Money/Credit/Debt
After hitting an all-time high of $68,000 in November 2021, Bitcoin has suffered a 40 percent drawdown. Where is it heading from here? BCA Research strategists are divided about the long-term outlook for cryptocurrencies. Our Global Investment Strategy team…
Dear client, In lieu of our weekly bulletin next week, I will be hosting a webcast on Friday, January 28 at 11:00 am EST, to discuss recent dollar trends. I hope you all tune in. Kind regards, Chester Ntonifor Highlights While not often discussed, it is well known that the dollar is expensive. It is true that valuations tend to matter less until they trigger a tipping point. Such inflections usually coincide with huge external imbalances, especially generated by an overvalued exchange rate. The US dollar could be stepping into such a paradigm - the DXY is 1.5 standard deviations above fair value, at the same time as the goods trade deficit is hitting record lows, and real interest rates are deeply negative. More importantly, there has been limited precedence to such a dollar configuration. Historically, it has required much higher real interest rates, or an improving balance of payments backdrop, to justify such lofty valuations. Our trading model shows that selling a currency when it is expensive and buying it when it is cheap generates excess returns over time. Within our valuation ranking, the cheapest currencies are JPY, SEK and NOK. On a terms-of-trade basis, the AUD stands out as a winner. Feature Chart 1High Dollar Valuation And Ultra-Low Real Rates Is Unprecedented Valuations usually get little respect when it comes to medium-term currency movements. This has been especially the case over the last few years, where the macroeconomic environment has been by far the biggest driver of the US dollar. The bull market in the dollar from 2011 to 2020 coincided with higher real interest rates in the US, relative to the rest of the developed world. In fact, since 2008, no developed market central bank has been able to hike rates by more than 200bps, except for the US Federal Reserve. Our report last week focused on why aggressive interest rate increases by the Federal Reserve could be bullish for the US dollar in the short term, but eventually set the stage for depreciation. In this report, we argue that valuations will also become a more important factor for currency strategy over the next 1-2 years (Chart 1). The Dollar And The External Balance The framework to understand currencies and the external balance is straightforward - a rising trade deficit (imports > exports) requires a lower exchange rate to boost competitiveness in the manufacturing sector, or less spending to reduce the trade deficit. Reduced domestic spending is unlikely in most developed economies, given ample pent-up demand and loose fiscal policy. Therefore, the natural adjustment mechanism for countries running wide trade deficits will have to be the exchange rate. Within a broad spectrum of developed and emerging market currencies, the US dollar stands out as overvalued on a real effective exchange rate basis (Chart 2A and 2B). It is true that valuations tend to matter less until they trigger a tipping point. Such inflections usually occur with a shift in animal spirits, coinciding with huge external imbalances. In the US, these imbalances are already starting to trigger a shift. The US trade deficit is deteriorating, with the goods deficit hitting a record low of -$98bn in November. Over the last few years, it has become increasingly difficult to fund this widening trade deficit via foreign purchases of US Treasuries (Chart 3). Meanwhile, as we highlighted last week, substantial equity inflows over the last few years have started to roll over. In a nutshell, the basic balance in the US (the sum of the current account and foreign direct investment) is deteriorating at an accelerated pace (Chart 4). The US current account deficit for Q3 came in at -$214.8 billion, the widest in over a decade. This has reversed a lot of the improvement in the basic balance since the Global Financial Crisis. The dollar tends to decline on a multi-year basis when the basic balance peaks and starts deteriorating. Chart 4Deteriorating Balance Of Payments Dynamics US Balance Of Payments Chart 3It Is Becoming Increasingly Difficult To Fund The Widening Deficit Fiscal policy is likely to become tighter in the next couple of years, easing the domestic spending constraint for the exchange rate. That said, fiscal policy will remain loose compared to pre-pandemic levels and relative to underlying employment conditions. This has historically led to a deterioration in the external balance and pulled the real effective exchange rate of the dollar down (Chart 5). Chart 5The Dollar And The Budget Deficit Real Interest Rates And The Dollar It is remarkable that at a time when real rates are the most negative in the US, the dollar is as overvalued as it has been in decades on a simple PPP model. This is a perfect mirror image of the dollar configuration at the start of the bull market in 2010, where the dollar was cheap and real rates were more supportive (Chart 1). According to economic theory, a currency should adjust to equalize returns across countries. This is a no-arbitrage condition. In the early 80s, an overvalued dollar was supported by very positive real rates. The subsequent dollar declines thereafter also coincided with falling real interest rates. In fact, over the last decade, it has been an anomaly that the dollar is so strong despite relative real interest rates being so negative (Chart 6). Our view remains that the terminal interest rate for the US should be higher than what is currently discounted in the 10-year Treasury yield. According to the overnight index swap curve, the Fed will not hike interest rates past 1.75%. This is much lower than past cycles and will keep real interest rates low. This does not justify an expensive greenback. Our shorter-term interest rate model also shows the DXY as slightly expensive, even though short-term interest rates have moved in favor of the dollar over the past year (Chart 7). Chart 6The Level Of Relative Real Yields Also Matters Chart 7Our Timing Model Suggests ##br##A Pullback Other Considerations While real effective exchange rates and purchasing power parity models are among our favorite valuation gauges, they are not foolproof. Countries with structurally higher inflation (and so a higher real effective exchange rate), could also have higher productivity. According to the Balassa-Samuelson Hypothesis, competitiveness in the tradeable goods sector will boost wages across all sectors of the economy, leading to higher prices. This argument particularly resonates with proponents that suggest the US is a fast-growing economy, and so will tend to run a current account deficit, like Australia during the commodity boom of the early 2000s. Meanwhile, the US earns more on its overseas assets than it spends on its liabilities, suggesting that the funding gap will eventually close. Unfortunately, the overvaluation of the dollar has not been due to higher relative productivity in the US, especially when compared to other economies. Across a broad spectrum of developed and emerging market economies, the dollar is expensive according to our productivity models. The Chinese RMB (which is much overvalued on a PPP basis) is closer to fair value when productivity is taken into consideration (Chart 8). Meanwhile, the sizeable US deficit is not completely offset by its positive investment balance (Chart 9). This is occurring at a time when many faster growing countries (such as China for example) are generating current account surpluses (Chart 10A and 10B). In a nutshell, whether one looks at relative price levels, relative productivity trends, or relative real returns on government assets, the dollar is expensive. Chart 9The Positive Income Balance Has Not Helped The Us Investment Position Conclusion Last summer, we introduced a trading model for FX valuation enthusiasts. We used both our in-house purchasing power parity models (PPP) and our intermediate-term timing models as valuation tools. Since the 2000s, both valuation models have outperformed a buy-and-hold currency strategy with much lower volatility (Chart 11). Currency valuation tends to matter over the longer term, while the macro environment tends to dominate short-term currency trading. Given that the dollar has been overvalued for the last three to five years, the above analysis suggests we might be entering this “longer-term” tipping point where valuations will start to matter more going forward. Within our valuation ranking, the cheapest currencies are JPY, SEK and NOK. On a terms-of-trade and productivity basis, the AUD stands out as a winner. This is being reflected in a record-high basic balance surplus (Chart 12). In our trade tables, we went long AUD at 70 cents, and will upgrade this to a high conviction bet on signs that currency volatility is ebbing. Chart 11A Trading Rule Solely Based On Valuation Chart 12AUD And Balance Of Payments Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Forecast Summary
Dear Client, Next week there will be no regular strategy report. Instead, we will hold our quarterly webcast which will discuss the outlook for the European economy and assets in 2022. I look forward to this interaction. Best regards, Mathieu Savary Highlights European and global yields have considerable upside over the coming year, even if inflation peaks in 2022. The post-World War II experience is instructive: massive war-time fiscal and monetary stimulus allowed for an upward re-estimation of the neutral rate as trend nominal growth improved. A similar development is likely to result in an improvement in nominal growth and the neutral rate compared to the post-GFC decade. China and a financial accident outside the US constitute the greatest risks this year to higher yields. European stocks and value stocks will benefit from this rise in yields. Cyclicals in general and industrials in particular are the European sectors most levered to higher yields. Overweight these assets. Defensives will underperform meaningfully if yields rise further. Long Sweden and the Netherlands / Short Switzerland is an appealing trade to bet on higher yields, especially if inflation peaks in 2022. Feature Last week, US Treasury yields finally reached levels that prevailed before the pandemic started. In Europe, German 10-year yields flirted with the symbolic 0% level, rising to their highest reading since May 2019. With the Fed preparing to increase interest rates in March, and global inflation remaining perky, do yields already reflect all the bearish bond news or will they continue to climb higher on a cyclical basis? Moreover, what would be the implications for equity