Currencies

Executive Summary A True Bond Bear Market, USD-Hedged Or Unhedged The US dollar has appreciated in 2022, most notably against the euro and Japanese yen. The rally has been more muted against the currencies of major US trading partners like the Canadian dollar and Chinese yuan. The dollar strength to date has had minimal impact on US inflation and will not force any adjustment in the Fed’s hawkish path on interest rates. The weakness of the euro and yen versus the USD will not turn the ECB or Bank of Japan more hawkish, given the lack of visible pass-through from currency depreciation to domestic inflation in Europe and Japan. The two largest owners of US Treasuries, China and Japan, have not increased Treasury purchases in response to higher US yields and a firmer US dollar. Geopolitical tensions and a desire to diversify out of US assets will continue to limit China buying of US Treasuries. Even higher US yields will be needed to compensate Japanese investors for higher bond and currency volatility at a time when the cost to hedge USD exposure is high and rising. Bottom Line: An appreciating US dollar is not yet a reason to expect a peak in US inflation or Treasury yields, or a change in ECB/BoJ policy. Maintain a neutral global duration stance and continue to underweight US Treasuries versus German Bunds and JGBs. Feature The strengthening US dollar (USD) has gotten the attention of investors, with the DXY index up +8.1% since the start of 2022 and threatening a major breakout from the range that has prevailed since 2016 (Chart 1). There have been notable moves in the major currencies that are in the DXY index, especially the euro (EUR) and Japanese yen (JPY). EUR/USD now sits at 1.05 and is threatening a move towards the parity level last seen in 2002. USD/JPY has seen a stunningly rapid increase to the current 130 level, rising 15 big figures in just two months. On a broader basis, the USD rally has been less impressive. The Federal Reserve’s nominal broad trade-weighted dollar index is up a more modest +3.7%  year-to-date (Chart 2). Currencies of the major US trading partners have seen less impressive moves versus the dollar compared to the euro and yen. The Canadian dollar is down -1.9%, while the Mexican peso is flat, versus the dollar so far in 2022. Even the tightly managed Chinese currency (CNY) has belatedly joined the depreciation party, with USD/CNY up +4% since mid-April. Chart 1USD Breaking Out Against The Majors​​​​​ Chart 2Smaller FX Moves From The Larger US Trade Partners​​​​​​ For bond markets, the move towards a stronger US dollar is relevant if a) it is sustainable; b) it helps cool off the overheating US economy; and c) it induces capital flows into US Treasuries. On all three counts, the current bout of dollar strength has not been enough to reverse the upward trajectory of US Treasury yields, in absolute terms and relative to government bonds in Europe and Japan. Multiple Drivers Of The USD Rally First and foremost, the latest appreciation of the USD has been about rising US interest rate expectations. The Fed’s increasingly hawkish rhetoric in response to surging inflation has forced a sharp upward adjustment of both the near-term and medium-term path for US bond yields. This has been most evident in the real yield component of yields, with the yield on the 10-year inflation-protected TIPS now in positive territory at +0.15% - a big increase from the -0.5 to -1% range that has prevailed during the past two years of the COVID pandemic. Related Report  Global Fixed Income StrategyWe’re All Yield Chasers Now The momentum of the USD rally, with a +13.6% year-over-year gain in the DXY index, has been robust compared to the outright level of US bond yield spreads versus the major developed markets, especially after adjusting for realized inflation differentials (Chart 3). This reflects other USD-bullish factors beyond US interest rate expectations. The US dollar typically behaves as a defensive currency, appreciating during periods of slowing global growth and/or rising investor risk aversion. Both are happening at the same time right now, boosting the safe haven appeal of the US dollar. Global growth expectations are depressed, with the ZEW survey of investment professionals back down to the pandemic lows of 2020 (Chart 4, top panel).1 Worries about slowing growth and high inflation, and the rapid tightening of global monetary policies needed to combat that inflation, are also weighing on investor confidence. US equity market volatility has picked up and investors are paying up to protect their portfolios via options - the VIX index is back above 30 and the CBOE put/call ratio is at a two-year high (middle panel). Chart 3A Big USD Rally Fueled By Wider Real Yield Differentials​​​​​​ Chart 4Slowing Global Growth & Rising Risk Aversion Weighing On USD​​​​​​ This “perfect storm” of USD-bullish factors – rising US interest rate expectations, slowing global growth expectations and increased investor nervousness – has pushed to USD to a level that now appears stretched. BCA Research’s US Dollar Composite Technical Indicator, which combines measures of breadth, momentum, sentiment and trader positioning, is now at an overbought extreme that has heralded past US dollar reversals (bottom panel). Bottom Line: The rising US dollar now discounts a lot of Fed tightening, growth pessimism and investor fear. Conditions for a reversal are in place if any of those USD-bullish factors lose influence, most notably Fed expectations. USD Strength Does Not Impact The Outlook For The Fed, ECB Or BoJ Chart 5A True Bond Bear Market, USD-Hedged Or Unhedged USD strength has made life even more difficult of bond investors, at a time when returns across the fixed income universe have suffered because of the duration-related losses from rising bond yields. The Bloomberg Global Treasury index is down -12.2% so far in 2022, and down -18% from the 2020 peak, on a currency-unhedged basis (Chart 5). The returns are not much better this year on a USD-hedged basis, down -6.8% since the start of the year. The latter is suffering from both duration losses and the rising cost to hedge the US dollar. An investor hedging USD exposure into JPY must pay an annualized 165bps (using 3-month currency forwards), while hedging USD exposure into EUR costs 200bps. Those hedging costs primarily reflect higher US interest rate expectations versus Europe and Japan. They will only come down when markets believe that the Fed will stop raising interest rates and begin to easy policy. It is not clear that the current bout of USD strength, on its own, is enough to change the Fed’s plans. Typically, a substantially stronger US dollar would lead the Fed along a less hawkish path, as it would act to slow imported inflation pressures. However, this is not a typical Fed cycle with US headline CPI inflation at a 41-year high of 8.5%. A huge part of that US inflation overshoot is due to global supply squeezes that have impacted the prices of traded goods and commodities. On a rate-of-change basis, the appreciating US dollar is coinciding with some slowing of commodity price momentum, but less so for goods prices. The index of world export prices compiled by the CPB Research Bureau in the Netherlands is up +12.2% on a year-over-year basis, a rapid pace that typically exists during periods of US dollar depreciation (Chart 6, top panel). The annual growth of the CRB commodity index is +17.2%, down from the peak of +54.4% in June 2021, and has roughly tracked the acceleration of the US dollar (middle panel). Yet even with the moderation of commodity inflation, the US dollar strength seen to date has not been enough to slow overshooting global goods price inflation – a necessary condition for central banks like the Fed to turn less hawkish (bottom panel). We do expect global goods price inflation to moderate over the rest of 2022, especially in the US, as post-pandemic consumer spending patterns shift away from goods back towards services. This will be a demand-related story, however, not a USD-strength-related story. Until there is more decisive evidence that goods inflation is slowing meaningfully, the Fed will be forced to deliver on its latest hawkish rhetoric. This includes shifting to a path of hiking rates by 50bps per meeting and moving towards a faster reduction of the Fed’s balance sheet. Right now, there is not much evidence suggesting that the stronger dollar should derail that trajectory (Chart 7): Chart 6USD Strength Not Helping To Slow Global Inflation​​​​​ Chart 7The Fed Will Remain Hawkish, Despite A Firmer USD​​​​​​ Non-oil import prices are expanding at a +7.5% pace and accelerating in the face of a firmer US dollar that would normally coincide with slowing import price growth (top panel) The overall level of US financial conditions – which includes not only the currency but other variables like equity prices and corporate bond yields - remains stimulative, both in absolute terms and relative to the level of the trade-weighted US dollar (middle panel). One area of concern is the widening US trade deficit, now nearly -5% of GDP in nominal terms (bottom panel). That wider deficit is primarily related to the combination of strong import demand (and soaring import prices) and soft export demand given slowing global growth. A stronger US dollar does not help reverse either of those trends. However, it is difficult for the Fed to isolate the impact of the currency on the trade deficit given the other non-currency-related factors weighing on US export and import demand (i.e. weaker exports because of the Ukraine war and China COVID lockdowns). In sum, the US dollar strength seen so far does not change our expectations on the path of US inflation, and the pace of Fed tightening, over the next 6-12 months. We still see the Fed delivering multiple rate hikes, but less than the 298bps discounted in the US overnight index swap (OIS) curve over the next year. Conversely, the weakness of the euro and yen versus the US dollar does not change our outlook for the ECB and Bank of Japan. We see both central banks not delivering anything close to the rate hikes discounted in OIS curves. Chart 8Not Much Inflation From A Weaker Euro & Yen On a trade-weighted basis, the euro is only down -5% over the past year - a modest move in comparison to soaring euro area inflation, which hit +7.5% on a headline basis and +3.5% on a core basis in April (Chart 8, middle panel). The ECB is under pressure to end its asset purchases very quickly and begin raising rates, but the euro does not appear to be a reason to accelerate the ECB’s timetable. In Japan, the very rapid weakening of the yen has generated shockingly little inflation, especially in the current environment of strong global goods/commodities inflation. The trade-weighted yen is down -12.7% on a year-over-year basis, yet Japan’s “core-core” CPI index that excludes food and energy prices remains in deflation hitting -0.7% in March – a move exaggerated by plunging mobile phone prices, but still very weak compared to the path of the yen and global goods prices. OIS curves are currently discounting 183bps of ECB rate hikes and 9bps of Bank of Japan rate hikes over the next year. We recommend fading that pricing by staying overweight core Europe and Japan in global bond portfolios, especially versus the US where the Fed is far more likely to follow through on discounted rate hikes. Bottom Line: The dollar strength to date has had minimal impact on US inflation and will not force any adjustment in the Fed’s hawkish path on interest rates. At the same time, the weakness of the euro and yen versus the USD will not turn the ECB or Bank of Japan more hawkish, given the lack of visible pass-through from currency depreciation to domestic inflation in Europe and Japan. Can Foreign Investors Replace Fed Treasury Buying? Chart 9UST Demand Shifting To More Price-Sensitive Buyers For bond investors, the role of non-US demand for US Treasuries has always been a source of mystery that is often used to explain yield movements. Rumors of flows from major emerging market currency reserve managers or large Asian pension funds has often been used to justify a bullish or bearish view on Treasuries – even when hard data that could prove the existence of such flows is published with long lags that make it useless for timely analysis. The impact of potential foreign bond buying on US Treasury yields has been less influential over the past couple of years. Fed buying via quantitative easing (QE) has swamped all other sources of demand for Treasuries. With the Fed now in a rate hiking cycle that will also lead to a rapid start of quantitative tightening (QT) this summer, the question of who will replace the Fed’s demand for US Treasuries becomes once again relevant for the future path of US bond yields beyond the expected path of the fed funds rate. Already, there has been an adjustment in the term premium for longer-term US Treasury yields – the component of bond yield valuation that would be most impacted by large flows - as the Fed has slowed its pace of bond buying (Chart 9). The New York Fed’s estimates of the term premium on the 10-year Treasury yield reached deeply depressed levels – around -100bps - at the peak of the Fed’s pandemic QE program in 2020. As the US economy has recovered from the 2020 COVID recession, US interest rate expectations have increased but so have estimates of the term premium, which are now back to zero or even slightly positive. The Fed’s QE bond buying has been purely volume driven, with the size and timing of the purchases announced well in advance. The Fed is often called a “price insensitive” buyer since its buying is done without any consideration of yield levels. Other Treasury investors, including foreign buyers, are more price sensitive, with demand influenced by the level of yields. According to the TIC database on US capital flows produced by the US Treasury Department, net foreign buying of Treasuries has picked up, totaling +$346 billion over the 12 months to the most recently available data from February 2022 (Chart 10). That increase has entirely come from private investors, as so-called “official” flows have been flat. Chart 10China Remains On A UST Buyer's Strike​​​​​​ Chart 11European Buying Of USTs Set To Peak?