Economy

Highlights Important leading indicators of Eurozone activity point to record growth in the coming quarters. Progress on the vaccination front, global pent-up demand, and easing fiscal policy will fuel the Euro Area recovery. Consensus growth expectations for the Eurozone do not reflect this upbeat outlook; hence, European economic surprises will remain firm. Robust economic surprises will help European stocks, especially small-cap ones. They will also allow for a stronger EUR/USD and rising German 10-year yields. The UK economy is strong, and the BoE will be among the first central banks to tighten policy meaningfully. However, investors understand the UK’s strength well. While the cyclical outlook for the pound is bright against both the USD and the EUR, the GBP is vulnerable to some near-term profit taking. Downgrade UK small-cap stocks to neutral on a tactical basis.  Feature The case for the Eurozone’s recovery is only growing stronger. However, consensus growth forecasts for the Euro Area remain modest. Faced with this dichotomy, the European economy has ample room to generate positive surprises in the coming months. This process will support European financial assets, small-cap stocks in particular. This contrasts with UK assets, where investors have already embedded generous growth assumptions in response to the country’s rapid pace of vaccination. A tactical downgrade of UK small-cap equities is appropriate. Surprise! Two indicators from outside the Eurozone point to an elevated likelihood that the European economy will generate some exceptionally strong growth numbers over the coming 12 months. First, the Swiss KOF Economic Barometer hit an all-time high in April. The KOF series is an excellent leading indicator of Switzerland’s economic activity, and it currently forecasts record GDP growth and PMIs for that country (Chart 1). This message of strength for Switzerland bodes well for the Eurozone. While the Swiss market is defensive, owing to its heavy exposure to healthcare and consumer staple stocks, the Swiss economy is pro-cyclical. Exports represent 60% of GDP, and exports to the Eurozone account for 40% of this total. Moreover, the growth-sensitive machinery, consumer goods, and chemicals categories account for almost 50% of shipments. Based on these observations, the KOF Economic Barometer forecasting ability unsurprisingly extends beyond Swiss economic variables; it also anticipates positive growth for the Global Manufacturing PMI, the Euro Area Manufacturing PMI, and the Eurozone’s forward earnings (Chart 2). Chart 1Climbing Swiss Peaks Chart 2A Good Sign For The Eurozone Second, an aggregation of Swedish economic data confirms the KOF indicator’s message and also calls for record economic activity in Europe. Our Swedish Economic Diffusion Index, which incorporates 14 data series from the Nordic country, points toward a further acceleration in the Euro Area PMIs relative to the US (Chart 3). It is also consistent with a pick-up in the performance of European equities relative to the US. These important indicators of the European economy reflect a variety of forces at play that increasingly point toward stronger growth. Among them, the improvement in the pace of vaccination is crucial to lifting the mood across the continent. As the top panel of Chart 4 illustrates, the number of daily vaccine doses administered across major Euro Area economies is accelerating sharply. While it took three months to inoculate 20% of the population, it only took one month to raise the vaccinated population to nearly 40% (Chart 4, bottom panel). Chart 3Sweden Leads The Eurozone Chart 4Accelerating Vaccinations Euro Area fiscal policy is also moving in a more growth-friendly direction. The Italian Budget announced on April 26 will add EUR248 billion in spending over the next six years. For the moment, Germany has abandoned its debt brake, and, as we wrote three weeks ago, the September election is likely to reify this outcome and further ease fiscal policy in Europe’s biggest economy. Spain is the second largest recipient of the NGEU funds, and it is expected to increase fiscal spending by EUR167 billion over the coming six years. In addition, France has yet to give clear hints about its plan, but next year’s elections are likely to result in further stimulus measures as well. Thus, fiscal easing in Europe will only increase from this point on (Chart 5). Chart 5The Expanding European Stimulus Accumulated pent-up demand remains another potent fuel for growth in the Euro Area. Unlike in the US, spending on durable goods in the Eurozone has not overtaken its pre-pandemic levels (Chart 6). Furthermore, global inventory-to-sales ratio are low, which hints at a coming inventory restocking cycle. These two trends will benefit Euro Area economic activity. The service sector recovery has more to go. Despite some recent improvements, the Eurozone’s Service PMI remains depressed compared to that of the US (Chart 7, top panel). However, the acceleration in the European vaccination campaign and the continued injection of fiscal support at the same time as the lockdowns ebb should result in a significant catch up in service activity in the Euro Area. Thus, the double-dip recession is on the verge of ending and giving way to a robust GDP expansion (Chart 7, bottom panel). Chart 6Ample European Pent-up Demand Chart 7The Service Sector Recovery Is Paramount Even though the recovery in GDP growth will lead to strong positive economic surprises for the Euro Area, consensus growth expectations for the region remain conservative. According to Bloomberg, Eurozone annual GDP growth is expected to reach 12.6% in Q2 because of an extremely strong base effect. However, growth will decelerate suddenly and hit 2.3% in Q3 and 4.3% in Q4. Growth is anticipated to be 4.1% in 2022. These are low thresholds to beat, and thus, economic surprises will remain positive. Chart 8Decomposing The Surprises The source of positive economic surprises is likely to be broad-based. If the service sector recaptures some of its previous shine, the Surveys and Business Cycle component and the Labor Market component of the Bloomberg surprises index will improve and remain positive for many months (Chart 8). Moreover, the absorption of pent-up demand will allow the Retail and Wholesale as well the Personal/Household components to remain robust or firm up further. Finally, the strength of the global manufacturing sector and the