Economy

Listen to a short summary of this report.       Executive Summary Second Fastest Hiking Cycle Ever? Can the Fed achieve a soft landing, bringing inflation back to its 2% target without causing growth to slow significantly below trend? It has managed this only once in the past (in 2004). Every other cycle triggered a recession or, at best, a fall in the PMI to below 50. Recession is not a certainty. A higher neutral rate than in the past – partly due to the build-up of household savings – means the economy may be unusually robust this time. But the risk is high. We recommend a neutral weighting in equities, with a tilt to more defensive positioning: Overweight the US, and a focus on quality and defensive growth sectors. China’s slowdown is particularly worrying. We expect the RMB to fall, which will put downward pressure on other Emerging Markets. Bottom Line: Investors should maintain low-risk portfolio positioning until the outcome of the sharp tightening of financial conditions is clearer.     Recommended Allocation The key to the performance of financial markets over the next year is whether the Fed and other central banks can kill inflation without killing economic growth. This is not impossible. But the risk that aggressive tightening of monetary policy triggers a recession – or at best a sharp slowdown – is high. Investors should maintain relatively low-risk portfolio positioning. If the Fed raises rates in line with what the futures market is projecting – by 286 basis points over the next 12 months – it will be the second fastest tightening on record, after only the “full Volcker” of 1980-1981 (Chart 1). Other central banks, even in countries and regions with much weaker growth than the US, are predicted to tighten almost as aggressively (Table 1). At the same time, the Fed will start to run down its balance-sheet rapidly; we estimate its holdings of US Treasurys will fall by more than $1 trillion by end-2023 (Chart 2). What was the impact on the economy of previous Fed hiking cycles? It varied, but on only one occasion in the past 50 years (2004) was there neither a recession nor a fall of the Manufacturing ISM to below 50 in the two years or so following the first hike (Table 2).1 The ISM (and other global PMIs) falling to below 50 is important because that is typically the dividing line between equities outperforming bonds and vice versa (Chart 3). Chart 1Second Fastest Hiking Cycle Ever? Table 1Futures Projected Interest Rate Hikes Chart 2Fed Balance-Sheet Will Shrink Rapidly Too Table 2What Happened To The Economy In Fed Hiking Cycles Chart 3Will PMIs Fall Below 50?  A recent paper by Alex Domash and Larry Summers showed that, since 1955, when US inflation was above 4% and unemployment below 5%, there was a 73% probability of recession over the next four quarters, and 100% over the next eight quarters (Table 3). On each of the three occasions when inflation was above 5% and unemployment below 4% (as is the case now), recession followed within a year. How could the Fed avoid a hard landing? Inflation could come down quickly, which would allow the Fed to ease back on tightening. As consumption switches back to services from durables, and the supply side succeeds in increasing production, the price of manufactured goods could fall (Chart 4). There were signs of this happening already in March, when US durables prices fell by 0.9% month-on-month. The problem, however, is that because of rising energy costs and lockdowns in China, the supply-side response has been delayed. The fall in semiconductor and shipping costs, which we previously argued would happen this year, is not yet clearly coming through (Chart 5). There are also signs of a price-wage spiral, with US wages rising (with a lag) in line with prices (Chart 6). Table 3This Level of Inflation And Unemployment Usually Leads To Recession Chart 4Can The Price Of Durables Now Fall? Chart 5Supply-Side Recovery Delayed? The economy could be more robust than in the past, leaving it unscathed by higher rates. Our model of the equilibrium level of short-term rates is 3.2%, well above the Fed’s estimate of 2.4% (Chart 7). Our colleague Peter Berezin has argued that the neutral rate could be as high as 4%.2 In particular, the $2 trillion-plus of excess US household savings (equal to 10% of GDP) could support consumption for some years even if real wage growth is negative (Chart 8). However, there are already signs that higher rates are hurting the housing market, the most interest-rate sensitive part of the economy. The average US 30-year fixed-rate mortgage rate has risen to 5.1% from 3.2% since the start of the year. This is negatively impacting home sales and mortgage applications (Chart 9). Moreover, even if the Fed can succeed in raising rates without killing the expansion, the markets – for a while – will worry that it cannot. Chart 6A Price-Wage Spiral? Chart 7Rates Are Still A Long Way Below Neutral Chart 8Excess Savings Could Support The Economy Chart 9Higher Rates Already Impacting Home Sales There are clear signs of a slowdown in the global economy. Europe