Switzerland
Highlights The dollar will continue to rally despite the trade truce agreed upon last weekend between U.S. President Donald Trump and China President Xi Jinping. Not only is this truce far from a permanent deal, but global growth continues to slow. Moreover, if the truce were to generate a genuine improvement in global growth conditions, this would likely result in a much more hawkish Federal Reserve than the market is currently pricing in. This would lead to a further deterioration in global liquidity conditions, causing additional growth problems for the world. Buy EUR/CHF, as the Swiss National Bank will soon have to intervene in the market. Sell AUD/NOK, as oil should outperform metals and the Norges Bank is better placed to tighten policy than the Reserve Bank of Australia. Feature Presidents Donald Trump and Xi Jinping have agreed to freeze additional new tariffs on Chinese exports to the U.S. for three months. This means that as of January 1, 2019, U.S. tariffs on US$200 billion of Chinese exports to the U.S. will remain at 10%, and will not jump to 25%. Meanwhile, China has agreed to immediately resume its imports of soybeans and LNG from the U.S. Moreover, China has also agreed to begin talks to open up Chinese markets to U.S. exports as well as to address U.S. worries regarding intellectual property theft. The world has let out a collective sigh of relief. A potent narrative exists that fears of a trade war have been the root cause of the slowdown in global growth witnessed this year. Consequently, since the dollar performs well when global industrial activity slows, this also means that ending the trade war could be key to abort the dollar’s bull market. We are doubtful this narrative will pan out, and we do not think that the Buenos Aires truce will lead to the end of the dollar rally. This also means that the G-20 armistice is also unlikely to reverse the underperformance of commodity and Scandinavian currencies. First, this truce does not mark the end of the trade war. It is only an agreement to delay the implementation of U.S. tariffs. Come March, the Trump administration may well sing a very different tune. The U.S. domestic political climate has not changed one iota, and protectionism, particularly when directed at China, still wins votes (Chart I-1). Meanwhile, the concessions China is willing to give are long-term in nature; however, Trump wants visible wins well ahead of the 2020 elections. This mismatch creates a real danger that the White House imposes new tariffs again beyond the three-month armistice agreed at the G-20. The news yesterday afternoon that the CFO of Huawei was indicted in Vancouver already casts doubts on the deal. Chart I-1Americans Will Remain Tough On China Second, the dollar has been strong, and risk assets have been weak for more reasons than the trade war alone. As shown by the slowdown in Japanese or Taiwanese exports, as well as by the contraction in German foreign orders and in the CRB Raw Industrial Index’s inflation, global trade and global growth are slowing (Chart I-2). This development is likely to last until mid-2019, as our global leading economic indicator continues to fall. This deterioration in the global LEI does not look set to stop soon, as normally any improvement in the global LEI is first telegraphed by a stabilization in the Global LEI Diffusion Index – an indicator that is still falling (Chart I-3). Chart I-2Global Growth Continues To Slow Chart I-3No Bottom In Sight For The Global LEI China is not yet coming to the rescue either. The slowdown in Chinese economic activity continues, and in fact, the paucity of a rebound in Chinese credit growth despite injections of liquidity by Beijing suggests that a bottom is not yet in sight (Chart I-4). Hopes that were raised by increased bond issuance from local governments have also been dashed as this proved to be a very temporary phenomenon (Chart I-5). What is more worrisome is that so far Chinese exports have held their ground; however, the decline in the new export orders of the Chinese PMI suggests that this support to growth is likely to taper sharply in the coming months (Chart I-6). Chart I-4Credit Growth Decelerating Despite Stimulus Chart I-5Chinese Infrastructure Push Looks Transitory Chart I-6Chinese Exports: The Last Shoe To Drop Finally, despite the cloudy outlook for global growth that built up this year, U.S. yields had risen 80 basis points by November 8, adding stress to economies already negatively impacted by weakening manufacturing activity. This increase in global borrowing costs has worsened the already noticeable decline in U.S.-dollar based liquidity (Chart I-7). This decline in liquidity has been a great source of concern as EM economies, the source of marginal growth in the global economy, have large dollar-denominated debt loads, and thus need abundant dollar liquidity in order to support their economies (Chart I-8). Chart I-7Slowing Dollar Liquidity Explains Weak Global Growth... Chart I-8...Because There Is A Lot Of Dollar Debt Where Growth Is Generated This last point is especially unlikely to change in response to the Buenos Aires truce. Since November, 10-year U.S. yields have fallen around 25 basis points, and now fed funds rate futures are only pricing in 45 basis points of rate hikes over the coming two years, including the December hike. If business sentiment improves because of a trade truce, and consequently U.S. capex proves more resilient than anticipated by market participants, the Federal Reserve will increase rates by much more than what is currently priced into the futures curve (Chart I-9). Chart I-9U.S. Rates Have Plenty Of Upside, Even More So If The Trade Truce Becomes A Peace Treaty This will lift yields, resuscitating one of the first reasons why markets have been weak this fall. This risk is even greater than the market appreciates. After Fed Chair Jerome Powell gave what was perceived as a dovish speech last week, markets were further emboldened to bet on a Fed pause. However, Fed Vice-Chairman Richard Clarida and New York Fed President John Williams have both argued since that the U.S. economy will continue to run above trend and warrants further gradual increases in interest rates. A truce in Buenos Aires may only provide them with more ammunition to implement those hikes. Global liquidity conditions are unlikely to improve significantly anytime soon. Moreover, the truce could also change the calculus in Beijing. Much of the stimulus implemented since last summer in China has been to limit the negative impact of a trade war. However, if a trade war is not in the cards, Beijing has fewer reasons to abandon its deleveraging campaign. It thus raises the possibility that with a risk to China evaporating, the Xi Jinping administration would instead not do anything to limit the slowdown in credit. This implies that Chinese capex would stay weak and that China’s intake of raw materials and machinery would not pick up. This means that the euro area and countries like Australia will continue to lag behind the U.S. Ultimately, the market speaks louder than anything else. The incapacity for risk assets to catch a bid in the wake of what was good news is disconcerting. It suggests that the combined assault of slowing global growth and a tightening Fed remains the main problem for global financial markets. Hence, in this kind of deflationary environment, the dollar reign supreme – even if U.S. growth were to slow (Chart I-10). Chart I-10A Strong Dollar Is Not A Function Of Strong U.S. Growth Bottom Line: A trade truce in Buenos Aires could have aborted the bull market in the dollar. So far, it has not, and we do not think it will be able to end the dollar’s rally. First, this truce remains flimsy, and does not guarantee an end of the trade war between China and the U.S. Second, global growth continues to exhibit downside. Finally, the Fed is unlikely to change its course and pause its hiking campaign. In fact, if a trade truce is so good for trade, it will give more reasons for the Fed to hike and may even incentivize Chinese authorities to abandon their efforts to cushion the Chinese economy against slowing global trade. Stay long the dollar and keep a defensive exposure in the FX market, one that favors the yen and the greenback at the expense of Scandinavian and commodity currencies. Buy EUR/CHF Despite our view that global growth is set to slow, we are inclined to buy EUR/CHF this week. We expect the Swiss National Bank to stop sitting on its hands as a stronger CHF is becoming too painful. First, as we highlighted last week, aggregate Swiss economic activity is slowing sharply.1 What is more concerning is that consumer spending is also suffering, as shown by the contraction in real retail sales (Chart I-11). This implies that despite record-low interest rates, Swiss households are feeling the pinch of the tightening in Swiss monetary conditions created by the stronger CHF. Chart I-11Swiss Households Are Feeling The Pinch Second, the franc remains a problem for Swiss competitiveness. As Chart I-12 shows, Swiss labor costs are completely out of line with its competitors. This phenomenon worsened significantly after 2008 due to the Franc’s strength vis-à-vis the euro. Despite the weakness in the franc from mid-January 2015 to April 2018, Swiss unit labor costs remain uncompetitive. This means that going forward, either the SNB will have to tolerate a further contraction in wages, something unpalatable as Swiss households have a debt load equal to 212% of disposable income, or the franc will have to fall. Chart I-12The CHF Makes Switzerland Uncompetitive Third, the franc’s recent strength is only accentuating the deflationary impact of softer global growth on the local economy. As Chart I-13 illustrates, the recent strengthening in the trade-weighted CHF portends to a potentially painful contraction in import prices, while core inflation is already well off the SNB’s 2% objective. Moreover, as the second panel of Chart I-13 shows, our CPI model suggests that Swiss inflation is about to fall into negative territory again. This would imply that not only will the Swiss economy suffer from the recent strengthening in the franc, but also that Swiss real interest rates are about to increase by 100 basis points, the last thing a slowing economy needs. Chart I-13Swiss Deflation Will Return This economic backdrop suggests to us that after 16 months where the SNB played nearly no active role in managing the CHF exchange rate, the Swiss central bank is about to come back to the market in order to limit the downside in EUR/CHF. This makes buying this cross attractive, as it offers a favorable asymmetric payoff. EUR/CHF generates a small positive carry, has limited downside and offers ample upside if the SNB intervenes – all while offering low volatility. Meanwhile, if global growth picks up, EUR/CHF should also rebound. In fact, the pro-cyclical behavior of EUR/CHF, as well as its asymmetric payoff, increases the attractiveness of this trade within our broadly defensive portfolio stance: It hedges us against being wrong on the global growth outlook and the importance of the trade truce. Furthermore, any resolution to Italy’s battle with Brussels will also boost this cross. Bottom Line: EUR/CHF normally depreciates when global growth slows. While this pattern materialized in 2018, we anticipate EUR/CHF to stabilize and potentially rally, even if global growth slows. The strong CHF is now causing serious pain to the Swiss economy, and the SNB will have to prevent any deepening of the malaise. The SNB is thus set to begin intervening in the market. Additionally, if we are wrong and global growth does not slow further, being long EUR/CHF provides a hedge to our defensive market stance. AUD/NOK To Be Knocked Down An attractive opportunity to sell AUD/NOK has emerged. First, on the back of the weakness in oil prices relative to metals prices, AUD/NOK has caught a furious bid in recent weeks (Chart I-14). However, we expect the underperformance of oil relative to metals to peter off. The main factor that has weighed on petroleum prices is that Saudi Arabia has kept extracting oil at full speed, expecting a shortage of oil in global markets once U.S. sanctions on Iran kicked in. Chart I-14AUD/NOK Strength: A Reflection Of Weak Crude Prices However, with President Trump greatly softening his stance and allowing exemptions for some countries to import Iranian oil, the crude market instead has experienced a mini unforeseen oil glut. OPEC 2.0, just agreed to essentially remedy this problem by limiting their oil output. This should boost oil prices. Meanwhile, slowing global growth centered on slowing Chinese capex will have a much deeper impact on industrial metals prices than on oil. This represents a negative terms-of-trade shock for Australia vis-à-vis Norway. Second, domestic economic conditions also favor betting on a weaker AUD/NOK. Australian nominal GDP growth often weakens when compared to Norway’s ahead of periods of depreciation in AUD/NOK. Today, Australia’s nominal GDP growth is sagging relative to Norway’s, and the contraction in Australia’s LEI relative to Norway suggests that this trend will deepen (Chart I-15). A rebound in oil prices relative to metals prices will only reinforce this process. Chart I-15Domestic Economic Conditions Point To A Lower AUD/NOK Third, AUD/NOK seems expensive relative to the anticipated path of policy of the Reserve Bank of Australia relative the Norges Bank (Chart I-16). Moreover, the Norwegian central bank has begun lifting rates, and since real interest rates in Norway are still negative, it will continue to tighten policy next year. Meanwhile, the RBA remains reticent to increase interest rates as Australian inflation and wage growth are still tepid. The recent deceleration in Australian GDP growth as well as budding problems in the Aussie real estate market will only further cajole the RBA in its reluctance to lift the cash rate higher. Hence, the real interest rate differentials will continue to point toward a lower AUD/NOK. Chart I-16AUD/NOK At A Premium To Expected Rates Fourth, AUD/NOK is once again very expensive, trading at a 12% premium to it purchasing power parity equilibrium (Chart I-17). It only traded for an extended period of time at a richer premium when Brent was free-falling to US$25/bbl. Since we anticipate oil to rebound, such a premium in AUD/NOK is unwarranted. Chart I-17AUD/NOK Is Pricey Finally, all our technical indicators show that AUD/NOK is massively overbought (Chart I-18). The study on momentum we conducted last year showed that out of 45 G-10 FX pairs tested, after AUD/SEK, AUD/NOK was the second worst one to implement momentum-continuation trades.2 As a result, we would anticipate that the recent period of overbought conditions will lead to a period of oversold conditions. Chart I-18The Mean-Reverting AUD/NOK Is Overbought Bottom Line: Selling AUD/NOK today makes sense. BCA anticipates oil prices to rebound relative to metals prices, the Australian economy is slowing relative to Norway’s, monetary policy is moving in a NOK-friendly fashion, AUD/NOK is expensive, and the cross is well-placed to experience a large episode of momentum reversal. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, titled “2019 Key Views: The Xs And The Currency Market”, dated November 30, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, titled “Riding The Wave: Momentum Strategies In Foreign Exchange Markets”, dated December 8, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: The price component of the ISM manufacturing survey underperformed expectations, coming in at 60.7. This measure also declines sharply from the previous month. However, the headline ISM Manufacturing survey surprised to the upside, coming in at 59.3. Total vehicle sales also outperformed expectations, coming in at 17.50 million. The DXY U.S. dollar Index was flat for the past two weeks. We continue to be bullish on the U.S. dollar. The current environment of falling global growth and falling inflation has historically been very positive for this currency. Moreover, the fed will likely hike more than anticipated by the market, providing another tailwind for the dollar until at least the first quarter of 2019. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in Europe has been mixed: Retail sales growth underperformed expectations, coming in at 1.7%. Moreover, core inflation also surprised to the downside, coming in at 1%. However, market services and composite PMI surprised positively, coming in at 53.4 and 52.7 respectively. EUR/USD has been flat for the past two weeks. We are bearish on the euro, given that we expect Chinese tightening to continue to weigh on global growth. Furthermore, recent disappointment in euro area inflation confirms our view that it will be very difficult for the ECB to tighten policy. This means that rate differentials will continue to move against EUR/USD. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Evaluating The ECB’s Options In December - November 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: The Nikkei manufacturing PMI outperformed expectations, coming in at 52.2. Moreover, housing starts yearly growth came in line with expectations, at 0.3%. However, Markit Services PMI came in at 52.3, decreasing from last month’s number. USD/JPY has decreased by -0.4% these past two weeks. We are positive on the yen for the first quarter of 2019. The current risk off environment should be positive for safe havens like the yen. We are particularly negative on EUR/JPY, as this cross is very well correlated with bond yields, which should keep decreasing as markets continue to sell off. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Nationwide housing prices yearly growth came in at 1.9%, outperforming expectations. Moreover, Markit manufacturing PMI as well as construction PMI both surprised positively, coming in at 53.1 and 53.4 respectively. However, Markit Services PMI underperformed expectations, coming in at 50.4. GBP/USD has decreased by 0.7% these past two weeks. The pound continues to be a complex currency to forecast. While the pound is cheap and makes for a potentially attractive long-term buy, current political risk continue to make a shorter-term position very risky. Report Links: Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been negative: Gross domestic product yearly growth underperformed expectations, coming in at 2.8%. Moreover, building permits month-on-month growth also surprised negatively, coming in at -1.5%. Finally, construction done also surprised to the downside, coming in at -2.8%. AUD/USD has decreased by -0.5% these past two weeks. We believe that the AUD is the currency with the most potential downside in the G10. After all, the Australian economy is the economy in the G10 most leveraged to the Chinese industrial cycle, due to Australia’s high reliance on industrial metal exports. This means that the continued tightening by Chinese authorities should be most toxic for this currency. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn’t Always Help The World - June 29, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: Building permits month on month growth outperformed expectations, coming in at 1.5%. However, retail sales as well as retail sales ex-autos both declines from the previous quarter, coming in at 0% and 0.4%. NZD/USD has increased by 1% these past two weeks. After being bullish in the NZD for a couple of months, we have recently turned bearish, as we believe that this currency is very likely to suffer in the current environment of declining inflation and global growth. With that said, we remain bullish on the NZD relative to the AUD, given that the kiwi economy is less exposed to the Chinese industrial cycle than Australia. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been positive: Retail sales month on month growth outperformed expectations, coming in at 0.2%. Moreover, headline inflation also surprised to the upside, coming in at 2.4%. Finally, the BOC core inflation measure increased from last month’s number, coming in at 1.6%. USD/CAD has risen by 1.7% these past two weeks. A lot of this weakness was caused by the dovish communication of the Bank of Canada following their announcement to keep rates on hold at 1.75%. This change in stance is likely a response to the collapse in oil prices in the past months. With that in mind, we are inclined to believe that the CAD might be reaching oversold levels, as oil is likely to stabilize and the economy continue to show signs of strength. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been negative: Gross domestic product yearly growth underperformed expectations, coming in at 2.4%. Moreover, the KOF leading indicator also surprised to the downside, coming in at 99.1. Finally, headline inflation also surprised negatively, coming in at 0.9%. EUR/CHF has decreased by 0.5% these past two weeks. Our bullish view on EUR/CHF is a high conviction view for the first part of 2019. This is because the recent strength in the franc is choking out any inflationary pressures in the Swiss economy. Thus, we are reaching the threshold at which the SNB is very likely to intervene in the currency market to prevent the franc’s strength from derailing the path toward the inflation target. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been negative: Retail sales growth underperformed expectations, coming in at -0.2%. Moreover, registered unemployment also surprised negatively, coming in at 2.3%. Finally, the credit indicator came in line with expectations at 5.7%. USD/NOK has been flat these past two weeks. We are shorting AUD/NOK this week, as a way to take advantage of stabilizing oil prices and a continued growth slowdown in China. Moreover, AUD/NOK is expensive in PPP terms, and is technically overbought. Finally, this currency shows one the most mean reverting tendencies in the G10, which means that the recent surge in this cross is likely to reverse. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been negative: Consumer confidence underperformed expectations, coming in at 97.5. Moreover, retail sales growth also underperformed expectations, coming in at -0.1%. Finally, gross domestic product yearly growth also surprised negatively, coming in at 1.6%. USD/SEK has fallen by roughly 1% these past two weeks. On a short-term basis, we are negative on the krona, given that this currency is very sensitive to global growth dynamics, which means that the continued tightening by both Chinese authorities and the Fed will create a headwind for any SEK rally. That being said, on a longer-term basis we are more positive on the krona, as the Riksbank continues to be too dovish given the current inflationary backdrop. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights The U.S. dollar is likely to correct further over the coming weeks. The CAD should benefit as it is cheap and oversold, and the inflationary back-drop warrants tighter monetary conditions. This will be a bear market rally, not the ultimate trough for the loonie. EUR/SEK should correct as the Riksbank will start tightening policy in December; a pause in the global growth slowdown should also give the cheap SEK a welcome boost. Cheap long-term valuations will not help the yen in the coming weeks; instead, falling Japanese inflation expectations and growing investor expectations of Chinese stimulus will weigh on the JPY. A better opportunity to buy the yen on its crosses will emerge later this year. EUR/CHF has upside over the coming months; the swissie needs additional global growth weakness to rally further. This is unlikely to happen for a few months. Feature Chart I-1DXY Correction Has Further To Run By the middle of the summer, the dollar had hit massively overbought levels, which left it vulnerable to any signs of stabilization in global growth, especially if some key U.S. activity gauges began to soften (Chart I-1). This is exactly what is transpiring. As we highlighted last week, BCA's Global LEI Diffusion Index is rebounding, EM and Japanese exports are stabilizing and U.S. core inflation and building permits have disappointed. This bifurcation in the data suggests the dollar has more room to correct, as neither our Capitulation Index nor our Intermediate-Term Technical Indicator have hit technically oversold levels. Last week we also argued that this correction in the dollar is likely to prove a temporary reprieve, but that in the interim the euro and the Australian dollar were well placed to experience significant rebounds.1 This week, we explore if the same case can be built for the Canadian dollar, the Swedish krona, the yen and the Swiss Franc. CAD: The Bank of Canada Will Proceed Cautiously The first half of 2018 has not been kind to the Canadian dollar. A rout in EM assets, signs of softening global growth and tough rhetoric from the White House on trade generally and NAFTA and Canada in particular have conspired to create fertile grounds for loonie-selling. Since the end of June, the CAD has managed to regain some composure, rallying by 3.3% against the USD. Essentially, much bad news has been embedded in this currency, which now trades at a significant discount to BCA's estimate of its short-term fair value (Chart I-2). Moreover, speculators, who had been aggressively buying the CAD at the end of 2017, now hold large short positions in the currency (Chart I-2, bottom panel). This combination is now resulting in a situation where any pause in the USD's strength is being mirrored in CAD strength. Can this rebound continue? Canadian economic data sends a murky message. Canadian real GDP growth had overtaken that of the U.S., peaking at 3.6% in February last year. However, it is now below U.S. growth (Chart I-3). Canadian consumers have been the main source of the slowdown as Canadian capex growth is in line with the U.S. and the Trudeau government has been spending generously. Can this rebound continue? Canadian economic data sends a murky message. Canadian real GDP growth had overtaken that of the U.S., peaking at 3.6% in February last year. However, it is now below U.S. growth (Chart I-3). Canadian consumers have been the main source of the slowdown as Canadian capex growth is in line with the U.S. and the Trudeau government has been spending generously. Chart I-2No One Is Going Crazy For The Loonie Chart I-3Canada: Growth Picture Is Mixed The weakness in Canadian consumption partly reflects the underperformance of Canadian employment relative to the U.S. However, the slowdown in house prices has played a bigger role (Chart I-4). Canadian households are burdened by a debt load of 170% of disposable income. Now that mortgage rates are rising, Canadians are spending more than 14% of their disposable income servicing their debt, a burden last experienced in 2008 when mortgage rates were 220 basis points higher. Without the benefit of rapidly rising real estate assets, it is much more difficult for Canadian retail sales to grow at an 8.7% annual rate as they did three quarters ago. Despite these weaknesses, it is hard to justify that Canadian monetary conditions - as approximated by the slope of the yield curve, the level of real rates, and the trade-weighted CAD - should be as easy as they are today (Chart I-5). This is even truer when we take into account Canadian inflationary conditions. Chart I-4Canadian Consumers Have A Problem Chart I-5Canadian Monetary Conditons Are Very Easy The three inflation gauges targeted by the Bank of Canada stand between 1% and 3%, or at its objective. This means that the BoC's 1.5% policy rate is negative in real terms. Moreover, this inflationary pressure is unlikely to abate. The BoC estimates that the output gap has closed, and companies are running into growing capacity constraints (Chart I-6, top panel). Despite a correction last month, wages are in an uptrend, powered by growing and severe labor shortages (Chart I-6, bottom panel). Thanks to these conditions, we anticipate that the BoC will track the pace of rate increases by the Federal Reserve over the next 12 months. This is not very different from what is currently priced into Canadian money markets. Chart I-6Canadian Capacity Pressures Point To A Hawkish ##br##BoC Inflation Will Force The BoC's Hand If the BoC does not disappoint, the combination of a cheap and oversold CAD should help the loonie rally against the USD, so long as the current stabilization in global growth continues. A move toward USD/CAD 1.26 is likely. The biggest risk to this view is that trade negotiations between the U.S. and Canada deteriorate further. While we do not anticipate an imminent breakthrough in these negotiations, we do not see much scope for significant deterioration in the relationship either. The energy market could prove to be another positive for the loonie. Bob Ryan, who leads BCA's Commodity and Energy Strategy service, argues that the oil market is currently very tight and vulnerable to supply disruptions.2 Under these circumstances, the removal of Iranian exports, tensions in Iraq, declining Nigerian production and Venezuela's cascading implosion all risk causing a melt-up in oil prices by the first half of 2019. This could help the CAD as well, even if the Canadian oil benchmark remains at a large discount to Brent. Longer-term, the upside in the CAD is likely to be capped. There is only one rate hike priced into the U.S. OIS curve from June 2019 to December 2020. We expect the Fed to hike rates by more than that. Meanwhile, the emerging softness in the Canadian household sector suggests it will be much more difficult for the BoC to keep following the Fed higher over that period. The CAD is not cheap enough to compensate for these long-term headwinds (Chart I-7). Bottom Line: On a short-term basis, the Canadian dollar is cheap and oversold. While the Canadian consumer has begun to disappoint, the inflationary pressures present in Canada should keep the BoC on track to follow the Fed and push rates higher over the coming 12 months. The CAD should therefore benefit from any USD weakness, with USD/CAD moving toward 1.26. Once the short-term undervaluation and oversold conditions are corrected, USD/CAD should rebound toward 1.40. Chart I-7We Like The CAD For Now, But The Rally Has A Limited Shelf Life EUR/SEK Will Trade Heavy Any which way we cut it, the SEK is cheap. The trade-weighted krona is trading at its cheapest levels relative to BCA's long-term fair value since the Great Financial Crisis (Chart I-8). The SEK is not only trading at a 32% discount to its purchasing-power parity against the greenback, it is also trading at a 10% discount against its PPP relative to the euro. Chart I-8The SEK Is An Attractive Long-Term Buy... The SEK is not only cheap on a long-term basis, it is also cheap on a short-term basis. This is most evident against the euro. Currently the SEK trades at a 7% discount to the euro according to our short term fair value model based on real rate differentials, commodity prices and global risk aversion. Historically, this kind of discount in the SEK has been followed by a prompt rebound (Chart I-9). Are there any catalysts to convert this good value into good returns? We see many. First, as was the case in Canada, Sweden's Monetary Gauge has not been at such easy levels since the Great Financial Crisis (Chart I-10). Meanwhile, the economy is also experiencing rising capacity pressures. The OECD's estimate of the output gap stands at 0.7% of GDP, and inflationary pressures are building, as evidenced by the Riksbank's Capacity Utilization measure (Chart I-11). Chart I-9...And A Short-Term One As Well Chart I-10The Riksbank Is Too Easy Chart I-11Swedish Inflation Has Upside This set of circumstances suggests the Riksbank could start hiking rates as early as this coming December, well ahead of the European Central Bank. As a result, we project that Swedish real interest rates could rise further relative to the euro area. Historically, falling euro area / Swedish real interest rate spreads precede depreciations in EUR/SEK (Chart I-12). Chart I-12Real Rate Differentials Point To A Lower EUR/SEK Chart I-13Chinese Liquidity Injections Point To A Lower EUR/SEK The global context also points toward an imminent correction in EUR/SEK. The krona is much more pro-cyclical than the euro. This reflects the more volatile nature of the Swedish economy and the extraordinarily large role of trade in its GDP. EUR/SEK greatly benefited from the tightening in Chinese liquidity conditions, as evidenced by the widening between the 1-month and 1-week Chinese interbank rate (Chart I-13). EUR/SEK essentially sniffed out a slowdown in Chinese capex, a key source of ultimate demand for Swedish goods. However, now that the PBoC is injecting liquidity in the Chinese interbank system, EUR/SEK is likely to suffer. Moreover, the outperformance of Chinese infrastructure and real estate stocks in recent weeks also suggests the SEK could appreciate further against the EUR. The rally of risk assets on the day that U.S. President Donald Trump announced an additional 10% tariff on US$200 billion worth of Chinese exports further confirms that investors may be in the process of discounting additional stimulus out of China, which would further hurt EUR/SEK. To be clear, we have already noted that we do not anticipate the Chinese authorities to attempt to boost growth - we only expect them to limit the damage created by an intensifying trade war with the U.S. As a result, the positive impact of China on the krona should prove transitory. But for the time being, it could be enough to help correct the SEK's 7% discount to the euro. Since we anticipate the USD to continue to correct in the coming weeks, this also implies that USD/SEK possesses ample tactical downside. This negative EUR/SEK view is not without risks. The first comes from the fact that the Swedish current account surplus is now smaller than the euro area's, something not seen since the early 1990s. This is mitigated by the fact that Sweden's net international investment position is now 10% of GDP, while it used to be negative as recently as 2015. The euro area NIIP is still in negative territory. The second risk is that Swedish house prices have begun to contract in response to macroprudential measures. However, we believe that Sweden's inflationary backdrop is likely to dominate the Riksbank's reaction function. Bottom Line: The SEK is cheap against the dollar and the euro on both long-term and short-term metrics. As the Riksbank is set to lift rates in December, we expect EUR/SEK to decline significantly. Recent injections of liquidity by the PBoC and growing expectations among investors of Chinese stimulus could create additional downward impetus under both EUR/SEK and USD/SEK. This is a tactical view. We anticipate the reprieve in the global growth slowdown to be temporary. Once it resumes, the SEK will find it difficult to rally further. JPY: Down Now, Up Later Investors are well aware that the yen is one of the cheapest G10 currencies on a long-term basis. BCA's long-term fair value model shows that the real trade-weighted yen is trading at a 17% discount, close to its cheapest levels in 36 years. However, despite its prodigious long-term cheapness, the yen is not nearly as attractive when compared to its short-term determinants, which show a small premium in the price of the yen versus the dollar (Chart I-14). This means the direction of Japanese monetary policy and global growth will remain more important for the yen's price action over the coming months than its long-term cheapness. When it comes to growth, Japan is doing okay. We witnessed a decline in industrial production driven by foreign demand this summer, but domestic machinery orders are improving and export growth is finding a floor. Actually, BCA's real GDP model for Japan is suggesting that growth could re-accelerate significantly next quarter (Chart I-15). In our view, this improvement reflects the fact that business credit is once again growing after decades of hibernation. Chart I-14Is The JPY A Bargain? Long Term, Yes; Short Term, No! Chart I-15Japanese Growth Doing Just Fine However, we doubt this is enough to prompt any tightening in the Bank of Japan's policy. The most immediate problem facing the BoJ is that Japanese inflation expectations are in free fall (Chart I-16). Since the BoJ assigns the blame of low realized inflation on depressed inflation expectations, this aforementioned weakness, despite the yen's softness, guarantees that the BoJ will stay on the sidelines for much longer. After all, if any little shock can spur such a sharp impact on Japanese inflation expectations, despite an unemployment rate at 2.5% and an output gap at 0.8% of GDP, the BoJ has not anchored inflation expectations higher. Further reinforcing our bias that the BoJ is not set to tighten policy for many more quarters, the VAT is set to be increased to 10% in October 2019. The LDP leadership race is currently underway, and no one is mentioning postponing that hike. This suggests that significant fiscal tightening could emerge next year. The fact that the BoJ will continue to lag behind other global central banks forces us to be negative on the yen. However, could an external event push the yen higher, despite this absence of domestic support? A big downgrade in EM asset prices and global growth would do the trick. While we do think this is likely to happen over the next six to nine months, now does not appear to be the moment to implement such a bet. As we highlighted above, the deceleration in global growth seems to be pausing, and Chinese liquidity conditions have eased. Seven weeks ago, we introduced our China Play Index to track whether or not investors were discounting additional easing on the part of China.3 This indicator looks as if it is forming a base right now (Chart I-17), indicating that pro-growth plays could perform well over the coming weeks while countercyclical plays, like the yen, could perform poorly. Until this indicator begins a new down leg - something we anticipate for the backend of the year - the yen will remain under downward pressure against the dollar, the euro or the aussie. Chart I-16The BoJ's Problem Chart I-17Chinese Plays Are Stabilizing As a result, while we continue to expect more upside in the yen in the latter part of the year, for the time being we will remain on the sidelines as neither short-term valuations, monetary policy dynamics or the global growth environment point to an imminent rally in the yen. Bottom Line: The yen is an attractive long-term play as it displays prodigiously cheap long-term valuations. However, the short-term outlook is less favorable. The yen is not cheap enough based on our augmented interest rate differentials models, the BoJ will remain dovish for the foreseeable future, and an uptick in our China Play Index bodes poorly for countercyclical currencies like the yen. However, since we do expect that global growth will stabilize only on a temporary basis, we will look to open some long yen bets later this fall. Close Short EUR/CHF Trade Last March, we argued that EUR/CHF had more cyclical upside, but that bouts of volatility in global markets would cause periods of weaknesses in the cross.4 Based on this insight, we proceeded to sell EUR/CHF on April 6 as we worried that markets were set to price in a period of weakness in global growth.5 We closed this trade in August, but EUR/CHF kept falling. Now, is EUR/CHF more likely to rally or selloff in the coming quarter? We think a rebound is in the cards. First, the franc is once again highly valued, based on the Swiss National Bank's assessment. It is true that the SNB has not intervened to limit the franc's upside recently, but the CHF's strength is likely to short-circuit the increase in inflation that could have justified betting on the Swissie moving higher (Chart I-18). Ultimately, there is limited domestic inflationary pressures in Switzerland. Moreover, since the import penetration of goods and services in Switzerland is the highest of all the G10, imported deflation will soon be felt. Further, as Swiss labor costs remain very high internationally, the large improvement in full-time jobs witnessed this year is likely to peter off as Swiss businesses work to maintain their competitiveness. Second, the franc received an additional fillip this year as the breakup risk premium in Europe surged (Chart I-19). Every time investors perceive that the probability of a disintegration of the euro rises, they end up pouring money into stable Switzerland. Marko Papic, BCA's Geopolitical Strategy expert, believes that the euro break-up risk will continue to be a red herring in the coming few years. Investors will therefore price out this risk, pulling money out of Switzerland where interest rates remain 30 basis points below the euro area, and boosting EUR/CHF in the process. Chart I-18The Swissie's Strength Will Be Deflationary Chart I-19If A Euro Break-Up Is A Red Herring... Finally, if a temporary stabilization in global growth will hurt the yen, it will also hurt the Swiss franc. As a result, the stabilization in the China Play Index should support EUR/CHF. While we expect EUR/CHF to rally over the coming months, we worry that any such rebound will prove temporary. The current expansion in Chinese stimulus is only a passing phenomenon, and not one powerful enough to put a durable bottom under global growth and EM assets. Hence, while EUR/CHF could easily rally to 1.15, any such rebound should be faded. This move, if followed by a deterioration in our China Play Index, should be used to re-open EUR/CHF shorts. Bottom Line: The Swiss franc remains in a cyclical bear market, punctuated by occasional rallies against the euro when global growth sentiment sours. We just experienced such a rally in the Swissie, but it is ending as the deflationary impact of the CHF's rally will soon be felt. Moreover, the breakup risk premium in the euro is currently too large, and the pricing-in of slowing global growth is likely to take a breather. As a result, EUR/CHF is likely rally over the coming months. We will look to bet again on a CHF rally once the reprieve in global growth ends. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Policy Divergence Are Still The Name Of The Game", dated September 14, 2018, available at fes.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report, titled "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl", dated September 20, 2018, available at ces.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "The Dollar And Risk Assets Are Beholden To China's Stimulus", dated August 3, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Retail sales and retail sales ex autos yearly growth underperformed expectations, coming in at 0.1% and 0.3% respectively. Capacity utilization and building permits also surprised to the downside, coming in at 78.1% and 1.229 million respectively. However, Housing starts and the Michigan Consumer Sentiment Index surprised positively, coming in at 9.2% and 100.8 respectively. DXY has fallen by nearly 1% this week. Overall, we continue to be bullish on the dollar on a cyclical basis, as inflationary pressures inside the U.S. will force the Fed to hike more than the market expects. That being said, the slowdown in the dollar's momentum, the growing Chinese stimulus, and accumulating signs of stabilizing global economic activity are likely to further weigh on the dollar on a more immediate basis. We will monitor these factors closely in order to gauge whether or not this pullback will remain a garden-variety correction or something more serious. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 The Dollar And Risk Assets Are Beholden To China's Stimulus - August 3, 2018 Rhetoric Is Not Always Policy - July 27, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area has been positive: Labor costs growth outperformed expectations, coming in at 2.2%. Moreover, construction output yearly growth also surprised positively, coming in at 2.6%. Finally, both core and headline inflation came in line with expectations, at 1% and 2% respectively. EUR/USD has rallied by 1.1% this week We are bearish on the cyclical outlook for the euro, given that core inflation measures are continue to be too weak for the ECB to meaningfully change their dovish monetary policy stance. However, the current tactical rebound is likely to continue, as the weakness in the euro this year has eased financial conditions, which could lead to a temporary boon for the economy. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Industrial production yearly growth surprised negatively, coming in at 2.2%. Moreover, capacity utilization also underperformed expectations, coming in at -0.6%. Finally, both export and import yearly growth outperformed expectations, coming in at 6.6% and 15.4% respectively. USD/JPY has been relatively flat this week. We are bearish on the yen on a structural basis, given that the economy continues to suffer from strong deflationary forces, which will force the Bank of Japan to keep their ultra-easy monetary policy. Report Links: Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been positive: The retail price index yearly growth surprised to the upside, coming in at 3.5%. Moreover, both core and headline inflation outperformed expectations, coming in at 2.1% and 2.7% respectively. Finally, the DCLG House Price Index also surprised positively, coming in at 3.1%. GBP/USD has rallied by roughly 1.5% this week. The GBP's vol is likely to increase further going foirward, as very little political risks is priced into it. A practical strategy will be to lean against large weekly moves, both on the upside and downside. This strategy should be particularly profitable versus the euro. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been positive: The participation rate surprised to the upside, coming in at 65.7%. Moreover, the total change in employment also outperformed expectations, coming in at 44 thousand. Finally, the house price index yearly growth also surprised positively, coming in at -0.6%. AUD/USD has risen by roughly 1.8% this week. We continue to be cyclically bearish on the Australian dollar, as the deleveraging campaign in China will weigh on demand for industrial metals, Australia's main export. Moreover, the AUD will also have downside against the CAD, as oil should continue to hold up relative to other commodities thanks to supply cuts from OPEC. That being said, the AUD's recent rebound is likely to continue on a short-term basis. Hence, investors already shorting the Aussie should consider buying hedges. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has rallied nearly 1.9% this week. We are negative on the New Zealand dollar on a structural basis due to the measures taken by the Ardern government, which include reducing immigration, and adopting_a dual mandate for the RBNZ. Both of these measures will weigh on the real neutral rate, which means that the RBNZ will have to hold rates lower than otherwise. However, on a more tactical basis, this cross could rally, thanks to the temporary stimulus by the Chinese authorities which will help risk assets. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mixed: Manufacturing shipments monthly growth outperformed expectations, coming in at 0.9%. However, capacity utilization surprised to the downside, coming in at 85.5%. Finally, the new house price index yearly growth was in line with expectations, coming in at 0.5% USD/CAD has depreciated by 1% this week. We remain bullish on the CAD among the dollar bloc currencies, given that inflationary pressures continue to be strong in Canada. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has rallied by 0.5% this week. We continue to be bullish on this cross on a cyclical basis, as the Swiss economy is still too fragile for the SNB to remove its ultra-dovish monetary stance. Moreover, the recent appreciation in the franc that has taken place over the last four months should be very negative for inflation, as Switzerland is the country with the most imports as a percentage of demand in the G10, and thus the country with the most sensitive inflation to currency movements. Finally, on a tactical basis we are also bullish on this cross, as the recent easing of monetary policy by Chinese authorities should be weigh on safe heaven assets like the franc. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Yesterday, Norges Bank increased rates for the first time since 2011, yet the NOK was flat against a weak USD, and fell against the euro and the Swedish krona, suggesting that the hike was well anticipated by market participants. Despite this price action, USD/NOK has depreciated by 1.2% this week. We are positive on the NOK against other non-oil commodity currencies, as oil should outperform base metals in the current environment. After all, OPEC supply cuts and geopolitical risk in the Middle East should provide a boon for oil prices. On the other hand, while temporary easing is likely, the Chinese deleveraging campaign will continue once the Chinese economy has stabilized. Finally, the positive NIIP, and positive current account of the NOK should give it an additional advantage against the rest of the commodity currencies. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been negative: Headline inflation underperformed expectations, coming in at 2%. Moreover, the unemployment rate increased from 6% in July to 6.1% on the August reading. USD/SEK has depreciated by almost 2.8% this week. We expect the Riksbank to begin tightening policy in December, as Swedish inflationary pressures remain strong. Moreover, the recent stimulus from the PBoC should put additional downward pressure on EUR/SEK, given the krona's more pro-cyclical profile than the euro. Finally, valuations also support the SEK, as the krona is cheap according to multiple measures. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights The global economic mini-cycle is set to weaken while the euro is set to grind higher. Upgrade Telecoms to overweight. Also overweight Healthcare and Airlines. Underweight Banks, Basic Materials and Energy. Overweight France, Ireland, U.K., Switzerland and Denmark. Underweight Italy, Spain, Sweden and Norway. The Eurostoxx50 will struggle to outperform the S&P500. Feature We are strong believers in Investment Reductionism, a philosophy synthesized from the Pareto Principle and Occam's Razor.1 Investment reductionism offers a liberating thesis - the incessant barrage of investment research, newsfeeds and ten thousand word commentaries is largely superfluous to the investment process. What seems like a complexity of investment choice usually reduces to getting a few over-arching decisions right. Chart of the WeekIn Quadrant 4, Overweight Domestic Defensives And Underweight International Cyclicals For equity sector and country allocation, two over-arching decisions dominate: Whether the global economic mini-cycle is set to strengthen or weaken (Chart I-2). Whether the domestic currency is set to strengthen or weaken. Chart I-2The Empirical Evidence For Credit And Economic Mini-Cycles Is Irrefutable The four permutations of these two decisions create the four quadrants of cyclical investing (Chart of the Week). Right now, European investors find themselves in quadrant four: the global economic mini-cycle is set to weaken while the euro is set to grind higher. This favours an overweight stance to defensives, especially domestic-focused defensives. Therefore today, we are upgrading Telecoms to overweight. We also recommend an underweight stance to the most cyclical sectors, especially international-focused cyclicals such as Basic Materials and Energy. Country allocation then just drops out of this sector allocation. The Global Economic Mini-Cycle Is Set To Weaken We can predict the changes of the seasons and the tides of the sea with utmost precision. How? Not because we have an ingenious leading indicator for the seasons and tides, but because we recognise that these phenomena follow perfectly regular cycles. Regular cycles create predictability. Significantly, global bank credit flows also exhibit remarkably regular cycles with half-cycle lengths averaging around eight months. Recognizing these mini-cycles is immensely powerful because, just as for the seasons and the tides, it creates predictability. Furthermore, if most investors are unaware of these cycles, the next turn will not be discounted in today's price - providing a compelling investment opportunity for those who do recognise the predictability. The empirical evidence for credit mini-cycles is irrefutable. The theoretical foundation is also rock solid, based on an economic model called the Cobweb Theory.2 This states that in any market where supply lags demand, both the quantity supplied and the price must oscillate. Given that credit supply clearly lags credit demand, the quantity of credit supplied and its price (the bond yield) must experience mini-cycles (Chart I-3). And as the quantity of credit supplied is a marginal driver of economic activity, economic activity will also experience the same regular oscillations. Today, the global 6-month credit impulse is turning from mini-upswing to mini-downswing, with all three subcomponents - the euro area, the U.S. and China - now in decline (Chart I-4). This is exactly in line with prediction. Mini half-cycles average eight months, and the latest mini-upswing started eight months ago. Chart I-3The Global Economic Mini-Cycle##br## Is Set To Weaken Chart I-4All Three Subcomponents Of The Global 6-Month ##br##Credit Impulse Are Now Declining More importantly, as we enter a mini-downswing, we can also predict that global growth is likely to experience at least a modest deceleration through the coming two to three quarters. The Euro Is Set To Grind Higher, Except Versus The Yen Chart I-5Lost In Translation Nowadays, mainstream stock markets tend to be eclectic collections of multinational companies which happen to be quoted on bourses in Frankfurt, Paris, New York, and so on. For example, BASF is not really a German chemical company, it is a global chemical company headquartered in Germany. For operational hedging, multinational companies like BASF will intentionally diversify their sales and profits across multiple major currencies, say euros and dollars. But of course, the primary stock market quotation will be in the currency of its home bourse, euros. Therefore, when the euro strengthens, the company's multi-currency profits, translated back into a stronger euro, will necessarily weaken (Chart I-5). Clearly, more domestic-focused companies like telecoms will not experience such a strong currency-translation headwind. We expect the main euro crosses to continue strengthening over the next 8 months, with the exception being the cross versus the Japanese yen. Our central thesis is that the payoff profile for a foreign exchange rate just tracks the bond yield spread. This means that when a central bank has already taken bond yields close to their lower bound, its currency possesses a highly attractive asymmetry called positive skew. In essence, as the ECB is at the realistic limit of ultra-loose policy, long-term expectations for the ECB policy rate possess an asymmetry: they cannot go significantly lower, but they could go significantly higher. Exactly the same applies to long-term expectations for the BoJ policy rate. In contrast, long-term expectations for the Fed policy rate possess full symmetry: they could go either way, lower or higher. This stark asymmetry of central bank 'degrees of freedom' favours the euro and the yen over the dollar. Which Sectors And Countries To Own And Which To Avoid? Pulling together the preceding two sections, the global economic mini-cycle is set to weaken while the euro is set to grind higher. This puts Europe in quadrant four of our four quadrant framework for cyclical investing. Unsurprisingly, the relative performance of the most cyclical sectors - Banks, Basic Materials and Energy - very closely tracks the regular mini-cycles in the global 6-month credit impulse. In a mini-downswing these cyclical sectors always underperform (Chart I-6, Chart I-7 and Chart I-8). Accordingly, underweight these three sectors on a two to three quarter horizon. Chart I-6In A Mini-Downswing, ##br##Banks Always Underperform Chart I-7In A Mini-Downswing,##br## Basic Materials Always Underperform Chart I-8In A Mini-Downswing,##br## Energy Always Underperforms Conversely, overweight the relatively defensive Healthcare sector. Also overweight the Airlines sector. Airlines' performance is a mirror-image of the oil price cycle, given that aviation fuel comprises the sector's main variable cost. Furthermore, as aviation fuel is priced in dollars, it also insulates European Airlines against a strengthening euro. Today, we are also upgrading the Telecoms sector to overweight given its relative non-cyclicality (Chart I-9), its domestic-focus, and the excessively negative groupthink towards it (Chart I-10). Chart I-9In A Mini-Downswing, ##br##Telecoms Always Outperform Chart I-10Telecoms Are Due ##br##A Trend Reversal In summary: Overweight: Healthcare, Telecoms, and Airlines Underweight: Banks, Basic Materials and Energy Then to arrive at a country allocation, just combine the cyclical view on the major sectors with the country sector skews in Box 1. The result is the following unchanged European equity market allocation. Overweight: France, Ireland, U.K., Switzerland and Denmark Neutral: Germany and Netherlands Underweight: Italy, Spain, Sweden and Norway Lastly, what is the prognosis for the Eurostoxx50 relative to the S&P500? Essentially, this reduces to a battle between the multinational cyclicals - especially banks - that dominate euro area bourses and the multinational technology giants that dominate the U.S. stock market. With the global economic mini-cycle set to weaken and the euro set to grind higher, the Eurostoxx50 will struggle to outperform the S&P500. Box 1: The Vital Few Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks. France (CAC) is underweight Banks and Basic Materials. Italy (MIB) is overweight Banks. Spain (IBEX) is overweight Banks. Netherlands (AEX) is overweight Technology, underweight Banks. Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy. And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound. Switzerland (SMI) is overweight Healthcare, underweight Energy. Sweden (OMX) is overweight Industrials. Denmark (OMX20) is overweight Healthcare and Industrials. Norway (OBX) is overweight Energy. The U.S. (S&P500) is overweight Technology, underweight Banks. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 The Pareto Principle, often known as the 80-20 rule, says that 80% of effects come from just 20% of causes. Occam's Razor says that when there are many competing explanations for the same effect, the simplest explanation is usually the best. 2 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11, 2018 and available at eis.bcaresearch.com. Fractal Trading Model* This week's recommended trade is to short the Helsinki OMX versus the Eurostoxx600. Apply a profit target of 3% with a symmetrical stop-loss. In other trades, we are pleased to report that short Japanese Energy versus the market achieved its 8% profit target at which it was closed. This leaves four open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart 11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations