Currencies

Highlights Since June, 6 structured recommendations achieved their profit targets: short building and construction (XLB) versus healthcare (XLV); long USD/CAD; long USD/HUF; long Nike versus L’Oréal; short corn versus wheat; and short marine transport versus market. Additionally, short AMC Entertainment expired in profit, while short Australian versus Canadian 30-year bonds expired flat. Within the open trades, 3 are in profit. Against this, 2 structured recommendations hit their stop-losses: short Austria versus Chile; and short lead versus platinum. Additionally, short France versus Japan expired in loss. Within the open trades, 6 are in loss. This results in a ‘win ratio’ at a very pleasing 59 percent. Even more commendably, the 9 unstructured recommendations have all anticipated reversals or exhaustions – most notably for the ZAR, BRL, and stocks versus bonds. Feature Chart of the WeekFractal Fragility Correctly Signalled The Exhaustion Of Stocks Versus Bonds Fractal Fragility Correctly Signalled The Exhaustion Of Stocks Versus Bonds Fractal Fragility Correctly Signalled The Exhaustion Of Stocks Versus Bonds A major advance in our understanding of financial markets is that the Efficient Market Hypothesis (EMH) is only partly true. The market is efficient only when a wide spectrum of investment horizons is setting the price, signified by the market having a rich fractal structure. The market is efficient only when a wide spectrum of investment horizons is setting the price, signified by the market having a rich fractal structure. The eponymous Fractal Market Hypothesis (FMH) teaches us that when the fractal structure becomes extremely fragile, the information and interpretation of longer-term investors is missing from the recent price setting. Meaning that the market has become inefficient. When the longer-term investors do re-enter the price setting process, the question is: will they endorse the most recent trend as a justification of a change in the fundamentals. In which case, the trend will continue. Or will they reject it as an unjustified deviation from a fundamental anchor. In which case, the trend will reverse. In most cases, it is the latter: a rejection and a reversal. As most investors are unaware of the FMH, it gives a competitive advantage to the few investors that use it to signal a potential countertrend reversal. On this basis, we have used it – and continue to use it – to identify countertrend investment opportunities with truly excellent results. Fractal Trade Update This a brief review and update of the 29 short-term trades that we have recommended since our last update on 3rd June 2021, including recommendations that were open on that date. The 29 recommendations have comprised 20 structured trades – which include profit-targets, symmetrical stop-losses, and expiry dates – plus a further 9 recommendations without structured exit points. In summary, 6 structured recommendations achieved their profit targets: short building and construction (XLB) versus healthcare (XLV); long USD/CAD; long USD/HUF; long Nike versus L’Oréal; short corn versus wheat; and short marine transport versus market. Additionally, short AMC Entertainment expired in profit, while short Australian versus Canadian 30-year bonds expired flat. Within the open trades, 3 are in profit. Against this, 2 structured recommendations hit their stop-losses: short Austria versus Chile; and short lead versus platinum. Additionally, short France versus Japan expired in loss. Within the open trades, 6 are in loss. This results in a ‘win ratio’ at a very pleasing 59 percent – counting a win as achieving the profit target, a loss as hitting the (symmetrical) stop-loss, and pro-rata for partial wins and losses. Even more commendably, the 9 unstructured recommendations have all anticipated reversals or exhaustions. The sections below review the structured and unstructured recommendations in chronological order. The 20 Structured Trades 1.  6th May: Short Building and Construction (PKB) vs. Healthcare (XLV) Achieved its profit target of 15 percent. 2.  6th May: Short MSCI France vs. Japan Expired after three months in partial loss but went on to become very profitable – implying that a longer holding period was required (Chart I-2). Chart I-2Short France Versus Japan Became Very Profitable Short France Versus Japan Became Very Profitable Short France Versus Japan Became Very Profitable 3.  13th May: Long USD/CAD Achieved its profit target of 3.7 percent and went on to reach a high-water mark of 5.7 percent. 4.  20th May: Long 10-year T-bond vs. TIPS Open, in profit, having reached a high-water mark of 2.7 percent (versus a 3.6 percent target). 5.  3rd June: Short MSCI Austria vs. Chile Hit its stop-loss of 7 percent, albeit after previously reaching a high-water mark of 5.3 percent – implying that the profit target needed to be tighter. 6.  10th June: Short AMC Entertainment Expired at a 4 percent profit, having reached a high-water mark of 65.3 percent (versus a 100 percent target) (Chart I-3). Chart I-3Fractal Analysis Works Very Well For Meme Stocks Fractal Analysis Works Very Well For Meme Stocks Fractal Analysis Works Very Well For Meme Stocks 7.  10th June: Long USD/HUF Achieved its 3 percent profit target, before continuing to a high-water mark of 7.6 percent (Chart I-4). Chart I-4HUF/USD Corrected By 7.6 Percent HUF/USD Corrected By 7.6 Percent HUF/USD Corrected By 7.6 Percent 8.  17th June: Long Nike vs. L’Oréal Achieved its 9 percent profit target, before continuing to a high-water mark of 31.3 percent (Chart I-5). Chart I-5L’Oréal Underperformed Nike By 31 Percent L'Oreal Underperformed Nike By 31 Percent L'Oreal Underperformed Nike By 31 Percent 9.  24th June: Short Corn vs. Wheat  Achieved its 12 percent profit target, before continuing to a high-water mark of 38.7 percent (Chart I-6). Chart I-6Corn Underperformed Wheat By 39 Percent Corn Underperformed Wheat By 39 Percent Corn Underperformed Wheat By 39 Percent 10.  1st July: Short US REITs vs. Utilities  Open, in profit, having reached a high-water mark of 3 percent (versus a 5 percent target). 11.  8th July: Short Marine Transport vs. Market Achieved its profit target of 16.5 percent. 12.  15th July: Short Lead vs. Platinum Hit its stop loss of 6.4 percent. 13.  15th July: Short Australia vs. Canada 30-year T-Bonds Expired flat. 14.  5th August: Short Tin vs. Platinum Open, in loss, albeit having reached a high-water mark of 9.3 percent (versus a 16.5 percent target). 15.  12th August: Long MSCI Hong Kong vs. MSCI World Open, in loss. 16.  12th August: Long New Zealand vs. Netherlands Open, in loss. 17.  19th August: Short India vs. China Open, in loss (Chart I-7). Chart I-7The Outperformance Of India Versus China Is Fractally Fragile The Outperformance Of India Versus China Is Fractally Fragile The Outperformance Of India Versus China Is Fractally Fragile 18.  26th August: Short Sugar vs. Soybeans Open, in loss. 19.  2nd September: Short Aluminum vs. Gold Open, in loss (Chart I-8). Chart I-8The Outperformance Of Base Metals Versus Precious Metals Is Fractally Fragile The Outperformance Of Base Metals Versus Precious Metals Is Fractally Fragile The Outperformance Of Base Metals Versus Precious Metals Is Fractally Fragile 20.  9th September: Short US Medical Equipment vs. Healthcare Services Open, in profit. The 9 Unstructured Trades 1.  10th June: Short ZAR/USD ZAR/USD subsequently corrected by 12 percent. 2.  24th June: Short Copper Copper’s rally subsequently exhausted. 3.  1st July: Short MSCI ACWI vs. 30-year T-bond The rally in stocks versus bonds has subsequently exhausted (Chart of the Week). 4.  8th July: Short BRL/COP BRL/COP subsequently corrected by 4 percent. 5.  8th July: Short Saudi Tadawul All-Share vs. FTSE Malaysia All Share KLCI The rally in Saudi Arabian equities versus Malaysian equities subsequently exhausted. 6.  12th August: Long NOK/GBP        NOK/GBP has subsequently rallied by 3 percent. 7.  26th August: Short Hungary vs. EM Hungary’s outperformance is losing steam. 8.  26th August: Short USD/PLN USD/PLN subsequently corrected by 3 percent. 9.  2nd September: Short Trade Weighted US Dollar Index The dollar rally is meeting near-term resistance.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Mohamed El Shennawy Research Associate Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Canada has been a G10 leader in innoculating its population. This should allow economic activity to resume, boosting the CAD/USD. A cresting in COVID-19 infections should permit the Bank of Canada to reintroduce a hawkish bias in upcoming policy meetings. While the CAD/USD is likely to strengthen, it will underperform at the crosses. Feature The Canadian dollar has been rather resilient amid broad US dollar strength this year. While the DXY is up 2.8%, the loonie has still managed to outperform marginally. This is a remarkable feat, given that the Canadian dollar is very much a procyclical currency, and is usually held hostage by broad movements in the trade-weighted dollar. The vaccination campaign in Canada has been very successful, pinning the country as a leader in the G10. This has partly helped curtail the number of new infections from the Delta variant of COVID-19, allowing the economy to reopen faster than its peers (Chart I-1). This is important because there has been a very clear correlation between currency markets and vaccination rates. In general, the countries with higher vaccination rates (UK, Canada, US) have seen better currency performance than countries with the worst vaccination rates (Australia, Japan, Chart I-2). Chart I-1Vaccinations Have Worked For Canada Vaccinations Have Worked For Canada Vaccinations Have Worked For Canada Chart I-2CAD/USD An Outperformer This Year An Update On The Canadian Dollar An Update On The Canadian Dollar In our October 20, 2020 report, we suggested the loonie will hit 82 cents, a level around which it peaked this year. Going forward, the key question is whether Canada’s vaccination success will allow the loonie to eventually overtake these highs. The outlook hinges on two critical calls: What happens to natural resource prices, specifically crude oil; and the Bank of Canada’s (BoC) monetary policy stance relative to the Federal Reserve. Our bias is that a cresting in COVID-19 infections should allow the BoC to reintroduce a hawkish bias in upcoming policy meetings, while oil prices should stay well bid over a cyclical horizon. This will allow the loonie to strengthen in a 12-18 month timeframe. This said, we also expect the loonie to underperform other commodity currencies. Improving Domestic Conditions The latest GDP report out of Canada was surprisingly weak, but by most measures, this represents a temporary blip. Canada is adding jobs at the fastest pace in decades, an average of 102 thousand per month this year. This is leading to the quickest recovery in the unemployment rate on record (Chart I-3). A total of 18.9 million Canadians are currently employed, a smidgen away from the February 2020 high of 19.1 million. At the current pace of job additions, employment should overtake pre-pandemic levels during the next couple of job reports. There remains a sizeable deficit of jobs in service-producing industries (Chart I-4). This suggests that as mobility trends improve, job gains should accrue. The majority of job losses since the pandemic have been in the accommodation, food services, wholesale trade, and retail trade sectors. Chart I-3Canadians Are Quickly Getting Back ##br##To Work Canadians Are Quickly Getting Back To Work Canadians Are Quickly Getting Back To Work Chart I-4Pent Up Recovery In Services Jobs Still Ahead of Us An Update On The Canadian Dollar An Update On The Canadian Dollar Strong employment growth has spurred an improvement in consumer demand. Consumer confidence is rebounding in Canada. Retail sales are robust, having handily overtaken pre-pandemic levels. Mortgage credit has also rebounded amidst low interest rates (Chart I-5).   Chart I-5Lower Rates Are Boosting Household Borrowing Lower Rates Are Boosting Household Borrowing Lower Rates Are Boosting Household Borrowing It is therefore no surprise that inflationary pressures have begun to surface in the Canadian economy. In the latest Business Outlook Survey, capacity pressures were at a decade high. Firms reported that shortages in skilled and specialized labor will persist. There are obviously fewer workers with the skills needed in a post-COVID-19 world, but government support schemes have also eaten up labor supply in traditionally fluid labor demand/supply sectors such as hospitality. Meanwhile, supply bottlenecks have also led to production constraints. This is beginning to show up in the key inflation prints to which the BoC pays attention (Chart I-6). Both the trimmed-mean and median CPI are well above the midpoint of the central bank’s 1%-3% target. While the BoC maintains that some upward pressure on inflation is due to temporary factors, the Canadian unemployment rate is declining faster than that in the US, giving scope for the BoC to normalize policy before the Fed, and putting upward pressure on the CAD (Chart I-7). Asset purchases have already been cut in half from C$4 billion to C$2 billion a week. Chart I-6CPI Is Above Midpoint Of The BoC Target Range CPI Is Above Midpoint Of The BoC Target Range CPI Is Above Midpoint Of The BoC Target Range Chart I-7Canada Versus US ##br##Employment Canada Versus US Employment Canada Versus US Employment Meanwhile, house prices are rising quite strongly. The rise in prices has been very broad based, making housing unaffordable for most Canadians (Chart I-8). Residential investment represents almost 9% of Canadian GDP, a significant chunk of aggregate demand (Chart I-9). This suggests that if left unchecked, a housing market bust will deal a severe blow to the Canadian economy. Chart I-8Surging Home Prices A Headache For The BoC Surging Home Prices A Headache For The BoC Surging Home Prices A Headache For The BoC Chart I-9Canadian GDP Is Highly Exposed To Residential Housing Canadian GDP Is Highly Exposed To Residential Housing Canadian GDP Is Highly Exposed To Residential Housing In a nutshell, despite the BoC standing aside this week, the path of least resistance for Canada is towards tighter monetary policy. This dovetails with the recommendation from our Global Fixed Income Strategy colleagues, who recommend an underweight position in Canadian bonds. Elections And Fiscal Policy A snap federal election will be held in Canada on September 20. Prime Minister Justin Trudeau’s bet is that an astute handling of the pandemic, combined with massive fiscal stimulus, gives him a legitimate shot at a majority government. During his Throne Speech last year, he vowed to do “whatever it takes” to support people and businesses throughout the crisis. The rationale is to deliver on this promise going into 2022. The Conservatives have taken a slight lead over the Liberals in the opinion polls, even though a similar state of affairs did not secure them a victory back in the 2019 election (Chart I-10). In general, the Liberals are pushing for more fiscal spending, but are also focused on issues that Canadians care about, such as housing and climate change. The Conservatives, on the other hand, are focused on balancing the budget, which could jeopardize the nascent economic recovery that Canada currently enjoys. Historically, minority governments tend to be positive for the Canadian dollar, while majority governments generally nudge the loonie lower post-election (Chart I-11). In the current context, a Liberal minority will allow fiscal policy to stay easy, giving room for the BoC to curtail accommodative monetary conditions. Tighter monetary policy and easy fiscal policy tend to be positive for a currency in a Mundell-Fleming framework. Meanwhile, a Conservative minority might dial back a little on fiscal stimulus, but not by much due to political gridlock. Chart I-10Polling Ahead Of The ##br##Election An Update On The Canadian Dollar An Update On The Canadian Dollar Chart I-11Historically, The Market Likes A Minority Government Historically, The Market Likes A Minority Government Historically, The Market Likes A Minority Government In a nutshell, a Liberal minority is likely to be positive for the loonie. Should the Trudeau government win a majority, then fiscal policy might become much more profligate, which will boost inflation expectations in Canada and depress real rates. This will be negative for the loonie, unless the BoC aggressively tightens monetary policy. The Canadian Dollar And Crude Oil The above synopsis highlights that a key driver of the Canadian dollar is the BoC’s monetary policy stance, particularly vis-à-vis the Fed. The other critical variable is what happens to natural resource prices, specifically crude oil. The loonie has a strong correlation with the price of oil, chiefly the Western Canadian Select (WCS) blend (Chart I-12). Chart I-12The Loonie Tracks WCS Oil Prices The Loonie Tracks WCS Oil Prices The Loonie Tracks WCS Oil Prices Going forward, the path for oil prices will be highly dependent on the interplay between demand and supply, especially given the various waves of COVID-19. Oil demand tends to follow the ebbs and flows of the business cycle, with over 60% of global petroleum consumed by the transportation sector. A population under lockdown is negative for crude. Nonetheless, our commodity strategists expect oil prices to average $73 per barrel next year, around today’s levels for Brent, as supply dynamics adjust to the current paradigm. With the WCS blend trading at a discount to this price, there is room for upside surprises due to the following reasons: Investment in the Canadian oil sands has dropped tremendously, while the environmental efficiency (emissions per barrel) has been improving (Chart I-13). This has narrowed the spread between WCS and Brent, something that is likely to persist. Canadian producers have gained market share in the heavy crude oil market, on the back of a drop in Venezuelan production. Production cuts in Alberta have also helped mitigate the oversupply of heavy crude. Canadian oil exports remain near record highs, even though the US is rapidly becoming energy independent (Chart I-14). A lot of refining capacity in the US has been fine-tuned to handle the cheaper, heavier blend from Canada. Finally, pipeline capacity remains a major hurdle in Canada but it is slated to ease. The Trans Mountain Expansion project (590K additional barrels), connecting Alberta to the Westridge Marine Terminal and Chevron refinery in Burnaby, is slated to be competed by the end of 2022. Both the Liberals and the Conservatives support the project. This could narrow the discount between WCS and WTI crude oil. Chart I-13Will A Cleaner Oil Sector See A Bottom In Investments? An Update On The Canadian Dollar An Update On The Canadian Dollar Chart I-14The Energy Independent US Still Likes Canadian Oil The Energy Independent US Still Likes Canadian Oil The Energy Independent US Still Likes Canadian Oil Netting it all out, we expect crude oil prices to stay firm, in line with our colleagues at the Commodity and Energy Strategy team, and the Canadian discount not to widen by much. This should provide modest upside for the Canadian dollar, which has lagged the improvement in terms of trade (Chart I-15). It is remarkable that long-term portfolio flows into Canadian assets have started picking up, a sign of bargain hunting by international investors (Chart I-16). This should provide a modest tailwind to the Canadian dollar over the next 9-to-12 months. Chart I-15The Loonie Is Undervalued Based On Terms Of Trade The Loonie Is Undervalued Based On Terms Of Trade The Loonie Is Undervalued Based On Terms Of Trade Chart I-16Will The Rising Capital Inflow Provide A Support For The Loonie? Will The Rising Capital Inflow Provide A Support For The Loonie? Will The Rising Capital Inflow Provide A Support For The Loonie? Investment Implications We expect the CAD/USD to break above the recent 82-cent high, towards 85 and eventually 90 cents. The key catalysts are both favorable interest rates versus the US and a gradual recovery in WCS oil prices as global economic activity picks up. According to our fundamental models, the CAD is still very undervalued (Chart I-17). Chart I-17The Loonie Is Undervalued By 19% According To Our Model The Loonie Is Undervalued By 19% According To Our Model The Loonie Is Undervalued By 19% According To Our Model Chart I-18The NOK Will Lead The CAD ##br##For Now The NOK Will Lead The CAD For Now The NOK Will Lead The CAD For Now Relative to other commodity currencies, the CAD should lag the AUD as the green energy revolution exhibits staying power, which will benefit metals more than oil over the longer term. In the shorter term, Canadian crude is likely to remain trapped in the oil sands for now, while North Sea crude will face fewer transportation bottlenecks. This suggests that the path of least resistance for the CAD/NOK is down (Chart I-18). Rising oil prices are a terms-of-trade boost for oil exporters, but lead to demand destruction for oil importers. In general, a strategy for playing oil upside is to be long a basket of energy producers versus energy consumers. This suggests that the CAD has upside against the euro, the Indian rupee, and the Turkish lira. But given that the latter currencies are oversold, we will wait for a better buying opportunity.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

9 September 2021 at 10:00 EDT Emerging Markets Strategy/Webcast EM/China: See The Forest For The Trees 9 September 2021 at 21:00 EDT Emerging Markets Strategy/Webcast Emerging Asia: See The Forest For The Trees Highlights Structural inflation in India has abated noticeably since the mid-2010s. The cyclical inflation outlook is also benign (Chart 1). As such, the specter of inflation does not pose a material threat to this stock market. Indian stocks’ high valuation is a risk; yet this bourse’s structurally high premium relative to EM will likely continue as India’s earnings growth will stay strong and its volatility low. Investors should stay overweight Indian stocks in an EM equity portfolio, and local currency bonds in an EM domestic bond portfolio. Feature Chart 1India's Cyclical Inflation Outlook Is Benign Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? In a recent Emerging Markets Strategy report we showed that India stands out as the only country in Asia with rather high inflation. Indeed, core CPI in India, at about 6%, is higher than all other major EM and DM countries, save Turkey and Russia. The question is, with the economy re-opening, will Indian inflation rise further and thus derail the rally in Indian equities? Our research indicates that both the structural and cyclical inflation outlook for India remains benign. Our models for headline and core CPI both point to lower inflation in the coming months (Chart 1). As such, inflation is unlikely to pose any major threat to Indian assets in the foreseeable future. Investors should remain overweight Indian stocks in an EM equity portfolio. Fixed-income investors should also continue to overweight Indian local bonds in an EM domestic bond portfolio. Currency traders should favor the rupee versus its EM peers. Inflation Outlook: Structural … The first of the two principal drivers of India’s structural inflation trend is the country’s productivity. The stronger the productivity gains, the more contained has been its structural inflation.   The second major driver is broad money supply. The higher the money growth, the steeper have been inflationary pressures – especially during those periods when productivity gains were timid. Top panel of Chart 2 shows that up until the early-2000s, India’s average productivity gains used to be rather low: of the order of 3% annually. That period was also marked by very strong broad money growth: at times, the latter would rise to 20% annually (Chart 2, bottom panel). This growth was due to chronically high fiscal deficits that were monetized, coupled with intermittent surges in bank credit. Chart 2Slower Money Supply Amid Decent Productivity Led To A Structural Decline In Inflation Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? The consequence of persistently low productivity gains amid strong money supply was structurally high inflation, with occasional flare-ups well into double digits (Chart 2). Chart 3Steady Fall In Budget Deficits In Post-GFC Era Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? From the early 2000s, however, that dynamic began to change. A surge in capital spending in infrastructure and other productive capacity propelled India’s productivity trend up by several notches. In the past 15 years, the productivity growth rate has averaged around 6% a year; even though more recently that rate has slowed. In the post-GFC period, both major sources of money creation were stymied. First, successive Indian governments, regardless of political affiliation, adopted a rather tight fiscal policy. They reined in fiscal outlays substantially. Non-interest expenditures of the central government fell from 14% of GDP in 2010 down to 9% by 2019, just before the pandemic (Chart 3, top panel). As a result, during that period, fiscal and primary deficits narrowed significantly: from almost 7% of GDP to 3%, and from almost 4% of GDP to nearly zero, respectively (Chart 3, bottom panel). In addition, a myriad of reasons1 caused commercial bank credit to decelerate materially – from as high as 30% before the GFC to a mere 6% by 2019. The upshot of all this was a secular decline in broad money growth. That eventually led India’s inflationary pressures to decline structurally since the mid-2010s (Chart 2, bottom panel, above). Going forward, those major drivers (both productivity and money growth) will warrant a benign inflation outlook. The country has been continuing its high capital spending for over a decade now (around 30% to 35% of GDP, a rate second only to China). This year, India’s capital spending has already revived. Other corroborating indicators such as imports of capital goods have also recovered robustly. This indicates a new capex cycle is unfolding. Therefore, odds are that the productivity growth rate will stay decent. Prudent fiscal policy, on the other hand, will keep the money growth in check. Chart 4Low Wages Will Help Keep Inflation Subdued Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? Finally, wage pressures in India will also stay muted. In rural areas, both farm and non-farm nominal wages have been growing at a very slow pace; and are now flirting with outright contraction (Chart 4, top panel). Industrial wage expectations have also been tepid over the past several years (Chart 4, bottom panel). The broader picture is unlikely to change in the future as tens of millions of young people continue to join the work force every year. Taken together, these factors point to subdued structural inflation ahead. … And Cyclical The chance that inflation in India will flare up over a cyclical horizon (12 months) is also low: First, one of the major cyclical drivers of inflation in India, the government’s food procurement prices (called Minimum Support Price or MSP) have stayed low for the past several years. The announced MSPs for some of the crops for the 2021-22 agriculture season (July-June) have also shown no marked increase. This will surely help keep the wholesale prices for food in check, which, in turn, will keep a lid on consumer inflation expectations and ultimately on both headline and core consumer inflation (Chart 5). Second, the country’s money growth is also unlikely to witness an immediate, major boom. While the budget deficit has swelled over the past year or so, odds are that the government will revert to the tighter fiscal stance that prevailed over the past decade – as soon as the pandemic is brought under control. Chart 6 shows that government non-interest spending leads core CPI. Reduced expenditure growth will cap inflation. Chart 5Low Food Prices Will Keep A Lid On Inflation Expectations Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? Chart 6Slowing Fiscal Spending Will Cap Core Inflation Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? Chart 7Fuel Price Inflation Is Set To Decelerate Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? The other contributor to money growth, bank credit, is expected to accelerate; but its expansion will not be rapid as banks are still suffering from elevated NPLs. Third, fuel price inflation has likely peaked in India. Last year authorities imposed substantial new taxes on local gasoline and diesel prices, which artificially raised consumer inflation (Chart 7). Since there is little chance of new fuel levies this year and given that crude prices are unlikely to rise much from the current levels (which is EMS’s view), fuel inflation will subside materially next year. And as fuel costs often eventually spill into core inflation, this deceleration will help check the latter as well. Finally, given the massive negative output gap that opened up in the economy during the pandemic-related lockdowns, it will take a while before the economy overheats again. Odds are therefore low that India’s inflation will accelerate much in the coming months. Notably, our cyclical inflation models for both headline and core CPI – built using the drivers discussed above – also vouch for a modest decline in inflation (Chart 1, on page 1). Does Inflation Hurt Stocks? Currently, the Indian economy is not plagued by any major excesses and therefore has no major macro vulnerability. The only potential vulnerability that the economy and stock markets face stem from any possible rise in inflation. Notably, the primary driver of Indian stocks is economic growth and corporate profits. Historically, inflation (CPI) in low- and mid-single digits did not hurt Indian stocks. However, once inflation approached a high-single digit mark (usually 8%), a sell-off in stocks typically occurred. Chart 8 shows that, during India’s high-inflation era (from 1994 to 2013), every time CPI breached the 8% mark (the dotted line in the chart), stocks fell in absolute USD terms, or at the minimum, were weak. Chart 8Indian Stocks Faced Major Headwinds When Headline CPI Approached 8% Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? Chart 9In Recent Years Inflation Has Ceased To Be A Headwind For Indian Stocks Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? Interestingly, the above correlations have changed dramatically since 2014. The top panel of Chart 9 shows that core CPI does not have any steady correlation with stock prices anymore. And core PPI, in fact, has developed a strong positive correlation with stocks (Chart 9, bottom panel) – in complete reversal of the dynamics that prevailed in the previous two decades. The adverse impact of inflation on stock prices is via multiple compression, as rising interest rates lead to equity de-rating. What’s notable is that the multiple compressions do not begin as soon as a rate hike cycle commences. Rather, it takes a meaningful rise in interest rates before it starts to hurt multiples (Chart 10). Given the above, one can expect a material multiple compression only if inflation rises a few notches above the central bank’s target (Chart 11). The odds of that happening now are low. Therefore, policy rates will remain lower for longer, and stock valuations will remain at a higher level than usual. Chart 10Interest Rates Usually Needed To Rise Several Points Before Stock Multiple Compression Began Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? Chart 11India's Inflation Remains Within RBI Target Bands Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart?   Incidentally, thanks to material rate cuts, real interest rates paid by Indian firms – deflated by both core producer and core consumer prices – have plummeted. Lower real rates benefit the borrowers (i.e., non-financial listed companies) (Chart 12). The bottom line is that, with India’s inflation now being both structurally low (by Indian history) and cyclically tame, it is unlikely to be a cause of any major equity sell-off. Are Indian Equity Valuations Justified? With a trailing P/E of 31, and P/Book of 3.9, there is no doubt that Indian stocks are expensive. Yet, part of the multiple expansion in India, like most other DM countries, has been a direct outcome of a sharply lower policy rate, as discussed above. Incidentally, if one were to look at the cyclically adjusted valuation measures (CAPE), Indian markets appear to be only moderately expensive (Chart 13, top panel). Chart 12Lower Real Rates Boost Firms' Profits And Warrant Higher Stock Prices Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? Chart 13Cyclically-Adjuted P/E Ratio Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? Chart 14Relative Equity Multiples: India vs. EM Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? In terms of relative valuation vis-à-vis the rest of the EM, Indian stocks continue to command a high premium: around 90% in the case of P/E and P/Book multiples. (Chart 14). In terms of cyclically adjusted valuation (CAPE) relative to the EM, India also appears to be quite pricey (Chart 13, bottom panel). The bottom line is that Indian stocks are expensive; and that is a risk to this bourse. A pertinent question here is whether India still merits the structurally high premium that it has enjoyed over the years relative to its peers. Our answer is in the affirmative. One reason this bourse has continued to enjoy a high premium, especially since the mid-2000s, is because the growth of Indian corporate earnings has been superior to those of most other EM countries. But more importantly, the volatility of those earnings has been much lower than its peers. These strong, yet less volatile earnings are what investors have been willing to pay a premium for. Going forward, we see both traits remaining intact. Long-term growth in India will likely stay as one of the highest in the EM world. Earnings volatility is also unlikely to change anytime soon. The reason is, first, lower inflation going forward will entail relatively lower interest rate volatility, and therefore, lower business cycle / earnings volatility. Second, India’s currency volatility will also likely stay lower. Part of the reason is the near absence of foreign investors on government bonds in India. This has precluded India from suffering a major currency sell-off during global risk-off episodes – as few bond investors head for the exit. We discussed this and several other issues related to Indian bond markets and the rupee in much greater detail in our last report on India. Taken together, lower volatility in both local currency earnings and the exchange rate entails lower overall volatility for US dollar-denominated earnings. That will help Indian stocks’ premium to stay elevated beyond any short-term fluctuations. Inflation And The Rupee Chart 15The Rupee Strengthens When Relative Inflation In India Versus US Decelerates Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? The impact of inflation on the rupee is nuanced. It’s not the absolute level of India’s CPI or PPI that affects the rupee-dollar exchange rate; it’s the relative inflation between these two economies that does so. Chart 15 shows that the rupee usually strengthens versus the dollar when inflation in India falls relative to that of US (shown in inverted scale in the chart). These relative inflation dynamics could also provide insight into the exchange rate outlook. Chart 16 shows that the rupee is currently 10% cheaper when measured against what would be its “fair value” (Chart 16, bottom panel). The fair value has been derived from a regression analysis of the exchange rate on the manufacturers’ relative producer prices of the two countries. Investment Recommendations Indian stocks have decisively broken out both in absolute terms and relative to their EM counterparts (Chart 17). Notably, the outperformance is not just due to a sell-off in Chinese TMT stocks. It is even more impressive relative to the ‘mainstream EM’ bourses (i.e., EM excluding China, Taiwan and Korea). Given India’s relatively superior structural and cyclical backdrops, this outperformance should continue for a while (Chart 17, bottom two panels). Investors should stay overweight this bourse in an EM equity portfolio. Chart 16The Indian Rupee Is Now About 10% Below Its Fair Value Versus The US Dollar Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? Chart 17Indian Stocks' Breakout Is Decisive And The Relative Outperformance Is Broad-based Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? Chart 18Higher Carry And A Better Currency Outlook Will Lead To Indian Domestic Bonds' Outperformance Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? The medium-term outlook for the rupee is also positive. The currency is cheap and competitive –an added incentive for both foreign direct investors and portfolio investors. Finally, Indian domestic bonds offer value – both relative to their EM peers and the US treasuries. 10-year government bonds yields, at 6.2%, offer an enticing 480 basis points over similar duration US Treasuries. Given the sanguine rupee and inflation outlooks, Indian bonds will likely continue to outperform EM local bonds (Chart 18). Investors should stay on with our recommendation of overweighting India in an EM local currency bond portfolio. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1 The reasons include a surge in bank NPLs, lack of bankable projects, a kind of policy paralysis resulting in delay in various regulatory clearances for capital projects etc.

Highlights A trio of ECB hawks raised the prospect of an ECB taper. In the past, the current set of economic conditions in the Euro Area would have prompted the ECB to tighten policy. A potential economic deceleration this fall, the transitory nature of the Eurozone’s inflation spike, and the level of inflation expectation in the region limit the ECB’s ability to taper this week. We expect a one-off return to the pre-Q2 2021 level of asset purchases couched in a very dovish forward guidance. Peripheral bonds and European corporate bonds will outperform German and other core European paper. Stay long European curve steepeners, while buying US curve flatteners. Overweight German Bunds versus US Treasury Notes, on a USD-hedged basis. European productivity will remain structurally hampered compared to that of the US. US real bond yields will rise relative to Europe. Feature Last week, a chorus of ECB Governing Council members raised the idea among investors that the central bank may soon begin to taper its asset purchases, which prompted Bund yields to hit -0.35% on Wednesday. Robert Holzmann of Austria, Klaas Knot of the Netherlands, and Jens Weidmann of Germany all suggested that monetary conditions were too accommodative for the Eurozone and that the ECB needed to remedy this problem. The complaints of this hawkish trio reflect the current environment. In August, the Eurozone HICP reached a 3% annual rate while the preliminary estimate for core CPI clicked in at 1.6%. Meanwhile, July PPI rose to 12.1%. Such robust inflation readings are at odds with the low level of interest rates in the Eurozone, where the yields on European IG credit and 10-year Italian BTPs average a paltry 0.45% (Chart 1). Beyond the level of inflation, its broad geographic nature is an additional source of concern. Headline CPI is accelerating across all the bloc’s nations, and it stands above 2% in 82% of the members’ states. Historically, this kind of inflationary backdrop resulted in either higher interest rates or some tapering of asset purchases, especially when economic activity was also improving in the Eurozone (Chart 2). Chart 1A Gap For The Hawks A Gap For The Hawks A Gap For The Hawks Chart 2In The Past, The ECB Would Have Tightened In The Past, The ECB Would Have Tightened In The Past, The ECB Would Have Tightened Will the ECB listen to its most hawkish members and follow its past script? We do not believe that the Governing Council is about to start a sustained period of decreased bond buying, even if a return to the pre-Q2 2021 pace of buying is likely this fall. Thus, a dovish taper is the most likely outcome of this week’s meeting. The ECB’s Three Constraints The outlook for growth, the temporary nature of the current spike in European inflation, and the low-level of Euro Area inflation expectations limit the ECB’s ability to remove monetary accommodation. First, European economic growth is at its apex and will decelerate over the next six months. Currently, domestic activity as approximated by the Services PMI stands at near a 15-year high of almost 60. Moreover, despite the spike in COVD-19 cases linked to the Delta variant, mobility remains very robust. If anything, the decline in cases in Spain and France should lead to further improvement in mobility (Chart 3). Nonetheless, the recent fall in consumer confidence and the recent US experience, which the European economy usually follows, point to a deceleration in the Services PMI. The case for a decline in manufacturing activity is more pronounced. The European manufacturing sector responds strongly to the fluctuation of the global industrial sector. US consumer spending on durable goods is 21% above its pre-pandemic trend and is beginning to weaken as pent-up demand for such products has been satiated and households shift their spending back toward services. Moreover, the Chinese credit cycle, which leads the Eurozone Manufacturing PMI by nine months, indicates a greater deceleration in the coming quarters, because European exports to China will slow (Chart 4, top and middle panels). In response to these two forces, Europe will not diverge from the deterioration in our Global Activity Nowcast (Chart 4, bottom panel). Chart 3So Far, No Delta Impact So Far, No Delta Impact So Far, No Delta Impact Chart 4The Coming Manufacturing Slowdown The Coming Manufacturing Slowdown The Coming Manufacturing Slowdown Chart 5Abnormal Goods Inflation Abnormal Goods Inflation Abnormal Goods Inflation Second, most evidence still suggests that the current inflation increase will be temporary, despite its violence. To begin with, the spike in inflation remains consigned to the goods sectors, while services inflation stands at 1.1%, in line with the experience of the past 10 years (Chart 5). Even within goods prices, the spike in CPI is limited to sectors facing bottlenecks or linked closely to commodity and shipping prices. As Chart 6 illustrates, the categories experiencing abnormal inflation are directly related to higher energy prices, cars, complex machinery, hotels, and fresh food. Meanwhile, underlying inflation as estimated by our trimmed-mean CPI measure is bottoming, but remains at a very low 0.2% annual rate (Chart 7). Chart 6Inflation Remains A Commodity and Bottleneck Story The ECB Taper Dilemma The ECB Taper Dilemma In the same vein, the surge in Selling Price Expectations of the European Commission Business Survey is a function of commodity inflation (Chart 8). In other words, companies feel they can increase their selling prices, because natural resource prices have spiked. However, inflation across many commodities is currently peaking, which suggests that Selling Price Expectations will soon do so as well. Moreover, this process indicates that headline inflation should hit its summit by year end, because Selling Price Expectations are a coincident indicator of inflation (Chart 8, bottom panel). Chart 7Narrow Inflation Narrow Inflation Narrow Inflation Chart 8Rising Selling Prices And Commodities Rising Selling Prices And Commodities Rising Selling Prices And Commodities A wage-inflation spiral also remains far away. Historically, rapidly accelerating wage growth marked periods of elevated inflation. Despite current fears, such a development is not taking place in the Eurozone. For the whole bloc, negotiated wages are growing at a modest 1.7% annual rate (Chart 9). Even in Germany, negotiated wages are only increasing at the same rate. While some labor shortages have been reported, total hours worked remain below the equilibrium level based on the Euro Area demographic profile (Chart 9, bottom panel). Furthermore, the past ten years reveal that labor shortages only caused stronger salary growth with a multi-year delay. Third, the market doubts the credibility of the ECB when it comes to achieving a 2% inflation target. So far, survey-based inflation expectations remain below 2% at all tenors (Chart 10, top panel). The same is true of market-based measures, which are still lower than the levels that prevailed before the sovereign debt crisis of the past decade (Chart 10, bottom panel). Chart 9No Wages/Inflation Spiral No Wages/Inflation Spiral No Wages/Inflation Spiral Chart 10The ECB's Inflation Mandate Is Not Yet Credible The ECB's Inflation Mandate Is Not Yet Credible The ECB's Inflation Mandate Is Not Yet Credible Bottom Line: Risks to growth over the winter, the transitory nature of the recent inflation shock, and inflation expectations that remain significantly below target are constraints limitating the ability of the ECB to announce a true tapering of its asset purchases this Thursday. A Dovish Taper? Considering the current set of conditions prevailing in the Eurozone, we expect the ECB to announce a return to the pace of asset purchases that existed prior to Q2 2021. However, the Governing Council (GC) will go out of its way to issue clear forward guidance that strongly indicates this is not the beginning of a taper campaign. Instead, the GC will hint at the transmutation of a large proportion of the PEPP monthly buying into the PSPP after March 2022. The inflation target change enacted at the conclusion of the ECB’s strategy review in July limits the central bank’s ability to go back to its old rule book and tighten policy at the first hint of inflation. First, the ECB must believe that inflation will overshoot 2% on a durable basis, which will necessitate an upgrade to its long-term inflation forecast above the target. Too many members of the GC do not share this view, which makes it unlikely that inflation forecasts will rise this much this week. Moreover, inflation expectations are also too low to warn of a meaningful change in the behavior of European economic agents, especially if the current spike in inflation proves to be transitory. Another problem for the ECB is the Fed. If the ECB were to announce a durable tapering of its asset purchase this week, it would be doing so ahead of the Fed. The GC fears that this action would put considerable upward pressure on EUR/USD, which would create a grave deflationary tendency in the Eurozone (Chart 11). Despite these shackles, the ECB will also acknowledge that the current emergency pace of asset purchases is no longer warranted. Starting Q2 2021, the ECB increased its average monthly purchase from EUR80 billion in the August 2020 to March 2021 period, to EUR95 billion since April 2021 (Chart 12). However, these increased purchases followed a 0.1% GDP contraction in Q1 in the wake of a spike in COVID-19 cases and deaths, which prompted a large reduction in mobility. Moreover, the larger bond buying also followed large increases in bond yields across the main economies of the continent, a rise which, if it had been left unchecked, would have exacerbated the economic malaise. Chart 11The ECB Fears A Strong Euro The ECB Fears A Strong Euro The ECB Fears A Strong Euro Chart 12Normalizing Purchases The ECB Taper Dilemma The ECB Taper Dilemma None of these factors are still present. The increasing level of vaccination has dulled the economic impact of the third wave of infection. The economy is expanding robustly and, even if it slows in the months ahead, growth will remain well above trend. Crucially, financial conditions are much more generous than in the first half of the year, with a euro that trades 4% below its January peak and with yields in the bloc’s four largest economies 25 to 45 basis points below their spring peaks. Bottom Line: In response to the aforementioned crosscurrents, we anticipate the ECB to announce a return of its monthly asset purchases to the level that prevailed in the August 2020 to March 2021 period. However, the GC will also clearly indicate, as it did last March, that this policy shift is a one-off, and that investors must not anticipate any further curtailment of asset purchases over the next six months. To reinforce this guidance, we expect the ECB’s inflation forecast to show a return of HICP below 2% by the end of 2023. The GC might also hint at the roll-over of the PEPP program into the PSPP after March 2022. Investment Implications An ECB that conducts a dovish taper on Thursday will support our main fixed-income themes in Europe. First, it will remain a tailwind behind an overweight position in peripheral government bonds versus German bonds. The combination of continued purchases of EUR80 billion a month of bonds over the foreseeable future, above-trend growth, and the fiscal risk mutualization from the NGEU and REACT EU programs means that investors can continue to safely pocket the yield premium offered by BTPs and BONOs. Moreover, our geopolitical strategists expect a left-wing coalition to govern Germany after the September 26 election, which will limit the pressures to tighten budgets in the periphery over the coming years. Chart 13European Corporates Remain Attractive European Corporates Remain Attractive European Corporates Remain Attractive Second, continued liquidity injections by the ECB are also consistent with a preference for European corporate credit over government securities, especially in Germany, France, and the Netherlands. European breakeven spreads for IG and high-yield debts are in the 18th and 13th percentile rank, respectively (Chart 13). Easy monetary conditions and above-trend growth will facilitate further yield-seeking behavior in the Eurozone. This process will allow these securities to offer continued excess returns over at least the next six months. Third, we hold on to our box trade of being long Eurozone curve steepeners and long US curve flatteners. In our base case scenario, the Fed will soon indicate the beginning of its tapering campaign and will be on track to raise rates by early 2023, while the ECB will still conduct a very easy monetary policy. In this context, the US yield curve will flatten relative to the European one, driven by a more rapid increase at the short end of the curve. Chart 14Still Favor Bunds Over T-Notes The ECB Taper Dilemma The ECB Taper Dilemma Finally, in a global bond portfolio, it still makes sense to overweight German Bunds (hedged into USD) relative to US Treasury Notes. Bunds display a significantly lower yield beta than their US counterparts, which creates an attractive defensive feature in an environment in which global yields are likely to rise. Moreover, as the model in Chart 14 highlights, the US/German 10-year yield spread is roughly 50bps below an equilibrium estimate based on relative inflation, unemployment and policy rates, and the size of the Fed and ECB balance sheets. US inflation is likely to remain perkier than that of Europe over the coming quarters, and the US unemployment rate will decline faster as well. Additionally, in the unlikely scenario that the Fed declines to taper its purchases this year, but the ECB does, inflation expectations will rise in the US relative to the Euro Area, which will put upward pressure on yield spreads. Bottom Line: A dovish ECB taper, whereby the GC executes a one-off adjustment in asset purchases with an easy forward guidance, will support our overweight in peripheral government bonds relative to bunds, our preference for European corporate credit relative to government paper, our Europe / US box trade, and BCA’s underweight in Treasurys relative to Bunds. Europe’s Productivity Deficit Is Not Over Compared to the US, GDP growth in the Eurozone has been trending lower since the introduction of the euro in 1999. While a weaker demographic profile has hurt Europe, so has slower productivity growth. Going forward, the gap between European and US productivity growth will somewhat narrow compared to last decade, but it will still favor the US. The cross-Atlantic gap in output per hour growth between has a cyclical and a structural component. The cyclical element is set to ebb. Last decade, the Eurozone suffered a double-dip recession, as the European sovereign debt crisis raged. As a result, capex and debt accumulation in Europe lagged that of the US, which hurt demand and, thus, output-per-hour worked (Chart 15, top panel). Going forward, the European debt crisis has been addressed, the ECB has demonstrated its willingness to do “whatever it takes” to support the monetary union and both the European Commission and the German government have thrown their full weight behind the integrity of Europe, even if it means bailing out their profligate southern neighbors. Despite this positive, some structural headwinds will continue to handicap European productivity. Since 2000, total factor productivity in the major Euro Area economies has lagged that of the US (Chart 15, bottom panel). Many factors suggest this will not change: Chart 15Europe’s Productivity Deficit The ECB Taper Dilemma The ECB Taper Dilemma The Eurozone’s big four economies continue to linger well behind the US in terms of ICT investment, which in recent decades has been a crucial driver of productivity. R&D represents a significantly lower share of GDP in the Eurozone than it does in the US (Chart 16). More investment in intangible assets has been linked to higher productivity growth. Additionally, Ortega-Argilés et al. have shown that EU companies do not convert R&D into productivity gains as well as US businesses do, because they generate lower return on investments.1 Confirming this insight, an empirical study using microdata on R&D spending for EU and US firms highlights that both R&D intensity and productivity are lower for EU firms than for their US counterparts.2 For a 10% increase in R&D intensity, US businesses generated a 2.7% increase in productivity, while EU firms enjoyed a much smaller 1% gain. The gap is larger for high-tech companies, where the same rise in R&D intensity produced a 3.3% productivity gain in the US, but only a 1.2% one in the EU. The European economy remains much more fragmented than that of the US, and the greater prevalence of small firms in the Euro Area results in a less efficient use of the human and capital stocks. Finally, the low rate of investments in recent years has caused the European capital stock to age faster than that of the US. An older pool of assets is further away from the technological frontier and thus weighs on TFP and overall labor productivity (Chart 17). Chart 16Lagging European R&D The ECB Taper Dilemma The ECB Taper Dilemma Chart 17The Ageing European Capital Stock The Ageing European Capital Stock The Ageing European Capital Stock Notwithstanding cyclical fluctuations related to the global debt cycle, the Eurozone profit margins and RoEs will not converge meaningfully toward US levels on a structural basis because of this productivity problem. Europe’s lower industry concentration ratios, lower markups, and greater share of output absorbed by wages will only accentuate this problem. Chart 18TIPS Yields Vs Real Bunds TIPS Yields Vs Real Bunds TIPS Yields Vs Real Bunds As a result of the lower trend growth rate caused by lower productivity and its inferior return on invested capital, Europe’s R-Star is unlikely to catch up meaningfully to US levels. Consequently, the gap between US and Germany real rates will remain wide and will drive the increase in US yields relative to those of Germany, as the Fed begins to tighten policy while the ECB stands pat (Chart 18). Bottom Line: Europe’s productivity deficit is not the only consequence of last decade’s sovereign debt crisis. Thus, the Euro Area’s potential GDP growth and return on invested capital will lingers behind those of the US. As a corollary, the Eurozone’s R-star is well below that of the US. Hence, we expect higher real rates to drive the increase in US yields over Germany as the Fed tightens policy ahead of the ECB.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes 1R. Ortega-Argilés, M. Piva, and M. Vivarelli, “The Transatlantic Productivity Gap: Is R&D the Main Culprit?,” Canadian Journal of Economics 47.4 (2014), pp. 1342-71. 2D. Castellani, M. Piva, T. Schubert, and M. Vivarelli, “The Productivity Impact of R&D Investment: A Comparison between the EU and the US,” IZA Discussion Papers 9937 (2016). Tactical Recommendations The ECB Taper Dilemma The ECB Taper Dilemma Cyclical Recommendations The ECB Taper Dilemma The ECB Taper Dilemma Structural Recommendations The ECB Taper Dilemma The ECB Taper Dilemma Closed Trades The ECB Taper Dilemma The ECB Taper Dilemma Currency Performance Fixed Income Performance Equity Performance

Highlights A lot of pessimism is embedded in the Aussie dollar, making it a potent candidate for a powerful mean-reversion rally. The key catalyst will be a reversal in COVID-19 infection rates which are holding the Aussie economy hostage. Marginally, there is good news on that front. On a terms-of-trade basis, the Australian dollar is very cheap. Falling commodity prices are a handicap, but the valuation margin of safety makes the AUD a safer bet on a reflationary theme. At the crosses, we are already long AUD/NZD, but AUD/JPY and AUD/CHF should be winners in the next six-to-nine months. Feature The Australian economy was on a strong recovery path before a resurgence in Covid-19 infections handicapped this improvement. Australian GDP recovered to pre-pandemic levels in Q1 and the latest Q2 release suggests the Australian economy was on the path to achieve escape velocity (Chart I-1). Chart I-1The Aussie Economy Has Recovered Is The Australian Dollar A Buy? Is The Australian Dollar A Buy? The bounce in the Australian dollar has mirrored the improvement in the economy. From a low of 55 cents in early 2020, the Aussie rose over 40% to a high of 80 cents in earlier this year. However, more recently, there has been a strong correction in the AUD, reflecting both domestic and global concerns about growth. The key question for investors is whether the decline in the Aussie represents an excessive move or heralds a more malignant outcome for the currency. In our view, if risk sentiment stays ebullient, then the Australian dollar will be a potent candidate for a coiled-spring rebound. However, on the downside, there has already been a lot of bad news priced into the Aussie, making the reward/risk picture more favorable (Chart I-2). The Delta Variant The Delta variant of Covid-19 is ravaging across most countries, and the Australian economy has been particularly susceptible. While in absolute terms, Australia’s infection rates are faring better than most developed markets, the momentum of the latest wave has knocked down a nascent boom in Aussie economic conditions (Chart I-3). Chart I-2The Aussie And Global Stocks Have Diverged The Aussie And Global Stocks Have Diverged The Aussie And Global Stocks Have Diverged Chart I-3The Delta Variant Is Ravaging Australia The Delta Variant Is Ravaging Australia The Delta Variant Is Ravaging Australia   Sydney is now entering its third month of lockdown, and the state of Victoria has just extended mobility restrictions for another three weeks. However, the population is getting vaccinated quickly, with almost 40% having received two jabs. Should the current trajectory of vaccinations continue, Australia could fully lift restrictions on its citizens by the fourth quarter. It is noteworthy that Australia has been here before, and during the last two waves in March and August of last year, the country was able to weather the storm with lower vaccination rates. As such, the latest wave should prove transient, allowing economic conditions to normalize after a weak Q3. AUD And The Global Cycle As a premier commodity producer, the Australian economy is intricately linked to the global economic cycle, especially what happens in China. Chart I-4 shows that both the Caixin and National Bureau of Statistics manufacturing PMIs in China lead Australian manufacturing activity. With the majority of Australian exports going to China, it makes the Aussie economy very sensitive to Chinese domestic conditions. Our China Investment Strategy colleagues believe that fiscal policy will be eased going forward, while the tightening in monetary conditions is past its peak, especially in the face of Covid-19 and floods ravaging China. Chinese bond yields have already dropped, reflecting an easing in domestic financial conditions. With the Chinese bond market becoming more and more liberalized, it is becoming a good proxy for monetary conditions in China. As such, the trend in bond yields has tended to lead Chinese imports. This suggests that Aussie exports should remain robust in the coming months (Chart I-5). Chart I-4How Long Will The China Slowdown Last? How Long Will The China Slowdown Last? How Long Will The China Slowdown Last? Chart I-5Easing Financial Conditions In China Easing Financial Conditions In China Easing Financial Conditions In China Chart I-6Chinese Policy And The AUD Chinese Policy And The AUD Chinese Policy And The AUD A similar pattern to March of last year might be repeated this year, should Covid-19 fears remain persistent. China led the pack vis-à-vis other countries by injecting stimulus much earlier on, which helped ease domestic financial conditions. As a result, imports of key raw materials such as copper, iron ore, steel, and crude oil rose higher, helping Australian export volumes. This time around, excess money supply in China is rebounding from extremely depressed levels. While the near-term trajectory suggests some more volatility for the Aussie, the cyclical outlook is improving (Chart I-6). A Terms-Of-Trade Boom Despite a slowing Chinese economy, commodity prices remain resilient. Australian terms-of-trade have outperformed that of other commodity-producing nations (Chart I-7). Australia is relatively competitive in supplying the types of raw materials that China needs and wants. For example, Australian exporters produce higher-grade ore, which is more expensive, pollutes less, and is in high demand in China. Similarly, Australia is a big exporter of liquefied natural gas, whose prices have been soaring in recent months. Going forward, Australia’s terms-of-trade improvement is likely to continue. China’s clear energy policy shift away from coal and towards natural gas will buffet LNG export volumes. Also, given that reducing, if not outright eliminating, pollution is a long-term strategic goal in China, this will provide a multi-year tailwind for both cleaner ore and gas exports. The pattern of an improving terms-of-trade picture but deteriorating domestic fundamentals has placed the AUD in a tug-of-war scenario. One of the key primary drivers of the AUD exchange rate has been the basic balance, the sum of the current account and long-term capital flows. The basic balance is making secular highs, suggesting the AUD should be above its 2011 peak near 1.10 (Chart I-8). This suggests that room for mean reversion is substantive. Chart I-7A Boom In Aussie Terms Of Trade A Boom In Aussie Terms Of Trade A Boom In Aussie Terms Of Trade Chart I-8The AUD Has Lagged Terms Of Trade The AUD Has Lagged Terms Of Trade The AUD Has Lagged Terms Of Trade   In a nutshell, Australia sports the best improvement in both trade and current account balances in the G10 over the last few years (Chart I-9). Investment in projects in the resource space are now bearing fruit, easing the external funding requirement. This has ended the 35-year-long deficit in the current account. A rising current account naturally increases the demand for the Australian dollar, which buffets the currency. Domestic Considerations And The RBA By most accounts, the Reserve Bank of Australia (RBA) has achieved its objectives. Most measures of inflation are near target, unemployment is close to NAIRU, and wages have bottomed and are marginally inflecting higher (Chart I-10). The next batch of numbers coming out of Australia will likely be weak, as the RBA will outline next week, but any weakness in the Aussie will represent a buying opportunity. Chart I-9A Record Surplus In Australias Basic Balance A Record Surplus In Australias Basic Balance A Record Surplus In Australias Basic Balance Chart I-10Fundamentals In The Aussie Economy Are On The Mend Fundamentals In The Aussie Economy Are On The Mend Fundamentals In The Aussie Economy Are On The Mend   Taking a step back, the recovery in the Australian jobs market has been spectacular. Unemployment is at 4.6%, very close to NAIRU. Meanwhile, the participation rate has recovered to pre-pandemic levels as pandemic-aid schemes wear off. The Liberal-National coalition government was very proactive, especially with the “Job Seeker” and “Job Keeper” schemes, providing a valuable cushion for domestic economic conditions. With a very low government debt burden, there is obviously scope to expand the scheme further should conditions dictate. House prices are rebounding in a trajectory the RBA likes to see, driven by credit from owner-occupied housing (Chart I-11). This suggests that at least at the margin, house prices are being driven by domestic demand/supply fundamentals. The key takeaway is that relative to its commodity-currency peers, Australia is well along its house-price adjustment path, having been one of the first developed market countries to introduce macroprudential measures. This suggests that beyond the very near term, emergency policy settings are no longer appropriate for the Aussie economy. The RBA is likely to taper asset purchases from $A5 billion a week, to $A4 billion as telegraphed (Chart I-12), but there is scope for a hawkish surprise at next week’s meeting. Markets are already discounting an increasing path for interest rates starting next year, but not so relative to the US. This could change as the RBA responds to improving economic conditions. Chart I-11A Sustainable Increase In House Prices A Sustainable Increase In House Prices A Sustainable Increase In House Prices Chart I-12The RBA Could Unexpectedly Change Policy Settings The RBA Could Unexpectedly Change Policy Settings The RBA Could Unexpectedly Change Policy Settings   Meanwhile, real rates are already more attractive in Australia compared to the US, especially at the short end of the curve. A Valuation Cushion The cherry on the cake for the Aussie is that it is cheap according to most of our valuation measures. As we highlighted in a recent report, trading the Aussie on a valuation basis alone has added significant alpha over the last several years. One of our favorite metrics for the Australian dollar’s fair value is its real effective exchange rate relative to its terms of trade. On this basis, the Aussie dollar is cheap by about 20% (Chart I-13). Our intermediate-term timing models, published a fortnight ago, shows the Australian dollar as 9% cheap, or near one standard deviation below the mean. Our purchasing power parity (PPP) models point to a slight undervaluation in the Australian dollar. It also helps that speculators are very short the Aussie, which is bullish from a contrarian perspective (Chart I-14). Chart I-13The AUD Is Cheap The AUD Is Cheap The AUD Is Cheap Chart I-14Investors Are Short The AUD Investors Are Short The AUD Investors Are Short The AUD   How Should Investors Position Themselves? AUD/USD will close its undervaluation gap in the medium-to-long term, as happens with most currencies. This will lift the AUD towards 85 cents. In the short term, long AUD/NZD and long AUD/JPY remain attractive bets for those not willing to take directional dollar bets. In our portfolio, we are already long AUD/NZD for the following reasons: The markets have already priced in a very hawkish RBNZ and a very dovish RBA (Chart I-15). Our bias is that as Covid-19 proves to be a global problem, there will be a renormalization in interest rate expectations. Terms of trade in Australia will continue to outperform that of New Zealand. AUD/NZD and relative terms of trade tend to move together (Chart I-16). Chart I-15AUD/NZD Remains A Buy AUD/NZD Remains A Buy AUD/NZD Remains A Buy Chart I-16Terms Of Trade And AUD/NZD Terms Of Trade And AUD/NZD Terms Of Trade And AUD/NZD   AUD/NZD is very cheap on a historical basis. This level of valuation has provided strong support in the past (Chart I-17). Meanwhile, the Australian yield curve has steepened, albeit with some recent flattening, but banks have still underperformed the improvement in the interest rate term structure (Chart I-18). A bottoming economy will benefit banks, which make up almost 35% of the Australian MSCI index, and thus there could be renewed foreign inflows. Chart I-17AUD/NZD Is Cheap AUD/NZD Is Cheap AUD/NZD Is Cheap Chart I-18Stay Long Aussie Banks Stay Long Aussie Banks Stay Long Aussie Banks   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Data out of the US this week was mixed: The payrolls report was well below expectations. Non-farm payrolls came in at 235K, versus an expected increase of 733K. Both the labor force participation rate and average hourly earnings remained steady at 61.7% and 4.3% year-on-year, respectively. The ISM report was robust for August. The manufacturing PMI improved from 59.5 to 59.9. New orders rose from 64.9 to 66.7 The PCE deflator came it at 3.6% year-on-year, in line with estimates. The US dollar DXY index fell this week. The weak payrolls report reiterates the fact that risks from tighter monetary policy in the US are overstated. This was the conclusion from the Jackson Hole meeting last week, that saw a drop in both the US dollar and bond yields. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Euro area data remains robust: Core CPI came in at 1.6% year-on-year in August. Headline CPI was a more robust 3%. The final read from the Markit manufacturing PMI remained at a robust 61.4 in August. The services PMI did decline from 59.5 to 59. Retail sales increased by a robust 3.1% in July. The euro rose by almost 1% this week. Covid-19 cases seem to be rolling over in Europe while firing in other nations. This will increase support for the euro, as well as expectations the ECB could dial back monetary accommodation. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 The Euro Dance: One Step Back, Two Steps Forward - April 2, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent Japanese data has been on the strong side: Retail sales rose 2.4% year-on-year in July. The employment report was strong. The unemployment rate fell to 2.85 and the job-to-applicant ratio rose from 1.13 to 1.15. Housing starts rose 10% year-on-year in July. Capital spending for Q2 was 5.3% year-on-year, well above expectations. The yen was flat against the dollar this week. In an environment where global risk is ebullient, the yen tends to underperform other pro-cyclical currencies. This was very evident this week. Report Links: The Case For Japan - June 11, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Data out of the UK this week was encouraging: The Lloyds business barometer improved from 30 to 36. Nationwide home prices rose 11% year-on-year in August. The Markit services PMI was steady at 55 in August. The pound rose by 0.6% this week. UK will continue to benefit from higher vaccination rates, compared to the rest of the G10. That said, other pro-cyclical currencies, such as the AUD, could benefit from a robust vaccination campaign, outperforming GBP. Report Links: Why Are UK Interest Rates Still So Low? - March 10, 2021 Portfolio And Model Review - February 5, 2021 Thoughts On The British Pound - December 18, 2020 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data is slated to slow, but the recent numbers have been encouraging: Private sector credit rose 4% year-on-year in August. Q2 GDP was a robust 9.6% year-on-year. Exports rose 5% month-on-month in July. The AUD was the best-performing currency this week, rising almost 2%. We discuss the AUD at length in this week’s front section. Our bias is that the AUD will benefit from easing monetary policy in China and high commodity prices. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The was scant data out of New Zealand this week: Building permits rose 2.1% month-on-month in July. CoreLogic house prices are inflecting 27% year-on-year in August. ANZ Business confidence slipped from -3.8 to -14.2 in August. The NZD was up almost 2% this week. We like the NZD cyclically, but our bias is that hawkish expectations from the RBNZ could be watered down, which could make the kiwi lag other commodity currencies like the Aussie. Report Links: How High Can The Kiwi Rise? - April 30, 2021 Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Data out of Canada this week has been weak: Q2 GDP missed expectations, falling 1.1% versus an expected increase of 2.5%. The Markit manufacturing PMI increased from 56.2 to 57.2 in August. Net trade deteriorated in July, but Canada is still booking a C$0.8bn surplus. The CAD rose by 0.7% this week. The backdrop for the loonie is positive as the Bank of Canada continues to taper asset purchases and remains on a path to increase interest rates. The upcoming election could also usher in more fiscal stimulus for Canada. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 The Outlook For The Canadian Dollar - October 9, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 The data out of Switzerland this week was weak: The KOF indicator declined from 129.8 to 113.5 in August. This was well below expectations. CPI in August was slightly above expectations at 0.4% year-on-year for the core and 0.9% for headline. GDP for Q2 was in line with expectations, at 1.8% quarter-on-quarter. The Swiss franc was flat this week. The franc will continue to benefit from rolling bouts of volatility, but at the margin, it will lag the bounce in other currencies as global risk sentiment stays ebullient. Report Links: An Update On The Swiss Franc - April 9, 2021 Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Data out of Norway this week was positive: Credit growth improved 5.3% year-on-year in July The current account balance was a healthy NOK 93.2bn in June. The unemployment rate fell from 3.1% to 2.7%. The NOK was up around 1% this week. We are long Scandinavian currencies on a bet that the dollar will fall cyclically. Meanwhile, the Norges Bank has signaled they will increase interest rates ahead of both the Federal Reserve and the ECB. This will benefit real rates in Norway. Report Links: The Norwegian Method - June 4, 2021 Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data from Sweden have been improving: The Swedbank manufacturing and services PMI remained robust in August at 60.1 and 64.7 respectively. The August current account balance showed a healthy surplus of SEK 80.3 billion. The economic tendency survey for August came in at 121.1 from 119.8. Consumer confidence rose from 106.5 to 108.6 in August. The SEK was up almost 1% this week. There are many signs the Swedish economy is improving. This is paring back expectations of more stimulus from the Riksbank. We are short both EUR/SEK and USD/SEK as reflation plays. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Sweden Beyond The Pandemic: Poised To Re-leverage - March 19, 2020 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades Footnotes

Highlights An Iran crisis is imminent. We still think a US-Iran détente is possible but our conviction is lower until Biden makes a successful show of force. Oil prices will be volatile. Fiscal drag is a risk to the cyclical global macro view. But developed markets are more fiscally proactive than they were after the global financial crisis. Elections will reinforce that, starting in Germany, Canada, and Japan. The Chinese and Russian spheres are still brimming with political and geopolitical risk. But China will ease monetary and fiscal policy on the margin over the coming 12 months. Afghanistan will not upset our outlook on the German and French elections, which is positive for the euro and European stocks. Feature Chart 1Bull Market In Iran Tensions Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Iran is now the most pressing geopolitical risk in the short term (Chart 1). The Biden administration has been chastened by the messy withdrawal from Afghanistan and will be exceedingly reactive if it is provoked by foreign powers. Nuclear weapons improve regime survivability. Survival is what the Islamic Republic wants. Iran is surrounded by enemies in its region and under constant pressure from the United States. Hence Iran will never ultimately give up its nuclear program, as we have maintained. Chart 2Biden Unlikely To Lift Iran Sanctions Unilaterally Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) However, Supreme Leader Ali Khamenei could still agree to a deal in which the US reduces economic sanctions while Iran allows some restrictions on uranium enrichment for a limited period of time (the 2015 nuclear deal’s key provisions expire from 2023 through 2030). This would be a stopgap measure to delay the march into war. The problem is that rejoining the 2015 deal requires the US to ease sanctions first, since the US walked away from the deal in 2018. Iran would need domestic political cover to rejoin it. Biden has the executive authority to ease sanctions unilaterally but after Afghanistan he lacks the political capital to do so (Chart 2). So Biden cannot ease sanctions until Iran pares back its nuclear activities. But Iran has no reason to pare back if the US does not ease sanctions. Iran is now enriching some uranium to a purity of 60%. Israeli Defense Minister Benny Gantz says it will reach “nuclear breakout” capability – enough fissile material to build a bomb – within 10 weeks, i.e. mid-October. Anonymous officials from the Biden administration told the Associated Press it will be “months or less,” which could mean September, October, or November (Table 1). Table 1Iran Nearing "Breakout" Nuclear Capability Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Meanwhile the new Iranian government of President Ebrahim Raisi, a hardliner who is tipped to take over as Supreme Leader once Ali Khamenei steps down, is implying that it will not rejoin negotiations until November. All of these timelines are blurry but the implication is that Iran will not resume talks until it has achieved nuclear breakout. Israel will continue its campaign of sabotage against the regime. It may be pressed to the point of launching air strikes, as it did against nuclear facilities in Iraq in 1981 and Syria in 2007 under what is known as the “Begin Doctrine.” Chart 3Israel Cannot Risk Losing US Security Guarantee Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) The constraint on Israel is that it cannot afford to lose America’s public support and defense alliance since it would find itself isolated and vulnerable in its region (Chart 3). But if Israeli intelligence concludes that the Iranians truly stand on the verge of achieving a deliverable nuclear weapon, the country will likely be driven to launch air strikes. Once the Iranians test and display a viable nuclear deterrent it will be too late. Four US presidents, including Biden, have declared that Iran will not be allowed to get nuclear weapons. Biden and the Democrats favor diplomacy, as Biden made clear in his bilateral summit with Israeli Prime Minister Naftali Bennett last week. But Biden also admitted that if diplomacy fails there are “other options.” The Israelis currently have a weak government but it is unified against a nuclear-armed Iran. At very least Bennett will underscore red lines to indicate that Israel’s vigilance has not declined despite hawkish Benjamin Netanyahu’s fall from power. Still, Iran may decide it has an historic opportunity to make a dash for the bomb if it thinks that the US will fail to support an Israeli attack. The US has lost leverage in negotiations since 2015. It no longer has troops stationed on Iran’s east and west flanks. It no longer has the same degree of Chinese and Russian cooperation. It is even more internally divided. Iran has no guarantee that the US will not undergo another paroxysm of nationalism in 2024 and try to attack it. The faction that opposed the deal all along is now in power and may believe it has the best chance in its lifetime to achieve nuclear breakout. The only reason a short-term deal is possible is because Khamenei may believe the Israelis will attack with full American support. He agreed to the 2015 deal. He also fears that the combination of economic sanctions and simmering social unrest will create a rift when he dies or passes the leadership to his successor. Iran has survived the Trump administration’s “maximum pressure” sanctions but it is still vulnerable (Chart 4). Chart 4Supreme Leader Focuses On Regime Survival Supreme Leader Focuses On Regime Survival Supreme Leader Focuses On Regime Survival Moreover Biden is offering Khamenei a deal that does not require abandoning the nuclear program and does not prevent Iran from enhancing its missile capabilities. By taking the deal he might prevent his enemies from unifying, forestall immediate war, and pave the way for a smooth succession, while still pursuing the ultimate goal of nuclear weaponization. Bringing it all together, the world today stands at a critical juncture with regard to Iran and the unfinished business of the US wars in the Middle East. Unless the US and Israel stage a unified and convincing show of force, whether preemptively or in response to Iranian provocations, the Iranians will be justified in concluding that they have a once-in-a-generation opportunity to pursue the bomb. They could sneak past the global powers and obtain a nuclear deterrent and regime security, like North Korea did. This could easily precipitate a war. Biden will probably continue to be reactive rather than proactive. If the Iranians are silent then it will be clear that Khamenei still sees the value in a short-term deal. But if they continue their march toward nuclear breakout, as is the case as we go to press, then Biden will have to make a massive show of force. The goal would be to underscore the US’s red lines and drive Iran back to negotiating table. If Biden blinks, he will incentivize Iran to make a dash for the bomb. Either way a crisis is imminent. Israel will continue to use sabotage and underscore red lines while the Iranians will continue to escalate their attacks on Israel via militant proxies and attacks on tankers (Map 1). Map 1Secret War Escalates In Middle East Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Bottom Line: After a crisis, either diplomacy will be restored, or the Middle East will be on a new war path. The war path points to a drastically different geopolitical backdrop for the global economy. If the US and Iran strike a short-term deal, Iranian oil will flow and the US will shift its strategic focus to pressuring China, which is negative for global growth and positive for the dollar. If the US and Iran start down the war path, oil supply disruptions will rise and the dollar will fall. Implications For Oil Prices And OPEC 2.0 The probability of a near-term conflict is clear from our decision tree, which remains the same as in June 2019 (Diagram 1). Diagram 1US-Iran Conflict: Critical Juncture In Our Decision Tree Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Shows of force and an escalation in the secret war will cause temporary but possibly sharp spikes in oil prices in the short term. OPEC 2.0 remains intact so far this year, as expected. The likelihood that the global economic recovery will continue should encourage the Saudis, Russians, Emiratis and others to maintain production discipline to drain inventories and keep Brent crude prices above $60 per barrel. OPEC 2.0 is a weak link in oil prices, however, because Russians are less oil-dependent than the Gulf Arab states and do not need as high of oil prices for their government budget to break even (Chart 5). Periodically this dynamic leads the cartel to break down. None of the petro-states want to push oil prices up so high that they hasten the global green energy transition. Chart 5OPEC 2.0 Keeps Price Within Fiscal Breakeven Oil Price Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Chart 6Oil Price Risks Lie To Upside Until US-Iran Deal Occurs Oil Price Risks Lie To Upside Until US-Iran Deal Occurs Oil Price Risks Lie To Upside Until US-Iran Deal Occurs As long as OPEC 2.0 remains disciplined, average Brent crude oil prices will gradually rise to $80 barrels per day by the end of 2024, according to our Commodity & Energy Strategy (Chart 6). Imminent firefights will cause prices to spike at least temporarily when large amounts of capacity are taken offline. Global spare capacity is probably sufficient to handle one-off disruptions but an open-ended military conflict in the Persian Gulf or Strait of Hormuz would be a different story. After the next crisis, everything depends on whether the US and Israel establish a credible threat and thus restore diplomacy. Any US-Iran strategic détente would unleash Iranian production and could well motivate the Gulf Arabs to pump more oil and deny Iran market share. Bottom Line: Given that any US-Iran deal would also be short-term in nature, and may not even stabilize the region, some of the downside risks are fading at the moment. The US and China are also sucking in more commodities as they gear up for great power struggle. The geopolitical outlook is positive for oil prices in these respects. But OPEC 2.0 is the weak link in this expectation so we expect volatility. Global Fiscal Taps Will Stay Open Markets have wavered in recent months over softness in the global economic recovery, COVID-19 variants, and China’s policy tightening. The world faces a substantial fiscal drag in the coming years as government budgets correct from the giant deficits witnessed during the crisis. Nevertheless policymakers are still able to deliver some positive fiscal surprises on the margin. Developed markets have turned fiscally proactive over the past decade. They rejected austerity because it was seen as fueling populist political outcomes that threatened the established parties. Note that this change began with conservative governments (e.g. Japan, UK, US, Germany), implying that left-leaning governments will open the fiscal taps further whenever they come to power (e.g. Canada, the US, Italy, and likely Germany next). Chart 7Global Fiscal Taps Will Stay Open Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Chart 7 updates the pandemic-era fiscal stimulus of major economies, with light-shaded bars highlighting new fiscal measures that are in development but have not yet been included in the IMF’s data set. The US remains at the top followed by Italy, which also saw populist electoral outcomes over the past decade. Chart 8US Fiscal Taps Open At Least Until 2023 US Fiscal Taps Open At Least Until 2023 US Fiscal Taps Open At Least Until 2023 The Biden administration is on the verge of passing a $550 billion bipartisan infrastructure bill. We maintain 80% subjective odds of passage – despite the messy pullout from Afghanistan. Assuming it passes, Democrats will proceed to their $3.5 trillion social welfare bill. This bill will inevitably be watered down – we expect a net deficit impact of around $1-$1.5 trillion for both bills – but it can pass via the partisan “budget reconciliation” process. We give 50% subjective odds today but will upgrade to 65% after infrastructure passes. The need to suspend the debt ceiling will raise volatility this fall but ultimately neither party has an interest in a national debt default. The US is expanding social spending even as geopolitical challenges prevent it from cutting defense spending, which might otherwise be expected after Afghanistan and Iraq. The US budget balance will contract after the crisis but then it will remain elevated, having taken a permanent step up as a result of populism. The impact should be a flat or falling dollar on a cyclical basis, even though we think geopolitical conflict will sustain the dollar as the leading reserve currency over the long run (Chart 8). So the dollar view remains neutral for now. Bottom Line: The US is facing a 5.9% contraction in the budget deficit in 2022 but the blow will be cushioned somewhat by two large spending bills, which will put budget deficits on a rising trajectory over the course of the decade. Big government is back. Developed Market Fiscal Moves (Outside The US) Chart 9German Opinion Favors New Left-Wing Coalition Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Fiscal drag is also a risk for other developed markets – but here too a substantial shift away from prudence has taken place, which is likely to be signaled to investors by the outperformance of left-wing parties in Germany’s upcoming election. Germany is only scheduled to add EUR 2.4 billion to the 25.6 billion it will receive under the EU’s pandemic recovery fund, but Berlin is likely to bring positive fiscal surprises due to the federal election on September 26. Germany will likely see a left-wing coalition replace Chancellor Angela Merkel and her long-ruling Christian Democrats (Chart 9). The platforms of the different parties can be viewed in Table 2. Our GeoRisk Indicator for Germany confirms that political risk is elevated but in this case the risk brings upside to risk assets (Appendix). Table 2German Party Platforms Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) While we expected the Greens to perform better than they are in current polling, the point is the high probability of a shift to a new left-wing government. The Social Democrats are reviving under the leadership of Olaf Scholz (Chart 10). Tellingly, Scholz led the charge for Germany to loosen its fiscal belt back in 2019, prior to the global pandemic. Chart 10Germany: Online Markets Betting On Scholz Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Chart 11Canada: Trudeau Takes A Calculated Risk Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) In June, the cabinet approved a draft 2022 budget plan supported by Scholz that would contain new borrowing worth EUR 99.7 bn ($119 billion). This amount is not included in the chart above but it should be seen as the minimum to be passed under the new government. If a left-wing coalition is formed, as we expect, the amount will be larger, given that both the Social Democrats and the Greens have been restrained by Merkel’s party. Canada turned fiscally proactive in 2015, when the institutional ruling party, the Liberals, outflanked the more progressive New Democrats by calling for budget deficits instead of a balanced budget. The Liberals saw a drop in support in 2019 but are now calling a snap election. Prime Minister Trudeau is not as popular in general opinion as he is in the news media but his party still leads the polls (Chart 11). The Conservatives are geographically isolated and, more importantly, are out of step with the median voter on the key issues (Table 3). Table 3Canada: Liberal Agenda Lines Up With Top Voter Priorities Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Nevertheless it is a risky time to call an election – our GeoRisk Indicator for Canada is soaring (Appendix). Granting that the Liberals are very unlikely to fall from power, whatever their strength in parliament, the key point is that parliament already approved of CAD 100 billion in new spending over the coming three years. Any upside surprise would give Trudeau the ability to push for still more deficit spending, likely focused on climate change. Chart 12Japan: Suga Will Go, LDP Will Stimulate Japan: Suga Will Go, LDP Will Stimulate Japan: Suga Will Go, LDP Will Stimulate Japanese politics are heating up ahead of the Liberal Democrats’ leadership election on September 29 and the general election, due by November 28. Prime Minister Yoshihide Suga’s sole purpose in life was to stand in for Shinzo Abe in overseeing the Tokyo Olympics. Now they are done and Suga will likely be axed – if he somehow survives the election, he will not last long after, as his approval rating is in freefall. The Liberal Democrats are still the only game in town. They will try to minimize the downside risks they face in the general election by passing a new stimulus package (Chart 12). Rumor has it that the new package will nominally be worth JPY 10-15 trillion, though we expect the party to go bigger, and LDP heavyweight Toshihiro Nikai has proposed a 30 trillion headline number. It is extremely unlikely that the election will cause a hung parliament or any political shift that jeopardizes passage of the bill. Abenomics remains the policy setting – and consumption tax hikes are no longer on the horizon to impede the second arrow of Abenomics: fiscal policy. Not all countries are projecting new spending. A stronger-than-expected showing by the Christian Democrats would result in gridlock in Germany. Meanwhile the UK may signal belt-tightening in October. Bottom Line: Germany, Canada, and Japan are likely to take some of the edge off of expected fiscal drag next year. Emerging Market Fiscal Moves (And China Regulatory Update) Among the emerging markets, Russia and China are notable in Chart 7 above for having such a small fiscal stimulus during this crisis. Russia has announced some fiscal measures ahead of the September 19 Duma election but they are small: $5.2 billion in social spending, $10 billion in strategic goals over three years, and a possible $6.8 billion increase in payments to pensioners. Fiscal austerity in Russia is one reason we expect domestic political risk to remain elevated and hence for President Putin to stoke conflicts in his near abroad (see our Russian risk indicator in the Appendix). There are plenty of signs that Belarussian tensions with the Baltic states and Poland can escalate in the near term, as can fighting in Ukraine in the wake of Biden’s new defense agreement and second package of military aid. China’s actual stimulus was much larger than shown in Chart 7 above because it mostly consisted of a surge in state-controlled bank lending. China is likely to ease monetary and fiscal policy on the margin over the coming 12 months to secure the recovery in time for the national party congress in 2022. But China’s regulatory crackdown will continue during that time and our GeoRisk Indicator clearly shows the uptick in risk this year (Appendix). Chart 13China Expands Unionization? China Expands Unionization? China Expands Unionization? The regulatory crackdown is part of a cyclical consolidation of Xi Jinping’s power as well as a broader, secular trend of reasserting Communist Party and centralization in China. The latest developments underscore our view that investors should not play any technical rebound in Chinese equities. The increase in censorship of financial media is especially troubling. Just as the government struggles to deal with systemic financial problems (e.g. the failing property giant Evergrande, a possible “Lehman moment”), the lack of transparency and information asymmetry will get worse. The media is focusing on the government’s interventions into public morality, setting a “correct beauty standard” for entertainers and limiting kids to three hours of video games per week. But for investors what matters is that the regulatory crackdown is proceeding to the medical sector. High health costs (like high housing and education costs) are another target of the Xi administration in trying to increase popular support and legitimacy. Central government-mandated unionization in tech companies will hurt the tech sector without promoting social stability. Chinese unions do not operate like those in the West and are unlikely ever to do so. If they did, it would compound the preexisting structural problem of rising wages (Chart 13). Wages are forcing an economic transition onto Beijing, which raises systemic risks permanently across all sectors. Bottom Line: Political and geopolitical risk are still elevated in China and Russia. China will ease monetary and fiscal policy gradually over the coming year but the regulatory crackdown will persist at least until the 2022 political reshuffle. Afghanistan: The Refugee Fallout September 2021 will officially mark the beginning of Taliban’s second bout of power in Afghanistan. Will Afghanistan be the only country to spawn an outflux of refugees? Will the Taliban wresting power in Afghanistan trigger another refugee crisis for Europe? How is the rise of the Taliban likely to affect geopolitics in South Asia? Will Afghanistan Be The Last Major Country To Spawn Refugees? Absolutely not. We expect regime failures to affect the global economy over the next few years. The global growth engine functions asymmetrically and is powered only by a fistful of countries. As economic growth in poor countries fails to keep pace with that of top performers, institutional turmoil is bound to follow. This trend will only add to the growing problem of refugees that the world has seen in the post-WWII era. History suggests that the number of refugees in the world at any point in time is a function of economic prosperity (or the lack thereof) in poorer continents (Chart 14). For instance, the periods spanning 1980-90 and 2015-20 saw the world’s poorer continents lose their share in global GDP. Unsurprisingly these phases also saw a marked increase in the number of refugees. With the world’s poorer continents expected to lose share in global GDP again going forward, the number of refugees in the world will only rise. Chart 14Refugee Flows Rise When Growth Weak In Poor Continents Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Citizens of Syria, Venezuela, Afghanistan, South Sudan, and Myanmar today account for two-thirds of all refugees globally. To start with, these five countries’ share in global GDP was low at 0.8% in the 1980s. Now their share in global GDP is set to fall to 0.2% over the next five years (Chart 15). Chart 15Refugee Exporters Hit All-Time Low In Global GDP Share Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Per capita incomes in top refugee source countries tend to be very low. Whilst regime fractures appear to be the proximate cause of refugee outflux, an economic collapse is probably the root cause of the civil strife and waves of refugee movement seen out of the top refugee source countries. Another factor that could have a bearing is the rise of multipolarity. Shifting power structures in the global economy affect the stability of regimes with weak institutions. Instability in Afghanistan has been a direct result of the rise and the fall of the British and Russian empires. American imperial overreach is just the latest episode. If another Middle Eastern war erupts, the implications are obvious. But so too are the implications of US-China proxy wars in Southeast Asia or Russia-West proxy wars in eastern Europe. Bottom Line: With poorer continents’ economic prospects likely to remain weak and with multipolarity here to stay, the world’s refugee problem is here to stay too. Is A Repeat Of 2015 Refugee Crisis Likely In 2021? No. 2021 will not be a replica of 2015. This is owing to two key reasons. First, Afghanistan has long witnessed a steady outflow of refugees – especially at the end of the twentieth century but also throughout the US’s 20-year war there. The magnitude of the refugee problem in 2021 will be significantly smaller than that in 2015. Secondly, voters are now differentiating between immigrants and refugees with the latter entity gaining greater acceptance (Chart 16). Chart 16DM Attitudes Permissive Toward Refugees Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Chart 17Refugees Will Not Change Game In German/French Elections Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Concerns about refugees will gain some political traction but it will reinforce rather than upset the current trajectory in the most important upcoming elections, in Germany in September and France next April. True, these countries feature in the list of top countries to which Afghan refugees flee and will see some political backlash (Chart 17). But the outcome may be counterintuitive. In the German election, any boost to the far-right will underscore the likely underperformance of the ruling Christian Democrats. So the German elections will produce a left-wing surprise – and yet, even if the Greens won the chancellorship (the true surprise scenario, looking much less likely now), investors will cheer the pro-Europe and pro-fiscal result. The French election is overcrowded with right-wing candidates, both center-right and far-right, giving President Macron the ability to pivot to the left to reinforce his incumbent advantage next spring. Again, the euro and the equity market will rise on the status quo despite the political risk shown in our indicator (Appendix). Of course, immigration and refugees will cause shocks to European politics in future, especially as more regime failures in the third world take place to add to Afghanistan and Ethiopia. But in the short run they are likely to reinforce the fact that European politics are an oasis of stability given what is happening in the US, China, Brazil, and even Russia and India. Bottom Line: 2021 will not see a repeat of the 2015 refugee crisis. Ironically Afghan refugees could reinforce European integration in both German and French elections. The magnitude of the Afghan crisis is smaller than in the past and most Afghan refugees are likely to migrate to Pakistan and Iran (Chart 17). But more regime failures will ensure that the flow of people becomes a political risk again sometime in the future. What Does The Rise Of Taliban Mean For India? The Taliban first held power in Afghanistan from 1996-2001. This was one of the most fraught geopolitical periods in South Asia since the 1970s. Now optimists argue that Taliban 2.0 is different. Taliban leaders are engaging in discussions with an ex-president who was backed by America and making positive overtures towards India. So, will this time be different? It is worth noting that Taliban 2.0 will have to function within two major constraints. First, Afghanistan is deeply divided and diverse. Afghanistan’s national anthem refers to fourteen ethnic groups. Running a stable government is inherently challenging in this mountainous country. With Taliban being dominated by one ethnic group and with limited financial resources at hand, the Taliban will continue to use brute force to keep competing political groups at bay. Chart 18Taliban In Line With Afghanis On Sharia Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) At the same time, to maintain legitimacy and power, the Taliban will have to support aligned political groups operating in Afghanistan and neighboring Pakistan. Second, an overwhelming majority of Afghani citizens want Sharia law, i.e. a legal code based on Islamic scripture as the official law of the land (Chart 18). Hence if the Taliban enforces a Sharia-based legal system in Afghanistan then it will fall in line with what the broader population demands. It is against this backdrop that Taliban 2.0 is bound to have several similarities with the version that ruled from 1996-2001. Additionally, US withdrawal from Afghanistan will revive a range of latent terrorist movements in the region. This poses risks for outside countries, not least India, which has a long history of being targeted by Afghani terrorist groups. The US will remain engaged in counter-terrorism operations. To complicate matters, India’s North has an even more unfavorable view of Pakistan than the rest of India. With the northern voter’s importance rising, India’s administration may be forced to respond more aggressively to a terrorist event than would have been the case about a decade ago. It is also possible that terrorism will strike at China over time given its treatment of Uighur Muslims in Xinjiang. China’s economic footprint in Afghanistan could precipitate such a shift. Bottom Line: US withdrawal from Afghanistan is bound to add to geopolitical risks as latent terrorist forces will be activated. India has a long history of being targeted by Afghani terrorist movements. Incidentally, it will take time for transnational terrorism based in Afghanistan to mount successful attacks at the West once again, given that western intelligence services are more aware of the problem than they were in 2000. But non-state actors may regain the element of surprise over time, given that the western powers are increasingly focused on state-to-state struggle in a new era of great power competition.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com   Section II: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator United Kingdom UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator Section III: Geopolitical Calendar