Interview

«The Fed Will Overdo It»

Chen Zhao, chief strategist at Canadian research boutique Alpine Macro, argues that inflation will soon fall rapidly. This will pave the way for a recovery in equity and bond markets – but the road will be very bumpy.

Mark Dittli
Drucken

Deutsche Version

Chen Zhao, Founding Partner and Chief Strategist of Montreal-based Alpine Macro, has been analyzing global financial markets for more than thirty years. Investors worldwide know him as the long-serving former Chief Strategist of BCA Research. Zhao often has contrarian views, pitting him against the crowd in financial markets.

At present, he believes that the Federal Reserve will pull the monetary policy rudder too hard and trigger a recession – although it will soon be apparent that inflation is falling quickly. He is somewhat bullish for stocks and bonds in the US, but not for Europe. «The ECB raising rates into a relative price shock and into a recession, where households are already stressed, is bad policy. Households and companies in Europe are getting a double whammy», Zhao says.

In an in-depth conversation with The Market NZZ, which has been edited for clarity, Zhao shares his views on the current environment for global financial markets.

«From a global perspective, the slowdown in China is actually quite good for the fight against inflation»: Chen Zhao.

«From a global perspective, the slowdown in China is actually quite good for the fight against inflation»: Chen Zhao.

Picture: Alpine Macro

Financial markets have woken up to a difficult world. What’s your assessment of the current environment?

It’s easy to give a bearish story. Everybody is bearish these days. Sentiment is very subdued, just look at the latest Bank of America fund manager survey: The extent of portfolio managers underweighting stocks is so large that it exceeds even the 2008/09 levels. Everytime you see that, your instinct tells you that you should bet on the other side.

You’re bullish?

Don’t ask me what stocks will do tomorrow, next week or next month. Nobody knows that. The market could easily break to new lows in the near term. But given the bearishness out there, and given what we see in terms of inflation and monetary policy, I think there is a good chance that US equities by the end of the year will be higher than today.

Walk us through your case, please.

First, let’s agree that inflation is the dominant factor right now. We saw that on September 13th when the CPI report came in hotter than expected, causing stocks and bonds to plummet as markets began to price higher rates for longer. The fear of a much more hawkish Federal Reserve is rampant. Now we have kind of a binary situation going forward: If inflation starts to go down faster than people anticipate, then you have to be bullish. If inflation stays stubbornly high and moves even higher, then we have a serious problem both in bonds and in equities.

And you think it’s the former?

Chart: Alpine Macro

Yes. Based on our research, we have come to the conclusion that inflation has peaked and will move down faster than anticipated. This is not just an assertion. In our analysis, we broke down the core PCE inflation for the US, that’s the inflation gauge that the Fed cares about, and we grouped it into two categories: Supply side driven inflation and demand side inflation. What we found is that demand side inflation has already fallen to 1%, while supply side is still high but falling. Based on this, we see core PCE inflation going down to about 1% by the end of next year. The bond market seems to agree with our forward-looking assessment, as it is anticipating inflation to fall to around 2% one year out, supporting the conclusion of our model forecast. That’s why we think it’s not the right time to be panicking about inflation.

The Fed has been cranking up the hawkishness in terms of inflation. What do you make of that?

You’re right, Fed Chair Jerome Powell is super hawkish right now. But if you look at history, you were almost always right by betting against what Powell is saying. In late 2018 he said that the Fed's quantitative tightening would be on «autopilot», and a month later he flipped by cutting rates. In 2021 he was talking about not thinking about thinking about raising rates – and then in 2022 he has not only raised rates, but did so very aggressively. A little more than a month ago he was talking about an economic soft landing, and now he’s talking about more pain ahead. If you look at his past performance, you basically have to bet against what he says. If you take Powell as a contrarian indictor, his turn towards super hawkishness could be an indication that inflation not only has peaked but will fall fast soon.

Markets were hoping for a pivot in July and August, and then again in early September. Both times, they were whacked by the hawkish Fed. What gives?

If you look at the forward curve of the Fed Funds Rate, since Jackson Hole and again since the CPI report of September 13th, there was a selloff in bonds. The curve moved up, reflecting Powell’s hawkishness. But the shape of the curve has remained largely unchanged. Basically this tells you that the bond market does not believe what Powell says. Yes, he’s hawkish in the short term, but the bond market still expects the Fed to pivot and lower interest rates by spring of 2023. Sure, the bond market could be wrong, but if our prediction is right and inflation will fall faster than anticipated, then by Q1 2023 the Fed may face a situation where inflation drops rapidly while unemployment will move above 4%. That will give grounds to the Fed to perform a dovish pivot. That’s why I’m not bearish over the medium term.

