Disasters/Disease
Dear Clients, Next week, in addition to sending you the China Macro And Market Review, we will be presenting our 2022 outlook on China at our last webcasts of the year “China 2021 Key Views: A Challenging Balancing Act”. The webcasts will be held Wednesday, December 15 at 10:00 am EDT (English) and Thursday, December 16 at 9:00 am HKT (Mandarin). Best regards, Jing Sima China Strategist Highlights China’s policymakers are balancing between staying the course with structural reforms and stabilizing the economy. This carefully calibrated approach means that Beijing will only initiate piecemeal policy easing in the near term. China will ramp up investment in the new economy, which is too small to fully offset the drag on the aggregate economy from weakening old economy sectors. In the next three to six months, the economy will deteriorate further, but Beijing will only press the stimulus accelerator harder if their pressure points are breached. A zero-tolerance policy towards COVID will be maintained for the foreseeable future. Uncertainties surrounding the Omicron variant will reinforce this approach. The common prosperity policy initiative will likely accelerate ahead of the 20th National Congress of the Chinese Communist Party (NCCCP) in the fall of 2022. While the plan will ultimately benefit income and consumption for the majority of Chinese households, the uncertainties surrounding impending tax reforms will curb demand for housing and luxury goods in the short term. We remain underweight Chinese stocks. Prices for onshore stocks will likely fall in the next three to six months when the market starts to price in lower-than-expected economic growth and disappointing stimulus. Selloffs in the first half of 2022 may present an opportunity to turn positive on onshore stocks in absolute terms. We will turn bullish on Chinese stocks relative to global equities only when credit expansion overshoots weakness in the economy, which has a low likelihood. We continue to favor onshore stocks versus offshore within a Chinese equity portfolio. Tensions between the US and China may intensify leading up to the political events next year. Chinese offshore stocks, highly concentrated in internet companies, still face the risks of being caught in both geopolitical crossfires and domestic regulatory pressures. Feature China’s economy slowed significantly in 2H21, with the extent of policy tightening and magnitude of the decline in growth much larger than global investors expected. As we forecasted in our last year’s Key Views report, 2021 marked the beginning of a new era in which policymakers would switch gears from building a "moderately prosperous society" to becoming a "great modern socialist nation”.The pivot means that officials would tolerate slower economic growth, implement tougher financial and industry regulations, and accelerate structural reforms. On the cusp of 2022, we are cautious about the willingness of China’s top leadership to initiate large-scale policy easing. Even though policy tone has shifted to a more pro-growth bias, authorities are still trying to replace old economic drivers with the new economy sectors. Furthermore, they are struggling to maintain a delicate balance between boosting short-term growth and maintaining long-term reforms goals. As a result, their policies are sending mixed signals. As seen in 2018 and 2019, the policymakers’ reluctance to activate a full-scale stimulus does not bode well for global commodity prices. Chinese onshore stocks underperformed their global counterparts during the 2018-19 period. Chinese stocks will face nontrivial headwinds in the coming months and warrant a cautious stance until more stimulus is introduced and the macro picture begins to meaningfully improve. The main themes in our outlook for 2022 are discussed below. Key View #1: Balancing Between The Old And New Economies Despite a recent pro-growth bias in the policy tone, the speed of easing has been incremental and the magnitude piecemeal. Moreover, authorities are telegraphing policy support in new economy sectors (such as high tech and clean energy), while only somewhat loosening restrictions in old economy sectors (mainly property and infrastructure). Chart 1Current Easing Path Is Looking A Lot Like In 2018/19 China’s policy framework has shifted since late 2017 as we noted in previous reports. The top leadership is more determined to stay the course with reforms and tolerate slower growth in the old economy. Our BCA Li Keqiang Leading Indicator highlights policymakers’ carefully calibrated policy actions to avoid a dramatic overshoot of credit growth; these actions are consistent with 2018/19 and starkly contrast with policy frameworks in 2012 and 2015. Monetary conditions have meaningfully eased, but the rebound in money supply and credit growth has lagged and is muted due to heightened regulatory oversight (Chart 1). Investors should keep low expectations about the policymakers’ willingness to boost growth in old economy sectors. The easing of restrictions in property sector – from prompting banks to resume lending to qualified homebuyers and developers, to allowing funding for developers to acquire distressed real estate assets – are steps to alleviate an escalating risk of widespread bankruptcies among real estate developers. However, regulators have not changed the direction of their structural policies. Funding constraints placed on both developers and banks since last August remain intact. Banks still need to meet the “two red lines” that set the upper limit on the portion of their lending to the property sector, while developers must bring their leverage ratios below the “three red lines” by end-2023. Maintaining these binding constraints on developers and banks will continue to weigh on the housing market in the coming years. The recent easing may reduce the intensity of funding constraints, but the banks will be extremely cautious to extend lending to a broad range of developers. Aggressive crackdowns on property market speculation in the past 12 months has fundamentally shifted both developers’ and consumers’ expectations for future home prices. Growth in home sales and new projects dropped to their 2015 lows, while current real estate inventories are comparable to 2015 highs (Chart 2). Therefore, unless regulators are willing to initiate more aggressive policy boosts, such as cutting mortgage rates and/or providing government funds to monetize inventory excesses in the housing market, the current easing measures probably will not revive sentiment in the property market. Thus, odds are that the property market downtrend will extend through 2022 (Chart 3). Chart 2Downward Momentum In Property Market Comparable To 2015 Chart 3Policymakers Will Have To Allow Significant Re-leveraging To Revive The Market Chart 4Key Indicators Show Weak Signs Of Revival In Infrastructure Spending We expect some modest increase in infrastructure spending next year from the meager 0.7% growth in 2021, but we are skeptical that policymakers will allow any substantial rebound. Shadow banking activity and infrastructure project approval, two key indicators we monitor for signs of a meaningful easing in infrastructure spending, show little improvement (Chart 4). Our outlook for infrastructure investment is based on the following: Since 2017 policymakers have assumed a much more hawkish approach toward reducing investment in the capital-intensive and unproductive old economic sectors. Next year’s 20th NCCCP will not fundamentally change this policy setting. The 19th NCCCP in late 2017 deviated from the past; infrastructure investment growth downshifted following the event, whereas significant spending boosts had followed previous NCCCPs (Chart 5). Beijing adhered to its structural downshift in infrastructure spending even during the 2018/19 US-China trade war and after last year’s pandemic-induced economic contraction. Chart 5Infrastructure Investment Shifted To A Lower Gear Following The 19th NCCCP Secondly, government spending since 2017 has tilted towards social welfare over building “bridges to nowhere”, a meaningful change from the past and in keeping with President Xi Jinping’s political priorities (Chart 6). The trend will likely continue next year because local governments need to maintain large social welfare budgets to counter the economic impact of the prolonged domestic battle against COVID. Local government revenues, on the other hand, will be reduced due to slumping land sales. Thirdly, there has been strong policy guidance by the central government to shift investment to the new economy sectors and away from traditional infrastructure projects. The PBoC in early November launched the carbon emission reduction facility (CERF) to offer low interest loans to financial institutions that help firms cut carbon emissions. China’s new economy sectors have experienced rapid growth in recent years, but in the short-term, infrastructure spending in those sectors will not fully offset a reduction in traditional infrastructure (Chart 7). The combined spending in tech infrastructure (including information transmission such as 5G technology and services) and green energy stood at RMB1.6 trillion last year, compared with the RMB19 trillion investment in traditional infrastructure and RMB14 trillion in the real estate sector. Bottom Line: Beijing will continue to push for investment in new economy sectors since the leadership is determined to reduce dependency on unproductive segments of the economy. Even as the economy slows, they will be reluctant to ramp up leverage and channel capital to the old economy sectors. Unfortunately, the small size of the new economy’s sectors versus the old economy will inhibit their ability to stabilize and accelerate economic growth via these policies. Key View #2: The Pressure Points We do not think Beijing will allow the economy to freefall past the “point of no return”. The economy still needs to grow by 4.5-5.0% per annum between 2021 and 2035 to achieve the target of doubling GDP by 2035 (Chart 8A and 8B). Chart 8AThe Structural Downshift In Chinese Growth Will Continue… Chart 8B...But A 5%+/- Rate Of Growth Will Keep China Well On Track Of Doubling Its GDP By 2035 Investors should watch the following pressure points to assess whether China’s leaders will feel the urgency to turn policy to outright reflationary: A collapse in onshore financial market prices. China’s economic fundamentals will weaken further in the next three to six months and the risks to Chinese equity prices are on the downside. However, the odds are still low that the onshore equity, bond and currency markets will plunge as in 2015. Onshore stocks are cheaper than during the height of their 2015 boom-bust cycle, margin trading remains well below its 2015 level and economic fundamentals are stronger (Chart 9). Selloffs by global investors in China’s offshore equity and high-yield bond markets have not triggered much panic in the onshore markets and, therefore, will not drive Beijing to change its macro policy (Chart 10). Chart 9Valuations In Chinese Stocks Are Not As Extreme As In 2015 Chart 10Onshore Markets Have Been Relatively Calm Chart 11China/US Growth Rates In 2022 Will Be Uncomfortably Close, Based On IMF Forecasts Narrowing growth differentials between China and the US. In the IMF’s October World Economic Outlook, economic growth in 2022 for China and the US is projected at 5.6% and 5.2%, respectively. The forecast suggests that next year the growth differential between the two largest economies will be narrowed to less than one percentage point, rarely seen in China’s post-reform history (Chart 11). Notably, the most recent Bloomberg consensus estimate for the 2022 US real GDP growth is much lower at 3.9%, whereas China is expected to grow by 5.3% and in line with the IMF forecast. We do not suggest that Beijing will make its policy decisions based on these growth projections. Rather, we expect that if China’s growth in 1H22 falls behind that in the US, Chinese policymakers will feel an urgency to stimulate the economy and show a better economic scorecard ahead of the all-important 20th NCCCP next fall. Rising unemployment. Current data shows a mixed picture. Unemployment rates have been falling in all age groups (Chart 12). Demand for labor in urban areas, on the other hand, has been shrinking (Chart 13). The employment subindex in China’s service PMIs has also been dropping. Our view is that the resilient export/manufacturing sector has provided strong support to employment this year, while the labor supply in urban areas has been sluggish due to tighter travel restrictions and frequent regional lockdowns. The combination of strong manufacturing demand for labor and a lack of supply has reduced excesses in the labor market and the urgency to stimulate the economy (Chart 13, bottom panels). However, the picture could change if China’s exports start to slow into next year. Chart 12China's Unemployment Rate Is Falling... Chart 13...But Demand For Labor Is Also Falling Bottom Line: In the coming year, investors should watch for three pressure points that may trigger more forceful growth-supporting actions from policymakers: the onshore financial markets, economic growth differentials between the US and China, and labor market dynamics. Key View #3: The Exit Strategy Chart 14Service Sector Activities Have Been Restricted By Domestic Covid Cases And Frequent Lockdowns China will not completely lift its zero-tolerance policy toward COVID in the coming year. We will likely see tightened domestic preventive measures leading to the Beijing Olympics in February and the NCCCP in October. The zero-tolerance policy cannot be sustained in the long run; China’s stringent counter-COVID measures have created a stop-and-go pattern in China’s service sector, which has taken a toll on household consumption (Chart 14). As such, Chinese policymakers will face a trade-off between hefty economic costs from its current counter-COVID measures, and the potential social costs and risks if there is a dramatic increase in domestic COVID cases. China is estimated to have fully vaccinated more than 80% of its citizens and is close to launching its own mRNA vaccine next year to be used as a booster shot. However, the inoculation rate will likely matter less to Beijing’s decision to relax its draconian approach towards COVID given the emergence of the virulent Omicron variant. Recent statement by China's top respiratory experts suggests that China will return to normalcy if fatality rate of COVID-19 drops to around 0.1%, and when R0 (the virus reproduction ratio) sits between 1 and 1.5. A more important factor that could influence Beijing’s decision is the development and effectiveness of anti-viral drug treatments. Pfizer recently announced that its anti-viral oral drug Paxlovid can reduce the hospitalization and death rates by 89% if taken within three days of the onset of symptoms. The drug-maker has announced its intention to produce enough of the medication to treat 50 million people in 2022. China’s Tsinghua University has also developed an antibody combination drug that may reduce hospitalization and mortality by 78% and is expected to be approved by Chinese regulators within this year. Beijing’s decision to abandon its zero-tolerance policy, therefore, will be based on the combined effectiveness of both vaccines and treatments. If clinical trials prove that the new antiviral drugs are effective in treating COVID patients, combined with China’s aggressive rollout of booster shots, then Beijing may incrementally relax its COVID containment measures by late 2022 or early 2023. Bottom Line: China will not loosen its zero-tolerance policy until a combination of vaccines and treatments proves to be effective against COVID. Key View #4: Common Prosperity Will Gather Steam We expect the notion of common prosperity espoused by President Xi Jinping to gain momentum ahead of the 20th NCCCP. Beijing will likely roll out measures to support consumption, particularly for low-income households. At the same time, there is a high possibility that policymakers will introduce taxes on luxury goods and accelerate the legislative process on real estate taxes. Chart 15The Slump In Property Market Will Likely Be An Extended One The property market will remain in a limbo in 2022. In the near term, potential homebuyers will likely maintain their wait-and-see attitude before details of real estate taxes are disclosed. Home sales will remain in contraction despite improved mortgage lending conditions (Chart 15). Consumption taxes are expected to increase, targeting consumer discretionary and/or luxury goods. Chinese consumption of luxury goods benefited from government pro-growth measures last year, flush liquidity in the market and global travel restrictions. Meanwhile, growth in aggregate household income and consumption has been lackluster. President Xi Jinping’s common prosperity policy initiative is intended to narrow the income and wealth gap between the rich and poor. Moreover, empirical studies show that the marginal propensity to consume among lower- and middle-income groups, which account for more than 80% of China’s total population, is significantly higher than that of high-income groups. We expect more support for lower income groups as Beijing looks to stabilize the economy and narrow the wealth gap. Bottom Line: There is a high probability that policymakers will introduce taxes on the consumption of luxury goods and initiate the legislative process on real estate taxes in the next 12 months. Investment Conclusions Chinese stocks in both the onshore and offshore markets have cheapened relative to global equities. However, in absolute terms onshore stocks are not unduly cheap and offshore stocks are cheap for a reason (Chart 16). We remain defensive in our investment strategy for Chinese stocks in the next two quarters, given the headwinds facing the onshore and offshore markets. We do not rule out the possibility that China’s authorities will stimulate more forcefully in the next 12 months. However, for Chinese policymakers to ramp up leverage again, the near-term dynamics in the country’s economic cycle will have to significantly worsen. Chinese stocks will sell off in this scenario, but the selloff will provide investors with a good buying opportunity in the expectation of a more decisive stimulus (Chart 17). Chart 16Chinese Onshore Stocks Are Not Particularly Cheap, While Offshore Stocks Are Cheap For A Reason Chart 17Selloff Risks Are High Before The Economy Stabilizes Chart 18A Deja Vu Of 2018-2019? If the economy slows in an orderly and gradual manner, then there is a slim chance that policymakers will allow an overshoot in stimulus. The Politburo meeting on Monday sent a stronger pro-growth message, the PBoC cut the reserve requirement ratio (RRR) rate by 50bps, and regulators will likely allow a front-loading of local government special-purpose bonds in Q1 next year. However, based on the lessons learned in 2019, regulators can be quick to scale back policy support if they see there is a risk of overshooting in credit expansion (Chart 18). The measured stimulus during the 2018-2019 period did not bode well for Chinese stocks or global commodity prices (Chart 19A and 19B). Meanwhile, we do not think the recent selloff in offshore stocks provided good buying opportunities. In the next 6 to 12 months, any tactical rebound in Chinese investable stocks will present a good selling point. Chart 19AChina's Measured Stimulus In 2018-2019 Did Not Bode Well For Global Commodity Prices Chart 19BChinese Stocks Underperformed In 2018-2019 Investable stocks, highly concentrated in China’s internet companies, are caught in domestic regulatory clampdowns and geopolitical crossfires. We expect tensions between China and the US to intensify in 2022 in light of next fall’s 20th NCCCP in China and mid-term elections in the US. Furthermore, Didi Global’s decision to delist from the New York Stock Exchange last week highlights that both China and the US are unanimous in their efforts (although for different reasons) to remove Chinese firms from US bourses. Risks associated with future delisting of Chinese firms will continue to depress the valuations of Chinese technology stocks. Jing Sima China Strategist jings@bcaresearch.com Market/Sector Recommendations Cyclical Investment Stance
BCA Research’s European Investment Strategy service concludes that despite the ongoing recovery, the European economy will face significant headwinds in the first half of the year. China’s economic travail constitutes Europe’s first headwind. European exports…
