ã¢ãžã¢
On Tuesday, Bank Indonesia unexpectedly hiked its 7-day Reverse Repurchase Rate by 25bps to 3.75%, marking the first rate increase since 2018. The central bank cited price pressures as the motive for the hike, noting that âthe decision to raise the policyâŠ
CNY weakness versus the USD accelerated over the past week. USD/CNY broke above its May peak of 6.8 on Friday and continued to march higher on Monday. Does the yuan face further downside? In Mondayâs BCA Live & Unfiltered meeting, our Emerging MarketsâŠ
Recent Asian trade data are sending a negative signal about the global manufacturing cycle. Overall Taiwanese export orders fell by 1.9% y/y, disappointing expectations of a 6.2% y/y increase. The latest contraction confirms that the prior monthâs 9.5% y/yâŠ
Executive Summary Lingering Weakness In The Economy Is Reflected In Low Core Inflation The Philippine economy will struggle to gain traction as the fiscal thrust remains negative and monetary policy is tightening. Consistent with tepid growth, there are no genuine inflationary pressures in the Philippines. The countryâs bond yields should drop in the months to come. Soaring trade and current account deficits will abate soon. Net debt portfolio outflows should ease and could turn into net inflows. These will help the peso find a bottom. Philippine stocksâ relative performance versus the EM benchmark will likely remain rangebound. The reason is that an uninspiring domestic economy in the Philippines is juxtaposed with a poor outlook for the overall EM equity benchmark. Recommendation Inception Date RETURN Book Profits On Long USD/Short PHP 2021-03-18 10.9% Go Long Philippine Local Currency 10-year Government Bonds 2022-08-18 Bottom Line: A struggling Philippine economy warrants that absolute return investors avoid Philippine stocks. EM and Emerging Asian equity portfolios should continue with a neutral allocation to the Philippines. Feature Chart 1Philippines Stocks Are Failing To Outperform Despite EM Being In A Bear Market Despite being traditionally a defensive market within EM, Philippine stocks failed to outperform the EM benchmark; even though the latter continues to do poorly in absolute terms (Chart 1, top panel). In November 2021, we upgraded this bourse from underweight to neutral, rather than overweight, because of our negative outlook on the peso and the headwinds emanating from rising US/ global interest rates for the rate-sensitive Philippine markets. That call has worked out in line with our view (Chart 1, bottom two panels). Going forward, a neutral stance on the Philippines makes sense, but this time for a different reason than a vulnerable peso. The tepid domestic economic recovery does not justify turning bullish on this bourse in absolute or relative terms. On the currency front, the peso has depreciated markedly versus the dollar since early 2021. We now book profits on our short peso call as the risk-reward trade-off is no longer attractive. Tight Policy Is Choking Growth The Philippine economy contracted marginally (-0.1%) in the second quarter of 2022 vis-Ã -vis the first on a seasonally adjusted basis. The drag was mostly from household consumption which shrank by 2.7% QoQ (also seasonally adjusted). A major cause for the insipid growth is the authoritiesâ rather tight policy. The hope that the government could ramp up fiscal spending during an election1 year did not pan out. The reason had to do with the already very steep fiscal and primary deficits, at 7.9% and 5.6% of GDP respectively (Chart 2, top panel). Notably, the countryâs fiscal revenues have remained tepid as well. This also prevented authorities from ramping up fiscal spending. Weak tax collections (especially internal revenue collections), in turn, are a sign of feeble economic activity (Chart 2, bottom two panels). Further, over the coming year, the countryâs fiscal stance will remain rather tight and provide little reprieve to the economy. The IMF estimates that the fiscal thrust for both 2022 and 2023 will be negative (Chart 3). Chart 2Already Steep Fiscal Deficts And Weak Revenues Preclude Further Stimulus Chart 3A Negative Fiscal Thrust Means Little Reprieve For The Economy The Philippinesâ monetary stance has also tightened over the past year. Banking system liquidity has fallen measurably since mid-2021. More recently, the central bank has raised rates by a cumulative 125 basis points since May to 3.25%. It has also indicated further hikes in the near future. All this credit and fiscal tightening amid tepid domestic demand is weighing on business activity and credit growth. Bank loans were already rather weak since the advent of the pandemic in all sectors of the economy, barring real estate (Chart 4). Now, the credit impulse for the private sector appears to be peaking again â which does not bode well for economic growth (Chart 5). Chart 4Tightening Policy Amid Weak Domestic Demand Will Hurt Credit Growth Chart 5Peaking Credit Impulse Does Not Augur Well For Economic Growth There is yet another reason why credit could be struggling to grow: firmsâ reluctance towards capital investments. The share of capex in the economy has languished in a much lower level