prices of higher yields? BCA expects yields to rise further, for which German Bunds will not be an exception. This process will continue to generate volatility in stock prices, but ultimately, higher equities will prevail. Increasing yields will help European stocks and are strongly associated with an outperformance of cyclical equities. What’s Moving Yields Up? Not all yield increases are created equal. A breakdown of yields helps us understand what investors are pricing in for the future. In the US, the upside in 10-year yields mostly reflects the increase in 5-year yields. This maturity has moved back to levels that prevailed prior to the pandemic, while the 5-year/5-year forward yield remains below its spring 2021 peak (Chart 1, top panel). Moreover, these shifts mirror higher real interest rates, which are rising across maturities, while inflation expectations have been declining in recent weeks or have been flat since mid-2021 on a 5-year/5-year forward basis (Chart 1, middle and bottom panels). This breakdown confirms investors are driving yields higher because they expect more Fed tightening. However, this upgraded view of the Fed’s policy path is limited to the next few years, and long-term policy expectations approximated by the forward rates are not rising as much. In other words, markets do not expect that the Fed will be able to push up interest rates on a long-term basis. In Germany, the breakdown of the most recent shift in yield paints a different picture (Chart 2). As in the US, real yields, not inflation expectations, drove the latest bond selloff. This points toward pricing in an eventual policy tightening in Europe. However, unlike what is happening in the US, 5-year/5-year forward rates are the main force driving yields higher; investors are therefore expecting the ECB to have to follow the Fed later on. Chart 1Near-Term Tightening Is Driving Treasurys Chart 2longer-Term Tightening Is Driving Bunds Can the Yield Upside Continue? While BCA’s target for the 10-year Treasury yield in 2022 stands at 2.25% and the Bund yield at 0.25%, the coming two to three years should witness significantly higher yields. The period after World War II offers an interesting historical equivalent. During the War, government spending as a share of GDP exploded, lifting US gross federal debt from 52% of GDP at the dawn of the conflict to 114% at the end of 1945. However, the Fed kept a lid on interest rates during this period to help finance the war effort. T-Bill rates were pegged at 3/8th of a percent and the Fed also capped T-Bond yields at 2.5%. Chart 3The Post WWII Experience As a consequence of this policy effort, the Fed balance sheet increased significantly and continued to do so after the war (Chart 3). The stimulative fiscal and monetary policy, as well as the capacity constraints associated with shifting production from military goods to consumer and capital goods, contributed to an inflation spike to 20% in March 1947. Moreover, the Korean War boosted government spending between 1950 and 1953, resulting in another inflation spike to 9.5% in 1951. The Fed’s cap on yields ended after the March 1951 Treasury-Fed Accord. It was followed by the beginning of a multi-decade uptrend in bond yields, which culminated in 1981 with T-Bond yields above 15% following the inflationary surge of the 1970s. Nonetheless, the yield increase from 2.5% in 1951 to 4% at the end of the 1950s happened after the inflation peak of the Korean War. This original inflection reflected economic vigor and a normalization of the neutral rate after the trauma of the Great Depression. The current situation is not dissimilar. The neutral rate and the market-based estimates of the terminal rate of interest are still very low in the US and in Europe (Chart 4). However, the vast amount of monetary and fiscal stimulus injected in the economy has jolted a recovery. It has also caused a massive wealth transfer to households and the private sector in general that is likely to increase consumption permanently. As a result, growth in the coming decade will be stronger than it was in the past decade, in both the US and Europe. This process will allow the neutral rate to rise over time, which in turn will lift the terminal rate of interest and yields. In this context, even if inflation were to cool in 2022 because some of the supply constraints that marked 2021 dissipate, yields may continue to rise and do so for the remainder of the decade. This is also true in Europe where the household savings rate still towers near 19% of disposable income and may fall by 6% to reach its pre-pandemic levels, as the US experience presages (Chart 5). Chart 4Terminal Rates Proxies Are Too Low Chart 5European Savings Rate Has Downside A simple modeling exercise confirms that yields will have greater upside over the coming year. Conceptually, yields are anchored by policy rates and the terminal rate, which is somewhere above the neutral rate of interest. One of the key determinants of the nominal neutral rate is the trend growth rate of nominal GDP. While the market cannot know precisely where that growth rate stands, recent experience influences the perception of market participants. Thus, a long-term moving average of nominal GDP growth constitutes a rough proxy of this measure and will relate to investors’ assessment of the neutral rate and the terminal interest rates. Chart 6Bond Yields Are Too Low, Especially If Trend Nominal Growth Picks Up Using this approach reveals two important bearish forces for bonds. Even after accounting for the slow growth rate of both the US and Eurozone economies over the past ten years, as well as extraordinarily low policy rates, T-Notes and Bunds yields are too low (Chart 6). More importantly, if nominal GDP growth is higher this decade than next, this alone will push up the equilibrium level of yields in Advanced Economies. The upside in yields is not without risks. China is still going through a deflationary shock whereby growth is slowing. As China eases policy, Chinese yields will continue to fall, bucking the global trend (Chart 7). In recent years, Chinese yields have rarely diverged from global yields. If Chinese growth plummets from here, the divergence will not be resolved via higher Chinese yields. However, Chinese authorities do not want growth to collapse. Reports from the State Council suggest an acceleration of the implementation of major spending projects under the 14th Five-year plan and that the credit impulse is trying to bottom. Nonetheless, China remains a risk to monitor closely. The second major risk stems from the intertwined nature of the global financial system. The US economy is able to withstand higher Treasury yields, but is the rest of the world? As Chart 8 highlights, US private debt-servicing costs are low today, as a result of minimal interest rates and the decline in debt loads after the GFC. The same is not true for the G-10 outside the US, let alone EM economies. These differences suggest that the US will be much more resilient to rising yields than the rest of the world. A major financial accident outside the US would prompt a wave of risk aversion that would decrease yields around the world. Chart 7An Unusual Divergence Chart 8Will The Rest Of The World Withstand Higher US Yields? Bottom Line: Global yields have much greater upside for the years ahead, even if inflation slows in 2022. While BCA targets 2.25% and 0.25% for, respectively, Treasurys and Bund yields this year, the multi-year upside is much greater as neutral rates are re-adjusted upward. The change will not move in a straight line, but the trend will not be friendly for bondholders. In the near-term, the main culprits preventing higher yields are a further slowdown in China as well as a financial accident outside the US. Investment Implications The most obvious investment implication is that investors should use any pullback in yields to sell duration. As a corollary, investors should maintain an overweight stance on equities relative to bonds. The equity risk premium, especially in Europe, remains elevated, and European dividend yields stand near record highs compared to Bund yields (Chart 9). Moreover, when yields rise because of a higher neutral rate, this also means that the expected long-term growth rate of earnings is firming, which negates some of the adverse impacts on valuations of higher discount rates. Nonetheless, if inflation does not stabilize, the increase in yields could become much more painful for stocks, as the negative correlation between stock prices and bond yields would reassert itself—a possibility we described five weeks ago. A rising neutral rate and terminal rate are also associated with an outperformance of European stocks compared to the US and an outperformance of value stocks over growth stocks in Europe (Chart 10). These relationships reflect the greater procyclicality of European equities and value stocks. Chart 9A Valuation Cushion For Stocks Chart 10Higher Terminal Rates Favor Europe And Value Finally, we looked at the performance of European sectors based on the trend in yields. Table 1 highlights that industrials are the great winner when yields rise, which is a testament to their pro-cyclicality. They beat the market on 3-month, 6-month and 12-month horizons by 1.6%, 2.9% and 5.8%, respectively. The regularity of their benchmark-beating performance is extremely high. When yields rise, financials also see a marked improvement of their relative returns compared to their historical average returns. Surprisingly, so do European tech firms, which reflect the more hardware focus of European tech compared to the US. Table 1Rising Yields & Sector Relative Performance Table 2 repeats the same exercise, but, this time, we control for the slope of the yield curve, focusing on periods when the yield curve is positively sloped. Again, industrials are the star sector, but other cyclicals such as materials and consumer discretionary also stand out. European tech remains dominated by its cyclical properties, while the outperformance of financials becomes more marked. Table 2Rising Yields & Sector Relative Performance With Postive Yield Curve Slope As A Control Variable Table 3 looks at the behavior of sectors when yields rise and when the Euro Area PMI Manufacturing improves, which is a scenario we expect for most of 2022 once the winter passes. Industrials win more clearly than materials or consumer discretionary. The European tech sector continues to generate a very strong outperformance, while the excess return of financials firms up as well. This scenario also shows a particularly steep underperformance for all the defensive sectors. Table 3Rising Yields & Sector Relative Performance With Improving Manufacturing PMI As A Control Variable Table 4 completes the picture, focusing on rising yields when core CPI decelerates, another development we foresee in 2022. Once again, industrials stand out as a result of the extent and regularity of their outperformance. However, under this controlling variable, the performance of materials and consumer discretionary stocks deteriorates significantly. Financials also see a large downgrade to their relative performance. Tech performs best under these circumstances. Here, staples suffer the worst fate, closely followed by utilities and healthcare. Table 4Rising Yields & Sector Relative Performance With Falling Core CPI As A Control Variable Based on these observations, the highest likelihood scenario is that European cyclicals will outperform defensive equities significantly this year after a period of consolidation since last spring. A more targeted approach would be to overweight industrials and tech at the expense of staples and utilities. Geographically, investors should buy a basket of Swedish (overweight industrials) and Dutch stocks (overweight tech), while selling Swiss stocks (overweight healthcare). Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance
Highlights Global equities are poised to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Non-US markets are likely to outperform. We examine the four pillars that have historically underpinned stock market performance. Pillar 1: Technically, the outlook for equities is modestly bullish, as investor sentiment is nowhere near as optimistic as it usually gets near market tops. Pillar 2: The outlook for economic growth and corporate earnings is modestly bullish as well. While global growth is slowing, it will remain solidly above trend in 2022. Pillar 3: Monetary and financial conditions are neutral. The Fed and a number of other central banks are set to raise rates and begin unwinding asset purchases this year. However, monetary policy will remain highly accommodative well into 2023. Pillar 4: Valuations are bearish in the US and neutral elsewhere. Investors should avoid tech stocks in 2022, focusing instead on banks and deep cyclicals, which are more attractively priced. The Bedrock For Equities In assessing the outlook for the stock market, our research has focused on four pillars: 1) Sentiment and other technical factors, which are most pertinent for stocks over short-term horizons of about three months; 2) cyclical fluctuations in economic growth and corporate earnings, which tend to dictate the path for stocks over medium-term horizons of about 12 months; 3) monetary and financial conditions, which are also most relevant over medium-term horizons; and finally 4) valuations, which tend to drive stocks over the long run. In this report, we examine all four pillars, concluding that global equities are likely to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Pillar 1: Sentiment And Other Technical Factors (Modestly Bullish) Chart 1US Equities: Breadth Is A Concern Scaling The Wall Of Worry Stocks started the year on a high note, before tumbling on Wednesday following the release of the Fed minutes. Market breadth going into the year was quite poor. Even as the S&P 500 hit a record high on Tuesday, only 57% of NYSE stocks and 38% of NASDAQ stocks were trading above their 200-day moving averages compared to over 90% at the start of 2021 (Chart 1). The US stock market had become increasingly supported by a handful of mega-cap tech stocks, a potentially dangerous situation in an environment where bond yields are rising and stay-at-home restrictions are apt to ease (more on this later). That said, market tops often occur when sentiment reaches euphoric levels. That was not the case going into 2022 and it is certainly not the case after this week's sell-off. The number of bears exceeded the number of bulls in the AAII survey this week and in six of the past seven weeks (Chart 2). The share of financial advisors registering a bullish bias declined by 25 percentage points over the course of 2021 in the Investors Intelligence poll. Option pricing is far from complacent. The VIX stands at 19.6, above its post-GFC median of 16.7. According to the Minneapolis Fed’s market-based probabilities model, the market was discounting a slightly negative 12-month return for the S&P 500 as of end-2021, with a 3.6 percentage-point larger chance of a 20% decline in the index than a 20% increase (Chart 3). Chart 3Option Pricing Is Not Pointing To Elevated Complacency Chart 2Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Equities do best when sentiment is bearish but improving (Chart 4). With bulls in short supply, stocks can continue to climb the proverbial wall of worry. Whither The January Effect? Historically, stocks have fared better between October and April than between May and September (Chart 5). One caveat is that the January effect, which often saw stocks rally at the start of the year, has disappeared. In fact, the S&P 500 has fallen in January by an average annualized rate of 5.2% since 2000 (Table 1). Other less well-known calendar effects – such as the tendency for stocks to underperform on Mondays but outperform on the first trading day of each month – have persisted, however. Table 1Calendar Effects Bottom Line: January trading may be choppy, but stocks should rise over the next few months as more bears join the bullish camp. Last year’s losers are likely to outperform last year’s winners. Pillar 2: Economic Growth And Corporate Earnings (Modestly Bullish) Economic Growth And Earnings: Joined At The Hip The business cycle is the most important driver of stocks over medium-term horizons of about 12 months. The reason is evident in Chart 6: Corporate earnings tend to track key business cycle indicators such as the ISM manufacturing index, industrial production, business sales, and global trade. Chart 6The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons Chart 7PMIs Signaling Above-Trend Growth Global growth peaked in 2021 but should stay solidly above trend in 2022. Both the service and manufacturing PMIs remain in expansionary territory (Chart 7). The forward-looking new orders component of the ISM exceeded 60 for the second straight month in December. The Bloomberg consensus is for real GDP to rise by 3.9% in the G7 in 2022, well above the OECD’s estimate of trend G7 growth of 1.4% (Chart 8). Global earnings are expected to increase by 7.1%, rising 7.5% in the US and 6.7% abroad (Chart 9). Our sense is that both economic growth and earnings will surprise to the upside in 2022. Chart 9Analysts Expect Single-Digit Earnings Growth Plenty Of Pent-Up Demand For Both Consumer And Capital Goods US households are sitting on $2.3 trillion in excess savings (Chart 10). Around half of these savings will be spent over the next few years, helping to drive demand. Households in the other major advanced economies have also buttressed their balance sheets. Chart 10Plenty Of Pent-Up Demand After two decades of subdued corporate investment, capital goods orders have soared. This bodes well for capex in 2022. Inventories remain at rock-bottom levels, which implies that output will need to exceed spending for the foreseeable future (Chart 11). On the residential housing side, both the US homeowner vacancy rate and the inventory of homes for sale are near multi-decade lows. Building permits are 11% above pre-pandemic levels (Chart 12). Chart 11Business Investment Should Be Strong In 2022 Chart 12Residential Construction Will Remain Well Supported Chart 13China's Credit Impulse Has Bottomed Chinese Growth To Rebound, Europe To Benefit From Lower Natural Gas Prices Chinese credit growth decelerated last year. However, the 6-month credit impulse has bottomed, and the 12-month impulse is sure to follow (Chart 13). Chinese coal prices have collapsed following the government’s decision to instruct 170 mines to expand capacity (Chart 14). China generates 63% of its electricity from coal. Lower energy prices and increased stimulus should support Chinese industrial activity in 2022. Like China, Europe will benefit from lower energy costs. Natural gas prices have fallen by nearly 50% from their peak on December 21st. A shrinking energy bill will support the euro (Chart 15). Chart 14Coal Prices Are Renormalizing In China Chart 15A Shrinking Energy Bill Will Support The Euro Omicron Or Omicold? While the Omicron wave has led to an unprecedented spike in new cases across many countries, the economic fallout will be limited. The new variant is more contagious but significantly less lethal than previous ones. In South Africa, it blew through the population without triggering a major increase in mortality (Chart 16). Preliminary data suggest that exposure to Omicron confers at least partial immunity against Delta. The general tendency is for viral strains to become less lethal over time. After all, a virus that kills its host also kills itself. Given that Omicron is crowding out more dangerous strains such as Delta, any future variant is likely to emanate from Omicron; and odds are this new variant will be even milder than Omicron. Meanwhile, new antiviral drugs are starting to hit the market. Pfizer claims that its new drug, Paxlovid, cuts the risk of hospitalization by almost 90% if taken within five days from the onset of symptoms. Bottom Line: While global growth has peaked and the pandemic remains a risk, growth should stay well above trend in the major economies in 2022, fueling further gains in corporate earnings and equity prices. Pillar 3: Monetary And Financial Factors (Neutral) Chart 17The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months Tighter But Not Tight Monetary and financial factors help govern the direction of equity prices both because they influence economic growth and also because they affect the earnings multiple at which stocks trade. There is little doubt that a number of central banks, including the Federal Reserve, are looking to dial back monetary stimulus. However, there is a big difference between tighter monetary policy and tight policy. Even if the FOMC were to raise rates three times in 2022, as the market is currently discounting, the fed funds rate would still be half of what it was on the eve of the pandemic (Chart 17). Likewise, even if the Fed were to allow maturing assets to run off in the middle of this year, as the minutes of the December FOMC meeting suggest is likely, the size of the Fed’s balance sheet will probably not return to pre-pandemic levels until the second half of this decade. A Higher Neutral Rate We have argued in the past that the neutral rate of interest in the US is higher than widely believed. This implies that the overall stance of monetary policy remains exceptionally stimulative. Historically, stocks have shrugged off rising bond yields, as long as yields did not increase to prohibitively high levels (Table 2). Table 2As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Will Recover If the neutral rate ends up being higher than the Fed supposes, the danger is that monetary policy will stay too loose for too long. The question is one of timing. The good news is that inflation should recede in the US in 2022, as supply-chain bottlenecks ease and spending shifts back from goods to services. The bad news is that the respite from inflation will not last. As discussed in Section II of our recently-published 2022 Strategy Outlook, inflation will resume its upward trajectory in mid-2023 on the back of a tightening labor market and a budding price-wage spiral. This second inflationary wave could force the Fed to turn much more aggressive, spelling the end of the equity bull market. Bottom Line: While the Fed is gearing up to raise rates and trim the size of its balance sheet, monetary policy in the US and in other major economies will remain highly accommodative in 2022. US policy could turn more restrictive in 2023 as a second wave of inflation forces a more aggressive response from the Fed. Pillar 4: Valuations (Bearish In The US; Neutral Elsewhere) US Stocks Are Looking Pricey… While valuations are a poor timing tool in the short run, they are an excellent forecaster of stock prices in the long run. Chart 18 shows that the Shiller PE ratio has reliably predicted the 10-year return on equities. Today, the Shiller PE is consistent with total real returns of close to zero over the next decade. Investors’ allocation to stocks has also predicted the direction of equity prices (Chart 19). According to the Federal Reserve, US households held a record high 41% of their financial assets in equities as of the third quarter of 2021. If history is any guide, this would also correspond to near-zero long-term returns on stocks. Chart 19Valuations Matter For Long-Term Returns (II) … But There Is More Value Abroad Valuations outside the US are more reasonable. Whereas US stocks trade at a Shiller PE ratio of 37, non-US stocks trade at 20-times their 10-year average earnings. Other valuation measures such as price-to-book, price-to-sales, and dividend yield tell a similar story (Chart 20). Chart 20AUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) Chart 20BUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) Cyclicals And Banks Overrepresented Abroad Our preferred sector skew for 2022 favors non-US equities. Increased capital spending in developed economies and incremental Chinese stimulus should boost industrial stocks and other deep cyclicals, which are overrepresented outside the US (Table 3). Banks are also heavily weighted in overseas markets; they should also do well in response to faster-than-expected growth and rising bond yields (Chart 21). Table 3Deep Cyclicals And Financials Are Overrepresented Outside The US Chart 21Rising Bond Yields Will Help Bank Shares Bottom Line: Valuations are more appealing outside the US, and with deep cyclicals and banks set to outperform tech over the coming months, overseas markets are the place to be in 2022. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Highlights Our three strategic themes over the long run: (1) great power rivalry (2) hypo-globalization (3) populism and nationalism. The implications are inflationary over the long run. Nations that gear up for potential conflict and expand the social safety net to appease popular discontent will consume a lot of resources. Our three key views for 2022: (1) China’s reversion to autocracy (2) America’s policy insularity (3) petro-state leverage. The implications are mostly but not entirely inflationary: China will ease policy, the US will pass more stimulus, and energy supply may suffer major disruptions. Stay long gold, neutral US dollar, short renminbi, and short Taiwanese dollar. Stay tactically long global large caps and defensives. Buy aerospace/defense and cyber-security stocks. Go long Japanese and Mexican equities – both are tied to the US in an era of great power rivalry. Feature Chart 1US Resilience Global investors have not yet found a substitute for the United States. Despite a bout of exuberance around cyclical non-US assets at the beginning of 2021, the year draws to a close with King Dollar rallying, US equities rising to 61% of global equity capitalization, and the US 30-year Treasury yield unfazed by inflation fears (Chart 1). American outperformance is only partly explained by its handling of the lingering Covid-19 pandemic. The US population was clearly less restricted by the virus (Chart 2). But more to the point, the US stimulated its economy by 25% of GDP over the course of the crisis, while the average across major countries was 13% of GDP. Americans are still more eager to go outdoors and the government has been less stringent in preventing them (Chart 3). Chart 3Social Restrictions Short Of Lockdown Going forward, the pandemic should decline in relevance, though it is still possible that a vaccine-resistant mutation will arise that is deadlier for younger people, causing a new round of the crisis. The rotation into assets outside the US will be cautious. Across the world, monetary and credit growth peaked and rolled over this year, after the extraordinary effusion of stimulus to offset the social lockdowns of 2020 (Chart 4). Government budget deficits started to normalize while central banks began winding down emergency lending and bond-buying. More widespread and significant policy normalization will get under way in 2022 in the face of high core inflation. Tightening will favor the US dollar, especially if global growth disappoints expectations. Chart 4Waning Monetary And Credit Stimulus Chart 5Global Growth Stabilization Global manufacturing activity fell off its peak, especially in China, where authorities tightened monetary, fiscal, and regulatory policy aggressively to prevent asset bubbles from blowing up (Chart 5). Now China is easing policy on the margin, which should shore up activity ahead of an important Communist Party reshuffle in fall 2022. The rest of the world’s manufacturing activity is expected to continue expanding in 2022, albeit less rapidly. This trend cuts against US outperformance but still faces a range of hurdles, beginning with China. In this context, we outline three geopolitical themes for the long run as well as three key views for the coming 12 months. Our title, “The Gathering Storm,” refers to the strategic challenge that China and Russia pose to the United States, which is attempting to form a balance-of-power coalition to contain these autocratic rivals. This is the central global geopolitical dynamic in 2022 and it is ultimately inflationary. Three Strategic Themes For The Long Run The international system will remain unstable in the coming years. Global multipolarity – or the existence of multiple, competing poles of political power – is the chief destabilizing factor. This is the first of our three strategic themes that will persist next year and beyond (Table 1). Our key views for 2022, discussed below, flow from these three strategic themes. Table 1Strategic Themes For 2022 And Beyond 1. Great Power Rivalry Multipolarity – or great power rivalry – can be illustrated by the falling share of US economic clout relative to the rest of the world, including but not limited to strategic rivals like China. The US’s decline is often exaggerated but the picture is clear if one looks at the combined geopolitical influence of the US and its closest allies to that of the EU, China, and Russia (Chart 6). China’s rise is the most destabilizing factor because it comes with economic, military, and technological prowess that could someday rival the US for global supremacy. China’s GDP has surpassed that of the US in purchasing power terms and will do so in nominal terms in around five years (Chart 7). True, China’s potential growth is slowing and Chinese financial instability will be a recurring theme. But that very fact is driving Beijing to try to convert the past 40 years of economic success into broader strategic security. Chart 8America's Global Role Persists (If Lessened) Since China is capable of creating an alternative political order in Asia Pacific, and ultimately globally, the United States is reacting. It is penalizing China’s economy and seeking to refurbish alliances in pursuit of a containment policy. The American reaction to the loss of influence has been unpredictable, contradictory, and occasionally belligerent. New isolationist impulses have emerged among an angry populace in reaction to gratuitous wars abroad and de-industrialization. These impulses appeared in both the Obama and Trump administrations. The Biden administration is attempting to manage these impulses while also reinforcing America’s global role. The pandemic-era stimulus has enabled the US to maintain its massive trade deficit and aggressive defense spending. But US defense spending is declining relative to the US and global economy over time, encouraging rival nations to carve out spheres of influence in their own neighborhoods (Chart 8). Russia’s overall geopolitical power has declined but it punches above its weight in military affairs and energy markets, a fact which is vividly on display in Ukraine as we go to press. The result is to exacerbate differences in the trans-Atlantic alliance between the US and the European Union, particularly Germany. The EU’s attempt to act as an independent great power is another sign of multipolarity, as well as the UK’s decision to distance itself from the continent and strengthen the Anglo-American alliance. If the US and EU do not manage their differences over how to handle Russia, China, and Iran then the trans-Atlantic relationship will weaken and great power rivalry will become even more dangerous. 