Developed Countries

Executive Summary Everything the banks see indicates that their household customers are in fantastic shape, with overstuffed checking accounts and unusually low outstanding credit card balances. Despite low confidence measures, they are spending with vigor, showering revenue on pandemic-squeezed businesses. Inflation in the price of necessities like food and gasoline most harms households at the low end of the wealth and income distributions, but the banks report that they are bearing up remarkably well so far. Credit quality remains exceptionally good and delinquencies and other leading indicators are still flashing the all-clear sign. Growing deposits demonstrate that the world is still awash in liquidity and credit stresses are not at hand, but highlight the challenges the Fed faces in trying to cool the economy. The banks expressed little to no appetite for deploying their idle cash into securities. It appears that another constituency will have to step up to replace the Fed’s QE purchases of Treasuries and agencies. A Blessing And A Curse Bottom Line: The biggest banks’ observations support a rosy near-term outlook – the consumer is firing on all cylinders, businesses are well positioned and there is no credit distress on the horizon. The Fed will have its hands full slowing an economy that has so much momentum, however, and there is little chance that volatility will not be elevated over the rest of the year. What The Banks See The SIFI banks (BAC, C, JPM and WFC) and USB kicked off fourth quarter earnings across three days bracketing Easter weekend. Their results were ho-hum – it remains our view that the banks lack a fundamental catalyst to drive relative outperformance – and mainly illustrated that higher interest rates, despite boosting net interest income, are far from the industry cure-all they’re cracked up to be. The SIFIs have languished over the last three months after consistently outperforming the overall market since late 2020, often by wide margins, and now find themselves modestly leading since the first effective COVID vaccines were developed in November 2020 (Chart 1). Chart 1An Incomplete Comeback We do not compile the Big Bank Beige Book every quarter to assess the banks’ relative investment merits, however. The S&P 500 Diversified Banks have a uniquely privileged vantage point into activity across the economy and we are simply trying to look over their shoulders. The banks’ earnings releases and analyst calls offer insight into the broad macro backdrop via borrower performance, lender willingness, financial system liquidity and the actions, intentions and financial capabilities of households and businesses. The following is what we heard and how it informs our take on financial markets and the economy. Households Are Still Flush … Related Report  US Investment StrategyThe Big Bank Beige Book, January 2022 Bank of America consumers spent at the highest-ever [first quarter] level, … [a] double-digit percentage increase over 2021, … despite the stimulus bonus [boosting the year-ago numbers]. (Moynihan, BAC CEO) [C]ombined credit and debit [card] spend was up 21% year-on-year, with growth stronger in credit as we see a continued pickup in travel and dining. And as the quarter progressed, we saw robust reacceleration of T[ravel] and E[ntertainment] spend, up 64%. (Barnum, JPM CFO) Consumer credit card spend remained strong, up 33% from a year ago. All spending categories were up (Chart 2) with the highest growth in travel, entertainment, fuel and dining. … Discretionary [debit card] spending remained strong with entertainment up 39% and travel up 29% from a year ago. (Scharf, WFC CEO) Chart 2Making Up For Lost Time In the first quarter …, credit and debit card travel volumes exceeded pre-pandemic levels. March airline volume was flat compared to March 2019, the first … [monthly] recovery to pre-pandemic levels. Although corporate T&E-related volumes … are still below pre-pandemic levels, they continue their upward trajectory … [and were] 75% of their pre-pandemic level in March. (Dolan, USB CFO) We’re still seeing quite a bit of excess liquidity sitting there in the back pocket of our consumers and very healthy balance sheets (Chart 3). I think [credit card payment rates] have peaked … and I think that’s good, because it should be the return this year to more healthy behavior. The spend is obviously … quite remarkable, … up in the mid-20s%. [It’s] also great to see the experience side, and … services coming back in again. We’ve been seeing it in travel, we’ve been seeing it in apparel. People like getting dressed up to go to dinner again in their [favorite] restaurant. (Fraser, C CEO) Chart 3Up, Up And Away … Even The Ones In Higher Inflation’s Crosshairs [Today’s] very strong underlying growth will go on. It’s not stoppable. The consumer has money. They pay down credit card debt. Confidence isn’t high, but the fact that they have money, they’re spending their money. They have $2 trillion still in their savings and checking accounts. Businesses are in good shape. Home prices are up. Credit is extraordinarily good. … That’s going to continue in the second quarter, third quarter. After that, it’s hard to predict. (Dimon, JPM CEO) Q: Are you seeing any signs of pullbacks and shifts in the type of [consumer] spend[ing] that could point to some softening there? A1: What we are continuing to see [across the board] … is good, strong, both [in terms of] year-over-year growth and comparisons back to 2019. … I would expect that there’s probably going to be a shift to some extent from … durable goods … to more service-oriented sorts of activities, but in terms of the overall level of spend, I feel like that will continue at least for some period of time. (Dolan, USB) A2: Consumer credit card spend is up 35% versus pre-pandemic. … [W]e’re not seeing any negative trends thus far and it continues to be very strong. (Cecere, USB CEO) March was the eighth straight month in which inflation outpaced income, with lower-income consumers being most impacted by rising energy and food prices. That said, higher deposit balances and rising wages have thus far allowed consumers to weather these headwinds. (Scharf, WFC) Our data show continued growth in average deposit balance[s] across all customer levels … , suggest[ing] … strong spending [can] continue. On an aggregated basis, average deposit balances were up 47% from pre-pandemic levels … and the momentum continued through the first quarter, particularly in the low-balance accounts. [C]ustomers who had $1,000 to $2,000 of balances [pre-pandemic], with an average $1,400 balance … now have $7,400. [T]hose with $2,000 to $5,000 [and a pre-pandemic average of $3,250] today have an average … of $12,500. … Consumers are sitting on lots of cash. (Moynihan, BAC) Q: Are you starting to see any drawdown [of consumer deposits] because of inflation? A: It’s actually the opposite; they grew faster from February to March. That [jump is] probably because of tax refunds, but … beginning around May of last year, they pretty consistently grew 1-2% per month, [with the most growth in] lower-end balances. [The only exception was] November, [when] we saw a slight downdraft in lower-end balances and [then it] picked back up in December. … It grew [every] month this quarter and March had the strongest growth. We haven’t seen the data for April yet, but [deposits are still growing very strongly] all the way up into the people who carried balances of $10,000 – 20,000 pre-pandemic. We’re not seeing that deteriorate at all yet. (Moynihan, BAC) Some Business Loan Demand Is Returning (Chart 4) Chart 4No Thanks For The Loan; We Issued Bonds Instead C[ommercial]&I[ndustrial] loans were up 3% sequentially, ex-PPP [Paycheck Protection Plan loans], reflecting higher revolver utilization and originations across middle market and in corporate client banking. (Barnum, JPM) We do see pretty nice loan growth in the commercial bank. There’s a bunch of different factors there, it could be [some pent-up capex,] some inventory effects and so on. (Barnum, JPM) The economy is returning more towards normal and our line utilization is, … too. That’s part of what’s driving our loan growth. Revolver utilization in commercial banking now is 31.7%; pre-pandemic, our normal was around 35%. (Borthwick, BAC CFO) I think that most businesses have been kind of holding back … on capex [over the last couple of years] and so I think there’s a bit of an increase in that spend related to it. And then as companies see more and more inflationary pressure, they’re going to look to automation as a way of offsetting some of the [cost] pressure they see [when they try to hire]. At least in the near term, our expectation is that capex will continue to be reasonably strong. And our utilization rates support that. We’ve been running [around] 19%, plus or minus, for a number of quarters and we saw an increase, certainly not to normal levels, but up to 22-23% in the last few months. (Dolan and Cecere, USB) Revolver utilization rates have increased, but are still well below historical levels. Loan demand has been driven by larger clients who are increasing borrowing due to the impact of inflation on material and transportation costs as well as to support inventory growth. We’re also seeing new demand from some clients who are catching up from underinvestment in projects and capex over the past couple of years. (Santomassimo, WFC CFO) No Credit Warning Signals Yet Q: Are you seeing any stresses in the levered parts of the debt markets, … levered loan, high yield, CLO, private credit? A: Obviously, in this environment, everyone’s looking very closely everywhere for any risks and trying to see around the corner. But as of right now, we’re really not seeing anything of concern in the … spot metrics. (Barnum, JPM) Q: Are there any [household] income buckets where you’re seeing early-stage delinquencies picking up? A: In short, no. It’s an interesting question as you look across our customer base, particularly in card, that heavily debated question of real income growth and gas prices and what’s that doing to consumer balance sheets. And so we’re watching that, especially in the kind of LMI [lower-to-middle-income] segment of our customer base. But right now, we’re not actually seeing anything that gives us reason to worry. (Barnum, JPM) Consumers remain in good shape. … The average card balances of our credit card customers [with whom we have] deposit relationships are 8% lower than they were pre-pandemic. … These [card and deposit] customers have built significant additional savings and their average deposit balances are up 39%. … The small low-FICO-score subset of our customer base was even stronger [in terms of higher] cash balances and lower debt levels. We believe this is not a [BAC-specific] phenomenon, as … debt service levels are hovering near historic lows (Chart 5) and household deposit and cash levels are $3 trillion higher than when we entered the crisis. (Moynihan, BAC) Chart 5Debt Service Is Easy For Households We continue to see strong credit performance across our [U.S.] portfolio as clients’ balance sheets remain healthy. (Mason, C CFO) Credit is still exceptionally good, and certainly will be into the next quarter based on everything that we see and possibly beyond (Chart 6), even though at one point [charge-offs] will go up. (Scharf, WFC) Chart 6Consumer Credit Leading Indicators Are Healthy Credit quality remains strong. Over the next few quarters, we expect the net charge-off ratio will remain lower than historical levels, but continue to normalize over time. (Dolan, USB) The Banks Aren’t Eager To Buy Securities Deposits continued to grow in the first quarter and despite a pickup in loan growth, the largest banks continue to hold a great deal of cash (Chart 7). The sharp rise in interest rates affords them an opportunity to put that cash to work, potentially driving a big increase in net interest income (NII). Every bank that raised its NII guidance, however, stated that the increased guidance was independent of any growth in the aggregate size of its loan and securities portfolios. The banks’ priority is to lend to household and business customers (Chart 8) and if demand for loans continues to rise, their commentary implied that securities holdings may well shrink. Chart 7Demand For Loans Is Still Lagging ... Chart 8... Banks' Willingness To Make Them Q: Any appetite to deploy the excess liquidity? A: No, don’t expect that. (Dimon, JPM) Guys, we were just talking about interest rates going up maybe more than 3%. Convexity is going up. [Mark-to-market loss on available-for-sale securities] is going up. There are all these various reasons not to [move cash into securities]. We’re not going to do it just to give you a little bit more NII next quarter. (Dimon, JPM) When it comes to deploying liquidity, it’s going to be loans first. … And then based on what we see there, we will decide if we’re going to grow the securities portfolio. (Santomassimo, WFC) At the end of the day, the reason why we have securities investments is because we have $2 trillion of deposits and $1 trillion of loans, and we got to do something with the money. (Moynihan, BAC) We’re not interest rate traders, we’re interest rate managers through a cycle. (Borthwick, BAC) What Ails The Banks’ Stocks? We did not join the chorus of investors and strategists at the beginning of the year who were singing the praises of bank stocks in a rising rate environment. We loved the SIFIs back in 2020 when they built up enormous loan-loss reserves in the first two quarters of the pandemic because we believed they would not be needed given monetary and fiscal efforts to shield the economy from COVID disruptions. Those reserves were eventually released back into earnings, pumping the banks' per-share book values above expectations, but once the truing up of actual versus expected credit losses was complete, the stocks had no apparent outperformance catalyst. Rising rates didn’t do much to entice us because we believe investors dramatically overestimate banks’ earnings sensitivity to interest rates and the slope of the yield curve. Higher rates help boost net interest income, but they are not an unmitigated positive, as first-quarter results and management commentary indicated. Every bank suffered hits to its accumulated other comprehensive income (AOCI) from the decrease in the value of the securities it holds in the available-for-sale bucket. AOCI is not an income statement item, but it does reduce equity and thereby undermines the banks’ regulatory capital positions and makes regulatory constraints more binding. Rising rates also entice depositors to shift some money away from banks and raise the cost of retaining deposits and every call featured analyst questions about the sensitivity of bank deposit pricing to changes in interest rates (deposit betas). Rising rates might also lead to pressure on non-interest income, which is nearly equal to the SIFIs' net interest income. As WFC CEO Charlie Scharf put it, “The mortgage origination market experienced one of its largest quarterly declines that I can remember, and it will take time for the industry to reduce excess capacity.” Volumes will fall as that capacity is reduced and so will gain-on-sale margins as the banks shed their remaining inventory. The bottom line is that somewhat higher rates are a net positive but much higher rates will be a drag on bank earnings, just as they will on the overall economy, and investors right now seem to be skipping to the end of the rate hike story and ignoring the benign chapters along the way. Finally, it appears that the extraordinary volume of bond issuance over the last two years displaced some of the need for C&I loans. Given that any CFO or corporate treasurer who didn’t term out company debt in 2020-21 ought to have his or her head examined, the shortfall in credit line utilization and sharply below trend C&I loans outstanding may extend well into the intermediate term. Investment Implications The banks’ calls reinforced our take that the economy has a lot of momentum in the form of flush consumers and amply funded businesses. Credit performance is tremendously strong and net charge-off rates will remain subdued for the foreseeable future. Low delinquency rates will not suddenly spike when business and consumer deposit balances are extremely high and still growing. The Fed’s response to uncomfortably high inflation was a shadow looming over all the calls, just as it was over equities at the end of last week, but it will take a steady diet of rate hikes to rein in a galloping economy. While there is no shortage of concerns, our view remains that they will not be realized in 2022 and that it is therefore too soon to take evasive action in individual portfolios or at the broad asset allocation level. We still recommend that investors with a six-to-twelve-month timeframe remain at least equal weight equities in a multi-asset portfolio, though we are more confident about the next six months than we are about the next twelve and believe it is appropriate to manage portfolios more tactically. We wholeheartedly agree with JPM CEO Jamie Dimon’s assessment and think investors would do well to try to manage in accordance with it. I cannot foresee any scenario at all where you’re not going to have a lot of volatility in markets going forward. We’ve … spoken about the enormous strength of the economy, QT, inflation, war, commodity prices – there’s almost no chance that you won’t have volatile markets … and I think people should be prepared for that. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com  

Listen to a short summary of this report.         Executive Summary Small Caps Are Looking Attractive Relative To Their Large Cap Peers Adverse supply shocks have pushed down global growth this year, while pushing up inflation. With the war raging in Ukraine and China trying to contain a major Covid outbreak, these supply shocks are likely to persist for the next few months. Things should improve in the second half of the year. Inflation will come down rapidly, probably even more than what markets are discounting. Global growth will reaccelerate as pandemic headwinds abate. The return of Goldilocks will allow the Fed and other central banks to temper their hawkish rhetoric, helping to support equity prices while restraining bond yields. Unfortunately, this benign environment will sow the seeds of its own demise. Falling inflation during the remainder of the year will lift real incomes, leading to increased consumer spending. Inflation will pick up towards the end of 2023, forcing central banks to turn hawkish again. Trade Inception Level Initiation Date Stop Loss Long iShares Core S&P Small Cap ETF (IJR) / SPDR S&P 500 ETF (SPY) 100 Apr 21/2022 -5% Trade Recommendation: Go long US small caps vs. large caps via the iShares Core S&P Small-Cap ETF (IJR) and the SPDR S&P 500 ETF (SPY). Bottom Line: Global equities are heading towards a “last hurrah” starting in the second half of this year. Stay overweight stocks on a 12-month horizon. Push or Pull? Economists like to distinguish between “demand-pull” and “cost-push” inflation. The former occurs in response to positive demand shocks while the latter reflects negative supply shocks. In order to tell one from the other, it is useful to look at real wages. When real wages are rising briskly, households tend to spend more, leading to demand-pull inflation. In contrast, when wages fail to keep up with rising prices, it is a good bet that we have cost-push inflation on our hands. Chart 1 shows that real wages have been falling across the major economies over the past year. The decline in real wages has coincided with a steep drop in consumer confidence (Chart 2). This points to cost-push forces as the main culprits behind today’s high inflation rates. Chart 1Real Wages Are Declining Chart 2Consumer Confidence Has Soured A close look at the breakdown of recent inflation figures supports this conclusion. The US headline CPI rose by 8.5% year-over-year in March. The bulk of the inflation occurred in supply-constrained categories such as food, energy, and vehicles (Chart 3). Chart 3The Acceleration In Inflation Has Been Driven By Pandemic And War-Impacted Categories The Toilet Paper Economy When the pandemic began, shoppers rushed out to buy essential household supplies including, most famously, toilet paper. Chart 4In A Break From The Past, Goods Prices Soared During The Pandemic The toilet paper used in offices is somewhat different than the sort used at home. So, to some extent, work-from-home (and do other stuff-at-home) arrangements did boost the demand for consumer-grade toilet paper. However, a much more important factor was household psychology. People scrambled to buy toilet paper because others were doing the same. As often occurs in prisoner-dilemma games, society moved from one Nash equilibrium – where everyone was content with the amount of toilet paper they had – to another equilibrium where they wanted to hold much more paper than they previously did. What has gone largely unnoticed is that the toilet paper fiasco was replicated across much of the global supply chain. Worried that they would not have enough intermediate goods on hand to maintain operations, firms began to hoard inputs. Retailers, anxious at the prospect of barren shelves, put in bigger purchase orders than they normally would have. All this happened at a time when demand was shifting from services to goods, and the pandemic was disrupting normal goods production. No wonder the prices of goods – especially durable goods — jumped (Chart 4).   Peak Inflation? The war in Ukraine could continue to generate supply disruptions over the coming months. The Covid outbreak in China could also play havoc with the global supply chain. While the number of Chinese Covid cases has dipped in recent days, Chart 5 highlights that 27 out of 31 mainland Chinese provinces are still reporting new cases, up from 14 provinces in the beginning of February. The number of ships stuck outside of Shanghai has soared (Chart 6). Chart 527 Out Of 31 Chinese Provinces Are Reporting New Cases, Up From 14 Provinces In The Beginning Of February Chart 6The Clogged-Up Port Of Shanghai Chart 7Inflation Will Decelerate This Year Thanks To Base Effects Nevertheless, the peak in inflation has probably been reached in the US. For one thing, base effects will push down year-over-year inflation (Chart 7). Monthly core CPI growth rates were 0.86% in April, 0.75% in May, and 0.80% in June of 2021. These exceptionally high prints will fall out of the 12-month average during the next few months. More importantly, goods inflation will abate as spending shifts back toward services. Chart 8 shows that spending on goods remains well above the pre-pandemic trend in the US, while spending on services remains well below. Excluding autos, US retail inventories are about 5% above their pre-pandemic trend (Chart 9). Core goods prices fell in March for the first time since February 2021. Fewer pandemic-related disruptions, and hopefully a stabilization in the situation in Ukraine, could set the stage for sharply lower inflation and a revival in global growth in the second half of this year. How long will this Goldilocks environment last? Our guess is that it will endure until the second half of next year, but probably not much beyond then. As inflation comes down over the coming months, real income growth will rise. What began as cost-push inflation will morph into demand-pull inflation by the end of 2023. The Fed will need to resume hiking at that point, potentially bringing rates to over 4% in 2024. Chart 8Spending On Services Remains Well Below The Pre-Pandemic Trend, While Spending On Goods Is Above It Chart 9Shelves Are Well Stocked In The US Investment Implications Wayne Gretzky famously said that he always tries to skate to where the puck is going to be, not where it has been. Macro investors should follow the same strategy: Ask what the global economy will look like in six months and invest accordingly. The past few months have been tough for the global economy and financial markets. Last week, bullish sentiment fell to the lowest level in 30 years in the American Association of Individual Investors poll (Chart 10). Global growth optimism dropped in April to a record low in the BofA Merrill Lynch Fund Manager Survey.    Chart 10AAII Survey: Equity Bulls Are In Short Supply Chart 11The Equity Risk Premium Remains Elevated Yet, a Goldilocks environment of falling inflation and supply-side led growth awaits in the second half of the year. Even if this environment does not last beyond the end of 2023, it could provide a “last hurrah” for global equities. Despite the spike in bond yields, the earnings yield on stocks still exceeds the real bond yield by 5.4 percentage points in the US, and by 7.8 points outside the US (Chart 11). TINA’s siren song may have faded but it is far from silent. Global equities have about 10%-to-15% upside from current levels over a 12-month horizon. We recommend that investors increase allocations to non-US stock markets, value stocks, and small caps over the coming months (see trade recommendation below). Consistent with our view that the neutral rate of interest is higher than widely believed in the US and elsewhere, we expect the 10-year Treasury yield to eventually rise to around 4% in 2024. However, with US inflation likely to trend lower in the second half of this year, we do not expect much upside for yields over a 12-month horizon. If anything, the fact that bond sentiment in the latest BofA Merrill Lynch survey was the most bearish in 20 years suggests that the near-term risk to yields is to the downside.  Trade Idea: Go Long US Small Caps Versus Large Caps Small caps have struggled of late. Over the past 12 months, the S&P 600 small cap index has declined 3%, even as the S&P has managed to claw out a 5% gain. At this point, small caps are starting to look relatively cheap (Chart 12). The S&P 600 is trading at 14-times forward earnings compared to 19-times for the S&P 500. Notably, analysts expect small cap earnings to rise more over the next 12 months, as well as over the long term, than for large caps. Chart 12Small Caps Are Looking Attractive Relative To Their Large Cap Peers Chart 13Small Caps Tend To Outperform When Growth Is Picking Up And The Dollar Is Depreciating Small caps tend to perform best in settings where growth is accelerating and the US dollar is weakening (Chart 13). Economic growth should benefit from a supply-side boost later this year as pandemic headwinds fade and more low-skilled workers rejoin the labor market. With inflation set to decline, the need for the Fed to generate hawkish surprises will temporarily subside, putting downward pressure on the dollar. Investors should consider going long the S&P 600 via the iShares Core S&P Small-Cap ETF (IJR) versus the S&P 500 via the SPDR S&P 500 ETF (SPY). Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on  LinkedIn Twitter   Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

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 Brent Stable As Demand + Supply Fall Oil demand growth will slow this year and next by 1.6mm b/d and 1mm b/d, respectively. These expectations are in line with sharp downgrades in World Bank and IMF economic forecasts, which cite pressures from the Ukraine War, COVID-19-induced lockdowns in China, and central-bank policy efforts to contain rising inflation. Lower oil demand will be offset by lower supply from Russia and OPEC 2.0, which now are ~ 1.5mm b/d behind on pledges to restore production taken from the market during the pandemic. In 2022, US production will increase ~750k b/d year-on-year. The strategic relationship between the US and core OPEC 2.0 producers Saudi Arabia and the UAE is fraying. The Core's unwillingness to increase production despite pleas from the Biden administration likely motivated the US’s record SPR release of 180mm barrels (1mm b/d over 6 months). This will be augmented by another 60mm-barrel release of refined products by IEA member states. The EU's threat to stop importing half of Russia's 5mm b/d of oil exports would, if realized, force Russian storage to fill, and lead to production shut-ins. Oil prices would surge to destroy enough demand to cover this loss. Our base-case Brent forecast is at $94/bbl this year and $88/bbl in 2023, leaving our forecast over the period mostly unchanged. Bottom Line: Despite major shifts in global oil supply and demand over the past month, oil markets have remained mostly balanced. We remain long commodity index exposure via the S&P GSCI index, and the COMT ETF. We also are long oil and gas producer exposure via the XOP, and base metals producers via the PICK and XME ETFs. Feature Related Report  Commodity & Energy StrategyDesperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma Oil demand and supply growth are weakening on the back of the Ukraine War, COVID-19-induced lockdowns in China, and central-bank efforts to contain rising inflation. We expect global demand growth to slow this year and next by 1.6mm b/d and 1mm b/d, respectively, in line with downgrades in IMF and World Bank global growth forecasts.1 Demand will fall to 100mm b/d on average this year, down from our earlier expectation of 101.5mm b/d published in March. For next year, we expect global oil consumption to come in at 102.2mm b/d, down from our March estimate of 103.2mm b/d (Chart 1). EM consumption, the engine of oil-demand growth, falls to 54.2mm b/d vs. 55.8mm b/d in last month's forecast for 2022 demand. We have been steadily lowering our estimate for 2022 Chinese demand this year due to its zero-tolerance COVID policy and its associated lockdowns, and again take it down 250k b/d in this month's balances to 15.7mm b/d on average. In our estimates, Chinese oil demand grows 2.6% from its 2021 level of 15.3mm b/d. We have been expecting DM oil consumption to flatten out this year, following massive fiscal and monetary stimulus fueling oil demand during and after the pandemic, and continue to expect it to come in at ~ 45.7mm b/d this year. Chart 1Sharply Lower Oil Demand Expected Oil Supply Gets Complicated Oil supply will continue to weaken along with demand this year, primarily due to sanctions imposed on Russia by Western buyers following its invasion of Ukraine. Russia's production reportedly was just above 10mm b/d. Estimates of Russian production losses over 2022-23 range from 1mm b/d to as much as 1.7mm b/d over at the US EIA. The outlier here is the IEA, which warns Russian production will fall 1.5mm b/d this month, then accelerate to 3mm b/d beginning in May. In our base-case modeling, we expect Russian output to average 9.8mm b/d in 2022 and 9.9mm b/d next year (Chart 2). Tracking Russia's production became more complicated, as the government this week announced it no longer would be reporting these data. Prices and satellite services will be needed to impute Russia's output in the future. Russia and the Kingdom of Saudi Arabia (KSA) are the putative leaders of OPEC 2.0 (otherwise known as OPEC+). In the wake of Russia's invasion of Ukraine, OPEC, the original cartel led by KSA, continues to maintain solidarity with Russia, referring in its Monthly Oil Market Report (MOMR), for example, to the "conflict between Russian and Ukraine," or the "conflict in Eastern Europe" – not the war in Ukraine. This would suggest KSA and its allies continue to place a high value in maintaining the OPEC 2.0 structure, which has shown itself to be an extremely useful organization for managing production and production declines among non-Core states – i.e., those states outside the Gulf that cannot increase output, or are managing declining production due to lack of capital, labor or both (Chart 3). Chart 2Brent Stable As Demand + Supply Fall Chart 3OPEC 2.0 Remains Useful To KSA And Russia The strategic relationship between core OPEC 2.0 producers capable of maintaining higher production – KSA and the UAE – and the US is fraying. Both states showed no interest in increasing production despite pleas from the Biden administration following Russia's invasion of Ukraine, and have shown a propensity to expand their diplomatic and financial relationships, e.g., exploring oil sales denominated in Chinese RMB, beyond their US relationships.2 This likely motivated the US’s record SPR release of 180mm barrels (1mm b/d over 6 months). This will be augmented by another 60mm-barrel release of refined products by IEA member states. Outside the OPEC 2.0 coalition, we continue to expect higher output from the US, led by shale oil production. According to Rystad Energy, horizontal drilling permits in the Permian basin hit an all-time high in March.3 If these permits are converted into new projects, oil supply growth will be boosted starting 2023. The US government’s recent announcement to lease around 144,000 acres of land to oil and gas companies – in a bid to bring down high US oil prices – also will spur supply growth towards the beginning of next year.4 These bullish factors are balanced out by nearer-term headwinds. Bottlenecks resulting from pent-up demand released following global lockdowns, the Russia-Ukraine crisis, and investor-induced capital austerity means US oil producers will not be able to turn on the taps as quickly this year as they've been able to do in days gone by. Given the near-term bearish factors and longer-term bullish factors, we expect total US crude production to grow slower this year and ramp up at a faster pace the next. US shale output (i.e., Lower 48 states (L48) ex Gulf of Mexico) is expected to average 9.73mm b/d in 2022 and 10.53mm b/d in 2023 (Chart 4). Total US crude supply is expected to average 11.92mm b/d and 12.74mm b/d, respectively, over this period. Additional production increases are expected from Canada, Brazil and Norway. Chart 4Shales Continue To Pace US Onshore Output Increases Upside Risk Remains KSA's and the UAE's strategy to hold off on production increases despite US entreaties upends one of our expectations – i.e., that these state would increase production as the deficit in OPEC 2.0 output being returned to the market widened. We are coming around to the idea this could represent a desire to diversify their exposure to USD payments and assets, which, as Russia's invasion of Ukraine demonstrated, can become liabilities in an economic war. This also would begin to reduce the heavy reliance KSA and the UAE place on the US vis-à-vis defending its interests.5 Lastly, we would observe KSA's and the UAE's spare capacity is being husbanded closely, given it constitutes most, if not all, of OPEC 2.0's 3.4mm b/d of spare capacity (Chart 5). There are multiple scenarios in which this spare capacity would be needed by global markets to address production outages. One of the most imposing is an EU embargo on Russian oil imports floated by France this week, which triggers a cut-off of natural gas supplies by Russia to the EU.6 An embargo of Russian oil imports by the EU is a very low-probability event, but it is not vanishingly small. The EU imports about 2.5mm b/d of Russia's crude oil exports. The EU's threat to stop importing half of Russia's 5mm b/d of oil exports would, if realized, force Russian pipelines and storage to fill, and would lead to production shut-ins. Oil prices would have to surge to destroy enough demand to cover this loss of supply, even after OPEC's spare capacity was released into the market. If realized, such an event also would throw the world into recession, in our view. The prospect of a cut-off of Russian oil imports by the EU was addressed last month by Energy Minister Alexander Novak, who said such an act would prompt Russia to shut down natural gas exports to the EU.7 If Russia follows through on such a threat, it would shut down much of the EU's industrial and manufacturing activity. The experience of this past winter – when aluminum and zinc smelters were forced to shut as natural gas prices surged and made electricity from gas-fired generation too expensive for their operations – remains fresh in the mind of the market. An oil-import ban by the EU followed by a cut-off of natgas exports by Russia almost surely would spike volatility in these markets (Chart 6). In addition, a global recession would be a foregone conclusion, in our view. Chart 5OPEC Spare Capacity Concentrated In KSA, UAE Chart 6Oil+ Gas Volatility Would Spike If EU Cuts Russian Oil Imports Markets Remain Roughly Balanced … For Now Our supply-demand modeling indicates production losses are roughly balanced by consumption losses at present (Chart 7). If anything, the lost demand slightly outweighs the loss of production, when we run our econometric models. However, we are maintaining a $10/bbl risk premium in our estimates for 2022-23 Brent prices, which keeps our current forecast close to last month's levels. Persistent strength in the USD, particularly in the USD real effective exchange rate, acts as a headwind on prices by making oil more expensive ex-US (Chart 8). We expect this to continue, given the Fed's avowed commitment to raise policy rates to choke off inflation, which, all else equal, will make USD-denominated returns attractive. Chart 7Markets Remain Mostly Balanced Chart 8Strong USD Restrains Oil Prices Investment Implications Despite the major shifts in oil supply and demand over the past month, markets have remained mostly balanced (Table 1). Falling Russian output and weak OPEC 2.0 production – where most states are managing production declines – is being exacerbated by falling Chinese demand and SPR releases from the US and IEA. The market does not yet need the 1.3mm b/d of Iranian output that is being held at bay due to a diplomatic impasse between the US and Iran, which we believe will persist. With overall economic output growth slowing – per the forecasts of the major supranational agencies (WTO, IMF, World Bank) – weaker demand can be expected to persist. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 This is not to say upside risk is non-existent. A move by the EU to ban Russian oil imports could set in motion sharply higher oil and gas prices and a deep EU recession, as discussed above. This could trigger an immediate need for OPEC spare capacity and those Iranian barrels waiting to return to export markets. We remain long commodity index exposure via the S&P GSCI index, and the COMT ETF. We also are long oil and gas producer exposure via the XOP, and base metals producers via the PICK and XME ETFs.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodity Round-Up Energy: Bullish Russia's concentration of exposure to OECD Europe – as customers for its energy exports – exceeds the latter's concentration of imports from Russia by a wide margin. Russia produced 10.1mm b/d of crude and condensates in 2021. Of the 4.7mm b/d of this Russia exported last year, OECD Europe was its largest customer, accounting for 50% of total oil exports, according to the US EIA (Chart 9). On the natgas side, more than one-third of the ~ 25 Tcf of natgas produced by Russia last year was exported via pipeline or as LNG, based on 2021 data from the EIA. This amounted to almost 9 Tcf. Most of this – 84% – was exported via pipeline to the OECD Europe, with the biggest customers being Germany, Turkey, Italy and France. As is the case with crude oil and liquids, OECD Europe is Russia's biggest natgas customer, accounting for ~ 75% of exports in either gaseous or liquid form. There is an argument to be made Russia needs OECD Europe as much or more than the latter needs Russia. Ags/Softs: Neutral Grains and vegetable oils are at multi-year or all-time highs, as a result of the war in Ukraine. This week, corn futures hit the highest since 2012, while wheat futures surged amid the ongoing war and unfavorable weather in U.S. growing areas. The U.N. Food and Agriculture Organization's Food Price Index rose 12.6% from February, its highest level since 1990. According to the FAO, the war in Ukraine was largely responsible for the 17.1% rise in the price of grains, including wheat and corn. Together, Russia and Ukraine account for around 30% and 20% of global wheat and corn exports. The cost of fertilizers has increased by almost 30% in many places due to the supply disruptions caused by the war and the tightening of natural gas markets, which is being driven by EU efforts to diversify away from Russian imports of the commodity.8 Planting is expected to be very irregular in the upcoming grain-sowing months, navigate through much higher prices for fuel and fertilizers (Chart 10). Chart 9 Chart 10     Footnotes 1     Please see the IMF's April 2022 World Economic Outlook report entitled War Sets Back the Global Recovery, and the World Bank's Spring Meetings 2022 Media Roundtable Opening Remarks by World Bank Group President David Malpass, posted on April 18, 2022. 2     Please see, e.g., Saudi Arabia Considers Accepting Yuan Instead of Dollars for Chinese Oil Sales published by wsj.com on March 15, 2022.   3    Please see Permian drilling permits hit all-time high in March, signaling production surge on the horizon, published by Rystad Energy on April 13, 2022. 4    Please see Joe Biden resumes oil and gas leases on federal land, published by the Financial Times on April 15, 2022. 5    Please see Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma, which we published on January 14, 2014. In that report, we noted, "… the U.S. has decided to stop micromanaging the Middle East. The latter policy sucked in too much of Washington's material resources, blood and treasure, at a time when regional powers like China and Russia were looking to establish their own spheres of influence in East Asia and Eurasia respectively." Building deeper commercial relationships with China also would bind both states together in terms of addressing KSA's security concerns, given China's existing relationships with Iran. This is a longer-term strategy, in our view. 6    Please see An EU embargo on Russian oil in the works - French minister, published by reuters.com on April 19, 2022. 7     Please see War in Ukraine: Russia says it may cut gas supplies if oil ban goes ahead, published by bbc.co.uk on March 8, 2022. 8    Please refer to Food prices soar to record levels on Ukraine war disruptions, published by abcNEWS on April 8, 2022.   Investment Views and Themes Strategic Recommendations Trades Closed in 2022