The speed at which the world is changing disrupts the long-term planning of a typical investor. Fortunately, Joyce Chang, one of Wall Street’s most knowledgeable analysts and seasoned observers, was able to walk us through the key trends and what they mean for the markets. Bottom line: Expect continued gains for stocks and oil. Don’t expect a supercycle for the latter, however. A modified version of our conversation follows.
Barron: Inflation is a major risk and opportunity. What other paradigm shifts affect investors?
Joyce Chang: The Federal Reserve shows what the risks are for “the new experiment”, which is the introduction of its new monetary framework targeting average inflation, focusing more on results than prospects. What surprised everyone was how quickly the storylines unfold. Before, you had more time. The Fed [initially] thought this experiment would take place over several years, and you wouldn’t see the first Fed [interest rate] increase until 2024. The reality of the inflation trend has caused it to increase.
Then there’s this feeling that the world of low rates, quantitative easing, and then tax cuts have actually made wealth inequalities worse. Now we have President Joe Biden [introducing] this element of real income redistribution which is also part of macro policy. It’s a paradigm shift.
What about the United States and China?
Under Trump, it was a G-2 competition. Biden is moving towards unilateralism, describing it as a challenge between democracy and autocracy. He wants the return of global alliances to offer alternatives to China. The initiative he proposed targets low-income emerging countries; advancing American leadership; return to transatlantic and multilateral relations and institutions. There is certainly more of a feeling, even with Russia, that we want to be predictable, stable.
Another related change is the rise of populism. It’s a very mixed bag and always evolving. Populist leaders are winning in Latin America, but you can really see a return to center in other parts of the world as well. In the United States, people will want to see what happens in the midterm elections.
What is the biggest change emerging?
The most unknown, and the fastest, is the digitization and demand for fintech and crypto. Market dynamics have gone beyond discussions of traditional market liquidity provided by banks and what hedge funds and mutual funds do, as nonbank financial institutions have stepped up their activities. Retail investors are a driving force; they have invested $ 500 billion each in equity and bond funds since the start of the year.
Crypto is too volatile for institutional investors to have much exposure. We have seen an increase in the Bitcoin / gold volatility ratio. Crypto is the poorest hedge for major stock declines. And tweets can lead to major movements. How will it be regulated? We watched El Salvador [which made Bitcoin legal tender in June]. There are risks surrounding the use of Bitcoin by malicious actors and the future of its dollarized monetary system. It is too early to say if other countries will take the path of partial bitcoinization. We have overweight recommendations on
What else do these trends mean for investors?
We anticipate a structural increase in demand for raw materials upon reopening. One of our main recommendations right now is the energy sector. Spot Brent [recently at $72 a barrel] is at its highest level since 2018, and we believe it will go higher because the summer driver season will continue until August. We brought it up to $ 80 by the start of next year. The combined valuation of the main oil companies in the European Union is 18% lower than it was before the pandemic. Plus, the positive correlation between bonds and stocks has returned, which means you’ll be wondering more about diversification. Commodities could benefit from this.
The oil bull cycle is distinct, as it is also supported not only by demand dynamics, but also by increasing flows, with fund allocations to energy having steadily declined in recent years. We also expect tighter environmental regulations and tax policy to support energy prices in the long run.
Are there other commodities besides oil?
Fed’s hawkish backlash makes us more bearish on gold as real [inflation adjusted] yields in the United States are increasing. Copper and base metals have become more China-centric over the past decade and China’s credit cycle has reached its peak, [meaning] a bearish bias for base metals during 2021. The other question we get is how to hedge inflation? We like equilibrium trades that protect against inflation and believe TIPS [Treasury inflation-protected securities] seem materially inexpensive. We recommend broadening the breakeven point over five years. We are still short of 10-year Treasury yields: we believe they will rise another 40 basis points by the end of the year.
And at the regional level?
It makes sense to look at the equity markets outside of the US, because what’s different about this recovery isn’t just the accelerated speed, but the fact that it’s not in sync. You had China first in and first out. Europe will join the American boom in the third quarter. We have [European] growth in the third quarter rebounds nearly 15% on a quarterly basis, breaking out of bottlenecks, and we expect a further 15% rise for eurozone stocks. We prefer national players to exporters and the periphery in the center.
You alluded to a possible policy error. What can it look like?
It’s really speculative. Everyone is wondering if inflation is transitory. By the time we find out, would it be too late? My personal opinion is that the price pressures, for the most part, can be explained by the pandemic. Inventories have really gone down in autos and transportation. But if you go to [a framework] it is more based on results than outlook / forecast, will be [the Fed] fall behind ?
The market does not devote enough time to the issue of employment. Stronger labor markets are actually more of a tipping point than inflation, given the Fed’s dual mandate. Will we really see unemployment move in September, when the kids are back in school? Mike Feroli, our chief economist in the United States, predicts that unemployment will rise to 4.5% next year. [It was 5.8% in May 2021.] It took eight years after the global financial crisis to close the output gap. But output gaps are closing for developed markets, as well as for the United States and China, much sooner.
The Fed began to consider the possibility of normalization.
We expect the first US rate hike at the end of 2023. We originally planned it for 2024. The rest of the world is becoming increasingly hawkish. It’s part of the story of emerging markets, where central banks are becoming more hawkish faster than developed markets. One of the reasons I’m not so worried about inflation is that the inflationary impulses in the United States still conflict with more deflationary and disinflationary impacts elsewhere. There is still a lot of slack in the rest of the world.
You’ve been bullish on emerging markets. How is it going to play out?
Don’t give up on emerging markets. Emerging market equities are down 6% versus developed market equities, given challenges related to the reopening and vaccine rollout. But the global context favors equities, emerging markets, value, commodities, cyclicality. Some good entry points are emerging. We decided to overweight Brazilian equities and maintained a basic view of overweighting emerging corporate debt.
What about American stocks?
Our S&P 500 target is 4,400, but we’ve raised our guidance for earnings per share in 2021 to $ 200 and for 2022 EPS to $ 225. Dubravko Lakos-Bujas, our chief U.S. equities strategist, predicts EPS for 2023 at $ 245. It’s a pretty solid earnings outlook. There are some [concerns] in 2022 about all this stimulus, but it is premature to talk about end-of-cycle dynamics. Look at other indicators: Companies will face pressure from investors to release excess cash through dividends, buyouts and mergers and acquisitions. Most of the S&P 500 companies are posting record margins and their ability to pay interest has improved due to falling rates. And there will be pressure to increase the return on capital. Companies have announced $ 350 billion in buybacks since the start of the year, compared to $ 307 billion for 2020 as a whole.
Consumption of services is lagging behind, so entertainment, recreation, real estate services will pick up. Profit dynamics seem to be in a fairly constructive position over a multi-year horizon, as does the consumer. Jesse Edgerton, our US economist, just released a report saying that although corporate debt is at an all time high, interest rate coverage is the same as it was in the 1960s when household debt was at its lowest in 40 years. So, you might see the performance of the stock markets prolonging for much longer, despite high valuations. This reflects shrinking household and consumer balance sheets, not just stimulus measures. Although you can have volatility and much shorter cycles.
What should people avoid?
It is still difficult to find value in much of the fixed income market. In high quality credit markets, you are close to record highs. But the Fed is still providing so much support that it’s hard to [see] a bond market that is completely collapsing.
We have removed some of the pandemic coins to move on to reopening trades. I think some equilibrium trades make sense as a hedge against inflation. What might come as a surprise is that the dollar has been a side story. The Fed’s hawkish pivot is a bullish turn for the dollar after an indecisive first half. We have a medium-term bullish outlook for the euro at $ 1.16 next year. But could he be more volatile in the second half? It’s not in our forecast, but it’s worth taking a look.
Write to Leslie P. Norton at [email protected]