elevated potential for a global inventory restocking will allow the Industrial component to firm up anew. Bottom Line: The European economy is in a good place to validate the upbeat message from the KOF Economic Barometer or the Swedish Economic Diffusion Index. Since expectations for European economic activity are still limited for the second half of 2021, this strong growth performance will result in positive economic surprises. Investment Implications The heightened odds that Europe will generate significant positive economic surprises for the coming quarters means that investors’ perspective of the Euro Area will gradually improve. While this process will ultimately curtail the ability of Europe to beat expectations, it will also lift Eurozone assets. If our forecast is correct that European economic surprises will largely be positive over the coming 6 to 12 months, then European equities are more likely to generate generous returns than otherwise. Table 1 highlights that positive changes in the Economic Surprise Index (ESI) on a 3-month, 6-month, and 12-month horizon coincide with returns of the Euro Area MSCI equity benchmarks that have positive batting averages of 72%, 70%, and 73%, respectively. Moreover, the average and median returns are significantly higher than when the ESI deteriorates. Table 1Forecasting Strong Surprises Means Forecasting Strong Equity Returns The signal from the ESI is weaker if we do not make forecasts about its direction. The batting averages of subsequent 3-month and 6-month equity returns following an improving ESI are 63% and 69%, respectively, and the median subsequent returns are higher than if today’s ESI is deteriorating, but not to the same extent as when we make a forecast of the ESI. 12-month returns for the Eurozone MSCI index have a 58% chance of being positive, if the ESI increases over a 12-month window, which is lower than the 63% batting average if the ESI worsens. Moreover, average and median 12-month expected returns are somewhat higher if the ESI has been deteriorating rather than improving over the past 12-month period. European small cap equities will be prime beneficiaries of the coming growth outperformance. From an economic perspective, this makes sense because small-cap stocks are geared more toward domestic growth than large-cap equities, which are dominated by multinationals. Table 2 shows that 3-month, 6-month, and 12-month periods of improvement in the surprise index precede an outperformance of small-cap relative to large-cap stocks over similar windows of time. Thus, the current positive level of the European ESI and its ability to rise further should favor small-cap European equities. Table 2Favor Small-Cap Stocks Table 3A Bullish Backdrop For EUR/USD The same exercise shows that the outlook also favors the euro. European economic surprises should continue to outpace the US, because Eurozone growth will catch up to the US, but investors already have much loftier expectations for US activity than for the Euro Area. Table 3 illustrates that periods when the Eurozone’s ESI is greater than that of the US, EUR/USD generates a positive 3-month return 65% of the time, with a median gain of 1.3%. When the US ESI is higher, the EUR/USD depreciates 55% of the time, with a median loss of -0.5%. Chart 9Rising German Yields? Finally, the potential for stronger European ESI is negative for Bunds. Speeches by various members of the European Central Bank Governing Council indicate that the ECB will tolerate higher yields, if they reflect stronger economic activity. As the European vaccination campaign advances and the fiscal stimulus increases, the need to maintain depressed Bunds yields recedes. Hence, a continuation of positive ESI readings is now more likely to boost these yields. Additionally, the gap between the European ESI and the US one will remain positive, thus, a period of rising German yields relative to the US is more likely (Chart 9).  Bottom Line: The ability of the European economy to continue to surprise positively should generate attractive equity returns on the continent. Moreover, this economic backdrop is consistent with an outperformance of small-cap equities, as well as an appreciating EUR/USD. Under these circumstances, Bunds yields should experience more upside. Country Focus: The UK’s Outlook Is Brightening, Unsurprisingly Last week, the Bank of England left the total size of its asset purchase program in place at GBP875 billion, even if the weekly pace of purchases was slowed to GBP3.4 billion from GBP4.4 billion. The BoE also raised its 2021 growth forecast to 7.5%, from 5% in February.  The BoE is joining the Bank of Canada as one of the first central banks to taper its asset purchase program. It will also be one of the first central banks to increase interest rates, after the Norges Bank, but ahead of the Fed. In a way, the UK shares many similarities with our recent positive depiction of the Swedish economy. Chart 10Support For Household Net Worth The rapid pace of vaccination in the UK allows for a vigorous economic recovery. In all likelihood, the UK economy will have contracted in Q1 2021 because of the severe lockdowns that prevailed then; however, these lockdowns are being eased and economic fundamentals point up. Our Global Fixed Income and Foreign Exchange strategists recently demonstrated that house prices are increasing on the back of rising mortgage approvals and falling household debt-servicing obligations (Chart 10). The robust readings of the RICS House Prices survey only confirm the positive outlook for housing prices. Expanding house prices will elevate consumption. An appreciating housing stock boosts the wealth of households and leads to higher UK consumer confidence. Moreover, business confidence is improving; the rise in capex intentions not only indicates that investments will increase, but is also a precursor to climbing job vacancies (Chart 11). Brighter labor market prospects often result in rising consumption, especially if wages firm up, as we argued seven weeks ago. The current bout of economic strength points to some upside in UK inflation as well. The elevated PMI readings and the rapid increase in construction activity are reliable forecasters of higher CPI prints (Chart 12). However, this not a uniquely British phenomenon, and it remains to be seen how durable this rising inflation will be. Chart 11UK Consumption Will Rise More Chart 12Accelerating UK Inflation   Despite this positive economic outlook, investors should adopt a more cautious tactical stance toward UK markets. The problem for British assets is that investors have understood UK’s vaccination strength so well that they embed much optimism in the price of financial instruments levered to domestic economic activity. In contrast to the Eurozone, Bloomberg consensus forecast anticipate Q2 year-on-year GDP growth of 20.7%, 6.1% for Q3 and 6.5% for Q4. Cable is particularly ripe for some near-term profit taking. Our Intermediate-Term Technical Indicator and the 52-week rate of change of GBP/USD, as well as net speculative positions and sentiment, all point to a correction in that pair (Chart 13). Moreover, the 13-week momentum measure for EUR/GBP shows that the rapid decline in this cross is also overdone. As a result, BCA’s Foreign Exchange strategists closed their short EUR/GBP position to book some gains.  