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In Section I, we note that the Fed’s new interest rate projections show that US monetary policy is set to rise soon into restrictive territory even relative to what we consider to be the neutral rate of interest, and to a level that has been consistent with the onset of recession since the 1960s. Imminent supply-side and pandemic-related disinflation is crucial for the US to avoid a recession over the coming year. Stay neutral stocks versus bonds for now, but the next shift in our recommended asset allocation stance is more likely to be a downgrade to underweight rather than an upgrade to overweight. In Section II, a guest piece from our European Investment Strategy service discusses the outlook for European assets.

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Dear Client, This month’s Special Report has been written by my colleagues Mathieu Savary and Jeremie Peloso, of BCA’s European Investment Strategy service. The report was published in that service on September 26, and addressed the outlook for European assets. The EUR/USD stop buy mentioned in the report has since been triggered, meaning that our European Investment Strategy service is now long the euro with a stop loss position at 0.94. Although this is a tactical position for that service, it is consistent with the view expressed in Section 1 of our report that the dollar has significantly overshot versus the euro what currency fundamentals would imply. I trust you will find their report both interesting and insightful. Jonathan LaBerge, CFA The Bank Credit Analyst Highlights The outlook for European assets is uniquely muddled. European energy prices will remain elevated, but the worst of the adjustment is already behind us. The global economy is teetering on the edge of a recession and weak global growth is historically very negative for European assets. However, European valuations and earnings forecasts already discount an extremely severe outcome for global growth. A hawkish Fed should support the dollar, but investors increasingly realize foreign central banks are fighting inflation equally aggressively. The dollar already anticipates a global recession. Meantime, European credit offers a large spread pickup over sovereigns and even appears as a decent alternative to equities. Within a credit portfolio, we adopt a more cautious approach towards European investment grade bonds (IG) relative to their US counterpart. Instead, we recommend favoring UK IG over Euro Area IG as well as Swedish IG relative to US IG. Feature Following the hawkishness that transpired from the Fed press conference and revised forecasts last week, EUR/USD plunged below 0.99 and hit a 20-year low. Moreover, President Vladimir Putin’s announcement of a broader mobilization of the Russian army is stoking fears that the Ukrainian conflict will only be prolonged. The prospects of a lengthier war and greater energy market shock are raising further worries for Europe’s growth outlook, which weighs on European asset prices, notably the euro and the pound. The odds of a global financial accident are on the rise. Global central banks have joined the Fed and are relentlessly tightening global monetary and financial conditions. Moreover, the surging dollar is adding to global risks by raising the cost of capital around the world. This is a very fragile situation and the odds of a global recession have jumped significantly. Against this backdrop, investors should continue to overweight defensive equities at the expense of cyclical stocks. The euro also has more downside, but we are issuing a tentative stop-buy at EUR/USD 0.9650 with a stop at 0.9400. Credit remains a safer alternative to European stocks. The Evolving European Energy Backdrop Chart II-1All About The Gas The surge of natural gas and electricity prices since the fall of 2021 has been one of the main drivers of the underperformance of European assets and the fall in the euro (Chart II-1). While the medium-term outlook for European energy prices remains fraught with risk, the near-term prospects have improved. Following a surge from €77.4/MWh in June to €340/MWh on August 26, one-month forward natural gas prices at the Dutch Title Transfer Facility (TTF) have declined 45% to €187/MWh. These wild gyrations reflect the evolution of both the natural gas flows from Russia, which have fallen from 3,060Mcm to 599 Mcm today, and the rapid buildup of natural gas inventories across the European Union. The good news is that the costly efforts to rebuild European gas inventories have been successful. EU-wide inventories are at 85.6% capacity, achieving its 80% storage objective well before November. Germany has gone even further, with storage use now standing at 90% of capacity. This large stockpile, along with the re-opening of coal power plants and consumption curtailment efforts, should allow Europe to survive the winter without Russian energy imports, as long as the temperatures are not abnormally cold. The absence of a summer dip in Norwegian gas exports and the surge in LNG flows to Europe have partially replaced the missing Russian inflows, thus helping Europe rapidly rebuild its natural gas inventories (Chart II-2). This success was a consequence of elevated European natural gas prices, which have allowed Europe to absorb LNG flows from the rest of the world (Chart II-3). Chart II-2No Restocking Without LNG Chart II-3LNG Flowed Toward High Prices     So far, the European industrial sector has managed to adjust better than expected to the jump in the price of natural gas, a crucial energy input. Take Germany as an example. For the month of August, Germany’s consumption of natural gas by the industrial sector fell 22% below the 2018-2021 average (Chart II-4, top panel), while PPI moved up vertically. Yet, industrial output is only down 5% year-on-year and industrial capacity utilization stands at 85%, which is still a level that beats two thirds of the readings recorded between 1990 and this the most recent quarter (Chart II-4, bottom panel). The adjustment will be uneven across various industries, with those most voracious of natural gas likely to experience a declining share of Europe’s gross value added. Using the German example once again, we can see that the chemicals, basic metal manufacturing, and paper products sectors are the most at risk from higher natural gas prices and most likely therefore to suffer the most from gas rationing this winter (Chart II-5). Chart II-4A Surprisingly Successful Transition Chart II-5The Three Sectors Most At Risk   Going forward, important changes are likely to take place that will allow the European economy to continue to survive on diminished Russian gas flows: European natural gas prices will remain elevated compared to the rest of the world to attract LNG flows to the region. Importantly, Europe’s capacity to absorb these flows keeps increasing, as more re-gasification ships are docked around the continent. Moreover, North America is building more facilities to export LNG to Europe. Chart II-6Nuclear Energy's Contribution Will Rebound Nuclear electricity production will rebound. Currently, the EU’s nuclear production is around 43.2TWh, well below the normal 60TWh to 70TWh winter levels, driven mostly by the collapse in French production from 35TWh to 18TWh (Chart II-6). This decline in nuclear electricity generation has accentuated the upward pressure on European natural gas and electricity prices. One of the key objectives of the nationalization of EDF by the French government is to accelerate the maintenance of France’s ageing nuclear power plants and allow a return to more normal production levels by the winter. The role of natural gas in European household’s energy mix will decline. Currently, EU households are the largest natural gas consumers and account for 41% of the bloc’s gas consumption (Chart II-7). It will be easier to replace their natural gas consumption over time with other sources of energy than it will be to cut the industrial sector’s consumption extensively. As a result, even if European natural gas imports are permanently below 2021 levels, the industrial sector will not bear the brunt of the adjustment. Chart II-7Households To Be Displaced These developments imply that natural gas prices have limited downside. However, we believe that the worst of the spike in prices is behind us, at least over the near term. The reason is that the inelastic buying created by the inventory re-stocking exercise since May 2022 is ending. In fact, the German Federal Minister for Economic Affairs and Climate Action, Robert Habeck, declared last week that his country would no longer purchase gas at any price. Chart II-8The Most Painful Part Of The Adjustment Is Over If prices stabilize around €200/MWh, European industrial activity will continue to face a headwind, but the worst of the adjustment process will be in the rearview mirror as natural gas inflation recedes (Chart II-8). Ultimately, capitalist systems are dynamic, and it is this rapid change in price that causes the most pain. In other words, the impoverishment of the European private sector has already happened. Steady states are easier to manage. Moreover, if natural gas prices eventually follow the future’s curve (this is a big “if”), the picture for Europe will improve considerably. One additional mitigating factor should ease the pain being experienced by the European private sector. Fiscal policy is responding very aggressively to the current energy crisis. So far, EU countries and the UK have allocated more than €500 billion to protect their private sectors against higher energy costs (Chart II-9) and the UK just announced tax cuts of £45 billion. This is in addition to the disbursement of €150 billion from the NGEU funds in 2023. Moreover, the European commission is planning to modify the EU fiscal rules to abandon annual structural deficit targets and for debt sustainability to be evaluated over a ten-year period. Bottom Line: The worst of Europe’s adjustment to higher energy prices is now behind us. However, European energy prices will remain elevated, which will continue to put Europe at a handicap compared to the rest of the world. Chart II-9Massive Fiscal Support Bad News From The Rest Of The World Chart II-10A Global Recession This Way Comes The worst of Europe’s energy crisis is behind us, but the world is teetering toward a recession, which will hurt the trade- and manufacturing-sensitive European economy. The tightening in global financial conditions created by the surge in the dollar and by the jump in global yields is pushing the US Manufacturing ISM and the Euro Area PMIs toward the low-40s, which is consistent with a recession (Chart II-10). The problem does not stop there. Global central banks have become solely focused on fighting inflation. For 2023, the FOMC’s dot plot forecasts both an interest rate rise to 4.6% and a 0.7% increase in the unemployment rate. This is tantamount to the Fed telling the market that it will increase interest rates as a recession emerges to repress inflation. Not to be undone, European central banks are also rapidly increasing their policy rates, even as they also forecast an imminent deterioration in domestic growth conditions. Quickly tightening policy in a slowing growth environment, especially as the dollar hits a 20-year high, is a recipe for a financial accident and a global recession. Chart II-11No Help From China Moreover, China’s economy is still unable to create a positive offset to the deterioration in global monetary and financial conditions. The marginal propensity of China’s private sector to consume remains in a downtrend, hampered by the country’s zero-COVID policy and the continuing meltdown in real estate activity (Chart II-11). Furthermore, the most rapid decline in the yuan exchange rate in 5 years is imparting an additional downside risk to the global economy. European stocks are uniquely exposed to these threats. Europe overweights deep cyclicals, which are currently squeezed by the deteriorating global growth outlook. The message from the collapse in FedEx’s stocks on very poor guidance is particularly ominous: this company has a much closer correlation with the Dow Jones Euro STOXX 50 than with the S&P 500 (Chart II-12). European share prices are already factoring in much of the bad news. Valuations are significantly less expensive than they once were. The Shiller P/E ratio of European equities and their equity risk premium stand at the same levels as those in the 1980s. This is in sharp contrast to the US (Chart II-13). Chart II-12FedEx's Gloomy Delivery Chart II-13Low CAPE In Europe   European forward earnings have also already done considerable work adjusting downward. Excluding energy, 2022 and 2023 forward EPS are down 11.7% and 13.3% since their peak, respectively (Table II-1). But inflation flatters earnings growth and European large-cap indices are dominated by multinational firms, which implies that looking at earnings in USD terms makes more sense. In both real and USD terms, 2022 and 2023 forward EPS, excluding energy, are already down 28.7% and 30.1%, respectively. These adjustments are in line with previous recessions. Table II-1A Deep Downgrade To European Earnings The counterargument is that analysts still expect positive earnings growth in 2023 relative to 2022. However, at 4%, this increase in expected earnings is still well below inflation and 6% below the average expected growth in forward earnings recorded over the past 35 years (Chart II-14). Additionally, a global recession could put further downward pressure on energy prices in Europe, which would create an additional cushion under European earnings in 2023. The implication here is that it still makes sense to be modestly long European equities in absolute terms, especially for investors with an investment horizon of twelve months or more. However, we cannot be complacent, as the risk of an additional selloff is still too large for comfort. As a result, for now investors should only garner a small exposure to European equities and do so while favoring defensive names over cyclical ones (Chart II-15). Chart II-14Weak Forward Earnings Growth Chart II-15Continue To Favor Defensive Names   Bottom Line: European stocks must still contend with the growing threat of a global recession catalyzed by tighter financial conditions and aggressive global central banks. The good news is that they already discount considerable pessimism, as illustrated by their low valuations and downgraded forward earnings. Consequently, investors can continue to nibble at European equities, but do so to a limited degree and by favoring defensive stocks over cyclical ones, at least for now. The Euro Dilemma On the back of the very hawkish Fed meeting and the announcement of Russia’s broadened military mobilization, the EUR/USD broke below the 0.99 support level and fell under 0.98, a level we judged in the past as very attractive on a six-to-nine months basis. Obviously, Fed Chair Jerome Powell’s reaffirmation of the FOMC’s war on inflation is a major boost to the dollar. The momentum property of the greenback implies that it has room to rally further in the near term. This narrative, however, overlooks the fact that the Fed is not the only central bank intent on fighting inflation, no matter the cost. The Norges Bank, the Riksbank, the ECB, and even the SNB have all showed their willingness to move aggressively against inflation. While the BoE only increased rates by 50bps last week, its communication suggested that an at least 75bps increase would be due at the November meeting, when the MPC publishes its Monetary Policy report that will incorporate the impact of the budget measures announced by new British Prime Minister, Liz Truss. As a result, market interest rate expectations are climbing in the US, but they are rising even faster in Europe, albeit from a lower base. However, the decline in the expected rate of interest in the US relative to Europe and in the number of expected hikes in the US relative to Europe are consistent with a sharp decline in the DXY in the coming months (Chart II-16). Due to its 80% weight in European currencies, a weaker DXY implies a rebound in the EUR, GBP, CHF, NOK, and SEK against the USD. Moreover, there could be room for expected interest rate differentials to narrow further against the dollar. The analysis we published two weeks ago shows that, even when the different nonfinancial private debt loads are accounted for, the gap in the US and Eurozone r-star stands at 1%. However, the spread between the Fed funds rate’s upper bound and the ECB Deposit Rate is 2%. The gap between the July 2023 US and Eurozone OIS is 1.7%. Since European inflation may prove more stubborn than that of the US in the near term, there is scope for the expected interest rate gap to narrow further, especially as the Euro Area final domestic demand is surprisingly more robust than that of the US (Chart II-17). Chart II-16The Rest Of The World Is Catching Up To The Fed Chart II-17Surprising European Resilience   What about global growth? The view that the global economy is about to experience a recession is consistent with a stronger dollar, since the greenback is an extremely countercyclical currency. However, the DXY’s 25% rally since January 2021 already prices in such an outcome (Chart II-18). Similarly, the euro is trading again at 2002 levels, which is also in line with a global recession with deep negative repercussions for the Eurozone. Additionally, the Euro has fallen 21% since May 2021, which compares to the 21.4% fall in 2008, the 20% decline in 2010, the 18% plunge in 2011/12 and the 24% collapse in 2014/15; yet EUR/USD is much cheaper now than in any of those instances. Moreover, the wide difference between the competitiveness of Germany and that of the rest of the Euro Area has now faded, which means that a major handicap against the euro has disappeared (Chart II-19). Chart II-18The Dollar Already Foresees A Recession Chart II-19Normalizing Eurozone Internal Competitiveness     This does not mean that the euro is not without risk. First, since the major euro collapse began in June 2021, EUR/USD breakdowns have been followed by average declines of 3.6%, ranging from 2.7% to 4.2%. Since the dollar is a momentum currency, it is unlikely that this time will be different. Second, if the tightening in global policy does cause a financial accident, the dollar will catch one last major bid that could push EUR/USD toward 0.9. As a result, to mitigate the danger, we recommend setting a stop-buy in the euro at EUR/USD 0.965 or 2.6% below the breakdown level of 0.9904. This position comes with a stop-loss at 0.94. For now, we would view this bet as a tactical position if it were triggered. Bottom Line: While a hawkish FOMC is very positive for the dollar, markets now expect foreign central banks to catch up to some extent with the Fed. This process is dollar bearish. Additionally, while a global recession would be supportive of the greenback, the USD already discounts this scenario. Instead, Europe is proving surprisingly resilient, which could soon create a tailwind for EUR/USD. Set a stop-buy at EUR/USD 0.965, with a stop-loss at 0.94. Market Update: European Credit After Central Bank Week For investors concerned with the left-tail risk in European equities, European credit offers a credible alternative in the near term. This asset class is also attractive relative to European government bonds. Chart II-20Central Bank Week Taken together, the Fed, the ECB, the BoE, the Riksbank, the Norges Bank, the SNB, and the BoC have tightened policy by 475bps over the past month (Chart II-20). Moreover, the SNB’s hike closed the chapter of negative rates in Europe. But make no mistake – there will be a second chapter. Until then, European corporate bond yields have risen enough to offer attractive spreads over duration-matched government bonds and to challenge the earnings yield provided by equities (Chart II-21). Besides, the volatility observed in equity markets over the past few months makes the European corporate bond more appealing. In the Euro Area, BB-rated bonds, which are the highest credit quality and largest tranche within the high-yield space, are particularly attractive. They sport a 6.6% YTM, at a spread of 480bps over 3-year German government bond yields. This compares to an equity earnings yield of 7.4% (Chart II-21, top panel). In other European corporate bond markets, there is no need to go down in credit quality. Yields-to-maturity for investment grade corporate bonds in the UK, Sweden, and Switzerland provide appealing alternatives to equities, with shorter duration still. This is especially true in Sweden, where the equity earnings yield has collapsed and is now only 60bps above Swedish IG yield, with substantially greater risk. Meanwhile, the spread pickup offered by Swiss IG over Swiss government bonds of similar duration is at its widest in more than ten years (Chart II-21, bottom panel). This week, we turn neutral on European credit versus US credit. Back in March, we made the case that European credit would outperform its US counterpart in response to a more hawkish Fed than the ECB. Since then, European IG outperformed US IG by 1% on a total return basis. However, with the Fed funds rate at 3.25%, traders now expect more monetary policy tightening from the ECB, which often corresponds to an underperformance of Euro Area credit relative to that of the US (Chart II-22, top panel). On the other hand, Swedish IG is expected to outperform US IG over the next six months (Chart II-22, bottom panel). Chart II-21Push Back Against TINA Argument Chart II-22Heed The Message From OIS Curve Differentials         Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Jeremie Peloso, Editor/Strategist JeremieP@bcaresearch.com Footnotes

Executive Summary For the first time in a decade, it is much less attractive to buy than to rent a home. In both the UK and US, the mortgage rate is now almost double the average rental yield. To reset the equilibrium between buying and renting a home, either mortgage rates must come down by around 150 bps, or house prices must suffer a large double-digit correction. Or some combination, such as mortgage rates down 100 bps and house prices down 10 percent. In the US, a 10-year upcycle in housing investment has resulted in overinvestment relative to the number of households.  Falling house prices coming hot on the heels of a combined stock and bond market crash will unleash a deflationary impulse in 2023, which will return economies to 2 percent inflation. This reiterates our ‘2022-23 = 1981-82’ template for the markets. A coordinated global recession will cause bond prices to enter a sustained rally in 2023, in which the 30-year T-bond yield will fall to sub-2.5 percent. Meanwhile, the S&P 500 will test 3500, or even 3200, before a strong rally will lift it through 5000 later in 2023. It Now Costs Twice As Much To Buy Than To Rent A UK Home! Bottom Line: Falling house prices coming hot on the heels of a combined stock and bond market crash will unleash a deflationary impulse in 2023, which will return economies to 2 percent inflation. Feature Mortgage rates around the world have skyrocketed. The UK 5-year fixed mortgage rate which started the year at under 2 percent has more than doubled to over 5 percent. And the US 30-year mortgage rate, which began the year at 3 percent, now stands at an eyewatering 7 percent, its highest level since the US housing bubble burst in 2008. This raises a worrying spectre. Is the recent surge in mortgage rates about to trigger another housing crash? (Chart I-1 and Chart I-2). Chart I-1UK Mortgage Rate Has Doubled Chart I-2US Mortgage Rate Has Doubled A good way to answer the question is to compare the cashflow costs of buying versus renting a home. This is because home prices are set by the volume of homebuyers versus home-sellers. If would-be homebuyers decide to rent rather than to buy – because renting gets them ‘more house’ – then it will drag down home prices. Here’s the concern. For the first time in a decade, it is much less attractive to buy than to rent a home. In both the UK and US, the mortgage rate is now almost double the average rental yield. Put another way, whatever your monthly housing budget, you can now rent a home worth twice as much as you can buy (Chart I-3 and Chart I-4). Chart I-3It Now Costs Twice As Much To Buy Than To Rent A UK Home! Chart I-4It Now Costs Twice As Much To Buy Than To Rent A US Home! The Universal Theory Of House Prices Buying and renting a home are not the same thing, so the head-to-head comparison between the mortgage rate and rental yield is a simplification. Buying and renting are similar in that they both provide you with somewhere to live, a roof over your head or, in economic jargon, the consumption service called ‘shelter’. But there are two big differences. First, unlike renting, buying a home also provides you with an investment whose value you expect to increase in the long run. Second, unlike renting, buying a home incurs you the costs of maintaining it and keeping it up-to-date. Studies show that the annual cost averages around 2 percent of the value of the home.1 So, versus renting, buying a home provides you with an expected capital appreciation, but incurs you a ‘depreciation’ cost of around 2 percent a year. Which results in the following equilibrium between buying and renting: Mortgage rate = Rental yield + Expected house price appreciation - 2 But we can simplify this. In the long run, the price of any asset must trend in line with its income stream. Therefore, expected house price appreciation equates to expected rental growth. Also, rents move in lockstep with wages (Chart I-5). Understandably so, because rents must be paid from wages. And wage growth itself just equals consumer price inflation plus productivity growth, which averages around 1 percent (Chart I-6). Pulling all of this together, the equilibrium simplifies to: Chart I-5Rents Track Wages Chart I-6Rent Inflation = Wage Inflation = Consumer Price Inflation + 1 Mortgage rate = Rental yield + Expected consumer price inflation - 1 So, here’s our first conclusion. Assuming central banks achieve their long-term inflation target of 2 percent, the equilibrium becomes: Mortgage rate = Rental yield + 1 Under this assumption, to justify the current UK rental yield of 3 percent, the UK mortgage rate must plunge to 4 percent. But given that the government has just triggered an incipient balance of payments and currency crisis, the mortgage rate is likely to head even higher. In which case the rental yield must rise to at least 4 percent. Meaning either house prices falling 25 percent, or rents rising 33 percent. Meanwhile, to justify the current US rental yield of 3.7 percent, the US mortgage rate must plunge to 4.7 percent. Alternatively, to justify the current mortgage rate of 7 percent, the rental yield must surge to 6 percent. Meaning either house prices crashing 40 percent, or rents surging 60 percent. More likely though, all variables will correct. The equilibrium between buying and renting will be re-established by some combination of lower mortgage rates, lower house prices, and higher rents. The Housing Investment Cycle Is Turning Down The relationship between buying and renting a home raises an obvious counterargument. What if central banks cannot achieve their goal of price stability? In this case, expected inflation in the equilibrium would be considerably higher than 2 percent. This would justify a much higher mortgage rate for a given rental yield. Put differently, it would justify rental yields to stay structurally low (house prices to stay structurally high), even if mortgage rates marched higher. In an inflationary environment, houses would become the perfect foils against inflation. In an inflationary environment, houses would become the perfect foils against inflation because expected rental growth would track inflation – allowing rental yields to stay depressed versus much higher mortgage rates. This is precisely what happened in the 1970s. When the US mortgage rate peaked at 18 percent in 1981, the US rental yield barely got above 6 percent (Chart I-7). Chart I-7In The Inflationary 70s, The Rental Yield Remained Well Below The Mortgage Rate... If the market fears another such inflationary episode, would it make the housing market a good investment? In the near term, the answer is still no, for two reasons. First, even if rental yields do not track mortgage rates higher point for point, the yields do tend to move in the same direction – especially when mortgage rates surge as they did in the 1970s (Chart I-8). Some of this increase in rental yields might come from higher rents, but some of it might also come from lower house prices. Chart I-8...But Even In The 70s, The Rental Yield And Mortgage Rate Moved Directionally Together Second, based on the US, it is a bad time in the housing investment cycle. Theoretically and empirically, residential fixed investment tracks the number of households in the economy. But there are perpetual cycles of underinvestment and overinvestment – the most spectacular being the overinvestment boom that preceded the 2007-08 housing crisis. US housing investment has just experienced a 10-year upcycle in which it has overshot its relationship with the number of households. Therefore, contrary to the popular perception, there is not an undersupply of homes, but a marked oversupply relative to the number of households. (Chart I-9). This is important because, as the cycle turns down now – as it did in 1973, 1979, 1990, and 2007 – the preceding overinvestment always weighs down housing valuations (Chart I-10). Chart I-9The US Housing Investment Cycle Has Moved Into Overinvestment Chart I-10A Housing Investment Downcycle Always Weighs On Housing Valuations The Investment Conclusions Let’s sum up. If the market believes that economies will return to price stability, then to reset the equilibrium between buying and renting a home, either mortgage rates must come down by around 150 bps, or house prices must suffer a large double-digit correction. Or some combination, such as mortgage rates down 100 bps and house prices down 10 percent. If the market believes that economies will not return to price stability, then house prices are still near-term vulnerable to rising mortgage rates – especially in the US, as a 10-year upcycle in housing investment has resulted in overinvestment relative to the number of households.  US housing investment has just experienced a 10-year upcycle in which it has overshot its relationship with the number of households. Falling house prices coming hot on the heels of a combined stock and bond market crash will unleash a deflationary impulse in 2023, which will return economies to 2 percent inflation – even if the markets do not believe it now. This reiterates our ‘2022-23 = 1981-82’ template for the markets, as recently explained in Markets Still Echoing 1981-82, So Here’s What Happens Next. In summary, a coordinated global recession will cause bond prices to enter a sustained rally in 2023, in which the 30-year T-bond yield will fall to sub-2.5 percent. Meanwhile, the S&P 500 will test 3500, or even 3200, before a strong rally will lift it through 5000 later in 2023. Analysing The Pound’s Crash Through A Fractal Lens Finally, the incipient balance of payments and sterling crisis triggered by the UK government’s unfunded tax cuts has collapsed the 65-day fractal structure of the pound (Chart I-11). This would be justified if the Bank of England does not lean against the fiscal laxness with a compensating tighter monetary policy. But if, as we expect, monetary policy adjusts as a short-term counterbalance, then sterling will experience a temporary, but playable, countertrend bounce. Chart I-11The Pound Usually Turns When Its Fractal Structure Has Collapsed On this assumption, a recommended tactical trade, with a maximum holding period of 65 days, is to go long GBP/CHF, setting a profit target and symmetrical stop-loss at 4 percent. Chart 1Hungarian Bonds Are Oversold Chart 2Copper's Tactical Rebound Maybe Over Chart 3US REITS Are Oversold Versus Utilities Chart 4FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable Chart 5Netherlands' Underperformance Vs. Switzerland Has Ended Chart 6The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 7Food And Beverage Outperformance Is Exhausted Chart 8German Telecom Outperformance Has Started Is Fragile Chart 9Japanese Telecom Outperformance Vulnerable To Reversal Chart 10The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 11The Strong Downtrend In The 3 Year T-Bond Is Fragile Chart 12The Outperformance Of Tobacco Vs. Cannabis Is Fragile Chart 13Biotech Is A Major Buy Chart 14Norway's Outperformance Has Ended Chart 15Cotton Versus Platinum Has Reversed Chart 16Switzerland's Outperformance Vs. Germany Is Exhausted Chart 17USD/EUR Is Vulnerable To Reversal Chart 18The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 19US Utilities Outperformance Vulnerable To Reversal Chart 20The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The Rate of Return on Everything, 1870–2015 (frbsf.org) Fractal Trading System Fractal Trades 6-12 Month Recommendations 6-12 MONTH RECOMMENDATIONS EXPIRE AFTER 15 MONTHS, IF NOT CLOSED EARLIER. Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

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Please note I will be hosting a live webcast on September 29, 2022 at 9:00 AM HKT for the APAC region. I will discuss the global/China/EM macro outlooks and financial market implications. For clients in the Americas and EMEA, we had a webcast on September 28, 2022. You can access the replay via this link. Arthur Budaghyan Executive Summary Global Semi Stock Prices: Further Downside Ahead Global semiconductor stock prices are still vulnerable to meaningful downside over the next three months. Global semi consumption will contract due to the corresponding waning demand of smartphones, personal computers, and other consumer electronics. Global semi demand in sectors of automobiles and datacenters will continue growing. However, such an increase in demand cannot offset the demand reduction in other sectors. Semiconductor consumption in China has entered a contraction phase.  Semiconductor inventories have swelled. Alongside a sharp upsurge in chip production capacity, this increase in inventories will lead to chip price deflation in the next nine months. Nevertheless, the structural outlook for global semiconductor demand remains constructive. We are waiting for a better entry point for semi stocks.  Bottom Line: There is more downside in global semiconductor share prices as well as Taiwanese and Korean tech stocks. We will seek to recommend buying semiconductor stocks when a more material decline in semi companies’ profits is priced in their share prices. At the moment, we are downgrading Taiwanese stocks from neutral to underweight relative to the EM equity benchmark but are maintaining an overweight stance on the Korean bourse within an EM equity portfolio.   The global semiconductor equity index is breaking below its technical support (Chart 1). The implication is that these share prices are in an air pocket and investors should not chase a declining market. Based on previous cycles, we expect global semiconductor stocks to bottom late this year or early next year and semi sales to trough in 2023Q2. In the previous five cycles, global semi stocks always bottomed before global semi sales and lead times varied from three-to-six months. Chart 2 shows that Taiwan’s semiconductor new export orders lead global semi sales by about three months, and they continue to point to considerable downside in the global semi-industry. Chart 1Global Semi Stocks: Breaking Down Chart 2Global Semi Sales: More Downside Ahead The semiconductor industry has a history of cyclicality. Shortages have been followed by oversupply, which has led to declining prices, revenues, and profits for semi producers. This time is no exception Global Semi Sales: A Cyclical Slump Underway Global semiconductor demand began its downward trajectory in May of this year and will continue to slide in the next three-to-six months. Both the volume and value of China’s semiconductor imports are in a deep contraction and China’s imports from Taiwan have also plummeted (Chart 3). China is the world’s largest consumer of semiconductors, accounting for 35% of global demand. We expect semi sales to remain in contraction in China and to shrink in regions outside China in the next six-to-nine months (Chart 4).  Chart 3China's Semi Imports Plummeted Chart 4Semi Sales Will Contract Across Regions There are several important reasons for the retrenchment worldwide. First, the lockdowns around the world in 2020 and 2021 generated an unprecedented increase in online activities and a corresponding surge in demand for smartphones/PCs/tablets/game consoles/electronic gadgets. This was the main driving force for the boom in global semiconductor sales from 2020Q3 to 2022Q1. The excessive demand for consumer goods and electronics has run its course and global demand will sag in the next six months. As we have been contending since early this year, global exports are set to contract. Households that bought these goods in the past two years probably will not make new purchases in the near term. In addition, declining real disposable income and rising interest rates will constrain consumer spending. Smartphones, PCs, tablets, home appliances, and other household electronic goods consume about half of global semi output. In addition, rising job uncertainties resulting from China’s dynamic zero-COVID policy and slowing household income growth will curb consumption within China. Here are our takeaways for each segment: Chart 5China's Output Of Mobile Phones And PCs Has Been Shrinking Mobile phones: Mobile phones are the largest contributor to global semi sales, with a share of 31% as of 2021, based on the data from World Semiconductor Trade Statistics (WSTS). According to the International Data Corporation (IDC), global smartphone shipments are set to decline by 6.5% year-over-year in volume terms in 2022. Smartphone OEMs cut their orders drastically in 2022 because of high inventories and low demand, with no signs of an immediate recovery. China accounts for 67% of global mobile phone production and its mobile phone production has been contracting (Chart 5, top panel).   Traditional PCs and tablets: Based on data from the IDC, global traditional PC1  and tablet shipments are set to decline by 12.8% year-over-year in 2022 and by an additional 2.6% next year in volume terms. Computer production in China, which is the world’s largest computer producer and exporter, also shows massive downsizing (Chart 5, bottom panel).   Home appliances: China is also the largest producer and exporter of air conditioners (ACs), washing machines, refrigerators, and freezers. Except for a slight growth in AC output in response to heatwaves in China and Europe, China’s output of other home appliances will shrink. Globally, these industries accounted for about half of all semiconductor sales in 2021. Given the overconsumption of these goods worldwide over the past two years, we expect a material decline in these sectors in the next six-to-nine months. Second, automobiles, servers, and industrial electronics, which together account for about 30% of global semi sales, will have positive single-digit growth going forward. Yet, such an increase will not be enough to offset the lost demand from the consumer electronic goods sector in the next six-to-nine months.  Chart 6Global Auto Production Will Rise Automotive (accounts for 11% of world chip demand): The chip shortage in this sector has eased only moderately. Auto output levels in major producing countries remain well below their pre-pandemic levels (Chart 6). In light of improved foundry capacity, semiconductor producers will be able to produce automotive chips and reduce lingering shortages. However, for most chips to automakers, there are no supply shortages. Only a small number of categories of automotive chips, such as microcontrollers (MCU) and insulated-gate bipolar transistors (IGBT), are still in tight supply. Given that the total automotive sector only accounted for about 5% of total global semi sales last year, the recovery in global automobile output will contribute only limited growth to global semi sales.   Servers (account for 10% of world chip demand): The surge in online activities resulted in greater demand for cloud services and remote work applications, both of which require computer servers. Total server demand is comprised of data servers for cloud providers and private enterprises, with the former as the main driving force in recent years.  Data center expansion among cloud service providers will be driven by 5G, automotive, cloud gaming, and high-performance computing. After expanding by 10% last year, the pace of annual growth in global server shipments will likely be more moderate, to about 5%-6% in the next couple of quarters.   Chart 7Global Industrial Demand For Chips Is Set to Decelerate Industrial electronics (account for 9% of world chip demand): The growth rate in semi demand for this sector is falling. The global manufacturing new order-to-inventory ratio has plunged, and global manufacturing production is set to decline for the rest of this year and through to 2023H1 (Chart 7). Nevertheless, given structural tailwinds for industrial electronics, we expect semi demand in this sector to dip to single-digit growth in the near term rather than to contract.  Third, with semiconductor inventories having surged, new orders for chips, and hence their production, will plummet.   The length and intensity of the chip shortage, which started in 2020H2, triggered stockpiling among a broad range of customers, including manufacturers of smartphones and other consumer electronics. Moreover, the recent slowdown in smartphone/PC demand increased the inventory of silicon chips. Chart 8Semiconductor Inventory Overhang China had also stockpiled semiconductors from 2020Q2 to 2021Q4. With faltering demand, the country will continue its destocking process in the next couple of quarters. Semiconductor inventories in Taiwan and Korea have surged, corroborating the fact that the current cyclical downturn in the global semi sector will be a severe one (Chart 8). Hence, businesses in the semi supply chain will continue to draw upon their inventories rather than increase their semiconductors orders. This will reduce semiconductor demand meaningfully in the coming months. Bottom Line: The cyclical slump in worldwide semiconductor sales has further to go, with the sector’s sale volumes and prices projected to contract in the next six months. Semi producers will experience a substantial decline in their profits. Comparing Cycles Previous cycles may provide insight in the downside of the cyclical slump in global semi sales. In the previous five cycles, global semi sales experienced a contraction, ranging from 7% to 45% (Table 1). In the current cycle, global semi sales still had 7% year-over-year growth in 2022Q2 (Chart 9). Table 1Six Cyclical Downturns In Global Semiconductor Market Chart 9Global Semi Stocks And Global Semi Sales Global Semiconductor Market: Sales & Share Prices In fact, the current downturn could be deeper than the one between 2018 and 2019 (when sales contracted by 16%) for the following reasons: Sales of both cell phones and PCs will likely dwindle further this time than they did in 2018 to 2019. The pandemic boosted demand for consumer electronics, but this also brought forward future demand. In comparison with 2018, the current cycle might have a longer replacement cycle for mobile phones and PCs. Unlike 2019, global demand for consumer goods will likely contract rather than decelerate. This has ramifications for the duration and magnitude of the semi downturn.   Economic growth, and job and income uncertainties in China are much worse now than they were between 2018 and 2019. These factors will likely lead to a bigger cut in IT spending by both consumers and businesses, resulting in a larger downturn in global semi demand in this cycle. The tech battle between the US and China is more intense than in it was from 2018 to 2019. In mid-2018, the U.S. imposed a 25% tariff on Chinese imports of semiconductor goods, including machines and flat panel displays. China retaliated by imposing its own 25% tariff on U.S. exports of semiconductor goods, such as test equipment. This month, the US imposed new restrictions on NVIDIA and AMD in relation to selling artificial intelligence chips to Chinese customers. The US also plans to curb further its shipments of chipmaking tools to China. These plans will cut China’s imports of high-end semi products, for which producers enjoy high profit margins. In addition, the shortage of these chips will stall the development and sales of many consumer products within China, which will thereby reduce demand for other types of chips needed for consumer products. Chart 10Rapid Semi Capacity Expansion Worldwide Global semi capacity expansion has recently been much stronger in current cycle than it was in the 2016-2018 cycle. This may lead to a bigger supply surplus in this cycle than in the last one. It takes about 18-24 months, on average, to build a new semiconductor fabrication plant. Thus, large capital expenditures by semi producers in 2021-22 entail considerable new supply in 2023-24. According to IC Insights, the annual wafer capacity growth rates were 6.5% in 2020, 8.5% in 2021 and 8.7% in 2022. This compares with 4%-6.5% between 2016 and 2018 (Chart 10). Rapid capacity expansion typically leads to price deflation for chips and is therefore negative for the semi producers’ profitability and their share prices. Are global semi stock prices already pricing bad news? We do not think so. Nearly all major players saw a drop in revenues in the past cycle. In sharp contrast, only Intel’s revenues have dropped so far in the current cycle (Chart 11). Global semi stock prices will continue falling as companies report shrinking sales and earnings in the next couple of quarters. In former cycles when global semi stocks bottomed, investor sentiment – as measured by the net EPS revisions – was more downbeat than it is currently (Chart 12). Chart 11More Semi Companies' Sales Are Likely To Contract Chart 12Global Semi Stock Prices: Net EPS To Drop More Bottom Line: The global semiconductor sector’s cyclical slump could be deeper than it was in the 2018-2019 cycle. Hence, shares prices will fall considerably more than they did in late 2018. Ramifications For Taiwanese And Korean Markets Taiwanese and Korean semiconductor stock prices will probably continue to fall in absolute terms. The former recently broke its three-year moving average and the latter its six-year moving average (Chart 13). Chart 13Taiwanese And Korean Semi Stock Prices Will Fall Further Chart 14TSMC: Smartphone And HPC Make 81% Of Revenue For TSMC, the smartphone sector still accounts for 38% of revenues (Chart 14). Hence, a contraction in global smartphone sales in the next six-to-nine months could hurt the company’s top and bottom lines considerably. Meanwhile, the high-performance computing (HPC) sector became the largest contributor of TSMC revenues with a 43% share. A slowdown in data center investment and a decrease in GPU demand due to falling bitcoin prices will also materially affect the company’s profitability. In addition, the US government’s AI chips export restriction policy will decrease NVIDIA and AMD AI sales to China. According to NVIDIA’s news release, approximately US$400 million in potential chip sales to China (including Hong Kong) will likely be subject to this new restriction. AI chips are manufactured by TSMC with its advanced node technology and have a high-profit margin. Hence, the new policy will negatively impact TSMC’s revenues and profits. For Samsung, the memory market is in a free-fall due to plummeting demand (Chart 15). TrendForce expects the average overall DRAM price to drop by 13-18% in 2022Q4 because of high inventories in the supply chain and stagnant demand. The semi shipment-to-inventories ratios for both Taiwan and South Korea nosedived, pointing to lower semi stock prices in these two markets (Chart 16). Chart 15Samsung: Vulnerable To Sinking Prices Of Memory Chips Chart 16Semi Shipments-to-Inventory Ratios Plunged In Taiwan And Korea Bottom Line: Both TSMC and Samsung stock prices have more downside over the next three months.  Equity Valuations And Investment Conclusions The global semiconductor stock index in USD terms has tumbled by 45% from its recent peak. Multiples of semiconductor stocks are near their long-term average levels (Chart 17 and 18). These multiples could undershoot as they did in 2018-2019, which means even more downside is ahead. Chart 17Multiples Of Semi Stocks Could Undershoot Chart 18Multiples Of Semi Stocks Could Undershoot Aside from the profit outlook, higher US bond yields are also causing multiple compression for global semiconductor stocks (Chart 19). As to the allocation to semi stocks within an EM equity portfolio, we recommend downgrading Taiwan from a neutral allocation to underweight and reiterate an overweight stance on the KOSPI. The US-China geopolitical confrontation will escalate in the coming years and Taiwan is at the epicenter of this. These are relative calls, that is against the EM benchmark (Chart 20). We remain negative on their absolute performance. Chart 19Higher US Bond Yields = Multiple Compression In Global Semi Stocks Chart 20Downgrade Taiwan To Underweight Relative To The EM Benchmark   Finally, the structural outlook for global semiconductor demand remains constructive. We are waiting for a better entry point. We would recommend buying semiconductor stocks after pricing in a more material contraction in semi companies’ revenues and profits. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Footnotes 1     Traditional PCs are comprised of desktops, notebooks and workstations.

特別レポート

エグゼクティブ・サマリー 堅調な労働市場と大量のパンデミック期貯蓄という強力な支えによって、家計は広く認識されているよりも良好な状態にあるという当社の見方は変わりません。 株式の弱気相場が、今後数四半期にわたって消費が経済を支え続けるという当社のベースケースを覆すとは考えていません。経験的には、株式の富の変化は消費にほとんど、あるいはまったく影響を及ぼしていません。 住宅は明瞭な富の効果を持ち、消費は株価上昇よりも下落に対して敏感である可能性があります。多くの投資家が恐れている急激な住宅価格下落は、住宅所有者に引き締めを促し得るため、当社の建設的見方にとって最大のリスクとなります。 住宅価格の上昇率は減速しているものの、住宅は供給不足の状態が続いており、住宅価格が急落することはないでしょう。住宅バブル論は根拠がありません。   消費の低下はまれである 消費の減少はごくまれだ 消費の減少はごくまれだ 要点：株式の弱気相場も住宅市場の軟化も消費を萎縮させることはないでしょう。FRBのインフレ対策キャンペーンは最終的に景気後退を引き起こすでしょうが、富の効果に関する懸念は大げさです。 特集 2020年および2021年にかけて蓄えられた過剰貯蓄の山を切り崩す好況にある消費者が、リスク資産と経済に対する当社の短期的な建設的見方の基盤を提供しています。消費者の引き締めは当社見解に対する二大リスクの一つ1であり、家計のかなりの割合が支出を削減し始めた場合には、当社はこの見解を放棄します。家計がトレンドに近いペースで消費を維持するために貯蓄を取り崩すかどうかを我々は知りませんが、銀行預金を膨らませた財政移転の規模は前例がなく、低水準かつ低下中の貯蓄率は当社の論旨を継続的に裏付けるものと考えます。家計は危機後のトレンドに対して持続的に貯蓄を取り崩すことが可能です（チャート1）、というのも貯蓄率が5%であれば残りの2.1兆ドルの蓄えは四半期ごとにわずか1500億ドルしか取り崩されないためです。   チャート1 長期にわたる貯蓄取り崩しは持続可能である 長期にわたる貯蓄の取り崩しは持続可能である 長期にわたる貯蓄の取り崩しは持続可能である 富の効果は実在します—家計支出は富とともに変動します—が、株式の弱気相場の只中で、そして住宅ローン金利が3ポイント上昇して住宅価値に圧力がかかる状況で消費者が消費を続けるかどうかは疑問でしょう。直感に反するようですが、株式の富の変化は消費に対して控えめで一貫性に欠ける影響しか与えていません。住宅の富の変化のほうがより大きな影響を与えており、著名な研究者によるある研究では、住宅価格が下落する場合にその効果がより強くなることが示唆されています。本レポートでは、株式および住宅の富の効果に関する経験的証拠と、住宅価格の急落の見通しを検討します。 何が支出を動かすのか？ 富の効果について多く語られますが、消費者支出は主として所得の関数です。我々が行った全ての多変量回帰分析（ボックス1）は、名目所得の変化が名目消費の変化の大部分を説明していると示しており、その推計は最大で75%に達します。実質消費を実質所得および実質の株式・住宅富で回帰した場合、所得の影響推計は大幅に低下し通常10〜25%の範囲となりますが、モデルの堅牢性は著しく低下しました。したがって本レポートの残りでは名目の関係に着目しますが、実質回帰も名目回帰が示唆する「株式富の変化は消費変化を説明する上でほとんど無関係である」という鋭い示唆を補強したことには注意します。 ボックス1：回帰分析の復習 多変量線形回帰は、どの独立変数が従属変数の動きを説明しているかを明らかにする統計手法です。回帰分析は独立変数と従属変数の経験的関係に基づき独立変数の統計的有意性を明らかにします。関係が偶然に起こったとは考えにくいほど堅牢であれば、その独立変数は有意と見なされます。 回帰方程式は各観測値の線からの偏差の合計を最小化する最良適合線を記述します。定数項 b は最良適合線が y 軸と交差する点を示し、x 項は各独立変数を表し、それぞれに係数 a が付されます。各係数は独立変数の値の変化に対する従属変数の感応度を表します。従属変数 y と独立変数 x1, x2, …, xn に対する方程式は次のように表されます： y = a1x1 + a2x2 + … + anxn + b。 回帰の堅牢性は 0 から 1 の範囲の決定係数（r二乗値）で示され、従属変数の変動のうち独立変数の変動で説明される割合を定量化します。 本調査では、消費と所得の尺度として国民所得勘定の個人消費支出と個人所得を使用しました。株式富の測定には、FRBの四半期報告「Financial Accounts of the United States（Z.1）」における家計および非営利団体が保有する企業株式の項目を使用し、住宅富の算出には Case, Quigley and Shiller（2005および2013）の方法論に従いました2。3また、変数の値の自然対数の前年比変化率を回帰に用いる点でも Case, Quigley and Shiller の方法論に従いました。 住宅は株式に勝る 単回帰（単一の独立変数が従属変数に与える経験的影響を測る）では、株式富の変化は住宅富の変化に比べて消費変化への影響がかなり小さいことが示されています。2四半期ラグで、前年比の消費は株式富が1ドル動くごとにほぼ3セント変化しました（チャート2）。3セントという数値は経験則に沿ったものですが、この回帰の決定係数は3%未満である点に留意してください。ラグなしの前年比回帰では、株式富が1ドル動くごとに0.6セントの消費変化を示し、決定係数は微小な0.1%に留まります。 チャート2 株式と消費の関係は弱く信頼できない、… 世帯資産 世帯資産   住宅富の回帰は、住宅富の1ドルの変化が消費に38セントの変化をもたらすことを示しています。決定係数は38%で、住宅富の回帰は明らかに適合度が高く（チャート3）、その関係に対する信頼感を高めますが、消費に影響を与える他の変数の役割を考慮しない限り不完全です。住宅の関係はラグなしの方がはるかに強いことも示されます（表1）。 チャート3 … 対して住宅の引力はより強く一貫している 家計資産 家計資産   表1 単回帰の出力 家計の資産 家計の資産     チャート4 株式は限界消費性向の低い家計に所有されている 家計の資産 家計の資産   住宅富の変化が、目に見えやすい株式の変化よりも消費に強い影響を与えることは驚くかもしれません。これは住宅所有の幅広さによると考えられます。世帯のほぼ3分の2が住宅を所有しており、富裕層を除けば住宅が最大の資産であることが大多数です。一方、株式所有は高度に集中しており、富裕層上位1%の世帯が株式の50%以上を保有し、上位10%でほぼ90%を保有しています（チャート4）。株式市場の変動は主に限界消費性向の低い家計に影響しますが、住宅価格の変動はより広範な米国民に影響を与えます。 単回帰の結果は、我々が行った多変量回帰で確認され、先行研究者の所見を支持しました。所得が消費の主要な駆動因子であり、名目所得が1ドル変化すると名目支出は65〜72セント変化し、モデルにおけるその統計的有意性は疑いの余地がありません（表2）。 表2 重回帰の出力 家計の資産 家計の資産   株式の富の効果は、ラグなしモデルでは5%の有意水準で統計的に有意ではありません（寛容な10%有意水準でも有意とは言えません）し、いずれにせよその大きさは控えめで（ドル当たり約1.5セント）、独立変数として株式富を含めない方がモデルの適合度は良くなります。消費を2四半期ラグさせたモデルでは適合度がやや良く、富の効果が即時に生じないという我々の直感にも合致し、株式富が1ドル増えるごとに消費は3セント減少し、1ドル減るごとに消費は3セント増加するという逆の動きが示されます。この結果は統計的に有意ですが、理解しづらい面があります。 住宅富の変数は1%の有意水準でも十分に有意であり、その影響はラグなし仕様で14.5セント、2四半期ラグ仕様で11.75セントとかなり大きいです。両モデル仕様は高い決定係数を生み出し、それぞれ消費の変動の58%および60%を説明しており、パンデミックが消費とその駆動因子の関係をかき乱す前の期間ではモデル化された値は実際の値に非常によく適合していました（チャート5）。   チャート5 パンデミック前の高い適合度 パンデミック前の逼迫 パンデミック前の逼迫 また、モデルの一例として可処分所得（Disposable Income）を個人所得の代わりに用いるバージョンも試しましたが、説明力はやや弱まり、より広い意味の個人所得シリーズがより良い入力であると判断しました。さらに、FRBの四半期Z.1報告の家計の不動産保有額と住宅ローン残高を用いて、総住宅富を純住宅富に変換する要因を計算するバージョンも実行しました。すなわち全ての家計が住宅を無借金で所有しているわけではないことを反映させました4。純住宅富に置き換えるとモデルの説明力は約2ポイント低下しましたが、個々の変数の有意性は概ね維持され、住宅のラグなしおよび2四半期ラグの富の効果はそれぞれ7セントおよび5セントに低下しました（表3）。純住宅富は理論的には総住宅富よりも満足のいく指標であり、より小さな富の効果推計は査読済み文献と整合します。 表3 純住宅富を用いた重回帰の出力 家計の富 家計の富   住宅価格はどこへ向かうか？ 主要な反復売買価格指数の過去50年の歴史において名目価格の下落は稀であるにもかかわらず、投資家は大幅な住宅価格下落に備えているようです。ケース・シラー・ナショナル・インデックスは連続的なベースで見ると下落したのは19%に過ぎず、前年比では14%に過ぎません（チャート6）。1Q07から1Q12までの21四半期連続の前年比下落を除けば、ケース・シラー・ナショナル・インデックスが前年比で下落したのは41年でわずか5四半期のみであり、すべて1990〜91年のリセッション時に集中しており、その際は税法の変更により個人が不動産投資の損失から恩恵を受ける能力が急減しました。FHFA（旧 OFHEO）住宅価格指数が前年比で下落したのはわずか11%であり、2007〜2012年の期間外で下落が発生したのは1回だけです（チャート7）。   チャート6 危機を除けば、下落は稀である、… 危機を除くと、下落はまれで、... 危機を除くと、下落はまれで、... ​​​​​​   チャート7 … 両主要シリーズにおいて ... 両方の主要シリーズで ... 両方の主要シリーズで ​​​​​​ したがって下落を予想する投資家は極端なアウトライヤーにアンカリングしているように見えます。我々は「住宅バブル」という語が今日の状況を金融危機前のそれと同一視するために使われるたびに眉をひそめます。断じて違います：住宅金融市場は2007年の状況とはあらゆる面で異なります。居住用モーゲージの貸し出しは危機前の時期に比べてはるかに優良な借手に対して行われており（チャート8）、ローン・トゥ・バリュー比率はバブル崩壊直後から25ポイント低下し、1980年代初頭の容易に持続可能な水準に回帰しています（チャート9）。   チャート8 モーゲージはより良い借手に拡大されている … 家計資産 家計資産   チャート9 … 危機前よりも良好な条件で ... 危機前よりも有利な条件で ... 危機前よりも有利な条件で   チャート10 住宅供給は逼迫している 住宅供給はひっ迫している 住宅供給はひっ迫している 住宅は広範に供給不足であり、これは記録的な低い空き住戸率が示しています（チャート10）。高いモーゲージ金利は確かに一部の志望買主の月々の支払いを手の届かないものにし、彼らを傍観者に追いやっていますが、供給は依然制約されているため住宅価格はゆっくりとしか下落しません。カーネマンとトヴェルスキーは、人々は値上がりした資産は売って利益を確定するのが速い一方、含み損のある資産からは手放すのが遅いことを示しました。たとえ住宅価格の最終的な下落幅を過小評価しているとしても、下落が突然に起こることはないと確信しています。売却のタイミングを裁量で決められる住宅所有者は売るのを待つでしょう；価格が軟化すると回転率は低下し、供給の減少が下落を緩和する手助けをします。 投資への示唆 我々が住宅富の効果を検討するきっかけとなったのは、2週間前の有力なマーケット誌に掲載された驚くべき主張でした。ある独立系ストラテジストは、住宅価格が1ドル下落した場合の富の効果が驚異の40セントであり、同じ規模の株価下落の効果は10セントだと述べていました。その主張は、その刊行物によりコメントや批判なしに伝えられましたが、同誌は長年にわたり懐疑主義と強気の主張を鵜呑みにしない姿勢を掲げてきました。残念ながら、弱気の主張に対してはその基準が適用されないようで、どれほど的外れであっても批判がなされませんでした。（我々の結果に基づけば、これらの富の効果推計は単回帰に基づくものと推察されます。） 見解の相違がマーケットを形成しますが、査読済み研究の本体には、直接保有株式が6.5兆ドル減少し、仮に住宅持分が6月30日時点でほぼ30兆ドルから10%下落したとしても、それがそれぞれ6500億ドルおよび1.2兆ドルの消費を消し去るという考えを支持するものは何もありません。合計で約2兆ドルの打撃は、現在の年率換算で約17兆ドルの消費を考えれば痛烈なものです。それはまた前例がありません：個人消費支出（Personal Consumption Expenditures）シリーズが1950年に開始されて以来、名目消費が肉眼で見て明らかなほどに減少したのは大恐慌を除くとリーマン危機とCOVIDパンデミック時のみでした（チャート11）。これらの歴史的な減少は、2008年第3四半期のピークから2009年第2四半期の谷までで3.5%、および2020年第4四半期のピークからロックダウンでの2021年第2四半期の谷までで11.4%に相当しました。   チャート11 名目支出の目に見える減少は稀である 名目支出の顕著な減少は稀である 名目支出の顕著な減少は稀である 我々は、核戦争や別のパンデミックがない限り、さらに11%の減少があり得るという見方には喜んで反対の立場を取ります。金融危機は銀行システムの翼が規制により徹底的に切り取られた今、再び起こり得ない一連の出来事から生じたため、我々は3.5%の大恐慌期に匹敵する下落も達成困難であると考えます。すべての投資家が住宅市場に関する「空の恐怖」を信奉しているわけではありませんが、「バブル」という語が乱用されることの多さは、合意見解が悲観的な経済結果の確率を過大評価していることを強く示唆しています。後に出来事が明らかになってショック確率が過大評価されていたことが分かれば、合意的な経済見通しおよび S&P 500 の収益見通しは上方修正されねばならず、我々はその修正がリスク資産に今年失った一部の地歩を回復する道を提供すると信じています。そうした修正が行われる前に全面的なディフェンシブな資産配分を実行するのは時期尚早であると引き続き考えます。   Doug Peta, CFAチーフ 米国投資ストラテジストdougp@bcaresearch.com 脚注 1      長期的なインフレ期待の急騰がもう一つのリスクです。 2      Case, Karl E., John M. Quigley, and Robert J. Shiller, “Comparing Wealth Effects: the Stock Market versus the Housing Market,” Advances in Microeconomics, 5(1),2005: 1-32. Case, Karl E., John M. Quigley, and Robert J. Shiller, “Wealth Effects Revisited: 1975-2012,” NBER Working Paper 18667, January 2013. 3      Case, Quigley and Shiller は時点 t における住宅富 HWt を、米国の世帯数 Nt、住宅所有率 ORt、基準期間（我々の研究では1Q75）における単世帯平均住宅価格 AVGBASE、および基準期間値に対する加重反復売買価格指数（PIt/PIBASE）の積として計算しています。我々は AVG と PI の変数について、それぞれ全米リアルター協会（National Association of Realtors）の既存住宅平均価格シリーズとケース・シラー・ナショナル・インデックスを使用し、以下の式に従いました： HWt = Nt × ORt × AVG1Q75 × (PIt/PI1Q75) 4     HWt（第二脚注で説明）は総住宅富の尺度です。我々は未払い住宅ローン残高を家計の不動産保有額で割って住宅ローンの総合的なローン・トゥ・バリュー比率 LTV を計算しました。NHW を推計するために 1 – LTV を HWt に乗じて家計の総住宅持分の割合を求め、これを HWt から算出しました： NHWt = HWt × (1 – LTVt)

Executive Summary The USD has appreciated by over 25% since the beginning of 2021. This is a negative for US corporate sales and profits and is a drag on US equity performance. According to BCA FX strategists, the USD is likely to roll over as it appears overbought and overvalued. However, even if the USD has peaked, the effects of its appreciation will be imprinted in the earnings of US corporates for months. Our earnings model signals an earnings recession, with earnings expected to contract to the tune of 20% into the year-end. Technology and Materials are most exposed to the dollar, while Utilities, Financials, and Real Estate are the most domestic sectors. Growth is a more international style than Value, while midcaps offer the best protection from a stronger greenback. USES Model Breakdown Bottom Line: While a strong dollar is certainly a headwind for US earnings growth and for the performance of US equities, its adverse effects are minor compared to the effects of tighter monetary policy, slowing growth at home and abroad, rising costs, falling productivity, and fading pricing power. An earnings recession is inevitable. Dollar depreciation will be a welcome development, yet the dollar should be the least of investors’ worries. Feature The USD has appreciated by over 25% since the beginning of 2021 (Chart 1), a concerning development for US equity investors. The S&P 500 companies derive roughly 40% of sales from abroad and the strong dollar is a headwind: Not only does an appreciating domestic currency diminish foreign earnings through a currency translation effect, but it also makes US goods and services more expensive and less competitive in a global marketplace. Related Report  US Equity StrategyUS Dollar Bear Market: What To Buy & What To Sell Over the past few months, a number of US multinationals have complained about the adverse effect of the strong greenback on their sales and earnings. The list is both long and diverse and includes technology giants like Microsoft, Dell, and Netflix as well as the likes of Philip Morris, Johnson and Johnson, TJX, and Costco. Investors paid attention: Since the beginning of 2021, US companies with a high share of international sales underperformed their more domestically oriented counterparts by about 20% (Chart 2). However, partially this divergence in performance may be explained by the international index heavily overrepresenting Tech, which has headwinds of its own. Chart 1The USD Has Appreciated By Over 25%​​​​​​ Chart 2US Multinationals Have Underperformed​​​​​​ In this week’s report, we will analyze the effects of the stronger dollar on US corporate earnings, zooming in on its implications for the S&P 500 sectors and styles. Sneak Preview: A strong dollar is a definite negative for US corporate sales and profits and is a drag on US equity performance. However, when compared in magnitude to the effects of tighter monetary policy, slowing growth, and rising costs – the dollar should take a backseat to the other investor worries. USD: The Best House On The Worst Street The reasons for the rapid rise of the USD are manifold. The following are just a few: The Dollar smile: The USD outperforms when global growth is strong and investors are optimistic, as well as when growth slows and investors are fearful, benefiting from its status as a reserve currency. Over the past two years, both scenarios have played out. In 2021, investor flows pushed the dollar higher as the US was ahead of the rest of the world in terms of post-pandemic recovery. This year, the USD became a safe haven for jittery investors and became one of the rare assets delivering positive returns in the “sea of misery.” Chart 3Rate Differentials Favored The US The US looks good compared to other regions: Despite its own economic maladies, such as high inflation and slowing growth, the US has been in an advantageous position compared to the rest of the world. The US appears well insulated from global shudders compared to Europe, which is in the midst of a recession and an energy crisis, China roiling from the zero-COVID policy and property market fallout, and EM countries on the verge of food and energy shortages. Interest rate differentials: The Fed is being viewed as the most credible central bank to curb inflation. As a result, US rates have risen more than in other markets (Chart 3). The USD has been strengthening as the US has been enjoying relative stability and better growth compared to the other regions. The Fed is also ahead of the curve. Will The USD Appreciation Continue? BCA FX Strategist Chester Ntonifor does not expect the dollar to continue to appreciate for the following reasons: While the Fed is ahead of the curve, other central banks are also becoming more hawkish. As such, interest rate differentials will not materially move further in favor of the dollar. Inflation is a global problem as opposed to US-centric. Thanks to the Fed’s aggressive policy stance compared to the other central banks, the inflation impulse is slowing in the US, relative to a basket of G10 countries (Chart 4). In addition, the dollar is expensive, overbought, and is a crowded consensus trade (Chart 5). Chart 4The US Inflation Impulse Has Turned​​​​​ Chart 5The Dollar Is Overvalued On A PPP Basis​​​​​​ We concur. While we will not outright bet against the dollar, to our mind, risks are skewed to the downside. The dollar must be close to its peak, and we are neutral on a tactical basis. Effects Of USD Moves On S&P 500 Sales And Earnings Growth It Takes Time While US dollar appreciation may have come to an end, its toll will be imprinted on US earnings growth for a while. There is a lag between currency appreciation and its effects on company sales and earnings: It takes companies three to six months to change contracts, adjust prices and record revenue (Table 1). Stronger Dollar: Lower Sales And Lower Costs It is foreign sales that are most affected by the variation in the purchasing power of foreign currencies relative to the dollar (Chart 6). And while US multinationals hate the strengthening dollar, they also get a hand from it on the cost side of the equation, especially if they outsource a sizeable part of production abroad. Thus, the net effect on profits depends on the cost structure and the type of business. That explains why changes in the dollar are never one-to-one to changes in earnings growth. Table 1Sensitivity Of EPS YoY% To USD YoY% Over Time Modeling Effects Of A Stronger Dollar In the “Is An Earnings Recession In The Cards?” report published this past June, we introduced our EPS Growth Forecast Model (Table 2). The model has five intuitive factors: Chart 6The USD Primarily Affects Sales​​​​​​ Table 2EPS Growth Forecast Model ISM PMI is a gauge of US economic growth and a proxy for top-line growth. PPI stands for the change in costs. Pricing Power is a BCA proprietary indicator and captures companies’ ability to pass costs onto their customers. HY Spreads indicate costs of borrowing and also the state of the economy (spreads tend to shoot up in a slowing economy). USD represents the ability of US multinationals to sell goods abroad. These five factors explain 65% of the variation in earnings growth,1 and all factors are statistically significant. Earnings Recession Is Still In The Cards Back in June, we predicted an earnings recession later this year. After all, economic growth is slowing at home and abroad, and demand is rolling over while costs are rising, especially wages. Making things worse, productivity is falling, and Unit Labor Costs (ULC) hit nearly 10% in August. At the same time, consumers are reeling from rising prices, while companies are coming to realize that their ability to pass on costs to customers is pushing the limit. We have updated the model with three more months of data and expect earnings to start contracting in the third quarter, falling as much as 20% in the fourth quarter (Chart 7). None of this is surprising. S&P 500 margins have fallen by 2% in the second quarter, and earnings growth ex Energy came in at -2% on a nominal basis. Analysts expect six out of 11 S&P 500 sectors to deliver negative EPS Growth in Q3-2022. And while a 20% earnings drawdown sounds terrible, it is fairly mild compared to recent recessions – at the worst point in 2008, nominal earnings went to 0, printing a -100% contraction (Table 3). Chart 7The BCA Earnings Model Predicts A Earnings Recession Later This Year​​​​​​ Table 3The S&P 500 Earnings Drawdowns Here, we would like to emphasize that financial econometrics is not an exact science, and earnings growth point estimates are rarely precise. However, it is abundantly clear that earnings growth will trend well past the zero mark. Costs And Pricing Power Are Key Drivers Of S&P 500 Earnings In 2022 Breaking down the negative earnings growth forecast into contributions from different factors (Chart 8), we observe that the outcome is mostly driven by the interplay between PPI and Pricing Power – costs are rising and companies’ ability to pass them on further defines their profitability. And while commodity prices have fallen, these changes will take a while to flow into earnings. In addition, tighter monetary policy and slowing growth are the new speed bumps (HY Spreads and ISM PMI). Chart 8Interplay Of PPI And Pricing Power Drives The Direction Of Earnings Chart 9The USD Contribution Is Negative… USD Is Less Important So what about the dollar? According to our model, 1% of dollar appreciation is shaving off roughly 50bps from earnings growth. However, we need to keep this number in context. While the dollar has appreciated more than 25% since the beginning of 2021, only the last three to six months matter on a rolling basis. And over the past three months, USD has appreciated by about 8%, which will detract 4% from earnings in Q4-2022 (Chart 9). The importance of the USD for earnings growth is fairly minor compared to the other factors, such as pricing power, PPI, HY spreads, and ISM PMI (Chart 10). Chart 10... But Is Minor Compared To The Other Factors Bottom Line: A strong dollar is a headwind for earnings growth. However, its effects are dwarfed by other factors. Sectors Most Affected By The Strong Currency And Weakening Global Growth Table 4The S&P 500: % Of Foreign Sales By Sector While the overall negative effect of a strong dollar on the S&P 500 earnings is relatively minor, some sectors in the index are more exposed than others (Table 4). While the S&P 500 derives about 40% of sales from abroad, the Technology and Materials sectors have about 60% of foreign sales, and for the companies in these sectors, a strong currency is a serious concern. Utilities, Financials, and Real Estate are the most domestic in the index. It is important to note, that, at present, US multinationals are dealing not only with the effects of a stronger currency but also with global growth slowdown. Effects Of Strong Dollar On US Equity Performance While over the long term, a link between earnings growth and equities performance is irrefutable, in the short run, there may be significant variations. In this section, we will look at the relationship between equity returns and the USD. We will also isolate sectors and styles that are best positioned to withstand the current environment. And when the dollar swoons, we will also know which parts of the equity market are most likely to bounce back. USD Dollar Regimes To better understand the relationship between equity returns and the USD, we demarcate two distinct USD regimes, defined rather simplistically as “USD Rising” and “USD Falling” (Chart 11). Then we compile median monthly returns in each regime and keep track of how many months the S&P 500 was positive in each. Chart 11The USD Regimes Chart 12The USD Is A Headwind For The Performance Of Equities We found that when the USD is appreciating, median monthly returns are only 0.5% and are positive only 37% of the time. However, when the dollar is depreciating, median monthly returns are 1.4% and are positive 63% of the time (Chart 12). This relationship is significant at a 10% confidence level. Sector Performance Under Different USD Regimes When the USD rises, more defensive sectors, such as Utilities, Healthcare, and Consumer Staples tend to outperform. Energy has made the list thanks to the recent rally – normally Energy does not benefit from dollar strength (Chart 13). Chart 13Materials And Comm Services Will Outperform If The USD Turns The weakening dollar supports Materials as it stimulates demand, as well as the Communications sector, as it is home to multinational media and entertainment companies like Netflix, Facebook, and Google. Style Performance Under Different USD Regimes Growth Vs Value: Growth is more exposed to the USD than Value thanks to the index composition (Chart 14). Growth is home to Tech as well as Media & Entertainment, and “growthy” Consumer Discretionary, all of which have a higher share of earnings from abroad than the index. Value is dominated by Financials, Industrials, and Utilities, which are fairly domestic. Thus, while over time, exposure to the dollar fluctuates, over the long term, Growth is clearly more sensitive than Value (Chart 15). Chart 14Growth Is Dominated By Multinationals​​​​​​ Chart 15Growth Is More Exposed To The USD Than Value​​​​​​ Chart 16Mid Is A More Domestic Asset Class Than Small Small Vs Mid: According to a popular belief, small caps are insulated from currency moves as they don’t have reach and scale and earn very little outside of the US. However, small caps are often part of the ecosystem and supply chain of multinationals, and when the profitability of those is under pressure, they also start to feel the heat. Small caps have little leverage with their large clients and their profitability changes with the ebbs and flows of their larger brethren. Hence, they are quite sensitive to currency moves. Arguably, it is midcaps that are the most domestic asset class, as their exposure to the USD is less and more stable compared to the S&P 500 and small caps (Chart 16). Midcaps are usually not big enough to have much international reach but are big enough to have bargaining power with their multinational customers to guard their profitability. Investment Implications The S&P 500 derives roughly 40% of sales from abroad, which makes its earnings quite sensitive to dollar moves and global growth. The recent dollar bull market and slowing growth abroad have challenged US corporates and have detracted from their profit growth. However, slower growth, rising costs, and diminished pricing power by far dwarf the effects of the dollar. Overall, challenges at home and abroad are likely to trigger an earnings recession, which in all likelihood, has already started this summer, and is about to get worse. The dollar may be close to its peak, and our colleagues from the FX team expect dollar devaluation over the long term. A turn in the dollar will offer some respite for the performance of US equities despite the domestic backdrop of slowing growth and rising rates. It will also trigger a change in leadership, with sectors such as Materials and Communications rebounding from their lows. In terms of styles, a strong dollar lends support to Value, thanks to its sector composition. Once the dollar starts to depreciate, Growth will get another tailwind towards recovery. And lastly, midcap is one area in the US equity market somewhat more insulated from currency moves. Bottom Line While a strong dollar is certainly a headwind for US earnings growth and for the performance of US equities, its adverse effects are minor compared to the effects of tighter monetary policy, slowing growth at home and abroad, rising costs, falling productivity, and companies, diminished ability to pass on costs to customers—who are already strapped by rising prices. In short, dollar depreciation will be a welcome development, yet the dollar is the least of investors’ worries.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com Footnotes 1      The model’s adjusted R-squared is 0.65. Recommended Allocation

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Executive Summary What To Do With The Euro? The outlook for European assets is uniquely muddled. European energy prices will remain elevated, but the worst of the adjustment is already behind us. The global economy is teetering on the edge of a recession and weak global growth is historically very negative for European assets. However, European valuations and earnings forecasts already discount an extremely severe outcome for global growth. A hawkish Fed should support the dollar, but investors increasingly realize foreign central banks are fighting inflation equally aggressively. The dollar already anticipates a global recession. Meantime, European credit offers a large spread pickup over sovereigns and even appears as a decent alternative to equities. Within a credit portfolio, we adopt a more cautious approach towards European investment grade bonds (IG) relative to their US counterpart. Instead, we recommend favoring UK IG over Euro Area IG as well as Swedish IG relative to US IG.    Recommendations INCEPTION DATE RETURN SINCE INCEPTION (%) COMMENT Set a stop buy at EUR/USD 0.9650 with a stop-loss at 0.9400 9/26/2022     Bottom Line: Investors should maintain a modest long position in equities in European portfolios, with a preference for defensive stocks over cyclicals. The conditions are falling in place to buy the euro tentatively.   Following the hawkishness that transpired from the Fed press conference and revised forecasts last week, EUR/USD plunged below 0.99 and hit a 20-year low. Moreover, President Vladimir Putin’s announcement of a broader mobilization of the Russian army is stoking fears that the Ukrainian conflict will only be prolonged. The prospects of a lengthier war and greater energy market shock are raising further worries for Europe’s growth outlook, which weighs on European asset prices, notably the euro and the pound. The odds of a global financial accident are on the rise. Global central banks have joined the Fed and are relentlessly tightening global monetary and financial conditions. Moreover, the surging dollar is adding to global risks by raising the cost of capital around the world. This is a very fragile situation and the odds of a global recession have jumped significantly. Against this backdrop, investors should continue to overweight defensive equities at the expense of cyclical stocks. The euro also has more downside, but we are issuing a tentative stop-buy at EUR/USD 0.9650 with a stop at 0.9400. Credit remains a safer alternative to European stocks. The Evolving European Energy Backdrop Chart 1All About The Gas The surge of natural gas and electricity prices since the fall of 2021 has been one of the main drivers of the underperformance of European assets and the fall in the euro (Chart 1). While the medium-term outlook for European energy prices remains fraught with risk, the near-term prospects have improved. Following a surge from €77.4/MWh in June to €340/MWh on August 26, one-month forward natural gas prices at the Dutch Title Transfer Facility (TTF) have declined 45% to €187/MWh. These wild gyrations reflect the evolution of both the natural gas flows from Russia, which have fallen from 3,060Mcm to 599 Mcm today, and the rapid buildup of natural gas inventories across the European Union. The good news is that the costly efforts to rebuild European gas inventories have been successful. EU-wide inventories are at 85.6% capacity, achieving its 80% storage objective well before November. Germany has gone even further, with storage use now standing at 90% of capacity. This large stockpile, along with the re-opening of coal power plants and consumption curtailment efforts, should allow Europe to survive the winter without Russian energy imports, as long as the temperatures are not abnormally cold. The absence of a summer dip in Norwegian gas exports and the surge in LNG flows to Europe have partially replaced the missing Russian inflows, thus helping Europe rapidly rebuild its natural gas inventories (Chart 2). This success was a consequence of elevated European natural gas prices, which have allowed Europe to absorb LNG flows from the rest of the world (Chart 3). Chart 2No Restocking Without LNG Chart 3LNG Flowed Toward High Prices So far, the European industrial sector has managed to adjust better than expected to the jump in the price of natural gas, a crucial energy input. Take Germany as an example. For the month of August, Germany’s consumption of natural gas by the industrial sector fell 22% below the 2018-2021 average (Chart 4, top panel), while PPI moved up vertically. Yet, industrial output is only down 5% year-on-year and industrial capacity utilization stands at 85%, which is still a level that beats two thirds of the readings recorded between 1990 and this the most recent quarter (Chart 4, bottom panel). The adjustment will be uneven across various industries, with those most voracious of natural gas likely to experience a declining share of Europe’s gross value added. Using the German example once again, we can see that the chemicals, basic metal manufacturing, and paper products sectors are the most at risk from higher natural gas prices and most likely therefore to suffer the most from gas rationing this winter (Chart 5). Chart 4A Surprisingly Successful Transition Chart 5The Three Sectors Most At Risk Going forward, important changes are likely to take place that will allow the European economy to continue to survive on diminished Russian gas flows: European natural gas prices will remain elevated compared to the rest of the world to attract LNG flows to the region. Importantly, Europe’s capacity to absorb these flows keeps increasing, as more re-gasification ships are docked around the continent. Moreover, North America is building more facilities to export LNG to Europe. Chart 6Nuclear Energy's Contribution Will Rebound Nuclear electricity production will rebound. Currently, the EU’s nuclear production is around 43.2TWh, well below the normal 60TWh to 70TWh winter levels, driven mostly by the collapse in French production from 35TWh to 18TWh (Chart 6). This decline in nuclear electricity generation has accentuated the upward pressure on European natural gas and electricity prices. One of the key objectives of the nationalization of EDF by the French government is to accelerate the maintenance of France’s ageing nuclear power plants and allow a return to more normal production levels by the winter. The role of natural gas in European household’s energy mix will decline. Currently, EU households are the largest natural gas consumers and account for 41% of the bloc’s gas consumption (Chart 7). It will be easier to replace their natural gas consumption over time with other sources of energy than it will be to cut the industrial sector’s consumption extensively. As a result, even if European natural gas imports are permanently below 2021 levels, the industrial sector will not bear the brunt of the adjustment. Chart 7Households To Be Displaced These developments imply that natural gas prices have limited downside. However, we believe that the worst of the spike in prices is behind us, at least over the near term. The reason is that the inelastic buying created by the inventory re-stocking exercise since May 2022 is ending. In fact, the German Federal Minister for Economic Affairs and Climate Action, Robert Habeck, declared last week that his country would no longer purchase gas at any price. Chart 8The Most Painful Part Of The Adjustment Is Over If prices stabilize around €200/MWh, European industrial activity will continue to face a headwind, but the worst of the adjustment process will be in the rearview mirror as natural gas inflation recedes (Chart 8). Ultimately, capitalist systems are dynamic, and it is this rapid change in price that causes the most pain. In other words, the impoverishment of the European private sector has already happened. Steady states are easier to manage. Moreover, if natural gas prices eventually follow the future’s curve (this is a big “if”), the picture for Europe will improve considerably. One additional mitigating factor should ease the pain being experienced by the European private sector. Fiscal policy is responding very aggressively to the current energy crisis. So far, EU countries and the UK have allocated more than €500 billion to protect their private sectors against higher energy costs (Chart 9) and the UK just announced tax cuts of £45 billion. This is in addition to the disbursement of €150 billion from the NGEU funds in 2023. Moreover, the European commission is planning to modify the EU fiscal rules to abandon annual structural deficit targets and for debt sustainability to be evaluated over a ten-year period. Chart 9Massive Fiscal Support Bottom Line: The worst of Europe’s adjustment to higher energy prices is now behind us. However, European energy prices will remain elevated, which will continue to put Europe at a handicap compared to the rest of the world. Bad News From The Rest Of The World The worst of Europe’s energy crisis is behind us, but the world is teetering toward a recession, which will hurt the trade- and manufacturing-sensitive European economy. Chart 10A Global Recession This Way Comes The tightening in global financial conditions created by the surge in the dollar and by the jump in global yields is pushing the US Manufacturing ISM and the Euro Area PMIs toward the low-40s, which is consistent with a recession (Chart 10). The problem does not stop there. Global central banks have become solely focused on fighting inflation. For 2023, the FOMC’s dot plot forecasts both an interest rate rise to 4.6% and a 0.7% increase in the unemployment rate. This is tantamount to the Fed telling the market that it will increase interest rates as a recession emerges to repress inflation. Not to be undone, European central banks are also rapidly increasing their policy rates, even as they also forecast an imminent deterioration in domestic growth conditions. Quickly tightening policy in a slowing growth environment, especially as the dollar hits a 20-year high, is a recipe for a financial accident and a global recession. Chart 11No Help From China Moreover, China’s economy is still unable to create a positive offset to the deterioration in global monetary and financial conditions. The marginal propensity of China’s private sector to consume remains in a downtrend, hampered by the country’s zero-COVID policy and the continuing meltdown in real estate activity (Chart 11). Furthermore, the most rapid decline in the yuan exchange rate in 5 years is imparting an additional downside risk to the global economy. European stocks are uniquely exposed to these threats. Europe overweights deep cyclicals, which are currently squeezed by the deteriorating global growth outlook. The message from the collapse in FedEx’s stocks on very poor guidance is particularly ominous: this company has a much closer correlation with the Dow Jones Euro STOXX 50 than with the S&P 500 (Chart 12). European share prices are already factoring in much of the bad news. Valuations are significantly less expensive than they once were. The Shiller P/E ratio of European equities and their equity risk premium stand at the same levels as those in the 1980s. This is in sharp contrast to the US (Chart 13). Chart 12FedEx's Gloomy Delivery Chart 13Low CAPE In Europe Table 1A Deep Downgrade To European Earnings European forward earnings have also already done considerable work adjusting downward. Excluding energy, 2022 and 2023 forward EPS are down 10.3% and 11.9% since their peak, respectively (Table 1). But inflation flatters earnings growth and European large-cap indices are dominated by multinational firms, which implies that looking at earnings in USD terms makes more sense. In both real and USD terms, 2022 and 2023 forward EPS, excluding energy, are already down 25% and 26.4%, respectively. These adjustments are in line with previous recessions. The counterargument is that analysts still expect positive earnings growth in 2023 relative to 2022. However, at 4%, this increase in expected earnings is still well below inflation and 6% below the average expected growth in forward earnings recorded over the past 35 years (Chart 14). Additionally, a global recession could put further downward pressure on energy prices in Europe, which would create an additional cushion under European earnings in 2023 The implication here is that it still makes sense to be modestly long European equities in absolute terms, especially for investors with an investment horizon of twelve months or more. However, we cannot be complacent, as the risk of an additional selloff is still too large for comfort. As a result, for now investors should only garner a small exposure to European equities and do so while favoring defensive names over cyclical ones (Chart 15). Chart 14Weak Forward Earnings Growth Chart 15Continue To Favor Defensive Names Bottom Line: European stocks must still contend with the growing threat of a global recession catalyzed by tighter financial conditions and aggressive global central banks. The good news is that they already discount considerable pessimism, as illustrated by their low valuations and downgraded forward earnings. Consequently, investors can continue to nibble at European equities, but do so to a limited degree and by favoring defensive stocks over cyclical ones, at least for now. The Euro Dilemma On the back of the very hawkish Fed meeting and the announcement of Russia’s broadened military mobilization, the EUR/USD broke below the 0.99 support level and fell under 0.98, a level we judged in the past as very attractive on a six-to-nine months basis. Obviously, Fed Chair Jerome Powell’s reaffirmation of the FOMC’s war on inflation is a major boost to the dollar. The momentum property of the greenback implies that it has room to rally further in the near term. This narrative, however, overlooks the fact that the Fed is not the only central bank intent on fighting inflation, no matter the cost. The Norges Bank, the Riksbank, the ECB, and even the SNB have all showed their willingness to move aggressively against inflation. While the BoE only increased rates by 50bps last week, its communication suggested that an at least 75bps increase would be due at the November meeting, when the MPC publishes its Monetary Policy report that will incorporate the impact of the budget measures announced by new British Prime Minister, Liz Truss. Chart 16The Rest Of The World Is Catching Up To The Fed As a result, market interest rate expectations are climbing in the US, but they are rising even faster in Europe, albeit from a lower base. However, the decline in the expected rate of interest in the US relative to Europe and in the number of expected hikes in the US relative to Europe are consistent with a sharp decline in the DXY in the coming months (Chart 16). Due to its 80% weight in European currencies, a weaker DXY implies a rebound in the EUR, GBP, CHF, NOK, and SEK against the USD. Chart 17Surprising European Resilience Moreover, there could be room for expected interest rate differentials to narrow further against the dollar. The analysis we published two weeks ago shows that, even when the different nonfinancial private debt loads are accounted for, the gap in the US and Eurozone r-star stands at 1%. However, the spread between the Fed funds rate’s upper bound and the ECB Deposit Rate is 2%. The gap between the July 2023 US and Eurozone OIS is 1.7%. Since European inflation may prove more stubborn than that of the US in the near term, there is scope for the expected interest rate gap to narrow further, especially as the Euro Area final domestic demand is surprisingly more robust than that of the US (Chart 17). What about global growth? The view that the global economy is about to experience a recession is consistent with a stronger dollar, since the greenback is an extremely countercyclical currency. However, the DXY’s 25% rally since January 2021 already prices in such an outcome (Chart 18). Similarly, the euro is trading again at 2002 levels, which is also in line with a global recession with deep negative repercussions for the Eurozone. Additionally, the Euro has fallen 21% since May 2021, which compares to the 21.4% fall in 2008, the 20% decline in 2010, the 18% plunge in 2011/12 and the 24% collapse in 2014/15; yet EUR/USD is much cheaper now than in any of those instances. Moreover, the wide difference between the competitiveness of Germany and that of the rest of the Euro Area has now faded, which means that a major handicap against the euro has disappeared (Chart 19). Chart 18The Dollar Already Foresees A Recession Chart 19Normalizing Eurozone Internal Competitiveness This does not mean that the euro is not without risk. First, since the major euro collapse began in June 2021, EUR/USD breakdowns have been followed by average declines of 3.6%, ranging from 2.7% to 4.2%. Since the dollar is a momentum currency, it is unlikely that this time will be different. Second, if the tightening in global policy does cause a financial accident, the dollar will catch one last major bid that could push EUR/USD toward 0.9. As a result, to mitigate the danger, we recommend setting a stop-buy in the euro at EUR/USD 0.965 or 2.6% below the breakdown level of 0.9904. This position comes with a stop-loss at 0.94. For now, we would view this bet as a tactical position if it were triggered. Bottom Line: While a hawkish FOMC is very positive for the dollar, markets now expect foreign central banks to catch up to some extent with the Fed. This process is dollar bearish. Additionally, while a global recession would be supportive of the greenback, the USD already discounts this scenario. Instead, Europe is proving surprisingly resilient, which could soon create a tailwind for EUR/USD. Set a stop-buy at EUR/USD 0.965, with a stop-loss at 0.94. Market Update: European Credit After Central Bank Week For investors concerned with the left-tail risk in European equities, European credit offers a credible alternative in the near term. This asset class is also attractive relative to European government bonds. Taken together, the Fed, the ECB, the BoE, the Riksbank, the Norges Bank, the SNB, and the BoC have tightened policy by 475bps over the past month (Chart 20). Moreover, the SNB’s hike closed the chapter of negative rates in Europe. But make no mistake – there will be a second chapter. Until then, European corporate bond yields have risen enough to offer attractive spreads over duration-matched government bonds and to challenge the earnings yield provided by equities (Chart 21). Besides, the volatility observed in equity markets over the past few months makes the European corporate bond more appealing. Chart 20Central Bank Week Chart 21Push Back Against TINA Argument In the Euro Area, BB-rated bonds, which are the highest credit quality and largest tranche within the high-yield space, are particularly attractive. They sport a 6.6% YTM, at a spread of 480bps over 3-year German government bond yields. This compares to an equity earnings yield of 7.4% (Chart 21, top panel). In other European corporate bond markets, there is no need to go down in credit quality. Yields-to-maturity for investment grade corporate bonds in the UK, Sweden, and Switzerland provide appealing alternatives to equities, with shorter duration still. This is especially true in Sweden, where the equity earnings yield has collapsed and is now only 60bps above Swedish IG yield, with substantially greater risk. Meanwhile, the spread pickup offered by Swiss IG over Swiss government bonds of similar duration is at its widest in more than ten years (Chart 21, bottom panel). Chart 22Heed The Message From OIS Curve Differentials This week, we turn neutral on European credit versus US credit. Back in March, we made the case that European credit would outperform its US counterpart in response to a more hawkish Fed than the ECB. Since then, European IG outperformed US IG by 1% on a total return basis. However, with the Fed funds rate at 3.25%, traders now expect more monetary policy tightening from the ECB, which often corresponds to an underperformance of Euro Area credit relative to that of the US (Chart 22, top panel). On the other hand, Swedish IG is expected to outperform US IG over the next six months (Chart 22, bottom panel).   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Jeremie Peloso, Editor/Strategist JeremieP@bcaresearch.com   Tactical Recommendations Cyclical Recommendations Structural Recommendations