2. Hypo-Globalization The second strategic theme is hypo-globalization, in which the ancient process of globalization continues but falls short of its twenty-first century potential, given advances in technology and governance that should erode geographic and national boundaries. Hypo-globalization is the opposite of the “hyper-globalization” of the 1990s-2000s, when historic barriers to the free movement of people, goods, and capital seemed to collapse overnight. Chart 9From 'Hyper-Globalization' To Hypo-Globalization The volume of global trade relative to industrial production peaked with the Great Recession in 2008-10 and has declined slowly but surely ever since (Chart 9). Many developed markets suffered the unwinding of private debt bubbles, while emerging economies suffered the unwinding of trade manufacturing. Periods of declining trade intensity – trade relative to global growth – suggest that nations are turning inward, distrustful of interdependency, and that the frictions and costs of trade are rising due to protectionism and mercantilism. Over the past two hundred years globalization intensified when a broad international peace was agreed (such as in 1815) and a leading imperial nation was capable of enforcing law and order on the seas (such as the British empire). Globalization fell back during times of “hegemonic instability,” when the peace settlement decayed while strategic and naval competition eroded the global trading system. Today a similar process is unfolding, with the 1945 peace decaying and the US facing the revival of Russia and China as regional empires capable of denying others access to their coastlines and strategic approaches (Chart 10).1 Chart 10Hypo-Globalization And Hegemonic Instability Chart 11Hypo-Globalization: Temporary Trade Rebound No doubt global trade is rebounding amid the stimulus-fueled recovery from Covid-19. But the upside for globalization will be limited by the negative geopolitical environment (Chart 11). Today governments are not behaving as if they will embark on a new era of ever-freer movement and ever-deepening international linkages. They are increasingly fearful of each other’s strategic intentions and using fiscal resources to increase economic self-sufficiency. The result is regionalization rather than globalization. Chinese and Russian attempts to revise the world order, and the US’s attempt to contain them, encourages regionalization. For example, the trade war between the US and China is morphing into a broader competition that limits cooperation to a few select areas, despite a change of administration in the United States. The further consolidation of President Xi Jinping’s strongman rule will exacerbate this dynamic of distrust and economic divorce. Emerging Asia and emerging Europe live on the fault lines of this shift from globalization to regionalism, with various risks and opportunities. Generally we are bullish EM Asia and bearish EM Europe. 3. Populism And Nationalism A third strategic theme consists of populism and nationalism, or anti-establishment political sentiment in general. These forces will flare up in various forms across the world in 2022 and beyond. Even as unemployment declines, the rise in food and fuel inflation will make it difficult for low wage earners to make ends meet. The “misery index,” which combines unemployment and inflation, spiked during the pandemic and today stands at 10.8% in the US and 11.4% in the EMU, up from 5.2% and 8.1% before the pandemic, respectively (Chart 12). Large budget deficits and trade deficits, especially in the US and UK, feed into this inflationary environment. Most of the major developed markets have elected new governments since the pandemic, with the notable exception of France and Spain. Thus they have recapitalized their political systems and allowed voters to vent some frustration. These governments now have some time to try to mitigate inflation before the next election. Hence policy continuity is not immediately in jeopardy, which reduces uncertainty for investors. By contrast, many of the emerging economies face higher inflation, weak growth, and are either coming upon elections or have undemocratic political systems. Either way the result will be a failure to address household grievances promptly. The misery index is trending upward and governments are continually forced to provide larger budget deficits to shore up growth, fanning inflation (Chart 13). Chart 12DM: Political Risk High But New Governments In Place Chart 13EM: Political Risk High But Governments Not Recapitalized Chart 14EM Populism/Nationalism Threatens Negative Surprises In 2022 Just as social and political unrest erupted after the Great Recession, notably in the so-called “Arab Spring,” so will new movements destabilize various emerging markets in the wake of Covid-19. Regime instability and failure can lead to big changes in policies, large waves of emigration, wars, and other risks that impact markets. The risks are especially high unless and until Chinese imports revive. Investors should be on the lookout for buying opportunities in emerging markets once the bad news is fully priced. National and local elections in Brazil, India, South Korea, the Philippines, and Turkey will serve as market catalysts, with bad news likely to precede good news (Chart 14). Bottom Line: These three themes – great power rivalry, hypo-globalization, and populism/nationalism – are inflationary in theory, though their impact will vary based on specific events. Multipolarity means that governments will boost industrial and defense spending to gear up for international competition. Hypo-globalization means countries will attempt to put growth on a more reliable domestic foundation rather than accept dependency on an unreliable international scene, thus constraining supplies from abroad. Populism and nationalism will lead to a range of unorthodox policies, such as belligerence abroad or extravagant social spending at home. Of course, the inflationary bias of these themes can be upset if they manifest in ways that harm growth and/or inflation expectations, which is possible. But the general drift will be an inflationary policy setting. Inflation may subside in 2022 only to reemerge as a risk later. Three Key Views For 2022 Within this broader context, our three key views for 2022 are as follows: 1. China’s Reversion To Autocracy As President Xi Jinping leads China further down the road of strongman rule and centralization, the country faces a historic confluence of internal and external risks. This was our top view in 2021 and the same dynamic continues in 2022. The difference is that in 2021 the risk was excessive policy tightening whereas this coming year the risk is insufficient policy easing. Chart 15China Eases Fiscal Policy To Secure Recovery In 2022 China’s economy is witnessing a secular slowdown, a deterioration in governance, property market turmoil, and a rise in protectionism abroad. The long decline in corporate debt growth points to the structural slowdown. Animal spirits will not improve in 2022 so government spending will be necessary to try to shore up overall growth. The Politburo signaled that it will ease fiscal policy at the Central Economic Work Conference in early December, a vindication of our 2021 view. Neither the combined fiscal-and-credit impulse nor overall activity, indicated by the Li Keqiang Index, have shown the slightest uptick yet (Chart 15). Typically it takes six-to-nine months for policy easing to translate to an improvement in real economic activity. The first half of the year may still bring economic disappointments. But policymakers are adjusting to avoid a crash. Policy will grow increasingly accommodative as necessary in the first half of 2022. The key political constraint is the Communist Party’s all-important political reshuffle, the twentieth national party congress, to be held in fall 2022 (usually October). While Xi may not want the economy to surge in 2022, he cannot afford to let it go bust. The experience of previous party congresses shows that there is often a policy-driven increase in bank loans and fixed investment. Current conditions are so negative as to ensure that the government will provide at least some support, for instance by taking a “moderately proactive approach” to infrastructure investment (Chart 16). Otherwise a collapse of confidence would weaken Xi’s faction and give the opposition faction a chance to shore up its position within the Communist Party. Chart 16China Aims For Stability, Not Rapid Growth, Ahead Of 20th National Party Congress Party congresses happen every five years but the ten-year congresses, such as in 2022, are the most important for the country’s overall political leadership. The party congresses in 1992, 2002, and 2012 were instrumental in transferring power from one leader to the next, even though the transfer of power was never formalized. Back in 2017 Xi arranged to stay in power indefinitely but now he needs to clinch the deal, lest any unforeseen threat emerge from at home or abroad. Xi’s success in converting the Communist Party from “consensus rule” to his own “personal rule” will be measurable by his success in stacking the Politburo and Politburo Standing Committee with factional allies. He will also promote his faction across the Central Committee so as to shape the next generations of party leaders and leave his imprint on policy long after his departure. The government will be extremely sensitive to any hint of dissent or resistance and will move aggressively to quash it. Investors should not be surprised to see high-level sackings of public officials or private magnates and a steady stream of scandals and revelations that gain prominence in western media. The environment is also ripe for strange and unexpected incidents that reveal political differences beneath the veneer of unity in China: defections, protests, riots, terrorist acts, or foreign interference. Most incidents will be snuffed out quickly but investors should be wary of “black swans” from China in 2022. Chinese government policies will not be business friendly in 2022 aside from piecemeal fiscal easing. Everything Beijing does will be bent around securing Xi’s supremacy at all levels. Domestic politics will take precedence over economic concerns, especially over the interests of private businesses and foreign investors, as is clear when it comes to managing financial distress in the property sector. Negative regulatory surprises and arbitrary crackdowns on various industrial sectors will continue, though Beijing will do everything in its power to prevent the property bust from triggering contagion across the economic system. This will probably work, though the dam may burst after the party congress. Relations with the US and the West will remain poor, as the democracies cannot afford to endorse what they see as Xi’s power grab, the resurrection of a Maoist cult of personality, and the betrayal of past promises of cooperation and engagement. America’s midterm election politics will not be conducive to any broad thaw in US-China relations. While China will focus on domestic politics, its foreign policy actions will still prove relatively hawkish. Clashes with neighbors may be instigated by China to warn away any interference or by neighbors to try to embarrass Xi Jinping. The South and East China Seas are still ripe for territorial disputes to flare. Border conflicts with India are also possible. Taiwan remains the epicenter of global geopolitical risk. A fourth Taiwan Strait Crisis looms as China increases its military warnings to Taiwan not to attempt anything resembling independence (Chart 17A). China may use saber-rattling, economic sanctions, cyber war, disinformation, and other “gray zone” tactics to undermine the ruling party ahead of Taiwan’s midterm elections in November 2022 and presidential elections in January 2024. A full-scale invasion cannot be ruled out but is unlikely in the short run, as China still has non-military options to try to arrange a change of policy in Taiwan. Chart 17BMarket-Based Risk Indicators Say China/Taiwan Risk Has Not Peaked China has not yet responded to the US’s deployment of a small number of troops in Taiwan or to recent diplomatic overtures or arms sales. It could stage a major show of force against Taiwan to help consolidate power at home. China also has an interest in demonstrating to US allies and partners that their populations and economies will suffer if they side with Washington in any contingency. Given China’s historic confluence of risks, it is too soon for global investors to load up on cheap Chinese equities. Volatility will remain high. Weak animal spirits, limited policy easing, high levels of policy uncertainty, regulatory risk, ongoing trade tensions, and geopolitical risks suggest that investors should remain on the sidelines, and that a large risk premium can persist throughout 2022. Our market-based geopolitical risk indicators for both China and Taiwan are still trending upwards (Chart 17B). Global investors should capitalize on China’s policy easing indirectly by investing in commodities, cyclical equity sectors, and select emerging markets. 