Currencies

Highlights On a 2-3 year horizon, stay overweight the US stock market, in absolute terms and relative to the non-US stock market… …and stay overweight the US dollar. A good model for the US stock market is the 30-year T-bond price multiplied by US profits. A good model for the non-US stock market is the 2-year T-bond price multiplied by non-US profits. A major long-term risk to the US stock market comes from the blockchain, which is set to return the ownership and control of our data and digital content back to us – from Facebook, Google, and the other tech behemoths that currently control, manipulate, and monetise it… …but this risk is only likely to manifest itself on a 5-10 year horizon. Fractal analysis: The Israeli shekel is overbought. Feature Chart of the WeekThe US Stock Market = The 30-Year T-Bond Multiplied By US Profits Fears that inflation will stay stubbornly high have lit a fuse under short-dated bond yields. But further along the curve, longer-dated bonds have remained an oasis of relative calm. Indeed, the 30-year T-bond yield stands 50 bps lower today than it stood in March. Given that long-duration bonds underpin the valuation of long-duration stocks, the relative calm of the 30-year bond yield explains the relative calm of the stock market in the face of higher short-term bond yields. The corollary is that substantially higher 30-year yields would threaten that calm. Inflation Will Crash Back To Earth In 2022 The relative calm of the 30-year bond yield is telling central banks: go ahead and hike rates if you want. You’ll just have to slash them again and, on average, keep them lower than you would if you didn’t hike them so soon. Rate hikes work by choking aggregate demand, but aggregate demand doesn’t need choking. Aggregate demand is barely on its pre-pandemic trend in the US, and remains far below its pre-pandemic trend in other major economies, such as the UK, Germany, and France. The pre-pandemic trend is important because it is our best estimate of potential supply. On this best estimate, aggregate demand is still below potential supply (Chart I-2). Chart I-2The 30-Year T-Bond Yield Sees That Aggregate Demand Is Fragile If aggregate demand is below potential supply, then what can explain the recent surge in inflation? The answer is the massive and unprecedented displacement of demand from services to goods, combined with modern manufacturing processes unable to meet even a 5 percent excess demand, let alone the 26 percent excess demand for durables recently experienced in the US (Chart I-3). Chart I-3The Booming Demand For Goods Is Crashing Back To Earth While Services Remain In Shortfall Yet as we highlighted last week in The Global Demand Shortfall Of 2022, the recent booming demand for goods is crashing back to earth while the demand for some services will remain structurally below the pre-pandemic trend. Combined with a tsunami of supply that will hit the global economy with a lag, inflation is also likely to crash back to earth by late 2022. The US Stock Market = The 30-Year T-Bond Multiplied By US Profits An important characteristic of any investment is its duration. If all an investment’s cashflows were converted into one ‘lump-sum’ cashflow, then the duration of the investment quantifies how far into the future that lump-sum cashflow would be. For a bond, the duration also equals the percentage change in its price for every 1 percent change in its yield.1 Interestingly, the durations of the US stock market and the 30-year T-bond are very similar, at around 25 years. Therefore, all else being equal, the US stock market should track the 30-year T-bond price. Of course, all else is not equal. The 30-year T-bond has fixed cashflows, whereas the stock market has cashflows that track profits. Allowing for this key difference, the US stock market should track: (The 30-year T-bond price) multiplied by (US profits) multiplied by (a constant) In which the constant connects current profits to the theoretical lump-sum payment 25 years ahead, thereby quantifying the structural growth of profits. But to the extent that the constant does not change, we can ignore it. Simplistic as this model appears, it does provide an excellent explanation for the US stock market’s evolution through the past 40 years (Chart of the Week and Chart I-4) – with deviations from the ‘fair-value’ giving a good gauge of the market’s over- or under-valuation. Chart I-4The US Stock Market = The 30-Year T-Bond Multiplied By US Profits Looking ahead, there are three ways in which the structural bull market could end: If the overvaluation (deviation from fair-value) became so extreme that a substantial decline in price was required to re-converge with the 30-year T-bond price multiplied by profits. If the 30-year T-bond price could no longer rise to counter a substantial decline in profits. If the constant that links current profits to future profits phase-shifted down, implying that the growth rate of US stock market profits had phase-shifted down – as happened for non-US stock market profits after the dot com bust (Chart I-5). Going through each of these, the US stock market’s current overvaluation of around 10 percent is not so extreme as to be a structural impediment. Chart I-5The Valuation Of The Non-US Stock Market Phase-Shifted Down Meanwhile, the 30-year T-bond yield has scope to decline by at least 150 bps, equating to a 40 percent counterweight to a decline in profits. Hence, this is not a structural impediment either, but will become one once the 30-year T-bond yield reaches 0.5 percent in the next deflationary shock. As for a phase-shift down in profit growth, this is a genuine long-term risk. The main risk comes from the blockchain and its threat to the pseudo-monopoly status that the US tech behemoths have in owning, controlling, manipulating, and monetising our data and the digital content that we create. The blockchain is set to return that ownership and control back to us, to the detriment of Facebook, Google, and the other behemoths of the US stock market. However, this is a long-term risk, likely to manifest itself on a 5-10 year horizon. We conclude that on a 2-3 year horizon, investors should own the US stock market. The Non-US Stock Market = The 2-Year T-Bond Multiplied By Non-US Profits We can extend the preceding analysis to the non-US stock market, with two differences. First, the non-US stock market has a much shorter duration given its much lower exposure to growing cashflows. A higher weighting to financials – which underperform when long yields are falling – further lowers the effective duration to just 2 years (empirically). Second, and obviously, the non-US stock market depends on non-US profits (Chart I-6). Chart I-6The Non-US Stock Market = The 2-Year T-Bond Multiplied By Non-US Profits It follows that the non-US stock market tracks: (The 2-year T-bond price) multiplied by (non-US profits) We can now decompose the post dot com performance of the US and non-US stock markets into their underlying structural components. The US stock market has received a massive tailwind: a 60 percent increase in the 30-year T-bond price plus a 200 percent increase in profits (Chart I-7). While the non-US stock market has received a lesser tailwind: a 10 percent increase in the 2-year T-bond price plus a 60 percent increase in profits (Chart I-8).2   Chart I-7The US Stock Market Has A Powerful Tailwind... Chart I-8...The Non-US Stock Market Has A Weak Tailwind Therefore, over the past two decades, the non-US stock market has been hampered by its low duration and by its profits that are fossilised, both metaphorically and literally. Metaphorically fossilised, because the non-US stock market is over-exposed to industries that are in structural decline such as financials and basic resources. And literally fossilised, because it is also over-exposed to the dying fossil fuel industry. Looking ahead, there are three ways that non-US stocks could outperform US stocks: If the relative valuation (deviation from respective fair-values) became extreme in favour of non-US stocks. If the 2-year T-bond price outperformed the 30-year T-bond price – effectively meaning that the 30-year T-bond price would have to fall far given that the 2-year T-bond is like cash. If non-US profits outperformed US profits. Going through each of these: both the US and non-US stock markets appear similarly overvalued versus their respective fair-values; the 30-year T-bond is unlikely to fall far given that it would destabilise the global financial system; and fossilised non-US profits are unlikely to outperform those in the US in the next few years. We conclude that on a 2-3 year horizon, investors should stay overweight the US stock market relative to the non-US stock market. One final consideration is the US dollar. Successive deflationary shocks – the 2008 GFC, the 2015 EM recession, and the 2020 pandemic – have taken the greenback to new highs as capital flows have flooded into US T-bonds (Chart I-9). It follows that the ultimate high in the dollar will coincide with the ultimate low in the 30-year T-bond yield. Chart I-9Successive Deflationary Shocks Take The Dollar To New Highs Stay structurally overweight the US dollar. The Israeli Shekel Is Overbought In this week’s fractal analysis, we note that the strong recent rally in ILS/GBP has reached the point of maximum fragility on its 130-day fractal structure that has signalled several previous reversals (Chart I-10). Chart I-10The Israeli Shekel Is Overbought On this basis, a recommended trade would be short ILS/GBP, setting a profit target and symmetrical stop-loss at 4.2 percent. Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Defined fully, the duration of an investment is the weighted average of the times of its cashflows, in which the weights are the present values of the cashflows. 2 From January 1, 2005. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights Despite strong economic activity throughout most of 2021, economic surprises have decreased considerably. This helped the US equity market outperform Europe. It also significantly contributed to the euro’s depreciation versus the dollar. Even though growth will slow in 2022, economic surprises should increase. Growth expectations are much lower than they were entering 2021, and some key headwinds will fade. This picture is not without risks. China’s credit slowdown and the US’s elevated inflation represent the greatest threats. Based on the outlook for economic surprises, the euro will stage a rebound next year and small-cap stocks are attractive. Feature Global economic activity has been exceptionally robust this year, boosted by the re-opening of the world economy, as well as by the considerable fiscal and monetary stimuli injected globally over the past 20 months. However, market participants also anticipated such a rebound; as a result, global economic surprises peaked in September 2020, and they are now in negative territory. Unanticipated developments have a substantial effect on market prices. Under this lens, the deterioration in economic surprises has had a strong impact on financial markets. It helps explain why the defensive US market has outperformed, why the dollar has been strong, and why bond yields have been flat since March 2021, even though inflation has risen, growth has been high by historical standards, and many major central banks have been eschewing their accommodative biases. Going forward, the evolution of economic surprises will remain crucial to market trends. While we anticipate global economic activity will decelerate in 2022, it will likely remain above trend and surprise to the upside, which will allow global economic surprises to recover. There are significant risks to this view, with large unanswered questions about the Chinese economy and the outlook for inflation in the US. In this context, despite near-term risks, we continue to expect EUR/USD to appreciate in 2022 and European small-cap stocks to outperform large-cap equities. Deteriorating Surprises Matter This year, the underperformance of global equities (both EM and Europe) relative to the US, the weakness in the euro, and the limited increase in yields have all caught investors off guard. At the beginning of 2021, investors were massively short the greenback and duration, while surveys showed a large preference for non-US equities. These views grew out of the expectation that global growth would be strong. Global growth turned out to be strong but began to disappoint expectations by the middle of the year. Expectations had become extremely lofty, suggesting that the bar had been set too high. Additionally, the tightening credit conditions in China and the growing supply constraints around the world caused growth to decelerate somewhat. The deterioration in short-term economic momentum and in surprises harmed European equities relative to the US. As Chart 1 highlights, the relative performance of European stocks is greatly affected by the earnings revision ratio of cyclicals stocks vis-à-vis defensive ones. This relationship reflects the greater pro-cyclicality of European equities compared to those of the US. Moreover, the earnings revision ratio of cyclical stocks relative to that of defensive equities mimics the fluctuations in economic surprises (Chart 1, bottom panel), as weaker-than-expected growth invites analysts to lower their relative earning expectations. The dynamics in the economic surprise index also weighed heavily on the FX market. The dollar is a highly counter-cyclical currency; therefore, it performs poorly when growth is not only increasing, but also doing so at a rate faster than anticipated. However, economic surprises did the exact opposite this year, which boosted the dollar’s appeal and pushed