiers. EM sovereigns have the edge in the Aa credit tier. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 9 basis points in August, dragging year-to-date excess returns down to +262 bps (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings were already positive through the end of Q1 2021 and they received another significant boost in Q2 as funds from the American Rescue Plan were doled out (Chart 6). With state & local government balance sheets in such good shape, we are comfortable moving down in quality within municipal bonds. A move down in quality is especially compelling because of tight Aaa muni valuations relative to Treasuries (top panel). Valuation is more compelling in the lower investment grade credit tiers, especially at the long-end of the curve.7 GO munis in the 12-17 year maturity bucket offer a 5% breakeven tax rate versus corporates with the same credit rating and duration. 12-17 year Revenue munis actually offer a before-tax yield pick-up (panel 2). Finally, high-yield muni spreads are reasonably attractive relative to high-yield corporates, offering a breakeven tax rate of 23% (panel 4). But despite the attractive spread, we recommend only a neutral allocation to high-yield munis versus high-yield corporates as the deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2/10 Barbell Versus 5-Year Bullet Chart 7Treasury Yield Curve Overview Treasury yields moved higher in August, with the 5-year and 7-year maturities bearing the brunt of the sell-off. The 2-year/10-year Treasury slope steepened 5 bps to end the month at 110 bps. The 5-year/30-year slope flattened 5 bps to end the month at 115 bps. We expect bond yields to be higher in 6-12 months, but we also anticipate that the next significant move higher in bond yields will coincide with curve flattening, not steepening. At 1.93%, the 5-year/5-year forward Treasury yield is not that far below our target fair value range of 2% - 2.25%. In a recent report, we demonstrated that yield curve steepening only occurs when either the Fed is cutting rates or the 5-year/5-year forward yield rises.8 This means that the 2/10 Treasury curve is more likely to flatten than steepen during the next 6-12 months, even as bond yields move higher. Similarly, we observe that the overnight index swap (OIS) curve is priced for the fed funds rate to be 0.21% in one year’s time and 1.47% in five years (Chart 7). The latter rate has 146 bps of upside if it converges all the way back to its 2018 high, but this pales in comparison to the 265 bps of upside in the 12-month forward rate. The yield curve will flatten as the 12-month forward OIS rate converges with the 5-year forward rate (panel 3). Investors should position in yield curve flatteners on a 6-12 month horizon. Specifically, we recommend shorting the 5-year bullet versus a duration-matched 2/10 barbell. TIPS: Neutral Chart 8TIPS Market Overview TIPS performed in line with the duration-equivalent nominal Treasury index in August, leaving year-to-date excess returns unchanged at +578 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates both fell by 7 bps in August. At 2.37%, the 10-year TIPS breakeven inflation rate is near the middle of the 2.3% to 2.5% range that is consistent with inflation expectations being well anchored around the Fed’s target (Chart 8). Meanwhile, at 2.21%, the 5-year/5-year forward TIPS breakeven inflation rate is only just below target (panel 3). With long-dated inflation expectations close to the Fed’s target levels, we see limited upside on a 6-12 month investment horizon. We also see the cost of short-maturity inflation protection falling during the next few months as realized inflation continues to moderate from its current extremely high level. This will lead to some modest steepening of the inflation curve (bottom panel). While the inflation curve has some room to steepen, we don’t see it returning to positive territory. An inverted inflation curve is simply more consistent with the Fed’s Average Inflation Target than a positively sloped one. This is because the Fed’s new framework calls for it to attack its inflation target from above rather than from below. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in August, bringing year-to-date excess returns up to +40 bps. Aaa-rated ABS outperformed by 2 bps on the month, bringing year-to-date excess returns up to +30 bps. Non-Aaa ABS outperformed by 4 bps, bringing year-to-date excess returns up to +92 bps. The stimulus from last year’s CARES Act led to a significant increase in household savings when individual checks were mailed in April 2020. That excess savings has still not been spent and the most recent round of stimulus checks has only added to the stockpile (Chart 9). The extraordinarily large stock of household savings means that the collateral quality of consumer ABS is also extraordinarily high. Indeed, many households have been using their windfalls to pay down consumer debt (bottom panel). Investors should remain overweight consumer ABS and should also take advantage of the high quality of household balance sheets by moving down the quality spectrum. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in August, bringing year-to-date excess returns up to +193 bps. Aaa Non-Agency CMBS outperformed Treasuries by 10 bps in August, bringing year-to-date excess returns up to +92 bps. Non-Aaa Non-Agency CMBS underperformed Treasuries by 9 bps on the month, dragging year-to-date excess returns down to +529 bps (Chart 10). Though returns have been strong and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 4 basis points in August, bringing year-to-date excess returns up to +91 bps. The average index option-adjusted spread held flat on the month. It currently sits at 35 bps (bottom panel). Though Agency CMBS spreads have recovered to well below pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight. Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of August 31st, 2021) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of August 31st, 2021) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 12 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 12 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of August 31st, 2021) Footnotes 1 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 2 For ideas on how to increase the average spread of a US bond portfolio please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 3 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 4 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 5 Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 6 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 7 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 8 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Bump On The Road To Recovery”, dated July 27, 2021.
Dear Client, There will be no US Investment Strategy next week as we take our summer vacation. We will return on Monday, September 6th. We wish everyone a happy and safe conclusion to the summer. Best regards, Doug Peta Highlights Economy – COVID-19 and the official and individual responses to it continue to exert considerable influence over economic activity: We expect that labor force participation and employment will rise as people return to the workforce, provided that resurgent infection rates don’t provide a new reason to stay on the sidelines. Markets – Financial asset valuations are elevated, but a de-rating catalyst may not emerge any time soon: Massive infusions of fiscal aid and a Fed that is determined to err on the side of being too easy should support the fundamental backdrop, even as the Delta variant runs wild in communities with low vaccination rates. Strategy – Be alert, but stay the course unless policy makers change direction or their measures lose their force: We continue to expect that risk assets will outperform Treasuries and cash. Feature Labor Day, just two weeks away, will mark the unofficial end of summer in the United States and this year the end of August will mark its own milestone: eighteen months of the pandemic. COVID-19’s year-and-a-half residency has been filled with uncertainty and misdirection, but it now seems clear that it will be staying for good. It is disheartening to concede that we will have to accommodate an unwanted malign presence, especially when we seemed to be on the verge of cornering and trapping it. The emotional letdown may have accounted for the slide in consumer confidence, but it is important to note that the virus we’ll be living with indefinitely has morphed from a peril to a nuisance. One constant amidst the pandemic confusion has been the federal shock-and-awe campaign to protect the economy from its ravages. The Fed went big immediately, cutting the fed funds rate to zero, instituting $120 billion of monthly securities purchases and unveiling a range of novel programs to ease financial stresses. Before the first month was out, Congress passed the gigantic CARES Act package, raining money down on the unemployed and households in all but the top quartile of the income distribution. It followed up with a more modest stopgap measure in late December before embarking on the largest round of economic impact payments this spring. The net effect has been to do more than enough to buffer the economy from the pandemic and push any potential hangover beyond the range of our twelve-month investment timeframe. Away from the constant of the policy efforts, however, there is much that is uncertain about key elements of the economic and market outlook. We do not have a definitive answer about what the future holds for the labor market, consumption, or equity valuations. For each topic we consider what is known, what is unknown and list the series we’ll be monitoring to assess whether our base case is on track. We remain constructive on financial markets and the economy, though we recognize that our conviction levels must be lower given the lack of close empirical comparisons to the current backdrop. We will shift with the data series if they move in ways that convincingly challenge our base-case scenarios. The Work Force Known Factor(s): The pandemic has driven a reduction in labor force participation. After catching up from the cyclical damage inflicted by the Global Financial Crisis, the share of people age 16 and above who are working or looking for work has once again fallen well off its implied demographic pace (Chart 1, top panel). GDP and S&P 500 earnings are making new highs, but labor force participation is still down by 2%, after having fallen a whopping 4.9% at the April 2020 trough (Chart 1, bottom panel). Labor force participation typically slips during recessions, but the pandemic’s peak-to-trough decline was more than five times the decline experienced during the GFC, which held the previous record. Chart 1The Pandemic Washed Away A Chunk Of The Work Force Unknown Factor(s): The explosion in unemployment while communities were sheltering in place was a foregone conclusion, and it’s easy to see how people might have slipped out of the labor force as they withdrew from jobs that lost their luster. There are more