Don't you think the economy will be in a recession by then?

Yes, that is our base case scenario. But the stock market is already discounting a mild recession. Let’s take a simple calculation: Right now, S&P 500 realized earnings is 225 $ per share. In a garden-variety recession when GDP drops anywhere between 1 and 1.5%, usually earnings contract by 5%. But let’s be a bit more aggressive and take EPS down by 10%. That means that next year, earnings per share for the S&P 500 will be around 205 $. At today’s stock prices, you are talking about a P/E of below 19 based on that level of earnings. Is that too expensive or too cheap? It depends, because you have to also look at bond yields. Right now, the ten-year Treasury yield is at 3.6%. In a recession, bond yields in the US typically drop by 200 basis points, but let’s say they drop to 2 to 2.5% in a recession next year. That kind of bond yield would correspond to a fair P/E of about 22 for the S&P 500. If that is the case, the current P/E of less than 19 is already pricing in a recession.

Analyst’s expectations are still very high. They currently calculate with an earnings growth of 7% for the S&P 500 in 2023. How do you square that?

You’re right. Currently, they are still expecting earnings to rise next year, which will prove to be wrong given the very high probability of a recession. They are starting to move their expectations down now. But remember: Analysts are always late. The market is already discounting what will happen to earnings.

What about the risk that the Fed will overdo it and provoke a really bad recession?

I have no doubt: The Fed will overdo it. But for a really bad recession, you usually have to have a financial crisis. Something in the system will have to break. I don’t see that currently. Besides, right now, nominal GDP growth today is around 7 to 8% given current inflation. That actually is a protection for earnings, because earnings are nominal. So let’s say by the middle of next year headline inflation goes down to 4%: Even if we have a moderate recession with real growth of minus 1%, you still have a positive nominal growth of 3%, which is not too bad an environment for corporate earnings.

Why are you confident that there won't be a financial crisis?

I wouldn’t call it confident. In our business you can’t be confident about anything. But I would say the aggregate balance sheet of the household sector in the US is pretty good, they have lowered their indebtedness after the financial crisis dramatically. In the corporate sector, balance sheets are pretty good too, they sit on a lot of cash. Corporate bond spreads confirm this picture. Plus, this is probably the most anticipated recession ever, which limits the potential for nasty surprises.

As a result of the hawkish Fed, the dollar is very strong. The exchange rate to the Japanese yen is at 1998 highs. History tells us that this kind of dollar strength causes a lot of stress in the global financial system. Where do you see the weak links?

Historically, a strong dollar always caused stress in emerging markets, because many of them had pegged their exchange rate to the dollar. But now, with floating exchange rates, they have been able to devalue their currencies which helps their growth. In trouble are only the subjects who have loaded up on dollar debt. So yes, a strong dollar is never good for emerging markets, but it’s not as universally bad anymore as when most EM currencies were pegged. But make no mistake: The strong dollar is in America’s interest right now and is consistent with the Fed policy objective of fighting inflation. Besides, the US has never cared about any blowup risk in emerging markets. The key point is that I don’t see any major EM countries that are about to plunge into debt crises due to the surging dollar.

There has been chatter of a new global currency accord, perhaps around the G20 meeting in Bali in November. Do you see that?

No, I don’t think so. A global accord about what? About driving down the dollar? That would not serve the purpose of the US. Remember, they want a strong dollar because it helps to drive down inflation. A global accord would have to serve the purpose of the US.

You say there is a very high probability for a recession in the US. How about Europe?

Oh, that’s a clear case. Europe will drop into a recession because of their severe energy crisis. Europe is in a very tough spot, as it suffers from a relative price shock. Take German households, for example: spending on electricity and natural gas used to be about 1.5% of disposable income before the war in Ukraine. Now it’s 13%. If you throw in rent plus utilities and gasoline consumption, before the war it was about 21% of disposable incomes in Germany, now it’s 36%. So most of the German middle income households are being squeezed badly. This is a classic case of a relative price shock. There is no other way than cutting on spending for other stuff, which means a recession. That’s why I don’t think Europe has an inflation problem. Inflation is always a phenomenon that comes from aggregate demand exceeding aggregate supply. I don’t see that in Europe. Where’s the boom in aggregate demand? What we have in an explosive surge in energy costs that have lifted price levels.

Still, the ECB is under pressure to raise rates to combat inflation. Is that wrong, then?

Raising rates into a relative price shock and into a recession, where households are already stressed, is bad policy. Households and companies in Europe are getting a double whammy.

That’s the reason why you’re much more bullish on the US vs. Europe?

Yes, exactly. Even though the European stock market is much cheaper. On a relative basis, European stocks have been underperforming the US with no interruption since 2010. For that trend to turn, you’d have to give me a very convincing catalyst. I don’t see any.

The economy in China is flatlining as well. What’s your assessment there?

First, from a global perspective, the slowdown in China is actually quite good for the fight against inflation. Why? Because domestic demand in China is contracting, but their net exports are very strong. That means they currently have a very strong production side and a weak demand side in China. That is good for everybody who is dealing with an inflation problem. You don’t want to add any more demand to the global system, but you want to add more supply. Just imagine what inflation in the US or in Europe would be if China was booming.

China’s domestic economy has been weighed down by their Zero Covid policy. Do you have any expectations that they will shift after the 20th Party Congress in October?

The Party Congress won’t necessarily trigger a complete removal of the policy, but it could be the starting process for them to relax it. The problem is that millions of elderly did not get vaccinated. Why should they if there was a stringent Zero Covid policy in place? But if the government would let the virus spread now, they don’t know the consequences. What will Omicron do to a society where millions of elderly did not get even one jab? They don’t know. So they are boxed in: If they don’t reopen, their economy will flatline. If they reopen, they will be victims of their earlier success. In the end, Xi Jinping is a populist leader, he will do whatever is popular. Zero Covid was extremely popular in 2020 and 2021, when the whole world was in chaos and practically no one in China was dying. Now it’s becoming extremely unpopular because the rest of the world has returned to normal and China has not. So my bet is that Xi will do whatever is popular. He will probably start to open up the economy and abandon the stupid zero covid policy some time next year.

The Renminbi has weakened to the magic level of 7 CNY/USD. What do you read into this?

The currency reflects the relative economic problems. The US is tightening hard to get inflation down, while the Chinese economy is half dead. With a weaker Renminbi, the Americans get a price discount on their imports from China. That’s all helpful for President Biden. However, the trade weighted CNY is not particularly weak, so a big chunk of the CNY decline is in fact reflective of a strong dollar.

So out of all market segments, you would be most bullish on the US right now?

Yes, I’m bullish on US equities and bullish on US Treasuries on a six month time horizon. I think long-term bond yields have peaked out – although, mind you, I said that a while ago and was wrong. But unless my logic about the path of inflation and the weakening economy is completely wrong, I think the equilibrium bond yield level in the US is about 2.5%. So today, duration represents a lot of value. I don’t think you want to be overweight anything else right now, because every world region has particular problems that are more severe than the US. But sometime in the later part of this year or early part of 2023, the dollar will probably start to soften. Because the forex market will sniff out a Fed pivot and move first.

And that would be a sign to be bullish for emerging markets again?

Yes, but you’ll first have to look what the Chinese economy will do then. We need to see if we get a marginal shift in their Zero Covid policy. Because before they do that, they can’t stimulate the economy. If they do shift, that’s the point where you should buy EM equities.

Chen Zhao

Chen Zhao is Founding Partner and Chief Strategist of Alpine Macro. From 2015 to 2016, he was Co-Director of Macro Research at Brandywine Global Investment Management. Prior to Brandywine Global, Chen spent 23 years at BCA Research. As a Partner, Managing Editor and Chief Global Strategist, Chen developed and wrote BCA’s China and Emerging Markets publications in the 1990s. He became the firm’s Chief Global Strategist in the 2000s and was the author of BCA’s flagship publication, Global Investment Strategy, from 2005 to 2015.
Chen Zhao is Founding Partner and Chief Strategist of Alpine Macro. From 2015 to 2016, he was Co-Director of Macro Research at Brandywine Global Investment Management. Prior to Brandywine Global, Chen spent 23 years at BCA Research. As a Partner, Managing Editor and Chief Global Strategist, Chen developed and wrote BCA’s China and Emerging Markets publications in the 1990s. He became the firm’s Chief Global Strategist in the 2000s and was the author of BCA’s flagship publication, Global Investment Strategy, from 2005 to 2015.