It is also time to downgrade British mid- and small-cap stocks from our current overweight stance, at least on a tactical basis. Compared to large-cap UK stocks, small-cap names have moved in a parabolic fashion, and the ratio’s elevated 52-week rate-of-change measure warns of a pullback, especially in light of the deterioration in near-term momentum (Chart 14). The message from technical indicators is particularly concerning, because the forward earnings of small-cap stocks are plunging relative to large cap ones (Chart 15). Additionally, valuation multiples on UK small-cap stocks have vastly outpaced those of their larger counterparts, despite a rapid decline in relative RoE (Chart 16). Chart 13Cable Is Ripe For Some Near-Term Profit Taking Chart 14UK Small-Cap Stocks Are Technically Vulnerable Chart 15Deteriorating Profit Performance Chart 16Quite The Valuation Premium Ultimately, these cautious views are of a short-term nature. BCA’s Foreign Exchange strategists remain upbeat on the pound on a 12- to 24-month basis. Cable continues to trade at a deep discount to our purchasing-power parity estimate, which adjusts for the composition of price indexes in the UK and the US (Chart 17). Moreover, real short rate differentials still favor GBP/USD. The pound also trades at a discount to the euro based on long-term valuation metrics. Most importantly, real interest rates differentials at both the short- and long-end of the curve, as well as the outlook for the evolution of monetary policy in the UK relative to the Euro Area, indicate a significantly lower EUR/GBP (Chart 18). Chart 17Despite Nera-term risks, Cable's Cyclical Underpinning Is Strong Chart 18Lower EUR/GBP Ahead For small-cap equities, the cyclical picture is more complex. On the one hand, their domestic exposure and a higher pound over the coming 12 to 24 months should help them, unlike the large-cap UK stocks, which derive most of their income from abroad and are negatively affected by a higher GBP. On the other hand, UK small-cap stocks have become so expensive that we need to see how an appreciating pound will boost their earnings relative to large-cap stocks before adjusting our neutral stance. Bottom Line: The strong UK economy will allow the BoE to be one of the first major DM central banks to tighten policy. This will support a further appreciation of the pound against both the dollar and the euro over the coming 12 to 24 months. Nonetheless, the GBP has been overbought on a tactical basis and is vulnerable to a near-term pullback. Similarly, compared to large-cap equities, we are downgrading small-cap UK stocks from overweight to neutral on a tactical basis.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com   Cyclical Recommendations Structural Recommendations Trades Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance​​​​​​​ Closed Trades

Highlights Non-US stocks have greatly underperformed US equities over the last decade, but a leadership change might be underway. As such, equity flows could be an important factor in dictating currency trends over a cyclical horizon. The narrative in favor of non-US stocks includes a recovery in profits, cheap valuations, and a secular theme that will favor capital spending in traditionally “heavy” industries. Non-US growth should also overtake the US beyond 2021, when most of the global population is vaccinated. Cyclical currencies have historically tracked the relative performance of their respective bourses. This implies a lower dollar. Higher bond yields also present a formidable headwind for the outperformance of US stocks, relative to other markets. An outperformance of non-US bourses will be particularly favorable for the AUD, NOK, SEK, and GBP. The yen will likely play catchup towards the middle of the cycle. Feature Currencies respond to broad inflows, including into bonds, equities or foreign direct investment. For most of 2020, the dominant currency flows were from fixed income investors. As most short rates are now anchored near zero, the story is morphing towards the potential winners from a recovery, especially in the equity market sphere. Non-US stocks tend to outperform the US when the dollar is falling. That said, the causality-effect link is not so clear-cut, as we penned in our Special Report last year.1 Admittedly, a lower dollar boosts the common-currency returns for US-based investors, leading to more capital deployment in offshore markets. Meanwhile, commodities tend to do well when the dollar declines, benefiting emerging market and commodity-producing countries. Financing costs for non-US corporations borrowing in dollars are also eased. Historically, profit growth has been the ultimate driver of stock prices and profitability is more contingent on productivity gains than translation effects. This suggests the starting point for gauging relative equity flows, and the potential impact on currencies, is to evaluate which countries/economies could be primed for outperformance. Relative Growth As A Starting Point One of the key drivers of relative earnings growth between two countries is relative economic performance. Chart I-1 shows that earnings-per-share in the G10 relative to the US tended to improve when growth was shifting in favor of the rest of the world. This, in turn, has been a key driver of relative equity performance. Chart I-1Relative Profits And Relative Growth What is remarkable is that this relationship has been pretty consistent across countries, including those that have huge exposures to the global economy such as Sweden, Norway, or