​​​​​​ The latter is a continuation of the trend seen over the past few years where China, the nation with the second largest holdings of US Treasuries, has stopped buying them. This is a decision rooted in both geopolitics and economics. Smaller trade surpluses mean China has fewer new currency reserves to invest, while worsening Sino-US tensions have led Chinese authorities to diversify existing reserve holdings away from US Treasuries into gold and other assets. Looking ahead, China is unlikely to significantly ramp up its Treasury purchases despite more attractive US yields and Chinese policymakers tolerating some mild currency weakness versus the US dollar. Beyond China, demand for Treasuries from Europe and Japan has picked up but remains moderate by historical standards. For European investors, there has been a major swing in the TIC data, moving from a net outflow (on a 12-month running total basis) of -$194 billion in December 2020 to a net inflow of +$24 billion in February 2022 (Chart 11, top panel). Typically, net inflows into Treasuries are linked to the FX-hedged spread between US and German government debt. Specifically, when the hedged 10-year Treasury-Bund spread widens to a level between 100-150bps, the flows from Europe into Treasuries begin to improve (middle panel) When that hedged spread narrows to zero or lower, the flows turn the other way and European demand for Treasuries begins to wane. That is typically followed by a widening of the unhedged Treasury-Bund spread (bottom panel). With the current FX-hedged Treasury-Bund spread now at zero, a result of the high cost of hedging US dollars into euros given elevated US rate expectations, we expect European demand for Treasuries to diminish over the rest of 2022. This will help support a wider Treasury-Bund spread as the Fed delivers far more rate hikes than the ECB. For Japan, the largest holder of Treasuries, there has only been a stabilization of outflows over the 12 months to February 2022 (Chart 12, top panel). Past periods of large net inflows from Japan into US Treasuries have occurred when the hedged 10-year US Treasury-JGB spread has approached 200bps (middle panel). With the current spread at only 112bps, Japanese investor demand for Treasuries is unlikely to return without a significant increase in US yields. Chart 12UST Yields Not Attractive Enough To Induce More Japanese Demand​​​​​​ Chart 13Foreign Bond Investing Is Too Volatile For Japanese Investors Right Now More timely weekly capital flow data from Japan shows that Japanese investors have been reluctant to move money into foreign bonds (Chart 13). Elevated levels of bond/rate volatility, and currency volatility given the huge rally in USD/JPY, have made large Japanese bond investors more cautious on increasing foreign bond allocations, even on a currency-hedged basis. If bond/FX volatility subsides, Japanese investors will become “better buyers” of foreign bonds once again. However, Japanese investors may opt to increase allocations to European bonds rather than US Treasuries, with European yields at comparable levels to US Treasuries in JPY-hedged terms (Tables 1-4). For example, a 30-year German Bund hedged into yen now yields 1.46%, compared to a JPY-hedged 30-year US Treasury yield of 1.33%. Table 12-Year Developed Market Government Bond Yields, Hedged Into USD, EUR & JPY Table 25-Year Developed Market Government Bond Yields, Hedged Into USD, EUR & JPY Table 310-Year Developed Market Government Bond Yields, Hedged Into USD, EUR & JPY Table 430-Year Developed Market Government Bond Yields, Hedged Into USD, EUR & JPY Bottom Line: Foreign demand for US Treasuries is unlikely to accelerate enough to replace diminished Fed QE purchases over the next 6-12 months, given high USD-hedging costs and elevated Treasury yield volatility. Non-US investors will not help bring an end to the US bond bear market. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The Global ZEW expectations series shown in Chart 4 is an equal-weighted average of the individual expectations series for the US and euro area. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Tactical Overlay Trades

Executive Summary German GeoRisk Indicator Russia and Germany have begun cutting off each other’s energy in a major escalation of strategic tensions. The odds of Finland and Sweden joining NATO have shot up. A halt to NATO enlargement, particularly on Russia’s borders, is Russia’s chief demand. Tensions will skyrocket. China’s reversion to autocracy and de facto alliance with Russia are reinforcing the historic confluence of internal and external risk, weighing on Chinese assets. Geopolitical risk is rising in South Korea and Hong Kong, rising in Spain and Italy, and flat in South Africa. France’s election will lower domestic political risk but the EU as a whole faces a higher risk premium. The Biden administration is doubling down on its defense of Ukraine, calling for $33 billion in additional aid and telling Russia that it will not dominate its neighbor. However, the Putin regime cannot afford to lose in Ukraine and will threaten to widen the conflict to intimidate and divide the West. Trade Recommendation Inception Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 14.2% Bottom Line: Stay long global defensives over cyclicals. Feature Chart 1Geopolitical Risk And Policy Uncertainty Drive Up Dollar The dollar (DXY) is breaking above the psychological threshold of 100 on the back of monetary tightening and safe-haven demand. Geopolitical risk does not always drive up the dollar – other macroeconomic factors may prevail. But in today’s situation macro and geopolitics are converging to boost the greenback (Chart 1). Global economic policy uncertainty is also rising sharply. It is highly correlated with the broader trade-weighted dollar. The latter is nowhere near 2020 peaks but could rise to that level if current trends hold. A strong dollar reflects slowing global growth and also tightens global financial conditions, with negative implications for cyclical and emerging market equities. Bottom Line: Tactically favor US equities and the US dollar to guard against greater energy shock, policy uncertainty, and risk-aversion. Energy Cutoff Points To European Recession Chart 2Escalation With Russia Weighs Further On EU Assets Russia is reducing natural gas flows to Poland and Bulgaria and threatening other countries, Germany is now embracing an oil embargo against Russia, while Finland and Sweden are considering joining NATO. These three factors are leading to a major escalation of strategic tensions on the continent that will get worse before they get better, driving up our European GeoRisk indicators and weighing on European assets (Chart 2). Russia’s ultimatum in December 2021 stressed that NATO enlargement should cease and that NATO forces and weapons should not be positioned east of the May 1997 status quo. Russia invaded Ukraine to ensure its military neutrality over the long run.1 Finland and Sweden, seeing Ukraine’s isolation amid Russian invasion, are now reviewing whether to change their historic neutrality and join NATO. Public opinion polls now show Finnish support for joining at 61% and Swedish support at 57%. The scheduling of a joint conference between the country’s leaders on May 13 looks like it could be a joint declaration of their intention to join. The US and other NATO members will have to provide mutual defense guarantees for the interim period if that is the case, lest Russia attack. The odds that Finland and Sweden remain neutral are higher than the consensus holds (given the 97% odds that they join NATO on Predictit.org). But the latest developments suggest they are moving toward applying for membership. They fear being left in the cold like Ukraine in the event of an attack. Russia’s response will be critical. If Russia deploys nuclear weapons to Kaliningrad, as former President Dmitri Medvedev warned, then Moscow will be making a menacing show but not necessarily changing the reality of Russia’s nuclear strike capabilities. That is equivalent to a pass and could mark the peak of the entire crisis. The geopolitical risk premium would begin to subside after that. Related Report  Geopolitical StrategyLe Pen And Other Hurdles (GeoRisk Update) However, Russia has also threatened “military-political repercussions” if the Nordics join NATO. Russia’s capabilities are manifestly limited, judging by Ukraine today and the Winter War of 1939, but a broader war cannot entirely be ruled out. Global financial markets will still need to adjust for a larger tail risk of a war in Finland/Sweden in the very near term. Most likely Russia will retaliate by cutting off Europe’s natural gas. Clearly this is the threat on the table, after the cutoff to Poland and Bulgaria and the warnings to other countries. In the near term, several companies are gratifying Russia and paying for gas in rubles. But these payments violate EU sanctions against Russia and the intention is to wean off Russian imports as soon as possible. Germany says it can reduce gas imports starting next year after inking a deal with Qatar. Hence Russia might take the initiative and start reducing the flow earlier. Bottom Line: If Europe plunges into recession as a result of an immediate natural gas cutoff, then strategic stability between Russia and the West will become less certain. The tail risk of a broader war goes up. Stay cyclically long US equities over global equities and tactically long US treasuries. Stay long defense stocks and gold. Stay Short CNY At the end of last year we argued that Beijing would double down on “Zero Covid” policy in 2022, at least until the twentieth national party congress this fall. Social restrictions serve a dual purpose of disease suppression and dissent repression. Now that the state is doubling down, what will happen next? The economy will deteriorate: imports are already contracting at a rate of 0.1% YoY. The manufacturing PMI has fallen to 48.1  and the service sector PMI to 42.0, indicating contraction. Furthermore, social unrest could emerge, as lockdowns serve as a catalyst to ignite underlying socioeconomic disparities. Hence the national party congress is less likely to go smoothly, implying that investors will catch a glimpse of political instability under the surface in China as the year progresses. The political risk premium will remain high (Chart 3). Chart 3China's Confluence Of Domestic And Foreign Risk Weighs On Stocks And Currency While Chairman Xi Jinping is still likely to clinch another ten years in power, it will not be auspicious amid an economic crash and any social unrest. Xi could be forced into some compromises on either Politburo personnel or policy adjustments. A notable indicator of compromise would be if he nominated a successor, though this would not provide any real long-term assurance to investors given the lack of formal mechanisms for power transfer. After the party congress we expect Xi to “let 100 flowers bloom,” meaning that he will ease fiscal, regulatory, and social policy so that today’s monetary and fiscal stimulus can work effectively. Right now monetary and fiscal easing has limited impact because private sector actors are averse to taking risk. Easing policy to boost the economy could also entail a diplomatic charm offensive to try to convince the US and EU to avoid imposing any significant sanctions on trade and investment flows, whether due to Russia or human rights violations. Such a diplomatic initiative would only succeed, if at all, in the short run. The US cannot allow a deep re-engagement with China since that would serve to strengthen the de facto Russo-Chinese strategic alliance. In other words, an eruption of instability threatens to weaken Xi’s hand and jeopardize his power retention. While it is extremely unlikely that Xi will fall from power, he could have his image of supremacy besmirched. It is likely that China will be forced to ease a range of policies, including lockdowns and regulations of key sectors, that will be marginally positive for economic growth. There may also be schemes to attract foreign investment. Bottom Line: If China expands the range of its policy easing the result could be received positively by global investors in 2023. But the short-term outlook is still negative and deteriorating due to China’s reversion to autocracy and confluence of political and geopolitical risk. Stay short CNY and neutral Chinese stocks. Stay Short KRW South Koreans went to the polls on March 9 to elect their new president for a five-year term. The two top candidates for the job were Yoon Suk-yeol and Lee Jae-myung. Yoon, a former public prosecutor, was the candidate for the People Power Party, a conservative party that can be traced back to the Saenuri and the Grand National Party, which was in power from 2007 to 2017 under President Lee Myung-bak and President Park Geun-hye. Lee, the governor of the largest province in Korea, was the candidate for the Democratic Party, the party of the incumbent President Moon Jae-in. Yoon won by a whisker, garnering 48.6% of the votes versus 47.8% for Lee. The margin of victory for Yoon is the lowest since Korea started directly electing its presidents. President-elect Yoon will be inaugurated in May. He will not have control of the National Assembly, as his party only holds 34% of the seats. The Democratic Party holds the majority, with 172 out of 300 seats. The next legislative election will be in 2024, which means that President Yoon will have to work with the opposition for a good two years before his party has a chance to pass laws on its own. President-elect Yoon was the more pro-business and fiscally restrained candidate. His nomination of Han Duck-soo as his prime minister suggests that, insofar as any domestic policy change is possible, he will be pragmatic, as Han served under two liberal administrations. Yoon’s lack of a majority and nomination of a left-leaning prime minister suggest that domestic policy will not be a source of uncertainty for investors through 2024. Foreign policy, by contrast, will be the biggest source of risk for investors. Yoon rejects the dovish “Moonshine” policy of his predecessor and favors a strong hand in dealing with North Korea. “War can be avoided only when we acquire an ability to launch pre-emptive strikes and show our willingness to use them,” he has argued. North Korea responded by expanding its nuclear doctrine and resuming tests of intercontinental ballistic missiles with the launch of the Hwasong-17 on March 24 – the first ICBM launch since 2017. In a significant upgrade of North Korea’s deterrence strategy, Kim Yo Jong, the sister of Kim Jong Un, warned on April 4 that North Korea would use nuclear weapons to “eliminate” South Korea if attacked (implying an overwhelming nuclear retaliation to any attack whatsoever). Kim Jong Un himself claimed on April 26 that North Korea’s nuclear weapons are no longer merely about deterrence but would be deployed if the country is attacked. President-elect Yoon welcomes the possibility of deploying of US strategic assets to strengthen deterrence against the North. The hawkish turn is not surprising considering that North-South relations failed to make any substantive improvements during President Moon’s five-year tenure as a pro-engagement president. South Koreans, especially Yoon’s supporters, are split on whether inter-Korean dialogue should be continued. They are becoming more interested in developing their own nuclear weapons or at the very least deploying US nuclear weapons in South Korea. Half of South Korean voters support security through alliance with the US, while a third support security through the development of independent nuclear weapons. The nuclear debate will raise tensions on the peninsula. An even bigger change in South Korea’s foreign policy is its policy towards China. President-elect Yoon has accused President Moon of succumbing to China’s economic extortion. Moon had established a policy of “three No’s,” meaning no to additional THAAD missiles in South Korea, no to hosting other US missile defense systems, and no to joining an alliance with Japan and the United States. By contrast, Yoon’s electoral promises include deploying more THAAD and joining the Quadrilateral Dialogue (US, Japan, Australia, India). Polls show that South Koreans hold a low opinion of all of their neighbors but that China has slipped slightly beneath Japan and North Korea in favorability. Even Democratic Party voters feel more negative towards China. While negative attitudes towards China are not unique to Korea, there is an important difference from other countries: the Korean youth dislike China the most, not the older generations. Negative sentiment is less tied to old wounds from the Korean war and more related to ideology and today’s grievances. Younger Koreans, growing up in a liberal democracy and proud of their economic and cultural success, have been involved in campus clashes against Chinese students over Korean support for Hong Kong democrats. Negative attitudes towards China among the youth should alarm investors, as young people provide the voting base for elections to come, and China is the largest trading partner for Korea. Korea’s foreign policy will hew to the American side, at risk to its economy (Chart 4). Chart 4South Korean Geopolitical Risk Rising Under The Radar President-elect Yoon’s policies towards North Korea and China will increase geopolitical risk in East Asia. The biggest beneficiary will be India. Both Korea and Japan need to find a substitute to Chinese markets and labor, which have become less reliable in recent years. South Korea’s newly elected president is aligned with the US and West and less friendly toward China and Russia. He faces a rampant North Korea that feels emboldened by its position of an arsenal of 40-50 deliverable nuclear weapons. The North Koreans now claim that they will respond to any military attack with nuclear force and are testing intercontinental ballistic missiles and possibly a nuclear weapon. The US currently has three aircraft carriers around Korea, despite its urgent foreign policy challenges in Europe and the Middle East. Bottom Line: Stay long JPY-KRW. South Korea’s geopolitical risk premium will remain high. But favor Korean stocks over Taiwanese stocks. Stay Neutral On Hong Kong Stocks Hong Kong’s leadership change will trigger a new bout of unrest (Chart 5). Chart 5Hong Kong: More Turbulence Ahead On April 4, Hong Kong’s incumbent Chief Executive, Carrie Lam, confirmed that she would not seek a second term but would step down on June 30. John Lee, the current chief secretary of Hong Kong, became the only candidate approved to run for election, which is scheduled to be held on May 8. With the backing of the pro-Beijing members in the Election Committee, Lee is expected to secure enough nominations to win the race. Lee served as security secretary from when Carrie Lam took office in 2017 until June 2021. He firmly supported the Hong Kong extradition bill in 2019 and National Security Law in 2020, which provoked historic social unrest in those years. He insisted on taking a tough security stance towards pro-democracy protests. With Lee in power, Hong Kong will face more unrest and tougher crackdowns in the coming years, which will likely bring more social instability. Lee will provoke pro-democracy activists with his policy stances and adherence to Beijing’s party line. For example, his various statements to the news media suggest a dogmatic approach to censorship and political dissent. With the adoption of the National Security Law, Hong Kong’s pro-democracy faction is already deeply disaffected. Carrie Lam was originally elected as a popular leader, with notable support from women, but her popularity fell sharply after the passage of the extradition bill and National Security Law, as well as her mishandling of the Covid-19 outbreak. Her failure to handle the clashes between the Hong Kong people and Beijing damaged public trust in government. Trust never fully recovered when it took another hit recently from the latest wave of the pandemic. Putting another pro-Beijing hardliner in power will exacerbate the trend. Hong Kong equities are vulnerable not merely because of social unrest. During the era of US-China engagement, Hong Kong benefited as the middleman and the symbol that the Communist Party could cooperate within a liberal, democratic, capitalist global order. Hence US-China power struggle removes this special status and causes Hong Kong financial assets to contract mainland Chinese geopolitical risk. As a result of the 2019-2020 crackdown, John Lee and Carrie Lam were among a list of Hong Kong officials sanctioned by the US Treasury Department and State Department in 2020. Now, after the Ukraine war, the US will be on the lookout for any Hong Kong role in helping Russia circumvent sanctions, as well as any other ways in which China might further its strategic aims by means of Hong Kong. Bottom Line: Stay neutral on Hong Kong equities. Favor France Within European Equities French political risk will fall after the presidential election, which recommits the country to geopolitical unity with the US and NATO and potentially pro-productivity structural reforms (Chart 6). France is already a geopolitically secure country so the reduction of domestic political risk should be doubly positive for French assets, though they have already outperformed. And the Russia-West conflict is fueling a risk premium regardless of France’s positive developments. Chart 6France's Domestic Political Risk Will Subside But Russian War Will Keep Geopolitical Risk Elevated The French election ended with a solid victory for the political establishment as we expected. President Emmanuel Macron gaining 58% of the vote to Marine Le Pen’s 42%. Macron beat his opinion polling by 4.5pp while Le Pen underperformed her polls by 4.5pp. A large number of voters abstained, at 28%, compared to 25.5% in 2017. The regional results showed a stark divergence between overseas or peripheral France (where Marine Le Pen even managed to get over half of the vote in several cases) and the core cities of France (where Macron won handily). Macron had won an outright majority in every region in 2017. Macron did best among the young and the old, while Le Pen did best among middle-aged voters. But Macron won every age group except the 50 year-olds, who want to retire early. Macron did well among business executives, managers, and retired people, but Le Pen won among the working classes, as expected. Le Pen won the lowest paid income group, while Macron’s margin of victory rises with each step up the income ladder. Macron’s performance was strong, especially considering the global context. The pandemic knocked several incumbent parties out of power (US, Germany) and required leadership changes in others (Japan, Italy). The subsequent inflation shock now threatens to cause another major political rotation in rapid succession, leaving various political leaders and parties vulnerable in the coming months and years (Australia, the UK, Spain). Only Canada and now France marked exceptions, where post-pandemic elections confirmed the country’s leader. The Ukraine war constitutes yet another shock but it helped Macron, as Le Pen had objective links and sympathies with Russian President Vladimir Putin. Macron’s timing was lucky but his message of structural reform for the sake of economic efficiency still resonates in contemporary France, where change is long overdue – at least compared with Le Pen’s proposal of doubling down on statism, protectionism, and fiscal largesse. The French middle class was never as susceptible to populism as the US, UK, and Italy because it had been better protected from the ravages of globalization. Populism is still a force to be reckoned with, especially if left-wing populists do well in the National Assembly, or if right-wing populists find a fresher face than the Le Pen dynasty. But the failure of populism in the context of pandemic, inflation, and war suggests that France’s political establishment remains well fortified by the economic structure and the electoral system. Whether Macron can sustain his structural reforms depends on legislative elections to be held on June 12-19. Early projections are positive for his party, which should keep a majority. Macron’s new mandate will help. Le Pen’s National Rally and its predecessors may perform better than in the past but that is not saying much as their presence in the National Assembly has been weak. Bottom Line: France is geopolitically secure and has seen a resounding public vote for structural reform that could improve productivity depending on legislative elections. French equities can continue to outperform their European peers over the long run. Our European Investment Strategy recommends French equities ex-consumer stocks, French small caps over large caps, and French aerospace and defense.   Favor Spanish Over Italian Stocks Chart 7Italian And Spanish Political Risk Will Rise But Favor Spanish Stocks What about Spain? It is still a “divided nation” susceptible to a rise in political risk ahead of the general election due by December 10, 2023 (Chart 7). In the past few months, a series of strategic mistakes and internal power struggles have led to a significant decline in the popularity of Spain’s largest opposition party, the People’s Party. Due to public infighting and power struggle, Pablo Casado was forced to step down as the leader of the People’s Party on February 23, as requested by 16 of the party’s 17 regional leaders. It is yet to be seen if the new party leader, Alberto Nunez Feijoo, can reboot People’s Party. The far-right VOX party will benefit from the People Party’s setback. The latter’s misstep in a regional election (Castile & Leon) gave VOX a chance to participate in a regional government for the very first time. Hence VOX’s influence will spread and it will receive greater recognition as an important political force. Meanwhile the ruling Socialist Worker’s Party (PSOE) faces anger from the public amid inflation and high energy prices. However, Spanish Prime Minister Pedro Sanchez’s decision to send offensive military weapons to Ukraine is widely supported among major parties, including even his reluctant coalition partner, Unidas Podemos. The People’s Party’s recent infighting gives temporary relief to the ruling party. The Russia-Ukraine issue caused some minor divisions within the government but they are not yet leading to any major political crisis, as nationwide pro-Ukraine sentiment is largely unified. The Andalusia regional election, which is expected this November, will be a check point for Feijoo and a pre-test for next year’s general election. Andalusia is the most populous autonomous community in Spain, consisting about 17% of the seats in the congress (the lower house). The problem for Sanchez and the Socialists is that the stagflationary backdrop will weigh on their support over time. Bottom Line: Spanish political risk is likely to spike sooner rather than later, though Spanish domestic risk it is limited in nature. Madrid faces low geopolitical risk, low energy vulnerability, and is not susceptible to trying to leave the EU or Euro Area. Favor Spanish over Italian stocks. Stay Constructive On South Africa The political and economic status quo is largely unchanged in South Africa and will remain so going into the 2024 national elections. Fiscal discipline will weaken ahead of the election, which should be negative for the rand, but the global commodity shortage and geopolitical risks in Russia and China will probably overwhelm any negative effects from South Africa’s domestic policies. Rising commodity prices have propped up the local equity market and will bring in much-needed revenue into the local economy and government coffers. But structural issues persist. Low growth outcomes amid weak productivity and high unemployment levels will remain the norm. The median voter is increasingly constrained with fewer economic opportunities on the horizon. Pressure will mount on the ruling African National Congress (ANC), fueling civil unrest and adding to overall political risk (Chart 8). Chart 8South Africa's Political Status Quo Is Tactically Positive For Equities And Currency Almost a year has passed since the civil unrest episode of 2021. Covid-19 lockdowns have lifted and the national state of disaster has ended, reducing social tensions. This is evident in the decline of our South Africa GeoRisk indicator from 2021 highs. While we recently argued that fiscal austerity is under way in South Africa, we also noted that fiscal policy will reverse course in time for the 2024 election. In this year’s fiscal budget, the budget deficit is projected to narrow from -6% to -4.2% over the next two years. Government has increased tax revenue collection through structural reforms that are rooting out corruption and wasteful expenditure. But the ANC will have to tap into government spending to shore up lost support come 2024. Already, the ANC have committed to maintaining a special Covid-19 social-grant payment, first introduced in 2020, for another year. This grant, along with other government support, will feature in 2024 and possibly beyond. Unemployment is at 34.3%, its highest level ever recorded. The ANC cannot leave it unchecked. The most prevalent and immediate recourse is to increase social payments and transfers. Given the increasing number of social dependents that higher unemployment creates, government spending will have to increase to address rising unemployment. President Cyril Ramaphosa is still a positive figurehead for the ANC, but the 2021 local elections showed that the ANC cannot rely on the Ramaphosa effect alone. The ANC is also dealing with intra-party fighting. Ramaphosa has yet to assert total control over the party elites, distracting the ANC from achieving its policy objectives. To correct course, Ramaphosa will have to relax fiscal discipline. To this outcome, investors should expect our GeoRisk indicator to register steady increases in political risk moving into 2024. The only reason to be mildly optimistic is that South Africa is distant from geopolitical risk and can continue to benefit from the global bull market in metals. Bottom Line: Maintain a cyclically constructive outlook on South African currency and assets. Tight global commodity markets will support this emerging market, which stands to benefit from developments in Russia and China. Investment Takeaways Stay strategically long gold on geopolitical and inflation risk, despite the dollar rally. Stay long US equities relative to global and UK equities relative to DM-ex-US. Favor global defensives over cyclicals and large caps over small caps. Stay short CNY, TWD, and KRW-JPY. Stay short CZK-GBP. Favor Mexico within emerging markets. Stay long defense and cyber security stocks. We are booking a 5% stop loss on our long Canada / short Saudi Arabia equity trade. We still expect Middle Eastern tensions to escalate and trigger a Saudi selloff.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Yushu Ma Research Analyst yushu.ma@bcaresearch.com Guy Russell Senior Analyst GuyR@bcaresearch.com Footnotes 1   The campaign in the south suggests that Ukraine will be partitioned, landlocked, and susceptible to blockade in the coming years. If Russia achieves its military objectives, then Ukraine will accept neutrality in a ceasefire to avoid losing more territory. If Russia fails, then it faces humiliation and its attempts to save face will become unpredictable and aggressive. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Geopolitical Calendar

Executive Summary Using the real yield on inflation protected bonds as a gauge of the long-term real interest rate is possibly the biggest mistake in finance. The ultra-low real yield on inflation protected bonds captures nothing more than a stampede for inflation protection overwhelming a tiny supply of inflation protected bonds. The long-term real interest rate embedded in the US bond and US stock markets is likely to be significantly higher than the -0.2 percent real yield on US inflation protected bonds. Long-term investors should overweight conventional bonds and stocks versus inflation protected bonds. On a 6-12 month horizon, overweight both US bonds and US stocks. With core inflation on the cusp of rolling over and global growth decelerating, the end is in sight for the sell-offs both in long duration bonds and in the stock market. Fractal trading watchlist: High dividend stocks, and MSCI Hong Kong versus MSCI China. The Low ‘Real Bond Yield’ Just Reflects A Massive Demand For Inflation Protection Bottom Line: The end is in sight for the sell-offs both in long duration bonds and in the stock market. Feature “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so” One of my favourite quotes, ostensibly attributed to Mark Twain, warns us that trouble doesn’t come from what you don’t know. Rather, trouble comes from what you think you know for certain but turns out to be wrong. In economics and finance the “what you know for sure that just ain’t so” is the long-term real interest rate. In economics and finance the “what you know for sure that just ain’t so” is the long-term real interest rate. The long-term real interest rate is arguably the most fundamental concept in economics and finance. It encapsulates the risk-free real return on savings, and it is embedded in the returns offered by all assets such as bonds and equities. The trouble is, the way that most people quantify the long-term real interest rate turns out to be wrong. Specifically, most people define the long-term real interest rate as the real yield on (10-year) inflation protected bonds, which now stands at -0.2 percent in the US and -2.3 percent in the UK. US and UK inflation protected bonds will of course deliver the negative long-term real returns that their yields offer. So, most people believe that the long-term real interest rate is still depressed, permitting many rate hikes from the Federal Reserve and Bank of England before monetary policy becomes ‘restrictive’, and providing a massive cushion to asset valuations before they become expensive.This commonly held belief is arguably the biggest mistake in finance. The Long-Term Real Interest Rate Is Not What You Think The biggest mistake in finance stems from the confluence of two factors: first, the inflation protected bond market is the only true hedge against inflation; and second, it is tiny. Compared with the $45 trillion US equity market and the $25 trillion T-bond market, the Treasury Inflation Protected Securities (TIPS) market is worth just $1.5 trillion. Many other economies do not even have an inflation protected bond market! The ultra-low real yield on inflation protected bonds captures nothing more than the massive imbalance between huge demand for inflation hedges and tiny supply. When the price level surges, as it has recently, stock and bond investors have a fiduciary duty to seek an inflation hedge, even if they are shutting the stable door after the horse has bolted (Chart I-1). With at least $70 trillion worth of investors all wanting a piece of the $1.5 trillion TIPS market, the demand for TIPS surges, meaning that their real yield collapses. Therefore, the ultra-low real yield on inflation protected bonds captures nothing more than the massive imbalance between huge demand for inflation hedges and tiny supply. Chart I-1When The Price Level Surges, Investors Flood Into Inflation Protected Bonds The proof comes from the perfect positive correlation between the oil price and so-called ‘inflation expectations.’ As a surging oil price drives down the 10-year TIPS yield relative to the 10-year T-bond yield, this difference in yields – which is the commonly accepted definition of expected inflation through 2022-32 – also surges (Chart I-2and Chart I-3). This perfect positive correlation also applies to the so-called ‘5-year, 5-year forward’ inflation rate, the expected inflation rate through 2027-32 (Chart I-4). Chart I-2Inflation Expectations Just Track The Oil Price Chart I-3Inflation Expectations Are Just A Mathematical Function Of The Oil Price Chart I-4Even The ‘5-Year, 5-Year Forward’ Inflation Expectation Just Tracks The Oil Price Yet this observed positive correlation between the oil price and inflation expectations is nonsensical, because the reality is the exact opposite! The higher the price level at a given moment, the lower will be the subsequent inflation rate. This is just basic maths. The subsequent inflation rate is the future price divided by the current price, so dividing by a higher price results in a lower number. The empirical evidence over the last 50 years confirms this. The higher the oil price, the lower the subsequent inflation rate (Chart I-5). Chart I-5But A Higher Oil Price Means Lower Subsequent Inflation As the price level surges, subsequent inflation declines, both in theory and in practice. Hence, we should subtract a smaller number from the nominal bond yield to get a higher long-term real interest rate. In other words, all else being equal, the impact of a higher price level is to lift the long-term real interest rate. To repeat, the very low real yield on inflation protected bonds just captures the stampede of inflation hedging demand overwhelming a tiny supply (Chart I-6). Given this distortion, the real yield on inflation protected bonds is likely not the long-term real interest rate embedded in the much larger bond and stock markets. Right now, the long-term real interest rate embedded in the bond and stock markets is likely to be significantly higher than the -0.2 percent real yield on TIPS. Chart I-6The Low ‘Real Bond Yield’ Just Reflects A Massive Demand For Inflation Protection To which the obvious rejoinder is: if the real yield embedded in conventional bonds and stocks is much higher than in inflation protected bonds, why does the market not arbitrage it away? The simple answer is that the market will arbitrage it away, but in slow motion. This is because the mispricing between expected and realised inflation will crystallise in real time, and not ahead of it. Nevertheless, this slow motion arbitrage provides a compelling opportunity for patient long-term investors. Overweight conventional bonds and stocks versus inflation protected bonds. The Best Way To Value The Stock Market Given that we cannot use the yield on inflation protected bonds as a reliable measure of the long-term real interest rate embedded in stock prices, it is also a big mistake to value equities versus the real bond yield. In The Case Against A ‘Super Bubble’ (And The Case For) we explained the much better way to value equities. The basic idea is that the cashflows of any investment can be condensed into one future ‘lump sum payment’. So, we just need to know the size of this lump sum payment, and then to calculate its present value. The US stock market tracks (the 30-year T-bond price) multiplied by (profits expected in the year ahead). For a stock market, the size of the payment just tracks current profits multiplied by ‘a structural growth constant’, and the present value just tracks the value of an equal duration bond. For example, the duration of the US stock market is the same as that of the 30-year T-bond, at around 25 years.1  It follows that the US stock market price should track: (The 30-year T-bond price) multiplied by (profits expected in the year ahead) multiplied by (a structural growth constant) To the extent that the structural growth outlook for profits does not change, we can simplify the expression to: (The 30-year T-bond price) multiplied by (profits expected in the year ahead) This approach might seem simplistic, yet it perfectly explains the US stock market’s evolution both over the past 40 years (Chart I-7) and over the past year (Chart I-8). Specifically, in 2022 to date, the major drag on the US stock market has been the sell-off in the 30-year T-bond. Chart I-7The US Stock Market = The 30-Year T-Bond Price Times Profits (40 Year Chart) Chart I-8The US Stock Market = The 30-Year T-Bond Price Times Profits (1 Year Chart) For the foreseeable future, we expect profit growth to be lacklustre, keeping the 30-year T-bond price as the dominant driver of the US stock market. With core inflation on the cusp of rolling over and global growth decelerating, the end is in sight for the sell-off in long duration bonds and therefore for the sell-off in the stock market. On a 6-12 month horizon, overweight both US bonds and US stocks. Fractal Trading Watchlist This week, we note that the MSCI index outperformance of Hong Kong versus Chinese has reached a point of fragility on its 260-day fractal structure that has signalled previous major turning points in 2015, 2016, 2018, 2019, and 2020. Therefore, we have added this to our watchlist of investments that are at or approaching turning points, which is available in full on our website: cpt.bcaresearch.com We also highlight that the strong rally in high dividend stocks (the ETF is HDV) is vulnerable to correction if, as we expect, bond yields stabilise or reverse (Chart I-9). Accordingly, the recommended trade is to short high dividend stocks (HDV) versus the 10-year T-bond, setting the profit target and symmetrical stop-loss at 6 percent. Chart I-9The Outperformance Of High Dividend Stocks Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile   Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Reversing Chart 5Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal Chart 7Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 8A Potential Switching Point From Tobacco Into Cannabis Chart 9Biotech Is A Major Buy Chart 10CAD/SEK Reversal Has Started Chart 11Financials Versus Industrials To Reverse Chart 12Norway's Outperformance Could End Chart 13Greece's Brief Outperformance To End Chart 14BRL/NZD At A Resistance Point Chart 15The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 16The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 17Cotton's Outperformance Is Vulnerable To Reversal Chart 18US Homebuilders' Underperformance Has Reached A Potential Turning Point Chart 19Switzerland's Outperformance Vs. Germany Has Started To End Chart 20The Rally In USD/EUR Could End Chart 21The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The duration of any investment quantifies how far into the future its cashflows lie, by averaging those cashflows into one theoretical future ‘lump sum’. Defined mathematically, it is the weighted average of the times of its cashflows, in which the weights are the present values of the cashflows. For a bond, the duration also equals the percentage change in the bond price for every 1 percent change in its yield. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Executive Summary Allies Still Have Faith In USD The Biden administration’s use of sanctions has prompted market speculation about the longevity of the dollar. Yet the DXY has hit 100 and could break out, in the context of rising interest rates and safe-haven demand. The US’s increasingly frequent recourse to economic sanctions is a sign of growing foreign policy challenges. US rivals will continue to diversify away from dollar-denominated reserves. However, from a big picture point of view, there is no clear case that the dollar suffers from US sanctions. When global growth reaccelerates, the dollar can weaken. But until then it will remain resilient. Recommendation (Tactical) Inception Level Inception Date Return Long DXY 96.19 23-FEB-22 5.8% Bottom Line: Tactically stay long DXY and defensives over cyclicals. Feature The US’s aggressive use of sanctions against Russia, in response to its invasion of Ukraine, has prompted market speculation about the future of the global financial and monetary system. Related Report  US Political StrategyBiden's Foreign Policy And The Midterms               It is helpful to begin with facts – what we really know – before launching into grandiose predictions for the future. For example, while some analysts are predicting the demise of the US dollar’s position as the leading reserve currency, so far global investors have bid up the dollar in the face of rising policy uncertainty (Chart 1). In this report we conduct a short overview of US sanctions policy and draw a few simple investment conclusions. Chart 1US Political Risk And The Dollar US Extra-Territorialism Not Yet Hurting The USD The DXY is now trading at 101.2, above the psychological threshold of 100, suggesting that it could break out above its 2016 102.2 peak. The drivers are an expected sharp rise in real interest rates, in both absolute and relative terms, as the Federal Reserve starts on a rate hike cycle that is expected to add 225 basis points to the Fed funds rate this year alone to combat core inflation of 6.5%. This monetary backdrop must be combined with extreme global political and economic instability to explain the dollar’s potential breakout. The global situation is growing less stable, as EU-Russia energy trade breaks down while China imposes lockdowns to stop the spread of Covid-19. Over the past twenty years, the US has struggled to maintain its global leadership. Washington became distracted by wars in the Middle East and South Asia, a national property market crash and financial crisis, and a spike in political polarization and populism. The US public grew war-weary, while the US faced growing challenges from large and powerful nations that it could not confront militarily. Therefore US policymakers turned to economic tools to try to achieve their objectives: namely sanctions but also tariffs and export controls. Many economists and political scientists have warned that the US’s expanding use of economic sanctions – and broader trend of international, extra-territorial, law enforcement – would drive other countries to sell the US dollar and buy other assets, so as to reduce their vulnerability to US tools. This reasoning is sound, as we can see with Russia, which has reduced its dollar-denominated foreign exchange reserves from 41% to 16% since 2016, while increasing its gold holdings from 15% to 22% over the same period. Other major countries vulnerable to US sanctions could follow in Russia’s footsteps. However, so far, the dollar is not suffering excessively from such moves. On the contrary it is rising. The US started using sanctions aggressively with North Korea in 2005, Iran in 2010, and Russia since 2012. The dollar has fluctuated based on other factors, namely rising when the global commodity and industrial cycle was falling (Chart 2). Chart 2TWUSD And DXY Since 2000 Sanctions are a limited prism through which to examine the dollar. But if there is any observable effect of the US’s turn toward sanctions against major players like Russia in 2012 and China in 2018, it is that it has boosted the dollar rather than hurt it. Obviously that trend could change someday. But for now, as the Ukraine war dramatically heightens the US struggle with its rivals, investors should observe that the dollar is on the verge of a breakout. If the dollar continues to rise, it suggests that the US’s structural turn toward more aggressive economic and financial sanctions is not negative for the dollar. It may be neutral or positive. Cyclically the trade-weighted dollar is nowhere near its 2020 peak and could still fall short of that peak, especially if global tensions subside. But the collapse in the euro has caused the DXY to break above its 2020 peak already. Bottom Line: Stay tactically long DXY while watching whether it can break sustainably above 100 to determine whether our cyclically neutral view should be upgraded. US Sanctions On North Korea In this century, the US began to turn more aggressive in its use of sanctions when it confronted the “Axis of Evil” following the terrorist attacks on September 11, 2001. North Korea withdrew from the Nuclear Non-Proliferation Treaty in 2003 and began to pursue a nuclear and ballistic missile program more intently. The US responded by levying serious sanctions on that state beginning in 2005. Gradually tougher US sanctions never caused a change in the North Korean regime or foreign policy. On the contrary North Korea achieved nuclear weaponization and is today outlining an expansive nuclear doctrine.  US sanctions on North Korea were never going to drive global macro trends. However, they could have had an impact on South Korean trends. Initially none of the US sanctions reversed the dollar’s decline against the Korean won. After the global financial crisis in 2008, when the dollar began an uptrend against the won, we observe periods of significant new sanctions in which the won rises and the dollar falls (Chart 3, top panel). The same can be said for the outperformance of US equities relative to South Korean equities – if sanctions had any impact, they simply reinforced the flight to US assets in a globally disinflationary context. The trend was mirrored within the US equity market by the rise of tech versus industrials (Chart 3, bottom panel). Chart 3US Sanctions On North Korea Since Covid-19, the outperformance of US tech is now being overturned by high inflation, which has triggered a vicious selloff in tech. In 2022, global growth is slowing, stagflation is taking shape, and the odds of a recession are rising. Stagflation is negative for both industrials and tech, but more so tech. However, South Korea is still suffering from a deteriorating global macro and geopolitical backdrop, as globalization falters, US-China competition rises, and the US fails to contain North Korean ambitions. Sanctions are a symptom rather than a cause.  Bottom Line: US sanctions on North Korea pose no threat to the US dollar. Tactically US industrials can continue to outperform tech but both sectors will suffer in a stagflationary context. US Sanctions On Venezuela The US has slapped sanctions on Venezuela since the early 2000s but these sanctions kicked into high gear in 2015 after President Nicolas Maduro took power and eliminated the last vestiges of democratic and constitutional order. The US recognized the opposition as the legitimate government so sanctions relief will not be easy or convenient. Sanctions have not changed the regime’s behavior, but the regime has all but collapsed and major changes could happen sooner than people expect. Moreover any short-term sanction relief prompted by high oil prices will not be sustainable: the Republican Party will oppose it, hence private US corporations will doubt its durability, and Venezuela’s failing oil industry cannot be revived quickly anyway (Chart 4, top panel).    The US has strong relations with Venezuela’s neighbor Colombia. Yet Colombia faces the greatest economic and security risks from Venezuelan instability. The US dollar vastly outstripped the Colombian peso over the past decade, consistent with the US energy sector’s underperformance (Chart 4, bottom panel). Chart 4US Sanctions On Venezuela With Covid-19, this trend reversed because of the global energy squeeze and inflationary environment. The implication was positive for the Colombian peso as well as global (and US) energy sector relative performance. But the peso only marginally improved against the dollar, while US energy outperformance is now stretched.  Bottom Line: Energy sector still enjoys macro tailwinds but it is no longer clear that US energy stocks will outperform the broad market for much longer. Favor energy by staying long US energy small caps versus large caps. Also stay long oil and gas transportation and storage sub-sector relative to the broad market. The Biden administration is unlikely to give sanction relief to Venezuela. If it does, it will be ineffective at reducing oil prices in the short term. Either way, there will be little impact on the US dollar. US Sanctions On Iran US policy toward Iran is critical to global stability and energy prices in 2022 and the coming years. US sanctions did not change Iran’s behavior alone, but in league with the P5+1 (the UK, France, China, Russia, plus Germany) sanctions forced Iran to accept limit on its nuclear program in 2015. However, the Trump administration withdrew from that agreement and imposed “maximum pressure” sanctions on Iran in 2018, leading to a sharp depreciation in the market exchange rate of the Iranian toman (Chart 5, top panel). The Saudi Arabian riyal, by contrast, is pegged to the dollar and remains steady except when oil prices collapse (Chart 5, middle panel). The Saudis still rely on the Americans for national security so they are unlikely to abandon the dollar, though they may marginally diversify their foreign exchange reserves. The Biden administration wants to rejoin the 2015 deal but first is trying to extract concessions from Iran. Iran feels limited pressure: while its currency is still weak and inflation high, Iran has not succumbed to social unrest. Iranian oil production and exports are rising amid global high prices (Chart 5, bottom panel). Ultimately Iran wants to continue to advance its nuclear program in line with the North Korean strategy. Hence Biden can rejoin the deal unilaterally if he wants to avoid Middle Eastern instability ahead of the midterm elections. But it would be a short-term, stop-gap agreement and the reduction in oil prices would be fleeting. By contrast, if Biden fails to lift Iran’s sanctions, then the risk of oil disruptions from the Middle East goes way up. Tactically investors should expect upside risks to the oil price, but that would kill more demand and weigh on global growth. Over the past decade the outperformance of US equities relative to Saudi and Emirati equities falls in line with the outperformance of US tech relative to energy sectors. As mentioned, this trend has largely run its course, although it can go further in the short run. But there is a broader trend related to growth versus value styles. The UAE’s stock market is heavily weighted toward financials, while the US is heavily weighted toward tech. The US tech sector has collapsed relative to financials (Chart 6).  Chart 5US Sanctions On Iran Chart 6US Sanctions On Iran Bottom Line: US energy and financials sectors can fare reasonably well in a stagflationary context but their outperformance relative to tech is largely priced from a cyclical point of view. US maximum pressure sanctions on Iran never hurt the US dollar. US Sanctions On Russia The US’s extraordinary sanctions against Russia in 2022 – including freezing its dollar-denominated foreign exchange reserves – have sparked market fears that countries will divest from US dollars to protect themselves from any future US sanctions. To be clear, the US has confiscated foreign enemies’ property and foreign exchange reserves in the past. True, Russia is qualitatively different from other countries, such as Iran, because it is one of the world’s great powers. Yet the US closed off all economic and financial linkages with Russia from 1949-1991 because of the Cold War, the very period when the US dollar rose to prominence as the global reserve currency. In 2022, sanctions on Russia have primarily hurt the Russian ruble, not the US dollar (Chart 7). The Russians divested from the dollar after invading Ukraine in 2014 to reduce the impact of sanctions. But they were not able to divest fast enough to prevent the 2022 sanctions from pummeling their financial system and economy. Chart 7US Sanctions On Russia Going forward Russia will be much more insulated from the US dollar but at a terrible cost to long-term productivity. The lesson for other US rivals may be to diversify away from the dollar – but that will be a secondary lesson. The primary lesson will be to take economic stability into account when making strategic security decisions. Economic stability requires ongoing engagement in the global financial system and US dollar system. US sanctions on Russia have benefited US equities and dollar relative to Russian assets as one would expect. Russia’s invasion of Ukraine exacerbated the trend. The takeaway for US investors is that the energy sector’s outperformance sector’s outperformance can continue in the short run but is becoming stretched from a cyclical perspective. Bottom Line: Investors should expect oil and the energy sector to remain strong in the short run, while tech will suffer in an inflationary and stagflationary environment. But energy may not outperform tech for much longer. US Sanctions On China US policy toward China is the critical question today. China holds $1 trillion in dollar-denominated exchange reserves and must recycle around $200 billion in current account surpluses every year into global assets. The US has imposed sweeping sanctions on Iran since 2010, Russia since 2012, and China since 2018. China began diversifying away from dollar-denominated foreign exchange reserves in 2011 in the wake of the Great Recession. The US-initiated trade war in 2018 solidified the change in China’s foreign reserve strategy. The US sanctions against Russia will further solidify it. There are some signs that US punitive measures affected the USD-CNY exchange rate but global economic cycles are far more powerful. The yuan appreciated from 2005 until the global financial crisis, during the height of US-China economic and diplomatic engagement. It depreciated through the manufacturing slowdown of 2015 and the US-China trade war. It appreciated again with the pandemic stimulus and global trade rebound. The yuan was affected by US sanctions and tariffs on the margin amid these larger macro swings (Chart 8, top panel). Still, the overarching trend since 2014 points to a rising dollar and falling yuan. Globalization is in retreat and US-China strategic competition is heating up. As with South Korea, these trends are negative for Chinese assets. US sanctions are a symptom rather than a cause of the underlying macro and geopolitical dynamics. The same point can be made with regard to US equity performance relative to Chinese – and hence US tech outperformance relative to US industrial stocks (Chart 8, bottom panel). However, as with Korea, the cyclical takeaway is to favor industrials over technology in a stagflationary environment. Chart 8US Sanctions On China Bottom Line: Tactically favor US industrials over tech until the world’s stagflationary trajectory is corrected. US-China relations are one area where US sanction policy can hurt the dollar, as China will seek to diversify over time. But so far the evidence is scant. US Sanctions And Foreign Holdings Of Treasuries Having examined US sanctions on a country-by-country basis, we should now turn toward holdings of US dollars and Treasury securities. Are US economic sanctions jeopardizing the willingness of states to hold US assets? First, Americans hold 74% of outstanding treasuries. Foreigners hold the remaining 26% (Chart 9, top panel). This is a large degree of foreign ownership that reflects the US’s openness as an economy, as well as the size of the treasury market, which makes it attractive to foreign savers who need a place to store their wealth. Of this 26%, defense allies hold about 36%. Theoretically up to 17% of treasuries stand at risk of rapid liquidation by non-allied states afraid of US sanctions. But a conservative estimate would be 6%. Notably the share of foreign-held treasuries held by non-allies has fallen from 40% in 2009 to 23% today. Non-allies are reducing their share fairly rapidly (Chart 9, middle panel). What this really means is that China and Hong Kong are reducing their share – from 26% in 2008 to 16% today. Brazil and India have maintained a steady 6% of foreign-held treasuries. Notably the offshore financial centers see a growing share, suggesting that trust in the dollar remains strong even among states and entities that wish to hide their identity. Some of the divestment that has occurred from non-allied states may be overstated due to rerouting through these third parties. Looking at the data in absolute terms, only China – and arguably Brazil – can be said with any certainty to be pursuing a dedicated policy of divesting from US dollar reserves (Chart 10). This makes sense, as China, like Russia, is engaged in geopolitical competition with the US and therefore must take precautions against future US punitive measures. But these measures are not so far generating a worldwide flight from the dollar, either at the micro level or the macro level. Chart 9Foreign Purchases Of US Treasuries Chart 10Foreigners With Large Treasury Holdings In fact, the biggest competitor to the US dollar is the euro. This is clear from looking at the share of global currency reserves – the two are inversely proportional (Chart 11). And yet it is the European Union, not the US, that could suffer a long-term loss of security, productivity, and stability as a result of Russia’s invasion of Ukraine. The euro is losing status as a reserve currency and the war could exacerbate that trend. Chart 11Global Reserve Currency Basket Europe does not provide protection from US sanctions. The EU, like the US, utilizes economic sanctions and the two entities share many similar foreign policy objectives. Europe is also allied with the US through NATO. When the US withdrew from the Iran nuclear deal, the EU did not withdraw, yet EU entities enforced the sanctions, as their economic linkages with the US were much more valuable than those with Iran. In the case of Russia, the two have imposed sanctions in league, as they will likely do toward other small or great powers that attempt to reshape the global order through military force. The next competitors to the dollar and euro are grouped together in Chart 11 above because they are the US’s “maritime allies,” such as Japan, the United Kingdom, and Australia. These countries will pursue a similar foreign policy to the United States and they do not offer protection from US sanctions during times of conflict or war.  The true competitor is the Chinese renminbi. The renminbi will grow as a share of global reserves. But it faces serious obstacles from China’s economic policy, currency controls, closed capital account, and geopolitical competition with the United States. Washington’s sanctions have already targeted China yet the US dollar has remained resilient.  Bottom Line: The US’s erratic foreign policy in recent decades has potentially weighed on the US’s commanding position as a global reserve currency, with its share of reserves falling from 71% in 2000 to 59% today. But US allies have mostly picked up the slack. And the dollar’s top competitor, the euro, is likely to suffer more than the dollar from the Ukraine war. Still it is true that US sanctions are alienating China, which will continue to diversify away from the dollar.  Investment Takeaways Tactically stay long the US dollar (DXY). The combination of monetary policy tightening and foreign policy challenges is driving a dollar rally that could result in a breakout.  US sanctions policy is not a convincing reason to sell the dollar in today’s context. Over the medium term dollar diversification poses a risk, although the dollar will still remain the single largest reserve currency over a long-term, strategic horizon. For further discussion see the Special Report by our Foreign Exchange Strategy and Geopolitical Strategy, “Is The Dollar’s Reserve Status Under Threat?” Given US domestic policy uncertainty in an election year, and foreign policy challenges, stay long defensive sectors, namely health care, over cyclical sectors.   Tactically our renewable energy trade has dropped sharply. But cyclically it remains attractive, as our recent Special Report with our US Equity Strategy team demonstrates. If Congress fails to succeed in promoting its new climate and energy bill, then this trade could suffer bad news in the near term. Tactically US industrials can continue to outperform the tech sector, given the stagflationary context that is developing. Energy’s outperformance, especially relative to tech, is becoming stretched, at least from a cyclical point of view. But geopolitical trends suggest oil risks are still to the upside tactically. For now, maintain exposure to high energy prices by staying long energy small caps versus large caps and O&G transportation and storage.   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)   Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets

Listen to a short summary of this report.     Dear Client, In lieu of our weekly report next week, I will be hosting a webcast on Tuesday with my colleague Mathieu Savary, Chief European Strategist, on the implications of stagflation on European assets and global FX markets. I look forward to answering any questions you might have. Kind regards, Chester Executive Summary The Yen And Interest Rates The Japanese yen is in liquidation. The historical evidence suggests waiting for an exhaustion in selling pressure, before placing fresh bets. This exhaustion is likely to occur once global bond yields stabilize (Feature chart), and energy price inflation abates. A move lower in these two key variables would catalyze an explosive rebound in the yen, on the back of very cheap valuations and a large net short speculative position. The Bank of Japan will not meaningfully pivot soon. The reason is that downside risks to the Japanese economy supersede the risk of an inflation overshoot. What Japan needs is stronger fiscal spending, that would offset deficient domestic demand. That said, Japan is also one of the best candidates for generating non-inflationary growth, a bullish backdrop for the currency. Our 2022 target for the yen is 110. Our sense is that most of the downside risks are well understood by markets, while upside surprises are much underappreciated. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short chf/JPY 135 2022-04-21 - Bottom Line: The yen has undershot. According to our in-house PPP models, the Japanese currency is undervalued by 35%. Historically, an investor buying the yen at such undervalued levels has made 6% per year over the subsequent 5 years. Feature The yen’s move in recent weeks has been explosive. Since early March, the yen has collapsed by 11%, pushing USD/JPY from around 115 to a nudge below 130. Over the last year, the yen is down 16%. In retrospect, a chart formation since 1990 suggests this is a classic liquidation phase that is unlikely to reverse until fundamentals shift. The two key drivers of yen weakness have been higher global yields, and elevated energy prices. Chart 1 shows that the yen has been perfectly tracking the US 10-year Treasury yield. Yield curve control (YCC) is leading to a capitulation of both domestic and foreign investors, fleeing from Japanese bonds towards external bond markets. Looking out the curve, investors do not expect the Bank of Japan to lift rates higher than 50 bps until 2028 (Chart 2). Chart 1The Yen And Interest Rates Chart 2The BoJ Is Expected To Stay Dovish Meanwhile, higher energy costs are also putting selling pressure on the yen as merchants sell JPY to pay for more expensive imports in US dollars.    Is Selling Pressure Exhausted? Chart 3A Technical Profile Of The Japanese Yen The key question for investors is whether the carnage in the yen is in an apocalyptic phase. The answer depends on the time horizon. Daily traders, reconciling positions every few hours, should continue shorting the yen. Exhaustion in selling pressure is likely to manifest itself through a few technical patterns, most notably, a consolidation phase. Chart 3 suggests that reversals in the yen have tended to pass through a period of indigestion, allowing investors enough time to play on a reversal. We are not there yet.  That said, for longer-term investors, being contrarian could pay off handsomely. The 1-year drawdown in the yen is within the scope of historical capitulation phases (Chart 4). Since JPY became freely floating, selloffs have been around 15%-20% especially during major events (the Asian financial crisis or the manufacturing recession the last decade, for example). The last major selloff was around Abenomics in 2012, a pivotal event. Chart 4The Yen Drawdown Has Matched Previous Capitulation Phases Speculators are also very short JPY and sentiment is quite depressed. This is bullish from a contrarian perspective. Low rates in Japan have led to the proliferation of carry trades. While these are likely to persist, the bulk of investors have already jumped on this bandwagon. A stabilization and/or reversal in US Treasury yields could flush out stale shorts in the yen (Chart 5). If, as we expect, the greenback does weaken in the second half of this year, that will also support the yen. Chart 5Sentiment On The Yen Is Very Depressed Japan’s Economic Outlook The yen tends to appreciate when the Japanese economy is exiting a recession (Chart 6). Part of the reason why the yen has been so weak is because economic growth in Japan has been anemic. While the external sector has been benefiting from a global trade boom, the domestic sector has been under siege from the pandemic, until recently. Chart 6The Yen Tends To Rebound When The Japanese Economy Recovers It is notable that while goods spending has been picking up around the world, the personal consumption component of GDP in Japan remains 5% below the pre-pandemic trend. Shinkansen passenger volumes are still down 42% this year after an even bigger collapse last year. Inbound tourists, a meaningful source of demand, has collapsed from about 25% of the overall Japanese population before the pandemic to zero today. These dire statistics are likely to reverse. The manufacturing PMI is ticking higher. The number of daily new COVID-19 cases has dramatically rolled over. This will be a welcome fillip to much subdued consumer and business sentiment. 2% Inflation = Mission Impossible? The BoJ is likely to get its wish of 2% inflation in the coming months. However, it will prove fleeting. The overarching theme for Japan is an aging and declining population which has put a lid on consumer prices (Chart 7). This will support real interest rates. Inflation does not tend to accelerate on the island until the output gap is fully closed. That has yet to occur. Meanwhile, the political push to cut mobile phone prices has been a drag on CPI. Mobile phone charges alone have cut around 1.2%-1.5% from the core core measure of Japanese inflation, according to the BoJ. This has been a structural trend. As a result, long-term inflation expectations in Japan remain anchored near 1%, even though the rest of the world is seeing a price boom (Chart 8). The revealed preference is for low/stable prices. Chart 7Demographics Are Weighing On Japanese##br##Inflation Chart 8Long-Term Inflation Expectations In Japan Are Rising, But Muted Clearly, the Bank of Japan would like this to change, as it aims for a persistent 2% inflation target. That said, it will be unable to adjust monetary settings aggressively. The BoJ already owns over 50% of Japanese government bonds, and that has made the market very illiquid. As a result, ownership as a share of GDP is nearing attrition (Chart 9). Related Report  Foreign Exchange StrategyThe Yen In 2022 Arguably, the BoJ could widen the target band for yield curve control, while lowering short rates further below zero, but that is unlikely to do much for inflation expectations. It could also expand its 0% bank loan scheme beyond renewable industries, and/or small/medium-sized firms, but the problem in Japan is a lack of demand. The currency remains the sole policy lever for the BoJ. Unfortunately, for a small, open economy, the BoJ has less control over the currency. The Ministry of Finance last intervened to support the currency in 1998 (Chart 10). That helped the yen temporarily, but global factors dictated its longer-term trend. Intervention this time around will not assuage the whale of carry traders. Chart 9The BoJ Has Not Been Aggressively Buying Government Bonds Chart 10The MoF Could Soon ##br##Intervene A falling yen would allow some pass-through inflation, but this is unlikely to be sticky. The yen needs to fall 10% every year to generate 1% inflation in Japan (Chart 11). Meanwhile, a policy based on depreciating your currency could lead to a crisis of confidence, especially vis-à-vis Japanese trade partners. Our model for core core inflation suggests that all the weakness in the currency will only boost this print to 0.5% in the coming months (Chart 12). Chart 11Currency Weakness Will Only Temporarily Help Boost Inflation Chart 12Core CPI Will Not Meaningfully ##br##Recover What Japan needs is more fiscal spending. For a low-growth economy, with ultra-loose monetary settings, the fiscal multiplier tends to be much larger. Putting it all together, real rates are unlikely to fall very much in Japan. This is very positive for the yen in a world with deeply negative real rates. As demand recovers, and the Japanese economy generates non-inflationary growth, the currency should find a solid footing. Why Valuation Matters Chart 13The Yen Is Very Cheap Japan is running a big trade deficit on the back of high energy prices. A cheap currency at least increases Japan’s competitiveness. This is particularly the case since the boom in external demand has been a much welcome cushion for Japanese growth. According to our PPP models, the Japanese yen is the cheapest G10 currency, undervalued by around 35% (Chart 13). Why valuations matter is because an investor who buys the yen today can expect to make 6% a year over the next half decade, based on the historical correlation between valuation and subsequent currency returns (Chart 14). This will especially be the case if Japanese inflation keeps lagging inflation in the US. As we argued at the beginning of this report, US yields will need to stabilize before long yen positions make sense on a tactical basis (Chart 15). Chart 14Valuation Matters For The Japanese Yen Chart 15Global Yields Need To Stabilize For The Yen To Bounce The Yen As A Safe Haven The yen still appears to have the best correlation with a rising VIX (Chart 16). In a world of slowing global growth and the potential for equity market turbulence, this bodes well for long yen positions. That said, the carry on this position will be unbearable especially if the Federal Reserve continues to sound hawkish. The better play on potential yen strength is a short CHF/JPY position. Historically, these currencies have tended to move together. However, more recently, the CHF has risen substantially versus the JPY, suggesting some mean reversion is due (Chart 17). Chart 16The Yen Remains A Good Hedge Chart 17Go Short CHF/JPY Strategically, we were stopped out of our short USD/JPY position at 128, initiated at 124. Our 2022 target for the yen is 110. Our sense is that most of the downside risks are well understood by markets, while upside surprises are much underappreciated. Tactically, we will wait for the consolidation phase we outlined earlier in this report, before initiating fresh positions.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary After having overspent on goods ex-autos over the past two years and experiencing contracting incomes in real terms, US and European households will reduce their purchases of goods ex-autos. Risks to global growth stemming from China remain to the downside. Leading indicators from Asia and global financial markets are signaling a contraction in global trade. Yet, US core inflation will not drop below 4% for the rest of this year. Consequently, the Fed will likely end up hiking rates and sounding hawkish amidst a major global trade slump. This will give rise to stagflation anxiety among investors and will be negative for global risk assets in general and EM equities, currencies and credit markets in particular. The yuan is breaking down versus the US dollar. A weaker RMB will pull down Emerging Asian as well as other EM currencies. Does This Divergence From A Historic Correlation Signify Stagflation? Bottom Line: Global equity and credit portfolios should remain defensive and continue underweighting EM. Currency investors should be positioned for another upleg in the US dollar and a downleg in EM currencies. Feature The volume of global trade is about to contract. Meantime, US inflation will remain well above the Fed’s target. This combination will produce stagflation anxiety among investors. It is impossible to know whether stagflation will be a long-lasting phenomenon in the real economy. In our view, the stagflation narrative will dominate global financial markets in the coming months. This heralds a cautious stance on global and EM risk assets. The slowdown in global manufacturing and trade will be pervasive and broad-based but will exclude auto production. The latter will in fact recover as chip/input shortages ease. The main drivers of the slowdown are (1) a mean reversion in US and European demand for goods ex-autos; (2) China’s economic woes and (3) moribund domestic demand in mainstream EM. Shrinking DM Household Demand For Goods ex-Autos Chart 1DM Household Demand For Goods ex-Autos Will Experience Mean Reversion After having overspent on goods ex-autos over the past two years and experiencing contracting income in real terms (after adjusting for inflation), US and European households will reduce their purchases of goods ex-autos. US and European consumption of goods ex-autos exploded at the onset of the pandemic two years ago and has stayed robust until now. Chart 1 illustrates that since mid-2020, the consumption of goods ex-autos was running well above its trend, which signifies excessive demand over the past two years. Such excessive demand has led to bottlenecks and shortages, giving producers an opportunity to hike prices. In a nutshell, inflation in tradable goods in the past 18 months was primarily driven by demand, not supply constraints. A portion of future goods consumption has been pulled forward, which implies that household demand for these goods has become saturated. Moreover, as the pandemic subsides, consumers are shifting their spending from goods to services. These dynamics could create an air pocket in the demand for certain goods. Chart 2DM Household Real Incomes Are Contracting Critically, US and European household income is contracting in real terms (Chart 2). Wage growth has not kept up with the surge in inflation. Due to shrinking disposable real income, consumers in advanced economies will curtail their consumption of discretionary items, primarily goods ex autos on which they have overspent during the past two years. Bottom Line: Demand for goods ex-autos will shrink in advanced economies in the next 6-12 months. This will weigh on global merchandise trade. China’s Trilemma Chinese authorities are facing an “impossible trinity” in their attempts to simultaneously achieve three objectives: (1) pursuing the dynamic zero-Covid policy, (2) delivering decent economic growth, and (3) not resorting to “irrigation-style” massive stimulus. We do not think all three objectives can be achieved. China’s economy was struggling prior to the recent lockdowns. The COVID-related restrictions have only made matters worse and have weighed heavily on economic activities and household income. Domestic orders for industrial enterprises plunged below 50, i.e., they are in contraction territory (Chart 3). These surveys, released on March 30-31, were not affected by the Shanghai lockdowns, which have proliferated since March 28. Exports orders are also contracting (Chart 4). Chart 3China: Domestic Orders Were Plunging Prior To Lockdowns Chart 4China: Exports Are Set To Contract   Further, China’s import and export volumes were contracting in January – prior to the Ukraine war and the recent lockdowns. Notably, Chart 5 highlights that prior to the recent lockdowns, import weakness was broad-based, including commodities, machinery and semiconductors. In particular, total imports in USD are flat in March compared to a year ago. With commodity prices up significantly, it is clear that import volumes in March have shrunken substantially. National disposable income per capita was growing at about 6% in nominal terms before the lockdowns (Chart 6, top panel). Household mortgage growth had decelerated considerably before lockdowns became widespread (Chart 6, bottom panel). Chart 5Chinese Imports Were Shrinking Before Lockdowns Chart 6China: Household Income And Mortgage Borrowing ​​​​​​​​​​​​​​​​​​​​​   As the lockdowns wreak havoc on the economy and household income, and with the government not providing direct transfers to the population, household consumption will be severely affected in the months ahead. The property market remains in the doldrums and is unlikely to recover soon. As we have highlighted in previous reports, structural headwinds, continue to weigh down on the property market. Since 2009, there has been no business cycle recovery in China without the real estate market playing the leading role. Residential floor space sold was down by 20% in Q1 from a year ago (Chart 7, top panel). House prices have begun deflating in tier-3 cities. Deflation will likely spread to tier-1 and -2 cities due to a pandemic-driven decline in income and confidence. Critically, the plunge in property developers’ financing entails shrinkage in housing completion (construction work) (Chart 7, bottom panel). The latter has so far held up as authorities have been forcing developers to use their limited financing to complete projects that they had already started. The massive issuance of local government bonds will spur an acceleration in infrastructure spending. China’s government gave the green light already this year to infrastructure projects worth nearly 70% of what was allowed for the whole of last year. Yet, this might be insufficient to produce a rapid business cycle recovery in an environment of rolling lockdowns and with other segments of the economy facing challenges. Related Report  Emerging Markets StrategyGlobal Semi Stocks: More Downside Given these negative forces, the Chinese economy requires massive government stimulus in the form of direct transfers to households and SMEs – as the US offered in the spring of 2020. Yet, it does not seem that the government is rushing to provide such direct and significant stimulus. In our opinion, the policy stimulus measures announced so far by the government fall short of what is required to lift the economy. Policymakers are neither ready to abandon the dynamic zero-Covid policy nor provide “irrigation-type” stimulus, especially for households and the property market. With these two constraints, economic growth in China is set to underwhelm. Bottom Line: Risks to global growth stemming from China remain to the downside. In EM ex-China, ongoing fiscal tightening, monetary tightening in LATAM and feeble household income growth in India and ASEAN will all cap consumer spending and business investment (Chart 8). Chart 7China: Property Construction Is Set To Shrink Chart 8EM ex-China: Domestic Demand Will Remain Sluggish Signs Of A Global Trade Contraction There is already evidence to suggest that a major relapse in global manufacturing and trade is beginning: Taiwanese shipments to China are dipping into negative territory, and they lead global exports (Chart 9). Taiwanese exports to China are a good leading indicator of global trade dynamics because mainland producers order inputs from Taiwan first before they produce final goods for export. When producers located in China order less inputs, they evidently expect less in the way of production and shipments. Korea’s business survey of exporting companies indicates a substantial deterioration in their business conditions in April (Chart 10). This points to a major slump in the nation’s exports and, hence, global trade. Chart 9Global Trade Is Set To Contract Chart 10Korean Exporters Are Downgrading Their Expectations Korean and Japanese non-financial share prices have plunged despite considerable currency depreciation, which is typically positive for their competitiveness. As many of these non-financial companies are major exporters, this development points to a major downtrend in global trade. Global cyclicals have been underperforming global defensives. This dynamic has historically been a good leading indicator for the global industrial downturn (Chart 11). Finally, early cyclical stocks in the US have sold off and have substantially underperformed domestic defensives (Chart 12). This also points to a slowdown in US growth. Chart 11Global Equity Sector Performance Points To A Relapse In Global Manufacturing Chart 12Beware Of A Relapse in US Early Cyclical Stocks   Bottom Line: Leading indicators from Asian economies and global financial markets are signaling that global trade will experience a contraction and global growth will slow. Inflation Amid A Global Trade Contraction? Chart 13US Wages Are Surging in Nominal Terms Yet Shrinking In Real Terms A natural question is why worry about inflation when global trade volumes will be contracting? The primary source of anxiety in this context is US inflation and the Fed’s tightening. A decline in global trade will not be enough to bring down US core inflation substantially. By contrast, China and Asia do not face an inflation problem. US inflation worries will persist, and the Fed will likely continue to hike rates and sound hawkish for the following reasons: First, US capital expenditures by companies and household spending on services will remain robust. US services make up a larger share of the American economy and employment than do goods-producing sectors. Hence, we do not expect a broad-based recession in the US this year. Second, as we have previously noted, the US has a genuine inflation problem. American wages are accelerating, and a tight labor market will push up wage growth above 5-6% (Chart 13, top panel). Importantly, real wages in the US have contracted (Chart 13, bottom panel). Faced with a decline in purchasing power, employees will demand higher wages. The tight labor market raises the odds that companies will likely accommodate higher wages. Chart 14Unit Labor Costs Are The Key To Core Inflation Given that US productivity growth is no more than 1.5-2%, wage growth over 5-6% means that unit labor costs will be rising by more than 3-4%. This will prevent core inflation from falling a lot. Unit labor costs have historically been the main driver of core inflation in the US (Chart 14). Finally, inflation is a lagging and inert phenomenon. It takes a long time (more than six to nine months) of sub-par growth for inflation to subside. Odds are that even though global trade volumes will be contracting, the Fed will continue hiking rates and sounding hawkish because US inflationary pressures will remain acute. Bottom Line: Annual core CPI inflation will drop in the US due to the base effect and a drop in some goods prices. Yet, we expect core CPI and PCE to remain above 4% for the rest of this year. Underlying inflationary pressures have spilled over into the labor market, and the wage-price spiral has probably unraveled. Therefore, inflation cannot be reduced meaningfully without bringing economic growth down below potential growth and weakening the labor market for a few quarters. Investment Implications Shrinking global trade volumes and a hawkish Fed are bearish for global risk assets in general and EM equities, currencies and credit markets in particular. Contracting exports and a hawkish Fed are negative for the Chinese yuan and other Asian currencies. The CNY/USD exchange rate has broken below its 200-day moving average and odds are that it will depreciate further (Chart 15). Our target for CNY/USD is 6.7. The broad trade-weighted US dollar has more upside and EM currencies will depreciate. Chart 16 illustrates that investors’ net long positions in ZAR, BRL and MXN are high. Chart 15The RMB Is Breaking Down Chart 16Investors Are Long EM Commodity Currencies   Our recommended currency shorts for now are ZAR, PHP, IDR, COP, HUF, PEN and PLN. Global equity and credit portfolios should continue underweighting EM. Notably, global defensive equity sectors have been outperforming non-TMT stocks despite rising US/global bond yields (Chart 17). This is a major departure from the historical relationship and likely signifies a period of slower global growth ahead but continuous Fed tightening. Global equity managers should favor defensive stocks. Chart 17Does This Divergence From A Historic Correlation Signify Stagflation? For EM equity managers, we also recommend favoring defensive sectors like consumer staples. Presently, our country overweights are Korea, Singapore, Chinese A-shares, Mexico and Brazil. Our underweights are India, Central Europe, Indonesia, Turkey, South Africa, Colombia and Peru. In local rates, we continue recommending receiving Chinese and Malaysian 10-year swap rates, a long position in Brazilian 10-year bonds, betting on yield curve flattening in Mexico and paying Polish 10-year swap rates while receiving Czech 10-year swap rates. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com​​​​​​​