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Executive Summary Economic growth is now a casualty, and not a driver, of monetary policy choices. Inflation is dictating where central banks are taking interest rates. Our baseline view remains that core US inflation will cool by enough on its own without the need for the Fed to deliver a policy-induced recession. However, the odds of the latter have increased after the upside surprise in the May US CPI report. The ECB has been dragged into the same morass as other major central banks – tightening policy because of soaring inflation, despite broad-based signs of sluggish economic growth. We still see the pricing of cumulative rate hikes in the euro area as being too aggressive, even after last week’s clear announcement from the ECB that a string of future rate hikes was coming. With the ECB also announcing an end to its QE program, but offering no details on a replacement, markets have been given the green light to push Italian yields/spreads higher (and the euro lower) until there is an ECB response to market fragmentation in European sovereign debt. Bottom Line: The Fed is still more likely than the ECB to follow through on rate hikes discounted in US and European interest rate curves - position for renewed widening of the Treasury-Bund spread. Italian bond yields will remain under upward pressure until the contours of an ECB plan to stabilize Peripheral Spreads alongside rate hikes are revealed – tactically position for a wider BTP-Bund spread. Central Bankers Cannot Worry About Growth … Or Your Investment Portfolio The US consumer price index (CPI) report for May was yet another bond-bearish shock in a year full of them. With US headline US inflation hitting an 41-year high of 8.6%, the Treasury market adjusted bond yields upward to reflect both higher inflation expectations and even more aggressive Fed tightening. Coming only a day after the June European Central Bank (ECB) meeting that provided guidance that a series of rate hikes would begin in July, that could include a 50bp hike at the September meeting, financial markets worldwide moved to price in the risk that policy-induced recessions were the only way to bring down soaring global inflation. The result: global bond yields soared to new highs for the year, while risk assets of all shapes and sizes were hammered. We have our doubts that today’s class of policymakers – especially the Fed - has the stomach to repeat the actions of former Fed Chair Paul Volcker, who famously pushed US interest rates above the double-digit inflation rates of the late 1970s to engineer a deep recession to crush inflation. The starting point of the current tightening cycle is even further behind the curve than during the Volcker era, in terms of “realized” real interest rates, with the 10-year US Treasury yield now over five percentage points below headline US CPI inflation (Chart 1). Related Report Global Fixed Income StrategyAssessing The Risks To Our Main Views Central bankers are now faced with the no-win scenario of pushing nominal policy rates higher to chase soaring inflation in a bid to maintain inflation fighting credibility, regardless of the spillover effects on financial market stability or economic growth expectations. More worryingly, the rate hikes needed to establish that credibility are not only becoming more frequent but larger. 50bps has become the “standard” size for developed market rate hikes. The Fed may have upped the ante with the 75bp hike at yesterday's FOMC meeting. Such is the reality of a funds rate still only at 1.75% but with US inflation pushing toward 9%. The timing of the latest hawkish shifts from the Fed, ECB and others is surprising, looking purely from a growth perspective. The OECD leading economic indicators for the US, euro area and China are slowing, alongside depressed consumer confidence and deteriorating business sentiment (Chart 2). Similar readings are evident in comparable measures in other major economies, both in developed and emerging economies. This would normally be the type of backdrop that would entice central banks to consider easing monetary policy - IF inflation was subdued, which is clearly not the case today. Chart 1Does Powell Need To Channel His Inner Volcker? In fact, high inflation is the reason why economic sentiment has worsened. Chart 2Worrying Signs For Global Growth Consumers see income growth that is lagging inflation, especially for everyday items like gasoline and food. Businesses are seeing input costs rising, especially for labor in an environment of tight job markets. Inflation has become broad-based, across goods, services and wages. This is true for countries that are more advanced in their monetary tightening cycles - the US, Canada and the UK - where inflation rates are remarkably similar (Chart 3). But it is also now true in countries with lower (but still accelerating) inflation rates and where central banks have been slower to tighten monetary conditions, like the euro area and Australia (Chart 4). Chart 3Inflation Turning More 'Domestic' (Services / Wages) Here Chart 4Still No Major Services/Wage Inflation Overshoots Here For the Fed, assessing the underlying momentum of US inflation, and setting monetary policy accordingly, has become a bit trickier. While headline inflation continues to accelerate in response to rising energy and food prices, core inflation ticked lower in both April and May and now sits at 6.1%, down from 6.5% in March. Longer-term survey-based measures of inflation expectations have been moving steadily higher, with the University of Michigan 5-10 year consumer inflation expectations survey now up to a 14-year high of 3.3% (Chart 5). Yet longer-term market-based inflation expectations have been more stable, with the 10-year TIPS breakeven now at 2.66%, down from the late April peak of 3.02%. There are also some mixed signals visible within the US inflation data. Core goods CPI inflation clocked in at 8.5% in May, down from the recent peak of 12.4% in February 2022, while core services CPI inflation accelerated to a 14-year high of 5.2% in May (Chart 6). A similar divergence can be seen when looking at the Atlanta Fed’s measures of “sticky” and “flexible” price inflation. Core flexible CPI inflation – measuring prices that adjust more rapidly – has fallen from a peak of 19% to 12.3% in May. At the same time, core sticky CPI inflation for prices that are slower to adjust sped up to an 31-year high of 5% in May. Chart 5Some Mixed Inflation Messages For The Fed Chart 6US Inflation Will Eventually Be Lower, But 'Stickier' Chart 7Stick With UST-Bund Spread Widening Trades In terms of the Fed’s next policy moves, the acceleration of core services (and sticky) inflation means underlying inflation momentum remains strong enough to make it difficult for the Fed to tighten by less than markets are discounting over the next year. Yet the deceleration of core goods (and flexible) inflation, if it continues, can lead to an eventual peak in overall US inflation. This would ease pressure on the Fed to tighten policy more aggressively than markets are expecting to slam the brakes on US economic growth. For nervous markets worried about Fed-induced recession risks, the clear peak in US inflation that we had been expecting has likely been pushed out further into the latter half of 2022. Thus, a significant fall in US Treasury yields that would provide relief to stressed risk assets is unlikely in the near term. Our preferred way to play that upward pressure on US Treasury yields is through an underweight stance on US Treasuries in global bond portfolios, rather than a below-benchmark duration stance. That is particularly true versus German Bunds - the 10-year UST-Bund yield spread is now well below the fair value level from our fundamental valuation model (Chart 7). Bottom Line: It is not clear that the Fed needs to “pull a Volcker” and generate a policy-induced recession to cool off US inflation. However, the Fed is far more likely to hike rates in line with market expectations than the ECB over the next 6-12 months. Stay underweight US Treasuries versus core Europe in global bond portfolios. The ECB Takes The Patient Off Life Support The ECB is finally coming to grips with surging European inflation. At last week’s policy meeting, the ECB Governing Council voted to end new bond buying via the Asset Purchase Program, while also signaling that a 25bp rate hike was on the way in July, with more hikes to follow – perhaps as much as 50bps in September if inflation remains elevated. Chart 8Markets Pricing In A Highly Aggressive ECB The central bank provided a new set of quarterly economic projections that, unsurprisingly, included significant upward revisions to the inflation forecasts. The 2022 headline HICP inflation forecast was bumped from 5.1% to 6.8%, the 2023 forecast from 2.1% to 3.5% and the 2024 forecast was nudged higher from 1.9% to 2.1%. The projections for core HICP inflation were also increased to 3.3% for 2022, 2.8% for 2023 and 2.3% for 2024. The central bank now expects euro area inflation to stay above its 2% inflation target throughout its forecast period – even with a 20% decline in oil prices, and 36% fall in natural gas prices, built into the projection between 2022 and 2024. A move towards tighter monetary policy has been heralded by our ECB Monitor, which remains elevated largely due to its inflation component (Chart 8). By contrast, the growth component of the Monitor has rolled over and is now at levels consistent with unchanged monetary policy. Yet in the current environment of very elevated inflation, concerns about the economy are taking a back seat to maintaining the ECB’s inflation-fighting credibility. In the relatively young history of the ECB, dating back to the inception of the euro in 1998, there have only been three true hiking cycles that involved multiple interest rate increases: 2000, 2006-08 and 2011. In each case, both growth and inflation were accelerating in a broad-based way across the majority of euro area countries. Today, inflation is surging, with the headline HICP inflation rate hitting 8.1% in May, while core inflation (ex energy and food) is a more subdued but still high 4.4%. Economic growth is decelerating, however, with leading economic indicators now slowing in a majority of euro area countries (Chart 9). Chart 9Coming Up: An Unusual ECB Tightening Cycle That Ignores Growth The ECB’s updated economic growth forecasts were downgraded for this year and next, with real GDP growth now expected to reach 2.8% in 2022 and 2.1% in both 2023 and 2024. Cutting growth forecasts for the current year was inevitable given the uncertainties stemming from the Ukraine war and soaring European energy prices. However, the projected growth rates do seem optimistic in the face of deeply depressed readings on economic sentiment from reliable measures like the ZEW index or the European Commission consumer confidence index, both of which have fallen sharply to levels last seen during the 2020 pandemic shock (Chart 10). Demand for European exports is also sluggish, particularly exports to China which are now flat in year-over-year terms. A similar pattern can be seen in the ECB’s inflation forecasts, which seem too optimistic in projecting lower wage growth and core inflation through 2024, even with the euro area unemployment rate forecasted to stay below 7% - under the OECD’s full employment estimate of 7.7% over the same period (Chart 11). Chart 10Overly Optimistic ECB Growth Forecasts Chart 11Overly Optimistic ECB Inflation Forecasts? The ECB is facing the same communications problem as other central banks at the moment. There is a fear of forecasting a major growth slowdown that would scare financial markets, even though that is a necessary condition to help bring down elevated inflation. At the same time, projections of a big decline in inflation that would limit the need for economy-crushing monetary tightening are not credible in the current environment of historically elevated headline inflation with very low unemployment rates. Interest rate markets understand the bind that the ECB finds itself in, and have moved to price in a very rapid jump in policy rates over the next 1-2 years. The 1-month OIS rate, 2-years forward is now at 2.5%, a high level compared to estimates of the neutral ECB policy rate, which lies between 1-1.5%. Core European bond yields have moved up alongside those rising rate expectations, with the 10-year German bund yield now at 1.64%, a far cry from the -0.18% yield at the start of 2022. Additional German yield increases will prove to be more difficult in the months ahead. There has already been a major upward adjustment in the inflation expectations component of yields, with the 10-year euro CPI swap rate now up to 2.6% compared to 2% at the start of this year (Chart 12). Importantly, those inflation expectations have stabilized of late, even in the face of high oil prices. Meanwhile, real bond yields, while still negative, have also moved up substantially and are now back to levels that prevailed before the ECB introduced negative policy rates in 2014 (bottom panel). With so much bond-bearish news now priced into core European bond yields, additional yield increases from here would require a more fundamental driver – an upward repricing of terminal interest rate expectations. On that note, the German yield curve is signaling that the terminal rate in the euro area is not much above 1.75%, as that is where bond yield forwards have converged to for both long and short maturity bonds (Chart 13). Chart 12How Much Higher Can Bund Yields Realistically Go? Chart 13Markets Signaling A 1.75% Terminal Rate Given our view that the neutral rate in Europe is, at best, no more than 1.5%, ECB rate hikes much beyond that level would likely invert a Bund curve that is priced for only a 1.75% terminal rate. An inverted Bund curve would also raise the odds that Europe enters a policy-induced recession – turning a bond bearish outcome into a bond bullish one. Even with the relatively aggressive policy expectations priced into European bond yields, it is still too soon to raise European duration exposure with inflation still accelerating. We prefer maintaining a neutral duration stance until there is a clear peak in realized European inflation – an outcome that would also favor a shift into Bund curve steepeners as the markets price out rate hikes and, potentially, begin to discount future rate cuts. Does The ECB Even Have A Plan For Italian Debt? The ECB seems to have a clear near-term plan on the timing, and even the potential size, of rate hikes. There is far less clarity on how it will deal with stabilizing sovereign bond yields post-APP in the countries that benefitted from ECB asset purchases, most notably Italy. By offering no details on a replacement to APP buying of riskier European debt at last week’s policy meeting, markets were given the green light to test the ECB’s resolve by pushing Italian bond yields higher (and the euro lower). Volatility in both markets will continue until there is a credible ECB response to so-called “market fragmentation” in European sovereign debt (i.e. higher yields and wider spreads versus Bunds in the Periphery). With the benchmark 10-year Italian BTP yield pushing above 4%, the ECB tried to calm markets yesterday by announcing an emergency meeting of the Governing Council to discuss “anti-fragmentation” policy options. The announcement triggered a relief rally in BTP prices, likely fueled by short covering. But the ECB statement was again light on concrete details, only noting that: a) reinvestments from maturing bonds from the now-completed Pandemic Emergency Purchase Program (PEPP) could be used “flexibly” to support stressed parts of the European bond market b) the timeline for ECB researchers to prepare proposals for a “new anti-fragmentation instrument” would be accelerated. We expect the ECB to eventually produce a credible bond buying plan to support Peripheral European bond markets – but only after an “iterative” trial-and-error process where trial balloon proposals are floated and skeptical financial markets respond. Chart 14Stay Cautious On Italian Government Bonds There is almost certainly some serious horse trading going on within the ECB Governing Council, with inflation hawks demanding more rate hikes in exchange for their support of new plans to deal with market fragmentation. Details such as the size of any new program, the conditions under which it would be activated, and country purchase limits (if any) will need to be ironed out. Internal ECB debates will prolong that trial-and-error process with financial markets, keeping yield/spread/FX volatility elevated in the short-term. On a strategic (6-18 month) time horizon, we see a neutral allocation to Italy in global bond portfolios as appropriate, given the tradeoff between increasingly attractive yields and the uncertain timing of effective ECB market stabilization proposals. On a more tactical horizon (0-6 months), we expect Italian yields and spreads versus Germany to remain under upward pressure until a viable anti-fragmentation program is announced (Chart 14). To play for that move, we are introducing a new position in our Tactical Overlay Trade portfolio, selling 10-year Italy futures and buying 10-year German Bund futures. The details of the new trade, including the specific futures contracts and weightings for the two legs of the trade to make it duration-neutral, can be found in the Tactical Trade table on page 18. As we monitor and discuss this trade in future reports, we will refer to the well-followed 10-year Italy-Germany spread (currently 225bps) to determine targets and stop levels of this bond futures spread trade. We are setting a stop-out on this trade if the 10-year Italy-Germany spread has a one-day close below 200bps, while targeting a potential widening to 275-300bps (the 2018 peak in that spread). Bottom Line: The ECB’s lack of conviction on designing a plan to support Peripheral bond markets during the upcoming period of interest rate hikes will keep upward pressure on Peripheral yields/spreads over the next few months. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com GFIS Model Bond Portfolio Recommended Positioning Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Tactical Overlay Trades
In lieu of next week’s report, I will host a Webcast on Monday, June 27 to explain the recent market turmoil and how to navigate it through the second half of 2022. Please mark the date, and I do hope you can join. Executive Summary The recent sharp underperformance of the HR and employment services sector presages an imminent rise in the US unemployment rate. Central banks have decided that a recession is a price worth paying to slay inflation. In this sense, the current setup rhymes with 1981-82, when the Paul Volcker Fed made the same decision. The correct investment strategy for stocks, bonds, sectors and FX is to follow the template of 1981-82. In a nutshell, an imminent recession will require a defensive strategy for most of 2022, before a strong recovery in markets unfolds in 2023. Go long the December 2023 Eurodollar (or SOFR) futures contract. While interest rates are likely to overshoot in the near term, the pain that they will unleash will require a commensurate undershoot in 2023-24. Cryptocurrencies will rally strongly once the Nasdaq reaches a near-term bottom, which in turn will depend on a peak in long bond yields. Fractal trading watchlist: Czechia versus Poland, German telecoms, Japanese telecoms, and US utilities. The Underperformance Of Human Resources Warns That The US Jobs Market Is Rolling Over Bottom Line: An imminent recession will require a defensive strategy for most of 2022, before a strong recovery in markets unfolds in 2023. Feature Financial markets have collapsed in 2022, but jobs markets have held firm, at least so far. For example, the US economy has added an average of 500 thousand jobs per month1, and the unemployment rate, at 3.6 percent, remains close to a historic low. But now, an excellent real-time indicator warns that cracks are appearing in the US jobs market. The excellent real-time indicator of the jobs market is the performance of the human resources (HR) and employment services sector. After all, with its role to place and support workers in their jobs, what better pulse for the jobs market could there be than HR? What better pulse for the jobs market could there be than the human resources sector? Worryingly, the recent sharp underperformance of the HR and employment services sector warns that the pulse of the jobs market is weakening, and that consumers will soon be reporting that jobs are becoming less ‘plentiful’ (Chart I-1). In turn, consumers reporting that jobs are becoming less plentiful presages an imminent rise in the unemployment rate (Chart I-2). Chart I-1The Underperformance Of Human Resources Warns That The US Jobs Market Is Rolling Over Chart I-2Jobs Becoming Less 'Plentiful' Presages Higher Unemployment 2 Percent Inflation Will Require A Sharp Rise In Unemployment The health of the jobs market has a huge bearing on the big issue du jour – inflation. Specifically, in the US, the unemployment rate (inversely) drives the inflation of rent and owners’ equivalent rent (OER) because, to put it simply, you need a steady job to pay the rent. Furthermore, with rent and OER comprising almost half of the core CPI basket, the ‘rent of shelter’ component is by far the most important long-term driver of core inflation.2 Shelter inflation at 3.5 percent equates to core inflation at 2 percent. For the past couple of decades, full employment has been consistent with rent of shelter inflation running at 3.5 percent, which itself has been consistent with core inflation running at 2 percent (Chart I-3). Hence, the Fed could achieve the Holy Grail of full employment combined with inflation running close to 2 percent. Chart I-3Core Inflation At 2 Percent = Shelter Inflation At 3.5 Percent... But here’s the Fed’s problem. In recent months, there has been a major disconnect between the jobs 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-4). Chart I-4...But Full Employment Now = Shelter Inflation At 5.5 Percent This means that to bring rent of shelter and core inflation back to 3.5 percent and 2 percent respectively, the unemployment rate will have to rise by 2 percent. In other words, to achieve its inflation goal, the Fed will have to sacrifice its full employment goal. Put more bluntly, if the Fed wants to reach 2 percent inflation quickly, it will have to take the economy into recession. The cracks appearing in the HR and employment services sector suggest this process is already underway. There Are Two ‘Neutral Rates Of Interest’. Which One Will Central Banks Choose? The ‘neutral rate of interest rate’, also known as the long-run equilibrium interest rate, the natural rate and, to insiders, r-star or r*, is the short-term interest rate that is consistent with the economy at full employment and stable inflation: the rate at which monetary policy is neither contractionary nor expansionary. But here’s the subtle point that many people miss. The neutral rate is defined in terms of stable inflation without stating what that stable rate of inflation is. Therein lies the Fed’s problem. The near-term neutral rate that is consistent with inflation at 2 percent is much higher than the near-term neutral rate that is consistent with full employment. The near-term neutral rate that is consistent with inflation at 2 percent is much higher than the near-term neutral rate that is consistent with full employment. Now let’s add a third goal of ‘financial stability’, and the message from the ongoing crash in stock, bond, and credit markets is crystal clear. The near-term neutral rate that is consistent with inflation at 2 percent is also much higher than the near-term neutral rate that is consistent with financial stability (Chart I-5 and Chart I-6). Chart I-5Markets Have Crashed Because Valuations Have Crashed. Profits Have Held Up… So Far Chart I-6When The Mortgage Rate Exceeds The Rental Yield, It Spells Trouble For House Prices This leaves the Fed, and other central banks, with a major dilemma. Which neutral rate goal to pursue – full employment and financial stability, or inflation at 2 percent? In the near term, the answer seems to be inflation at 2 percent. This is because the lifeblood of central banks is their credibility. With their credibility as inflation fighters in tatters, this may be the last chance to repair it before it is shredded forever. Taking this long-term existential view, central banks have decided that a recession is a price worth paying to slay inflation and repair their credibility. In this important sense, the current setup rhymes with 1981-82 when the Paul Volcker Fed made the same decision. Therefore, the correct investment strategy for stocks, bonds, sectors and FX is to follow the template of 1981-82, which we detailed in More On 2022-2023 = 1981-82, And The Danger Ahead. In a nutshell, an imminent recession will require a defensive strategy for most of 2022, before a strong recovery in markets unfolds in 2023. Eventually, the central banks’ major dilemma between inflation and growth will resolve itself. The triple whammy of a recession in asset prices, profits, and jobs will unleash a strong disinflationary – or even outright deflationary – impulse, causing inflation to collapse to well below 2 percent in 2023-24. And suddenly, there will be no conflict between the neutral rate that is consistent with full employment and financial stability, and that which is consistent with inflation at 2 percent. Both neutral rates will be ultra-low. Hence, while interest rates are likely to overshoot in the near term, the pain that they will cause will require a commensurate undershoot in 2023-24. On this basis, go long the December 2023 Eurodollar (or SOFR) futures contract (Chart I-7). Chart I-7Go Long The Dec 2023 Eurodollar (Or SOFR) Future Cryptos Will Bottom When The Nasdaq Bottoms The turmoil across financial markets has naturally engulfed cryptocurrencies, and this has generated the usual Schadenfreude among the crypto-doubters. But in the short-term, cryptocurrencies just behave like leveraged tech stocks, meaning that as the Nasdaq has fallen sharply, cryptos have fallen even more sharply (Chart I-8). Chart I-8In the Short Term, Cryptos = A Leveraged Nasdaq Most cryptocurrencies are just the tokens that secure their underlying blockchains, so their long-term value hinges on whether their underlying blockchain technologies will succeed in displacing the current ‘trusted third party’ model of intermediation. In this sense, blockchain tokens are the ultimate long-duration growth stocks, whose present values are highly sensitive to the performance of the blockchain technology sector, which in turn is highly sensitive to the long-duration bond yield. Hence, while the bear markets in bonds, Nasdaq, and cryptos appear to be separate stories, they are just one massive correlated trade! Given that nothing fundamental has changed in the outlook for blockchains, long-term investors should treat this crypto crash, just like all the previous crypto crashes, as a buying opportunity. Cryptos will rally strongly once the Nasdaq reaches a near-term bottom, which in turn will depend on a peak in long bond yields. Fractal Trading Watchlist Amazingly, while most markets have crashed, the financial-heavy Czech stock market is up by 20 percent this year, in sharp contrast to its neighbouring Polish stock market which is down by 25 percent. In fact, over the last year, Czechia has outperformed Poland by 100 percent. From both a fundamental and technical perspective, this outperformance is now vulnerable to reversal (Chart I-9). Accordingly, a recommended trade is to underweight Czechia versus Poland, setting the profit target and stop-loss at 15 percent. Elsewhere, the outperformances of German telecoms, Japanese telecoms, and US utilities are all at, or close, to points of fractal fragilities which make them vulnerable to reversals. As such, these have entered out watchlist. The full watchlist of 27 investments that are at, or approaching turning points, is available on our website: cpt.bcaresearch.com Chart I-9Czechia's Spectacular Outperformance Is Vulnerable To Reversal Fractal Trading Watchlist: New Additions German Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 1BRL/NZD At A Resistance Point Chart 2Homebuilders Versus Healthcare Services Has Turned Chart 3CNY/USD At A Potential Turning Point Chart 4US REITS Are Oversold Versus Utilities Chart 5CAD/SEK Is Vulnerable To Reversal Chart 6Financials Versus Industrials Has Reversed Chart 7The Outperformance Of Resources Versus Biotech Has Ended Chart 8The Outperformance Of Resources Versus Healthcare Has Ended Chart 9FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 10Netherlands' Underperformance Vs. Switzerland Is Ending Chart 11The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 12The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 13Food And Beverage Outperformance Is Exhausted Chart 14German Telecom Outperformance Vulnerable To Reversal Chart 15Japanese Telecom Outperformance Vulnerable To Reversal Chart 16The Strong Downtrend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 17The Strong Downtrend In The 3 Year T-Bond Is Fragile Chart 18A Potential Switching Point From Tobacco Into Cannabis Chart 19Biotech Is A Major Buy Chart 20Norway's Outperformance Has Ended Chart 21Cotton Versus Platinum Is At Risk Of Reversal Chart 22Switzerland's Outperformance Vs. Germany Has Ended Chart 23USD/EUR Is Vulnerable To Reversal Chart 24The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 25A Potential New Entry Point Into Petcare Chart 26GBP/USD At A Potential Turning Point Chart 27US Utilities Outperformance Vulnerable To Reversal Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Based on the nonfarm payrolls. 2 Rent of shelter also includes lodging away from home, but the two dominant components are rent of primary residence and owners’ equivalent rent of residences. Fractal Trading System Fractal Trades 6-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 ECB & Inflation: Whatever It Takes? Inflation is the European Central Bank’s single focus. This single-mindedness heightens the risks to Euro Area growth, especially because wider peripheral spreads do not seem to worry the ECB yet. Italian spreads will widen further, which will contribute to weaker financials, especially in the periphery. The money market curve already prices in the path of the ECB; the upside in Bund yields is therefore capped. Cyclical assets, including stocks, are vulnerable to the confluence of weaker growth and tighter monetary policy. Industrials are fragile. Downgrade to neutral for now. German industrials will outperform Italian industrials. Bottom Line: The ECB will do whatever it takes to slow inflation, which will further hurt an already brittle European economy. This backdrop threatens European stocks and peripheral bonds. Downgrade industrials to neutral and go long German / short Italian industrials. Feature Last week, the European Central Bank’s Governing Council sided with the hawks. The doves have capitulated. This development creates mounting risks this summer for European assets, especially when global growth is slowing. Worryingly, the ECB has given speculators the green light to widen peripheral and credit spreads in the near term. Cyclical assets remain at risk. We are downgrading industrials and financials. Hawkish Chart 1Higher Inflation Forecast = Hawkish ECB The ECB’s forward guidance proved more hawkish than anticipated by the market, as highlighted by the 16bps increase in the implied rate of the December 22 Euribor contract following the press conference. The ECB also refused to sooth investors’ nerves regarding fragmentation risk in the periphery. A large part of the ECB move was already anticipated. The ECB will lift its three interest rate benchmarks by 25bps at its July meeting. It also increased its headline inflation forecasts to 6.8% from 5.1% in 2022, to 3.5% from 2.1% in 2023, and most importantly, it raised its long-term HICP forecast to 2.1% from 1.9% (Chart 1). The ECB now expects medium-term inflation to be above its 2% target. The true hawkish shock came in response to the higher-than-target medium-term inflation forecast. By September, if the 2024 inflation forecast does not fall back below 2%, then a 50bps hike that month will be inevitable. The whole interest rate curve moved up in response to that guidance. The most concerning part of the statement was the lack of clarity about the fragmentation fighting tool. The ECB specified that it will re-invest the principal of its holdings under the APP and PEPP until 2024, at least. However, the program to prevent stress in peripheral bond markets was not revealed and was presented as an eventuality to be deployed only if market conditions deteriorate further. Investors may therefore assume that the ECB is still comfortable with Italian bond yields above 3.5% and high-yield spreads of 464bps (Chart 2). Ultimately, the ECB’s single-minded focus is inflation, even though it is mostly an imported shock. The ECB cares little for the effect of its actions on growth. It will therefore remain very hawkish until it sees enough evidence that the medium-term inflation outlook will fall back below 2%. Before the ECB can tabulate a decline in the inflation outlook, the following developments must take place: The economy must slow in order to extinguish domestic inflationary pressures. The labor market, to which President Christine Lagarde referred often in the press conference, must cool. Specifically, the very elevated number of vacancies must decline relative to the low number of unemployed persons (Chart 3). A weaker economy will cause this shift. Energy inflation must recede to choke secondary effects on prices. Chart 2Tight But Not Tight Enough For The Hawks Chart 3The Labor Market Must Cool The good news is that the decline in commodity inflation is already underway. Last week, we argued that if energy prices remain at their current levels, (or if Brent experiences the additional upside anticipated by BCA’s Commodity and Energy strategists), then energy inflation will decelerate significantly. Already, the inflationary impact of commodities is dissipating (Chart 4). European growth has not slowed enough to hurt the labor market, but it will decline further. Real disposable income is falling, and the manufacturing sector is decelerating globally. Moreover, European terms of trade are tumbling, which hurts the Euro Area’s growth outlook, especially compared to the US where the terms of trade are improving (Chart 5). Chart 4Dwindling Commodity Impulse Chart 5Europe's Terms-of-Trade Problem The European periphery, especially Italy, faces particularly acute problems. We argued two months ago that Italian yields of 4.5% would not cause a sovereign debt crisis if economic activity were strong. As we go to press, Italian yields stand at 3.7%, or higher than those in Canada and Australia. Yet, Italy suffers from poor demographic and productivity trends; its neutral rate of interest is lower than that of both Canada and Australia. Moreover, Canada and Australia today enjoy robust terms-of-trades. Meanwhile, Italy is among the European economies most hurt by surging energy prices. Consequently, a vicious circle of higher yields and lower growth is likely to develop. Chart 6The BTP-EUR/USD Valse Italy’s economic problems imply that investors will continue to push Italian spreads higher until the ECB provides a clear signal of support for BTPs, which could happen after spreads reach 300bps over German 10-year yields. Italy’s weakness is a major handicap for the monetary union as well. The higher Italian spreads widen, the weaker the euro will be (Chart 6). However, a depreciating euro is inflationary, which invites higher rates for the Euro Area and tighter financial conditions. The great paradox is that, if the ECB were more pro-active about the fragmentation risk, it could fight inflation with less danger to the economy and thus, the Eurozone could achieve higher rates down the road. Weaknesses in global and European growth, risks of higher Italian and peripheral spreads, and an ECB solely focused on inflation will harm European risk assets further. Specifically, credit spreads will widen more and cyclical stocks will remain vulnerable. Within cyclical stocks, Italian and Spanish financials are the most exposed to the fragmentation threat in Euro Area bond markets. We have held an overweight recommendation on industrial equities. We maintain a positive long-term bias toward this sector, but a neutral stance is warranted in the near term. Finally, Bund yields have limited upside from here. The curve already anticipates 146bps of tightening by the end of this year and 241bps by June 2023. The ECB is unlikely to increase rates more than is anticipated, which caps German yields. Instead, the ECB is likely to undershoot the €STR curve pricing if it increases interest rates once a quarter after the September 50bps hike. Bottom Line: Don’t fight the ECB. The Governing Council is single-mindedly focused on fighting inflation. Growth must slow significantly to cool the labor market and allow the ECB to cut back its medium-term inflation forecast to 2%. Therefore, European assets will remain under stress in the coming months as global growth deteriorates. Italian and peripheral spreads are particularly vulnerable, which will also weigh on financials because of Spanish and Italian banks. Chart 7Pricey Industrials Neutral On Industrials Industrials stocks have outperformed other cyclicals and have moved in line with the Euro Area broad market. However, relative forward EPS have not tracked prices; industrials are now expensive and vulnerable to shocks (Chart 7). The increase in the relative valuations of industrials reflects their robust pricing power. Normally, the economic weakness pinpointed by the Global Growth Expectations component from the ZEW Survey results in falling valuations for industrials, since it is a growth-sensitive sector (Chart 8). However, this year, the earnings multiples of industrials relative to the broad market have followed inflation higher (Chart 8, bottom panel). This paradox reflects the strong pricing power of the industrial sector, which allows these firms to pass on a greater share of their increasing input-costs and protect their profits (Chart 9). Chart 8Ignore Growth, Loving Inflation Chart 9Pricing Power Is The Savior The ability of industrials to weather a growth slowdown is diminishing: European inflation will peak in response to the decline in commodity inflation (see Chart 4, on page 4). Already, the waning inflation of metal prices is consistent with lower relative multiples for industrials (Chart 10) Last week, we argued that global PMIs have greater downside because of the tightening in global financial conditions. Weaker global manufacturing activity hurts the relative performance of industrials. Capex in advanced economies is likely to drop in the coming quarters. US capex intentions are rapidly slowing, which has hurt European industrials. European capex intentions have so far withstood this headwind; however, the outlook is worsening. European final domestic demand is weakening, and European inventories are growing rapidly (Chart 11). Capex is a form of derived demand; the challenges to European growth translate into downside for investment. Chart 10The Commodity Paradox Chart 11The Inventory Buildup Threat The Euro Area Composite Leading Economic Indicator is already contracting and will fall further. The ECB’s focus on inflation and its neglect of financial conditions will drag the LEI lower. Moreover, central banks across the world are also tightening policy, which will filter through to weaken global and Europe LEIs. A declining LEI hurts industrials (Chart 12). The relative performance of European industrials is positively correlated to that of US industrials (Chart 13). BCA’s Global Asset Allocation has recently downgraded industrials to neutral from overweight. Chart 12Weaker LEIs Spell Trouble Chart 13Where the US Goes, So Does Europe Despite these risks, we are reluctant to go underweight industrials because financials are more exposed to the ECB’s neglect of financial conditions. Moreover, the headwinds against the industrial complex are temporary, especially when it comes to China. Chinese authorities have greatly stimulated their economy, and Beijing is softening its stance on the tech sector. A loosening of the regulatory crackdown would revive animal spirits and credit demand. Moreover, the aerospace and defense industry, which is a large component of the industrial sector, still offers attractive prospects. Instead, we express our concerns for industrials via the following pair trade: Long German industrials / short Italian Industrials. This is a relative value trade. German industrials have underperformed their relative earnings, while Italian ones have moved significantly ahead of their earning power. Thus, German industrials are very cheap and oversold relative to their southern neighbors (Chart 14). Interestingly, this derating took place despite the widening in Italian government bond spreads, which normally explains this price ratio well (Chart 15). This disconnect presents a trading opportunity. Chart 14A Relative Value Trade Chart 15An Unusual Disconnect Chart 16German Industrials And Growth Expectations While global growth has yet to bottom, the performance of German relative to Italian industrials fluctuates along growth expectations (Chart 16). Germany seats earlier in the global supply chain than Italy. The Global Growth Expectations component from the ZEW Survey is extremely depressed and approaching levels where a rebound would be imminent. German industrials suffer more from the energy crunch than Italian ones. They will therefore benefit more from the decline in energy inflation. Historically, German industrials outperform Italian ones when commodity prices rise, but this relationship normally reflects the strong global demand that often lifts natural resource prices (Chart 17). Today, commodities are skyrocketing because of supply constraints, not strong demand. Therefore, they are hurting rather than mimicking growth. This inversion in the relationship between the performance of German compared to Italian industrials and natural resources prices is particularly evident when looking at European energy prices (Chart 18). Consequently, once the constraint from commodities and global supply chains ebb, German industrials will outshine their Italian counterparts. Chart 17Commodities: From Friends To Foes Chart 18Energy: From Friend To Foe German industrials suffer when stagflation fears expand (Chart 19). The ECB’s focus on inflation will assuage the apprehension of entrenched inflation in Europe. The recent improvement in our European Stagflation Sentiment Proxy will continue to the advantage of German industrials. Additionally, a firm ECB stance will push European inflation expectations lower, which will help German industrials compared to their Italian competitors (Chart 20). Chart 19Stagflation Hurts Germany More Chart 20The ECB"s Inflation Focus Helps German Industrials German PMIs are improving relative to Italian ones. The trend in Germany’s industrial activity compared to that of Italy dictates the evolution of industrials relative performance between the two countries (Chart 21). The tightening in financial conditions in Italy due to both wider BTP spreads and their negative impact on the Italian banking sector will accentuate the outperformance of Germany’s manufacturing sector. German industrials are more sensitive than Italian ones to the gyrations of the Chinese economy. BCA’s Geopolitical Strategy service anticipates an improvement in China’s economy for the next 18 months or so in response to previous stimuli and the easing regulatory burden. The close link between the performance of German industrials relative to Italian ones and the yuan’s exchange rate indicates that a stabilizing Chinese economy will undo most of the valuation premium of Italian industrials (Chart 22). An improvement in China’s economy will also lift its marginal propensity to consume (which the spread between the growth rate of M1 and M2 approximates). A rebound in Chinese marginal propensity to consume will boost comparative rates of returns in favor of Germany (Chart 22, bottom panel). Chart 21Relative Growth Matters Chart 22The China Factor Bottom Line: Industrials have become expensive relative to the rest of the market, but they are still too exposed to the global economy’s downside risk. This tug-of-war warrants a downgrade to neutral for now. Going long German industrials / short Italian industrials is an attractive pair trade within the sector. German industrials are cheap and they will benefit from both the ECB’s policy tightening and the upcoming decline in European inflation. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades
Executive Summary Is Relative Inflation Peaking In The US? The dollar has likely peaked in the near term. An unwinding of speculative bets, based on structurally higher inflation in the US, is the key driver (Feature Chart). Our theme of central bank convergence continues to play out. Rates in the euro area are headed higher. The next bet for higher rates is in Japan. The key for picking currency winners will be global growth barometers. The US dollar embeds a huge safety premium that will be eroded as we get more clarity on global growth and inflation. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short DXY 104.80 2022-05-13 2.22 Bottom Line: We are short the DXY index as of 104.8. We recommend sticking with this position. Feature The dollar very much remains well bid (Chart 1). But the macroeconomic environment that has helped the dollar is likely to reverse. As inflation in the US cools, especially relative to other DM economies, the policy divergence between the US and other economies will move in the opposite direction (Chart 2 and Chart 3). Chart 1Long Dollar Positions Still Profitable Chart 2Is Relative Inflation Peaking In The US Chart 3The Dollar And Interest Rates Last month, we posited that interest rate differentials played a key role in pushing the dollar higher but have not been the sole factor. The safe-haven premium in the DXY is around 8-10%. That premium will remain if growth concerns are at the forefront of investors’ minds but will evaporate otherwise. Over the last few weeks, we have had a few surprises from central banks, notably the ECB and the RBA. In this Month-In-Review, we go over our current currency thinking, and implications for portfolio strategy. US Dollar: Peak Hawkishness? Chart 4Is Inflation Peaking In The US The dollar DXY index is up 7.4% year to date. However, over the last month, there has been a big reversal in the dollar, down 1.5% month-to-date. As a momentum currency, technical forces are moving against the greenback. Incoming data for the US remains robust, but a peak in inflation expectations, that will temper the pace of Fed interest rate hikes, has been driving dollar momentum. Headline CPI is expected to come in at 8.3% in May, while the core measure should decelerate to 5.9%. It is possible that these numbers surprise to the downside. For example, used car prices, an important contribution to US CPI, are rolling over sharply (panel 2). Overall, supply-side price pressures appear to be easing (panel 3). The US added 390K jobs in May, so the employment report remains robust. Encouragingly, the participation rate is also picking up. This suggests the US can absorb more willing workers before we see additional upward pressure in wage growth. We are closely watching the Atlanta Fed wage growth tracker (panel 4). The ISM manufacturing index had a solid print of 56.1 in May, but the prices paid index dipped from 84.6 to 82.2. As we highlighted above, these developments have sapped market expectations for aggressive interest rate increases in the US relative to other G10 countries. Speculative froth in the dollar is also unwinding (panel 5). We went short the DXY index at 104.8, with a stop loss at 107. We recommend sticking with this position. The Euro: A European Soft Landing? Chart 5The Euro Has Priced A Recession The euro is down 6.6% year-to-date. Over the last month, the euro is up 0.7%. The ECB cemented the fact that interest rates are headed higher this week. With a mandate of taming inflation, the central bank faces a tough job of reigning in price pressures, while engineering a soft landing in the economy. From the perspective of the euro, it is our view that most of the downside risks to this scenario have been priced in, while upside surprises have not (panel 1). Incoming data from the euro area has been improving. The Sentix Investor Confidence index ticked up in June. Energy prices remain high, but momentum has been softening. The ZEW expectations survey also delivered an upside surprise in May. The key point from an FX perspective is that the euro has already priced a recession in the European economy, but no prospect of a soft landing. That is positive from a contrarian perspective. With HICP inflation at 8.1% (panel 2), emergency monetary settings are no longer required, and the ECB should lift rates. As we suggested last month, a “least regrets” approach will gently nudge rates higher to address inflationary pressures but pay attention to cyclical sectors of the economy (panel 3). It is important to remember that interest rates in the eurozone are still at -0.5%. Related Report Foreign Exchange StrategyMonth In-Review: A Hefty Safe-Haven Premium In The Dollar We remain long EUR/GBP on the prospect that the ECB could better engineer a soft landing, compared to the BoE. We also remain sellers of the EUR/JPY cross. In a risk-off environment, EUR/JPY will collapse. In a Goldilocks scenario, the cross has already priced in a much stronger global economy (panel 4). This is also a perfect hedge for a pro-cyclical currency positioning. The Japanese Yen: Back To Carry Trades Chart 6The Yen Will Soon Bottom The Japanese yen is down 14.3% year-to-date, the worst performing G10 currency this year. Over the last month, the yen is down 2.9%. The yen is a classic case of the risks of fighting the trend in currency markets (panel 1). That said we remain buyers, rather than sellers, on weakness. The drivers of the yen have been very clear and absolute. First, rising interest rates abroad, as we saw this week, have put selling pressure on the JPY (panel 2), given the BoJ will maintain yield curve control. Second, the pickup in energy prices continues to deflate the Japanese trade balance. These are negative shocks that are likely to continue inflicting pain on yen long positions in the near term. From a contrarian perspective, there is solace for yen bulls. First, it 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 (panel 4). In terms of data, there have also been positive surprises over the last month. The Eco Watcher’s Survey surprised to the upside. PMIs have rebounded above 50. Inflation is above the 2% target and should keep rising. Machinery orders are picking up. The Bank of Japan is likely to stay dovish next week but that is largely priced in. Meanwhile, the BoJ will have no choice but to pivot if inflationary pressures prove stronger than they anticipate, and/or the output gap in Japan closes much faster as demand recovers. We have no active position on the yen right now but will be buyers on weakness. British Pound: Sterling And A Policy Mistake Chart 7Cable Is At Risk Near Term The pound is down 7.6% year to date. Over the last month, the pound is up by 1.3%. We wrote a report on sterling last week. In our view, sterling faces headwinds in the near term but is likely to be a profitable long position for investors with a more structural view. First, the deterioration in the UK’s trade balance is cyclical and not structural. Fuels constitute 11% of UK imports so higher energy prices are affecting the balance of trade. This will soon reverse. Second, goods imports have picked up, but it is encouraging that a huge share has been machinery and transport equipment. Inflation remains a problem in England, with CPI at 9%. In our view, while sterling is pricing in a policy mistake by the BoE – tightening too fast into a slowing economy, our bias is that the BoE can engineer a soft landing for the economy. Only one-third of the rise in UK inflation has been driven by demand-side pull, with the balance related to supply-side factors. The latter have been the usual suspects – rising energy costs, supply shortages, and even legacies of the Brexit shock (Chart 10). These could ease going forward. 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 8CAD Should Benefit From Terms Of Trade The CAD is down 0.6% year to date. Over the last month, it is up 2.4%. The CAD has been the best performing G10 currency this year after the DXY, and the key drivers of loonie strength will persist. First, the CAD will benefit from a terms-of-trade boost, given it is trading at a discount to prevailing oil prices. Second, the BoC will stay hawkish, having hiked interest rates by 50 bps last month, and telegraphing more tightening going forward. Economic data out of Canada suggests tighter monetary policy is warranted. Both headline and core inflation remain strong, with headline inflation at 6.8% in April. The common, trim, and median inflation prints were at 3.2%, 5.1%, and 4.4%, respectively, well above the BoC’s target. This continues to suggest inflationary pressures in Canada are broad based (panel 2). House prices are rolling over so the wealth effect could temper hawkishness from the BoC. However, recent speeches from policy officials have highlighted a need to tame housing price pressures in Canada (panel 4). We remain buyers of the CAD on a lower dollar but are monitoring risks from a tightening in financial conditions. New Zealand Dollar: Will Weaken At The Crosses Chart 9The RBNZ Is Trying To Engineer A Soft Landing The NZD is down 6.6% this year. Over the last month, the kiwi is down 1.0%. The RBNZ hiked interest rates by 50 bps in May, taking the overnight rate to 2%. This seems to be having the intended effect, with house price inflation rolling over as mortgage rates adjust higher. This “least regrets” approach is likely to continue in the short term. The labor market is extremely tight, with a shortage of high skilled labor given immigration has slowed. This is leading to substantial wage increases. As such, the RBNZ has been increasing guidance for annual CPI inflation, and therefore, interest rates, raising its overnight projection for June 2023 to 3.9% from 2.8%. There is reason to believe the RBNZ will tone down its hawkish rhetoric. For one, terms of trade are softening. Dairy prices, circa 20% of exports, are down 1% this month after reaching a 10-year high in May. A domestic slowdown is also likely to nudge the RBNZ toward more accommodation. In a nutshell, the kiwi has upside versus the dollar, but will underperform at the crosses. Australian Dollar: Our Top Pick Against The Dollar Chart 10The RBA Will Continue To Hike The Australian dollar is down 2.3% year to date. Over the last month, the AUD is up 2%. The Reserve Bank of Australia raised interest rates by 50 bps this week, a surprise to markets, but in line with the hawkish tone telegraphed in prior meetings. Inflation in Australia is surprising to the upside. Meanwhile, unemployment remains well below NAIRU. As a result, an exit from emergency monetary settings makes sense. The key will be whether the RBA can engineer a soft landing in the Aussie economy. Job gains remain robust, and both the unemployment rate and the participation rate are at healthy levels. Terms of trade are holding up, and wage gains are improving. Home prices are rolling over, but it is a welcome development as the RBA is trying to calibrate financial conditions. We are long the AUD as of 72 cents. The big concern for this trade is China, and the potential for renewed lockdowns that will hurt the external balance. As such, we expect this trade to be volatile near-term, but pay off over a longer horizon. Swiss Franc: A Safe Haven Chart 11The SNB Will Stay Constructive On The Franc The Swiss franc is down 7% year-to-date, but up versus the dollar over the last month. Swiss economic conditions have been rather resilient. GDP expanded by 0.5% in Q1, slightly above expectations, while industrial production also rose 2.4% in the same period. In April, Switzerland’s trade surplus widened to CHF 3.8bn, boosted by demand for machinery and chemicals. In May, the KOF leading indicator clocked 96.8 and the manufacturing PMI stood at 60, a slowdown month-on-month but still a very healthy reading. Inflation is surprising to the upside in Switzerland. Headline and core CPI growth came in at 2.9% and 1.7% year-on-year in May, respectively. Recently, several SNB board members have voiced the primacy of price stability and preparedness to hike rates if inflation becomes broad based. This has helped support the franc. The market now expects SNB to follow the ECB in removing the NIRP starting in September. But it is always good to remember that the Swiss franc is a defensive currency, so a path to policy normalization still presents upside for EUR/CHF. In our trading book, we are short CHF/SEK, but will take profits if Thomas Jordan proves to be more of an inflationary hawk. Norwegian Krone: Bullish On A 12-to-18 Month Horizon Chart 12The Norges Bank Will Stay Hawkish NOK is down 8.1% year to date and up 1.5% over the last month. In the three months through March, Norway’s GDP contracted by 1% quarter on quarter, led by drops in private consumption (1.5%), government spending (1.4%), and exports (3.5%). The decline largely reflects restriction measures imposed at the start of the year. That said, economic growth is rebounding and GDP growth will be around 3% in the next 12 months. Meanwhile, the trade surplus remains very healthy at 92.6bn NOK. As a result, the current account surplus hit at an all-time high of 341bn NOK in Q1. From a broader perspective, incoming numbers in Norway reflect a slowdown in global growth. Consumer confidence dropped to the lowest levels since 2016. The manufacturing PMI fell sharply to 54.9 in May, the lowest reading in over a year. Industrial production also decreased by 0.5% month-on-month in April. That said, the labor market continues to tighten. The unemployment rate fell to 1.7% in May, significantly below Norge Bank’s 2% projection. Renewed immigration might help alleviate some of the labor market tightness, but the strength in employment trends is very evident. As a result, our bias is that the committee will stick to its quarterly 25bps hikes, but upside surprises to this baseline are non-trivial. Terms of trade are a tailwind for Norway. In particular, NOK/SEK can be an attractive bet on a 12-month horizon, should oil prices remain firm. Swedish Krona: Into A Capitulation Phase Chart 13More Hawkish Surprises From The Riksbank The SEK is down 8.7% year to date and up 1.6% over the last month. Sweden sits right at the crosshairs of the Russia-Ukraine conflict. As a result, inflation remains a problem with CPIF at 6.4%, year-over-year in April, above updated projections from Riksbank. The issue is that there are rising risks that inflation will not be transitory, raising the prospect of a policy surprise from the Riksbank. The OIS curve is now pricing in a 1.75% policy rate by year-end. In our view, this will be a baseline scenario. The critical point is whether the Riksbank is on the verge of making a policy mistake. Economic growth is slowing. Swedish GDP contracted by 0.8% in Q1 from the previous quarter. However, if policymakers are overly fixated on inflation, the prospect of grinding the Swedish economy to a halt becomes a rising risk. Major rounds of collective wage negotiations early next year, affecting as much of as 40% of total labor force, is a risk to monitor. There is already some evidence of a slowdown in economic activity. Consumers reported the lowest level of confidence since the Global Financial Crisis. PMIs remain resilient, well above 50 but the risk is to the downside. Should the Chinese credit impulse bottom and supply constraints ease, economic activity will pick up in the second half of the year, but the risk of downside surprises are worth monitoring. The bottom line is that SEK has already priced in much of the negative news and remains undervalued in our models. We are short CHF/SEK on these grounds, a position 1.5% in the money. 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
Executive Summary Singapore stocks are at risk as an impending contraction in global trade will hurt this very open economy and its markets. The country’s foreign reserves are already shrinking as the balance of payments has slid into deficit. The Monetary Authority of Singapore’s (MAS) attempts to rein in inflation by pushing up the currency is also causing foreign reserves to contract, and local money supply to decelerate sharply. Inflationary pressures in Singapore are not entrenched and will soon subside. Wage growth is under control, and unit labor cost increases are subdued. Singapore’s export competitiveness remains robust; yet that does not preclude it from a period of shrinking exports over the next 6-12 months. Falling exports, shrinking foreign reserves, decelerating money supply and peaking inflation will dissuade MAS from pushing up the Singapore dollar much higher from current levels. Manufacturing Cycles Dictate The Performance Of Singapore Stocks Recommendation Inception Date RETURN Downgrade Singapore stocks from overweight to neutral May 10, 2021 2.3% Bottom Line: Equity investors should reduce their exposure to Singapore stocks in EM and Asian portfolios by downgrading their allocation from overweight to neutral. Absolute return investors should wait for a better entry point. Feature Chart 1Singapore Stocks' Outperformance Is Set To Take A Breather Like most global markets, Singapore stocks have sold off materially since early this year. Relative to EM and Asian counterparts, however, they have fared well – in line with our call back in May 2021 when we upgraded this bourse to overweight (Chart 1). The question is, given the changing macro backdrop − where a whiff of stagflation has permeated global investment landscapes – what should investors now do about this market? We believe that higher inflation in Singapore is a temporary phenomenon and will subside sooner rather than later. Contracting global trade, on the other hand, is a much more vital risk for this very open economy and its equity markets; and is a reason to downgrade this bourse. Indeed, Singapore stocks in absolute US dollar terms face more downside over the next several months. Relative to its EM and Asian counterparts also, this bourse’s outperformance is likely to take a breather. Asian and EM equity portfolios would therefore do well to downgrade this market by a notch from overweight to neutral in EM and Asian equity baskets. Absolute return investors should stay on the sidelines for now. Unfavorable Settings Contracting global trade and tightening liquidity will weigh on Singapore stocks in the months ahead. Global trade volumes will fall as developed countries’ demand for goods (ex-auto) shrinks following the pandemic-era binge. Chinese growth will also likely be struggling to recover. What this means is that both global manufacturing and exports are heading towards a contraction. As a very open economy where goods exports make up 115% of GDP (and services exports another 55%), manufacturing and exports of goods drive income for the entire Singaporean economy and influence its stock market cycles. Chart 2 shows how ebbs and flows in manufacturing new orders dictate Singapore’s equity market performances. Chart 2Manufacturing Cycles Dictate The Performance Of Singapore Stocks The performances of financial and real estate stocks, which make up two-thirds of the MSCI Singapore index, are also highly dependent on business cycles − which in turn, are driven by swings in manufacturing and exports (Chart 3). One reason for that is, at 23% of GDP, manufacturing is the single largest sector in the economy. By comparison, finance and insurance make up 14% of the nation’s output, and real estate 3%. Any acceleration or deceleration in manufacturing activity therefore has a strong impact on the performance of tertiary sectors, including those of banking and real estate. In addition, MAS’ tightening is causing local money supply to decelerate (discussed in more detail later). Slower money growth is never bullish for stock prices (Chart 4). Chart 3Banks And Real Estate Stocks Also Move With Manufacturing And Exports Chart 4Decelerating Money Supply Is A Bad Omen For Share Prices In sum, given the changing global macro backdrop of slowing manufacturing and trade, and elevated US inflation, Singapore stocks have not yet found a sustainable bottom in absolute terms. Relative to their EM counterparts, Singapore’s outperformance could also take a breather. During periods of weakening global trade and manufacturing, Singapore stocks usually do poorly relative to their EM peers. The top panel of Chart 5 shows US manufacturing PMI new orders as decelerating rapidly. Periods of falling and/or sub-50 PMI prints usually herald Singapore stocks’ underperformance relative to EM, with a few months lag. Singapore’s own new export orders are also about to slip into contraction territory. If history is any guide, this too entails a period of underperformance of this bourse versus EM going forward (Chart 5, bottom panel). Is Inflation Genuine In Singapore? The short answer is no; there is little genuine inflation in Singapore. The country is not witnessing any wage-price spiral either, unlike in the US. What we see there instead is just a one-off surge in inflation. Average monthly wages in Singapore have accelerated in the past year but are not out of line when compared to the past 20 years (Chart 6, top panel). Chart 5Weakening Manufacturing Orders Foreshadow Singapore Equities' Underperformance Chart 6Limited Wage Growth And Subdued Unit Labor Costs Will Rein In Inflationary Pressures A controlled rise in wages has helped keep Singaporean firms’ unit labor costs (ULCs) in check. The middle panel of Chart 6 shows ULCs for the overall economy vis-à-vis the consumer price index. ULCs are much below pre-pandemic levels. This happens to be the case even in the service sector of the economy where productivity gains are much harder to achieve. In the goods producing sector, where productivity gains are relatively easier to achieve, ULCs have remained particularly low (Chart 6, bottom two panels). What this means is that firms are facing little wage-related cost pressures. They are, therefore, less likely to pass it on to customers via higher selling prices. That, in turn, will help cap inflationary pressures in the economy. Chart 7Sharply Slowing Money Growth Points To Peaking Inflation In fact, much of the recent rise in headline and core consumer inflation in Singapore has had to do with the explosive money growth seen during the pandemic. Both narrow (M1) and broad money (M3) growth rates in Singapore accelerated in 2020 to levels not seen since the Global Financial Crisis of 2008-09. Inflation usually follows money growth with several months lag, and this time was no different. That said, both measures of money have since decelerated markedly this year. This will rein in inflationary pressures going forward (Chart 7). Looking forward, money supply itself will likely decelerate further in the months ahead. A critical reason for that is the manner in which the central bank (MAS) uses the currency to achieve its monetary policy objectives (i.e., to maintain price stability). When inflation rises, MAS typically guides the trade-weighted Singapore dollar to appreciate, in an attempt to rein in inflation. In so doing, MAS buys local currency and sells foreign currency. This reduces local liquidity and money supply. Chart 8 shows that MAS is indeed guiding the Singapore dollar up: the trade weighted currency has risen by over 3% in the past six months tracking inflation. Not surprisingly, money growth in Singapore has decelerated meaningfully. In time, that will help pull inflation lower. There was an external factor too. In the past couple of years, the country had witnessed a massive improvement in its balance of payments (BoP). It skyrocketed from a minus 3% of GDP in 2019 to a plus 27% in 2021. To prevent the currency from surging, the central bank had resorted to a rapid accumulation of foreign reserves. As MAS pumped local currency into the system while purchasing foreign currencies, local money supply boomed (Chart 9). Chart 8In Order To Check Inflation, The MAS Has Pushed The Singapore Dollar Up... Chart 9...Causing Foreign Reserves To Drop, And Money Supply To Decelerate Materially Chart 10The Trade Surplus Will Narrow, Putting More Pressure On The Balance Of Payments But the tide has turned this year. The trade surplus has rolled over and will continue to shrink as global trade is set to weaken further this year as explained above. As such, Singapore’s current account surplus will also likely roll over. The capital account has already slipped back into massive deficits; so has the BoP (Chart 10). The upshot is that foreign reserves have begun to contract. This means MAS is now selling foreign reserves to buy back local currency. This is causing a deceleration in local money supply (Chart 9, above). In sum, the absence of meaningful wage pressures, a decelerating money supply, and a strengthening currency will help Singapore see its inflation ease sooner than in the US. Can Singapore Withstand A Stronger Currency? As discussed above, Singapore’s monetary policy entails tackling higher inflation by letting the Singapore dollar appreciate in nominal terms. But given the high inflation prints, an appreciating currency would mean that it gets even stronger in real terms (i.e., in inflation-adjusted terms). An expensive currency in real terms could erode competitiveness. So, the question is, can the Singapore economy withstand a stronger currency? The short answer is yes. Chart 11 shows that while the Singapore dollar has appreciated to new highs in nominal trade weighted terms, in real terms (ULC-based) it remains at around 15-year lows. As such, currency competitiveness should not be an issue anytime soon. Notably, real exchange rates calculated using ULCs are more representative of currency competitiveness than the use of consumer prices allows. The reason is that employee compensation is a major component of any company’s overall cost structure; and therefore, ULCs matter for a company much more directly than do consumer prices. The very low levels of the ULC-based real exchange rate indicates that the Singapore dollar is still very competitive. Indeed, Singapore’s export volumes have been on an upward trend relative to global exports (Chart 12). Chart 11The Singapore Dollar Remains A Highly Competitive Currency Chart 12Singapore Is Grabbing Export Market Share From The Rest Of The World Notably, Singapore continues to attract a very high amount of FDI. This will help raise productivity going forward, thereby keeping ULCs in check down the line. All that said, strong competitiveness (i.e., the ability to maintain global market share) does not preclude Singapore from experiencing a drop in its export revenues over the next 6-to-12 months. The reason is faltering goods demand in the US and Europe after a pandemic-era overconsumption. Falling exports, in turn, will lead to shrinking foreign reserves, decelerating money supply, and finally slowing growth and inflation. This will discourage MAS from pushing the Singapore dollar much higher from current levels. As Chart 11 showed, the Singaporean currency is already at an all-time high in trade-weighted terms. The rally in the trade-weighted Singapore dollar is therefore in late stages. Investment Recommendations Chart 13The Singapore Dollar's Outperformance Vesus Other Asian Currencies Is Late Singapore stocks, with a P/E ratio of 21.5, have become relatively expensive vis-à-vis their EM (13.1) and Asian (14.1) counterparts. In terms of the price-to-book value ratio however, they are not expensive. Considering all, we recommend that investors reduce their exposure to Singapore stocks in EM and Asian equity portfolios by downgrading their allocation from overweight to neutral. Our overweight stance since May 10, 2021, has yielded a gain of 2.3% so far. Absolute return investors should wait for a better entry point. The depreciation of the Singapore dollar vis-à-vis the US dollar likely has some more room given the impending deterioration in global trade. But the latter will also soon check the appreciation of the Singapore dollar versus other Asian currencies − as MAS will be dissuaded from guiding the currency up in view of peaking domestic inflation and shrinking trade (Chart 13). Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com
Executive Summary The Efficient Market Hypothesis (EMH) is flawed. This Holy Grail of financial economics assumes that investors are a homogenous bunch with identical investment horizons, when the reality is that investors have a wide spectrum of time horizons. The alternative but less well-known Fractal Market Hypothesis (FMH) recognizes that investors with different time horizons interpret the same facts and information differently. The key conclusion of the FMH is that when the different investment horizons are all active in the market, the price reflects all available information, meaning that the market is efficient, liquid, and stable. But when the different investment horizons start to converge and coalesce, the market becomes inefficient, illiquid, and vulnerable to a trend reversal. Using the FMH over the past six months, 5 structured recommendations were closed in profit: Short ILS/GBP, Short Coffee versus Cocoa, Short World Basic Resources versus Market, Long EUR/CHF, and Short Semiconductors versus Tech. Against this, 3 structured recommendations were closed in loss: Short Nickel versus Silver, Long Polish Bonds versus US Bonds, and Short World Semiconductors versus Biotech. Within the 10 open trades, 3 are in healthy profit, 4 are flat, and 3 are in loss. The Efficient Market Hypothesis Does Not Describe The Truth; The Fractal Market Hypothesis Does Bottom Line: As few investors are aware of the Fractal Market Hypothesis, it gives a competitive advantage to those that use it to identify potential trend reversals. Feature For nations and societies, disagreement and conflict are unhealthy. But for financial markets, the opposite is true – it is the lack of disagreement and conflict that is unhealthy. This is because the market needs disagreement to generate liquidity, the ability to trade quickly and in large volume without destabilizing the market price. If I want to buy a share, then somebody must sell me that share. It follows that I and the seller must disagree about the attractiveness of the share at the current price. Likewise, if I and like-minded individuals want to buy ten million shares, it follows that lots of market participants must disagree with us. If lots of market participants do not disagree with us, there will be insufficient liquidity to complete the transaction without a price change. And if too many people are engaged in groupthink, the price change could be extreme. Markets Become Inefficient When There Is Not Enough Disagreement How can there be major disagreement about the attractiveness of an investment when we all have access to the same facts and information? According to the Efficient Market Hypothesis (EMH) there cannot be, because asset prices always reflect all available information.1 Unfortunately, the Efficient Market Hypothesis is flawed. This Holy Grail of financial economics assumes that investors are a homogenous bunch with identical investment horizons, when the reality is that investors have a wide spectrum of time horizons – ranging from the milliseconds of momentum-driven high-frequency trading (HFT) to the decades of a value-driven pension fund. The market is efficient only when a wide spectrum of investment horizons is setting the price, signified by the market having a rich fractal structure. The alternative but less well-known Fractal Market Hypothesis (FMH) recognizes the reality of different time horizons. Crucially, the FMH acknowledges that investors with different time horizons interpret the same facts and information differently. In other words, they disagree (Box I-1). Box 1-1The Efficient Market Hypothesis Does Not Describe The Truth; The Fractal Market Hypothesis Does For example, the momentum-based high frequency trader might interpret a sharp one-day sell-off as a sell signal, but the value-based pension fund might interpret the same information as a buying opportunity. This disagreement will create liquidity without requiring a big price adjustment. Thereby it also fosters market stability. The key conclusion of the Fractal Market Hypothesis is that when the different investment horizons are all active in the market, the price does reflect all available information, meaning that the market is efficient, liquid, and stable. But when the different investment horizons start to converge and coalesce, the market becomes inefficient, illiquid, and vulnerable to a trend reversal. Buy and sell orders will no longer match without a price change, possibly extreme. Can we measure the loss of efficiency in a specific investment, and thereby anticipate a potential trend reversal? The answer is yes, by monitoring its fractal dimension, using the expression in the Appendix. Although many readers may find the concept of a fractal dimension intimidating, the idea is simple and intuitive. It just measures the complexity – or information content – in an object or structure. Thereby, when an investment’s fractal dimension reaches its lower limit, it warns that the information content of longer-term investors is missing from the price. When the longer-term investors do ultimately re-enter the price setting process, the question is: will they endorse the recent trend because of some major change in the fundamentals – such as the start of the Russia/Ukraine war? Or will they reject it, as an unjustified deviation from a fundamental anchor. In most cases, it is the latter: a rejection and a trend reversal. As few investors are aware of the Fractal Market Hypothesis, it gives a competitive advantage to those that use it to identify potential trend reversals. Fractal Trading Update Using the Fractal Market Hypothesis over the past six months, 5 structured recommendations were closed in profit: Short ILS/GBP, Short Coffee versus Cocoa, Short World Basic Resources versus Market, Long EUR/CHF, and Short Semiconductors versus Tech. A fragile fractal structure warns of a crowded trade. One structured recommendation was closed flat: Short Personal Goods versus Consumer Services. Against this, 3 structured recommendations were closed in loss: Short Nickel versus Silver, Long Polish Bonds versus US Bonds, and Short World Semiconductors versus Biotech. Within the 10 open trades, 3 are in healthy profit, 4 are flat, and 3 are in loss. As for the unstructured recommendations, for which we do not define profit targets or expiry dates, we are pleased to report that out of 31 recommendations, only 2 failed to experience a countertrend reversal. Wins 1) November 18th: Short ILS/GBP Achieved its profit target of 4.2 percent. 2) November 25th: Short Coffee versus Cocoa (Chart I-1) Achieved almost half of its 30 percent profit target at expiry. Chart I-1Fractal Analysis Correctly Predicted A Reversal In Coffee Versus Cocoa 3) January 20th: Short World Semiconductors versus Tech (Chart I-2) Achieved its profit target of 6 percent. Chart I-2Fractal Analysis Correctly Predicted A Reversal In World Semiconductors Versus Technology 4) March 10th: Long EUR/CHF Achieved its profit target of 3.6 percent. 5) April 14th: Short World Basic Resources versus Market (Chart I-3) Achieved its profit target of 11.5 percent. Chart I-3Fractal Analysis Correctly Predicted A Reversal In World Basic Resources Versus Market In addition, Short World Personal Goods versus Consumer Services which was opened on December 9th reached a high-water mark of 10.5 percent but expired flat. Losses 1) December 2nd: Short World Semiconductors versus Biotech Hit its stop loss of 9.5 percent. 2) January 13th: Long Poland versus US: 10-Year Government Bonds Reached a high-water mark of 3.7 percent, but then reversed to hit its stop loss of 8 percent. In the current geopolitical crisis, Poland has been a casualty due to its lengthy border with Ukraine. 3) February 3rd: Short Nickel versus Silver (Chart I-4) Hit its stop loss at 20 percent following an explosive short-squeeze rally in the Nickel price. Chart I-4Nickel's Short-Squeeze Rally Forced A Price Trend Prolongation Open Trades 1) January 27th: Long MSCI Korea versus All-Country World (Chart I-5) Open, in profit, having reached a high-water mark of 6 percent (versus an 8 percent target). Chart I-5Fractal Analysis Correctly Predicted A Rebound In Korea Versus All-Country World 2) February 24th: Long US Biotech versus US Tech Open, in profit, having reached a high-water mark of 10.5 (versus a 17.5 percent target). 3) March 3rd: Short World Banks versus Consumer Services Reached a high-water mark of 7.3 percent (versus a 12 percent target), but then reversed and is in loss. 4) March 24th: Long 5-Year T-bond Open, in modest loss. 5) April 7th: Short World Non-Life Insurance versus Homebuilders (Chart I-6) Open, in profit having reached a high-water mark of 12.4 percent (versus a 14 percent target). Chart I-6Fractal Analysis Correctly Predicted A Reversal In World Non-Life Insurance Versus Homebuilders 6) April 7th: Long JPY/CHF Reached a high-water mark of 3.4 percent versus a 4 percent target, but then reversed into modest loss. This suggests that the trade needed a narrower profit target. 7) April 28th: Short High Dividend ETF versus US 10-Year T-bond Open, in modest loss, having reached a high-water mark of 2.9 percent (versus a 6 percent target). 8) May 19th: Short FTSE 100 versus STOXX Europe 600 Open, and flat. 9) June 2nd: Long JPY/USD (Chart I-7) Open, and flat. Chart I-7The Sell-Off In JPY/USD Has Reached A Potential Turning Point 10) June 2nd: Short Australia Basic Resources versus World Market (Chart I-8) Open, and flat. Chart I-8The Australian Basic Resources Sector Is Vulnerable To Reversal Our full watchlist of 29 investments that are at, or approaching turning points, is available on our website: cpt.bcaresearch.com Appendix: Calculating The Fractal Dimension Of A Financial Market Chart 1AUD/KRW Is Vulnerable To Reversal Chart 2Canada Versus Japan Is Reversing Chart 3Canada's TSX-60's Outperformance Might Be Over Chart 4US Healthcare Providers Vs. Software At Risk of Reversal Chart 5BRL/NZD At A Resistance Point Chart 6Homebuilders Versus Healthcare Services Has Turned Chart 7CNY/USD Has Reversed Chart 8CAD/SEK Is Vulnerable To Reversal Chart 9Financials Versus Industrials To Reverse Chart 10The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 11The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 12FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing Chart 13Netherlands Underperformance Vs. Switzerland Is Ending Chart 14The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 15The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 16Food And Beverage Outperformance Exhausted Chart 17The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 18The Strong Trend In The 3 Year T-Bond Is Fragile Chart 19A Potential Switching Point From Tobacco Into Cannabis Chart 20Biotech Is A Major Buy Chart 21Norway's Outperformance Could End Chart 22Cotton Versus Platinum Is Reversing Chart 23Switzerland's Outperformance Vs. Germany Has Ended Chart 24The Rally In USD/EUR Has Ended Chart 25The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 26A Potential New Entry Point Into Petcare Chart 27Czech Outperformance Near Exhaustion Chart 28US REITS Are Oversold Versus Utilities Chart 29GBP/USD At A Turning Point Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Hadi Elzein Research Associate hadi.elzein@bcaresearch.com Footnotes 1 Strictly speaking, the EMH assumes there is some disagreement, but that this disagreement is random and follows a standard Gaussian (bell-curve) distribution. Therefore, the EMH assumes that a share price just follows a random walk until new (unpredictable) fundamental information arrives. Fractal Trades 6-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
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Listen to a short summary of this report. Executive Summary Sentiment On Sterling Is Depressed The pound will suffer in the short term, setting the stage for a coiled-spring rebound. Cable is extremely cheap by most measures (Feature chart). The BoE could engineer a soft landing in the UK economy. If successful, it will annihilate sterling vigilantes, in a volte-face of the ERM crisis. We are cognizant of near-term risks. As such, we are long EUR/GBP with a target of 0.90, but will be buyers of cable at 1.20. Ultimately, the pound is undervalued on a longer-term basis. GBP/USD should touch 1.36 over the next 12-18 months. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN long eur/gbp 0.846 2021-10-15 0.27 Bottom Line: The pound will likely face pressure in the near term, but will fare well over a cyclical horizon. Our 12-month target is 1.36. This target is based on a modest reversion towards PPP fair value, and some erosion in the “crisis” discount. Admittedly, sentiment on the pound is very depressed, and we could be wrong in our near-term assessment and cable has indeed bottomed. Feature Chart 1A Play On Cable Downside There has been much discussion around the premise that the pound could enter a capitulation phase, akin to an emerging market-style currency crisis. With inflation sitting at 9%, well above the Bank of England’s 2% target, the narrative is that interest rates need to rise substantially but will, at the same time, kill any recovery. The result will be a sharp fall in the pound. We began to highlight the near-term risks to cable in October of last year, going long EUR/GBP in the process, as a way to play sterling downside (Chart 1). That said, our longer-term view on the pound remained positive. In this report, we review what has changed since, and if a negative longer-term view is now warranted. UK Balance Of Payments Almost all currency crises are rooted in a deterioration of the external balance, and this is certainly true for the UK. The trade deficit sits at 7.9% of GDP, the worst among G10 countries (Chart 2). As a result, the current account is also in deficit. That said, there are reasons for optimism. Related Report Foreign Exchange StrategyAn Update On Sterling The Office for National Statistics (ONS) suggests that a change in methodology in January 2022 could be exarcebating the deterioration in the latest release of the trade balance. In our view, there are two key reasons why the UK’s balance of trade is worsening. The first is the oil shock – fuels constitute 11% of UK imports. Second, unprecedented fiscal stimulus led to an overshoot in goods imports. These negative forces are likely cyclical in nature, rather than structural. It is also noteworthy that most of the goods imported into the UK are machinery and transport equipment, which could go a long way in improving its productive capacity (Chart 3). Chart 2The UK Trade Balance Has Deteriorated Chart 3Goods Imports Have Been A Hit To The UK Trade Balance In parallel, there has been a structural improvement in the UK’s current account balance. This has mostly been driven by a rising primary income balance. In short, investments abroad are earning more, relative to domestic liabilities (Chart 4). The UK runs a large negative international investment position. Despite this, it has maintained the ability to issue debt bought by foreigners, while investing in high-return assets abroad. Secondary income has admittedly been in a structural deficit, but a falloff in transfer payments under the Brexit agreement will significantly improve this balance (Chart 5). Chart 4The UK Current Account Is Improving Chart 5A Fall In Brexit Payments Will Mend Secondary Income Finally, the pound’s share of global foreign exchange turnover is 12.8%, just behind the dollar, euro, and yen. That said, London dwarfs New York, Hong Kong, and Tokyo as a hub for foreign exchange trading (Chart 6). The pound also very much remains among the most desirable global currencies. Global allocation of FX reserves in sterling have been rising over the last decade (Chart 7). It currently stand at 4.8%, higher than the RMB at 2.8%, and all other emerging market currencies combined. Chart 6London Remains An Important Financial Center Chart 7The Pound Is Still A Reserve Currency It is noteworthy to revisit the period the pound experienced an EM-style crisis – under the European Exchange Rate Mechanism (ERM), when cable was effectively pegged to the German mark at an expensive level. At the time, UK inflation was running hot, while German inflation was more subdued. By importing monetary policy from the Bundesbank, the BoE was able to tame inflation, but at a high cost to growth. In Germany, the reunification boom warranted much higher interest rates, which was not appropriate for the UK . Cable eventually collapsed by 32.9% peak-to-trough, as the UK ran out of foreign currency reserves. Chart 8Cable Is Very Cheap There are three key differences between that episode and today: The pound is freely floating. Foreign exchange markets are extremely fluid and adjust to expectations quite quickly. A collapse in the pound seems unlikely, unless the UK faces a new large exogenous shock. Inflation is running hot in many countries, not just the UK. The pound is extremely cheap, and stimulative for the economy. On a real effective exchange rate basis, the pound is at record lows (Chart 8). Will The BoE Make A Policy Mistake? Sterling is pricing in a policy mistake by the BoE. First, inflation is well above its 2% target. Second, the labor market has tightened significantly. The unemployment rate hit a 47-year low of 3.7%, and job vacancies are low, pushing wages higher. As such, either the BoE allows inflation expectations to become unmoored, destroying the purchasing power of the pound, or kills the recovery to maintain credibility (Chart 9). Chart 9The UK Labor Market Is Tight While difficult, there are reasons to believe the BoE can achieve a soft landing. According to an in-house study, only one-third of the rise in UK inflation has been driven by demand-side pull, with the balance related to supply factors.1 The latter have been the usual suspects – rising energy costs, supply shortages, and even legacies of the Brexit shock (Chart 10). UK electricity prices have cratered since the opening of the 1,400MW undersea cable with Norway (Chart 11). Chart 10Most Of The Increase To UK Prices Is Supply-Driven Chart 11A Sharp Drop In Electricity Prices Second, it is likely that the neutral rate of interest in the UK is lower in a post-Brexit, post-COVID-19 world. This is visible in trend productivity growth, but even the size of the labor force has shrunk significantly. The UK workforce is down by 560,000 people since the start of the pandemic. This has been partly due to less immigration and more retirees, but the vast majority has been due to health side-effects from the pandemic, and delays in getting adequate medical care. As a result, there has barely been a recovery in the UK participation rate (Chart 12). Chart 12AThe Participation Rate In The UK Is Below Trend Chart 12BA Low Participation Rate Across Many Regions In hindsight, a least-regrets strategy to policy tightening – lift rates faster now, and then back off if financial conditions tighten sufficiently – seems appropriate. Frontloading the pace of tightening will flatten the UK gilts curve further. With most borrowing costs in the UK tied to the longer end of the curve, refinancing costs might not edge up that much, while inflation expectations will be well contained. The real canaries in the coal mine from this strategy are the economies of Australia, New Zealand, and Canada, where household debt is much more elevated (Chart 13), and the percentage of variable rate mortgages are higher. Chart 13Household Debt Is Not Alarming In The UK Larger fiscal stimulus will partially offset the near-term hit from tighter monetary policy. The additional £15 billion cost-of-living package announced last month is quite substantial at 0.7% of GDP. This gives the BoE breathing room to tighten policy in the near term. The redistributionist nature of the plan – taxing windfall profits from large energy companies, and using that to subsidize consumers most in need – could be what is required to achieve a soft landing, if the energy shock is temporary. Our Global Fixed Income colleagues upgraded UK gilts to overweight last month, on the basis that market pricing further out the SONIA curve was too aggressive. In our prior report on sterling, we also suggested that market expectations for interest rate increases may have overshot. Money markets are discounting a peak in the bank rate at 2.8%. The BoE’s new Market Participants survey suggests it will peak at 1.75%. While the BoE will deliver sufficient monetary tightening to lean against near-term inflationary pressures, it will be very wary to overdo it. This is especially true if the neutral rate in the economy is much lower. What Next For The Pound? Our view is that the pound faces near-term risks but is a buy longer term. There is an old adage that credibility is hard to earn, but easy to lose. For the UK in particular, this hits the mark. The Bank of England is the oldest central bank in the world, after the Riksbank. Yes, the BoE can make a policy mistake (as it has in the past), but treating the pound as an emerging market asset is a stretch (Chart 14). That said, our Chief European Strategist, Mathieu Savary, believes stagflation is not fully priced into UK assets. In the near term, he might be right. The UK’s large trade deficit puts the onus on foreigners to dictate movements in the pound. The pound does well when animal spirits are fervent. So far, markets have bid up a substantial safe-haven premium into the dollar (Chart 15). As a proxy, the pound has been sold. Northern Ireland could also return as a thorn in the side of sterling. Chart 14The Pound Is A Risk-On Currency Cable And EM Stocks Chart 15The Dollar Has A Hefty Safe-Haven Premium From a bird’s eye view, three factors tend to drive currencies – the macroeconomic environment, valuation, and sentiment. For now, markets have latched on to the GBP’s vulnerability to an EM-style crisis. That said, cable is very cheap, even accounting for elevated UK inflation. Our in-house PPP model suggests the pound could appreciate by 4% per year, over the next 10 years, just to revert to fair value (Chart 16). Chart 16Cable Is Cheap Admittedly, the UK desperately needs an improvement in productivity growth for further currency gains. To encourage capital inflows that the pound depends on, the UK needs to be at the forefront of disruptive technologies such as electric cars, digital currencies, 3D printing, and even innovations in gene therapy. High finance and fashion will remain relevant for London, but the need for innovation is high. Investment Conclusions Chart 17Sentiment On Sterling Is Depressed The pound will likely face pressure in the near term, but will fare well over a cyclical horizon. Our 12-month target is 1.36. This target is based on a modest reversion towards PPP fair value, and some erosion in the “crisis” discount. Admittedly, sentiment on the pound is very depressed, and we could be wrong in our near-term assessment if cable has indeed bottomed. Our intermediate-term timing model suggests that GBP is undervalued and has bottomed. Technical indicators also warn that cable is ripe for a fervent rebound (Chart 17). Particularly, our intermediate-term technical indicator is rebounding from oversold levels. The Aussie would outperform the pound in the long term, but AUD/GBP is vulnerable to a commodity relapse in the shorter term. Housekeeping We were stopped out of our short EUR/JPY trade for a loss of -2.78%, as oil prices and bond yields rebounded. This trade is a hedge to our pro-cyclical portfolio, so we will look to reenter it at more attractive levels. We are also lowering the stop-loss on our short RUB trade. This is a speculative bet many clients will not be able to play, but we expect it to payoff over the longer term. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Michael Saunders, "The route back to 2% inflation," (Speech given at the Resolution Foundation), May 9, 2022. Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary