Fed Versus ECB

This chart shows the preferred price measures of the Fed and ECB. The Fed targets the PCE deflator, whereas the ECB focuses on the harmonized index of consumer prices (HICP). Based on these price indices, inflation rates in the two economies have been largely identical for the last two decades. Currently, U.S. inflation is running at 5.0% versus 4.9% in the eurozone.

Despite very similar inflation rates, there is a chasm in the market’s outlook for central bank policies. Interest rate futures are pricing an early and rapid tightening from the Fed, while the ECB is expected to be slow and measured.

Will there be some convergence in the expected path for Fed and ECB policy rates? What will be the investment implications?

U.S. Payrolls & Covid Cases

November’s gain in U.S. nonfarm payrolls fell well short of the consensus. Will the Omicron variant lead to more disappointments ahead?

Cut Cyclical and Boost Defensive Equity Exposure

The Chart shows that relative cyclical/defensive equity performance is “joined at the hip” with long-term inflation expectations. This holds true for both domestic-oriented and global-oriented stocks. One-sided upside inflation surprises and a surging dollar cannot last forever. Higher equity volatility in 2022 should also lend support to defensive plays.

But not all defensive equities are created equal. Some normally stable companies, such as consumer and health care services, have been hammered by the pandemic. Others, such as commercial services, have been and will remain steady. Still others, such as utilities and telecom services, face structural headwinds like stranded energy assets that warn against bottom-fishing.

One-Sided Inflation Surprises: How Much Longer?

The Fed is under intense pressure to “do something”. Money markets keep ratcheting up and bringing forward expected Fed rate hikes as one-year inflation expectations go vertical. Consumers are spooked by a rising cost of living. Yet, under the surface, long-term inflation expectations are grounded, judging from 10/2-year breakeven spreads and 5-year, 5-year forwards. Inflation relief is not imminent, but that could be the big theme for next year. Among the winners: Big Tech, homebuilders and energy stocks.

Japanization of the U.S. Economy?

Is there such thing as “Japanization” of the US economy? Here you will find my take on this important issue, along with those from Mohamed El-Erian, Jim O’Neil, Richard Koo, Takatoshi Kato and others.

Chinese Reflation: Reaching An Inflection Point?

China’s latest macro numbers confirm that the economy has continued to decelerate across the board. The upshot is that Chinese policymakers appear to be awakening to the deteriorating growth numbers and are stepping up easing efforts, particularly in the real estate sector. We have been repeatedly warning that immediate policy loosening is urgently needed to avoid a major economic slump and a hard landing in the housing sector. It is encouraging that the Chinese authorities are finally taking action. What does this mean for Chinese growth? How will Chinese stocks perform Where does the RMB fit in?

Inflation: Transitory Or Not?

It is difficult to make the case that the U.S. economy has completely maxed out the use of its productive resources. Employment has yet to return to pre-pandemic levels and the same can be said for capacity utilization. Temporary bottlenecks are preventing the economy from tapping its full productive potential. Whether the supply bottlenecks have a longer lasting impact on inflation depends on two inter-related factors: inflationary expectations and wages. Should investors worry about unanchored inflation expectations leading to a wage-price spiral?

More Zombies Stalk the U.S. Corporate Bond Sector

The proportion of highly-indebted but unprofitable U.S. companies has escalated since the pandemic began. Some worry that there is a growing mass of pent-up corporate defaults that represent a ticking time bomb for the U.S. financial system, a biproduct of years of ultra easy monetary policy. The chart shows that the proportion of zombies has indeed increased over the past year, but only to near the long-term mean. This does not constitute a systemic risk, although the U.S. may only be in the early innings of a major corporate leveraging cycle. Near term, the surge in oil prices provides some interesting opportunities in zombie energy company bonds.

Stagflation Scare Is Putting Pressure on the Fed

The stagflation scare is gathering momentum which increases the odds of a Fed policy mistake that will boost volatility and flatten the yield curve. The Chart shows that there has been an avalanche of “stagflation” articles in the media. Consensus forecasts for inflation are getting revised higher, even as growth forecasts are getting revised lower. Meanwhile, stocks viewed as inflation hedges have broken out to the upside. Needless to say, the Fed has failed to convince financial markets that imminent QE tapering has nothing to do with the timing of the first Fed rate hike.

Why Rogoff et al. (And Chinese Policymakers) Are Wrong

The Evergrande debacle has not yet morphed into a pernicious Chinese “Lehman moment”, but it has stoked deeper concerns in the marketplace about the health of the Chinese real estate sector. Mainstream financial media frequently quotes a 2020 paper, “Peak China Housing”, authored by renowned Harvard Professor Kenneth Rogoff, highlighting Chinese real estate excesses. In our view, the paper lacks historical context, and confuses housing demand in China, a rapidly urbanizing economy, with that of fully urbanized countries where housing demand is a lot more measured and stable. Therefore, the conclusion that China’s housing market is overbuilt is highly questionable.