even the United Kingdom. In general, relative economic performance has driven relative EPS growth (Chart I-2A & 2B). The reason is that these bourses still have a sizeable dependence on the domestic economy. Chart I-3 shows that for even the most export-driven economies, exposure to domestic sales is still at least 20%. Australia, a commodity country has almost 60% of sales from domestic sources. Our bias is that non-US growth will start to outperform towards the backend of this year. This will pressure the dollar lower (Chart I-4). This conviction rests on three critical pillars: Chart I-2AA Cross Country Look At Relative Profits Growth Chart I-2BA Cross Country Look At Relative Profits Growth   Chart I-3Domestic Sales Matter A Lot For Global Equity Bourses Chart I-4The Dollar Trends With ##br##Relative Growth   The rest of the world will catch up in vaccination campaigns relative to the US. This is almost a fait accompli. Canada is well behind in terms of vaccination progress compared to the US or the UK (Chart I-5). But in Quebec, where BCA is headquartered, Premier François Legault has suggested that everyone who wants a vaccine will be able to get their first dose by June 24. Relative employment growth in Canada is already picking up, and the central bank has already begun tapering asset purchases ahead of the Fed. The broader message is that the service sector has been held hostage by relatively closed economies outside the US. This will change as economies open up.   Producer prices (PPI) are picking up globally and the US is leading the pack. This will also rotate in favor of other economies. Producer prices first took off in the US as the sectors that benefited from the pandemic were those related to technology and healthcare. Norway also gained from the rebound in oil prices. Other countries should begin to catch up, as demand for goods and services broadens beyond the pandemic-related scope (Chart I-6). From a longer-term perspective, PPI usually peaks and troughs in the US ahead of other economies. Again, as we exit a recession, consumption tends to broaden from defensive goods towards more discretionary spending. Given that other economies are bigger producers of these discretionary items, this should start to shift relative pricing power towards these countries (Chart I-7). Non-US growth has been held hostage to cascading crises since the US housing market bust. In 2010, we had the euro area debt crisis. In 2011, the Fukushima disaster knocked down Japanese growth. In 2015, tight monetary policy in China led to a global manufacturing recession. In short, rest-of-world growth has not been able to catch breath for a decade. Chart I-5Many Countries Will Replicate The US and UK Vaccination Success Chart I-6Global PPIs Are ##br##Picking Up   Chart I-7US PPI Usually Leads Other Countries The silver lining is that the COVID-19 crisis has ushered in coordinated global monetary and fiscal stimulus. For the first time in a long while, non-US growth can start to outperform, according to IMF estimates (Chart I-8). Chart I-8The IMF Expects Non-US Growth To Outperform Flows tend to gravitate to capital markets with the highest expected returns, and this is certainly the case when US versus non-US stocks are concerned. If we accept the premise that relative growth matters for equity allocations, then it also makes sense that relative equity performance will coincide with currency performance, due to portfolio flows. Across the G10 economies, getting the equity call right has usually been synonymous with having the appropriate currency strategy (Chart I-9). This is especially the case since equity flows have been supportive of the dollar (Chart I-10). Chart I-9ACurrencies And Equities Move Together Chart I-9BCurrencies And Equities Move Together Chart I-10Equity Flows Have Been Supportive Of The Dollar A More Quantitative Approach While relative growth is important, it is not the sole factor in determining which countries or sectors will outperform. Most investors have at least two other powerful tools that have stood the test of time in making equity allocations. These include the valuation starting point, and the historical return on capital. Valuation is the easiest place to start. Over time, non-US bourses have tended to outperform the US when the relative valuation starting point was attractive. This has been especially true around recessions, when leadership changes tend to occur. Chart I-11A, 11B, 11C, and 11D show that countries such as Japan, Mexico, and Germany should sport more attractive returns over the next decade compared to the US. The list is not comprehensive, but our previous work suggests this valuation tool works across many countries and various geographies. Chart I-11AValuation Matters For Long-Term Returns Chart I-11BValuation Matters For Long-Term Returns Chart I-11CValuation Matters For Long-Term Returns Chart I-11DValuation Matters For Long-Term Returns   Not surprisingly, the currencies that are the most undervalued in our models also have cheap equity markets. These include the Scandinavian currencies, commodity plays, the Japanese yen, and the pound. A rerating of these markets will be synonymous with a rerating in their currencies (Chart I-12). The rise in global bond yields will also prove to be a formidable headwind for US stocks. Technology constitutes 28% of the US equity market, the largest allocation within the G10. Together with defensive sectors such as health care and consumer staples, this ratio rises to 60%. As a result, the relative performance of the US equity market has been inversely correlated to bond yields (Chart I-13). Should bond yields continue to gravitate higher over the next few years, this will lead to a powerful rotation towards more cyclical bourses. The rise in yields will be particularly favorable for deep value sectors like banks (due to rising net interest margins) and commodities (due to inflation protection). Chart I-12The Dollar Remains ##br##Expensive Chart I-13US Outperformance Has Dovetailed With Lower Bond Yields Going forward, expected return on capital will be more difficult to gauge, but countries that have a history of providing superior shareholder returns are a good place to start. For example, we know that the winners of the last decade have had the largest returns on equity, as was the case for the winners during the prior decade. Given the mammoth task of performing this exercise on a cross-country basis, and