Economy

Listen to a short summary of this report.       Executive Summary Global Equities Are More Attractively Valued After The Recent Sell-Off We tactically downgraded global equities in late February but see the current level of stock prices as offering enough upside to warrant an overweight. Global equities are now trading at 15.6-times forward earnings, and only 12.6-times outside the US. More importantly, the forces that pushed down stock prices are starting to abate: The war in Ukraine no longer seems likely to devolve into a broader conflict; the number of new Covid cases in China has fallen by half; and global inflation has peaked. The next 18 months of falling inflation and receding recession fears could see stocks recover much of their losses. The “Last Hurrah” for equities is coming. We continue to think that over a 5-year horizon, bond yields will rise from current levels, value stocks will outperform growth stocks, and crypto prices will fall. However, countertrend rallies are likely. To express this view, we recommend taking partial profits on our short 10-year Treasury trade recommendation (up 9.3% from an initial entry yield of 1.45% on June 30, 2021). We are also halving our long global value/growth position (up 20.1% since inception on December 10, 2020) and our short Bitcoin position (up 98% based on our exponential shorting technique). Bottom Line: Global equities are heading towards a “last Hurrah” starting in the second half of this year. Tactically upgrade stocks to overweight.   Feature Dear Client, We published a Special Alert early this afternoon tactically upgrading global equities to overweight. As promised, the enclosed report elaborates on our view change. Best regards, Peter Berezin Restore Tactical Overweight On Global Equities Chart 1Global Equities Are More Attractively Valued After The Recent Sell-Off We tactically downgraded global equities from overweight to neutral on February 28th. The war in Ukraine, the Covid outbreak in China, and most importantly, the rise in bond yields have kept us on the sidelines ever since. At this point, however, the outlook for stocks has brightened, and thus we are restoring our tactical (3-month) overweight to stocks so that it is consistent with our bullish 12-month cyclical view. First, valuations have discounted much of the bad news. After the recent sell-off, global equities are trading at 15.6-times forward earnings (Chart 1). Outside the US, they trade at only 12.6-times forward earnings. Second, the forces that pushed down stock prices are starting to abate. The war in Ukraine is approaching a stalemate, with Russian troops unable to take much of the country, let alone seriously threaten regional neighbours. A European embargo on Russian oil is likely but will be watered down significantly before it is implemented. European officials have shied away from banning Russian natural gas, an action that would have much more severe economic implications. While still very high in absolute terms, December-2022 European natural gas futures are down 36% from their peak on March 7 (Chart 2). The 7-day average of new Covid cases in China has fallen by more than half since late April (Chart 3). Considering that a significant fraction of China’s elderly population is unvaccinated, the authorities will continue to play whack-a-mole with the virus for the next few months (Chart 4). Fortunately, Chinese domestic production of Pfizer’s Paxlovid anti-Covid drug is starting to ramp up, which should allow for some easing in lockdown measures later this year. Chart 2European Natural Gas Futures Have Come Off The Boil Chart 3Covid Cases Are Falling In China… The 20th Chinese National Party Congress is slated for this fall. In the lead-up to the Congress, it is likely that the government will move to diffuse social tensions over its handling of the pandemic by showering the economy with stimulus funds. Of note, the credit impulse has already turned higher, which bodes well for both Chinese growth and growth abroad (Chart 5). Chart 4… But Low Vaccination Rates Among The Elderly Remain A Risk Chart 5A Rebound In China's Credit Impulse Bodes Well For China And The Rest Of The World   Inflation Is Peaking On the inflation front, the data flow has gone from unambiguously bad to neutral (and perhaps even slightly positive). In the US, core goods inflation fell by 0.4% month-over-month in April, the first outright decline in core goods prices since February 2021. The Manheim Used Vehicle Value Index has crested and is now 6.4% below its January peak (Chart 6). Global shipping rates have moved up a bit recently on the back of Chinese port shutdowns but remain well below their highs earlier this year (Chart 7). Chart 6Used Car Prices Appear To Have Peaked Chart 7Global Shipping Rates Are Well Off Their Highs It Is The Composition Of Spending That Is Distorted Despite the often-heard claim that US consumer spending is well above trend, the reality is that spending is more or less in line with its pre-pandemic trend (Chart 8). It is the composition of spending that is out of line: Goods spending is well above trend while services spending is well below. One might think that only the overall level of spending should matter for inflation, and that the composition of spending is irrelevant. However, this ignores the reality that services prices are generally stickier than goods prices. Companies that sold fitness equipment during the pandemic had no qualms about raising prices. In contrast, gyms barely cut prices, figuring that lower membership fees would do little to drive new business through the door (Chart 9). Chart 8Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Chart 9Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices This asymmetry matters, and it suggests that goods inflation should continue to fall over the coming months as the composition of spending shifts back to services. A Lull In Wage Growth Wages are the most important determinant of services inflation. While it is too early to be certain, the latest data suggest that wage growth has peaked. The 3-month annualized growth rate in average hourly earnings for production and nonsupervisory workers slowed from 7.2% in the second half of 2021 to 3.8% in April (Chart 10). Assuming productivity growth of around 1.5%, this is consistent with inflation of only slightly more than 2%. Nominal wage growth is a function of both labor market slack and expected inflation. Slack should increase modestly during the rest of the year as labor participation recovers. Chart 11 shows that the labor force participation rate is still about 0.9 percentage points below where one would expect it to be, even adjusting for an aging population and increased early retirements. Chart 10Wage Growth Seems To Be Topping Out Chart 11Labor Participation Has Further Scope To Recover Employment has been particularly depressed among lower-wage workers (Chart 12). This should change as more low-wage workers exhaust their savings and are forced to seek employment. According to the Fed, the lowest-paid 20% of workers are the only group to have seen their bank deposits dwindle since mid-2021 (Chart 13). Chart 12More Low-Wage Employees Will Return To Work Chart 13The Savings Of Low-Wage Workers Are Dwindling Inflation expectations should come down as goods inflation recedes and oil prices come off their highs (Chart 14). Bob Ryan, BCA’s Chief Commodity Strategist, sees the price of Brent averaging $86/bbl in the second half of this year, down 16% from current levels.  Central Banks Will Dial Back The Hawkishness With inflation set to fall over the remainder of the year, and financial markets showing increasing signs of stress, the Fed and other central banks will adopt a softer tone. It is worth noting that the median terminal dot for the Fed funds rate actually declined from 2.5% to 2.4% in the March Summary of Economic Projections (Chart 15). Given that markets expect US interest rates to rise to 3.25% in 2023, the Fed may not want investors to further rachet up rate expectations. Chart 14US Inflation Expectations Should Recede If Oil Prices Drop Chart 15Rate Expectations Have Moved Well Above The Fed's Estimate of Neutral   The Bank of England has already veered in a more dovish direction. Its latest forecast, released on May 5, showed real GDP contracting slightly in 2023. Based on market interest rate expectations, the BoE sees headline inflation falling to 1.5% by end-2024, below its target of 2%. Even assuming that interest rates remain at 1%, the BoE believes that inflation will only be slightly above 2% at the end of 2024, implying little need for incremental policy tightening. Not surprisingly, the pound has sold off. We have been tactically short GBP/USD but are using this opportunity to turn tactically neutral. Given favorable valuations, we like the pound over the long run. Chart 16Spending In The Euro Area Is Well Below Its Pre-Pandemic Trend The euro area provides a good example of the dangers of focusing too much on short-term inflation dynamics. Supply-side disruptions stemming from the pandemic and the war in Ukraine have weighed on European growth this year. Yet, those very same factors have also pushed up inflation. Harmonized inflation across the euro area reached 7.5% in April, the highest since the launch of the common currency. The ECB is eager to put some distance between policy rates and the zero bound. However, there is little need for significant tightening. Unlike in the US, spending in the euro area is well below its pre-pandemic trend (Chart 16). If anything, more inflation would be welcome since that would give the ECB scope to bring real rates further into negative territory if economic conditions warrant it. To its credit, the Bank of Japan has stuck with its yield curve control system, even as bond yields have risen elsewhere in the world. Japan’s currency has weakened but given that inflation expectations are too low, and virtually all of its debt is denominated in yen, that is hardly a bad thing. Too Late? Has the surge in bond yields already done enough damage to the global economy to make a recession inevitable? We do not think so. As noted above, much of the recent harm has been caused by various dislocations, namely the war in Ukraine and the ongoing effects of the pandemic. As these dislocations dissipate, inflation will fall and global growth will recover. Despite the hoopla over how the US economy contracted in the first quarter, real private final sales to domestic purchasers (a measure of GDP growth that strips out the effects of changes in government spending, inventories, and net exports) rose by 3.7% at an annualized rate. As Table 1 shows, this measure of economic activity has the highest predictive power for GDP growth one-quarter ahead. Table 1A Good Sign: Real Final Sales To Private Domestic Purchasers Rose By 3.7% In Q1 Meanwhile, and completely overlooked at this point, S&P 500 earnings have come in 7.3% above expectations so far in Q1, with nearly 80% of S&P 500 companies surprising on the upside. Earnings are up 10.4% year-over-year in Q1. Sales are up 13.6%. Looking out to Q4 of 2022, S&P companies are expected to earn $60.93 in EPS, up 4.3% from what analysts expected at the start of the year. It is also worth noting that homebuilder stocks have basically been flat over the past 30 days, even as the S&P 500 has dropped by nearly 10% over this period. Housing is the most interest rate-sensitive sector of the economy. With the homeowner vacancy rate at record low levels, even today’s mortgage rates may not be enough to push the economy into recession (Chart 17). Economic vulnerabilities are greater outside the US. Nevertheless, there is enough pent-up demand on both the consumer and capital spending side to sustain growth. The Last Hurrah How long will the “Goldilocks” period of falling inflation and supply-side driven growth last? Our guess is about 18 months, starting this summer and lasting until the end of 2023. Unfortunately, as is often the case, the benign environment that will emerge in the second half of this year will sow the seeds of its own demise. Real wages are currently falling across the major economies (Chart 18). That has dampened consumer confidence and spending. However, as inflation comes down, real wage growth will turn positive. This will stoke demand, leading to a reacceleration in inflation, most likely in late 2023 or early 2024. Chart 17Tight Supply Makes Housing More Resilient Chart 18Real Wages Are Falling In Most Countries   In the end, central banks will discover that the neutral rate of interest is higher than they thought. That is good news for stocks in the short-to-medium run because it means that forthcoming rate hikes will not induce a recession. Down the road, however, a higher neutral rate means that investors will eventually need to value stocks using a higher discount rate. It also means that the disinflation we envision over the next 18 months will not last. All this puts us in the rather lonely “transitory transitory” camp: We think much of today’s high inflation will prove to be transitory, but the transitory nature of that inflation will itself be transitory. Be that as it may, the next 18 months of falling inflation and receding recession fears could see stocks recover much of their losses. For most investors, that is too long a period to sit on the sidelines. The “Last Hurrah” for equities is coming. Taking Partial Profits On Our Short Treasury, Long Value/Growth, And Short Bitcoin Trades We continue to think that over a 5-year horizon, bond yields will rise from current levels, value stocks will outperform growth stocks, and crypto prices will fall. However, with the “Last Hurrah” approaching, countertrend rallies are likely. To express this view, we recommend taking half profits on our short 10-year Treasury trade recommendation (up 9.3% from an initial entry yield of 1.45% on June 30, 2021). We are also halving our long global value/growth position (up 20.1% since inception on December 10, 2020), and our short Bitcoin position (up 98% based on our exponential shorting technique). Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Executive Summary The Fed offered more explicit near-term forward rate guidance at its meeting last week. This guidance will reduce yield volatility at the front-end of the curve during the next few months. We expect the Fed to deliver two more 50 basis point rate hikes (in June and July) before settling into a pattern of hiking by 25 bps at each meeting. Our anticipated Fed hike path is shallower than what is priced in the market, but it also lasts longer. Investors should position for this outcome by buying the December 2022 SOFR futures contract versus the December 2024 contract. Economic and financial market indicators suggest that the 10-year Treasury yield will fall back during the next six months, alongside falling inflation. Rate Expectations Bottom Line: Investors should keep portfolio duration close to benchmark for now, though we expect to get an opportunity to reduce portfolio duration later this year once inflation and bond yields are lower. Feature Last week was a chaotic one for the US bond market. Treasury yields rose and the Fed delivered its first 50 basis point rate increase since 2000. Yet, there is a broad consensus that the Fed’s message was dovish relative to expectations. In this week’s report we try to make sense of these confusing market signals. We do this by focusing on two important occurrences: (1) The Fed’s “dovish” 50 basis point rate hike and (2) The 10-year Treasury yield breaking above 3% for the first time since 2018. The Fed Takes Back Control Chart 1An Uncertain Rates Market Fed Chair Jay Powell had a clear agenda for last week’s FOMC press conference. Simply, he wanted to provide more concrete forward rate guidance to a market that had become increasingly volatile (Chart 1). The problem is that while the Fed had been explicit about its intention to lift rates, it hadn’t provided any firm guidance about its anticipated pace of tightening. This led to wild speculation in rates markets. Will the Fed lift rates at every meeting or every other meeting? Will it move in traditional 25 basis point increments or perhaps 50 basis point increments? Maybe even 75 basis point increments? This sort of speculation is unacceptable to Chair Powell who said in his opening remarks that the Fed “will strive to avoid adding uncertainty to what is already an extraordinarily challenging and uncertain time.”1 New Explicit Forward Guidance From Chair Powell’s post-meeting press conference, we can discern the following about the Fed’s near-term rate hike intentions. The Fed will not lift rates by 75 basis points at any single meeting. Two more 50 basis point rate hikes are likely at the June and July FOMC meetings. After July, the Fed will likely continue to lift rates at each FOMC meeting. Inflation’s trend will dictate whether these rate increases are delivered in 50 bps or 25 bps increments. The Fed will continue to lift rates at every meeting until it is confident that it has “done enough to get us on a path to restore price stability.” It’s also worth noting that, in addition to delivering a 50 basis point rate hike and providing firmer forward rate guidance, the Fed announced that it will begin shrinking its balance sheet on June 1. The Fed will follow the plan that was presented in the minutes from the March FOMC meeting and that we discussed in a recent report.2 Turning to markets, we see that the overnight index swap curve (OIS) is priced for an additional 201 bps of rate increases between now and the end of 2022 (Chart 2). This is consistent with three more 50 basis point rate hikes and two more 25 basis point rate hikes at this year’s five remaining FOMC meetings. If delivered, those hikes would bring the fed funds rate up to a range of 2.75% to 3.00%. Chart 2Rate Expectations Looking out until the end of 2023, we see the OIS curve priced for 262 bps of rate increases. That is, the market is priced for roughly 200 bps of tightening between now and the end of 2022, but only another 62 bps of rate increases in 2023. In fact, Chart 2 shows that the OIS curve has the funds rate peaking at 3.49% near the middle of 2023 and then edging slowly back down. Related Report  US Investment StrategyWage-Price Spiral? Not So Fast Based on our view that inflation will decline between now and the end of the year, we see the Fed delivering only 175 bps of additional tightening this year (50 bps rate hikes in June and July, followed by three more 25 bps hikes). This is slightly lower than what is priced in the curve. However, given the strong state of private sector balance sheets, we can also easily envision 25 basis point rate increases continuing at every meeting in 2023. That scenario would push the fed funds rate above 4% by the end of 2023, significantly higher than what is priced in the market. We recommend that investors position for this “slower, but longer” tightening cycle by buying the December 2022 SOFR futures contract versus the December 2024 contract (see “Yield Curve Trades” table on page 12). Charts 3A-3D focus more specifically on what’s priced in for the next few FOMC meetings. The charts show where the fed funds rate is expected to land after each meeting, as implied by the fed funds futures curve. Additionally, we use an ‘x’ to denote where we expect the fed funds rate to be at the end of each meeting. You can see that we expect the fed funds rate to be about 25 bps lower than the market by the end of September. Our expectation of a slower near-term hike pace stems from our view that inflation has already peaked.3 With that in mind, it’s notable that monthly core PCE inflation printed below levels consistent with the Fed’s 2022 forecasts in both February and March (Chart 4). In addition, last week’s employment report showed a significant deceleration in average hourly earnings (Chart 5). Average hourly earnings are an imperfect wage measure because they don’t adjust for the changing industry composition of the workforce. However, an adjusted measure that gives each industry group equal weighting is also starting to slow (Chart 5, bottom panel). Chart 3AMay 2022 FOMC Meeting Chart 3BJune 2022 FOMC Meeting Chart 3CJuly 2022 FOMC Meeting Chart 3DSeptember 2022 FOMC Meeting Chart 4Tracking Below The Fed's Forecast Chart 5Peak Wage Growth Bottom Line: The Fed’s more explicit rate guidance will reduce yield volatility at the front-end of the curve. Two more 50 basis point rate hikes are likely in June and July, but we expect falling inflation will prompt the Fed to switch to 25 basis point hikes after that. We also expect the tightening cycle to last longer than what is currently priced in the curve. Investors should keep portfolio duration close to benchmark and should position for our expected “slower, but longer” tightening cycle by owning the December 2022 SOFR futures contract versus the December 2024 contract. A Quick Note On The Neutral Rate And Financial Conditions Chart 6Financial Conditions Chart 2 shows that the market expects the Fed to lift the funds rate until it is slightly above the range of the Fed’s long-run neutral rate estimates (2% - 3%). At that point, restrictive monetary policy will presumably weigh on economic growth enough for the Fed to back away from tightening. While forecasters need some estimate of the neutral rate to predict where bond yields will land at the end of the cycle, it’s important to understand that Fed policymakers are not guided by these same concerns. In fact, Chair Powell said the following last week when asked whether the Fed intended to lift rates above estimates of neutral: … there’s not a bright line drawn on the road that tells us when we get [to neutral]. So we’re going to be looking at financial conditions, right. Our policy affects financial conditions and financial conditions affect the economy. So we’re going to be looking at the effect of our policy moves on financial conditions. Are they tightening appropriately? And then we’re going to be looking at the effects on the economy. And we’re going to be making a judgment about whether we’ve done enough to get us on a path to restore price stability. In other words, actual Fed policy will not be guided by neutral rate estimates. Instead, the Fed will continue lifting rates at a regular pace until it sees enough evidence of tightening financial conditions and slowing inflation. For this reason, it will be critical to monitor broad indexes of financial conditions as the Fed tightens policy. At present, the Goldman Sachs Financial Conditions Index remains deep in “accommodative” territory, but it is rising quickly (Chart 6). Based on history, we might expect the pace of tightening to slow once the index breaks into “restrictive” territory. Conversely, if financial conditions don’t tighten very much, then it will encourage the Fed to hike more aggressively.  The Return Of 3% Treasury Yields Chart 7Back Above 3% The 10-year Treasury yield broke above 3% after the FOMC meeting on Wednesday and it has so far held firm above that key psychological level. The last time the 10-year yield reached these heights was near the end of the last tightening cycle in 2018 (Chart 7). One big difference between today and 2018 being that today’s 3% 10-year yield consists of a much higher inflation component and a much lower real yield (Chart 7, bottom panel). At 2.88%, the cost of inflation compensation embedded in the 10-year yield is too high, and it will fall as inflation rolls over and the Fed tightens. There is a question, however, about whether this drop in 10-year inflation expectations will translate into a lower nominal bond yield or simply be offset by a rising 10-year real yield. The answer will depend on how quickly inflation comes down off its highs. Chart 85y5y Is Above Neutral If inflation falls quickly during the next few months, then the market will start to price-in a less aggressive Fed. This will hold down the 10-year real yield. However, if inflation remains sticky near its current level, then the market will judge that the Fed still has a lot of work to do. This will pressure 10-year real yields higher even if long-dated inflation expectations recede. It’s often simpler to ignore the breakdown between real yields and inflation expectations and focus purely on the nominal bond yield itself. This exercise strongly suggests that long-maturity nominal bond yields will fall back somewhat during the next six months. First, we observe that the 5-year/5-year forward Treasury yield has risen to 3.19%, above the upper-end of survey estimates of the long-run neutral fed funds rate (Chart 8). Long-maturity forward yields have rarely moved much above the range of neutral rate estimates during the past decade. Second, high-frequency indicators that historically correlate with bond yields have not justified the recent move higher in the 10-year yield. The ratio between the CRB Raw Industrials commodity price index and gold and the relative performance of cyclical versus defensive equity sectors have both stalled out, even as yields have shot up (Chart 9). Finally, the change in bond yields correlates strongly with the level of economic data surprises. Positive data surprises tend to coincide with a rising Treasury yield, and vice-versa. Economic data surprises have been positive during the past few months, justifying the move higher in yields (Chart 10). However, that trend is poised to reverse in the coming months. Economic momentum is bound to slow now that the Fed is tightening and the labor market is close to full employment. Further, the Economic Surprise Index exhibits a strong mean-reverting pattern. Extremely high values tend to be followed by lower values, and vice-versa. A simple auto-regressive model of the Surprise Index suggests that it is on track to turn negative within the next month. Chart 9Bonds Go Their Own Way Chart 10Economic Data Surprises Bottom Line: Our indicators suggest that the 10-year Treasury yield will fall back somewhat during the next six months. That said, on a longer-run horizon we continue to expect that interest rates will rise further than the market anticipates. Investors should maintain neutral portfolio duration for now, but stand ready to re-initiate below-benchmark positions later this year once inflation and bond yields are lower. A Quick Note On The Yield Curve And Credit Spreads Yield Curve Positioning Not only have bond yields increased since the Fed meeting last Wednesday, but the Treasury curve has also steepened significantly. The turnaround in the yield curve has been startling. The 2-year/10-year Treasury slope was inverted one month ago, but it is now back up to 40 bps (Chart 11). But despite the big moves in the 2/10 slope, the yield curve remains quite flat beyond the 5-year maturity point. In fact, the 2/5/10 butterfly spread – the 5-year yield minus the yield on a duration-matched 2/10 barbell – remains far too high compared to the 2/10 slope (Chart 11, bottom 2 panels). Therefore, our recommended yield curve positioning remains unchanged. Investors should buy the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. Credit Spreads A steeper yield curve has positive implications for corporate bond spreads. All else equal, a steeper yield curve suggests that we are further away from the end of the economic recovery, meaning that corporate bonds have a longer window for outperformance. That said, at 40 bps, the 2-year/10-year Treasury slope is still relatively flat, and while corporate bond spreads have widened during the past few months, the high-yield index option-adjusted spread is still close to its 2019 level and the 12-month breakeven spread for the investment grade index is still below its median since 1995 (Chart 12). Chart 11Favor The 5-Year Chart 12Corporate Bond Valuation We remain cautious on corporate credit for the time being. Specifically, we recommend an underweight allocation (2 out of 5) to investment grade corporates and a neutral allocation (3 out of 5) to high-yield. However, if the 2-year/10-year Treasury slope were to steepen to above 50 bps and/or if corporate bond spreads were to widen further, then we may see an opportunity this year to tactically increase exposure. Stay tuned. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1    https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20220504.p… 2    Please see US Bond Strategy Weekly Report, “Peak Inflation,” dated April 19, 2022. 3    Please see US Bond Strategy Weekly Report, “Peak Inflation,” dated April 19, 2022.   Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary Ingredients For A Policy Mistake The hawks on the European Central Bank Governing Council have become vocal about a July rate hike. Such a move would be a policy mistake because European growth is weak, while inflation is supply-driven and will soften meaningfully. July 2022 hike is not yet certain. A policy mistake suggests that the current interest rate pricing for June 23 is too aggressive. Buy June 2023 Euribor contract. The serious risk of a policy mistake and the uncertainty surrounding Europe’s energy security confirm that investors should maintain a defensive stance in European assets. The pronounced threats to UK growth warrant a negative view on the pound.   Recommendation INCEPTION DATE RETURN SINCE INCEPTION (%) COMMENT Buy June 2023 Euribor contract 05/09/2022     Bottom Line: Stay defensive in Europe. The risk of a policy mistake is high. Only when inflation peaks should investors move into cyclical stocks.   In recent weeks, a chorus of ECB hawks expressed the need to increase rates as early as July 2022. Inflation data is on their side; HICP stands at 7.5% and core CPI has reached 3.5%, levels never seen since the introduction of the euro. Markets are responding. The ESTR curve is pricing in a positive ECB deposit rate for the October 2022 Governing Council meeting. We need to examine the underlying European economic picture to address two key questions: Will the ECB lift rates as early as July? And will doing so constitute a policy mistake that would hurt European assets? Weaker Growth Let’s start with the growth outlook. European economic activity is rapidly deteriorating. Real GDP growth in the Eurozone has slowed markedly. In Q1, real GDP growth fell to 0.2% quarter-on-quarter or an annualized rate of 0.8%. Worrisomely, Italy’s GDP contracted by -0.2% over that time frame and the very economically sensitive Swedish activity contracted by -0.4%, which suggests that Europe’s deceleration is only starting. Soft data confirm the flagging economic outlook on the continent. Consumer confidence is plunging to levels that are consistent with a recession, led by the collapse in the willingness to make large purchases (Chart 1, top panel). The ZEW as well as the Ifo survey confirm that growth expectations point to a very large decline in output (Chart 1, bottom panel). The weakness is also evident in hard data. High inflation erodes real household income, which squeezes consumer spending. Retail sales across Europe are slowing sharply, only growing at an annual rate of 0.8% while contracting -0.4% on a monthly basis; on a level basis, they are lower today than they were in June 2021. Meanwhile, German retail sales volumes are falling at a -5.4% annual rate. The situation is even worse for new car registrations, which are collapsing at an annual rate of 20.2% (Chart 2). Chart 1Soft Data Point To Soft Growth... Chart 2...So Do Hard Data Industrial production has not been spared. Euro Area IP softened to 2% annually in February and contractions are now visible in Germany and France. Some of this weakness reflects supply difficulties, but the -3.1% annual fall in German factory orders indicates that demand is frail too and that industrial production will shrink further in the months ahead (Chart 2, bottom panel). The deterioration in the global outlook further hurts Europe economic prospects. Our global growth tax indicator, based on energy prices, the dollar, and global bond yields, points toward a further deceleration in the global and US manufacturing PMI, it suggests Euro Area PMIs could fall below 50 (Chart 3). China woes continue to reverberate throughout the global economy. Potential supply constraints will hurt industrial production, but, more importantly, the weakness in China’s marginal propensity to consume (as measured by the gap between the growth rate of M1 relative to M2) predicts a much greater deterioration in European industrial orders, which means that the demand for European capital goods will slow (Chart 3, bottom panel). Chart 3Risks To The Downside Chart 4Tightening Financial Conditions European financial conditions are also tightening significantly. The iTraxx Crossover Index is rising swiftly. European high-yield corporate spreads are now above 450bps, levels that coincide with past recessions in the Euro Area (Chart 4). Government bond markets are increasingly under duress too. Italian BTPs now yield close to 200bps above German Bunds (Chart 4, bottom panel), which accentuates the periphery’s pain. Bottom Line: The Eurozone economy is slowing sharply. While Q1 GDP avoided a contraction, soft and hard data indicators suggest that Q2 is likely to record an actual output contraction for the whole Euro bloc. High Inflation, But For How Long? At first glance, European inflation numbers scream for an ECB rate hike, preferably one yesterday. However, the picture is not that clear-cut. Supply factors predominantly drive the Eurozone’s inflation surge. Chart 5 highlights the role of energy, utilities, food, and transportation costs in the HICP and shows that these factors account for more than 80% of the 7.5% HICP rate. Moreover, the fluctuations in energy CPI continue to explain most of the gyration in headline CPI. The close relationship between energy CPI and core CPI highlights an elevated degree of pass-though, the result of higher electricity and transportation costs (Chart 6). Chart 5Energy, Food And Transport Dominate European CPI Chart 6All About Energy Chart 7No Demand Pull-Inflation In Europe Unlike those in the US, Euro Area underlying inflation drivers are weak and inconsistent with demand-pull inflation. Wage growth in Europe stands at a paltry 1.6% annual rate, while in the US, the Atlanta Fed Wage Tracker has jumped to 4.5% (Chart 7, top panel). Moreover, Eurozone rent inflation remains stable at 1.2%, while it is a very elevated 4.5% in the US (Chart 7, bottom panel). The bifurcation in demand-driven inflation reflects vastly different output gaps between the two regions. US nominal GDP stands 2.5% above its 2014-2019 trend, while that of the Eurozone is still 5.3% below it. In the consumer durable goods sector, where the US experienced the greatest demand-supply mismatch – and therefore, the greatest inflation pressures – purchases are 25% above their 2014-2019 trend, while in Europe, they are still 9.5% below that trend (Chart 8) Year-on-year inflation prints should roll over this summer, as highlighted by weakening sequential inflation. Even if it remains elevated, the monthly Trimmed Mean CPI peaked last year. Energy inflation, moreover, is already contracting on a month-to-month basis (Chart 9). Chart 8Mind The Output Gap Chart 9Weakening Sequential Inflation Chart 10A Naive Inflation Forecast Simple simulation exercises also confirm that annual inflation will peak this summer (Chart 10). Monthly headline inflation averaged 0.11% from 2010 to 2019, 0.31% in the first half of 2021, and 0.55% from mid-2021 to January 2022. If we assume that monthly inflation prints remain in line with its most recent average, annual inflation will peak by year-end at 9.1%, before falling to 6.8% by April 2023. However, if monthly inflation falls back to an historically elevated monthly average of 0.31%, annual headline inflation will peak in September and fall back to 3.8% by April 2023. Similarly, if monthly core CPI averages 0.28%, annual core CPI will peak in October before declining to 3.4% by April 2023, but it will fall to 2.1% by April 2023, if monthly core CPI averages an historically elevated 0.17%, or the average observed in the first half of 2021 (Chart 10, bottom two panels). Chart 11A Conditional Inflation Forecast A more sophisticated exercise based on energy prices and the EUR/USD exchange rate also underlines the downside for Euro Area headline inflation. Energy inflation, which drives headline CPI, closely tracks the evolution of brent prices in euro terms and Deutsch natural gas prices. Assuming that natural gas prices average the historically very high level of €100/MWh over the next twelve months, that Brent averages US$95/bbl over that time frame (consistent with BCA’s commodity and energy team forecasts), and that the euro progressively moves back to EUR/USD1.10 by April 2023 (a weaker expectation than BCA’s Foreign Exchange Strategy team  anticipates), then the Eurozone’s energy inflation will collapse to -10% by April 2023 (Chart 11). We can also assume that Russia enacts a full energy embargo on Western Europe if Sweden and Finland apply for NATO membership. In this case, Brent would spike quickly to $140/bbl and natural gas to €250/MWh. In our scenario, prices stay elevated for two months, before they ultimately normalize by early 2023. Under this scenario, energy inflation would experience a spike to 80% (!) in June 2022 before falling back sharply. In all cases, the collapse in energy inflation is consistent with a rapid decline in headline inflation toward 2% in 2023. Bottom Line: European inflation is elevated but remains mainly driven by supply factors, particularly the evolution of energy inflation. Demand-pull inflation is minimal, unlike that in the US. Additionally, both core and headline inflations are set to peak in the coming months based on the evolution of sequential monthly inflation as well as the behavior of the energy market. A July ECB rate hike would constitute a policy mistake for three reasons: (i) the ECB has no control over supply-driven inflation; (ii) Eurozone inflation is set to weaken; and (iii) economic growth will remain poor. Investment Implications Despite the noise made by the hawks, a large amount of uncertainty around the July 2022 meeting’s outcome remains. It is easy to forget that the ECB’s decisions are consensual. Influential members such as Vice-President Luis de Guindos continues to see a July 2022 hike as possible but unlikely. Others, such as Executive Board member Fabio Panetta, are very worried about the Eurozone’s economic slowdown. Moreover, ECB President Christine Lagarde has not endorsed the hawks. In the context of weak growth and a potential top in inflation, achieving consensus about an early summer hike could be difficult. Chart 12Patience Would Be Rewarded The great paradox is that, if the ECB waits before pushing interest rates up, it will have an opportunity to increase rates durably next year. Wage growth is anemic today, but the decline in the Eurozone unemployment rate is consistent with a pickup in salaries in 2023 (Chart 12). Moreover, if energy inflation slows, the relative price-shock that is hurting households and domestic demand will ebb, which will allow consumption to recover. Patience would give Europe strength and the ECB a very strong basis to lift rates sustainably. The hawks will sway the council to their views. Inflation has latency, which means that its inertia may cause HICP to remain elevated beyond this summer. Moreover, the EU’s proposed ban on Russian oil imports along with Sweden’s and Finland’s likely accession-demand to NATO in the upcoming weeks could provoke Russia to strike first by cutting all its energy export to the EU to zero immediately. This would lift inflation for somewhat longer, as we showed in Chart 9. Related Report  European Investment StrategyThe Three Forces Hurting European Earnings In response to the significant risk of a rate hike, we continue to recommend investors stay short cyclical stocks relative to defensive ones. Moreover, if the risk of a Russian energy cutoff increases, so does the threat of a severe recession in Europe, as a recent Bundesbank study posits (Chart 13). Capital preservation is paramount in today’s context; thus, we continue to lean on the side of prudence, especially considering Europe’s soft profit outlook. Once risks recede, we will abandon this strategy. This decision, however, would require clarification of Sweden and Finland’s decision about their membership in NATO as well as Russia’s response, a confirmation that the ECB is not hiking rates in July, and a pullback in inflation surprises, which would prove a powerful help for European equities and the cyclicals/defensive split (Chart 14). Chart 13The Russian Embargo Risk Chart 14Wait For Inflation To Turn In fact, our view that inflation will peak leads to direct implications for European markets. The periods that followed the previous four peaks in European core inflation were associated with an outperformance of small-cap stocks and cyclical stocks over the subsequent six and twelve months as well as declines in German yields and narrower credit spreads (Table 1A). The sectoral implications were not as clear, but industrials enjoyed an edge, while healthcare stocks suffered marked declines. Our conviction is strongest that energy CPI will fall. Again, this environment is associated with an outperformance of small-caps stocks and cyclicals over the following six months (Table 1B). Sector-wise, energy names suffer in this climate along with defensives, especially communication services equities. Table 1APeaks In Core CPI & Subsequent European Asset Performance Table 1BPeaks In Energy CPI & Subsequent European Asset Performance Looking at this period of disinflation more broadly rather than just following peaks in inflation, we find similar results. Declining core CPI is associated with an outperformance of cyclicals relative to defensives as well as strength in small-cap equities (Table 2A). This larger sample allows for a clearer view of sectors. Specifically, the performance of industrials and tech relative to the broad market improves markedly, while utilities suffer greatly. We reach roughly similar conclusions when energy CPI is contracting, except that, in this instance, energy stocks also underperform (Table 2B). Interestingly, so do financial companies. This is a surprising result, but previous instances of weaker energy CPI in the sample reflected weaker demand, not an evolving supply shock. Weaker aggregate demand always hurts financials.  Table 2ADisinflation & Subsequent European Asset Performance Table 2BEnergy Deflation & Subsequent European Asset Performance Bottom Line: The risk of a policy mistake at the July ECB meeting is elevated. A policy mistake suggests that the current interest rate pricing for June 23 is too aggressive. Buy June 2023 Euribor contract. Moreover, Russian energy exports are still under threat. Accordingly, we continue to emphasize capital preservation and favor defensives over cyclicals. However, a buying opportunity will emerge rapidly once inflation peaks, especially if the ECB follows our base case. At this point, investors should buy small-cap and cyclical stocks. Industrials will beat energy, while all the defensive sectors will suffer. The BoE’s Tough Choice The Bank of England is stuck between a rock and a hard place. UK inflation shares characteristics of that of both the Eurozone and the US. On the one hand, energy inflation is increasing and could push headline CPI into double-digit territory around October 2022, once fuel subsidies fully expire. On the other hand, wage growth is strong as labor supply elasticity declined after Brexit. Demand-pull inflation is also rampant, which has pushed core CPI to a 5.7% annual rate. The UK’s cost push inflation, along with the growth slowdown in Europe and increasing tax rates are likely to cause a recession in the UK over the coming twelve months. The demand-pull inflation, however, will force the BoE to hike interest rates. This accentuates the downside risk to UK economic activity. Chart 15BoE's First Victim: The Pound The obvious victim of this configuration is the pound. Weak growth will prevent the BoE from matching the pace of rate hikes of the Fed and poor economic growth will detract from investments in the UK. As a result, we see further downside in GBP/USD (Chart 15). BCA’s FX strategy team is also selling the pound versus the euro. This position is likely to generate further gains as investors will revise down their views for UK economic activity relative to the Euro Area, since they already hold much more dire expectations for the latter than the former. Bottom Line: EUR/GBP possesses more upside. The growth outlook for the Eurozone is poor, but investors currently overestimate the growth path of the UK relative to that of its southern neighbor.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations

Special Report

Executive SummaryIn this report, we look at recent macroeconomic developments through the lens of the business cycle, inflation, and Treasury yield regimes to select winning sectors and styles.The US economy is currently in the slowdown stage of the business cycle, with all of its hallmark attributes, such as slowing growth, elevated inflation, and rising rates.We find that, despite being a real asset, equity performance deteriorates when inflation is on the rise. However, once inflation goes past its apex, the equity rebound is swift.During periods when both inflation and rates are rising, the Energy and Materials sectors tend to outperform, while the Financials and Consumer Discretionary sectors lag.The market is currently in a “high inflation and rising rates” regime but is about to transition to the “inflation is high but falling” regime, and today’s winners may turn into tomorrow’s losers. The new winners are likely to be the Financials, Consumer Discretionary, and Technology sectors.Bottom Line: As inflationary regimes shift, investors can tilt the odds of positive returns in their favor by taking a granular approach to sector selection. So far, 2022 has not been a welcoming year for investors.  All at once, slowing growth, surging inflation, impending monetary tightening, soaring energy prices, lockdowns in China, and a war in the heart of Europe have been thrown at them.With so much happening, it is difficult to separate signal from noise in the cross-currents of economic data. To make sense of the markets, we will look at recent developments through the lens of macroeconomic regimes, focusing on the stages of the business cycle, level and change in inflation, and the direction of Treasury yields.The Business Cycle Is In A Slowdown StageThe business cycle is a cornerstone of any investment decision as it underpins the fundamentals, and preordains the types of assets likely to outperform based on their level of risk and sensitivity to economic growth. The stage of the business cycle is a succinct way to summarize a wide range of economic data, such as capacity utilization, growth, policy, credit conditions, and valuation (Table 1). Table 1Business Cycle Is In A Slowdown Stage While we are barraged with somewhat contradictory economic data, it is still fair to say that we are currently in the middle of the slowdown stage of the business cycle. Our proprietary business cycle indicator, constructed from a mix of soft and hard data across multiple economic dimensions, is trending down, consistent with that position (Chart 1). Furthermore:Growth is slowing, albeit off high levels, and the most recent disappointing ISM PMI is just another case in point. More concerning is that the new orders-to-inventories ratio has plunged (Chart 2);Unemployment is at a 2-year low of 3.6%, and there are currently two job openings per job seeker;Capacity utilization is high;Inflation is elevated;The Fed has commenced a monetary tightening cycle. Chart 1Economic Growth Is Slowing  Chart 2ISM PMI Disappointed As such, during slowdown stage of a business cycle, returns tend to be lower than during recovery and expansion, while volatility is elevated (Chart 3).Chart 3During A Slowdown, Equity Returns Are Paltry, While Volatility Is Elevated If equities are set to deliver pedestrian returns, we need to be more discerning in our sector and style selection. In an environment of slowing growth, growth stocks, large caps, and defensives tend to outperform (Chart 4).  However, we have all observed that Growth has not fared that well due to rapidly rising interest rates and soaring inflation. In order to better understand the implication of the macroeconomic backdrop for equities, we need to drill further down into the inflation and interest-rate regimes.Chart 4During A Slowdown, Quality, Growth, And Defensives Outperform Inflation And Rates RegimesHigh Inflation: Then And NowThe recent spike in inflation came as a shock to most money managers – the last time inflation hit this level was in the 1980s, which predated their investment careers.In the wake of major oil shocks, oil prices quadrupled in 1973-74 and doubled in 1979-80. The combination of high inflation with weak economic growth, fueled by repeated supply shocks, gave rise to the phenomenon of “stagflation”, i.e., soaring inflation accompanied by stagnating economic growth and high unemployment.The high inflation we are living through now was brought about by the pandemic, which ushered in unprecedented fiscal and monetary easing, soaring demand for consumer goods, and a disrupted global supply chain. More recently, inflation has been further exacerbated by the indirect effects of the war in Ukraine, such as skyrocketing energy, food, and materials prices. Despite the challenges of the current period, economic growth is still robust, and unemployment is at historically low levels. Energy and materials prices have soared, but not to the same extent as in the 1970s. And while economic growth is slowing, and stagflation is a risk, it is hardly inevitable.To ensure a more precise study of the sector and style analysis, we will separate the 1970-1984 period and look at it as a template for the performance of equities during a stagflation regime. We will use the 1984 to 2022 period to analyze sector performance during more ordinary inflation regimes.Equities Hate ItEquities are a real asset and, theoretically, should not be affected by inflation – sales and earnings growth are reported in nominal terms, and underlying economic growth is, by far, more important than inflation.Of course, reality is often different from theory, and businesses hate inflation: Not only do they have difficulty budgeting and planning ahead, but they are also often not able to convert sales growth into earnings growth, i.e., their costs may grow faster than their revenues. According to the most recent NFIB survey, 31% of small businesses consider inflation their biggest problem compared to 1-2% in 2019.In addition, high inflation is a harbinger of a hawkish Fed and rising interest rates. Hence, on balance, high inflation is bad news for equities (Chart 5). As inflation climbs, equity returns decline, as multiples contract in anticipation of lower earnings and higher discount rates (Chart 6). Chart 5Equities Underperform In A High-Inflation Environment  Chart 6High Inflation Leads To Multiple Contraction Investing In Periods Of High-Inflation And Rising RatesHigh inflation is often accompanied by rising rates both because of strong economic growth and imminent monetary tightening which aims to arrest growth to combat inflation. As a result, high inflation comes hand in hand with elevated risk aversion and the repricing of more economically sensitive areas of the market.Indeed, when inflation is high (>3.5%) and rates are rising, median three-month equity returns are outright negative, and positive three-months returns occur less than 50% of the time (Chart 7). To beat the market, we need to tilt the return distribution in our favor.Chart 7We Are In High Inflation / Rising Rates Regime When inflation is elevated (above 3.5%) and Treasury yields are climbing, the most appropriate portfolio stance is a tilt toward all-weather defensive sectors like Consumer Staples and Health Care, which hold their own in an environment of slowing growth, as well as sectors that command significant pricing power (Chart 8). The following is a brief summary of the winners and losers. Chart 8Sector Performance In High Inflation / Rising Rates Regime High Inflation/Rising Rate WinnersEnergy: High oil prices are often one of the culprits behind runaway inflation, with the exception of the mid-1980s episode when Saudi Arabia drowned the world in oil, causing a collapse in oil prices, while inflation was on the rise. The energy sector has significant pricing power as it is upstream of the supply chain and can pass on costs to customers (Chart 9). This sector also benefits from high operating leverage. Outperformance usually peaks when inflation turns.Health Care: Health Care stocks tend to outperform when overall consumer prices advance. The non-cyclical nature of health care services reflects their resilience against economic volatility, irrespective of the direction of pricing pressures (Chart 10).  Over the past few years, health care companies have struggled, mostly because of the pressure exerted on pharma by hospitals, insurers, and the government. However, recently, the sector’s pricing power has turned because of pent-up demand for medical procedures. Chart 9The Energy Sector Wields Significant Pricing Power  Chart 10Pricing Power Of The Health Care Sector Has Picked Up Thanks To Pent-up Demand Consumer Staples: Historically, Consumer Staples have outperformed during periods of high inflation (Chart 11). Just like Health Care, this is a non-cyclical sector, because the demand for necessities is inelastic. While this sector is experiencing challenges because of the rising prices of raw materials, it is able to pass on its costs to customers, who have to allocate an increasing share of their budget to necessities. It has also helped multinationals in the S&P 500 index, as they invest in brand building, which now aids them to differentiate their offerings even when consumers are under duress.Utilities: Utilities is another quintessential defensive sector, with a stable revenue stream, significant pricing power, and profitability controlled by the regulators.    Of course, one might argue that this is a highly leveraged sector which may be hurt by rising borrowing costs.  However, it fares well, as regulators have a target return-on-investment for utilities companies, thus allowing them to raise prices to offset rising costs.  Furthermore, with high inflation, long-term debt is smaller in real terms.  Chart 11Consumer Staples Companies Have Invested In Brand-building High Inflation/Rising Rates LosersConsumer Discretionary companies underperform in an environment of high and rising inflation as inflation reduces consumers’ purchasing power and forces them to shift spending away from discretionary goods and services, and toward necessities. The high negative correlation of the sector with the Consumer Drag Indicator is a case in point (Chart 12). Further, rising interest rates often follow high inflation, and weigh on demand for durable goods that require financing.Financials: High inflation is a headwind for the sector because monetary tightening which follows on the heels of high inflation tends to flatten the yield curve, affecting banks’ Net Income Margins (NIM), or the spread between loans and deposits. Inflation also hurts S&P Financials due to the mismatch between bank assets and liabilities. A typical bank has longer maturity for its assets (loans) than for its liabilities (deposits). Consequently, as inflation rises, this reduces the future net inflow because creditors demand higher interest rates, while the returns earned by the bank on its current loan book are mostly fixed by existing contracts. Chart 12Raging Inflation Cuts Into Consumers' Discretionary Spending Inflation Will Turn Soon (Hopefully), And So Will Sector PerformanceInflation is likely to fade somewhat over the coming quarters, as supply chains normalize, and consumer demand wanes because of saturation and elevated prices. Arithmetic will also help, i.e., the base effect will kick in. Also, aggressive monetary policy is likely to slow economic growth and demand for labor further. With all of that, inflation will trend down but will reach the elusive 2% only years from now.However, when it comes to inflation, it is both the level of inflation and the direction of change that matter. While, overall, high inflation is bad for equities, it is necessary to differentiate between “inflation high and rising” and “inflation high and falling” regimes (Chart 13). As such, it is likely that we are about to shift into the “inflation is above 3.5% but falling” regime, where the median three-month return is 3.0% and returns are positive 69% of the time. We do anticipate a rebound in equities once the tighter monetary regime is priced in, and inflation shows signs of abating.Chart 13When Inflation Turns, Equities Will Rebound With the Fed assuming an active role, we believe that going forward, equity returns will be more of a function of the monetary tightening cycle than of inflation. However, falling inflation readings may slow the pace of monetary tightening, or even put the Fed on hold.According to our analysis of sector performance in the “inflation is above 3.5% and is falling” regime, Energy and Materials will be the first sectors to reverse recent gains. The Consumer Discretionary sector is likely to rebound as pressure on consumer purses eases. Financials will also be among sectors that outperform in this regime, since fading inflation will help with asset/liability management. Consumer Staples and Health Care are likely to keep their outperformance going as inflation will continue to be an issue.Last, while empirical analysis does not show that the Technology sector outperforms when inflation is falling, we believe this will be the case based on the simple assumption that falling inflation will imply a lower discount rate (Chart 14). In this regime, we also anticipate a rotation from Value to Growth, and from Large to Small (Chart 15). Chart 14New Inflation Regime Will Usher In New Winners  Chart 15Changes In Inflation Regimes Brought About Market Rotations Stagflation: Magnifying Glass On The 1970sStagflation, along with a recession, is now on investors’ minds – concern about the Fed making a policy mistake. After all, the Fed is already behind the curve, and it is hard to put the inflation genie back into the bottle. What would happen then?In this case, just as in the 1970s, we will see continued growth slowdown accompanied by raging inflation (Chart 16). Back then, equities pulled back every time inflation was on the rise (Chart 17), with Energy, Materials, and Health Care outperforming.The market rebounded at the first signs of inflation abating, reversing sector performance, and turning losers into winners, i.e., Consumer Discretionary and Real Estate started outperforming (Chart 18).Chart 16In The 1970s’ Stagflation Crushed Equities  Chart 17Energy And Materials Were Biggest Winners In the "Inflation High And Rising" Regime...  Chart 18...But They Gave Back Their Gains In "Inflation High But Falling" Regime Bottom LineWe are in a slowdown stage of the business cycle, and Quality, Defensives, and Growth are expected to outperform. However, high inflation has mixed up all the cards and sent Growth into a tailspin. High inflation is unfavorable, not only for Growth but also for equities in general, even though they are a real asset. However, investors can shift the odds of positive returns in their favor by taking a granular approach to sector selection suitable for different inflation regimes.The market is currently in a “high inflation and rising rates” regime, with Energy and Materials outperforming. However, we are about to transition into the “inflation is high but falling” regime, and today’s winners may turn into losers. Defensives is the only group which holds up across all high inflation regimes, thanks to its earnings resilience even in the face of slowing growth.  Irene TunkelChief Strategist, US Equity Strategyirene.tunkel@bcaresearch.com 

Executive Summary EM Credit Spreads Correlate With The EM Business Cycle A buying opportunity in EM local bonds and sovereign credit (EM USD bonds) will open up once US Treasury yields roll over and the US dollar begins its descent. US 10-year Treasury yields will likely peak at around 3.3-3.4%. The US dollar will roll over soon after that. Although we are getting closer to a buying opportunity in EM local currency bonds, it is not imminent. EM sovereign and corporate credit spreads fluctuate with their exchange rates and the EM/global business cycle. The near-term outlook for EM currencies and EM/global growth remains unfavorable.   Bottom Line: For now, continue shorting a basket of EM currencies versus the US dollar: ZAR, COP, PEN, PLN, HUF, PHP and IDR. Maintain a defensive tilt within an EM local bond portfolio. Our only outright long has been Brazilian 10-year domestic bonds but we recommend that investors hedge currency risk over the near term. Continue underweighting EM credit relative to US credit, quality adjusted. Feature Bond yields are surging around the world. How advanced are the bond selloffs in the US and in EM? Our short answer is that while the global bond selloff is fairly advanced, volatility will remain high in the near term and yields might rise further. A buying opportunity in EM local bonds and sovereign credit (EM USD bonds) will emerge when US bond yields roll over and the US dollar begins its descent. For now, investors should continue shorting EM currencies versus the US dollar and stay defensive in their EM domestic bond and credit portfolios. US Inflation And Bond Yields Since the top in US bond prices in 2020, US 10-year Treasurys have experienced their second largest drawdown of the past 42 years (Chart 1). The bond rout has pushed net bullish sentiment on US Treasurys to extremely low levels (Chart 2, top panel). From a contrarian perspective, depressed sentiment is positive for the outlook for bonds. Chart 1US 10-Year Treasurys Are Experiencing Their Second Worst Drawdown In 45 years Chart 2Traders Are Very Bearish On Bonds However, the term premium on 10-year bonds is still too low (Chart 2, bottom panel). Extremely high inflation uncertainty warrants a higher risk premium on US bonds. Given that the term premium is a gauge of the risk premium embedded in bonds, it will likely rise further due to inflation and policy uncertainty. Moreover, the tight labor market and surging wages imply that the fundamental outlook for US bonds is also unfavorable. Chart 3 displays that the US labor market has not been this tight since the late 1960s when inflation rose sharply, got embedded in consumer and business expectations and stayed structurally elevated util the early 1980s. The bottom panel of Chart 3 shows the US employment cost index and the Atlanta wage tracker. Both are high and accelerating. Chart 3The US Labor Market Is Very Tight And Wage Growth Is Accelerating Critically, US unit labor costs (ULC) – which have a significant impact on core inflation’s medium-term trends – are accelerating (Chart 4). Productivity growth will not be able to keep up with the pace of wage increases, which implies that unit labor costs will continue to rise at a rapid rate. As a result, any decline in core and headline CPI will be technical and limited in nature. US headline and core inflation rates will drop from the current extremely high levels as transitory forces – which exacerbated price pressures over the past 12 months – ebb. Trimmed-mean core PCE and median core CPI measures suggest that underlying US core consumer price inflation is probably in the 3.5% to 4% range (Chart 5). These two measures strip out outliers like used auto prices. Chart 4Unit Labor Costs Drive Core CPI Chart 5US Core Inflation Will Roll Over But Stay Above 3.5-4%   Thus, core PCE and CPI will drop in H2 this year but will stay above 3.5-4%. That is well above the Fed’s 2-2.25% target range for core inflation. Hence, the Fed will maintain its hawkish stance and continue to tighten monetary policy for now. That is why we have been arguing that the Fed and US stocks are on a collision course. The Fed will adopt a dovish tilt only after financial conditions tighten dramatically, i.e., when the S&P500 is down more than 20% from its January high. Bottom Line: Even though headline and core inflation measures will decline later this year, genuine price pressures will remain intense. US government bond yields might be approaching a turning point. Odds are that US 10-year yields will roll over when they reach 3.3-3.4% (Chart 6). EM Domestic Bonds The current drawdown in the total return of EM domestic bonds is the largest on record in local currency terms, but not in US dollar terms (Chart 7, top and middle panels). The basis is that in the current cycle, EM currencies have depreciated less than they did during previous bond selloffs in 2014-15 and 2020. Chart 6The Next Technical Resistance For 10-Year Treasurys Yields Is Around 3.4% Chart 7EM Local Currency GBI Bond Index: Total Return And Yields   However, historical comparisons do not take into account changes to the composition of the JP Morgan GBI-EM index. Specifically, China was included in 2020 and it now makes up 10% of the index. Chinese onshore government bond yields have been falling and are now very low (comparable with the yields on US Treasurys). Plus, the Chinese yuan is a low beta currency in the EM universe. In brief, Chinese onshore bonds have been supporting the GBI-EM index’s performance over the past 12 months. However, even after considering this favorable compositional change to the GBI-EM index, the recent drawdowns in both local currency and US dollar terms have been significant (Chart 7, middle panel). From a valuation point of view, EM bonds are beginning to offer value (Chart 7, bottom panel). However, risks to ex-China EM local currency bond yields remain to the upside over the near term. First, as long as EM exchange rates depreciate versus the US dollar, EM ex-China central banks will hike their policy rates because weak currencies will aggravate domestic inflationary pressures. Odds are that the greenback’s rally will continue in the near term. Net bullish sentiment on the US dollar is not yet at a peak level (Chart 8). Plus, investors’ net long positions in high-beta EM currencies was elevated as of April 29 (Chart 9). Chart 8Bullish Sentiment On US Dollar Is Not Extreme Chart 9EM Currencies Have Near-Term Downside     Critically, the Chinese yuan’s depreciation versus the US dollar will continue to exert downward pressure on commodity prices and other EM currencies. Besides, EM ex-China currencies have failed to break above the falling trendline (Chart 10). This is a sign that the rebound has been exhausted and a new downleg is in the offing. Second, the pass-through effect of high food and energy prices into core inflation is higher among EM economies than DM ones. Given that food prices are surging and oil prices are elevated, mainstream EM central banks will continue hiking interest rates. Finally, EM local bond yields will not drop until US TIPS yields roll over (Chart 11). TIPS yields are still low, and their path of least resistance would be up. Chart 10Stay Short EM Currencies for Now Chart 11EM Local Yields Correlate With US TIPS Yields   Bottom Line: A buying opportunity in EM domestic bonds will likely occur when US Treasury yields and the US dollar roll over. These are not imminent. EM local currency bond investors should stay defensive for now. EM Credit Spreads EM sovereign and corporate credit spreads fluctuate with their exchange rates and the EM/global business cycle, as was discussed in A Primer on EM USD Bonds and illustrated in Chart 12 and 13. Chart 12EM Credit Spreads Correlate With EM Currencies Chart 13EM Credit Spreads Correlate With The EM Business Cycle     As we discussed above, the outlook for EM currencies remains unfavorable. Risks to EM/global business cycle are also to the downside. China’s growth remains weak. The favorable impact of fiscal and monetary stimulus is being offset by the harsh lockdowns. Copper prices seem to be breaking down in line with China’s economic weakness (Chart 14). This is negative for many EM economies that export raw materials. Domestic demand in many emerging economies is subdued (Chart 15). Monetary tightening and negative fiscal thrust will cause domestic demand in the majority of EM economies to slow further. Chart 14Copper Prices Have Broken Down Chart 15EM Domestic Demand Has Been Very Weak   Finally, global trade volumes will shrink as DM consumption of goods ex-autos declines. Bottom Line: A combination of weakening growth and depreciating currencies will cause EM sovereign and credit spreads to widen further. Investment Recommendations Chart 16EM Credit Spreads Will Widen Further US Treasury yields will likely peak at around 3.3-3.4%. The US dollar will roll over soon after. For now, continue shorting a basket of EM currencies versus the US dollar: ZAR, COP, PEN, PLN, HUF, PHP and IDR. Be patient before buying EM local currency bonds. Our current positions are as follows: receiving 10-year swap rates in China and Malaysia, betting on yield curve inversion in Mexico and Colombia (receiving 10-year/paying 1-year and 6-month swap rates, respectively) and paying Polish/receiving Czech 10-year rates. Our only outright long has been Brazilian 10-year bonds but we recommend that investors hedge currency risk in the near term. EM sovereign and credit spreads will widen further (Chart 16). Continue underweighting EM credit relative to US credit, quality adjusted. Our country allocation for EM domestic bond and sovereign credit portfolios is presented in the tables below. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Special Report

Executive Summary The US Still Dominates Economic Output While the Ukraine war has been positive for the greenback, there is a slow tectonic shift away from the dollar as China rethinks holding concentrated foreign currency reserves. In the near term, the dollar faces positive macro variables and still-rising geopolitical tensions. Longer term, as global trade slows and countries gravitate into regional trading blocs, the dollar will need to fall to narrow the US trade deficit. By the same token, the Chinese RMB could weaken in the near term but will stabilize longer term. China will promote its currency across Asia. Currency volatility will take a step-function higher in this new paradigm. Winners will be the currencies of small open economies, especially in resource-rich nations. Trade Recommendation Inception Date Return LONG GOLD 2019-12-06 27.7% Bottom Line: Cyclical forces continue to underpin the dollar, such as rising US interest rates, a slowdown in global growth, and a safe haven premium from still-high geopolitical tensions. That said, the dollar is overbought, expensive, and vulnerable to reserve diversification over the longer term. While tactical long positions make sense, strategic investors should not chase the dollar higher. Feature Currency market action this week focused on two key central bank meetings: the Federal Reserve and the Bank of England. The Fed raised rates by 50 basis points while the BoE raised by 25 points, yet the market expectation differs. In the US, markets imply that the Fed can keep real interest positive while engineering a soft landing in the economy. In the UK (and Euro Area), markets see more acute stagflationary risks and assign a higher probability to a policy error. This situation, together with rising geopolitical risk, has put a bid under the dollar. Related Report  Commodity & Energy StrategyDie Cast By EU: Inflation, Recession Risks Rise Brewing in the background is the prospect that the Ukraine war and US sanctions on Russia could have longer-term consequences on the dollar. Specifically, Russia and China are now locked into a geopolitical partnership to undermine US geopolitical dominance, including the dollar’s supremacy. While this discussion will inevitably come with some speculation about what will happen in the future, what does the evidence say so far? More importantly, what are some profitable investment opportunities that could arise from any shift? The Russo-Chinese Rebellion Chart 1The US Needs To Externally Finance Defense Spending From Russia’s and China’s point of view, the United States threatens to establish global hegemony. The US possesses the world’s largest economy and most sophisticated military. It has largely maintained its preponderance in these spheres despite the rise of China, the resurgence of Russia, and the formation of the European Union as a geopolitical entity (Chart 1). If the US succeeds in its current endeavor of crippling Russia’s economy and surrounding it with NATO military allies, the world will be even more imbalanced in terms of power, while China will be isolated and insecure. To illustrate this point, NATO’s military spending is much higher than that of the Shanghai Cooperation Organization (SCO), which is not nearly as developed a military alliance (Chart 2). Hence Russia and China believe they must take action to counter the US and establish a global balance of power. When Presidents Vladimir Putin and Xi Jinping met on February 4 to declare that their strategic partnership will suffer “no limits,” which means no military limits, they declared a new multipolar era and warned against US domination under the guise of liberalism. If China allows Putin to fail in his conflict with the West, the Russian regime will eventually undergo a major leadership and policy change and China will become isolated. Whereas if China accepts Russia’s current strategic overture, China will be fortified. Russia can be immensely supportive of China’s Eurasian strategy to bypass US maritime dominance and improve supply security (Chart 3). Chart 2NATO Vs SCO: US Threat Of Dominance The consequence of this Russo-Chinese alliance will be to transact in a currency that falls outside sanctions by the US. This will be no easy feat. The US dollar still monopolizes the world’s monetary system, even though the US is likely to lose economic clout over time.  Chart 3China Cannot Reject Russia​​​​​ De-Dollarization And A Brewing USD Crisis? Fact Versus Fiction A reserve currency must serve the three basic functions of money on a global scale – providing a store of value, unit of account, and accepted medium of exchange. This status gives the dominant reserve currency an “exorbitant privilege,” a range of advantages including the ability to run persistent current account deficits and impose devastating sanctions on geopolitical rivals. Since the turn of the century, the US has struggled to maintain domestic political stability and has failed to deter challenges to its global leadership posed by Russia, China, and lesser powers. Lacking public support for foreign military adventures after Iraq and Afghanistan, Washington turned to economic sanctions to try to influence the behavior of other states. The results have been mixed in terms of geopolitics but cumulatively they have been neutral or positive for the trade-weighted dollar. The US adopted harsh sanctions against North Korea in 2005, Iran in 2010, Russia in 2012, Venezuela in 2015, and China in 2018. The primary trend in the dollar was never altered (Chart 4). Chart 4A Chronicle Of Sanctions And The Dollar Yet sweeping sanctions against Russia and China are qualitatively different from other sanctions– as they are among the world’s great powers. The extraordinary sanctions on Russia in 2022 – including cutting off its access to US dollar reserves – have proven deeply unsettling for China and other nations that fear they might someday end up on the wrong side of the US’s foreign policy. Russia’s own experience proves that diversification away from the dollar is likely to occur. From a peak of 47% in 2007, Russia reduced its dollar-denominated foreign exchange reserves to 16%. It cut its Treasury holdings from a peak of over 35% of international reserves to less than 1% today. Meanwhile Russia increased its gold holdings from 2% in 2008 to 20% (Chart 5). The Russians accelerated their diversification away from the dollar after invading Ukraine in 2014 to reduce the impact of sanctions. However, the world is familiar with Russian economic isolation. The West embargoed the USSR throughout the Cold War from 1949-1991. The dollar rose to prominence during this period, so it is not intuitive that Russia’s latest withdrawal from the global economy will enable other countries to abandon the dollar when they have failed in the past due to lack of alternatives. What is clear is that there is no clean or easy exit today from a dollar-denominated financial system. But there are a few lessons from Russia: The ruble has recouped all the losses since the implementation of sanctions. It runs a large current account surplus and has stemmed capital outflows. Another factor has been a sharp reduction in its dependence on the dollar. This will cushion the inflationary impact of US sanctions. Going forward, Russia will be much more insulated from the US dollar but at a terrible cost to potential economic growth (Chart 6). A dearth of US dollar capex into Russia will cripple productivity growth. The lesson for other US rivals will be to take economic stability into account when engaging in geopolitical rivalry.  Chart 5Russia Was Able To Dump Treasurys... The dollar has been unfazed by the Russian debacle. The victims have been other reserve currencies such as the euro, British pound, and Japanese yen, which are engulfed in an energy crisis from Russia’s actions.  Chart 6...But The Economic Impact Will Remain Severe​​​​​​ The key question that matters for investors will be what China will do. As one of the largest holders of US Treasurys, a destabilizing exit would have dramatic currency market impacts and could backfire on China. The trick will be to continue exiting this system without precipitating domestic instability. What Will China Do? China has learned two critical lessons from the Russo-Ukrainian conflict, with regard to raising the appeal of the RMB. First, the economic impact of US sanctions can still be devastating even when you have diversified out of dollars. Second, access to commodities is ever more important. As such, any strategy China chooses will need to mitigate these risks. China started diversifying away from the dollar in 2011 and today holds $1.05 trillion in US Treasurys. A little less than half of its foreign exchange reserves are denominated in dollars (Chart 7). This has been a gradual diversification that has not upended the current monetary regime. More importantly, China’s diversification accounts for the bulk of the shift by non-allies away from treasuries. Their share of foreign-held treasuries has fallen from 41% in 2009 to 23% today (Chart 8). Chart 7China Has Lowered USD Reserve Holdings​​​​​​ Chart 8US Allies Still Willing To Hold USDs...​​​​​​ China’s diversification has helped drive down the overall foreign share of US government debt holdings (excluding domestic central banks) from close to 50% in the middle of the last decade to 36% today (Chart 9). It has also weighed on the dollar. China can and will speed up its diversification from the dollar in the wake of the Ukraine war. While Americans will say that China only need fear such sanctions if it attacks Taiwan or other countries, China will not rest assured. Beijing must respond to US capability, not the Biden Administration’s stated intentions. A new Republican administration could arise as soon as January 2025 and take the offensive against China. The US and China are already engaged in great power rivalry and Beijing cannot afford to substitute hope for strategy. China ran a $224 billion current account surplus in 2021, so part of its strategy could be to reduce the pool of savings that need to be recycled every year into global assets. Since 2007 China has sent large amounts of outward direct investment into the world to acquire real assets and natural resources. The Xi administration tried to bring coherence to this outward investment by prioritizing different countries and investments adhere to China’s economic and strategic aims. The Belt and Road Initiative is the symbol of this process (Chart 10). Going forward, China will continue this process. It will also recycle more of its savings at home by increasing investment in critical industries such as energy security, semiconductors, and defense. Chart 9...But A Slow Diversification From US Debt Persists The key priorities will remain a Eurasian strategy of circumventing the US navy. Building natural gas pipelines and other infrastructure to link up with Russia is an obvious area of emphasis, although it will involve tough negotiations with Moscow. China will also prioritize Central Asia, the Middle East, South Asia, and mainland Southeast Asia as areas where its influence can grow with limited intervention by the US and its allies (Chart 11). Chart 10The Belt And Road Initiative In Progress​​​​​​   Chart 11China Outward Investment Will Need To Be Strategic Chart 12The RMB Could Dominate Intra-Regional Asean Trade As China invests more at home and in other countries, financing and invoicing deals in the renminbi will grow. While the dollar is the transactional currency globally, it is far less relevant when considering local trading blocs. The euro dominates intra-European trade, suggesting China can try to expand RMB invoicing for intra-Asian trade (Chart 12). Even then, however, the yuan faces serious obstacles from China’s inability or unwillingness to extend security guarantees to its partners, failure shift the economic model to consumerism, persistent currency controls, closed capital account, and geopolitical competition with the United States. Investors should pay close attention to shifts occurring at the margin. The number of bilateral swap lines offered to foreign central banks by the People’s Bank of China has grown (Chart 13), with a total amount of around 4 trillion yuan. This allows the PBoC to use its massive foreign exchange reserves, worth about US$3.2 trillion, to back yuan liabilities. As China continues to grow and increases the share of RMB trade within its sphere of influence, the yuan will rise as an invoicing currency (Chart 14). This could take years, even decades, but a shift is already underway. Chart 13The People's Bank Of Asia?​​​​​​ Chart 14China Is Growing In Economic Importance​​​​​​ In the near term, any US sanctions on China will hurt the RMB. Combined with hypo-globalization, China’s zero-Covid policy, narrowing interest rate differentials, and flight from Chinese assets, it is too soon to be positive on the RMB in the context of US-China confrontation (Chart 15). Longer term, China’s ability to ascend the reserve currency ladder will require a more radical change in Chinese policy to move the dollar. Chart 15CNY And US Sanctions Where Does The Euro Fit In? The biggest competitor to the US dollar is the euro, which took the largest chunk out of the US’s share of the global currency reserve basket in recent decades (Chart 16). Yet the EU could suffer a long-term loss of security, productivity, and stability from Russia’s invasion of Ukraine and the ensuing energy cutoff with Russia. Chart 16The Dollar Remains A Reserve Currency The EU will have to spend more on energy security and national defense. This will lead to an increase in debt securities that other countries could buy, which offers a way for countries to diversify from the dollar. However, Europe does not provide China or Russia with protection from US sanctions. The EU is allied with the US, it imposed sanctions on Russia along with the US, and like the US is pursuing extra-territorial law enforcement with its sanctions. When the US withdrew from the 2015 Iran nuclear deal, the EU disagreed technically, but in practice it enforced the sanctions anyway. The euro is hardly a safer reserve currency than sterling or the yen for countries looking to quarrel with the United States. The fact is that all of these allied states are likely to cooperate together in the event that any other state attempts to revise the global order as Russia has done. Not necessarily because they are democracies and share similar values but because they derive their national security from the US and its alliance system. The takeaway is that the euro will become a buying opportunity if and when the security environment stabilizes. Then diversification into the euro will occur. But it will not become a landslide that unseats the dollar, since the euro will still have a higher geopolitical risk premium. Investment Takeaways The historical evidence suggests that US sanctions have not weighed on the dollar. In the case of the Russo-Ukrainian conflict, it has been positive for the greenback. That said, there is a slow tectonic shift from the dollar, as each economic powerhouse evaluates the merits of holding concentrated foreign currency reserves. In the near term, the dollar will continue to be driven by traditional economic variables – global growth, real interest rate differentials, and the resilience of the US economy. That remains a positive. Geopolitical tensions reinforce the dollar’s current rally. Longer term, as globalization deteriorates and countries gravitate into regional trading blocs, the dollar will need to adjust lower to narrow the US trade deficit. By the same token, the RMB could weaken in the near term but will need to stabilize longer term, if Beijing wants it to be considered an anchor and store of value for other Asian currencies. Chart 17Silver Demand Could Explode Higher As Currency Volatility Rises The key takeaway is that currency volatility will take a step-function higher in this new paradigm. The winners could be the currencies of small open economies, especially in resource-rich nations. A world in which economic powers increasingly pursue national interests is likely to be inflationary. These powers will deplete the external pool of global savings, as current account balances wind down in favor of national and strategic interests. They will also likely encourage the demand for anti-fiat assets as currency volatility takes a step-function higher. Gold is likely to do well is this environment, but silver could be on the cusp of an explosion higher. The metal has found some measure of support around $22-23 per ounce even as manufacturing bottlenecks have hammered industrial demand. Long-only investors should hold both gold and silver, but a short gold/silver position makes sense both economically and from a valuation standpoint (Chart 17). Geopolitical Housekeeping: We are closing our Long FTSE 100 / Short DM-ex-US Equities trade for a gain of 19.5%. We still favor this trade cyclically and will look to reinstate it at a future date. We are also booking gains on our short TWD-USD trade for a return of 5.8% — though we remain short Taiwanese equities and continue to expect a fourth Taiwan Strait geopolitical crisis.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Special Report

Executive Summary Europe's Largest Import Bill: Oil The EU crossed the Rubicon this week, proposing to eliminate Russian oil imports within six months. The speed of putting the sanctions into effect, and Russia’s retaliation, will be critical to whether the world endures continued inflationary pressures or whether a global recession ensues. Russia indicated it will launch its own round of sanctions in the near future, which could profoundly affect not only global oil and gas markets, but once again induce input price shocks to electricity markets – which will hit firms and households again with higher prices – and agricultural markets. Turmoil in commodity markets has opened a policy debate over whether the world will be forced to migrate to a new monetary order based on access to commodities and control of commodity flows, which would replace the fiat-money architecture that succeeded the post-WWII Bretton Woods system. This debate draws together numerous trends – the centrality of commodities to price levels and inflation; central-bank policy; failed regulation at commodity exchanges; and commodity scarcity due to weak capex. Bottom Line: Commodity markets are changing rapidly as fundamentals adapt to supply tightness and an extremely erratic demand recovery.  However, this does not mark the beginning of a new Bretton Woods era.  Markets adapt quickly to changing fundamentals and that will continue. Feature With its proposal this week to ban the import of Russian oil, the EU crossed the Rubicon and now will prepare for an escalation of its economic war with Russia. Oil imports are, by far, the EU's largest energy import expense, and Russia is its largest supplier (Chart 1). Russian natural gas exports to Europe account for 74% of its total natgas exports, although natgas comprises a much smaller share of Russia’s revenue than oil (Chart 2). In a pecuniary sense, oil is far more important, but in an economic sense gas is more meaningful for Europe. Chart 1Europe's Largest Import Bill: Oil Chart 2Russia's Largest Market: Europe Russia produced 10.1mm b/d of crude and condensates in 2021. Of the 4.7mm b/d of this that Russia exported, OECD Europe was its largest customer, at 50% of total, according to the US EIA. If Russia's production is curtailed by roughly 1mm b/d this year and next year due to sanctions, we estimate Brent prices could reach $120/bbl. Losing 1.8mm this year and another 700k b/d next year could push Brent prices above $140/bbl (Chart 3). On the natgas side, one-third of the ~ 25 Tcf of Russian production last year was exported via pipeline or as LNG, based on 2021 data from the EIA. This amounted to almost 9 Tcf. Most of this – 74% – was exported via pipeline to the OECD Europe. These are dedicated volumes flowing through Russia's network into Europe. Until the Power of Siberia pipeline is expanded – likely over the next 2-3 years — this gas will not be available for export. Chart 3Losing Russian Oil Exports Will Push Prices Sharply Higher Oil and gas exports last year accounted for close to 40% of the Russian government's budget. Crude and product revenue last year came in at just under $180 billion, while pipeline and LNG shipments of natgas accounted for close to $62 billion of the Russian government's revenues. Clearly, the stakes are extremely high for Russia if Europe embargoes oil imports. Escalation Of Economic War Russian Energy Minister Alexander Novak last month threatened to shut off Russian exports of natural gas if the EU cut off oil imports. Whether – or how quickly – that threat is acted upon will be critical for Europe. Speculation around the EU's proposal to embargo oil imports of all kinds from Russia centers on the ban becoming effective by the end of this week, with a six-month phase-down of imports.1 It is still possible that the sanctions will be vetoed and revised. But with Germany changing its position and now willing to embargo oil, it is only a matter of time before the majority of the EU cuts off Russian oil imports. In response, Russia will launch its own round of embargoes, which could profoundly affect not only global oil and gas markets, but once again induce input-price shocks to electricity markets – which will hit household budgets and base-metals smelters and refiners – and agricultural markets, given the large share of natgas in fertilizers (Chart 4). It is not difficult to imagine base-metals refining operations closing again in Europe, along with crop-planting delays rising.2 On the back of this collateral damage from the cut-off of Russian oil and gas exports, we would expect inflation and inflation expectations to take another leg up. This comes against a backdrop in which central banks led by the US Fed already have initiated a rate-hiking program to address inflation that is running far hotter than previously forecast. Chart 4Tight Natgas Markets Drive Fertilizer/Grain Prices Higher Power, Fertilizer, Base Metals Could Be Shocked By Russian Cut-Offs Policymakers Reassess Commodities This turmoil in commodity markets has ignited a policy debate over whether the world will be forced to migrate to a new monetary order. The new order, so the argument goes, would be based on access to commodities and control of commodity flows and would replace the fiat-money architecture that succeeded the post-WWII Bretton Woods system. This debate draws together numerous trends – the centrality of commodities to price levels and inflation; central-bank policy; failed regulation at commodity exchanges; non-USD invoicing and funding; and commodity scarcity – particularly in industrial commodities like oil, natgas and metals due to weak capex over almost a decade. The debates around these different crises are being framed around the heightened geopolitical awareness of the critical role of commodities in the language of financial markets. This is a novel innovation; however, it essentially is an argument by analogy and can obfuscate underlying causes and effects. Bretton Woods III In The Offing? Following WW II, the US and other advanced economies launched the Bretton Woods system, under which the US would operate and maintain a commodity-money regime – i.e., the gold standard – that maintained convertability of USD to gold upon demand. This post-World War II Bretton Woods (BW) system – call it BWI – remained in place until the early 1970s and made the USD the preeminent currency in the world during that period. Literally, the system, operated by the Fed, made the USD "as good as gold." That didn't last, as US domestic exigencies – the Vietnam War and the War on Poverty – forced the US to abandon gold-convertibility and adopt a fiat-money system to finance these multiple wars. Nevertheless the dollar retained its centrality to global markets. Call this fiat system BWII. As of 2022, the dollar remains the world’s dominant reserve currency, accounting for ~ 60% of the $12.25 trillion of foreign exchange reserves, according to IMF data (Chart 5).3 As a vehicle currency, it accounts for close to 90% of daily FX trading – amounting to ~ $6 trillion/day of turnover. The dollar also is the preeminent funding and invoice currency. Trade invoicing denominated in USD accounts for 93% of imports and 97% of exports worldwide. Chart 5USD Remains Dominant Reserve Currency According to the WTO, global trade in 2019 (just before the COVID-19 pandemic) was just shy of $19 trillion (Chart 6). This global dominance of the USD means the dollar’s funding-currency role “mediates the transmission of U.S. monetary policy to global financing conditions.”4 This has been the case for the 23 years since the creation of the euro, including the periods before and after the 2008 global financial crisis. Chart 6USD Dominates World Trade The dollar’s importance to the global economy has only grown since the BWI era.5 Obstfeld notes US gross external assets and liabilities relative to GDP “grow sharply (but roughly commensurately) up until the global financial crisis, reaching ratios to GDP in the neighborhood of 150 percent. Since then, assets have levelled off but liabilities have continued to grow.” The dollar faces a range of challenges, as we discuss below, but any discussion must begin with its resilience as the top currency – a resilience that spans the creation of the euro, the rise of China, vast US budget and trade deficits, multiple rounds of quantitative easing, and political instability in Washington. A Return To Commodity-Based Money? The full power of the Fed's role at the center of the global monetary system – as a reserve currency and as the preeminent medium for funding and invoicing trade – was revealed following the invasion of Ukraine by Russia. The US froze Russian foreign reserves, denied it access to the international SWIFT payments system, and imposed sanctions on Russian firms and individuals, and anyone trading with them. Following the US actions, Russia's economy was partially frozen out of global trade, banking and finance. Western partners abandoned their Russian investments, taking their capital and technology out of the country. Outside of the sanctions, individual firms such as refiners, shippers and trading companies “self-sanctioned” their dealings with Russia, and refused to handle inbound or outbound Russian commodities. Given the US capability revealed, and the threat posed to other countries should the US sanction them in a likely manner, new risks to the dollar system will emerge. The primacy of the USD, and the Fed's role in maintaining its central banking position to the world, are by no means assured. Indeed, other states – namely China – will try to insulate themselves from similar sanctions. India is apparently willing to trade with Russia in rubles. Saudi Arabia is exploring being paid in RMB for oil exports to China and a wide range of states could increase their acceptance of RMB at least to cover their growing trade with China. China has been pushing hard to have its RMB recognized and used as a global reserve currency, and a trade-invoicing and trade-funding currency. For this to happen, China also would have to allow its currency to become a vehicle currency – i.e., the anchor leg in FX trading. Zoltan Pozsar, a Credit Suisse analyst, recently penned an article exploring the new terrain exposed by the Russian invasion of Ukraine and the US and EU responses.6 For Pozsar, "Commodity reserves will be an essential part of Bretton Woods III, and historically wars are won by those who have more food and energy supplies – food to fuel horses and soldiers back in the day, and food to fuel soldiers and fuel to fuel tanks and planes today." Pozsar avers that his formulation of Bretton Woods III will reverse the disinflation created by globalization, and "serve up an inflationary impulse (de-globalization, autarky, just-in-case hoarding of commodities and duplication of supply chains, and more military spending to be able to protect whatever seaborne trade is left)." These conclusions are similar to conclusions we have reached over the course of the past few years, as it became increasingly apparent that the US was losing geopolitical clout relative to rising powers, mainly China, and that the international system was becoming multipolar and unstable. The Ukraine war confirmed the new environment of Great Power Rivalry. Nation-states will indeed amass and hoard commodities as they will need to gird for battle as this rivalry heats up. Preparation for war and war itself are historically inflationary (Chart 7). Chart 7War And Preparation For War Are Inflationary However, countries still have to pay for commodities in a currency that exporters are willing to receive. Yet the biggest global oil and food exporters depend on the US for their security, except Russia. Even in base metals the US wields extraordinary influence over the non-aligned exporters. These states could reduce their dollar invoicing to cover their share of trade with countries outside the West, but their national security alliances and partnerships imply a hard-to-change view on which economies and currencies will be most stable over the long run. The dollar is again preeminent. China unquestionably wants to diversify away from the dollar. But China’s trade partners will have a limit on how much yuan cash they are willing to hold. If they want to recycle this cash into China’s economy, China must open its capital account. But this would reduce the Communist Party’s control of the domestic economy due to the Impossible Trinity (the yuan would have to float freely). So until China makes this change, the world is stuck in today’s monetary system. By contrast, if China totally closes its system due to domestic or foreign political threats, then the world faces a recession and investors will not be rushing to sell the dollar. For now China is trying to have it both ways: maintaining large foreign exchange reserves while gradually diversifying away from the dollar (Chart 8). China selling off its Treasury holdings and dollar reserves, which began in the aftermath of the Great Recession, is the biggest monetary shift since 1999, when the euro emerged and China’s purchases of Treasuries began to surge due to trade surpluses on the back of its joining the WTO. But there is little basis for China or anyone else to abandon fiat currencies and return to the gold standard. Fiat currencies enable states to control the money supply and hence to try to control their economies and societies. The Chinese are the least likely to abandon fiat currency given their laser focus on employment, manufacturing, and social stability. China is a commodity importer, so that if it seeks to amass commodities as strategic reserves in the midst of a commodity boom, it will pay top price. This means the yuan would need to be kept strong. But in fact China is allowing the yuan to depreciate, as it would face higher unemployment and instability if domestic demand were further suppressed by a rising yuan. China is already undergoing a painful transition away from export orientation – and Beijing has already acknowledged that de-industrialization should slow down because it poses a sociopolitical threat (Chart 9). A monetary revolution that strengthens the yuan at the expense of the dollar would force an immediate conclusion to China’s transition away from export-manufacturing. That would be politically destabilizing. Chart 8China Diversifies from USD - But Closed Capital Account Prevents Global RMB Chart 9Stronger RMB Would De-Industrialize China At Great Political Risk If China or other countries attempt to create a commodity base for their currencies, but simultaneously try to prevent a fixed exchange rate that constrains their money supply, then there will be little difference from a fiat currency regime. Today’s major reserve currency issuers already possess reserves of physical wealth (e.g. commodities) beneath their flexible monetary policy regimes – this dynamic would not inherently change. Of course, Europe, Japan, and the United Kingdom are the leading providers of reserve currencies outside the US and yet they are relatively lacking in commodity reserves. If global investors begin chasing currencies primarily on the basis of commodity reserves, the USD will not suffer the most, as the United States is a resource-rich country. China’s policy and strategy may become clearer after the twentieth party congress this fall, but most likely the current contradictions will persist. China will want to prolong the period of economic engagmeent with the West for as long as possible even as it prepares for a time when engagement is utterly broken. While China knows that the US will pursue strategic containment, and US-China engagement is over, it also knows that European leaders have a different set of interests. They have enough difficulty dealing with Russia and are not eager to expand their sanctions to China. Yet switching from dollar to euro reserves offers China little protection against sanctions in any major confrontation in the coming years. A radical decision by China to buy high and sell low (realize big losses on Treasuries and buy high-priced commodities) would show that Beijing is expecting Russian-style confrontation with the West immediately, which would scare foreign investors away from China. Net foreign direct investment in China has surged since the downfall of the Trump presidency (Chart 10). But that process would reverse as companies saw China going down Russia’s path and disengaging from the global monetary system. In that context, western governments would also penalize their own companies for investing in a geopolitical rival that was apparently preparing for conflict (while buttressing Russia). In short, private capital will flee countries that abandon the global financial system because that would be an economically inefficient decision taken for reasons of state security, and hence it would imply higher odds of conflict. Wealthy nations see China’s and other emerging markets’ foreign exchange reserves as “collateral” against asset seizures and geopolitical risks: if China reduces the collateral, private capital will feel less secure flowing into China.7 Chart 10If China Abandonds USD To Prepare For Sanctions, FDI Will Reverse Ultimately China will try to wean itself off the dollar – but it will keep doing so gradually to avoid a catastrophic social and economic change at home and abroad. This is continuation of post-2008 status quo. An accelerated shift away from USD will be interpreted by global actors as preparation for war (just like Russia’s shift). This will drive investors to swap Chinese assets for American or other assets. History suggests that USD devaluations followed US wars and budget expansions. Investors should wait until the next US military adventure, in Iran or elsewhere, before expecting massive dollar depreciation. If the US pursues an offshore balancing strategy, as it appears to be doing today, then other countries will become less stable and the dollar will remain appealing as a safe haven. Bottom Line: Russia’s and China’s diversification away from the dollar over the past decade has not caused global flight from the dollar. International trust in the economy and government of Russia and China is not very high. The euro, the viable alternative to the dollar, is less attractive in the face of the Ukraine war and broader geopolitical instability. The path toward monetary revolution is for China to open up its capital account, make its currency convertible, and sell USD assets while appreciating the yuan. Yet China’s leaders have not embarked on this course for fear of domestic instability. In lieu of that, the current monetary regime continues.     Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com     Footnotes 1     Please see Brussels proposes EU import ban on all Russian oil published by ft.com on May 4, 2022 for summary of the EU's export-ban proposals. 2     Please see our report from March 31, 2022 entitled Germany Closer To Rationing Natgas for further discussion. It is available at ces.bcaresearch.com. 3    See Obstfeld, Maurice (2020), Global Dimensions of U.S. Monetary Policy, International Journal of Central Banking, 16:1, pp. 73-132. 4    Obstfeld (2020, p. 113). 5    Obstfeld (2020, p. 77-78). 6    Please see Pozsar, Zoltan (2022), "Money, Commodities, and Bretton Woods III," published by Credit Suisse Economics. 7     For the “collateral” interpretation of US dollar-denominated foreign exchange reserves, see Michael P. Dooley, David Folkerts-Landau, and Peter M. Garber, “US Sanctions Reinforce The Dollar’s Dominance,” NBER Working Paper Series 29943, April 2022, nber.org.