Watling: The 'anything but expensive US equity' rotation

In July of 2021, Chris Watling shared two of his big calls with Livewire readers. One of them he nailed, the other he missed - and now it has him worried. Watling was firmly in the transitory inflation camp, arguing that base effects would see the spike in inflation rollover in 2022. Now, he is wary that inflation could become much harder to contain. While that call turned out to be incorrect, he did predict the rotation away from Growth to Value. On this front, he says many of these sectors, like financials and commodities, remain "screaming cheap". For more, click the link below. 
James Marlay

Livewire Markets

In July of 2021, Chris Watling shared two of his big calls with Livewire readers. One of them he nailed, the other he missed - and now it has him worried.

Watling was firmly in the transitory inflation camp, arguing that base effects would see the spike in inflation rollover in 2022. I spoke with Chris last week as the U.S. was printing inflation numbers of 7.9%, and the Fed had embarked on the impending rate hiking cycle.

Watling will be the first to acknowledge where his calls miss the mark, and he is also quick to respond to new information. With the supply-side shocks associated with the humanitarian disaster in Ukraine and cashed-up consumers, he is wary that inflation could become very hard to contain.

And while he sees inflation as problematic, Watling says there is a low chance of a recession in 2022 due to global economies firing on all cylinders and household balance sheets flush with cash.

"If you look at U.S. housing equity, it's up by $17 trillion in a decade, which is almost one times GDP, and consumers are starting to tap this. Their balance sheets are good. If they need to tap a credit card, they've got tonnes of capacity to do that." 

So Watling missed on his inflation call, but in the same breath, he correctly called the rotation away from 'expensive' growth sectors into cyclical sectors, including financials and resources.

On this front, he says many of these sectors remain 'screaming cheap', he's anticipating a resources supercycle, and he says financial companies are well placed to benefit from the rising yield curve.

"That relative expensive position of the U.S. versus everything else, it's still there. That story is just beginning. I think it's a structural story, potentially a multi-year story with rotation into all those things you mentioned; financials, value, commodities."

I always enjoy asking Chris for his outside perspective on the Australian economy, which he says is "wonderfully placed" with multiple sectors set to benefit healthy consumption trends and high commodity prices.

You can access the full interview by watching the video below or read the edited transcript.


James Marlay:

Hi there, Livewire viewers. It's James Marlay, the co-founder at Livewire Markets, and I've got something special for you. One of my favourite international guests, it's Chris Watling, CEO and Chief Market Strategist at Longview Economics. Chris provides economic insights and analysis, he provides asset allocation and strategy recommendations, and Chris is also a lovely guy and a great communicator. So Chris, it's great to see you, and I really appreciate you making some time for me and for the Livewire viewers today.

Chris Watling:

Absolute pleasure. Just a real pleasure to be here with you James and talking to you again as always. I just wish I was there in person, but hopefully soon. Hopefully soon we'll get to that.

James Marlay:

Yes, and we'll make a point of catching up when you do come out. Now, I'm sorry to put you on the skewer straight off the bat, Chris, but last time we spoke, you made two calls. One of them was good. The other one, not so good. So let's start with the not so good and get it done and dusted. Your call was that inflation was going to be transitory. It looks what the U.S. is printing 7%, 8% inflation numbers, and that transitory word is a 2021 story. So, I'm keen to know how your view has evolved on this front given we saw the first Fed rate hike today.

Chris Watling:

Clearly we were too optimistic on that. We thought there would be some base effects and some easier global supply chains. But I'd say on inflation, the monetarists won. The monetarists were the guys who got it right, and I think they made some really, really valid points. This whole growth in money supply that we've seen over the last two years, particularly broad money, not narrow money. So, it's important to make the point. This is very distinct from post-GFC.

This is helicopter money that we've had in two in the past two years. And those who focus on those metrics nailed the inflation forecast, and were absolutely correct.

And if I look at some of the inflation models now, the momentum is troubling. On top of which, we've had some more price shocks just in the last few weeks, what with this war in terms of global food prices and energy prices and so on, and the labour market seems to be tightening up.

I'm also starting to worry about that labour market in terms of this long COVID story. So, we all know there's lots of issues with the labour market, it's tightening up quick in the states and so on, but I think there's another thing to worry about, which is long COVID which is affecting people, and I think meaning people are not able to work because they're fatigued. 

And the numbers in the UK, just to give you a flavour on that is 1.3 million people out of a population of 70 million. So in the U.S., you're looking at probably 5 million with long COVID, and a quarter of them are probably not working.

So, yes. We are wrong on the inflation, wrong on the transitory thing, and actually quite nervous, and I think the monetarists have it. It's been a fantastic experiment in economic policy and we are on a real learning curve, I think, for us all. So, yeah. Thank you for bringing that up. I appreciate that.

James Marlay:

That's all right. We like to keep you honest, Chris, but thank you for making the call. It keeps it interesting. I mentioned earlier in the chat, we've just had The Federal Reserve hiked rates pretty gently, let's be honest, given how hawkish the market really is on rate hikes. What are the implications of the inflation settings and the new information you received? How does that feed into your forecast from here?

Chris Watling:

I mean, it worries me. I think The Fed's set for the next few months now. They've laid out their stool and they've managed to get the market to price in a bunch of hikes over the course of this year; 4, 5, 6, and so on. And they were a little bit more hawkish last night pricing in a few more hikes further out the curve.

If you think about it, real interest rates aren't deeply negative. Inflation's running at 6%, 7%, maybe it comes back to three or four. Difficult to know with any precision. I don't think there's anyone out there that can accurately forecast that if you're looking out for the rest of this year.

It's going to soften, but even so, rates will be three quarters of percent or 1%, and inflation will be three. So, real rates are still going to be negative, and I think the momentum in the economy is very strong. The underlying structural momentum, I should say. There's perhaps a little bit of softening near term.

But what concerns me is there's so much money sitting in people's bank accounts still, and it's a global phenomenon, particularly in Western and developed economies; that it's going to add to that push and keep labour markets tight, keep that inflation pressure building. 

So, yeah. I think it's a real challenge out there and The Fed will need to price in more hikes as they get later into this year. We'll start worrying about that very tight labour market. That's going to become very, very obvious if it isn't already.

James Marlay:

Now, the other thing that's grabbed my attention, Chris, and it was in one of your notes and it was on the Australian Financial Review today was the immediate emergence of the ‘R’ word, meaning recession, and people talking about hiking cycles being the precursor. The Fed always goes too hard and causes a recession. Given how healthy the economies appear to be, why is it worth talking about that scenario now, and what were some of the conclusions that you came to?

Chris Watling:

Well, people are talking about that because obviously The Fed started raising rates and they've finished doing QE now, but also of course because the energy price spikes. Both the oil price, but in Europe in particular, the natural gas prices which is a very big part of the electricity and energy consumption, provides a lot of that energy consumption in the Euro zone. 

So, people are worried about that, and they're worried about where the yield curve is. 

We're about 25 basis points steep, so we're quite close to inverted. All of that's got the debate going. The hit to confidence, people are looking at the Michigan Sentiment survey in the U.S., which is collapsed in terms of household confidence in the last year or so, and they're looking at real incomes being squeezed.

So you can make a bearish argument, absolutely. There is an ability to make it. 

Personally, I would put a sort of 10% probability on a recession this year. I think it's unlikely, simply because as I said earlier, there's so much money in people's bank accounts. 

There's so much wealth that's been created over the last two years. If you look at U.S. housing equity, it's up by $17 trillion in a decade, which is almost one times GDP, and consumers are starting to tap this. Their balance sheets are good. If they need to tap a credit card, they've got tonnes of capacity to do that. All income groups have got a load of money in their bank accounts. So, they're cushioned. They're cushioned against energy price spikes. And money's not tight. 

Some economists make this argument, all recessions are about oil price spikes. I take you back to your Stats 101 class at university, where if you remember it, the professor would always say, "Just because lollipops and umbrellas are correlated doesn't mean they're causal," and I think that's the same with the oil price spikes. The Fed is always tightening when the economy's strong, and when the economy's strong, the oil price tends to spike. So, it's definitely not the case that all oil price spikes create recessions, particularly when money's not tight. And our reading of U.S. liquidity at the moment is definitely not tight, and there are lots of ways of showing that.

So, I think the recession risk is a very low probability event at the moment. Over 12 months, those things can change quickly, but certainly that's where we see it at the moment.

James Marlay:

Now we've gone through the changing of the view. Let's talk about the call that you made where you hit it on the head, which was about this rotation away from really growthy part of the market.

What's your view on how the equity market plays out? I had one manager telling me today that we've not even seen the tip of the iceberg when it comes of the sell off in unprofitable tech stocks. I'm keen to know your views.

Chris Watling:

Yeah. Well, that's great. I love that, and thank you for bringing up one of the good things. I appreciate that. This is a tough gig. It's a tough gig forecasting in the future, particularly when you got people like Putin out there doing all sorts of terrible, strange things.

The rotation has played out wonderfully. It's been fantastic. And of course, absolutely your market over there has done really, really well. The UK market's done pretty well as well, given that commodity exposure, and banks exposure.

James Marlay:

And it was starting off a pretty low base as well. The valuations in the UK weren't great, were they?

Chris Watling:

It was screaming cheap in the UK, and it still is actually. I mean, that relative expensive position of the U.S. versus everything else, it's still there. That story is just beginning. I think it's a structural story, potentially a multi-year story with rotation into all those things you mentioned; financials, value, commodities.

I mean, you look at some of the banks that, particularly in the Europe, UK, and the U.S.; they've all rebuilt capital over the last 10, 11 years. They are awash with cash, awash with capital, desperate to put money to work, and they love a rising yield curve. But that allows them to get going. And I think we'll find they'll do well. The commodity guys will do well. I think we're in a commodity super cycle, and all those sort of areas of the market.

There has been a distinct lack of investment in many commodity spaces. We've got this green inflation story playing out. We've still got loose money, basically. Interest rates have gone up by 25 bips in the States. It's almost by the by. So, I think those themes are there. 

We're yet to our unwind the U.S. tech story fully.

But what I would say is, these things have chapters. They're not straight lines. As a trader on a by month basis, I'd be buying tech now. I think it will do well in this rally that's coming. But that's a 1, 2, 3 month story. That's not a 1, 2, 3 year story. I think the 1, 2, 3 year story is very much intact and remains as it was with that rotation ongoing.

I said to people that we're going back to the economic shape that was similar to the noughties. I would characterise the post-GFC phase as rebuilding Western balance sheets, which is basically deflationary, which favoured secular growth, the growth stocks, because there was no growth elsewhere because people were paying down debt, rebuilding their balance sheets. 

I think we're going back to the noughties when it was more about strong trending house prices, about home equity withdrawal, about consumers spending money and borrowing money, and about the U.S. consumer really driving global growth in many ways, along with China at that time.

So, all of that flavour favours, I think, classic cyclicals. There's more growth around it. It's not good for the U.S. growth stocks, because it is not about just secular growth. There's broader growth everywhere. So yeah, I think that's a theme that's coming back into play. It's working, so it's good news.

James Marlay:

At an index level, which are the markets that favour those? I'm going to throw Australia in the bucket there. Where are the indices that you are talking to clients about?

Chris Watling:

So, that tends to favour basically non-U.S. equity indices primarily. In Europe it favours some of the cyclical markets; Germany, Sweden, for example. It favours some of the big banking markets like Italy. It favours the UK because it's got a mixture of commodities, financials. And as you say, it favours the classic developed market, commodity markets like Australia and Canada. 

And then you go further afield and you can look into some of the emerging markets as well. So, the Southeast Asian equity markets. So, a very good play on global trade growth, and global trade growth tends to do really well when the U.S. consumer is starting to spend a lot of money. They'll do well. 

And if you look at that basket of Southeast Asian equity markets; Vietnam, Philippines, Malaysia, Thailand, they've all gone sideways for a decade and they're starting, I think, to move to the upside.

So, things like that. Some of the commodity emerging market equity indices as well. Not Russia, of course, but some of the other ones; Brazil, Chile, so on, I think they will all do well. 

And let's not forget, China's engaging in another monetary easing cycle. So again, that's good and you would've seen that on your iron ore prices and so on. So, those areas over the U.S. where, and I think we're going to redress that imbalance between the U.S. and the rest of the world that's built up over the last seven or eight years.

James Marlay:

Chris, final question. We've done around the ground. I always loved getting your outside looking in perspective on Australia. Happy for you to touch on things like that commodity super-cycle that you talked about. Keen to hear views around that. Aussie dollar, Aussie housing, Aussie equity market. Could you give me a bit of an outside-in on what you see?

Chris Watling:

Yeah. I mean, I think it's an economy that's running reasonably hot, isn't it? And it seems to me it's got a lot of the characteristics that we see in the U.S. and the UK; a tight labour market, some wage inflation, strong house prices, banks that want to make money off the back of this. I mean, I think, what? Your Aussie house price inflation was 20-odd percent last time I looked to it a month or two ago.

And these trends, to my mind, should continue because central banks will be behind the curve. Money will remain cheap. I'm guessing you've got a short of inventory there as well. So, I think you've got that consumer flavour that we have in the UK and the U.S., a very similar consumer culture, and that's all firing on lots of cylinders, lots of cash in bank accounts and all that sort of stuff.

And then of course, you've got the strong housing markets we've got in the UK, U.S., and Euro zone. And then on top of that, of course, you've got this wonderful exposure to commodities, which is absolutely the thing you want at the moment. Perfect, really. The world needs more natural gas, and I know that's been a thing that's growing in Australia in the last 5, 6, 7, 8 years. China's got an easing cycle, so great for the iron ore prices. And it's a long list, I know, of commodities. Farming commodities as well, of course you were mentioning when we're talking beforehand.

So all of this stuff, the world's short of food, the world's short of commodities; you're wonderfully placed, and maybe your Sydney house prices are going to get even more expensive.

James Marlay:

I don't know if it's possible, but we've been wrong before on that one.

Chris Watling:

Frightening thought.

James Marlay:

Well, Chris, listen. I could spend a lot longer on the call with you, but I'm going to save it for a chat when you come out in person. Hopefully we can go have a really good catch up. But it was lovely to see you, I really appreciate your views and taking the time to chat with the Livewire readers. Thanks very much for your time.

Chris Watling:

Yeah. Lovely. Great to speak with you, James. I really appreciate it all the very best, and all the very best to everyone down there, and very much looking forward to being in the country. It's been too long. 

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James Marlay
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Livewire Markets

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