Highlights Economy: Chair Powell retired the term “transitory” last week, signaling that the Fed may take a harder line on inflation in the coming year: The Fed coined the transitory term to describe the current inflation backdrop, and publicly throwing in the towel on the idea allows the FOMC to open the door to a more hawkish approach in 2022. Markets: Financial markets continued their post-Thanksgiving gyrations, but the Omicron variant was a more meaningful driver than Fedspeak: Powell’s hints simply brought the Fed’s liftoff date closer to the markets' estimate. Omicron was the main force behind the fall in interest rates, as evidenced by the swoon in oil and pandemic-exposed equities. Strategy: Don’t fight the crowd in the near term, but position for a higher-than-expected terminal rate down the road: We expect rates will remain well behaved in 2022, but we do not share the seeming market conviction that rates will be permanently lower. Feature A US investor who called it a week the day before Thanksgiving may think twice about leaving his/her desk for even a day going forward. Stocks and other risk assets were hammered in the abbreviated Black Friday session on concerns about Omicron, COVID’s latest variant. The S&P 500 recovered much of its losses last Monday, only to be jolted again on Tuesday, as Fed Chair Powell testified before a Senate committee. Stocks duly surged on Wednesday, leaving the S&P off just over 1% from its pre-Thanksgiving close, until news that the Omicron variant had been discovered in California sparked a sharp intra-day reversal. They then came back very strong on Thursday – lather, rinse, repeat. The action was a reminder that volatility often picks up as a perceived inflection point nears. The VIX, which measures implied volatility on S&P 500 index options, spent the week ensconced above the 20 level that has mostly contained it since the financial crisis faded and effective COVID vaccines became widely available (Chart 1). Despite the recent gyrations, our base-case cyclical outlook, as described in last week’s report, remains in place. We expect US growth will come in well above trend for this quarter and all of 2022, monetary policy settings will likely remain easy for another two years, and the accumulated monetary and fiscal stimulus that’s already been injected into the economy will keep the expansion going at least through 2023. Chart 1An Eventful Stretch What The Chair Said Fed Chair Powell testified before the Senate and the House Tuesday and Wednesday last week, respectively. His comments on the pace of tapering, the economy’s progress in meeting the Fed’s inflation criteria for hiking rates, the way inflation might thwart employment gains and the word "transitory" captured the attention of investors and the financial media. On tapering: “At this point, the economy is very strong, and inflationary pressures are high. It is therefore appropriate in my view to consider wrapping up the taper of our asset purchases, which we … announced at our November meeting, perhaps a few months sooner.” On the inflation criteria for hiking rates: “The test that we’ve articulated clearly has been met [.] … Inflation has run well above 2% for long enough now [given recent data releases].” On inflation as a threat to full employment: “What I am taking on board is it is going to take longer to get labor force participation back. … That means to get back to the kind of great labor market we had before the pandemic, we’re going to need a long expansion. To get that we’re going to need price stability, and in a sense, the risk of persistent high inflation is also a major risk to getting back to such a labor market.” On “transitory” inflation: Though some people interpreted it as short-lived, we used “transitory” to “mean that it won’t leave a permanent mark in the form of higher inflation. I think it’s probably a good time to retire that word and try to explain more clearly what we mean.” How Powell’s Comments Might Shift Monetary Policy Table 1The Liftoff Checklist The taper timetable will be sped up. It seems clear that the FOMC will vote to accelerate the taper at its meeting ending December 15th. Given how carefully the Fed has telegraphed its asset purchase actions, Powell would not have raised the issue unless it were a done deal. Instead of ending in June upon the purchase of an additional $420 billion of Treasury and agency securities, as per the November FOMC meeting's guidance, this round of QE will end sometime sooner after buying somewhat less. While we do not think that the parameters of the taper matter all that much in themselves, Powell has stated that the FOMC will not begin hiking rates until it has stopped purchasing securities and accelerating the tapering pace will afford it the flexibility to bring the liftoff date forward if it so chooses. Chart 2Hikes May Not Wait For Full Employment The economic prerequisites for hiking rates are closer to being met. Our US Bond Strategy service has maintained a checklist of the three criteria the FOMC laid out as preconditions for hiking rates (Table 1). With consumer prices rising by more than the 2% target for several months, our bond colleagues checked the inflation boxes a while ago and noted that the full employment1 criterion would become the swing factor for rate hikes. Per the FOMC’s Summary of Economic Projections, it has been reasonable to assume that full employment would entail an unemployment rate at or below 4% (Chart 2, top panel), with the prime-age participation rate near its pre-pandemic level (Chart 2, middle panel), even if overall participation continues to lag (Chart 2, bottom panel). Powell’s Senate testimony indicated that the criterion has been relaxed, as his comments calling out too-high inflation as a threat to the labor market countered the Fed’s previously firm resolve to let the economy run hot until the economy achieved maximum employment. The bottom line is that Powell’s testimony has given the Fed some flexibility to raise rates sooner than the second half of next year if it sees fit. As Cleveland Fed president Loretta Mester, a 2022 FOMC voter, said after Powell wrapped up his appearances on Capitol Hill, “Making the taper faster is definitely buying insurance and optionality so that if inflation doesn’t move back down significantly next year we’re in a position to be able to hike if we have to. Right now, with the inflation data the way it is and with the job market as strong as it is, I do think we have to be in a position that if we need to raise rates a couple times next year, we’re able to do that.” The Fixed Income Market Reaction Chart 3What A Difference A Week Makes Ahead of Powell’s testimony, the overnight index swap curve took out almost an entire hike for the next twelve months, falling from 66 basis points ("bps") (two hikes and a 64% chance of a third) on Thanksgiving to 43 bps on Monday (one hike and a 72% chance of a second). The same went for the next twenty-four months, which fell from 140 bps to 117 bps, or five hikes and a 60% chance of a sixth to four hikes and a 68% chance of a fifth by Thanksgiving 2023. Rate hike odds regained some ground on Powell’s remarks, though the ultimate rebound was half-hearted – at press time, the probability of a third hike in the next twelve months stood at just 8% (Chart 3, top panel); only two hikes were priced in for the following twelve months, with an 80% chance of a third hike (Chart 3, middle panel); and the chances of getting the fed funds rate above 1.5% by November 2024 were judged to be slim (Chart 3, bottom panel). How can it be that a hawkish shift in Fed rhetoric would coincide with a decline in fed funds rate expectations? The bulk of the decline resulted from the emergence of the Omicron variant and the toll it might take on economic activity. If Omicron fears prove to be overstated, fed funds rate expectations likely will as well, but as we showed last week, market terminal rate expectations were in line with the FOMC’s guidance – they just foresaw a sooner liftoff date. Powell’s comments and the increased tapering pace suggest that the Fed’s expectations are moving closer to market expectations. The other aspect is the fact that markets were on board with the transitory inflation narrative. Sharply downward sloping inflation expectations curves indicated that fixed income markets agreed that high near-term inflation would not leave a lasting mark on longer-run inflation. Since Thanksgiving, the curves derived from TIPS (Chart 4) and CPI swap prices (Chart 5) have put a new spin on Operation Twist, with the front end shifting in while the back end has stood pat. Omicron aside, if retiring the transitory term means the Fed will be more vigilant about upward inflation pressures, it increases the probability they will turn out to be transitory, as the Fed will give them less of a chance to take root. Investment Implications In our view, adaptive expectations will keep long-end interest rates on a fairly tight leash over the next year. It seems that investors are unable to shake what they perceive to be the central lesson of the post-crisis era: rates will be permanently lower. That view rests on a conviction that inflation is kaput and the widely shared sense that the Fed can’t hike rates beyond 2% because it would be: a) too disruptive for a fundamentally fragile economy, b) too disruptive for financial markets weaned on ZIRP, and/or c) too disruptive for a prodigally indebted federal government. We don’t think those views will hold up over the next few years – encouraging inflation would seem to be the easiest way to wriggle out from c) – but we do not advise challenging them head-on in the near term. We also push back – rhetorically for now – on the view that long maturity Treasury yields are low, and the yield curve has flattened, because the Fed is on track to make a policy mistake by unnecessarily tightening into a recession. Monetary policy affects the economy with long and variable lags – our rule of thumb is somewhere from six to twelve months – and if the neutral fed funds rate is north of 2% (an admittedly out-of-fashion view), it appears as if it will take at least two years to get there. Under our rule-of-thumb lag, then, the economy will be subject to a tailwind from monetary accommodation at least until the middle or end of 2024. Given the additional consumption support from households' remaining $2.2 trillion of pandemic excess savings, we are confident that a recession is not on the horizon. We are therefore staying the course, overweighting equities and high yield while underweighting Treasuries, and remaining vigilant for threats to our base-case macro backdrop of strong growth and easy monetary policy. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 “Full employment” is a somewhat ambiguous concept that turns on estimates of the natural slack that results from structural frictions in the labor market, like geographic and skills mismatches.
Highlights The big issue is not whether the omicron variant of SARS-Cov-2 is a ‘super-variant’. The big issue is that, eventually, a new variant will be a super-variant. This is because the billions of unvaccinated people in the developing world will prove to be fertile ground for new variants. It is no coincidence that three of the most dangerous variants have emerged from Africa (beta and omicron) and India (delta). Tactically overweight healthcare versus energy. Overweight tech, communication services, and interactive entertainment. The 30-year T-bond is a ‘must own’ investment in all long-term portfolios. Fractal analysis: The US dollar, and semiconductors. Feature Chart of the WeekCovid Infections Form A Near-Perfect 'Sine Wave'... Which Will Propagate Into 2022 Perhaps the most telling sign of the ongoing pandemic is the use of the Greek alphabet to designate new variants of the virus. The point being that the Greek alphabet doesn’t end at delta. Or, for that matter, at omicron. Both the flu and the SARS-CoV-2 viruses are ‘RNA viruses’ that suffer poor proof-reading ability during replication. This means that they mutate like crazy. And as they mutate like crazy, new variants arrive like clockwork. As the American Society of Microbiology explains:1 “The influenza virus is constantly evolving and experiencing varying levels of antigenic drift (and shift) that can make it less recognizable to our immune systems. This has made the development of a universally effective flu vaccine particularly challenging and explains the constant underlying threat that new zoonotic influenza strains might emerge and become pandemic. Likewise, the spike proteins of SARS-CoV-2 undergo adaptive evolution that is consistent with selection for antibody escape (Figure 1). It is therefore not surprising that SARS-CoV-2 continues to mutate. The emergence of new variants with increased transmissibility and/or pathogenesis suggest that the novel coronavirus is undergoing selective evolution at the population level” Describing this selective evolution in Viral Variants Strike Down The Reflation Trade, we warned on June 17 that: “After the delta variant will come the epsilon variant, the zeta variant, the eta variant… and so on until we run out of Greek alphabet… (Hence) managing infections will also require non-pharmaceutical interventions, dialled up and down based on the severity of future waves of infection” And just as we predicted in June, along came Omicron (though we did get the letter wrong) plus renewed non-pharmaceutical interventions. In fact, all the SARS-CoV-2 variants have arrived like clockwork. With such a predictability, that the virus reproduction rate and the number of new global cases of infection forms a near-perfect mathematical ‘sine wave’ (Chart I-1 and Chart I-2). Therefore, the big issue is not whether the omicron variant is a ‘super variant’. The big issue is that, eventually, a new variant will be a ‘super-variant’. Chart I-2Covid Infections Form A Near-Perfect 'Sine Wav'... Which Will Propagate Into 2022 Every Time The Virus Mutates, It Rolls The Dice On Becoming A ‘Super Variant’ The overall danger of a virus comes from the combination of three of its properties: Its contagiousness Its immuno-evasion (the ability to escape vaccinations and natural immunity) Its pathogenicity (the severity of the disease it causes) Every time the virus mutates, it is rolling the dice on these three properties. Figuratively speaking, if it rolls three ‘ones’, then that mutation will not thrive. But if it rolls three ‘sixes’, then that mutation will be a ‘super-variant’. What if it rolls high on contagiousness and immuno-evasion, but low on pathogenicity – wouldn’t such a dominant variant that causes only a mild disease be the perfect outcome? Yes, but only for a while. Because, as the benign variant circulated, it would just get more chances to roll the dice again to displace that benign variant with an even more contagious and immuno-evasive version which is more pathogenic. But wouldn’t a more pathogenic virus be bad for the virus itself, given that killing the host means killing itself? No, because what is considered highly pathogenic for us is not highly pathogenic for the virus. For example, while a 1 percent mortality rate would be unacceptable to most societies, it would be inconsequential for the virus. Moreover, highly pathogenic could also mean low mortality with high morbidity (severe sickness) which would be perfect for the virus but disastrous for our healthcare systems (Chart I-3). Chart I-3High Morbidity Is Disastrous For Healthcare Systems Can We Stop The Virus Rolling The Dice? To reduce the chance of a super-variant of SARS-CoV-2, we must stop the virus rolling the dice. Meaning we must stop it circulating. However, just as with the flu virus, immuno-evasion means that vaccinations need regular refreshing. The question is: what proportion of the world’s population will be (up-to-date) vaccinated? The answer is, not nearly enough. In the US, the proportion of the population that is not fully vaccinated has levelled off at an alarmingly high 42 percent. But the bigger concern is populous developing economies, where the number of unvaccinated will remain in the billions (Chart I-4). Chart I-4The Number Of Unvaccinated Will Remain In The Billions Admittedly, many of the unvaccinated have been infected with a variant of the virus so have some natural immunity. But to repeat, the immuno-evasion of new variants means that the protection from natural immunity will fade. Hence, developing economies will prove to be fertile ground for new variants. It is no coincidence that three of the most dangerous variants have emerged from Africa (beta and omicron) and India (delta). What about anti-viral drugs? Unfortunately, those that target the mutated spike proteins – such as the antibody cocktails from Regeneron and Eli Lilly – will lose their efficacy. Essentially, the monoclonal antibodies in these anti-viral drugs bind to the virus surface to prevent it replicating. If this binding is compromised, then they will not work. We arrive at three investment conclusions, one tactical and two for longer-term investors: 1. The tactical conclusion is that the performance of healthcare versus energy closely tracks the sine wave of new global infections. As this sine wave is in the middle of an upcycle, healthcare should continue to outperform energy for at least the remainder of this year (Chart I-5). Chart I-5Healthcare Versus Energy Tracks The Sine Wave Of Covid Infections 2. As the sine wave of new infections continues uninterrupted into 2022, our ‘more remote’ way of working, shopping, and living our lives will become established as the ‘new normal’. This will benefit the large technology and communication services companies that are facilitating this new normal – as well as the interactive entertainment sector (look out for a Special Report on this coming out soon). 3 .Although the emergence of a super-variant of the virus is not a base case for 2022, it is a source of a not insignificant tail-risk. Bear in mind that the probability of a shock (from any source) in any one year is a greatly underestimated 28 percent.2 As such, the 30-year T-bond is a ‘must own’ investment in all long-term portfolios. Candidates For Countertrend Reversals: The Dollar And Semiconductors In this week’s fractal analysis, we note that the US dollar’s recent rally is approaching fragility on its 130-day fractal structure, though has not quite reached the point of maximum fragility that signalled the last three turning points in 2018, 2020 and early-2021 (Chart I-6). Stay tuned. Chart I-6The US Dollar Is Approaching A Potential Countertrend Reversal Elsewhere, the spectacular recent rally in semiconductor stocks versus the broader technology sector is now fragile on both its 65-day and 130-day fractal structures (Chart I-7). Accordingly, a good trade would be to short global semis versus biotech, setting the profit target and symmetrical stop-loss at 9.5 percent. Chart I-7Short Global Semis Versus Biotech Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 American Society for Microbiology: COVID-19 and the Flu, October 7, 2021 COVID-19 and the Flu (asm.org) 2 We define a shock as any event that moves a major-economy 30-year bond price by 20 percent or more, and we derive this probability from the temporal distribution of shocks through the past 50 years. 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Global risk assets recovered some of Friday’s losses on Monday. The S&P 500 and Euro Stoxx 50 rebounded 1.3% and 0.5%, respectively, the US 10-year Treasury yield ended the day 2.6 bps higher, and Brent regained 1%. Whether these “risk on” moves continue…