than it was before the pandemic (Chart 6). That is unlikely to change in any meaningful way in the foreseeable future as firmsâ capacity-utilization levels are still low (Chart 8, bottom panel). Philippine Inflation Is Transitory The tepid growth in domestic demand is reflected in several aspects of the Philippine economy. Manufacturing sales, in both value and volume terms, are barely at 2018â2019 levels. Car sales are well below those levels (Chart 7). Chart 6Firms' Reluctance To Boost Capex Is Weighing On Domestic Demand Chart 7The Demand Side Of The Economy Remains Quite Weak The supply side data are giving a similar message. Industrial production volumes are no higher than they were in 2018. The same holds true for manufacturing production (Chart 8, top panel). This might have weakened further recently, as the latest PMI data suggests (Chart 8, middle panel). On another note, money supply has also begun to decelerate. Both narrow and broad money measures have rolled over (Chart 9), which is not a good sign for the economy. Chart 8The Supply Side Is Faring Not Much Better Chart 9Decelerating Money Supply Is Not A Positive Sign For The Economy The lingering weakness in growth is evident in rather muted core inflation. While headline inflation has risen well above the central bankâs upper target of 4%, it is mostly due to a sharp rise in fuel prices, and to some extent in food prices. Once all the fuel and food related items are excluded, the core CPI turns out to be much lower at 2.3%, near the lower end of the central bankâs target band (Chart 10). Notably, crude oil prices might have peaked in this cycle given the deteriorating Chinese and global growth outlook. If so, that will bring down the Philippinesâ headline CPI prints over the next several months. Easing headline inflation, in turn, will likely lead the countryâs bond yields to roll over (Chart 11). Chart 10Lingereing Weakness In The Economy Is Reflected In Low Core Inflation Chart 11As Headline CPI Ease With Subsiding Fuel Prices, So Will Bond Yields Stay Neutral On Stocks The near-term outlook on Philippine stocks in absolute terms is not promising. The nationâs economic recovery is uninspiring, while the fiscal and monetary stance is unsupportive. Chart 12Philippine Stocks Will Struggle As Foreign Investors Continue To Leave The wider EM and global growth outlooks are also deteriorating. Foreign equity investors continue to be net sellers of Philippine stocks (Chart 12). Given this backdrop, it is hard to imagine that this market could usher in a sustainable bull market in absolute terms any time soon. Relative to the EM benchmark, Philippine stocks will likely remain rangebound. The reason is that overall EM stocks are also vulnerable. Notably, Philippine stocks usually do well relative to EM when the latter do poorly in absolute terms (Chart 1, top panel). The basis is as follows: EM stocks fall when EM/China (and global) growth decelerates. But growth deceleration generally comes with falling global interest rates. Falling global/US interest rates/bond yields are typically a tailwind for the rate sensitive Philippine stock markets. The reason is the prevalence of real estate, banking and utility sectors in the Philippines equity index. In the current episode, however, despite a growth deceleration in EM/China, interest rates are still rising globally â robbing Philippine stocks of their tailwinds. This is why this market is struggling to outperform the EM benchmark. The situation is unlikely to change in the next several months, as sticky inflation in much of the developed world will preclude their central banks from cutting interest rates. It therefore makes sense to continue with a neutral allocation to the Philippines in an EM equity portfolio for now. Go Overweight Philippine Domestic Bonds Chart 13Elevated Bond Yields, Despite Little Genuine Inflation Indicates Relative Value In Bonds Philippine domestic bond yields are around 6%. Such high yields are unsustainable given the softness in the economy, and the lack of genuine inflationary pressures therein. As such, Philippine domestic bonds are a buy in absolute terms. Relative to their EM counterparts also, they have become attractive. Odds are that they will outperform their EM peers: Philippine bond yields are now nearly at par with that of EM â which is historically on the higher side (Chart 13, top panel). This is despite genuine inflationary pressures in the Philippines being on the lower side vis-Ã -vis most other economies in Latin America and EMEA. This entails that Philippine yields will come down relative to other EM yields in the months ahead as and when food and fuel prices ease. Philippine bond yields have also risen measurably relative to safe-haven (US treasuries) bonds over the past year and a half. Foreign investors are marginal buyers of Philippine bonds, and their appetite for the latter depends on how much extra yield the Philippines offers over safe-haven bonds. Chart 14 shows that whenever the yield differential widens enough (to over 300 basis points), the Philippines begins to attract net debt inflows. This is what is likely to happen now: the net debt outflows of the recent past should abate and could even turn into net inflows over the coming quarters. The fact that Philippine bond yields are likely to fall due to domestic considerations â weak growth and subsiding inflation â will also entice foreign investors. Finally, the peso has already fallen significantly over the past year and a half (discussed in more detail in the next section). As and when local bond yields will begin to fall, these bonds will attract more foreign debt inflows, which will support the peso. A stable exchange rate will make domestic bond investments more attractive for foreigners (Chart 13, bottom panel, and Chart 15). Chart 14Net Debt Portfolio Outflows Should Abate, And Could Turn Into Inflows Chart 15As Foreign Debt Inflows Resume, Bond Yields Will Fall And The Peso Will Bottom All this suggests that investors would do well to upgrade their allocation to Philippine domestic bonds from neutral to overweight. We also initiate a long position in 10-year domestic bonds, currency unhedged. Book Profits On The Short Peso Trade Chart 16The Peso Will Get A Support As The Current Account Deficit Bottoms Philippine external accounts deteriorated in a major way over the past year. As a result, the peso depreciated markedly â in line with our previous forecast. Now, however, investors should book profit on this trade, as the vulnerability of the peso has diminished: The root cause behind the peso depreciation has been this countryâs plunging current account balance (Chart 16). Current account deterioration, in turn, was caused by high crude prices. The latter led to mammoth trade deficits as exports rose at a much slower pace. But crude prices are now dropping and the nationâs oil import bill will likely subside meaningfully in the months ahead. The import cost of raw materials will also fall in line with falling resource prices. As a result, Philippine trade and current account deficits will likely bottom soon (Chart 17). That will help put a floor under the currency. Philippine capital account balance has remained in healthy surplus â buoyed by FDI and other investment inflows (Chart 18, top panel). Chart 17As Oil Import Costs Subside, The Trade Deficit Will Find A Floor Chart 18A Resumption In Debt Portfolio Inflows Will Keep Capital Account In Healthy Surplus If the ongoing net debt portfolio outflows subside and/or turn into inflows (as explained in the previous section), that will help keep the financial account balance afloat (Chart 18, bottom panel). Finally, the peso is no longer expensive vis-Ã -vis the US dollar in purchasing power terms (Chart 19). This entails only a limited downside from now on. Book Profits On Sovereign Credit Our negative outlook on the EM sovereign credits prompted us to recommend an overweight stance on Philippine credit relative to the EM benchmark. The reason is the defensive nature of the Philippine sovereign bond market: during periods of EM stress, Philippine sovereign spreads widen much less than their EM counterparts. That call has worked out well. This market has massively outperformed its EM peers (Chart 20). But now, we recommend that investors protect profits by downgrading their allocation to the Philippines from overweight to neutral. Chart 19The Peso Is No Longer Expensive Versus The US Dollar Chart 20Sovereign Bond Investors Should Book Profits After The Recent Outperformance One reason for that is that the relative excess return on Philippine bonds have surged recently to levels seen only during the height of EM stress in 2008-09 and then again in early 2020. As such, the relative performance might already be discounting a massive rise in EM spreads, and further outperformance may be hard to come by. Another reason for our cautious stance is Philippine external public debt. Though still low as a share of the economy at 15% of GDP, this has surged in the recent past. It therefore makes sense to pare back some of the exposure to Philippine sovereign credit and await a better entry point in future. Investment Recommendations Currency: The vulnerability of the peso has eased, and investors should book profits on our short PHP/long USD call. This trade has yielded 10.9% (including carry) since our recommendation on March 18, 2021. Equities: Absolute return investors should avoid Philippine stocks as its near-term outlook is not promising. EM and Emerging Asian equity portfolios should continue with a neutral allocation to the Philippines relative to the EM benchmark. Domestic Bonds: Given the improved peso outlook, and rather high relative yields, local currency bond investors should upgrade their allocation to the Philippines from neutral to overweight in EM domestic bond portfolios. For absolute-return investors, we recommend buying 10-year domestic government bonds, currency unhedged. Sovereign Credit: Philippine sovereign credit has massively outperformed its EM counterparts. We recommend that investors protect profits by downgrading their allocation from overweight to neutral. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1 The Philippines held its federal elections in May 2022. The new President Ferdinand Marcos Jr. took office on June 30, 2022.
