Let’s wrap up last week’s Wall Street strategist drivel. BofA:
BofA Bull & Bear Indicator: down to 5.9 from 6.1 (Chart 1) driven by weaker EM debt inflows, HY flows, and deterioration in equity breadth (global indices less overbought).
On Stagflation: preference for quality & defensives driven by inflationcausinggrowth&EPS estimates to fall; US consumer (#1 driver of world growth) has peaked.
On Fiscal Policy: bipartisan infrastructure bill likely to pass but no needle-mover…adds $110bn per annum next 5 years; bond yields rise if reconciliation allows Dems to pass$3.5tn“soft” infrastructure bill (= big expansion of welfare state in US); note“soft” infrastructure spend now bigger US government priority than physical infrastructure and much more beneficial to dependency-culture consumption (i.e. FAANG stocks & inflation hedges)rather than productivity-enhancing investment (i.e. long-term US growth &financial market stability).
On China Policy: in stark contrast to west, making clear government policy is to not allow tech billionaires to run their country, PBOC policy is to not allow speculative bubbles to worsen wealth inequality; but China’s Q2 widening of HY spreads + decline inBY“no bueno”…prior episodes in May-Aug’15 foreshadowed CNY devaluation, Oct’19-Feb-19…trade war & US leveraged loan meltdown, Mar’20…Covid led to China easing;China easing, weaker US dollar, secular bid to commodities…EM our preferred Q3cyclical (note EM spreads highest relative to US high yield in 20 years–Chart10).
We say: own defensive quality in H2 = good market hedge H1 (policy flip-flops will end in market correction) & good macro hedge H2 (peak profits)…long defensives in vaccinated markets US/EU, long cyclicals/reopening in markets with vaccine-upside, i.e.Japan/China/EM.
BofA has quietly dropped commodities in the last few weeks in favour of an outright bearish position for an equities correction. Yet it still sees stagflation not deflation. If that correction comes it will be much more severe on EMs than it will DMs.
We expected ‘Reflation Moderation’ in 2H but in the last few months there has been ‘Reflation Capitulation’, with markets significantly de-rating nominal growth expectations across and within assets. This has been driven by a combination of concerns about peaking growth and peak fiscal and monetary stimulus. Weaker growth in China in Q2 coupled with concerns on the near-term and medium-term impact of COVID-19 on the growth/inflation mix also weighed on risk appetite. Indeed, US 10-year real yields led the bond rally and fell below last year’s lows, pointing to growing stagflation concerns.
We remain pro-risk in our asset allocation into the second half (OW equities and commodities, N credit, UW bonds) but also are more selective and balanced on procyclical exposure across and within assets. Our economists’ expectations for the level of global growth in 2H remain at healthy levels, and they expect concerns over inflation and monetary policy tightening to ease. Still, there are risks for the current pessimism to linger near term without clear catalysts for a procyclical turn, especially with ongoing COVID-19 concerns. At the margin, that favours assets that are less forward-looking and more driven by current macro, such as commodities, and which have supportive data near term, such as equities supported by the ongoing, strong earnings seasons.
Despite the ‘reflation capitulation’, equities, at least the S&P 500 and STOXX600, are hovering around all-time highs: the gap between S&P 500 returns and the change in US 10-year yields has increased materially. With both equities and bonds getting more expensive, multi-asset portfolios are becoming more vulnerable to rates and growth shocks. As portfolio overlays, we like equity correction hedges, e.g., put spreads in Europe, and also see merit in selling upside on bonds, e.g., TLT, to buy downside protection for equities.
On a regional basis we continue to prefer non-US to US equities for 12m – after another strong rally in US secular growth stocks due to the decline in real yields,non-US stocks are trading at much more attractive valuations, and we expect US earnings growth below consensus and non-US markets next year. Near term(3m), we see potential further headwinds from China sentiment for MXAPJ and shift to neutral, the same as S&P 500; we prefer Europe and Japan and see the highest 3m upside for Japanese equities.
The reflation is going bust in China so buy commodities and EMs. I assume that’s a joke.
Cornerstone has a better idea of what’s going on:
Chinese stocks held up well … until last week, when the Shanghai compositewas smashed4%w/w(with other markets hit as well), prompting Beijing to hintat added easing, to follow up on mid-July’s RRR cut. Last Wednesday, theChinaDaily’stop headline was “Fiscal stance to balance growth, potential risks.” Thearticle went on to say: “China is likely to ramp up fiscal support while keepingmonetary policy stable over the rest of the year…” Earlier in July, Beijing didsuggest they would ease up on local govt bond financing, and will focus stimuluson SMEs. As theChina Dailynoted: “Premier Li called for efforts to keepeconomic performance within a reasonable range ‘over the second half of thisyear as well as next year’ and to conduct ‘cross-cycleregulation’.
”We’ll be watching for more policy hints from Beijing, as we track total socialfinancing, govt expenditure data, and SHIBOR. Indeed, July’s RRR cut waspreceded by a clear decline in 3-month SHIBOR. To be sure, going into theWinter Olympics (February 2022), Beijing will not want a weakening economy.But as we continue to stress, they also do not want a booming economy, somoderate easing seems the most likely path. Will it be enough to restart theGlobal reflation trade? We don’t think so–don’t forget, other EMs aretightening, so overall EM short rates are actually trending higher. Stay tuned.
…Looking back at the U.S. economic backdrop over the past 30 years, anunappreciated reason (if not THE reason) for the bout of secular stagnation wasthe exodus of mfg from the U.S.It destroyed blue collar jobs, productivity, laborforce participation, and in turn, real median family income, increasing thepoverty rate, people on disability, etc.The credit bubble popping in 2008-2009 didn’t cause secular stagnation. Itwas the destruction of blue collar jobs (which at their peak wereabout20% ofall jobs), which slashed the percentage of industries hiring (see the decliningtrend in the employment diffusion index from 2000-2010), crushing labordemand, and curbing wage gains (the ECI shifted down from 4% in the late1990s to 1.4% by 2010,before recovering to just 2% for the bulk of the lastexpansion). That is, stagnation wasn’t the result of Wall Street going awry, itwas Washington encouraging blue collar jobs (good, high paying work) to moveto China … and then doing nothing for the hallowed out industries.Finally, Washington is getting the joke. A headline in aWSJarticle last weekprompted me to write the above (again): “Industrial Policy Returns” to the U.S.Better late than never. We kicked off the U.S. Mfg Ren theme backin 2010,when Beijing recognized its investment % GDP was too high, and companiesrealized China was a less attractive place to site production than back home inthe U.S.Blue collar jobs started to return during the last expansion(with capexstronger than GDP), and today, demand is booming (look at JOLTs job openingsfor mfg jobs). Covid, Beijing’s increasingly heavy hand, and the sudden realization that Global supply chains were way overconcentrated in China,constituted DC’s big wake up call. I’ll stop now. Encouraging U.S. industrialdevelopment, as the country leads in Digitization, will provide sustained shiftsup in productivity and labor force participation, with a shot at boostingPotential GDP growth back up toward 3%.
Ongoing US reflation plus China deflation is a recipe for a major commodities bust as DXY adds financial pressure to falling fundamental demand.
My base case remains for a muddle-through for equities based upon good profits and a decent and ongoing global recovery. But the risk case for a material equity correction is now at its highest this year as US and Chinese growth slow and a commodities bust arrives.