Chris Wood, the global head of equity strategy for Jefferies, was a recent guest on the Market Policy Partners podcast for a long form discussion of his views on global markets. The link to the interview is embedded below. Worth a listen in its entirety, but I have also added some notes regarding certain topics of interest (these are for personal reference only and any mistakes in transcription are my own).
Energy:
This was the best performing sector in the US in 2021 and 2022, so there would be a risk of staying too long in the trade if this was a traditional cycle (given his base case is for a US recession later this year). But he doesn’t think this is a traditional cycle and he is not selling energy for a few reasons.
One, he wants to retain energy exposure as a hedge against a geopolitically driven spike in inflation, which undermines his base case. Second, he thinks this cycle is different because the normal demand destruction you would get in a recession will be offset to a significant extent by the massive supply constraint in the energy sector, particularly oil. This is partly the consequence of the political attack on fossil fuels over the last several years, which has disincentivized the oil and gas industry from investing and has had the practical consequence of meaning that OPEC, and Saudi in particular, is the swing producer again. The other problem for the energy sector is that US shale, which was the big source of growth in the last decade, has peaked out geologically. So even if energy prices rise sharply, you won’t get the supply response from US shale that some people might be expecting because the best areas have already been fracked and the law of diminishing returns has set in.
China is coming back so that will increase demand energy because the one area there was demand destruction in oil in recent quarters was China. But it is not going to lead to a massive surge in oil prices short term because the Chinese have stockpiled a lot of oil. They have used the opportunity to buy cheap Russian oil to build their stockpiles, which is the opposite of what the Biden Administration has done, using up a lot of the US Strategic Reserve.
The key point, however, is that energy is fundamentally supply constrained because of politics. Oil companies are disincentivized to invest in energy, at least in the developed world, because of the political attack on fossil fuels. The problem with this political attack is that it has neglected one simple point and that is we still consume fossil fuels and there is very little evidence about that changing anytime soon. The best source on energy consumption is the BP energy book. In 2021, fossil fuels still accounted for 82% of world energy demand and his guess is when the 2022 data comes out it will be higher than 82% because a lot of people had to burn coal last year. So there’s a huge difference between the political rhetoric on this subject and the practical reality.
Outlook for emerging markets:
He was bullish on emerging markets at the end of 2021 because China was in a totally different easing cycle. Jerome Powell had made his u-turn on inflation and started signaling tightening in November 2021. By then China had just started to ease monetary policy, fiscal policy and policy towards the property market, having basically been tightening during most of the pandemic. So it made sense to go into China and emerging markets late 2021 but then we had this extraordinary situation where Xi, contrary to the advice of his technocrats, did not adjust the Covid policy for the practical reality that Omicron was too infectious to make these lockdowns practical anymore. So that’s the reason China’s economy collapsed, but otherwise the rest of the emerging markets behaved remarkably well last year given that we had two things going on which are traditionally very negative for emerging markets – a strong dollar and the most aggressive Fed tightening cycle since the late 1970s. What we have right now is China joining the party.
If he had to highlight an area which outperformed global benchmarks last year but historically has been negatively impacted by a strong dollar and higher rates, he would point to Indonesia. He thinks we are on the brink of a sustained period of emerging market outperformance in equities.
Allocations towards emerging markets have also turned down a lot and in terms of the frontier markets, allocations have almost collapsed so there is huge potential for money to flow into this area. But there will be some people who won’t be comfortable investing in China, so you also have this growing interest in the emerging markets ex-China asset class. More broadly, he says liquidity is a movable feast, so the key point is to get positioned before the liquidity arrives.
India has been his favorite stock market to own for many years from a long-term standpoint. He thinks if you have to own one market globally for 10 years and you’re not able to sell, you should own the Indian market because this is a strong domestic demand story, it has positive population dynamics, there have been significant economic reforms particularly under Modi and there are a lot of good companies. So India is undoubtedly the best stock market over the long-term in his view. Short-term though, India is expensive; it is trading at 19 times forward earnings at the start of this year and India is also being sold this year to fund increased positions in China.