Executive Summary Russiaâs Crude Oil Output Will Fall Russia will have to lower oil production to ensure output it hasnât placed with non-EU buyers does not tax its limited storage facilities, ahead of the blocâs December 5 embargo. The EUâs insurance/reinsurance ban on ships carrying Russian material also commences in December. It will profoundly affect Russian output, if fully implemented. Russian and Chinese firms will expand ship-to-ship transfers on the high seas, along with external processing and storage services to mask crude and product exports. The EU embargos will force Russia to shut in ~ 1.6mm b/d of output by year-end, rising to 2mm b/d in 2023, by our reckoning. Gas-to-oil switching in Europe will boost distillate and residual fuel demand by ~ 800K b/d this winter. Chinese policymakers will be compelled to deploy greater fiscal and credit support to reverse weakening GDP. Tighter monetary policy in DM economies will dampen aggregate demand. Bottom Line: EU embargoes on Russian oil imports will significantly tighten markets, and lift Brent to $119/bbl by year-end. This has a 60% chance of being offset by ~ 1mm b/d of Iranian oil exports in 2023, in our estimation. We are maintaining our Brent forecast at $110/bbl on average for this year, and $117/bbl next year. WTI will trade $3-$5/bbl lower. At tonightâs close we are re-establishing our long COMT ETF position. Risks remain to the upside. Feature Chart 1Russiaâs Crude Oil Output Will Fall Following an unexpected increase in production during June and July, Russia will have to begin reducing its oil output ahead of the implementation of the EUâs embargo on its seaborne crude oil imports, which kicks on December 5. EU, UK and US shipping insurance and reinsurance sanctions also are scheduled to be implemented in December. If fully implemented, ~ 2.3mm b/d of seaborne imports of Russian crude oil will be excluded from EU markets by year-end. Come February, another 800k b/d of refined products will be embargoed. On the back of these lost sales, and production that cannot be loaded on ships due to insurance/reinsurance bans, we expect Russian production to fall ~ 2mm b/d by the end of next year (Chart 1).1 As noted in previous research, a goodly chunk of Russian crude continues to go to China and India. Together, these two states accounted for just over 40% of Russiaâs crude sales last month â ~ 1.9mm b/d of a total of ~ 4.5mm b/d. This is down from just under 45.5% in May, according to Reuters. Both China and India have benefited from discounted prices of ~ 30% vs. Brent, which is a powerful inducement to buy. Asia accounts for more than half of Russiaâs seaborne crude oil sales, according to Bloomberg data. Related Report Commodity & Energy StrategyTighter Oil Markets On The Way Whether China and India can maintain these purchases depends on whether ships taking oil to them can get their cargoes insured. Both states have domestic insurance providers, and, in the case of the latter, long-standing trade relationships going back decades. Other Asian economies do not have such financial infrastructure. Still, this is a high concentration of sales to two buyers. In addition, press reports indicate China spent $347mm to secure tankers to conduct high-risk ship-to-ship (STS) transfers of Russian crude in the Atlantic Ocean.2 Similar STS transfers have been used to move ~ 1.2mm b/d of Iranian and Venezuelan crude oil, most of which ends up in China, according to Lloyds. Base Case Sees Markets Balance In our base case analysis, markets remain relatively balanced going into winter. On the supply side, we expect core OPEC 2.0 â the Kingdom of Saudi Arabia (KSA) and the United Arab Emirates (UAE) â to continue to provide crude to the markets subject to their spare-capacity constraints (Chart 2, top panel). KSA likely will be producing close to 11mm b/d by year-end â vs its current output of 10.6mm b/d output presently â and the UAE will be close to 3.5mm b/d, vs 3.1mm b/d at present. KSAâs max capacity is 12mm b/d, while the UAEâs is 4mm b/d; both will want to maintain spare capacity to offset unexpected exogenous supply shocks next year. These two states account for most of the spare capacity in the world (Chart 3). The rest of OPEC 2.0 will continue to struggle to maintain its production, which makes the core producersâ spare capacity critically important (Chart 2, bottom panel). Chart 2Core OPEC 2.0 Will Increase Supply Chart 3Spare Capacity Concentrated In Core OPEC 2.0 Outside of OPEC 2.0, we are expecting the largest contribution to global supply will continue to come from US shale production (Chart 4). Shale-oil output in the top 5 US basins is expected to increase ~540K b/d this year, and next. This will take shale output to slighly above 7.5mm b/d and account for 76% of Lower 48 production in the States this year. Next year, we are expecting US Lower 48 production to rise 700K b/d, and for total US crude output to go to 12.8mm b/d, a new record. Chart 4US Remains Top Non-OPEC 2.0 Supplier This winter we are expecting an uptick in oil demand â particularly for distillates like gasoil and diesel in Europe, as EU firms switch from natural gas to oil on the margin. We expect this will add 800K b/d of demand over the winter months (November through March), which will lift our overall demand estimate 150k b/d this year, and 20K b/d next year â +2.19mm b/d vs +2.04mm b/d, and 1.82mm b/d vs. 1.80mm b/d next year. Chinese year-on-year oil demand growth remains negative. January-July 2022 demand was 15.24mm b/d vs 15.34mm b/d in 2021, continuing a string of y/y contractions. The two other major economic pillars of global oil demand â the US and Europe â show positive y/y growth of 800K b/d each over the same period. Global demand in 1H22 recovered to 98% of its pre-COVID-19 level â even with Chinaâs negative y/y growth â while supply recovered to 96% of its pre-pandemic level, according to the International Energy Forum (IEF). Over most of the forecast period, we estimate global balances will continue to show the level of supply below that of demand, which will lead to continued physical deficits (Chart 5). Refined-product inventories increased by 34mm barrels in 1H22, while crude-oil stocks fell 23mm barrels. Global crude and product inventories are ~ 460mm barrels below their five-year average, which includes pandemic demand destruction, the IEF reported. We continue to expect inventories to remain below their 2010-14 average, which we prefer to track â it excludes the market-share wars of 2015-17 and that of 2020, and the pandemicâs effects on inventories (Chart 6). This will revive the backwardation in Brent and WTI prices, particularly if the loss of Russian barrels is larger than we expect this year and next. This could be dampened if the US resumes its SPR releases after theyâve run their course in October. Chart 5Global Market Balanced, But Slight Deficits Will Persist Chart 6OECD Inventories Below 5Y Average Investment Implications Our analysis indicates markets are mostly balanced going into winter (Table 1). That said, the balance of risks remains to the upside ahead of the EUâs embargoes on Russian crude and product imports, and the EU/UK/US insurance/reinsurance bans on providing cover for vessels carrying Russian material. This all is highly contingent on the extent to which the EU and its allies follow through on these punitive actions imposed on Russia in retaliation for its invasion of Ukraine. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 The removal from the market of some 2mm b/d of Russian oil production due to the various EU embargoes â even if it is offset by the return of 1mm b/d of Iranian exports on the back of a deal with the US â will push crude oil prices higher and inventories lower (Chart 7).3 Chart 7Brent Price Expectation Unchanged, But Demand Shifts To Winter Given these views, we remain long the oil and gas producer XOP ETF, which is up 19.5% since we re-established it on July 5, and, at tonightâs close, will be re-establishing our COMT ETF, to take advantage of higher energy and commodity prices and increasing backwardation in oil markets as inventories draw. 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 Commodities Round-Up Energy: Bullish US distillate inventories â diesel and heating oil mostly â were up less than 1% for the week ended 12 August 2022, according to the US EIA. US distillate inventories stood at 112mm barrels. This did nothing to reverse the deep drawdown in distillate inventories of 18.5% y/y, which, along with European stocks, refiners are attempting to rebuild going into the 2022-23 winter. We expect natgas-to-oil switching this winter to add 800k b/d of demand to the market over the Nov-Mar winter season. Most of this demand will be for distillates, in our view, given its dual use as a fuel for industrial applications and household space-heating. Distillate demand could be higher this winter, if a La Niña produces colder-than-normal temperatures. The US Climate Prediction Center gives the odds of such an outcome 60% going into the 2022-23 winter. This would lift ultra-low-sulfur diesel futures in the US and gasoil futures in Europe higher as inventories draw (Chart 8). Base Metals: Bullish Copper prices dropped on weaker-than-expected Chinese macroeconomic data for July, although the fall was bounded by the Peopleâs Bank of Chinaâs decision to cut interest rates. According to US CFTC data, copper trading volumes are lower than pre-pandemic levels, as hedge funds' net speculative positions turned negative beginning in May and have mostly remained in the red since then. Low trading volumes will result in copper prices being highly susceptible to macroeconomic events, especially those occurring in China. Precious Metals: Neutral Gold prices are facing difficulty overcoming market expectations of high interest rates for the rest of this year (Chart 9). The bearish influence of tightening monetary policy and a strong USD has the upper hand on the supportive effect of recession risks, inflation, and geopolitical uncertainty for gold prices. Recent strength in US stock markets - which historically is inversely correlated with gold prices - following better-than-expected earnings, also contributed to recent gold price weakness. Chart 8 Chart 9 Footnotes 1 Please see Oil: It Ain't Over Till It's Over, which we published 11 August 2022, for additional discussion. NB: We discuss the differences between our view and that of our Geopolitical Strategy service regarding a deal between the US and Iran, which returns 1mm b/d of crude oil exports to the market. We give 60% odds to such a deal, while our colleagues at the GPS service assign a 40% probability to it. In our base case modeling presented herein, we expect these barrels to return to the market by 2Q23, perhaps sooner. 2 Please see Anonymous Chinese shipowner spends $376m on tankers for Russian STS hub published by Lloydâs List 9 August 2022. The report notes, âAll the ships are aged 15 years or older, precluding them from chartering by most oil majors, as well being unable to secure conventional financing, suggesting the beneficial owner is cash rich. The high seas logistics network offers scant regulatory and technical oversight as crude cargoes loaded on aframax tankers from Baltic Russian ports are transferred to VLCCs mid-Atlantic for onward shipment to China. One cargo has been tracked to India.â 3 Please see Oil: It Ain't Over Till It's Over, which we published 11 August 2022, for additional discussion. NB: We discuss the differences between our view and that of our Geopolitical Strategy service regarding a deal between the US and Iran, which returns 1mm b/d of crude oil exports to the market. We give 60% odds to such a deal, while our colleagues at the GPS service assign a 40% probability to it. In our base case modeling presented herein, we expect these barrels to return to the market by 2Q23, perhaps sooner. Investment Views and Themes Strategic Recommendations Trades Closed in 2022
Chinese data releases on Monday reflected a broad-based deceleration in the countryâs economy. Key indicators of domestic activity in July such as industrial production, fixed assets investment, retail sales, and property investment all generated negativeâŠ
Listen to a short summary of this report. Executive Summary The Euro And The Chinese Credit Impulse The US dollar has bounced off its 50-day moving average. In the recent past, that had led to a period of cyclical strength. The yen rally can be explained by the decline in Treasury yields and the fall in energy prices. Where next for the yen will depend on the time horizon. For investors trying to time the bottom, the euro is not yet a buy, but the common currency is incredibly cheap. Much depends on global/Chinese growth (Feature Chart). One of the key drivers of the dollar is volatility, and the correlation with the MOVE index. Less uncertainty will ease safe-haven demand. Stay short EUR/JPY and CHF/JPY. Remain long EUR/GBP. Maintain a limit sell on CHF/SEK at 10.76. RECOMMENDATIONS inception date RETURN Short EUR/JPY 2022-07-21 3.68 Bottom Line: We are tactically neutral the dollar but will be sellers on strength. Questions And Answers Chart 1Currencies And Yield Differentials It is rare that we receive clients in our Montreal office. This has obviously been doubly the case due to the pandemic and the general hassle of travel nowadays. But when we do, it is a delight. In this weekâs report, we got asked a few difficult questions on a tea date. The most important was not surprisingly the dollar view, but also our highest conviction trades in FX markets. We enjoyed the conversation and the intellectual debate, so we thought we would share this with our clients. Hopefully, this answers some of the most pressing questions. We have sliced this into as brief and concise a conversation as we could. Question: It is hard not to notice the steep decline in the dollar over the last few weeks. Should we fade this decline or lean into it? That is a tough question, but our educated guess is to fade it for now. That said, longer-term asset allocators should really be looking at buying extremely cheap G10 currencies on any declines. The drivers of dollar downside have been clear. First, long-term interest rates in the US have fallen substantially. The US 10-year Treasury yield has fallen from 3.5% to 2.7%. In real terms, they have also declined. The 10-year TIPS yield has fallen from 0.85% to 0.23%. On a relative basis, the market is also pricing in that the Fed will cut interest rates next year much faster than other central banks. More simply put, 2-year real bond yields in the US are rolling over, relative to the euro area and Japan, the biggest components of the DXY index (Chart 1). Related Report Foreign Exchange StrategyHow Deep A Recession Is The Dollar Pricing In? Specific to Japan and the euro area, there has also been another critical factor â the decline in energy import costs. Germanyâs trade balance improved markedly in June (Chart 2). This has been the first genuine improvement in a year. There is also discussion to extend the life of existing nuclear power plants, which will help assuage energy import costs. In Japan, trade balance data comes out on Monday next week, so we will see what it reveals. But what has been clear is a political drive to restart nuclear power and wean the Japanese economy off its dependence on oil and gas (Chart 3). Japanese prime minister Fumio Kishida has been very vocal about this in recent speeches. Chart 2Euro Area And Japanese Trade Balances Are Improving Chart 3A Nuclear Renaissance In Japan? Turning to the more important part of your question, should we fade the decline or lean into it? We are of two minds on this to be honest, and here is why. The DXY has bounced off its 50-day moving average, which has been a sign in the past that the rally is not over (Chart 4). Our Geopolitical and Commodity & Energy colleagues are telling us not to trust the decline in oil prices. Our bond strategists think US yields are heading higher, with a whisper floor of 2.5%. Chart 4The DXY Has Support At The 50-Day Moving Average Given these crosscurrents, there are many better opportunities that exist in FX at the crosses, rather than playing the dollar outright. But of course, the dollar call is critical. We would be neutral over the next three-to-six months but be incremental sellers of the dollar on strength. Question: Okay, neutral dollar for now, but bearish long term. We tend to consider longer-term investments as well, and we are confused about the euro, but even more so about the yen. Would you buy the yen today? If so, why? Our starting point for many currencies is valuation. On this basis, the yen is incredibly cheap. So, if you have a five-to-ten-year horizon, you can unlock incredible value in Japan, simply on a buy-and-hold basis. Our in-house curated model shows that the yen is at a multi-general low in value terms (Chart 5). Currencies mean-revert. Consider this for a minute â we are not equity experts, but Toyota trades at a P/E of 10.75, while Tesla trades at a P/E of 109.15. And yes, Toyota has electric cars. Chart 5The Japense Yen Is Incredibly Cheap Chart 6The Yen Is A Favorite Short It is true that a winner-takes-all mantra can be attributed to Teslaâs valuation over Toyota, but our colleagues in the Global Investment Strategy are telling us this era is over. As such, at a 40% discount, the yen is a long-term buy in our books. Interestingly, nobody likes the yen, at least by our preferred measure â net speculative positions. It is one of the most shorted G10 currencies (Chart 6). A cheap currency that is the most shorted ranks quite well in our evaluation of bargains in currency markets. Given my discussion above about the dollar, we have played the yen at the crosses. We are short EUR/JPY and CHF/JPY. On the euro, Japanese car manufacturers are simply becoming more competitive than their eurozone or US counterparts. This is not only related to the car industry, but according to the OECD, EUR/JPY is expensive on a purchasing power parity basis (Chart 7). Meanwhile, a short EUR/JPY trade is a perfect hedge for a pro-cyclical portfolio. The DXY index has historically traded in perfect inverse correlation to the euro-yen exchange rate (Chart 8). This suggests the collapse in the yen, relative to the euro, is very much overdone. In a risk-off environment, EUR/JPY will sell off. Meanwhile, there are also fundamental reasons to suggest that the yen should trade higher vis-Ã -vis the euro. Chart 7Remain Short ##br##EUR/JPY Chart 8The DXY And EUR/JPY Usually Track Each Other Question: Okay, letâs switch to the euro. I know you are short EUR/JPY, which has been working out well in the last few days. But the euro touched parity and I get a sense that it has bottomed. You have often mentioned that the euro has priced in one of the deepest recessions in the eurozone. I am surprised you are not trumpeting this currency and a once-in-a-lifetime buying opportunity. We agree somewhat with your conclusion but not the premise. Letâs consider the narrative over the last few months in the media. The first was that eurozone inflation will never catch up to the US, because the economy was structurally weak. Well, it did, albeit due to an exogenous shock. So, among a ranking of stagflationary candidates, the euro area is a top contender. If you believe in the idea that currencies are driven by real interest rates, rising inflation, and falling growth are an anathema for the exchange rate. When we typically have doubts about the euro area economy, and the outlook for its financial markets, we consult with our European Investment Strategy colleagues. We did just that and Mathieu Savary, who heads the service, mentioned two things: one â Chinese import volumes are imploding. For net creditor nations, this is a negative as their source of income is waning. The euro area falls into that category. The second thing to consider is that the dollar is a momentum currency. So is the euro. We mentioned earlier that the dollar bounced off its 50-day moving average, which explains euro weakness in recent trading days. In the end, Mathieu and the FX team did not really disagree, but I highlighted two charts to track. The euro tracks the Chinese credit impulse due to the importance of Chinese import demand for the euro area. It looks like our measure of that impulse has bottomed (Chart 9). If it has, you buy the euro on a long-term view. Relatedly, financial conditions are easing in China. As the Chinese bond market becomes more open and liberalized, bond yields become a financial conditions valve. That has been the case and has perfectly tracked the propensity for imports in the last few years (Chart 10). Chart 9The Euro And The Chinese Credit Impulse Chart 10Financial Conditions Are Easing In China In short, we will buy the euro if it touches parity, and even more so below parity with a 5â10-year view, but we think EUR/USD could touch 0.95 in the near term. I guess what we are saying is that a 5%-7% move is big in FX markets, but a 26% move (the undervaluation of the euro) is a whale. We do not see the catalyst for a whale in our current compass. Question: We have talked about the yen and the euro. I do not want to get into the pound, Australian dollar, and other currencies as you have told me your team has upcoming reports on those. But the Chinese yuan is very important in my investment portfolio. Any ideas on its next move? USD/CNY topped out near 6.8 in May. Since then, it has been in a trading range despite the DXY breaking to multi-decade highs (Chart 11). When a pattern like this emerges, it is always useful to revisit fundamentals. Those fundamentals are real interest rate differentials. We care about the yuan because China is a big trading partner of the US. As such, it is also a huge weight in the broad trade-weighted dollar index. China has huge problems, especially related to the property market, which need to be resolved. Bond yields have also collapsed. But the real interest rate in China is very attractive (Chart 12). It is also important to consider that if the dollar is the global safe haven, that means that the yuan could be becoming the haven in Asia. So, yuan downside is not a big risk for our long-term dollar bearish call. That said, we will be short CNY versus the yen, but not the dollar. Chart 11The RMB Has Been Relatively Resilient Chart 12The RMB Has Undershot Real Rate Differentials Question: I think I could sit with you all morning to discuss other aspects of FX, but I respect you have a tight stop due to the BLU meeting. Any concluding thoughts? I have one. Very often, we debate with our colleagues about capital flows. The dollar rises (in general), as capital inflows accelerate into the US and vice versa. It is often said that getting the dollar call right gets everything else right. So, if you can predict the path of the dollar, the performance of, say, US versus non-US equities becomes easy. Chart 13The Dollar And Earnings Revisions We agree that the dollar is a real-time indicator of relative fundamentals. But here is one important observation: relative earnings revisions are deteriorating in the US vis-Ã -vis other countries (Chart 13). That has historically had an impact on exchange rates, as it affects equity capital flows. If the Federal Reserve also cut rates next year as the market is predicting, that will also be a negative for bond inflows. We think the global economy will avoid a deep recession, and that will allow growth to pick up outside the US. When the euro area and China bottom, then the dollar will truly peak, as capital flows to these economies will accelerate. So we are watching relative earnings and bond yield differentials closely. 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