Commodities & Energy Sector

Highlights The economic and financial market developments that have occurred over the past month are consistent with several of the risks that we identified in our recent reports. We warned in our April report that the outlook for equities had deteriorated meaningfully since the beginning of the year and recommended that investors maintain, at most, a very modest overweight toward stocks in a global multi-asset portfolio. We see the performance of the equity market over the past month as reflecting the beginning of the recession scare that we warned was coming. Still, several factors continue to suggest that this is indeed a scare, and not an actual recession. Section 2 of this month’s report reviews the US housing market for signs of an imminent recession. While a slowdown in the housing market is clearly underway, we do not yet see signs that this slowdown is recessionary. It remains an open question how forcefully Russia is willing to weaponize its natural gas exports in response to a seemingly imminent European embargo on Russian oil, and whether Russia will deploy this strategy now or later. For now, our base case view is that the euro area economy will slow and will probably contract in Q2, but it will avoid a debilitating energy-driven recession. China’s zero-tolerance COVID policy has failed to contain the disease, and it is now clear that more and more outbreaks will occur across the country over the coming months. Our base case view is that additional fiscal & monetary support is forthcoming if the spread of the disease progresses as we expect. We are likely to downgrade our outlook for global economic activity as well as our recommended allocation to risky assets if it does not materialize. Our profit margin warning indicators have deteriorated over the past month, and it is now our view that a contraction in S&P 500 margins is likely. Still, a major decline should be avoided, and we expect that S&P 500 earnings will grow at a low, single-digit rate over the coming year. We continue to recommend a marginally overweight stance towards risky assets over the coming 6-12 months, along with a neutral regional equity stance, a modestly overweight stance towards value over growth, an overweight stance towards small caps, a modestly short duration stance within a fixed-income portfolio, and short US dollar positions. Not Out Of The Woods Yet Chart I-1In May, Global Stocks Nearly Fell Into Bear Market Territory In May, Global Stocks Nearly Fell Into Bear Market Territory In May, Global Stocks Nearly Fell Into Bear Market Territory May was a painful month for the equity market. Globally, stocks fell more than 4% in US$ terms, led by the US. May’s selloff pushed global stocks close to bear market territory relative to their early-January high (Chart I-1), a threshold that was breached in intra-day terms in the US last week. We warned in our April report that the outlook for equities had deteriorated meaningfully since the beginning of the year and recommended that investors maintain, at most, a very modest overweight toward stocks in a global multi-asset portfolio. In our view, the economic and financial market developments that occurred over the past month are consistent with several of the risk we identified in our recent reports. We continue to recommend that investors remain minimally overweight risky assets. Our view that investors should not be underweight risky assets hinges on three expectations: the avoidance of a US recession over the coming year, a continuation of Russian natural gas exports to key gas-reliant European countries, and the announcement from Chinese policymakers of either significant additional stimulus in its traditional form or income-support policies of the type that prevailed in developed economies in the early phase of the COVID-19 pandemic. Confirmation of these expectations is likely to push us to upgrade our recommended stance toward risky assets, especially if equities continue to sell off in response to growth fears. Conversely, we are likely to recommend downgrading risky assets to neutral or underweight if evidence mounts that our expectations are unlikely to materialize. A US Recession Scare Is Underway We noted in last month’s report that the US economy would likely avoid a recession over the coming year, but that a recession scare was quite likely. We emphasized a probable slowdown in the housing market as the locus of investors’ recessionary concern, and the US housing market data is indeed now surprising significantly to the downside (Chart I-2). We see the performance of the equity market over the past month as reflecting the beginning of the recession scare that we warned was coming. Chart I-3 highlights that the composition of the US equity selloff since the beginning of the year has looked quite unlike the growth-driven selloffs that occurred over the past decade, in that real bond yields have been a strong driver of the decline in stocks. By contrast, May’s decline has looked more like a typical growth scare, with real bond yields somewhat cushioning the impact of a significant rise in the equity risk premium. Chart I-2The US Housing Market Is Clearly Slowing The US Housing Market Is Clearly Slowing The US Housing Market Is Clearly Slowing Chart I-3May’s Selloff Was Driven By Growth Fears, Not Rising Interest Rates June 2022 June 2022   Chart I-4 highlights that it is not just the housing market that is worrying investors. The chart shows that the Conference Board’s US leading economic indicator (LEI) is slowing quite sharply, in line with previous episodes of a major growth scare. And while the weakest components of the LEI modestly improved on average in April, Chart I-5 highlights that the collapse in real wage growth alongside the recently severe underperformance of consumer stocks has fed concerns that high inflation has eroded household purchasing power – and that a contraction in real spending is imminent. Chart I-4A Serious US Growth Scare Is Underway A Serious US Growth Scare Is Underway A Serious US Growth Scare Is Underway Chart I-5The Decline In Real US Wage Growth Has Caused A Major Selloff In Consumer Stocks The Decline In Real US Wage Growth Has Caused A Major Selloff In Consumer Stocks The Decline In Real US Wage Growth Has Caused A Major Selloff In Consumer Stocks     In Section 2 of this month’s report we provide further analysis supporting the view that the US housing market will not drive the US economy into recession. But we do continue to believe that a slowdown in housing activity is likely, and that concerns about a housing-driven recession will linger. Still, several factors continue to suggest that the US is experiencing a recession scare, and not an actual recession: The Atlanta Fed’s GDPNow model is currently predicting US real GDP growth that is only modestly below trend in Q2, and the overall estimate continues to be dragged significantly lower by a sizably negative contribution from the change in inventories (Chart I-6). Without this negative inventories effect, the Atlanta Fed’s model would be forecasting real annualized growth of over 3%. After having decelerated significantly in the second half of last year because of a broadening in consumer price inflation, Chart I-7 highlights that real personal consumption expenditures reaccelerated and real personal income ex-transfers stabilized in Q1. Chart I-6No Sign Of A Major Decline In Q2 Consumer Spending June 2022 June 2022 Chart I-7Real Income Growth Is Stabilizing, And Real Consumer Spending Is Accelerating Real Income Growth Is Stabilizing, And Real Consumer Spending Is Accelerating Real Income Growth Is Stabilizing, And Real Consumer Spending Is Accelerating     US manufacturing industrial production surged in April, led by motor vehicle production (Chart I-8, panel 1). It is true that industrial production is a coincident indicator and thus does not necessarily argue against the idea that a recession is imminent. A pickup in vehicle production is encouraging, however, as it suggests that the 15% surge in the level of new car prices over the past year that contributed to the erosion in household real incomes may be set to reverse (panel 2). Chart I-8A Pickup In Auto Production Should Help Lower Car Prices And Improve Consumer Purchasing Power A Pickup In Auto Production Should Help Lower Car Prices And Improve Consumer Purchasing Power A Pickup In Auto Production Should Help Lower Car Prices And Improve Consumer Purchasing Power Services spending is likely to improve, as deliveries of Pfizer’s Paxlovid antiviral drug continue to ramp up and vaccines are eventually approved for children under the age of six. Charts I-9A and I-9B highlight several real services spending categories that remain below their pre-pandemic levels, which in our view have been clearly linked to the pandemic and are not likely to be permanently lower. Americans have not likely stopped going to the gym, amusement parks, movies, live concerts, or the dentist, nor have their stopped needing to put elderly relatives in nursing care homes. They are also highly unlikely to stop traveling. There is some internal debate at BCA about the impact that working-from-home trends will have on the level of services spending, but we would note that essentially all of the spending categories shown in Charts I-9A and I-9B have exhibited uptrends that only appear to have been affected by consumer responses to the Delta and Omicron waves of the pandemic. Widely-available treatment options that reduce the fatality rate of the disease close to that of the flu are likely to be perceived by the public as an effective end of the pandemic, boosting spending on lagging categories of services spending. Chart I-9AAn Eventual End To The Pandemic… June 2022 June 2022 Chart I-9B…Will Cause A Further Improvement In Services Spending ...Will Cause A Further Improvement In Services Spending ...Will Cause A Further Improvement In Services Spending     Based on high-frequency data from OpenTable, the number of seated diners in US restaurants is not exhibiting any major warning signs for US consumer spending (Chart I-10). Real spending in restaurants has been strongly correlated with overall real personal consumption expenditures over the past two decades, and thus Chart I-10 is not suggesting that a collapse in overall spending is imminent. Chart I-10High-Frequency Data Does Not Yet Show A Major Pullback In US Consumer Spending High-Frequency Data Does Not Yet Show A Major Pullback In US Consumer Spending High-Frequency Data Does Not Yet Show A Major Pullback In US Consumer Spending As a final point concerning the risk of recession in the US, investors should note that the recent behavior of inflation expectations is encouraging and points to a potentially imminent peak in Fed hawkishness. Over the past few months, we have expressed our concern about the pace of increase in long-dated household inflation expectations. We highlighted last month that long-term market-based inflation expectations were also exhibiting some potential signs of becoming unanchored. However, Chart I-11 highlights that the momentum of long-dated household inflation expectations is now starting to flag, and that long-term market-based inflation expectations recently decreased in response to escalating growth fears. Chart I-12 clearly shows a slowing pace of core consumer prices, which will act to restrain further significant increases in long-dated inflation expectations. Chart I-11Long-Dated Inflation Expectations Point To A Potentially Imminent Peak In Fed Hawkishness June 2022 June 2022 Chart I-12Core Inflation Momentum Is Clearly Slowing Core Inflation Momentum Is Clearly Slowing Core Inflation Momentum Is Clearly Slowing     Chart I-13 highlights that investors expect the Fed to raise the policy rate by the end of the year to a level even higher than what Jerome Powell implied during the Fed’s May press conference: a target range for the Fed funds rate of 2.5-2.75%, corresponding to two more 50 basis point hikes and three 25 basis point hikes during the FOMC’s September, November, and December meetings. Chart I-13Expectations For Fed Rate Hikes This Year Are Likely To Come Down If Inflation Continues To Moderate June 2022 June 2022 It is likely that the market’s expectation for rate hikes this year will fall over the coming few months if the monthly pace of core inflation continues to slow. The Fed itself may soon signal a less intense pace of tightening than Powell recently implied – a perspective that we feel is supported by the minutes of the May FOMC meeting. That would allow the US economy to “digest” the recent adjustment in interest rates with less uncertainty about the economic outlook, which would lower the odds that a “mid-cycle slowdown” morphs into a full-blown recession. A Debilitating Energy-Driven Recession In Europe Is Not In The Cards, For Now The key issue pertaining to the European economic outlook remains the question of whether Europe’s imports of Russian natural gas will be interrupted. A European embargo of Russian oil now seems likely, which would likely cause Russian oil production to decline. Our Commodity & Energy strategy service now expects Brent oil to trade at $120/bbl on average for the remainder of the year, $5/bbl higher than current levels (Chart I-14). We agree with our Commodity & Energy Strategy team’s updated oil price forecast, but we have a different view about the odds that Russia will respond to a European oil embargo by cutting its natural gas exports to the EU. We still think this is a risk, not yet a likely event, although it may still occur later in the year. A full and immediate cutoff of natural gas exports to gas-dependent European countries such as Germany and Italy would not only destabilize the Russian economy by substantially reducing its current account surplus, it would also cause a severe recession in Europe through a combination of gas rationing to industries by government decree and surging energy prices (Chart I-15). Chart I-14A European Embargo Of Russian Oil Will Cause Brent To Rise To $120/bbl A European Embargo Of Russian Oil Will Cause Brent To Rise To $120/bbl A European Embargo Of Russian Oil Will Cause Brent To Rise To $120/bbl Chart I-15A Full Cutoff Of Russian Natural Gas Would Cause A Severe European Recession A Full Cutoff Of Russian Natural Gas Would Cause A Severe European Recession A Full Cutoff Of Russian Natural Gas Would Cause A Severe European Recession   That could erode European voters’ willingness to provide military support for Ukraine, but it could instead backfire and galvanize European public opinion against Russia – and remove leverage that may be potentially used to secure a ceasefire agreement that will preserve its military gains in eastern Ukraine. Chart I-16Europe Is Replenishing Its Gas Storage, But It Cannot Yet Withstand A Full Cutoff June 2022 June 2022 Russia may respond to an oil embargo by throttling the amount of natural gas exported to key European countries in a fashion that raises natural gas prices and prevents European countries from building up sufficient storage for the upcoming winter – a process that is underway but is far from complete (Chart I-16). But it remains an open question how forcefully Russia is willing to weaponize its natural gas exports, and whether it will deploy this strategy now or later. For now, our base case view is that the euro area economy will slow and will probably contract in Q2, but it will avoid a debilitating energy-driven recession. China: The Only Way Out Is Through Among the three pillars of the global economy – the US, China, and Europe – the last is arguably the least important. Today, the US and China are the core drivers of global demand, and we are therefore more concerned about the economic impact of China’s zero-tolerance COVID policy than we are about a slowdown or mild recession in Europe. Given how contagious the Omicron variant of COVID-19 has shown itself to be, and given how widespread recent outbreaks have been, it is now clear that China’s zero-tolerance policy has failed to contain the disease and that more and more outbreaks will occur across the country over the coming months. Despite public statements to the contrary, we suspect that Chinese policymakers are well aware of this situation, but are constrained by the consequences of removing the zero-tolerance policy. Recent studies suggest that China could face intensive care demand that is sixteen times existing capacity and upwards of 1.5 million deaths by removing the policy,1 roughly 1.5 times the cumulative amount of deaths that have occurred in the US during the pandemic. But the economic consequences of maintaining the zero-tolerance policy will also be severe, and therefore also likely represent a constraint on policymakers. Charts I-17 and I-18 show that China’s labor market and industrial sector have already slowed sharply over the past few months, at a pace and magnitude that is unlikely to be politically sustainable for much longer. In addition, Chart I-19 shows that China’s credit impulse fell meaningfully in April. Chart I-17China’s Labor Market Is Cratering… China's Labor Market Is Cratering... China's Labor Market Is Cratering... Chart I-18…As Is Its Manufacturing Sector ... As Is Its Manufacturing Sector ... As Is Its Manufacturing Sector       Chart I-19More Fiscal & Monetary Support Will Be Needed In China Soon, If COVID-19 Cases Continue To Spread More Fiscal & Monetary Support Will Be Needed In China Soon, If COVID-19 Cases Continue To Spread More Fiscal & Monetary Support Will Be Needed In China Soon, If COVID-19 Cases Continue To Spread This would be tolerable if the decline in activity was likely to be short-lived as it was at the very beginning of the pandemic, but we no longer see this as a probable outcome. We acknowledge that reported cases of COVID-19 have steadily declined in cities in the Yangtze River region, and we agree that the Shanghai lockdown may soon end for a time. But we doubt that this will mark the end of outbreaks in the region, or prevent major outbreaks from occurring in other parts of the country. If China cannot relax its zero-tolerance policy or tolerate the degree of economic weakness entailed by its continued application, then additional fiscal and monetary support is likely. While China’s leadership has stepped up its pro-growth policy measures, as evidenced by the recent cut in the 5-year loan prime rate, we strongly suspect that more support will be needed. This support may take the form of traditional stimulus via local government spending, or it may involve the introduction of income-support policies of the kind that prevailed in developed economies in the early phase of the COVID-19 pandemic. Chart I-20The Chinese Housing Market Is Slowing Significantly, Lowering The Risk Of Speculation From Income Support Policies The Chinese Housing Market Is Slowing Significantly, Lowering The Risk Of Speculation From Income Support Policies The Chinese Housing Market Is Slowing Significantly, Lowering The Risk Of Speculation From Income Support Policies Chinese policymakers who are eager to prevent another significant releveraging of the economy and who want to avoid another major deterioration in housing affordability may perhaps be forgiven for seeing the developed economy experience with these programs as a poor roadmap to follow. House prices have exploded in most advanced economies during the pandemic, which has significantly contributed to a major decline in affordability. However, with the benefit of hindsight, Chinese policymakers would likely be able to recalibrate any income support program to avoid some of the excesses that occurred in DM countries, such as policies that caused aggregate disposable income to increase in the US and Canada during the pandemic. In addition, Chart I-20 highlights that the starting point for the Chinese property market is one in which house prices are seemingly poised to contract at the worst pace since late 2014 / early 2015. The latter suggests that Chinese policymakers have more ability to support household income without causing an explosion in house prices and speculative activity than DM policymakers did in 2020. Regardless of its form, it is the view of the Bank Credit Analyst service that China cannot avoid the provision of significant additional fiscal/monetary support if it maintains its zero-tolerance COVID policy for the remainder of the year given our assumption that potentially major outbreaks will continue. It is our base case view that additional support is forthcoming over the coming weeks and months if the spread of the disease progresses as we expect. We are likely to downgrade our outlook for global economic activity as well as our recommended allocation to risky assets if it does not materialize. US Corporate Profits In A Nonrecessionary Slowdown Scenario Chart I-21US Forward Earnings Very Rarely Fall While The Economy Continues To Expand June 2022 June 2022 Chart I-3 highlighted that the US equity market selloff in May shifted from one that was strongly driven by rising real government bond yields to one in which a rising equity risk premium was the dominant driver. And yet, the chart showed that there has been no negative contribution to US stock prices from falling earnings expectations, with expected earnings having continued to rise since the beginning of the year. While it may seem counterintuitive to investors that forward earnings expectations are not falling in the middle of a major growth scare, Chart I-21 highlights that this is not abnormal. The chart highlights that forward earnings expectations rarely decline outside of the context of a recession, because actual earnings typically do not decline when the economy is expanding. This means that the potential for earnings to decline shows up as a rise in the equity risk premium during growth scares, which is what has generally occurred since the beginning of the year (excluding energy, forward EPS estimates have fallen slightly this year). In last month’s Section 2, we noted that nonrecessionary earnings declines almost always occur because of contractions in profit margins. We argued that risks to US equity margins might rise later this year. In fact, since we published our report last month, some of these risks have already materialized: our new profit margin warning indicator has jumped significantly (Chart I-22), and our sector profit margin diffusion index has fallen below the boom/bust line (Chart I-23). As such, it is now our view that a contraction in S&P 500 profit margins is likely over the coming year, which contrasts with analyst EPS growth expectations of 9.5% and sales per share growth expectations of 8% (meaning that analysts are currently forecasting a margin expansion). Chart I-22A Contraction In S&P 500 Profit Margins... A Contraction In S&P 500 Profit Margins... A Contraction In S&P 500 Profit Margins... Chart I-23...Now Looks Likely ...Now Looks Likely ...Now Looks Likely     Will a likely contraction in profit margins cause an outright decline in earnings over the coming year? Investors should acknowledge that this is a risk, but for now our answer is no. Chart I-24For Now, A Severe Contraction In Margins Does Not Seem Probable For Now, A Severe Contraction In Margins Does Not Seem Probable For Now, A Severe Contraction In Margins Does Not Seem Probable Taken at face value, our sector diffusion index shown in Chart I-23 suggests that profit margins are set to decline by 2 percentage points over the coming year, which would indeed imply a 7-8% contraction in earnings per share assuming 8% revenue growth. However, the index is much better at predicting inflection points in profit margins than the magnitude of the change; in several cases over the past three decades the model correctly predicted a decline in profit margins, but implied a much larger change in margins than what actually occurred. In addition, our model shown in Chart I-22 has yet to cross above the 50% mark into probable territory, and Chart I-24 highlights that net earnings revisions and net positive earnings surprises are falling but have not yet reached levels that would be consistent with a major margin decline. In sum, we expect that S&P 500 earnings will grow at a low, single-digit rate over the coming year given our expectation of a nonrecessionary slowdown scenario. This implies that US equity returns will be uninspiring over the coming year, but they will be likely be positive and will likely beat the returns offered from bonds. Investment Strategy Recommendations Considerable uncertainty remains about the global economic and financial market outlook, and there are several identifiable risks that would warrant an underweight stance towards risky assets were they to materialize. We agree that an aggressively overweight stance is not justified. Chart I-25Without A Recession, The US Equity Risk Premium Is Very Likely To Decline Without A Recession, The US Equity Risk Premium Is Very Likely To Decline Without A Recession, The US Equity Risk Premium Is Very Likely To Decline However, the fact that corporate profits do not usually fall while the economy is expanding underscores why investors should be reluctant to significantly cut their risky asset exposure unless a recession appears likely. Without a recession, the US equity risk premium is very likely to decline (Chart I-25), meaning that 10-year Treasury yields closer to 4% or a significant contraction in profit margins would be required for US stocks to post negative returns over the coming 6-12 months. We would not rule out either of these outcomes, but we also do not think that they are probable. To conclude, it is fair to say that global investors are not out of the woods yet, but we continue to recommend a marginally overweight stance towards risky assets on the basis that the US will avoid a recession over the coming year, Russia is not yet likely to push Europe into a debilitating recession, and China will further ease fiscal & monetary policy to support growth. In addition to a modest overweight towards stocks in a multi-asset portfolio, we continue to recommend the following: A neutral regional equity stance, with global ex-US equities on upgrade watch in response to an improvement in the European economic outlook and further fiscal & monetary support in China. The recent passive outperformance of global ex-US stocks has occurred mainly because US stocks have fallen more than global stocks, which have “caught up” to mounting US and global growth fears. As such, ex-US stocks have outperformed for the wrong reasons, and investors should wait for durable signs of an improving global growth outlook and a falling US dollar before shifting in favor of a global ex-US equity stance. A modestly overweight stance towards value over growth stocks on the basis of better valuation. However, most of the pandemic-related outperformance of growth stocks has already reversed (Chart I-26), suggesting that the outperformance of value is getting late. An overweight stance toward global small-cap stocks over their large-cap peers, as they are now unequivocally inexpensive and have remained resilient as global growth fears have intensified (Chart I-27). Chart I-26Modestly Favor Value Stocks Due To Better Valuation, But The COVID Effects On Equity Style Have Mostly Reversed Modestly Favor Value Stocks Due To Better Valuation, But The COVID Effects On Equity Style Have Mostly Reversed Modestly Favor Value Stocks Due To Better Valuation, But The COVID Effects On Equity Style Have Mostly Reversed Chart I-27Small Cap Stocks Have Recently Proven Resilient, And Are Extremely Cheap Small Cap Stocks Have Recently Proven Resilient, And Are Extremely Cheap Small Cap Stocks Have Recently Proven Resilient, And Are Extremely Cheap   A modestly short duration stance within a fixed-income portfolio. Short US dollar positions, as the dollar is clearly benefiting from growth fears that will wane. In addition, the US dollar is very expensive, and extremely overbought. Concerning our recommended duration stance, we acknowledge that a slower pace of rate hikes than what investors currently expect and a slowing pace of inflation would normally argue for a long duration stance. But we do not expect the Fed to stop raising interest rates unless a recession seems likely, and a slower but steady path of tightening, in conjunction with easing inflation, makes it more likely that the US economy will be able to “digest” the recent adjustment in rates without tipping into recession. This, in turn, increases the odds that the Fed funds rate will peak at a higher level than investors currently expect, which should ultimately push long-maturity yields higher rather than lower. On balance, this suggests that investors should be modestly short duration, even if long-maturity bond yields move temporarily lower over the coming few months. Long-duration positions are perhaps reasonable on a 0-3 month time horizon, but over a 6-12 month time horizon we continue to recommend a modestly short stance. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst May 26, 2022 Next Report: June 30, 2022 II.  Is The US Housing Market Signaling An Imminent Recession? The Fed’s hawkish shift over the past six months has caused a sharp increase in US interest rates. In this report we examine the US housing market for signs of an imminent recession, given the housing sector’s strong interest rate sensitivity. In addition to a severe contraction in real home improvement spending, there are several other housing-related indicators that are ostensibly pointing in a bearish direction. The growth in total home sales and the MBA mortgage application purchase index are already in negative territory, housing affordability has deteriorated meaningfully, and the National Association of Home Builders’ (NAHB) housing market index is falling sharply. However, the breadth of house prices and building permits, consumer surveys, housing equity sector relative performance, and the fact that mortgage rates have likely peaked for the year point to a more optimistic outlook for housing. At a minimum, they do not yet suggest that the current slowdown in housing-related activity is recessionary. Structural factors are also supportive of the pace of housing construction in the US. While a slowdown in the housing market is clearly underway, it is not occurring after a period of excessive housing construction. The opposite is true: the US and several other developed market economies have underbuilt homes over the past decade. This should limit the drag on economic growth from housing-related activity, and reduces the odds that a housing market slowdown will morph into a housing-driven US recession. Chart II-1The Fed's Hawkish Shift Has Caused An Extremely Sharp Rise In Interest Rates The Fed's Hawkish Shift Has Caused An Extremely Sharp Rise In Interest Rates The Fed's Hawkish Shift Has Caused An Extremely Sharp Rise In Interest Rates The Fed’s hawkish shift over the past six months has caused US interest rates to rise at an extremely rapid pace. Panel 1 of Chart II-1 highlights that the spread between the US 2-year Treasury yield and the 3-month T-bill yield reached a 20-year high in early April of this year. Panel 2 shows that the two-year change in the 30-year mortgage rate will reach the highest level since the early 1980s by the end of this year if mortgage rates remain at their current level. Over the longer run, it is the level of interest rates that matters more than their change. However, changes in interest rates and other key financial market variables are also important drivers of economic activity, especially when they happen very rapidly. Given the speed of the recent adjustment in US interest rates, and the fact that the Fed funds rate will have likely reached the Fed’s neutral rate forecast by the end of this year, investors have understandably become concerned about the potential for a recession in the US. In this report we examine the US housing market for signs of an imminent recession, given the housing sector’s strong interest rate sensitivity. We conclude that while a slowdown in the housing market is clearly underway, several signs suggest that this slowdown is not recessionary. Investors should remain laser-focused on the pace of housing-related activity over the coming 6-12 months, but for now our assessment of the housing market is consistent with a modest overweight stance towards stocks within a multi-asset portfolio. A Brief Review Of The Housing Sector’s Contribution To Growth Table II-1 highlights the importance of the housing sector as a driver/predictor of US recessions. This table highlights that real residential investment is not a particularly important contributor to real GDP growth during nonrecessionary quarters, but it is the only main expenditure component exhibiting negative growth on average in the year prior to a recession.2 Table II-1Real Residential Investment Tends To Contract In The Year Prior To A Recession June 2022 June 2022 When examining the contribution to economic growth from the housing sector, investors and housing market analysts often fully equate real residential investment with housing construction. In fact, while direct construction of housing units accounts for a sizeable portion of the contribution to growth from housing, it is just one of four components. This is an important point, as one of the often-overlooked elements of real residential investment has strongly leading properties and is currently providing a very negative signal about the housing sector. Chart II-2 breaks down what we consider as aggregate real “housing-related activity”, and Chart II-3 presents the contributions to annualized quarterly growth in housing activity from the four components. For the sake of completeness, we include personal consumption expenditures on furnishings and household equipment as part of housing-related activity, alongside the two main components of real residential investment: permanent site construction (including single and multi-family properties), and “other structures.” In reality, “other structures” is not predominantly accounted for by the construction of different types of residential properties; it is almost entirely composed of spending on home improvements and brokerage commissions on the sale of existing residential properties. Chart II-2Housing Construction Is An Important Part Of Residential Investment, But There Are Other Contributing Factors June 2022 June 2022 Chart II-3Home Improvement Spending And Brokerage Commissions Also Drive Residential Investment June 2022 June 2022     Aside from the link between existing home sales and the general demand for newly-built homes, the prominence of brokerage commissions in other residential structures investment helps explain why existing home sales are strongly correlated with real residential investment (Chart II-4, panel 1). Given that a distributed lag of monthly housing starts maps closely to permanent site construction (panel 2), starts and existing home sales explain a good portion of the contribution to growth from housing-related activity. Of the two remaining components of housing-related activity, Chart II-5 highlights that personal consumption expenditures on furniture and household equipment generally coincide with the pace of housing construction and new home sales. We take this to mean that the consumption component of housing-related activity is typically a derivative of the decision to build a new home or sell an existing one. Chart II-4Existing Home Sales Explain Commissions, And Housing Starts Explain Permanent Site Construction Existing Home Sales Explain Commissions, And Housing Starts Explain Permanent Site Construction Existing Home Sales Explain Commissions, And Housing Starts Explain Permanent Site Construction Chart II-5The Pace Of Contraction In Home Improvement Spending Is Worrying The Pace Of Contraction In Home Improvement Spending Is Worrying The Pace Of Contraction In Home Improvement Spending Is Worrying   What is not coincident with construction and existing home sales is residential home improvement: Panel 2 of Chart II-5 highlights that it has strongly leading properties, and is currently contracting at its worst rate since the 2008 recession. Data on real home improvement spending is only available quarterly from 2002, so the ability to compare the current situation to previous housing market cycles is limited. But the pace of contraction is worrying and underscores that investors should be on the lookout for corroborating signs of a major contraction in the housing market. Is The Housing Data Sending A Recessionary Signal? In addition to the severe contraction in real home improvement spending shown in Chart II-5, there are several other housing-related indicators that are ostensibly pointing in a bearish direction. In particular, Chart II-6 highlights that both the growth in total home sales and the MBA mortgage application purchase index are already in negative territory, that housing affordability has deteriorated meaningfully, and that the National Association of Home Builders’ (NAHB) housing market index is falling sharply. However, there are also several signs pointing to a more optimistic outlook for housing, or at least indicating that the current slowdown in housing-related activity is not recessionary. We review these more optimistic indicators below. The Breadth Of House Prices And Building Permits In sharp contrast to previous periods of serious housing market weakness and/or recessionary periods, there is no sign yet of a major slowdown in US house price appreciation including cities with the weakest gains. In fact, Chart II-7 highlights that house prices have recently been reaccelerating on a very broad basis after having slowed in the second half of last year, which hardly bodes poorly for new home construction. Chart II-6A US Housing Sector Slowdown Is Certainly Underway A US Housing Sector Slowdown Is Certainly Underway A US Housing Sector Slowdown Is Certainly Underway Chart II-7No Sign Yet Of A Major Deceleration In House Prices No Sign Yet Of A Major Deceleration In House Prices No Sign Yet Of A Major Deceleration In House Prices   It is true that US house price data is somewhat lagging, so it is quite likely that price weakness is forthcoming. However, there has been no sign of a major slowdown in prices through to March 2022, by which point 30-year mortgage rates had already risen 200 basis points from their 2021 low. More importantly, Chart II-8 highlights that a state-by-state diffusion index of authorized housing permits has done a very good job at leading the growth in permits nationwide, and is currently not pointing to a contraction in activity. Chart II-9 presents explanatory models for the growth in US housing starts and total home sales based on our state permits diffusion index, pending home sales, the change in mortgage rates, and housing affordability. The chart underscores that a contraction in housing activity is not what these variables would predict, even though starts and sales should be growing at a much more modest pace than what has prevailed on average over the past two years. Chart II-8Our Building Permits Diffusion Index Leads Housing Construction Activity, And Is Not Pointing To A Major Slowdown Our Building Permits Diffusion Index Leads Housing Construction Activity, And Is Not Pointing To A Major Slowdown Our Building Permits Diffusion Index Leads Housing Construction Activity, And Is Not Pointing To A Major Slowdown Chart II-9Reliably Leading Indicators Of Construction And Home Sales Do Not Point To A Recessionary Outcome Reliably Leading Indicators Of Construction And Home Sales Do Not Point To A Recessionary Outcome Reliably Leading Indicators Of Construction And Home Sales Do Not Point To A Recessionary Outcome     Consumer Surveys The University of Michigan consumer survey shows that consumers feel it is the worst time to buy a home since the early-1980s (Chart II-10), which seems like a clearly negative sign for the housing market and an indication of the likely impact of tighter policy on housing-related activity. And yet, panel 2 highlights that this is the result of the fact that house prices in the US have surged during the pandemic, not that mortgage rates have risen too high. It is true that the number of survey respondents citing “interest rates are too high” is rising sharply, but this factor as a share of all “bad time to buy” reasons given is not meaningfully higher than it was in 2018, 2011, or 2006. It is clear that high prices are also the culprit for why consumers report that it is a bad time to buy large household durables and not that large household durables are unaffordable or that interest rates are too high (Chart II-11). Chart II-10Nearly The Worst Time To Buy A Home, Mostly Due To Prices (Not Interest Rates) Nearly The Worst Time To Buy A Home, Mostly Due To Prices (Not Interest Rates) Nearly The Worst Time To Buy A Home, Mostly Due To Prices (Not Interest Rates) Chart II-11Same Story For Large Household Durables Same Story For Large Household Durables Same Story For Large Household Durables   It may seem counterintuitive for investors to see Charts II-10 and II-11 as in any way positive for the housing market. But, to us, the notion that elevated house prices are the main source of poor affordability supports the idea that a normalization of the housing market will occur through a combination of marginally lower demand, a slower pace of house price appreciation, and a sustained pace of housing market construction. This implies that existing home sales may be weaker than housing construction over the coming year, but the latter will help to support the contribution to overall economic growth from housing-related activity. Housing Sector Relative Performance Despite the significant slowdown in real home improvement spending and the recent decline in the NAHB’s housing market index, Chart II-12 highlights that home improvement retail and homebuilding stocks have not exhibited significantly negative abnormal returns over the past year – as they did in 1994/1995 and in the lead up to the global financial crisis. The chart, which presents a rolling 1-year “Jensen’s alpha” measure for both industries, attempts to capture the risk-adjusted performance of the industry versus the S&P 500. While the chart shows that both industries have generated negative alpha over the past year, the magnitude does not appear to be consistent with a recession. In the case of homebuilder stocks in particular, negative abnormal returns over the past year should have been meaningfully worse given the year-over-year change in mortgage rates. Chart II-13 highlights that homebuilder performance has not been cushioned by a deep valuation discount in advance of the rise in mortgage rates. Chart II-12Housing-Related Equity Sectors Are Not Warning Of A Housing-Driven Recession Housing-Related Equity Sectors Are Not Warning Of A Housing-Driven Recession Housing-Related Equity Sectors Are Not Warning Of A Housing-Driven Recession Chart II-13Homebuilders Were Not Excessively Cheap Before Mortgage Rates Spiked Homebuilders Were Not Excessively Cheap Before Mortgage Rates Spiked Homebuilders Were Not Excessively Cheap Before Mortgage Rates Spiked   In short, the important takeaway for investors is that the relative performance of housing-related stocks is not yet consistent with a housing-led US recession. Mortgage Rates Are Not Restrictive, And Have Likely Peaked As we highlighted in Chart II-1, the two-year change in the US 30-year conventional mortgage rate will be the largest in history by the end of this year, save the Volcker era, if the mortgage rate remains at its current level. However, it is not just the change in interest rates that matters for economic activity, but rather also the level. Encouragingly, Chart II-14 highlights that the level of mortgage rates has not yet risen into restrictive territory relative to the economy’s underlying potential rate of growth. In addition, it appears that mortgage rates have overreacted to the expected pace of monetary tightening – and thus have likely peaked for this year. Two points support this view: First, panel 2 of Chart II-14 highlights that the 30-year mortgage rate is one standard deviation too high relative to the 10-year Treasury yield, underscoring that the former has overshot. And second, Chart II-15 highlights that the mortgage rate is still too high even after controlling for business cycle expectations, current coupon MBS yields, and bond & equity market volatility. Chart II-14Mortgage Rates Are Not Yet Restrictive, But Have Likely Peaked For The Year Mortgage Rates Are Not Yet Restrictive, But Have Likely Peaked For The Year Mortgage Rates Are Not Yet Restrictive, But Have Likely Peaked For The Year Chart II-15No Matter How You Slice It, US Mortgage Rates Are Stretched No Matter How You Slice It, US Mortgage Rates Are Stretched No Matter How You Slice It, US Mortgage Rates Are Stretched   Structural Factors Supporting Housing Construction Chart II-16The US And Several Other DM Countries Have Underbuilt Homes Since The Global Financial Crisis The US And Several Other DM Countries Have Underbuilt Homes Since The Global Financial Crisis The US And Several Other DM Countries Have Underbuilt Homes Since The Global Financial Crisis Our analysis above points to a scenario in which the housing market slows in a nonrecessionary fashion, supported by relatively buoyant construction activity. Structural factors, which are mostly a legacy of the global financial crisis, are also supportive of the pace of housing construction in the US and other developed market economies. We presented Chart II-16 in our June 2021 Special Report, which shows the most standardized measure of cross-country housing supply available for several advanced economies: the trend in real residential investment relative to real GDP over time. These series are all rebased to 100 as of 1997, prior to the 2002-2007 US housing market boom. The chart makes it clear that advanced economies generally fall into two groups based on this metric: those that have seen declines in real residential investment relative to GDP, especially after the global financial crisis (panel 1) and those that have experienced either an uptrend in housing construction relative to output or a flat trend (panel 2). The US, along with the euro area, the UK, and Japan, all belong to the first group, with commodity-producing and Scandinavian countries belonging to the second group. The point of the chart is that the US and most other major DM economies have seemingly experienced a chronic undersupply of homes in the wake of the global financial crisis, which should continue to support housing construction activity even if demand for housing is slowing because of a sharp increase in mortgage rates. Given that the trend in real residential investment to GDP is a somewhat crude metric of housing supply, Chart II-17 presents a more precise measure for the US. It shows the standardized trend in permanent site residential structures investment (both single- and multi-family) relative to both the US population and the number of households. The chart makes it clear that the US vastly overbuilt homes from the late-1990s to 2007, but also vastly underbuilt since 2008. Relative to the number of households, real permanent site residential structures investment is still half of a standard deviation below its long-term average – even after the surge in construction that occurred in 2020. Chart II-18 highlights a similar message: it shows that the US homeowner vacancy rate (the proportion of the housing stock that is vacant and for sale) was at a 66-year low at the end of the first quarter. Chart II-19 shows that the monthly supply of existing one-family homes on the market is also at a multi-decade low, but that the supply of new homes for sale spiked in April. Chart II-17More Precise Home Supply Measures Underscore That The US Needs To Build More Houses More Precise Home Supply Measures Underscore That The US Needs To Build More Houses More Precise Home Supply Measures Underscore That The US Needs To Build More Houses Chart II-18The Homeowner Vacancy Rate Is Extremely Low The Homeowner Vacancy Rate Is Extremely Low The Homeowner Vacancy Rate Is Extremely Low     At first blush, this spike in the monthly supply of new homes relative to sales is quite concerning, as it has risen back to levels that prevailed in 2007. One point to note is that the increase in new home inventory relates to homes still under construction; the inventory of completed homes for sale remains quite low. In addition, from the perspective of a homebuilder, a rise in the monthly supply of new homes relative to home sales is only concerning if it translates into a significant increase in the amount of time to sell a completed home, as has historically been the case (Chart II-20). Chart II-19Existing Home Inventories Remain Low Relative To Sales... Existing Home Inventories Remain Low Relative To Sales... Existing Home Inventories Remain Low Relative To Sales... Chart II-20...And Higher New Home Inventories Are Not Affecting Time-To-Sale Of Completed Homes ...And Higher New Home Inventories Are Not Affecting Time-To-Sale Of Completed Homes ...And Higher New Home Inventories Are Not Affecting Time-To-Sale Of Completed Homes   Chart II-20 highlights that a fairly significant divergence between these two series has emerged over the past decade. Despite roughly five-six months’ supply of new home inventory on average since 2012, the median number of months required to sell a new home rarely exceeded four. In early-2019 the monthly supply of new homes also spiked, and a relatively modest and nonrecessionary slowdown in housing starts was sufficient to prevent any meaningful rise in the amount of time required to sell a newly completed home. Notably, the models that we presented in Chart II-9 led the slowdown in total home sales and starts in late-2018/early-2019, and they are not pointing to a major contraction today. The key point for investors is that while a slowdown in the housing market is clearly underway, it is not occurring after a period of excessive housing construction. In fact, the opposite is true: despite a surge in construction during the pandemic, it remains below its historical average relative to the population and especially the number of households. This should act to limit the drag on economic growth from housing-related activity, and therefore reduces the odds that a housing market slowdown will morph into a housing-driven US recession. Investment Implications We noted in our May report that the inversion of the 2-10 yield curve has set a recessionary tone to any weakness in US macroeconomic data, and that a recession scare was likely. Recent negative housing market data surprises underscore that a slowdown in the US housing market is clearly underway, and that this will likely feed recessionary concerns for a time. Investors should continue to be highly focused on the evolution of US macro data when making asset allocation decisions over the coming 6-12 months, as the current economic and financial market environment remains highly uncertain. This should include a strong focus on the housing market, as consumer surveys highlight that the overall impact of falling real wages and high house prices could cause a more pronounced slowdown in housing-related activity than we expect – and that the change and level of interest rates would imply. Nevertheless, our analysis of the historical predictors of housing construction and sales points to the conclusion that the ongoing housing market slowdown is not likely to be recessionary in nature. This, in conjunction with the factors that we noted in Section 1 of our report, support maintaining a modest overweight towards stocks within a multi-asset portfolio over the coming 6-12 months. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators generally paint a pessimistic picture for stock prices. Our monetary indicator is at its weakest level in almost three decades, and our valuation indicator highlights that stocks are still expensive. Meanwhile, both our sentiment and technical indicators have broken down, and have not yet reached levels that would indicate an imminent reversal. Investors should be, at most, very modestly overweight stocks versus bonds over the coming year. Equity earnings will likely rise over the coming year if the US economy avoids a recession (as we expect), but analysts are pricing in too much growth over the coming year. A contraction in profit margins is now likely, signaling that earnings will grow at a low single-digit pace. Net earnings revisions are falling, but are not yet signaling a large enough decline in margins that would cause earnings to contract even in the face of positive revenue growth. Within a global equity portfolio, we recommend a neutral regional equity allocation. The recent passive outperformance of global ex-US stocks has occurred mainly because US stocks have fallen more than global stocks, which have “caught up” to mounting US and global growth fears. Investors should wait for durable signs of an improving global growth outlook and a falling US dollar before shifting in favor of a global ex-US equity stance. Within a fixed-income portfolio, long-duration positions are reasonable on a 0-3 month time horizon given that 10-year Treasurys are significantly oversold. But over a 6-12 month time horizon, we continue to recommend a modestly short stance. A slower but steady path of tightening, in conjunction with easing inflation, makes it more likely that the US economy will be able to “digest” the recent adjustment in rates without tipping into recession. This should ultimately push long-maturity yields higher rather than lower. Our composite technical indicator for commodity prices continues to highlight that commodities are overbought. Still, the geopolitical situation continues to favor higher energy prices, as a seemingly imminent European oil embargo against Russia will likely lower Russian oil production.  Additional fiscal & monetary support in China is likely to cause a renewed rally in industrial metals, although they may fall in the nearer-term as COVID-19 cases continue to spread across China. We remain structurally bullish on industrial metals prices given that Russia’s aggression has sped up Europe’s decarbonization timeline. US and global LEIs remain in positive territory but have now rolled over significantly from very elevated levels. Our global LEI diffusion index is now rising, which may herald a stabilization in our global LEI. Manufacturing PMIs are falling in the US and globally, but have not yet fallen below the boom/bust line and are far from levels normally consistent with a recession. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators     Chart III-4US Stock Market Breadth US Stock Market Breadth US Stock Market Breadth Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate Footnotes 1     Cai, J. . et al., Modeling Transmission Of SARS-CoV-2 Omicron in China, Nature Medicine. May 10, 2022. 2     This is aside from the contribution to growth from imports, which mechanically subtract from consumption and investment when calculating GDP.

Listen to a short summary of this report.         Executive Summary The US Inflation Surprise Index Has Rolled Over Goldilocks: A Skeptical Q&A Goldilocks: A Skeptical Q&A Global equities are nearing a bottom and will rally over the coming months as inflation declines and growth reaccelerates. While equity valuations are not at bombed-out levels, they have cheapened significantly. Global stocks trade at 15.3-times forward earnings. We are upgrading tech stocks from underweight to neutral. The NASDAQ Composite now trades at a forward P/E of 22.6, down from 32.9 at its peak last year. The 10-year Treasury yield should decline to 2.5% by the end of the year, which will help tech stocks at the margin. The US dollar has peaked. A weakening dollar will provide a tailwind to stocks, especially overseas bourses. US high-yield spreads are pricing in a default rate of 6.2% over the next 12 months, well above the trailing default rate of 1.2%. Favor high-yield credit over government bonds within a fixed-income portfolio.   Bottom Line: The recent sell-off in stocks provides a good opportunity to increase equity allocations. We expect global stocks to rise 15%-to-20% over the next 12 months. Back to Bullish We wrote a report on April 22nd arguing that global equities were heading towards a “last hurrah” in the second half of the year as a Goldilocks environment of falling inflation and supply-side led growth emerges. Last week, we operationalized this view by tactically upgrading stocks to overweight after having downgraded them in late February. This highly out-of-consensus view change, coming at a time when surveys by the American Association of Individual Investors and other outfits show extreme levels of bearishness, has garnered a lot of attention. In this week’s report, we answer some of the most common questions from the perspective of a skeptical reader.   Q: Inflation is at multi-decade highs, global growth is faltering, and central banks are about to hike rates faster than we have seen in years. Isn’t it too early to turn bullish? A: We need to focus on how the world will look like in six months, not how it looks like now. Inflation has likely peaked and many of the forces that have slowed growth, such as China’s Covid lockdown and the war in Ukraine, could abate.   Q: What is the evidence that inflation has peaked? And may I remind you, even if inflation does decline later this year, this is something that most investors and central banks are already banking on. Inflation would need to fall by more than expected for your bullish scenario to play out. A: That’s true, but there is good reason to think that this is precisely what will happen.  Overall spending in the US is close to its pre-pandemic trend. However, spending on goods remains above trend while spending on services is below trend (Chart 1). Services prices tend to be stickier than goods prices. Thus, the shift in spending patterns caused goods inflation to rise markedly with little offsetting decline in services inflation. To cite one of many examples, fitness equipment prices rose dramatically, but gym membership fees barely fell (Chart 2). Chart 1Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Chart 2Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices As goods demand normalizes, goods inflation will come down. Meanwhile, the supply of goods should increase as the pandemic winds down, and hopefully, a detente is reached in Ukraine. There are already indications that some supply-chain bottlenecks have eased (Chart 3). Q: Even if supply shocks abate, which seems like a BIG IF to me, wouldn’t the shift in spending towards services supercharge what has been only a modest acceleration in services inflation so far? A: Wages are the most important driver of services inflation. Although the evidence is still tentative, it does appear as though wage inflation is peaking. The 3-month annualized growth rate in average hourly earnings for production and nonsupervisory workers slowed from 7.2% in the second half of 2021 to 3.8% in April (Chart 4). Assuming productivity growth of 1.5%, this is consistent with unit labor cost inflation of only slightly more than 2%, which is broadly consistent with the Fed’s CPI inflation target.1 Image Chart 4Wage Pressures May Be Starting To Ease Wage Pressures May Be Starting To Ease Wage Pressures May Be Starting To Ease Image Moreover, a smaller proportion of firms expect to raise wages over the next six months than was the case late last year according to a variety of regional Fed surveys (Chart 5). The same message is echoed by the NFIB small business survey (Chart 6). Consistent with all this, the US Citi Inflation Surprise Index has rolled over (Chart 7).   Chart 6... Small Business Owners Included ... Small Business Owners Included ... Small Business Owners Included Chart 7The US Inflation Surprise Index Has Rolled Over The US Inflation Surprise Index Has Rolled Over The US Inflation Surprise Index Has Rolled Over   Q: What about the “too cold” risk to your Goldilocks scenario? The risks of recession seem to be rising. A: The market is certainly worried about this outcome, and that has been the main reason stocks have fallen of late. However, we do not think this fear is justified, certainly not in the US (Chart 8). US households are sitting on $2.3 trillion excess savings, equal to about 14% of annual consumption. The ratio of household debt-to-disposable income is down 36 percentage points from its highs in early 2008, giving households the wherewithal to spend more. Core capital goods orders, a good leading indicator for capex, have surged. The homeowner vacancy rate is at a record low, suggesting that homebuilding will be fairly resilient in the face of higher mortgage rates.   Q: It seems like the Fed has a nearly impossible task on its hands: Increase labor market slack by enough to cool the economy but not so much as to trigger a recession. You yourself have pointed out that the Fed has never achieved this in its history. A: It is correct that the unemployment rate has never risen by more than one-third of a percentage point in the US without a recession occurring (Chart 9). That said, there are three reasons to think that a soft landing can be achieved this time. Image Chart 9When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising First, increasing labor market slack is easier if one can raise labor supply rather than reducing labor demand. Right now, the participation rate is nearly a percentage point below where it was in 2019, even if one adjusts for increased early retirement during the pandemic (Chart 10). Wages have risen relatively more at the bottom end of the income distribution. This should draw more low-wage workers into the labor force. Furthermore, according to the Federal Reserve, accumulated bank savings for the lowest-paid 20% of workers have been shrinking since last summer, which should incentivize job seeking (Chart 11). Chart 10Labor Participation Has Further Scope To Recover Labor Participation Has Further Scope To Recover Labor Participation Has Further Scope To Recover Chart 11Depleted Savings Will Force More Lower-Wage Workers Into The Labor Market Depleted Savings Will Force More Lower-Wage Workers Into The Labor Market Depleted Savings Will Force More Lower-Wage Workers Into The Labor Market Second, long-term inflation expectations remain well contained, which makes a soft landing more likely. Median expected inflation 5-to-10 years out in the University of Michigan survey stood at 3% in May, roughly where it was between 2005 and 2013 (Chart 12). Median expected earnings growth in the New York Fed Survey of Consumer Expectations was only slightly higher in April than it was prior to the pandemic (Chart 13). Chart 12Consumer Long-Term Inflation Expectations Have Risen But Remain Relatively Low Consumer Long-Term Inflation Expectations Have Risen But Remain Relatively Low Consumer Long-Term Inflation Expectations Have Risen But Remain Relatively Low Chart 13US Consumers Do Not Expect Wages To Grow At A Much Higher Rate Than In The Pre-Pandemic Period US Consumers Do Not Expect Wages To Grow At A Much Higher Rate Than In The Pre-Pandemic Period US Consumers Do Not Expect Wages To Grow At A Much Higher Rate Than In The Pre-Pandemic Period A third reason for thinking that a soft landing may be easier to achieve this time around is that the US private-sector financial balance – the difference between what the private sector earns and spends – is still in surplus (Chart 14). This stands in contrast to the lead-up to both the 2001 and 2008-09 recessions, when the private sector was living beyond its means.   Q: You have spoken a lot about the US, but the situation seems dire elsewhere. Europe may already be in recession as we speak! A: The near-term outlook for Europe is indeed challenging. The euro area economy grew by only 0.8% annualized in the first quarter. Mathieu Savary, BCA’s Chief European Strategist, expects an outright decline in output in Q2. To no one’s surprise, the war in Ukraine is weighing on European growth. The Bundesbank estimates that a full embargo of Russian oil and gas would reduce German real GDP by an additional 5% on top of the damage already inflicted by the war (Chart 15). Chart 14The US Private-Sector Financial Balance Remains In Surplus The US Private-Sector Financial Balance Remains In Surplus The US Private-Sector Financial Balance Remains In Surplus Chart 15Germany’s Economy Will Sink Without Russian Energy Goldilocks: A Skeptical Q&A Goldilocks: A Skeptical Q&A While such a full embargo is possible, it is not our base case. In a remarkable about-face, Putin now says he has “no problems” with Finland and Sweden joining NATO, provided that they do not place military infrastructure in their countries. He had previous threatened a military response at the mere suggestion of NATO membership. In any case, there are few signs that Putin’s increasingly insular and dictatorial regime would respond to an oil embargo or other economic incentives. The wealthy oligarchs who were supposed to rein him in are cowering in fear. It is also not clear if Europe would gain any political leverage over Russia by adopting policies that push its own economy into a recession. It is worth noting that the price of the December 2022 European natural gas futures contract is down 39% from its peak at the start of the war (Chart 16). It is also noteworthy that European EPS estimates have been trending higher this year even as GDP growth estimates have been cut (Chart 17). This suggests that the analyst earnings projections were too conservative going into the year. Chart 16European Natural Gas Futures Are High But Below Their Peak European Natural Gas Futures Are High But Below Their Peak European Natural Gas Futures Are High But Below Their Peak Chart 17European And US EPS Estimates Have Been Trending Higher This Year European And US EPS Estimates Have Been Trending Higher This Year European And US EPS Estimates Have Been Trending Higher This Year Chart 18Chinese Property Sector: Signs Of Contraction Chinese Property Sector: Signs Of Contraction Chinese Property Sector: Signs Of Contraction Q: What about China? The lockdowns are crippling growth and the property market is in shambles. A: There is truth to both those claims. The government has all but said that it will not abandon its zero-Covid policy anytime soon, even going as far as to withdraw from hosting the 2023 AFC Asian Cup. While the number of new cases has declined sharply in Shanghai, future outbreaks are probable. On the bright side, China is likely to ramp up domestic production of Pfizer’s Paxlovid drug. Increased availability of the drug will reduce the burden of the disease once social distancing restrictions are relaxed. As far as the property market is concerned, sales, starts, completions, as well as home prices are all contracting (Chart 18). BCA’s China Investment Strategy expects accelerated policy easing to put the housing sector on a recovery path in the second half of this year. Nevertheless, they expect the “three red lines” policy to remain in place, suggesting that the rebound in housing activity will be more muted than in past recoveries.2  Ironically, the slowdown in the Chinese housing market may not be such a bad thing for the rest of the world. Remember, the main problem these days is inflation. To the extent that a sluggish Chinese housing market curbs the demand for commodities, this could provide some relief on the inflation front.   Q: So bad news is good news. Interesting take. Let’s turn to markets. You mentioned earlier that equity sentiment was very bearish. Fair enough, but I would note the very same American Association of Individual Investors survey that you cited also shows that investors’ allocation to stocks is near record highs (Chart 19). Shouldn’t we look at what investors are doing rather than what they’re saying? A: The discrepancy may not be as large as it seems. As Chart 20 illustrates, investors may not like stocks, but they like bonds even less. Chart 19Individual Investors Still Hold A Lot Of Stock Individual Investors Still Hold A Lot Of Stock Individual Investors Still Hold A Lot Of Stock   Image Chart 20B... But They Like Bonds Even Less ... But They Like Bonds Even Less ... But They Like Bonds Even Less Chart 21Global Equities Are More Attractively Valued After The Recent Sell-Off Global Equities Are More Attractively Valued After The Recent Sell-Off Global Equities Are More Attractively Valued After The Recent Sell-Off Global equities currently trade at 15.3-times forward earnings; a mere 12.5-times outside the US. The global forward earnings yield is 6.7 percentage points higher than the global real bond yield. In 2000, the spread between the earnings yield and the real bond yield was close to zero (Chart 21). It should also be mentioned that institutional data already show a sharp shift out of equities. The latest Bank of America survey revealed that fund managers cut equity allocations to a net 13% underweight in May from a 6% overweight in April and a net 55% overweight in January. Strikingly, fund managers were even more underweight bonds than stocks. Cash registered the biggest overweight in two decades.   Q: Your bullish equity bias notwithstanding, you were negative on tech stocks last year, arguing that the NASDAQ would turn into the NASDOG. Given that the NASDAQ Composite is down 29% from its highs, is it time to increase exposure to some beaten down tech names? A: Both the cyclical and structural headwinds facing tech stocks that we discussed in These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth and The Disruptor Delusion remain in place. Nevertheless, with the NASDAQ Composite now trading at 22.6-times forward earnings, down from 32.9 at its peak last year, an underweight in tech is no longer appropriate (Chart 22). A neutral stance is now preferable.   Chart 22Tech Stock Valuations Have Returned To Earth Tech Stock Valuations Have Returned To Earth Tech Stock Valuations Have Returned To Earth Q: I guess if bond yields come down a bit more, that would help tech stocks? A: Yes. Tech stocks tend to be growth-oriented. Falling bond yields raise the present value of expected cash flows more for growth companies than for other firms. While we do expect global bond yields to eventually rise above current levels, yields are likely to decline modestly over the next 12 months as inflation temporarily falls. We expect the US 10-year yield to end the year at around 2.5%.   Q: A decline in US bond yields would undermine the high-flying dollar, would it not? A: It depends on how bond yields abroad evolve. US Treasuries tend to be relatively high beta, implying that US yields usually fall more when global yields are declining (Chart 23). Thus, it would not surprise us if interest rate differentials moved against the dollar later this year. Chart 23US Treasuries Have A Higher Beta Than Most Other Government Bond Markets US Treasuries Have A Higher Beta Than Most Other Government Bond Markets US Treasuries Have A Higher Beta Than Most Other Government Bond Markets It is also important to remember that the US dollar is a countercyclical currency (Chart 24). If global growth picks up as pandemic dislocations fade and the Ukraine war winds down, the dollar is likely to weaken. Chart 24The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Image A wider trade deficit could also imperil the greenback. The US trade deficit has increased from US$45 billion in December 2019 to US$110 billion. Equity inflows have helped finance the trade deficit, but net flows have turned negative of late (Chart 25). Finally, the dollar is quite expensive – 27% overvalued based on Purchasing Power Parity exchange rates.   Q: Let’s sum up. Please review your asset allocation recommendations both for the next 12 months and beyond. A: To summarize, global inflation has peaked. Growth should pick up later this year as supply-chain bottlenecks abate. The combination of falling inflation and supply-side led growth will provide a springboard for equities. We expect global stocks to rise 15%-to-20% over the next 12 months. Historically, non-US stocks have outperformed their US peers when the dollar has been weakening (Chart 26). EM stocks, in particular, have done well in a weak dollar environment Chart 26Non-US Stocks Will Benefit From A Weaker US Dollar Non-US Stocks Will Benefit From A Weaker US Dollar Non-US Stocks Will Benefit From A Weaker US Dollar Chart 27The Market Is Too Pessimistic On Default Risk The Market Is Too Pessimistic On Default Risk The Market Is Too Pessimistic On Default Risk Within fixed-income portfolios, we recommend a modest long duration stance over the next 12 months. We favor high-yield credit over safer government bonds. US high-yield spreads imply a default rate of 6.2% over the next 12 months compared to a trailing 12-month default rate of only 1.2% (Chart 27). Chart 28Falling Inflation Will Buoy Consumer Sentiment Falling Inflation Will Buoy Consumer Sentiment Falling Inflation Will Buoy Consumer Sentiment Our guess is that this Goldilocks environment will end towards the end of next year. As inflation comes down, real wage growth will turn positive. Consumer confidence, which is now quite depressed, will improve (Chart 28). Stronger demand will cause inflation to reaccelerate in 2024, setting the stage for another round of central bank rate hikes.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on           LinkedIn Twitter       Footnotes 1    The Federal Reserve targets an average inflation rate of 2% for the Personal Consumption Expenditures (PCE) index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of 2.3%-to-2.5%. 2    The People’s Bank of China and the housing ministry issued a deleveraging framework for property developers in August 2020, consisting of a 70% ceiling on liabilities-to-assets, a net debt-to-equity ratio capped at 100%, and a limit on short-term borrowing that cannot exceed cash reserves. Developers breaching these “red lines” run the risk of being cut off from access to new loans from banks, while those who respect them can only increase their interest-bearing borrowing by 15% at most. Global Investment Strategy View Matrix Goldilocks: A Skeptical Q&A Goldilocks: A Skeptical Q&A Special Trade Recommendations Current MacroQuant Model Scores Goldilocks: A Skeptical Q&A Goldilocks: A Skeptical Q&A

Executive Summary Loss Of Russian Production Will Lift Brent Loss Of Russian Production Will Lift Brent Loss Of Russian Production Will Lift Brent With German imports of Russian oil close to 10% of its total requirements – following an impressive decline from 35% pre-invasion – we expect the EU to declare an embargo on Russian oil imports this week or next. Smaller states – e.g., Hungary and Slovokia – will be granted embargo waivers; their import volumes will not affect the EU effort. Russia will be forced to shut in ~ 1.6mm b/d of production, rising to 2mm b/d next year (vs. pre-invasion levels). Demand will fall as Brent prices surpass $120/bbl by 2H22, in our revised base case. Prices above $140/bbl are likely if Russia immediately halts EU oil exports. Our revised forecast calls for Brent to average $113/bbl this year, and $122/bbl next year. WTI will trade $3/bbl lower. Per earlier threats, Russia will cut EU natgas exports following the EU embargo. Benchmark euro natgas prices will go back above €225/MWh, and trigger an EU recession. Bottom Line: An EU embargo on Russian oil imports is close. Brent crude will rally above $120/bbl by 2H22, with $140/bbl or higher likely, depending on how quickly Russia reacts to the EU oil embargo. Eurozone natgas will trade above €225/MWh again. We remain long the S&P GSCI index, the COMT ETF, and the XOP and CRAK ETFs to retain exposure to higher prices. We are getting long 1Q23 ICE Brent futures and 4Q22 TTF futures at tonight's close. Feature Related Report  Commodity & Energy StrategyDie Cast By EU: Inflation, Recession Risks Rise The stage is set for the EU to announce an embargo on Russian oil imports this week or next. Odds of an EU embargo being declared sooner rather than later increased, in our view, in the wake of Germany's success in cutting Russian oil imports by more than half in a very short period – from ~ 35% prior to Russia's invasion of Ukraine on 24 February to ~ 12% earlier this month (Chart 1). Further reductions in Russian oil imports we expect from Germany will make it easier for the EU's largest economy to walk away from Russian crude and product imports sooner rather than later.1 Other EU member states already stand with Germany on the issue of an embargo on Russian imports. Those that do not – Hungary and Slovakia, e.g. – do not import Russian oil on a scale that can meaningfully derail EU solidarity on the embargo, which means waivers for these states can be expected to keep the embargo on track. In addition, four of the Five-Eyes states – the US, UK, Australia and Canada – already have imposed embargoes on Russian oil imports. Chart 1EU Energy Import Dependency (2021) EU Energy Import Dependency (2021) EU Energy Import Dependency (2021) Russian Shut-ins Will Tighten Supply The immediate fallout of the EU embargo will be to accelerate the rate at which Russia is forced to shut in production, as increasing volumes of its oil remain stranded on the water looking for a home. We reckon 1mm b/d or so of Russian crude oil output already has been cut. This will continue to increase. Russia will be forced to shut in ~ 1.6mm b/d of crude output this year, rising to 2mm b/d next year (averages vs. pre-invasion levels), in our modelling. This takes Russian oil production down to 8.4mm b/d this year, on average, and 8.0mm b/d next year.2 As more and more Russian crude is shut in, the pipelines carrying Urals and Eastern Siberia-Pacific Ocean (ESPO) crude from the Siberian oil fields to ports will fill, along with inventory in the ports where ships are loaded for export. When storage and pipelines fill, the only alternative Russian producers will have will be to shut in crude and condensate production. While some states obviously will benefit from the increasing availability of Russian crude on offer at 30% discounts or more – e.g., India and China – there is a limit as to how much surplus Russian output they can take in. China, in particular, will not want to jeopardize long-term contracts with key suppliers – e.g., the Kingdom of Saudi Arabia (KSA) – nor will India, which will limit the total volumes both are willing to take from Russia longer term. Security of supply becomes an increasingly important consideration as Russia's oil output continues a long-term decline going forward: Costs were rising prior to Russia's invasion of Ukraine from 2008 to 2019. Falling drilling efficiency and production, were accompanied by rising water cuts – i.e., the amount of water being produced drilling for oil – in Russia's largest fields, which rose to as high as 86%. Shutting production from these older fields will force hard choices as to whether these fields are ever revived.3 Demand Will Be Stressed Shortly after Russia invaded Ukraine, the country's Energy Ministry Alexander Novak warned the EU it would cut off natural gas pipeline supplies being sent to the continent, in retaliation for embargoing oil imports.4 Oil exports of close to 5mm b/d accounted for just under half of Russia's revenue from energy exports last year, with OECD Europe representing half of that amount.5 For Russia, oil exports are far more important than gas exports, which will incline it to immediately cut pipeline flows to Europe as soon as an oil embargo is announced. For the EU, natgas exports from Russia are critical to the economies of its member states (Chart 2). The EU imported ~ 155 bcm of natgas from Russia in 2021, or just over 40% of its total natgas consumption. Germany's share amounted to 45 bcm, or 45% of domestic gas use . If, as we expect, the EU is close to announcing its oil embargo on Russia, an immediate retaliation from Moscow in the form of a cutoff of pipeline exports to the EU most likely will follow. This will throw the EU into a recession, as natgas prices surge. Chart 2Losing Russia's Natgas Will Be Painful For EU Oil, Natgas Prices Set To Surge Oil, Natgas Prices Set To Surge Revised Forecast Reflects Falling Russian Output We are revising our Brent forecast and crude oil balances in line with our expectation Russian oil output will decline meaningfully. As noted above, we now expect Russian crude oil output to fall to 8.4mm b/d this year and 8.0mm b/d in 2023. This pushes non-core OPEC 2.0 production – which now includes Russia – lower, as a result (Chart 3). We moved Russia out of the core OPEC 2.0 producer group, given the production declines we expect this year and next, and into the "Other Guys" group. Our base case demand reflects a shift in OECD vs. non-OECD consumption estimates, with the OECD gaining incrementally, while EM demand (via non-OECD consumption) falls incrementally (Chart 4). Chart 3Falling Russia Output Pushes Non-Core OPEC 2.0 Output Lower Oil, Natgas Prices Set To Surge Oil, Natgas Prices Set To Surge Chart 4DM Demand Shifts Higher, EM Shifts Lower DM Demand Shifts Higher, EM Shifts Lower DM Demand Shifts Higher, EM Shifts Lower The lower EM demand growth reflects weaker China oil consumption resulting from the country's zero-COVID policy. In addition, because we expect Russia to act quickly on cutting off EU natgas exports, benchmark TTF natgas prices will move back above €225/MWh. Higher oil and natgas prices in the EU will lead to recession later this year. How quickly this shows up depends on how quickly Russia reacts to an EU oil embargo. In addition, a strong USD – bid higher by global economic uncertainty and safe-haven demand – will pushing the local-currency costs of refined products like gasoline, diesel and jet fuel higher, also will contribute to lower EM demand (Chart 5). Chart 5USD Remains Well Bid Oil, Natgas Prices Set To Surge Oil, Natgas Prices Set To Surge In our base case, we expect a tighter market on balance (Chart 6). Oil inventories remain under pressure, owing to falling as Russian output and declines in production outside core OPEC 2.0 and the US (Chart 7). We cannot rule out additional SPR releases from the US or IEA to offset tightening global inventories. Chart 6Global Balances Tighten Global Balances Tighten Global Balances Tighten Chart 7Inventories Draw As Supply Tightens Inventories Draw As Supply Tightens Inventories Draw As Supply Tightens Our forecast for Brent this year has been lifted on the back of a much stronger expectation of an EU oil embargo against Russia. This will result in 2mm b/d of Russian production being shut in by next year, which will not be fully replaced (Table 1). We are lifting our Brent forecast to $110/bbl for 2022, and $115/bbl for next year as a result (Chart 8). Chart 8Loss Of Russian Production Will Lift Brent Loss Of Russian Production Will Lift Brent Loss Of Russian Production Will Lift Brent Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Oil, Natgas Prices Set To Surge Oil, Natgas Prices Set To Surge Investment Implications An EU embargo on Russian oil imports is close at hand, in our view. Brent crude will rally above $120/bbl by 2H22, with $140/bbl or higher possible, depending on Russia's reaction to the EU oil embargo. We expect Brent prices to average $113/bbl this year, and $122/bbl in 2023. WTI will trade $3/bbl lower on average. Eurozone natgas will trade above €225/MWh again and stay at elevated levels, likely moving higher following a Russian cutoff of natgas supplies to the continent. This will throw the EU into recession. We remain long the S&P GSCI index, the COMT ETF, and the XOP and CRAK ETFs to retain exposure to higher prices. We are getting long 1Q23 ICE Brent futures and TTF natgas futures at tonight's close. A word of caution is in order: We are assuming Russia will follow through on its threat to shut off natgas exports to the EU in the event of an embargo against importing its oil is declared. This, we believe, is Russia's red line. If the EU fails to declare an embargo, or if Russia fails to follow through on its threat to cut off gas supplies in the wake of an EU oil embargo of its exports we will have to re-assess our outlook.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com     Commodities Round-Up Energy: Bullish European natural gas inventories are building at a rapid rate, as competition from Asia – typically led by Chinese demand – remains weaker than in previous seasons. EU natgas storage stood at ~446 MWh as of May 16, 2022, the latest available reports indicate (Chart 9). The EU has weathered two extremely difficult winters in 2020-21 and 2021-22. Natgas storage levels were drawn hard to meet space heating demand, which, owing to a winter energy crisis in China at the time, forced European buyers into a competition for liquified natural gas (LNG) during the former period. Following unexpected spring-summer demand in 2021 when cold weather lingered in Europe and wind power generation fell sharply, storage owners again were hard pressed to secure LNG to rebuild storage levels going into this past winter, which caused European TTF natgas prices to soar, as demand surged (Chart 10). With the threat of a cutoff of Russian natgas hanging over the EU, there is a singular focus right now on getting storage as full as possible ahead of next winter. The EU aims to replace two-thirds of Russian gas imports before yearend. Precious Metals: Bullish The Fed has adopted a more hawkish rhetoric, as it acts more aggressively to reduce US inflation. Interest rates have increased from near-zero levels in March to 0.75%, and BCA’s US Bond strategy service expects two more 50 bps rate hikes in June and July. Post July, rate hikes will depend on the Fed’s assessment of inflation, inflation expectations and financial conditions. The Fed faces the risk of either remaining behind the inflation curve or sparking a recession in case it’s either not hawkish enough, or too hawkish. Base Metals: Bullish High power prices in Europe will continue to plague refined base metals production in the continent and keep refined metal prices buoyed. LME Europe aluminum stocks are close to 17-year lows. In China – whose metal smelters were also hit by high power prices in 2021 – aluminum smelting has revived, with the country reportedly producing a record amount of primary aluminum in April. Lockdowns, however, have reduced economic activity, demand for the metal and its domestic price. China has taken advantage of this arbitrage opportunity, sending most of its primary aluminum exports to Europe. This aluminum price spread between the two states has contributed to China’s steady rise in primary aluminum exports this year, after having exported nearly none in 2020 and 2021. Chart 9 Oil, Natgas Prices Set To Surge Oil, Natgas Prices Set To Surge Chart 10Dutch Title Transfer Facility Going Down Dutch Title Transfer Facility Going Down Dutch Title Transfer Facility Going Down     Footnotes 1     German officials have stated the country will wind down all oil imports from Russia by year end, even if the rest of the EU does not join it in an embargo.  We highly doubt Germany will act alone, given the support an embargo already has received from EU member states.  Please see Germany to Stop Russian Oil Imports Regardless of EU Sanctions, published by bloomberg.com on May 15, 2022. 2     Our expectation for shut-in volumes is lower than the IEA's, which sees Russia being forced to shut in 3mm b/d of production by 2H22.  We continue to monitor this closely via satellite and reporting services and will adjust our estimates as needed.  Obviously, if the IEA is correct oil markets will tighten even more than we expect. 3    Please see "The Future of Russian Oil Production in the Short, Medium, and Long Term," published by the Oxford Institute for Energy Studies in September 2019.  The OIES study notes production in Russia's highest-producing area – the Khanty-Mansi Autonomous (KMA) district – actually fell 15% between 2008-19, even as drilling activity surged 66%.  While output in 2018 rose due to intensified oil recovery (IOR), the OIES noted that the water cut rose sharply in 2018 as well in the KMA district. 4    Please see Russia warns of $300 oil, threatens to cut off European gas if West bans energy imports, published by cnbc.com on March 8, 2022.  The article notes Novak threatened to close the Nord Stream 1 pipeline delivering gas to Germany in retaliation for an EU oil embargo.  Almost three-quarters of Russia's natgas exports were sent to Europe prior to its invasion of Ukraine.  Natgas export revenues accounted for $62 billion of the $242 billion funding Russia's budget last year, while crude oil revenues made up $180 billion (just under 75%). 5    Please see Die Cast By EU: Inflation, Recession Risks Rise, which we published on May 5, 2022.  It is available at ces.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Trades Closed in 2022

Executive Summary The Fed will continue to hike rates at a time when global trade is contracting. Earlier this week, Fed Chairman Jerome Powell reiterated that the Fed will not hesitate to hike rates until core consumer price inflation gets closer to 2%. Given that US core consumer price inflation is currently at around 5-6%, a mere rollover in core inflation from current levels will not be enough for the Fed to tone down its hawkishness. Besides, according to Powell, US financial conditions are not yet at a level that is consistent with inflation coming down substantially. China will stick to its dynamic zero-COVID policy this year. The economy will continue to underwhelm as the magnitude and nature of stimulus measures announced thus far are not adequate to produce a recovery. Industrial metal prices and global material stocks are at risk of gapping down. Play these markets on the short side. Commodity Currencies Are Signaling Lower Commodity Prices Commodity Currencies Are Signaling Lower Commodity Prices Commodity Currencies Are Signaling Lower Commodity Prices Bottom Line: It is still dangerous to bottom fish in global equities and risk assets in general. The US dollar has more upside. Continue underweighting EM stocks and credit within global equity and credit portfolios, respectively. Feature The risks to global and EM risk assets are still skewed to the downside. Although investor sentiment on global equities has soured of late, we do not think global or EM equities have made a bottom, and the US dollar has not yet reached an apex. Consequently, absolute-return investors should stay defensive, and global equity portfolios should continue to underweight EM stocks. The Fed and Equities Are Still On A Collision Course Earlier this week, Fed Chairman Jerome Powell reiterated the Fed’s commitment to hiking interest rates until core consumer price inflation gets closer to 2%. Notably, in his speech at a WSJ event on May 17, Powell noted: “This is not a time for tremendously nuanced readings of inflation”… “We need to see inflation coming down in a convincing way. Until we do, we’ll keep going.” Given that US core consumer price inflation is currently at around 5-6%, a mere rollover in core inflation from current levels will not be enough for the Fed to tone down its hawkishness. Chart 1US Core Inflation Will Roll Over But Stay Above 3.5-4% For Now US Core Inflation Will Roll Over But Stay Above 3.5-4% For Now US Core Inflation Will Roll Over But Stay Above 3.5-4% For Now Chart 1 shows the average of core median CPI, core trimmed-mean CPI and core sticky CPI, which are better indicators of genuine inflationary pressures because they are less affected by outliers. Even though core CPI inflation ticked down in April, other core measures such as core median CPI, core trimmed-mean CPI and core sticky CPI continued to rise. These core inflation measures are not likely to ease back to 2% unless economic growth falls below its potential. In his same speech, Chairman Powell also asserted: “We will go until we feel like we are at a place where we can say, ‘Yes, financial conditions are at an appropriate place. We see inflation coming down.’ We will go to that point, and there will not be any hesitation about that.” This means that US financial conditions have not yet tightened enough for the Fed to back down on its hawkishness. Finally, we have been arguing that a wage-price spiral has developed in the US as the labor market has become very tight (Chart 2, top panel). Wages and unit labor costs have been surging. Unit labor costs are the most important driver of US core CPI (Chart 2, bottom panel). Therefore, it will be impossible for the Fed to bring down core inflation toward 2% without a retrenchment in the labor market, i.e., layoffs. Rising unemployment will in turn weigh on household income growth and consumption. Chart 2The US Labor Market Is Very Tight And Wage Growth Is Accelerating The US Labor Market Is Very Tight And Wage Growth Is Accelerating The US Labor Market Is Very Tight And Wage Growth Is Accelerating The cost of borrowing for companies is rising globally, and these periods often coincide with equity selloffs. Notably, surging US high-yield ex-energy corporate bond yields herald lower US share prices ahead (Chart 3, top panel). Similarly, rising EM corporate bond yields foreshadow a further decline in EM ex-TMT share prices (Chart 3, bottom panel). Chart 3Rising Corporate Bond Yields Are Bearish For Stocks Rising Corporate Bond Yields Are Bearish For Stocks Rising Corporate Bond Yields Are Bearish For Stocks On the whole, the Fed and many other central banks will be hiking interest rates at a time when global trade volumes are contracting in H2 2022. As discussed in our report A Whiff Of Stagflation? US and EU imports of consumer goods are set to shrink following the pandemic boom. Chart 4Global Export/Manufacturing Are Heading Into Contraction Global Export/Manufacturing Are Heading Into Contraction Global Export/Manufacturing Are Heading Into Contraction Meantime, rolling lockdowns and extremely weak income growth are depressing domestic demand in China. High food and energy prices as well as rising interest rates are weighing on EM ex-China consumption. The sharp underperformance of global cyclicals equities versus global defensive sectors corroborates our expectation that global manufacturing activity will contract (Chart 4). The trade-weighted US dollar typically benefits from both Fed hikes and a global trade slump. As long as the Fed is hawkish and global exports are contracting, the greenback will continue to appreciate. For now, the US dollar remains in a strong position for further appreciation, especially versus EM currencies (Chart 5). Consistently, the selloff in broad EM risk assets is not yet over.  Chart 5EM Currencies: More Downside EM Currencies: More Downside EM Currencies: More Downside A major reversal in the trade-weighted dollar will be a signal that the global macro backdrop is improving and that global share prices and EM risk assets are bottoming. Bottom Line: Although equities have become oversold and investor sentiment is depressed, any rebound will prove to be short lived. The Fed will continue to hike rates at a time when global trade is about to shrink. The global/EM equity selloff has further to run. China: Ordinary Stimulus Despite Extraordinary Conditions Only one thing is currently certain in China: authorities are committed to the dynamic zero-COVID policy. However, most experts outside China believe that it will be very difficult to wholly limit the spread of the easily transmissible Omicron variants, even with such stringent mainland containment policies. As a result, rolling lockdowns are the most likely scenario for China’s regions and cities in 2022. These lockdowns will depress household income, confidence and consumption. Private business investment and hiring will also tank. Have authorities provided enough stimulus to support a recovery in H2 2022? We do not think so. Chinese stimulus has so far been ordinary in nature and in magnitude. Policy easing will likely prove to be insufficient to lift the economy out of the current extraordinary slump. First, Chinese exports are set to shrink in H2 as US and EU consumption of consumer goods revert to their pre-pandemic trend. Demand from EM will remain weak. Second, rising unemployment and under-employment is hindering household income. Generous cash transfers are needed to offset this hit to income. Not only did aggregate retail sales collapse in April, but online sales of goods and service also plunged (Chart 6). It is hard to imagine that private businesses will be investing when consumer spending and exports are weak. Our proxies for the marginal propensity to spend for households and enterprises continue to fall (Chart 7). Chart 6China: Even Online Retail Sales Are Shrinking China: Even Online Retail Sales Are Shrinking China: Even Online Retail Sales Are Shrinking Chart 7China: Household And Enterprise Propensity To Spend Have Been Declining China: Household And Enterprise Propensity To Spend Have Been Declining China: Household And Enterprise Propensity To Spend Have Been Declining   Critically, China’s credit impulse, excluding government bond issuance, remains in negative territory (Chart 8). Third, China’s property market is frail. Despite modest policy easing for the real estate market, sentiment among home buyers and developers remains downbeat. Given that the housing sector faces structural headwinds, odds are that buyers and developers might not react to the modest property market easing that authorities have so far provided. It is worth noting that Chinese property stocks seem to have had a structural breakdown, and offshore corporate bonds of real estate developers remain in a bear market (Chart 9). These market patterns corroborate that China's housing market has experienced a structural breakdown. Chart 8Chinese Stimulus Has So Far Been Tame Chinese Stimulus Has So Far Been Tame Chinese Stimulus Has So Far Been Tame Chart 9Chinese Property Market Has Experienced A Structural Breakdown Chinese Property Market Has Experienced A Structural Breakdown Chinese Property Market Has Experienced A Structural Breakdown   Finally, even though infrastructure spending is being ramped up, it will prove to be insufficient for the economy to recover from a deep slump. Local governments are facing a major financing shortfall. Land sales – which make up about 40% of local government revenues – have dried up. This will hinder local governments’ ability to finance infrastructure projects. As to Chinese equities, internet/platform stocks have become oversold. However, their long-term outlook remains dismal. As we have been arguing since late 2020, the fundamental case for their de-rating remains intact. This week’s meeting between government officials and technology companies has not produced any positive news. Although the tone from authorities was more balanced, they did not offer any relief from already imposed regulations. Chart 10Implications Of China's Common Prosperity Policies Implications Of China's Common Prosperity Policies Implications Of China's Common Prosperity Policies Looking forward, implementing common prosperity policies will be the primary objective of the Communist Party in the coming years. These policies will assure that labor’s share of income will rise further at the expense of corporate profits. Chart 10 demonstrates that the share of labor in national income has been rising since 2011. Conversely, the share operating profits peaked in 2011 and has dropped to a 30-year low. These dynamics will persist as income will continue to be redistributed from shareholders to labor in the majority of industries/companies in China. This is an unfriendly outlook for shareholders, especially foreign ones. Bottom Line: Chinese policy stimulus has so far been insufficient. The economy is in a deep slump, and share prices remain at risk of further decline. Short Industrial Metals And Material Stocks Chart 11Chinese Imports Of Metals Was Shrinking In 2021 Chinese Imports Of Metals Was Shrinking In 2021 Chinese Imports Of Metals Was Shrinking In 2021 Industrial metals’ resilience last year in the face of shrinking Chinese import volumes was unusual (Chart 11). This resilience was probably due to robust DM demand for goods, supply bottlenecks and investors buying commodities as an inflation hedge. As we elaborated in the April 28 report, risks to industrial metals are skewed to the downside. This is despite the fact that agriculture prices will likely rise further, and energy prices will remain volatile due to the geopolitical situation. We continue to recommend investors underweight/short materials stocks and industrial metals for the following reasons: It is ill-advised to play the US inflation story by being long industrial metals and materials stocks. As shown in Chart 2 above, US unit labor costs are driving core inflation, not industrial metals. China accounts for 50-55% of global industrial metal consumption, and since early 2021 the key risk in China has been decelerating demand/deflation not inflation. In fact, commodities have become a crowded hedge against inflation and a global growth slowdown poses a substantial risk to industrial metals. Chart 12 demonstrates that Chinese materials stocks have plunged. We read this as a warning sign for global materials because China is by far the largest consumer of raw materials (excluding energy). Chart 12Chinese Material Stocks Are Signaling Trouble For Global Materials Chinese Material Stocks Are Signaling Trouble For Global Materials Chinese Material Stocks Are Signaling Trouble For Global Materials When share prices of customers are falling, equity prices of suppliers will likely follow. Chart 13 shows that over the past 200 years raw material prices in real US dollar terms (deflated by US headline CPI) have oscillated around a well-defined downtrend. The pandemic surge in commodity prices has pushed raw material prices to two standard deviations above this long-term trend. Chart 13Raw Material Prices (In Real Terms) Are At The Upper End Of A 200-Year Downtrend Raw Material Prices (In Real Terms) Are At The Upper End Of A 200-Year Downtrend Raw Material Prices (In Real Terms) Are At The Upper End Of A 200-Year Downtrend Historically, commodity rallies (and even their secular bull markets) ended when prices reached this threshold. Hence, odds are that industrial commodities might hit a soft spot. Energy prices remain a wild card due to geopolitics. It is critical to note that the raw materials price index shown in Chart 13 does not include energy, gold and semi-precious metals. Finally, shrinking global trade volumes are also negative for raw materials. The average of AUD, NZD and CAD points to lower industrial metal prices (Chart 14). Chart 14Commodity Currencies Are Signaling Lower Commodity Prices Commodity Currencies Are Signaling Lower Commodity Prices Commodity Currencies Are Signaling Lower Commodity Prices Chart 15Bearish Technical Patterns: BHP Share Price And Copper Bearish Technical Patterns: BHP Share Price And Copper Bearish Technical Patterns: BHP Share Price And Copper The share price of BHP, the world’s largest mining company, has put in a major top and is now gapping down (Chart 15, top panel). Copper prices have broken below their 200-day moving average that served as a support in the past 12 months (Chart 15, bottom panel). These market profiles point to more downside. We continue to recommend that investors play this theme in the following ways: Short copper or short copper / long gold; Short global materials / long global industrials; Short ZAR / long USD. Also, we downgraded Brazil early this week  partly due to expectations of lower iron ore prices and souring investor attitude toward commodity plays in general. Investment Conclusions Global and EM equities have entered a capitulation phase. It is still dangerous to bottom fish in global equities and risk assets in general. Continue underweighting EM stocks and credit within global equity and credit portfolios, respectively. The US dollar has more upside. Continue shorting the following EM currencies versus the USD: ZAR, PLN, HUF, COP, PEN, PHP and IDR. As we discussed in a recent report, we are approaching a major buying opportunity in EM local currency bonds. However, the US dollar needs to peak for that to transpire. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Next Thursday May 26, we will hold the BCA Debate – High Inflation: Here To Stay,Or Soon In The Rear-View Mirror? – a Webcast in which I will debate my colleague, Chief Commodity & Energy Strategist, Bob Ryan on the outlook for inflation, and take the side that inflationary fears will soon recede. I do hope you can join us. As such, the debate will replace the weekly report, though we will renew the fractal trading watchlist on our website. Dhaval Joshi Executive Summary The second quarter’s synchronised sell-off in stocks, bonds, inflation protected bonds, industrial metals and gold is an extremely rare star alignment. The last time that the ‘everything sell-off’ star alignment happened was in early 1981 when the Paul Volcker Fed ‘broke the back’ of inflation and turned stagflation into an outright recession. In 2022, the Jay Powell Fed risks doing the same. If history repeats itself, then the template of 1981-82 could provide a useful guide for 2022-23. In which case, bond prices are now entering a bottoming process.  Stocks would bottom next. While the near term outlook is cloudy, we expect stock prices to be higher on a 12-month horizon, especially long-duration stocks that are most sensitive to bond yields. But just as in 1981-82, the biggest casualty will be industrial metals, which are likely to suffer at least double-digit losses over the coming year. Fractal trading watchlist: FTSE 100 versus Stoxx Europe 600, Czech Republic versus Poland, Food and Beverages, US REITS versus Utilities, CNY/USD. 2022-23 Could Be An Echo Of 1981-82 2022-23 Could Be An Echo Of 1981-82 2022-23 Could Be An Echo Of 1981-82 Bottom Line: The 1981-82 template for 2022-23 suggests that bonds will bottom first, followed by stocks. But steer clear of gold and industrial metals. Feature Investors have had a torrid time in the second quarter, with no place to hide.1  Stocks are down -10 percent. Bonds are down -6 percent. Inflation protected bonds are down -6 percent. Industrial metals are down -13 percent. Gold is down -6 percent. To add insult to injury, even cash is down in real terms, because the interest rate is well below the inflation rate! (Chart I-1) Chart I-1The 'Everything Sell-Off' In 2022 Last Happened In 1981, When Stagflation Morphed Into Recession The 'Everything Sell-Off' In 2022 Last Happened In 1981, When Stagflation Morphed Into Recession The 'Everything Sell-Off' In 2022 Last Happened In 1981, When Stagflation Morphed Into Recession Such a star alignment of asset returns, in which stocks, bonds, inflation protected bonds, industrial metals, and gold all sell off together, is unprecedented. In the eighty calendar quarters since the inflation protected bond market data became available in the early 2000s there has never been a quarter with an ‘everything sell-off’. Everything Has Sold Off, But Does That Make Sense? The rarity of an ‘everything sell-off’ is because there are virtually no economic or financial scenarios in which all five asset-classes should fall together (Chart I-2 and Chart I-3). Chart I-2An 'Everything Sell-Off' Is Extremely Rare An 'Everything Sell-Off' Is Extremely Rare An 'Everything Sell-Off' Is Extremely Rare Chart I-3An 'Everything Sell-Off' Is Extremely Rare An 'Everything Sell-Off' Is Extremely Rare An 'Everything Sell-Off' Is Extremely Rare A scenario dominated by rising inflation is bad for bonds, but good for inflation protected bonds, especially relative to conventional bonds. Yet inflation protected bonds have not outperformed either in absolute or relative terms. A scenario of rising inflation should also support the value of stocks, industrial metals and certainly gold, given that all three are, to varying degrees, ‘inflation hedges.’ Yet the prices of stocks, industrial metals, and gold have all plummeted. The rarity of an ‘everything sell-off’ is because there are virtually no economic or financial scenarios in which all asset classes should fall together. Conversely, a scenario dominated by slowing growth is bad for industrial metal prices, but good for conventional bond prices – as bond yields decline on diminished expectations for rate hikes. Yet conventional bonds have sold off. What about a scenario dominated by both rising inflation and slowing growth – which is to say, stagflation? In this case, we would expect inflation protected bonds to perform especially well. Meanwhile, with the economy still growing, the prices of industrial metals should not be collapsing, as they have been recently.  In a final scenario of an imminent recession we would expect stocks, industrial metals and even gold to sell off, but conventional bonds to perform especially well. The upshot is there are virtually no economic scenarios in which stocks, bonds, inflation protected bonds, industrial metals, and gold plummet together, as they have recently. So, what’s going on? To answer, we need to take a trip back to the 1980s. 1981 Was The Last Time We Had An ‘Everything Sell-Off’ Inflation protected bonds did not exist before the late 1990s. But considering the other four asset-classes – stocks, bonds, industrial metals, and gold – to find the last time that they all fell together we must travel back to 1981, the time of Margaret Thatcher, Ronald Reagan, and the Paul Volcker Fed. And suddenly, we discover spooky similarities with the current Zeitgeist. Just like today, the world’s central banks were obsessed with ‘breaking the back’ of inflation, which, like a monster in a horror movie, kept appearing to die before coming back with second and third winds (Chart I-4). Chart I-4In 1981, Just As In 2022, Central Banks Would 'Do Whatever It Takes' To Kill Inflation In 1981, Just As In 2022, Central Banks Would 'Do Whatever It Takes' To Kill Inflation In 1981, Just As In 2022, Central Banks Would 'Do Whatever It Takes' To Kill Inflation Just like today, the central banks were desperate to repair their badly damaged credibility in managing the economy. As the biography “Volcker: The Triumph of Persistence” puts it: “He restored credibility to the Federal Reserve at a time it had been greatly diminished.” And just like today, central bankers hoped that they could pilot the economy to a ‘soft landing’, though whether they genuinely believed that is another story. Asked at a press conference if higher interest rates would cause a recession, Volcker replied coyly “Well, you get varying opinions about that.” 2022 has spooky similarities with 1981. In fact, in its single-minded aim ‘to do whatever it takes’ to kill inflation, the Volcker Fed hiked the interest rate to near 20 percent, thereby triggering what was then the deepest economic recession since the Depression of the 1930s (Chart I-5 and Chart I-6). With hindsight, it was a price worth paying because the economy then began a quarter century of low inflation, steady growth, and mild recessions – a halcyon period for which the Volcker Fed’s aggressive tightening in the early 1980s have been lauded. Chart I-5In 1981, The Fed Hiked Rates To Near 20 Percent... In 1981, The Fed Hiked Rates To Near 20 Percent... In 1981, The Fed Hiked Rates To Near 20 Percent... Chart I-6...And Thereby Morphed Stagflation Into Recession ...And Thereby Morphed Stagflation Into Recession ...And Thereby Morphed Stagflation Into Recession Granted, the problems of 2022 are a much scaled down version of those in 1981, yet there are spooky similarities – a point which will not have gone unnoticed by the current crop of central bankers. It is no secret that Jay Powell is a big fan of Paul Volcker.   The Echoes Of 1981-82 In 2022-23 The answer to why everything sold off in early 1981 is that central banks took their economies from stagflation to outright recession, and the risk is that the same happens again in 2022-23 (Chart I-7). Chart I-7The Echoes Of 1981-82: Aggressive Rate Hikes In 2022-23 Will Morph Stagflation Into Recession The Echoes Of 1981-82: Aggressive Rate Hikes In 2022-23 Will Morph Stagflation Into Recession The Echoes Of 1981-82: Aggressive Rate Hikes In 2022-23 Will Morph Stagflation Into Recession In the transition from stagflation fears to recession fears, everything sells off because first the stagflation casualties get hammered, and then the recession plays get hammered. This leaves investors with no place to hide, as no mainstream asset is left unscathed. Just as in 1981, a transition from stagflation fears to recession fears likely explains the recent ‘everything sell-off’ because the sell-off in April was most painful for the stagflation casualties – bonds. Whereas, the sell-off in May has been most painful for the recession casualties – industrial metals and stocks.  In a stagflation that morphs to recession, everything sells off. What happens next? The template of 1981-82 could provide a useful guide. Bond prices bottomed first, in the late summer of 1981, as it became clear that the economy was entering a downturn which would exorcise inflation. Of the three other asset classes – all recession casualties – stocks continued to remain under pressure for the next few months but were higher 12 months later. Gold fell another 30 percent, though rebounded sharply in 1982. But the greatest pain was in the industrial metals, which fell another 30 percent and did not recover their highs for several years (Chart I-8). Chart I-82022-23 Could Be An Echo Of 1981-82 2022-23 Could Be An Echo Of 1981-82 2022-23 Could Be An Echo Of 1981-82 2022-23 could be an echo of 1981-82, with bond prices now entering a bottoming process.  Stocks would bottom next, with one difference being a quicker recovery than in 1981-82 because of their higher sensitivity to bond yields. While the near term outlook is cloudy, we expect stock prices to be higher on a 12 month horizon, especially long-duration stocks that are most sensitive to bond yields. But just as in 1981-82, the biggest casualty of a stagflation that morphs into a recession will be the overvalued industrial metals, which are likely to suffer at least double-digit losses over the coming year. Fractal Trading Watchlist This week’s new additions are Czech Republic versus Poland, and Food and Beverages versus the market, which appear overbought. And US REITS versus Utilities, and CNY/USD, which appear oversold. Finally, our new trade recommendation is to underweight the FTSE 100 versus the Stoxx Europe 600. The resource heavy FTSE 100 is especially vulnerable to our anticipated sell-off in commodities, and its recent outperformance is at a point of fragility that has marked previous turning points (Chart I-9). Set the profit target and symmetrical stop-loss at 5 percent. Chart I-9FTSE 100 Outperformance Is Near Exhaustion FTSE 100 Outperformance Is Near Exhaustion FTSE 100 Outperformance Is Near Exhaustion Fractal Trading Watchlist: New Additions Chart I-10Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Chart I-11Food And Beverage Outperformance Near Exhaustion CHART 1 Food And Beverage Outperformance Near Exhaustion CHART 1 Food And Beverage Outperformance Near Exhaustion CHART 1 Chart I-12US REITS Are Oversold Versus Utilities CHART 12 US REITS Are Oversold Versus Utilities CHART 12 US REITS Are Oversold Versus Utilities CHART 12 Chart I-13CNY/USD At A Support Level CNY/USD At A Support Level CNY/USD At A Support Level Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Reversing Canada Versus Japan Is Reversing Canada Versus Japan Is Reversing Chart 5Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal Chart 7A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 8Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 9CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 10Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 11Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 12Greece's Brief Outperformance To End Greece's Brief Outperformance To End Greece's Brief Outperformance To End Chart 13BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point Chart 14The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 15The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 16Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Chart 17Homebuilders Versus Healthcare Services Has Turned Homebuilders Versus Healthcare Services Has Turned Homebuilders Versus Healthcare Services Has Turned Chart 18Switzerland's Outperformance Vs. Germany Has Started To End Switzerland's Outperformance Vs. Germany Has Started To End Switzerland's Outperformance Vs. Germany Has Started To End Chart 19The Rally In USD/EUR Could End The Rally In USD/EUR Could End The Rally In USD/EUR Could End Chart 20The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 21A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 22FTSE100 Outperformance Vs. Euro Stoxx 50 Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Vulnerable To Reversal Chart 23Netherlands Underperformance Vs. Switzerland Close To Exhaustion Netherlands Underperformance Vs. Switzerland Close To Exhaustion Netherlands Underperformance Vs. Switzerland Close To Exhaustion Chart 24The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 25The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 26Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Chart 27Food And Beverage Outperformance Near Exhaustion CHART 1 Food And Beverage Outperformance Near Exhaustion CHART 1 Food And Beverage Outperformance Near Exhaustion CHART 1 Chart 28US REITS Are Oversold Versus Utilities CHART 12 US REITS Are Oversold Versus Utilities CHART 12 US REITS Are Oversold Versus Utilities CHART 12 Chart 29CNY/USD At A Support Level CNY/USD At A Support Level CNY/USD At A Support Level   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The returns are based on the S&P 500, the 10-year T-bond, the 10-year Treasury Inflation Protected Security (TIPS), the LMEX index, and gold.   Fractal Trading System Fractal Trades Markets Echo 1981, When Stagflation Morphed Into Recession Markets Echo 1981, When Stagflation Morphed Into Recession Markets Echo 1981, When Stagflation Morphed Into Recession Markets Echo 1981, When Stagflation Morphed Into Recession 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary   The surge in food prices following Russia's invasion of Ukraine will drive EM headline inflation higher, given more of individuals' incomes in these economies are spent on food. Economies in the MENA will remain at risk for higher food prices, given their reliance on wheat imports from Ukraine and Russia, which together comprise ~ 30% of global wheat exports.  Wheat is the most widely traded grain in the world; its production is second only to that of corn.  Higher shipping and input costs – especially for fertilizers – will exacerbate the upside price pressure on grains, particularly wheat. Tenuous social contracts raise the risk of social unrest in MENA reminiscent of the Arab Spring unrest of 2011, which was fueled by food scarcity, economic stagnation and popular anger at autocratic governments. A strong USD will continue to raise the local-currency cost of grains and food, which also will fuel EM inflation. The War Increased Food Prices… High Food Prices Drive EM Inflation High Food Prices Drive EM Inflation Bottom Line: Wheat prices will remain volatile with a bias to the upside for as long as the Russia-Ukraine war persists.  The uncertain evolution of this war means EM states will be more exposed to grain-price volatility and higher inflation.  This could prove to be destabilizing to MENA states in particular.  Separately, we update our recommendations below.  Feature High food prices will drive EM headline inflation, owing to the fact a higher proportion of individuals’ incomes in these economies are spent on food. These pressures are particularly acute for wheat following Russia's invasion of Ukraine. Related Report  Commodity & Energy StrategyCopper Demand Will Ignore Recession Wheat is the most widely traded grain in the world, according to the World Population Review (WPR).1 In terms of global production, it is second only to corn, totaling 760mm tons in 2020. In order, the top three wheat producers in the world are China, India, and Russia, which account for 41% of global output. The US is the fourth-largest producer. The WPR notes that if the EU were to be counted as a single country, its wheat production would be second only to China (Chart 1). Within emerging markets, the Middle East and North African (MENA) nations will be worst hit by rising wheat prices.2 This is because the bulk of their wheat imports are sourced from Russia and Ukraine, and shipped from Black Sea ports, which are literally caught in the crosshairs of the Russia-Ukraine war. Many of these states do not have sufficient grain reserves to tide themselves over this crisis, and will be forced to import food at elevated prices. A strong USD, which this past week hit a 19-year high, will add to the price of USD-denominated commodity imports, particularly wheat. Russia’s invasion of Ukraine will continue to exacerbate EM food scarcity and drive input costs – e.g., fertilizers – and shipping rates higher. This will keep food and wheat prices volatile with a strong bias to the upside (Chart 2). Chart 1Wheat Production Faces Concentration Risk High Food Prices Drive EM Inflation High Food Prices Drive EM Inflation Chart 2The War Increased Food Prices… High Food Prices Drive EM Inflation High Food Prices Drive EM Inflation In addition to the inflation risk from high food and energy prices, the tenuous social contracts in many states again raises the risk of social unrest in MENA, as occurred in the 2011 Arab Spring protests against food scarcity, economic stagnation and autocratic government.3 War Disruptions Will Continue Russia’s invasion of Ukraine jeopardized wheat supply from two countries which together constitute nearly 30% of total global wheat exports. The invasion will continue to keep wheat prices volatile and biased to the upside (Chart 3). The UN Food and Agriculture Organization (FAO) forecasts Ukraine’s 2021/22 wheat output will drop below its 5-year average, since at least 20% of total arable land cannot be used due to the war. While nearly 60% lower than this time last year, Ukrainian wheat exports in March were not completely shut down. However, they were re-routed around the direct routes from the Black Sea.4 In March, Ukraine managed to export 309k tons of wheat. Chart 3...Particularly Wheat ...Particularly Wheat ...Particularly Wheat Ukraine will need to rely on these convoluted routes until port services are either restored or unblocked. Exports through more circuitous routes will delay distribution and increase transport costs. This, of course, also adds to the delivered cost of wheat that is being rerouted and slows the overall distribution of grains globally. Additionally, Ukrainian exports via other countries will be disrupted by those countries’ own trade slowdowns, since global bottlenecks affects all trade. Thus far, Russia has been able to maintain wheat exports. Russia continued to supply wheat to global markets in March and April. The USDA estimates that during the 2021/22 crop year, which ends in June, Russian wheat exports will total 33mm tons, which is just 2mm tons lower than the USDA's pre-crisis estimate.5 Because of high carryover stocks and record production, Russia's exports in the 2022/23 crop year are expected to be more than 40mm tons. Sourcing Alternative Wheat Supplies With a sizable portion of global wheat supply at risk – primarily from Ukraine – other exporting countries will need to increase output to fill this gap (Chart 4). This production, however, is not guaranteed, as it depends primarily on weather and fertilizer prices. New trade routes will also need to be created. This will tax existing export infrastructures as shipping dynamics are reconfigured. Particularly important will be how far the new-found sources of supply have to travel to deliver grain, shipping availability, and, of course, the incremental costs incurred to move supplies. As of 2021, the EU – the Black Sea states’ principle competitor in the wheat-export market – and 48% of total wheat exports to Middle East and African countries (Chart 5). The EU's ability to increase exports for the remainder of the 2021/22 crop year will depend on its production, since demand for exports will be guaranteed given the crisis in the Black Sea. Chart 4Other Exporters Will Need To Ramp Up High Food Prices Drive EM Inflation High Food Prices Drive EM Inflation Chart 5MENA Is EU’s Primary Wheat Export Market High Food Prices Drive EM Inflation High Food Prices Drive EM Inflation The European Commission expects the EU to export a record 40mm tons of wheat for the 2022/23 market year, 6mm tons higher than its expected 2021/22 exports. Based on past trade patterns, these excesses will go to the Middle East, Northern and Sub-Saharan Africa. Strong USD Favors LatAm Exports US wheat exports will not be competitive this year or next, given the strong USD and relatively high prices (Chart 6). Additionally, this year’s winter-wheat crop will be affected by current drought conditions in the key Hard Red Winter wheat growing regions of Western Kansas, Colorado, Oklahoma and Texas. Canada faces a similar issue to its North American neighbor. Compared to other major wheat exporting states, it exports wheat at the second highest price, after the US. Furthermore, in 2021/22 Canadian wheat output is expected to be the lowest in 14 years following a warm and dry summer. The USDA expects strong Argentinian and Brazilian wheat exports in 2021/22. Compared to exports from the EU, US, Australia and Canada, wheat from these two sources is cheaper and hence will attract price sensitive bids from the Middle East and Africa. Chart 6US Wheat Remains Non-Competitive US Wheat Remains Non-Competitive US Wheat Remains Non-Competitive A strong USD will incentivize the LatAm giants’ wheat exports since their input costs are in local-currency terms and their revenues are in USD. While some countries have taken advantage of high wheat and food prices to increase exports, others have imposed restrictions or outright bans on exports, which will continue to drive prices higher. Kazakhstan, which constitutes nearly 5% of global wheat exports, now has a quota on such exports, which will affect Central Asian import markets. India was expected to constitute an uncharacteristically large share of wheat exports this year and next. However, the country is experiencing its hottest March in 122 years, which most likely will reduce its harvest this year and incentivize it to keep wheat stocks at home. The world’s second largest wheat producing and consuming nation expects a 6% drop in production this year.6 Fertilizer Costs Will Remain High … Countries’ abilities to increase production will depend on fertilizer availability and costs. The USDA cited high fertilizer prices as one of the causes for lower expected Australian wheat output in 2022/23. Prices of natural gas – the primary feedstock for fertilizers – took off like a rocket following Russia's invasion of Ukraine. High natgas prices feed directly into fertilizer costs (Chart 7). The EU's proposal to ban Russian oil imports could see Russia embargo natgas supply in retaliation, which would further spike natgas and fertilizer costs. This will have knock-on effects on all ags markets. Fertilizer export bans announced by Russia and China are another factor driving fertilizer prices higher (Chart 8). High fertilizer costs most likely will dissuade farmers from using fertilizers in volumes associated with more normal market conditions, and likely will cause them to wait on planting and treating acreage, which will lower crop quality or delay planting. Both scenarios will lead to higher crop prices (Chart 9). Chart 7High Natgas Prices Feeds Right Into Fertilizers High Natgas Prices Feeds Right Into Fertilizers High Natgas Prices Feeds Right Into Fertilizers Chart 8Russia, China Are Big Fertilizer Exporters High Food Prices Drive EM Inflation High Food Prices Drive EM Inflation Chart 9Nitrogen Fertilizer Prices Continue To Rise Nitrogen Fertilizer Prices Continue To Rise Nitrogen Fertilizer Prices Continue To Rise …As Do Shipping Costs Redrawing trade routes – i.e., finding new supplies and new shippers to compensate for the loss of Ukrainian wheat exports – will be expensive. For example, US grain shipping costs soared to an 8-year high after countries, led by China, dramatically increased soybean imports from the US due to a drought in Brazil.7 In 2021, high shipping costs led directly to higher food prices (Chart 10).8 Shipping, like any other commodity, is a function of supply and demand for different types of vessels capable of carrying grain from one part of the world to another. On the supply-side, port closures in China and the Black Sea are increasing port congestion, and making ships available for moving grains scarce. The Ukraine war has stranded ships in the Black Sea and forced merchants to re-route their shipments. This increases sailing times, which has the effect of contributing to supply scarcity in shipping markets. Fewer available ships, coupled with high fuel prices are keeping freight rates elevated. A low orderbook of expected new-vessel additions to the global shipping fleet in 2022 and 2023, along with guidance for ships to reduce speeds to increase fuel efficiency, will exacerbate current ship supply scarcity.9 On the demand side, the major international economic organizations have reduced 2022 GDP estimates due to lower economic activity. Lower economic activity will translate into lower ship demand and hence reduce prices (Chart 11). Chart 10Shipping Prices Remain Elevated Shipping Prices Remain Elevated Shipping Prices Remain Elevated Chart 11Shipping Demand Driven By Economic Activity Shipping Demand Driven By Economic Activity Shipping Demand Driven By Economic Activity   Shipping prices will drop meaningfully once port congestion clears. This will depend on the duration of COVID-19 in China and the evolution of the Russia-Ukraine war. A recession – the probability of which will increase if the EU bans Russian oil imports and Russia retaliates with its own natgas ban – acts as a downside risk to shipping costs. Investment Implications The gap in Black Sea wheat exports produced by the Russia-Ukraine war will require a ramp-up in other countries’ supply. Higher production is contingent on weather conditions and input costs. Changing weather patterns, due to climate change, will increase food insecurity, and make it more difficult to predict how ag markets – particularly grain trading – will handle this shock and other shocks down the road. We remain neutral agricultural commodities but will follow wheat and food market developments closely.   Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodity Round-Up Energy: Bullish Going into the Northern Hemisphere's summer driving season, US retail gasoline prices are trading at record levels -- $4.328/gal ($181.78/bbl) as of 9 May 2022, according to the US Energy Information Administration (Chart 12). Regular gasoline (RBOB specification traded on the NYMEX) for delivery in the NY Harbor settled at $144.27/bbl ($3.4349/gal) on Tuesday, giving refiners a rough wholesale margin (versus Brent crude oil) of $41.81/bbl. Retail diesel fuel prices also have been extremely well bid, posting record highs as well of $5.623/gal ($236.17/bbl) on 9 May 2022 (Chart 13). On the NYMEX, the ultra-low sulfur diesel fuel contract for July delivery settled at $3.6793/gal ($154.53/bbl). Jet fuel prices also are extremely well bid, as demand increases against a backdrop of lower refinery output pushed NY Harbor prices to $7.61/gal ($319.62/bbl) on 4 April 2022. NY Harbor jet-fuel prices have been much stronger than US Gulf prices and European prices seen in the Amsterdam-Rotterdam-Antwerp (ARA) markets, which were averaging ~ $3.60/gal, according to the EIA. This is accounted for by robust demand – evident since mid-2021, when it recovered pandemic-induced losses – and lower-than-normal output of jet by refiners. Assuming the US does not go into a profound recession, refined-product markets likely will remain tight during the summer-driving season and into the rest of this year, in our estimation. As is the case with the Exploration & Production companies, refiners also have been parsimonious with their capex, which translates into lower capacity to meet demand. Base Metals: Bullish Per the latest US CFTC data, we believe hedge funds and speculators investing in copper are dismissing bullish micro fundamentals and are focusing on bearish macroeconomic factors, such as the probability of an economic slow down increases. This would explain why funds’ short positions have exceeded long positions for the first time since end-May 2020. We have written about medium-to-long-term bullish micro fundamentals at length in previous reports.10 On micro fundamentals, the Chilean constitutional assembly passed articles expanding environmental protection from mining over the weekend. These will be added to the draft constitution to be voted on in September. The article expanding state control in Chilean mining activity did not pass and will be renegotiated before being sent back to the constitutional assembly for a second vote. Uncertain governance will affect mining investment in the state, as BHP recently highlighted. Chart 12 High Food Prices Drive EM Inflation High Food Prices Drive EM Inflation Chart 13 High Food Prices Drive EM Inflation High Food Prices Drive EM Inflation           Footnotes 1     Please see Wheat Production by Country 2022, published by worldpopulationreview.com. 2     Awika (2011) notes, "… cereal grains are the single most important source of calories to a majority of the world population. Developing countries depend more on cereal grains for their nutritional needs than the developed world. Close to 60% of calories in developing countries are derived directly from cereals, with values exceeding 80% in the poorest countries." Please see Joseph M. Awika (2011), "Major Cereal Grains Production and Use around the World," published by the American Chemical Society. The three most important grains in this regard are rice, corn and wheat. 3    Please see Egypt's Arab Spring: The bleak reality 10 years after the uprising, published by dw.com on January 25, 2021. 4    Please see First Ukrainian corn cargo leaves Romanian Black Sea port, published by Reuters on April 29, 2022. 5    All USDA estimates mentioned in this report are taken from the USDA’s Grain and Feed Annual for each country. 6    Please refer to After five record crops, heat wave threatens India’s wheat output, export plans, published by Reuters on May 2, 2022. 7     Please refer to U.S. Grain Shipping Costs Soar With War and Drought Swinging Demand, published by Bloomberg on March 18, 2022. 8    For a more detailed discussion, please refer to Risk of Persistent Food-Price Inflation, which we published on November 11, 2021. 9    For estimates of orderbook vessels in 2022/23 please see Shipping market outlook 2022 Container vs Dry bulk, published by IHS Markit on November 30, 2021; slower speeds could reduce effective shipping capacity by 3-5%, according to S&P Global (see Shipping efficiency targets could prompt slower speeds and reduced capacity: market sources). 10   For the latest on this, please see Copper Demand Will Ignore Recession, which we published on April 14, 2022.   Investment Views and Themes Recommendations   Recommendations: We are re-establishing our positions in XME, PICK and XOP, which were stopped out APRIL 22, 2022 with gains of 42.42%, 9.77% and 20.91%, respectively, at tonight's close. We also will be adding the VanEck Oil Refiners ETF (CRAK) to our recommendations, given our bullish view of the global refining sector. Strategic Recommendations   Trades Closed in 2022 Image  

Executive Summary Ingredients For A Policy Mistake Ingredients For A Policy Mistake Ingredients For A Policy Mistake The hawks on the European Central Bank Governing Council have become vocal about a July rate hike. Such a move would be a policy mistake because European growth is weak, while inflation is supply-driven and will soften meaningfully. July 2022 hike is not yet certain. A policy mistake suggests that the current interest rate pricing for June 23 is too aggressive. Buy June 2023 Euribor contract. The serious risk of a policy mistake and the uncertainty surrounding Europe’s energy security confirm that investors should maintain a defensive stance in European assets. The pronounced threats to UK growth warrant a negative view on the pound.   Recommendation INCEPTION DATE RETURN SINCE INCEPTION (%) COMMENT Buy June 2023 Euribor contract 05/09/2022     Bottom Line: Stay defensive in Europe. The risk of a policy mistake is high. Only when inflation peaks should investors move into cyclical stocks.   In recent weeks, a chorus of ECB hawks expressed the need to increase rates as early as July 2022. Inflation data is on their side; HICP stands at 7.5% and core CPI has reached 3.5%, levels never seen since the introduction of the euro. Markets are responding. The ESTR curve is pricing in a positive ECB deposit rate for the October 2022 Governing Council meeting. We need to examine the underlying European economic picture to address two key questions: Will the ECB lift rates as early as July? And will doing so constitute a policy mistake that would hurt European assets? Weaker Growth Let’s start with the growth outlook. European economic activity is rapidly deteriorating. Real GDP growth in the Eurozone has slowed markedly. In Q1, real GDP growth fell to 0.2% quarter-on-quarter or an annualized rate of 0.8%. Worrisomely, Italy’s GDP contracted by -0.2% over that time frame and the very economically sensitive Swedish activity contracted by -0.4%, which suggests that Europe’s deceleration is only starting. Soft data confirm the flagging economic outlook on the continent. Consumer confidence is plunging to levels that are consistent with a recession, led by the collapse in the willingness to make large purchases (Chart 1, top panel). The ZEW as well as the Ifo survey confirm that growth expectations point to a very large decline in output (Chart 1, bottom panel). The weakness is also evident in hard data. High inflation erodes real household income, which squeezes consumer spending. Retail sales across Europe are slowing sharply, only growing at an annual rate of 0.8% while contracting -0.4% on a monthly basis; on a level basis, they are lower today than they were in June 2021. Meanwhile, German retail sales volumes are falling at a -5.4% annual rate. The situation is even worse for new car registrations, which are collapsing at an annual rate of 20.2% (Chart 2). Chart 1Soft Data Point To Soft Growth... Soft Data Point To Soft Growth... Soft Data Point To Soft Growth... Chart 2...So Do Hard Data ...So Do Hard Data ...So Do Hard Data Industrial production has not been spared. Euro Area IP softened to 2% annually in February and contractions are now visible in Germany and France. Some of this weakness reflects supply difficulties, but the -3.1% annual fall in German factory orders indicates that demand is frail too and that industrial production will shrink further in the months ahead (Chart 2, bottom panel). The deterioration in the global outlook further hurts Europe economic prospects. Our global growth tax indicator, based on energy prices, the dollar, and global bond yields, points toward a further deceleration in the global and US manufacturing PMI, it suggests Euro Area PMIs could fall below 50 (Chart 3). China woes continue to reverberate throughout the global economy. Potential supply constraints will hurt industrial production, but, more importantly, the weakness in China’s marginal propensity to consume (as measured by the gap between the growth rate of M1 relative to M2) predicts a much greater deterioration in European industrial orders, which means that the demand for European capital goods will slow (Chart 3, bottom panel). Chart 3Risks To The Downside Risks To The Downside Risks To The Downside Chart 4Tightening Financial Conditions Tightening Financial Conditions Tightening Financial Conditions European financial conditions are also tightening significantly. The iTraxx Crossover Index is rising swiftly. European high-yield corporate spreads are now above 450bps, levels that coincide with past recessions in the Euro Area (Chart 4). Government bond markets are increasingly under duress too. Italian BTPs now yield close to 200bps above German Bunds (Chart 4, bottom panel), which accentuates the periphery’s pain. Bottom Line: The Eurozone economy is slowing sharply. While Q1 GDP avoided a contraction, soft and hard data indicators suggest that Q2 is likely to record an actual output contraction for the whole Euro bloc. High Inflation, But For How Long? At first glance, European inflation numbers scream for an ECB rate hike, preferably one yesterday. However, the picture is not that clear-cut. Supply factors predominantly drive the Eurozone’s inflation surge. Chart 5 highlights the role of energy, utilities, food, and transportation costs in the HICP and shows that these factors account for more than 80% of the 7.5% HICP rate. Moreover, the fluctuations in energy CPI continue to explain most of the gyration in headline CPI. The close relationship between energy CPI and core CPI highlights an elevated degree of pass-though, the result of higher electricity and transportation costs (Chart 6). Chart 5Energy, Food And Transport Dominate European CPI An ECB Policy Mistake And Your Portfolio An ECB Policy Mistake And Your Portfolio Chart 6All About Energy All About Energy All About Energy Chart 7No Demand Pull-Inflation In Europe No Demand Pull-Inflation In Europe No Demand Pull-Inflation In Europe Unlike those in the US, Euro Area underlying inflation drivers are weak and inconsistent with demand-pull inflation. Wage growth in Europe stands at a paltry 1.6% annual rate, while in the US, the Atlanta Fed Wage Tracker has jumped to 4.5% (Chart 7, top panel). Moreover, Eurozone rent inflation remains stable at 1.2%, while it is a very elevated 4.5% in the US (Chart 7, bottom panel). The bifurcation in demand-driven inflation reflects vastly different output gaps between the two regions. US nominal GDP stands 2.5% above its 2014-2019 trend, while that of the Eurozone is still 5.3% below it. In the consumer durable goods sector, where the US experienced the greatest demand-supply mismatch – and therefore, the greatest inflation pressures – purchases are 25% above their 2014-2019 trend, while in Europe, they are still 9.5% below that trend (Chart 8) Year-on-year inflation prints should roll over this summer, as highlighted by weakening sequential inflation. Even if it remains elevated, the monthly Trimmed Mean CPI peaked last year. Energy inflation, moreover, is already contracting on a month-to-month basis (Chart 9). Chart 8Mind The Output Gap Mind The Output Gap Mind The Output Gap Chart 9Weakening Sequential Inflation Weakening Sequential Inflation Weakening Sequential Inflation Chart 10A Naive Inflation Forecast A Naive Inflation Forecast A Naive Inflation Forecast Simple simulation exercises also confirm that annual inflation will peak this summer (Chart 10). Monthly headline inflation averaged 0.11% from 2010 to 2019, 0.31% in the first half of 2021, and 0.55% from mid-2021 to January 2022. If we assume that monthly inflation prints remain in line with its most recent average, annual inflation will peak by year-end at 9.1%, before falling to 6.8% by April 2023. However, if monthly inflation falls back to an historically elevated monthly average of 0.31%, annual headline inflation will peak in September and fall back to 3.8% by April 2023. Similarly, if monthly core CPI averages 0.28%, annual core CPI will peak in October before declining to 3.4% by April 2023, but it will fall to 2.1% by April 2023, if monthly core CPI averages an historically elevated 0.17%, or the average observed in the first half of 2021 (Chart 10, bottom two panels). Chart 11A Conditional Inflation Forecast A Conditional Inflation Forecast A Conditional Inflation Forecast A more sophisticated exercise based on energy prices and the EUR/USD exchange rate also underlines the downside for Euro Area headline inflation. Energy inflation, which drives headline CPI, closely tracks the evolution of brent prices in euro terms and Deutsch natural gas prices. Assuming that natural gas prices average the historically very high level of €100/MWh over the next twelve months, that Brent averages US$95/bbl over that time frame (consistent with BCA’s commodity and energy team forecasts), and that the euro progressively moves back to EUR/USD1.10 by April 2023 (a weaker expectation than BCA’s Foreign Exchange Strategy team  anticipates), then the Eurozone’s energy inflation will collapse to -10% by April 2023 (Chart 11). We can also assume that Russia enacts a full energy embargo on Western Europe if Sweden and Finland apply for NATO membership. In this case, Brent would spike quickly to $140/bbl and natural gas to €250/MWh. In our scenario, prices stay elevated for two months, before they ultimately normalize by early 2023. Under this scenario, energy inflation would experience a spike to 80% (!) in June 2022 before falling back sharply. In all cases, the collapse in energy inflation is consistent with a rapid decline in headline inflation toward 2% in 2023. Bottom Line: European inflation is elevated but remains mainly driven by supply factors, particularly the evolution of energy inflation. Demand-pull inflation is minimal, unlike that in the US. Additionally, both core and headline inflations are set to peak in the coming months based on the evolution of sequential monthly inflation as well as the behavior of the energy market. A July ECB rate hike would constitute a policy mistake for three reasons: (i) the ECB has no control over supply-driven inflation; (ii) Eurozone inflation is set to weaken; and (iii) economic growth will remain poor. Investment Implications Despite the noise made by the hawks, a large amount of uncertainty around the July 2022 meeting’s outcome remains. It is easy to forget that the ECB’s decisions are consensual. Influential members such as Vice-President Luis de Guindos continues to see a July 2022 hike as possible but unlikely. Others, such as Executive Board member Fabio Panetta, are very worried about the Eurozone’s economic slowdown. Moreover, ECB President Christine Lagarde has not endorsed the hawks. In the context of weak growth and a potential top in inflation, achieving consensus about an early summer hike could be difficult. Chart 12Patience Would Be Rewarded Patience Would Be Rewarded Patience Would Be Rewarded The great paradox is that, if the ECB waits before pushing interest rates up, it will have an opportunity to increase rates durably next year. Wage growth is anemic today, but the decline in the Eurozone unemployment rate is consistent with a pickup in salaries in 2023 (Chart 12). Moreover, if energy inflation slows, the relative price-shock that is hurting households and domestic demand will ebb, which will allow consumption to recover. Patience would give Europe strength and the ECB a very strong basis to lift rates sustainably. The hawks will sway the council to their views. Inflation has latency, which means that its inertia may cause HICP to remain elevated beyond this summer. Moreover, the EU’s proposed ban on Russian oil imports along with Sweden’s and Finland’s likely accession-demand to NATO in the upcoming weeks could provoke Russia to strike first by cutting all its energy export to the EU to zero immediately. This would lift inflation for somewhat longer, as we showed in Chart 9. Related Report  European Investment StrategyThe Three Forces Hurting European Earnings In response to the significant risk of a rate hike, we continue to recommend investors stay short cyclical stocks relative to defensive ones. Moreover, if the risk of a Russian energy cutoff increases, so does the threat of a severe recession in Europe, as a recent Bundesbank study posits (Chart 13). Capital preservation is paramount in today’s context; thus, we continue to lean on the side of prudence, especially considering Europe’s soft profit outlook. Once risks recede, we will abandon this strategy. This decision, however, would require clarification of Sweden and Finland’s decision about their membership in NATO as well as Russia’s response, a confirmation that the ECB is not hiking rates in July, and a pullback in inflation surprises, which would prove a powerful help for European equities and the cyclicals/defensive split (Chart 14). Chart 13The Russian Embargo Risk An ECB Policy Mistake And Your Portfolio An ECB Policy Mistake And Your Portfolio Chart 14Wait For Inflation To Turn Wait For Inflation To Turn Wait For Inflation To Turn In fact, our view that inflation will peak leads to direct implications for European markets. The periods that followed the previous four peaks in European core inflation were associated with an outperformance of small-cap stocks and cyclical stocks over the subsequent six and twelve months as well as declines in German yields and narrower credit spreads (Table 1A). The sectoral implications were not as clear, but industrials enjoyed an edge, while healthcare stocks suffered marked declines. Our conviction is strongest that energy CPI will fall. Again, this environment is associated with an outperformance of small-caps stocks and cyclicals over the following six months (Table 1B). Sector-wise, energy names suffer in this climate along with defensives, especially communication services equities. Table 1APeaks In Core CPI & Subsequent European Asset Performance An ECB Policy Mistake And Your Portfolio An ECB Policy Mistake And Your Portfolio Table 1BPeaks In Energy CPI & Subsequent European Asset Performance An ECB Policy Mistake And Your Portfolio An ECB Policy Mistake And Your Portfolio Looking at this period of disinflation more broadly rather than just following peaks in inflation, we find similar results. Declining core CPI is associated with an outperformance of cyclicals relative to defensives as well as strength in small-cap equities (Table 2A). This larger sample allows for a clearer view of sectors. Specifically, the performance of industrials and tech relative to the broad market improves markedly, while utilities suffer greatly. We reach roughly similar conclusions when energy CPI is contracting, except that, in this instance, energy stocks also underperform (Table 2B). Interestingly, so do financial companies. This is a surprising result, but previous instances of weaker energy CPI in the sample reflected weaker demand, not an evolving supply shock. Weaker aggregate demand always hurts financials.  Table 2ADisinflation & Subsequent European Asset Performance An ECB Policy Mistake And Your Portfolio An ECB Policy Mistake And Your Portfolio Table 2BEnergy Deflation & Subsequent European Asset Performance An ECB Policy Mistake And Your Portfolio An ECB Policy Mistake And Your Portfolio Bottom Line: The risk of a policy mistake at the July ECB meeting is elevated. A policy mistake suggests that the current interest rate pricing for June 23 is too aggressive. Buy June 2023 Euribor contract. Moreover, Russian energy exports are still under threat. Accordingly, we continue to emphasize capital preservation and favor defensives over cyclicals. However, a buying opportunity will emerge rapidly once inflation peaks, especially if the ECB follows our base case. At this point, investors should buy small-cap and cyclical stocks. Industrials will beat energy, while all the defensive sectors will suffer. The BoE’s Tough Choice The Bank of England is stuck between a rock and a hard place. UK inflation shares characteristics of that of both the Eurozone and the US. On the one hand, energy inflation is increasing and could push headline CPI into double-digit territory around October 2022, once fuel subsidies fully expire. On the other hand, wage growth is strong as labor supply elasticity declined after Brexit. Demand-pull inflation is also rampant, which has pushed core CPI to a 5.7% annual rate. The UK’s cost push inflation, along with the growth slowdown in Europe and increasing tax rates are likely to cause a recession in the UK over the coming twelve months. The demand-pull inflation, however, will force the BoE to hike interest rates. This accentuates the downside risk to UK economic activity. Chart 15BoE's First Victim: The Pound BoE's First Victim: The Pound BoE's First Victim: The Pound The obvious victim of this configuration is the pound. Weak growth will prevent the BoE from matching the pace of rate hikes of the Fed and poor economic growth will detract from investments in the UK. As a result, we see further downside in GBP/USD (Chart 15). BCA’s FX strategy team is also selling the pound versus the euro. This position is likely to generate further gains as investors will revise down their views for UK economic activity relative to the Euro Area, since they already hold much more dire expectations for the latter than the former. Bottom Line: EUR/GBP possesses more upside. The growth outlook for the Eurozone is poor, but investors currently overestimate the growth path of the UK relative to that of its southern neighbor.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations

Executive Summary The US Still Dominates Economic Output The US Still Dominates Economic Output The US Still Dominates Economic Output While the Ukraine war has been positive for the greenback, there is a slow tectonic shift away from the dollar as China rethinks holding concentrated foreign currency reserves. In the near term, the dollar faces positive macro variables and still-rising geopolitical tensions. Longer term, as global trade slows and countries gravitate into regional trading blocs, the dollar will need to fall to narrow the US trade deficit. By the same token, the Chinese RMB could weaken in the near term but will stabilize longer term. China will promote its currency across Asia. Currency volatility will take a step-function higher in this new paradigm. Winners will be the currencies of small open economies, especially in resource-rich nations. Trade Recommendation Inception Date Return LONG GOLD 2019-12-06 27.7% Bottom Line: Cyclical forces continue to underpin the dollar, such as rising US interest rates, a slowdown in global growth, and a safe haven premium from still-high geopolitical tensions. That said, the dollar is overbought, expensive, and vulnerable to reserve diversification over the longer term. While tactical long positions make sense, strategic investors should not chase the dollar higher. Feature Currency market action this week focused on two key central bank meetings: the Federal Reserve and the Bank of England. The Fed raised rates by 50 basis points while the BoE raised by 25 points, yet the market expectation differs. In the US, markets imply that the Fed can keep real interest positive while engineering a soft landing in the economy. In the UK (and Euro Area), markets see more acute stagflationary risks and assign a higher probability to a policy error. This situation, together with rising geopolitical risk, has put a bid under the dollar. Related Report  Commodity & Energy StrategyDie Cast By EU: Inflation, Recession Risks Rise Brewing in the background is the prospect that the Ukraine war and US sanctions on Russia could have longer-term consequences on the dollar. Specifically, Russia and China are now locked into a geopolitical partnership to undermine US geopolitical dominance, including the dollar’s supremacy. While this discussion will inevitably come with some speculation about what will happen in the future, what does the evidence say so far? More importantly, what are some profitable investment opportunities that could arise from any shift? The Russo-Chinese Rebellion Chart 1The US Needs To Externally Finance Defense Spending The US Needs To Externally Finance Defense Spending The US Needs To Externally Finance Defense Spending From Russia’s and China’s point of view, the United States threatens to establish global hegemony. The US possesses the world’s largest economy and most sophisticated military. It has largely maintained its preponderance in these spheres despite the rise of China, the resurgence of Russia, and the formation of the European Union as a geopolitical entity (Chart 1). If the US succeeds in its current endeavor of crippling Russia’s economy and surrounding it with NATO military allies, the world will be even more imbalanced in terms of power, while China will be isolated and insecure. To illustrate this point, NATO’s military spending is much higher than that of the Shanghai Cooperation Organization (SCO), which is not nearly as developed a military alliance (Chart 2). Hence Russia and China believe they must take action to counter the US and establish a global balance of power. When Presidents Vladimir Putin and Xi Jinping met on February 4 to declare that their strategic partnership will suffer “no limits,” which means no military limits, they declared a new multipolar era and warned against US domination under the guise of liberalism. If China allows Putin to fail in his conflict with the West, the Russian regime will eventually undergo a major leadership and policy change and China will become isolated. Whereas if China accepts Russia’s current strategic overture, China will be fortified. Russia can be immensely supportive of China’s Eurasian strategy to bypass US maritime dominance and improve supply security (Chart 3). Chart 2NATO Vs SCO: US Threat Of Dominance FX Consequences Of The US-Russia Conflict FX Consequences Of The US-Russia Conflict The consequence of this Russo-Chinese alliance will be to transact in a currency that falls outside sanctions by the US. This will be no easy feat. The US dollar still monopolizes the world’s monetary system, even though the US is likely to lose economic clout over time.  Chart 3China Cannot Reject Russia FX Consequences Of The US-Russia Conflict FX Consequences Of The US-Russia Conflict ​​​​​ De-Dollarization And A Brewing USD Crisis? Fact Versus Fiction A reserve currency must serve the three basic functions of money on a global scale – providing a store of value, unit of account, and accepted medium of exchange. This status gives the dominant reserve currency an “exorbitant privilege,” a range of advantages including the ability to run persistent current account deficits and impose devastating sanctions on geopolitical rivals. Since the turn of the century, the US has struggled to maintain domestic political stability and has failed to deter challenges to its global leadership posed by Russia, China, and lesser powers. Lacking public support for foreign military adventures after Iraq and Afghanistan, Washington turned to economic sanctions to try to influence the behavior of other states. The results have been mixed in terms of geopolitics but cumulatively they have been neutral or positive for the trade-weighted dollar. The US adopted harsh sanctions against North Korea in 2005, Iran in 2010, Russia in 2012, Venezuela in 2015, and China in 2018. The primary trend in the dollar was never altered (Chart 4). Chart 4A Chronicle Of Sanctions And The Dollar A Chronicle Of Sanctions And The Dollar A Chronicle Of Sanctions And The Dollar Yet sweeping sanctions against Russia and China are qualitatively different from other sanctions– as they are among the world’s great powers. The extraordinary sanctions on Russia in 2022 – including cutting off its access to US dollar reserves – have proven deeply unsettling for China and other nations that fear they might someday end up on the wrong side of the US’s foreign policy. Russia’s own experience proves that diversification away from the dollar is likely to occur. From a peak of 47% in 2007, Russia reduced its dollar-denominated foreign exchange reserves to 16%. It cut its Treasury holdings from a peak of over 35% of international reserves to less than 1% today. Meanwhile Russia increased its gold holdings from 2% in 2008 to 20% (Chart 5). The Russians accelerated their diversification away from the dollar after invading Ukraine in 2014 to reduce the impact of sanctions. However, the world is familiar with Russian economic isolation. The West embargoed the USSR throughout the Cold War from 1949-1991. The dollar rose to prominence during this period, so it is not intuitive that Russia’s latest withdrawal from the global economy will enable other countries to abandon the dollar when they have failed in the past due to lack of alternatives. What is clear is that there is no clean or easy exit today from a dollar-denominated financial system. But there are a few lessons from Russia: The ruble has recouped all the losses since the implementation of sanctions. It runs a large current account surplus and has stemmed capital outflows. Another factor has been a sharp reduction in its dependence on the dollar. This will cushion the inflationary impact of US sanctions. Going forward, Russia will be much more insulated from the US dollar but at a terrible cost to potential economic growth (Chart 6). A dearth of US dollar capex into Russia will cripple productivity growth. The lesson for other US rivals will be to take economic stability into account when engaging in geopolitical rivalry.  Chart 5Russia Was Able To Dump Treasurys... Russia Was Able To Dump Treasurys... Russia Was Able To Dump Treasurys... The dollar has been unfazed by the Russian debacle. The victims have been other reserve currencies such as the euro, British pound, and Japanese yen, which are engulfed in an energy crisis from Russia’s actions.  Chart 6...But The Economic Impact Will Remain Severe ...But The Economic Impact Will Remain Severe ...But The Economic Impact Will Remain Severe ​​​​​​ The key question that matters for investors will be what China will do. As one of the largest holders of US Treasurys, a destabilizing exit would have dramatic currency market impacts and could backfire on China. The trick will be to continue exiting this system without precipitating domestic instability. What Will China Do? China has learned two critical lessons from the Russo-Ukrainian conflict, with regard to raising the appeal of the RMB. First, the economic impact of US sanctions can still be devastating even when you have diversified out of dollars. Second, access to commodities is ever more important. As such, any strategy China chooses will need to mitigate these risks. China started diversifying away from the dollar in 2011 and today holds $1.05 trillion in US Treasurys. A little less than half of its foreign exchange reserves are denominated in dollars (Chart 7). This has been a gradual diversification that has not upended the current monetary regime. More importantly, China’s diversification accounts for the bulk of the shift by non-allies away from treasuries. Their share of foreign-held treasuries has fallen from 41% in 2009 to 23% today (Chart 8). Chart 7China Has Lowered USD Reserve Holdings China Has Lowered USD Reserve Holdings China Has Lowered USD Reserve Holdings ​​​​​​ Chart 8US Allies Still Willing To Hold USDs... US Allies Still Willing To Hold USDs... US Allies Still Willing To Hold USDs... ​​​​​​ China’s diversification has helped drive down the overall foreign share of US government debt holdings (excluding domestic central banks) from close to 50% in the middle of the last decade to 36% today (Chart 9). It has also weighed on the dollar. China can and will speed up its diversification from the dollar in the wake of the Ukraine war. While Americans will say that China only need fear such sanctions if it attacks Taiwan or other countries, China will not rest assured. Beijing must respond to US capability, not the Biden Administration’s stated intentions. A new Republican administration could arise as soon as January 2025 and take the offensive against China. The US and China are already engaged in great power rivalry and Beijing cannot afford to substitute hope for strategy. China ran a $224 billion current account surplus in 2021, so part of its strategy could be to reduce the pool of savings that need to be recycled every year into global assets. Since 2007 China has sent large amounts of outward direct investment into the world to acquire real assets and natural resources. The Xi administration tried to bring coherence to this outward investment by prioritizing different countries and investments adhere to China’s economic and strategic aims. The Belt and Road Initiative is the symbol of this process (Chart 10). Going forward, China will continue this process. It will also recycle more of its savings at home by increasing investment in critical industries such as energy security, semiconductors, and defense. Chart 9...But A Slow Diversification From US Debt Persists FX Consequences Of The US-Russia Conflict FX Consequences Of The US-Russia Conflict The key priorities will remain a Eurasian strategy of circumventing the US navy. Building natural gas pipelines and other infrastructure to link up with Russia is an obvious area of emphasis, although it will involve tough negotiations with Moscow. China will also prioritize Central Asia, the Middle East, South Asia, and mainland Southeast Asia as areas where its influence can grow with limited intervention by the US and its allies (Chart 11). Chart 10The Belt And Road Initiative In Progress The Belt And Road Initiative In Progress The Belt And Road Initiative In Progress ​​​​​​   Chart 11China Outward Investment Will Need To Be Strategic FX Consequences Of The US-Russia Conflict FX Consequences Of The US-Russia Conflict Chart 12The RMB Could Dominate Intra-Regional Asean Trade FX Consequences Of The US-Russia Conflict FX Consequences Of The US-Russia Conflict As China invests more at home and in other countries, financing and invoicing deals in the renminbi will grow. While the dollar is the transactional currency globally, it is far less relevant when considering local trading blocs. The euro dominates intra-European trade, suggesting China can try to expand RMB invoicing for intra-Asian trade (Chart 12). Even then, however, the yuan faces serious obstacles from China’s inability or unwillingness to extend security guarantees to its partners, failure shift the economic model to consumerism, persistent currency controls, closed capital account, and geopolitical competition with the United States. Investors should pay close attention to shifts occurring at the margin. The number of bilateral swap lines offered to foreign central banks by the People’s Bank of China has grown (Chart 13), with a total amount of around 4 trillion yuan. This allows the PBoC to use its massive foreign exchange reserves, worth about US$3.2 trillion, to back yuan liabilities. As China continues to grow and increases the share of RMB trade within its sphere of influence, the yuan will rise as an invoicing currency (Chart 14). This could take years, even decades, but a shift is already underway. Chart 13The People's Bank Of Asia? FX Consequences Of The US-Russia Conflict FX Consequences Of The US-Russia Conflict ​​​​​​ Chart 14China Is Growing In Economic Importance China Is Growing In Economic Importance China Is Growing In Economic Importance ​​​​​​ In the near term, any US sanctions on China will hurt the RMB. Combined with hypo-globalization, China’s zero-Covid policy, narrowing interest rate differentials, and flight from Chinese assets, it is too soon to be positive on the RMB in the context of US-China confrontation (Chart 15). Longer term, China’s ability to ascend the reserve currency ladder will require a more radical change in Chinese policy to move the dollar. Chart 15CNY And US Sanctions CNY And US Sanctions CNY And US Sanctions Where Does The Euro Fit In? The biggest competitor to the US dollar is the euro, which took the largest chunk out of the US’s share of the global currency reserve basket in recent decades (Chart 16). Yet the EU could suffer a long-term loss of security, productivity, and stability from Russia’s invasion of Ukraine and the ensuing energy cutoff with Russia. Chart 16The Dollar Remains A Reserve Currency The Dollar Remains A Reserve Currency The Dollar Remains A Reserve Currency The EU will have to spend more on energy security and national defense. This will lead to an increase in debt securities that other countries could buy, which offers a way for countries to diversify from the dollar. However, Europe does not provide China or Russia with protection from US sanctions. The EU is allied with the US, it imposed sanctions on Russia along with the US, and like the US is pursuing extra-territorial law enforcement with its sanctions. When the US withdrew from the 2015 Iran nuclear deal, the EU disagreed technically, but in practice it enforced the sanctions anyway. The euro is hardly a safer reserve currency than sterling or the yen for countries looking to quarrel with the United States. The fact is that all of these allied states are likely to cooperate together in the event that any other state attempts to revise the global order as Russia has done. Not necessarily because they are democracies and share similar values but because they derive their national security from the US and its alliance system. The takeaway is that the euro will become a buying opportunity if and when the security environment stabilizes. Then diversification into the euro will occur. But it will not become a landslide that unseats the dollar, since the euro will still have a higher geopolitical risk premium. Investment Takeaways The historical evidence suggests that US sanctions have not weighed on the dollar. In the case of the Russo-Ukrainian conflict, it has been positive for the greenback. That said, there is a slow tectonic shift from the dollar, as each economic powerhouse evaluates the merits of holding concentrated foreign currency reserves. In the near term, the dollar will continue to be driven by traditional economic variables – global growth, real interest rate differentials, and the resilience of the US economy. That remains a positive. Geopolitical tensions reinforce the dollar’s current rally. Longer term, as globalization deteriorates and countries gravitate into regional trading blocs, the dollar will need to adjust lower to narrow the US trade deficit. By the same token, the RMB could weaken in the near term but will need to stabilize longer term, if Beijing wants it to be considered an anchor and store of value for other Asian currencies. Chart 17Silver Demand Could Explode Higher As Currency Volatility Rises Silver Demand Could Explode Higher As Currency Volatility Rises Silver Demand Could Explode Higher As Currency Volatility Rises The key takeaway is that currency volatility will take a step-function higher in this new paradigm. The winners could be the currencies of small open economies, especially in resource-rich nations. A world in which economic powers increasingly pursue national interests is likely to be inflationary. These powers will deplete the external pool of global savings, as current account balances wind down in favor of national and strategic interests. They will also likely encourage the demand for anti-fiat assets as currency volatility takes a step-function higher. Gold is likely to do well is this environment, but silver could be on the cusp of an explosion higher. The metal has found some measure of support around $22-23 per ounce even as manufacturing bottlenecks have hammered industrial demand. Long-only investors should hold both gold and silver, but a short gold/silver position makes sense both economically and from a valuation standpoint (Chart 17). Geopolitical Housekeeping: We are closing our Long FTSE 100 / Short DM-ex-US Equities trade for a gain of 19.5%. We still favor this trade cyclically and will look to reinstate it at a future date. We are also booking gains on our short TWD-USD trade for a return of 5.8% — though we remain short Taiwanese equities and continue to expect a fourth Taiwan Strait geopolitical crisis.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary Europe's Largest Import Bill: Oil Die Cast By EU: Inflation, Recession Risks Rise Die Cast By EU: Inflation, Recession Risks Rise The EU crossed the Rubicon this week, proposing to eliminate Russian oil imports within six months. The speed of putting the sanctions into effect, and Russia’s retaliation, will be critical to whether the world endures continued inflationary pressures or whether a global recession ensues. Russia indicated it will launch its own round of sanctions in the near future, which could profoundly affect not only global oil and gas markets, but once again induce input price shocks to electricity markets – which will hit firms and households again with higher prices – and agricultural markets. Turmoil in commodity markets has opened a policy debate over whether the world will be forced to migrate to a new monetary order based on access to commodities and control of commodity flows, which would replace the fiat-money architecture that succeeded the post-WWII Bretton Woods system. This debate draws together numerous trends – the centrality of commodities to price levels and inflation; central-bank policy; failed regulation at commodity exchanges; and commodity scarcity due to weak capex. Bottom Line: Commodity markets are changing rapidly as fundamentals adapt to supply tightness and an extremely erratic demand recovery.  However, this does not mark the beginning of a new Bretton Woods era.  Markets adapt quickly to changing fundamentals and that will continue. Feature With its proposal this week to ban the import of Russian oil, the EU crossed the Rubicon and now will prepare for an escalation of its economic war with Russia. Oil imports are, by far, the EU's largest energy import expense, and Russia is its largest supplier (Chart 1). Russian natural gas exports to Europe account for 74% of its total natgas exports, although natgas comprises a much smaller share of Russia’s revenue than oil (Chart 2). In a pecuniary sense, oil is far more important, but in an economic sense gas is more meaningful for Europe. Chart 1Europe's Largest Import Bill: Oil Die Cast By EU: Inflation, Recession Risks Rise Die Cast By EU: Inflation, Recession Risks Rise Chart 2Russia's Largest Market: Europe Die Cast By EU: Inflation, Recession Risks Rise Die Cast By EU: Inflation, Recession Risks Rise Russia produced 10.1mm b/d of crude and condensates in 2021. Of the 4.7mm b/d of this that Russia exported, OECD Europe was its largest customer, at 50% of total, according to the US EIA. If Russia's production is curtailed by roughly 1mm b/d this year and next year due to sanctions, we estimate Brent prices could reach $120/bbl. Losing 1.8mm this year and another 700k b/d next year could push Brent prices above $140/bbl (Chart 3). On the natgas side, one-third of the ~ 25 Tcf of Russian production last year was exported via pipeline or as LNG, based on 2021 data from the EIA. This amounted to almost 9 Tcf. Most of this – 74% – was exported via pipeline to the OECD Europe. These are dedicated volumes flowing through Russia's network into Europe. Until the Power of Siberia pipeline is expanded – likely over the next 2-3 years — this gas will not be available for export. Chart 3Losing Russian Oil Exports Will Push Prices Sharply Higher Losing Russian Oil Exports Will Push Prices Sharply Higher Losing Russian Oil Exports Will Push Prices Sharply Higher Oil and gas exports last year accounted for close to 40% of the Russian government's budget. Crude and product revenue last year came in at just under $180 billion, while pipeline and LNG shipments of natgas accounted for close to $62 billion of the Russian government's revenues. Clearly, the stakes are extremely high for Russia if Europe embargoes oil imports. Escalation Of Economic War Russian Energy Minister Alexander Novak last month threatened to shut off Russian exports of natural gas if the EU cut off oil imports. Whether – or how quickly – that threat is acted upon will be critical for Europe. Speculation around the EU's proposal to embargo oil imports of all kinds from Russia centers on the ban becoming effective by the end of this week, with a six-month phase-down of imports.1 It is still possible that the sanctions will be vetoed and revised. But with Germany changing its position and now willing to embargo oil, it is only a matter of time before the majority of the EU cuts off Russian oil imports. In response, Russia will launch its own round of embargoes, which could profoundly affect not only global oil and gas markets, but once again induce input-price shocks to electricity markets – which will hit household budgets and base-metals smelters and refiners – and agricultural markets, given the large share of natgas in fertilizers (Chart 4). It is not difficult to imagine base-metals refining operations closing again in Europe, along with crop-planting delays rising.2 On the back of this collateral damage from the cut-off of Russian oil and gas exports, we would expect inflation and inflation expectations to take another leg up. This comes against a backdrop in which central banks led by the US Fed already have initiated a rate-hiking program to address inflation that is running far hotter than previously forecast. Chart 4Tight Natgas Markets Drive Fertilizer/Grain Prices Higher Power, Fertilizer, Base Metals Could Be Shocked By Russian Cut-Offs Tight Natgas Markets Drive Fertilizer/Grain Prices Higher Power, Fertilizer, Base Metals Could Be Shocked By Russian Cut-Offs Tight Natgas Markets Drive Fertilizer/Grain Prices Higher Power, Fertilizer, Base Metals Could Be Shocked By Russian Cut-Offs Policymakers Reassess Commodities This turmoil in commodity markets has ignited a policy debate over whether the world will be forced to migrate to a new monetary order. The new order, so the argument goes, would be based on access to commodities and control of commodity flows and would replace the fiat-money architecture that succeeded the post-WWII Bretton Woods system. This debate draws together numerous trends – the centrality of commodities to price levels and inflation; central-bank policy; failed regulation at commodity exchanges; non-USD invoicing and funding; and commodity scarcity – particularly in industrial commodities like oil, natgas and metals due to weak capex over almost a decade. The debates around these different crises are being framed around the heightened geopolitical awareness of the critical role of commodities in the language of financial markets. This is a novel innovation; however, it essentially is an argument by analogy and can obfuscate underlying causes and effects. Bretton Woods III In The Offing? Following WW II, the US and other advanced economies launched the Bretton Woods system, under which the US would operate and maintain a commodity-money regime – i.e., the gold standard – that maintained convertability of USD to gold upon demand. This post-World War II Bretton Woods (BW) system – call it BWI – remained in place until the early 1970s and made the USD the preeminent currency in the world during that period. Literally, the system, operated by the Fed, made the USD "as good as gold." That didn't last, as US domestic exigencies – the Vietnam War and the War on Poverty – forced the US to abandon gold-convertibility and adopt a fiat-money system to finance these multiple wars. Nevertheless the dollar retained its centrality to global markets. Call this fiat system BWII. As of 2022, the dollar remains the world’s dominant reserve currency, accounting for ~ 60% of the $12.25 trillion of foreign exchange reserves, according to IMF data (Chart 5).3 As a vehicle currency, it accounts for close to 90% of daily FX trading – amounting to ~ $6 trillion/day of turnover. The dollar also is the preeminent funding and invoice currency. Trade invoicing denominated in USD accounts for 93% of imports and 97% of exports worldwide. Chart 5USD Remains Dominant Reserve Currency Die Cast By EU: Inflation, Recession Risks Rise Die Cast By EU: Inflation, Recession Risks Rise According to the WTO, global trade in 2019 (just before the COVID-19 pandemic) was just shy of $19 trillion (Chart 6). This global dominance of the USD means the dollar’s funding-currency role “mediates the transmission of U.S. monetary policy to global financing conditions.”4 This has been the case for the 23 years since the creation of the euro, including the periods before and after the 2008 global financial crisis. Chart 6USD Dominates World Trade Die Cast By EU: Inflation, Recession Risks Rise Die Cast By EU: Inflation, Recession Risks Rise The dollar’s importance to the global economy has only grown since the BWI era.5 Obstfeld notes US gross external assets and liabilities relative to GDP “grow sharply (but roughly commensurately) up until the global financial crisis, reaching ratios to GDP in the neighborhood of 150 percent. Since then, assets have levelled off but liabilities have continued to grow.” The dollar faces a range of challenges, as we discuss below, but any discussion must begin with its resilience as the top currency – a resilience that spans the creation of the euro, the rise of China, vast US budget and trade deficits, multiple rounds of quantitative easing, and political instability in Washington. A Return To Commodity-Based Money? The full power of the Fed's role at the center of the global monetary system – as a reserve currency and as the preeminent medium for funding and invoicing trade – was revealed following the invasion of Ukraine by Russia. The US froze Russian foreign reserves, denied it access to the international SWIFT payments system, and imposed sanctions on Russian firms and individuals, and anyone trading with them. Following the US actions, Russia's economy was partially frozen out of global trade, banking and finance. Western partners abandoned their Russian investments, taking their capital and technology out of the country. Outside of the sanctions, individual firms such as refiners, shippers and trading companies “self-sanctioned” their dealings with Russia, and refused to handle inbound or outbound Russian commodities. Given the US capability revealed, and the threat posed to other countries should the US sanction them in a likely manner, new risks to the dollar system will emerge. The primacy of the USD, and the Fed's role in maintaining its central banking position to the world, are by no means assured. Indeed, other states – namely China – will try to insulate themselves from similar sanctions. India is apparently willing to trade with Russia in rubles. Saudi Arabia is exploring being paid in RMB for oil exports to China and a wide range of states could increase their acceptance of RMB at least to cover their growing trade with China. China has been pushing hard to have its RMB recognized and used as a global reserve currency, and a trade-invoicing and trade-funding currency. For this to happen, China also would have to allow its currency to become a vehicle currency – i.e., the anchor leg in FX trading. Zoltan Pozsar, a Credit Suisse analyst, recently penned an article exploring the new terrain exposed by the Russian invasion of Ukraine and the US and EU responses.6 For Pozsar, "Commodity reserves will be an essential part of Bretton Woods III, and historically wars are won by those who have more food and energy supplies – food to fuel horses and soldiers back in the day, and food to fuel soldiers and fuel to fuel tanks and planes today." Pozsar avers that his formulation of Bretton Woods III will reverse the disinflation created by globalization, and "serve up an inflationary impulse (de-globalization, autarky, just-in-case hoarding of commodities and duplication of supply chains, and more military spending to be able to protect whatever seaborne trade is left)." These conclusions are similar to conclusions we have reached over the course of the past few years, as it became increasingly apparent that the US was losing geopolitical clout relative to rising powers, mainly China, and that the international system was becoming multipolar and unstable. The Ukraine war confirmed the new environment of Great Power Rivalry. Nation-states will indeed amass and hoard commodities as they will need to gird for battle as this rivalry heats up. Preparation for war and war itself are historically inflationary (Chart 7). Chart 7War And Preparation For War Are Inflationary War And Preparation For War Are Inflationary War And Preparation For War Are Inflationary However, countries still have to pay for commodities in a currency that exporters are willing to receive. Yet the biggest global oil and food exporters depend on the US for their security, except Russia. Even in base metals the US wields extraordinary influence over the non-aligned exporters. These states could reduce their dollar invoicing to cover their share of trade with countries outside the West, but their national security alliances and partnerships imply a hard-to-change view on which economies and currencies will be most stable over the long run. The dollar is again preeminent. China unquestionably wants to diversify away from the dollar. But China’s trade partners will have a limit on how much yuan cash they are willing to hold. If they want to recycle this cash into China’s economy, China must open its capital account. But this would reduce the Communist Party’s control of the domestic economy due to the Impossible Trinity (the yuan would have to float freely). So until China makes this change, the world is stuck in today’s monetary system. By contrast, if China totally closes its system due to domestic or foreign political threats, then the world faces a recession and investors will not be rushing to sell the dollar. For now China is trying to have it both ways: maintaining large foreign exchange reserves while gradually diversifying away from the dollar (Chart 8). China selling off its Treasury holdings and dollar reserves, which began in the aftermath of the Great Recession, is the biggest monetary shift since 1999, when the euro emerged and China’s purchases of Treasuries began to surge due to trade surpluses on the back of its joining the WTO. But there is little basis for China or anyone else to abandon fiat currencies and return to the gold standard. Fiat currencies enable states to control the money supply and hence to try to control their economies and societies. The Chinese are the least likely to abandon fiat currency given their laser focus on employment, manufacturing, and social stability. China is a commodity importer, so that if it seeks to amass commodities as strategic reserves in the midst of a commodity boom, it will pay top price. This means the yuan would need to be kept strong. But in fact China is allowing the yuan to depreciate, as it would face higher unemployment and instability if domestic demand were further suppressed by a rising yuan. China is already undergoing a painful transition away from export orientation – and Beijing has already acknowledged that de-industrialization should slow down because it poses a sociopolitical threat (Chart 9). A monetary revolution that strengthens the yuan at the expense of the dollar would force an immediate conclusion to China’s transition away from export-manufacturing. That would be politically destabilizing. Chart 8China Diversifies from USD - But Closed Capital Account Prevents Global RMB China Diversifies from USD - But Closed Capital Account Prevents Global RMB China Diversifies from USD - But Closed Capital Account Prevents Global RMB Chart 9Stronger RMB Would De-Industrialize China At Great Political Risk Stronger RMB Would De-Industrialize China At Great Political Risk Stronger RMB Would De-Industrialize China At Great Political Risk If China or other countries attempt to create a commodity base for their currencies, but simultaneously try to prevent a fixed exchange rate that constrains their money supply, then there will be little difference from a fiat currency regime. Today’s major reserve currency issuers already possess reserves of physical wealth (e.g. commodities) beneath their flexible monetary policy regimes – this dynamic would not inherently change. Of course, Europe, Japan, and the United Kingdom are the leading providers of reserve currencies outside the US and yet they are relatively lacking in commodity reserves. If global investors begin chasing currencies primarily on the basis of commodity reserves, the USD will not suffer the most, as the United States is a resource-rich country. China’s policy and strategy may become clearer after the twentieth party congress this fall, but most likely the current contradictions will persist. China will want to prolong the period of economic engagmeent with the West for as long as possible even as it prepares for a time when engagement is utterly broken. While China knows that the US will pursue strategic containment, and US-China engagement is over, it also knows that European leaders have a different set of interests. They have enough difficulty dealing with Russia and are not eager to expand their sanctions to China. Yet switching from dollar to euro reserves offers China little protection against sanctions in any major confrontation in the coming years. A radical decision by China to buy high and sell low (realize big losses on Treasuries and buy high-priced commodities) would show that Beijing is expecting Russian-style confrontation with the West immediately, which would scare foreign investors away from China. Net foreign direct investment in China has surged since the downfall of the Trump presidency (Chart 10). But that process would reverse as companies saw China going down Russia’s path and disengaging from the global monetary system. In that context, western governments would also penalize their own companies for investing in a geopolitical rival that was apparently preparing for conflict (while buttressing Russia). In short, private capital will flee countries that abandon the global financial system because that would be an economically inefficient decision taken for reasons of state security, and hence it would imply higher odds of conflict. Wealthy nations see China’s and other emerging markets’ foreign exchange reserves as “collateral” against asset seizures and geopolitical risks: if China reduces the collateral, private capital will feel less secure flowing into China.7 Chart 10If China Abandonds USD To Prepare For Sanctions, FDI Will Reverse If China Abandonds USD To Prepare For Sanctions, FDI Will Reverse If China Abandonds USD To Prepare For Sanctions, FDI Will Reverse Ultimately China will try to wean itself off the dollar – but it will keep doing so gradually to avoid a catastrophic social and economic change at home and abroad. This is continuation of post-2008 status quo. An accelerated shift away from USD will be interpreted by global actors as preparation for war (just like Russia’s shift). This will drive investors to swap Chinese assets for American or other assets. History suggests that USD devaluations followed US wars and budget expansions. Investors should wait until the next US military adventure, in Iran or elsewhere, before expecting massive dollar depreciation. If the US pursues an offshore balancing strategy, as it appears to be doing today, then other countries will become less stable and the dollar will remain appealing as a safe haven. Bottom Line: Russia’s and China’s diversification away from the dollar over the past decade has not caused global flight from the dollar. International trust in the economy and government of Russia and China is not very high. The euro, the viable alternative to the dollar, is less attractive in the face of the Ukraine war and broader geopolitical instability. The path toward monetary revolution is for China to open up its capital account, make its currency convertible, and sell USD assets while appreciating the yuan. Yet China’s leaders have not embarked on this course for fear of domestic instability. In lieu of that, the current monetary regime continues.     Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com     Footnotes 1     Please see Brussels proposes EU import ban on all Russian oil published by ft.com on May 4, 2022 for summary of the EU's export-ban proposals. 2     Please see our report from March 31, 2022 entitled Germany Closer To Rationing Natgas for further discussion. It is available at ces.bcaresearch.com. 3    See Obstfeld, Maurice (2020), Global Dimensions of U.S. Monetary Policy, International Journal of Central Banking, 16:1, pp. 73-132. 4    Obstfeld (2020, p. 113). 5    Obstfeld (2020, p. 77-78). 6    Please see Pozsar, Zoltan (2022), "Money, Commodities, and Bretton Woods III," published by Credit Suisse Economics. 7     For the “collateral” interpretation of US dollar-denominated foreign exchange reserves, see Michael P. Dooley, David Folkerts-Landau, and Peter M. Garber, “US Sanctions Reinforce The Dollar’s Dominance,” NBER Working Paper Series 29943, April 2022, nber.org.