across factors, we enlisted the help of our colleagues who run BCA’s Equity Analyzer platform. The EA platform provides a BCA score of 0 to 100 for all developed market stocks, according to their ranking on 30 carefully selected and curated factors. Crunching the numbers revealed a few interesting results: A long strategy based on selecting the top decile stocks according to their EA score outperformed both domestic and global indices (Chart I-14). The quality factor has been one of the better determinants of future stock market returns. The EA quality score is based on return on equity, asset growth, accruals, and margins. On this basis, the bourses with a higher concentration of quality stocks in their indices are found outside the US (Chart I-15). Using an overall blended score, which includes not only the quality factor, but also others such as value, size, and momentum, suggests investors will be rewarded by tilting away from the US. For example, 20%-30% of stocks in Scandinavian bourses make it into the top decile EA portfolio (Chart I-16). Even if one focuses solely on growth sectors such as technology and health care, non-US companies are still more attractive (Chart I-17). Chart I-14The BCA EA Platform Allows Investors To Pick Winners Chart I-15Quality Stocks Are Heavily Weighted Outside The US Chart I-16A Composite Score Ranks US Stocks Poorly Chart I-17Lots Of Attractive Growth Stocks Outside The US In a nutshell, non-US markets are attractive from a valuation standpoint and across a swathe of other metrics that have been useful in benchmarking future returns. An outperformance of non-US stocks will favor cyclical currencies, as portfolio flows gravitate to these markets. We are already selectively long a basket of Scandinavian currencies; we will be gradually accumulating other currencies such as the GBP, the CAD, and the JPY on weakness. Specifically, the yen is becoming interesting not only as portfolio insurance, but also as a play on the cyclical Japanese market. We will be covering these currencies in depth in upcoming reports. Housekeeping Three important central banks met this week. The general tone was dovish. The Bank of England kept policy roughly unchanged, but there were three important takeaways. First, the BoE suggested any pickup in UK inflation will be transitory. Second, the BoE will slow its bond purchases, as they approach the central bank’s target. And finally, growth estimates were revised upward. Our take is that the meeting was a non-event for cable in the near term and bullish longer term. The message from the Reserve Bank of Australia was bit more dovish. They kept open the possibility of additional measures on the July 6 meeting. Our bias is that the RBA is trying to fend off deflationary pressures from a strong currency. This only delays the bullish backdrop for the AUD. Next Tuesday’s budget will provide some information about additional support to the Aussie economy. The Norges bank remains on the path to hike interest rates later this year. This supports our bullish NOK thesis. We have been reluctant to establish fresh long positions as we enter a seasonally strong month for the dollar. However, our buy list is growing as we highlighted above. For now our open positions are highlighted on page 14.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, "Currencies And The Value-Versus-Growth Debate," dated July 10, 2020. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The recent data out of the US were mildly positive. The ISM Manufacturing PMI came in at 60.7 in April, well below an estimate of 65. The ISM Manufacturing New Orders Index came in at 64.3 in April, slightly below an expectation of 66.6. The trade deficit for March was -74.4B USD, in line with expectations. Personal Spending for March was 4.2% month-on-month, as expected. The dollar DXY index rose by 0.8% this week. While the PMI data for April came in on the mild side, inflationary pressures continue to build up as reflected in the robust New Orders, Backlog of Orders as well as the Prices Paid indices. That said, the Fed’s current stance is that price surges will likely be transitory. This is near-term negative for the greenback since it implies policy will not be tightened anytime soon. 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 Chart II-4EUR Technicals 2 The recent Euro data have been mildly positive. Unemployment rate for March was 8.1%, slightly better than the predicted 8.3%. GDP fell 1.8% year-on-year, compared to an expected 2% decrease. CPI came in at 1.6% for April year-on-year, in line with expectation. German Retail Sales for March came in at 7.7% month-on-month comfortably beating a 3% expectation. Overall euro area retail sales surged 12% year-on-year in March, comfortably outpacing consensus of a 9.4% rise. The euro was down 0.9% against USD this week. However, as the weekly vaccination increase in both the US and the UK are slowing down, it continues to rise in the euro area.  Infections are stabilizing in Germany and the Netherlands, and are on a downtrend in France and Italy. This puts a floor under the euro. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 The recent data out of Japan have been strong. The unemployment rate for March came in at 2.6%. Industrial Production for March came in at 2.2% month-on-month, versus the estimate of -2%. Tokyo Core CPI came in at -0.2%, below market consensus. Vehicles sales surged by 22.2% year-on-year in April. The Japanese yen was flat against USD this week. A lagging vaccine campaign, rising COVID-19 case count, and the state of emergency continue to drag down sentiment towards Japan. However, the yen’s real effective exchange rate is trading at one standard deviation below fair value and our intermediate-term indicator is hinting at a rebound. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 The recent data out of UK have been positive. The Nationwide HPI for April was 7.1% higher than a year ago, beating an expectation of 5%. The BoE kept interest rates at 0.1% and its asset purchase target at £895bn. The pound was flat against the USD this week. The Bank of England kept policy on hold this week, but there were three important takeaways. First, the BoE sees any near-term pickup in inflation as temporary. This should keep a near-term lid on rate hike expectations and the pound. Second, the BoE will slow its bond purchases, as they approach the central bank’s target. And finally, growth estimates were revised upward, especially for 2022. This is bullish cable longer term. On the political front, a potential surprise of another Scottish independence may put some downward pressure on the currency. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The recent data out of Australia have been strong. The AIG Manufacturing Index for April came in at 61.7, higher than the prior 59.9 reading. The AIG Construction Index for April came in at 59.1, below the 61.8 print in March. The trade balance for March came in at AUD 5.6bn, below an expectation of AUD 8bn. The RBA cash rate remained at 0.1%. The Australian dollar was flat this week against the USD. The RBA provided a dovish tone at its meeting this week, extending QE until February, and kept open the possibility of additional measures on the July 6 meeting. In the near term, upbeat economic data continue to provide support for the AUD. However, the tourism industry (6% of employment) is needed to get Australia back to full employment. Our bias is that the RBA will continue to fight against an appreciating currency, until the economy reaches escape velocity. 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 Chart II-12NZD Technicals 2 The recent data out of New Zealand have been strong. Employment grew by 0.6% quarter-on-quarter in Q1. The Labor Cost Index for Q1 came in at 0.4% over prior quarter, and 1.6% year-on-year. The unemployment rate for Q1 declined to 4.7%, from 4.9%. Building consents increased 17.9% month-on-month in March. The New Zealand dollar was down 0.5% against USD this week. As we indicated in our report last week, the NZD is overpriced by several measures and the elevated equity market is of particular concern. The weakening GlobalDairyTrade Price Index could potentially be a harbinger of peaking agricultural prices in the coming months. This will lead the NZD to underperform other commodity currencies.  Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The recent data out of Canada have been soft. The trade balance for March came in at -1.14bn CAD versus CAD 1.42bn the previous month. Building permits rose 5.7% month-on-month in March. The CAD was flat against USD this week. Despite concerns over elevated commodity prices and a vaccination campaign that is lagging other advanced economies, recent strong employment growth and the tapering of asset purchases by the BoC should continue to boost the currency, the top performing among G10 so far this year. In the near term, Canadian exports will benefit from US fiscal stimulus, which will also provide support for the loonie. 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 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The recent Swiss data have been strong. The KOF Leading Indicator for April came in at 134, beating the 119.5 estimate.  CPI for April came in at 0.3%. SECO Consumer Climate for Q2 came in at -18, higher than the -30 back in Q1. The Swiss franc was down 0.5% against the USD this week. The Swiss economy continues to surprise to the upside. With our intermediate-term indicator on a downward path, we remain optimistic on our long EUR/CHF position for now, despite potential upside risks to the franc given the Indian COVID-19 outbreak. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The recent data out of Norway have been strong. The unemployment rate for April came in at 4%, from 4.2% the prior month. The house price index for April came in at 12.2% year-on-year, similar to the 12.5% reading of March. Interest rate were held at 0% by the Norges Bank. The NOK was down 1.8% against the USD this week. The krone is the winning currency since the pandemic hit, suggesting some consolidation was much due. With Norwegian inflation rising sharply above the central bank’s 2% target earlier this year, the Norges Bank reiterated during its meeting on Thursday that a rate hike later this year is well in sight. Against the backdrop of the impending European recovery this summer and Norway’s own commendable vaccination progress, we continue to be long the NOK against the USD and EUR.  Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The recent Swedish data have been strong. Industrial Production for March came in at 1.1% month-on-month. Year-on-year, IP is rising by 5.7%. Industrial New Orders for March came in at 10% year-on-year. GDP in Q1 was 1.1% higher than the prior quarter, beating the estimate of 0.5%. The Swedish krona was down 1.4% against the USD this week. BCA Research’s European Investment Strategy service indicated that there is significantly more upside to Swedish stocks against both Eurozone and US equities over the remainder of the cycle. Sweden is levered to the global industrial cycle with exports representing 45% of GDP. The recovery in both Europe and across the globe should continue to benefit the krona. The tapering of asset purchases by the Riksbank later this year will also provide support to the currency in the meantime. We continue to be long SEK/USD and SEK/EUR. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The modern-day version of the Phillips curve posits that core inflation is determined by long-term inflation expectations and the amount of slack in the economy. In practice, using the Phillips curve to forecast inflation is complicated by uncertainty over: 1) the true size of the output gap; 2) the degree to which changes in the output gap affect inflation; and 3) the drivers of long-term inflation expectations. While economists should be humble in forecasting inflation trends, the bulk of the evidence suggests that core inflation will remain subdued for the next two-to-three years. However, when inflation eventually does begin to rise, it could happen faster and more forcefully than expected. For the time being, inertia in inflation expectations will allow the Fed and other central banks to maintain a highly accommodative monetary stance. This will keep a lid on bond yields, while fueling further gains in equity prices. Today’s goldilocks environment will give way to a period of stagflation in the second half of the decade, however.  The Phillips Curve: Flat… For Now It has become fashionable to criticize the Phillips curve. The reason is understandable: Wild swings in the unemployment rate over the past few decades have failed to translate into meaningful changes in inflation. As we argue in this report, however, it is too early to write off the Phillips curve. Perhaps not today, perhaps not tomorrow, but at some point, it will come roaring back. Investors need to be on guard for when it happens. Conceptually, the modern-day version of the Phillips curve posits that core inflation is a function of long-term inflation expectations and the amount of slack in the economy. Mathematically, it can be written as:   Where πt is core inflation at time t, πe is expected long-term inflation, y is GDP, ȳ is the potential (or “full employment”) level of GDP, and α is a parameter specifying how sensitive inflation is to changes in the output gap, yt – ȳt. A positive output gap implies that output is above potential while a negative gap implies output is below potential. The equation reveals three sources of uncertainty about inflation: 1) the true size of the output gap; 2) the degree to which changes in the output gap affect inflation; and 3) the drivers of long-term inflation expectations. Let’s examine all three sources of uncertainty in order to gauge where the balance of risks to inflation lie over the coming months and years.   1. What Is The Current Size Of The Output Gap? Chart 1Prime-Age Employment-To-Population Ratios Remain Below Pre-Pandemic Levels The short answer is that no one knows. The employment-to-population ratio in the OECD for workers between the ages of 25-to-54 was still more than two percentage points below pre-pandemic levels as of the end of last year (Chart 1). The labor market has tightened since then, especially in the US. However, even if US payrolls rise by 1 million in April as per Bloomberg consensus estimates, total employment would still be down 4.7% from January 2020. Admittedly, other data point to a much tighter labor market. US small businesses surveyed by the NFIB have been reporting grave difficulty in finding qualified workers (Chart 2). The job openings rate is at an all-time high, while the quits rate is near pre-pandemic levels (Chart 3). Chart 2US: Temporary Labor Shortage (I) Chart 3US: Temporary Labor Shortage (II)     How does one square widespread stories of labor shortages with the fact that total employment remains depressed? A pessimistic interpretation is that the pandemic pushed up structural unemployment. We are skeptical of this thesis. A similar narrative was invoked shortly after the Great Recession to justify tighter fiscal policy and an early start to rate hikes. In the end, not only did the unemployment rate return to pre-GFC levels, but it dropped to a 50-year low. A more plausible explanation is that many service sector workers are currently reluctant to re-enter the labor market due to lingering fears about the pandemic, and in some cases, the need to remain home to look after young children studying remotely. In addition, generous unemployment benefits – which for more than half of US workers exceed their take-home pay – have reduced the incentive to work. Expanded unemployment benefits will expire in September. As the pandemic winds down and schools fully reopen, more workers will rejoin the labor force. Bottom Line: Temporary dislocations are curbing labor supply. However, the level of employment will probably not return to its pre-pandemic trend for another 12 months in the US. It will take even longer to get back to full employment in the euro area and Japan. 2. How Do Changes In The Output Gap Affect Inflation? The Phillips curve was reasonably steep between the mid-1960s and mid-1980s. As such, a falling output gap generally corresponded to rising inflation and vice versa. The result was a series of “clockwise spirals” in inflation-unemployment space, as illustrated in Charts 4A & 4B. Chart 4AThe Phillips Curve Was Steep In The 1960s-1980s Chart 4BThe Phillips Curve Has Been Flat In Recent Decades Starting in the 1990s, the Phillips curve flattened out. By the time of the Great Recession, the slope of the curve was indistinguishable from zero. Will the Phillips curve remain flat? Over the next two years, the answer is probably yes. However, looking beyond then, it is likely to re-steepen again. Chart 5 shows that the “wage version” of the Phillips curve never became very flat. Even after the mid-1980s, there was still a consistently strong negative correlation between wage growth and the unemployment rate. Chart 5The Wage Version Of The Phillips Curve Is Alive And Well Chart 6Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s   Why, then, did stronger wage growth fail to translate into rising price inflation over the past three decades? To a large extent, the answer is that the Fed began to hike interest rates every time the labor market showed signs of overheating. Higher rates, in turn, led to asset busts. During the 1991 recession, it was the commercial real estate bust; in 2001, it was the dotcom bust; and in 2008, it was the housing bust. All three asset busts led to recessions and higher unemployment before wage growth could seep into inflation. What is different this time is that the Fed is a lot more patient. This means that the economy may eventually overheat to a degree not seen in recent history. How long will that take? Probably a few more years. Consider the case of the 1960s. The unemployment rate was at or below its full employment level for four straight years before inflation took off in 1966 (Chart 6). The shortage of workers spawned a major wage-price spiral. Workers demanded higher wages in response to rising prices, which forced firms to further lift prices in order to defend profit margins. Chart 7US Wage Barometers Disaggregated The US is nowhere near that point now. While some measures of wage growth have accelerated, this mainly reflects a “composition bias” in the way wage indices are constructed. The pandemic led to significant job losses in low-wage sectors such as retail and hospitality, which skewed the calculation of average hourly wages and median weekly earnings to the upside. Cleaner measures of wage growth, such as the Employment Cost Index or the Atlanta Fed Wage Tracker, have been fairly stable over the course of the pandemic1 (Chart 7). Bottom Line: There is good reason to think that the Phillips curve is “kinked”, meaning that inflation might not rise much until the labor market has severely overheated. For now, no major economy is near the kink.   3. Will Long-Term Inflation Expectations Stay Well Anchored? One of the distinguishing features of the clockwise spirals in Chart 4 is that they trace out a series of “higher highs” and “higher lows” for inflation during the period