Highlights The euro has entered a period of acute stress. Some of the EUR/USD’s plunge reflects the dollar’s broad-based strength. The dollar is supported by the market’s pricing of the Fed and China’s economic weakness. The euro also suffers from idiosyncratic forces. Investors appreciate better now that the Eurozone’s inflation is much narrower than that of the US. They are adjusting their ECB pricing accordingly. Europe’s growth prospects are also hurt by a renewed wave of lockdowns and China’s property woes. The revival of the European natural gas surge is the coup de grâce that is hurting the Euro. Nonetheless, euro sentiment is extremely depressed, which suggests that the euro already discounts many of these negatives. Consequently, we are adhering to our long EUR/USD trade implemented four weeks ago, but we will not re-open it if the stop-loss is triggered. Feature Four weeks ago, we tentatively recommended buying the euro, acknowledging that this view was fraught with near-term risks. However, the recent collapse in the euro forces us to revisit this stance. 2022 will be a better year for EUR/USD; nevertheless, the next three months could result in pronounced weakness in the currency, and the odds have increased that this pair might retest the pandemic lows. We are sticking with our long EUR/USD bet for now, as we have a floor under the position, the result of our stop at 1.1175. If this stop is reached, we will wait before reinstating a long euro position. What’s Going Well With The USD? The first element of the euro’s weakness is the generalized strength in the USD. The dollar is rallying against all the components of the DXY, which is pushing the USD’s Advanced/Decline line up (Chart 1). Moreover, as BCA’s Emerging Market Strategy team recently highlighted, the dollar is breaking out above its three-year moving average, which constitutes an important technical signal. The dollar strength is multi-faceted and reflects both domestic and international factors. On the domestic front, markets are responding to growing inflationary forces and signs of economic vigor to price in a more aggressive Fed outlook than two months ago (Chart 2), especially following the implementation of the Fed’s tapering program this month. Chart 1The Dollar Is Strong Chart 2More Hikes Prices In The inflation picture is of prime concern to investors. As Chart 3highlights, US core CPI is at a 30-year high and median inflation measures are also strengthening. Most concerning, inflationary pressures are broadening beyond energy and goods, with shelter prices accelerating anew (Chart 3, bottom panel). The labor market is also gearing up to move toward full employment conditions. The quits rate is near a record high, which corroborates the impression among households that jobs are easy to secure (Chart 4). Moreover, wages among low-skill employees are strengthening, which indicates that the labor market is tight (Chart 4, bottom panel). Granted, this is happening in a context in which the labor force participation rate is low, especially for women, and could rise anew, which would alleviate the labor market’s tightness. However, this process will likely entail higher wages first. Chart 3Broadening US Inflation Chart 4Getting To Maximum Employment? Economic data is also firming up, despite rises in COVID cases in many states. For example, nominal retail sales were robust in October, even if inflation contributed to their strength. Moreover, both the New York Fed’s Empire State Manufacturing Survey and the Philly Fed’s Manufacturing Business Outlook Survey highlighted an acceleration in activity (Chart 5). As a result, the Atlanta Fed’s Q4 GDPNow Forecast has rebounded to 8.2%, which would represent a marked improvement from the 2.2% quarterly annualized rate recorded in Q3. Whether or not this is an error, market participants may continue to use this economic backdrop to price in additional hikes by the Fed and feed the dollar rally. The international backdrop also helps the USD. The main positive comes from China. BCA’s emerging market strategists highlight that the weakness in the Chinese credit impulse is often a harbinger of dollar strength (Chart 6). The US economy is less exposed to manufacturing and trade than the economies of Europe, Australia, and EM, which means that it is less impacted by Chinese growth slowdowns than other parts of the world. This explains why the dollar loves a slowing Chinese economy. Chart 5A Pick Up In US Growth Chart 6The Dollar Loves A Weaker China China’s economic problems have once again become more relevant to market participants, as recent prints have been weak. Following the fall of Chinese GDP growth to 4.9% in the third quarter, new releases have shown that house prices are contracting and property investment is decelerating. These data sets are feeding the dollar rally. The dollar’s strength will beget further dollar appreciation. We have often highlighted that the dollar is the premier momentum currency within the G-10, along with the yen (Chart 7). Today, the most reliable momentum indicator for the greenback, the crossover of the 20-day MA above the 200-day one, continues to send a very supportive signal, which the economic backdrop reinforces (Chart 8). Moreover, historically, the dollar’s trading in the first few weeks of January often echoes the trend of the previous year. Hence, we may witness a continued blow off until February 2022. Chart 8Positive Momentum Signal For The Dollar Bottom Line: The dollar is breaking out on a broad basis. Not only is the US economy inviting investors to reprice the Fed’s expected policy path, but the economic weakness in China is also contributing to the rally. Technically, the dollar’s pro-momentum attribute accentuates the risk that this breakout morphs into a melt-up until February 2022, especially if US equities continue to outperform the rest of world and attract flows into the USD. The Euro’s Specific Problems Chart 9Europe Doesn't Have The US Inflation Problem The spectacular collapse in EUR/USD goes beyond the strength in the dollar, because crucial catalysts are also pushing the euro lower. First, investors are increasingly differentiating between the Eurozone and the US inflation picture. We have often made the case that European inflation is much more limited than that of the US. For example, the dynamics in the trimmed-mean inflation and the CPI adjusted for VAT highlights that lack of broad inflation in Europe (Chart 9). Moreover, recent ECB’s communications have made it eminently clear that it is in no rush to raise rates. As a result, investors have been curtailing the number of ECB hikes priced in for 2022 compared to early November. Second, European economic activity is unable to catch a break. The recent uptick of COVID-19 cases in Germany, the Netherlands, and Austria is prompting local governments to impose renewed lockdowns of various scales, as worries emerge that hospital capacity will suffer as it did last winter (Chart 10). We doubt these lockdowns will last as long or will be as severe from a pan-European perspective, but, for now, they are weighing on investor sentiment and contributing to the euro-bearish widening in US-German 2-year yield differentials (Chart 11). Chart 10A New Wave Chart 11Rate Differentials Hurt The Euro Third, the Chinese economy continues to act as a drag on Europe. China’s real estate activity is slowing, as credit spreads and share prices of property developers remain distressed (Chart 12). It is of concern that the Chinese and EM credit market stresses are broadening beyond this sector, which indicates a tightening in financial conditions for a large swath of the Eurozone’s important trading partners. Moreover, Europe’s machinery exports are particularly exposed to the Chinese construction sector. Under these circumstances, the wave of weakness in Chinese construction activity could herald additional problems for EUR/USD, since they amount to a weakening in Euro Area growth relative to the US (Chart 13). Chart 12Downside To Chinese Construction Activity Chart 13Slowing Chinese Construction Is A Threat to EUR/USD Fourth, equity outflows out of the Eurozone into the US are likely to continue as long as China suffers. BCA’s Emerging Market strategists anticipate the deterioration in China’s stock-to-bond ratio (SBR) to last, because this economy is weakening. Over the past five years, a deteriorating Chinese SBR has coexisted with a deepening underperformance of European equities relative to those of the US (Chart 14). Over this timeframe, equity flows have played a significant role in the EUR/USD exchange rate determination; thus, the weaker Chinese SBR also correlates well with a softer euro (Chart 14, bottom panel). Finally, the renewed energy crisis is particularly painful for the euro. German regulators indicated that they will temporarily suspend the approval of the Nord Stream 2 pipeline, which prompted European natural gas prices to surge anew. As Chart 15 shows, this proved to be the coup de grâce for the euro. The response of the euro to higher natural gas prices is rational. Surging natural gas prices are a growth shock for the region, yet they are unlikely to prompt a tightening in policy by the ECB, because they only push headline inflation, not the core measure. In fact, they could widen the dichotomy between underlying and headline inflation, because rising energy costs sap other spending categories. In other words, rising energy prices point to a stagflationary outcome this winter in Europe, which is poison for the euro. Chart 14More European Equity Outflows? Chart 15The Nat-Gas Coup De Grace Bottom Line: The weakness of the euro reflects more than the strength in the USD. The narrower nature of European inflation prevents a hawkish repricing of the ECB to take place, while renewed lockdowns are hurting growth sentiment. Moreover, the travails of China’s property sector are harming European economic activity, while also inviting equity outflows. Finally, the recent revival of the natural gas price surge is once again raising the specter of stagflation this winter in Europe, which is a dreadful scenario for the euro. What To Do? Our long EUR/USD bet initiated four weeks ago has a stop loss at 1.1175. Due to the bullish dollar forces and bearish euro factors described in this report, we will not re-open the trade if the stop-loss is triggered. Its activation would indicate that the bear-trend in the euro is gathering steam. When coupled with the momentum nature of the dollar and the euro’s anti-dollar behavior imparted by EUR/USD’s great market liquidity, this combination could easily push EUR/USD to 1.08 or lower by January 2022. We are not closing the trade either. While the list of euro-negative forces is long, sentiment toward EUR/USD is now quite lopsided, which suggests that a significant proportion of the euro bearish factors are already discounted. One-month, three-month, and six-month risk reversals in EUR/USD have fallen close to their Q2 2020 levels. Moreover, investors now hold large short positions in EUR/USD, especially compared to their large long bets on the DXY (Chart 16); meanwhile, the Euro Capitulation Index is now depressed relative to that of the dollar (Chart 16, bottom panel). Finally, the most important signal comes from our Intermediate-Term Timing Model (ITTM), which is an augmented interest-rate parity model that accounts for global risk aversion and the currency’s trend. The ITTM is now trading at 1 sigma, a level that has historically been followed by a positive return six months later 75% of the time since 2002 (Chart 17). Chart 16Negative Euro Sentiment Chart 17Much Pessimism Is In The Price Chart 18Peak US Inflation? Finally, the US is likely experiencing peak inflationary pressures right now. If inflation rolls over in the near future, investors will breathe a collective sigh of relief, and they will not price in more rate hikes. The decline in DRAM prices and the recent ebb in shipping costs, with the Baltic Dry down 57% from its peak and the WCI Composite Container Freight Benchmark 12% below its September apex, suggest that the most severe supply bottlenecks are passing while energy indexes are also softening (Chart 18). In this context, the best strategy remains to keep the trade open and to follow the discipline imposed by the stop loss. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance
Dear Client, We had an error in our oil balances/forecasts report from 18 November 2021 resulting from a double counting of select US onshore production figures. This has been corrected below. Highlights Higher oil production will restrain price increases in the short term, and give the impression the burst in inflation is transitory. Re-opening of airline travel and releasing of pent-up demand will absorb much of the higher output by year-end 2022. We are doubtful a US SPR release is forthcoming, as its impact would be trivial. Likewise, we do not expect the US to limit or ban exports of crude oil again, as it would unbalance markets. We are maintaining our Brent forecasts for 2022 and 2023 at $80 and $81/bbl. We again include a caveat, noting upside price risk is increasing going forward, due to inadequate capex (Chart of the Week). Stronger inflation prints going into 1Q22 will test the conviction underpinning central bankers' view that the current bout of price increases is transitory. If inflation appears to be more persistent going into 2H22, the Fed and other systemically important central banks likely will signal earlier-than-expected policy-rate hikes. This would be negative for commodities, as it would raise debt-service costs and investment hurdle rates, and reduce consumption. Higher oil prices and tighter monetary policy will temper demand. If capex is not forthcoming, however, prices will have to rise sharply to destroy demand. Feature It hardly deserves mention that the US has been hectoring the leadership of OPEC 2.0 to increase oil production, in order to reduce the cost of gasoline and home-heating fuels going into the winter … And, there's a mid-term election next year. The Biden administration also has been threatening – if that is the proper term – to release barrels from the US Strategic Petroleum Reserve (SPR), and reportedly asked China to consider a similar release.1 The leadership of OPEC 2.0, on the other hand, is flagging the risk to stronger oil prices from higher production next year. Much to the chagrin of the Biden administration, the coalition led by the Kingdom of Saudi Arabia (KSA) and Russia will not be increasing output by more than the 400k b/d it agreed to earlier this year. OPEC 2.0 will keep this up until June or July 2022, when most of its output sidelined by the COVID-19 pandemic will have been returned to the market. We expect the core Gulf-state producers – mostly KSA – will want to maintain ~ 3mm b/d of spare capacity thereafter. Chart of the WeekStable Oil-Price Trajectory Chart 2OPEC 2.0 Production Continues To Lift Higher Oil Output Expected Overall OPEC 2.0 production is expected to total 52.3mm b/d next year and 53.1mm b/d in 2023 (Chart 2). Most of the increase in the coalition's production will be accounted for by its core producers – KSA, Russia, Iraq, the UAE and Kuwait (Table 1). The "Other Guys" – i.e., those producers in OPEC 2.0 that can only maintain existing output levels or are managing continual declines in output – will account for a decreasing share of the coalition's production (Chart 3).2 Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Including drilled-but-uncompleted wells (DUCs), we expect an additional 600k b/d from US shale-oil producers next year, which would take their output up to 8.39mm b/d, and another 350k b/d increase in their output in 2023. Output in the Lower 48 (L48) states of the US overall is expected to increase to 9.65mm b/d next year and 9.93mm b/d in 2023 (Chart 4). The increase in L48 output will continue to be led by higher shale-oil production, notably from the prolific Permian Basin play (Chart 5). US Gulf of Mexico and Alaska production tops up our total average output forecasts in the States to 11.89mm b/d next year and 12.20mm b/d in 2023. Chart 4US L48 Production Continues To Grow Demand Continues To Expand On the demand side, we continue to expect 2021 consumption growth of ~ 5.0mm b/d this year. Our growth expectation for 2022 and 2023 remains close to ~ 4.6mm b/d and 1.3mm b/d, respectively. We also expect demand to cross back over 100mm b/d in the current quarter, as can be seen in Table 1. As has been our wont during the recovery from the pandemic, we expect DM demand to level off next year after a stout recovery, and for EM demand to pick up the baton and lead global oil-consumption growth in the next two years (Chart 6). We remain bullish re the rollout of COVID-19 vaccines using mRNA technology globally, which will allow EM economies to step up growth. Re-opening of DM and EM economies will continue, pushing refined-product demand above 2019 levels next year, including jet-fuel toward the end of 2H22. Chart 6EM Oil Demand Growth Will Take The Lead Oil Market Remains Balanced Our supply-demand balances are largely unchanged from last month. This keeps global crude-oil markets in a physical deficit for most of next year. We expect OPEC 2.0's core producers will maintain their production-management strategy – i.e., keeping the level of supply below the level of demand. Producers in the price-taking cohort outside the coalition – chiefly the US, Canada and Brazil – will lift production subject to capital-market constraints on producing oil profitably (Chart 7). This supply-demand dynamic keeps inventories drawing through this year, then leveling off in 2022 and rebounding slowly in 2023 (Chart 8). Chart 7Global Crude Markets Mostly Balanced Chart 8Crude Inventories Continue To Draw Global crude-oil inventories could come under pressure during the 2021-22 winter, if natural-gas markets remain supply-constrained. This week, the Russian state-owned supplier and operator of Nord Stream 2 (NS2) pipeline delivering Russian gas to Germany was told it must comply with German law before its gas will be allowed to flow. It is unlikely this will be done this year.3 This could keep demand for oil higher at the margin, as we noted earlier.4 Oil's Known Unknowns: Capex, Inflation The big unknowns – and risks – to our view are when and how much capex is going to be deployed in the oil and gas exploration-and-production space, and what we can expect from the Fed and other systematically important central banks if inflation looks to be persistent. OPEC 2.0 leaders and officials from the price-taking cohort agree that the dearth of capex for the industry threatens to destabilize oil and gas markets in the near future. Among the 90 international oil and gas producers tracked quarterly by the US EIA capex has collapsed (Chart 9). The industry appears to have made shareholder and investor interests their priority, so as to be competitive in the pursuit of capital that all firms engage in. This also is true for state-owned entities, which also compete for capital and access to technology. These firms and producers will continue to work to produce oil and gas profitably. Still, they likely will continue to find an unreceptive audience to invest in these energy sources; Governments and policymakers are actively discouraging investment in fossil fuels. This risks setting in motion a process in which supply erodes much faster than demand – similar to what is happening in coal markets presently – and prices for fossil fuels rocket higher. This is not a strategy, particularly as it disregards the fact there is insufficient renewables capacity and storage to cover the energy from hydrocarbons that is being lost because of the lack of a transition policy at any level. Recent strong inflation prints are a small-scale example of how this process could play out over the next decade or longer. When China eliminated Australian coal imports earlier this year in favor of Indonesian supplies, and forced its coal mines to shut as part of its dual-circulation policy to become more self-reliant, the resulting shortages set off chain reactions in global natural gas markets. European gas prices shot higher, which, along with higher Asian and American natgas prices, sent food prices soaring on the back of higher fertilizer prices.5 Shipping bottlenecks and container shortages worldwide exacerbated these problems. CBs' Inflation View Challenged Going into 2022, central bankers' view that the current bout of price increases is transitory is going to be put to the test. If inflation appears to be more persistent going into 2H22 – after hoped-for one-offs in coal, gas, oil and food markets are worked out – the Fed and other systemically important central banks likely would start signaling earlier-than-expected policy-rate hikes. This would be negative for commodities generally, as it would raise debt-service costs and investment hurdle rates, and reduce consumption. Higher oil prices and tighter monetary policy will temper demand. These inflationary pressures can be addressed, but this will require a serious re-thinking of the strategy the world needs to pursue if it is to pull off a successful energy transition. Such a strategy will have to give greater consideration to the role of fossil fuels in this transition. If capex is not forthcoming, however, oil prices will have to rise to destroy demand. This will feed into inflation, and ultimately could result in stagflation, as economic growth grinds lower. Investment Implications The level of uncertainty surrounding oil and gas prices remains elevated, given the background condition of 90% odds we see a La Niña in the Northern Hemisphere's winter (Nov21 – Mar22), and ~ 50% chance it persists into the Spring (March-May22). This could leave markets with colder-than-normal temperatures past the end of winter, as it did last year. Given this uncertainty, we remain long the S&P GSCI and the COMT ETF, to keep our exposure to higher prices and a return to higher backwardation. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Commodities Round-Up Energy: Bullish Natural-gas price volatility in Europe and the EU exploded higher once again, following reports the German government would not certify Nord Stream 2 (NS2) unless and until it complies with German law (Chart 10). The European Commission also is setting conditions for its approval. Lastly, outgoing Chancellor Angela Merkel said further sanctions against Russia were possible if the pipeline was used against Ukrainian interests.6 The EU's TTF natural gas benchmark is up 24% this week alone, on the back of this news, while the UK's benchmark Balancing Point index is up 7%. These higher costs will feed into food costs, given the importance of natural gas to fertilizer markets, accounting for ~ 70% of fertilizer costs.7 Given the higher likelihood of another La Niña in the Northern Hemisphere (90% odds from the US Climate Prediction Center), we expect continued volatility in gas prices. Base Metals: Bullish Steel demand in China has been contracting after the government began tightening the supply of credit to the property sector following the Evergrande debt crisis. Construction makes up approximately one-fourth of total Chinese steel demand. At the same time, supply has been falling as, in addition to government regulation to curb carbon emissions, steel mills have voluntarily cut output due to decreasing margins on the back of soft demand. The fact that Chinese steel prices have been falling since their highs in May this year indicates that demand is dropping faster than supply (Chart 11). Reduced Chinese steel demand is feeding through to demand for iron ore – the main steel input in China – while disruptions in the top two iron ore exporters, Australia and Brazil are easing, increasing the possibility of an oversupplied market. Precious Metals: Bullish Gold ended last Thursday above $1,860/oz for the first time since mid-June after the October CPI data release showed that the US had its biggest inflation surge in nearly 30 years. As long as the Federal Reserve does not turn more hawkish, consecutive months of high CPI prints will mean low real rates well into 2022, which will reduce the opportunity cost of holding gold. The high US twin deficits – which as of Q3 2021 was 17.44% of GDP – support the long-term dollar bearish view our colleagues at BCA's Foreign Exchange Strategy hold. A weak dollar over the next 12-18 months will increase the inflation-hedge appeal of the yellow metal relative to the greenback. Chart 11 Footnotes 1 We note in passing the Biden administration has been mostly successful in getting massive fiscal and monetary stimulus deployed into the US economy, which has increased household savings and potential spending power dramatically, as our colleagues in BCA's US Investment Strategy noted in their 1 November 2021 report Half-Empty Or Half-Full?: "Massive fiscal transfers and an unprecedented increase in household wealth will support consumption and keep the economy from stagnating." We cannot view higher gasoline prices in the wake of this stimulus and growth as an economic emergency of the sort the SPR is designed to address. Nor can we view the pick-up in mobility – particularly in air travel expected shortly with the re-opening of routes closed due to the pandemic – as a supply-side emergency. 2 It's worthwhile mentioning here that OPEC 2.0 has been returning less than the 400k b/d every month it agreed due to shortfalls in production outside the core group broken out in Table 1. Reduced capex and maintenance is responsible for this. Higher oil prices might allow this group within the coalition to attract additional capex, but, given the uncertain long-term support for such exploration-production-maintenance investment, this will remain a long-term challenge to these producers. Lastly, we continue to expect Iran to return to markets as a bona fide exporter; we expect its production to return to 3.70-3.85mm b/d by 2H22. 3 Please see Nord Stream 2: Germany halts approval of Russian gas link published on November 16, 2021. 4 Please see last month's oil balances and price-forecast report Short-Term Oil-Price Risk Moves To The Downside, published 21 October 2021. 5 Please see our October 14, 2021 report entitled Inflation Surges, Slows, Then Grinds Higher, and last week's report entitled Risk Of Persistent Food-Price Inflation for additional discussion. 6 Please see fn 3 above. 7 Please see fn 5 above. Investment Views and Themes Strategic Recommendations
Europe is once again at the center of the pandemic. On Friday, the WHO reported that two million COVID-19 cases were reported in Europe last week – an all-time high. Governments are responding. A three-week partial lockdown began in the Netherlands on…
Highlights Economy – It is more likely that the third quarter slowdown reflected demand deferral than demand destruction: We are not concerned that the lousy third quarter GDP release heralds stagflation. Massive fiscal transfers and an unprecedented increase in household wealth will support consumption and keep the economy from stagnating. Markets – Another quarter, another sizable earnings beat: Despite shortages, bottlenecks and logistics challenges, S&P 500 profit margins held up much better than expected in the third quarter, allowing earnings to maintain their pandemic streak of exceeding the analyst consensus by an unusually wide margin. Strategy – Stay on the right side of the cycles: The business cycle, the credit cycle and the monetary policy cycle all support overweighting equities and underweighting Treasuries and cash. There will be a time to turn defensive, but it’s not here yet. Feature Stagflation, combining stagnant activity and high inflation, is a clever phrase but a deeply unpleasant economic outcome. It is central bankers’ and elected officials’ bête noire because there is no politically palatable way to counter it. Raising rates to throttle inflation risks driving unemployment higher while stimulating the economy to bolster employment risks letting inflation burn out of control. Paul Volcker was hung in effigy for taking the former route, plunging the economy into a painful double-dip recession to shatter the inflationary mindset, while Jimmy Carter saw his re-election prospects evaporate once voters were asked how they’d fared over his stagflation-ridden term. The November edition of the Bank Credit Analyst examines the drivers of the ‘70s/early ‘80s stagflation. After a through then-and-now comparison, it concludes that a stagflationary outcome is unlikely albeit not impossible. We agree, for the simple reason that you can’t have stagflation without stagnating and we expect that the economy will grow well above its trend level all the way through 2022. We expect that sustained nominal GDP growth of 6% or more, in contrast to the 4% rate that has prevailed since 2000, will support risk asset outperformance over the next twelve months. A Discouraging Quarter The rise of the Delta variant cast a pall over the economy in the third quarter, as the first estimate of GDP made clear. A summer that began with great optimism about getting back to normal quickly fizzled in the face of surging infections (Chart 1), stalled vaccinations (Chart 2), spotty supplies and logistical bottlenecks. GDP growth forecasts cratered (Chart 3, top panel) and economists went on to dial back their expectations for next quarter (Chart 3, middle panel) and 2022 (Chart 3, bottom panel). In the end, growth proved to be even worse than expected, falling all the way to 2% with real final domestic demand (GDP after backing out inventory stocking and net exports) growing just 1%. Chart 1So Much For The Summer Of Fun Chart 2Grinding To A Halt Chart 3Downward Revisions A bear could interpret the decline as evidence that extraordinary policy measures have failed, giving way after just two quarters of Potemkin village growth. We are decidedly bullish, however, and view the third quarter as a stumble that will merely stretch out a consumption-fueled blowout that has already begun. A swoon in motor vehicle purchases lopped off 240 basis points of GDP by itself, while declining residential investment cost 40 basis points. The third quarter’s decline in auto sales was unprecedented during an expansion, however (Chart 4), and we view it as a supply-driven hiccup that will disappear once production revives. (Ford’s double-digit rise after reporting earnings last week suggests the equity market sees it that way, too.) Chart 4An Unprecedented Expansion Event As for residential investment, we stand by our view that the housing market has been inadequately supplied for several years.1 Structural issues like tight local zoning rules may be as much of a constraint on supply as cyclical factors, but they are not new and we do not expect that they will thwart builders’ response once the requisite human and material inputs can again be accessed. Like auto sales, residential investment does not typically decline amidst expansions (Chart 5). We attribute the slowdown in services consumption, particularly in food services and accommodations (Chart 6, top panel) and recreation services (Chart 6, bottom panel), to last quarter’s spike in COVID infections. Now that the Delta variant seems to have run its course and 5-to-11-year-olds are poised to become vaccination-eligible, we expect the recovery in discretionary services consumption to return to something between its first half and third quarter pace. Chart 5Residential Investment Looks More Likely To Contribute To Growth Than Detract From It Chart 6Not So Bad For An Outbreak The Creeping Menace The Delta variant upended a quarter’s output, but inflation could prove to be a more durable threat. Nominal GDP growth in the third quarter (7.8%) slowed considerably from the first half (12.1%), but the decline in real growth to 2% from 6.5% was much worse. If inflation doesn’t come down more rapidly than it did last quarter – as measured by the GDP deflator, it was 6.1% in 2Q and 5.7% in 3Q – it threatens to swallow up much of the quickened nominal growth pace. If upward price pressures are not as transitory as they first appeared, the expansion may fail to live up to its hype. The good news from our perspective is that long-run inflation expectations remain muted. Neither consumer surveys nor market-based measures suggest that a potentially self-fulfilling inflationary mindset has taken hold. The University of Michigan’s consumer confidence survey reveals that households’ inflation expectations curve is sharply inverted, with inflation over the next five to ten years, 2.8%, expected to be two percentage points lower than next year’s 4.8% rate (Chart 7). The market-based inflation expectations curve is not so steeply negative – investors aren’t as gloomy about the near-term outlook – but it is decidedly inverted and reinforces the transitory narrative (Table 1). Chart 7Households Think Inflation's Transitory ... We (and the Fed) focus so much attention on the inflation expectations curve because high inflation will not become self-sustaining until economic actors – workers, businesses, consumers and lenders – begin to expect it will persist into the future and change their behavior accordingly. When inflation is expected to be persistently high, workers insist on higher wages to maintain purchasing power, businesses demand higher prices to preserve their margins, consumers accelerate their big-ticket purchases to get the most bang for their buck and lenders require higher nominal pro forma returns. The resulting feedback loops help inflation become entrenched in the same way that expectations of falling prices have enabled the deflationary mindset that continues to grip Japan. As long as households and investors expect inflation to decelerate over time, the inflation genie will not have gotten out of the bottle. Table 1... And So Do Financial Markets Households Have A Great Deal Of Dry Powder We have closely monitored US households’ pandemic savings ever since the CARES Act payments began to flow. We viewed the growing pile of excess savings – aggregate household savings above the level that would have accumulated if pre-pandemic income and consumption trends had continued – as a proxy for households’ ability to make up for foregone consumption once COVID-19 loosened its grip on economic activity. Our running tally, now $2.2 trillion, has stabilized since the final round of economic impact payments was distributed this spring: spending caught up to its pre-pandemic trajectory in August and income slipped below its pre-COVID trend last month upon the expiration of federal supplemental unemployment insurance benefits. Households flexed their formidable spending capacity in the first half of the year, when consumption grew at a whopping 11.7% annualized real rate even while excess savings continued to grow. The experience of the first half testifies to the force of pent-up demand, the magnitude of fiscal support extended to households and the staggering wealth gains that have resulted from the appreciation of home prices and financial assets. As our Global Investment Strategy colleagues highlighted in their latest report, since the end of 2019, household net worth as a share of GDP has grown at its highest rate on record (Chart 8). Citing empirical studies finding that households spend 5 to 8 cents of every incremental dollar of housing wealth and 2 to 4 cents of every incremental dollar of stock market gains, they estimate that the wealth effect will support about $600 to $900 billion of consumption. Chart 8A Wealth Surge For The Books We have lauded excess savings as the primary support for elevated consumption, but those numbers suggest that household net worth gains deserve nearly equal billing. Our ballpark assumption has been that households will spend around one half of their excess savings, or $1.1 trillion, equivalent to nearly 5% of GDP. $600 to $900 billion of wealth effect consumption would tack on another 2.5 to 4%, bringing the total incremental spending capacity to 7 to 9% of GDP. Though these estimates are imprecise and should not be viewed as predictions, they testify to the force of the consumption tailwinds available to support the US economy. Another Robust Quarter For S&P 500 Earnings Amazon’s sizable third quarter earnings miss and stark fourth quarter guidance banished the budding sense of celebration surrounding the current reporting season, but it has nonetheless been exceptional by pre-COVID standards. Through the first three weeks, with 279 companies having reported results, third quarter earnings are projected to be 7.4% ahead of the final consensus estimate (Chart 9). Though it will fall short of the two- and three-standard-deviation level the index has reached the previous five quarters, this quarter is on track to top the maximum 6% beat recorded from 2012 through 2019 (Chart 10). Possibly the most surprising factor within the bottom-line EPS data has been the magnitude and breadth of margin surprises. Through last Friday, revenues had surprised to the upside by 2% while earnings had beaten by 11%. The 9-percentage-point spread reveals how much margins have surpassed expectations in the face of upward wage and other input cost pressures. Breadth has also been impressive, with every sector but Materials achieving wider-than-expected margins (Table 2). Table 2Margins Positively Surprised Nearly Across The Board We do not know why margins fared better in the real world than they did in analyst models – it was presumably a combination of increased operating leverage and an ability to continue to reduce or eliminate some costs – but we expect margins will contract in subsequent quarters, as per our US Equity Strategy team’s recent detailed analysis. In this regard, perhaps the reduced magnitude of this quarter’s earnings beat heralds a return to the pre-pandemic pattern in which companies were not able to achieve unanticipated efficiency gains quarter after quarter. For the last two quarters, we have been highlighting that expectations were very low because the consensus was calling for highly unusual quarter-over-quarter declines in earnings. If those laughably easy comparisons go away, the path may become a little rockier for equities. For the next twelve months, however, we expect gale-force consumption tailwinds will allow equities to continue to generate positive excess returns over Treasuries and cash. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the July 12, 2021 US Investment Strategy Special Report, "The US Housing Market: Déjà Vu All Over Again?" available at usis.bcaresearch.com.