2. America’s Policy Insularity Our second view for 2022 centers on the United States, which will focus on domestic politics and will thus react or overreact to the many global challenges it faces. The US faces the first midterm election after the chaotic and contested 2020 presidential election. Political polarization remains at historically high levels, meaning that social unrest could flare up again and major domestic terrorist incidents cannot be ruled out. So far the Biden administration has focused on the domestic scene: mitigating the pandemic and rebooting the economy. Biden’s signature “Build Back Better” bill, $1.75 trillion investment in social programs, has passed the House of Representatives but not the Senate. The spike in inflation has shaken moderate Democratic senators who are now delaying the bill. We expect it to pass, since tax hikes were dropped, but our conviction is low (65% subjective odds), as a single defection would derail the bill. The implication would be inflationary since it would mark a sizable increase in government spending at a time when the output gap is already virtually closed. Spending would likely be much larger than the Congressional Budget Office estimate, shown in Chart 18, because the bill contains various gimmicks and hard-to-implement expiration clauses. Equity markets may not sell if the bill fails, since more fiscal stimulus would put pressure on the Federal Reserve to hike rates faster. Whether the bill passes or fails, Biden’s legislative agenda will be frozen thereafter. He will have to resort to executive powers and foreign policy to lift his approval rating and court the median voter ahead of the midterm elections. Currently Democrats are lined up to lose the House and probably also the Senate, where a single seat would cost them their majority (Chart 19). The Senate is still in play so Biden will be averse to taking big risks. For the same reason, Biden’s foreign policy goal will be to stave off various bubbling crises. Restoring the Iranian nuclear deal was his priority but Russia has now forced its way to the top of the agenda by threatening a partial reinvasion of Ukraine. In this context Biden will not have room for maneuver with China. Congress will be hawkish on China ahead of the midterms, and Xi Jinping will be reviving autocracy, so Biden will not be able to improve relations much. Biden’s domestic policy could fuel inflation, while his domestic-focused foreign policy will embolden strategic rivals, which increases geopolitical risks. 3. Petro-State Leverage A surge in gasoline prices at the pump ahead of the election would be disastrous for a Democratic Party that is already in disarray over inflation (Chart 20). Biden has already demonstrated that he can coordinate an international release of strategic oil reserves this year. Oil and natural gas producers gain leverage when the global economy rebounds, commodity prices rise, and supply/demand balances tighten. The frequency of global conflicts, especially those involving petro-states, tend to rise and fall in line with oil prices (Chart 21). Chart 20Inflation Constrains Biden Ahead Of Midterms Both Russia and Iran are vulnerable to social unrest at home and foreign strategic pressure abroad. Both have long-running conflicts with the US and West that are heating up for fundamental reasons, such as Russia’s fear of western influence in the former Soviet Union and Iran’s nuclear program. Both countries are demanding that the US make strategic concessions to atone for the Trump administration’s aggressive policies: selling lethal weapons to Ukraine and imposing “maximum pressure” sanctions on Iran. Biden is not capable of making credible long-term agreements since he could lose office as soon as 2025 and the next president could reverse whatever he agrees. But he must try to de-escalate these conflicts or else he faces energy shortages or price shocks, which would raise the odds of stagflation ahead of the election. The path of least resistance for Biden is to lift the sanctions on Iran to prevent an escalation of the secret war in the Middle East. If this unilateral concession should convince Iran to pause its nuclear activities before achieving breakout uranium enrichment capability, then Biden would reduce the odds of a military showdown erupting across the region. Opposition Republicans would accuse him of weakness but public opinion polls show that few Americans consider Iran a major threat. The problem is that this logic held throughout 2021 and yet Biden did not ease the sanctions. Given Iran’s nuclear progress and the US’s reliance on sanctions, we see a 40% chance of a military confrontation with Iran over the coming years. With regard to Ukraine, an American failure to give concessions to Russia will probably result in a partial reinvasion of Ukraine (50% subjective odds). This in turn will force the US and EU to impose sanctions on Russia, leading to a squeeze of natural gas prices in Europe and eventually price pressures in global energy markets. If Biden grants Russia’s main demands, he will avoid a larger war or energy shock but will make the US vulnerable to future blackmail. He will also demoralize Taiwan and other US partners who lack mutual defense treaties. But he may gain Russian cooperation on Iran. If Biden gives concessions to both Russia and Iran, his party will face criticism in the midterms but it will be far less vulnerable than if an energy shock occurs. This is the path of least resistance for Biden in 2022. It means that the petro-states may lose their leverage after using it, given that risk premiums would fall on Biden’s concessions. Of course, if energy shocks happen, Europe and China will suffer more than the US, which is relatively energy independent. For this reason Brussels and Beijing will try to keep diplomacy alive as long as possible. Enforcement of US sanctions on Iran may weaken, reducing Iran’s urgency to come into compliance. Germany may prevent a hardline threat of sanctions against Russia, reducing Russia’s fear of consequences. Again, petro-states have the leverage. Therefore investors should guard against geopolitically induced energy price spikes or shocks in 2022. What if other commodity producers, such as Saudi Arabia, crank up production and sink oil prices? This could happen. Yet the Saudis prefer elevated oil prices due to the host of national challenges they face in reforming their economy. If the US eases sanctions on Iran then the Saudis may make this decision. Thus downside energy price shocks are possible too. The takeaway is energy price volatility but for the most part we see the risk as lying to the upside. Investment Takeaways Traditional geopolitical risk, which focuses on war and conflict, is measurable and has slipped since 2015, although it has not broken down from the general uptrend since 2000. We expect the secular trend to be reaffirmed and for geopolitical risk to resume its rise due to the strategic themes and key views outlined above. The correlation of geopolitical risk with financial assets is debatable – namely because some geopolitical risks push up oil and commodity prices at the expense of the dollar, while others cause a safe-haven rally into the dollar (Chart 22). Global economic policy uncertainty is also measurable. It is in a secular uptrend since the 2008 financial crisis. Here the correlation with the US dollar and relative equity performance is stronger, which makes sense. This trend should also pick up going forward, which is at least not negative for the dollar and relative US equity performance (Chart 23). Chart 22Geopolitical Risk Will Rise, Market Impacts Variable Chart 23Economic Policy Uncertainty Will Rise, Not Bad For US Assets We are neutral on the US dollar versus the euro and recommend holding either versus the Chinese renminbi. We are short the currencies of emerging markets that suffer from great power rivalry, namely the Taiwanese dollar versus the US dollar, the Korean won versus the Japanese yen, the Russian ruble versus the Canadian dollar, and the Czech koruna versus the British pound. We remain long gold as a hedge against both geopolitical risk and inflation. We recommend staying long global equities. Tactically we prefer large caps and defensives. Within developed markets, we favor the UK and Japan. Japan in particular will benefit from Chinese policy easing yet remains more secure from China-centered geopolitical risks than emerging Asian economies. Within emerging markets, Mexico stands to benefit from US economic strength and divorce from China. We would buy Indian equities on weakness and sell Chinese and Russian equities on strength. We remain long aerospace and defense stocks and cyber-security stocks. -The GPS Team We Read (And Liked) … Conspiracy U: A Case Study “Crazy, worthless, stupid, made-up tales bring out the demons in susceptible, unthinking people.” Thus the author’s father, a Holocaust survivor translated from Yiddish, on conspiracy theories and the real danger they present in the world. Scott A. Shay, author and chairman of Signature Bank, whose first book was a finalist for the National Jewish Book Award, has written an intriguing new book on the topic and graciously sent it our way.2 Shay is a regular reader of BCA Research’s Geopolitical Strategy and an astute observer of international affairs. He is also a controversialist who has written essays for several of America’s most prominent newspapers. Shay’s latest, Conspiracy U, is a bracing read that we think investors will benefit from. We say this not because of its topical focus, which is too confined, but because of its broader commentary on history, epistemology, the US higher education system – and the very timely and relevant problem of conspiracy theories, which have become a prevalent concern in twenty-first century politics and society. The author and the particular angle of the book will be controversial to some readers but this very quality makes the book well-suited to the problem of the conspiracy theory, since it is not the controversial nature of conspiracy theories but their non-falsifiability that makes them specious. As the title suggests, the book is a polemical broadside. The polemic arises from Shay’s unique set of moral, intellectual, and sociopolitical commitments. This is true of all political books but this one wears its topicality on its sleeve. The term “conspiracy” in the title refers to antisemitic, anti-Israel, and anti-Zionist conspiracy theories, particularly the denial of the Holocaust, coming from tenured academics on both the right and the left wings of American politics. The “U” in the title refers to universities, namely American universities, with a particular focus on the author’s beloved alma mater, Northwestern University in Chicago, Illinois. Clearly the book is a “case study” – one could even say the prosecution of a direct and extended public criticism of Northwestern University – and the polemical perspective is grounded in Shay’s Jewish identity and personal beliefs. Equally clearly Shay makes a series of verifiable observations and arguments about conspiracy theories as a contemporary phenomenon and their presence, as well as the presence of other weak and lazy modes of thought, in “academia writ large.” This generalization of the problem is where most readers will find the value of the book. The book does not expect one to share Shay’s identity, to be a Zionist or support Zionism, or to agree with Israel’s national policies on any issue, least of all Israeli relations with Arabs and Palestinians. Shay’s approach is rigorous and clinical. He is a genuine intellectual in that he considers the gravest matters of concern from various viewpoints, including viewpoints radically different from his own, and relies on close readings of the evidence. In other words, Shay did not write the book merely to convince people that two tenured professors at Northwestern are promoting conspiracy theories. That kind of aberration is sadly to be expected and at least partially the result of the tenure system, which has advantages as well, not within the scope of the book. Rather Shay wrote it to provide a case study for how it is that conspiracy theories can manage to be adopted by those who do not realize what they are and to proliferate even in areas that should be the least hospitable – namely, public universities, which are supposed to be beacons of knowledge, science, openness, and critical thinking, but also other public institutions, including the fourth estate. Shay is meticulous with his sources and terminology. He draws on existing academic literature to set the parameters of his subject, defining conspiracy theories as “improbable hypotheses [or] intentional lies … about powerful and sinister groups conspiring to harm good people, often via a secret cabal.” The definition excludes “unwarranted criticism” and “unfair/prejudiced perspectives,” which are harmful but unavoidable. Many prejudices and false beliefs are “still falsifiable in the minds of their adherents,” which is not the case with conspiracy theories, although deep prejudices can obviously be helpful in spreading such theories. Conspiracy theories often depend on “a stunning amount of uniformity of belief and coordination of action without contingencies.” They also rely excessively on pathos, or emotion, in making their arguments, as opposed to logos (reason) and ethos (credibility, authority). Unfortunately there is no absolute, infallible distinction between conspiracy theories and other improbable theories – say, yet-to-be-confirmed theories about conspiracies that actually occurred. Conspiracy theories differ from other theories “in their relationship to facts, evidence, and logic,” which may sound obvious but is very much to the point. Again, “the key difference is the evidence and how it is evaluated.” There is no ready way to refute the fabrications, myths, and political propaganda that people believe without taking the time to assess the claims and their foundations. This requires an open mind and a grim determination to get to the bottom of rival claims about events even when they are extremely morally or politically sensitive, as is often the case with wars, political conflicts, atrocities, and genocides: Reliable historians, journalists, lawyers, and citizens must first approach the question of the cause or the identity of perpetrators and victims of an event or process with an open mind, not prejudiced to either party, and then evaluate the evidence. The diagnosis may be easy but the treatment is not – it takes time, study, and debate, and one’s interlocutors must be willing to be convinced. This problem of convincing others is critical because it is the part that is so often left out of modern political discourse. Conspiracy theories are often hateful and militant, so there is a powerful urge to censor or repress them. Openly debating with conspiracy theorists runs the risk of legitimizing or appearing to legitimize their views, providing them with a public forum, which seems to grant ethos or authority to arguments that are otherwise conspicuously lacking in it. In some countries censorship is legal, almost everywhere when violence is incited. The problem is that the act of suppression can feed the same conspiracy theories, so there is a need, in the appropriate context, to engage with and refute lies and specious arguments. Clients frequently email us to ask our view of the rise of conspiracy theories and what they entail for the global policy backdrop. We associate them with the broader breakdown in authority and decline of public trust in institutions. Shay’s book is an intervention into this topic that clients will find informative and thought-provoking, even if they disagree with the author’s staunchly pro-Israel viewpoint. It is precisely Shay’s ability to discuss and debate extremely contentious matters in a lucid and empirical manner – antisemitism, the history of Zionism, Holocaust denialism, Arab-Israeli relations, the Rwandan genocide, QAnon, the George Floyd protests, various other controversies – that enables him to defend a controversial position he holds passionately, while also demonstrating that passion alone can produce the most false and malicious arguments. As is often the case, the best parts of the book are the most personal – when Shay tells about his father’s sufferings during the Holocaust, and journey from the German concentration camps to New York City, and about Shay’s own experiences scraping enough money together to go to college at Northwestern. These sequences explain why the author felt moved to stage a public intervention against fringe ideological currents, which he shows to have gained more prominence in the university system than one might think. The book is timely, as American voters are increasingly concerned about the handling of identity, inter-group relations, history, education, and ideology in the classroom, resulting in what looks likely to become a new and ugly episode of the culture and education wars. Let us hope that Shay’s standards of intellectual freedom and moral decency prevail. Matt Gertken, PhD Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 The downshift in globalization today is even worse than it appears in Chart 10 because several countries have not yet produced the necessary post-pandemic data, artificially reducing the denominator and making the post-pandemic trade rebound appear more prominent than it is in reality. 2 Scott A. Shay, Conspiracy U: A Case Study (New York: Post Hill Press, 2021), 279 pages. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Appendix: GeoRisk Indicator China Russia United Kingdom Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Australia South Africa Section III: Geopolitical Calendar
Highlights The risk to European stocks from higher yields is overstated for 2022. Not only do equities possess a valuation cushion compared to bonds, but also the stock returns/bond yields correlation remains positive. This positive correlation is only two decades old, and it is a consequence of the stabilization of inflation and inflation expectations, which caused bond yield changes to mostly reflect adjustment in anticipated economic activity. As long as the recent inflation upsurge peters off next year, the equity/yield correlation will remain positive in 2022. Despite this sanguine short-term view, the long-term outlook is fraught with risks because next year’s inflation decline will be temporary; inflation is on a secular uptrend. The equity returns/bond yield correlation will become negative toward the middle of the decade, which will create a major headwind for the secular returns of both stocks and bonds. Feature Extremely low yields and elevated valuations constitute a potentially toxic mix for the equity outlook next year. The logic is straightforward: if yields rise enough, nosebleed multiples will become unjustifiable and the stock market will crash. Chart 1Protection Against Higher Yields The picture is more complex and instead, European equities are likely to withstand higher yields. To begin with, BCA Research’s US Bond strategists anticipate a modest rise in Treasury yields to 2.25% in 2022, and our Global Fixed-Income strategists foresee an even more limited increase in German rates. Moreover, as we showed in our 2022 Key Views piece published last week, European equities embed a large valuation cushion in the form of a significant premium in their dividend yield relative to Bund yields (Chart 1). The correlation between yields and equities is another facet that will impact the effect of higher yields on the equity bull market. For now, it is premature to conclude that the positive correlation between yields and the absolute performance of European equities is poised to turn negative again in 2022. However, over the next couple of years, such a correlation reversal will take place, because inflation expectations are increasingly likely to become unmoored to the upside. Stocks Like Higher Yields Over the past two decades, one of the major financial market paradoxes has been the relationship between equity prices and bonds yields. Since 1998, the weekly returns of the MSCI Euro Area equity benchmark have correlated positively with the change in 10-year German yields (Chart 2). However, prior to the late 1990s, changes in bond yields and stocks prices were negatively correlated. Chart 2For Two Decades, Bond Yields And Stocks Prices Have Moved Together The key to the shifting relationship between stocks and bonds is the link between yields and economic activity. Stock returns have always been procyclical because earnings are the most important driver of equity returns (Chart 3). However, bond yields have become increasingly pro-cyclical over time. Today, Bund yields and the German LEI move in tandem, but, prior to 1986, their five-year rolling correlation was negative (Chart 4). Chart 3Stocks Follow Earnings Who Follow Growth Chart 4Shifting Link Between Bunds And German Growth The positive correlation between German growth and German yields sheds light on why the correlation between yields and stocks is now positive, but it does not explain why this positive link emerged in the late 1990s and not earlier. Financial asset prices reflect global phenomena. Stock indices in advanced economies overrepresent multinationals which are affected by global economic fluctuations. Meanwhile, capital is fungible and flows freely across borders. As a result, German bond yields are not the unique factor that matters to the correlation between equities and stock. Instead, the behavior of global yields and equities is critical. Chart 5Living In The Shadow Of The Asian Crisis According to this logic, the correlation between global yields and global growth becomes important. As Chart 5 illustrates, the relationship between global bond returns and global economic activity became much closer around 1998 than it was prior to this date. The key turning point was the Asian crisis of 1997/98. Why was the Asian crisis so fundamental? It was the end state of the disinflationary trend started under Federal Reserve Chairman Paul Volker. After the Asian crisis, the region’s newly industrialized economies switched from chronic current account deficits to chronic surpluses, which added to the global supply of savings. Moreover, Asian economies became hypercompetitive because of severely devalued exchange rates, which limited pricing power around the world. Finally, the Chinese economy became a force to be reckoned with and its share of global trade expanded massively. Together, these forces amplified competitive pressure around the world and made every inflation uptick self-limiting. The impact of the shock is visible in the inflation data. As Chart 6 shows, core inflation in the US and in the G7 has been stable since 1998, capped near 2.5%, except for 2021. Additionally, after the Asian crisis, the volatility of core inflation collapsed among both the G7 and Eurozone economies (Chart 7). Chart 62.5%, A 20-Year Old Ceiling Chart 71998: RIP CPI Volatility The effect of this steady inflation was to stabilize inflation expectations. Thus, after 1998, the most important driver of bond price annual changes has been fluctuations in anticipated real economic activity, which explains why the relationship between global bond returns and the global LEI became much tighter afterward (Chart 5, on page 4). This result is crucial to understand the impact of higher yields for equities. It suggests that, if rising yields reflect improving economic growth, then the correlation between yields and stocks will remain positive and equities may climb higher along with mounting long-term interest rates. Bottom Line: Higher yields do not necessarily portend the end of the equity bull market. Stock prices and bond yields have been positively correlated since the Asian crisis of 1997/98 because fluctuating growth expectations drive most of the change in yields. As long as this remains the case, equities can handle higher yields. Can The Correlation Shift Sign Again? The correlation between equities and bonds is not static. There are threats that could restore both temporarily or permanently the negative correlation between changes in bond yields and stock returns that prevailed prior to 1998. A Temporary Correlation Shift? Since their March 2020 lows, 10-year yields have increased 94bps and 51bps in the US and Germany, respectively. Meanwhile, the MSCI Eurozone equity benchmark is up 78%. We are clearly not yet in an environment in which rising long-term interest rates hurt stocks. In the short term, the correlation between yield changes and equity returns may turn negative if yield moves into constraining territory—this is to say, if they rise enough to risk a recession. In more academic terms, this equates to rates moving above the neutral rate of interest, or r-star. Chart 8A Long Way To Go Before Policy Becomes Tight There is little indication that interest rates are moving above this level in the short term. US and European policy rates remain well below Taylor rule estimates of equilibrium (Chart 8), which suggests that policies are still highly accommodative. The most worrisome signal comes from the slope of the yield curve. Since March 2021, the US 2-/10-year yield curve has flattened by 76bps to 81bps and, since October 2021, the same yield curve has flattened by 23bps to 35bps in Germany. Moreover, the 20-/30-year US yield curve became inverted in October 2021. These dynamics may indicate that policy is already on the verge of becoming too tight, even if only five interest rate hikes are expected in the US over the next two years. Chart 9Term Premia Are Still Negative A curve flattening episode is the normal course of events when central banks become less accommodative; it is not a sign of impending doom. Instead, an inverted yield curve is the indication that the policy rate is above r-star. After all, if interest rates genuinely constrain growth, they will slow economic activity in the future, which will necessitate lower rates and generate a negative curve slope. We are not there yet. Moreover, the term-premium remains negative across major advanced economies, which suggests that a recessionary signal will come from a deeper yield-curve inversion than in the past (Chart 9). Chart 10Upside To The Terminal Rate Another factor likely to allow yields to rise without killing the equity market is that the expected terminal rate of interest remains too low, as we wrote in our 2022 Key Views piece last week. Historically, it is common for the expected terminal rate to rise as central banks begin to lift interest rates, especially if the economy handles the first hikes well. Today, the expected terminal rate is below the levels that prevailed after the GFC, despite a much firmer economy unburdened by private sector deleveraging and excessive fiscal tightening (Chart 10). As such, we anticipate the expected terminal rate to increase, which will limit how quickly the yield curve will flatten next year even if the Fed elevates interest rates and the ECB aggressively downshifts its pace of asset purchases once the PEPP ends. Chart 11Long-Term Inflation Expectations Are Not A Concern, Yet Under this aperture, the biggest risk for stocks remains inflation. Further acceleration in inflation, especially if it pushes the 5-year/5-year forward inflation breakeven rate above the Fed’s comfort zone (Chart 11), could hurt stocks. Essentially, investors would price in a shift in the monetary policy environment whereby risks of a severe tightening would increase. However, as we recently wrote, the odds are mounting that short-term inflation will soon peak. Oil inflation is ebbing, while transportation costs are declining and supply bottlenecks are beginning to ease. Moreover, money growth in the US and the Eurozone, which proved relevant variables to explain inflation this year, is also waning (Chart 12). Finally, a mounting number of global central banks are tightening policy, which implies that maximum accommodation is behind us (Chart 13) In this context, we expect the positive correlation between stock returns and yield changes to remain broadly positive. A short-term rise in yields could easily contribute to equity market volatility and may even cause a deeper stock market correction than any experienced since April 2020. However, this will prove to be a temporary phenomenon, and thus we remain buyers of the dip. Chart 12Slowing Money Supply Growth, At Last Chart 13Global Policy Is Becoming Less Easy A Longer-Term Correlation Shift? A shift in the long-term correlation between equity returns and bond yield changes is a much more meaningful risk to stocks than short-term changes. BCA expects inflation to peak in the short term, but this will only be part of a stop-and-go process. Inflation is on a structural uptrend and so, any decline in 2022 and early 2023 will morph into renewed pressure, after the global output gap becomes positive again by the end of next year. Chart 14A Deflationary Tailwind Is Gone Many structural forces are moving away from deflationary to inflationary. True, technological progress remains a deflationary anchor. However, this downward pressure on inflation is no longer buttressed by a deepening of globalization (Chart 14). Moreover, because of the rise of populism around the world over the past five years, fiscal policy is unlikely to move back to the austere Washington Consensus that dictated governance from President Reagan up to the moment President Trump took power. Additionally, ageing across advanced economies and China, as well as the so-called “Great Resignation,” will constrain the expansion of the global supply side. This background suggests that the period of flat inflation that prevailed from 1998 to 2020 is ending. As a corollary, inflation expectations will embark on a multi-year upward drift. This process is likely to loosen the correlation between economic activity and yields. As a result, the period of positive correlation between yield changes and equity returns is in its last innings. This will represent a major difficulty for asset allocators over the next ten to twenty years, as it points to poor long-term real returns for both bonds and stocks. Bottom Line: The correlation between stock returns and bond yield changes is likely to remain positive in 2022, which implies that European stocks will eke out another year of positive returns, despite BCA’s house view that yields will rise. However, the long-term outlook is more problematic. The growing likelihood that inflation is making a secular upturn means that the two-decades old positive correlation between equity returns and bond yield change will become negative again around the middle of the decade. This shift will have a profound and deleterious impact on both stocks’ and bonds’ secular returns. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance
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