EUR/USD lower (Chart 2). While the strength in the dollar was accentuated by the increasingly aggressive pricing of Fed hikes in the OIS curve, relative interest rate expectations between the US and the Euro Area are also influenced by global economic activity because of the European economy’s greater cyclicality than that of the US. Chart 1Where Surprises Go, European Stocks Follow Chart 2Surprises Matter For The Dollar And The Euro Bottom Line: Global growth has been very strong in 2021, but it has begun to decelerate. Moreover, economic surprises are now in negative territory. The evolution of economic surprises this year was a key component of the strength in the dollar, the weakness of the euro, and the underperformance of European equities. Improving Surprises In 2022? We anticipate economic surprises to pick up in 2022. First, investors and analysts around the world rightfully expect a slowdown in global growth next year. This means that the bar for the economy to generate positive surprises is lower than it was in 2021. Second, we are already seeing signs that global economic surprises are trying to stabilize. A GDP-weighted aggregate of 48 countries is forming a trough at a low level, which historically precedes a pick-up in broader aggregate measures (Chart 3). Third, economic surprises move closely with the global PMI diffusion index. The diffusion index has fallen to levels historically associated with a rebound (Chart 4). Moreover, the share of countries whose Leading Economic Indicator is rising is still very depressed for a mid-cycle slowdown (Chart 4, bottom panel). As vaccination rates are improving around the world, including those in emerging markets, and as the global economy continues to re-open, we anticipate both the PMI and LEI diffusion indexes to improve next year, which will boost economic surprises. Chart 3A Budding Rebound? Chart 4The dispersion Of Growth Matters or Surprises Fourth, the global capex outlook remains very positive. Capex intentions in the US and in the Euro Area are highly elevated and cash flows are strengthening. Moreover, US and European credit standards are very loose (Chart 5). This combination suggests that companies have the desire and the wherewithal to increase their investments next year, especially as capacity constraints limit their ability to meet final demand. Additionally, companies around the world need to rebuild inventory levels, which are depressed relative to sales, while customer inventories are still woefully low (Chart 6). Chart 5Capex Tailwinds Chart 6Not Enough Inventories Chart 7Households Are Rich Fifth, households globally also have ample firepower to support their spending, despite some weakness in real income caused by rising inflation. As Chart 7 shows, household net worth in the US is up by 128% of GDP since December 2019. Additionally, the accumulated stocks of household excess savings have reached USD2.4 trillion in the US, EUR150 billion in German, EUR130 billion in France and GBP180 billion in the UK. With respect to the Eurozone specifically, fiscal and monetary policy will remain very accommodative. The fiscal thrust in 2022 will be negative 2.1%, which is significantly less onerous than the US’s -5.9% of GDP. Moreover, economies like Italy and Spain may have a negligible fiscal thrust because of the NGEU program’s disbursements. In addition, while the fiscal thrust will be slightly negative next year, government deficits will remain wide, which indicates that fiscal policy in Europe continues to support demand. Meanwhile, monetary policy still generates deeply negative interest rates on the continent, which sustains demand further. This view is not without risks. The first threat stems from the Chinese credit slowdown. BCA’s China strategists expect credit flows to bottom out by the second quarter of 2022, which implies that Chinese domestic activity should accelerate meaningfully in the second half of the year.  Already, we are seeing tentative signs that authorities in China are trying to curb the credit slowdown. For example, Beijing cut the reserve requirement ratio last summer and excess reserves in the banking system are moving back up as liquidity injections grow (Chart 8). The problem is that, so far, Chinese credit demand is not responding to these small measures designed to ease policy. More will be needed as the tightening in financial conditions for real estate developers points to significant downside ahead in construction activity (Chart 9). For now, it is difficult for Beijing to ease policy much more than it has done so far: PPI has reached a 25-year high at 13.5%. Chart 8Not Enough... Chart 9... Especially With Such A Drag These Chinese inflationary pressures are likely to decline in the first months of 2022, which will allow Beijing to become more aggressive in its support to economic activity. First, Chinese demand is weak, unlike demand in the US. Second, the surge in the PPI is mostly driven by a 17% increase in the energy PPI and a 66% surge in the mining component. These jumps are unlikely to repeat themselves, which will reduce overall inflationary numbers in that economy. The second major risk is global inflation, which is hurting real wages. As a case in point, US real wages are contracting at a 3.2% annual rate, or their deepest cut in six decades. In Europe too, real wages are weak because of the increase in inflation. While these inflationary pressures have had limited effect on European consumer confidence so far, US consumer confidence is breaking down (Chart 10), driven by a collapse in the willingness to buy. If this trend continues, we might see a significant deceleration in global real consumer spending. Chart 10Not All Is Dark On The Inflation Front We still expect the European inflationary risk to start dissipating in the first half of 2022. Unlike in the US, the spike in core CPI mostly reflects an increase in VAT and remains narrow, with trimmed-mean CPI lingering near record lows. Moreover, the 24-month rate of change of core CPI remains within the historical norm, which is not the case in the US. The US situation is more tenuous. Last week’s inflation data showed a broadening of inflationary pressures across major sectors of the economy unaffected by the pandemic, with shelter inflation being of particular concern. However, there are positives. Long-term inflation expectations, as approximated by the 5-year/5-year forward inflation breakeven rate, are still below the levels that prevailed before the oil price crash of 2014 (Chart 11, top panel). Additionally, shipping costs have started to ebb, with global container freight rates losing steam and the Baltic Dry index collapsing by 50% since beginning of October (Chart 11, bottom panel). Moreover, as health restrictions are being relaxed in Asia, Asian PMI’s are improving, while the production of semiconductors is rising again in the region (Chart 12). As a result, although there is still significant inflation risk over the next five years, 2022 is likely to witness a temporary pullback in CPI growth. Chart 11Not All Is Dark On The Inflation Front Chart 12Semiconductor Production Is Picking Up Bottom Line: Global investors are right to anticipate a decline in global growth next year. However, even if growth slows, it will remain above trend. Moreover, the considerable stimuli in the global economy and the decreased expectations of investors improve the odds that global economic surprises will increase in 2022. China’s domestic weakness and the rise in US inflation constitute the two greatest risks to this view. Investment Implications The level of the global economic surprise index as well as its evolution have important implications for many key European assets. Table 1 highlights the performance of various financial markets at three months, six months, and a year following various ranges of readings of the surprise index (the categories are based on one standard-deviation intervals from the mean). We highlight this methodology, because there remains significant uncertainty about the near-term outlook of the surprise index. Table 1Level Of Surprises And Subsequent Returns Currently, the global economic surprise index stands at -20, or between its -1-sigma and its historical average. This level offers limited clear results for investors when it comes to the performance of the Eurozone benchmark relative to the MSCI All Country World Index (ACWI), and no clear results in terms of the performance of value stocks relative to growth. However, the current reading of the surprise index is consistent with an outperformance of growth stocks relative to momentum over both the three- and six-month horizons. It is also showing a 74% probability of small-cap equities beating large-cap ones over a 12-month basis. Table 2 shows the performance of the same assets over the same windows, following three consecutive months or more of an improving global economic surprise index. This is consistent with our main hypothesis that global economic surprises are set to increase by early next year. Table 2Surprise Upticks And Subsequent Returns Using this method again shows no strong call for the Euro Area equity benchmark relative to the ACWI. There is a small improvement in performance, but Europe on average still underperforms, which reflects the thirteen years of a relative bear market in European equities. Similarly, results for European value stocks compared to growth equities are limited, as the sample is dominated by the structurally poor performance of value equities. However, this method highlights that the euro is likely to appreciate against the USD on both the three- and six-month investment horizon. This message is consistent with that of our Intermediate-Term Timing Model. Finally, this approach once again underscores the attractiveness of European small-cap equities on a three-, six-, and twelve-month investment horizon. Consequently, we maintain our buy recommendation on the euro. As we wrote three weeks ago, the near-term outlook for the common currency is fraught with risks and the low readings of the global economic surprise index confirm this reality.  Moreover, markets might enter a phase when they aggressively discount Fed rates hikes next year, which would further hurt the euro. However, the outlook for global growth will ultimately put a floor under EUR/USD. Chart 13Small-Caps: Almost There We also view European small-cap stocks as the premier equity vehicle in Europe over the coming 18 months because of their heightened pro-cyclicality.  However, the timing around shifting toward overweighing small-cap remains risky in the near-term, as they have not fully worked out the overbought conditions we flagged four weeks ago (Chart 13). Thus, we maintain small-cap equities on an upgrade alert, and we are looking to pull the trigger very soon.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com     Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance

Highlights US growth will slow next year, not because demand will falter, but because supply-side constraints will prevent the economy from producing as much output as households and businesses want to buy. If aggregate demand exceeds aggregate supply, the price level will rise. We argue that the US aggregate demand curve is currently quite steep. This implies that the price level may need to rise a lot to restore balance to the economy. In fact, if the aggregate demand curve is not just steep but upward-sloping, which is quite possible, there may be no price level that brings aggregate demand in line with supply; the US economy could go supernova. When supply is the binding constraint to growth, investors need to throw the old playbook for dealing with growth slowdowns out the window. Rather than positioning for lower bond yields, investors should position for higher yields. Rather than expecting a stronger dollar, investors should expect a weaker one. Rather than favoring growth stocks, large caps, and defensives, investors should favor value stocks, small caps, and cyclicals. The Binding Constraint To Growth Is Now Supply After a post-Delta wave rebound in Q4, the US economy is expected to slow over the course of 2022. The Bloomberg consensus is for US growth to decelerate from 4.9% in 2021Q4 to 4.1% in 2022Q1, 3.9% in 2022Q2, 3.0% in 2022Q3, and 2.5% in 2022Q4. Growth in the first quarter of 2023 is expected to dip further to 2.3%. We agree that US growth will slow next year but think the market narrative around this slowdown is misguided. Chart 1Plenty Of Pent-Up Demand The standard market playbook for dealing with an economic slowdown is to position for lower bond yields, a stronger US dollar, and a decline in commodity prices. On the equity side, the playbook calls for shifting equity exposure from cyclicals to defensives, favoring large caps over small caps, and growth stocks over value stocks. There are two major problems with this narrative. First, growth is peaking at much higher levels than before and is unlikely to return to trend at least until the second half of 2023. Second, and more importantly, US growth will slow due to supply-side constraints rather than inadequate demand. US final demand will remain robust for the foreseeable future. Households are sitting on $2.3 trillion in excess savings, equivalent to 15% of annual consumption (Chart 1). The household deleveraging cycle is over. After initially plunging during the pandemic, credit card balances are rising (Chart 2). Banks are falling over themselves to make consumer loans (Chart 3). Chart 2Revolving Credit On The Rise Again Chart 3Banks Are Easing Credit Standards For Consumers Chart 4A Record Rise In Household Net Worth Household net worth has risen by over 100% of GDP since the start of the pandemic (Chart 4). As we discussed two weeks ago, the wealth effect alone could boost annual consumer spending by up to 4% of GDP. Investment demand should remain strong. Business inventories are near record low levels (Chart 5). Core capital goods orders, a leading indicator for corporate capex, have soared (Chart 6). Chart 5Business Inventories Are Near Record Low Levels Chart 6Rise In Durable Goods Orders Bodes Well For Capex Chart 7The Homeowner Vacancy Rate Is Signaling The Need For More Homebuilding The Dodge Momentum Index, which tracks planned nonresidential construction, rose to a 13-year high in October. The home­owner vacancy rate is at multi-decade lows, signifying the need for more homebuilding (Chart 7). While increased investment will augment the nation’s capital stock down the road, the short-to-medium term effect will be to inflate demand. Policy Won’t Tighten Enough To Cool The Economy What is the mechanism that will push down aggregate demand growth towards potential GDP growth? It is unlikely to be policy. While budget deficits will narrow over the next few years, the IMF still expects the US cyclically-adjusted primary budget deficit to be nearly 3% of GDP larger between 2022 and 2026 than it was between 2014 and 2019 (Chart 8). Chart 9The Fed And Investors Still Believe In Secular Stagnation   As Matt Gertken, BCA’s Chief Geopolitical Strategist, writes in this week’s US Political Strategy report, the passage of the $550 billion infrastructure bill has increased, not decreased, the odds of President Biden and the Democrats passing their social spending bill via the partisan budget reconciliation process. On the monetary side, the Federal Reserve will finish tapering asset purchases next June and begin raising rates shortly thereafter. However, the Fed has no intention of raising rates aggressively. Most FOMC members see the Fed funds rate rising to only 2.5% this cycle (Chart 9). The “dots” call for only one rate hike in 2022 and three rate hikes in both 2023 and 2024. Investors expect rates to rise even less by end-2024 than the Fed foresees (Chart 10).   The Inflation Outlook Hinges On The Slope Of The Aggregate Demand Curve If policy tightening will not suffice in cooling demand, the economy will overheat and inflation will rise. But by how much will inflation increase? The answer is of great importance to investors. It also hinges on a seemingly technical question: What is the slope of the aggregate demand curve? As Chart 11 illustrates, prices will rise more if the aggregate demand curve is steep than if it is flat. Chart 12Wages Rose Faster Than Prices During The Inflationary Late-60s and 70s It is tempting to think of the aggregate demand curve in the same way one might think of the demand curve for, say, apples. When the price of apples rises, there is both a substitution and an income effect. An increase in the price of apples will cause shoppers to substitute away from apples towards oranges. In addition, if apples are so-called “normal goods,” shoppers will buy fewer apples in response to lower real incomes. This chain of reasoning breaks down at the aggregate level. When economists say the price level has risen, they are referring to all prices; hence, there is no substitution effect. Moreover, since one person’s spending is another’s income, rising prices do not necessarily translate into lower overall real incomes. Granted, if nominal wages are sticky, as they usually are in the short run, an unanticipated increase in prices will reduce real wage income. However, this will be offset by higher business income. Over time, wages tend to catch up with prices. In fact, wage growth usually outstrips price growth during inflationary periods. For example, real wages rose during the late-1960s and 70s but fell during the disinflationary 1980s (Chart 12). Textbook Reasons For A Downward-Sloping Aggregate Demand Curve According to standard economic theory, there are three main reasons why aggregate demand curves are downward-sloping: The Pigou Effect: Higher prices erode the purchasing power of money, resulting in a negative wealth effect. The Keynes Effect: Higher prices reduce the real money supply. This pushes up real interest rates, leading to lower investment spending. The Mundell-Fleming Effect: Higher real rates push up the value of the currency, causing net exports to decline. None of these three factors are particularly important for the US these days. Chart 13Base Money Has Swollen Since The Subprime Crisis Strictly speaking, the Pigou wealth effect applies only to “base money,” also known as “outside money.” Outside money includes cash notes, coins, and bank reserves. Inside money such as bank deposits are not included in the Pigou effect because while an increase in consumer prices decreases the real value of bank deposits, it also decreases the real value of commercial bank liabilities.1  In the US, the monetary base has swollen from 6% of GDP in 2008 to 28% of GDP as a result of the Fed’s QE programs (Chart 13). Nevertheless, even if one were to generously assume a wealth effect of 10% from changes in monetary holdings, this would still imply that a 1% increase in consumer prices would reduce spending by only 0.03% of GDP. Simply put, the Pigou effect is just not all that big. In contrast to the Pigou effect, the Keynes effect has historically had a significant impact on the business cycle. However, the importance of the Keynes effect faded following the Global Financial Crisis as the Fed found itself up against the zero lower bound on interest rates. When interest rates are very low, there is little to distinguish money from bonds. Rather than holding money as a medium of exchange (i.e., for financing transactions), households and businesses end up holding money mainly as a store of wealth. In the presence of the zero bound, the demand for money becomes perfectly elastic with respect to the interest rate (Chart 14). As a result, changes in the real money supply have no effect on interest rates, and by extension, interest-rate sensitive spending. And if a decline in the real money supply does not push up interest rates, this undermines the Mundell-Fleming effect as well. Could The Aggregate Demand Curve Be Upward-Sloping? The discussion above, though rather theoretical in nature, highlights an important practical point: The aggregate demand curve may be quite steep. This means that the price level might need to rise a lot to equalize aggregate demand with aggregate supply. Chart 15US Real Bond Yields Hitting Record Lows In fact, one can easily envision a scenario where a rising price level boosts spending; that is, where the demand curve is not just steep but upward-sloping. One normally assumes that higher inflation will prompt central banks to raise rates by more than inflation has risen, leading to higher real rates. However, if the Fed drags its feet in hiking rates, as it is wont to do given its concerns about the zero bound, rising inflation will translate into a decline in real rates. Lower rates will boost demand, leading to higher inflation, and even lower real rates. In addition, lower real rates will benefit debtors, who tend to have a higher marginal propensity to spend than creditors. This, too, will also boost aggregate demand. It is striking in this regard that real bond yields hit a record low this week, with the 10-year TIPS yield falling to -1.17% and the 30-year yield drooping to -0.57% (Chart 15). Black Holes Vs. Supernovas In the case where the aggregate demand curve is upward-sloping, there is no stable equilibrium (Chart 16). If demand falls short of supply, demand will continue to shrink as the price level declines, leading to ever-rising unemployment. Unless policymakers intervene with stimulus, the economy will sink into a deflationary black hole. In contrast, if demand exceeds supply, demand will continue to rise as the price level increases exponentially. The economy will go supernova. Tick Tock Young stars fuse hydrogen into helium, releasing excess energy in the process. After the star has run out of hydrogen, if it is big enough, it will start fusing helium into heavier elements such as carbon and oxygen. The process of nucleosynthesis continues until it reaches iron. That is the end of the line. Fusing elements heavier than iron requires a net input of energy. Unable to generate enough external pressure through fusion, the star loses its battle to gravity. The core collapses, spewing material deep into interstellar space (a good thing since your body is mainly made from this stardust). Observing the star from afar, one would be hard-pressed to see anything abnormal until it explodes. The path to becoming a supernova is highly non-linear. The same is true for inflation. Just like a star with an ample supply of hydrogen, the Fed can burn through its credibility for a while longer. During the 1960s, it took four years for inflation to take off after the economy had reached full employment (Chart 17). By that time, the unemployment rate was two percentage points below NAIRU. Most of today’s inflation is confined to durable goods. This is not a sustainable source of inflation. The durable goods sector is the only part of the CPI where prices usually fall over time (Chart 18). Chart 17Inflation Spiked In The 1960s Only Once The Unemployment Rate Had Fallen Far Below Equilibrium Chart 18Inflation Has Been Concentrated In Durable Goods, A Sector Where Prices Usually Fall Over Time To get inflation to go up and stay up in modern service-based economies, wages need to rise briskly. While US wage growth has picked up, the bulk of the increase has been among low-wage workers, particularly in the services and hospitality sector (Chart 19). Chart 19Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution The most likely scenario for next year is that firms will simply ration output, fearful that raising prices too quickly will hurt brand loyalty and trigger accusations of price gouging. Shortages will persist, but this time they will be increasingly concentrated in the service sector. Such a state of affairs will not last, however. Competition for workers will cause wages to rise much more than they have so far. Keen to protect profit margins, firms will start jacking up prices. A wage-price spiral will develop. The US economy could go supernova. Investment Conclusions Chart 20Long-Term Inflation Expectations Are Near The Bottom End Of The Fed's Comfort Zone US growth will slow next year, not because demand will falter, but because supply-side constraints will prevent the economy from producing as much output as households and businesses want to buy. This means that the old playbook for dealing with growth slowdowns needs to be thrown out the window. Rather than positioning for lower bond yields, investors should position for higher yields. Rather than expecting a stronger dollar, investors should expect a weaker one. Rather than favoring growth stocks, large caps, and defensives, investors should favor value stocks, small caps, and cyclicals. While inflation expectations have recovered from their pandemic lows, the 5-year/5-year forward TIPS breakeven inflation rate is still near the bottom end of the Fed’s comfort zone (Chart 20). Rising inflation expectations will lift long-term bond yields, justifying a short duration stance in fixed-income portfolios. Higher bond yields will benefit value stocks. Chart 21 shows that there has been a strong correlation between the relative performance of growth and value stocks and the 30-year bond yield this year. Rising input prices will make the US export sector less competitive, leading to a weaker dollar. Historically, non-US stocks have done well when the dollar has been weakening (Chart 22). Chart 21The Relative Performance of Value Stocks Has Closely Tracked Bond Yields This Year Chart 22Non-US Stocks Tend To Do Best When The US Dollar Is Weakening As for the overall stock market, with the Fed still in the dovish camp, it is too early to turn negative on equities. An equity bear market is coming, but not until rising inflation forces the Fed to step up the pace of rate hikes. That will probably not happen until mid-2023. Short Gilt Trade Activated We noted last week that we would go short the 10-year UK Gilt if the yield broke below 0.85%. Our limit order was activated on November 5th and we are now short this security.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1  To distinguish between inside and outside money, one should ask where the liability resides. If the liability resides within the private sector, it is inside money. By convention, central bank reserves are classified as outside money. However, one could argue that since taxpayers ultimately own the central bank, an increase in the price level will benefit taxpayers by eroding the real value of the central bank’s liability. If one were to take this view, the Pigou effect would be even weaker. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Dear client, This week, we are introducing our new “Currency Month-In-Review” report. The new format should dovetail nicely with the historical back sections you have become accustomed to, but with a more holistic approach to interpreting data releases, along with actionable investment advice. We would appreciate any comments, criticisms, and feedback to help us better serve you. Kind regards, The Foreign Exchange Strategy team   Highlights The DXY index has broken above our 95-threshold level. As a momentum currency, the prospect for further gains in the near term are high. That said, we are sticking with our longer-term (12-18 month) bearish view. Most of the catalysts propping the dollar in the near-term should reverse. The Fed will continue to lag the inflation curve, and economic growth will rotate from the US to other economies that are getting their populations vaccinated. Both are dollar bearish. Speculative positioning in the dollar is now approaching extremes. This warns against establishing fresh long positions. Amidst the volatility in currency markets, trading opportunities are emerging. This week, we are initiating a limit-buy on EUR/CHF trade at 1.05. Feature The latest CPI report from the US was strong, taking markets much by surprise. In the currency world, the spread between the 3-month Eurodollar and Euribor interest rate shot up, pushing up the dollar (Chart 1). December 2022 Eurodollar futures are now pricing in a much faster pace of rate hikes than they did earlier this year. This helped cement the dollar as king this year (Chart 2). Chart 1The Dollar And Interest Rates Chart 2AThe Strength In The DXY Is Not Fully Justified By The Economic Picture Chart 2BThe Strength In The DXY Is Not Fully Justified By The Economic Picture Chart 2CThe Strength In The DXY Is Not Fully Justified By The Economic Picture Chart 2DThe Strength In The DXY Is Not Fully Justified By The Economic Picture Economic data has also been moving in favor of the US of late. The economic surprise index in the US is at 19, while in the eurozone and Japan, it is at -50 and -73.9, respectively. From a broader perspective, the recovery in the services PMI in the US had been more robust than most other developed economies. That said, there are also signs that US economic momentum is giving way to other countries. The US is likely to be the first country to close its output gap, and commensurately, inflation is surprising to the upside (Chart 3). Wage growth has also inflected higher. This is raising the prospect that inflation might be more of a genuine concern. For many other countries, surging house prices are threatening financial stability. In New Zealand, the central bank now has a mandate to consider house prices when calibrating policy. Chart 3AThe US Is Generating Genuine Inflation. This Is Depressing Real Rates Chart 3BThe US Is Generating Genuine Inflation. This Is Depressing Real Rates Chart 3CThe US Is Generating Genuine Inflation. This Is Depressing Real Rates Chart 3DThe US Is Generating Genuine Inflation. This Is Depressing Real Rates The key point is that many central banks have already withdrawn accommodation ahead of the Fed, which puts the recent dollar rally into question. QE has ended in Canada and New Zealand. Norway and New Zealand have hiked interest rates. Forward curves suggest that most central banks should continue to withdraw accommodation. The key question is whether the Fed turns more hawkish that what is already priced in, or disappoints market expectations. We side with the latter. In the meantime, real rates continue to remain deeply negative in the US. With negative real rates and a deteriorating trade balance, the US will need to significantly raise interest rates to attract portfolio investment. For the US, portfolio investment has mostly been in the form of equity purchases rather than bond flows (Chart 4) and Chart 5). But even an increase in the US 10-year yield to 2.25% will keep real interest rates low. In the following sections, we look at the latest economic releases and provide our assessment of the impact going forward on various currencies. Chart 4AThe Fed Could Disappoint Market Expectations Chart 4BThe Fed Could Disappoint Market Expectations Chart 4CThe Fed Could Disappoint Market Expectations Chart 5AThe US Trade Deficit Needs To Be Financed Externally Chart 5BThe US Trade Deficit Needs To Be Financed Externally Chart 5CThe US Trade Deficit Needs To Be Financed Externally Chart 5DThe US Trade Deficit Needs To Be Financed Externally US Dollar The last month has seen US economic data outperform that of its peers. Within the G10, the Citigroup economic surprise index is much higher in the US (+19), than say, the euro area (-50) or Japan (-74). This has supported the DXY, which is up almost 1% over the last month. For risk-management purposes, we are turning neutral on the DXY in the near term, even though our longer-term view remains bearish. The two most important releases in the US over the last month were the jobs report and this week’s CPI report. Nonfarm payrolls increased by 531,000 jobs and unemployment fell to 4.6% in October. This is inching closer to NAIRU. Meanwhile, headline CPI came in at 6.2% year-on-year in September while core inflation came in at 4.9%, the highest for several decades. This is occurring within the context of accelerating wage growth (unit labor costs in the nonfarm business sector surged 8.3% in Q3), higher house prices, and an ebullient stock market, reinforcing the wealth effect.  That said, strong domestic demand in the US will have to trigger a much more hawkish Fed for the dollar to reach escape velocity. This is because it will push real interest rates lower as it inflates the US current account deficit. The trade deficit grew 11.2% in September, the sharpest monthly increase since July of 2020. Equity portfolio flows, which have been sustaining the trade deficit, are softening of late. Bond portfolio flows will need a much weaker dollar, or higher Treasury yields, to accelerate. Against such a backdrop, the Fed recently announced a “dovish taper” by reducing the monthly pace of its asset purchases by $15 billion, with the tapering expected to be completed by mid-2022. No imminent rate hike was signaled. The market is likely to continue to challenge such a dovish stance, which will put near-term upward pressure on the dollar, until inflation eventually rolls over. From a relative standpoint, the Fed is lagging many other major developed market central banks in normalizing monetary policy. We are sticking to our long-term bearish view on the dollar index, but a more proactive Fed is a risk to this view. We are upgrading our near-term outlook on the dollar to neutral.  Chart 6AUS Dollar Chart 6BUS Dollar Euro The euro has been breaking down in recent sessions and is the main cause of the surge in the DXY index. The euro is down 0.7% over the last month and is currently at 1.145. The key catalyst for the weakness in the euro is the perception that the ECB will severely lag the Fed in normalizing policy settings. This is occurring within the context of surging inflation in the euro area. Headline CPI came in at 4.1% in October, above expectations of 3.7% and well above September’s 3.4% print. The is dampening real rates in the entire eurozone. On the flip side, there is credence to the ECB’s dovish stance given that unemployment is still above NAIRU and eurozone wage growth remains very tepid. On the economy, the recent improvement in both the Sentix and ZEW expectations bode well for euro area activity.  Lower real rates have been the proximate driver of a soft euro in recent trading sessions. That said, real rates could improve if inflation proves transitory. The energy component of the CPI was up 23% year-on-year, by far the biggest contributor to the headline print. Any sign that the ECB is tilting towards a more hawkish direction will initially materialize in the form of reduced asset purchases. This would curtail the significant portfolio outflows from the eurozone this year. From a positioning standpoint, speculative long positions in the euro have also been liquidated, which provides some footing for the currency. We are maintaining a neutral stance on the euro in the very near term, with a bias to buy on weakness.  Chart 7AEuro Chart 7BEuro   Japanese  Yen JPY is the worst-performing currency this year and it is also one of the most shorted. Over the last month, the yen is down 0.4%. Japan is just now emerging from the pandemic, having vaccinated most of its population. Ergo, the economic surprise index, which currently sits at -74, could stage a powerful rebound. While both the inflation print and employment data were in line with expectations (the unemployment rate came in at 2.8% in September), there were other encouraging signs. In October, the Eco Watcher’s Survey rose from 42.1 to 55.5, the manufacturing PMI rose from 51.5 to 53.2, and machine tool orders accelerated 81.5% year-on-year.  The Bank of Japan kept monetary policy unchanged at its latest meeting. The policy stance of the BoJ remains dovish, with little prospect of any interest rate increase until 2025. Therefore, in an environment where interest rates rise, that will hurt the yen at the margin. That said, the underperformance of Japanese assets is attracting portfolio inflows, especially from equity investors. As we wrote last week, the underperformance of certain Japanese equity sectors has not been fully justified by the improving earnings picture. From a valuation standpoint, the yen is the cheapest G10 currency according to our PPP models, and it is also quite cheap according to our intermediate-term timing model. Therefore, even given the breakout in the DXY index, we are maintaining our near-term positive for the yen. Chart 8AJapanese Yen Chart 8BJapanese Yen British Pound As a high-beta currency, sterling has been one of the victims of dollar strength. GBP is down 1.6% over the last month. The biggest driver was the volte-face from the BoE. The BoE kept rates on hold despite their seemingly hawkish messaging weeks ahead of the MPC meeting. Gilt yields fell along with the pound. Following the expiry of the furlough scheme in September, the central bank is waiting to the see the potential impact on the labor market before curtailing accommodation. Hence, a hike in December is still on the table. Incoming data continues to strengthen the case for the BoE to tighten policy. CPI is at 3.5%, with the transport and housing sectors continuing to see surging prices. At 4.5%, the unemployment rate is at NAIRU. Wages are also inflecting higher. The latest GDP report (Q3 GDP rose 6.6% year-on-year) continues to suggest the UK economy maintains upward momentum. The October manufacturing PMI rose from 57.1 to 57.8.  Near term, the pound could continue to face weakness as speculators liquidate positions and capital inflows soften. This is especially the case as the post-Brexit environment remains quite volatile. As a play on this trend, we are tactically long EUR/GBP. However, we remain bullish sterling on a cyclical horizon as real rates should continue to normalize. Chart 9ABritish Pound Chart 9BBritish Pound Australian Dollar The Australian dollar is down 0.8% over the last month, as both a stronger dollar and lower iron ore prices exert downward pressure on the exchange rate. The biggest developments over the last few weeks in Australia were the CPI report and the RBA policy meeting. The Q3 print for CPI was 3%, the upper bound of the central bank’s target range, with the trimmed-mean and weighted-median figure coming in at 2.1%. This helped justify the RBA’s decision to abandon the 0.1% yield target on the April 2024 bond. That said, the central bank maintained its cash rate target of 0.1% until earliest 2023 and left the pace of asset purchases unchanged. The RBA trimmed its forecast for GDP for this year to 3% from 4% and said more than 50% of jobs were currently experiencing little to no wage growth. Wages grew just 1.7% in the year to June, far below the 3%-plus levels the RBA believes is necessary to keep inflation sustainably within the 2%-3% band and trigger a rate hike. Hence, the release of the Q3 wage price index, on November 17, will be closely watched. Any upward surprise can challenge the RBA’s measured projections. The bearish case for the Aussie is well known, with speculative positioning near a record short. That said, real yields in Australia have been improving and portfolio flows are accelerating, especially into the mining and energy sectors, which are benefiting from a terms-of-trade tailwind. This sets the stage for a coil-spring rebound in the Aussie. Meanwhile, the AUD is cheap, especially on a terms-of-trade basis. At the crosses, we are long AUD/NZD as a play on these trends. From a tactical standpoint, we are neutral the Aussie, but will buy outright at 70 cents.  Chart 10AAustralian Dollar Chart 10BAustralian Dollar New Zealand Dollar The New Zealand dollar is up 1.3% over the last month. New Zealand’s economy is firing on all cylinders. CPI accelerated sharply from 3.3% to 4.9% in Q3, well above the RBNZ’s target band of 1%-3%, and behind only that of the US. The unemployment rate fell to 3.4% in Q3, far lower than the 3.9% forecasted by economists polled by Reuters. Wage growth was strong in the quarter with the private sector labor cost index registering a 0.7% lift. The seasonally adjusted employment number jumped 2.0% on the quarter, beating expectations of a 0.4% increase. The participation rate also rose to 71.2%, higher than the 70.6% forecast. Meanwhile, house prices continue to move higher, especially in Wellington.  As a result, the RBNZ has been one of the most hawkish G10 central banks, hiking rates last month for the first time in seven years to 0.5%. Another 0.25% hike is likely at the November 24 meeting. Meanwhile, at 2.6%, New Zealand currently has the highest G10 10-year bond yield. This is bullish for the kiwi. The one caveat is that the Covid-19 situation in New Zealand continues to deteriorate, which could be a catalyst for a pause.  Portfolio flows into New Zealand have turned negative in recent quarters. The equity market, which is quite expensive, has underperformed and the currency is overvalued according to our models, which has dampened the appeal of higher yields. We continue to believe the NZD will fare well cyclically, but hawkish expectations from the RBNZ are already priced in. This provides room for disappointment.  Chart 11ANew Zealand Dollar Chart 11BNew Zealand Dollar Canadian Dollar The CAD is the best-performing currency this year, even though it is down 1% over the last month. The key driver of the CAD in recent weeks remains the outlook for monetary policy, and the path of energy prices. CPI inflation came in at 4.4% year-on-year for September, beating market expectations and among the highest across the G10. The CPI-trim hit 3.4% year-on-year. With all eight major components of the CPI rising year-over-year, upward price pressures are broad-based. The housing market also appears bubbly, all providing fertile ground for tighter monetary settings. At first blush, the October employment report was disappointing, with only 31,000 jobs added. However, employment in Canada is already above pre-pandemic levels and is likely to now settle towards trend growth of around 2%. This suggests a print of 30,000 - 40,000 jobs, in line with October’s release. The unemployment rate continues to drop, hitting 6.7%. Incoming data justified the Bank of Canada’s policy response. It delivered a hawkish surprise announcing an end to its quantitative easing program and shifting to the reinvestment phase whereby its holdings of Canadian government bonds will be held constant. It also brought forward the first rate hike to Q2 2022. The BoC will marginally diverge from the US Fed, which is expected to keep rates unchanged through most of next year. This will continue to boost real rates in Canada. Meanwhile, net purchases of Canadian securities continue to inflect higher, as the commodity sector benefits from a terms-of-trade boom. That said, from a tactical standpoint, speculators are marginally long the CAD. As such, our near-term view is cautious. We however doubt the CAD will significantly break below 78 cents, given burgeoning tailwinds.  Chart 12ACanadian Dollar Chart 12BCanadian Dollar Swiss Franc The Swiss franc is up 1% against the dollar over the last month. EUR/CHF has also been very weak in recent trading sessions, constantly testing the 1.054 level. In our view, this has been much more due to euro weakness (see euro section above) than franc strength. The Swiss franc is trading near 11-month highs versus the euro. On the economic front, the labor market is improving and inflation in Switzerland is picking up. House prices have also risen quite robustly. This is lessening the need for the central back to maintain ultra-accommodative settings.  That said, the Swiss National Bank is likely to lag the rest of the G10 in lifting rates from -0.75%, currently the lowest benchmark interest rate in the world. This suggests that market pricing of a 25 basis-point rate rise by the SNB by the end of 2022 is misplaced. Inflation would have to rise substantially more - above the SNB's target range of less than 2% - before any hike is possible. The SNB has also said it remained ready to intervene to weaken a highly valued Swiss franc. The ECB’s dovish stance is one reason why the SNB will be loath to let the currency appreciate. Our guess is that the 1.05 level provides a near-term line in the sand, which will prompt the SNB to intervene. We would be buyers of EUR/CHF below 1.05.  Chart 13ASwiss Franc Chart 13BSwiss Franc Norwegian Krone The Norwegian krone has violently sold off in recent weeks, prompting our long Scandinavian basket to be stopped out. This has been mostly due to low liquidity and the high-beta nature of the krone. Norway’s central bank kept interest rates on hold at its latest meeting but reiterated it will likely hike its key rate by 25 basis points to 0.5% in December. The central bank noted that the economic recovery pushed activity back to pre-pandemic levels, while unemployment receded further. That said, underlying inflation still runs below the bank’s target.  The recent surge in oil prices has provided strong support for Norway’s trade balance and terms of trade. Oil and gas make up around 18% of Norway’s GDP. This is encouraging portfolio flows and has provided underlying support for the NOK. That said, given that much of the Norges Bank’s hawkishness has likely been priced into the NOK, the rewards of going long the currency should start shifting to its carry.  Chart 14ANorwegian Krone Chart 14BNorwegian Krone Swedish Krona The SEK was up 0.9% over the last month. Sweden never closed its economy, yet Covid-19 still had an impact. The good news is that this is mostly behind them. GDP expanded by 1.8% on the quarter in Q3, beating forecasts and the country recently ended all pandemic curbs. The labor market is recovering, and inflation is rising. CPIF inflation, on which the Riksbank sets its 2% target, is at 2.8%. Surging energy prices should turn out to be less of a problem for Sweden than the more coal-dependent countries in Europe, suggesting any increase in prices will be more genuine.  The Riksbank will complete its planned balance-sheet expansion later this year and has committed to maintaining the size of its bond holdings through 2022. The central bank, one of the most dovish amongst the G10, is slated to keep its policy rate flat at least until 2024. This could change if inflationary pressures remain persistent.  The big risk for Sweden is a slowdown in Europe and China. Supply chain bottlenecks are another issue. Several Swedish car and truck makers were forced to halt production in August due to semiconductor shortages. With the recent surge in the dollar, we were stopped out of our short EUR/SEK and USD/SEK positions for a profit. We will be looking to reinstate these trades from higher levels.  Chart 15ASwedish Krona Chart 15BSwedish Krona Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Kate Sun Research Analyst kate.sun@bcaresearch.com   Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Highlights So far, both the demand and supply side of the Philippine economy have been rather weak; yet there are signs that growth is set to revive. Fiscal expenditures have bottomed. Bank lending is also reviving. Acceleration in broad money supply is usually a good omen for stronger economic activity (Chart 1). Being a defensive market within EM, Philippine stocks will benefit in an impending period of weak EM stock prices. Upgrade this bourse from underweight to neutral in an EM equity portfolio. Philippine sovereign credit is also defensive in nature relative to its EM peers. Stay overweight in an EM portfolio. A deteriorating external accounts outlook makes the peso vulnerable. The central bank will also likely tolerate a weaker currency. Stay short the peso versus the US dollar. A vulnerable peso renders Philippine domestic bonds unappealing. Stay neutral in an EM domestic bonds portfolio. Feature The steep underperformance of Philippine stocks over the past several years is due for a pause. While this bourse may not see a sustainable rally in absolute terms, a period of flattish relative performance vis-à-vis the EM benchmark is likely. We recommend upgrading this market from underweight to neutral within an EM equity portfolio (Chart 2). Chart 1Accelerating Fiscal Spending And Credit Is A Good Omen For Economic Growth Chart 2Philippine Stocks' Underperformance Is Set For A Breather But It's A Risk In Absolute Terms One reason why Philippine stocks are unlikely to rally in absolute US dollar terms is a vulnerable peso. Philippine external accounts will likely deteriorate further, and therefore the peso is set to continue to trade on the weaker side. Currency investors should stick with our recommended short the peso versus US dollar trade for now. Philippine domestic bonds also remain unattractive to foreign investors. Local bond yields are not high enough relative to those of safe-haven bonds (US treasuries). As a result, the country is witnessing net debt portfolio outflows. The nation’s sovereign USD bonds, however, will likely outperform the EM benchmark going forward and merit an overweight stance in an EM sovereign bond portfolio. A Feeble Economy …   The Philippine economy, so far, continues to be soft. Demand has been sluggish: manufacturing sales remain well below pre-pandemic levels – both in value and volume terms. So are car sales (Chart 3). On the supply side, production volume gives a similar message: they are still below pre-pandemic levels. Manufacturing PMI is barely in the expansion territory (Chart 4). In other words, there is palpable weakness in both the demand and supply side of the domestic economy. Chart 3The Demand Side Of The Economy Has Been Weak... Chart 4...So Has Been The Supply Side The soft domestic demand is also evident from the import cargo throughput in the country’s ports. While exports cargo has risen well above pre-pandemic levels, import cargo has not (Chart 5). Part of the reason behind the lingering frailty is muted fiscal spending. Over the past 12 months, the latter has decelerated measurably. To be sure, Philippine fiscal outlays during the entire pandemic period have not been extraordinary; and yet this has slowed further (Chart 6, top panel). Chart 5Weak Domestic Demand Is Also Evident In Still Subdued Imports Chart 6Govt Spending Had Decelerated, Even As QE Proceeds Remained Unspent   The sharp widening seen in the country’s fiscal deficits had more to do with dwindling fiscal revenues, rather than strong spending. In fact, central bank data shows that most of its government bond purchase proceeds (‘QE’ proceeds) are unspent – still sitting in the government’s accounts with the central bank, i.e., they have not been channeled into the economy (Chart 6, bottom panel). … But Plenty Of Dry Powder Going forward, however, that picture is likely to change. The country is heading into general elections in May 2022. Lawmakers therefore have an incentive to spend the amount currently lying in the central bank. The amelioration in the number of new Covid-19 cases has enabled a re-opening of the economy, which will make stimulus spending easier. In addition, the federal budget for 2022 passed last month1 includes an 11.5% hike in government outlays. With core CPI at 3%, this translates into a robust 8.5% government expenditure growth rate in real terms. Chart 7Credit Is Finally Reviving Beyond fiscal spending, the country’s bank credit might also gain some traction: During the pandemic, banks shunned loan disbursements. Lately, however, there are signs that credit is reviving (Chart 7). Real borrowing costs (prime lending rates deflated by core CPI) from banks are low, close to only 1%. Such low cost of credit should encourage new borrowing at a time when economic activity is resuming. On their part, banks have made sizeable provisions against the rising NPLs during the pandemic, and therefore have already taken a substantial hit on their books (Chart 8, top panel). Relatively cleaner balance sheets should encourage banks to lend. Banks have also been able to materially raise their operating efficiency in the past couple of years (by way of rising net interest income). As a result, operating margins have improved measurably. This has helped absorb part of the NPL-related losses and has somewhat cushioned the blow to banks’ bottom line (Chart 8, bottom panel). Relatively better margins (than otherwise would have been the case) should prompt banks to take relatively higher risks, i.e., expand their loan books going forward. Should fiscal authorities ramp up their spending, and should banks also begin to lend again, the activity that has resumed following a lessening of Covid-19 cases will get a fillip. Higher fiscal spending and bank credit will lift money supply in the economy, usually a good omen for stronger economic activity (see Chart 1 on page 1). Incidentally, inflation in the Philippines is under control. The relatively high headline inflation print is not indicative of any genuine inflationary pressures, and is due mostly to food prices, which account for 38% of the CPI basket. Core and trimmed mean CPI are much lower at around 3% (Chart 9, top panel). Chart 8Banks Have Cleaner Books Now As They Made Sizable NPL Provisions Chart 9There Are No Genuine Inflationary Pressures In The Philippines The central bank expects the headline inflation rate to decelerate to within its target band of 2% to 4% by the end of this year and settle close to the midpoint in 2022 and 2023. At the same time, Philippine nominal wages are barely growing (Chart 9, bottom panel). This implies that businesses have little margin pressures to raise their selling prices. Genuine inflationary pressures, therefore, are unlikely to become acute in the foreseeable future. That, in turn, will help keep fiscal and monetary policies accommodative.  Domestic Bond Yields Will Stay Flattish With the resumption of economic activity, will come higher fiscal revenues. That should help the Philippine fiscal deficit to narrow.  