job openings than unemployed people now, though (Chart 2), and there are still 3.2 million fewer people in the labor force than there were before the pandemic. The persistence of high unemployment and low participation is a mystery that no study has fully explained. The most frequently cited hypotheses involve generous unemployment insurance (UI) benefits, difficulty securing care for children or adults, and fear of infection. Chart 2The Labor Market Is Unusually Tight We are skeptical of claims that supplemental UI benefits and the additional cushion provided by the three rounds of direct payments to households are a principal driver. $3,200 per adult ($1,200 in Round 1, $600 in Round 2 and $1,400 in Round 3) is nice but it won’t replace even $10 hourly wages for more than a couple months. UI benefits can’t be blamed for the low participation rate (you can’t collect them if you drop out), and their impact on the unemployment rate may also be less than it’s been cracked up to be. We found a very weak negative relationship between state-level replacement rates (the value of average UI benefits relative to average compensation) and changes in state unemployment rates while the most generous $600 weekly federal UI benefit supplement was in effect (Chart 3). Chart 3State Unemployment Rates Were Indifferent To Replacement Rates July’s state unemployment rates were inconclusive on the question of whether exiting the federal supplemental UI benefit program reduced unemployment. The 25 states that ended their participation early (Chart 4, top panel) saw a smaller decline in their average unemployment rate than the 26 (including Washington, DC) that remain in the program (Chart 4, bottom panel), but the early-exit states had a lower starting average unemployment rate. Of the 18 states that had statistically significant month-on-month unemployment rate declines, 8 have already exited the supplement UI benefit program and 10 remain. Of the 39 states with statistically significant employment gains, 17 have already exited the supplement UI benefit program and 22 remain. We expect the end of augmented benefits in early September will give the labor market a modest boost, but curtailing benefit supplements does not appear to be a silver bullet for reducing unemployment or increasing participation. Chart 4Much Ado About Nothing Chart 5Fewer Care Options, Fewer Workers We suspect family care burdens have been more of a drag on participation and/or exiting the unemployment rolls. Young children attending school remotely had to have adult supervision, sidelining adults who could not work remotely. Similarly, many workers who relied on outside providers to care for adult family members during the day found themselves unable to work or petrified of exposing their homebound loved ones to the virus if they did. Family care burdens regularly fall more heavily on females than males and the greater decline in aggregate female participation (Chart 5, top panel) and across the below prime-age (second panel), prime-age (third panel) and above prime-age (bottom panel) categories suggests care issues are restraining employment. Infection fears likely waned with the development of effective vaccines and their initially rapid distribution, but the spread of the Delta variant may have rekindled them, especially in areas with low vaccination rates. It will take progress in vaccinating the reluctant and the dissemination of antibodies via new infections to hasten the peak in the Delta wave, which should align with a peak in infection fears. What We’re Watching: Net nonfarm payrolls gains; labor force participation; COVID-19 infections, hospitalizations and deaths; vaccinations; schools’ ability to host in-person learning; ongoing data from states exiting the federal UI benefit; approval of vaccines for children under 12. Consumption Chart 6More Came In, Less Went Out Known Factor(s): Increased income from fiscal transfers and decreased spending from activity constraints have allowed households to amass $2.3 trillion of excess pandemic savings (Chart 6). Some of the savings went to pay down outstanding debt, with households cutting their credit card balances by 14% before slowly starting to build them back up over the last few months (Chart 7). The combination of less debt and low rates has pushed debt-service burdens to their lowest level in four decades (Chart 8). Powered by savings, financial market gains and home price appreciation, household net worth grew at its fastest five-quarter rate ever from 1Q20 through 1Q21. Chart 7Households Actively De-levered During The Pandemic Chart 8Plenty Of Room To Service New Debt Unknown Factor(s): Changes in household net worth lead changes in personal consumption expenditures by two quarters, though 2020 consumption fell way short of the level predicted by the best-fit regression line. We do not know how much of last year’s consumption was lost to the pandemic and how much was merely deferred. We also don’t know where the savings rate will stabilize going forward or how much it might overshoot to the downside before settling into its new longer-run range. Simply put, we don’t know how much households will spend from their newly accumulated stash. We do know, however, that the savings rate fell steadily from the mid-seventies, when the baby boomers began entering their prime working years, to the onset of the GFC (Chart 9). In recent client meetings we have made the conservative assumption that half of the $2.3 trillion of excess savings will be spent by the end of 2022. That would amount to a tailwind equivalent to 5% of a year’s GDP and keep the US growing at well above trend in 2021 and 2022. It remains to be seen, however, how much of their excess savings households will spend and when. Chart 9The Savings Rate Will Come Down What We’re Watching: Household income, consumption, savings rate, credit card and other consumer loan balances, borrower performance, lender willingness, spending on services and spending on goods. Asset Prices Known Factor(s): Ample and immediate monetary and fiscal accommodation put a floor under financial asset prices at the beginning of the pandemic. Thanks to the policy actions, stock prices have soared, investment grade and high yield bonds have delivered solid excess returns and home prices have surged (Table 1). The S&P 500 has risen 36% on a fundamental boost from an 18% increase in forward four-quarter earnings estimates and a valuation boost in the form of a 15% forward multiple expansion (Chart 10). Investment grade and high yield spreads have tightened to near their all-time lows (Chart 11) while trailing and forecasted defaults are low and rating upgrades are outpacing rating downgrades. Table 1Riskier Assets Are Having A Great Pandemic Chart 10Fundamentals Have Taken The Baton From Valuation Unknown Factor(s): We have argued that the next four quarters’ S&P 500 earnings estimates, which project a 1.9% decline from last quarter’s annualized run rate, will have to be revised higher to align with expected nominal annualized GDP growth near 9% in the second half of this year and 6% in the first half of next year. The future direction of forward earnings multiples is a much harder call, as it is largely a function of sentiment. It is also influenced by investors’ asset allocation options, and it does not look to us like TINA is going to be dislodged any time soon, as caution at the major developed world central banks will keep interest rates from gaining much upward momentum and a surfeit of liquidity will keep fixed income spreads tight. We argued with high conviction in a recent Special Report that housing poses no immediate threat to US financial stability because banks have no more than modest exposure to residential mortgages and the loans they have made are eminently sound. We stand by that view and further note that home prices are well supported in the near term by tight supplies and limited new construction activity. Finally, mortgage rates are extremely low and though we expect they will rise, we think they will do so at a slow, grinding pace throughout the second half and across 2022. What We’re Watching: Corporate earnings, interest rates, mortgage availability, flows into and out of risky assets, Fed guidance and anything bearing on risk appetites. Chart 11Don't Look For Further Capital Gains On Bonds Investment Implications Investors’ default position seems to be to assume that policy interventions will be exposed as artifice and elevated valuations will soon deflate. Neither has happened yet, however, and it doesn’t look like either will over the next twelve months. The Fed’s measures will have an extended influence because the fed funds rate will likely be zero until at least late 2022, monetary policy works with a lag and it will be a while before policy settings become truly restrictive. As for the fiscal transfers, they’ve largely been squirreled away as excess savings and their effect will only be felt as they’re consumed and/or funneled into financial markets. We don’t see elevated valuations retreating without a catalyst, given the ocean of liquidity in the US and the rest of the major developed economies. The money has to go somewhere as rapidly accelerating home prices around the world attest. Upward pressure on asset prices, especially for homes, has been a reliable source of instability but we don’t yet have concerns in the US, where mortgages have been extended to highly rated borrowers and the banking system has comparatively little exposure to residential loans. We are not saying multiples (or spreads) will remain elevated (tight) forever. We believe that today’s high prices will suppress long-term returns. Conditions look favorable for the next twelve months, however, and we think investors should take advantage of them before the longer-term adverse consequences emerge to weigh on returns. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com
Highlights Fed: The Fed is preparing markets for a taper announcement in Q4 of this year. But we don’t see asset purchase tapering as a catalyst for higher bond yields. Rather, bond yields will move higher as the employment data continue to come in hot. Job growth will be strong enough to reach the Fed’s definition of maximum employment by the end of 2022, and the fed funds rate will rise more quickly than is implied by current market expectations. Duration: The 10-year Treasury yield will reach a range of 2% to 2.25% by the time the Fed is ready to lift rates, near the end of 2022. Strong employment data will catalyze the next significant jump in bond yields, but this may not happen until Q4 of this year. The spread of the delta COVID variant could limit the pace of hiring during the next month or two, and bond market positioning may need to turn more bullish before yields can rise. Labor Market: After July’s strong employment report, we calculate that average monthly nonfarm payroll growth of 431k is required to reach the Fed’s “maximum employment” liftoff criteria by the end of 2022. Feature Chart 1A Tapering Announcement Is Coming It’s finally time to talk about tapering. Several Fed governors and regional presidents made media appearances last week, each one presenting a timeline that sets up a tapering announcement before the end of this year. Federal Reserve Governor Christopher Waller: I think you could be ready to do an announcement by September. That depends on what the next two jobs reports do. If they come in as strong as the last one, then I think you have made the progress you need. If they don’t, then I think you are probably going to have to push things back a couple of months.1 St Louis Fed President James Bullard: I don’t think that we need to continue with these purchases now that we’ve got new risks on the horizon and possibly inflation risks on the horizon. […] What I think we should do here is start sooner and go faster and get finished by the end of the first quarter of next year. We don’t really need the purchases anymore.2 Dallas Fed President Robert Kaplan: As long as we continue to make progress in July (jobs) numbers and in August jobs numbers, I think we’d be better off to start adjusting these purchases soon. Doing so gradually, over a time frame of plus or minus about eight months, will help give ourselves as much flexibility as possible to be patient and be flexible on the fed funds rate.3 Fed Governor Lael Brainard presented the most detailed description of what it will take for the Fed to start paring its asset purchases.4 Since December, the Fed’s criteria for tapering has been “substantial further progress” toward its employment and price stability goals. In December, nonfarm payrolls were about 10 million below pre-pandemic levels (Chart 2A). In her speech, which was given prior to the release of July’s jobs report, Brainard noted that if employment grows at the same rate in Q3 as it did in Q2, then “about two-thirds of the outstanding job losses as of December 2020” would be made up by the end of 2021. That figure rose to 71% after July’s strong jobs number (Chart 2B). Chart 2AConditions For Tapering Chart 2BDefining "Substantial Further Progress" In other words, as long as employment growth stays solid – in the 500k/month range – then the Fed will be well over 50% of the way toward its maximum employment goal by the end of this year. This would certainly count as “substantial further progress”. Our expectation is that Q3 jobs growth will be strong enough for the Fed to make an official taper announcement in Q4, with the actual tapering starting in January 2022.5 There is an outside chance that the Fed will rush to start tapering earlier, but only if long-dated inflation expectations rise to well above the Fed’s target range (Chart 2A, bottom panel). As for market impact, we don’t expect the tapering announcement to move markets all that much. First, we mainly care about asset purchase tapering because it could signal that the Fed intends to move more quickly toward rate hikes (Chart 1). This is the concern that prompted the 2013 taper tantrum. This time around, however, the Fed has tied liftoff to explicit employment and inflation criteria. This forward guidance significantly weakens the signaling power of any tapering announcement. Second, surveys indicate that market participants already anticipate that tapering will start in early-2022 (Tables 1A & 1B). In other words, a Q4 taper announcement shouldn’t be that much of a shock to expectations. Table 1ASurvey Of Market Participants Expected Fed Timeline Table 1BSurvey Of Primary Dealers Expected Fed Timeline Interestingly, Fed Vice-Chair Richard Clarida did manage to shock markets with his speech last week, but only because he went further than just a discussion of tapering. Specifically, Clarida articulated his expected timeline for lifting interest rates: Chart 3Median FOMC Forecasts While, as Chair Powell indicated last week, we are clearly a ways away from considering raising interest rates and this is certainly not something on the radar screen right now, if the outlook for inflation and outlook for unemployment I summarized earlier turn out to be the actual outcomes for inflation and unemployment realized over the forecast horizon, then I believe that these three necessary conditions for raising the target range for the federal funds rate will have been met by year-end 2022.6 What are the economic forecasts that Clarida says would meet the conditions for liftoff by the end of 2022? It turns out that they are very close to the FOMC’s median projections (Chart 3). The Fed’s forecast calls for 3% core PCE inflation in 2021, falling to 2.1% in 2022 and 2023. The Fed also sees the unemployment rate falling to 4.5% by the end of this year, 3.8% by the end of 2022 and 3.5% by the end of 2023. Clarida said that he views this forecast as consistent with overall employment returning to its pre-pandemic levels by the end of 2022. We think Clarida’s expected timeline is reasonable. The Appendix at the end of this report presents different scenarios for when the Fed’s “maximum employment” liftoff condition might be met. We estimate that average monthly nonfarm payroll growth of 431k will get us to maximum employment by the end of 2022, in time for early-2023 liftoff. At least so far, monthly nonfarm payroll growth is tracking well above the 431k threshold. If we compare our (and Clarida’s) forecast to market prices, we conclude that market rate expectations are too low. The overnight index swap curve is priced for Fed liftoff in January 2023 but for not even three 25 basis point rate hikes in total by the end of 2023 (Chart 4). This seems too low if the Fed’s liftoff criteria are in fact met by the end of 2022, as is our expectation. Chart 4Rate Expectations Bottom Line: The Fed is preparing markets for a taper announcement in Q4 of this year. But we don’t see asset purchase tapering as a catalyst for higher bond yields. Rather, bond yields will move higher as the employment data continue to come in hot. Job growth will be strong enough to reach the Fed’s definition of maximum employment by the end of 2022, and the fed funds rate will rise more quickly than is implied by current market expectations. Timing The Move Higher In Yields Our expectation for a return to maximum employment by the end of 2022 implies that bond yields will be significantly higher by then. Specifically, we expect that both the 5-year/5-year forward Treasury yield and the 10-year Treasury yield will be in a range between 2% and 2.25% by the time of the first rate hike (Chart 5). The 2% to 2.25% range is consistent with survey estimates of the long-run neutral fed funds rate. But a big question remains over the timing of the next move higher in yields. Are bond yields poised to jump higher immediately? Or will they remain low for the next few months and move up only in 2022? Our sense is that the catalyst for the next significant jump in bond yields will be surprisingly strong employment data. There is widespread consensus that inflation will be close to the Fed’s target (if not higher) by the end of 2022, but recent concerns about labor supply have increased the uncertainty around employment projections. Ultimately, we think that labor supply constraints will ease and that the unemployment rate will catch up to levels implied by different labor demand indicators (Chart 6). However, this may not happen during the next month or two. Chart 5A Target For Long-Dated Yields Chart 6Labor Demand Is Strong The spread of the Delta coronavirus variant has just started to ramp up in the United States (Chart 7). The UK’s experience with the variant shows that vaccination significantly limits the number of hospitalizations and suggests that economic lockdowns can be avoided. However, it took about one month for the UK’s new case count to peak once the variant started spreading. A similar roadmap could lead to hiring delays in the US during the next month or two, at least until the new case count starts to fall and concerns abate. From a market technical perspective, we also note that bond market positioning remains significantly net short and that bond market sentiment is less bullish than is often the case at major inflection points (Chart 8). This is not the ideal technical set-up for a large immediate jump in bond yields. Chart 7Delta Is A Near-Term Risk To Hiring Chart 8Positioning & Sentiment Bottom Line: The 10-year Treasury yield will reach a range of 2% to 2.25% by the time the Fed is ready to lift rates, near the end of 2022. Strong employment data will catalyze the next significant jump in bond yields, but this may not happen until Q4 of this year. The spread of the delta COVID variant could limit the pace of hiring during the next month or two, and bond market positioning may need to turn more bullish before yields can rise. Appendix: How Far From “Maximum Employment” And Fed Liftoff? Chart A1Defining “Maximum Employment” The Federal Reserve has promised that the funds rate will stay pinned at zero until the labor market returns to “maximum employment”. The Fed has not provided explicit guidance on the definition of “maximum employment”, but we deduce that “maximum employment” means that the Fed wants to see the U3 unemployment rate within a range consistent with its estimates of the natural rate of unemployment, currently 3.5% to 4.5%, and that it wants to see a more or less complete recovery of the labor force participation rate back to February 2020 levels (Chart A1). Alternatively, we can infer definitions of “maximum employment” from the New York Fed’s Surveys of Primary Dealers and Market Participants. These surveys ask respondents what they think the unemployment and labor force participation rates will be at the time of Fed liftoff. Currently, the median respondent from the Survey of Market Participants expects an unemployment rate of 3.5% and a participation rate of 63%. The median respondent from the Survey of Primary Dealers expects an unemployment rate of 3.7% and a participation rate of 63%. Tables A1-A4 present the average monthly nonfarm payroll growth required to reach different combinations of unemployment rate and participation rate by specific future dates. For example, if we use the definition of “maximum employment” from the Survey of Market Participants, then we need to see average monthly nonfarm payroll growth of +431k in order to hit “maximum employment” by the end of 2022. Table A1Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4.5% By The Given Date Table A2Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4% By The Given Date Table A3Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 3.5% By The Given Date Table A4Average Monthly Nonfarm Payroll Growth Required To Reach “Maximum Employment” As Defined By Survey Respondents Chart A2 presents recent monthly nonfarm payroll growth along with target levels based on the Survey of Market Participants’ definition of “maximum employment”. This chart is to help us track progress toward specific liftoff dates. For example, if monthly nonfarm payroll growth continues to print at the same level as last month, then we could anticipate a Fed rate hike by June 2022. Table A2Tracking Toward Fed Liftoff We will continue to track these charts and tables in the coming months, and will publish updates after the release of each monthly employment report. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.bloomberg.com/news/articles/2021-08-02/waller-says-strong-job-reports-may-warrant-september-taper-call?sref=Ij5V3tFi 2 https://www.stlouisfed.org/from-the-president/video-appearances/2021/bullard-washington-post-inflation-tapering 3 https://www.reuters.com/business/finance/exclusive-feds-kaplan-wants-bond-buying-taper-start-soon-be-gradual-2021-08-04/ 4 https://www.federalreserve.gov/newsevents/speech/brainard20210730a.htm 5 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A Central Bank Timeline For The Next Two Years”, dated June 1, 2021. 6 https://www.federalreserve.gov/newsevents/speech/clarida20210804a.htm Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns
Highlights Economy – A range of economic and fundamental indicators are at such high levels that deceleration is inevitable: US growth will peak any day if it hasn’t done so already. Markets – Financial markets typically pay closer heed to direction than level: All else equal, we prefer direction to level as well, but levels are likely to remain elevated for a while even as deceleration takes hold, and investors should take that into account when assessing the outlook. Strategy – Remain overweight equities and credit in multi-asset portfolios: Risk assets are likely to continue to generate positive excess returns over Treasuries and cash despite moderating growth. Feature COVID-19’s arrival ushered in a wave of extremes in monetary and fiscal policy measures, economic data and financial markets. Everywhere investors look, data series are at unusually outlying levels. Inflation pressures are more intense than they have been in decades, as measured by consumer price indexes and a range of business surveys. Household net worth has advanced at its fastest-ever five-quarter pace despite the record setback that began the pandemic, S&P 500 earnings growth has demolished analyst expectations over the last five quarters, the federal government has injected a head-spinning amount of fiscal stimulus into the economy and the Fed has done all it seemingly could to cushion the pandemic’s economic blow. Much of the growth has resulted from Herculean stimulus measures that cannot be maintained on a rate-of-change basis. The slowdown in fiscal and monetary thrust implies that economic growth, along with several other series that are viewed as significant financial market drivers, will soon peak if they haven’t already. The looming deceleration has kindled a recurring debate among BCA researchers: What matters most for financial markets, level or direction? The answer to the most challenging questions in markets and economics is often “it depends,” and that’s the way we view the level-versus-direction debate. We’d position a portfolio based on direction if key series were just breaking above or below trend levels with robust momentum, but it’s a more nuanced decision when they are slowing from exceedingly high levels and a modestly decelerating pace should have them still sitting well above trend this time next year. Our view, then, is that the interaction between level and direction will drive markets going forward. Given that we have cited a range of levels in support of our bullish stance, however, it is prudent to ask how good might be too good for reliably mean-reverting series. We therefore examine the empirical record of how S&P 500 returns have interacted with the level and direction of the unemployment rate, earnings-per-share growth, and interest rates. We conclude that the humble level matters as well as the more celebrated rate of change and that deceleration will not spell the end of the equity bull market. The Unemployment Rate We used the unemployment rate as a proxy for the impact of macroeconomic changes on S&P 500 returns. While the unemployment rate is quite variable from month to month, it tends to follow a clear pattern over longer periods of time, rising very rapidly to cyclical peaks before meandering its way to cyclical troughs. Over the series’ 73-year history, there have been eleven complete rising phases and it is currently in its eleventh declining phase (Chart 1). Owing to unemployment’s established pattern – it takes the elevator up and the stairs down, flipping equity indexes’ pattern on its head – the eleven rising phases have spanned 30% of the nearly 900 months while the falling phases currently total 70% of them. Chart 1Unemployment Takes The Elevator Up And The Stairs Down A simple compilation of one-month forward S&P 500 returns based on the level of the unemployment rate has a clear theme – stocks do well when the rate is at least one standard deviation above the mean (about 7.4% or higher) and poorly when it is one or more standard deviations below it (about 4.2% or lower) (Chart 2, left side). A compilation based on the month-to-month direction of the unemployment rate – up, down or unchanged – also favors rising unemployment, though it is unclear what investors should conclude from the fact that rising and falling both outperform unchanged (Chart 2, right side). Chart 2The S&P 500 Is Sensitive To Anticipated Turns In Unemployment We think the analysis is much improved if the unemployment rate is combined with its direction as indicated by the cycle phase. The interaction of level and phase provides more information than the simple message that high unemployment is good for equities and low unemployment is bad. Applying the rising or falling unemployment rate phase to the ranges shown in Chart 2, we find that direction matters quite a lot within four of the five ranges, where the annualized return differs by thirteen to sixteen percentage points based on the underlying trend (Table 1). Table 1Level And Direction Tell The Most Compelling Story Equities are just coming off their bottom, on balance, when the unemployment rate exceeds a standard deviation above its mean and is still rising. Direction is everything when the rate is below its mean (5.8%). When it’s falling, there’s plenty of money to be made in an expanding economy before the Fed has designs on removing the punch bowl, though once the rate is a standard deviation below the mean (4.2% or lower), the equity top is near. Once the unemployment rate rises off the bottom, even though it’s still at an unusually low level, the equity tide has already begun to go out. Losses are in store until the rate gets back above the mean, signaling future improvement. Chart 3Up, Up And Away It is important to recognize that we can only demarcate the unemployment rate’s phases in retrospect. There is no telling with certainty in real time how far a nascent trend will go. We do expect, however, in line with every FOMC voter, that the unemployment rate is likely to approach the vicinity of last cycle’s lows before the current phase ends. If that expectation is realized, there is a stretch of downward movement ahead (a good chunk of the 1.7% standard deviation, though July claimed 50 basis points of it) that has empirically been quite favorable for the S&P 500. The speed with which it covers the ground from here to 4% or below is unknown. Given the tremendous pent-up demand for labor, as evidenced by a record high job openings rate (Chart 3), the unemployment rate may come down much faster than it normally does. The level-and-direction analysis makes it clear that 5.9% and falling has provided an auspicious backdrop for equity investors, and the Fed’s more relaxed reaction function may allow the economy to run a little hotter than it normally would once unemployment falls below its natural rate. All in all, the empirical record of the relationship between the unemployment rate and equities suggests that stocks have room to run while the labor market improves. Earnings The unemployment rate may not be too low for equities to continue to rally, but is earnings growth too good for stocks’ own good? It doesn’t appear to be, given the historical interaction between forward one-quarter S&P 500 performance and the speed and acceleration of growth in trailing four-quarter earnings. We use trailing earnings because they exhibit extended trends that highly variable sequential changes in single-quarter data do not. Since 1948, trailing four-quarter operating earnings have experienced eleven complete double-digit declines from cycle peaks and eleven complete earnings growth phases, while beginning a new growth phase in the first quarter (Chart 4). Chart 4Steady Growth With Occasional Hiccups The chart shows that four-quarter earnings have grown in a pattern that features extended growth phases punctuated by concentrated declines that are occasionally severe. This pattern is the mirror image of the unemployment rate’s and S&P 500 earnings have been in a growth phase three out of every four quarters on the way to an annualized growth rate of 6.4%. Since P/E multiples are a mean-reverting series, stocks need to grow earnings to rise over time, but there is little difference in lagged S&P 500 returns when earnings are in growth or contraction mode (Chart 5). The disparity widens within each broad phase when we considered the growth rates – deceleration has been better for stock prices than acceleration within expansion phases, while a slowing rate of decline has been a tremendous catalyst when earnings are in a contraction phase. Chart 5More Money Is Made From Terrible To Bad Than From Good To Great To explore S&P 500 index performance during acceleration and deceleration phases within growth ranges, we repeated the unemployment rate analysis. The return disparities for different earnings ranges were not nearly as clear cut as they were for different unemployment ranges, but acceleration was good for near-term equity returns in the middle of the earnings growth distribution, while deceleration trumped acceleration at growth rates plus or minus three quarters of a standard deviation from the mean (Table 2). Table 2Headed Out Of The Earnings Sweet Spot The muddled empirical record does not point to a clear path for S&P 500 returns over the next few quarters. We assign a very low probability to a recession over the next year, virtually ensuring that the growth phase that began last quarter will continue. If actual earnings turn out to be somewhat close to the current consensus expectation, however, all subsequent quarters in this growth phase will be decelerating, and deceleration within growth phases (Table 2, circled three outcomes) has previously yielded below-average price returns. Trailing four-quarter earnings growth appears sustainable over the next year, however, and history is hardly sounding an alarm. Interest Rates We have already examined the relationship between moves in real 10-year Treasury yields and equity performance in a dedicated Special Report.1 The executive summary is that the level of real rates has exerted a greater influence on S&P 500 returns than their direction. The empirical evidence suggests that stocks generally outperform when real rates are rising, though they hit a wall once the real 10-yield exceeds estimated potential real GDP growth. They also underperform at the other extreme, as extremely negative real rates tend to be associated with dire economic conditions, but potentially frightening weakness is not a feature of today’s negative real-rate backdrop. Per the potential-GDP-rule-of-thumb, the nominal 10-year Treasury yield that would begin to crimp economic activity is around 4.5-5%, assuming potential GDP growth of 1.75-2% and annual inflation with a central tendency near 3%. It is very difficult to see the 10-year yield exceeding one-half of that threshold level in the next twelve months. Though a yield backup to 2% or above over the next year would likely have significant implications for relative returns within the S&P 500, we do not think it would spell the end of the equity rally. The bottom line, then, is that we do not believe that interest rates are at a level that makes equities especially vulnerable. Price-earnings multiples may well contract if real rates rise in line with our expectations, but we expect that earnings and earnings estimates would rise enough to offset the de-rating pressure. Investment Implications Mean reversion is a bedrock investment concept, and it helps explain why the level of variables that impact equity returns can be deceiving. When key variables reach extremes, the potential of an abrupt reversal increases. Financial markets are additionally forward discounting mechanisms and the rate of change – a variable’s “second derivative” – may offer more insight into its future path than its existing position. It is easy to see why investors typically favor direction over level when looking ahead. Level does not always take a back seat to direction, however, and we think a consideration of how level and direction interact is important when assessing the current landscape. Economic growth will surely slow from double or triple its long-run trend level, earnings will surely stop beating estimates by three or four times the maximum magnitude of the previous 32 quarters, nonfarm payrolls won’t expand by 900,000 every single month (though they may for much of the rest of this year) and a range of other variables won’t keep setting records. But deceleration from record highs will not necessarily spell the end of the rallies in risk assets. While important variables remain at elevated levels, equities and credit are likely to continue to generate excess returns. Extraordinary monetary and fiscal accommodation, combined with remarkably swift and successful action to blunt the threat of COVID-19, have carried financial markets for the last year-plus and we don’t think they’re finished yet. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the September 24, 2018 US Investment Strategy Special Report, "When Will Higher Rates Hurt Stocks?", available at usis.bcaresearch.com.
Highlights Globalization is recovering to its pre-pandemic trajectory. But it will fail to live up to potential, as the “hyper-globalization” trends of the 1990s are long gone. China was the biggest winner of hyper-globalization. It now faces unprecedented risks in the context of hypo-globalization. Global investors woke up to China’s domestic political risks this year, which include arbitrary regulatory crackdowns on tech and private business. While Chinese officials will ease policy to soothe markets, the cyclical and structural outlook is still negative for this economy. Growth and stimulus have peaked. Political risk will stay high through the national party congress in fall 2022. US-China relations have not stabilized. India, the clearest EM alternative for global investors, is high-priced relative to China and faces troubles of its own. It is too soon to call a bottom for EM relative to DM. Feature Global investors woke up to China’s domestic political risk over the past week, as Beijing extended its regulatory crackdown to private education companies. Our GeoRisk Indicator shows Chinese political risk reaching late 2017 levels while the broad Chinese stock market continued this year’s slide against emerging market peers (Chart 1). Chart 1China: Domestic Political Risk Takes Investors By Surprise A technical bounce in Chinese tech stocks will very likely occur but we would not recommend playing it. The first of our three key views for 2021 is the confluence of internal and external headwinds for China. True, today’s regulatory blitz will pass over like previous ones and the fast money will snap up Chinese tech firms on the cheap. The Communist Party is making a show of force, not destroying its crown jewels in the tech sector. However, the negative factors weighing on China are both cyclical and structural. Until Chinese President Xi Jinping adjusts his strategy and US-China relations stabilize, investors do not have a solid foundation for putting more capital at risk in China. Globalization is in retreat and this is negative for China, the big winner of the past 40 years. Hypo-Globalization Globalization in the truest sense has expanded over millenia. It will only reverse amid civilizational disasters. But the post-Cold War era of “hyper-globalization” is long gone.1 The 2010s saw the emergence of de-globalization. In the wake of COVID-19, global trade is recovering to its post-2008 trend but it is nowhere near recovering the post-1990 trend (Chart 2). Trade exposure has even fallen within the major free trade blocs, like the EU and USMCA (Chart 3). Chart 2Hypo-Globalization Chart 3Trade Intensity Slows Even Within Trade Blocs Of course, with vaccines and stimulus, global trade will recover in the coming decade. We coined the term “hypo-globalization” to capture this predicament, in which globalization is set to rebound but not to its previous trajectory.2 We now inhabit a world that is under-globalized and under-globalizing, i.e. not as open and free as it could be. A major factor is the US-China economic divorce, which is proceeding apace. China’s latest state actions – in diplomacy, finance, and business – underscore its ongoing disengagement from the US-led global architecture. The US, for its part, is now on its third presidency with protectionist leanings. American and European fiscal stimulus are increasingly protectionist in nature, including rising climate protectionism. Bottom Line: The stimulus-fueled recovery from the global pandemic is not leading to re-globalization so much as hypo-globalization. A cyclical reboot of cross-border trade and investment is occurring but will fall short of global potential due to a darkening geopolitical backdrop. Still No Stabilization In US-China Relations Chart 4Do Nations Prefer Growth? Or Security? A giant window of opportunity is closing for China and Russia – they will look back fondly on the days when the US was bogged down in the Middle East. The US current withdrawal from “forever wars” incentivizes Beijing and Moscow to act aggressively now, whether at home or abroad. Investors tend to overrate the Chinese people’s desire for economic prosperity relative to their fear of insecurity and domination by foreign powers. China today is more desirous of strong national defense than faster economic growth (Chart 4). The rise of Chinese nationalism is pronounced since the Great Recession. President Xi Jinping confirmed this trend in his speech for the Communist Party’s first centenary on July 1, 2021. Xi was notably more concerned with foreign threats than his predecessors in 2001 and 2011 (Chart 5).3 China has arrived as a Great Power on the global stage and will resist being foisted into a subsidiary role by western nations. Chart 5Xi Jinping’s Centenary Speech Signaled Nationalist Turn Meanwhile US-China relations have not stabilized. The latest negotiations did not produce agreed upon terms for managing tensions in the relationship. A bilateral summit between Presidents Biden and Xi Jinping has not been agreed to or scheduled, though it could still come together by the end of October. Foreign Minister Wang Yi produced a set of three major demands: that the US not subvert “socialism with Chinese characteristics,” obstruct China’s development, or infringe on China’s sovereignty and territorial integrity (Table 1). The US’s opposition to China’s state-backed economic model, export controls on advanced technology, and attempts to negotiate a trade deal with the province of Taiwan all violate these demands.4 Table 1China’s Three Demands From The United States (July 2021) The removal of US support for China’s economic, development – recently confirmed by the Biden administration – will take a substantial toll on sentiment within China and among global investors. US President Joe Biden and four executive departments have explicitly warned investors not to invest in Hong Kong or in companies with ties to China’s military-industrial complex and human rights abuses. The US now formally accuses China of genocide in the Xinjiang region.5 Bottom Line: There is no stabilization in US-China relations yet. This will keep the risk premium in Chinese currency and equities elevated. The Sino-American divorce is a major driver of hypo-globalization. China’s Regulatory Crackdown President Xi Jinping’s strategy is consistent. He does not want last year’s stimulus splurge to create destabilizing asset bubbles and he wants to continue converting American antagonism into domestic power consolidation, particularly over the private economy. Now China’s sweeping “anti-trust” regulatory crackdown on tech, education, and other sectors is driving a major rethink among investors, ranging from Ark-founder Cathie Wood to perma-bulls like Stephen Roach. The driver of the latest regulatory crackdown is the administration’s reassertion of central party control. The Chinese economy’s potential growth is slowing, putting pressure on the legitimacy of single-party rule. The Communist Party is responding by trying to improve quality of life while promoting nationalism and “socialism with Chinese characteristics,” i.e. strong central government control and guidance over a market economy. Beijing is also using state power and industrial policy to attempt a great leap forward in science and technology in a bid to secure a place in the sun. Fintech, social media, and other innovative platforms have the potential to create networks of information, wealth, and power beyond the party’s control. Their rise can generate social upheaval at home and increase vulnerability to capital markets abroad. They may even divert resources from core technologies that would do more to increase China’s military-industrial capabilities. Beijing’s goal is to guide economic development, break up the concentration of power outside of the party, prevent systemic risks, and increase popular support in an era of falling income growth. Sociopolitical Risks: Social media has demonstrably exacerbated factionalism and social unrest in the United States, while silencing a sitting president. This extent of corporate power is intolerable for China. Economic And Financial Risks: Innovative fintech companies like Ant Group, via platforms like Alipay, were threatening to disrupt one of the Communist Party’s most important levers of power: the banking and financial system. The People’s Bank of China and other regulators insisted that Ant be treated more like a bank if it were to dabble in lending and wealth management. Hence the PBoC imposed capital adequacy and credit reporting requirements.6 Data Security Risks: Didi Chuxing, the ride-sharing company partly owned by Uber, whose business model it copied and elaborated on, defied authorities by attempting to conduct its initial public offering in the United States in June. The Communist Party cracked down on the company after the IPO to show who was in charge. Even more, Beijing wanted to protect its national data and prevent the US from gaining insights into its future technologies such as electric and autonomous vehicles. Foreign Policy Risks: Beijing is also preempting the American financial authorities, who will likely take action to kick Chinese companies that do not conform to common accounting and transparency standards off US stock exchanges. Better to inflict the first blow (and drive Chinese companies to Hong Kong and Shanghai for IPOs) than to allow free-wheeling capitalism to continue, giving Americans both data and leverage. Thus Beijing is continuing the “self-sufficiency” drive, divorcing itself from the US economy and capital markets, while curbing high-flying tech entrepreneurs and companies. The party’s muscle-flexing will culminate in Xi Jinping’s consolidation of power over the Politburo and Central Committee at the twentieth national party congress in fall 2022, where he is expected to take the title of “Chairman” that only Mao Zedong has held before him. The implication is that the regulatory crackdown can easily last for another six-to-12 more months. True, investors will become desensitized to the tech crackdown. But health care and medical technology are said to be in the Chinese government’s sights. So are various mergers and acquisitions. Both regulatory and political risk premia in different sectors can persist. The current administration has waged several sweeping regulatory campaigns against monopolies, corruption, pollution, overcapacity, leverage, and non-governmental organizations. The time between the initial launch of one of these campaigns and their peak intensity ranges from two to five years (Chart 6). Often, but not always, central policy campaigns have an express, three-year plan associated with them. Chart 6ABeijing Cracked Down On Monopolies, Corruption, Pollution... Chart 6B...NGOs, Overcapacity, And Leverage Chart 7China Tech: Buyer Beware The first and second year mark the peak impact. The negative profile of Chinese tech stocks relative to their global peers suggests that the current crackdown is stretched, although there is little sign of bottom formation yet (Chart 7). The crackdown began with Alibaba founder Jack Ma, and Alibaba stocks have yet to arrest their fall either in absolute terms or relative to the Hang Seng tech index. Bottom Line: A technical bounce is highly likely for Chinese stocks, especially tech, but we would not recommend playing it because of the negative structural factors. For instance, we fully expect the US to delist Chinese companies that do not meet accounting standards. The Chinese Government’s Pain Threshold? The government is not all-powerful – it faces financial and economic constraints, even if political checks and balances are missing. Beijing does not have an interest in destroying its most innovative companies and sectors. Its goal is to maintain the regime’s survival and power. China’s crackdown on private companies goes against its strategic interest of promoting innovation and therefore it cannot continue indefinitely. The hurried meeting of the China Securities Regulatory Commission with top bankers on July 28 suggests policymakers are already feeling the heat.7 In the case of Ant Group, the company ultimately paid a roughly $3 billion fine (which is 18% of its annual revenues) and was forced to restructure. Ant learned that if it wants to behave more like a bank athen it will be regulated more like a bank. Yet investors will still have to wrestle with the long-term implications of China’s arbitrary use of state power to crack down on various companies and IPOs. This is negative for entrepreneurship and innovation, regardless of the government’s intentions. Chart 8China's Pain Threshold = Property Sector Ultimately the property sector is the critical bellwether: it is a prime target of the government’s measures against speculative asset bubbles. It is also an area where authorities hope to ease the cost of living for Chinese households, whose birth rates and fertility rates are collapsing. While there is no risk of China’s entire economy crumbling because of a crackdown on ride-hailing apps or tutoring services, there is a risk of the economy crumbling if over-zealous regulators crush animal spirits in the $52 trillion property sector, as estimated by Goldman Sachs in 2019. Property is the primary store of wealth for Chinese households and businesses and falling property prices could well lead to an unsustainable rise in debt burdens, a nationwide debt-deflation spiral, and a Japanese-style liquidity trap. Judging by residential floor space started, China is rapidly approaching its overall economic pain threshold, meaning that property sector restrictions should ease, while monetary and credit policy should get easier as necessary to preserve the economic recovery (Chart 8). The economy should improve just in time for the party congress in late 2022. Bottom Line: China will be forced to maintain relatively easy monetary and fiscal policy and avoid pricking the property bubble, which should lend some support to the global recovery and emerging markets economies over the cyclical (12-month) time frame. China’s Regulation And Demographic Pressures Is the Chinese government not acting in the public interest by tamping down financial excesses, discouraging anti-competitive corporate practices, and combating social ills? Yes, there is truth to this. But arbitrary administrative controls will not increase the birth rate, corporate productivity, or potential GDP growth. First, it is true that Chinese households cite high prices for education, housing, and medicine as reasons not to have children (Chart 9). However, price caps do not attack the root causes of these problems. The lack of financial security and investment options has long fueled high house prices. The rabid desire to get ahead in life and the exam-oriented education system have long fueled high education prices. Monetary and fiscal authorities are forced to maintain an accommodative environment to maintain minimum levels of economic growth amid high indebtedness – and yet easy money policies fuel asset price inflation. In Japan, fertility rates began falling with economic development, the entrance of women in the work force, and the rise of consumer society. The fertility rate kept falling even when the country slipped into deflation. It perked up when prices started rising again! But it relapsed after the Great Recession and Fukushima nuclear crisis (Chart 10, top panel). Chart 9China: Concerns About Having Children China’s fertility rate bottomed in the 1990s and has gradually recovered despite the historic surge in property prices (Chart 10, second panel), though it is still well below the replacement rate needed to reverse China’s demographic decline in the absence of immigration. A lower cost of living and a higher quality of life will be positive for fertility but will require deeper reforms.8 Chart 10Fertility Fell In Japan Despite Falling Prices At the same time, arbitrary regulatory crackdowns that punish entrepreneurs are not likely to boost productivity. Anti-trust actions could increase competition, which would be positive for productivity, but China’s anti-trust actions are not conducted according to rule of law, or due process, so they increase uncertainty rather than providing a more stable investment environment. China’s tech crackdown is also aimed at limiting vulnerability to foreign (American) authorities. Yet disengagement with the global economy will reduce competition, innovation, and productivity in China. Bottom Line: China’s demographic decline will require larger structural changes. It will not be reversed by an arbitrary game of whack-a-mole against the prices of housing, education, and health. India And South Asia Chart 11China Will Ease Policy... Or India Will Break Out Global investors have turned to Indian equities over the course of the year and they are now reaching a major technical top relative to Chinese stocks (Chart 11). Assuming that China pulls back on its policy tightening, this relationship should revert to mean. India faces tactical geopolitical and macroeconomic headwinds that will hit her sails and slow her down. In other words, there is no great option for emerging markets at the moment. Over the long run, India benefits if China falters. Following the peak of the second COVID-19 wave in May 2021, some high frequency indicators have showed an improvement in India’s economy. However, activity levels appear weaker than of other emerging markets (Chart 12). Given the stringency levels of India’s first lockdown last spring, year-on-year growth will look faster than it really is. As the base effect wanes, underlying weak demand will become evident. Moreover India is still vulnerable to COVID-19. Only 25% of the population has received one or more vaccine shots which is lower than the global level of 28%. The result will be a larger than expected budget deficit. India refrained from administering a large dose of government spending in 2020 (Chart 13). With key state elections due from early 2022 onwards, the government could opt for larger stimulus. This could assume the form of excise duty cuts on petroleum products or an increase in revenue expenditure. These kinds of measures will not enhance India’s productivity but will add to its fiscal deficit. Chart 12Weak Post-COVID Rebound In India – And Losing Steam Chart 13India Likely To Expand Fiscal Spending Soon Such an unexpected increase in India’s fiscal deficit could be viewed adversely by markets. India’s fiscal discipline tends to be poorer than that of peers (see Chart 13 above). Meanwhile India’s north views Pakistan unfavorably and key state elections are due in this region. Consequently, Indian policy makers may be forced to adopt a far more aggressive foreign policy response to any terrorist strikes from Pakistan or territorial incursions by China over August 2021. The US withdrawal from Afghanistan poses risks for India as it has revived the Taliban’s influence. India has a long history of being targeted by Afghani terrorist groups. And its diplomatic footprint in Afghanistan has been diminishing. Earlier in July, India decided temporarily to close its consulate in Kandahar and evacuated about 50 diplomats and security personnel. As August marks the last month of formal US presence in Afghanistan, negative surprises emanating from Afghanistan should be expected. Bottom Line: Pare exposure to Indian assets on a tactical basis. Our Emerging Markets Strategy takes a more optimistic view but geopolitical changes could act as a negative catalyst in the short term. We urge clients to stay short Indian banks. Investment Takeaways US stimulus contrasts with China’s turmoil. The US Biden administration and congressional negotiators of both parties have tentatively agreed on a $1 trillion infrastructure deal over eight years. Even if this bipartisan deal falls through, Democrats alone can and will pass another $1.3-$2.5 trillion in net deficit spending by the end of the year. Stay short the renminbi. Prefer a balance of investments in the dollar and the euro, given the cross-currents of global recovery yet mounting risks to the reflation trade. A technical bounce in Chinese stocks and tech stocks is nigh. China’s policymakers are starting to respond to immediate financial pressures. However, growth has peaked and structural factors are still negative. The geopolitical outlook is still gloomy and China’s domestic political clock is a headwind for at least 12 more months. Prefer developed market equities over emerging markets (Chart 14). Emerging markets failed to outperform in the first half of the year, contrary to our expectation that the global reflation trade would lift them. China/EM will benefit when Beijing eases policy and growth rebounds. Chart 14Emerging Markets: Not Out Of The Woods Yet Stay short Indian banks and strongman EM currencies, including the Turkish lira, the Brazilian real, and the Philippine peso. The biggest driver of EM underperformance this year is the divergence between the US and China. But until China’s policy corrects, the rest of EM faces downside risks. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 Dani Rodrik, The Globalization Paradox: Democracy and the Future of the World Economy (New York: Norton, 2011). 2 See my "Nationalism And Globalization After COVID-19," Investments & Wealth Monitor (Jan/Feb 2021), pp13-21, investmentsandwealth.org. 3 Our study of Xi’s speech is not limited to this quantitative, word-count analysis. A fuller comparison of his speech with that of his predecessors on the same occasion reveals that Xi was fundamentally more favorable toward Marx, less favorable toward Deng Xiaoping and the pro-market Third Plenum, utterly silent on notions of political reform or liberal reform, more harsh in his rhetoric toward the outside world, and hawkish about the mission of reunifying with Taiwan. 4 The Chinese side also insisted that the US stop revoking visas, punishing companies and institutes, treating the press as foreign agents, and detaining executives. It warned that cooperation – which the US seeks on the environment, Iran, North Korea, and other areas – cannot be achieved while the US imposes punitive measures. 5 See US Department of State, "Xinjiang Supply Chain Business Advisory," July 13, 2021, and "Risks and Considerations for Businesses Operating in Hong Kong," July 16, 2021, state.gov. 6 Top business executives are also subject to these displays of state power. For example, Alibaba founder Jack Ma caricatured China’s traditional banks as “pawn shops” and criticized regulators for stifling innovation. He is now lying low and has taken to painting! 7 See Emily Tan and Evelyn Cheng, "China will still allow IPOs in the United States, securities regulator tells brokerages," CNBC, July 28, 2021, cnbc.com. Officials are sensitive to the market blowback but the fact remains that IPOs in the US have been discouraged and arbitrary regulatory crackdowns are possible at any time. 8 Increasing social spending also requires local governments to raise more revenue but the central government had been cracking down on the major source of revenues for local government: land sales and local government financing vehicles. With the threat of punishment for local excesses and lack of revenue source, local governments have no choice but to cut social services, pushing affluent residents towards private services, while leaving the less fortunate with fewer services. As with financial regulations, the central government may backpedal from too tough regulation of local governments, but more economic and financial pain will be required to make it happen. The Geopolitics Of The Olympics The 2020 Summer Olympics are currently underway in Tokyo, even though it is 2021. The arenas are mostly empty given the global pandemic and economic slowdown. Every four years the Summer Olympics create a golden opportunity for the host nation to showcase its achievements, infrastructure, culture, and beauty. But the Olympics also have a long history of geopolitical significance: terrorist acts, war protests, social demonstrations, and boycotts. In 1906 an Irish athlete climbed a flag pole to wave the Irish flag in protest of his selection to the British team instead of the Irish one. In 1968 two African American athletes raised their fists as an act of protest against racial discrimination in the US after the assassination of Martin Luther King Jr. In 1972, the Palestinian terrorist group Black September massacred eleven Israeli Olympians in Munich, Germany. In 1980 the US led the western bloc to boycott the Moscow Olympics while the Soviet Union and its allies retaliated by boycotting the 1984 Los Angeles Olympics. In 2008, Russia used the Olympics as a convenient distraction from its invasion of Georgia, a major step in its geopolitical resurgence. So far, thankfully, the Tokyo Olympics have gone without incident. However, looking forward, geopolitics is already looming over the upcoming 2022 Winter Olympics in Beijing. How the world has changed. The 2008 Summer Olympics marked China’s global coming-of-age celebration. The breathtaking opening ceremony featured 15,000 performers and cost $100 million. The $350 million Bird’s Nest Stadium showcased to the world China’s long history, economic prowess, and various other triumphs. All of this took place while the western democratic capitalist economies grappled with what would become the worst financial and economic crisis since the Great Depression. In 2008, global elites spoke of China as a “responsible stakeholder” that was conducting a “peaceful rise” in international affairs. The world welcomed its roughly $600 billion stimulus. Now elites speak of China as primarily a threat and a competitor, a “revisionist” state challenging the liberal world order. China is blamed for a lack of transparency (if not virological malfeasance) in handling the COVID-19 pandemic. It is blamed for breaking governance promises and violating human rights in Hong Kong, for alleged genocide in Xinjiang, and for a list of other wrongdoings, including tough “Wolf Warrior” diplomacy, cyber-crime and cyber-sabotage, and revanchist maritime-territorial claims. Even aside from these accusations it is clear that China is suffering greater financial volatility as a result of its conflicting economic goals. Talk of a diplomatic or even full boycott of Beijing’s winter games is already brewing. Sponsors are also second-guessing their involvement. More than half of Canadians support boycotting the winter games. Germany is another bellwether to watch. In 2014, Germany’s president (not chancellor) boycotted the Sochi Olympics; in 2021, the EU and China are witnessing a major deterioration of relations. Parliamentarians in the UK, Italy, Sweden, Switzerland, and Norway have asked their governments to outline their official stance on the winter games. In the age of “woke capitalism,” a sponsorship boycott of the games is a possibility. This is especially true given the recent Chinese backlash against European multinational corporations for violating China’s own rules of political correctness. A boycott which includes any members of the US, Norway, Canada, Sweden, Germany, or the Netherlands would be substantial as these are the top performers in the Winter Olympics. Even if there is no boycott, there is bound to be some political protests and social demonstrations, and China will not be able to censor anything said by Western broadcasters televising the events. Athletes usually suffer backlash at home if they make critical statements about their country, but they run very little risk of a backlash for criticizing China. If anything, protests against China’s handling of human rights will be tacitly encouraged. Beijing, for its part, will likely overreact, as these days it not only controls the message at home but also attempts more actively to export censorship. This is precisely what the western governments are now trying to counteract, for their own political purposes. The bottom line is that the 2008 Beijing Olympics reflected China’s strengths in stark contrast with the failures of democratic capitalism, while the 2022 Olympics are likely to highlight the opposite: China’s weaknesses, even as the liberal democracies attempt a revival of their global leadership. Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Section II: GeoRisk Indicator China Russia United Kingdom Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Australia Section III: Geopolitical Calendar
Dear Client, I will be on vacation next week. In lieu of our regular report, we will be sending you a Special Report written by my colleague Arthur Budaghyan, BCA Research’s Chief Emerging Markets Strategist. Arthur’s report will discuss the long-term outlook for industrial companies. He argues that the US is entering an industrial boom prompted by infrastructure stimulus and onshoring. This will benefit US industrial equities, or ones selling into the US on a multi-year horizon. I trust you will find it insightful. Best regards, Peter Berezin, Chief Global Strategist Highlights Investors keep asking whether the recent increase in US inflation is transitory. However, this is the wrong question to ask. Annualized core CPI inflation reached 10.6% in the second quarter. There is little doubt that inflation will fall from such elevated levels. The key question that investors should be asking is whether inflation will decline more or less than what the market is discounting. The widely watched 5-year/5-year forward TIPS inflation breakeven rate has sunk to 2.11%, below the Fed’s “comfort zone” of 2.3%-to-2.5%. Thus, the market already expects a substantial decline in inflation. Our sense is that US inflation will come down fast enough to allow the Fed to maintain a highly dovish policy stance, but not as fast as market expectations currently imply. As inflation surprises on the upside, long-term bond yields will rise. This should revive bank shares and other reflationary plays. The combination of a weaker US dollar, faster sequential Chinese growth, increased vaccine supplies, and favorable valuations should all help EM stocks later this year. Go long the Vanguard FTSE Emerging Markets ETF (VWO) versus the Vanguard S&P 500 ETF (VOO). The Right Question About Inflation Chart 1After A Spike In Q2, US Inflation Will Decelerate Investors remain focused on whether the recent bout of US inflation is transitory. However, this is not the correct question to be asking at the present juncture. The US core CPI rose by 10.6% at an annualized pace in Q2 relative to the first quarter (Chart 1). It is almost inevitable that inflation will come down from such high levels. The key question investors should be asking is whether inflation will decline more or less than what is already baked into market expectations. As Chart 2 shows, investors expect US inflation to come down rapidly over the next two years. The 5-year/5-year forward TIPS breakeven inflation rate – a good proxy for where investors expect inflation to be over the long haul – has sunk to 2.11% (Chart 3). This is below the Fed’s comfort zone of 2.3%-to-2.5%.1 Globally, long-term inflation expectations remain subdued (Chart 4). Chart 2Inflation Is Expected To Moderate Over The Coming Years Chart 3Inflation Expectations Have Fallen Back Below The Fed's Target Zone Chart 4Long-Term Inflation Expectations Remain Subdued Inflation Will Fall, But… Our sense is that US inflation will come down fast enough to allow the Fed to maintain a highly dovish policy stance, but not as fast as market expectations currently imply. Broad-based inflationary pressures would make the Fed nervous. However, that is not what we are seeing. Wages have accelerated markedly in only a few relatively low-skilled sectors such as retail trade and leisure and hospitality (Chart 5). For the economy as a whole, wage growth is broadly stable (Chart 6). The expiration of extended unemployment benefits, the reopening of schools, and increased immigration should also boost labor supply in the fall. Chart 5Faster Wage Growth Has Been Confined To A Few Low-Wage Sectors Chart 6No Sign Of A Wage-Price Spiral... For Now On the price front, more than two-thirds of the increase in the core CPI in June stemmed from pandemic-afflicted sectors (Chart 7). The price of the median item within the CPI index rose by just 2.2% year-over-year in June, somewhat below the pre-pandemic pace of inflation (Chart 8). Chart 7Most Of The Recent Increase In Inflation Is Pandemic-Related Chart 8The Median Price In The CPI Basket Is Up Only 2.2% … Not As Fast As The Market Expects While inflation will fall as pandemic effects recede, investors are overestimating how fast this will happen. US growth has undoubtedly peaked, but at a very high level. Economists surveyed by Bloomberg estimate that US GDP rose by 9.0% in Q2. Growth is expected to slow to 7.1% in Q3 and 5.1% in Q4, while averaging 4.2% in 2022 (Table 1). By any standard, these are very strong, above-trend growth rates. Table 1Growth Is Peaking, But At A Very High Level Chart 9Nearly 90% Of US Seniors Have Had At Least One Shot The current Delta-variant wave is unlikely to slow US growth by very much. Although vaccination rates among younger people are at middling levels, they are quite high for the elderly who are most at risk of serious illness. Close to 89% of Americans above the age of 65 have received at least one shot, and nearly 80% are fully vaccinated (Chart 9). The 65+ age group accounts for four-fifths of all Covid deaths in the United States. Widespread vaccination coverage for older Americans will take pressure off the hospital system, allowing the economy to remain open. Fiscal Support In The US And Abroad As we noted last week, Senate Democrats are likely to use the reconciliation process to both raise the debt ceiling and pass President Biden’s $3.5 trillion American Jobs and Families Plan. They are also likely to move forward on Biden’s proposed $600 billion in infrastructure spending, with or without Republican support. Meanwhile, much of the fiscal stimulus that has already been undertaken has yet to make its way through to the economy. US households are sitting on about $2.5 trillion in excess savings, about half of which stems from increased government transfers (Chart 10). Chart 10A Lot Of Excess Savings Chart 11Inventories Are At Low Levels Satiating that demand has not been easy for many companies. Retail sector inventories are at record lows (Chart 11). The number of homes that have been authorized for construction but where building has yet to begin has increased by 62% since the start of the pandemic (Chart 12). By limiting production, supply-chain bottlenecks will push some spending towards the future. This will keep growth from decelerating more than it otherwise would. Outside the US, fiscal policy will remain supportive. All 27 EU countries ratified the €750 billion Next Generation fund on May 28th. The allocations from the fund for southern European countries are relatively large (Chart 13). Most of the money will be spent on public investment projects with high fiscal multipliers. Chart 12Growing Backlog Of New Home Construction Projects Chart 13EU Fiscal Policy: Allocations To Southern European Countries Are Relatively Large Chart 14Economic Growth In China Was Slow In H1 The Japanese government is contemplating sending stimulus checks to low-income citizens in advance of the general election due by October 22nd. It is an understandable move. Covid cases are rising again. As a result, the authorities have declared a state of emergency in Tokyo and barred spectators from attending the Olympic games in and around the city. Fortunately, the Japanese vaccination campaign has accelerated after a slow start. A third of the population has now received at least one shot. The government intends to vaccinate all eligible people by November. Looking at quarter-over-quarter growth rates, Chinese growth averaged just 3.8% on an annualized basis in the first half of 2021 (Chart 14). Growth should pick up in the second half of the year thanks in part to increased fiscal spending. As of June, local governments had used only 28% of their annual bond issuance quotas, compared with 61% over the same period last year and 65% in 2019. Most of the proceeds from local government bond sales will likely flow into infrastructure projects. Resumption Of The Dollar Bear Market Will Keep Inflation From Falling Too Far As a countercyclical currency, the US dollar usually weakens when global growth is strong (Chart 15). Short-term real interest rate differentials have moved sharply against the dollar, a trend that is unlikely to change anytime soon given the Fed’s dovish bias (Chart 16). While inflation in the US is not as sensitive to currency fluctuations as in most other countries, a weaker dollar will still lift tradeable goods prices (Chart 17). Chart 15The Dollar Is A Countercyclical Currency Chart 16Rate Differentials Are A Headwind For The Dollar Chart 17The Dollar And Inflation Structural Forces Turning More Inflationary Not only are cyclical forces likely to turn out to be less disinflationary than investors believe, but many of the structural factors that have suppressed inflation over the past 40 years are reversing direction: Chart 18Globalization Plateaued More Than A Decade Ago Globalization is in retreat: The ratio of global trade-to-manufacturing output has been flat for over a decade (Chart 18). Looking out, the ratio could even decline as more companies shift production back home in order to gain greater control over supply chains of essential goods. Baby boomers are leaving the labor force en masse. As a group, baby boomers hold more than half of US household wealth (Chart 19). They will continue to run down their wealth once they retire. However, since they will no longer be working, they will no longer contribute to national output. Continued spending against a backdrop of diminished production could be inflationary. Despite a pandemic-induced bounce, underlying productivity growth remains anemic (Chart 20). Slow productivity growth could cause aggregate supply to fall short of aggregate demand. Social stability is in peril, as exemplified by the recent dramatic increase in the US homicide rate. In the past, social instability and higher inflation have gone hand in hand (Chart 21). Perhaps most importantly, policymakers are deliberately aiming to run the economy hot. A tight labor market will eventually lift wage growth to a greater degree than what we have seen so far (Chart 22). Not only could higher wage growth push up inflation through the usual “cost-push” channel, but by boosting labor’s share of income, a tight labor market could spur aggregate demand. Chart 19Baby Boomers Have Accumulated A Lot Of Wealth Chart 20Trend Productivity Growth Has Been Disappointing Chart 21Historically, Social Unrest And Higher Inflation Move In Lock-Step Chart 22A Tight Labor Market Eventually Bolsters Wages Investment Implications Chart 23Positive Earnings Revisions Are At High Levels The path to higher rates is lined with lower rates. The longer central banks keep interest rates below their neutral level, the more economies will overheat, and the more rates will eventually need to rise to bring inflation back down. For now, we are still in the warm-up phase to higher inflation. With long-term inflation expectations below target, central banks will be able to maintain accommodative monetary policies. This is good news for stocks, at least in the short-to-medium term. The recent wobble in equity markets has occurred despite a strong second quarter earnings season. According to the latest available data from I/B/E/S, 90% of S&P 500 companies have reported earnings above analyst expectations. Earnings have surprised on the upside by an average of 19.2%, compared to a historical average of 3.9%. Positive earnings revisions are at record high levels (Chart 23). Full year 2021 S&P 500 EPS estimates have risen 16% since the start of the year. Analysts have also raised their estimates for 2022 and 2023 (Chart 24). We continue to recommend that asset allocators favor stocks over bonds over a 12-month horizon. Chart 24Analysts Have Been Revising Up Earnings Estimates This Year Chart 25The Gains Of Recent Winners Have Not Been Fully Mirrored In Relative Earnings Growth Chart 26Bank Shares Thrive In A Rising Yield Environment Tech stocks have outperformed the broader market over the past seven weeks. However, unlike during the pandemic, 12-month forward EPS estimates for tech have not risen in relation to other sectors (Chart 25). As long-term bond yields move back up, tech shares will underperform. In contrast, banks will benefit from higher yields (Chart 26). Along the same lines, US stocks have outpaced other stock markets by more than one would have expected based on relative EPS trends. Notably, EM earnings have moved sideways versus the US since mid-2019. Yet, US stocks have outperformed EM by 17% over this period. Today, the forward P/E ratio for EM stands at 13.8, compared to 22.1 for the US (Chart 27). The combination of a weaker US dollar, faster sequential Chinese growth, increased vaccine supplies, and favorable valuations should all help EM stocks later this year. Go long the Vanguard FTSE Emerging Markets ETF (VWO) versus the Vanguard S&P 500 ETF (VOO). Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Chart 27Wide Valuation Gap Between US And Non-US Markets Footnotes 1 The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores