The speed at which the world is changing is wreaking havoc with a typical investor’s long-term planning. Luckily, Joyce Chang, one of Wall Street’s ablest analysts and most experienced observers, was able to unpack key trends for us and what they mean for the markets. The upshot: expect continued gains for stocks and oil. Don’t expect a supercycle for the latter, though. An edited version of our conversation follows.
Barron’s: Inflation is a major risk and opportunity. What other paradigm shifts are affecting investors?
Joyce Chang: The Federal Reserve is showing its hand about what the risks are to “the new experiment,” which is the introduction of its new monetary framework of average inflation targeting, more outcomes-based than outlook-based. What has surprised everybody is how quickly scenarios are playing out. You used to have more time. The Fed [initially] thought this experiment would play out over a number of years, and you wouldn’t see the first Fed [interest rate] hike until 2024. The reality of the inflation trend has moved that up.
Then, there’s this sense that the world of low rates, quantitative easing, and then tax cuts actually worsened wealth inequality. Now we have President Joe Biden [introducing] this real redistribution of income element that is also part of macro policy. That’s a paradigm shift.
What about U.S. and China?
Under Trump, it was a G-2 competition. Biden is moving to unilateralism, outlining it as a challenge between democracy and autocracy. He wants global alliances back to provide alternatives to China. The initiative he has proposed is picking up the low-income, emerging market countries; advancing U.S. leadership; going back to transatlantic and multilateral relations and institutions. There’s definitely more of a sense, even with Russia, that we want to be predictable, stable.
Another, related, shift is the rise of populism. That’s a very mixed bag and still evolving. Populist leaders are winning in Latin America, but you can also really see a return to the center in other parts of the world. In the U.S., people will want to see what happens at the midterm elections.
What’s the biggest emerging shift?
The most unknown, and happening the most quickly, is digitalization and the demand for fintech and crypto. Market dynamics have moved beyond talking about traditional market liquidity provided by banks and what hedge funds and mutual funds are doing, as nonbank financial institutions have ramped up activity. Retail investors are a driving force; they have poured $500 billion into equity and bond funds each since the beginning of the year.
Crypto is too volatile for institutional investors to have big exposure. We’ve seen a rise in the Bitcoin/gold volatility ratio. Crypto is the poorest hedge for major drawdowns in equities. And tweets can result in major moves. How will it be regulated? We looked at El Salvador [which made Bitcoin legal tender in June]. There are risks around the use of Bitcoin by malicious actors and the future of its dollarized monetary system. It’s too early to say whether other countries will go the route of partial Bitcoinization. We have overweight recommendations on Square [ticker: SQ], Coinbase Global [COIN], Flywire [FLYW].
What else do these trends mean for investors?
We’re looking at a structural rise in commodity demand as we reopen. One of our top recommendations right now is the energy sector. Spot Brent [recently at $72 a barrel] is at its highest level since 2018, and we think it will go higher because the seasonally strong summer driver season will go through August. We have it going to $80 by early next year. The combined valuation of the European Union major oil companies is 18% below where they were prepandemic. Also, the positive correlation between bonds and stocks has returned, meaning you’ll have more questions about diversification. Commodities could benefit.
The upcycle for oil is distinct, as it is also supported not just by demand dynamics but also by increased flows as fund allocations to energy have steadily declined in recent years. We also expect more-stringent environmental regulations and tax policy to support energy prices in the long run.
Any other commodities beside oil?
The Fed’s hawkish reaction makes us more bearish on gold as real [inflation adjusted] yields in the U.S. rise. Copper and base metals have gotten more China-centric over the past decade and China’s credit cycle has peaked, [meaning] a bearish bias for base metals over the course of 2021. The other question we’re getting is how do you hedge inflation? We like break-even trades that protect against inflation and think that TIPS [Treasury inflation-protected securities] appear materially cheap. We recommend five-year break-even wideners. We’re still short 10-year Treasury yields: We think they go up another 40 basis points between now and year end.
What about regionally?
It makes sense to look at equity markets outside the U.S. because what’s different about this recovery is not just the accelerated speed, but that it isn’t synchronized. You had China first in and first out. Europe will join the U.S. boom by the third quarter. We have [European] third-quarter growth rebounding by close to 15% on a quarterly basis, coming out of the lockdowns, and we predict another 15% upside for euro-zone equities. We like domestic players over exporters, and the periphery over the core.
You alluded to a possible policy mistake. What might that look like?
It’s really speculative. Everyone is talking about whether inflation is transitory. By the time we know, could it be too late? My own view is that price pressures, for the most part, can be explained by the pandemic. Inventories really came down in autos and transportation. But if you go to [a framework] that’s more outcome-based rather than outlook/forecast-based, will [the Fed] be behind the curve?
The market isn’t spending enough time on the employment question. Stronger labor markets are actually more of a tipping point than inflation, given the Fed’s dual mandate. Will we see the unemployment really move in September, when kids are back in school? Mike Feroli, our chief U.S. economist, has unemployment going to 4.5% by next year. [It was 5.8% in May 2021.] It took eight years after the global financial crisis to close the output gap. But we have output gaps closing for developed markets, and for the U.S. and China, much earlier.
The Fed has started addressing the possibility of normalizing.
We expect the first U.S. rate hike in late 2023. We originally had it for 2024. The rest of the world is becoming more hawkish. That’s part of the emerging market story, where central banks are becoming more hawkish more quickly than developed markets. One reason I’m not as worried about inflation is that the inflationary impulses from the U.S. are still in conflict with more deflationary, disinflationary impacts elsewhere. There’s still a lot of slack in the rest of the world.
You’ve been bullish on emerging markets. How will that play out?
Don’t give up on emerging markets. EM equities are down 6% versus developed market equities, given challenges to reopening and vaccine rollouts. But the global backdrop favors equities, emerging markets, value, commodities, cyclicality. Some good entry points are emerging. We moved Brazil equities to overweight and have kept a core view to overweight EM corporate debt.
What about U.S. equities?
Our S&P 500 target is 4400, but we’ve raised our forecast for 2021 earnings per share to $200 and for 2022 EPS, to $225. Dubravko Lakos-Bujas, our chief U.S. equity strategist, sees EPS for 2023 at $245. That’s a pretty strong earnings outlook. There are some [concerns] in 2022 about all this stimulus coming off, but it’s premature to talk about late-cycle dynamics. Look at other indicators: Corporates will face pressure from investors to release excess cash via dividends, buybacks, and mergers and acquisitions. Most S&P 500 companies are earning record margins, and their ability to pay interest has improved due to lower rates. And there will be pressure to ramp up capital return. Corporates have announced $350 billion in buybacks year to date, versus $307 billion for all of 2020.
Consumption of services has lagged, so entertainment, leisure, real estate services will pick up. Earnings momentum looks to be in a pretty constructive place over a multiyear horizon, just like the consumer. Jesse Edgerton, our U.S. economist, just put out a report saying that even though corporate debt is at all-time highs, the interest-rate coverage is where it was in the 1960s, when household debt was at a 40-year low. So, you could see equity market performance extend for much longer, despite high valuations. It reflects shrinking household and consumer balance sheets, not just stimulus. Though you can have volatility and much shorter cycles.
What should people avoid?
It’s still hard to find value in a lot of the fixed-income market. In high-grade credit markets, you’re close to record highs. But the Fed is still providing so much support, it’s hard to [see] a bond market that completely falls apart.
We’ve taken off some of the pandemic plays to shift toward reopening trades. I do think some break-even trades make sense as protection against inflation. What could be a surprise is that the dollar has been a secondary story. The Fed’s hawkish pivot is a bullish watershed for the dollar after an indecisive first half. We have a medium-term bullish view for the euro at $1.16 over the next year. But could it be more volatile in the second half? That’s not in our forecast, but it’s worth taking a look at.
Write to Leslie P. Norton at firstname.lastname@example.org