Narrower fiscal deficit in the Philippines is usually bond bullish (i.e., bond yields go down). Yet, lower bond yields will have negative implications for Philippine capital inflows. Foreign investors are the marginal buyers of Philippine bonds. And their appetite for the latter depends on how much extra yield the Philippines offers over safe-haven bonds (US treasuries). Chart 10 shows that whenever the yield differential narrows too much (to around 200 basis points), net debt portfolio inflows into the Philippines typically stop, and often turn into outflows. This is what is happening now. On the other end, when the differential widens enough (about 400 - 500 basis points), those outflows turn into inflows again. Chart 10The Philippines Need To Offer Relatively Higher Yields To Attract Capital Inflows Given that we expect US long-term bond yields to rise, if Philippine bond yields do not rise at an even faster pace, its yield differential would stay low. Thus, the country will be hard-pressed to see any debt portfolio inflows in the near future. The absence of foreign buyers, in turn, would put a floor under bond yields. This will counterbalance any yield-suppressing forces coming from improving fiscal deficits. Thus, overall, the country will likely see flattish yields over the next six to nine months. And The Peso, Shaky Chart 11Debt Dominates The Philippines' Capital Inflows Low bond yields and short-term interest rates will have negative ramifications for the currency: It’s the foreign debt flows, rather than equity investments, that dominate Philippine capital inflows. This is true for all categories of inflows: FDI, portfolio and other investments (Chart 11). The fact that debt investors are the dominant group among foreign investors has some implications. Debt investors do not like lower interest rates while equity investors do. As such, debt inflows into the Philippines diminish when the interest rates (bond yields) are relatively low. Muted foreign capital inflows, in turn, are bearish for the peso. The country’s current account outlook is also not rosy. The trade deficit has widened significantly, and the robust current account surplus has given way to deficits – in line with our forecast in our previous report. With domestic demand reviving (government spending, household consumption and business investment), imports will now likely grow faster than exports, and therefore, will weigh down on both trade and current account deficits further in the months ahead. Notably, the country’s overseas workers’ remittances have also rolled over in recent months. All these will be a headwind for the peso (Chart 12). As noted, the central bank does not expect inflation to overshoot their target in the next two years. They have also been a net buyer of US dollars year-to-date, i.e., they have been leaning against their currency. This implies that they would not mind a weaker currency – especially when the economy is still not strong, and inflation is not a threat. Incidentally, the peso is also about 7% expensive vis-à-vis the US dollar in purchasing power terms (Chart 13). Chart 12Current Account Balance Will Deteriorate As Rising Domestic Demand Fuels Imports Chart 13The Peso Is Somewhat Expensive In PPP Terms And Is Vulnerable To A Downside Equity Underperformance Is Late An improving fiscal balance is usually bullish news for Philippine stock multiples. The connection is via bond yields/interest rates. An improving fiscal balance leads to lower bond yields, which, in turn, boost this market which is dominated by interest rate sensitive sectors (real estate, financials/banks and utilities make up 50% of market cap). Chart 14Weak EM Stock Prices Herald Outperformance by The Defensive Philippine Markets Yet, in this cycle, an improving fiscal balance may not herald a material fall in the country’s bond yields due to net debt portfolio outflows (as explained above). Thus, Philippine stocks would miss the tailwind from rising multiples. A dim outlook for the peso also calls for caution on the part of absolute-return foreign investors. That said, the resumption of economic activity will lead to rising earnings, and that should provide some tailwinds for this market. Moreover, as a defensive market within EM, Philippine stocks usually outperform the overall EM benchmark during periods of weak EM stock prices. Incidentally, we have a negative outlook on EM stock prices over the coming several months (Chart 14). Weighing all the pros and cons, we infer that Philippine stocks’ relative performance will likely be rangebound over the next six to nine months. Sovereign Credit Will Outperform Chart 15The Philippines' Sovereign Credit Outperforms During EM Risk-Off Periods, Stay Overweight A negative outlook on overall EM sovereign credit warrants overweighting Philippine sovereign credit relative to its EM brethren. The reason is the defensive nature of the Philippine sovereign bond market – just like its equity market. During periods of stress, Philippine sovereign spreads widen much less than its EM peers. Chart 15 shows that in each of the last three risk-off periods (2008-09, 2015, 2020), Philippine sovereign credit massively outperformed the EM benchmark. The basis for the defensive features of Philippine sovereign credit is that the nation’s external public debt is quite low at 18% of GDP, down from 25% ten years back. Of this, foreign bonds outstanding are 10% of GDP, down from 12% ten years back (the rest being loans and contingent liabilities). Such low debt means the defensive nature of this market is unlikely to change soon. Hence, it makes sense to overweight Philippine sovereign bonds in view of impending sovereign credit spreads widening in the broader EM universe. Investment Conclusions Stocks: The Philippine economy will likely see some traction in the months ahead as fiscal spending rises and bank credit revives. This bourse’s relative performance will also benefit in an impending risk-off period in emerging markets. Asset allocators should upgrade this market from underweight to neutral in an EM equity portfolio. Our underweight call on this market vis-à-vis an EM equity portfolio has yielded a gain of 16% since we recommended it in October 2018. The Peso: The peso remains vulnerable in the face of deteriorating external accounts. Currency investors should stay with our recommended long USD/ short PHP trade for now. This call has yielded 2.1% so far since our recommendation on March 18, 2021. Chart 16Philippine Domestic Bonds Warrants A Neutral Allocation In An EM Portfolio Domestic Bonds: Local currency bond yields in the Philippines are likely to stay flattish despite the slated improvements in the country’s fiscal balance. The peso is also set to stay weak. These call for a cautious stance on Philippine domestic bonds. Yet, they tend to do well relative to their EM counterparts during periods of EM stress – as they did in 2015 and in 2020 (Chart 16). Since another such period is around the corner, we recommend that investors maintain a neutral allocation of Philippine local currency bonds in an EM portfolio.    Sovereign Bonds: Philippine sovereign bonds are set to outperform their EM counterparts. Asset allocators should stay overweight the Philippines in a dedicated EM sovereign bonds portfolio. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes 1 Passed in the third and final reading in the lower house and sent to the Senate, the upper house.

Highlights Japan’s long-term weaknesses – a shrinking population, low productivity growth, excess indebtedness – are very well known. However, it still punches above its weight in the realm of geopolitics. Abenomics – sorry, Kishidanomics – can still deliver some positive surprises every now and then. As the global pandemic wanes, and China faces a historic confluence of internal and external risks, investors should begin buying the yen on weakness. Japanese industrials also are an attractive play in a global portfolio. While the yen will likely fare better than the dollar over the next 6-9 months, it will lag other procyclical currencies. Feature Japan has always been an “earthquake society,”  in which things seem never to change until suddenly everything changes at once. The good news for investors is that that change occurred in 2011 and the latest political events reinforce policy continuity. Why “Abenomics” Remains The Playbook Over ten years have passed since Japan suffered a triple crisis of earthquake, tsunami, and nuclear meltdown. In fact, the Fukushima nuclear crisis merely punctuated a long accumulation of national malaise: the country had suffered two “Lost Decades” and was in the thrall of the Great Recession, a rare period of domestic political change, and a rise in national security fears over a newly assertive China. The nuclear meltdown marked the nadir. The result of all these crises was a miniature policy revolution in 2012 – Prime Minister Shinzo Abe and the Liberal Democratic Party (LDP) returned to power and initiated a range of bolder policies to whip the country’s deflationary mindset and reboot its foreign and trade relations. The new economic program, “Abenomics,” consisted of easy money, soft budgets, and pro-growth reforms. It succeeded in changing Japan. Both private debt and inflation, which had fallen during the lost decades, bottomed after the 2011 crisis and began to rise under Abe (Chart 1). By the 2019 House of Councillors election, however,  Abe was running out of steam. Consumption tax hikes, the US-China trade war, and COVID-19 thwarted his plans of national revival. In particular, Abe hoped to capitalize on excitement over the 2020 Tokyo Olympics to hold a popular referendum on revising the constitution. Constitutional revision is necessary to legitimize the Self-Defense Forces and thus make Japan a “normal” nation again, i.e. one that can maintain armed forces. But the global pandemic interrupted. Until the next heavyweight prime minister comes along, Japan will relapse into its old pattern of a “revolving door” of prime ministers who come and go quickly. For example, the only purpose of Abe’s immediate successor, Yoshihide Suga, was to tie off loose ends and oversee the Olympics before passing the baton (Chart 2). Chart 1Abenomics Was Making Progress The next few Japanese prime ministers will almost inevitably lack Abe’s twin supermajority in parliament, which was exceptional in modern history (Chart 3). It will be hard for the LDP to expand its regional grip given that it holds a majority in all 11 of the regional blocks in which the political parties contend for seats based on their proportion of the popular vote (Table 1). Table 1LDP+ Komeito Regional Performance Short-lived, traditional prime ministers will not be able to create a superior vision for Japan and will largely follow in Abe’s footsteps.   In September Prime Minister Fumio Kishida replaced Suga – a badly needed facelift for the ruling Liberal Democrats ahead of the October 31 election. The LDP retained its single-party majority in the Diet, so Kishida is off to a tolerable start (Chart 4). But he is far from charismatic and will not last long if he fumbles in the upper house elections in July 2022. This gives him a little more than half a year to make a mark. Kishida will oversee a roughly 30-40 trillion yen stimulus package, or supplemental budget, by the end of this year. Japanese stimulus packages are almost always over-promised and under-delivered. However, given the electoral calendar, he will put together a large package that will not disappoint financial markets. His other goal will be to build on recent American efforts to cobble together a coalition of democracies to counter China and Russia. Japan’s Grand Strategy In Brief Chart 5Japan Exposed To China Trade Japan’s grand strategy over centuries consists of maintaining its independence from foreign powers, controlling its strategic geographic approaches to prevent invasion, and stopping any single power from dominating the eastern side of the Eurasian landmass. Originally the hardest part of this grand strategy was that it required establishing unitary political control over the far-flung Japanese archipelago. However, since the Meiji Restoration, Tokyo has maintained centralized government. Since then Japan has focused on controlling its strategic approaches and maintaining a balance among the Asian powers. During the imperialist period it tried to achieve these objectives on its own. After World War II, the United States became critical to Japan’s grand strategy. Through its broad alliance with Washington, Tokyo can maintain independence, make sure critical territories are not hostile (e.g. Taiwan and South Korea), and deter neighboring threats (North Korea, China, Russia). It can at least try to maintain a balance of power in Eurasia. Yet these constant national interests underscore Japan’s growing vulnerabilities today: China’s economy is now two-times larger than Japan’s and Japan is more dependent on China’s trade than vice versa (Chart 5). Under Xi Jinping, Beijing is actively converting its wealth into military and strategic capabilities that threaten Japan’s security. Rising tensions across the Taiwan Strait are fueling nationalism and re-armament in Japan.  Russia’s post-Soviet resurgence entails an ever-closer Russo-Chinese partnership. It also entails Russian conflicts with the US that periodically upset any attempts at Russo-Japanese détente. North Korea’s asymmetric war capabilities and nuclearization pose another security threat. South Korea’s attempts to engage with the North and China, and compete with Japan, are unhelpful.    All of these realities drive Japan closer to the United States. Even the US is increasingly unpredictable, though not yet to the point of causing serious doubts about the alliance. If the US were fundamentally weakened, or abandoned the alliance, Japan would either have to adopt nuclear weapons or accommodate itself to Chinese hegemony to meet its grand strategy. Nuclearization would be the more likely avenue. The stability of Asia depends greatly on American arbitration. Japan’s Strategy Since 1990 Beneath this grand strategy Japan’s ruling elites must pursue a more particular strategy suited to its immediate time and place. Ever since Japan’s working population and property bubble peaked in the early 1990s, the country’s relative economic heft has declined. To maintain stability and security, the central government in Tokyo has had to take on a very active role in the economy and society. The first step was to stabilize the domestic economy despite collapsing potential growth. This has been achieved through a public debt supercycle (Chart 6). Unorthodox monetary and fiscal policy largely stabilized demand, at the cost of the world’s highest net debt-to-GDP ratio. The economic adjustment was spread out over a long period of time so as to prevent a massive social and political backlash. Unemployment peaked in 2009 at 5.5% and never rose above this level. The ruling elite and the Liberal Democrats maintained control of institutions and government. The second step was to ensure continued alliance with the United States. Japan could deal with its economic problems – and the rise of China – if it maintained access to US consumers and protection from the US military. To maintain the alliance required making investments in the American economy, in US-led global institutions, and cooperating with the US on various initiatives, including controversial foreign policies. As in the 1950s-60s, Japan would bulk up its Self-Defense Forces to share the burden of global security with the United States, despite the US-written constitution’s prohibition on keeping armed forces. The third step was to invest abroad and put Japan’s excess savings to work, developing materials and export markets abroad while employing foreign workers and factories to become Japan’s new industrial base in lieu of the shrinking Japanese workforce (Chart 7).  Chart 6Japan's Public Debt Supercycle Japan’s post-1990 strategy has staying power because of the massive pressures on Japan listed above: China’s rise, Russo-Chinese partnership, North Korean threats, and American distractions. Investors tend to underrate the impact of these trends on Japan. Unless they fundamentally change, Japan’s strategy will remain intact regardless of prime minister or even ruling party. Russia’s role is less clear and could serve as a harbinger of any future change. President Vladimir Putin and Abe had the best chance in modern memory to resolve the two countries’ territorial disputes, build on mutual interests, and maybe even sign a peace treaty. But Russia’s clash with the West  proved an insurmountable obstacle. New opportunities could emerge at some later juncture, as Japan’s interest in preventing China from dominating Eurasia gives it a strong reason to normalize ties with Russia. Russia will at some point worry about overdependency on China. But this change is not on the immediate horizon.  Japan’s Tactics Since 2011 Japan is nearly a one-party state. Brief spells of opposition rule, in 1993 and 2009-11, are exceptions that prove the rule. The Liberal Democrats did not fall from power so much as suffer a short “time out” to reflect on their mistakes before voters put them right back into power. However, these timeouts have been important in forcing the ruling party to adjust its tactics for changing times, as with Abenomics. Kishida will not have enough political capital to change direction. The emphasis will still be on defeating deflation and rekindling animal spirits and corporate borrowing (as opposed to relying exclusively on public debt). Kishida has talked about a new type of capitalism and a more active redistribution of wealth, in keeping with the current zeitgeist among the global elite. However, Japan lacks the impetus for dramatic change. Wealth inequality is not extreme and political polarization is non-existent (Chart 8). The LDP is wary of losing votes to the populist Japan Innovation Party, or other regional movements, but populism does not have as fertile ground in countries with low inequality.  The desire to boost wages was a central plank of Abenomics (Chart 9) and an area of success. It will come through in Kishida’s policies as well. But the ultimate outcome will depend on how tight the labor market gets in the upcoming economic cycle. Similarly Kishida can be expected to encourage, or at least not roll back, women’s participation in the labor force, as labor markets tighten (Chart 10). As the pandemic wanes it is also likely that he will reignite Abe’s loose immigration policy, which saw the number of foreign workers triple between 2010 and 2020. This inflow is perhaps the surest sign of any that insular and xenophobic Japan is changing with the times to meet its economic needs.  Chart 9Kishidanomics To Build On Abe's Wage Growth Chart 10Women Off To Work But Fertility ##br##Relapsed The only substantial difference between Kishidanomics and Abenomics is that Abe compromised his reflationary fiscal efforts by insisting on going forward with periodic hikes to the consumption tax. Kishida is under no such expectation. Instead he is operating in a global political and geopolitical context in which ambitious public investments are positively encouraged even at the expense of larger budget deficits (Chart 11). Yet interest rates are still low enough to make such investments cheaply. The stage is set for fiscal largesse. Chart 11Fiscal Largesse To Continue Kishida can be expected to promote large new investments in supply-chain resilience, renewable energy, and military rearmament. The US and EU may exempt climate policies from traditional budget accounting – Japan may do the same. Even more so than China and Europe, Japan has a national interest in renewable energy since it is almost entirely dependent on foreign imports for its fossil fuels. The green transition in Japan is lagging that of Germany but the Japanese shift away from nuclear power has gone even faster, creating an import dependency that needs to be addressed for strategic reasons (Chart 12). Monetary-fiscal coordination began under Abe and can increase under Kishida. What is clear is that public investment is the top priority while fiscal consolidation is not. Military spending is finally starting to edge up as a share of GDP, as noted above. For many years Japanese leaders talked about military spending but it remained steady at 1% of GDP. Now, at the onset of the US-China cold war, the Japanese are spending more and say the ratio will rise to 2% of GDP (Chart 13). Tensions with China, especially over Taiwan, will continue to drive this shift, though North Korea’s weapons progress is not negligible. The Biden administration is prioritizing US allies and the competition with China, which makes the Japanese alliance top of mind. Tokyo’s various attempts to talk with Beijing in recent years have amounted to nothing, with the exception of the Regional Comprehensive Economic Partnership, which is far from ratification and implementation. Japan’s relations with China are driven by interests, not passing attitudes and emotions. If Biden proves too dovish toward China – a big “if” – then it will be Japan pushing the US to take a more hawkish line rather than vice versa. Japan will take various strategic, economic, technological, and military actions to defend itself from the range of external threats it faces. These actions will intimidate and provoke China and other neighbors, which will help to entrench the “security dilemma” between the US and China and their allies. For example, Japan will eagerly participate in US efforts to upgrade its military and its regional alliances and partnerships, including via the Quadrilateral Security Dialogue with India and Australia. The Biden administration might force Japan to play nice with South Korea and patch up their trade war. But that is a price Japan can pay since American involvement also precludes any shift by South Korea fully into China’s camp. If China should invade Taiwan – which we cannot rule out over the long run – Japan’s vital supply lines and national security would fall under permanent jeopardy. Japan would have an interest in defending Taiwan but its willingness to war with China may depend on the US response. However, both Japan and the US would have to draw a stark line in defense of Japanese territory, not least Okinawa, where US troops are based. Both powers would mobilize and seek to impose a strategic containment policy around China at that point. Until The Next Earthquake … For Japan to abandon its post-1990 strategy, it would need to see a series of shocks to domestic and international politics. If China’s economy collapsed, Korea unified, or the US abandoned the Asia Pacific region, then Tokyo would have to reassess its strategy. Until then the status quo will prevail. At home Japan would need to see a split within the Liberal Democrats, or a permanent break between the LDP and their junior partner Komeito, combined with a single, consolidated, and electorally viable opposition party and a charismatic opposition leader. This kind of change would follow from major exogenous shocks. Today it is nowhere in sight – the last two shocks, in 2011 and 2020, reinforced the LDP regime. Theoretically some future Japanese government could adopt a socialist platform that relies entirely on public debt rather than trying to reboot private debt. It could openly embrace debt monetization and modern monetary theory  rather than trying to raise taxes periodically to maintain the appearance of fiscal rectitude. But if it tried to distance itself from the United States and improve relations with Russia and China, such a strategy would not go very far. It would jeopardize Japan’s grand strategy. For the foreseeable future, Japan’s economic security and national security lie in maintaining the American alliance and continuing an outward investment strategy focused on emerging markets other than China. Macroeconomic Developments The key message from an economic context is that fiscal stimulus is likely to be larger in Japan than the market currently expects. The IMF is penciling in a fiscal deficit of around 2% of potential GDP next year, which will be a drag on growth (Chart 14). More likely, Kishida will cobble together a slightly larger package to implement most of the initiatives he has proposed on the campaign trail. Meanwhile, a large share of JGBs are about to mature over the next couple of years, providing room for more issuance, which the BoJ will be happy to assimilate (Chart 15). Chart 14More Fiscal Stimulus In Japan Likely Chart 15Lots Of JGBs Mature In The Next Few Years Real numbers on the size of the fiscal package have been scarce, but it should be around 30-40 trillion yen, spread over a few years. With Japan’s net interest expense at record lows (Chart 16), and a lot of the spending slated for worthwhile productivity-enhancing projects such as supply chains, green energy, education and some boost to the financial sector in the form of digital innovation and consolidation, we expect fiscal policy in Japan will remain moderately loose, with the BoJ staying accommodative. The timing of more fiscal stimulus is appropriate as Japan has managed to finally put the pandemic behind it. The number of new Covid-19 cases is at the lowest recorded level per capita, and Japan now  has more of its population vaccinated than the US. As a result, the manufacturing and services PMIs, which have been the lowest in the developed world, could stage a coiled-spring rebound. This will be a welcome fillip for Japanese assets (Chart 17). Chart 16Little Cost To Issuing More Debt Chart 17The Japanese Recovery Has Lagged Consumption could also surprise to the upside in Japan. With the consumption tax hike of 2019 and the 2020 pandemic now behind us, pent-up demand could finally be unleashed in the coming quarters. Rising wages and high savings underscore that Japan could see a vigorous rebound in consumption, as was witnessed in other developed economies. This will be particularly the case as inflation stays low. The big risk for Japan from a macro perspective is an external slowdown, driven by China. A boom in foreign demand has been a much welcome cushion for Japanese growth, especially amidst weak domestic demand. The risk is that this tailwind becomes a headwind as Chinese growth slows, especially as a big share of Japanese exports go to China. Our view has been that policy makers in China will be able to ring-fire the property crisis, preventing a “Lehman” moment. As such, while China’s slowdown is a reality and downside risks warrant monitoring, we also expect China to avoid a hard landing. Meanwhile, Japanese exports are also diversified, with other developed and emerging markets accounting for the lion’s share of total exports. For example, exports to the US account for 19% of sales while EU exports account for 9%. Both exports and foreign machinery orders remain quite robust, suggesting that the slowdown in China will not crush all external demand (globally, export growth remains very strong).  It is noteworthy that many countries now have “carte blanche” to boost infrastructure spending, especially in areas like renewable energy and supply chain resiliency. Japan continues to remain a big supplier of capital goods globally. This will ensure that an economic recovery around the world will buffer foreign machinery orders. Market Implications Japanese equities have underperformed the US over the last decade, and Kishidanomics is unlikely to change this trend. But to the extent that more fiscal stimulus helps lift aggregate demand, a few sectors could begin to see short-term outperformance. More importantly, the underperformance of certain Japanese equity sectors have not been fully justified by the improving earnings picture (Chart 18). This suggests some room for catch-up. Banks in particular could benefit from a steeper yield curve in Japan, rising global yields and proposed reform in the sector (Chart 19). We will view this as a tactical opportunity however, than a strategic call. Our colleagues in the Global Asset Allocation service have clearly outlined key reasons against overweighting Japan, and are currently neutral.  More importantly, industrials also look poised to see some pickup in relative EPS growth, as global industrial demand stays robust. An improvement in domestic demand should also favor small caps over large caps. Chart 18ADismal Earnings Explain Some Underperformance Of Japanese Equities Chart 18BDismal Earnings Explain Some Underperformance Of Japanese Equities Chart 19Japanese Banks Will Benefit From A Steeper Yield Curve Foreigners have huge sway over the performance of Japanese assets, especially equities. Foreign holders account for nearly 30% of the Japanese equity float. This is important not only for the equity call but for currency performance as well since portfolio flows dominate currency movements. Historically, the yen and the Japanese equity market have been negatively correlated. This was due to positive profit translation effects from a lower currency. However, it is possible that Japanese domestic profits are no longer driven only by translation effects, but rather by underlying productivity gains. This could result in less yen hedging by foreign equity investors, which would restore a positive relationship between the relative share price performance and the currency. As for the yen, the best environment for any currency is when the economy can generate non-inflationary growth. Japan may well be entering this paradigm. Historically, now has been the exact environment where the yen tends to do well, as the economy exits deflation and enters non-inflationary growth (Chart 20). Chart 20The Yen And Japanese Growth Markets have been wrongly focusing on nominal rather than real yields in Japan and the implication for the yen. Therefore the risk to a long yen view is that the Bank of Japan keeps rates low as global yields are rising. However, in an environment where global inflationary pressures normalize (say in the next 6-9 months) and temper the increase in global yields, this could provide room for short covering on the yen. In our view, the yen is already the most underappreciated currency in the G10, as rising global yields have led to a massive accumulation of short positions. Finally, from a valuation standpoint, the yen is the cheapest G10 currency according to our PPP models, and is also quite cheap according to our intermediate-term timing model (Chart 21). With the yen being a risk-off currency, it also tends to rise versus the dollar not only during recessions, but also during most episodes of broad-based dollar weakness. This low-beta nature of the currency makes it a good portfolio hedge in an uncertain world. Chart 21The Yen Is Undervalued Given the historic return of geopolitical risk to Japan’s neighborhood, as the US and Japan engage in active great power competition with China, the yen is an underrated hedge. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Chester Ntonifor Vice President Foreign Exchange Strategy chestern@bcaresearch.com

The markets were deluged by a lot of information in late October. Several central banks made surprise moves towards tightening (the Bank of Canada, for example, ended asset purchases, and the Reserve Bank of Australia effectively abandoned its yield-curve control). Inflation continued to surprise on the upside (headline CPI in the US is now 5.4% year-on-year). But, at the same time, there were signs of faltering growth with, for example, US real GDP growth in Q3 coming in at only 2.0% quarter-on-quarter annualized, compared to 6.7% in Q2. This caused a flattening of the yield curve in many countries, as markets priced in faster monetary tightening but lower long-term growth (Chart 1). Nonetheless, equities shrugged off the barrage of news, with the S&P500 ending the month at a new high. All this highlights what we discussed in our latest Quarterly: That the second year of a bull market is often tricky, resulting in lower (but still positive) returns from equities and higher volatility. For risk assets to continue to outperform, our view of a Goldilocks environment needs to be “just right”: The economy must not be too hot or too cold. We think it will be – and so stay overweight equities versus bonds. But investors should be aware of the risks on either side. How too hot? Inflation is broadening out (at least in the US, UK, Australia and Canada, though not in the euro zone and Japan) and is no longer limited to items which saw unusually strong demand during the pandemic but where supply is constrained (Chart 2). Chart 1What Is The Message Of Flattening Yield Curves? Chart 2Inflation Is Broadening Out In The US There is a risk that this turns into a wage-price spiral as employees, amid a tight labor market, push for higher wages to offset rising prices. We find that wages tend to follow prices with a lag of 6-12 months (Chart 3). The Atlanta Fed Wage Tracker (good for gauging underlying wage pressures since it looks only at employees who have been in a job for 12 months or more) is already at 3.5% and looks set to rise further. On the back of these inflationary moves, the market has significantly pulled forward the date of central bank tightening. Futures now imply that the Fed will raise rates in both July and December next year (Chart 4) and that other major developed central banks will also raise multiple times over the next 14 months (Table 1). Breakeven inflation rates have also risen substantially (Chart 5). Chart 3Wages Tend To Rise After Prices Rise Chart 4Will The Fed Really Hike This Soon?   Table 1Futures Implied Path Of Rate Hikes Chart 5Breakevens Suggest Higher Inflation     We think these moves are a little excessive. There are several reasons why inflation might cool next year. Companies are rushing to increase capacity to unblock supply bottlenecks. For example, semiconductor production has already begun to increase, bringing down DRAM prices over the past few months (Chart 6). Another big contributor to broad-based inflation has been a 126% increase in container shipping costs since the start of the year (Chart 7). But currently the number of container ships on order is at a 10-year high; these new ships will be delivered over the next two years. Such deflationary forces should pull down core inflation next year (though we stick to our longstanding view that for multiple structural reasons – demographics, the end of globalization, central bank dovishness, the transition away from fossil fuels – inflation will trend up over the next five years). Chart 6DRAM Prices Falling As Production Ramps Up Chart 7All Those Ships On Order Should Bring Down Shipping Costs The Fed, therefore, will not be in a rush to raise rates. It does not see the labor market as anywhere close to “maximum employment” – it has not defined what it means by this, but we would see it as a 3.8% unemployment rate (the median FOMC dot for the equilibrium unemployment rate) and the prime-age participation rate back to its 2019 level (Chart 8). We continue to expect the first rate hike only in December next year. The Fed will feel the need to override its employment criterion only if long-term inflation expectations become unanchored – but the 5-year 5-year forward breakeven rate is only at 2.3%, within the Fed’s effective CPI target range of 2.3-2.5% (Chart 5). We remain comfortable with our view of only a moderate rise in long-term rates, with the US 10-year Treasury yield at 1.7% by end-2021, and reaching 2-2.25% at the time of the first Fed rate hike. It is also worth emphasizing that even a fairly sharp rise in long-term rates has historically almost always coincided with strong equity performance (Chart 9 and Table 2). This has again been evident in the past 12 months: When rates rose between August 2020 and March 2021, and then from July 2021, equities performed strongly. Chart 8We Are Not Back To "Maximum Employment" Chart 9Rising Rates Are Usually Accompanied By A Rising Stock Market   Table 2Episodes Of Rising Long-Term Rates Since 1990 But could the economy get too cold? We would discount the weak US GDP reading: It was mostly due to production shortages, especially in autos, which pushed down consumption on durable goods by 26% QoQ annualized, and by some softness in spending on services due to the delta Covid variant, the impact of which is now fading. US growth should continue to be supported by a combination of the $2.5 trillion of excess household savings, strong capex as companies boost their production capacity, and a further 5% of GDP in fiscal stimulus that should be passed by Congress by year-end. Similar conditions apply in other developed economies. Chart 10Real Estate Is A Big Part Of Chinese GDP We see three principal risks to this positive outlook: A new strain of Covid-19 that proves resistant to current vaccines – unlikely but not impossible. Our geopolitical strategists worry about Iran, which may have a nuclear bomb ready by December, prompting Israel to bomb the country. Iran would likely react by hampering oil supplies, even blocking the Strait of Hormuz, through which 25% of global oil flows. Chinese growth has been slowing and the impact from the problems at Evergrande is still unclear. Real estate is a major part of the Chinese economy, with residential investment comprising 10% of GDP (Chart 10) and, broadly defined to include construction and building materials, real estate overall perhaps as much as one-third. Our China strategists don’t expect the government to launch a major stimulus which would bail out the industry, since it is happy with the way that property-related lending has been shrinking in recent years (Chart 11). We expect the slowdown in Chinese credit growth to bottom out over the coming few months, but economic activity may have further to slow (Chart 12), and there is a risk that the authorities are unable to control the fallout from the property market. Chart 11Chinese Authorities Are Happy To See Slowing Property Lending Chart 12When Will Credit Growth Bottom?       Fixed Income: Given the macro environment described above, we remain underweight bonds and short duration. If we assume 1) a Fed liftoff in December 2022, 2) 100 basis points of rate hikes over the following year, and 3) a terminal Fed Funds Rate of 2.08% (the median forecast from the New York Fed’s Survey of Market Participants), 10-year US Treasurys will return -0.2% over the next 12 months, and 2-year Treasurys +0.3%.1 TIPs have overshot fair value and, although we remain neutral since they a tail-risk hedge against high inflation over the next five years, we would especially avoid 2-year TIPS which look very overvalued. We see some pockets of selective value in lower-quality high-yield bonds, specifically US Ba- and Caa-rated issues, which are still trading at breakeven spreads around the 35th historical percentile, whereas higher-rated bonds look very expensive (Chart 13). For US tax-paying investors, municipal bonds look particularly attractive at the moment, with general-obligation (GO) munis trading at a duration-matched yield higher than Treasurys even before tax considerations (Chart 14). Our US bond strategists have recently gone maximum overweight. Chart 14Muni Bonds Are A Steal     Equities: We retain our longstanding preference for US equities over other Developed Markets. US equities have outperformed this year, irrespective of whether rates were rising or falling, or how US growth was surprising relative to the rest of the world, emphasizing the much stronger fundamentals of the US market (Chart 15).  Analysts’ forecasts for the next few quarters look quite cautious, and so earnings surprises can push US stock prices up further (Chart 16). We reiterate the neutral on China but underweight on Emerging Markets ex-China that we initiated in our latest Quarterly. Our sector overweights are a mixture of cyclicals (Industrials), rising-interest-rate plays (Financials), and defensives (Heath Care). Chart 15US Equites Outperformed This Year Whatever Happened Chart 16Analysts Are Pessimistic About The Next Couple Of Quarters   Currencies: We continue to expect the US dollar to be stuck in its trading range and so stay neutral. Recent moves in prospective relative monetary policy bring us to change two of our currency recommendations. We close our underweight on the Australian dollar. The recent rise in Australian inflation (with both trimmed mean and 10-year breakevens now above 2% – Chart 17) has brought forward the timing of the first rate hike and should push up relative real rates (Chart 18). We lower our recommendation on the Japanese yen from overweight to neutral. The Bank of Japan will not raise rates any time soon, even when other central banks are tightening. This will push real-rate differentials against the yen (Chart 18, panel 2). Chart 17Australian Inflation Is Picking Up Chart 18Real Rates Moving In Favor Of The AUD And Against The JPY Chart 19Chinese-Related Metals' Prices Are Falling Commodities: We remain cautious on those industrial metals which are most sensitive to slowing Chinese growth and its weakening property market. The fall in iron ore prices since July is now being followed by aluminum. However, metals which are increasingly driven by investment in alternative energy, notably copper, are likely to hold up better (Chart 19). We are underweight the equity Materials sector and neutral on the commodities asset class. The Brent crude oil price has broadly reached our energy strategists’ forecasts of $80/bbl on average in 2022 and $81 in 2023 (Chart 20). Although the forward curve is lower than this, with December-22 Brent at only $75/bbl, it is a misapprehension to characterize this as the market forecasting that the oil price will fall. Backwardation (where futures prices are lower than spot) is the usual state of affairs for structural reasons (for example, producers hedging production forward). The market typically moves to contango only when the oil price has fallen sharply and reserves are high (Chart 21). We remain neutral on the equities Energy sector.   Chart 20Brent Has Reached Our 2022 And 2023 Forecast Level Chart 21Lower Oil Futures Don't Mean Oil Price Is Forecast To Fall Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com GAA Asset Allocation