may already be in recession, with sentiment indicators collapsing to recessionary levels (Chart 10). More esoteric indicators, which have historically signaled slowing growth ahead, such as the Swedish new orders/inventories ratio, are also flashing a warning signal (Chart 11). Global financial conditions have tightened at the fastest pace since 2008 (Chart 12). Corporate earnings forecasts have started to be revised down for the first time in this cycle (Chart 13). Chart 10Is Europe Already In Recession? Chart 1111. Signs Of Trouble Ahead Chart 12Financial Conditions Have Tightened Significantly Chart 13Corporate Earnings Forecasts Being Revised Down But what of the argument that investors have already turned ultra-pessimistic and that all the bad news is in the price? Global equities are down only 14% from their historic peak, barely in correction territory. It is true that sentiment (historically a contrarian indicator) is very poor, with twice as many respondents to the American Association of Individual Investors’ weekly survey expecting the stock market to fall over the next six months as expect it to rise (Chart 14). But, despite investor pessimism, there are few signs that investors have made their portfolios more defensive. The same AAII survey shows little decline in equity weightings, and no big shift into cash (Chart 15). Chart 14Investors Are Very Pessimistic... Chart 15...But Haven't Moved More Defensive Equities: The US is the best house on a tough street. Growth is likely to remain more robust than in the euro area or Japan. The US stock market has a lower beta (Chart 16). And, while the US is more expensive, valuations do not drive the 12-month relative performance of stocks and, anyway, the US premium valuation can be justified by higher ROE and the lower volatility of profits (Chart 17). Emerging markets continue to look vulnerable to the slowdown in China and tighter US financial conditions (Chart 18). We remain underweight. Chart 16US Stocks Are Lower Risk Chart 17US Premium Valuation Is Justified Chart 18Tightening Financial Conditions Are Bad For EM Chart 19Consumer Staples Are Defensive Chart 20IT Earnings Will Continue To Grow Strongly Within sectors, our preference remains for quality and defensive growth. Consumer staples tend to outperform when PMIs are falling (Chart 19) and are supported by attractive dividend yields. Information Technology is a more controversial overweight, given that it is expensive and sensitive to rising rates. Nevertheless, investment in tech hardware and software is likely to continue, giving the sector strong structural earnings growth in coming years (Chart 20). Currencies: The dollar has risen by 7.3% year-to-date driven by interest-rate differentials and the Fed being expected to be more aggressive than other central banks. But we are only neutral, since the Fed will probably not raise rates by as much as the market is pricing in, and because the dollar looks very overvalued (Chart 21). We lower our recommendation on the Chinese yuan to underweight. Interest-rate differentials with the US clearly point to it falling further – also the outcome desired by the authorities to help bolster growth (Chart 22). The likely CNY weakness will put further downward pressure on other EM currencies, particularly in Asia, given their high correlation to the Chinese currency (Chart 23). Chart 21The Dollar Is Very Overvalued Chart 22Rate Differentials Point To A Weaker RMB... Chart 23...Which Is Bad News For Other EM Currencies Fixed Income: With the 10-year US Treasury yield at 2.9% and that in Germany at 0.9%, there is a stronger argument for marginally raising weightings in government bonds. We are neutral on government bonds within the (underweight) fixed-income category. Remember, though, that real yields are still negative: -0.1% in the US and -2.1% in Germany. We do not expect long-term rates to rise much over the next 6-9 months, and so remain neutral on duration. The “golden rule of bond investing” says that government bond returns are driven by whether the central bank is more or less hawkish than expected over the next 12 months (Chart 24). We would expect the Fed to be slightly less hawkish than currently forecast. US high-yield bonds offer an attractive yield pick-up – as long as US growth does not collapse. In a way, HY bonds are like defensive equities, given their high correlation with equities but beta only one-third that of equities (Chart 25). Chart 24Will The Fed Be More Or Less Hawkish Than Expected? Chart 25High Yield Bonds Are Like MinVol Equities Chart 26Russian Oil Is Going Cheap Commodities: Oil prices are likely to fall back to around $90 a barrel by year-end, as demand softens and increased supply (from Saudi Arabia, UAE, and North American shale, and maybe from Venezuela and Iran) enters the market. But the risk is to the upside if this extra supply does not emerge. In particular, possible bans on Russian oil and gas into the European Union (or Russia blocking sales) could disturb the market. It will take time for Russia’s 11 million b/d of oil production, which used to go mainly to Europe, to be rerouted to Asia. This is why the Urals benchmark is at a 30% discount to Brent (Chart 26). The long-term story for industrial commodities remains good, but there is downside risk – especially for iron ore and steel – from China’s slowdown (Chart 27). Gold is an obvious hedge against geopolitical risks and high inflation. But over the past 20 years, it has been negatively correlated to real interest rates and the US dollar, suggesting upside is capped. There is a chance, however, that the relationship between rates and gold breaks down, as it did in the 1970s and 1980s (Chart 28). We, therefore, remain neutral on gold, believing that a moderate holding is a good diversifier for portfolios. Chart 27Chinese Slowdown Is Negative For Commodities Chart 28Will Gold Start To Behave As It Did Before 1990? Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Footnotes 1         In 2015, the ISM was already below 50 when the Fed hiked in December. 2         Please see Global Investment Strategy Report, “Is A Higher Neutral Rate Good Or Bad For Stocks?” dated March  18, 2022. Recommended Asset Allocation Model Portfolio (USD Terms)

Executive Summary Indonesia’s Balance Of Payments Will Be Under Pressure Indonesian domestic demand is struggling in the face of tight policy settings. High real borrowing costs are constraining credit growth, and hurting non-financial sectors. Monetary authorities have shown little intention to reduce borrowing costs by any good measure, and remain focussed on exchange rate stability. This is a major policy dilemma that the authorities need to break free from before this bourse can embark on a sustainable bull market. Indonesia’s only bright spot since the pandemic, its external accounts, will be deteriorating. Capital inflows will dwindle at a time when the current account balance is set to slip back into deficit. This will put downward pressure on the rupiah, which in turn raises the risk of policy error as the central bank might be tempted to raise rates in a bid to stabilize the currency. Doing so would hurt economic growth and stock prices.  Bottom Line: Currency investors should stay short the rupiah versus the US dollar. Equity investors should wait for relative weaknesses before considering an upgrade in EM and Emerging Asian portfolios. Investors should stay underweight Indonesia in EM local currency bond portfolios. Sovereign EM credit investors, however, should continue to overweight Indonesia. Feature In the past few months, Indonesian stocks have rallied to a pandemic-era high. They have outperformed their emerging market peers as well, albeit from a very low level (Chart 1). Could this mean that Indonesia’s decade-long underperformance is finally coming to an end? We are not convinced. The nation’s equity index in US dollar terms will find it hard to advance to new highs anytime soon. Absolute return investors, therefore, should not chase this bourse up. In terms of relative performance, odds are that some of the recent gains might be lost. The recent outperformance had more to do with investors fleeing Chinese stocks and Indonesia has been one of the major beneficiaries of this rotation (Chart 2). Meanwhile, Indonesia’s policy setting remains quite restrictive. Its external tailwinds are receding as well, which is making the rupiah vulnerable. Chart 1Indonesian Stocks Are Still Not Geared For A Sustainable Bull Market Chart 2Much of The Indonesian Outperformance Had To Do With Investors Leaving China That said, given Indonesia’s drawn-out equity underperformance since early 2013, this bourse’s relative bear market versus the EM benchmark is late. As such, following near-term weaknesses, asset allocators should consider upgrading this bourse from underweight to neutral in EM and Emerging Asian baskets. Domestic bond investors should stay underweight Indonesian local currency bonds in EM and Emerging Asian portfolios. Sovereign credit investors, however, should remain overweight Indonesia. Persistent Domestic Headwinds The recovery in Indonesian domestic demand has been quite slow over the past two years. The top panel of Chart 3 shows that the economy is still struggling. Two years into the pandemic, consumer confidence and retail sales volume are well below pre-pandemic levels. One reason for the muted consumer sentiment is meagre growth in household income. Nominal wage growth has stalled, sapping consumer demand. Wage growth in real terms (deflated by headline CPI) is shrinking outright (Chart 3, bottom panel). Weakness is palpable on the supply side as well. The capacity utilization rate for both manufacturing and other industries remains well below pre-pandemic levels (Chart 4, top two panels), despite the fact that Indonesia’s manufacturing exports have been very strong over the past year (details to come). This underscores the extent of the weakness in domestic demand. Chart 3Consumer Confidence Is Low As Household Income Is Moribund Chart 4Low Capacity Utilization And Labor Usage Points To Poor Domestic Demand Chart 5Fiscal Support Is In Short Supply In line with low capacity utilization, labor usage has also been consistently below par since the onset of the pandemic (Chart 4, bottom panel). That means hiring has been restrained and workers have had little bargaining power, which explains why nominal wage growth has halted. The restrictive macro policy is also exerting a considerable drag on economic recovery. Indonesia’s fiscal stance is rather tight. The government is planning to rein in the fiscal deficit this year to 4.3% of GDP from a revised 4.7% deficit last year. As such, the IMF estimates that the cyclically adjusted fiscal thrust will be a negative 0.9% of potential GDP this year, and a further negative 0.6% next year (Chart 5).  