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In lieu of next week’s report, I will host the monthly Counterpoint Webcast on Monday, July 25. Please mark the date in your calendar, and I do hope you can join. Executive Summary Central banks face a ‘Sophie’s choice’. Inflation at 2 percent, or full employment? If they choose inflation at 2 percent, they will have to take the economy into recession. To take the economy into recession, bond yields and energy prices do not need to move any higher. They just need to stay where they are. The stock market has not yet discounted a recession. With stocks and bonds having become equally ‘cheaper’ this year, but stocks now vulnerable to substantial downgrades to their profits, stocks are likely to underperform bonds over the coming 6-12 months. In the event of recession followed by plunging inflation, a valuation uplift for bonds will also underpin stock prices and limit further downside in absolute terms. The biggest loser will be commodities. On a 6-12 month horizon, the optimal asset allocation is: overweight bonds, neutral stocks, underweight commodities. Fractal trading watchlist: Ethereum. The Bear Market Is A Valuation Bear Market. Profits Are Not Discounting A Recession… Yet Bottom Line: On a 6-12 month horizon, overweight bonds, neutral stocks, underweight commodities. Feature The Greek mythological sea monsters, Scylla and Charybdis, sat on opposite sides of the narrow Strait of Messina, with one monster likened to a shoal of rocks, the other to a vortex. Avoiding the rocks meant getting too close to the vortex, and avoiding the vortex meant getting too close to the rocks. In today’s stock market, if Scylla is the monster of high bond yields, then Charybdis is the monster of falling profits. Whether the stock market can safely navigate these twin monsters without further damage depends on a sequence of questions. In today’s stock market, if Scylla is the monster of high bond yields, then Charybdis is the monster of falling profits. If the market can escape high bond yields, can it also escape falling profits? The answer to this depends on a second question. Can central banks guide inflation back to 2 percent without taking the economy into recession? The answer to this depends on a third question. Is 2 percent inflation still consistent with full employment? Central Banks Face A ‘Sophie’s Choice’ – Low Inflation, Or Full Employment? In the US, the main transmission mechanism from employment to inflation is through so-called ‘rent of shelter’. Because, to put it bluntly, you need a steady job to pay the rent. And rent comprises 41 percent of the core inflation basket. For the past couple of decades, the Fed could have its cake and eat it: full employment and inflation running close to 2 percent. This was because full employment was consistent with rent of shelter inflation running at 3.5 percent, which itself was consistent with core inflation running at 2 percent. The Fed faces a ‘Sophie’s choice’. Inflation at 2 percent, or full employment? If it chooses inflation at 2 percent, then the Fed will have to take the economy into recession. But recently, there has been a phase-shift between the employment market and rent of shelter inflation. The current state of full employment equates to rent of shelter inflation running not at 3.5 percent, but at 5.5 percent (Chart I-1). Chart I-1Central Banks Face A 'Sophie's Choice' - Low Inflation, Or Full Employment? Hence, the Fed faces a ‘Sophie’s choice’. Inflation at 2 percent, or full employment? If it chooses inflation at 2 percent, the unemployment rate will have to rise by 2 percent. Meaning, the Fed will have to take the economy into recession. The Economy Tries The ‘Cold Pressor Test’ To take the economy into recession, bond yields and energy prices do not need to move any higher – they just need to stay where they are. This is because the damage from elevated bond yields and energy prices doesn’t come just from their level. It comes from their level multiplied by the length of time that they stay elevated. Try putting your hand in a bucket of ice water. For the first few seconds, or even tens of seconds, you will not feel any discomfort. After a few minutes though, the pain becomes excruciating. This so-called ‘cold pressor test’ tells us that your discomfort results not just from the temperature level of the ice water, but equally from the length of time that you keep your hand in it. Likewise, a short-lived spike in the mortgage rate or in the price of natural gas, or a short-lived collapse in your stock market wealth will not cause any discomfort. But the longer the mortgage rate stays elevated, and more and more people are buying or refinancing a home at a much higher rate, the greater becomes the economic pain. In the same vein, most Europeans will not notice the sky-high prices of natural gas in the summer when the heating is off. But come the cold of October and November, many people will have to choose literally between physical or economic pain. Some commentators counter that the “war chest of savings” accumulated during the pandemic will buffer households against higher mortgage rates and energy prices. We strongly disagree. The savings accumulated during the pandemic just added to, and became indistinguishable from, other wealth. Yet now, in case you hadn’t noticed, wealth has been pummelled. In case you hadn’t noticed, wealth has been pummelled. The impact of wealth on spending is a huge topic which we will expand upon in a future report. In a nutshell, most spending comes from income and income proxies. Wealth generates income, but it also generates an income proxy via capital gain. So, to the extent that wealth can drive spending growth, the biggest contributor comes from the change in capital gain, also known as the ‘wealth impulse’. Unfortunately, the wealth impulse is now in deeply negative territory (Chart I-2). Chart I-2The Wealth Impulse Is In Deeply Negative Territory The Stock Market Has Not Yet Discounted A Recession Coming back to the stock market, does the 2022 bear market mean that it has already discounted a recession? No, this year’s bear market is entirely due to a collapse in valuations. Since the start of the year, US profit expectations have held up. If the bear market were front running profit downgrades, then it would be underperforming its valuation component, but it is not. The counterargument is that analysts are notoriously slow to downgrade their profit estimates. Isn’t the bear market the ‘real-time’ stock market ‘front running’ big downgrades to these profit estimates? Again, no. If the market were front running profit downgrades, then it would be underperforming its valuation component, but it is not (Chart I-3). Chart I-3The Bear Market Is A Valuation Bear Market. Profits Are Not Discounting A Recession...Yet The bear market in the S&P 500 has near-perfectly tracked the bear market in its valuation component, the 30-year T-bond price. The valuation component of the S&P 500 is the 30-year T-bond price because the duration of the S&P 500 equals the duration of the 30-year T-bond. Several clients have asked how to prove that the duration of the S&P 500 equals that of the 30-year T-bond. We can do it either a difficult theoretical way, or an easy empirical way. The difficult theoretical way is to take the projected cashflows, and calculate the weighted average time to those cashflows, where the weights are the discounted values of those cashflows. The much easier empirical way is to show that the S&P 500 tracks its profits multiplied by the 30-year T-bond price more faithfully than if we use a shorter maturity bond, such as the 10-year T-bond (Chart I-4 and Chart I-5) Chart I-4The S&P 500 Tracks Profits Multiplied By The 30-Year T-Bond Price More Faithfully... Chart I-5...Than Profits Multiplied By The 10-Year T-Bond Price One important upshot is that any valuation comparison of the S&P 500 with a bond other than the 30-year T-bond is a fundamental error of duration mismatch. Most strategists compare the S&P 500 with the 10-year T-bond because it is convenient. But the duration mismatch makes this ‘apples versus oranges’ valuation comparison one of the most common mistakes in finance. Overweight Bonds, Neutral Stocks, Underweight Commodities All of this is important to answer a crucial question about stock market valuations. With the stock market 20 percent down this year when expected profits have held up, it might appear that stocks have become much cheaper. The truth is more nuanced. Relative to expected profits over the next 12 months the US stock market is indeed much cheaper (Chart I-6). The caveat is that these expected profits are vulnerable to substantial downgrades in the event of a recession. Chart I-6The US Stock Market Is Cheaper Versus Expected Profits, But These Profits Are Too Optimistic Chart I-7The US Stock Market Is Not Cheaper Versus The 30-Year T-Bond But relative to the equal duration 30-year T-bond, the US stock market is not cheaper. Since, the start of the year, the uplift in the stock market’s (forward earnings) yield is precisely the same as the that on the 30-year T-bond yield (Chart I-7).  Relative to the equal duration 30-year T-bond, the US stock market has not become cheaper. With stocks and bonds having become equally ‘cheaper’ this year, but stocks now vulnerable to substantial downgrades to their profits, stocks are likely to underperform bonds over the coming 6-12 months. The good news is that a valuation uplift for bonds will also underpin stock prices, and limit further downside in absolute terms. Unfortunately, the same cannot be said for commodities, whose real prices are still close to the upper end of their 40-year trading range (Chart I-8) Chart I-8The Real Price Of Metals Is Still At The Upper End Of Its 40-Year Trading Range In the event of recession followed by plunging inflation, the biggest winner will be bonds and the biggest loser will be commodities. Therefore, on a 6-12 horizon, the optimal asset allocation is: Overweight bonds. Neutral stocks. Underweight commodities. Fractal Trading Watchlist This week we are adding Ethereum to our watchlist, as its 130-day fractal structure is approaching the capitulation point that signalled previous major trend reversals in 2018 (a bottom) and 2021 (a top). The full watchlist of 27 investments that are approaching, or at, potential trend reversals is available on our website: cpt.bcaresearch.com Fractal Trading Watchlist: New Additions Chart I-9Fractal Trading Watch List Chart 1CNY/USD At A Potential Turning Point   Chart 2US REITS Are Oversold Versus Utilities Chart 3CAD/SEK Is Vulnerable To Reversal Chart 4Financials Versus Industrials Has Reversed Chart 5The Outperformance Of Resources Versus Biotech Has Ended Chart 6The Outperformance Of Resources Versus Healthcare Has Ended Chart 7FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 8Netherlands' Underperformance Vs. Switzerland Is Ending Chart 9The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 10The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 11Food And Beverage Outperformance Is Exhausted Chart 12German Telecom Outperformance Vulnerable To Reversal Chart 13Japanese Telecom Outperformance Vulnerable To Reversal Chart 14ETH Is Approaching A Possible Capitulation Chart 15The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 16The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 17A Potential Switching Point From Tobacco Into Cannabis Chart 18Biotech Is A Major Buy Chart 19Norway's Outperformance Has Ended Chart 20Cotton Versus Platinum Has Reversed Chart 21Switzerland's Outperformance Vs. Germany Has Ended Chart 22USD/EUR Is Vulnerable To Reversal Chart 23The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 24A Potential New Entry Point Into Petcare Chart 25GBP/USD At A Potential Turning Point Chart 26US Utilities Outperformance Vulnerable To Reversal Chart 27The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-12 Month Recommendations 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  

Executive Summary Don’t Try Catching Falling Euros The euro is inexorably moving toward parity. However, many positives could still save EUR/USD, a cheap currency that will benefit if the fears of a global recession recede and if European inflation peaks by the fall. Nonetheless, many fundamental risks still weigh on the euro, including the dollar’s momentum and the continuing ructions in the European energy market. Moreover, technical vulnerabilities are likely to amplify the potential weakness in the euro. There is greater than a 30% chance that EUR/USD will fall to 0.9 or below. As a result, it is preferable to stay on the sidelines and opt for a neutral stance on the EUR/USD. Selling EUR/JPY offers a more attractive reward-to-risk ratio than EUR/USD. The GBP remains under threat. Bottom Line: Don’t be a hero. At this juncture, the EUR/USD outlook remains particularly uncertain. While EUR/USD possesses ample upside over the coming 12 months, there is roughly a 1/3 chance that it will plunge to 0.9 by the winter. Investors should sell EUR/JPY instead.   The euro’s race toward parity continues. From May 12 to July 1, EUR/USD attempted to form a triple bottom at 1.0375 that could have marked the end of this year’s decline. Alas, the euro did not hold that floor and now traders are inexorably pushing the common currency lower. The outlook for the euro is complex. At current levels, it is inexpensive and discounts many negative developments affecting both the global and European economies. However, the EUR/USD’s weakness is also a story of dollar strength, and the deteriorating global economic momentum remains the Greenback’s best friend, to the euro’s detriment. For now, we stick to our mantra of the past few months: don’t be a hero. The euro may soon bottom, but enough risks lie ahead that a move below 0.9 against the dollar should not be discarded. The risk-reward from bottom fishing is therefore poor. Instead, investors should sell EUR/JPY, for which downside remains ample. What We Like About The Euro… Despite the pervasive negativity engulfing the euro, there are plenty of positives that will soon help EUR/USD form a bottom. First, the euro is cheap on most metrics. The Purchasing Power Parity (PPP) model developed by BCA’s Foreign Exchange Strategists adjust for the different consumption baskets in the Eurozone and the US. It currently shows that EUR/USD trades 25% below fair value, its deepest discount since 2001. This degree of undervaluation is associated with a high probability of strong long-term returns for the euro (Chart 1). Based on interest rate parity and risk aversion, the euro also trades well below its fair value. Steep discounts are often followed by an imminent rebound in the currency (Chart 2). However, the euro hit a similar discount in January, but failed to rally because of the problems in the energy markets prompted by Russia’s invasion of Ukraine. Chart 1Strong Long-Term Returns based on PPP Chart 2Oversold on Many Metrics Second, the euro is oversold. Both BCA’s Intermediate-Term Technical Indicator and the Citi FX Euro PAIN Index are very depressed, which indicates pervasive negative sentiment toward the euro (Chart 2, bottom two panels). This kind of extremes in momentum are often followed by a euro rally. Chart 3Global Recession Fears Hurt EUR/USD Third, global economic pessimism is widespread. EUR/USD is a pro-cyclical pair, which mostly reflects the counter-cyclicality of the dollar and the great liquidity of the euro. It is therefore not surprising that spikes in global recession concerns are associated with a weakening EUR/USD (Chart 3). The recent wave of depreciation happened contemporaneously with a spike in Google searches for the word “recession.” If these fears, which reached extreme levels, subside further in the months ahead, the euro may benefit greatly. Fourth, pessimism toward China may ease, which would lift the euro in the process. Last week, it was announced that Beijing is considering allowing local governments to sell RMB1.5 trillion of special government bonds in the second half of the year to fund infrastructure spending. The news caused a rebound in the AUD, Brazilian assets, and copper. Europe too would benefit from greater activity in China. Chart 4Chinese Salvation? Chinese monetary conditions are also easing, which historically supports industrial activity in Europe relative to the US (Chart 4, top panel). The change in approach in the implementation of the zero-COVID policy is helping Chinese PMIs rebound, which will eventually translate into higher European shipments to China. Moreover, the rate of change of the performance of real estate stocks relative to the broad market has turned the corner, which may facilitate a stabilization of Chinese real estate transactions (Chart 4, second panel). Ultimately, the expanding excess reserves in the Chinese banking system point toward a stabilization of the performance of EUR/USD later this year (Chart 4, bottom panel). Fifth, our expectation that European inflation will peak by the autumn will prove the greatest help to the euro. The EUR/USD’s weakness over the past twelve months has coincided with a surge in European inflation surprises (Chart 5, top panel). This relationship reflects the negative impact on European real rates of both stronger realized and expected inflation (Chart 5, second panel). Investors understand that Europe’s inflation crisis is driven by a relative price shock in the energy market that greatly hurts economic activity in the Eurozone. Hence, even if they expect the ECB to increase interest rates, they believe policy rates will lag inflation because of Europe’s poor growth outlook. This is particularly true when compared to the US Fed. As a result, European real rates continue to lag far behind US ones and the European yield curve is steeper than that of the US, because traders foresee easier policy on the Eastern shores of the Atlantic (Chart 5, panel three and four). Chart 5Inflation Hurts the Euro Chart 6Declining Inflation Expectations? Declining Inflation Expectations? This situation is fluid and inflation expectations have begun to decrease. The recent easing in energy prices has contributed to a decline in long-term inflation expectations (Chart 6). We argued last week that the energy inflation is arithmetically set to decrease over the coming twelve months, which suggests further downside in inflation expectations is likely. Moreover, four of the five largest weights in the Eurozone HICP are running hot, but all are linked to commodity inflation, which confirms our bias that European inflation will soon peak (Chart 7). A top in both headline and core inflation will drag short- and long-term inflation expectations lower, which will help European real rates (Chart 8). Meanwhile, lower imported energy inflation will limit the damage to European economic activity, allowing the ECB to increase rates anyway.   Chart 7Key HICP Components Chart 8A durable Decline In Expected Inflation Depends On Realized Inflation Chart 9Balance Of Payment Support Bottom Line: The euro benefits from important tailwinds that suggest EUR/USD will be higher 12 to 18 months from now. It is cheap and oversold and the pervasive gloom among investors about the state of the global economy indicates that many negatives are already embedded in its pricing. Moreover, the Chinese economy could stabilize in the second half of 2022 and into 2023, which will hurt the dollar and boost the euro. Crucially, a peak in European inflation will allow European real rates to recover and curtail the handicap keeping EUR/USD under pressure, especially as the basic balance of payment remains in the euro’s favor (Chart 9).   … And What We Don’t EUR/USD may benefit from some important tailwinds, but it is still burdened by massive handicaps. The first problem that will place downward pressure on the euro is that its weakness is not unique and that it reflects broad-based dollar strength (Chart 10). This is a problem for the euro because the dollar (and the yen) is the foremost momentum currency in the G10. Its strength begets further strength, and the momentum signal from moving average crossovers remains dollar-bullish.  This headwind for the euro could even intensify in the coming months. JP Morgan EM FX Index is breaking down to new lows, which points to further tightening in EM financial conditions. Historically, tighter EM FCIs translate in both weaker Eurozone stock prices and a weaker EUR/USD, which reflects the closer link between the Euro Area and EM economies than between the US and EM (Chart 11). Chart 10The Dollar's Strength Is Broad-Based Chart 11More Trouble In Store This phenomenon is exacerbated by the underlying weakness in global economic activity. Arthur Budaghyan, BCA’s EM Chief Strategist, often reminds us that Asian exports remain soft. Additionally, the deterioration in US economic activity is likely to continue, as suggested by the weakness in the ISM new orders-to-inventories ratio and by the poor readings from the Regional Fed Surveys. Slowing US growth will generate a further decline in the business-sales-to-inventory ratio, which often coincides in a strong dollar and a weak euro. Chart 12Past Chinese Weaknesses Linger The second problem for EUR/USD is that China’s economic outlook may be improving in the future, but, for now, the impact of the recent Chinese slowdown continues to hamper Europe. More specifically, the recent decline in Chinese import volumes is consistent with a euro-bearish backdrop for the remainder of this year (Chart 12, top panel). In fact, even if the CNY remains stable against the USD, this does not guarantee a positive outcome for the euro as the past weakness in Chinese import volumes is also consistent with a depreciating EUR/CNY (Chart 12, bottom panel) The third euro-negative force is the natural gas market. As we showed last week, Dutch natural gas prices must settle between EUR500-600/MWh this upcoming winter to have the same inflationary impact as they did over the past 18 months. This is unlikely to happen, even according to the direst forecasts of BCA’s Commodity and Energy strategists. However, there is a greater than 30% chance that Europe must ration electricity this winter, which would cause a violent output contraction. As a result, any fluctuation in natural gas flows in Europe will cause the market-based odds of a European recession to swing widely. Consequently, the negative correlation between EUR/USD and TTF prices observed over the past twelve months is likely to remain intact (Chart 13). Related Report  European Investment StrategyQuestions From The Road The fourth issue hurting the euro is the US’s comparative isolation from the energy market’s travails. The US is a haven of relative economic stability today. Yes, its growth will slow further, but it is nonetheless set to outperform the Eurozone. The US is not under threat of rationing energy this winter. Moreover, the US terms of trades benefit from rising energy prices, unlike Europe (Chart 14). Furthermore, the US output gap is closing faster than that of in the Eurozone (Chart 14, bottom panel). As a result, the odds of dovish surprises by the ECB are much greater than those by the Fed. Chart 13Neutral Gas Is Still A Drag Chart 14The US As A Haven Of Stability The US’s relative resilience might also impact equity flows over the next few months in a euro-bearish fashion. US EPS have been stable relative to Euro Area ones, even in local currency terms. Interestingly, because relative EPS reflect broader economic forces, EUR/USD follows them (Chart 15). Thus, if the European economic outlook deteriorates further relative to that of the US, chances are high that Eurozone EPS estimates will be revised down relative to the US, which will coincide with a lower EUR/USD. In fact, the recent underperformance of Eurozone small-cap stocks (which are domestically focused) relative to European large-cap equities (which derive a greater proportion of their sales abroad) and US small-cap shares also confirms the worsening relative economic outlook between Europe and the US, and thus portend significant near-term risks to EUR/USD (Chart 16). Chart 15Follow Earnings Estimates Chart 16Small Caps Indicate More EUR Selling Chart 17An ECB Bungle Would Burden The Euro The last major fundamental risk weighing on EUR/USD is the significant probability that the ECB will disappoint markets with respect to its anti-fragmentation tool to be announced in July. Investor expectations are lofty. However, internal divisions within the ECB Governing Council remain, and, most importantly, the ECB is hamstrung by previous ECJ and German Constitutional Court rulings on bond purchases. Thus, our base case remains that the development of an appropriate bond purchase program will be an iterative process resulting from a back-and-forth between market tensions and ECB responses. As a result, there are risks of further widening in Italian spreads as well as European corporate bond spreads. These developments would further hurt the euro (Chart 17). Chart 18Much Selling To Be Unleashed Sentiment Could Get More Negative These fundamental problems with EUR/USD do not guarantee that the euro will punch below parity. After all, there are also plenty of positives with this currency. However, the risk of a violent selloff is elevated, at around 30%, because of underlying technical vulnerabilities. Global market liquidity has deteriorated in recent years, and this phenomenon is also impacting FX markets, resulting in sudden jumps being more frequent. Most crucially, the odds are high that automatic selling will be triggered if the euro tests parity, which would result in a cascading decline for a euro entering territory that has not been charted for the past 20 years. Specifically, speculators are marginally short the euro (Chart 18, top panel) and 1-month and 3-month risk reversals in the option markets are not yet at a capitulation point (Chart 18, bottom panel). Thus, if panic sets in, the euro could easily fall below 0.9, where the strongest supports lie. In essence, we worry that a sudden crash in the euro is becoming a growing threat. Bottom Line: The combination of the dollar’s momentum, the lagging impact of China’s economic woes, the risks to Europe’s energy supplies, the relative stability of the US economy, and the heightened chance that the ECB underdelivers with respect to its anti-fragmentation tool later next week all point to significant risks to the euro in the coming months. Moreover, the technical vulnerabilities present in the FX market suggest that, if further downside takes place, it will not only be large but also rapid. Investment Conclusions The dilemma between views and strategy is greatest with the euro today. There are many positives highlighted in this report that suggest that the euro has upside on a 12-month basis. However, the risks are abundant, and the potential downside in the coming six months not only carries a large probability, it is also likely to be pronounced if it takes place. As a result of this configuration, we fall back to the strategy we had adopted for European equities earlier this year: don’t be a hero. Even if the euro bottoms tomorrow, the risks are such that capital preservation remains paramount. Consequently, we recommend that investors stay on the sideline and maintain a neutral stance on EUR/USD. It is just as risky to try to bottom fish this pair as it is to chase it lower from current levels. Chart 19Sell EUR/JPY Instead, we follow BCA’s Foreign Exchange Strategists recommendation to go short EUR/JPY as a bet with a lower risk-reward ratio. Global recession worries and weakening commodity inflation are likely to allow for greater downside in global yields, which often results in a lower EUR/JPY (Chart 19). Additionally, investors do not expect much out of the BoJ this year, but if recession risks intensify in Europe because of energy rationing this winter, there is room to curtail the interest rate pricing for the ECB embedded in the €STR curve. Furthermore, the JPY is the cheapest currency in the G10. Finally, investors wanting to build greater exposure to European currencies should do so via the Swiss franc. We argued three weeks ago that the CHF enjoys significant structural tailwinds because of the Swiss economy’s strong productivity. Additionally, the SNB is no longer intervening to limit the CHF upside, as demonstrated by the decline in its current deposits. Instead, a stronger Swiss franc is the most potent weapon in the SNB’s arsenal to combat inflation. Moreover, the CHF offers a hedge against both recession risks in the Eurozone and further widening in European spreads. Bottom Line: Don’t be a hero. EUR/USD’s outlook is uniquely uncertain now. While many factors point to positive returns on a 12-to-18 month basis, if the euro hits parity in response to the many clouds still hanging over Europe, technical factors could plunge this currency to EUR/USD 0.9 into a steep decline. Instead, the clearer call is to sell EUR/JPY. Investors who want to assume a European FX exposure today should do so through the Swiss franc, not the euro. A Few Words On The UK Last week, Prime Minister Boris Johnson resigned. The initial response of the pound was to rebound. This reaction should fade. BCA Geopolitical strategists argue that, even though the person sitting at 10 Downing Street is about to change, the fundamental problems with the UK remain the same. The Labour Party is ascending, but it will still have to deal with the Brexit aftermath, rising populism, and popular discontent across the country. The economy is still fragile and engulfed in an inflationary spiral. Meanwhile, the risks created by a looming Scottish independence referendum are much more significant than was the case in 2014. As a result, the pound is likely to remain under stress over the coming quarters.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations

Executive Summary The Dollar And Volatility The dollar continues to be bid, as volatility rises. The MOVE volatility index is making fresh cycle highs and has pushed the DXY index above our stop level of 107 (Feature Chart). The move in the dollar suggests that we are experiencing a classic breakout pattern. Historically, this means that flows into the USD will continue, until it becomes clear that drivers of USD strength have abated. These include inflation peaking and global growth bottoming. We are moving our recommended stance on USD to neutral. It is becoming clear that the market sees the risk of a nasty recession in Europe to be high. The euro could break below parity, as speculators short the currency en masse. The yen is becoming a winner in the current context. We are reopening our short EUR/JPY trade this week, in addition to our short CHF/JPY position initiated last week.  Our long AUD/USD position was stopped out at 68 cents this week. Given our shift to a neutral view on the dollar, we recommend investors stand aside for now. Bottom Line: We were stopped out of our short DXY position at 107, for a loss of 2.34%. We are moving to a neutral stance on the greenback. While valuation and sentiment are at contrarian extremes, the current environment dictates that further gains in the greenback are likely in the near term. Feature The DXY index has staged a classic breakout and the next technical level is closer to the 2002 highs near 120. Year-to-date, the DXY has been one of the best performing currencies (Chart 1). In last week’s report, we presented a framework for managing currencies, suggesting that while the path of least resistance for the dollar was up, significant headwinds were also building. One of the closest correlations we have seen in recent trading days is with volatility. As Chart 2 shows, the dollar and the MOVE index have been the same line. As markets increasingly price in the probability of a recession, especially in Europe, the dollar will be bought. This puts central banks in a quandary: focusing on growth or inflation? As such bond volatility is shooting up and the dollar is commanding a hefty safety premium. In the next few sections, we go over the important data releases from our universe of G10 countries, and implications for currency strategy. Chart 1The Dollar Remains King Chart 2The Dollar And Volatility US Dollar: A Classic Breakout Chart 3A Clean Breakout In The DXY The dollar DXY index is up 11.3% year-to-date. Over the last month, the DXY index is up 4.7%. Technical forces are still in favor of the greenback as a momentum currency, given the classic breakout pattern. Looking at incoming data from the US, the case for dollar strength remains in place in the near term. The May CPI print came in well above expectations, at 8.6% for headline, versus 8.3% expected. A few days later, the PPI print was also strong at 10.8% year on year. This is happening at a time when consumer confidence is rolling over. The University of Michigan current conditions index fell from 63.3 to 53.8 in May. The expectations component dropped from 55.2 to 47.5. The conference board measure fell from 103.2 to 98.7 in June. After this print, the Fed met on June 15 and increased interest rates by 75bps, a surprise to the market. The current account deficit widened to $291.4bn US, a record low since the end of the Bretton Woods system . Retail sales disappointed in May. Excluding automobile and gasoline, sales were up 0.1% month on month, versus a consensus expectation of a 0.4% rise. It was also flat for the control group, suggesting basket changes were not responsible for the deterioration. The numbers are on a nominal basis, which suggests that retail sales volumes are contracting meaningfully. The rise in interest rates is filtering into the housing market. Mortgage applications fell 5.4% during the week of July 1. Housing starts declined from 1,810K to 1,724K in May, a 14.4% drop. Building permits also fell 7% month on month, in line with the 3.4% drop in existing home sales.  The ISM manufacturing index fell from 56.1 to 53 in June. US economic data is softening, which raises the odds that the US joins Europe and China in a classic slowdown. In such a configuration, the market is pricing in that the dollar will ultimately be the haven asset, as has been the case in recent history. We went short the DXY index at 104.8, with a stop-loss at 107, that was triggered overnight. We are moving to a neutral stance today and will revisit this position once global economic uncertainty subsides.  The Euro: A European Hard Landing Chart 4The Euro Is Pricing In A Deep Recession The euro is down 10.5% year-to-date. Over the last month, the euro is down 4.7%, and recent trading suggests we will probably breach parity versus the dollar in the coming weeks. Recent data from the eurozone continues to suggest it is trapped in stagflation. The preliminary CPI print for June came in at 8.6%, well above the previous 8.1% print. PPI in the euro area is at 36.3%. Meanwhile, consumer confidence (the European Commission’s measure) is approaching a record low. The Sentix investor confidence index peaked in July last year and has been falling ever since. With a mandate of bringing down inflation, the ECB may have no choice but to knock the eurozone economy to its knees. The proximate expression of this view has been via shorting the euro. Most of the incoming data for the euro area have been deteriorating. For example, on a seasonally adjusted basis, the trade deficit widened to -€31.7bn. This is a record since the creation of the euro. This has completely wiped the eurozone current account, meaning the euro is now becoming a borrower nation. The critical question for Europe lies in the adjustment mechanism towards a possible shut-off in natural gas supplies for the winter. European natural gas prices are soaring anew, though well below the peak this year. A cut-off of Russian supplies is becoming a very real possibility. The question then becomes how deep of a European recession the euro is pricing in. Back in 2020, the euro bottomed at 1.06. At the time, quarterly real GDP in the euro area fell 11.9% in the second quarter. That was worse than both during the global financial crisis, and anytime since the creation of the euro. This means that fundamentally, the euro has already priced in a nasty recession in Europe. If it occurs, the euro could undershoot but if it does not, the potential for a coiled spring rebound is immense. A hedged bet on the euro is to sell the EUR/JPY cross. In a risk-off environment, EUR/JPY will collapse. In a Goldilocks scenario, the yen has sold off much more that the euro, that the cross could move sideways.  The Japanese Yen: Now A Safe Haven Chart 5The Yen Is Becoming An Attractive Safe Haven The Japanese yen is down 15.4% year-to-date, the worst performing G10 currency. Over the last month, the yen is down 2.4%. Incoming data in Japan has been mixed with the domestic economy still showing some signs of weakness, while the external sector is faring relatively better. The Bank of Japan kept monetary policy on hold last month, despite a widely held view in markets that it would pivot, following the surprise hike by the Swiss National Bank. Inflation in Japan has been modest, with nationwide CPI at 2.5% in May. The Tokyo CPI release for June showed that inflation remains sticky around this level. Yet the BoJ views a large chunk of inflation in Japan to be transitory, due to rising energy costs, and base effects from the sharp drop in mobile phone prices last year. For inflation to pick up, ultimately wages need to rise. Labor cash earnings for May came in at 1%. For Japan, this is a healthy print compared to recent history, but still pins real cash earnings at -1.8%, suggesting little risk of a wage inflation spiral. The Tankan survey for the second quarter provided a glimmer of hope. While large manufacturers (mainly exporters) sensed a deterioration in the outlook, domestic concerns were more upbeat. The large non-manufacturing index improved from 9 to 13 in the second quarter. The small non-manufacturing index improved from -6 to -1. Notably, capex intentions rose 18.6%, the highest level since the late 80s. The drivers of the yen remain clear and absolute. First, rising global interest rates put selling pressure on the yen and vice versa. Second, energy prices sap the trade balance, which is also negative. Should these factors abate (as they are currently), the yen will benefit. This week, we are reopening our short EUR/JPY trade, in addition to being short CHF/JPY. From a contrarian perspective, the yen is the cheapest G10 currency according to our PPP models. It also happens to be one of the most heavily shorted currencies, according to CFTC data.  British Pound: Sterling Breaks Below 1.20 Chart 6Politics Will Keep Cable Volatile The pound is down 11.1% year-to-date. Over the last month, the pound is down by 4.5% as a combination of economic and political headwinds hit sterling. Politically, the resignation of Prime Minister Boris Johnson is fueling sterling volatility. According to our geopolitical strategists, investors’ focus should be on whether UK national policy will change. This will require an election that replaces the Conservative Party-led government, or at least removes its single-party majority. Boris Johnson’s approval rating had been collapsing in recent days on the back of a series of scandals, so a less unloved leader under the same party will at least assuage public opinion, while keeping existing policies largely the same. The next milestones to watch for are an early election (unlikely since the Conservative Party still has an interest in prolonging until 2025) and a Scottish referendum for independence next year. Labor will also continue to benefit from a tailwind of high inflation and the mishandling of the pandemic by the Tories that has left voters largely frustrated. Economically, data in the UK continues its whiff of stagflation. CPI came out at 9.1% in May, the RPI accelerated to 11.7%, and nationwide housing prices came in at 10.7% in June, while retail sales are tanking, falling 4.7% year on year in June, excluding auto and fuel costs. The GFK Consumer confidence indicator hit a record low of -41 in June. Our report on sterling suggested that headwinds remain likely in the near term, but the pound is becoming more and more attractive for longer-term investors. We are currently long EUR/GBP. This cross still heavily underprices the risks to the UK economy in the near term. However, if recession fears ease, our suspicion is that cable is poised for a coiled-spring rebound.  Canadian Dollar: The BoC Will Stay Hawkish Chart 7The CAD Has Decoupled From Oil Prices The CAD is down 2.5% year-to-date. Over the last month, it is down 3.4%. Incoming data continues to suggest there is little reason for the BoC to change course in tightening monetary policy. The employment market remains strong. In May, 40K new jobs were added, and the details below the surface were notable. 135K full time jobs were swapped for 96K part time roles. Hourly wages rose 4.5% and the unemployment rate dipped to 5.1%. This sort of data is carte blanche for the BoC to keep hiking, since it signals a soft landing in the economy. Housing has been a point of contention for higher rates in Canada (given indebted households), but the Teranet national house price index shows that home prices are still rising 18.3% year-on-year in Canada as of May. This is occurring within the context of widespread price gains. Headline CPI came in at 7.7% in May, with all measures of the BoC’s trimmed estimates (core-common, core-median, core-trim), well above target and expectations. It will be interesting to watch how the BoC calibrates monetary policy given that the closely watched Business Outlook Survey showed a large deterioration in participants’ outlook for the future. In a world where USD strength persists, CAD will trade on the weaker side, but we remain buyers of the CAD once recession fears ebb.   Australian Dollar: A Contrarian Play Chart 8A Jumbo Hike By The RBA The Australian dollar is down 5.8% year- to-date. Over the last month, the AUD is down 5.3% as the price of iron ore declined by over 10% and the Chinese economy remained on lockdown. The RBA raised its interest rate by 50bps for a second month in a row this week. This aggressively shifted market expectations for further rate increases, with pricing in the OIS curve one year out rising from 3.35 to 3.51% today. While the RBA admitted global supply chain issues have contributed to inflation, capacity constraints in certain sectors and a tight labor market are also helping fuel domestic inflation. Particularly, the May employment report was robust, with 69.4K full-time jobs added, and a healthy jump in the participation rate to 66.7%. Job vacancies continued to grow at 13.8%. Rising rates in Australia are having the desired effect. Home price inflation is cooling, especially in places like Sydney. Demand for housing and construction remains robust, suggesting the RBA is achieving a soft landing in the economy. For example, home loan values are growing 1.7% and building approvals are growing by 9.9%. Demand also appears strong as manufacturing PMI came out at 56.2 in June. We are bullish the AUD against the dollar; however, short-term headwinds from Chinese lockdowns do not currently make us buyers of the currency. We are exiting our long AUD/USD position after being stopped out at 0.68 for a loss of -5.67%.  New Zealand Dollar: Least Preferred G10 Currency Chart 9Terms Of Trade Are Waning For NZD The NZD is down 9.7% this year. Over the last month, it is down 4.7%. New Zealand has the highest policy rate in the G10, and that is beginning to take a toll on interest-rate sensitive parts of the economy. REINZ house sales fell 28.4% year on year in May. House price inflation is also rapidly cooling. In June, the ANZ consumer confidence index fell from 82.3 to 80.5. Business confidence deteriorated from -55.6 to -62.6. The external sector is no longer a tailwind for the NZ economy, as grain and meat prices cool off. The price of dairy, approximately 20% of New Zealand’s exports, continues to decline with a 10% drop in June. The 12-month trailing trade balance continues to plummet, hitting -9.5bn NZD in May. The current account for May came in at -6.14 billion NZD versus a consensus -5.5 billion NZD. China is an important economic partner for New Zealand, with circa 27% of Kiwi exports China bound. Restrictions seem to be easing as the latest non-manufacturing PMI from China data came in at 54.7 against a previous 48.4 reading. The number of days required to quarantine on arrival also dropped to 10 days from 21 days in June. If this trend continues, it will be positive for the NZD; however, China does not appear to have an exit strategy for their zero-case COVID-19 policy. Within the G10 currency space, many other currencies appear more attractive than the kiwi, though our view is that NZD will benefit when US dollar momentum rolls over.   Swiss Franc: A Safe Haven Chart 10A U-Turn From The SNB CHF is down 6.4% year-to-date and flat over the past month versus the dollar. Against the euro, the franc is up 4.7% year-to-date and 5.2% over the past month. Our special report on the franc was timely, given the surprise rate hike announcement from the SNB last month. Amidst currency market volatility, EUR/CHF broke below parity. The SNB views currency strength as a virtue in today’s paradigm. As such, it has halted currency interventions, evident through the decline in sight deposits. Markets are pricing in another 50bps hike in September. Inflation continued to accelerate above projections in June. Headline and core CPI were up 3.4% and 1.9% year on year respectively, lower than other G10 countries but high enough to keep the SNB on alert. Inflation remains largely driven by the prices of imported goods which strengthens the case for a strong franc. The labor market is also tight, with unemployment at 2.2% in May. The outlook for the Swiss economy remains positive for the rest of the year, albeit with some signs of slowing activity emerging. The manufacturing PMI at 59.1 and the KOF leading indicator at 96.8 were both down to multi-month lows in June. The trade surplus in May was down to CHF 2bn. The franc is undervalued against the dollar and can serve as a good hedge for spikes in global volatility.  Norwegian Krone: Improving The Current Account Chart 11NOK Has Decoupled From Oil Prices The NOK is down 13.2% YTD and down 6.2% over the last month. Against the euro, the NOK is down 2.4% YTD and 1.3% in over the past month. In June, the Norges Bank raised the policy rate from 0.75% to 1.25%, 25bps higher than broadly anticipated. The rate path was also revised sharply higher and now corresponds to a 25bps hike at each meeting until the rate steadies at around 3% next summer. Governor Ida Wolden Bache left the door open for more half-point hikes but also highlighted the potential risk of overtightening, suggesting a balanced approach. Inflation in Norway is surprising to the upside. In May, CPI came in at 5.7% and 3.4% for core, signaling that price increases are becoming more broad-based. The labor market remains tight. The unemployment rate dipped to 1.7% in June, the lowest reading since 2008. Wages are projected to grow 3.9% this year. Together with a positive output gap, and a weak currency, both domestic and imported inflation could remain sticky for a while. Economic activity remains healthy in Norway. The manufacturing PMI went up to 56.4 in June, private consumption is robust, and business investment is expected to increase around 8% this year. Petroleum investments are also expected to pick up markedly in the years ahead, spurred by elevated energy prices and tax incentives. Recent natural gas production hikes, approved by the government, will further contribute to the healthy trade surplus. The strike started by union workers this week threatened to halt a significant portion of Norway’s oil and natural gas output. However, a resolution was found rather quickly. Despite record energy prices, the krone is one of the worst-performing majors this year. Pronounced global risk-off sentiment in the first half weighed on the currency. Despite potential challenges in the near term, Norway’s trade balance will remain a major tailwind this year. Shorting EUR/NOK on rallies looks attractive.  Swedish Krona: Tracking The Euro Lower Chart 12The SEK Is At Capitulation Lows The SEK is down 14.2% year-to-date and 7.1% over the last month. Inflation is becoming a problem in Sweden. In May, the CPIF increased 7.2% year on year, while the core measure was up 5.4%. In response, the Riksbank raised the policy rate by 50bps to 0.75% at its June meeting. The Riksbank sees the policy rate at around 1.75% by year-end, implying 50bps hikes at the remaining two meetings this year. The bank also announced a faster run-off in its balance sheet. We had anticipated the hawkish pivot by the Riksbank in early June, but that has not helped the Swedish krona much. Like Europe, the Swedish economy is being held hostage by external shocks, the global slowdown and an energy crisis. Signs of economic slowdown are becoming more pronounced. The Riksbank’s GDP forecast for 2022 was revised down by 1% to 1.8% and cut in half to 0.7% for 2023. Industrial production and new order data also point to a cooling in economic activity. Manufacturing and services PMIs remain expansionary zone but are falling rapidly. Notably, export orders have been hovering around the 50 boom/bust line over the last few months. Housing market is also vulnerable, with the Riksbank projecting a more-than-10% decline in prices by next year. That said, the SEK is below the 2020 lows suggesting these risks are well priced in. We are buyers of SEK on weakness.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Artem Sakhbiev Research Associate artem.sakhbiev@bcaresearch.com Thierry Matin Research Associate thierry.matin@bcaresearch.com   Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary Global risk assets are oversold, and investor sentiment is downbeat. In this context, a technical equity rebound cannot be ruled out. However, we do not think it will be the beginning of a major cyclical rally. The Fed and the stock market remain on a collision course. An equity rally and easing financial conditions would make the Fed even more resolute to continue hiking interest rates. There are many similarities between dynamics that prevailed in US tech stocks and in previous bubbles. While it is not our baseline view, the odds of a protracted bear market are nontrivial. Resource prices and commodity plays have more downside. The History Of Financial Bubbles: Is This Time Different? Bottom Line: The decline in commodity prices and the relentless US dollar rally will ensure that EM currencies, bonds and stocks continue to sell off even if the US equity market rebounds in the near term. Feature Among the most frequently discussed topics in recent client calls are the upside and downside risks to our baseline view. We elaborate on these risks in this report. To recap, our baseline view is as follows: EM and DM stocks have another 15% downside in USD terms, the US dollar will continue overshooting and commodity prices will fall. Global yields are topping out, and the US yield curve will soon invert. Hence, defensive positioning for absolute-return investors is still warranted, and global equity and fixed-income portfolios should continue to underweight EM. The rationale is that US and EU demand for goods ex-autos, and hence global trade, is about to contract while the Fed is straightjacketed by high and broad-based inflation. China’s economy will be struggling to recover. In EM ex-China, domestic demand will relapse. Chart 1Will The S&P 500's Technical Support Hold? If one believes that the US equity bull market that began in 2009 is still alive (i.e. the March 2020 selloff is a short-lived red herring), odds are that the S&P 500 drawdown is over. The reasoning is that the S&P 500 is already down 23% from its 2021 peak, on par with the selloffs that occurred in 2011, 2015-16 and 2018 (Chart 1). However, if one believes that the structural bull market is over, the magnitude of the current equity selloff is likely to exceed the ones in 2011, 2015-16 and 2018. Hence, a bearish stance is still warranted. As we argue below, after a 12-year bull run, the excesses in the US equity market in general, and US tech stocks in particular, have become extreme. There are many signs of a bubble, or at least of a major top. Even though we risk overstaying in our negative view, our bias is that the global equity market rout is not yet over. A Bullish Scenario A (hypothetical) bullish case would look something like this: Weakening global and US growth and falling commodity prices bring down US inflation and Treasury yields. As US bond yields drop further, the S&P 500 rallies given their negative correlation of the past 18 months or so. As US inflation declines rapidly, the Fed makes a dovish pivot, reinforcing the risk asset rally and reversing the US dollar’s uptrend. Finally, Chinese stimulus produces a robust business cycle recovery in China that propels commodity prices higher and lifts the rest of EM out of the abyss. Chart 2Keep An Eye On Rising US Trimmed-Mean Inflation In our opinion, this scenario has no more than a 25% chance of playing out. Even if there are apparent signs of a US/global slowdown, elevated US core inflation and accelerating wages and unit labor costs would keep the Fed from dialing down its hawkishness Critically, even though US core PCE inflation has rolled over and will likely decline further, its trimmed-mean PCE inflation is rising (Chart 2). The latter means that inflation is broadening even as some volatile items like food, energy and used-auto prices deflate. As we have written extensively, wages and inflation are lagging variables. Despite the ongoing slowdown in the US economy, it will take many months before the underlying core inflation rate drops below 3%. We maintain that the Fed and the stock market remain on a collision course. An equity rally and easing financial conditions would make the Fed even more resolute to hike interest rates. The basis is that even if core inflation falls in the coming months, it would still be well above the Fed’s target of 2%. Notably, the Fed has recently communicated that its commitment to bring down inflation to 2% is unconditional. Chart 3The Anatomy Of The US Equity Bear Market In 2000-2002 This policy stance represents a major departure from the past several decades when the Fed was very sensitive to any tightening in financial conditions and often eased preemptively. In short, with inflation still well above its target, the Fed will, for now, err on the side of hawkishness if financial conditions ease. Importantly, US corporate profits will likely contract even if US real GDP does not shrink. As US corporate top-line growth slows and unit labor costs accelerate, profit margins will shrink. For example, the 2001-2002 recession was very mild – consumer spending did not contract at all, and housing boomed (Chart 3, top two panels). Yet, the S&P 500 operating earnings dropped by 30%, and the S&P 500 fell by 50% (Chart 3, bottom two panels). In brief, a devastating bear market does not necessarily require a hard landing. Concerning China, the recovery will likely be U-shaped rather than V-shaped with risks skewed to the downside. Finally, contracting global trade and falling commodity prices will continue, which are negative for EM currencies and assets. Notably, industry data from Taiwan’s manufacturing PMI suggest that the slowdown in the Asian and global economies is widespread. Taiwan’s substantial trade linkages with mainland China signify that the slowdown is not limited to the US and the EU but includes China too. Taiwanese PMI export orders of both semiconductor and basic material producers have plunged to 40 and 30, respectively (Chart 4). Barring a quick turnaround, global semiconductor and basic materials stocks have more downside. Even as US Treasury yields drop, the dollar will continue firming versus EM currencies, including those of Emerging Asian countries. In such a scenario, EM stocks and bonds will weaken further (Chart 5).  Chart 4A Broad-Based Contraction In Global Trade Is In The Cards Chart 5A Free Fall In EM Ex-China Stocks And Currencies   Bottom Line: The S&P 500 is oversold, and investor sentiment is downbeat. In this context, a technical equity rebound can occur at any moment. However, we do not think it will be the beginning of a major cyclical rally. A Bearish Case: Are US TMT Stocks A Bubble? What is a more bearish scenario than our baseline case? The bursting of bubbles or the unwinding of excesses would entail a more protracted and devastating bear market than the 15% drop in global share prices we currently expect. We can identify two major excesses in the global economy and financial system: In US TMT (Technology, Media & Entertainment and Internet & Catalog Retail) stocks and private equity In Chinese real estate. We have written extensively about property market excesses in China. Below we discuss the recent sharp selloff in commodities, which is partially linked to Chinese property construction. We also present the case for major excesses in US stocks. Chart 6 illustrates the history of bubbles of the past several decades: The Nifty-fifty (involving the 50 US large-cap stocks) bubble occurred in the 1960s and burst in the 1970s (not shown in the chart). The commodity bubble took place in the 1970s and burst in the 1980s. Japanese equity and property prices rose exponentially in the 1980s and deflated in the 1990s. The Nasdaq bubble occurred in the 1990s and was shattered in the early 2000s. Commodities/EM/China were the leaders of the 2000s, and they were devastated in the 2010s. We use iron ore in this chart because its price surged the most in the 2000s. FAANGM stocks, the Nasdaq 100 index and private equity were by far the biggest beneficiaries of the 2010s. No one can be certain about bubbles in real time because there are always superior fundamentals or persuasive stories that justify exponential price appreciation. That said, there are a lot of similarities between dynamics prevailing in US tech and private equity and in previous bubbles: In the past decade, FAANGM stocks, the Nasdaq 100 index and private equity companies registered gains comparable to the bubbles of the previous 60 years. Furthermore, as Chart 6 illustrates, the equal-weighted FAANGM index in inflation-adjusted terms rose 30-fold, much more than the bubbles of the previous decades. The Nasdaq 100 index and share prices of Blackstone, the largest private equity company, have risen by nearly 10-fold in real (inflation-adjusted terms) between 2010 and the end of 2021. Chart 6The History Of Financial Bubbles: Is This Time Different? The final phase of bubbles is often characterized by growing retail investor participation. This is exactly what happened with US tech/new economy stocks. Chart 7US TMT Stocks: Exponential Growth Rarely Ends Well Toward the end of the decade, not only retail but also institutional capital stampedes into the winners of the decade. This played out with US large-cap tech stocks as well as in private equity and private debt spaces. Inflows into private equity and private debt have been enormous. As a result of these inflows into US large-cap stocks, the market cap share of US TMT stocks as a percentage of total US market cap has surpassed 40%, its peak in 2000 (Chart 7). Bubbles often thrive during periods of low interest rates and crash when the cost of capital rises. This is exactly what has been happening in global financial markets since early 2019. The parameters of the overall US equity market were also excessive prior to this bear market. As of last year, the S&P 500 stock prices in real (inflation-adjusted) terms became as elevated relative to their long-term time trend as they were in the late 1960s and the late 1990s − the peaks of previous secular bull markets (Chart 8, top panel).   Chart 8The S&P 500 and Operating Profits: A Long-Term Perspective Chart 9Equity Issuance Marks Market Tops The S&P 500’s operating earnings in real terms have surpassed two standard deviations above its time trend (Chart 8, bottom panel). Some sort of mean reversion to its long-term trend is in the cards. US corporate profits have benefited from fiscal/monetary stimulus, low labor costs and pricing power. All of these are now working against profits.   Finally, new share issuance in the US mushroomed in 2021, another sign of a major top (Chart 9). Bottom Line: We are not entirely convinced that US TMT stocks are a bubble waiting to burst. Yet, the odds of this happening are nontrivial. This time might not be different. A Word On Commodities The selloff in the commodity space has been broad-based. Odds are that it will continue for the following reasons: A global business cycle downtrend is always bearish for commodity prices. In fact, oil prices are often lagging and are typically the last shoe to drop during global slowdowns. US sales of gasoline have started to contract. Besides, Saudi Arabia will likely increase its oil output and shipments following President Biden’s visit to the Kingdom next week. Chart 10Investors Have Been Long Commodity Futures As we have argued in recent months, China’s demand for commodities was contracting and, in our opinion, the rally in resource prices over the past 12 months was supported by investment demand for commodities, i.e., financial inflows into the commodity space. Many portfolios have bought commodities as an inflation hedge. When a hedge becomes a consensus trade and crowded, it stops being a hedge. Chart 10 demonstrates that net long positions in 17 commodities have been very elevated. The speed at which liquidation is taking place corroborates our thesis that it is investors not producers or consumers who have been caught being long commodities. China’s business cycle recovery will be U-shaped at best. Domestic orders point to weaker import volumes in the months ahead (Chart 11, top panel). ​​​​​​​Corporate loan demand has plunged suggesting that liquidity provisions by the PBoC might fail to produce a meaningful recovery in credit growth (Chart 11, bottom panel). Finally, technicals bode ill for commodity prices. As Chart 12 illustrates, copper prices and global material stocks have probably formed medium-term tops, and risks are skewed to the downside.  Chart 11China: The Economy Is Struggling To Gain Traction Chart 12A Major Top In Commodity Prices?   Bottom Line: Commodity prices and their plays have more downside. Investment Strategy The decline in commodity prices and the relentless US dollar rally will ensure that EM currencies, bonds and stocks continue to sell off even if the US equity market rebounds in the near term driven by lower Treasury yields. Global equity and fixed-income portfolios should continue underweighting EM. We also continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN, PHP and IDR; as well as HUF vs. CZK, and KRW vs. JPY. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Executive Summary Buying a home is now more expensive than renting in many parts of the world. In the US and UK, disappearing homebuyers combined with a flood of home-sellers will weigh on home prices over the next 6-12 months. Falling employment and falling house prices risk becoming a self-reinforcing negative feedback loop that turns a mild recession into a severe recession. To stop such a vicious cycle running out of control, policymakers will eventually bring down mortgage rates. For this reason, on a time horizon of 6-12 months, overweight bonds. A collapse in Chinese property development and construction activity will have negative long-term implications for commodities, emerging Asia, and developing countries that produce raw materials. Structurally underweight. On the other hand, stay structurally overweight the China 30-year government bond. Fractal trading watchlist: US Biotech versus Utilities. Buying A Home Is Now More Expensive Than Renting! Bottom Line: The decade-long global housing boom is over. Feature For the first time since 2018, the number of Brits wanting to buy a home is less than the number of Brits wanting to sell their home. The balance of homebuyers versus homes for sale is the main driver of any housing market. When multiple homebuyers are competing for a home for sale, the subsequent bidding war puts upward pressure on house prices. But when, multiple homes for sale are competing for a homebuyer, the subsequent discounting war puts downward pressure on house prices. The balance of homebuyers versus homes for sale is the main driver of any housing market. This makes the number of homebuyers versus homes for sale the best leading indicator of house prices. The recent collapse of this leading indicator in the UK warns that UK house prices are likely to soften through the remainder of 2022 and into 2023 (Chart I-1). Chart I-1With Fewer UK Homebuyers Than UK Home-Sellers, UK House Prices Are Set To Drop Homebuyers Are Disappearing While Home-Sellers Are Flooding The Market Disappearing homebuyers combined with a flood of home-sellers is also evident in the US. According to Realtor.com: “Weary US homebuyers face not only sky-high home prices but also rising mortgage rates, and that financial double whammy is hitting homebuyers hard: Compared with just a year ago, the cost of financing 80 percent of a typical home rose 57.6 percent, amounting to an extra $745 per month.” Compared with just a year ago, the cost of financing 80 percent of a typical US home rose 57.6 percent, amounting to an extra $745 per month. Unsurprisingly, US mortgage applications for home purchase have recently plunged by a third (Chart I-2) and homebuyer demand has declined by 16 percent since last June.1 Meanwhile, the inventory of homes actively for sale on a typical day in June has increased by 19 percent, the largest increase in the data history. Chart I-2With The Cost Of Financing A US Home Purchase Surging, Mortgage Applications Have Collapsed The flood of new homes on the market means that the dwindling pool of homebuyers will have more negotiating leverage on the asking price (Chart I-3 and Chart I-4). This will balance the highly lopsided negotiating dynamics in the raging seller’s market of the past two years. The shape of things to come can be seen in Austin, Texas, which was one of the hottest markets during the early pandemic real estate frenzy. Chart I-3US Homebuyers Are Disappearing... Chart I-4...While US Home-Sellers Are Flooding The Market “Prices are definitely starting to go down again… last Friday, an Austin home was listed at $825,000. The next day, at the open house, no one came. A few months ago, there would have been 20 or more buyers showing up. The sellers didn’t want to test the market, so on Sunday, they dropped it to $790,000. It sold for $760,000.” Buying A Home Is Now More Expensive Than Renting The nub of the problem for homebuyers is that the mortgage rate is higher than the rental yield. In simple terms, buying a home is now more expensive than renting (Chart I-5). The housing bulls counter that the high mortgage rate will force rental yields to adjust upwards by rents going up, but this argument is flawed. Chart I-5Buying A Home Is Now More Expensive Than Renting! The most important driver of rent inflation is the unemployment rate (inversely). Because, to put it bluntly, you need a steady job to pay the rent! Today, the Federal Reserve’s inflation problem, in a nutshell, is that rent inflation is too high even versus the tight jobs market (Chart I-6). Chart I-6The Fed Needs To Push Up Unemployment To Pull Down Rent Inflation Although the Fed cannot say this explicitly, its mechanism to bring down inflation is to push up unemployment, and thereby to pull down rent inflation, which constitutes almost half of the core inflation basket. In this case, the rental yield (rent divided by house price) would adjust upwards by the denominator – house prices – going down. The most important driver of rent inflation is the unemployment rate (inversely). Yet the housing bulls also argue that the housing boom is the result of a structural undersupply of homes. They claim that as this structural undersupply persists, it will underpin house prices. But this ‘housing shortage’ narrative is another myth, which we can debunk with two simple observations. Through the past decade, home prices have risen simultaneously and exponentially everywhere in the world. Now ask yourself, is it plausible that there could be a structural undersupply of homes everywhere in the world at the precisely the same time? If this doesn’t debunk the housing shortage narrative, then try this second observation. Through the past decade, gross rents have tracked nominal GDP. Theory says that gross rents should track nominal GDP, because the quality of the housing stock improves broadly in line with GDP, and therefore so too should rents. If there really was a structural undersupply of housing, then gross rents would be structurally outperforming nominal GDP. But that hasn’t happened in any major economy (Chart I-7). Chart I-7Rents Have Tracked GDP, So There Is No 'Structural Undersupply' Of Homes As an aside, if rents track GDP, then why do they constitute almost half of the core inflation basket?  The answer is that the rents included in inflation are ‘hedonically adjusted’, meaning that are supposedly deflated for quality improvements – though there is always a niggling doubt whether the statisticians do this adjustment correctly! Pulling all of this together, the synchronized global housing boom of the past decade was not the result of a structural undersupply. Instead, it was the result of a valuation boom – meaning, plummeting rental yields, which in turn were the result of plummeting mortgage rates, which in turn were the result of plummeting bond yields. But now that mortgage rates are much higher than rental yields, this ‘virtuous’ cycle risks turning vicious. Falling employment and falling house prices risk becoming a self-reinforcing negative feedback loop that turns a mild recession into a severe recession. To stop such a vicious cycle running out of control, policymakers will eventually have no other choice than to bring down mortgage rates. For this reason, on a time horizon of 6-12 months, overweight bonds. But The Prize For The Biggest Housing Boom Goes To… China The housing booms in the UK, US and other Western economies, extreme as they are, are small fry compared to the housing boom in China. Chinese real estate, now worth $100 trillion, is by far the largest asset-class in the world. And Chinese rental yields, at around 1 percent, are well below the yield on cash. Begging the question, how can Chinese real estate valuations be in such stratospheric territory, with a yield even less than that on ‘risk-free’ cash? The simple answer is that investors have been led to believe that Chinese real estate is a risk-free investment! Without a social safety net and with limited places to park their money, Chinese savers have for years been encouraged to buy homes, in the widespread belief that property is the safest investment, whose price is only supposed to go up (Chart I-8). Chart I-8Chinese Real Estate Is Perceived To Be A 'Risk Free' Investment With the bulk of Chinese households’ wealth in property acting as a perceived economic safety net, even a 10 percent decline in house prices would constitute a major shock to the household sector’s hopes and expectations of what property is. In turn, the ensuing ‘negative wealth effect’ would be catastrophic for household spending in the world’s second largest economy. Therefore, in contrast to the US housing debacle in 2008, the Chinese government will ensure that its property market adjustment does not come from a collapse in home prices. Rather, it will come from a collapse in property development and construction activity, combined with keeping interest rates structurally low. This will have negative long-term implications for commodities, emerging Asia, and developing countries that produce raw materials. Structurally underweight. On the other hand, Chinese bonds are an excellent investment for those investors who can accept the capital control risks. Stay structurally overweight the China 30-year government bond. Fractal Trading Watchlist Biotech and Utilities are both defensive sectors, based on the insensitivity of theirs profits to economic fluctuations. But whereas Biotech is ‘long duration’, Utilities is ‘shorter duration’. Over the coming months, as the economy falters and bond yields back down, long duration defensives, such as Biotech, are likely to be the winners. This is supported by the recent underperformance reaching the point of fractal fragility that has indicated previous major turning points (Chart I-9). The recommended trade is long US Biotech versus Utilities, setting a profit target and symmetrical stop-loss at 20 percent. This replaces our long US Biotech versus Tech position, which achieved its 17.5 percent profit target, and is now closed. Chart I-9Biotech Is Set To Be A Big Winner Chart 1CNY/USD Has Reversed Chart 2US REITS Are Oversold Versus Utilities Chart 3CAD/SEK Reversal Has Started Chart 4Financials Versus Industrials To Reverse Chart 5The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 6The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 7FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing Chart 8Netherlands Underperformance Vs. Switzerland Has Been Exhausted Chart 9The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 10The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 11Food And Beverage Outperformance Has Been Exhausted Chart 12AT REVERSAL Chart 13AT REVERSAL Chart 14The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 15The Strong Trend In The 3 Year T-Bond Is Fragile Chart 16A Potential Switching Point From Tobacco Into Cannabis Chart 17Biotech Is A Major Buy Chart 18Norway's Outperformance Could End Chart 19Cotton's Outperformance Is Vulnerable To Reversal Chart 20Fractal Trading Watch List Chart 21The Rally In USD/EUR Could End Chart 22The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 23A Potential New Entry Point Into Petcare Chart 24GBP/USD At A Turning Point Chart 25Fractal Trading Watch List Chart 26Fractal Trading Watch List Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Realtor.com gauge homebuyer demand by so-called ‘pending listings’, the number of listings that are at various stages of the selling process that are not yet sold. Fractal Trading System Fractal Trades 6-12 Month Recommendations 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  

Listen to a short summary of this report.       Executive Summary A Tremendous Inflow Into US Government Bonds Multiple frameworks exist for managing currencies. These include forecasting growth differentials, watching central banks, gauging terms of trade and balance of payment dynamics or even assigning a probability to the occurrence of black swans. For us, the most useful tool has been to simply track portfolio flows. In today’s paradigm, portfolio flows into US equities are rapidly dwindling, while those flowing into fixed income have picked up meaningfully. Gauging what happens next will be critical for the dollar call (Feature chart). 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. This has also pushed valuation and sentiment of the dollar to very elevated levels. If inflation peaks and the world economy achieves a soft landing, downside in the dollar will be substantial. On sentiment, being a contrarian can make you a victim, but when the stars are aligned where valuation, sentiment and the appropriate macro analysis point towards a single direction, our framework proves extremely useful. In a nutshell, many currencies, especially the euro, are already pricing in a nasty recession into their respective economies. If a recession does occur, they could undershoot. If one does not, they are poised for a coiled spring rebound. Bottom Line: Tactical investors should be neutral to overweight the dollar in the near term, as the probability of a recession rises. Longer-term investors should be slowly accumulating assets in countries where fundamentals make sense, and their currencies are deeply undervalued. Feature The real neutral rate of interest in the US is difficult to estimate ex ante, but Chart 1 highlights that the real Fed Funds rate is well below many estimates of neutral. In a world where inflation has become a widespread problem, and a few economies (like the US) are overheating, markets have moved to test the credibility of their respective central banks. The consensus has been that the Federal Reserve will be the most credible in taming runaway inflation by being able to raise rates faster than other central banks (Chart 2). This is especially the case as many European economies remain at firing range from the Russia-Ukraine conflict and, as such, face more supply-side driven inflation. Chart 1The Fed Has Scope To Tighten Further Chart 2Interest Rates Have Moved In Favor Of The Dollar The typical pattern for the dollar is that it tends to rise when growth is falling and inflation is also subsiding, which triggers tremendous haven flows into US Treasurys. Right now, inflation remains strong but growth is rolling over, which has historically painted a mixed picture for the dollar (Chart 3). Chart 3The Dollar Rises On Falling Growth What happens next is critical. The dollar tends to rise 10%-15% during downturns. We are already there. The DXY index is up 8.8% this year, and up 16.3% from the trough last year. European currencies like the SEK and the EUR have already priced in a recession as deep as in 2020. If this indeed proves to be the case, commodity currencies will be next, which could push the DXY to fresh highs. But as we outline below, even in a pessimistic scenario, a systematic approach to looking at currencies warns against fresh bets in favor of the dollar. Inflation And Central Banks One of the key themes we outlined in our outlook for this year is that inflation is a global problem, and not centric to the US. So, while supply side factors have had an outsized effect on energy deficient countries like Germany, the UK, Sweden and, to an extent Japan, inflation is also well above target in Canada, Australia, Norway, New Zealand, and many other developed and emerging market countries. In fact, the inflation impulse is slowing in the US, relative to a basket of G10 countries (Chart 4). Related Report  Foreign Exchange StrategyLessons From Fed Interest Rate Hikes Falling inflation will be a welcome relief valve from the tension in markets over much tighter financial conditions. It will also lower the probability of a global recession. For currency markets however, the starting point is that the market has priced the Fed to continue leading the tightening cycle until something breaks. If inflation does subside, then hawkish expectations by the Fed will be heavily priced out of the curve, which will remove a key source of support for the greenback. From a chartist point of view, the dollar has already overshot the level of rates the markets expect from the Fed, relative to more dovish central banks (Chart 5). This suggests a hefty safety premium is already embedded in the dollar. Chart 4US Inflation Is Peaking, Relative To Other ##br##Economies Chart 5The Dollar Has Overshot The Path Implied By Interest Rates The Dollar And Global Growth If the Fed and other central banks tame the inflation genie, then we will have achieved a soft landing. The dollar has tended to track the path of the US yield curve, and a flattening usually underscores longer-term worries about a recession (Chart 6). A steepening curve will signal mission accomplished. In the view of the Foreign Exchange Strategy service, recession risks could be relatively balanced. While major central banks have been tightening policy (the US and most of the G10), China, a big whale in terms of its monetary policy impact, has been easing monetary conditions. Chart 7 highlights that most procyclical currencies have tracked the Chinese credit impulse tick for tick. Bond yields in China are near the lows for the year. Unless China enters another economic down-leg in growth that matches the 2015 slowdown, we might just witness a rotation in economic vigor from the US towards other economies, led by China, allowing the world to achieve a soft landing. Chart 6The Dollar Is Tracking The US Yield ##br##Curve Chart 7Commodity Currencies Are Tracking The Chinese Credit Impulse   In the currency world, typical recessionary indicators are not yet flashing red. Cross-currency basis swaps remain well contained, suggesting dollar funding pressures, or that the ability to service dollar debt abroad remains healthy. The Fed’s liquidity swap lines, which allow foreign central banks to obtain dollar funding, also remain untapped (Chart 8). That said, currency put-call ratios are rising, suggesting the cost of obtaining downside protection has increased. Chart 8The Fed"s Recession Models Are Still Sanguine The Dollar And Portfolio Flows Aside from hedging against downside protection for the EUR, the AUD or even the CAD, one driver of dollar strength has been huge portfolio inflows into US Treasurys (Chart 9). That has occurred while equity inflows have collapsed. Admittedly, this took us by surprise since by monitoring the big Treasury whales (Japan and China), holdings have been rolling over for quite some time (Chart 10). This has also occurred amidst an accumulation of speculative short positions on US Treasurys. Chart 9A Tremendous Inflow Into US Government Bonds Chart 10Japan And China Remain Treasury Sellers Historically, bond inflows are the driver of portfolio flows into the US, but the equity market has also dictated the trend in the dollar from time to time. Overall, the basic balance in the US, sum of all portfolio flows, has done a good job capturing turning points in the dollar. Our focus on equity flows this time around is due to the conundrum the US faces. Relative profits tend to drive the performance of relative stock prices, and US profits tend to be more defensive – rising on a relative basis when bond yields and commodity prices are collapsing and falling otherwise (Chart 11). As such, the rise in bond yields has already derated US equity multiples but profits have held up remarkably well. An underperformance in US equities during a downturn has been unprecedented with a strong dollar since the end of the Bretton Woods system. So should a market shakeout lead to a violent rotation out of US equities, the profile for the dollar could be a mirror image of what we witnessed in 2008 or even 2020. The conundrum for bond inflows is that according to traditional measures, real rates in the US remain deeply negative, but they have improved significantly under the lens of market-based measures (Chart 12). This partly explains the dollar overshoot. A scenario of faster growth outside the US could see real rates improve more quickly abroad. Chart 11US Profits Have Held Up Remarkably Well Chart 12Market-Based Real Yields In The US Have Improved A final point: managing currencies is about anticipating the next macroeconomic driver. In our view, this could be fears about balance of payments dynamics, especially as the world becomes marginally less globalized. Since the 1980s, we have never had a configuration where the dollar is very overvalued, US real rates are extremely low, and the trade deficit is near a record high (meaning it needs to be financed externally). A bet on US exceptionalism has a natural limit, as competitiveness abroad is improving tremendously vis-à-vis many of the goods and services the US exports. Currencies And Valuations Currencies should revert to fair value. The question then becomes "which fair value should they mean-revert to?" In our view, simple works best – purchasing power parity values. A simple chart shows that selling the dollar when it is expensive and buying it when cheap according to its purchasing power generates alpha over the long term (Chart 13). In A Simple Trading Rule For FX Valuation Enthusiasts, we showed that a shorter-term trading strategy also based on valuation adds value. Granted, the dollar started to become overvalued in 2015, but it is now sitting close to a historical extreme. A fair assessment is that currencies will revert to their fair value, but that takes time (3-5 years). As such, longer-term investors should be slowly accumulating assets in countries where fundamentals make sense, and their currencies are deeply undervalued. These include Japan, Australia, Sweden and even Mexico (Chart 14). Chart 13The Dollar Is Overvalued On a PPP Basis Chart 14The Real Effective Exchange Rate For The Dollar Is High The Dollar And Momentum There is quite simply a dearth of dollar bears. Internally at BCA, a lot of strategists who see more downside to US (and global) equities, simply cannot be negative on the dollar. Within the foreign exchange strategy, we have been short the DXY index since 104.8, and are sticking with that bet on a 12-18-month horizon. For risk management purposes, our stop loss is at 107. First, we are seeing record long positions by speculators (Chart 15). Fielding clients, or even the media, no one wants to be a dollar bear when the Fed is clearly an inflation vigilante. If inflation keeps surprising to the upside, then speculators will keep bidding up the dollar. But it is also fair to say that most investors who want to be long the greenback at this point already have that position on.  Our intermediate-term indicator, a combination of technical variables, also warns against initiating dollar-long positions at the current juncture (Chart 16). This series mean-reverts quite quickly, so it does not dictate the trend in the dollar, but warns of capitulation extremes. Chart 15Speculators Are Very Long The Dollar Chart 16Technical Dollar Indicators Are Overbought Finally, the dollar has been used as a bet on rising volatility. The dollar is well above levels that a correction in the S&P 500 index would dictate (Chart 17). It has also moved in tandem with bond volatility (Chart 18). This suggests much of equity downside risk has been priced into the dollar. Chart 17The Dollar Has More Than Compensated For The Drawdown In Equities Chart 18The Dollar Is Tracking ##br##Volatility Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

In this <i>Strategy Outlook</i>, we present the major investment themes and views we see playing out for the rest of the year and beyond.

Executive Summary Accelerating wages will make core consumer inflation sticky in the US. In addition, inflation is a lagging variable and is still well above the Fed’s target. These dynamics imply that the Fed will not make a dovish pivot imminently. Following the re-normalization of economic activity after reopening, China’s recovery will be U-shaped, rather than V-shaped. Global manufacturing and exports are heading into contraction. Contracting global trade is bullish for the trade-weighted US dollar given that it is a counter-cyclical currency. A hawkish Fed is also positive for the greenback. Hence, the US dollar will likely overshoot. EM equities are unlikely to rally/outperform on a sustainable basis until an EM profit contraction is priced in and the US dollar starts depreciating. Asian Currencies Will Depreciate Bottom Line: Absolute return investors should stay defensive for now. The global equity selloff has entered its final capitulation phase. Feature Global equity and fixed-income portfolios should maintain an underweight allocation to EM. That said, we will likely be upgrading EM versus DM later this year. EM currencies have more downside. Global and EM risk assets will likely continue selling off. Our major macro themes remain intact. Accelerating wages will make core consumer inflation sticky in the US. In addition, inflation is a lagging variable and is still well above the Fed’s target. These dynamics imply that the Fed will not make a dovish pivot imminently. Meanwhile, global growth is slowing rapidly, and global trade volumes are on the verge of contracting. US and EU demand for consumer goods (ex autos) is set to shrink.  EM ex-China domestic demand will be weakening from already very low levels.  Following the re-normalization of Chinese economic activity after the reopening, China’s recovery will be U-shaped, rather than V-shaped. Overall, global profits − including US and EM –will contract. Our bias is that equity markets have not fully discounted a profit contraction. The combination of shrinking corporate profits and a hawkish Fed  that is focused on taming inflationary pressures is bearish for global stocks and risk assets. As long as the Fed maintains its hawkish bias and/or global trade contracts, the US trade-weighted dollar will continue to appreciate. The USD will likely overshoot in the near term. Contracting global trade is bullish for the counter-cyclical greenback. EM currencies will therefore continue to depreciate, weighing on EM bonds and stocks. Typically, EM stocks do not out outperform DM ones when the dollar is strengthening. Even though global risk assets have already sold off significantly and there is a temptation to buy, odds are high that there will be another downleg. Several markets are already breaking down below their technical support lines: The Nasdaq 100 index is slipping below its 3-year moving average which proved to be a major support in past selloffs (Chart 1, top panel). The average exchange rate of AUD, NZD and CAD (which are all cyclical commodity currencies) versus the US dollar has fallen below its 3-year moving average (Chart 1, bottom panel). In the commodity space, we have similar breakdowns. Share prices of gold mining companies, silver prices and the silver-to-gold price ratio have all clearly crossed below their 3-year moving averages (Chart 2). Chart 1Breakdowns in The Nasdaq 100 And Commodity Currencies Chart 2Precious Metal Prices Are Breaking Down Too   Emerging Asian financial markets underscore that growth is relapsing and demand for raw materials is weak. The top panel of Chart 3 illustrates that Korean materials stocks have broken below their 3-year moving average. Further, in China, rebar steel, rubber, cement and plate glass prices are all falling (Chart 3, middle and bottom panels). Chart 3Bearish Signals For Raw Materials From Asia The charts below provide more evidence, supporting our macro themes and investment strategy. Investment Conclusions Absolute return investors should stay defensive for now. The global equity selloff has entered its final capitulation phase. Global equity and fixed-income portfolios should continue underweighting EM. That said, we will likely be upgrading EM versus DM later this year. The US dollar has more upside. EM/Asian FX and commodity currencies are vulnerable. We also continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN, PHP and IDR; as well as HUF vs. CZK, and KRW vs. JPY. A buying opportunity in global and EM risk assets will emerge once US Treasury yields roll over decisively, the US dollar begins its descent and China provides more stimulus. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com The US Equity Bear Market: How Advanced Is It? If this US equity selloff is part of an ongoing bull market that began in 2009, then the drop in share prices is probably over. However, if this same bull market has reached its end, then this selloff has further room to go. Our best guess is that it is the latter, i.e., we might be witnessing the end of the S&P 500 bull market that commenced in 2009. Our S&P 500 Capitulation Indicator is low, but it can drop further. Also, the S&P 500 will likely break below its 3-year moving average, which acted as a support in the 2011, 2015-16 and 2018 selloffs. Chart 4The US Equity Bear Market: How Advanced Is It? US Corporate Credit And Share Prices The US corporate credit market does not yet point to a durable bottom in US share prices. Rising corporate HY ex-energy bond yields, and the underperformance of HY ex-energy corporate credit versus IG credit, point to lower share prices for now. Chart 5US Corporate Credit And Share Prices Chart 6US Corporate Credit And Share Prices The US Inflation Genie Is Out Of The Bottle US labor demand is outstripping labor supply by a record margin since 1950. US wages have accelerated and will remain sticky in the coming months. High wage growth and weaker output entail rising unit labor costs. The latter is a key driver of core inflation. Unless the unemployment rate rises, US core inflation will not drop below 3.5-4%. In fact, median and trimmed-mean CPI have continued rising even though core CPI has rolled over. Chart 7The US Inflation Genie Is Out Of The Bottle Chart 8The US Inflation Genie Is Out Of The Bottle       Chart 9The US Inflation Genie Is Out Of The Bottle Chart 10The US Inflation Genie Is Out Of The Bottle   US Manufacturing Is Downshifting Rapidly Railroad carload is declining, and new orders from the US regional Feds’ manufacturing surveys are in free fall. The ISM new orders index will drop below the critical 50 line. Chart 11US Manufacturing Is Downshifting Rapidly Chart 12US Manufacturing Is Downshifting Rapidly Chart 13US Manufacturing Is Downshifting Rapidly     The US Is Entering A Major Growth Slump US household demand for consumer goods ex-autos will shrink. The basis is excessive goods purchases in the last two years, falling household disposable income in real terms and a shift in preference for services versus goods. US retail inventories of consumer goods ex-autos have surged. Retailers will substantially cut back on their orders. Asian/Chinese exports are set to shrink. US consumption of gasoline is also contracting. Chart 14The US Is Entering A Major Growth Slump Chart 15The US Is Entering A Major Growth SlumpChart 16The US Is Entering A Major Growth Slump       Global Manufacturing And Exports Are Heading Into Contraction The relative performance of global cyclical stocks versus defensives points to a major relapse in global manufacturing. Chinese import volumes have been contracting and EM import volumes will drop too with the deteriorating purchasing power of households across many developing economies. Chart 17Global Manufacturing And Exports Are Heading Into Contraction Chart 18Global Manufacturing And Exports Are Heading Into Contraction Chart 19Global Manufacturing And Exports Are Heading Into Contraction     Contracting Asian Exports Are Negative For Asian Currencies There are already signs of contraction in Asian manufacturing/exports. Downshifting global trade typically leads to Asian currency depreciation. Chart 20Contracting Asian Exports Are Negative For Asian Currencies Chart 21Contracting Asian Exports Are Negative For Asian Currencies       Chart 22Contracting Asian Exports Are Negative For Asian Currencies Chart 23Contracting Asian Exports Are Negative For Asian Currencies   The USD Has More Upside, EM FX More Downside The EM ex-China currency total return index has failed to break above its technical resistance line. This entails a major downside. The underperformance of global cyclicals versus defensives points to lower Asian currencies. The US dollar (shown inverted on Chart 24) will be supported by a deceleration in global US dollar liquidity. Chart 24The USD Has More Upside, EM FX More Downside Chart 25The USD Has More Upside, EM FX More Downside     Chart 26The USD Has More Upside, EM FX More Downside EM Equity Capitulation Our EM Equity Capitulation Indicator has dropped significantly but is still above its 2008, 2015-16 and 2020 lows. Given the global and EM macro backdrops, odds point to an undershoot in EM share prices. Chart 27EM Equity Capitulation EM Equity And Bond Sentiment Investor sentiment on EM stocks and EM USD bonds is downbeat. This is positive from a contrarian perspective. However, as global risk assets continue selling off and the US dollar overshoots, EM stocks and bonds might undershoot. Chart 28EM Equity And Bond Sentiment Chart 29EM Equity And Bond Sentiment EM Equity Valuations And Profits Based on our cyclically adjusted P/E ratio, EM equity valuations have improved to one standard deviation below the mean. Relative to the S&P 500, EM stock valuations are at their record low based on a similar measure. Nevertheless, EM equities are unlikely to rally/outperform on a sustainable basis until an EM profit contraction is priced in and the US dollar starts depreciating. Chart 30EM Equity Valuations And Profits Chart 31EM Equity Valuations And Profits       Chart 32EM Equity Valuations And Profits Chart 33EM Equity Valuations And Profits   Four Large-Cap EM Stocks The four largest EM stocks (by market value) might not be out of the woods. Alibaba is facing resistance at its 200-day moving average. Tencent, TSMC and Samsung will likely drop to their next technical support lines. Chart 34Four Large-Cap EM Stocks Chart 35Four Large-Cap EM Stocks       Chart 36Four Large-Cap EM Stocks Chart 37Four Large-Cap EM Stocks   Chinese And EM ex-China Stocks The rally in the Chinese onshore CSI 300 stock index will probably dwindle at its 200-day moving average. Technical supports have held up for Chinese investable TMT and non-TMT stocks. However, the recent rebound is unlikely to be sustained if the global selloff continues. Finally, EM ex-China stocks have been in a free fall. Chart 38Chinese And EM ex-China Stocks Chart 39Chinese And EM ex-China Stocks       Chart 40Chinese And EM ex-China Stocks Chart 41Chinese And EM ex-China Stocks   Global Cross-Asset Interlinkages Rising US TIPS yields will keep upward pressure on EM local bond yields and downward pressure on EM currencies. The mainstream EM ex-China currencies are not cheap. Without EM currencies rallying, it will be difficult for EM stocks to outperform DM ones. Chart 42Global Cross-Asset Interlinkages Chart 43Global Cross-Asset Interlinkages Chart 44Global Cross-Asset Interlinkages     A Structural Breakdown In Chinese Real Estate The Chinese real estate market is experiencing a structural breakdown, as is illustrated by the collapse in share prices of Chinese property developers and their corporate bond prices. The breakdown in property developers’ financing heralds lower construction volumes with negative implications for raw material prices. Chart 45A Structural Breakdown In Chinese Real Estate Chart 46A Structural Breakdown In Chinese Real Estate       Chart 47A Structural Breakdown In Chinese Real Estate Chart 48A Structural Breakdown In Chinese Real Estate   Chinese Domestic Demand Has Been Absent Over The Past 12 Months Chinese imports of various commodities and goods have been contracting over the past 12 months. The resilience of commodity prices has not been due to China. As investors start pricing in the US economic downturn and the need for inflation protection wanes, commodity prices could gap down. Chart 49Chinese Domestic Demand Has Been Absent Over The Past 12 Months Chart 50Chinese Domestic Demand Has Been Absent Over The Past 12 Months     Will The Pendulum Swing From Inflation To Deflation? The US equity and bond market selloffs of the past 12 months have wiped out about $12 trillion and $3.5 trillion of their respective market value, respectively. This adds up to a combined $15 trillion or about 60% of US GDP, which already exceeds the wipeouts that occurred during the March 2020 crash and all other bear markets. Such wealth destruction and a hawkish Fed could swing the pendulum from inflation to deflation. Commodity prices are currently vulnerable. Stay tuned. Chart 51Will The Pendulum Swing From Inflation To Deflation? Chart 52Will The Pendulum Swing From Inflation To Deflation? Chart 53Will The Pendulum Swing From Inflation To Deflation?     Footnotes Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)