What is the UST bond market trying to tell us? The 10-year UST at 1.45% is certainly not telling us to fear embedded inflation, though many still do. Maybe it is telling us it is Goldilocks time. But as an investor/advisor, I do not get paid to believe in fables. Maybe the bond market (together with what I think is a healthy pause in commodities) is telling us to start worrying about a sharp slowdown in US growth, which is a much more worrisome bear case than a year of 3% US inflation.
I learned long ago that you should always have a bear case – the event/issue that will upend the bull case you normally lead with. So here is mine.
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What is the UST bond market trying to tell us? The 10-year UST at 1.45% is certainly not telling us to fear embedded inflation, though many still do. Maybe it is telling us it is Goldilocks time. But as an investor/advisor, I do not get paid to believe in fables. Maybe the bond market (together with what I think is a healthy pause in commodities) is telling us to start worrying about a sharp slowdown in US growth, which is a much more worrisome bear case than a year of 3% US inflation.
I learned long ago that you should always have a bear case – the event/issue that will upend the bull case you normally lead with. So here is mine.
Growth Slowing in US and China
Recall Covid’s timeline of first in, first out, and follow the leader logic. Look at China, first in and out: growth is clearly rolling over, though its 10-year still yields over 3% and its FX has been strong. China’s May CPI print surprised to the downside at 1.3% versus 1.6% consensus. While others focus on the much higher PPI numbers, my old Morgan Stanley colleague Stephen Jen indicates that these have been negatively correlated for years.
US growth is peaking as we speak – the May inflation print will be the high as 2020 base effects wash out. Given it is the Chinese Communist Party’s centennial year, I do not expect growth in China to plummet. But with both China and US growth slowing, that is something to consider.
Maybe, as Macro Tourist Kevin Muir notes, it is the Manchin effect. Maybe US Senator Joe Manchin blocks the passage of the Biden agenda, the American Jobs Plan and Families Plan fail to pass, and the economy does not get that stimulus. Current estimates are for the US fiscal deficit to more than halve – yes, halve – next year, from $3.4tn in 2021 to $1.6tn.
Significant US fiscal contraction coupled with a Fed leaning to taper (rather than ease further) would suggest that the 2022 US GDP and EPS estimates underpinning current US financial asset prices may need to be revised down. This would lead to equity and USD weakness and a further bond rally.
What about commodities? It is tricky – I am quite bullish and expect a commodity super cycle led mainly by demand for decarbonization (70% of global GDP now has emissions targets versus 30% just a few years ago). JPMorgan had some interesting work out this week showing that, as US stock-bond correlations turn positive again, 60-40, risk parity funds etc. will need to look to commodities as diversifiers. The firm notes further that the stock-commodities correlation is close to zero, suggesting commodities are not only inflation hedges but also diversification vehicles. Commodities just might be the boss.
Staggered Global Reopening to Synchronized Global Recovery Remains My Base Case
To clarify, this is a bear case I am just starting to contemplate. I am positioned for and continue to expect as a base case a move from a staggered global reopening to a synchronized global recovery as we exit 2021. TPW Advisory’s global multi-asset model portfolio positioning reflects this viewpoint, with heavy overweights to non-US equity and commodities as well as our thematic allocation.
As the rest of the world continues to recover, I expect USD weakness and equity leadership to shift to Europe and increasingly to the laggards such as Japan and Latin America. Japan’s LEI just hit a seven-year high, while it has already had its taper with the Bank of Japan not buying any ETFs last month for the first time in eight years (stocks went up). Capital International notes that on a price-to-book-value basis, Japan equity sells at a 70% discount to the US and a 35% discount to Europe.
FX is the only major asset class yet to have a big move this year – I expect that to change in 2H, with EMFX the major beneficiary of USD decline. Chase Taylor at Pinecone Macro showed an MXN chart this week titled ‘Blast Higher’; I agree and note that BRL and MXN are close to 20% of EMLC.
I remain of the view that the ‘testing time’ will come late summer or early autumn with Fed speak/meetings, clean economic data and clarity on the Biden policy agenda. In the interim, Macro Tourist’s Muir notes that equity volatility tends to go on vacation between the beginning of June and mid-July.
Main Takeaways
I do have two main takeaways: first, the USD is a loser in either scenario. If we get the synchronized global recovery, US exceptionalism fades and the rest of the world gets repriced higher. If the bear case manifests, it is certainly dollar down. EMFX is the big winner, especially in the former case.
Second, European equity is very well set up in either scenario. The ECB just raised its 2022 GDP forecast to 4.7% (well above the US’s 3.6%, which may be at risk). Most importantly, Europe’s Joint Recovery Fund (JRF) has yet to disburse a single euro, which should ensure that Europe’s medium-term outlook (2022- 2024) is the best of the Tri-Polar World’s three main regions: Asia, Europe and the Americas. Perhaps the idea that Europe can win the decade of the 2020s is not a complete pipe dream.
On a quick crypto note, it is interesting how repeated rounds of crypto carnage are not hurting the digital pick-and-shovel space. BlockFi is looking to raise another private round at a 70% premium since its last round a mere three months ago. BTC, in contrast, is down roughly 40% over the same period – private market bubble anyone?