between the mid-1960 and early-1980s. In essence, what happened back then was that inflation would rise, prompting the Fed to step on the brakes ever so gingerly. Inflation would then decline modestly, but not by enough to bring it back to its original level. The “stickiness” of inflation during that era highlights the importance of inflation expectations. In the context of the Phillips curve, a change in long-term inflation expectations could, at least theoretically, affect realized inflation independent of what happens to the output gap. In practice, however, the size of the output gap is likely to influence inflation expectations and vice versa. A persistently positive output gap will cause inflation to consistently exceed its long-term expected value. As Milton Friedman and Edmund Phelps pointed out more than four decades ago, this will eventually prompt businesses and the public to revise up their expectations of inflation. Unless the central bank lifts interest rates by enough, a rise in inflation expectations could spur people to increase spending in advance of higher prices. This could cause the economy to further overheat, leading to even higher inflation expectations. In other words, a positive output gap could lead to higher inflation expectations, and higher inflation expectations, in turn, could push aggregate demand even further above potential. Suppose that people jettison the expectation of a stable long-term inflation rate and adopt an “adaptive” approach whereby they assume that inflation this year simply will be what it was last year. This is equivalent to replacing πe in the Phillips curve equation with πt-1, yielding:   This is the “accelerationist” version of the Phillips curve. It says that the output gap determines the change in inflation rather than the level of inflation. With an accelerationist Phillips curve, inflation can increase without bound if the central bank tries to keep output above its potential level. The transition to an accelerationist Phillips curve appears to have happened in the 1970s. As my colleague Jonathan Laberge has argued, and as recent empirical work has emphasized, changes in inflation expectations generally have a larger impact on realized inflation than changes in the output gap. In particular, it is difficult to explain the Volcker disinflation solely based on the movement in the unemployment rate. Inflation continued to fall even after the unemployment rate peaked in December 1982. The surprising decline in inflation following the recession even prompted two young economists working at the Council of Economic Advisors, Paul Krugman and Larry Summers, to pen a memo entitled “The Inflation Timebomb?” in which they predicted a “significant reacceleration of inflation in the near future”. Chart 8Long-Term Inflation Expectations Remain Well Anchored Today Why did inflation keep falling in the 1980s as the economy recovered? A plausible theory is that Paul Volcker’s appointment to Fed chair marked a “regime shift” in the conduct of monetary policy. No longer would the Fed stand idly by as inflation galloped higher. Even if it took double digit interest rates and a deep recession, the Fed would do what was needed to break the back of inflation. This allowed the accelerationist Phillips curve of the 1970s to transition to its modern-day version characterized by low and stable inflation expectations. What does all this mean for today? Both survey and market-based measures of long-term inflation expectations remain well anchored (Chart 8). Given that inflation expectations have been low and stable for the past few decades, it may take even more overheating than what occurred in the 1960s to unmoor them. Such an unmooring of inflation expectations is not impossible, however. The Fed seems eager to overheat the economy. Fiscal policy is likely to remain highly accommodative long after the pandemic restrictions ease. Meanwhile, as we discussed in an earlier report, many of the structural factors that have suppressed inflation could go into reverse. Bottom Line: Inflation expectations are likely to remain well anchored for the next two years. However, they could become unmoored later on if monetary and fiscal policy remain highly accommodative. Concluding Thoughts There is a lot of concern over inflation these days. We would fade these concerns, at least for the time being. The much-discussed spike in manufacturing input prices is nothing new. The exact same thing happened in 2008 and 2011 (Chart 9). Pundits who hyperventilated about soaring inflation were proven wrong back then and they are likely to be proven wrong again this year. Chart 9Wholesale Inflation Rose (Briefly) In 2008 And 2011 Too Chart 10The Most Refined Measures Of Core Inflation Paint A Benign Picture   The pandemic distorted prices in all sorts of unprecedented ways. This means that looking at standard measures of core inflation may be misleading. It is much better to consider more refined measures of core inflation that go beyond simply stripping out the effects of volatile food and energy prices. Chart 10 shows that trimmed-mean inflation, median price inflation, and sticky price inflation all suggest that underlying inflation remains well contained. Continued low inflation will allow the Fed to maintain a highly accommodative monetary policy. This will keep a lid on bond yields, while fueling further gains in equity prices. When will it be time to worry? When the labor market starts to overheat to the point that a wage-price spiral erupts. As discussed above, that is not a near-term risk. However, such a spiral could occur in two-to-three years, setting the stage for a period of stagflation in the second half of the decade.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com   Footnotes 1 Unlike the widely followed average hourly wage series published every month in the payrolls report, the quarterly Employment Cost Index (ECI) does control for shifts in the weights of different industries in total employment. Thus, an increase in the relative number of low-paid hospitality workers would depress average hourly wages, but would not affect the ECI. Nevertheless, the ECI does not control for the possibility that the composition of the workforce within industries may change over time. The Atlanta Fed's Wage Tracker does overcome this bias because it uses the same sample of workers from one period to the next.   Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores