Economy
Executive Summary Turbulence remains the signal feature of 2022 as worries about inflation and the Fed’s reaction to it continue to haunt investors and plague financial markets. Despite four-decade highs in measured inflation, long-run inflation expectations have held fast, keeping an inflation vicious circle from taking hold. As the diminishing threat from COVID helps unsnarl supply and transportation bottlenecks, it will also reduce the potential for expectations to become unmoored. The labor market has been sending encouraging signals for the economy and corporate profit margins. Although payrolls continue to expand at a robust pace and job openings remain near record highs, upward wage pressures appear to be losing momentum. Households have proven willing to spend their excess pandemic savings and maintain a sizable cushion to keep the economy growing near its long-run trend pace. All Is Not Yet Lost Bottom Line: Markets remain volatile, subject to sharp swings upon any data points that portend a shift in the Fed’s tightening campaign. The August CPI report did not change our view that the consensus is underestimating the potential for positive earnings surprises in the next two quarters and we continue to recommend overweighting equities over the next three to six months. Feature Will the real inflation trend please stand up? Financial markets were emboldened by July’s CPI release, which reported a 0.1% month-over-month decline in inflation, 10 basis points below expectations, and demoralized by August’s edition, which reported a 0.1% month-over-month increase, 20 basis points above expectations. Core inflation, which backs out changes in volatile food and energy prices, came in at 0.6% in August after a 0.3% reading in July. In the harsh light of the August release, the July data point looked anomalous to the naked eye after holding between 0.6 and 0.7% in the three previous months. Related Report US Investment StrategyChartbook Equities swooned after the release, but policymakers and economic participants should focus on data trends rather than data points. Though we share in the general disappointment that inflation remains elevated, we continue to expect that headline CPI growth will abate to around 4% over the coming months. The supply of goods and services will increase as COVID’s threat continues to recede, while demand will slacken as the Fed and other major central banks continue to tighten monetary policy. The end of COVID restrictions will help to facilitate the ongoing shift in demand from goods to services. All in all, the underlying trend toward decelerating inflation will not be upended by noisy one-off data points. Stubbornly high inflation prints increase the risk that inflation expectations will become unmoored, feeding a self-reinforcing cycle in which high prices beget even higher prices, but there is no sign yet that they are poised to break out. Persistent inflation also increases the risk that the Fed will overdo the tightening and induce a deeper recession than would otherwise occur. We remain vigilant on both fronts, but believe markets are overestimating the probability of each risk. The charts that follow – tracking COVID’s course, inflation expectations, the labor market, household balance sheets and the outlook for S&P 500 earnings – show the data underpinning our stance. We will abandon our sanguine tactical view if consumers show signs of retrenching, which would torpedo our better-than-consensus growth outlook, or if inflation expectations show signs of becoming unmoored, which would force the Fed to move to throttle the economy immediately. Neither condition has yet been met, however, and we continue to believe that the consensus is underestimating the potential for upside earnings surprises. Chart 1Omicron Has Come And Gone ... Chart 2... With Much Less Of An Impact Than Delta Chart 3The Picture Looks Even Better Outside The US ... Chart 4... Though Ancillary Counts May Not Be So Rigorously Maintained Chart 5Watch This Space Chart 6Consumers Are Still Not Chasing Big-Ticket Items Chart 7Near-Term Expectations Are Way Down ... Chart 8... And Long-Term Expectations Remain Contained Chart 9Steady As She Goes Chart 10We're All Doomed! Chart 11Oh, Wait, Never Mind Chart 12Initial Claims Are Nearly 20% Below Their Mid-July Peak ... Chart 13... And Openings Have Come Only Slightly Off Of Theirs Chart 14Ready, Willing And Able To Keep The Economy Going Chart 15Down, But Not Out Chart 16Margins Remain Elevated ... Chart 17... And Profit Warnings Are Few And Far Between Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com
On the surface, Chinese industrial production, retail sales and fixed asset investments appeared to improve in August. Industrial production rose by 4.2% y/y following 3.8% y/y in July, retail sales growth accelerated to 5.4% y/y from 2.7% y/y, and fixed…
In August, total US industrial production declined by 0.2% m/m following a 0.5% m/m increase in July. However, the manufacturing sector’s output surprised to the upside, rising for the second consecutive month against expectations it would contract. Notably,…
The pulse from Singapore’s trade numbers continue to send a warning about the global trade cycle. Singapore’s non-oil domestic exports fell by 3.9% m/m in August while electronic exports registered the first year-on-year contraction since November 2020.…
Executive Summary The US inflation surprise increases the odds of both congressional gridlock and recession, which increases uncertainty over US leadership past 2024 and reduces the US’s ability to lower tensions with China and Iran. Despite the mainstream media narrative, the Xi-Putin summit reinforces our view that China cannot reject Russia’s strategic partnership. The potential for conflict in Taiwan forces China to accept Russia’s overture. For the same reason the US and China cannot re-engage their economies sustainably, even if Biden and Xi somehow manage to reduce tensions after the midterm elections and twentieth national party congress. Russia could reduce oil exports as well as natural gas, intensifying the global energy shock. Ukraine’s counter-offensive and Europe’s energy diversification increase the risk of Russian military and economic failure. The Middle East will destabilize anew and create a new source of global energy supply disruptions. US-Iran talks are faltering as expected. Russian Oil Embargo Could Deliver Global Shock Asset Initiation Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 19.1% Bottom Line: Stay long US stocks, defensive sectors, and large caps. Avoid China, Taiwan, eastern Europe, and the Middle East. Feature Several notable geopolitical developments occurred over the past week while we met with clients at the annual BCA Research Investment Conference in New York. In this report we analyze these developments using our geopolitical method, which emphasizes constraints over preferences, capabilities over intentions, reality over narrative. We also draw freely from the many valuable insights gleaned from our guest speakers at the conference. China Cannot Reject Russia: The Xi-Putin Summit In Uzbekistan Presidents Xi Jinping and Vladimir Putin are meeting in Uzbekistan as we go to press and Putin has acknowledged China’s “questions and concern” about the war in Ukraine.1 They last met on February 4 when Xi gave Putin his blessing for the Ukraine invasion, promising to buy more Russian natural gas and to pursue a “no limits” strategic partnership (meaning one that includes extensive military cooperation). The meeting’s importance is clear from both leaders’ efforts to make it happen. Putin is leaving Russia despite rising domestic criticism over his handling of the Ukraine war and European energy war. Ukraine is making surprising gains in the battlefield, particularly around Kharkiv, threatening Russia’s ability to complete the conquest of Donetsk and the Donbas region. Meanwhile Xi is leaving China for the first time since the Covid-19 outbreak, despite the fact that he is only one month away from the most important political event of his life: the October 16 twentieth national party congress, where he hopes to clinch another five, ten, or fifteen years in power, expand his faction’s grip over the political system, and take over Mao Zedong’s unique title as chairman of the Communist Party. We do not yet know the full outcome of the Uzbek summit but we do not see it as a turning point in which China turns on Russia. Instead the summit reinforces our key point to investors all year: China cannot reject Russia. Russia broke energy ties with Europe and is fighting a proxy war with NATO. The Putin regime has lashed Russia to China’s side for the foreseeable future. China may not have wanted to move so quickly toward an exclusive relationship but it is not in a position to reject Russia’s diplomatic overture and leave Putin out to dry. The reason is that China is constrained by the US-led world order and like Russia is attempting to change that order and carve a sphere of influence to improve its national security. Beijing’s immediate goal is to consolidate power across the critical buffer territories susceptible to foreign interests. It has already consolidated Tibet, Xinjiang, Hong Kong, and to some extent the South China Sea, the critical approach to Taiwan. Taiwan is the outstanding buffer space that needs to be subjugated. Xi Jinping has taken it upon himself to unify China and Taiwan within his extended rule. But Taiwanese public opinion has decisively shifted in favor of either an indefinite status quo or independence. Hence China and Taiwan are on a collision course. Regardless of one’s view on the likelihood of war, it is a high enough chance that China, Taiwan, the US, and others will be preparing for it in the coming years. Chart 1US Arms Sales To Taiwan The US is attempting to increase its ability to deter China from attacking Taiwan. It believes it failed to deter Russia from invading Ukraine – and Taiwan is far more important to US economy and security than Ukraine. The US is already entering discussions with Taiwan and other allies about a package of severe economic sanctions in the event that China attacks – sanctions comparable to those imposed on Russia. The US Congress is also moving forward with the Taiwan Policy Act of 2022, which will solidify US support for the island as well as increase arms sales (Chart 1).2 Aside from China's military preparation – which needs to be carefully reviewed in light of Russia’s troubles in Ukraine and the much greater difficulty of invading Taiwan – China must prepare to deal with the following three factors in the event of war: 1. Energy: China is overly exposed to sea lines of communication that can be disrupted by the United States Navy. Beijing will have to partner with Russia to import Russian and Central Asian resources and attempt to forge an overland path to the Middle East (Chart 2). Unlike Russia, China cannot supply its own energy during a war and its warfighting capacity will suffer if shortages occur or prices spike. 2. Computer Chips: China has committed at least $200 billion on a crash course to build its own semiconductors since 2013 due to the need to modernize its military and economy and compete with the US on the global stage. But China is still dependent on imports, especially for the most advanced chips, and its dependency is rising not falling despite domestic investments (Chart 3). The US is imposing export controls on advanced microchips and starting to enforce these controls on third parties. The US and its allies have cut off Russia’s access to computer chips, leading to Russian shortages that are impeding their war effort. Chart 2China’s Commodity Import Vulnerability Chart 3China's Imports Of Semiconductors 3. US Dollar Reserves: China is still heavily exposed to US dollar assets but its access will be cut off in the event of war, just as the US has frozen Russian, Iranian, Venezuelan, and Cuban assets over the years. China is already diversifying away from the dollar but will have to move more quickly given that Russia had dramatically reduced its exposure and still suffered severely when its access to dollar reserves was frozen this year (Chart 4). Where will China reallocate its reserves? To developing and importing natural resources from Russia, Central Asia, and other overland routes. Chart 4China's US Dollar Exposure Russia may be the junior partner in a new Russo-Chinese alliance but it will not be a vassal. Russia has resources, military power, and regional control in Central Asia that China needs. Of course, China will maintain a certain diplomatic distance from Russia because it needs to maintain economic relations with Europe and other democracies as it breaks up with the United States. Europe is far more important to Chinese exports than Russia. China will play both sides and its companies will develop parallel supply chains. China will also make gestures to countries that feel threatened by Russia, including the Central Asian members of the Shanghai Cooperation Organization (SCO). But the crucial point is that China cannot reject Russia. If the Putin regime fails, China will be diplomatically isolated, it will lose an ally in any Taiwan war, and the US will have a much greater advantage in attempting to contain China in the coming years and decades. Russo-Chinese Alliance And The US Dollar Many investors speculate that China’s diversification away from the US dollar will mark a severe downturn for the currency. This is of course possible, given that Russia and China will form a substantial anti-dollar bloc. Certainly there can be a cyclical downturn in the greenback, especially after the looming recession troughs. But it is harder to see a structural collapse of the dollar as the leading global reserve currency. The past 14 years have shown how global investors react to US dysfunction, Russian aggression, and Chinese slowdown: they buy the dollar! The implication is that a US wage-price spiral, a Russian détente with Europe, and a Chinese economic recovery would be negative for the dollar – but those stars have not yet aligned. Related Report Geopolitical StrategyThe Geopolitical Consequences Of The Ukraine War The reason China needs to diversify is because it fears US sanctions when it invades Taiwan. Hence reducing its holdings of US treasuries and the dollar signals that it expects war in future. But will other countries rush into the yuan and yuan-denominated bonds if Xi is following in Putin’s footsteps and launching a war of choice, with damaging consequences for the economy? A war over Taiwan would be a global catastrophe and would send other countries plunging into the safe-haven assets, including US assets. Nevertheless China will diversify and other countries will probably increase their yuan trade over time, just as Russia has done. This will be a cyclical headwind for the dollar at some point. But it will not knock the US off the premier position. That would require a historic downgrade in the US’s economic and strategic capability, as was the case with the United Kingdom after the world wars. China will continue to stimulate the economy after the party congress. A successful Chinese and global economic rebound next year – and a decision to pursue “jaw jaw” with the US and Taiwan rather than “war war” – would be negative for the dollar. Hence we may downgrade our bullish dollar view to neutral on a cyclical basis before long … but not yet and not on a structural basis. Bottom Line: Favor the US dollar and the euro over the Chinese renminbi and Taiwanese dollar. Underweight Chinese and Taiwanese assets on a structural basis. Ukraine’s Counter-Offensive And A Russian Oil Embargo Ukraine launched a counter-offensive against Russia in September and achieved significant early victories. Russians fell back away from Kharkiv, putting Izyum in Ukrainian hands and jeopardizing Russia’s ability to achieve its war aim of conquering the remaining half of Donetsk province and thus controlling the Donbas region of eastern Ukraine. Russian positions also crumbled west of the Dnieper river, which was always an important limit on Russian capabilities (Map 1). Map 1Status Of Russia-Ukraine War: The Ukrainian Counter-Offensive (September 15, 2022) Some commentators, such as Francis Fukuyama in the Washington Post, have taken the Ukrainian counter-offensive as a sign that the Ukrainians will reconquer lost territory and Russia will suffer an outright defeat in this war.3 If Russia cannot conquer the Donbas, its control of the “land bridge” to Crimea will be unsustainable, and it may have to admit defeat. But we are very skeptical. It will be extremely difficult for Ukrainians to drive the Russians out of all of their entrenched positions. US military officials applauded Ukraine’s counter-offensive but sounded a cautious note. The chief problem is that neither President Putin nor the Russian military can afford such a defeat. They will have to double down on the Donbas and land bridge. The war will be prolonged. Ultimately we expect stalemate, which will be a prelude to ceasefire negotiations. But first the fighting will intensify and the repercussions for global economy and markets will get worse. Russia’s war effort is also flagging because Europe is making headway in finding alternatives for Russian natural gas. Russia has cut off flows through the Nord Stream pipeline to Germany, the Yamal pipeline to Poland, and partially to the Ukraine pipeline system, leaving only Turkstream operating normally. Yet EU gas storage is in the middle of its normal range and trending higher (Chart 5). Chart 5Europe Handling Natural Gas Crisis Well … So Far Of course, Europe’s energy supply is still not secure. Cold weather could require more heating than expected. Russia has an incentive to tighten the gas flow further. Flows from Algeria or Azerbaijan could be sabotaged or disrupted (Chart 6). Chart 6Europe’s NatGas Supply Still Not Secure Chart 7Europe Tipping Into Recession Anyway Russia’s intention is to inflict a recession on Europe so that it begins to rethink its willingness to maintain a long-term proxy war. Recession will force European households to pay the full cost of the energy breakup with Russia all at once. Popular support for war will moderate and politicians will adopt more pragmatic diplomacy. After all they do not have an interest in prolonging the war to the point that it spirals out of control. Clearly the economic pain is being felt, as manufacturing expectations and consumer confidence weaken (Chart 7). Europe’s resolve will not collapse overnight. But the energy crisis can get worse from here. The deeper the recession, the more likely European capitals will try to convince Ukraine to negotiate a ceasefire. However, given Ukraine’s successes in the field and Europe’s successes in diversification, it is entirely possible that Russia faces further humiliating setbacks. While this outcome may be good for liberal democracies, it is not good for global financial markets, at least not in the short run. If Russia is backed into a corner on both the military and economic fronts, then Putin’s personal security and regime security will be threatened. Russia could attempt to turn the tables or lash out even more aggressively. Already Moscow has declared a new “red line” if the US provides longer-range missiles to Ukraine. A US-Russia showdown, complete with nuclear threats, is not out of the realm of possibility. Russia could also start halting oil exports, as it has threatened to do, to inflict a major oil shock on the European economy. Investors will need to be prepared for that outcome. Bottom Line: Petro-states have geopolitical leverage as long as global commodity supplies remain tight. Investors should be prepared for the European embargo of Russian oil to provoke a Russian reaction. A larger than expected oil shock is possible given the risk of defeat that Russia faces (Chart 8). Chart 8Russian Oil Embargo Could Deliver Global Shock US-Iran Talks Falter Again This trend of petro-state geopolitical leverage was one of our three key views for 2022 and it also extends to the US-Iran nuclear negotiations, which are faltering as expected. Tit-for-tat military action between Iran and its enemies in the Persian Gulf will pick up immediately – i.e. a new source of oil disruption will emerge. If global demand is collapsing then this trend may only create additional volatility for oil markets at first, but it further constrains the supply side for the foreseeable future. It is not yet certain that the talks are dead but a deal before the US midterm looks unlikely. Biden could continue working on a deal in 2023-24. The Democratic Party is likely to lose at least the House of Representatives, leaving him unable to pass legislation and more likely to pursue foreign policy objectives. The Biden administration wants the Iran deal to tamp down inflation and avoid a third foreign policy crisis at a time when it is already juggling Russia and China. The overriding constraints in this situation are that Iran needs a nuclear weapon for regime survival, while Israel will attack Iran as a last resort before it obtains a nuclear weapon. Yes, the US is reluctant to initiate another war in the Middle East. But public war-weariness is probably overrated today (unlike in 2008 or even 2016) and the US has drawn a hard red line against nuclear weaponization. Iran will retaliate to any US-Israeli aggression ferociously. But conflict and oil disruptions will emerge even before the US or Israel decide to launch air strikes, as Iran will face sabotage and cyber-attacks and will need to deter the US and Israel by signaling that it can trigger a region-wide war. Chart 9If US-Iran Talks Fail, Iraq Will Destabilize Further Recent social unrest in Iraq, where the nationalist coalition of Muqtada al-Sadr is pushing back against Iranian influence, is only an inkling of what can occur if the US-Iran talks are truly dead, Iran pushes forward with its nuclear program, and Israel and the US begin openly entertaining military options. The potential oil disruption from Iraq presents a much larger supply constraint than the failure to remove sanctions on Iran (Chart 9). A new wave of Middle Eastern instability would push up oil prices and strengthen Russia’s hand, distracting the US and imposing further pain on Europe. It would not strengthen China’s hand, but the risk itself would reinforce China’s Eurasian strategy, as Beijing would need to prepare for oil cutoffs in the Persian Gulf. Iran’s attempts to join the Shanghai Cooperation Organization should be seen in this context. Ultimately the only factor that could still possibly convince Iran not to make a dash for the bomb – the military might of the US and its allies – is the same factor that forces China and Russia to strengthen their strategic bond. The emerging Russo-Chinese behemoth, in turn, acts as a hard constraint on any substantial reengagement of the US and Chinese economies. The US cannot afford to feed another decade of Chinese economic growth and modernization if China is allied with Russia and Central Asia. Of course, we cannot rule out the possibility that the Xi and Biden administrations will try to prevent a total collapse of US-China relations in 2023. If China is not yet ready to invade Taiwan then there is a brief space for diplomacy to try to work. But there is no room for long-lasting reengagement – because the US cannot simply cede Taiwan to China, and hence China cannot reject Russia, and Russia no longer has any options. Bottom Line: Expect further oil volatility and price shocks. Sell Middle Eastern equities. Favor North American, Latin American, and Australian energy producers. Investment Takeaways Recession Risks Rising: The inflation surprise in the US in August necessitates more aggressive Fed rate hikes in the near term, which increases the odds of rising unemployment and recession. US Policy Uncertainty Rising: A recession will greatly increase the odds of US political instability over the 2022-24 cycle and reduce the incentive for foreign powers like Iran or China to make concessions or agreements with the US. European Policy Uncertainty Rising: We already expected a European recession. Russia’s setbacks make it more likely that it will adopt more aggressive military tactics and economic warfare. Chinese Policy Uncertainty Rising: China will continue stimulating next year but its economy will suffer from energy shocks and its stimulus is less effective than in the past. It will likely increase economic and military pressure on Taiwan, while the US will increase punitive measures against China. It is not clear that it will launch a full scale invasion of Taiwan – that is not our base case – but it is possible so investors need to be prepared. Long US and Defensives: Stay long US stocks over global stocks, defensive sectors over cyclicals, and large caps over small caps. Buy safe-havens like the oversold Japanese yen. Long Arms Manufacturers: Buy defense stocks and cyber-security firms. Short China and Taiwan: Favor the USD and EUR over the CNY. Favor US semiconductor stocks over Taiwanese equities. Favor Korean over Taiwanese equities. Favor Indian tech over Chinese tech. Favor Singaporean over Hong Kong stocks. Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Tessa Wong and Simon Fraser, “Putin-Xi talks: Russian leader reveals China's 'concern' over Ukraine,” BBC, September 15, 2022, bbc.com. 2 US Senate Foreign Relations Committee, “The Taiwan Policy Act of 2022,” foreign.senate.gov. 3 Greg Sargent, “Is Putin facing defeat? The ‘End of History’ author remains confident,” Washington Post, September 12, 2022, washingtonpost.com. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix
Listen to a short summary of this report Executive Summary GIS Projection For The EUR/USD We went long the euro early last week, as EUR/USD hit our buy limit price of $0.99. Despite a near cut-off of Russian gas imports, European gas inventories have reached 84% of capacity – above the 80% target that the EU set for November 1st. The latest meteorological forecasts suggest that Europe will experience a warmer-than-normal winter. This will cut heating usage, likely making gas rationing unnecessary. Currencies fare best in loose fiscal/tight monetary environments. This is what Europe faces over the coming months, as governments boost income support for households and businesses, while ramping up spending on energy infrastructure and defense. For its part, the ECB has started hiking rates. Since mid-August, interest rate differentials have moved in favor of the euro at both the short and long end. Rising inflation expectations make it less likely that the ECB will be able to back off from its tightening campaign as it did in past cycles. A hawkish Fed is the biggest risk to our bullish EUR/USD view. We expect US inflation to trend lower over the coming months, before reaccelerating in the second half of 2023. However, as the August CPI report highlights, the danger is that any dip in inflation proves to be shallower and shorter-lived than previously anticipated. Bottom Line: Although significant uncertainty remains, the risk-reward trade-off favors being long EUR/USD. Our end-2022 target is $1.06. Dear Client, I will be meeting clients in Asia next week while also working on our Fourth Quarter Strategy Outlook, which will be published at the end of the month. In lieu of our regular report next Friday, you will receive a Special Report from my colleague, Ritika Mankar, discussing the sources of US equity outperformance over the past 14 years and the likely path ahead. Best Regards, Peter Berezin, Chief Global Strategist It’s Just a Clown Chart 1Investors Are Bullish The Dollar, Not The Euro The scariest part of a horror movie is usually the one before the monster is revealed. No matter how good the special effects, the human brain can always conjure up something more frightening than anything Hollywood can dream up. Investors have been conjuring up all sorts of cataclysmic scenarios for the upcoming European winter. In financial markets, the impact has been most visible in the value of the euro, which has tumbled to parity against the US dollar. Only 23% of investors are bullish the euro at present, down from a peak of 78% in January 2021 (Chart 1). Conversely, 75% of investors are bullish the US dollar. More than half of fund managers cited “long US dollar” as the most crowded trade in the latest BofA Global Fund Manager Survey (“long commodities” was a distant second at 10%). As we discuss below, the outlook for the euro may be a lot better than most investors realize. While my colleagues, Chester Ntonifor, BCA’s chief FX strategist, and Mathieu Savary, BCA’s chief European strategist, are not quite ready to buy the euro just yet, we all agree that EUR/USD will rise over the long haul. Cutting Putin Loose Natural gas accounts for about a quarter of Europe’s energy supply. Prior to the Ukraine war, about 40% of that gas came from Russia (Chart 2). With the closure of the NordStream 1 pipeline, that number has fallen to 9% (some Russian gas continues to enter Europe via Ukraine and the TurkStream supply route). Yet, despite the deep drop in Russian natural gas imports, European natural gas inventories are up to 84% of capacity – roughly in line with past years and above the EU’s November 1st target of 80% (Chart 3). Chart 2Despite A Sharp Drop In Imports Of Russian Natural Gas… Chart 3...Europeans Managed To Stock Up On Natural Gas For The Winter Season Europe has been able to achieve this feat by aggressively buying natural gas on the open market. While this has caused gas prices to soar, it sets the stage for a retreat in prices in the months ahead. European spot natural gas prices have already fallen from over €300/Mwh in late August to €214/Mwh, and the futures market is discounting a further decline in prices over the next two years (Chart 4). Chart 4The Futures Market Is Discounting A Further Decline In Natural Gas Prices Chart 5Futures Prices Of Energy Commodities Provide Some Limited Information On Where Spot Prices Are Heading Follow the Futures? Futures prices are not a foolproof guide to where spot prices are heading. As Chart 5 illustrates, the correlation between the slope of the futures curve and subsequent changes in spot prices in energy markets is quite low. Nevertheless, future spot returns do tend to be negative when the curve is backwardated, as it is now, especially when assessed over horizons of around 12-to-18 months (Table 1). Table 1Energy Commodity Spot Price Returns Tend To Be Negative When The Futures Curve Is Backwardated Our guess is that European natural gas prices will indeed fall further from current levels. The latest meteorological forecasts suggest that Europe will experience a milder-than-normal winter (Chart 6). This is critical considering that natural gas accounts for over 40% of EU residential heating use once electricity and heat generated in gas-fired plants are included (Chart 7). Chart 6Meteorological Models Suggest Above-Normal Temperatures In Europe This Winter Chart 7Natural Gas Is An Important Source Of Energy For Heating Homes In The EU A warm winter would bolster the euro area’s trade balance, which has fallen into deficit this year as the energy import bill has soared (Chart 8). An improving balance of payments would help the euro. Europe is moving quickly to secure new sources of energy supply. In less than one year, Europe has become America’s biggest overseas market for LNG (Chart 9). A new gas pipeline linking Spain with the rest of Europe should be operational by next spring. Chart 8Soaring Energy Costs Have Pushed The Euro Area Trade Balance Into Deficit Chart 9Europe Is America's Largest LNG Customer In the meantime, Germany is building two “floating” LNG terminals. It has also postponed plans to mothball its nuclear power plants and has restarted its coal-fired power plants, a decision that even the German Green Party has supported. France is aiming to boost nuclear capacity, which had fallen below 50% earlier this summer. Électricité de France has pledged to nearly double daily production by December. For its part, the Dutch government has indicated it will raise output from the massive Groningen natural gas field if the energy crisis intensifies. Fiscal Policy to the Rescue On the policy front, European governments are taking steps to buttress household balance sheets during the energy crisis, with nearly €400 billion in support measures announced so far (and surely more to come). Although these support measures will be offset with roughly €140 billion of windfall profit taxes on the energy sector, the net effect will be to raise budget deficits across the region. However, following the old adage that one should “finance temporary shocks but adjust to permanent ones,” a temporary spike in fiscal support may be just what the doctor ordered. The last thing Europe needs is a situation where energy prices fall next year, but the region remains mired in recession as households seek to rebuild their savings. Such an outcome would depress tax revenues, likely leading to higher government debt-to-GDP ratios. Get Ready For a V-Shaped Recovery Stronger growth in the rest of the world should give the euro area a helping hand. That would be good news for the euro, given its cyclical characteristics (Chart 10). The European economy is especially leveraged to Chinese growth. It is likely that the authorities will loosen the zero-Covid policy once the Twentieth Party Congress concludes next month, and new anti-viral drugs and possibly an Omicron-specific booster shot become widely available later this year. That should help jumpstart China’s economy. More stimulus will also help. Chart 11 shows that EUR/USD is highly correlated with the Chinese credit/fiscal impulse. Chart 10The Euro Is A Cyclical Currency Chart 11EUR/USD Is Highly Correlated With The Chinese Credit & Fiscal Impulse All this suggests that the prevailing view on European growth is too pessimistic. Even if Europe does succumb to a technical recession in the months ahead, it is likely to experience a V-shaped recovery. That will provide a nice tailwind for the euro. Loose Fiscal/Tight Monetary Policies: The Winning Combo for Currencies Chart 12Fiscal Policy Has Eased Structurally In The Euro Area More Than In Other Advanced Economies A tight monetary and loose fiscal policy has historically been the most bullish combination for currencies. Recall that the US dollar soared in the early 1980s on the back of Paul Volcker’s restrictive monetary policy and Ronald Reagan’s expansionary fiscal policy, the latter consisting of huge tax cuts and increased military spending. While not nearly on the same scale, the euro area’s current configuration of loose fiscal/tight monetary policies bears some resemblance to the US in the early 1980s. Even before the war in Ukraine began, the IMF was forecasting a much bigger swing towards expansionary fiscal policy in the euro area than in the rest of the world (Chart 12). The war has only intensified this trend, triggering a flurry of spending on energy and defense – spending that is likely to persist for most of this decade. The ECB’s Reaction Function After biding its time, the ECB has joined the growing list of central banks that are hiking rates. On September 8th, the ECB jacked up the deposit rate by 75 bps. Investors expect a further 185 bps in hikes through to September 2023. While US rate expectations have widened relative to euro area expectations since the August US CPI report (more on that later), the gap is still narrower than it was on August 15th. Back then, investors expected euro area 3-month rates to be 233 bps below comparable US rates in June 2023. Today, they expect the gap to be only 177 bps (Chart 13). Real long-term bond spreads, which conceptually at least should be the more important driver of currency movements, have also moved in the euro’s favor. In the past, ECB rate hikes were swiftly followed by cuts as the region was unable to tolerate even moderately higher rates. While this very well could happen again, the odds are lower than they once were, at least over the next 12 months. Chart 13Interest Rate Differentials Have Moved In Favor Of The Euro Since Mid-August Chart 14Euro Area: Inflation Expectations Have Risen Briskly For one thing, median inflation expectations three years ahead in the ECB’s monthly survey have risen briskly (Chart 14). The Bundesbank’s own survey paints an even more alarming picture, with median expected inflation over the next five years having risen to 5% from 3% in mid-2021 (Chart 15). Expected German inflation over the next ten years stands at a still-elevated 4%. Whether this reflects Germans’ heightened historical sensitivity to inflation risks is unclear, but it is something the ECB cannot ignore. Structurally looser fiscal policy has raised the neutral rate of interest in the euro area, giving the ECB more leeway to lift rates. A narrowing in competitiveness gaps across the currency bloc has also mitigated the need for the ECB to set rates based on the needs of the weakest economies in the region. Chart 16 shows that collectively, unit labor costs among the countries most afflicted by the sovereign debt crisis a decade ago have completely converged with Germany. Chart 15German Inflation Expectations Are Elevated Chart 16Europe's Periphery Has Closed The Competitiveness Gap With Germany While Italy is still a laggard in the competitiveness rankings, the ECB’s new Transmission Protection Instrument (TPI) – which allows the central bank to buy sovereign debt with less stringent conditionality than under the Outright Monetary Transactions (OMT) program – should keep a lid on sovereign spreads. This, in turn, will allow the ECB to raise rates more than it otherwise could. Hawkish Fed is the Biggest Risk to Our Bullish EUR/USD View Chart 17Supplier Delivery Times Have Fallen Sharply Tuesday’s hotter-than-expected August US CPI report pulled the rug from under the euro’s incipient rally, pushing EUR/USD back to parity. We have been flagging the risks of high inflation for several years (see, for example, our February 19, 2021 report, 1970s-Style Inflation: Yes, It Could Happen Again). Our thesis is that inflation will follow a “two steps up, one step down” pattern. We are probably near the top of those two steps now, with the next leg for inflation likely to be to the downside, driven by ebbing pandemic-related supply side-dislocations. Perhaps most notably, supplier delivery times have fallen sharply in recent months (Chart 17). These pandemic-related dislocations extend to the housing rental market. Rent inflation dropped after rent moratoriums were put in place, only to rebound forcefully once the moratoriums were lifted and the labor market tightened. Although official measures of rent inflation will remain elevated for some time, owing to lags in how they are constructed, timelier data on new rental units coming to market already point to a sharp decline in rent inflation (Chart 18). This is something that the Fed is sure to notice. Ironically, falling inflation could sow the seeds of its own demise. Nominal wage growth is currently very elevated, yet because of high inflation, real wages are still shrinking. As inflation comes down, real wage growth will turn positive. This will lift consumer sentiment, helping to buoy consumption (Chart 19). A pickup in consumer spending will cause the economy to overheat again, leading to a second wave of inflation in the back half of 2023. Chart 18Timelier Measures Of Rent Inflation Have Rolled Over Chart 19Falling Inflation Will Boost Real Wages And Consumer Confidence As we discussed in our August 18th Special Report Dispatches From The Future: From Goldilocks To President DeSantis, the Fed will respond to this second inflationary wave by hiking the Fed funds rate to 5%. This will temporarily push up the value of the dollar, a process that will only stop once the US falls into recession in 2024 and the Fed is forced to cut rates again. Our projected rollercoaster ride for EUR/USD is depicted in Chart 20. We see the euro rising to $1.06 by year-end, peaking at $1.11 in the spring of 2023, falling back to $1.05 by late 2023, and then beginning a prolonged rally in 2024. Chart 20GIS Projection For The EUR/USD Chart 21The Dollar Is Very Overvalued Against The Euro Based On PPP Chart 21 shows that the dollar is 30% overvalued against the euro based on its Purchasing Power Parity (PPP) exchange rate. Thus, there is significant long-term upside to EUR/USD. Implications for Other Currencies and Regional Equity Allocation Chart 22Stock Markets Outside The US Tend To Fare Best When The Dollar Is Weakening The strengthening in the euro that we envision over the next six months or so will be part of a broad-based dollar decline. While BCA’s Foreign Exchange Strategy service sees more upside for the euro than the pound, GBP/USD will likely follow the same trajectory as EUR/USD. The yen is one of the cheapest currencies in the world and should finally gain some traction. If China abandons its zero-Covid policy and increases fiscal support for its economy, the RMB and other EM currencies should strengthen. Stock markets outside the US tend to fare best when the dollar is weakening. This includes Europe. As Chart 22 illustrates, there is a close correlation between EUR/USD and the relative performance of European versus US stocks. Thus, an above-benchmark exposure to international markets is appropriate during the coming months. 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
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