ALFONSO PECCATIELLO: Hey guys, welcome back to the Real Vision Daily Briefing. Today is Wednesday, 22nd of December 2021. I'm Alf, the author of The Macro Compass, and I'm here with the one and only Darius Dale, who is the CEO and founder of 42Macro. Hi, Darius. How are you doing?
DARIUS DALE: Oh, what's up, man? How are you doing, brother?
ALFONSO PECCATIELLO: Yeah, it's okay here. We're in lockdown here in the Netherlands.
DARIUS DALE: Lockdown from the seasonal cold? Interesting.
ALFONSO PECCATIELLO: Well, over here, basically, they closed down all non-essential shops, so if you want to go to the restaurants, you can't. If you're going to do sporting, you can't. The Omicron situation has complicated things for the healthcare sector in the Netherlands. They were pretty late with booster shots compared to the rest of Europe. And unfortunately, the situation got out of hand so they just decided to tighten in, which is very unfortunate that [?], but I guess we can't get around it.
DARIUS DALE: Quick question. Are they making a distinction between the ongoing Delta wave and the Omicron wave adding to that? Or are they saying, hey, look, COVID is COVID, we don't care?
ALFONSO PECCATIELLO: Well, they first started tightening in on the upside of the Delta wave itself. And then when Omicron came on top, they just said, okay, well, if you look at the projections of ICU hospitals, we're not doing good. The interesting part is that if you look at the intake of Omicron patients in the ICU, it's not extremely large, and especially the recovery period of these patients out of the ICU seems to be much faster than it was with previous waves. People take generally like, only 20% of the time, they took in previous waves to get out of ICU. Apparently symptoms are a bit milder than they were before.
DARIUS DALE: Yeah, well, not only 20% of the time, but it's only 20% of the hospitalizations if you look at the South Africa study data that was published this morning. I think that's a lot of what's driven the market higher. This growing realization that Omicron could actually be a blessing in disguise in terms of advancing society forward and out of the pandemic state phase of this whole process.
ALFONSO PECCATIELLO: Yeah, I think it's a good point. I also tried to look up for the date of booster shots which clearly can help in the process of getting this immunity back in. We have a chart we pulled up here. And I tried to plot the larger European counties and the US. And this chart shows the percentage of population which has already gotten a third shot for COVID.
And what is really impressive is the shape of the curve in European countries. They've really accelerated this campaign as you can see. It's already, like in Germany, for example, 35% of population has already got the third shot. And they announced that they're probably going to be able to do 60% of population by end of January. Once you have done that, I guess you can more confidently reopen already in February and the market seems to cherish this aspect today.
DARIUS DALE: Yeah, well, the one thing I'll piggyback on that, I saw some data from Johns Hopkins suggesting that the booster shot itself may only be good for a couple months of immunity with respect to this variant. It's going to be a fit and start process. But ultimately, where society has to go is something I've been saying for nine months now, which is this is an endemic. Treat it like the seasonal flu and move on. I think Omicron may be in fact, the catalyst for that, but we shall see.
ALFONSO PECCATIELLO: Yeah, indeed. What's really important here is this dichotomy between short term negative impact on growth that we are going to see, already we are seeing in some data coming in, but probably in January and February data, we might see some second round effects.
But you and I were chatting offline trying to really learn from each other and understand, what does this economy look like in 2022? Are we going to above potential trend GDP? Or are we just growing at trend GDP next year? How do you see that?
DARIUS DALE: Yeah, no. I think the consensus expectation is very much that we are going to still be comfortably above trend from growth expectations. For example, in the US in particular, Bloomberg consensus expectations for real GDP growth for next year is 3.9%. The five-year trend through 2019 is somewhere around 2.2%, 2.25%. That's obviously comfortably north of that.
It's the same with the Europe as well if you look at the Eurozone expectations, 4.2% GDP, the five-year trend through 2019 is 0.9%. And then the same for the globe, 4.3% expectation, five-year trend through 2019, 1.1%. The economists' consensus, and I would argue the economists' consensus forecasts certainly feed into certainly sell side expectations for earnings and things of that nature.
The street is already there in terms of reopening this economy into something that's a boom economy but the reality is I think the big question for investors is whether or not that's true. We've done a lot, we're starting to do a lot of work on unpacking that debate, if you will.
ALFONSO PECCATIELLO: Yeah. And the interesting part is that if you look at some parts of the market, they don't seem to believe this narrative too much. If you look at the bond market and what's priced in compared to what the Fed dotplot is pricing in, and especially if you look at more like the terminal rate, so the long term trends and how sustainable this growth path is, forward Fed Funds Futures are pricing a hiking cycle to stop at 1.50%, maybe 1.75%. And the Fed is telling you, terminal rate is 2.5%, and we're going to get there.
The bond market seems to be a bit hesitant to price in this sustainable above trend growth, while economists' consensus, as you said, seems to be pretty optimistic. What is the truth actually?
DARIUS DALE: Yeah. It's to be determined. We put together some analysis for you guys in terms of trying to get to that truth. One thing I'll start by saying is when the Fed is also very much in the camp that growth will be comfortably above trend next year. You have economists' consensus, Fed consensus, and I would argue, sell side consensus as it relates to consensus earnings expectations are all on one side of the boat.
The risk, according to the bond market, is that that expectation is ultimately proved to be false. The first analysis I wanted to show is the goods consumption trend relative to the services consumption trend, because clearly, there's this expectation that once the economy fully reopens, we're going to have this big lurching forward of services consumption demand relative to growth assumption demand that keeps the economy from slowing to a below trend growth rate.
When we actually do the math on it from a real goods consumption perspective, we're 538 billion north of where the trend line is through 2019, the five-year trend line through 2019. From services consumption, we're at 359 billion south of that trend line. That's a net minus $180 billion in terms of the deviation from trends we're likely to see from the goods and services side of the economy. How do we fill that hole? That's question number one that I think the bond market is wrestling with.
And then question number two, if you look at the GDP trend versus the fiscal balance, another chart I sent, you look at that, so GDP is obviously still in its below trend the output gap, or technically is systematically not necessarily fully closed. But then when you look at the fiscal balance, we are six percentage points below trend in terms of the US fiscal balance in terms of where we are.
There's not a ton of new laws, obviously, we're learning from Senator Manchin this past few days, there's not a ton of new law that suggests we got to stay down there. We could actually have a pretty sharp and meaningful fiscal contraction that takes place over the course of fiscal 2022, and maybe into the early part of fiscal 2023 that actually stymies that process of-- that actually accelerates the process of growth returning back to trend.
That to me is all on the negative side of the ledger. On the positive side of the ledger, and this is the number one pushback when I even just have this discussion with institutional clients, which is there's a ton of cash on the sideline. And that is very true. If you look at household net worth, obviously, household net worth is comfortably above trend to the tune of about 18 trillion in terms of overall aggregate net worth, but there's a ton of cash on the sidelines as well.
You look at the household cash, it's right around 3.7 trillion, that's about 2.6 trillion of delta relative to the five-year trend through 2019. There's a lot of money on the sidelines that could potentially be put to work in the real economy, mostly as a function of savings from the fiscal programs that we've seen thus far. But then the last chart I'll share is, look, the bottom 50% of households by household net worth in this country in the United States only account for 2.3% of all that household net worth.
There's a lot of moving parts. There's a lot of mixed signals, but I tend to side with the bond market in that because the consensus is all expecting above trend growth next year, and including the Fed, the reality is anything less than that is likely to cause some market activity.
ALFONSO PECCATIELLO: Yeah. I like to unpack a little bit, there's tons of information that you provided for our listeners, and one of the most relevant things you said in my opinion is the fiscal drag or the definition of a fiscal drag. The narrative out there is that governments are going to relentlessly keep on spending and keep on printing fiscal deficits. And we have seen already with the BBB plan that, yeah, maybe when inflation is already running at 6% and the projection for next year is already an above trend economy.
As a politician, you might want to maybe slow down a bit and keep your powder dry. It's easier to sell a narrative but the reality is that politics is all about compromise and especially keeping the status quo. Pushing on the accelerator pedal again, when the economy's already running relatively hot, it's not a great risk reward trade for a politician. It's not as easy as it might look like from the outside.
And the fiscal impulse and the credit impulse is as important as the level of deficits. In order to keep this above trend growth stimulating, you need to print more and more. Every year, you need to accelerate the pace of fiscal deficits, which as you pointed out, it's unlikely to happen next year. That's the definition of a fiscal drag that we are likely going to see in the bond market, as I showed in one of my last articles at The Macro Compass, but it's strongly disagreeing with the Fed.
This chart we can try to pull up shows that basically, expectations are a full percentage point away. The bond market is telling, well, next year, we do agree. If you look at the chart in there, December 22, three hikes. Yes, guys, we can do that next year. We agree with you.
And after that, sorry, but we flattened out pretty aggressively. The dotted black line is the FOMC median dots. And the orange line is the Fed Funds future being priced by traders that just don't believe we can go ahead with that.
DARIUS DALE: Yeah. I don't believe we can, either. Again, I think it's very difficult in the absence of incremental confirmation from high frequency data, which is something we certainly specialize in and been counting everything through the lens of our nowcast models. Until you get real confirmation on the magnitude, because we know the direction travels lower. We're not going to grow 5% again, it's probably lower.
But the reality is, is it at 4% or is it 2.25%, which is probably the appropriate growth rate for the economy absent all this incremental fiscal stimulus, and more importantly, with the addition of monetary tightening. I think we shall see, it's the real will debate out there. But again, I want to leave everyone with this very simple point.
The Fed, economists' consensus, sell side consensus already expects comfortably above trend growth next year, not just in the US economy, but also in the global economy, particularly in Europe as well. China's the only economy I've done this analysis for where the growth expectations are right around their trendline. The market expectation on China, if you're going to go buy something as an expectation of the pandemic being open, I'd say go buy China before you go buy anything else.
ALFONSO PECCATIELLO: Yeah, that's a very good point. And as we're talking a lot about economies and forecasts, etc., I want to make this a little bit more applicable for our listeners. If we look at asset classes here, and let's start first from the broad topic, S&P 500, you're looking at a relatively broad index, well, not that broad, still market cap weighted and skewed towards certain sectors, but what will be your view on this asset class? Is it something you want to lean long for next year? Or you'd rather prefer certain sectors? Do you have a target for the S&P next year?
DARIUS DALE: No, we don't do targets. I think that's a sell side activity. Man, we're trying to buy side macro for our buy side clients. No, the reality is, for us, it's all about sector and style factor dispersion. That's the name of the game on the buy side. That's the name of the game of what we try to do here at 42Macro. From a portfolio construction perspective, let's start with the asset allocation perspective, you probably want to be long less equities than you are in 2021. You probably want to be more longer more bonds than you were throughout 2021.
And again, we made all these calls going back to November of 2020 in terms of shorting the bond market, getting extremely long high beta stocks and things of that nature. We had some chops on this. But now we're on the wrong side of the cycle in terms of the rate of change cycle for growth, the rate of change cycle for inflation, and obviously, we're talking about a dual fiscal monetary policy tightening.
You add all those factors and variables together, you wind up with want to be in low beta securities, you want to be in the Russ, the REITs, the utilities, the staples of the world. Healthcare obviously is one of those sectors as well. But then it starts to run pretty thin in the equity market in terms of the sectors and style factors you're going to want to be long.
But again, you're just going to want to generally be a lot less longer of equity risk, because the reality is, in an environment where growth and inflation are slowing, potentially to at trend or below trend level, even if it slows to at trend, you're going to have a massive downside surprise to consensus expectations. You're talking about 150, 175 basis points in one calendar year. That's going to cause some problems in asset markets.
If we just slow to where people already expect it to, you're talking about earnings growth being really the only driver of equity markets, because you're probably going to lose the multiple expansion. It's going to be a tough slog, it could be a much more volatile slog as well to the extent that the growth expectation just does not come to fruition. That's what we guys are thinking.
ALFONSO PECCATIELLO: That's good. The interesting part is that our views are relatively similar, and I think that there is a window going into next year where there are some chances still to be long. I do agree with you that it's rather a low beta than a high beta long in the equity market. I am also very wary of valuations, and we can talk about that later, but I just wanted to first draw the attention of our listeners to the fact that I've interviewed, and the interview is going to be aired tomorrow, a new joiner to the show at Real Vision, Andy Constan.
You might have known in from Twitter, @DampedSpring is his Twitter handle, and the great wealth of experience trading for large shops in America. And I asked him what his target for S&P 500. Let's listen in for a second on what he said.
ANDY CONSTAN: I don't like targets. I know for a fact that between now and 2022, I will be max short equities at some point. I have a very simple thing. I am long. I put targets out because people seem to like them. My current target is 5000 for the S&P by the end of the first quarter. And more relevantly, I've got the 4800, 5000 call spread in March as my expression of my view, which I think is much better than a target and has skin in the game.
ALFONSO PECCATIELLO: And we're back. You asked question about valuations. We talked about earnings, and we talked about the long term growth or trend growth, but valuations and the delta valuation is also extremely important to assess equity market returns. If you look at valuations and you try to plot them against something to see if there is an explanatory variable here and there, there are a couple of things that generally make sense, and one of it is risk free real rates.
If the interest rate adjusted for inflation you can own by simply sitting on a relatively risk free security, like the Treasury, for example, is x, then obviously, when you look at valuations, and whether you want to be rewarded for taking risk, there is going to be some relationship between the two. And actually, the residual between the two is what we call that equity risk premium or a proxy for equity risk premium.
Now, obviously, if the Federal Reserve is going to tighten monetary policy next year, as we think it is, on the backdrop of a slowing growth involves an inflationary impulse and the same is going to happen by the way at the European level, and we can touch upon that a little bit later, the chance that risk free real rates are going to remain so depressed as they are now, if not that high. And if you have this gentle tightening process, at least that's what central banks are trying to engineer, that pushes real rates up, risk free real rates up, it's hard for the valuation side of the stock market, especially the high beta part to remain that [?].
I tend also to steer a little bit away from that asset allocation and that sector at the moment and prefer the more conservative side of the equity market, but still trying to be long, because we are not in mayhem yet. This is not the moment to run for the hills straightaway.
DARIUS DALE: Yeah, totally. And our back tests will definitely support exactly what you just said, which is when growth and inflation are slowing, generally, you want to be in lower beta securities. That isn't necessarily you would want to