Monetary policy, as we have repeatedly asserted, has remained extremely restrictive for the past six to seven years. Interest rates are prohibitively high.Banks’ lending rates, for instance, have consistently stayed above nominal GDP growth rate since 2012. That will likely be the case going forward as well given the muted growth outlook. If one looks at real bank lending rates (deflated by core CPI) vis-à-vis real GDP, the picture looks even more grim (Chart 6). Such high borrowing costs, which continued for a decade, have been a major headwind for the country’s non-financial sectors. Stock prices of non-financial firms as well as those of SMEs – which had to endure chronically high financing costs − have been in a decade-long bear market in absolute terms. By contrast, banks benefited from the high lending rates, and their share prices have rallied to their pre-pandemic highs (Chart 7). Chart 6Borrowing Costs Have Been Persistently High Relative To The Economy's Growth Rate... Chart 7...Hurting Stocks Of Non-Financial Firms And SMEs, While Benefitting Banks Chart 8Exorbitant Borrowing Costs Have Led To A Stagnation In Credit Penetration Very high real interest rates is one reason Indonesia’s credit penetration, at 34% of GDP, is unusually low for an economy at this stage of development. The ratio has not risen at all in the past 10 years. In fact, it has headed lower recently (Chart 8). This is not a sign of a healthy, recovering economy. As such, for Indonesian stocks to have a sustainable bull market, one of the macro imperatives is that the real borrowing cost needs to decline considerably. Yet, Indonesian monetary authorities have shown little intention to reduce real rates by any meaningful measure. The main reasons behind this hawkish stance on the part of the central bank has had to do with (i) the country’s persistent current account deficit over the past decade, and (ii) the central bank’s mandate of exchange rate stability. Indonesia needed to offer consistently high real rates to attract enough foreign capital so that it can finance its current account deficits, and thereby have a stable rupiah. Yet, that policy has created distortions elsewhere. Persistently high real rates have led to a steady drop in non-financial firms’ return on equity. That, in turn, discouraged foreign equity inflows but encouraged international fixed-income inflows into Indonesia. This is not surprising as equity investors dislike high real rates, while debt investors prefer it. The reliance on foreign debt inflows, in turn, incentivized the authorities to keep real interest rates persistently high − even in periods when growth was rather timid and inflation undershot the central bank’s target. This is a major distortion that the Indonesian economy needs to break free from before this bourse can embark on a sustainable bull market. Incidentally, a bill to expand the central bank’s mandate to include growth and employment was introduced to parliament last year. If passed, the bill-turned-law would allow Bank Indonesia to set interest rates more in line with domestic economic conditions, rather than just focussing on currency stability. Chart 9Inflation Is Inching Up From Very Low Levels Discussions on the bill, however, have been delayed in  Parliament, and it is not clear when, or if, it will be passed. Meanwhile, Bank Indonesia has begun to tighten policy on the margin by draining excess liquidity from the system. More worryingly, the central bank could begin to raise rates in the next couple of months as it fears inflation will creep up due to rising global commodity prices (Chart 9). Outflows from the bond market might also encourage the central bank to raise rates in an attempt to stem them (details in the next section).   Receding External Tailwinds In contrast to Indonesia’s lack of domestic recovery, the country’s external sector was the star performer over the past year or two. Yet, in the next few quarters, it’s the external sector that will likely be a threat to the nation’s growth. This is because Indonesia’s exports are set to shrink and its balance of payments is set to deteriorate. These factors could threaten the rupiah stability, which would then force the central bank to raise rates / tighten liquidity prematurely in a bid to support the rupiah. Tighter policy would be a major headwind for growth, and would hobble stock prices.  Indonesian exports grew remarkably over the past two years, which helped to push the country’s current account balance into surplus for the first time in a decade (Chart 10, top panel). A closer look, however, will reveal that much of it had to do with surging exports to China – which doubled to $55 billion in two years (Chart 11). Chart 10Indonesia's Balance Of Payments Will Be Under Pressure Chart 11Improvements In The Current Account Were Mostly Due to A Surge In Exports To China           That said, much of the improvements in the current account could unravel going forward: Some of the export windfalls accrued to Indonesia when China banned Australian coal imports in 2020 and switched to Indonesian coal instead.   But more recently, a decelerating economy in China has led to slowing electricity generation. The latter has always had a direct bearing on Indonesian coal exports volume – which is now shrinking (Chart 12, top panel). China’s electricity demand and production will slump further due to COVID lockdowns of enterprises and pending weakness in its exports. Chart 12Export Windfalls Are Ending As Chinese Growth Wanes Chinese thermal coal prices have been falling in recent months from the sky-high levels of late 2021, and could fall further by the end of the year as China keeps increasing its own coal output and its electricity generation drops (Chart 12, bottom panel). All these will weigh on Indonesian export earnings in the months to come. For its part, the Indonesian government has restricted coal exports by mandating that miners set aside 25% of their output for local sales as part of their “domestic market obligation.” The government has also banned shipments of some palm oil ingredients for an indefinite period – in an apparent attempt to check domestic food price inflation. Palm oil is the second largest Indonesian export after coal, and together they make up 22% of total export revenues. Indonesia is a large net crude and refined petroleum importer. Global crude prices will likely stay elevated due to sanctions on Russia. This will be a negative for the country’s trade balance. Chart 13Dwindling Goods Demand In The Developed World Will Hurt Indonesian Manufacturing Exports Moving beyond commodities, Indonesian manufacturing exports − which are as large as its’ commodities exports in US dollar terms − will also likely get hurt. A crucial reason for that is a slowing China. Chinese manufacturing imports are set to weaken in the next several months as that economy is entering a soft patch. That usually is an adverse development for Indonesian exports to China (Chart 13, top panel). In fact, Indonesia’s overall manufacturing exports will also likely slow. Falling household goods demand in developed countries will curtail manufacturing exports from Asia, including Indonesia. Notably, early signs of an impending slowdown in Indonesian manufacturing exports often appear in Chinese data − given the heft of the Chinese economy and its trade links in Asia and beyond (Chart 13, bottom panel). More generally, global trade will likely slow going forward, which is a negative for those economies that have relied on an export windfall over the past couple of years. Essentially, the days of boyant current account balances are numbered for Indonesia.  A slipping current account balance could spell larger problems for Indonesia as the country’s financial account surplus has been steadily eroding. From a high of $37 billion annually in 2019, it dropped to just $12 billion by the end of 2021. Much of that drop is due to a fall in net debt inflows – the type of capital inflows Indonesia strives to attract by keeping real interest rates very high (Chart 10, middle panel). Chart 14Falling Real Bond Yields In Indonesia Will Keep Foreign Debt Investors At Bay Critically, the country has not been able to attract much FDI either despite passing an Omnibus Law to boost new investments and create jobs a couple of years back (Chart 10, bottom panel). Chart 14 shows that foreign investor holdings of Indonesian government debt has shrunk materially from almost $80 billion in early 2020 to less than $60 billion now. In terms of their share in total bonds outstanding, the drop is even more remarkable: from 40% of the total to just 18%. Foreign bond purchases clearly react to the ebbs and flows of Indonesian real yields on offer (Chart 14, bottom panel). Given that Indonesian inflation will likely go up from the current very low levels − putting a downward pressure on the real yields available – foreign investors could continue to shun Indonesian bonds. Indonesian policymakers might also worry as such. That apprehension could prompt Bank Indonesia to raise rates preemptively in a bid to attract debt inflows and stabilize the currency. If so, higher real rates would add to the existing policy headwinds for the domestic economy. Growth will suffer; and markets will sell off.  Investment Conclusions The Currency: The rupiah remains vulnerable as the Indonesian balance of payments is set to deteriorate. A slipping current account balance amid receding capital inflows will be putting downward pressures on the rupiah. Stay short the rupiah versus the US dollar. Domestic Bonds: Indonesian bond yields have fallen massively relative to their EM counterparts, and are at 10-year lows in relative terms. As such, the nation’s local currency bonds have little more room to benefit from relative yield compression. The rupiah is also vulnerable. We went underweight Indonesian domestic bonds in November last year, and that recommendation remains in place (Chart 15). Sovereign Credit: Absolute return investors should reduce their exposure as the rupiah weaknesses going forward could lead to widening credit spreads, and result in negative total returns in US dollar terms (Chart 16). Chart 15Stay Underweight Indonesian Domestic Bonds In An EM Bond Portfolio Chart 16Absolute Return Investors Should Reduce Exposure To Indonesian Sovereign Credit   Asset allocators, however, should stay overweight Indonesia in an EM credit basket. This market has transitioned itself into a defensive one over the past several years – thanks to years of orthodox fiscal and monetary policies and low debt. Hence, given that a period of risk-off is around the corner – during which Indonesian credit tends to outperform as it did in 2015 and 2020 − it makes sense to stay overweight this market. Stocks: Absolute return investors should not chase this bourse up. Asset allocators should wait for relative weaknesses before considering an upgrade from underweight to neutral in EM and Emerging Asian portfolios.   Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com

Executive Summary China's Demand Was Very Weak before Lockdowns The selloff in risk assets is not over. Stay defensive. Stagflation fears will continue gripping financial markets. Global trade volumes are set to contract, but the Fed has little maneuvering room as US core inflation is well above its target. Commodity prices are at an important juncture. The plunge in Chinese material stock prices is a warning sign for global materials because China is by far the largest consumer of raw materials (excluding oil), accounting for about 50-55% of global industrial metal demand. The rally in EM commodity plays like Latin America and South Africa is at risk of a major reversal. Bottom Line: Global equity and credit portfolios should underweight EM equities and credit, respectively. The rally in the US dollar might be the final upleg before a major downtrend sets in. However, this final rally will be considerable, and the greenback will likely overshoot. A buying opportunity in EM local currency bonds will present itself after EM currencies hit a bottom versus the US dollar. Feature Global and EM risk assets will remain under selling pressure. This Charts That Matter report contains charts that will help investors navigate treacherous financial markets by shedding light on the following key issues: How much more downside in stocks? Chart 1 displays EM share prices in USD terms alongside their long-term moving averages. If EM equities break below the current technical support line, the next one implies that there is 20-25% further downside in EM stocks. For the S&P500, the next technical support is at 3650-3750. Our Equity Capitulation Indicators for both the S&P500 and EM stocks remain above their previous (2010-2020) lows (Charts 5 and 6 below). In addition, equity market breadth is deteriorating. Fundamental problems with financial markets are linked to mounting stagflation fears. Global trade volumes are set to contract in H2 due to a decline in US and European household spending on goods ex-autos and a delayed recovery in China as we discussed in last week’s report. In turn, US wage growth is accelerating, which will push up unit labor costs. US core inflation will likely drop due to base effects, but will remain above 3.5-4%, which far exceeds the Fed’s 2-2.25% target. Chart 1EM Share Prices: Their Long-Term Moving Averages Served As A Support In Bear Markets Chart 2 illustrates that stagflation fears have already gripped financial markets. Global defensive equity sectors have recently been outperforming global non-TMT stocks despite rising US and global bond yields (Chart 2). This is a major departure from the historical relationship between the two and likely foreshadows a period of continuous Fed tightening despite slower global growth. Global equity managers should favor defensive stocks as they will continue to outperform under the two most likely scenarios: (1) either these stagflation dynamics continue; or (2) a growth scare will dominate, during which US bond yields could drop. Chart 2Does This Divergence From A Historic Correlation Signify Stagflation? The US dollar continues to climb, and its strength has recently become very broad-based – extending to commodity currencies and Asian currencies. As we show in Charts 46-48 below, the US dollar has more upside.   Commodity prices are at an important juncture. On the one hand, supply shortages and risks to further supply disruptions could continue to support resource prices. On the other hand, demand will disappoint. Shrinking US and European consumer spending on goods ex-autos, contracting Chinese commodity intake and weakness in EM ex-China demand all suggest that global commodity consumption will decline in the months ahead. In our March 10 report, we noted that commodity prices would be volatile and this view has been validated: commodity prices swings have been extreme over the past two months. More recent evidence points to lower resource prices. Chart 3 shows that over the past 200 years raw material prices in real US dollar terms (deflated by US headline CPI) have oscillated around a well-defined downtrend. The pandemic surge in commodity prices has pushed them to two standard deviations above their time-trend. Historically, commodity rallies (and even their secular bull markets) ended when prices reached this threshold. Hence, odds are that industrial commodities might hit a soft spot. Energy prices remain a wild card due to geopolitics. It is critical to note that the raw materials price index shown in Chart 3 does not include energy, gold and semi-precious metals (the footnote of Chart 3 lists commodities included in this aggregate). Chart 3Raw Material Prices (In Real Terms) Are At The Upper End Of A 200-Year Downtrend Finally, Chart 4 demonstrates that Chinese materials stocks have plunged. We read this as a warning sign for global materials because China is by far the largest consumer of raw materials (excluding oil), accounting for about 50-55% of global industrial metal demand. Chart 4Chinese Material Stocks Are Signaling Trouble For Global Materials Investment Recommendations Stay defensive. Global equity and credit portfolios should underweight EM equities and credit, respectively. The rally in the US dollar might be the final upleg before a major downtrend sets in. However, this final rally will likely be considerable, i.e., the greenback will likely overshoot. The CNY has broken down versus the US dollar and our target is 6.70-6.75 for now. A depreciating yuan is bearish for Asian and EM currencies. We continue to recommend short positions in the following EM currencies versus the US dollar: ZAR, COP, PEN, HUF, IDR, PHP and PLN. A buying opportunity in EM local currency bonds will present itself when EM currencies hit a bottom versus the US dollar.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   US And EM Equity Capitulation Indicators These indicators have not reached their lows of 2010, 2011, 2018 and 2020. The magnitude of the S&P500 selloffs in 2011 and 2018, were 19.5% and 19.8%, respectively. Hence, our best guess for the size of a S&P500 drawdown in this selloff is about 20%. This puts the potential S&P500 low at 3800-3850. The latter is consistent with the technical support (3-year moving average) that held up in 2011, 2016 and 2018 (Chart 5, top panel).  Chart 5 Chart 6 Components Of Our US Equity Capitulation Indicator Not all components of our US Equity Capitulation Indicator have reached their previous lows. Odds are that US share prices will drop further. US equity valuations are still expensive, geopolitical risks are elevated, and inflation and inflation expectations are extremely high, which will limit the Fed’s maneuvering room. Chart 7 Chart 8 Components Of Our EM Equity Capitulation Indicator Similarly, the components of our EM Equity Capitulation Indicator have not reached their previous lows. The share of industry groups above their 200-day moving average, analysts’ net EPS revisions as well as the momentum and equity sentiment indicators remain above prior troughs. Further downside in EM share prices is likely.  Chart 9 Chart 10 S&P500 Overlays With Previous Geopolitical Crises The most recent examples of geopolitical shocks include the Cuban missile crisis in 1962, the oil embargo of 1973 in response to the Yom Kippur War and the Gulf War of 1990. The magnitude of the S&P 500 selloff was 28% in 1962, 23% in 1973 and 20% in 1990. Today, the S&P 500 is down only 12.8% from its peak. Based on the above three profiles, the current selloff in US stocks has further to go. This also means that non-US equities, including EM, will continue to suffer.  Chart 11 Chart 12 Chart 13 Table 1 Various EM Equity Indexes: Deteriorating Breadth Various EM equity indexes have been in a bear market. The deterioration has been broadening as recent leaders such as commodity producers and Taiwanese stocks have been gapping down. Yet, not all bourses are very oversold. We published a Special Report on semiconductors on April 14 arguing that semi stocks face more downside. Share prices of commodity producers have recently corrected, and, as we argue above, odds of a further drop are non-trivial. What are the odds that the overall EM equity index undershoots? See the next section.  Chart 14 Chart 15 Chart 16 Chart 17 EM Undershoot Is Likely Sentiment towards EM equities has fallen significantly, but it is not yet at previous lows. Similarly, there is still room for EM net EPS revisions by bottom-up analysts to fall further. Finally, platinum prices point to more downside in EM non-TMT share prices.  Chart 18 Chart 19 Chart 20 EM Bond Yields And Share Prices Historically, rising EM corporate USD bond yields and EM local currency bond yields led to a selloff in EM share prices. Unless EM USD and local currency bond yields start falling on a sustainable basis, EM equities will continue to struggle. Chart 21 Chart 22 Rising US Corporate Bond Yields Are Bearish For US Stocks Rising US corporate borrowing costs point to lower US share prices. Corporate bond yields could increase because of either rising US Treasury yields or widening credit spreads. Furthermore, bearish US equity market technicals are presently reinforcing this downbeat outlook for US stocks.  Chart 23 Chart 24 Chart 25 The S&P500 EPS Can Contract Outside Of A Recession Let’s recall what happened in 2000-2001 in the US. Real GDP contracted only slightly, household spending in real terms did not contract at all, and the housing market was booming. Yet, the S&P 500 operating EPS plunged by 30% and the stock index was down by 50%. In 1966, even though real and nominal GDP did not contract, the S&P500 operating EPS shrank by about 5% and share prices fell by 22%. This episode is the best analogy for US economic and financial market dynamics over the near term.  Chart 26 Chart 27 US Stagflation Scare US wage growth is accelerating, and unit labor costs are surging. The latter will make inflation sticky and hurt corporate profit margins. Besides, US consumer demand for goods ex-autos will shrink following a two-year period of overspending. This combination will produce a stagflation scare – a period when corporate profits are weak, but the Fed has little maneuvering room as core inflation is well above its target.  Chart 28 Chart 29 Chart 30 Chart 31 Global Trade Volumes Will Shrink Taiwanese shipments to China – which lead global exports – have started to contract. Korea’s business survey of exporting companies reveals that business conditions deteriorated substantially in April. Global cyclicals have been underperforming global defensives. Finally, early cyclical stocks in the US have sold off and have substantially underperformed domestic defensives. This also points to a slowdown in US growth. Chart 32 Chart 33 Chart 34 Chart 35 China’s Economy Requires Much More Aggressive Stimulus In China, monetary and fiscal stimulus have so far been insufficient to produce a major economic recovery given the headwinds from the property sector and the harsh lockdowns. The enacted fiscal stimulus has mainly been for infrastructure spending, and it does not include direct fiscal transfers to households who are losing income due to the lockdown. On the monetary front, the credit impulse – excluding local government bond issuance (which is counted in our fiscal spending impulse) – has barely bottomed.  Chart 36 Chart 37 Chart 38 Chart 39 China Has Been A Drag On Global Trade Chinese domestic demand was extremely weak even prior to the recent lockdowns in Shanghai. Chinese import volumes of various commodities, machinery, industrials goods and semiconductors were contracting as of March. Lockdowns and associated income/profit losses will further depress domestic demand. Chart 40 Chart 41 Chinese Property Woes Are Worsening Housing floor space sold in April is down by 50% from a year ago. Households are reluctant to borrow and buy, and property developers’ financing has dried up. All these point to shrinking construction activity. Chart 42 Chart 43 Chart 44 Chart 45 The US Dollar Has More Upside Our view on the greenback has played out well, and more upside is likely. The CNY has broken down against the dollar and it will reach at least 6.70-6.75. One exception to a strong US dollar might be the yen, as the trade-weighted yen has fallen to its previous lows. However, a rebound in the yen from current levels requires  a stabilization of US bond yields.  Chart 46 Chart 47 Chart 48 Chart 49 EM Currencies: Do Not Catch A Falling Knife EM currencies remain at risk. They are not cheap, and the recent rebound has faltered with many EM exchange rates unable to break above their technical resistance vis-à-vis the USD. However, we expect the US dollar to top and EM currencies to bottom later this year. Stay tuned.  Chart 50 Chart 51 EM Credit Markets: More Spread Widening Ahead EM and US credit spreads are not particularly wide and will likely widen further. China’s corporate USD bonds remain in a bear market. The two key drivers of EM credit spreads are the business cycle and exchange rates. EM growth will continue to disappoint, and EM currencies will relapse versus the US dollar. Hence, investors should be patient before buying/overweighting EM credit.  Chart 52 Chart 53 Chart 54 Chart 55 EM Domestic Bonds: A Buying Opportunity Down The Road The EM GBI domestic bonds total return index in USD terms has broken down and near-term weakness is likely. Meanwhile, EM local currency bond yields have risen significantly, and they offer good value. That said, a buying opportunity in local currency bonds will transpire only after their currencies bottom. Chart 56 Chart 57 Footnotes