Japan:
Japanese monetary policy is coming to a head, he thinks it can be compared to a pressure cooker. He calls the BoJ governor Kamikaze Kuroda because he has always thought his extreme monetary policy had the potential to ultimately blow things up. Last year, Kuroda maintaining the peg on the 10-year JGB yield had the practical effect of causing the Yen to collapse, which basically impoverished the Japanese people who imported inflation at a time when your average Japanese salaryman was lucky to get a wage rise of 2% (and most got less). Japan is a very passive, conformist society so people have taken that but even in Japan the pressure is building. Kuroda is due to retire in April and everybody was of the opinion that the policy would be adjusted by the new governor, because these policies were as personally associated with Kuroda as the Covid policy was associated with the Chinese president.
Kuroda kind of reduced the worst risk of a blow up by adjusting the yield curve control in December, when they fixed the 10 year JGB at 50 basis points not 25, so that has partly reduced the pressure but the BoJ is still having to buy huge amounts of JGBs to hold the line. At the end of the third quarter last year, it owned more than 50% of the JGBs outstanding but its ownership would have increased substantially since then, so it is only a matter of time before this policy is further adjusted. The question is does the market force it or can he hold the line until he is succeeded in April.
In his view, it is just a matter of time that the BoJ will move out of negative rates, like the European banks have done. The potential consequence of this is if bond yields become de-anchored in Japan then you have the potential for significant capital repatriation as Japanese institutions move their money back into a Yen world, because they can now get reasonable income in Japan in Yen terms. What they’ve been doing historically is buying a lot of overseas bonds and they’ve been hedging the currency, but last year they stopped buying US treasuries because the cost of hedging the Yen basically removed all the higher yield pickup. The good thing about this issue is that everybody is now focused on it and people can see the risk. If it had been suddenly triggered by a huge market move as nearly happened last year, the consequences would have been more explosive.
Gold:
If you have the view that the Fed is going to stop tightening, gold has clearly got some attractive features. Gold performed remarkably well last year and served its traditional function of preserving purchasing power because gold corrected marginally in US dollar terms and significantly outperformed equities and US treasuries, both of which declined by the most in more than 50 years. That is impressive performance by gold because we had a strong dollar and a far more hawkish Fed than anybody thought possible.
Gold will be positively geared to the end of Fed tightening, but we have not yet seen ETF flows into gold come back. That is what you need to see to believe it is going to get real momentum. Last year we had ETF outflows out of gold when it became clear how hawkish the Fed was going to be, so what supported the gold price was the biggest increase in buying from central banks for many years. His guess is that this was central banks outside the G7 world who basically wanted to buy more gold as a hedge because many countries were shocked by the US action of freezing a significant part of Russia’s foreign exchange reserves. Gold mining stocks are also very cheap and the companies are being run more cost effectively than they were in the last cycle.
Escalation of the China/Taiwan situation:
He doesn’t think the Chinese are thinking about it. All the escalation on Taiwan in the latter days of the Trump Administration and under the Biden administration have come from the US side (and the West in general) and all the Chinese have done is react to those escalations. The Chinese president has said he will sort the Taiwan issue out before he leaves power, but the key point is he is not planning on leaving power anytime soon. However, there is a risk that the more this is escalated, at a certain point China’s government will start to look weak to its own population if it doesn’t do anything. Everybody in China, rightly or wrongly, believes that Taiwan is part of China, even the people who don’t like the Chinese president.
What has been worrying him more about Taiwan over the last year from a stock market standpoint is the semiconductor downturn. The US has basically announced a very aggressive policy towards China on semiconductors where they basically want to stop the supply of advanced semiconductors to China. This is a very dramatic development if it is really enforced, and if other countries go along with it. That would severely cripple China’s ability to upgrade its economy and, given China’s demographics, would raise the risk of them being condemned to the middle-income trap. From a Chinese perspective, that’s the equivalent of declaring economic war against China. The key question which we don’t know the answer to yet is how strictly this will be enforced. To him, this is a much more important than the political issue of Taiwan. It has implications for the Taiwan semiconductor companies and the US tech companies.