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Executive Summary EU Surprises Carbon Market With Increased CO2 Emission Allowance Supply The EU's failed foreign policy – premised on ever-deeper engagement with the Soviet Union and, after it collapsed, Russia – will drive its hot mess of an energy policy for years. In the short term, the EU's REPowerEU scheme proposed last week to fund the decoupling from Russia will lift its green-house gas (GHG) emissions, if the sale of €20 billion of EU Emission Trading System (ETS) allowances goes forward. Markets traded lower over the week, to make room for the higher ETS pollution-permit supply. This could increase the volume of allowances sales needed to reach the €20 billion target. Another €10 billion investment in natgas pipelines also will be funded. Longer-term, the acceleration of the EU's renewable-power build-out via so-called Projects of Common Interest (PCI) will get an €800 billion boost, with another round of funding to be proposed for early next year. EU funding will lift base metals and steel prices – raising the cost of the renewables build-out – and keep fossil-fuels well bid. Bottom Line: The REPowerEU scheme will increase volatility in the EU's ETS market, and add significant new demand to base metals and fossil-fuel markets. The propensity of EU policymakers to interfere in its ETS market makes it unattractive. We remain long the S&P GSCI index, and the COMT, XOP, XME and PICK ETFs expecting higher base metals, oil and gas prices. Tactically, we are getting long 4Q22 Brent calls struck at $120/bbl, anticipating an EU embargo of Russian oil imports. Feature Over the past three decades, foreign policy for the EU largely was set by Germany, the organization's most powerful economy. Successive generations of German politicians championed the idea that the West could bring the former Soviet Union – and later Russia – into the modern world of global trade through Ostpolitik, which had, at its core, a belief in the power of trade to effect political and economic change.1 This change-through-trade policy survived the Cold War, the collapse of the Soviet Union and rise of Russia from its ashes. It also survived Russia's first invasion of Ukraine in 2014. Indeed, following that invasion, Russia marked the completion of its Nord Stream 2 (NS2) natural gas pipeline – running parallel to NS1 – in September of last year. If NS2 were up and running now, it would have increased Russian gas flows into the EU and its revenue flows.2 As our Geopolitical Strategists noted, Germany even got the Biden administration to agree in summer 2021 to set aside any sanctions so that Germany could operate NS2 with Russia. Related Report Commodity & Energy StrategyDie Cast By EU: Inflation, Recession Risks Rise Yet Russia did not share the German commitment to economic engagement within a US-led liberal international order. Russia's second invasion of Ukraine in February was a bridge too far, and catalyzed the EU's response, again led by Germany, to de-couple from Russia in the energy sector. The EU's reversal of a failed foreign policy, which produced its dependence on Russian energy, leaves it with a hot mess of an energy policy that is evolving rapidly. In its wake, volatility in the EU carbon-trading market has ensued, along with the promise of an accelerated doubling-down on renewable-energy generation. Higher Emissions, Lower Emissions Prices Last week, the EU proposed its REPowerEU scheme, which is meant to enable the decoupling of the EU from Russian energy dependence by funding hundreds-of-billions-of-euros in new energy investments over coming years.3 Chart 1EU Surprises Carbon Market With Increased CO2 Emission Allowance Supply In a history heavily laden with paradox, this new scheme will lift the EU's green-house gas (GHG) emissions – including CO2 – if the sale of €20 billion of EU Emission Trading System (ETS) allowances goes forward.4 So, in the breach, the EU is willing to significantly relax its environmental goals – the E in ESG – to begin undoing its failed foreign policy. Markets already are making room for this increased ETS pollution-permit supply, which, as allowances prices weaken, will require additional supplies to reach the €20 billion target (Chart 1). This will lead to higher coal and fossil fuel usage during Germany's hot-mess de-coupling with Russia. In addition to raising funds by selling pollution permits, the EU will invest another €10 billion in natgas pipelines. This will help counter the likely loss of Russian gas when it embargoes Russian oil imports, but will take time (a few years) to actually put in the ground.5 The additional pipe would address one of the EU's weakest energy links: the lack of pipeline capacity to transport liquified natural gas (LNG) inland once it arrives in Europe. Europe pushed hard to re-load natgas inventories ahead of the coming winter season, and appears to have made progress in this regard (Chart 2). Europe was a strong bid for LNG in the first four months of this year, according to Refinitiv reporting.6 LNG imports were up 58% over the first four months of this year, totaling 45.3mm MT. This kept European natgas prices elevated vs. Asia (Chart 3). Chart 2Europe Re-Loads Storage Chart 3Europe Outbids Asia For LNG The back-and-forth between the Asian and European markets will continue for the rest of this year, particularly going into the Northern Hemisphere's summer, when demand for natgas in Asia, in particular, will remain strong. REPowerEU Will Boost Base Metals Demand Longer term, the EU's REPowerEU proposal, if approved, will accelerate the EU's renewable-power build-out via so-called Projects of Common Interest (PCI). The proposal contains €800 billion to support new renewable-energy proposals, with another round of funding proposed for early next year. The doubling down by the EU on renewables will lift base metals and steel prices as soon as the REPowerEU program starts funding investments in renewable technology and short-term projects like pipeline buildouts (maybe sooner as hedges are placed). Given the tightness already apparent in the base metals markets, this will raise the price of critical materials – copper, aluminum, steel – and will, in the process, keep fossil-fuels well bid: large capital projects do not get done without a lot of diesel and gasoline being consumed.7 The EU is not alone in its desire to accelerate renewables investment: The US is funding a similar build-out, as is China, which will be accelerating its infrastructure and renewables investments. The constraint on all of these programs to build out renewables is low capex in base metals (Chart 4), and oil and gas (Chart 5). This has kept the level of supply from quickly responding to increased demand, which keeps these markets in sharp backwardations. Market tightness in metals and energy will be compounded by stronger bids from the three largest economic centers in the world – the EU, US and China.Chart 4Weak Capex Holds Base Metals Supply Growth Down … Investment Implications Chart 5… And Oil + Gas Supply Growth The EU's REPowerEU scheme is not a done deal, but we give it high odds of being adopted. It will increase volatility in the EU's ETS market, and add significant new demand to base metals and fossil-fuel markets. In terms of where to take risk, now that this proposal has been floated, we would avoid getting long carbon permits traded on the EU's ETS carbon market, given the propensity of policymakers to meddle excessively, which, in and of itself, is a risk that is difficult – if not impossible – to forecast. However, we do continue to favor being long the S&P GSCI index, and the COMT, XOP, XME and PICK ETFs expecting higher base metals, oil and gas prices. On a tactical basis, we are getting long 4Q22 Brent calls struck at $120/bbl at tonight's close, anticipating an EU embargo of Russian oil imports. 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 officials involved in negotiations to restore the Iran nuclear deal appear to be signaling US interests could be served by agreeing such a deal.8 Allowing Iran back into the market as a bona fide oil exporter would return ~ 1mm b/d or more to global crude markets by year-end. This would partly reverse the higher prices we expect in the wake of an EU to embargo Russian oil imports this week. Presently, oil markets are rallying as the necessity for Russia to shut in oil production post-embargo is discounted (Chart 6).9 That said, a deal to allow Iran back into export markets would dampen the move we expect in the wake of an EU embargo. The market will remain tight after a US-Iran deal, but this might be attractive to the Biden administration as mid-terms approach, and to the EU, as it also would reduce the funds available for Russia to wage war on Ukraine. On a tactical basis, we are getting long 4Q22 Brent calls struck at $120/bbl at tonight's close, anticipating the EU embargo. We will close this position out if the US and Iran reinstate the Joint Comprehensive Plan of Action (JCPOA), which would allow Iran to resume oil exports. Precious Metals: Bullish The World Platinum Investment Council (WPIC) projects a 2022 surplus of 627 koz, slightly lower than the previous forecast of 657k oz for this period. This year, strong automotive demand is expected to be offset by reductions in jewellery and industrial demand. Car manufacturers’ switch from Russian palladium to platinum – as they self-sanction – will bullish for platinum. Russia accounts for ~40% of global palladium mined output. The organization predicts lower mine supply caused primarily by supply-chain bottlenecks and COVID-19 restrictions. Nornickel, one of the world’s largest platinum miners is expected to reduce mined output on the back of supply-chain disruptions due to Russian sanctions. Base Metals: Bullish Iron ore prices rose on the wider than anticipated cut in China’s benchmark interest rate for mortgages on May 20th (Chart 7). The upcoming easing of lockdowns in Shanghai will further boost iron ore prices, as markets expect Chinese economic activity to pick up. However, if China sticks to its zero-COVID policy, lockdowns will continue to occur in different cities and regions. BCA’s Emerging Markets Strategy expects these ‘rolling lockdowns’ to last at least until the end of this year. This will affect manufacturing and steel production, primary iron ore demand drivers. Iron ore’s reliance on China’s economic health means price of the industrial metal will not meaningfully rise this year, barring a supply shortfall. Chart 6 Chart 7 Footnotes 1 Please see The Former Chancellor Who Became Putin’s Man in Germany, published by the New York Times 23 April 2022. This is an excellent precis of the history of German-Russian trade vis-à-vis the career of former German chancellor Gerhard Schröder, who held the office from 1998 – 2005. The deep energy relationship with Russia began in the late 1960s under the chancellorship of Willy Brandt. As much as 55% of Germany's gas needs were supplied by Russia prior to its invasion of Ukraine 24 February 2022. Now its Russian gas imports are closer to 20%; Germany and the EU are scrambling to eliminate any and all energy trade with Russia, beginning with reducing gas imports by two-thirds this year, and likely embargoing all oil imports by year-end. 2 Russia completes Nord Stream 2 construction, gas flows yet to start, published by reuters.com 10 September 2021. 3 Please see REPowerEU: A plan to rapidly reduce dependence on Russian fossil fuels and fast forward the green transition* published by the European Commission 18 May 2022. Energy accounted for 62% of the EU's Russian imports in 2021, just under €100 billion worth of gas (40%), oil (27%) and coal (46%), according to the European Commission's tally in In focus: Reducing the EU’s dependence on imported fossil fuels published 20 April 2022. In 2011, energy accounted for 77% of the EU's imports from Russia. 4 Please see Felix K. Chang's report Legacy of Ostpolitik: Germany's Russia Policy and Energy Security published by the Foreign Policy Research Institute in May 2014. This includes a summary of the paradoxical nature of Germany's Ostpolitik policy following Russia's first invasion of Ukraine. 5 Please see German economy minister expects EU embargo on Russian oil 'within days' -ZDF, published by reuters.com 23 May 2022. 6 Please see LNG momentum swinging back to Asia as Europe demand eases: Russell published by reuters.com on 24 May 2022. 7 Please see Tight Commodity Markets: Persistently High Inflation, which we published 24 March 2022. It is available at ces.bcaresearch.com. 8 Please see Analysis: Subtle shift in U.S. rhetoric suggests new Iran approach published by reuters.com 24 May 2022, and German economy minister expects EU embargo on Russian oil 'within days' -ZDF, published by reuters.com 23 May 2022. 9 Please see Oil, Natgas Prices Set To Surge, which we published last week. Investment Views and Themes Recommendations Strategic Recommendations Trades Closed in 2022 Summary of Closed Trades
Although Ukranian US dollar sovereign bonds have rebounded since the beginning of the war, their risk-reward tradeoff is not yet attractive. First, the war is likely to be prolonged. US and NATO military and economic assistance to Ukraine helps the latter…
Executive Summary Credit Demand Collapsed Business activity data from April showed a broad-based contraction in China’s economy. Credit growth tumbled as demand collapsed. Bank loan expansion slowed by the most in nearly five years and annual change in new household loans declined to an all-time low. Exports decelerated sharply in April. China’s export sector faces headwinds from Omicron-related supply chain disruptions and weakening global demand for goods. Export growth will rebound following the resumption of business activity in China’s major cities, but is set to decelerate from 2021 as external demand for goods weakens. The PBOC lowered the 5-year loan prime rate (LPR) by 15bps last Friday, following a cut in the floor rate of first-home mortgages to 20bp below the benchmark. These moves will help to arrest the ongoing deep contraction in the property market. However, these policies alone will not generate strong recovery in housing demand, amid near-term Covid-related disruptions and dampened household income growth. Barring major lockdowns, China’s economy will likely bottom around mid-2022. We expect a muted recovery in the second half of the year, despite an acceleration in policy easing. From a cyclical perspective, we continue to recommend a neutral allocation to Chinese onshore stocks in a global portfolio. Bottom Line: China’s economy has been hit by a relapse in demand and Covid-induced production disruptions. The economy will likely bottom by mid-year, but the ensuing recovery may be subdued. A Subdued Recovery In 2H 2022 A broad-based contraction in China’s economy in April reflects hit by a combination of slumping domestic demand and Covid-related disruptions. Growth in retail sales and industrial production contracted from a year ago and home sales shrunk further. Economic activity will rebound when the current Covid wave is under control and lockdown restrictions are lifted. However, we expect a much more muted recovery in the second half of this year compared with two years ago when China’s economy staged an impressive V-shaped recovery as it emerged from the first wave of lockdowns in spring 2020. Presently, reported virus cases have steadily declined in cities in the Yangtze River region, including Shanghai which aims to lift its lockdown on June 1st. The number of regions and cities under stringent confinement also fell. However, China firmly maintains its dynamic zero-Covid policy, which means tight mobility restrictions and some forms of lockdowns will occur across the country on a rolling basis going forward. China’s leadership has stepped up its pro-growth policy measures, such as a 15bps cut in the 5-year LPR last week. Given the pace of credit expansion collapsed in April and private-sector sentiment remains in the doldrums, a recovery will not be imminent or strong despite this rate cut (Chart 1). In the near term, the poor economic outlook in China, coupled with jitters in the global equity market, will continue to depress the performance of Chinese stocks in absolute terms (Chart 1, bottom panel). From a cyclical perspective, we maintain our neutral view on China’s onshore stocks and underweight view on China’s investable stocks within a global equity portfolio. China’s economy is set to underwhelm investor expectations and stock prices probably are unlikely to outperform their global counterparts (Chart 2). Chart 1Weak Economic Fundamentals Undermine Stock Performance Chart 2Too Early To Upgrade Chinese Stocks In A Global Portfolio Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Credit Growth Slowed Notably As Loan Demand Slumps Credit expansion in April relapsed, as lockdowns exacerbated the weakness in business activity and further depressed the demand for credit. Bank loan growth plummeted to its worst level in almost five years (Chart 3). Notably, annual change in new household loans origination contracted the most since data collection began because Covid lockdowns and the property market slump sapped consumers’ willingness to borrow (Chart 4). In addition, household propensity to spend declined to an all-time low, highlighting that bleak sentiment will continue to curb demand for loans (Chart 4, bottom panel). Moreover, a rapid deceleration in corporate medium-and long-term loans versus soaring short-term bill financing indicates corporates’ weak demand for credit and investment (Chart 5). The deterioration in corporate sentiment is also reflected in business condition surveys (Chart 6). Chart 3Subdued TSF Growth Due To Collapsed Loan Demand Chart 4Annual Change In New Household Loans Contracted The Most In April Chart 5Corporate Demand For Credit Remains in The Doldrums … Chart 6... And Unlikely To Turn Around Soon Despite Accommodative Monetary Conditions Chart 7Early Signs Of Authorities Loosening Their Grip On Shadow Banking Local government bond issuance unexpectedly moderated in April after most of the front-loaded local government special purpose bonds (SPBs) was issued in Q1. In the January-April period this year, the amount of SPBs issuance was RMB 1.41 trillion. The SPBs quota for 2022 is 3.65 trillion, along with 1.1 trillion of SPB proceeds that can be carried over from last year. Given that most of the planned SPBs will be issued by the end of June, we will likely see a peak in SPB issuance in Q2.This entails about RMB 3 trillion of SPBs will be issued in May-June. The intensified SPB issuance will underpin total social financing (TSF) growth in the next two to three months. However, barring an increase in the SPB quota or an approval to issue Special Treasury bonds as occurred in 2H 2020, the support from government bonds issuance to TSF will likely decline sharply in the second half of this year. Notably, there has been stabilization in shadow bank financing growth, although it remains below zero (Chart 7). It may be an early sign that China’s leadership is allowing some shadow banking activity; a meaningful relaxation of local governments’ shadow banking activity would be positive for infrastructure investment. Exports: Weaker Than Last Year China’s exports growth softened sharply in April, led by an extensive reduction in shipments to major developed markets (Chart 8). In addition, exports by product group also indicate a wide ranging slowdown in both exports of lower-end consumer goods and tech products (Chart 9). The softness in China’s exports reflects Omicron-related supply chain and logistical disruptions along with a weakening external demand for goods. Chart 8China's Exports To Developed Markets Fell Chart 9A Broad-Based Decline Among Categories of Exported Goods Chart 10Weakening Global Demand For Goods South Korean exports, a bellwether for global trade, have also been easing in line with Chinese exports, which indicates dwindling global demand for manufacturing goods (Chart 10). In addition, the sharp underperformance of global cyclical stocks versus defensives heralds a worldwide manufacturing downturn (Chart 11). Falling US demand for consumer goods corroborates diminishing external demand (Chart 12). China’s exports will likely rebound from its April levels when manufacturing production resumes in Shanghai and supply-chain interruptions subside in the Yangtze River Delta region. Nonetheless, we expect a contraction in exports this year, as global consumer demand for goods dwindles. Chart 11Global Manufacturing Sector Is Heading Into A Downturn Chart 12External Demand For Chinese Export Goods Is Dwindling Recovery In China’s Manufacturing Sector Will Be Muted In 2H 2022 Manufacturing production growth contracted in April at the fastest rate since data collection began. The contraction was due to Covid-induced production troubles and weak demand (Chart 13). Chart 13Manufacturing Output Growth Contracted The Most Since Data Reporting Began Chart 14Mounting Product Inventory Chart 15Chinese Manufacturing Output And Capacity Utilization Face Headwinds From Weakening Exports The inventory of finished products soared to the highest point in the past 10 years due to port closures and domestic logistical issues (Chart 14). Even when the impact of the current Covid wave wanes in the second half of this year, destocking pressures will dampen manufacturing production. In addition, Chinese manufacturing output and capacity utilization face headwinds from decelerating exports (Chart 15). While upstream industries, such as the mining, resources and materials sectors, benefit from strong pricing trends, profit margins for middle-to-downstream manufacturers remain very subdued (Chart 16). The large gap between prices for producer goods and consumer goods is a reflection of the inability of manufacturers to pass on higher input costs to consumers (Chart 17). Elevated input cost pressures and, hence, disappointing corporate profits, will continue to curb manufacturing investments and production in 2H 2022. Chart 16Manufacturing Sector's Profit Margins Are Further Squeezed Chart 17Manufacturers Are Under Rising Cost Pressures Housing Market Outlook Remains Gloomy The PBOC lowered the 5-year LPR by 15bps from 4.6% to 4.45% on May 20, the largest LPR rate cut since 2019. The easing measure followed a reduction in first-home mortgages to 20bps below the benchmark announced on May 15. The national-level mortgage rate floor and benchmark rate drops are clear signals that policymakers are ramping up policy easing measures in the property sector, given the failure of previous efforts to revive housing demand. Historically, mortgage rates tend to lead household loans and home sales by two quarters, suggesting that the housing market may see some improvement by year-end (Chart 18). However, as we pointed out in previous reports, without large-scale and direct fiscal transfers to consumers to boost household income, these housing measures will unlikely generate a strong rebound in household sentiment and home purchases (Chart 19). Chart 18Mortgage Rates Tend To Lead Consumer Loans And Home Sales By Two Quarters Chart 19Housing Market Sentiment Shows Little Signs Of Revival Lockdowns in April exacerbated the slump in all housing market indicators, with the exception of a moderate improvement in floor space completed (Chart 20). Home prices, which tend to lead housing starts, decelerated even more in April following seven consecutive month-to-month declines. Moreover, our housing price diffusion index suggests that home prices on a year-on-year basis will contract in the next six to nine months, a further drop from the current 0.7% growth (Chart 21, top panel). Falling home prices will curb housing starts and construction activity (Chart 21, bottom panel). In addition, real estate developers’ financing conditions have not improved because the “three red lines” policy is still in place and home sales have collapsed (Chart 22). Chart 20A Further Deterioration In Housing Market Indicators In April Chart 21Housing Prices Are Set To Contract In 2H 2022 Chart 22Slumping Home Sales Exacerbate Real Estate Developers’ Funding Woes A Collapse In Household Consumption Due To Covid Confinement Measures City lockdowns have taken a heavy toll on China’s household consumption. Both retail sales and service sector business activity experienced their deepest contractions since March 2020 (Chart 23). Notably, the growth of online goods sales slipped under zero in April, below that recorded in early 2000 and the first contraction since data collection began. Furthermore, both core and service consumer prices (CPI) weakened again in April, reflecting lackluster consumer demand (Chart 24). Chart 23Chinese Retail Sales Contracted The Most Since March 2020 Chart 24Weak Core And Service CPIs Also Reflect Lackluster Household Demand Labor market dynamics went downhill rapidly. The nationwide urban unemployment rate rose to its highest level since mid-2020, while the unemployment rate among younger workers climbed to an all-time high (Chart 25). Meanwhile, sharply slowing wage growth since mid-2021 has contributed to a deceleration of household income (Chart 26). The gloomy sentiment on future income also impedes a household’s willingness to consume (Chart 27). Chart 25Labor Market Situation Is Dramatically Worse Chart 26Household Income Growth Has Been Falling All in all, China’s household consumption will be hindered not only by renewed threats from flareups in domestic COVID-19 cases, but also by a worsening labor market situation and depressed household sentiment in the medium term. Chart 27Poor Sentiment On Funture Income Contributes To Consumers' Unwillingness To Spend Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Strategic Themes Cyclical Recommendations
After a resilient first quarter, the South African rand experienced a sharp late-April selloff that brought it back down near late-2021 lows. However, the currency has been appreciating over the past week, recouping some of the losses. Is the rand likely to…
Executive Summary Villains Still Lurking European assets and the euro already discount a significant worsening of Europe’s economic outlook. If the global economic situation were to stabilize, then European assets would be a buy at current levels. However, there remain very large risks lurking over the outlook. First, a further deterioration in energy flows between Russia and the EU is a major threat to the European economic outlook. Second, the ECB delivering the seven rate hikes priced in the June 2023 Euribor contract would be painful for the European economy. Third, further selloff in the US equity market could translate into more pain for European equities. And fourth, the weakness in the Chinese economy and aggressive monetary tightening in the broader EM space outside China are additional risks. These risks loom large enough, so that investors should avoid bottom-fishing the market. Wait until greater clarity emerges or valuations improve further. Bottom Line: Don’t be a hero. European assets and the euro are probably in the process of bottoming. However, the probability of a very significant additional decline is large enough that investors should continue to emphasize capital preservation over return maximization. Also, continue to favor defensives over cyclical assets. After declining nearly 8% since its January 2021 peak, the euro is down another 7% so far this year. Meanwhile, the Dow Jones Euro STOXX 50, which has plunged 17% since its January 5, 2022 apex, or 22% in US dollar terms, trades at 11.2 times 2023 earnings estimates. At these valuations, European assets already discount a major growth slump in Europe. Is it time to buy European assets, to favor cyclicals versus defensives, and to buy the euro? At face value, the answer is “yes,” but uncertainty abounds, which means that capital preservation remains paramount. As a result, we recommend investors avoid bottom-fishing European assets. They should wait for a safer entry point, rather than trying to pick through the market trough. Plenty Of Risks Four main risks cast a long shadow on the performance of European assets: The evolution of the energy crisis, the potential for an ECB policy mistake, the threat of a worsening US selloff, and the instability in EM. The Energy Crisis It’s official: Sweden and Finland are applying to join NATO. Turkey’s objection will create delays in the process, but it will not stop it. Turkey needs protection against Russia, and it needs help to support the lira. Turkey’s acquiescence, therefore, will be bought. What is genuinely surprising is Russia’s silence. President Putin threatened to flex Russia’s military muscles if Sweden and Finland were to abandon their neutrality. Yet, he now has “no problem” with their bid to join the alliance. We are skeptical, especially as the EU is aiming to ban Russian oil imports by the end of the year. Based on these observations, we continue to see a further deterioration in energy flows between Russia and the EU as a major threat to the European economic outlook. It is far from a guaranteed outcome, but its probability is elevated enough (more than 30%) and so impactful that any investment strategy must account for it. Chart 1Rebuilding Nat Gas Stocks Is A Must Chart 2Low-Income Households Are At Risk Moreover, European nations continue to pay a premium for their energy and are trying to rebuild their natural gas inventory ahead of winter (Chart 1). Thus, the energy market continues to carry a significant recession risk for the Eurozone. Lower-income households already spend a substantial portion of their income on utilities and transportation costs, and their consumption is highly sensitive to the evolution of energy prices (Chart 2). A Policy Mistake We consider a rate hike in July a policy mistake, but it would be a true error if the ECB ratified the pricing currently embedded in the €STR curve (Chart 3). Why would a rate hike constitute a policy mistake? The EU’s inflation spike is not a reflection of strong domestic demand. It reflects foreign factors over which the ECB has no control. Energy prices drive European inflation and are passing-through to core CPI (Chart 4). Yet, wage growth remains tepid at 2.6%. Hiking rates will not bring about the additional energy supply Europe needs to tame inflation. Chart 3Too Far Too Fast Chart 4European Inflation Is Energy inflation Chart 5The US Is Lifting Prices Around The World Even the analysis of the ECB is conflicted. On May 11, Executive Board Member Isabel Schnabel highlighted the need for an imminent interest rate hike, yet she also underscored the global nature of the current inflation outbreak. Goods prices in Europe not only reflect higher input costs, but they also bear the imprint of the excess demand in the US, which is lifting the price of goods prices around the world (Chart 5). However, an ECB rate hike will do little to tame US demand for manufactured goods. In the monetary policy realm, only aggressive tightening by the Fed will have the desired effect, which will trickle down to lower European inflation. Thus, European interest rate hikes will accentuate consumption weaknesses already visible across the region more than they will slow inflation. While a few rate hikes will not have a major impact, the seven rate hikes priced in the June 2023 Euribor contract would be disastrous as long as Europe is hamstrung by the current relative price shock. We remain long this contract. Worsening US Equity Selloff Investors seem to be waking up to the reality that US consumers are facing the same difficult predicament as European consumers: rising energy and food prices and contracting real incomes. The recent earnings call by Walmart was a shock that caused an 8% drubbing for consumer staples and a 7% fall in consumer discretionary equities. Until US inflation clearly peaks, investors will have to evaluate how much deeper the pain for consumers may run. Moreover, since consumers have begun to cut their discretionary spending in response to strained budgets, the ability of firms to pass on rising input costs is dwindling. Hence, investors will have to handicap the risks to margins as well. Chart 6Fed Put Not Exercised US inflation also impacts the Fed’s outlook. Until inflation has decelerated for a few months, the Fed will remain comfortable with tighter financial conditions. This means that the strike price of the so-called Fed put is inversely proportional to inflation, especially since FCIs are far from tight (Chart 6). As a result, inflation or energy prices must soften before the Fed can begin to send comforting signals to the market. Chart 7Where Walmart Goes, So Does The Market? The US market has cheapened significantly, and a floor should be close; but the risks remain considerable. A very smart investor with whom we regularly chat highlighted that we have not yet seen a full-fledged liquidation. Only once energy stocks have also been purged will the necessary condition for a bottom be met (since only then will all the speculative activity have been cleared). In fact, the recent poor performance of Walmart highlights the risk that the S&P 500 could suffer one last down leg to 3500, since over the past 12 years, WMT often leads the SPX (Chart 7). Another 300 points decline in the US benchmark could translate into significant selling pressure in the Euro STOXX, because it sports an elevated beta. EM Instability EM are still facing ample risks, which could easily dislodge the prospects of European firms servicing these economies. As a result, EM constitute another major threat for European equities. Chart 8Less COVID In Shanghai and Jilin The outlook for China remains fraught with risks. National COVID cases are declining as a result of the collapse in cases in the Shanghai and Jilin provinces (Chart 8). However, Omicron is spreading around the nation, with broadening lockdowns in Beijing and Tianjin. The one certainty is that the Chinese Communist Party remains wedded to its zero-COVID policy. Considering the size of the country and how contagious the various Omicron variants are, rolling lockdowns and their deleterious impact on activity are here to stay. China therefore remains a source of downside risk for global goods demand. Unemployment is surging, and the PMIs are extremely weak, suggesting a contraction in GDP is coming. Moreover, households continue to deleverage (Chart 9). The CNY’s weakness confirms the risks to earnings growth in Europe, and the yield spread between China and the US points to further downside in the RMB (Chart 10, top panel). Interestingly, the weakness of the yen could also drag the CNY lower because of competitive pressures. Chester Ntonifor, BCA’s Chief Foreign Exchange strategist recommends investors sell CNY/JPY. Historically, a depreciating CNY/JPY portends weakness in European stock prices (Chart 10, bottom panel). Chart 9Chinese Growth Problems Chart 10A Weaker CNY Augurs Poorly For European Stocks The broader EM space outside of China is also a source of risk. EM countries are tightening monetary policy, which is slowing economic activity in nations already exposed to declining Chinese imports. Additionally, as Arthur Budaghyan shows, the strength in the dollar is tightening EM financial conditions and invites further increases in EM policy rates because of the inflationary impact of depreciating currencies. An additional tightening in EM financial conditions in response to this toxic mix will invite greater downside for European equities (Chart 11). Bottom Line: European equities already reflect enough of a valuation cushion to compensate for a significant slowdown in European growth. However, ample risks to global growth still lurk in the background. If these risks materialize, European stocks could selloff another 15% or so. Moreover, the overvaluation of cyclical stocks relative to defensive ones has now been purged, but China’s economic weakness remains a major handicap (Chart 12). Consequently, don’t be hero: avoid bottom-fishing European assets, especially cyclical ones. Chart 11Brewing EM Troubles Chart 12Cyclicals At Risk From China Is it Time to Buy the Euro? After falling below 1.04, EUR/USD has rebounded to 1.055. Is it time to buy the euro? The euro now embeds a large discount that reflects fears of a recession and stagflation in the Eurozone. A purchasing power parity model developed by BCA’s Foreign Exchange Strategy team that accounts for the differences in consumption baskets in Europe and the US shows that EUR/USD is trading at its deepest discount to fair value since 2001. Moreover, BCA’s Intermediate-term timing model, which is based on an augmented interest rate parity framework, confirms that EUR/USD is cheap. Additionally, BCA’s Intermediate-Term Technical Indicator is massively oversold (Chart 13). For the euro to bottom durably, the dollar needs to reverse its rally. The combination of net speculative positions on the DXY and BCA’s Dollar Capitulation Index point to elevated chances of an imminent peak (Chart 14). Chart 13The Euro's Large Risk Premium Chart 14The Over Extended Dollar Despite this backdrop, three of the aforementioned risks to European stocks translate into threats to the euro: A Russian energy embargo would cause a much more severe European recession. Two weeks ago, we highlighted a Bundesbank study which showed that such a cutoff would curtail German growth by 5% point for 2022. We also highlighted that this shock would cause a temporary but significant increase in inflation. This combination would be poisonous for the euro, and it carries a roughly 30% probability. A policy mistake in the Euro Area would cause a period of significant spread widening in the periphery. Such shocks often prompt a widening in the breakup risk-premium for the euro. This risk premium pushes EUR/USD lower. Chart 15Chinese Assets Matter To The Euro Chinese growth problems often hurt the euro as well as European stocks. A fall in the Chinese stock-to-bond ratio often leads to a weaker EUR/USD, since both variables are correlated to Chinese economic activity. Additionally, a depreciating CNY is also synonymous with a softer euro because a declining renminbi hurts European exporters (Chart 15). Further weaknesses in the S&P 500 no longer guarantee a fall in EUR/USD. Investors are worried about the US equity outlook because they are extrapolating the impact on consumers of rising energy and food prices. They are applying the template of what is going on in Europe to US households, which means that they are pricing in a convergence of US growth toward European growth (barring the three additional shocks highlighted in the bullet points above). Related Report European Investment StrategyIs UK Stagflation Priced In? Bottom Line: From a technical and valuation perspective, the rebound in the euro that began this week could last longer. However, several exceptional risks could prevent this bounce from morphing into a durable rally. The significant odds of a Russian energy embargo stand at the top of the list of concerns, but so does the possibility of a policy mistake in Europe as well China’s problems. Thus, even if the euro is bottoming, don’t be a hero and wait on a safer entry point to focus on capital preservation. In fact, BCA’s Foreign Strategy team is now selling EUR/JPY. Within a European context, a short GBP/CHF position is attractive as a portfolio hedge. The Swiss National Bank seems more tolerant of a higher CHF as a vehicle to tame growing inflationary pressures, while the UK faces significant risks. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations
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The PBoC reduced the five-year loan prime rate – the mortgage reference rate – by 15bps on Friday to 4.45%, below expectations of 4.55%. This marks the latest attempt by Chinese policymakers to revive the housing market. Earlier in the week, financial…
Listen to a short summary of this report. Executive Summary The US Inflation Surprise Index Has Rolled Over Global equities are nearing a bottom and will rally over the coming months as inflation declines and growth reaccelerates. While equity valuations are not at bombed-out levels, they have cheapened significantly. Global stocks trade at 15.3-times forward earnings. We are upgrading tech stocks from underweight to neutral. The NASDAQ Composite now trades at a forward P/E of 22.6, down from 32.9 at its peak last year. The 10-year Treasury yield should decline to 2.5% by the end of the year, which will help tech stocks at the margin. The US dollar has peaked. A weakening dollar will provide a tailwind to stocks, especially overseas bourses. US high-yield spreads are pricing in a default rate of 6.2% over the next 12 months, well above the trailing default rate of 1.2%. Favor high-yield credit over government bonds within a fixed-income portfolio. Bottom Line: The recent sell-off in stocks provides a good opportunity to increase equity allocations. We expect global stocks to rise 15%-to-20% over the next 12 months. Back to Bullish We wrote a report on April 22nd arguing that global equities were heading towards a “last hurrah” in the second half of the year as a Goldilocks environment of falling inflation and supply-side led growth emerges. Last week, we operationalized this view by tactically upgrading stocks to overweight after having downgraded them in late February. This highly out-of-consensus view change, coming at a time when surveys by the American Association of Individual Investors and other outfits show extreme levels of bearishness, has garnered a lot of attention. In this week’s report, we answer some of the most common questions from the perspective of a skeptical reader. Q: Inflation is at multi-decade highs, global growth is faltering, and central banks are about to hike rates faster than we have seen in years. Isn’t it too early to turn bullish? A: We need to focus on how the world will look like in six months, not how it looks like now. Inflation has likely peaked and many of the forces that have slowed growth, such as China’s Covid lockdown and the war in Ukraine, could abate. Q: What is the evidence that inflation has peaked? And may I remind you, even if inflation does decline later this year, this is something that most investors and central banks are already banking on. Inflation would need to fall by more than expected for your bullish scenario to play out. A: That’s true, but there is good reason to think that this is precisely what will happen. Overall spending in the US is close to its pre-pandemic trend. However, spending on goods remains above trend while spending on services is below trend (Chart 1). Services prices tend to be stickier than goods prices. Thus, the shift in spending patterns caused goods inflation to rise markedly with little offsetting decline in services inflation. To cite one of many examples, fitness equipment prices rose dramatically, but gym membership fees barely fell (Chart 2). Chart 1Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Chart 2Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices As goods demand normalizes, goods inflation will come down. Meanwhile, the supply of goods should increase as the pandemic winds down, and hopefully, a detente is reached in Ukraine. There are already indications that some supply-chain bottlenecks have eased (Chart 3). Q: Even if supply shocks abate, which seems like a BIG IF to me, wouldn’t the shift in spending towards services supercharge what has been only a modest acceleration in services inflation so far? A: Wages are the most important driver of services inflation. Although the evidence is still tentative, it does appear as though wage inflation is peaking. The 3-month annualized growth rate in average hourly earnings for production and nonsupervisory workers slowed from 7.2% in the second half of 2021 to 3.8% in April (Chart 4). Assuming productivity growth of 1.5%, this is consistent with unit labor cost inflation of only slightly more than 2%, which is broadly consistent with the Fed’s CPI inflation target.1 Chart 4Wage Pressures May Be Starting To Ease Moreover, a smaller proportion of firms expect to raise wages over the next six months than was the case late last year according to a variety of regional Fed surveys (Chart 5). The same message is echoed by the NFIB small business survey (Chart 6). Consistent with all this, the US Citi Inflation Surprise Index has rolled over (Chart 7). Chart 6... Small Business Owners Included Chart 7The US Inflation Surprise Index Has Rolled Over Q: What about the “too cold” risk to your Goldilocks scenario? The risks of recession seem to be rising. A: The market is certainly worried about this outcome, and that has been the main reason stocks have fallen of late. However, we do not think this fear is justified, certainly not in the US (Chart 8). US households are sitting on $2.3 trillion excess savings, equal to about 14% of annual consumption. The ratio of household debt-to-disposable income is down 36 percentage points from its highs in early 2008, giving households the wherewithal to spend more. Core capital goods orders, a good leading indicator for capex, have surged. The homeowner vacancy rate is at a record low, suggesting that homebuilding will be fairly resilient in the face of higher mortgage rates. Q: It seems like the Fed has a nearly impossible task on its hands: Increase labor market slack by enough to cool the economy but not so much as to trigger a recession. You yourself have pointed out that the Fed has never achieved this in its history. A: It is correct that the unemployment rate has never risen by more than one-third of a percentage point in the US without a recession occurring (Chart 9). That said, there are three reasons to think that a soft landing can be achieved this time. Chart 9When Unemployment Starts Rising, It Usually Keeps Rising First, increasing labor market slack is easier if one can raise labor supply rather than reducing labor demand. Right now, the participation rate is nearly a percentage point below where it was in 2019, even if one adjusts for increased early retirement during the pandemic (Chart 10). Wages have risen relatively more at the bottom end of the income distribution. This should draw more low-wage workers into the labor force. Furthermore, according to the Federal Reserve, accumulated bank savings for the lowest-paid 20% of workers have been shrinking since last summer, which should incentivize job seeking (Chart 11). Chart 10Labor Participation Has Further Scope To Recover Chart 11Depleted Savings Will Force More Lower-Wage Workers Into The Labor Market Second, long-term inflation expectations remain well contained, which makes a soft landing more likely. Median expected inflation 5-to-10 years out in the University of Michigan survey stood at 3% in May, roughly where it was between 2005 and 2013 (Chart 12). Median expected earnings growth in the New York Fed Survey of Consumer Expectations was only slightly higher in April than it was prior to the pandemic (Chart 13). Chart 12Consumer Long-Term Inflation Expectations Have Risen But Remain Relatively Low Chart 13US Consumers Do Not Expect Wages To Grow At A Much Higher Rate Than In The Pre-Pandemic Period A third reason for thinking that a soft landing may be easier to achieve this time around is that the US private-sector financial balance – the difference between what the private sector earns and spends – is still in surplus (Chart 14). This stands in contrast to the lead-up to both the 2001 and 2008-09 recessions, when the private sector was living beyond its means. Q: You have spoken a lot about the US, but the situation seems dire elsewhere. Europe may already be in recession as we speak! A: The near-term outlook for Europe is indeed challenging. The euro area economy grew by only 0.8% annualized in the first quarter. Mathieu Savary, BCA’s Chief European Strategist, expects an outright decline in output in Q2. To no one’s surprise, the war in Ukraine is weighing on European growth. The Bundesbank estimates that a full embargo of Russian oil and gas would reduce German real GDP by an additional 5% on top of the damage already inflicted by the war (Chart 15). Chart 14The US Private-Sector Financial Balance Remains In Surplus Chart 15Germany’s Economy Will Sink Without Russian Energy While such a full embargo is possible, it is not our base case. In a remarkable about-face, Putin now says he has “no problems” with Finland and Sweden joining NATO, provided that they do not place military infrastructure in their countries. He had previous threatened a military response at the mere suggestion of NATO membership. In any case, there are few signs that Putin’s increasingly insular and dictatorial regime would respond to an oil embargo or other economic incentives. The wealthy oligarchs who were supposed to rein him in are cowering in fear. It is also not clear if Europe would gain any political leverage over Russia by adopting policies that push its own economy into a recession. It is worth noting that the price of the December 2022 European natural gas futures contract is down 39% from its peak at the start of the war (Chart 16). It is also noteworthy that European EPS estimates have been trending higher this year even as GDP growth estimates have been cut (Chart 17). This suggests that the analyst earnings projections were too conservative going into the year. Chart 16European Natural Gas Futures Are High But Below Their Peak Chart 17European And US EPS Estimates Have Been Trending Higher This Year Chart 18Chinese Property Sector: Signs Of Contraction Q: What about China? The lockdowns are crippling growth and the property market is in shambles. A: There is truth to both those claims. The government has all but said that it will not abandon its zero-Covid policy anytime soon, even going as far as to withdraw from hosting the 2023 AFC Asian Cup. While the number of new cases has declined sharply in Shanghai, future outbreaks are probable. On the bright side, China is likely to ramp up domestic production of Pfizer’s Paxlovid drug. Increased availability of the drug will reduce the burden of the disease once social distancing restrictions are relaxed. As far as the property market is concerned, sales, starts, completions, as well as home prices are all contracting (Chart 18). BCA’s China Investment Strategy expects accelerated policy easing to put the housing sector on a recovery path in the second half of this year. Nevertheless, they expect the “three red lines” policy to remain in place, suggesting that the rebound in housing activity will be more muted than in past recoveries.2 Ironically, the slowdown in the Chinese housing market may not be such a bad thing for the rest of the world. Remember, the main problem these days is inflation. To the extent that a sluggish Chinese housing market curbs the demand for commodities, this could provide some relief on the inflation front. Q: So bad news is good news. Interesting take. Let’s turn to markets. You mentioned earlier that equity sentiment was very bearish. Fair enough, but I would note the very same American Association of Individual Investors survey that you cited also shows that investors’ allocation to stocks is near record highs (Chart 19). Shouldn’t we look at what investors are doing rather than what they’re saying? A: The discrepancy may not be as large as it seems. As Chart 20 illustrates, investors may not like stocks, but they like bonds even less. Chart 19Individual Investors Still Hold A Lot Of Stock Chart 20B... But They Like Bonds Even Less Chart 21Global Equities Are More Attractively Valued After The Recent Sell-Off Global equities currently trade at 15.3-times forward earnings; a mere 12.5-times outside the US. The global forward earnings yield is 6.7 percentage points higher than the global real bond yield. In 2000, the spread between the earnings yield and the real bond yield was close to zero (Chart 21). It should also be mentioned that institutional data already show a sharp shift out of equities. The latest Bank of America survey revealed that fund managers cut equity allocations to a net 13% underweight in May from a 6% overweight in April and a net 55% overweight in January. Strikingly, fund managers were even more underweight bonds than stocks. Cash registered the biggest overweight in two decades. Q: Your bullish equity bias notwithstanding, you were negative on tech stocks last year, arguing that the NASDAQ would turn into the NASDOG. Given that the NASDAQ Composite is down 29% from its highs, is it time to increase exposure to some beaten down tech names? A: Both the cyclical and structural headwinds facing tech stocks that we discussed in These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth and The Disruptor Delusion remain in place. Nevertheless, with the NASDAQ Composite now trading at 22.6-times forward earnings, down from 32.9 at its peak last year, an underweight in tech is no longer appropriate (Chart 22). A neutral stance is now preferable. Chart 22Tech Stock Valuations Have Returned To Earth Q: I guess if bond yields come down a bit more, that would help tech stocks? A: Yes. Tech stocks tend to be growth-oriented. Falling bond yields raise the present value of expected cash flows more for growth companies than for other firms. While we do expect global bond yields to eventually rise above current levels, yields are likely to decline modestly over the next 12 months as inflation temporarily falls. We expect the US 10-year yield to end the year at around 2.5%. Q: A decline in US bond yields would undermine the high-flying dollar, would it not? A: It depends on how bond yields abroad evolve. US Treasuries tend to be relatively high beta, implying that US yields usually fall more when global yields are declining (Chart 23). Thus, it would not surprise us if interest rate differentials moved against the dollar later this year. Chart 23US Treasuries Have A Higher Beta Than Most Other Government Bond Markets It is also important to remember that the US dollar is a countercyclical currency (Chart 24). If global growth picks up as pandemic dislocations fade and the Ukraine war winds down, the dollar is likely to weaken. Chart 24The Dollar Is A Countercyclical Currency A wider trade deficit could also imperil the greenback. The US trade deficit has increased from US$45 billion in December 2019 to US$110 billion. Equity inflows have helped finance the trade deficit, but net flows have turned negative of late (Chart 25). Finally, the dollar is quite expensive – 27% overvalued based on Purchasing Power Parity exchange rates. Q: Let’s sum up. Please review your asset allocation recommendations both for the next 12 months and beyond. A: To summarize, global inflation has peaked. Growth should pick up later this year as supply-chain bottlenecks abate. The combination of falling inflation and supply-side led growth will provide a springboard for equities. We expect global stocks to rise 15%-to-20% over the next 12 months. Historically, non-US stocks have outperformed their US peers when the dollar has been weakening (Chart 26). EM stocks, in particular, have done well in a weak dollar environment Chart 26Non-US Stocks Will Benefit From A Weaker US Dollar Chart 27The Market Is Too Pessimistic On Default Risk Within fixed-income portfolios, we recommend a modest long duration stance over the next 12 months. We favor high-yield credit over safer government bonds. US high-yield spreads imply a default rate of 6.2% over the next 12 months compared to a trailing 12-month default rate of only 1.2% (Chart 27). Chart 28Falling Inflation Will Buoy Consumer Sentiment Our guess is that this Goldilocks environment will end towards the end of next year. As inflation comes down, real wage growth will turn positive. Consumer confidence, which is now quite depressed, will improve (Chart 28). Stronger demand will cause inflation to reaccelerate in 2024, setting the stage for another round of central bank rate hikes. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn Twitter Footnotes 1 The Federal Reserve targets an average inflation rate of 2% for the Personal Consumption Expenditures (PCE) index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of 2.3%-to-2.5%. 2 The People’s Bank of China and the housing ministry issued a deleveraging framework for property developers in August 2020, consisting of a 70% ceiling on liabilities-to-assets, a net debt-to-equity ratio capped at 100%, and a limit on short-term borrowing that cannot exceed cash reserves. Developers breaching these “red lines” run the risk of being cut off from access to new loans from banks, while those who respect them can only increase their interest-bearing borrowing by 15% at most. 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Listen to a short summary of this report. Executive Summary EUR/JPY And The DXY: Unsustainable Gap Three interrelated themes are likely to play out by the end of 2022 – peak Fed hawkishness, continued central bank convergence, and nascent green shoots in global economic growth. We are playing the first theme via an outright short DXY position. We are also hedging this bet through a short EUR/JPY trade, a corresponding play on the second theme. Betting on nascent green shoots in economic growth can be expressed via a long Aussie position, or more prudently, a short CHF/SEK bet. We are long a CAD and NOK basket against the RUB, a play on an eventual recovery in oil demand, and the premium that these blends will continue to command relative to Russian oil. Finally, most of our trades remain at the crosses due to elevated FX volatility which has boosted safe-haven demand for the dollar. The admission of Sweden and Finland into NATO could increases the risk of miscalculation on the part of Russia, which will continue to prop near-term safe-haven demand for the dollar. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short EUR/JPY 133.28 2022-05-12 -0.73 Bottom Line: Continue to focus on relative value trades at the crosses, until signs emerge that FX volatility is peaking, which will be more conducive for direct USD bets. Feature Chart 1Dollar Capitulation Occurs At Record Valuation And A Record Deficit Last week’s report focused on the key reasons why longer-term investors should begin to fade dollar strength. For one, the dollar already imbeds a hefty safe-haven premium. This premium manifests itself in an overvalued exchange rate (Chart 1). A simple PPP model shows that the dollar is overvalued by 27%. This is higher than the peak in the US dollar which preceded the bear market that began in the early 2000s. While valuations tend to matter little until they trigger a tipping point, such an inflection point could be around the corner. One catalyst has been the widening trade deficit which needs to be financed via foreign capital inflows. The US trade deficit continues to deteriorate, hitting a record low of $109.8bn in March. Over the last few years, it has become increasingly difficult to fund this widening trade deficit through foreign purchases of US Treasuries. That said, FX markets are likely to focus on three interrelated themes in the near term – peak Fed hawkishness, continued central bank convergence, and the potential for nascent green shoots in global economic growth. We are playing the first theme via an outright short DXY position. We are also hedging this bet with a short EUR/JPY trade, a corresponding play on the second theme. In the next few sections, we go through a few trades that would benefit from these themes. Short EUR/JPY: A Defensive Play Most of our trades in the portfolio are pro-risk. As such, a short EUR/JPY position acts as an attractive hedge in the near term. The DXY index has historically traded in perfect inverse correlation to the euro-yen exchange rate, but an unusually wide gap has opened up (Chart 2). In our view, this suggests that the collapse in the yen, relative to the euro, is very much overdone. In a risk-off environment, as we witnessed on Wednesday, EUR/JPY will sell off. Meanwhile, there are also fundamental reasons to suggest that this cross is stretched on a longer-term time horizon. First, the cross is expensive on a PPP basis. Chart 3 shows that EUR/JPY usually peaks when the real effective exchange rate is 1.5 standard deviations above its long-term mean. Today’s valuation pins it close to that, among the highest levels since the 1980s. Standard economic theory suggests that a reversal in the cross will be warranted to realign euro area competitiveness relative to Japan. Chart 2EUR/JPY And The DXY: Unsustainable Gap Chart 3EUR/JPY Is Not Cheap Meanwhile, there is a case to be made that an expensive EUR/JPY exchange rate is already affecting relative competitiveness. European exports are relapsing relative to those in Japan, which usually ensues after a period of euro-yen strength. Case in point: German factory orders are already contracting, while machinery orders in Japan remain relatively robust (Chart 4). Second, the European Central Bank has been relatively hawkish, vis-à-vis the Bank of Japan. The yield on December 2022 Euribor contracts is 78bps above the TIBOR equivalent, suggesting the ECB will hike rates 4-5 times this year versus the BoJ. Granted, inflation is overshooting in Europe relative to Japan (Chart 5). But as we have been witnessing around the world from the UK to Canada, and all the way to Australia, rising inflation is a global problem. If it persists, it will also begin to meaningfully show up in the Japanese numbers. This will nudge the BoJ away from the ultra-dovish camp. More likely, inflation will moderate, which will allow the ECB to dial back its hawkish rhetoric. Chart 4Europe Is Losing Competitiveness To Japan Chart 5Eurozone Inflation Could Subside In The Coming Months Even if inflation moderates in the eurozone, short-term real rates will remain deeply negative compared to Japan. This will be a significant drag for relative fixed income flows and the currency (Chart 6). At the same time, higher inflation in Europe also suggests the fair value for EUR/JPY should continue its structural downtrend. Chart 6Real Rates Are Very Low In The Eurozone Third, oil price volatility will remain high in the near term but will subside longer term. We are cognizant of the fact that, our Chief Commodity Strategist, Robert Ryan, expects the geopolitical risk premium in oil to increase in the near term. When rising oil coincides with rebounding economic activity, the yen tends to lag as a defensive currency (Chart 7). This time around, the premium in energy markets has come from a cutoff in Russian supplies. Japan imports almost all its energy and has structurally been more dependent on fossil fuels than Europe (Chart 8). This has boosted EUR/JPY and is a risk to a short position. Chart 7EUR/JPY Tracks Oil Chart 8Japan Will Accelerate A Shift From Fossil Fuels That said, adjustments are already underway. Japanese and European LNG imports from the US are rising. As a result, the price arbitrage between US Henry Hub prices and the Dutch TTF equivalent are collapsing (Chart 9). The Japanese have already ramped up nuclear power production, reducing their dependence on fossil fuels (Chart 10). That will be a welcome fillip for the Japanese trade balance. In a nutshell, a lot of bad news is already priced in the yen. As such, it has become an attractive hedge. Asian clients not willing to short the euro can short CNY/JPY as a close proxy. Interestingly, CNY/JPY has made a classic double-top and could meaningfully depreciate from current levels (Chart 11), along with EUR/JPY. Chart 9The European And Asian Natgas Premium Is Deflating Chart 10A Nuclear Renaissance In Japan? Chart 11CNY/JPY: A Double Top? Short CHF/JPY: Still Attractive, But Taking Profits We also played a long yen leg via a short CHF position but our trailing stop was triggered this week at 130 for a profit of 3.74%. While we believe the cross still faces meaningful downside, we will opportunistically look to sell CHF/JPY again at 135. First, historically, CHF/JPY has inversely tracked the inflation profiles between Switzerland and Japan. Given the collapse in the yen, and much higher Swiss inflation, CHF/JPY has become incrementally more expensive, especially relative to history (Chart 12). To realign competitiveness, the cross should depreciate. Second, from a technical perspective, CHF/JPY is in a classic double-top formation (Chart 13), akin to CNY/JPY. This suggests the safe-haven premium is much higher in the franc than it is in the yen. Chart 12Swiss Inflation Is Lowering CHF"s Puchasing Power Chart 13CHF/JPY: Look To Go Short Again The key risk to this trade is that the Swiss equity market is more defensive relative to Japanese bourses. As such, the hefty safe-haven premium in the franc could persist (Chart 14), pushing the cross to our initial entry short point at 135. Chart 14Swiss Equities Could See Inflows Near Term Short CHF/SEK: A Play On The Riksbank’s U-Turn Chart 15Short CHF/SEK Is The Great Value/Growth Play Value/Growth Turns Before The Dollar Last month, we argued that the dip in the Swedish krona had already priced a recession in the domestic economy. Meanwhile, with a mandate of price stability, we argued the Riksbank will have no choice but to turn more hawkish or lose credibility. As a play on this trend, we recommended going long the SEK relative to the CHF. In a major policy U-turn, the Riksbank raised rates and announced a faster pace of balance-sheet reduction. Most of the arguments made in the original report remain valid, so we will not revisit them here. The one point we will stress is that Sweden’s small open economy makes the SEK very sensitive to global economic conditions. One benefit of a short CHF/SEK position is that while value has been outperforming growth during this selloff, CHF/SEK remains strong which is a departure from the traditional relationship (Chart 15). Ergo, a major safety discount is imbedded in the SEK. Related Report Foreign Exchange StrategyMonth In-Review: A Hefty Safe-Haven Premium In The Dollar Sweden’s bourse is heavy in cyclicals, with large overweight positions in financials and industrials, that will benefit from a renewed capital spending cycle, and higher global rates. Meanwhile, the outperformance of value during a market riot point suggests a change in market leadership could be underway, even if bond yields temporarily crater. The krona remains vulnerable to geopolitical risk, especially if Russia retaliates against Sweden and Finland joining NATO. So far, Russia’s response has been muted. As such, while this pro-cyclical trade faces near-term risk, it remains a safer way, in our view, to play SEK strength. Long AUD: Bet On An Eventual China Rebound Chart 16The AUD And China We will be discussing Australia in an in-depth report next week, so we will keep our comments brief this week. What we will say is that the Aussie is one of the best candidates to play a rebound in global growth, given that it sits near the epicenter of where that growth will likely emanate from – China (Chart 16). Right now, the picture is not pretty, but it is always dark before dawn. Stay tuned. Long (CAD+NOK)/RUB: A Relative Value Play As many countries reroute their oil supplies from Russia to other countries, Canada and Norway could stand to benefit from a relative perspective. Understandably, many clients might not be able to trade the RUB, so we are filing this trade under speculative. First, both Brent and Western Canadian Select oil are trading at a significant premium to the Urals blend, which is likely to be sustained in the next 6 months. This will benefit NOK and CAD, relative to the ruble (Chart 17). Chart 17CAD And NOK Will Benefit From Premium Oil Second, from an FX point of view, Russia faces the trilemma of the impossible trinity – having decided to limit the free flow of capital, it has chosen independent monetary policy and managing the exchange rate. This will come at a cost, however: As the economy comes grinding to a halt and inflation surges, interest rates will have to stay high to maintain currency stability. This will crush the domestic economy for years to come. Luckily, Russia has a healthy current account surplus, but as production in Canada and Norway improve to offset embargoes on Russian crude, this will also boost their external balance. Long EUR/GBP: The Euro Is More Priced For A Recession We have discussed at length the rationale behind our long EUR/GBP position, so we will not reiterate the arguments here. Our Global Fixed Income colleagues upgraded Gilts to overweight last week, in line with expectations that markets will continue pricing a dovish tilt from the BoE. In our view, the EUR/GBP cross still heavily underprices the risks to the UK economy in the near term. As such, if interest rates in the UK continue to fall relative to those in the eurozone, EUR/GBP will benefit (Chart 18). Chart 18EUR/GBP Has Upside 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